ITEM 1. DESCRIPTION OF BUSINESS
General
Dunn Computer Corporation d/b/a SteelCloud Company ("SteelCloud" or the "Company") was founded in 1987 to manufacture and market its own brand of custom computers primarily to the Federal government.
Today the company delivers turnkey server appliances that deliver immediate results for the customer. These products are created in collaboration with some of the world's largest and leading software manufacturers. The appliances are sold, on an OEM basis to software manufacturers who resell them through their worldwide distribution channels under their own brand name. SteelCloud also markets its own brand appliances, directly or via SteelCloud's web site, to end users in both the private and public sectors. In addition, SteelCloud provides these end users with complimentary technical consulting services.
Dunn Computer Corporation was incorporated in Virginia on February 26, 1998 in connection with the reorganization of Dunn Computer Corporation, a Delaware Corporation, which was incorporated on April 22, 1997. The Company's operating subsidiary, Dunn Computer Operating Company, was incorporated in Virginia in July 1987. The Company's other subsidiaries are International Data Products (IDP), acquired May 1998, STMS, Inc (STMS), acquired September 1997 and Puerto Rico Industrial Manufacturing Operations, Acquisition Corporation (PRIMO), which was incorporated in Puerto Rico in May 1998.
On September 25, 2000 the Company began doing business as ("d/b/a") SteelCloud Company. On October 19, 2000 the Company changed its NASDAQ ticker symbol from DNCC and began trading as SCLD. Unless the context otherwise requires, the "Company" or "SteelCloud" refers to Dunn Computer Corporation d/b/a SteelCloud Company, its predecessor and its subsidiaries. The principal executive offices are located at 1306 Squire Court, Dulles, Virginia 20166. The Company's telephone number at that address is (703) 450-0400. Inquiries may also be sent to SteelCloud's internet address at "www.steelcloud.com".
Products and Services
The Company offers network appliances, infrastructure products, desktop and laptop computers, consulting and staffing services and key channel products.
Network Appliances: SteelCloud partners with leading manufacturers of e-business software products to create ready-to-use turnkey network server appliances. SteelCloud integrates the partner's software onto a custom designed server, running Linux or Microsoft NT. This results in an optimized, tested and certified appliance that is ready to deploy and use when it arrives at the customer site. The company's years of experience building custom servers for mission-critical DOD and security programs are directly applicable for this market; e.g., the appliance configuration is "frozen" and thus components or software only change after SteelCloud and the partner test and validate the change.
Appliances have been developed for Remote Access, E-commerce, Help Desk, Backup and E-mail Administration. A SteelCloud turnkey appliance shortens installation time and reduces client dependency on their internal technical staff while lowering overall technical support costs.
The appliances are sold by SteelCloud to end users and to the software manufacturer's channel partners. The network appliances may also be sold on an OEM (Original Equipment Manufacture) basis to the software manufacturers who then resell the appliances under their own brand name.
The Company believes their unique approach to the Network Appliance market (collaborating with leading software manufacturers and leveraging their marketing efforts) enables it to realize volume sales, at a lower cost of selling with better than industry average gross margins.
Infrastructure Products: These products include ISP server and Enterprise server lines which consist of a single, dual or quad processor versions of the Intel Pentium III and Xeon processors. These servers are designed to give customers the highest level of performance and reliability available in the market today. Infrastructure servers also include specialty servers for specific infrastructure applications such as Virtual Private Network (VPN), Web Caching and Load Balancing.
The Company believes that the infrastructure/server market offers opportunities for higher profit margins compared to other sectors in the industry. With the Internet exploding in popularity, this market represents a significant growth sector for the Company. Additionally, due to the complexity of server installation and maintenance, server sales complement the Company's services business.
Desktop and Laptops: Puerto Rico Industrial Manufacturing Operations (PRIMO) is SteelCloud's 20,000 sq. foot, ISO 9002 semiautomatic manufacturing facility in Guayama, Puerto Rico. PRIMO manufacturers notebook computers, desktops and servers for all SteelCloud customers. PRIMO also provides contract manufacturing services for companies who want to serve the Puerto Rican market through a Puerto Rican manufacturer with localized services.
In addition to its role as a contract computer manufacturer, PRIMO is also an indigenous supplier of computers and IT services in Puerto Rico. As part of the local community, the PRIMO facility qualifies for incentives when bidding on Government contracts. PRIMO augments its computer products with localized, bi-lingual IT services such as training, maintenance and consulting. In early 2000, SteelCloud PR was chosen as a major supplier by the Puerto Rican Board of Education. PRIMO's portion of the contract was $16.5M.
Consulting Services: SteelCloud provides network analysis, design, and implementation services primarily in the form of short-term (less than three months) projects. Specific completion criteria are achieved and deliverables submitted to signify the end of the project. These network-engineering services are performed for a fixed-fee or on an hourly labor basis at the pre-negotiated price and estimated levels of effort. In many cases, SteelCloud provides for customers of the Company's turnkey server appliances; i.e., end users often require additional technical services that complement their SteelCloud server purchases.
Specific project-based services SteelCloud performs include, network analysis, network design, systems implementation, integration, network security, software migrations, and messaging system implementation. SteelCloud strives to maintain expertise in specific areas and technologies rather than be generalists in all Information Technology areas. By maintaining a focus, SteelCloud provides highly skilled professionals and services that leverage our experience for maximum benefit to the client. Project management is the key component of SteelCloud's strategy and success in project-based engagements.
Staffing: SteelCloud provides network support services in the form of fixed-rate hourly engineering services. Contracts with commercial and government clients range from one month to one year in length. Staffing services consist of placing one or more network engineers, user support technicians, or programmers on-site with a client. These professionals perform work as a "virtual" employee for the client and typically work under the direction of the client's management.
Hourly rates for staffing engagements are normally lower than for project-based engagements; however, the contracts usually have substantially longer periods of performance. This continuous longer-term revenue accounts for approximately 60% of all engineering services delivered by SteelCloud.
SteelCloud's success in this area is achieved largely due to contract renewals and increasing staffing requirements from existing customers. The market for staffing is consistently increasing as customers try to focus on their core business and contract SteelCloud to handle their Information Technology support requirements.
Key Channel Products: The Company sells, integrates, installs, and maintains name brand networking hardware and software from its strategic alliance partners. For each of these partnerships, SteelCloud has attained a preferential status and has trained and certified engineers for each partner's product lines.
In addition, the Company has entered into an agreement with Network Associates, Inc. to sell their myCIO.COM service. MyCIO provides a complete range of security and virus protection solutions for organizations. Using an Applications Services Provider (ASP) model, the MyCIO services are delivered from Network Associates' Network Operating Centers (NOCs) throughout the USA. SteelCloud refers clients to myCIO.COM and collects a monthly royalty from Network Associates for all sales referred to them by SteelCloud.
Government Contracts
In fiscal 2000, the Company derived approximately 27% of its revenues from sales of hardware and services to the U.S. Federal Government pursuant to contracts with the General Services Administration (GSA) or other agency-specific contracts.
GSA Contract. The Company has a multiple award schedule contract with GSA (the "GSA" Contract). The Company's GSA contract was awarded in April 1996 and is valid through March 31, 2002. The GSA contract enables Government IT purchasers to acquire all of their requirements from a particular vendor and largely limits the competition to selected vendors holding GSA contracts. For fiscal year 2000, the Company's GSA contract had sales of $4 million, which accounted for approximately 10% of the Company's revenues.
In fiscal 2000, the Company derived approximately 40% of its revenues from sales of hardware and services to the Puerto Rican Government.
Commercial Contracts
In fiscal year 2000, SteelCloud derived approximately 73% of its revenues from sales of hardware and services to the commercial marketplace and state and local government. The Company's commercial customer base consists of several Fortune 500 companies as well as medium-size local commercial customers. The Company will continue to increase its commercial customer base in the upcoming fiscal year. The Company's Appliance Partner program and its own end user sales and marketing activities are concentrated on expanding the Company's commercial customer base. Strategic partnerships with industry leading companies such as Microsoft, Cisco, Intel and Network Associates will enable the Company to further diversify its product mix and attract high quality customers.
Manufacturing and Production
The Company's production capacity is 100,000 units per year in the existing Dulles, Virginia facility on a three-shift basis. The Company's production capacity at its Puerto Rico ISO 9002 facility is 100,000 systems per year.
Competition and Marketing
The markets for the Company's products and services are highly competitive. Many of the Company's competitors offer broader product lines, have substantially greater financial, technical, marketing and other resources. These competitors may benefit from component volume purchasing and product and process technology license arrangements that are more favorable in terms of pricing and availability than the Company's arrangements.
The Company competes with a large number of computer systems integrators, server appliance manufacturers, resellers and IT services companies. The Company believes it is likely that these competitive conditions will continue in the future. There can be no assurance the Company will continue to compete successfully against existing or new competitors that may enter markets in which the Company operates.
