UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1999.
[ ] 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 0-26392
LEVEL 8 SYSTEMS, INC.
---------------------
(Exact name of registrant as specified in its charter)
Delaware 11-2920559
- -------------------------------------------------------------------------------
(State or other jurisdiction of incorporation I.R.S Employer Identification
or organization) Number)
8000 Regency Parkway, Cary, NC 275111
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(Address of principal executive offices) (Zip Code)
(919) 380-5000
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15d 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
--
Indicate the number of shares outstanding in each of the issuer's classes of
common stock, as of the latest practicable date.
8,776,541 common shares, $.001 par value, were outstanding as of August 13,
1999.
1
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<TABLE>
<CAPTION>
LEVEL 8 SYSTEMS, INC.
INDEX
<S> <C> <C>
Page
PART I. Financial Information Number
------
Item 1. Financial Statements
Consolidated balance sheets as of June 30, 1999 (unaudited)
and December 31, 1998 3
Consolidated statements of operations (unaudited) for the three and six
months ended June 30, 1999 and 1998 4
Consolidated statements of cash flows (unaudited) for six months
ended June 30, 1999 and 1998 5
Consolidated statements of comprehensive income (unaudited) for
three and six months ended June 30, 1999 and 1998 6
Notes to consolidated financial statements (unaudited) 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures about Market Risk 21
PART II. Other Information 21
25
SIGNATURES
</TABLE>
2
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
June 30, December 31,
1999 1998
---------- --------------
Assets
<S> <C> <C>
Cash and cash equivalents $ 19,247 $ 6,078
Accounts receivable, less allowance for doubtful accounts
of $1,395 and $3,252 at June 30, 1999 and December 31,
1998, respectively 15,176 16,992
Due from related company 271 271
Note receivable for sale of subsidiary 2,000 2,000
Prepaid expenses and other current assets 2,195 2,606
---------- --------------
Total current assets 38,889 27,947
Property and equipment, net 2,030 2,682
Excess of cost over net assets acquired, net 27,527 32,217
Software development costs, net 9,627 6,753
Other assets 1,030 1,171
---------- --------------
Total assets $ 79,103 $ 70,770
========== ==============
Liabilities and stockholders' equity
Notes payable, due on demand $ 4,072 $ 12,275
Current maturities of loan from related company 618 628
Current maturities of long-term debt 758 799
Accounts payable 3,115 3,691
Accounts payable to related company 200 82
Accrued expenses:
Compensation 1,001 318
Commissions 428 1,021
Restructuring 533 973
Merger-related 2,452 4,803
Other 9,135 8,275
Deferred revenue 9,787 13,075
Income taxes payable 1,545 1,781
---------- --------------
Total current liabilities 33,644 47,721
Long-term debt, net of current maturities 11,561 1,541
Loan from related company, net of current maturities 12,000 12,519
Deferred revenue 1,775 97
Stockholders' equity
Preferred stock, $0.001 par value - -
Common stock, $0.001 par value 9 87
Additional paid-in-capital 53,501 34,045
Accumulated other comprehensive income (95) -
Accumulated deficit (33,292) (25,240)
---------- --------------
Total stockholders' equity 20,123 8,892
---------- --------------
Total liabilities and stockholders' equity $ 79,103 $ 70,770
========== ==============
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
3
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<TABLE>
<CAPTION>
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
------------- ---------- ------- --------
<S> <C> <C> <C> <C>
Revenue:
Software $ 3,190 $ 415 $ 5,902 $ 627
Maintenance 3,981 255 7,864 288
Services 5,836 2,485 12,446 5,333
----------- ---------- -------- --------
Total operating revenue 13,007 3,155 26,212 6,248
Cost of revenue:
Software 1,090 423 1,928 849
Maintenance 1,450 140 3,050 241
Services 5,069 1,284 11,087 2,949
----------- ---------- -------- --------
Total cost of revenue 7,609 1,847 16,065 4,039
Gross profit 5,398 1,308 10,147 2,209
Operating expenses:
Sales and marketing 2,754 881 5,374 1,081
Research and development 1,555 978 3,234 1,404
General and administrative 1,707 1,104 2,873 2,051
In-process research and development 744 -- 744 1,200
Amortization of intangible assets 1,687 573 3,384 679
------------ ---------- -------- --------
Total operating expenses 8,447 3,536 15,609 6,415
- ---------- ---------- -------- --------
Loss from operations (3,049) (2,228) (5,462) (4,206)
Other income (expense)
Interest income 81 80 156 154
Interest expense (847) (35) (1,607) (39)
Net foreign currency gains/(losses) (212) -- (740) --
------------ ---------- -------- --------
Loss before provision for income taxes (4,027) (2,183) (7,653) (4,091)
Income tax provision (benefit) 197 (157) 399 (558)
------------ ---------- -------- --------
Loss from continuing operations (4,224) (2,026) (8,052) (3,533)
Discontinued operations:
Loss from discontinued operation, net of tax -- -- -- 135
Loss on disposal, net of tax -- -- -- 843
------------ ---------- -------- --------
Loss from discontinued operations -- -- -- 978
Net loss $ (4,224) $ (2,026) $(8,052) $(4,511)
============ ========== ======== ========
Net loss per common share:
Loss from continuing operations - basic and diluted $ (0.49) $ (0.26) $ (0.93) $ (0.48)
Loss from discontinued operations - basic and diluted -- -- -- (0.13)
------------ ---------- --------
Net loss per share - basic and diluted $ (0.49) $ (0.26) $ (0.93) $ (0.61)
============ ========== ======== ========
Weighted common shares outstanding - basic and diluted 8,697 7,698 8,704 7,401
============ ========== ======== ========
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
4
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<TABLE>
<CAPTION>
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
Six Months Ended
June 30,
1999 1998
---------- --------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (8,052) $(4,511)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 5,600 1,399
Deferred income taxes 2 (825)
Loss from discontinued operations - 135
Loss on disposal of discontinued operations - 843
Purchased research and development 744 1,200
Write-off of capitalized software costs - 294
Other 368 406
Changes in assets and liabilities, net of assets acquired
and liabilities assumed:
Trade accounts receivable 1,527 930
Prepaid expenses and other assets 549 (72)
Accounts payable, income taxes payable, and accrued
expenses - excluding merger-related and restructuring (2,248) (615)
Merger-related and restructuring (2,791) -
Deferred revenue (1,610) 391
---------- --------
Net cash used in operating activities (5,911) (425)
Cash flows from investing activities:
Cash received from acquisition - 362
Purchases of property and equipment (102) (785)
Payments for acquisitions (2,190) -
Capitalization of software development costs (927) (95)
---------- --------
Net cash used in investing activities (3,219) (518)
Cash flows from financing activities:
Issuance of common shares 157 59
Issuance of preferred shares, net 20,896 -
Payments on borrowings from related company (528) -
Payments on capital leases (20) -
Proceeds on long-term debt - (150)
Net borrowings on line of credit 5,796 -
Pay down on line of credit (4,000) -
Deferred income taxes - (109)
Payment on other long-term debt - (63)
---------- --------
Net cash provided by (used) in financing activities 22,301 (263)
Effect of exchange rate changes on cash (2) -
Net increase (decrease) in cash and cash equivalents 13,169 (1,206)
Cash and cash equivalents:
Beginning of period 6,078 7,062
---------- --------
End of period $ 19,247 $ 5,856
========== ========
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
5
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<TABLE>
<CAPTION>
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)
(UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
------------ -------- -------- ---------
<S> <C> <C> <C> <C>
Net loss $ (4,224) $(2,026) $(8,052) $(4,510)
Other comprehensive income, net of tax
Foreign currency translation adjustment 66 - (95) -
------------ -------- -------- --------
Comprehensive loss $ (4,158) $(2,026) $(8,147) $(4,510)
============ ======== ======== ========
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
6
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LEVEL 8 SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
NOTE 1. INTERIM FINANCIAL STATEMENTS
The accompanying financial statements are unaudited and have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission.
Certain information and note disclosures normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to those rules and regulations.
Accordingly, these interim financial statements should be read in conjunction
with the audited financial statements and notes thereto contained in the
Company's Annual Report on Form 10-K for the year ended December 31, 1998. The
results of operations for the interim periods shown in this report are not
necessarily indicative of results to be expected for other interim periods or
for the full fiscal year. In the opinion of management, the information
contained herein reflects all adjustments necessary for a fair statement of the
interim results of operations. All such adjustments are of a normal, recurring
nature, except for the acquisition of Seer and non cash compensation.
The year-end condensed balance sheet data was derived from audited financial
statements, but does not include all disclosures required by generally accepted
accounting principles.
