Conformed
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Quarterly Period Ended September 30, 1999.
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the Transition Period from to .
Commission File Number: 0-26494
GSE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-1868008
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9189 Red Branch Road, Columbia, Maryland, 21045
(Address of principal executive office and zip code)
Registrant's telephone number,
including area code: (410) 772-3500
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
___ ___
As of November 5, 1999, there were 5,065,688 shares of the Registrant's
common stock (par-value $ .01 per share) outstanding.
<PAGE>
3
2
GSE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX
PAGE
PART I. FINANCIAL INFORMATION 3
Item 1. Financial Statements:
Consolidated Balance Sheets as of September 30, 1999 and
December 31, 1998 3
Consolidated Statements of Operations for the Three and Nine
Months Ended September 30, 1999 and September 30, 1998 4
Consolidated Statements of Comprehensive Income (Loss) for
the Three and Nine Months Ended September 30, 1999 and
September 30, 1998 5
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 1999 and September 30, 1998 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition 12
Item 3. Quantitative and Qualitative Disclosure About Market Risk 16
PART II.OTHER INFORMATION
16
Item 1. Legal Proceedings 16
Item 2. Changes in Securities and Use of Proceeds 16
Item 3. Defaults Upon Senior Securities 16
Item 4. Submission of Matters to a Vote of Security Holders 17
Item 5. Other Information 17
Item 6. Exhibits and Reports on Form 8-K 17
SIGNATURES 18
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C>
ASSETS September 30, December 31,
1999 1998
(unaudited)
---------------- --------------
Current assets:
Cash and cash equivalents $ 3,601 $ 2,240
Restricted cash 735 -
Contract receivables 18,572 24,426
Note receivable - 1,000
Inventories 3,300 2,892
Prepaid expenses and other current assets 2,290 1,654
Deferred income taxes 139 150
---------------- --------------
Total current assets 28,637 32,362
Property and equipment, net 3,446 2,714
Software development costs, net 5,287 4,715
Goodwill and other intangible assets, net 2,594 2,781
Deferred income taxes 3,042 3,366
Other assets 3,289 2,805
================ ==============
Total assets $ 46,295 $ 48,743
================ ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Lines of credit $ 6,974 $ 6,746
Accounts payable 5,686 8,407
Accrued expenses 5,607 4,344
Billings in excess of revenue earned 3,716 6,359
Accrued contract and warranty reserves 891 846
Other current liabilities 2,101 1,451
Income taxes payable - 151
---------------- --------------
Total current liabilities 24,975 28,304
Notes payable to related parties 116 148
Accrued contract and warranty reserves 719 596
Other liabilities 2,344 2,606
---------------- --------------
Total liabilities 28,154 31,654
---------------- --------------
Stockholders' equity:
Common stock $.01 par value, 8,000,000 shares authorized,
5,065,688 shares issued and outstanding 50 50
Additional paid-in capital 21,678 21,678
Retained earnings (deficit) - at formation (5,112) (5,112)
Retained earnings - since formation 2,032 1,158
Accumulated other comprehensive income (loss) (507) (685)
---------------- --------------
Total stockholders' equity 18,141 17,089
---------------- --------------
Total liabilities & stockholders' equity $ 46,295 $ 48,743
================ ==============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------------ ----------------
<S> <C> <C> <C> <C>
Contract revenue $ 15,587 $ 19,244 $ 51,152 $ 53,418
Cost of revenue 10,289 12,695 31,651 37,012
-------- -------- -------- --------
Gross profit 5,298 6,549 19,501 16,406
Operating expenses:
Selling, general and administrative 5,909 4,404 16,745 14,891
Depreciation and amortization 400 405 1,102 1,340
-------- -------- -------- --------
Total operating expenses 6,309 4,809 17,847 16,231
-------- -------- -------- --------
Operating income (loss) (1,011) 1,740 1,654 175
Gain (loss) on sale of assets - 5,025) - 550
Interest (expense),net (140) (81) (271) (295)
Other income (expense) (26) (80) 27 370
-------- -------- -------- --------
Income (loss) before income taxes (1,177) (3,446) 1,410 800
Provision for (benefit from) income taxes (450) (1,276) 535 659
-------- -------- -------- --------
Net income (loss) $ (727) $ (2,170) $ 875 $ 141
======== ======== ======== ========
Basic earnings (loss) per common share $ (0.14) $ (0.43) $ 0.17 $ 0.03
======== ======== ======== ========
Diluted earnings (loss) per common share $ (0.14) $ (0.43) $ 0.17 $ 0.03
======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
<PAGE>
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------------ -----------------
<S> <C> <C> <C> <C>
Net income (loss) $ (727) $ (2,170) $ 875 $ 141
Other comprehensive income (loss):
Foreign currency translation adjustment 106 (370) 178 (375)