There has been a consolidation in the industry as a result of acquisitions and the failure of many firms. The following companies are significant competitors of the Company:
Company Type - ------- ---- Cobalt Networks................................... Manufacturer Network Engines................................... Manufacturer Compaq............................................ Manufacturer PC Connect........................................ Systems Integrator VA Linux.......................................... Manufacturer
Federal Government Market. The emergence of the GSA Schedule as a significant procurement vehicle has enabled traditional mass-market commercial computer companies to be more responsive to government requirements and become more competitive with the Company in the Federal Government Market. The Company believes that the Government's selection criteria for vendor selection consist of price, quality, familiarity with the vendor, and size and financial capability of the vendor. The government has increased the amount of information products acquired through the GSA Schedule. We currently compete with national commercial computer manufacturers such as Dell Computer Corporation and Compaq, for a portion of the government market.
Commercial Market. The information technology industry is highly competitive. Pricing is very aggressive in the industry and the Company expects pricing pressures to continue. The industry is also characterized by rapid changes in technology and consumer preferences, short product life cycles and evolving industry standards.
The commercial market for the Company's IT products and services is a highly fragmented market served by thousands of small value-added resellers and specialized manufacturers. These companies typically service a small geographic area and resell national brand computer and/or network hardware. The Company believes its technical services can compete effectively in the local market because it provides engineering services in conjunction with its turnkey server appliances and with products from its strategic partners; e.g., Network Associates, Inc., Cisco, Microsoft and Intel. In addition, the Company's turnkey server appliances differentiate its offerings and provide the end customers with extra benefits.
The Company believes that its ability to integrate its server systems (SteelCloud brand or any other) with networking products also provides its technical services group a competitive advantage.
The principal elements of competition are product reliability and quality, customization, price, customer service, technical support, IT services and product availability. There can be no assurance that the Company will in the future be able to compete effectively against existing competitors, especially companies who have historically focused their energies on the commercial market.
Marketing. The Company markets to software manufacturers, their channel partners, select commercial accounts and the federal Government. The Company uses an in-house sales force and program managers to market its products and services. SteelCloud markets its products and services worldwide; either directly through its own sales personnel, the internet, or through the marketing organizations of its appliance partners. The Company believes that marketing is very important for all of its target markets.
The Company strives to build a strong relationship with its customers. The Company believes that a key to building customer loyalty is a team of knowledgeable and responsive account executives and a knowledgeable technical and support staff. The Company assigns each customer a trained account executive, to whom subsequent calls to the Company will be directed. The Company believes that these strong one-on-one relationships improve the likelihood that the customer may consider the Company for future purchases. The Company intends to continue to provide its customers with products and technical services that offer the customer the best value.
The Company uses electronic commerce technologies and believes that both the Government and commercial customers will continue to expand and utilize these technologies. Internet and on-line computer services are being used by the Government and commercial accounts to advertise opportunities, reference vendor information and in some cases make actual purchases. The Company maintains a web site on the Internet wherein its GSA catalogue and products can be referenced. In addition, the Company provides the capability for customers to download updated software and drivers that become available.
Suppliers
The Company devotes significant resources to establishing and maintaining relationships with its suppliers. The Company, where possible, purchases directly from component manufacturers such as Intel, Microsoft, Hitachi-Nissei Sanyo America, Ltd., Cisco and Chicony Corp. The Company also purchases multiple products directly from large national and regional distributors such as TechData Corporation, Ingram Micro Incorporated, Decision Support Systems, Incorporated, Wyle Electronics and Bell Micro.
Suppliers provide the Company with incentives in the form of discounts, rebates, credits, and cooperative advertising and market development funds. In accordance with the terms of certain of the Company's Government contracts, the Company provides periodic reporting of pertinent supplier contract terms and conditions to contracting officials. As a product reseller, the Company must continue to obtain products at competitive prices from leading suppliers in order to provide competitively priced products for its customers. In the event the Company is unable to purchase components from these suppliers, the Company has alternative suppliers it can rely upon. The Company believes its relationships with its key suppliers to be good and believes that generally there are multiple sources of supply available should the need arise.
Patents, Trademarks and Licenses
The Company does not maintain a traditional research and development group, but works closely with computer product suppliers and other technology developers to stay abreast of the latest developments in computer technology. While the Company does not believe its continued success depends upon the rights to a patent portfolio, there can be no assurance that the Company will continue to have access to existing or new technology for use in its products.
The Company conducts its business under the trademarks and service marks of "SteelCloud", "SteelCloud Company", "International Data Products," and "IDP." The Company believes its trademarks and service marks have significant value and are an important factor in the marketing of its products.
Because most software used on the Company's computers is not owned by the Company, the Company has entered into software licensing arrangements with several software manufacturers, including Microsoft.
Employees
As of October 31, 2000, the Company employed 84 persons. Of such persons, 6 were employed in an executive capacity, 8 in sales and marketing, 16 in administrative capacities, 37 in technical services and 17 in operations. As of January 18, 2001 the Company employed 89 persons. None of Dunn's employees are covered by a collective bargaining agreement. Dunn considers its relationships with its employees to be good.
The Company believes that its future success depends in large part upon its continued ability to attract and retain highly qualified management, technical and sales personnel. The computer industry is currently undergoing a shortage of trained and experienced technicians. The Company endeavors to be attractive to current and prospective employees and has an in-house training program to produce its own supply of highly qualified technicians and service providers. However, there can be no assurance that the Company will be able to attract and retain the qualified personnel necessary for its business.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
The Company leases approximately 35,000 square foot facility in Dulles, Virginia which is used primarily for manufacturing and administrative services. Pursuant to the lease, which expires in October 2004, the Company pays approximately $27,000 per month in rent.
The Company also leases a 20,000 square-foot facility in Guayama, Puerto Rico, which is used for manufacturing, technical support, and personal computer board level repair. Pursuant to the lease, which expires in 2004, the Company pays approximately $4,000 per month in rent. The Company believes that its current facilities are adequate for its existing needs and that additional suitable space will be available as required.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On July 31, 1998, the Company received notice from the SBA that it was denying the request of the U.S. Air Force to waive the requirement to terminate IDP's Desktop V contract for the convenience of the Government upon the change in control of IDP to the Company. The Company appealed the denial of the SBA to the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the appeal and ruled that the U.S. Air Force must terminate-for-convenience the Desktop V contract. Prior to this ruling by the SBA, the U.S. Air Force determined not to exercise any of the remaining option years under the Desktop V contract on May 1, 1999. In October 1999, the U.S. Air Force issued a termination-for-convenience letter to the Company. Under a termination-for-convenience, the government is required generally to reimburse a contractor for all costs incurred in the performance of the contract. The Company is in the process of attempting to recover from the government a portion or all of unreimbursed costs associated with the Desktop V Contract.
In November 1998, IDP entered into a Government Integrator Agreement, as amended, with Microsoft Corporation (Microsoft) for the licensing of certain Microsoft software. During 1999, Microsoft asserted that IDP owed approximately $800,000 under this due primarily to amended billing by Microsoft concerning sales by IDP to the U.S. Air Force in conjunction with the Desktop V contract. On October 31, 2000, Microsoft filed suit against the Company for breach of contract. In conjunction with the filing of the lawsuit, Microsoft increased its claim by asserting further amendments to billing and relating issues, resulting in a claim against the Company of approximately $1.3 million. Subsequent to October 31, 2000, the Company submitted a motion to dismiss the case and filed a counterclaim of fraud on behalf of IDP in the amount of $500,000. The Company believes that it has meritorious defenses to the claim and intends to vigorously defend itself. The Company cannot estimate at this time the amount of the liability to be incurred, if any, but does not believe that this matter will have a material adverse effect upon the Company's financial position or results of operations. The Company has accrued for amounts due Microsoft based on the original billing terms.
In August of 2000, the Company's former legal counsel filed a claim against the Company for approximately $343,087 for legal fees and costs. In response to the claim, the Company filed a counter claim for professional malpractice and breach of fiduciary duty in the amount of $1,568,000. The matter is currently in litigation. An outcome for this matter cannot be predicted. The Company has accrued amounts for this potential liability in the financial statements.
On October 19, 2000, the Company received a cease and desist letter from LoudCloud, Inc. alleging that the use of the "SteelCloud" mark and name would constitute an infringement of LoudCloud's rights to its "LoudCloud" mark and name and family of "Cloud" marks, that use of "SteelCloud" would dilute the distinctiveness and fame of the LoudCloud mark and name and, that such acts by the Company violated federal and state law regarding unfair competition. In response, the Company filed a declaratory judgment action in the U.S. District Court for the Eastern District of Virginia, seeking a judicial determination that its use of the "SteelCloud" mark and name would not violate the proprietary rights of LoudCloud nor dilute the alleged fame and distinctiveness of the "LoudCloud" mark and name. In this action, the Company also alleged a new claim that LoudCloud, Inc. has violated federal law through its misuse of the trademark provisions under the Lanham Act as amended in 1988. A hearing has been held on the LoudCloud motion to dismiss and the court has taken the matter under advisement. On January 10, 2001, the U.S. District Court for the Eastern District of Virginia dismissed the case. The Company has appealed such decision.