The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. All of the Company's subsidiaries are
wholly-owned for the entire six month period presented, except for Seer
Technologies, Inc. ("Seer"). The Company acquired a 69% interest in Seer on
December 31, 1998 and the remaining 31% interest on April 30, 1999. Prior to
the completion of the Seer acquisition, Level 8 assumed Seer's net liabilities.
The minority stockholders were deemed to have shared in the losses of Seer only
for their proportionate share of Seer's net assets until April 30, 1999.
Accordingly, there is no minority interest in the losses of the Seer subsidiary
reflected in the consolidated financial statements as for the periods ended June
30, 1999.
Certain prior year amounts in the accompanying financial statements have been
reclassified to conform to the 1999 presentation. Such reclassifications had no
effect on previously reported net income or stockholders' equity.
Statement of Position 98-9, "Modification of SOP 97-2, 'Software Revenue
Recognition,' with Respect to Certain Transactions" ("SOP 98-9") was
effective for the Company's fiscal year beginning January 1, 1999. Retroactive
application is prohibited. SOP 98-9 amends SOP 97-2 to require that an entity
recognize revenue for multiple element arrangements by means of the "residual
method" when (1) there is vendor-specific objective evidence ("VSOE") of the
fair values of all of the undelivered elements that are not accounted for by
means of long -term contract accounting, (2) VSOE of fair value does not exist
for one or more of the delivered elements, and (3) all revenue recognition
criteria of SOP 97 -2 (other than the requirement for VSOE of the fair value of
each delivered element) are satisfied. The provisions of SOP 98-9 that extend
the deferral of certain passages of SOP 97 -2 became effective December 15,
1998. The Company has implemented SOP 98-9 as of January 1, 1999.
NOTE 2. BUSINESS COMBINATION
As of April 30, 1999, the Company acquired the remaining minority interest in
Seer, for $0.35 in cash per share of the outstanding common stock of Seer. The
total purchase price for the remaining 31% of Seer was $1,697. As a result of
the completion of acquisition, Seer became a wholly-owned subsidiary of the
Company.
The purchase price was allocated to the assets acquired and liabilities assumed
based on the Company's estimates of fair value at the acquisition date. The
fair value assigned to intangible assets acquired was based on a valuation of
the purchased in-process research and development, developed technology,
installed customer base, and assembled workforce of Seer. The purchase price
was less than the amounts allocated to the tangible and intangible assets
acquired by approximately $1,307. The difference between the purchase price and
the fair values of the assets acquired less liabilities assumed was allocated to
goodwill.
7
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<CAPTION>
The cost of the acquisition was allocated as follows:
<S> <C>
In-process research and development $ 744
Developed technology 3,410
Goodwill and other intangibles (1,307)
Accrued liabilities (1,150)
--------
Cost of net assets acquired $ 1,697
========
</TABLE>
Approximately $744 of the purchase price represents purchased in-process
research and development that had not yet reached technological feasibility and
had no alternative future use. Accordingly, this amount was immediately
expensed in the Consolidated Statement of Operations upon consummation of the
acquisition. The value assigned to in-process research and development, based
on a valuation was determined by identifying research projects in areas for
which technological feasibility had not been established, primarily the
application warehousing project. The value of the in-process projects was
adjusted to reflect the relative value and contributions of the required
research and development. In doing so, consideration was given to the stage of
completion, the complexity of the work completed to date, the difficulty of
completing the remaining development costs already incurred, and the projected
cost to complete the projects. The discount rate included a factor that takes
into account the uncertainty surrounding successful development of the purchased
research and development.
NOTE 3. EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share is computed based upon the weighted average
number of common shares outstanding. Diluted earnings (loss) per share is
computed based upon the weighted average number of common shares outstanding and
any potentially dilutive securities. Potentially dilutive securities are not
included in the diluted earnings per share calculations if their inclusion would
be anti-dilutive to the basic earnings (loss) per share calculations.
Potentially dilutive securities outstanding during the first and second quarters
of fiscal year 1999 include stock options and stock warrants. In the second
quarter of fiscal year 1999, potentially dilutive securities also included
preferred stock.
NOTE 4. INCOME TAXES
The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes." The Company's
effective tax rate differs from the statutory rate primarily due to the fact
that no income tax benefit was recorded for the net loss for the first half of
fiscal year 1999. Because of the Company's inconsistent earnings history, the
deferred tax assets have been fully offset by a valuation allowance.
The income tax provision for the first half of fiscal year 1999 is primarily
related to income taxes from profitable foreign operations and foreign
withholding taxes.
NOTE 5. USE OF ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual amounts could differ from these estimates.
8
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NOTE 6. SEGMENT INFORMATION
Management of the Company makes operating decisions and assesses performance of
its operations based on the following reportable segments: (1) Software, (2)
Maintenance, (3) Services, and (4) Research and Development.
The accounting policies of the segments are the same as those described in the
"Summary of Significant Accounting Policies," included in the Company's Annual
Report on Form 10-K for year ended December 31, 1998. Segment data includes a
charge allocating all corporate-headquarters costs to each of its operating
segments based on each segment's proportionate share of expenses. The Company
evaluates the performance of its segments and allocates resources to them based
on earnings (loss) before interest, taxes and amortization of goodwill (EBITA).
Comparative information is not available for the same period of 1998 because the
Company previously reviewed its operations as one reportable segment and did not
have international operations.
The table below presents information about reported segments for the six month
period ending June 30, 1999:
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C>
Research
And
Software Maintenance Services Development Total
---------- ------------ --------- ------------- --------
Total Revenue $ 5,902 $ 7,864 $ 12,446 $ - $26,212
Total EBITA $ (2,251) $ 4,460 $ 68 $ (3,611) $(1,334)
</TABLE>
A reconciliation of total segment EBITA to total consolidated income before
taxes for the six months ended June 30, 1999 is as follows:
<TABLE>
<CAPTION>
<S> <C>
Total EBITA $(1,334)
Amortization of goodwill (3,384)
In-process research and development (744)
Other income/(expense), net (2,191)
--------
Total loss before income taxes $(7,653)
========
</TABLE>
The following table presents a summary of revenue by geographic region for the
six months ended June 30, 1999:
<TABLE>
<CAPTION>
<S> <C>
Australia $ 1,517
Denmark 4,036
Germany 1,469
Greece 859
Italy 1,881
Norway 1,149
Sweden 1,029
Switzerland 1,680
United Kingdom 2,528
USA 8,018
Other 2,046
-------
Total revenue $26,212
=======
</TABLE>
Presentation of revenue by region is based on the country in which the customer
is domiciled.
9
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NOTE 7. LONG-TERM DEBT AND CREDIT FACILITIES
On April 21, 1999, the Company's credit facility with a commercial bank was
amended and currently provides for borrowings up to the lesser of $25,000 or the
sum of 80% of eligible receivables and a $10,000 term loan payable on September
1, 2000. The receivables-based borrowings under this credit facility are due on
demand. This credit facility bears interest at the prime rate plus 2% per annum
and has no financial covenant provisions. This credit facility terminates on
December 31, 2001; however it is automatically renewed for successive terms of
one year each, unless terminated by either party. This credit facility is
collateralized by the Company's accounts receivable, equipment and intangibles,
including intellectual property.
On May 31, 1999 the Company's $12 million loan from Liraz Systems, Ltd.
("Liraz") was amended. The amendment changed the due date from June 30, 2000 to
December 15, 2000 and provides for semiannual interest payments rather than
payment of interest at maturity. No other terms of the loan were amended.
Subsequent to June 30, 1999 the Company used part of the proceeds from the
issuance of the Series A Preferred Stock to make an $8 million payment to Liraz
to pay down the balance of it's $12 million loan from Liraz.
NOTE 8. ISSUANCE OF PREFERRED STOCK
On June 29, 1999, Level 8 Systems, Inc. completed its agreement to sell
21,000 shares of Series A 4% Convertible Redeemable Preferred Stock ("Series A
Preferred Stock"), for $21,000, convertible into an aggregate of 2.1 million
shares of common stock of Level 8. The proceeds net of accrued issuance costs,
$19,050, will be used to pay down debt and other general corporate purposes.
The sale of the Series A Preferred Stock was made in a private transaction
exempt from the registration requirements of the federal securities laws.