-------- -------- -------- --------
Comprehensive income (loss) $ (621) $ (2,540) $ 1,053 $ ( 234)
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
<PAGE>
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
For theNine Months Ended
September 30,
1999 1998
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 875 $ 141
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 2,470 2,936
Provision for doubtful contract receivables (556) (245)
Amortization of fair value of warrants issued to non-employees 120 120
Deferred income taxes 335 409
Equity in loss of investee - 128
Gain on sale of assets - (550)
Changes in assets and liabilities:
Contract receivables 6,619 (1,618)
Inventories (408) (117)
Prepaid expenses and other assets (1,120) (1,123)
Accounts payable and accrued expenses (1,458) (2,156)
Billings in excess of revenues earned (2,643) 2,458
Accrued contract and warranty reserves 169 (42)
Other current liabilities 757 (677)
Income taxes payable (151) 572
Other liabilities (252) 83
-------- --------
Net cash provided by operating activities 4,757 319
-------- --------
Cash flows from investing activities:
Proceeds from sale of assets 791 8,955
Capital expenditures (1,517) (1,591)
Capitalization of software development costs (1,822) (2,414)
-------- --------
Net cash provided by (used in) investing activities (2,548) 4,950
-------- --------
Cash flows from financing activities:
Restricted cash (735) -
Increase (decrease) in lines of credit with bank 228 (3,364)
Repayments under capital lease obligations (119) (143)
Decrease in notes payable to related parties (32) (12)
-------- --------
Net cash provided by (used in) financing activities (658) (3,519)
-------- --------
Effect of exchange rate changes on cash (190) (147)
-------- --------
Net increase in cash and cash equivalents 1,361 1,603
Cash and cash equivalents at beginning of period 2,240 334
======== ========
Cash and cash equivalents at end of period $ 3,601 $ 1,937
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
<PAGE>
GSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 1999
(Unaudited)
1. Basis of Presentation
The consolidated financial statements included herein have been prepared by
GSE Systems, Inc. (the "Company") without independent audit. In the opinion
of the Company's management, all adjustments and reclassifications of a
normal and recurring nature necessary to present fairly the financial
position, results of operations and cash flows for the periods presented
have been made. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted. It is
suggested that these consolidated financial statements be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the period ended
December 31, 1998 filed with the Securities and Exchange Commission on
March 31, 1999.
2. Acquisitions and Dispositions
Acquisitions
In April, 1999, the Company completed two acquisitions for the Process
business unit using the purchase method of accounting. On April 20, the
Company purchased certain assets and employed the associates of BatchCAD
Limited, a United Kingdom-based supplier of batch process development and
design consulting services and simulation software tools. The purchase
price was approximately $548,000 payable in three equal installments on
January 1, 2000, 2001 and 2002 and was allocated as follows:
<TABLE>
<CAPTION>
<S> <C>
Property and equipment $ 22,000
Trade receivables 45,000
Purchased software (property and equipment) 481,000
-------
$548,000
========
</TABLE>
On April 30, the Company acquired all proprietary technology and software
assets from, and assumed substantially all customer contracts of, Mitech
Corporation, a Massachusetts company and supplier of event and alarm
management and reporting software tools. The purchase price was $350,000
(consisting of $300,000 in cash and $50,000 payable one year from the
closing) and was allocated 100% to property and equipment as purchased
software.
Dispositions
On November 10, 1998, the Company completed the sale of certain assets
related to the activities of its Oil & Gas business unit, to Valmet
Automation (USA), Inc. ("Valmet"), pursuant to an Asset Purchase Agreement,
effective as of October 30, 1998, by and between the Company and Valmet.
The Company recognized a loss on this transaction, in the quarter ended
September 30, 1998, of $5.0 million, including the write-off of
approximately $2.9 million in capitalized software development costs, since
all operations that supported the recoverability of these capitalized costs
had been sold. In connection with the sale of these assets, the Company
received approximately $742,000 in cash, subject to certain adjustments,
and Valmet assumed certain identified liabilities. Included in the
Consolidated Statement of Operations for the nine-month period ended
September 30, 1998, are revenues of $1.1 million and operating losses of
$721,000 attributable to the Oil & Gas business unit prior to the sale to
Valmet.
