Annual Report — [x] Reg. S-K Item 405 — Form 10-K
Filing Table of Contents
Document/Exhibit Description Pages Size
1: 10-K405 Annualreport 51 259K
2: EX-23.1 Consentofernst & Young LLP, Independent Auditors 1 5K
3: EX-23.2 Consentofernst & Young LLP, Independent Auditors 1 5K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended October 31, 2000
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ________________
Commission file number 0-24015
DUNN COMPUTER CORPORATION
D/B/A STEELCLOUD COMPANY
(Exact name of registrant as specified in its charter)
Commonwealth of Virginia 54-1890464
------------------------ ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1306 Squire Court
Dulles, Virginia 20166
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(Address of principal executive offices) (Zip Code)
(703) 450-0400
--------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Exchange Act
Title of each class Name of exchange on which registered
------------------- ------------------------------------
None.
Securities registered pursuant to Section 12(g) of the Act:
Title of each class Name of exchange on which registered
------------------- ------------------------------------
Common Stock, $.001 par value per share Nasdaq National Market System
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if there is disclosure of delinquent filers in
response to Item 405 of Regulation S-K contained herein and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. |X|
The aggregate market value of the voting stock held by non-affiliates
of the issuer as of January 18, 2001 was $9,926,167.
ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS
Indicate by check mark whether the registrant has filed all documents
and reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes |_| No |_|
APPLICABLE ONLY TO CORPORATE REGISTRANTS
The number of shares outstanding of the registrant's Common Stock,
$.001 par value per share, on January 18, 2001 was 9,806,962.
Documents incorporated by reference: None
DUNN COMPUTER CORPORATION
d/b/a SteelCloud Company
2000 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Page Number
Item 1. Description of Business 2
Item 2. Description of Properties 6
Item 3. Legal Proceedings 7
Item 4. Submission of Matters to a Vote of Security Holders 7
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters 8
Item 6. Selected Financial Data 10
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 11
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 14
Item 8. Financial Statements and Supplementary Data 14
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures 14
PART III
Item 10. Directors and Executive Officers of the Registrant 14
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
(Part III information is incorporated by reference to portions of
the Company's definitive Proxy Statement to be filed pursuant to
Regulation 14A)
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 15
Signatures 18
1
PART I
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.
2
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.
3
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
4
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.
5
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. 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.
6
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. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
7
PART II
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.
1999
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
2000
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
2001
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.
8
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.
9
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.
[Enlarge/Download Table]
Year ended October 31,
1996 1997(2) 1998(3) 1999 2000
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Consolidated Statement of Operations Data:
Net revenues ...................................................... $ 18,099 $ 21,766 $ 66,888 $ 34,475 $ 39,766
Costs of revenues ................................................. 14,103 17,549 54,969 27,981 32,636
Gross profit ...................................................... 3,996 4,217 11,919 6,494 7,130
Selling, general and administrative ............................... 1,972 2,198 9,983 37,749 6,716
Income (loss) from operations ..................................... 2,024 2,019 1,936 (31,255) 414
Other (expense) income ............................................ (9) 98 (270) (2,911) (298)
Net income (loss) before income taxes ............................. 2,015 2,117 1,666 (34,166) 116
Provision for (benefit from) income taxes ......................... 776 795 686 (559) (65)
Net income before extraordinary gain .............................. $ 1,239 $ 1,322 $ 980 $(33,607) 51
Extraordinary gain ................................................ -- -- -- -- 750
Dividends ......................................................... -- -- -- -- (625)
Net income (loss) to common stockholders .......................... $ 1,239 $ 1,322 $ 980 $(33,607) $ 176
Earnings (loss) per share(1) ...................................... $ 0.31 $ 0.29 $ 0.14 $ (3.57) $ 0.02
Earning (loss) per share assuming dilution(1) ..................... $ 0.31 $ 0.28 $ 0.13 $ (3.57) $ 0.02
Weighted average shares outstanding(1) ............................ 4,000 4,552 7,231 9,404 9,581
Weighted average shares outstanding assuming dilution(1) .......... 4,000 4,679 7,492 9,404 9,581
At October 31,
1996 1997 1998 1999 2000
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Consolidated Balance Sheet Data:
Working capital ................................................... $ 1,722 $ 4,339 $ 5,773 $ (1,422) $ 5,733
Total assets ...................................................... 5,275 18,703 62,965 22,287 23,005
Long-term debt .................................................... 75 51 2,845 2,598
Total liabilities ................................................. 3,335 10,465 24,592 17,470 14,149
Stockholders' equity .............................................. 1,939 8,238 38,373 4,817 8,856
----------
(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).