Other than the above, there are no material claims pending against the Company.
There are routine legal claims pending against the Company, but in the opinion of management, liabilities, if any, arising from such claims will not have a material adverse effect on the financial condition and results of operation of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Prior to the quotation of the Company's Common Stock beginning on April 22, 1997, there was no established trading market for the Company's common stock. The Company's Common Stock is traded in the over-the-counter market and prices are quoted on The Nasdaq National Market. The Company changed its symbol from "DNCC" to "SCLD" on October 19, 2000. The following table sets forth the high and low selling prices as reported by The Nasdaq National Market for each fiscal quarter during the fiscal years ended October 31, 2000 and 1999, as well as for the first quarter of fiscal 2001 through January 18, 2001. These quotations reflect inter-dealer prices without retail mark-up, mark-down or commission and may not represent actual transactions.
High Low -------------------
First Quarter............................................. $6.28 $2.71 Second Quarter............................................ $4.94 $2.03 Third Quarter............................................. $2.75 $1.97 Fourth Quarter............................................ $2.41 $1.03
High Low -------------------
First Quarter............................................. $4.84 $1.00 Second Quarter............................................ $4.28 $2.00 Third Quarter............................................. $2.50 $1.63 Fourth Quarter............................................ $1.84 $1.00
High Low -------------------
First Quarter (through January 18, 2001).................. $1.34 $0.69
On January 18, 2001 the closing price of the Company's Common Stock as reported by The Nasdaq National Market was $1.34 per share. There were approximately 5,085 shareholders of the Common Stock of the Company as of such date.
The Company has not paid cash dividends on its Common Stock and does not intend to do so in the foreseeable future.
Recent Sales of Unregistered Stock
On May 1, 1998, in connection with the IDP acquisition, the Company acquired all of the issued and outstanding capital stock of IDP Co. and substantially all of the net assets of PRIMO. In consideration for the IDP acquisition, the Company paid the former owners an aggregate of $14.9 million in cash and an aggregate of 750,000 shares of Common Stock. In November 1998, the Company received 350,000 shares of the stock previously issued to the Fusters in connection with a Purchase Price Adjustment Agreement. The shares sold to the Fusters in the IDP acquisition were sold in reliance upon the exemption from registration afforded by Section 4(2) of the Securities Act of 1933, as amended.
In March 2000, the Company sold 3,000 shares of its Series A Convertible Preferred Stock to one investor. In connection with the sale, the Company received an aggregate of $3,000,000. The shares of preferred stock were sold in reliance upon the exemption from registration provided by Regulation D Rule 506 of the Securities Act of 1933, as amended.
In March 2000, the Company issued 225,000 shares of its common stock in connection with the settlement of a lawsuit with a former employee. The shares of common stock were issued in reliance upon the exemption from registration afforded by Section 4(2) of the Securities Act of 1933, as amended.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA (In thousands, except per share data)
The following selected consolidated financial data of SteelCloud should be read in conjunction with the consolidated financial statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations". The consolidated statement of operations data set forth below with respect to the fiscal years ended October 31, 1998, 1999 and 2000 and the consolidated balance sheet data as of October 31, 1999 and 2000 is derived from and is referenced to the audited consolidated financial statements of SteelCloud included elsewhere in this Annual Report on Form 10-K. The consolidated statement of income data set forth below with respect to the fiscal years ended October 31, 1996 and 1997 and the consolidated balance sheet data as of October 31, 1996, 1997 and 1998 is derived from audited consolidated financial statements of SteelCloud not included in this annual report.
----------
(1) The earnings per share amounts prior to Fiscal 1998 have been restated as required to comply with Statement of Financial Accounting Standards No. 128, Earnings Per Share. For further discussion of earnings per share and the impact of Statement No. 128, see Note 2 to the Company's consolidated financial statements.
(2) Includes the activity of STMS from September 12, 1997 (date of acquisition).
(3) Includes the activity of IDP and PRIMO from May 1, 1998 (date of acquisition).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Founded in 1987, SteelCloud based in Dulles, Virginia, designs, develops and manufactures customized computers, appliances and network solutions. In addition, the Company provides Information Technology ("IT") solutions support to clients for those hardware and networking solutions implemented.
The following discussion should be read in conjunction with the consolidated financial statements. Certain statements contained herein may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, risks associated with the integration of businesses following an acquisition, competitors with broader product lines and greater resources, emergence into new market, the termination of any of the Company's significant contracts, the Company's inability to maintain working capital requirements to fund future operations or the Company's inability to attract and retain highly qualified management, technical and sales personnel.
Overview of Fiscal 2000
In fiscal year 2000, the Company experienced a significant change in its financial results as compared to fiscal year 1999. These significant changes are discussed below.
Award of a Significant Contract
In fiscal 2000, the Company received a contract award from the Puerto Rican Government for approximately $16.5 million. The contract commenced in March 2000 and is expected to be completed in early fiscal 2001. This contributed to the overall increase of the Company's revenues from fiscal 1999 to fiscal 2000.
Settlement of Arbitration award
In November 1998, a former employee of the Company (who had been an employee and stockholder of STMS) filed a demand for arbitration with the American Arbitration Association, alleging breach of his employment agreement with the Company and sought "in excess of $2,350,000" in damages from the Company. During fiscal 1999, the arbitration hearing was conducted resulting in a judgment in favor of the former employee for approximately $1.7 million.
In March 2000, the Company executed a settlement agreement with the former employee whereby the Company paid the former employee approximately $1 million in cash and issued 225,000 shares of the Company's common stock in full settlement of the judgment.
Private Placement
In March 2000, the Company sold 3,000 shares of its Series A Convertible Preferred Stock for net proceeds of approximately $2.7 million. The sale was executed in reliance upon the exemptions from registration provided by Regulation D Rule 506 promulgated by the Securities and Exchange Commission under the Securities Act of 1933, as amended. The sale was executed in order to obtain capital to fund current and future operations.
Settlement of Teaming Agreement
In May 1999, a former contract teaming partner filed a demand for arbitration with the American Arbitration Association, alleging breach of a certain contract agreement with the Company related to disputed commissions due to the former teaming partner.
In June 2000, the Company executed a settlement agreement with the former teaming partner whereby the Company paid $110,000 in full settlement of the claim.
Fiscal 1999 Termination of a Significant Contract
In May 1999, the U.S. Air Force determined not to exercise the remaining option years under the "Desktop V" (DTV) contract and therefore terminated the contract for all participating vendors. Initially awarded to IDP, the DTV contract was the Company's largest contract. Management believed at the date of the IDP acquisition, the contract would be renewed by the government through fiscal year 2003 and would generate over $100 million in revenues during that time. As a result of the termination of this contract, the recoverability of the Company's goodwill associated with the IDP acquisition was significantly impaired. Accordingly, management recorded an impairment charge of approximately $21 million during fiscal 1999.
Results of Operations
The following table sets forth for the fiscal years ended October 31, 1996, 1997, 1998, 1999 and 2000, certain income and expense items of SteelCloud as a percentage of net revenues.
Fiscal Year Ended October 31, 2000 Compared to Fiscal Year Ended October 31,
Net revenues of SteelCloud for fiscal year ended October 31, 2000 ("fiscal 2000") increased approximately 16% to $39.8 million from $34.5 million for fiscal year ended October 31, 1999 ("fiscal 1999"). The increase was primarily due to the contract award with the Puerto Rican Government which represented approximately $16.2 million of fiscal 2000 revenues. In addition, the Company experienced a significant growth with their OEM arrangements, consulting services and server appliance sales which offset the decline in government sales which was a result of (a) a loss of a significant government contract in 1999 and (b) the Company's focus to the commercial environment.
Gross profit for fiscal 2000 increased by approximately 10% to $7.1 million from $6.5 million. The increase is in proportion with the increase in net revenues. Gross profit as a percentage of net revenues during the same periods slightly decreased to 17.9% from 18.8% which is the result of higher sales volume at slightly lower margins.
Selling and marketing expense significantly decreased for fiscal 2000 by 55% to approximately $1 million from $2.3 million for fiscal 1999. During fiscal 2000, the Company reduced expensive marketing programs while increasing their marketing efforts through the use of cooperative marketing dollars which resulted in a significant decrease.
General and administrative expense for fiscal 2000 decreased 63% to $5.3 million from $14.1 million for fiscal 1999. As a percentage of net revenues, general and administrative expense decreased to 13.3% for fiscal 2000 from 40.9% for fiscal 1999. This decrease resulted primarily from the Company's efforts to manage general and administrative costs relative to its net revenue and gross margin. It should be noted that the Company incurred significant non-recurring general and administrative costs in fiscal 1999. These non-recurring expenses consisted of costs associated with the termination of the DTV contract, termination of certain benefit plans, and legal expenses associated with all of these factors.