On May 1, 1998, the Company completed the sale of substantially all of the
assets of Erudite Software to Keane, Inc. ("Keane"), pursuant to an Asset
Purchase Agreement, dated as of April 30, 1998, by and among the Company,
Erudite Software and Keane. The aggregate purchase price for the Erudite
assets was approximately $9.9 million (consisting of $8.9 million in cash
and $1.0 million in the form of an unsecured promissory note due on April
30, 1999, subject to certain adjustments). In connection with the
transaction, Keane purchased certain assets with a book value of $4.4
million and assumed certain operating liabilities totaling approximately
$2.2 million. The Company recognized a gain before income taxes on this
transaction of $5.6 million. In connection with the sale of these assets,
the Company wrote off approximately $800,000 in capitalized software
development costs, as well as $321,000 of purchased software, since all
operations that supported the recoverability of these costs were sold. The
write-off of these costs was reflected in the calculation of the gain on
the sale.
As noted above, the purchase price for the sale of Erudite Software was
subject to post-closing adjustments based upon a balance sheet as of the
closing date (the "Closing Balance Sheet"). Due to certain differences in
valuation amounts of the Closing Balance Sheet, the purchase price was
reduced by $269,000, which was accrued for during the prior year.
Accordingly, of the $1.0 million promissory note due GSE on April 30, 1999,
GSE received $731,000 plus $60,000 interest income.
3. Basic and Diluted Earnings (Loss) Per Common Share
Basic earnings per share is based on the weighted average number of
outstanding common shares for the period. Diluted earnings per share
adjusts the weighted average shares outstanding for the potential dilution
that could occur if stock options, warrants or other convertible securities
were exercised or converted into common stock. Diluted earnings per share
is the same as basic for the three months ended September 30, 1999 and 1998
because the effect of potential common shares is anti-dilutive.
The number of common shares and common share equivalents used in the
determination of basic and diluted earnings per share was as follows:
<TABLE>
<CAPTION>
Three months ended Six months ended
September 30, September 30,
1999 1998 1999 1998
------------------ ----------------
<S> <C> <C> <C> <C>
Weighted average shares outstanding:
Basic 5,065,688 5,065,688 5,065,688 5,065,688
--------- --------- --------- ---------
Diluted 5,065,688 5,065,688 5,239,756 5,219,421
========= ========= ========= =========
</TABLE>
The difference between the basic and diluted number of weighted average
shares outstanding for the nine months ended September 30, 1999 and 1998
represents dilutive options and warrants to purchase shares of common stock
computed under the treasury stock method, using the average market price
during the period.
4. Inventories
Inventories are stated at the lower of cost, as determined by the average
cost method, or market. Obsolete or unsaleable inventory is reflected at
its estimated net realizable value.
Inventories, net, consist of the following at:
<TABLE>
<CAPTION>
(In Thousands)
September 30, December 31,
1999 1998
------------ ------------
<S> <C> <C>
Raw materials $ 2,360 $ 1,873
Service parts 940 1,019
------------ ------------
Total $ 3,300 $ 2,892
============ ============
</TABLE>
5. Software Development Costs
Certain computer software development costs are capitalized in the
accompanying consolidated balance sheets. Capitalization of computer
software development costs begins upon the establishment of technological
feasibility. Capitalization ceases and amortization of capitalized costs
begins when the software product is commercially available for general
release to customers. Amortization of capitalized computer software
development costs is included in cost of revenues and is provided at the
greater of the amount computed using (a) the ratio of current gross
revenues for a product to the total of current and anticipated future gross
revenues or (b) the straight-line method over the remaining estimated
economic life of the product, not to exceed five years. Software
development costs capitalized were $790,000 and $300,000 for the three
months ended September 30, 1999 and 1998, respectively, and $1.8 million
and $2.0 million for the nine months ended September 30, 1999 and 1998,
respectively. Total amortization expense was $469,000 and $417,000 for the
three months ended September 30, 1999 and 1998, respectively, and $1.4
million and $1.5 million for the nine months ended September 30, 1999 and
1998, respectively.
6. Financing Arrangements
On June 4, 1999, the Company entered into a loan and security agreement
with a financial institution for a new credit facility with a maturity date
of May 31, 2002. Borrowings from this facility were used to pay off the
existing debt under the Company's previous credit facility. The new
agreement established two lines of bank credit, through the Company's
subsidiaries, which are cross-collateralized, and provide for borrowings up
to a total of $9.0 million to support foreign letters of credit, margin
requirements or foreign exchange contracts and working capital needs.
The first line, for $6.0 million, used by the Power business unit
("Power"), is 90% guaranteed by the Export-Import Bank of the United States
("EXIM") through March 31, 2000, is collateralized by substantially all of
Power's assets, and provides for borrowings up to 90% of eligible
receivables and 60% of unbilled receivables. The second line, for $3.0
million, used by the Process business unit ("Process"), is collateralized
by substantially all of Process' assets, and provides for borrowing up to
85% of eligible receivables and 20% of eligible inventory up to a maximum
of $600,000. Both lines are guaranteed by the Company and collateralized by
substantially all of the Company's assets. At September 30, 1999, the
Company's available borrowing base was $8.7 million, of which $7.0 million
had been utilized.