10
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.
11
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.
[Enlarge/Download Table]
1996 1997 1998 1999 2000
-------- -------- -------- -------- --------
Net Revenues ...................................................... 100.00% 100.00% 100.00% 100.00% 100.00%
Costs of revenues ................................................. 77.92% 80.63% 82.18% 81.16% 82.07%
Gross profit ...................................................... 22.08% 19.37% 17.82% 18.84% 17.93%
Selling, general and administrative ............................... 10.90% 10.10% 14.92% 109.50% 16.88%
Income (loss) from operations ..................................... 11.18% 9.27% 2.90% -90.66% 1.04%
Other (expense) income ............................................ -0.05% 0.45% -0.40% -8.44% 0.75%
Net income (loss) before income taxes ............................. 11.13% 9.72% 2.50% -99.10% 0.29%
Provision for (benefit from) income taxes ......................... 4.28% 3.65% 1.03% -1.62% 0.16%
Net income (loss) ................................................. 6.85% 6.07% 1.47% -97.48% 0.44%
Fiscal Year Ended October 31, 2000 Compared to Fiscal Year Ended October 31,
1999
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.
12
Fiscal Year Ended October 31, 1999 Compared to Fiscal Year Ended October 31,
1998
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.
13
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. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
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 ........................ F-1
Consolidated Balance Sheets .............................................. F-2
Consolidated Statements of Operations .................................... F-3
Consolidated Statements of Stockholders' Equity .......................... F-4
Consolidated Statements of Cash Flows .................................... F-5
Notes to the Consolidated Financial Statements ........................... F-6
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
(directors and executive officers of the Company), Item 11 (Executive
Compensation), Item 12 (security ownership of certain beneficial owners and
management), and Item 13 (certain relationships and related transactions).
14
PART IV
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,
15
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.)
16
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.
17
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
18
Index to Financial Statements
Dunn Computer Corporation d/b/a SteelCloud Company (a Virginia Corporation)
Report of Ernst & Young LLP, Independent Auditors......................... F-1
Consolidated Balance Sheets as of October 31, 1999 and 2000............... F-2
Consolidated Statements of Operations for the three years in the period
ended October 31, 2000.................................................. F-3
Consolidated Statements of Stockholders' Equity for the three years
in the period ended October 31, 2000.................................... F-4
Consolidated Statements of Cash Flows for the three years in the period
ended October 31, 2000.................................................. F-5
Notes to Consolidated Financial Statements................................ F-6
19
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
F-1
DUNN COMPUTER CORPORATION
D/B/A STEELCLOUD COMPANY
CONSOLIDATED BALANCE SHEETS
[Enlarge/Download Table]
OCTOBER 31,
-------------------------------------
1999 2000
-------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 655,450 $ 363,958
Accounts receivable, net of allowance for doubtful
accounts of $100,000 as of October 31, 1999 and 2000,
respectively 5,063,041 10,851,270
Inventory, net 5,497,634 4,318,936
Deferred tax asset 1,282,695 1,326,745
Income tax receivable 585,769 230,681
Prepaid expenses and other current assets 118,594 191,897
-------------------------------------
Total current assets 13,203,183 17,283,487
Property and equipment, net 1,323,696 819,798