Other expense, including interest, for fiscal 2000 decreased to approximately $298,000 from approximately $2.9 million for fiscal 1999. The reduction primarily relates to the settlement agreement with a former employee and the Company's significant debt reduction. In addition, the company recorded gains on the sales of certain leased assets.
Fiscal Year Ended October 31, 1999 Compared to Fiscal Year Ended October 31,
Net revenues of SteelCloud for fiscal year ended October 31, 1999 ("fiscal 1999") decreased approximately 48% to $34.5 million from $66.9 million for fiscal year ended October 31, 1998 ("fiscal 1998"). This decrease was primarily due to loss of the DTV contract with the U.S. Air Force. The Company anticipated that this contract would generate revenues of approximately $65 million for fiscal years 1999, 2000 and 2001. Fiscal year 1998 and 1999 revenues under this contract were approximately $18 million and $3 million, respectively.
Gross profit of SteelCloud for fiscal 1999 decreased by approximately 46% to $6.5 million from $11.9 million. This decrease is in proportion with the decrease in net revenues. Gross profit as a percentage of net revenues during the same periods slightly increased to 18.8% from 17.8%. The gross profit percentage increase is a direct result of greater proportion of higher-margin sales of services.
Selling and marketing expense of SteelCloud decreased for fiscal 1999 by 37% to $2.3 million from $3.7 million for fiscal 1998. During fiscal 1999, the Company consolidated its sales and marketing departments with that of IDP which resulted in an overall decrease of expenses.
General and administrative expense of SteelCloud for fiscal 1999 increased 171% to $14.1 million from $5.2 million for fiscal 1998. As a percentage of net revenues, general and administrative expense increased to 41% for fiscal 1999 from 7.8% for fiscal 1998. SteelCloud incurred significant general and administrative costs during fiscal 1999. These costs were associated with the termination of the DTV contract, the consolidation and integration of the IDP facilities and resources, termination of certain benefit plans, and legal expenses associated with all of these factors. Although the Company considers a majority of the 1999 general and administrative expenses to be nonrecurring, appropriate actions have been taken to significantly reduce general and administrative expenses in future periods.
Other expense including interest for fiscal 1999 increased to approximately $2,911,000 from approximately $271,000 for fiscal 1998. The increase was primarily due to the accrual of $2 million for the employee arbitration award. In addition, overall interest expense increased as a result of interest expenses required to support the debt assumed with the acquisition of IDP, interest expenses associated with the new debt obtained in 1999, and interest expense associated with certain operating leases. In fiscal 1999, the Company recorded gains on the sale of certain leased assets which reduced the overall other expense. In addition, the Company recorded an income tax benefit of approximately $559,000 in fiscal 1999.
Liquidity and Capital Resources
In fiscal 2000, the Company used approximately $118,000 in cash flow from operations. The Company generated cash from the reduction of inventories of approximately $1.2 million, collection of income tax receivables of approximately $355,000 and an increase in accounts payable of approximately $3.0 million. The cash generated was used to reduce accrued expenses by $400,000 and finance sales to its customers which resulted in an increase in receivables of approximately $5.8 million. The Company generated approximately $275,000 in its investing activities from the sale of certain leased assets.
The Company's financing activities during fiscal 2000 were provided by the Company's bank line of credit with First Union Bank. The line of credit expires on November 30, 2001 and currently bears interest at prime plus 1%. As of December 31, 2000, the Company had an outstanding balance on the line of credit of approximately $2.3 million and available borrowing capacity of approximately $1.2 million.
In fiscal 2000, the Company sold 3,000 shares of its Preferred Stock in order to raise approximately $2.7 million. The net proceeds were used primarily to reduce the obligation associated with a 1999 arbitration judgment of approximately $1.7 million relating to an employment agreement with a former employee. In conjunction with the settlement with the former employee, the Company issued 225,000 shares of Common Stock. The Company used the remaining proceeds from the Preferred Stock issuance to fund current and future operations.
In fiscal 1999, SteelCloud's subsidiary, IDP, had borrowing agreements with Deutsche Financial Services (DFS) for an aggregate of $25 million. The outstanding balance as of October 31, 1999 was approximately $4.7 million. In fiscal 2000, the Company executed an agreement terminating the borrowing arrangement whereby $3.25 million was repaid to DFS prior to December 31, 1999. Of the remaining outstanding balance, approximately $832,000 was converted to a 24 month note accruing interest at the prime rate and $750,000 was forgiven by DFS. The Company recorded the $750,000 as an extraordinary gain on the early extinguishment of debt.
As of October 31, 2000, the Company had working capital of approximately $5.7 million. The Company believes the bank facility, together with cash on hand, projected cash generated from operations and income tax refunds due will provide sufficient financial resources to finance the current operations of the Company through fiscal 2001.
The Company has obligations under its operating lease commitments of approximately $668,000 for fiscal 2001. In addition, the Company will receive approximately $375,000 in rental income which will be used to offset its lease commitments.
From time to time, the Company may pursue strategic acquisitions or mergers which may require significant additional capital, additional capital may be required to satisfy unusual or infrequent expenses. In such event, the Company may seek additional financing of debt and/or equity.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial Statements of Dunn Computer Corporation d/b/a SteelCloud Company
Page ---- Report of Ernst & Young LLP, Independent Auditors ........................ Consolidated Balance Sheets .............................................. Consolidated Statements of Operations .................................... Consolidated Statements of Stockholders' Equity .......................... Consolidated Statements of Cash Flows .................................... Notes to the Consolidated Financial Statements ...........................
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL ISSUES
None.
PART III
The Notice and Proxy Statement for the 2000 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A under the Securities and Exchange Act of 1934, as amended, which is incorporated by reference in this Annual Report on Form 10-K pursuant to General Instruction G (3) of Form 10-K, will provide the information required under Part III, including Item 10
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report
1. Financial Statements
Dunn Computer Corporation d/b/a SteelCloud Company
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II Valuation and Qualifying Accounts
Statements not listed above have been omitted because they are not applicable or the information required to be set forth therein is included in the Consolidated Financial Statements or the notes thereto under Item 8.
3. Exhibits.
Exhibit Description Number
2.1 Acquisition Agreement, dated March 9, 1998, by and among Dunn, the Company, George D. Fuster, D. Oscar Fuster, Carol N. Fuster and Wendy E. Fuster (refiling to add index of exhibits and schedules). (Filed as Exhibit 2.1 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
2.2 Agreement of Merger, dated as of March 18, 1998, by and among Dunn Merger Corp., a Delaware corporation, Dunn and the Company. (Filed as Exhibit 2.2 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
2.3 Stock Purchase Agreement, dated September 12, 1997, by and among STMS Acquisition Corp., Dunn, STMS, Inc., John Signorello, Timothy McNamee, Steve Salmon and certain other stockholders of Dunn. (Filed as Exhibit 2.3 to Dunn's Current Report on Form 8-K, dated September 12, 1997, filed September 27, 1997 (File No. 0-22263) and hereby incorporated by reference).
3.1 Articles of Incorporation of the Company, dated February 25, 1998, and effective as of February 26, 1998. (Filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1, Amendment No. 1, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
3.2 By-laws of the Company, effective as of March 5, 1998. (Filed as Exhibit 3.2 to the Company's Registration Statement on Form S-1, Amendment No. 2,
dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
4.1 Specimen common stock certificate for the Company. (Filed as Exhibit 4.1 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.1 GSA Schedule (Filed as Exhibit 10.2 to Dunn's Registration Statement on Form SB-2, Amendment 1, dated March 14, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.2 Agreement, dated November 21, 1995, by and between GCH Systems, Inc. and Dunn regarding Lockheed (Filed as Exhibit 10.4 to Dunn's Registration Statement on Form SB-2, Amendment 1, dated March 14, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.3 Agreement, dated March 25, 1997, by and between Dunn and the Social Security Administration (Filed as Exhibit 10.5 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.4 Agreement, dated June 12, 1995, by and between Dunn and the Administrative Office of the U.S. Courts (Filed as Exhibit 10.6 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.5 Agreement, dated September 29, 1994, by and between Dunn and the Health Care Finance Administration (Filed as Exhibit 10.7 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.6 Agreement effective September 8, 1997, by and between Virginia Contracting Authority and Dunn (Filed as Exhibit 10.6 to Dunn's Form 10-KSB, dated January 30, 1998 (File No. 0-22263) and hereby incorporated by reference).
10.7 Employment Agreement by and between Dunn and John D. Vazzana (Filed as Exhibit 99.1 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.8 Employment Agreement by and between Dunn and Thomas P. Dunne (Filed as Exhibit 99.2 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by reference).
10.9 Deed of Lease, dated October 31, 1994, between C&T Partnership and Dunn and addenda thereto (Filed as Exhibit 10.9 to Dunn's Form 10-KSB, dated January 30, 1998 (File No. 0-22263) and hereby incorporated by reference).
10.10 Deed of Lease, dated February 7, 1997, between APA Properties No. 6 L.P. and STMS, Inc. and First Amendment thereto, dated July 23, 1997 (Filed as Exhibit 10.10 to Dunn's Form 10-KSB, dated January 30, 1998 (File No. 0-22263) and hereby incorporated by reference).