The lines require the Company to comply with certain financial ratios and
preclude the Company from paying dividends and making acquisitions beyond
certain limits without the bank's consent. The Company was in compliance
with all covenants as of September 30, 1999. All balances under these lines
have been classified as current liabilities based on the fact that the
extension of the lines beyond March 31, 2000 is contingent on the extension
of the EXIM guarantee.
The Company has two outstanding letters of credit (totaling $735,000) that
were issued through the Company's previous financial institution and were
supported by the Company's credit facility. These letters of credit could
not be reissued by GSE's new financial institution, so the Company was
required to deposit funds with the issuing institution as collateral
against the letters of credit.
In 1998, in connection with the Company's previous credit facility, the
Company had arranged for certain guarantees to be provided on its behalf by
GP Strategies Corporation ("GP Strategies") and ManTech International
Corporation ("ManTech"), both of which are shareholders of the Company.
(These guarantees have been reissued for the new credit facility.) In
consideration for these guarantees, the Company granted each of ManTech and
GP Strategies warrants to purchase shares of the Company's common stock;
each of such warrants provides the right to purchase at least 150,000
shares of the Company's common stock at an exercise price of $2.375 per
share. In 1998, the Company recorded $300,000 as the estimated fair value
of such warrants in the consolidated financial statements and amortized
such value over the life of the initial guarantee, which expired in June
1999. The amortization was completed at June 30, 1999, resulting in a
year-to-date charge of $120,000. The fair value of the warrants was
determined using the Black-Scholes valuation model. Assumptions used in the
calculation were as follows: dividend yield of 0%, expected volatility of
61%, risk-free interest rates of 5.6% and expected terms of 2.5 years.
7. Income Taxes
The Company's effective tax rate is based on the best current estimate of
its expected annual effective tax rate. The difference between the
statutory U.S. tax rate and the Company's effective tax rate for the three
and nine months ended September 30, 1999 and 1998 is primarily due to the
effects of foreign operations being taxed at different rates and state
income taxes. As of September 30, 1999 and December 31, 1998, the aggregate
deferred tax assets are recorded net of a valuation allowance of $1.1
million.
8. Segment Reporting
The Company is primarily organized on the basis of two business units,
Process and Power. The Company has a wide range of knowledge concerning
control and simulation systems and the processes those systems are intended
to improve, control and model. The Company's knowledge is concentrated
heavily in the process industries, which include the chemicals, food and
beverage, and pharmaceutical fields, as well as in the power generation
industry. The Process business unit is primarily engaged in process control
and simulation in a variety of commercial industries. Contracts typically
range from three to nine months. The Power business unit is primarily
engaged in simulation for the power generation industry, with the vast
majority of customers being in the nuclear power industry. Contracts
typically range from 18 months to three years or longer.
GSE evaluates the performance of its business units utilizing "Business
Unit Contribution", which is substantially equivalent to earnings before
interest and taxes (EBIT) before allocating any corporate expenses. The
segment information regarding two businesses divested during 1998 is
included in "All Other".
The table below presents information about reported segments:
<TABLE>
<CAPTION>
(In Thousands)
Three Months Ended September 30, Nine Months Ended September 30,
1999 1999
<S> <C> <C> <C> <C> <C> <C>
Process Power Total Process Power Total
Contract revenue $8,151 $7,436 $15,587 $28,115 $23,037 $51,152
------ ------ ------- ------- ------- -------
Business unit contribution $ (462) $ 843 $ 381 $ 2,282 $ 3,453 $ 5,735
====== ====== ======= ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
1998 1998
<S> <C> <C> <C> <C> <C> <C>
Process Power Total Process Power Total
Contract revenue $11,669 $7,575 $19,244 $26,137 $20,877 $47,014
------ ------ ------- ------- ------- -------
Business unit contribution $1,757 $1,120 $ 2,877 $1,997 $ 3,157 $ 5,154
====== ====== ======= ====== ======= =======
</TABLE>
Below is a reconciliation of segment revenue to consolidated revenue and
segment business unit contribution to consolidated income before taxes.