Equipment on lease, net 3,906,011 1,443,704
Goodwill and other intangible assets, net 3,559,005 3,164,789
Investments 150,000 150,000
Other assets 145,121 143,193
-------------------------------------
Total assets $ 22,287,016 $ 23,004,971
=====================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,822,979 $ 7,886,342
Accrued expenses 2,515,653 2,753,361
Accrued litigation costs 2,000,000 343,087
Line of credit 3,790,705 -
Notes payable, current portion 324,933 431,597
Unearned revenue 1,170,417 135,690
-------------------------------------
Total current liabilities 14,624,687 11,550,077
Notes payable, long-term portion 545,250 115,290
Line of credit, long term 2,300,000 2,483,203
Stockholders' equity:
Preferred stock $.001 par value; 2,000,000 shares
authorized, 3,000 shares issued and 2,850 outstanding;
aggregate liquidation preference of $2,945,417 - 3
Common stock, $.001 par value; 20,000,000 shares
authorized, 9,419,509 and 9,806,962 shares issued
and outstanding at October 31, 1999 and 2000, respectively 9,420 9,807
Additional paid-in capital 37,721,749 41,584,844
Treasury stock, 400,000 shares at October 31, 1999 and 2000,
respectively (3,432,500) (3,432,500)
Accumulated deficit (29,481,590) (29,305,753)
-------------------------------------
Total stockholders' equity 4,817,079 8,856,401
-------------------------------------
Total liabilities and stockholders' equity $ 22,287,016 $ 23,004,971
=====================================
See accompanying notes.
F-2
DUNN COMPUTER CORPORATION
D/B/A STEELCLOUD COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
[Enlarge/Download Table]
YEARS ENDED OCTOBER 31,
---------------------------------------------------------
1998 1999 2000
---------------------------------------------------------
Net revenues $ 66,888,478 $ 34,475,297 $ 39,766,393
Costs of revenues 54,969,061 27,981,691 32,636,410
---------------------------------------------------------
Gross profit 11,919,417 6,493,606 7,129,983
Selling and marketing 3,671,765 2,311,091 1,035,698
General and administrative 5,201,745 14,112,227 5,285,767
Amortization of goodwill and other
intangible assets 544,687 675,743 394,216
Acquisition integration costs 564,776 - -
Impairment of goodwill - 20,649,335 -
---------------------------------------------------------
Income (loss) from operations 1,936,444 (31,254,790) 414,302
Other income (expense):
Interest income 104,606 27,998 34,276
Interest expense (494,504) (962,004) (654,329)
Settlement of litigation - (2,000,000) -
Gain on sale of assets - 193,516 228,062
Other, net 119,375 (170,621) 93,354
---------------------------------------------------------
Net income (loss) before income taxes and
extraordinary gain 1,665,921 (34,165,901) 115,665
Provision for (benefit from) income taxes 686,000 (558,756) 65,000
---------------------------------------------------------
Net income (loss) before extraordinary gain 979,921 (33,607,145) 50,665
Extraordinary gain - early extinguishment of debt - - 750,000
---------------------------------------------------------
Net income (loss) before dividends $ 979,921 $(33,607,145) $ 800,665
Dividends to preferred stockholders - - 624,828
---------------------------------------------------------
Net income (loss) attributable to common
stockholders $ 979,921 $(33,607,145) $ 175,837
=========================================================
Earnings (loss) per share, basic:
Earnings (loss) before extraordinary gain $ 0.14 $ (3.57) $ (.06)
Extraordinary gain - - .08
---------------------------------------------------------
Net earnings (loss) per share $ 0.14 $ (3.57) $ .02
=========================================================
Earnings (loss) per share, assuming dilution:
Earnings (loss) before extraordinary gain $ 0.13 $ (3.57) $ (.06)
Extraordinary gain - - .08
---------------------------------------------------------
Net earnings (loss) per share $ 0.13 $ (3.57) $ .02
=========================================================
See accompanying notes.