10.11 1997 Stock Option Plan, as amended. (Filed as Exhibit 10.11 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.12 General Service Administration Schedule for International Data Products, Corp. (Filed as Exhibit 10.12 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.13 Agreement, dated May 5, 1997, by and between International Data Products, Corp. and the U.S. Air Force, the Desktop V Contract. (Filed as Exhibit 10.13 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.14 Agreement, dated January 6, 1998, by and between International Data Products, Corp. and the Department of the Navy. (Filed as Exhibit 10.14 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.15 Deed of Lease, dated January 31, 1995, between Northtech Business Park and International Data Products. (Filed as Exhibit 10.15 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.16 Deed of Lease, dated July 15, 1994, between Puerto Rico Industrial Development Company and Puerto Rico Industrial Manufacturing Operations, Corp. (Filed as Exhibit 10.16 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.17 Agreement, dated July 11, 1995, by and between International Data Products, Corp. and the Social Security Administration. (Filed as Exhibit 10.17 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.18 Form of Employment Agreement by and between the Company and each of George D. Fuster and D. Oscar Fuster (refiling to reflect revised form). (Filed as Exhibit 10.18 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.19 Consent Agreement by and among Dunn, the Company, Network 1 Financial Securities, Inc., a Texas corporation, and Damon Testaverde, William Hunt and Richard Hunt, dated as of April 20, 1998. (Filed as Exhibit 10.20 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.20 Loan and Security Agreement, dated as of May 28, 1996 by and between Dunn and SIGNET BANK and Amendment Nos. 1, 2 and 3 thereto (Filed as Exhibit 4.2 to Dunn's Form 10-KSB, for the fiscal year ended October 31, 1997 (File No. 0- 22263) and hereby incorporated by reference).
10.21 Amendment No. 4, dated February 28, 1998 to the Loan and Security Agreement by and between Dunn and First Union National Bank, successor by merger to Signet Bank, dated as of May 28, 1996. (Filed as Exhibit 10.23 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference.)
10.22 Employee Stock Purchase Plan.
10.23 Employment Agreement, Termination Agreement, by and among the Company, George D. Fuster and D. Oscar Fuster, dated as of November 23, 1998.
10.24 Purchase Price Adjustment Agreement by and among the Company, George D. Fuster and D. Oscar Fuster, dated as of November 23, 1998.
10.25 Termination agreement, Promissory Note, dated December 29, 1999 by and between Dunn and Deutsche Financial Services.
10.26 Loan and Security Agreement, dated May 27, 1999 by and between Dunn and First Union Commercial Corporation.
10.27 Modification Agreement, dated February 11, 2000 by and between Dunn and First Union National Bank.
10.28 PR Starnet Contract, dated January 5, 2000, by and between Dunn and Office of Budget and Management of Puerto Rico.
*21.1 List of Subsidiaries.
*23.1 Consent of Ernst & Young LLP, Independent Auditors.
*23.2 Consent of Ernst & Young LLP, Independent Auditors.
----------
* Filed herewith
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the fourth quarter of fiscal 2000.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
Date: January 24, 2001 By: /s/ THOMAS P. DUNNE -------------------------------------- Thomas P. Dunne Chief Executive Officer
Pursuant to and in accordance with the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name Title Date ---- ----- ----
/s/ THOMAS P. DUNNE - -------------------------------- Thomas P. Dunne Chief Executive Officer January 26, 2001 and Director /s/ EDWARD SPEAR - -------------------------------- Edward Spear President, Chief Operating January 26, 2001 Officer and Director /s/ CLAUDIA N. DUNNE - -------------------------------- Claudia N. Dunne Director January 26, 2001
- -------------------------------- VADM E. A. Burkhalter USN (Ret.) Director January 26, 2001
- -------------------------------- Benjamin Kreiger Director January 26, 2001
/s/ JAY KAPLOWITZ - -------------------------------- Jay Kaplowitz Director January 26, 2001
- -------------------------------- James Bruno Director January 26, 2001
Dunn Computer Corporation d/b/a SteelCloud Company (a Virginia Corporation) Report of Ernst & Young LLP, Independent Auditors......................... Consolidated Balance Sheets as of October 31, 1999 and 2000............... Consolidated Statements of Operations for the three years in the period ended October 31, 2000.................................................. Consolidated Statements of Stockholders' Equity for the three years in the period ended October 31, 2000.................................... Consolidated Statements of Cash Flows for the three years in the period ended October 31, 2000.................................................. Notes to Consolidated Financial Statements................................
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors Dunn Computer Corporation d/b/a SteelCloud Company
We have audited the accompanying consolidated balance sheets of Dunn Computer Corporation d/b/a SteelCloud Company (a Virginia Corporation) as of October 31, 1999 and 2000, and the related consolidated statements of operations, stockholders' equity and cash flows for the three years in the period ended October 31, 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Dunn Computer Corporation d/b/a SteelCloud Company as of October 31, 1999 and 2000, and the consolidated results of its operations and its cash flows for the three years in the period ended October 31, 2000, in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
December 29, 2000 McLean, Virginia
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 1998, 1999 AND 2000
1. Organization
Dunn Computer Corporation was incorporated on July 27, 1987 under the laws of the Commonwealth of Virginia. On January 3, 1997, Dunn Computer Corporation, a Delaware corporation, was formed as a holding company for the stock of Dunn Computer Corporation, the Virginia corporation. On February 26, 1998, Dunn Computer Corporation was incorporated in Virginia in connection with the reorganization of Dunn Computer Corporation, the Delaware Corporation. The Company's subsidiaries are International Data Products ("IDP") acquired May 1998, STMS, Inc (STMS) acquired September 1997 and Puerto Rico Industrial Manufacturing Operations Acquisition Corporation, (PRIMO) which was incorporated in Puerto Rico on May 1, 1998. Unless the context otherwise requires, the "Company" or "SteelCloud" refers to Dunn Computer Corporation d/b/a SteelCloud, its predecessor and its subsidiaries.
On September 25, 2000 the Company began doing business as ("dba") SteelCloud Company. On October 19, 2000, the Company changed its NASDAQ ticker symbol from DNCC and began trading as SCLD.
The Company is engaged in the business of selling custom network appliances and computer systems along with computer training and maintenance service to businesses and government agencies. In addition, the Company provides Information Technology (IT) support and consulting services to certain government and commercial entities. The Company operates in a competitive environment subject to technological change and the emergence of new technologies, although the Company believes that its products and services are, or would be, upgradeable to new technologies.
2. Significant Accounting Policies
Use of Estimates
The preparation of the consolidated 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Cash and Cash Equivalents
The Company maintains demand deposits with several financial institutions. At times, deposits exceed federally insured limits, but management does not consider this a significant concentration of credit risk. The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents.
Investments
At October 31, 1999 and 2000, investments consisted of shares of common stock of a privately-held internet company, Worldwide Internet Solutions Network, Inc. ("WIZnet"), with a cost basis of approximately $150,000. The Company believes that this carrying amount represents the lower of cost or market. The Company is accounting for this investment using the cost method since the Company's investment represents less than 20% of the privately-held internet company's outstanding stock and the Company does not exert significant influence over WIZnet's operations.
Inventory
Inventory is stated at the lower of cost or market as determined by the first-in first-out (FIFO) method. The Company periodically evaluates its inventory obsolescence reserve to ensure inventory is recorded at net realizable value.
Impairment of Long-Lived Assets
Each year, management determines whether any property and equipment or any other assets have been impaired based on the criteria established in Statement of Financial Accounting Standards No. 121 (SFAS 121), "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of." During fiscal year 1999, management determined that goodwill associated with the purchase of IDP was impaired. Accordingly, the Company recorded an impairment charge of approximately $20.6 million (see Note 5). During fiscal 2000, the Company made no adjustments to the carrying values of the assets.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Goodwill and Other Intangible Assets
Goodwill and other intangibles represent the unamortized excess of the cost of acquiring subsidiary companies over the fair values of such companies' net tangible assets at the dates of acquisition. Goodwill related to the Company's acquisitions as described in Note 5 is being amortized on a straight-line basis over periods ranging from five to twenty years. Other intangibles, including contracts, are being amortized on a straight-line basis over a five year period.
Acquisition-Related Liabilities
During fiscal year 1998, the Company recorded $1,376,000 of acquisition-related liabilities in connection with the IDP Acquisition. These liabilities were recorded after certain actions had been identified, quantified and approved by management of the Company having authority to commit the Company to the plan. Those certain actions included closing the IDP facility in Maryland, integrating IDP and the Company's production, warehouse, sales, marketing and administrative functions, eliminating duplicative jobs and expanding space in the Company's office space in Virginia. During fiscal years 1998 and 1999, $232,000 and $894,000, respectively, of costs were charged against the liability. The acquisition-related liabilities remaining at October 31, 1999 and 2000 amounted to $250,000, consisting of severance payments to be made in future periods.