<TABLE>
<CAPTION>
(In Thousands)
Three Months Ended September 30. Nine Months Ended September 30,
1999 1998 1999 1998
<S> <C> <C> <C> <C>
Total segment revenue $15,587 $19,224 $51,152 $47,014
All other - - - 6,404
----- ----- ----- -----
Consolidated contract revenue $15,587 $19,244 $51,152 $53,418
======= ======= ======= =======
Segment business unit contribution $ 381 $ 2,877 $ 5,735 $5,154
All other business unit
contribution (loss) - - - (491)
Corporate expenses (1,418) (1,217) (4,054) (4,118)
(Loss) gain on sale of assets - (5,025) - 550
Interest expense, net (140) (81) (271) (295)
---- --- ---- ----
Consolidated income (loss) before
taxes $(1,177) $(3,446) $ 1,410 $ 800
======= ======= ======= =====
</TABLE>
9. Recent Pronouncements
In June, 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This Statement requires that an entity
recognizes all derivatives as either assets or liabilities in the statement
of financial position and measures those instruments at fair value. The
Company will be required to adopt this new accounting standard by June 30,
2000. Management does not anticipate early adoption. The Company believes
that the effect of adoption of FAS No.133 will not be material.
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition
General Business Environment
GSE Systems, Inc. (the "Company") designs, develops and delivers business
and technology solutions by applying high technology-related process
control and high fidelity simulation systems and services into applications
for worldwide industries including energy and process manufacturing. The
Company's solutions and services assist customers in improving quality,
safety and throughput; reducing operating expenses; and enhancing overall
productivity.
In 1998, the Company divested the assets of its Oil and Gas business unit
and of its wholly-owned subsidiary, Erudite Software, and refocused its
attention on its two core business units, Power and Process. The Power
business unit primarily provides simulation systems and services to the
power generation industry, while the Process business unit focuses on
providing process control and simulation in various process industries. For
a breakdown of relevant financial information by segment, see Note 8 to the
Consolidated Financial Statements, above.
The Company has begun the pursuit of strategic growth opportunities that
will complement the Company's core businesses and can be effected without
diverting the focus of the Company. In April, 1999, the Company completed
two asset purchase transactions for the Process business unit. On April 20,
the Company purchased certain assets and employed the associates of
BatchCAD Limited, a United Kingdom-based supplier of batch process
development and design consulting services and simulation software tools.
With this acquisition, the Company has gained a presence in the United
Kingdom, with an office in Hexham, England, which will provide the baseline
for future expansion in the region. On April 30, the Company acquired all
proprietary technology and software assets from, and assumed substantially
all customer contracts of, Mitech Corporation, a Massachusetts company and
supplier of event and alarm management and reporting software tools. Both
of these acquisitions have added to the current customer base of GSE
Systems, Inc. and offer new opportunities in promoting the Company's
existing products and services.
On May 24, 1999, the Company announced its new business and marketing
strategy "VirtualPlant[TM]". VirtualPlant[TM] combines the benefits of
real-time simulation with control systems to create a living, learning
real-time representation of an operating plant. VirtualPlant[TM] also
allows a company to create an environment for simulation rather than
experimentation. Based on sophisticated simulation technologies and expert
knowledge of processing realities, VirtualPlant[TM] is a fully integrated,
comprehensive program of customizable software, consulting services and
training that energy and process manufacturing companies can use to
dramatically reduce time to market, minimize development costs, achieve
greater optimization and improve overall profitability.
On October 1, 1999, the Company released D/3 DCS[TM] Version 10.0, the
Windows NT version of its core Distributed Control System software for the
process industry. The NT release of the D/3 product allows the powerful and
continuous batch processing system to be used in smaller applications with
no loss in functionality. Additionally, the flexibility of the NT offering
allows efficient integration with everyday desktop tools commonly available
in the NT environment, while at the same time protecting an investment in
existing control applications.
Results of Operations
The following table sets forth the results of operations for the periods
presented expressed as a percentage of revenues (in thousands).