Holders of the Series A Preferred Stock are entitled to receive 4% annual cash
dividends payable quarterly and will have one vote per share of Series A
Preferred Stock, voting together with the common stock and not as a separate
class except on certain matters adversely affecting the rights of holders of
the Series A Preferred Stock. The Series A Preferred Stock may be redeemed
at the option of Level 8 at a redemption price equal to the original purchase
price at any time after June 29, 2000 if the closing price of Level 8's common
stock over 20 consecutive trading days is greater than $20 per share. The
conversion price of the Series A Preferred Stock is subject to certain
anti-dilution provisions, including adjustments in the event of certain sales of
common stock at a price of less than $10 per share. In the event Level 8
breaches its obligations to pay dividends when due or issue common stock upon
conversion, or Level 8's common stock is delisted, the dividend rate on the
Series A Preferred Stock would increase to 18% per annum (partially payable in
shares of common stock at the option of Level 8 during the first 60 days of such
increased dividend rate). As part of the $21 million financing, Level 8 also
issued the investors warrants to purchase 2.1 million shares of common stock at
an exercise price of $10 per share. Level 8 has agreed to register the common
stock issuable upon conversion of the Series A Preferred Stock and exercise of
the warrants for resale under the Securities Act of 1933. Level 8 is required
to make certain payments in the event it is unable to meet its obligations in
connection with the Series A Preferred Stock and warrants, such as registration
under the Securities Act or issuance of shares of common stock upon conversion
or exercise. The aggregate amount of all such payments, together with dividends
on the Series A Preferred Stock, is limited to 19% of the liquidation value of
the Series A Preferred Stock. One of the investors in the Series A
Preferred Stock included Advanced Systems Europe B.V., which purchased $10
million of Series A Preferred Stock and warrants in the transaction, and is a
subsidiary of Liraz, Level 8's controlling stockholder.
NOTE 9. REINCORPORATION AND COMMON STOCK
Effective June 23, 1999, the Company completed its reincorporation under
Delaware law. As a result of the reincorporation of the Company under Delaware
law, the rights of stockholders of the Company are now governed by the
Certificate of Incorporation and Bylaws of Level 8 Systems, Inc., a Delaware
corporation, and the General Corporation Law of the State of Delaware. In
conjunction with the reincorporation, the Company changed the par value of it's
common stock from $.01 to $.001.
10
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NOTE 10. CONTINGENCIES
LITIGATION. On April 6, 1998, the Company sold substantially all assets
and operations of its wholly owned subsidiary ProfitKey International,
Inc. ("ProfitKey"). According to the terms of the ProfitKey sale
agreement, the purchase price is subject to adjustment to reflect any
variance in working capital from a specified amount. The purchaser has notified
the Company that it believes there are adjustments totaling $1,466 which would
require a reduction in the purchase price. The Company has attempted to
negotiate a settlement with the purchaser and has, pursuant to the terms of
the settlement agreement, entered arbitration proceedings to resolve this
matter. The Company has made a provision for its estimate of the purchase
price adjustment and the costs to resolve this matter. Management believes
at this time that any additional provision required to ultimately resolve
this matter will not have a material effect on the financial position, cash
flows, or results of operations of the Company.
In December 1997 a now wholly-owned subsidiary of the Company, Seer
Technologies, Inc. ("Seer"), instituted litigation in London, England against
Saadi Abbas ("Abbas") and Cambridge Business Solutions (UK) Ltd. ("CBS")
concerning a dispute over a license agreement between Seer, CBS and Abbas.
These entities counterclaimed against Seer. The case has proceeded through
discovery and various other procedural events and all that remains of the
litigation at this point in time are various claims against Seer by Abbas and
CBS. Most of those claims have been struck out by the court in London as
unarguable or otherwise time barred. The Company intends to continue to
vigorously defend against the few remaining claims. The Company has made
provisions for its estimated costs to resolve this matter. Management does not
believe at this point in the litigation that any additional amounts required to
ultimately resolve this matter will have a material effect on the financial
position, cash flows, or results of operations of the company.
LIQUIDITY. During the first six months of 1999, the Company incurred a net
loss of $8,697 and has working capital of $5,245 and an accumulated deficit of
$33,292 at June 30, 1999. The Company received $21,000 from the issuance of
preferred stock as discussed in Note 8 above and renegotiated the repayment of
certain long-term debt. Additionally, as a result of issuing more than $7,500
in equity financing, the Company no longer has a commitment from Liraz for
$7,500 in working capital. The Company's ability to generate positive future
cash flow is dependent upon the Company achieving and sustaining certain cost
reductions and generating sufficient revenues for the year. The Company already
implemented certain steps to, among other things, reduce headcount,
restructure operations and eliminate various costs from the business. The
Company believes that existing cash on hand, cash provided by future
operations, and additional borrowings under its line of credit will be
sufficient to finance its operations and expected working capital and capital
expenditure requirements for at least the next twelve months so long as the
Company continues to perform to its operating plan. However, there can be no
assurance that the Company will be able to continue to meet its cash
requirements through operations or, if needed, obtain additional financing on
acceptable terms, and the failure to do so may have an adverse impact on the
Company's business and operations.
11
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS.
- ---------------
GENERAL INFORMATION AND RECENT DEVELOPMENTS
- -----------------------------------------------
The company is a leading provider of business integration solutions.
Business integration solutions address the emerging need for a company's
information systems to deliver enterprise-wide views of the company's business
information processes. As new computer technologies have proliferated in
enterprise computing environments, the integration and management of the
applications which rely on them has become increasingly complex. Our products
and services are designed to enable organizations to address information systems
integration and management problems in a simple and cost effective way. We
provide customers with solutions to meet their enterprise application
integration (EAI) and development needs. Our products allow companies to link
their critical business applications internally across the enterprise and
externally with strategic business partners. Our products and services also
enable organizations to engage in electronic commerce. Electronic commerce or
"E-commerce" refers to business conducted over the Internet. Currently, our
products and services are sold worldwide through a network of regional sales
offices. To date, our products and services have been utilized by companies in a
wide variety of industries, including banking and financial services, insurance,
retail, manufacturing, data processing, public utilities and transportation.
On April 13, 1999, the Company announced the general release of its new
Geneva Integrator, formerly Geneva Integration Server ("Geneva"). Geneva is
an open, standards-based integration platform for connecting business
applications running on Windows with business systems running on other
platforms. Geneva functionally addresses the problem of functionally linking
custom, legacy, E-commerce, Web-enabled, and Windows DNA-based application
systems.
On April 30, 1999, the Company completed its acquisition of Seer
Technologies, Inc. ("Seer"). The Company purchased the remaining minority
interest in Seer, for $0.35 per share of the outstanding common stock in cash.
The total purchase price for the remaining 31% of Seer was $1,697. As a result
of the completion of acquisition, Seer became a wholly-owned subsidiary of the
Company.
RESULTS OF OPERATIONS
- -----------------------
In order to effect the Company's strategic shift to the EAI market, the
Company completed a series of dispositions and acquisitions during 1998. See
further descriptions of these transactions included in the Company's Annual
Report on Form 10-K for the year ended December 31, 1998. Operations for the
subsidiaries acquired during 1998 are included in the Company's results of
operations from the date of acquisition. Accordingly, the results of operations
for the first six months of 1998 include the operations of Momentum Software
Corporation ("Momentum") since March 26, 1998. The results of operations for
the first quarter of 1998 do not reflect any of Seer's operations since the
Company did not acquire an interest in Seer until December 31, 1998. Except as
otherwise indicated, the discussion below relates to the actual results of
operations without giving pro forma effect to the acquisitions and dispositions
in 1998. Pro forma combined data assumes the acquisition of Momentum and Seer
had each occurred as of January 1, 1998 and does not purport to be indicative
of the results which would have actually been obtained had the transactions
taken place as of such date or of future results of operations. The
acquisitions made in 1998 make it difficult to compare the actual results of
operations for the periods presented. A discussion of results of
operations on a pro forma combined basis has been included below where
considered meaningful for an understanding of the Company's results of
operations for the 1999 periods. However, pro forma combined results reflect
the operations of the three companies on a separate basis without
consideration for any synergies obtained through the integration of the
companies' operations.