Stock Compensation
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation". SFAS 123 allows companies to account for stock-based compensation under either the new provisions of SFAS 123 or the provisions of Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees," but requires pro forma disclosure in the footnotes to the consolidated financial statements as if the measurement provisions of SFAS 123 had been adopted. The Company continues accounting for its stock-based compensation in accordance with the provisions of APB 25.
Revenue Recognition
The Company generally recognizes revenues from product sales at the time of shipment. Revenues are earned principally pursuant to various contracts with agencies of the Federal government and commercial customers. Service revenues are recognized over the contractual period as the services are provided. Revenues from operating leases are recognized over the contract term.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Revenue Recognition (continued)
The products sold are generally covered by a warranty for periods ranging from one to three years. The Company accrues a warranty reserve for revenues recognized during the year to record estimated costs to provide warranty services.
Unearned revenue also relates to cash received from credit card sales as of year end for which the related inventory was shipped subsequent to year end and advance payments on operating leases.
During the year ended October 31, 1998, 1999 and 2000, the Company had revenues from the Federal government, which represented 40%, 12%, and 27%, respectively, of total revenue. As of October 31, 1998, 1999 and 2000, accounts receivable from agencies of the Federal government represented 67%, 40%, and 56%, respectively. In addition, the Company had revenues from one commercial customer which represents 10% of fiscal year 2000 revenues.
Advertising Expenses
The Company expenses advertising costs as incurred. Advertising costs amounted to approximately $468,000, $130,000 and $41,000 during fiscal 1998, 1999, and 2000, respectively.
Income Taxes
The Company provides for income taxes in accordance with the liability method.
Supplemental Information of Non-Cash Investing and Financing Activities:
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Earnings Per Share
The Company follows the provisions of Statement of Financial Accounting Standards No. 128, Earnings Per Share ("SFAS 128") which requires the Company to present basic and fully diluted earnings per share. Basic earnings per share is based on the weighted average shares outstanding during the period. Diluted earnings per share increases the shares used in the basic net loss per share calculation by the dilutive effect of stock options, warrants and convertible preferred stock. For 1999 and 2000, the Company's common stock equivalent shares outstanding from stock options, warrants and convertible preferred stock are excluded from the diluted earnings per share calculation as their effect is antidilutive to net income (loss) to common stockholders before extraordinary items.
Financial Instruments and Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, investments and accounts receivable. The cash is held by high credit quality financial institutions. For accounts receivable, the Company performs ongoing credit evaluations of its customers' financial condition and generally does not require collateral. The Company maintains reserves for credit losses. The concentration of credit risk is mitigated by the diverse customer base and the amount of receivables due by the Federal government. The carrying amount of the receivables approximates their fair value.
Recent Pronouncements
In December 1999, the SEC Staff issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB 101"). SAB 101 provides guidance related to revenue recognition based on interpretations and practices followed by the SEC Staff. The Company must adopt the guidance in SAB 101 no later than the fiscal quarter ending October 31, 2001. SAB 101 requires companies to report any changes in revenue recognition as a result of adoption as a cumulative change in accounting principle with restatement of prior quarterly information. The adoption of SAB 101 is not expected to have a material impact on the Company's consolidated financial statements.
3. Property and Equipment and Equipment Lease
Property and equipment, including leasehold improvements, are stated at cost. Property and equipment are depreciated and amortized using the straight-line method over the estimated useful lives ranging from three to seven years. Leasehold improvements are amortized over the lesser of the related lease term or the useful life.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. Property and Equipment and Equipment Lease (continued)
Property and equipment consisted of the following:
The Company owns equipment that is currently at customer sites under operating lease agreements (See Note 2 Revenue Recognition). The cost of the equipment was $6,345,508 and $6,821,801 at October 31, 2000 and 1999, respectively. The related accumulated depreciation on the equipment was $4,901,804 and $2,915,790 at October 31, 2000 and 1999, respectively.
4. Goodwill and Other Intangible Assets
Goodwill and other intangible assets were comprised of:
See discussion of goodwill impairment recorded during fiscal 1999 in Note 5.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. Acquisitions
STMS
On September 12, 1997, the Company acquired all of the outstanding stock of STMS, Inc., a Virginia corporation ("STMS"), for 150,000 shares of the Company's common stock, options to purchase 25,000 shares of the Company's common stock, and $1,044,500 in cash used specifically to repay certain debt of STMS. The transaction was accounted for using the purchase method. The 150,000 shares of common stock were valued at the market price of Company's common stock or $975,000 on the date of the transaction. The options to purchase 25,000 shares of common stock were issued to a stockholder/creditor of STMS and were valued at fair value of $84,000 using the Black-Scholes option-pricing model. The purchase price was allocated to the assets and liabilities acquired based on their estimated fair values. In conjunction with the acquisition, the Company recorded goodwill in the amount of $2,397,287 and other intangible assets (contracts) in the amount of $600,000. The operations of STMS are included in the consolidated financial statements of the Company beginning September 12, 1997 (date of acquisition).
The Company granted options to purchase an aggregate of 1,330,000 shares of the Company's common stock, at an exercise price equivalent to its fair market value at the date of grant, to the former stockholders of STMS in conjunction with their three-year employment agreements. The options vest over a three-year period. Certain of these options were repriced during fiscal 1999 in accordance with the employment agreements (see Note 10).
During February 1998, the Company repurchased an aggregate of 50,000 shares of common stock and the option to purchase 25,000 shares of common stock originally issued in connection with the STMS acquisition (see Note 10).
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. Acquisitions (continued)
IDP and PRIMO
On May 1, 1998, the Company acquired all of the outstanding stock of IDP and substantially all of the net assets of PRIMO for $14.9 million in cash and 750,000 shares of common stock of the Company, both subject to adjustment in the event that the combined net assets of IDP and PRIMO fell below a certain level stipulated in the Acquisition Agreement (See Note 10). The transaction was accounted for using the purchase method. The 750,000 shares of common stock were valued at the market price of the Company's common stock ($8.50 per share) on the date of the transaction. The purchase price was preliminarily allocated to the assets and liabilities acquired based on their estimated fair values. In conjunction with the acquisition, the Company recorded goodwill (as adjusted) in the amount of $22,453,929. The operations of IDP, including PRIMO, are included in the consolidated financial statements of the Company beginning May 1, 1998 (date of acquisition).
In connection with the IDP acquisition, two of the IDP sellers entered into employment agreements with the Company pursuant to which they each received options to purchase 300,000 shares of the Company's common stock. The grant price of the options was equivalent to the fair market value of the underlying common stock on the grant date and the options vested immediately.
During November 1998, the Company entered into an Employment Agreement Termination Agreement and a Purchase Price Adjustment Agreement with the two former stockholders of IDP whereby employment of the former stockholders of IDP was terminated and the former IDP stockholders agreed to return 350,000 shares of the Company's common stock originally issued in connection with the IDP Acquisition. See Note 10 for additional information.
The selected unaudited pro forma information for the year ended October 31, 1998 includes the operating results of the Company as if the Company acquired STMS, IDP, and PRIMO on November 1, 1997.
Year Ended October 31, -------------- -------------- (Unaudited)
Pro Forma net revenues $110,310,000 Pro Forma net income (loss) $ (6,768,000) Pro Forma earnings per share (0.75) Pro Forma earnings per share assuming dilution (0.75) Pro Forma weighted average shares outstanding 8,981,000 Pro Forma weighted average shares outstanding assuming dilution 8,981,000
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. Acquisitions (continued)
IDP and PRIMO (continued)
Impairment of Goodwill
Statement of Financial Accounting Standards No. 121 (SFAS 121) "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.
In May 1999, the U.S. Government determined not to exercise the remaining option years on one of the Company's significant contracts. This contract was a significant component of the Company's acquisition of IDP. The Company anticipated that the contract would have generated future revenues of approximately $65 million had all option years been renewed. The former IDP operations have been substantially curtailed as a result of this contract loss. In addition, significant future business is not expected from IDP operations as the majority of its sales force has separated from the Company.
The Company determined that these factors indicated that the carrying amount of goodwill associated with the IDP and PRIMO acquisition may not be recoverable. The Company performed an analysis of the goodwill in accordance with SFAS 121 and determined that the fair value of the remaining goodwill (estimated using the present value of expected future cash flows) was approximately $1.1 million at the time of the analysis. Accordingly, the Company recorded an impairment charge of approximately $20.6 million during fiscal year 1999.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. Bank Lines of Credit and Notes Payable
IDP Line of Credit
In conjunction with the purchase of IDP, the Company assumed a credit facility of $25,000,000 secured by inventory and accounts receivable of IDP. The outstanding balance on this line of credit at October 31, 1999 was approximately $4,622,000. The interest rate applicable to this line of credit as of October 31, 1999 was 8.05%.