<TABLE>
<CAPTION>
Three months ended September 30, Nine months ended September 30,
1999 % 1998 % 1999 % 1998 %
------------------------------------ ------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Contract revenue $15,587 100.0% $19,244 100.0% $51,152 100.0% $53,418 100.0%
Cost of revenue 10,289 66.0% 12,695 66.0% 31,651 61.9% 37,012 69.3%
------ ----- ------ ------ ------ ----- ------ -----
Gross profit 5,298 34.0% 6,549 34.0% 19,501 38.1% 16,406 30.7%
Operating expenses:
Selling, general and administrative 5,909 37.9% 4,404 22.9% 16,745 32.7% 14,891 27.9%
Depreciation and amortization 400 2.6% 405 2.1% 1,102 2.2% 1,340 2.5%
------ ----- ------ ------ ------ ----- ------ -----
Total operating expenses 6,309 40.5% 4,809 25.0% 17,847 34.9% 16,231 30.4%
------ ----- ------ ------ ------ ----- ------ -----
Operating income (loss) (1,011) -6.5% 1,740 9.0% 1,654 3.2% 175 0.3%
Gain/(loss) on sale of assets - 0.0% (5,025) -26.1% - 0.0% 550 1.0%
Interest expense, net (140) -0.9% (81) -0.4% (271) -0.5% (295) -.5%
Other income (expense) (26) -0.2% (80) -0.4% 27 0.1% 370 0.7%
------ ----- ------- ------ ------ ----- ------ -----
Income (loss) before income taxes (1,177) -7.6% (3,446) -17.9% 1,410 2.8% 800 1.5%
Provision for (benefit from)income taxes (450) -2.9% (1,276) -6.6% 535 1.1% 659 1.2%
------ ----- ------- ------ -------- ----- ------ -----
Net income (loss) $ (727) -4.7% $(2,170) -11.3% $ 875 1.7% $ 141 0.3%
====== ===== ======= ====== ======== ===== ====== =====
</TABLE>
Revenues. Revenues for the three months ended September 30, 1999 and 1998
totaled $15.6 million and $19.2 million, respectively. The Process
business' third quarter 1999 revenues have been affected by an order
slowdown as customers wait until after the Y2K date issue has passed to
continue their normal levels of investment in control system hardware and
software upgrades. Revenues for the nine months ended September 30, 1999
totaled $51.2 million as compared with revenues of $53.4 million for the
nine months ended September 30, 1998. As previously disclosed, the assets
of the Company's Erudite subsidiary and Oil and Gas business unit were
divested in 1998. Whereas the third quarter 1998 results included no
revenues related to these businesses, the revenues for the nine months
ended September 30, 1998 included $6.4 million from these businesses.
Gross Profit. Due to the lower revenues in the third quarter 1999, gross
profit decreased to $5.3 million (34% of revenues) for the three months
ended September 30, 1999 from $6.5 million (34% of revenues) for the
corresponding period in 1998. Conversely, gross profit for the nine months
ended September 30, 1999 as compared to the same period in the prior year,
increased to $19.5 million (38% of revenues) from $16.4 million (30.7% of
revenues). The increase in gross margin as a percentage of revenues
reflects a higher component of upgrade projects in the Process business
unit in 1999 than in 1998, mainly due to customer concerns about Year 2000
date calculations in their existing process control software. Such upgrade
projects typically have less hardware and instrumentation components and
more license fees and application engineering work, which tend to generate
better margins.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses totaled $5.9 million in the three months
ended September 30, 1999, a 34% increase from the corresponding period in
1998. The increase, excluding research and development costs, reflects
additional sales and marketing personnel in the Process business unit,
increased advertising and promotion related to the Company's VirtualPlant
TM suite of products and services, a European user's conference, and
internal Y2K compliance programs. For the nine months ended September 30,
1999, SG&A expenses increased 12% as compared to the nine months ended
September 30, 1998; however, after excluding the costs related to Erudite
and Oil and Gas in 1998 ($1.9 million), SG&A increased 30%. This increase
is due to the same reasons described above for the three months ended
September 30, 1999, as well as legal fees related to the Company's new
credit facility incurred during the second quarter.
Gross research and product development expenditures were $1.6 million in
the three months ended September 30, 1999 versus $0.9 million for the same
period in 1998. Capitalized software development costs totaled $790,000 and
$300,000 for the third quarter of 1999 and 1998, respectively; accordingly,
net research and development costs expensed and included in SG&A were
$810,000 and $600,000 for the three months ended September 30, 1999 and
1998, respectively. The Company continued to invest in the conversion of
its D/3 DCS (Version 10.0 was released during October 1999), FlexBatch, and
SimSuite Pro products to the Microsoft Windows NT[R] platform and the
productization of its SimSuite software tools. For the nine months ended
September 30, 1999, gross research and development expenditures,
capitalized development costs, and net research and development costs
expensed in SG&A were $4.0 million, $1.8 million and $2.2 million,
respectively, versus $3.4 million, $2.0 million and $1.4 million,
respectively, for the comparable period in 1998.
Depreciation and Amortization. Depreciation expense amounted to $314,000
and $324,000 during the three months ended September 30, 1999 and 1998,
respectively. During the nine months ended September 30, 1999 and 1998,
depreciation expense was $822,000 and $1.1 million, respectively. The
decrease in depreciation expense reflects the disposition of the Erudite
and Oil and Gas assets in 1998.
Amortization of goodwill was $86,000 and $81,000 during the three months
ended September 30, 1999 and 1998, respectively. During the nine months
ended September 30, 1999 and 1998, goodwill amortization was $280,000 and
$245,000, respectively.