12
<PAGE>
The following table sets forth, for the periods indicated, the Company's
unaudited results of continuing operations expressed as a percentage of revenue:
<TABLE>
<CAPTION>
Three months ended Six months ended
June 30, June 30,
1999 1998 1999 1998
----------- ------- ------- -------
<S> <C> <C> <C> <C>
Revenue:
Software products 24.5% 13.2% 22.5% 10.0%
Maintenance 30.5% 8.1% 29.9% 4.6%
Services 44.9% 78.8% 47.5% 85.4%
----------- ------- ------- -------
Total
100.0% 100.0% 100.0% 100.0%
Cost of revenue:
Software products 8.4% 13.4% 7.4% 13.6%
Maintenance 11.1% 4.4% 11.6% 3.9%
Services 39.0% 40.7% 42.3% 47.2%
----------- ------- ------- -------
Total
58.5% 58.5% 61.3% 64.7%
Gross profit 41.5% 41.5% 38.7% 35.3%
Operating expenses:
Sales and marketing 21.2% 27.9% 20.5% 17.3%
Research and product development 12.0% 31.0% 12.3% 22.5%
General and administrative 13.1% 35.0% 11.0% 32.8%
Amortization of goodwill and intangibles 13.0% 18.2% 12.9% 10.9%
Purchased research and development 5.7% ---- 2.8% 19.2%
----------- ------- ------- -------
Total 65.0% 112.1% 59.5% 102.7%
Loss from operations (23.5%) (70.6%) (20.8%) (67.4%)
Other income (expense), net (7.5%) 1.4% (8.4)% 1.8%
----------- ------- ------- -------
Loss before taxes (31.0%) (69.2%) (29.2%) (65.6%)
Income tax provision (benefit) 1.5% (5.0%) 1.5% (8.9%)
----------- ------- ------- -------
Loss from continuing operations (32.5%) (64.2%) (30.7%) (56.7%)
=========== ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
The following table sets forth unaudited data for total revenue by geographic
origin as a percentage of total revenue for the periods indicated:
Three months ended Six months ended
June 30, June 30,
1999 1998 1999 1998
--------- --------- ------ -----
<S> <C> <C> <C> <C>
United States 26 % 99 % 31 % 100 %
Western Europe 63 % --- 60 % ---
Asia Pacific 7 % --- 7 % ---
Other 4 % 1 % 2 % 1 %
--------- --------- ------ -----
Total 100 % 100 % 100 % 100 %
========= ========= ===== =====
</TABLE>
13
<PAGE>
REVENUE AND GROSS MARGIN. The Company has three categories of
revenue: software products, maintenance, and services. Software products
revenue is comprised primarily of fees from licensing the Company's
proprietary software products. Maintenance revenue is comprised of fees for
maintaining, supporting, and providing periodic upgrades to the Company's
software products. Services revenue is comprised of fees for consulting and
training services related to the Company's software products.
The Company's revenues vary from quarter to quarter, with the largest
portion of revenue typically recognized in the last month of each quarter. The
Company believes that these patterns are partly attributable to the Company's
sales commission policies, which compensate sales personnel for meeting or
exceeding quarterly quotas, and to the budgeting and purchasing cycles of
customers. The Company typically does not have any material backlog of unfilled
software orders, and product revenue in any quarter is substantially dependent
upon orders received in that quarter. Because the Company's operating expenses
are based on anticipated revenue levels and are relatively fixed over the short
term, variations in the timing of recognition revenue can cause significant
variations in operating results from quarter to quarter. Fluctuations in
operating results may result in volatility in the price of the Company's common
stock.
Effective January 1, 1998, the Company adopted Statement of Position 97-2,
"Software Revenue Recognition" ("SOP 97-2"), as amended by Statement of Position
98-4 "Deferral of the Effective Date of Certain Provisions of SOP 97-2." SOP
97-2 requires each element of a software sale arrangement to be separately
identified and accounted for based on the relative fair value of such element.
Revenue cannot be recognized on any element of the sale arrangement if
undelivered elements are essential to the functionality of the delivered
elements. Statement of Position 98-9, "Modification of SOP 97-2, 'Software
Revenue Recognition,' with Respect to Certain Transactions" ("SOP 98-9")
will be effective for the Company's fiscal year beginning January 1, 1999.
Retroactive application is prohibited. SOP 98-9 amends SOP 97-2 to require
that an entity recognize revenue for multiple element arrangements by means
of the "residual method" when (1) there is vendor-specific objective
evidence ("VSOE") of the fair values of all of the undelivered elements that
are not accounted for by means of long -term contract accounting, (2) VSOE of
fair value does not exist for one or more of the delivered elements, and
(3) all revenue recognition criteria of SOP 97 -2 (other than the requirement
for VSOE of the fair value of each delivered element) are satisfied. The
provisions of SOP 98-9 that extend the deferral of certain passages of SOP
97 -2 became effective December 15, 1998. The Company implemented SOP 98-9
as of January 1, 1999.
Total revenues increased significantly for the second quarter and
year-to-date periods of 1999 as compared to the same periods of 1998
primarily due to the acquisitions of Momentum and Seer during 1998. The gross
margin for the second quarter of 1999 was consistent as the same period of 1998
and improved to 39% in 1999 for the year-to-date period as compared to 35% for
the same period of 1998.
On a pro forma combined basis, total revenues for the year-to-date period
of 1998 were $37.8 million. The $11.6 million decline in revenue on a pro
forma combined basis is primarily due to a decline in consulting resources
employed by Seer for the first six months of 1998 compared to the same period of
1999. The gross margin for the year-to-date period on a pro forma
combined basis was approximately 24%.
SOFTWARE PRODUCTS. Software products revenue increased significantly
for the second quarter and year-to-date periods of 1999 as compared to the same
periods of 1998 primarily due to the sales of products acquired from Seer
during 1998 coupled with sales of the Company's new Geneva Integrator.
In the first six months of 1998, the Company's software sales were
primarily resales of IBM's MQ Series licenses and sales of FalconMQ and XIPC
messaging products. Through its acquisitions in 1998, the Company acquired
Momentum's XIPC messaging product and Seer's HPS products which are used for
application development. Additionally, as discussed above, the Company has
developed Geneva Integrator, an EAI solution, during late 1998 and early 1999.
Gross margins on software products increased significantly from
negative margins for the second quarter and year-to-date periods of 1998 to
66% for the second quarter and 67% for the year-to-date periods of 1999
primarily due to the increase in the Company's software products revenue. The
increase in gross margin was offset somewhat by an increase in the cost of
software of $.7 million and $1.1 million for the second quarter and year-to-date
period. Cost of software is composed of production and distribution costs,
amortization of capitalized software and royalties to third parties. The
increase in cost of software was primarily due to amortization of capitalized
software from Momentum's and Seer's developed technology valued in the purchase
transactions and royalties for technology acquired in 1998 from Liraz Systems,
Ltd. ("Liraz"), the Company's majority shareholder.
14
<PAGE>
MAINTENANCE. Maintenance revenue increased significantly in the second
quarter and year-to-date periods of 1999 in comparison to the same periods of
1998 primarily due to the addition of Seer*HPS to the Company's products, which
has historically had a significant revenue stream from maintenance. Maintenance
revenue on a pro forma combined basis for the year-to-date period of 1998
was $7.0 million.
Cost of maintenance is comprised of personnel costs and related overhead
and the cost of third-party contracts for the maintenance and support of the
Company's software products. Gross margins on maintenance increased to 64% for
the second quarter and 61% for the year-to-date period of 1999 from 45% and 16%
for comparable periods of 1998, respectively. The increase in gross margins is
primarily due to the addition of Seer*HPS and XIPC to the Company's products.
SERVICES. Services revenue increased significantly from the second
quarter and year-to-date periods of 1998 to the first quarter of 1999 primarily
due to the acquisition of Seer, which added an average of approximately 140
consultants to the Company's consulting staff.
Cost of services primarily includes personnel and travel costs related
to the delivery of services. Services gross margins declined from 48% to 13%
for the second quarter and from 45% to 11% for the year-to-date period of 1998
as compared to the same periods of 1999 primarily due to lower utilization of
billable resources. Additionally, changes in the composition of the Company's
services revenue have caused margins to decline since the
Seer*HPS-related services have historically generated lower margins than
the Company's other service offerings. The Company is seeking to improve
its consulting margins through better utilization of its consultants and
by retraining the Seer*HPS consulting resources to provide higher margin
services for the Company's FalconMQ and Geneva Integrator.
SALES AND MARKETING. Sales and marketing expenses primarily include
personnel costs for salespeople, travel, and related overhead, as well as
trade show participation and other promotional expenses. Sales and
marketing expenses increased significantly from the first quarter and
year-to-date period of 1998 to the same periods of 1999 due to an increase in
the size of the Company's sales force, both through acquisition and recruiting.
Sales and marketing expenses have also increased as a percentage of revenue from
17% in the first six months of 1998 to 21% in the same period of 1999. These
increases were necessitated by the reorganization of the Company's sales and
promotional activities to correspond with its new product strategy as well as
the Company's expansion into the global marketplace with the acquisition of
Seer. The Company intends to continue to increase its spending in the sales
and marketing area to increase market awareness and acceptance of its new
product Geneva Integration Server and to expand its indirect distribution
network.