F-3
DUNN COMPUTER CORPORATION
D/B/A STEELCLOUD COMPANY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
[Enlarge/Download Table]
Retained
Preferred Stock Common Stock Additional Earnings
---------------------------------------- Paid-In Treasury (Accumulated
Shares Amount Shares Amount Capital Stock Deficit) Total
---------------------------------------------------------------------------------------------
Balance at October 31, 1997 5,150,000 5,150 5,087,371 - 3,145,634 8,238,155
Repurchase of common stock
originally issued in the
acquisition of STMS - - - (457,500) - (457,500)
Repurchase of stock option
originally issued in the - - (75,750) - - (75,750)
acquisition of STMS
Issuance of common stock,
net of offering expenses
of $1,330,229 3,491,493 3,492 26,284,374 - - 26,287,866
Issuance of stock related to
acquisitions of IDP and PRIMO 750,000 750 6,374,250 - - 6,375,000
Return of common stock
originally issued in the
acquisitions of IDP and PRIMO - - - (2,975,000) - (2,975,000)
Net income - - - - 979,921 979,921
---------------------------------------------------------------------------------------------
Balance at October 31, 1998 9,391,493 9,392 37,670,245 (3,432,500) 4,125,555 38,372,692
Issuance of common stock under
employee stock purchase plan 28,016 28 51,504 - - 51,532
Net loss - - - - (33,607,145) (33,607,145)
---------------------------------------------------------------------------------------------
Balance at October 31, 1999 9,419,509 $9,420 $37,721,749 $(3,432,500) $(29,481,590) $4,817,079
Issuance of Common Stock in
connection with exercise of
employee incentive stock
option plan - - 4,900 5 15,308 - - 15,313
Issuance of Series A Convertible
Preferred Stock 3,000 3 - - 2,716,711 - - 2,716,714
Issuance of Common Stock - - 225,000 225 597,420 - - 597,645
Paid in Capital and Deemed - - - - 529,411 - (529,411) -
Dividend on Preferred Stock
Conversion of Series A Convertible
Preferred Stock (150) - 153,150 153 (153) - -
Conversion of Preferred Stock
dividends to shares of
Common Stock - - 4,403 4 4,398 - - 4,402
Dividend Declared on Series A (95,417) (95,417)
Convertible Preferred Stock
Net Income - - - - - - 800,665 800,665
---------------------------------------------------------------------------------------------
Balance at October 31, 2000 2,850 $3 9,806,962 $9,807 $41,584,844 $(3,432,500) $(29,305,753) $8,856,401
==============================================================================================
See accompanying notes.
F-4
DUNN COMPUTER CORPORATION
D/B/A STEELCLOUD COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
[Enlarge/Download Table]
YEARS ENDED OCTOBER 31,
----------------------------------------------------
1998 1999 2000
----------------------------------------------------
Operating activities
Net income (loss) $ 979,921 $(33,607,145) $ 800,665
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization of property and equipment 1,139,210 2,779,926 2,841,210
Amortization of goodwill and other intangibles 544,687 675,743 394,216
Impairment of goodwill - 20,649,335
Gain on sale of assets - (193,516) (228,062)
Gain on settlement of legal litigation - - (495,709)
Extraordinary debt extinguishment gain - - (750,000)
Changes in operating assets and liabilities:
Accounts receivable 2,057,540 11,801,135 (5,788,229)
Employee and stockholder advances 10,234 - -
Income tax receivable 316,461 11,556 355,088
Investment in sales-type leases (3,099,342) 3,099,342 -
Inventory 7,015,014 5,431,102 1,178,698
Prepaid expenses and other assets 31,480 175,823 (71,375)
Accounts payable (9,542,573) (7,328,184) 3,063,363
Accrued expenses 900,886 (211,112) (416,865)
Income taxes payable (13,290) - -
Deferred tax asset (credit) (761,714) (652,695) (44,050)
Unearned revenue and other liabilities 2,958,384 (2,296,764) (956,772)
----------------------------------------------------
Net cash provided by (used in) operating activities 2,536,898 334,546 (117,822)
Investing activities
Purchases of property and equipment (945,794) (2,532,509) (509,737)
Acquisitions, net of cash acquired (14,185,021) (652,231) -
Proceeds from sale of assets 7,315 740,023 784,838
----------------------------------------------------
Net cash used in investing activities (15,123,500) (2,444,717) 275,101
Financing activities
Proceeds from issuance of preferred stock 2,716,714
Proceeds from issuance of common stock 26,287,866 51,532 -
Proceeds from exercise of common stock options - - 15,313
Repurchase of common stock and options (533,250) - -
Payments on notes payable (928,980) (46,248) (323,296)
Payments on notes payable to related parties (587,181) (905,960) -
Proceeds from (repayments on) lines of credit, net (11,993,819) 3,666,297 (2,857,502)
Payments on capital leases - - -
----------------------------------------------------
Net cash provided by financing activities 12,244,636 2,765,621 (448,771)
Net increase (decrease) in cash and cash equivalents (341,966) 655,450 (291,492)
Cash and cash equivalents at beginning of year 341,966 - 655,450
----------------------------------------------------
Cash and cash equivalents at end of year $ - $ 655,450 $ 363,958
====================================================
Supplemental cash flow information
Interest paid $ 494,504 $ 962,004 $ 654,329
----------------------------------------------------
Income taxes paid $ 525,000 $ 223,850 $ 116,630
====================================================
See accompanying notes
F-5
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.