Operating Income (Loss) . Operating loss for the three months ended
September 30, 1999 was $1.0 million versus operating income of $1.7 million
for the three months ended September 30, 1998. This decrease is the result
of (1) an order slowdown in the Process business unit as customers wait
until the new year to make additional investments in their process control
systems (after resolution of the Y2K date issue), (2) investments in the
Company's VirtualPlantTM strategy, and (3) the Company's internal
infrastructure Y2K compliance program. For the nine months ended September
30, 1999, operating income increased to $1.7 million, or 3.2% of revenues,
from $175,000, or 0.3% of revenues for the nine months ended September 30,
1998. This significant increase in operating income reflects the
disposition of unprofitable businesses, increases in revenues of the core
business units, and improved contract margins.
Interest Expense, net. Net interest expense increased to $140,000 during
the three months ended September 30, 1999, a 73% increase from $81,000 in
the corresponding period in 1998. This increase was due to higher levels of
borrowing. For the nine months ended September 30, 1999, net interest
expense totaled $271,000 versus $295,000 for the comparable period in 1998.
Gain (Loss) on Sale of Assets. For the three months ended September 30,
1998, the Company recognized a loss of $5.0 million on the sale of assets
relating to the Oil and Gas business unit. For the nine months ended
September 30, 1999, the loss on sale of the Oil and Gas business unit was
offset by a $5.6 million gain on the sale of the assets relating to
Erudite. The sales and related gain and losses are described more fully
under Note 2 to the Consolidated Financial Statements, above.
Other Income. Other income fluctuated significantly during the periods
presented primarily due to the effect of gains and losses on foreign
currency transactions from the Company's Asian operations in 1998.
Income Taxes. The Compan's effective tax rate is based on the best current
estimate of its expected annual effective tax rate. The difference between
the statutory U.S. tax rate and the Company's effective tax rate for the
three months and nine months ended September 30, 1999 and 1998 is primarily
the result of the effects of foreign operations being taxed at different
rates, state income taxes, and a valuation allowance against all of the net
operating losses generated during the three and six months ended June 30,
1998.
Liquidity and Capital Resources
During the nine months ended September 30, 1999, the Company's operations
provided $4.8 million of net cash, primarily resulting from collection of
receivables, offset by a reduction in the amount of billings in excess of
revenues earned. At September 30, 1999, the Company had cash and cash
equivalents totaling approximately $3.6 million.
Cash used in investing activities during the first nine months of 1999 of
$2.5 million relates primarily to the Company's capitalization of software
development costs and normal capital expenditures off set by $791,000 of
proceeds from a note receivable related to the sale of the Erudite assets
in 1998.
On June 4, 1999, the Company entered into a loan and security agreement
with a financial institution for a new credit facility with a maturity date
of May 31, 2002. Borrowings from this facility were used to pay off the
existing debt under the Company's previous credit facility. These lines of
credit, which are cross-collateralized, provide for borrowings up to a
total of $9.0 million to support foreign letters of credit, margin
requirements or foreign exchange contracts and working capital needs. See
Note 6 to the Consolidated Financial Statements above, for complete details
about these lines of credit. At September 30, 1999, the Company's available
borrowing base was $8.7 million, of which $7.0 million had been utilized.
The Company has two outstanding letters of credit (totaling $735,000) that
were issued through the Company's previous financial institution and were
supported by the Company's credit facility. These letters of credit could
not be reissued by GSE's new financial institution, so the Company was
required to deposit funds with the issuing institution as collateral
against the letters of credit.
Management believes the Company has sufficient liquidity and working
capital resources necessary for currently planned business operations, debt
service requirements, planned investments and capital expenditures
Impact of the Year 2000 Issue
The Year 2000 issue, which arises in date calculations, is caused by
computer systems using two digits rather than four to define the applicable
year. After December 31, 1999, such systems may recognize "00" as 1900
rather than 2000. This could result in a system failure or miscalculation
causing disruptions to operations, including, among other things, a
temporary inability to process data or engage in normal business operations
and activities.
To address these contingencies, the Company has instituted a compliance
program covering not only the Company's products, but also its internal
administrative and financial systems. The program is intended to minimize
significant detrimental effects on both the Company's operations and the
software products it develops and markets to its customers.