On November 8, 1999, the Company executed an agreement with the financial institution to terminate this facility. Under the terms of the agreement, the Company repaid approximately $3.0 million of the principal outstanding at October 31, 1999 prior to December 31, 1999. In addition, outstanding principal totaling approximately $832,000 was converted to a term note bearing interest at the prime rate (9.5% at October 31, 2000) and maturing in January 2002. The outstanding balance on this term note at October 31, 2000 was approximately $519,000. The remaining amount of approximately $750,000 was forgiven by the financial institution and has been reflected as an extraordinary gain on early extinguishment of debt in fiscal year 2000.
Operating Line of Credit
In May 1999, the Company entered into a line of credit agreement with a bank that was subsequently amended in February 2000. The amended agreement allows the Company to borrow an amount limited to the minimum of its borrowing base or $5,000,000. As of October 31, 1999 and 2000, the Company's borrowing base, which is based on certain percentages of total accounts receivable less overdue accounts, was approximately $2.5 million and $3.2 million, respectively. Outstanding borrowings bear interest at the prime rate plus 1%.
As of October 31, 1999 and 2000, the Company had borrowed approximately $2.3 million and $2.5 million, respectively, against this line of credit facility and had an unused borrowing capacity of approximately $200,000 and $600,000, respectively. The Company pays a commitment fee based on the unused borrowings under the line of credit facility. The line of credit is secured by all assets of the Company and its subsidiaries. The amended line of credit expired on November 30, 2000. On November 10, 2000, the Company amended the line of credit whereby the maximum availability was reduced to $3.5 million, the interest rate remained unchanged and the line of credit expires on November 30, 2001. The Company has classified this line of credit as long term based on the amended maturity date.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. Bank Lines of Credit and Notes Payable (continued)
Operating Line of Credit (continued)
Notes payable consisted of the following:
Principal payments on the long-term debt for each of the fiscal years from 2001 to 2002 are due as follows:
Year ended October 31, ------------------ 2001 431,597 2002 115,290 ------------------- Total $546,887 ===================
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. Bank Lines of Credit and Notes Payable (continued)
Receivable Financing Program
In December 1999, the Company entered a Short Term Accounts Receivable Financing Program with one of its vendors. Under the terms of the program, the vendor extended credit to the Company for specific pre-approved sales orders in exchange for the assignment of the associated receivable once the product was delivered to the customer. During fiscal 2000, the Company assigned approximately $1.56 million of specific receivables under the program. As of October 31, 2000, uncollectible receivables assigned under this agreement were approximately $112,000. Interest expense for fiscal 2000 related to the receivables assigned was approximately $9,000.
7. Related Party Transaction
Thomas Dunne, the Company's President, and his wife, Claudia Dunne, the Company's Vice President, acquired a building for the purpose of leasing office space to the Company. In June 1999, the building was sold by Mr. and Mrs. Dunne and the lease was assigned to the new owner, an unaffiliated third party.
8. Commitments
Operating Leases
The Company leased office space under a noncancelable operating lease agreement with two stockholders (see Note 7). In June 1999, the two stockholders sold the building and assigned the lease to the new owner, an unaffiliated third party, under the same terms. The lease agreement was renewed in October 1999 for an additional five years under the renewal option within the original lease. Additionally, the Company leases various office equipment and other office space under non-cancelable operating leases. Rent expense under these leases was approximately $499,100, $321,000 and $330,147 for the years ended October 31, 1998, 1999, and 2000, respectively.
Future minimum lease payments under noncancelable operating leases, including the leases assumed in the STMS and IDP acquisitions, at October 31, 2000 are as follows:
2001 668,265 2002 686,804 2003 628,546 2004 401,259 2005 91,554 ------------------ Total $2,476,428 ==================
The Company will receive $1,151,370 in aggregate sublease income through fiscal 2003.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. Employment Agreements
The Company has an employment agreement with Thomas P. Dunne. The agreement for Mr. Dunne has a term of three years commencing April 1997 and automatically renews for additional one year terms unless terminated by either the Company or the employee.
All other employment agreements the company had with certain key executives expired in September 2000.
10. Stockholders' Equity
Equity Transactions
On April 21, 1997, the Company sold 1,000,000 shares of common stock in an initial public offering for net proceeds of $3,917,664. In connection with the offering, warrants were issued to the underwriter for 100,000 shares of common stock at an exercise price of $6.00 per share. Beginning April 21, 1998, the warrants are exercisable for a period of four years.
During February 1998, the Company repurchased 50,000 shares of its common stock held by former stockholders of STMS. The shares were repurchased at the current market price of $9.15 per share. The Company accounted for the repurchase as a treasury stock transaction. The Company also repurchased options to purchase 25,000 shares of the Company's common stock that were originally issued in connection with the STMS acquisition. The repurchase price of $75,750 represents the difference between the fair market value of the underlying common stock on the repurchase date and the grant price multiplied by the 25,000 options. The Company accounted for the repurchase as a reduction of additional paid-in capital.
The IDP Acquisition Agreement provided for an adjustment of the purchase price if the combined net worth of IDP and PRIMO exceeded or was below a specified level. Since the net worth on the closing balance sheet of IDP and PRIMO was below the specified level, the Company and the former IDP stockholders agreed to adjust the purchase price. In November 1998, the Company entered into a Purchase Price Adjustment Agreement with the two former stockholders of IDP whereby 350,000 shares of the Company's common stock originally issued in connection with the IDP acquisition were returned to the Company. The Company accounted for the return as a treasury stock transaction and valued such shares at the fair market value of the Company's common stock on the date of acquisition. In connection with the transaction, the Company and the two former stockholders also agreed to cancel the employment agreements in exchange for payments totaling $500,000, for which the Company recorded an adjustment to its purchase price allocation. In addition, the Company agreed and paid the balance of the notes payable to related parties of $905,960 in full by November 25, 1998. The two former stockholders retained their options to purchase the Company's common stock subject to all original terms and conditions. (See Note 5)
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Stockholders' Equity
Equity Transactions
In connection with the acquisitions of IDP and PRIMO, the Company completed a public offering of 3,491,493 shares of common stock for net proceeds of $26,287,866.
On March 3, 2000, the Company executed a settlement for a judgment in favor of a former employee relating to an employment contract. Under the terms of the settlement, the Company paid $1 million and issued 225,000 shares of its common stock to the former employee.
On March 13, 2000, the Company sold 3,000 shares of its Series A Convertible Preferred Stock in a private placement, which is exempt from registration provided by Regulation D Rule 506 promulgated by the Securities and Exchange Commission under the Securities Act of 1933, as amended. The Company received net proceeds of approximately $2.7 million, which was used to fund current and future operations.
In addition, the Company issued warrants to the preferred investor and broker of the transaction in the amount of 247,525 and 75,000 to purchase shares of the Company's common stock at $3.64 and $4.57 per share, respectively.
The holders of the preferred shares are entitled to cumulative dividends of 5% of the liquidation preference of $1,000 per share plus accrued but unpaid dividends whether or not declared. In October 2000, 150 shares of preferred stock plus accrued dividends were converted into common stock. As of October 31, 2000 there were approximately $91,000 in accrued and unpaid dividends. Each holder of preferred shares is entitled to voting rights equal to the number of shares of common stock into which such preferred shares are convertible.
The Series A Convertible Preferred Stock are convertible at the shareholders option into common stock at the price equal to the lesser of 85% of the average of the three lowest closing bid prices of the common stock for the 25 days prior to the conversion date or $3.64. The Company recorded a non-cash deemed dividend of $529,411 for the beneficial conversion feature. The transaction was reported as "Dividend to Preferred Stockholders" on the Company's 2000 Consolidated Statement of Operations.
Stock Options
On January 6, 1997, the Company adopted the 1997 Stock Option Plan (the Option Plan) which permits the Company to grant up to 600,000 options to officers, directors and employees who contribute materially to the success of the Company. In September 1997, the Company increased the number of options available for grant under the plan to 2,200,000. In June 1999, the Company increased the number of options available for grant under the plan to 2,500,000. Stock options are generally granted at prices which the Company's Board of Directors believes approximates the fair market value of its common stock at the date of grant. The options vest ratably over a stated period of time not to exceed four years. The contractual term of the options is five years.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Stockholders' Equity (continued)
Stock Options (continued)
Common stock option activity was as follows:
The total options outstanding include 600,000 options granted to the former IDP stockholders that are not included in the Option Plan.
As of October 31, 2000, there were 658,067 options available for future grants under the Option Plan.