RESEARCH AND DEVELOPMENT. Research and development expenses primarily
include personnel costs for product authors, product developers and product
documentation personnel and related overhead. Research and development expense
increased significantly from the second quarter and year-to-date periods of 1998
to the same periods of 1999 due to the addition of ninety developers from
Momentum and Seer. The Company intends to continue making a significant
investment in research and development while also improving efficiencies in this
area.
GENERAL AND ADMINISTRATIVE. General and administrative expenses consist
of personnel costs for the legal, financial, human resources, and administrative
staff and related overhead and all non-allocable corporate costs of operating
the Company. General and administrative expenses increased 55% and 40% in the
second quarter and year-to-date periods of 1999 as compared to the same periods
of 1998. The increases are primarily related to the additional infrastructure
necessary to support the Company after the acquisitions of Momentum and Seer.
As a percentage of revenue, general and administrative expense has declined from
33% in the first six months of 1998 to 11% in the first six months of 1999 due
to synergies obtained through the Company's 1998 acquisitions.
AMORTIZATION OF GOODWILL AND OTHER INTANGIBLE ASSETS. Amortization of
goodwill and other intangible assets was $1.7 million in the second quarter and
$3.4 million in the year-to-date period of 1999 as compared to $.6 million and
$.7 million in the respective periods of 1998. The amortization of goodwill in
the first and second quarters of 1998 was related to the purchase of Level 8
Technologies in April of 1995 and in the second quarter included amortization
related to the purchase of Momentum in March, 1998. In the second quarter and
year-to-date period of 1999, the amortization of goodwill and other intangible
assets related to the purchase of Seer, Momentum and Level 8 Technologies. The
Company will continue to assess the recoverability of its intangible assets on a
quarterly basis based on the net present value of the expected future cash
flows.
15
<PAGE>
PURCHASED RESEARCH AND DEVELOPMENT. Based on the results of a
third-party appraisal, the Company recorded a charge in the first quarter of
1998 of $1.2 million to expense purchased in-process research and development
costs related to the acquisition of Momentum. As a result of completing the
acquisition of the remaining 31% of Seer, the Company recorded a charge of $.7
million for in-process research and development costs.
PROVISION FOR INCOME TAXES. The Company's effective income tax rate
for continuing operations differs from the statutory rate primarily because
an income tax benefit was not recorded for the net loss incurred in the
second quarter or the year-to-date period of 1999. Because of the Company's
inconsistent earnings history, the deferred tax assets have been fully offset by
a valuation allowance. The income tax provision for the second quarter and the
year-to-date periods of fiscal year 1999 is primarily related to income taxes
from profitable foreign operations and foreign withholding taxes.
DISCONTINUED OPERATIONS. During 1998, the Company disposed of one of
its wholly-owned subsidiaries, ProfitKey International, Inc. The disposal
was accounted for as a discontinued operation. According, the results of
operations for the first quarter of 1998 reflects a $1.0 million loss from
discontinued operations.
IMPACT OF INFLATION. Inflation has not had a significant effect on
the Company's operating results during the periods presented.
LIQUIDITY AND CAPITAL RESOURCES
- ----------------------------------
Net cash used in operations during the first two quarters of 1999 was $5.9
million. Payments of approximately $2.8 million for merger and restructuring
costs related to the acquisition of Seer were two of the primary components of
the net cash outflow in addition to the Company's normal, recurring operating
expenses. Also, both the Company and Seer had lower than anticipated billings
in the fourth calendar quarter of 1998 which contributed to a reduction in cash
received from customers. The Company believes this trend was caused primarily
by internal distractions within both companies in the fourth calendar quarter of
1998 due to the November announcement of the Seer transaction which was
consummated on December 31, 1998.
Net cash used in investing activities for the first six months of 1999 was
$3.2 million. As of April 30, 1999, the Company acquired the remaining
minority interest in Seer, 3,375,833 shares of common stock, for $0.35 per share
in cash. The total purchase price for the remaining 31% of Seer acquired
through the Tender Offer and merger in April, 1999 was approximately $1.7
million for Seer's common stock. There were also $.5 million for other direct
costs of the Seer acquisition paid in the 1999 year-to-date period. As a
result of the completion of the Tender Offer and merger, Seer became a
wholly-owned subsidiary of the Company. Additionally, capitalized software
development costs were $.9 million.
Net cash provided by financing activities for the first six months of 1999
was $22.3 million. During the second quarter of 1999, the Company issued 21,000
shares of its Series A 4% Convertible Redeemable Preferred Stock ("Series A
Preferred Stock") for $21 million and paid down its line of credit by $4
million. During the first quarter of 1999, the Company also paid approximately
$.5 million on its outstanding debt obligations with its majority shareholder
Liraz.
The Company funded its cash needs during the first quarter of 1999 with
cash on hand at December 31, 1998, through first quarter operations, the
issuance of the Series A Preferred Stock and through $1.8 million in net
additional borrowings under its line of credit.
As of June 30, 1999, the Company had outstanding borrowings of $14.1
million under a credit facility with a commercial bank shared between the
Company and it's wholly-owned subsidiary, Seer, (the "Credit Facility") at
an interest rate of 9.75%. During the second quarter, the Credit Facility
was amended and currently provides for borrowings up to the lesser of $25
million or the sum of 80% of eligible receivables and a $10 million term loan
payable on September 1, 2000. The receivables-based borrowings under the Credit
Facility are due on demand. The Credit Facility bears interest at the prime
rate plus 2% per annum and has no financial covenant provisions. The Credit
Facility terminates on December 31, 2001; however, it is automatically renewed
for successive additional terms of one year each, unless terminated by
either party. The Credit Facility is collateralized by the Company's accounts
receivable, equipment and intangibles, including intellectual property.
16
<PAGE>
In addition to the Credit Facility, the Company has other outstanding
borrowings at June 30, 1999 including (i) $.13 million under a note payable to
Liraz which bears interest at 4% per year and is payable in equal quarterly
installments of $.035 million, including interest, (ii) $.5 million under a note
payable to Liraz which bears interest at 8% per year and is payable in annual
installments, (iii) $2.3 million of $3 million notes issued to the sellers of
Momentum which bear interest at 10% per year and are payable in annual
installments, and (iv) a $12 million loan from Liraz which bears interest at 12%
and is payable on December 15, 2000. The $12 million note and other debt
payable to Liraz is subordinate in right of payment to the Credit
Facility.
Future maturities on the Company's outstanding debt at June 30,1999 include
$6.5 million in 1999, $23.4 million in 2000, and $.7 million in 2001. Of
such amounts, $12.5 million in 2000 is due to Liraz.
On June 29, 1999, Level 8 Systems, Inc. completed the Series A
Preferred Stock agreement to sell 21,000 shares of Series A 4% Convertible
Redeemable Preferred Stock, for $21 million, convertible into an aggregate of
2,100,000 shares of common stock of Level 8. The net proceeds will be used to
pay down debt and other general corporate purposes. Subsequent to the end of
the second quarter, the Company paid down $8 million of the $12 million loan
from Liraz. The sale of the Series A Preferred Stock was made in a private
transaction exempt from the registration requirements of the federal securities
laws.
Holders of the Series A Preferred Stock are entitled to receive 4% annual
cash dividends payable quarterly and will have one vote per share of Series A
Preferred Stock, voting together with the common stock and not as a separate
class except on certain matters adversely affecting the rights of holders of
the Series A Preferred Stock. The Series A Preferred Stock may be redeemed
at the option of Level 8 at a redemption price equal to the original purchase
price at any time after June 29, 2000 if the closing price of Level 8's common
stock over 20 consecutive trading days is greater than $20 per share. The
conversion price of the Series A Preferred Stock is subject to certain
anti-dilution provisions, including adjustments in the event of certain sales of
common stock at a price of less than $10 per share. In the event Level 8
breaches its obligations to pay dividends when due or issue common stock upon
conversion, or Level 8's common stock is delisted, the dividend rate on the
Series A Preferred Stock would increase to 18% per annum (partially payable in
shares of common stock at the option of Level 8 during the first 60 days of such
increased dividend rate). As part of the $21 million financing, Level 8 also
issued the investors warrants to purchase 2.1 million shares of common stock at
an exercise price of $10 per share. Level 8 has agreed to register the common
stock issuable upon conversion of the Series A Preferred Stock and exercise of
the warrants for resale under the Securities Act of 1933. Level 8 is required
to make certain payments in the event it is unable to meet its obligations in
connection with the Series A Preferred Stock and warrants, such as registration
under the Securities Act or issuance of shares of common stock upon conversion
or exercise. The aggregate amount of all such payments, together with dividends
on the Series A Preferred Stock, is limited to 19% of the liquidation value of
the Series A Preferred Stock. Investors in the Series A Preferred Stock and
warrants include Advanced Systems Europe B.V., which purchased $10 million of
Series A Preferred Stock and warrants in the transaction, and is a
subsidiary of Liraz Systems, Ltd., Level 8's controlling stockholder.