While the Company believes that it has identified substantially all of the
potential "Year 2000" problems which could affect current versions of its
products, it is not possible to determine with certainty that all such
problems have been identified or corrected, with either current products or
previous versions thereof, due both to the complexity of these products,
and the fact that they interact with products of third party vendors not
under the Company's control
The Company also relies on various administrative and financial
applications of computer products and software, including processing of
customer orders and collection of customer accounts, which require
correction to properly handle "Year 2000" related dates. In the event that
one or more of these systems is not adequately corrected, the Company's
ability to obtain customers, and schedule and fulfill their demands, could
be impaired. Further, if a collection processing system, or a component
thereof, were to fail, the Company may not be able to properly determine
and apply payments to customer account balances or correctly determine cash
balances. While these events are possible, the Company anticipates that the
breadth of its customer base and its compliance programs and corrective
measures taken will effectively minimize the effects of such interruptions
without significant adverse effect on the Company. However, there can be no
assurance that such events will not have a material adverse effect on the
Company's business, results of operations, business prospects, or financial
performance and condition.
The Company estimates that the aggregate cost to address the "Year 2000"
issue will not exceed approximately $1.7 million in 1999. The Company
believes that most of the customer related costs associated with the "Year
2000" issue would have occurred as part of its normal operations. The
Company does not track these costs separately. Year-to-date, the Company
has spent approximately $238,000, incremental to normal operating costs, on
upgrades to its internal systems and outside consultant fees. While the
Company believes its efforts will provide reasonable assurance that
material disruptions to its internal systems and installed products will
not occur, the potential for interruption still exits. There can be no
assurance that the cost estimates associated with the Company's "Year 2000"
issue will prove to be accurate or that the actual costs will not have a
material adverse effect on the Company's business, results of operation, or
financial condition.
Item 3. Quantitative and Qualitative Disclosure about Market Risk.
The Company's market risk is principally confined to changes in foreign
currency exchange rates and potentially adverse effects of differing tax
structures. The Company's exposure to foreign exchange rate fluctuations
arises in part from inter-company accounts in which costs incurred in one
entity are charged to other entities in different foreign jurisdictions.
The Company is also exposed to foreign exchange rate fluctuations as the
financial results of all foreign subsidiaries are translated into U.S.
dollars in consolidation. As exchange rates vary, those results when
translated may vary from expectations and adversely impact overall expected
profitability.
The Company is also subject to market risk related to the interest rates on
its existing lines of credit. Such interest rates are currently based on
the prime rate plus three percent.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In accordance with its conduct in the ordinary course of business, certain
actions and proceedings are pending to which the Company is a party. In the
opinion of management, the aggregate liabilities, if any, arising from such
actions are not expected to have a material adverse effect on the financial
condition of the Company.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Forward-Looking Statements
This Form 10-Q contains certain forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, which are
subject to the safe harbors created by those Acts. These statements include
the plans and objectives of management for future operations, including
plans and objectives relating to the development of the Company's business
in the domestic and international marketplace. All forward-looking
statements involve risks and uncertainties, including, without limitation,
risks relating to the Company's ability to enhance existing software
products and to introduce new products in a timely and cost effective
manner, reduced development of nuclear power plants that may utilize the
Company's products, a long pay-back cycle from the investment in software
development, uncertainties regarding the ability of the Company to grow its
revenues and successfully integrate operations through expansion of its
existing business and strategic acquisitions, the ability of the Company to
respond adequately to rapid technological changes in the markets for
process control and simulation software and systems, significant
quarter-to-quarter volatility in revenues and earnings as a result of
customer purchasing cycles and other factors, dependence upon key
personnel, and general market conditions and competition. The
forward-looking statements included herein are based on current
expectations that involve numerous risks and uncertainties as set forth
herein, the failure of any one of which could materially adversely affect
the operations of the Company. The Companys plans and objectives are also
based on the assumptions that market conditions and competitive conditions
within the Company's business areas will not change materially or adversely
and that there will be no material adverse change in the Company's
operations or business. Assumptions relating to the foregoing involve
judgments with respect to, among other things, future economic, competitive
and market conditions and future business decisions, all of which are
difficult or impossible to predict accurately and many of which are beyond
the control of the Company. Although the Company believes that the
assumptions underlying the forward-looking statements are reasonable, any
of the assumptions could be inaccurate and there can, therefore, be no
assurance that the forward-looking statements included in this Form 10-Q
will prove to be accurate. In light of the significant uncertainties
inherent in the forward-looking statements included herein, the inclusion
of such information should not be regarded as a representation by the
Company or any other person that the objectives and plans of the Company
will be achieved.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
Change in Registrant's Certifying Accountant, as filed with the
Securities and Exchange Commission on October 26, 1999.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 12, 1999 GSE SYSTEMS, INC.
/S/ Christopher M. Carnavos
---------------------------
Christopher M. Carnavos
President and Director
(Principal Executive Officer)
/S/ Jeffery G. Hough
--------------------
Jeffery G. Hough
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
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