F-6
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.
F-7
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.
F-8
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:
[Enlarge/Download Table]
Year Ended October 31,
-----------------------------------------------------------
1998 1999 2000
-----------------------------------------------------------
Acquisitions
Fair value of assets acquired $ 58,951,000 - -
Less: cash paid 14,900,000 - -
Stock issued, net of value of stock returned
(see Note 10) 3,400,000 - -
-----------------------------------------------------------
Liabilities assumed (including $1,376,000 of
acquisition related liabilities in 1998) $40,651,000 - -
===========================================================
Common stock issued in connection with legal
settlement - - $ 597,645
===========================================================
Deemed dividend on preferred stock - - $ 529,411
===========================================================
Conversion of preferred stock and accrued
dividends to common stock - - $ 4,404
===========================================================
F-9
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.
F-10
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:
[Download Table]
October 31,
------------------------------------
1999 2000
------------------------------------
Computer and office equipment $ 1,515,017 $ 1,577,145
Furniture and fixtures 302,741 302,741
Leasehold improvements 491,059 491,059
Other 412,766 412,766
------------------------------------
2,721,583 2,783,711
Less accumulated depreciation and amortization (1,397,887) (1,963,913)
------------------------------------
$ 1,323,696 $ 819,798
====================================
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:
[Download Table]
October 31,
-------------------------------------
1999 2000
-------------------------------------
Goodwill $3,485,855 $3,485,855
Contracts 600,000 600,000
Less accumulated amortization (526,850) (921,066)
-------------------------------------
$3,559,005 $3,164,789
=====================================
See discussion of goodwill impairment recorded during fiscal 1999 in Note 5.
F-11
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).
F-12
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,
--------------
1998
--------------
(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
F-13
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.
F-14
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.
F-15
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:
[Enlarge/Download Table]
October 31,
-------------------------------
1999 2000
-------------------------------
Bank term note, bearing interest at the prime rate; payable in monthly
installments of $34,652 plus accrued interest, due in January 2002. $831,652 $519,119
Asset loans, bearing interest at annual interest rates ranging from
7.9% to 10.46%; due in aggregate monthly payments of $1,303 at
October 31, 1999 and 2000, respectively, due through August 2002,
secured by certain assets of the Company 38,531 27,768
-------------------------------
870,183 546,887
Less current portion 324,933 431,597
-------------------------------
Notes payable, long-term $545,250 $115,290
===============================
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
===================
F-16
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.
F-17
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)
F-18
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.
F-19
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:
[Download Table]
Weighted-Average
Shares Exercise Price
---------------------------------
Outstanding at October 31, 1997 1,857,000 $6.18
Options granted 865,000 7.46
Options exercised - -
Options canceled or expired (226,583) 5.35
---------------------------------
Outstanding at October 31, 1998 2,495,817 $6.70
Options granted 413,000 2.87
Options exercised - -
Options canceled or expired (1,026,384) 5.56
---------------------------------
Outstanding at October 31, 1999 1,882,433 $5.22
Options granted 1,147,000 1.26
Options exercised (4,900) 3.13
Options canceled or expired (582,600) 2.74
---------------------------------
Outstanding at October 31, 2000 2,441,933 $3.95
---------------------------------
Exercisable at October 31, 2000 1,476,183 $5.55
=================================
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.