As a result of issuing more than $7.5 million in new equity instruments,
the Company no longer has a commitment from Liraz for $7.5 million in working
capital.
As of June 30, 1999, the Company did not have any material commitments for
capital expenditures.
During the first six months of 1999, the Company incurred a net loss of
$8.1 million and has working capital of $5.3 million and an accumulated deficit
of $33.3 million at June 30, 1999. The Company's ability to generate positive
cash flow is dependent upon the Company achieving and sustaining certain cost
reductions and generating sufficient revenues for the year. The Company
already implemented certain steps to, among other things, reduce
headcount, restructure operations and eliminate various costs from the business.
The Company believes that existing cash on hand, cash provided by future
operations and additional borrowings under the Credit Facility will be
sufficient to finance its operations and expected working capital and capital
expenditure requirements for at least the next twelve months so long as the
Company continues to perform to its operating plan. However, there can be
no assurance that the Company will be able to continue to meet its cash
requirements through operations or, if needed, obtain additional financing on
acceptable terms, and the failure to do so may have an adverse impact on the
Company's business and operations.
17
<PAGE>
YEAR 2000
- ----------
The Company is aware of the issues associated with the programming code in
existing computer systems as the millennium (Year 2000) approaches. The "Year
2000 Problem" is pervasive and complex as virtually every computer operation
will be affected in some way by the rollover of the two digit year value to 00.
The issue is whether computer systems will properly recognize date sensitive
information when the year changes to 2000. Systems that do not properly
recognize such information could generate erroneous data or cause a system to
fail.
Software Sold to Consumers. The Company believes that it has substantially
identified potential Year 2000 Problems with the software products that it
develops and markets. See "Item 1. Business - Products and Services," of the
Company's Annual Report on Form 10-K for the year ended December 31, 1998 for a
further discussion of the Company's products. The Company's FalconMQ
products, Geneva Integrator, and other messaging products are capable of
accurately processing, providing, and/or receiving date data from, into, and
between the twentieth and twenty-first centuries, and the years 1999 and 2000,
including leap year calculations. The Company's Seer*HPS toolset products are
designed to allow developers to develop applications that are Year 2000
compliant, through the use of four-digit year fields which can accept and
accurately represent dates both before and after the Year 2000. Once a
four-digit year is properly input, applications built with the Seer*HPS toolset
can properly process the dates.
Dates may be input into these applications either by entering a four-digit
year or, as a shortcut, by entering the last two digits of the year. In the
latter case, the application assigns a century to the date and "feeds
back" a four-digit year to the user by displaying it on the screen. For all
versions of Seer*HPS above 5.2.3K, the century is assigned according to a moving
100-year window. The Company has made available documentation to its customers
that explains how this moving 100-year window can be adjusted, both on
the workstation platform and on the host. For version 5.2.3K, the
century is assigned a default value of "19". In either case, the user can either
accept the proposed four-digit date or correct it, if the application has
assigned the wrong century in a particular case.
The foregoing description related to Seer*HPS versions 5.2.4S and higher
(for the workstation) and 5.2.3K and higher (for the host), which were released
in December 1995. The Company believes that if operated properly, applications
constructed with these versions in accordance with the product documentation
should not manifest Year 2000-related errors traceable to the Seer*HPS product.
The Company does not believe any of its customers are using earlier versions of
the software.
The Company cannot, however, eliminate the possibility of input errors,
where input is in the form of two-digit years. Among other potential errors, it
is possible to introduce incorrect dates into applications using the shortcut
mentioned above if the operator is inattentive to the feedback, or if the
operator or batch data inputs dates represented as two-digit years, without any
way for the operator to determine which century a given year falls in. The
Company has attempted to identify the possible errors by making documentation
available to its customers.
With respect to the Company's Seer*HPS development environment itself, the
Company is not aware of any Year 2000 issues except the following. The tools
store certain information with respect to objects created using the tools (such
as the dates the object was created or last modified) as two-digit dates.
Because of the way the tools use these dates, the Company does not believe this
will cause any Year 2000-related problems except in the limited instance of
migrations spanning the century boundary. The Company has made available to its
customers documentation calling their attention to this issue and a workaround.
Accordingly, the Company believes that it has fulfilled its obligations to
its customers with respect to Year 2000 functionality. However, the law in this
area is still evolving and lawsuits are being filed against software companies
on an ongoing basis, many of them asserting novel theories of damage and
liability. Accordingly, no assurance can be given that claims will not be made
against the Company relating to date-processing issues or that the effect of
such claims on the Company will not be material.
Internal Infrastructure. The Company has identified substantially all
of the major computers, software applications, and related equipment used in
connection with its internal operations that must be modified, upgraded, or
replaced to minimize the possibility of a material disruption to its business
and has commenced the process of modifying, upgrading, and replacing
major systems that have been identified as adversely affected, and expects
to complete this process by the middle of 1999.
18
<PAGE>
Systems Other Than Information Technology Systems. In addition to
computers and related systems, the operation of office and facilities equipment,
such as fax machines, photocopiers, telephone switches, security systems,
elevators, and other common devices may be affected by the Year 2000 Problem.
The Company is currently assessing the potential effect of, and costs of
remediating, the Year 2000 Problem on its office and facilities equipment.
The Company's assessment of its internal systems is nearly complete.
Based on its current assessment, the Company does not believe the total cost
to the Company of completing any required modifications, upgrades, or
replacements of these internal systems will have a material adverse effect on
the Company's financial condition, cash flows, or results of operations.
Suppliers. The Company has reviewed information from third party suppliers
of the major computers, software, and other equipment used, operated, or
maintained by the Company to identify and, to the extent possible, to resolve
issues involving the Year 2000 Problem. However, the Company has limited or no
control over the actions of these third party suppliers. Thus, there can be no
assurance that these suppliers will resolve any or all Year 2000 Problems with
these systems before the occurrence of a material disruption to the business of
the Company or any of its customers. Any failure of these third parties to
resolve Year 2000 problems with their systems in a timely manner could have a
material adverse effect on the Company's business, financial condition, and
results of operation.
Most Likely Consequences of Year 2000 Problems. The Company does not
believe that the Year 2000 Problem will have a material adverse effect on the
Company's business or results of operations. However, management believes that
it is not possible to determine with complete certainty that all Year 2000
Problems affecting the Company have been identified or corrected. The number of
devices that could be affected and the interactions among these devices are
simply too numerous. In addition, one cannot accurately predict how many Year
2000 Problem-related failures will occur or the severity, duration, or financial
consequences of these perhaps inevitable failures. As a result, management
expects that the Company could suffer the following consequences:
1. a significant number of operational inconveniences and inefficiencies for
the Company and its clients that may divert management's time and attention and
financial and human resources from its ordinary business activities;
and
2. a lesser number of serious system failures that may require significant
efforts by the Company or its clients to prevent or alleviate material business
disruptions.
Contingency Plans. The Company is currently developing contingency plans
to be implemented as part of its efforts to identify and correct Year 2000
Problems affecting its internal systems. The Company expects to complete its
contingency plans by the middle of 1999. Depending on the systems
affected, these plans could include accelerated replacement of affected
equipment or software, short to medium-term use of backup equipment and
software, increased work hours for Company personnel or use of contract
personnel to correct on an accelerated schedule any Year 2000 Problems that
arise or to provide manual workarounds for information systems, and similar
approaches. If the Company is required to implement any of these contingency
plans, it could have a material adverse effect on the Company's financial
condition and results of operations.
Disclaimer. The discussion of the Company's efforts, and management's
expectations, relating to Year 2000 compliance are forward-looking statements.
The Company's ability to achieve Year 2000 compliance and the level of
incremental costs associated therewith, could be adversely impacted by, among
other things, the availability and cost of programming and testing resources,
vendors' ability to modify proprietary software, and unanticipated problems
identified in the ongoing compliance review.
EURO CONVERSION
- ----------------
Several European countries adopted a Single European Currency (the "Euro")
as of January 1, 1999 with a transition period continuing through January 1,
2002. The Company is reviewing the anticipated impact the Euro may have on its
internal systems and on its competitive environment. The Company believes its
internal systems will be Euro capable without material modification cost.
19
<PAGE>
Further, the Company does not presently expect the introduction of the
Euro currency to have an adverse material impact on the Company's
financial condition, cash flows, or results of operations.