During fiscal 1999, the Company repriced approximately 750,000 stock options granted to certain executives in accordance with their employment agreements. No compensation expense was recognized as the exercise price for the repriced options was at or above fair market value of the underlying stock at the end of each reporting period subsequent to June 30, 2000.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Stockholders' Equity (continued)
Stock Options (continued)
The following table summarizes information about fixed-price stock options outstanding at October 31, 2000:
Had compensation expense related to the stock options been determined based on the fair value at the grant date for options granted during the years ended October 31, 1998, 1999, and 2000 consistent with the provisions of SFAS 123, the Company's net income and earnings per share would have been as follows:
The effect of applying SFAS 123 on pro forma net income as stated above is not necessarily representative of the effects on reported net income for future years due to, among other things, the vesting period of the stock options and the fair value of additional options in the future years.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing fair value model with the following weighted- average assumptions used for grants in 1998, 1999 and 2000: dividend yield of 0%, expected volatility of 84%, 86% and 159% respectively; risk-free interest rates of 5.50%, 6.70% and 6.01% respectively; and expected life of the option term of five years. The weighted average fair values of the options granted in 1998, 1999 and 2000 with a stock price equal to the exercise price is $5.21, $2.02 and $1.26 respectively. The weighted average fair value of options granted in 1998 with a stock price greater than the exercise price is $7.36.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
Components of the Company's net deferred tax asset balance are as follows:
As of October 31, 2000, the Company had approximately $12.5 million in net operating loss carryforwards which expire between 2012 and 2020. Approximately $4.5 million of those net operating loss carryforwards relate to STMS and IDP and may be significantly limited under Section 382 of the Internal Revenue Service Code and the SRLY rules. The Company has recorded a valuation allowance for a portion of the deferred tax assets because realizability of those assets is uncertain.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. Income Taxes (continued)
The components of the provision for income taxes are as follows:
The reconciliation of income tax from the Federal statutory rate of 34% is:
In September 1997 and in May 1998, respectively, the Company acquired the stock of STMS and IDP in tax-free exchanges. The stock acquisitions were accounted for using the purchase method. Included in the Company's deferred tax assets at October 31, 2000 is approximately $3.8 million representing the differences between the assigned values and tax bases of the assets and liabilities acquired, as well as net operating loss carry forwards acquired. These deferred tax assets were fully reserved at the dates of acquisition. To the extent these deferred tax assets are subsequently realized, the resulting tax benefit will be applied to reduce goodwill recorded in connection with the acquisitions and there will be no impact on income tax expense.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. Retirement Plans
401(k) Plans
Effective April 1, 1995, the Company adopted a 401(k) plan (the "Former Plan"). Employees are eligible to participate after completing six months of services and attaining age 18. Employees can defer up to 15% of compensation. Employee contributions are subject to Internal Revenue Service limitations. All employees who contributed to the Former Plan are eligible to share in discretionary Company matching contributions. During the years ended October 31, 1998, 1999 and 2000, the Company did not contribute to the Former Plan.
In connection with the IDP Acquisition, the Company assumed IDP's tax-deferred savings plan under Section 401(k) of the Internal Revenue Code which is offered to all employees who have attained the age of 21. The plan provides for contributions by employees as well as matching and discretionary contributions by the Company. The Company made contributions of approximately $123,000 during the period from May 1, 1998 through October 31, 1998.
Effective May 1, 1999 the Company amended and terminated the existing plans. Simultaneous to the termination, the Company adopted a new 401(k) (the "Plan") for all current employees. Under the Plan, employees are eligible to participate after completing 90 days of service and attaining the age of 18. Employees can defer up to 15% of compensation. Employee contributions are subject to Internal Revenue Service limitations. All employees who contributed to the Plan are eligible to share in discretionary Company matching contributions. Company contributions vest over 5 years. In fiscal 2000, the Company contributed approximately $18,000 to the participants of the 401(k).
Defined Benefit Plan
The Company has a defined benefit plan (the "Pension Plan") covering substantially all salaried employees. The Pension Plan benefits are based on years of service and the employee's compensation. The Company's funding policy is to annually contribute amounts sufficient to meet minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974 ("ERISA"). Contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. The assets of the Pension Plan are invested in money market and corporate debt and equity instruments. The Company contributed approximately $63,777 for the Pension Plan year ending October 31, 1997. The Company has accrued, but not yet paid, approximately $19,000, which amount represents its minimum funding requirements under ERISA for fiscal years 1998, 1999 and 2000.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. Retirement Plans (continued)
Defined Benefit Plan (continued)
On January 6, 1997, the Company amended the Pension Plan to change the benefits to be paid out after retirement from 100% to 40% of its initial liability. This resulted in a reduction of the projected benefit obligation by approximately $150,000.
On October 31, 1999, the Company amended and terminated the Defined Benefit Plan. Under the termination, no additional benefits accrued to participants in the Plan after that date. In addition, all existing participants in the Plan became 100% vested in their accrued benefits in the Plan as of that date. No gain or loss was recognized as a result of the termination of the Pension Plan. The Company began to distribute the vested benefits to the participants in fiscal year 2000 and will complete the distributions is fiscal 2001.
The following table sets forth the Pension Plan's funded status as reported on activity, and amounts recognized in the Company's consolidated financial statements:
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. Retirement Plans (continued)
Defined Benefit Plan (continued)
Key assumptions used in the actuarial valuation were:
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. Contingencies
IDP Acquisition
On July 31, 1998 the Company received notice from the SBA that it was denying the request of the U.S. Air Force to waive the requirement to terminate IDP's Desktop V contract for the convenience of the Government upon the change in control of IDP to the Company. The Company appealed the denial by the SBA to the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the appeal and ruled that the U.S. Air Force must terminate-for-convenience the Desktop V contract. Under a termination-for-convenience, the Government shall reimburse the Company for all costs incurred in the performance of the contract. The Company expects to recover from the Government a portion or all of its unreimbursed costs. The Company is currently in negotiations with the Government regarding this matter.
Professional Services Malpractice Claim
In August of 2000, the Company's former legal counsel filed a claim against the Company for approximately $343,087 plus accrued interest for legal fees and costs. In response to the claim, the Company filed a counter claim for professional malpractice and breach of fiduciary duty in the amount of $1,568,000. The matter is currently in litigation. An outcome for this matter cannot be predicted. The Company has accrued amounts for this potential liability in the financial statements.
Microsoft Licensing Agreement
In November 1998, IDP entered into a Government Integrator Agreement, as amended, with Microsoft Corporation (Microsoft) for the licensing of certain Microsoft software. During 1999, Microsoft asserted that IDP owed approximately $800,000 under this due primarily to amended billing by Microsoft concerning sales by IDP to the U.S. Air Force in conjunction with the Desktop V contract. On October 31, 2000, Microsoft filed suit against the Company for breach of contract. In conjunction with the filing of the claim, Microsoft further amended the original billings, which resulted in a claim against the Company of approximately $1.3 million. Subsequent to October 31, 2000, the Company submitted a motion to dismiss the case and filed a counterclaim of fraud on behalf of IDP in the amount of $500,000. The Company believes that it has meritorious defenses to the claim and intends to vigorously defend itself. The Company cannot estimate at this time the amount of the liability to be incurred, if any. In the event the Company is not successful in its defense and a judgment is entered on behalf of Microsoft for the full amount sought, the payment would have a material adverse effect upon the Company's financial position and results of operations. The Company has accrued for amounts due Microsoft based on the original billing terms.
Trademark Infringement
On October 19, 2000, the Company received a cease and desist letter from LoudCloud, Inc. alleging that the use of the "SteelCloud" mark and name would constitute an infringement of LoudCloud's rights to its "LoudCloud" mark and name and family of "Cloud" marks, that use of "SteelCloud" would dilute the distinctiveness and fame of the LoudCloud mark and name and, that such acts by the Company violated federal and state law regarding unfair competition. In response, the Company filed a declaratory judgment action in the U.S. District Court for the Eastern District of Virginia, seeking a judicial determination that its use of the "SteelCloud" mark and name would not violate the proprietary rights of LoudCloud nor dilute the alleged fame and distinctiveness of the "LoudCloud" mark and name. In this action, the Company also alleged a new claim that LoudCloud, Inc. has violated federal law through its misuse of the trademark provisions under the Lanham Act as amended in 1988. A hearing has been held on the LoudCloud motion to dismiss and the court has taken the matter under advisement. On January 10, 2001, the U.S. District Court for the Eastern District of Virginia dismissed the case. The Company has appealed such decision. The Company cannot estimate at this time the amount of the liability to be incurred, if any, but does not believe that this matter will have a material adverse effect upon the Company's financial position or results of operations.
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. Quarterly Financial Information (unaudited)
Quarterly financial information for fiscal 2000 and 1999 is presented in the following tables:
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors Dunn Computer Corporation d/b/a SteelCloud Company
We have audited the consolidated financial statements of Dunn Computer Corporation d/b/a SteelCloud Company (a Virginia corporation) as of October 31, 1999 and 2000, and for each of the three years in the period ended October 31, 2000 and have issued our report thereon dated December 29, 2000 (included elsewhere in this Form 10-K). Our audits also included the consolidated financial statement schedule listed in Item 14 of this Form 10-K. The schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits.
In our opinion, the consolidated financial statement schedule referred to above, when considered in relation to the basic consolidated financial statements taken as a whole presents fairly, in all material respects, the information set forth herein.
/s/ Ernst & Young LLP
McLean, Virginia December 29, 2000
S-1
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
DUNN COMPUTER CORPORATION D/B/A STEELCLOUD COMPANY
- -----------
(1) Write-offs of accounts receivable
(2) Write-offs of inventory
S-2