FORWARD LOOKING AND CAUTIONARY STATEMENTS
- ---------------------------------------------
This report contains forward-looking statements relating to such matters as
anticipated financial performance, business prospects, technological
developments, new products, research and development activities, the pending
transaction with Seer, liquidity and capital resources, Year 2000 issues and
similar matters within the meaning of the Private Securities Reform Act of 1995
("Reform Act"). The Company may also make forward looking statements in other
reports filed with the Securities and Exchange Commission, in materials
delivered to shareholders, in press releases and in other public statements. In
addition, the Company's representatives may from time to time make oral forward
looking statements. Forward looking statements provide current expectations of
future events based on certain assumptions and include any statement that does
not directly relate to any historical or current fact. Words such as
"anticipates," "believes," "expects," "estimates," "intends," "plans,"
"projects," and similar expressions, may identify such forward looking
statements. In accordance with the Reform Act, set forth below are cautionary
statements that accompany those forward looking statements. Readers should
carefully review these cautionary statements as they identify certain important
factors that could cause actual results to differ materially from those in the
forward looking statements and from historical trends. The following cautionary
statements are not exclusive and are in addition to other factors discussed
elsewhere in the Company's filings with the Securities and Exchange Commission
and in materials incorporated therein by reference: the Company's future success
depends on the market acceptance of the new Geneva Integration Server; an
unexpected revenue shortfall may adversely affect the Company's business because
its expenses are largely fixed; the Company's quarterly operating results may
vary significantly because the Company cannot accurately predict the amount and
timing of individual sales and this may adversely impact the Company's stock
price; trends in sales of the Company's products and general economic conditions
may affect investors' expectations regarding the Company's financial performance
and may adversely affect the Company's stock price; because a substantial amount
of the Company's revenues have historically been derived from Seer*HPS,
decreased demand for services relating to this product could adversely affect
the Company's business; the Company's future results may depend upon the
continued growth and business use of the Internet; the Company may lose market
share and be required to reduce prices as a result of competition from its
existing competitors, other vendors and information systems departments of
customers; the Company may not have the resources to successfully manage the
integration of Seer; the Company's future results may depend upon the successful
integration of acquisitions; the Company may not have the resources to
successfully manage additional growth; rapid technological change could render
the Company's products obsolete; if the Company's relationship with Microsoft
weakens, it could adversely affect the Company's business; the loss of any one
of the Company's major customers could adversely affect the Company's business;
the Company's business is subject to a number of risks associated with doing
business abroad including the effect of foreign currency exchange fluctuations
on the Company's results of operations; the Company's products may contain
undetected software errors, which could adversely affect its business; because
the Company's technology is complex, the Company may be exposed to liability
claims; year 2000 issues may cause problems with the Company's systems and
expose the Company to liability; the failure of the Company to meet product
delivery dates could adversely affect its business; the Company may be unable to
enforce or defend its ownership and use of proprietary technology; because the
Company is a technology company, its Common Stock may be subject to erratic
price fluctuations; and the Company may not have sufficient liquidity and
capital resources to meet changing business conditions. See the Company's Form
10-K filed on April 1, 1999 for a more detailed description of certain risks
presented by the Company's operations.
20
<PAGE>
- ------
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- --------------------------------------------------------------------------
Approximately 70% of the Company's 1999 revenues for the first six months
were generated by sales outside the United States. The Company is
exposed to significant risks of foreign currency fluctuation primarily from
receivables denominated in foreign currency and are subject to
transactions gains and losses, which are recorded as a component in
determining net income. Additionally, the assets and liabilities of the
Company's non-U. S. operations are translated into U.S. dollars at
exchange rates in effect as of the applicable balance sheet dates, and
revenue and expense accounts of these operations are translated at average
exchange rates during the month the transactions occur. Unrealized
translation gains and losses will be included as an adjustment to
shareholders' equity. Based upon the foregoing, the Company began hedging
transactions subsequent to the second quarter of 1999 in an effort to reduce its
exposure to currency exchange rates. However, as a matter of procedure, the
Company will not invest in speculative financial instruments as a means of
hedging against such risk.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In December 1997 a now wholly-owned subsidiary of the Company, Seer
Technologies, Inc. ("Seer"), instituted litigation in London, England against
Saadi Abbas ("Abbas") and Cambridge Business Solutions (UK) Ltd. ("CBS")
concerning a dispute over a license agreement between Seer, CBS and Abbas.
These entities counterclaimed against Seer. The case has proceeded through
discovery and various other procedural events and all that remains of the
litigation at this point in time are various claims against Seer by Abbas and
CBS. In July, most of those claims had been struck out by the court in London
as unarguable or otherwise time barred. The Company intends to continue to
vigorously defend against the few remaining claims. The Company has made
provision for its estimated costs to resolve this matter. Management does not
believe at this point in the litigation that any additional amounts required to
ultimately resolve this matter will have a material effect on the financial
position, cash flows, or results of operations of the company.
John B. Stockton, a stockholder of Seer Technologies at the time of its
merger with a subsidiary of Level 8, has informed the Company that he has filed
a petition in the Delaware Court of Chancery asserting that Seer stockholders
perfecting appraisal rights are entitled to receive the fair value of their Seer
shares as determined in an appraisal proceeding under Section 262 of the
Delaware General Corporation Law. The Company has not yet been served a copy of
the complaint. The Company believes that less than 20,000 shares of Seer
Technologies common stock have validly perfected appraisal rights under Delaware
law, and that the fair value of such shares at the time of the merger does not
exceed $.35 per share of Seer.
From time to time, the Company is a party to routine litigation incidental
to its business. As of the date of this Report, the Company was not engaged in
any legal proceedings that are expected, individually or in the aggregate, to
have a material adverse effect on the Company.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On June 29, 1999, Level 8 Systems, Inc. completed a $21 million private
placement of 21,000 shares of Series A 4% Convertible Redeemable Preferred Stock
("Series A Preferred Stock"), convertible into an aggregate of 2.1 million
shares of common stock of Level 8. Holders of the Series A Preferred Stock are
entitled to receive 4% annual cash dividends payable quarterly and will have one
vote per share of Series A Preferred Stock, voting together with the common
stock and not as a separate class except on certain matters adversely affecting
the rights of holders of the Series A Preferred Stock. The Series A Preferred
Stock may be redeemed at the option of Level 8 at a redemption price equal to
the original purchase price at any time after June 29, 2000 if the closing price
of Level 8's common stock over 20 consecutive trading days is greater than $20
per share. The conversion price of the Series A Preferred Stock is
subject to certain anti-dilution provisions, including adjustments in the
event of certain sales of common stock at a price of less than $10 per share. In
the event Level 8 breaches its obligations to pay dividends when due or issue
common stock upon conversion, or Level 8's common stock is delisted, the
dividend rate on the Series A Preferred Stock would increase to 18% per
annum (partially payable in shares of common stock at the
21
<PAGE>
option of Level 8 during the first 60 days of such increased dividend rate). As
part of the $21 million financing, Level 8 also issued the investors warrants to
purchase 2.1 million shares of common stock at an exercise price of $10 per
share, subject to adjustment. As long as the Series A Preferred Stock is
outstanding, the Company may not purchase shares of its common stock or make
distributions on its common stock without the consent of the holders of 85% of
the outstanding Series A Preferred Stock. Level 8 has agreed to register the
common stock issuable upon conversion of the Series A Preferred Stock and
exercise of the warrants for resale under the Securities Act of 1933. Level 8 is
required to make certain payments in the event it is unable to meet its
obligations in connection with the Series A Preferred Stock and warrants, such
as registration under the Securities Act or issuance of shares of common stock
upon conversion or exercise. The aggregate amount of all such payments, together
with dividends on the Series A Preferred Stock, is limited to 19% of the
liquidation value of the Series A Preferred Stock. Investors in the Series A
Preferred Stock and warrants include Advanced Systems Europe B.V. and investment
funds affiliated with Brown Simpson Asset Management and Seneca Capital
Management. Advanced Systems Europe purchased $10 million of Series A Preferred
Stock and warrants in the transaction and is a subsidiary of Liraz Systems,
Ltd., Level 8's controlling stockholder. The foregoing summary description is
qualified in its entirety by reference to the definitive transaction documents,
copies of which are attached as exhibits to the Company's Current Report
on Form 8-K filed July 23, 1999. The Company placed the Series A Preferred
Stock and warrants in reliance upon the exemption from the registration
Requirements of the Securities Act of 1993 provided by Section 4(2) for
transactions not involving a public offering.
Effective June 23, 1999, Level 8 Systems, Inc. completed its
reincorporation under Delaware law. As a result of the reincorporation of the
Company under Delaware law, the rights of stockholders of the Company are
now governed by the Certificate of Incorporation and Bylaws of Level 8
Systems, Inc., a Delaware corporation, and the General Corporation Law of the
State of Delaware. See Proposal 3 in the Company's definitive proxy statement
for its 1999 annual meeting and "Description of Capital Stock" in the
Registration Statement on Form S-3 filed by the Company on August 6, 1999
in connection with the resale of the common stock underlying the Series A
Preferred Stock and warrants, registration number 333-84681.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Shareholders of the Company was held on May 26, 1999.
The following is a brief description of each matter voted upon at the
meeting and the number of affirmative votes and the number of negative votes
cast with respect to each matter.
a) The stockholders elected the following persons as directors of the
Company: Arie Kilman, Michel Berty, Robert Brill, Theodore Fine, Frank Klein,
Lenny Recanati, and Samuel Somech. The votes for, against(withheld) and votes
abstaining for each nominee were as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Votes Votes Votes
For Withheld Abstained
- ------------------------------------------------------------------
Arie Kilman 8,463,774 49,909 -
Michel Berty 8,467,383 46,300 -
Robert Brill 8,467,383 46,300 -
Theodore Fine 8,467,383 46,300 -
Frank Klein 8,463,774 49,909 -
Lenny Recanati 8,463,774 49,909 -
Samuel Somech 8,467,383 46,300 -
- ------------------------------------------------------------------
</TABLE>
b) The stockholders were asked to approve a proposal to issue shares of
common stock through a private placement. The proposal was approved with
6,014,787 shares voting for, 29,818 shares voting against, and 890 shares
abstained.
c) The stockholders were asked to approve a plan of merger to reincorporate
the Company under the laws of the State of Delaware. The proposal was approved
with 6,040,525 shares voting for, 4,100 shares voting against, and 870 shares
abstained.
22
<PAGE>
d) The stockholders were asked to approve the amendment to the Company's
certificate of incorporation to increase the number of authorized shares of
common stock from 15,000,000 to 40,000,000. The proposal was approved with
8,431,237 shares voting for, 68,518 shares voting against, and 17,540 shares
abstained.
e) The stockholders were asked to approve the amendment to the Company's
certificate of incorporation to increase the number of authorized shares of
preferred stock from 1,000,000 to 10,000,000. The proposal was approved with
5,958,140 shares voting for, 68,518 shares voting against, and 17,540 shares
abstained.
f) The stockholders were asked to approve an amendment to the Company's 1997
Stock Option Plan to increase the number of shares of common stock subject to
awards thereunder from 1,400,000 to 2,600,000. The proposal was approved with
5,970,807 shares voting for, 72,118 shares voting against, and 2,570 shares
abstained.
g) The stockholders were asked to approve the adoption of the Level 8
Systems, Inc. Employee Stock Purchase Plan (U.S.). The proposal was approved
with 6,037,116 shares voting for, 3,900 shares voting against, and 870 shares
abstained.
h) The stockholders were asked to approve the adoption of the Level 8
Systems, Inc. Employee Stock Purchase Plan (International). The proposal was
approved with 6,035,916 shares voting for, 5,100 shares voting against, and 870
shares abstained.
i) The stockholders were asked to approve the adoption of the Level 8
Systems, Inc. Outside Directors Stock Incentive Plan. The proposal was
approved with 6,011,596 shares voting for, 21,400 shares voting against, and
8,890 shares abstained.
j) The stockholders ratified the appointment of PricewaterhouseCoopers
L.L.P. as the Company's independent accountants by a vote of 8,505,413 shares
voting for, 6,300 shares voting against, and 1,970 shares abstained.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
2.1 Agreement and Plan of Merger providing for the reincorporation of Level 8
Systems under Delaware Law (incorporated by reference to Appendix A to
the Company's definitive proxy statement for its 1999 annual meeting
filed on Schedule 14A, No. 0-26392)
3.1 Certificate of Incorporation of Level 8 Systems, Inc., a Delaware
corporation (incorporated by reference to Annex B to the Company's
definitive proxy statement for its 1999 annual meeting filed on Schedule
14A, No. 0-26392)
3.2 Bylaws of Level 8 Systems, Inc., a Delaware corporation (incorporated by
reference to Annex C to the Company's definitive proxy statement for its
1999 annual meeting filed on Schedule 14A, No. 0-26392)
3.3 Certificate of Designation relating to Series A 4% Convertible Redeemable
Preferred Stock (incorporated by reference to Form 8-K filed July 23, 1999,
No.0-26392)
10.1 Securities Purchase Agreement dated June 29, 1999 among Level 8 Systems,
Inc. and the investors named on the signature pages thereof. (incorporated
by reference to Form 8-K filed July 23, 1999, No. 0-26392)
23
<PAGE>
10.2 Form of Warrants issued June 29, 1999 in connection with the sale of Series
A 4% Convertible Redeemable Preferred Stock. (incorporated by reference to
Form 8-K filed July 23, 1999, No. 0-26392)
10.3 Registration Rights Agreement dated June 29, 1999 among Level 8 Systems,
Inc. and the investors named on the signature pages thereof. (incorporated
by reference to Form 8-K filed July 23, 1999, No. 0-26392)
10.4 Amendment dated May 31, 1999 to amend the Loan document among the Company
and Liraz Systems, Ltd. (filed herewith)
On April 22, 1999, the Company filed a Form 10-Q/A to reflect the restatement of
the consolidated financial statements for the quarterly period ended March 31,
1999.
On April 22, 1999, the Company filed a Form 10-Q/A to reflect the restatement of
the consolidated financial statements for the quarterly period ended June 30,
1999.
On April 22, 1999, the Company filed a Form 10-Q/A to reflect the restatement of
the consolidated financial statements for the quarterly period ended September
30, 1999.
(b) Reports on Form 8-K
On April 30, 1999, the Company filed a Form 8-K announcing the completion of its
tender offer as part of the acquisition of Seer.
On June 29, 1999, the Company filed a Form 8-K/A including pro forma financial
information in connection with the completion of the acquisition of Seer.
24
<PAGE>
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.
Level 8 Systems, Inc.
/s/ Steven Dmiszewicki
Date: August 16, 1999
Steven Dmiszewicki
President
/s/ Renee Fulk
Date: August 16, 1999
Renee Fulk
Vice President of Finance
(Principal Financial and Accounting Officer)
25
<PAGE>
<TABLE> <S> <C>
<CAPTION>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET AND CONSOLIDATED STATEMENT OF INCOME FIELD AS PART OF
THE ANNYUAL REPORT ON FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<MULTIPLIER> 1,000
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-1-1999
<PERIOD-END> JUN-30-1999
<CASH> 19,247
<SECURITIES> 0
<RECEIVABLES> 16,571
<ALLOWANCES> 1,395
<INVENTORY> 0
<CURRENT-ASSETS> 38,889
<PP&E> 2,663
<DEPRECIATION> 633
<TOTAL-ASSETS> 79,103
<CURRENT-LIABILITIES> 33,644
<BONDS> 0
0
0
<COMMON> 9
<OTHER-SE> 20,114
<TOTAL-LIABILITY-AND-EQUITY> 79,103
<SALES> 0
<TOTAL-REVENUES> 26,212
<CGS> 0
<TOTAL-COSTS> 16,065
<OTHER-EXPENSES> 16,349
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,451
<INCOME-PRETAX> (7,653)
<INCOME-TAX> 399
<INCOME-CONTINUING> (8,052)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (8,052)
<EPS-BASIC> (0.93)
<EPS-DILUTED> (0.93)
</TABLE>
EXHIBIT 10.4
FIRST AMENDMENT TO THE PROMISSORY NOTE OF LEVEL 8 SYSTEMS, INC. IN FAVOR OF
LIRAZ SYSTEMS LTD.
This document when executed by Level 8 Systems, Inc. and Liraz Systems Ltd.
shall amend that certain Promissory Note of Level 8 Systems, Inc. in favor of
Liraz Systems Ltd. dated December 31, 1998.
1) The principal amount of the note shall bear simple interest at a rate per
annum equal to 12% payable semi-annually on June 30 and December 31 of each year
until fully paid.
2) The maturity date of the note is hearby changed from June 30, 2000 to
December 15, 2000.
All other terms of the Promissory Note shall remain unchanged and fully
enforceable.
This agreement shall have effect from the 31st day of May, 1999.
Level 8 Systems, Inc. Liraz Systems Ltd.
By: /s/ Steven Dmiszewicki By: /s/ Yossi Shemesh
Title: President Title: Director of Finance
Exhibit 10.4, Page 1
<PAGE>