F-20
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:
[Download Table]
Average Weighted-
Remaining Average
Range of Exercise Prices Number Contractual Exercise
Outstanding Life Price
-------------------------------------------------------
$1.22-$4.15 1,753,933 5.51 $2.23
$4.50-$6.50 88,000 2.55 5.53
$6.75-$8.75 600,000 8.00 8.75
-------------------------------------------------------
$1.22-$8.75 2,441,933 5.85 $3.95
=======================================================
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:
[Enlarge/Download Table]
October 31,
------------------------------------------------------
1998 1999 2000
-------------------------------------------------------
Net income (loss) - pro forma $ (2,535,579) $(34,865,823) $(491,904)
Loss per share - pro forma $ (0.35) $ (3.71) $(0.05)
Loss per share - assuming dilution pro forma $ (0.35) $ (3.71) $(0.05)
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.
F-21
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:
[Download Table]
October 31,
------------------------------------
1999 2000
------------------------------------
Deferred tax asset:
Accrued expenses $ 280,100 $ 776,714
Net operating loss carryforwards 5,569,085 4,834,470
Basis differences of acquired assets 411,334 -
Asset reserves 1,294,156 648,318
Other - 78,808
------------------------------------
Total deferred asset 7,554,675 6,338,310
------------------------------------
Deferred tax credit:
Acquisition of intangible assets (100,000) -
Depreciation (205,674) -
Valuation allowance (5,966,306) (5,011,565)
------------------------------------
Net deferred tax asset $1,282,695 $1,326,745
====================================
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.
F-22
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:
[Enlarge/Download Table]
Years ended October 31,
--------------------------------------------------
1998 1999 2000
--------------------------------------------------
Current tax expense (benefit):
Federal $411,709 $(974,781) $ -
State 91,144 (213,975) -
--------------------------------------------------
502,853 (1,188,756) -
Deferred tax expense:
Federal 155,675 535,500 49,000
State 27,472 94,500 16,000
--------------------------------------------------
183,147 630,000 65,000
--------------------------------------------------
Total provision for (benefit from) income taxes $686,000 $(558,756) $ 65,000
==================================================
The reconciliation of income tax from the Federal statutory rate of 34% is:
[Enlarge/Download Table]
Years ended October 31,
------------------------------------------------------
1998 1999 2000
------------------------------------------------------
Tax at statutory rates: $566,413 $(11,536,368) $ 49,089
Non-deductible expenses 35,480 7,277,936 68,966
Valuation allowance - 4,278,322 (69,097)
State income tax, net of federal benefit 84,107 (578,646) 16,042
------------------------------------------------------
$686,000 $ (558,756) $ 65,000
======================================================
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.
F-23
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.
F-24
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:
[Download Table]
October 31,
------------------------------------
1998 1999
------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of year $321,559 $376,404
Service cost 48,195 48,195
Interest cost 27,034 28,230
Actuarial gain (loss) (20,384) 60,770
------------------------------------
Benefit obligation at end of year 376,404 513,599
Change in plan assets:
Fair value of plan assets at beginning of year 147,041 306,341
Actual return on plan assets 95,523 81,840
Employer contributions 63,777 -
------------------------------------
Fair value of plan assets at end of year 306,341 388,181
Funded status:
Unrecognized actuarial loss (70,063) (125,418)
Unrecognized transition asset (11,339) 3,028
Unrecognized prior service cost 11,477 -
------------------------------------
Accrued benefit cost $(69,925) $(122,390)
====================================
F-25
DUNN COMPUTER CORPORATION
D/B/A STEELCLOUD COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. Retirement Plans (continued)
Defined Benefit Plan (continued)
[Download Table]
Years ended October 31,
----------------------------
1998 1999
----------------------------
Components of net periodic benefit cost
Service cost $ 48,195 $ 48,195
Interest cost 27,034 28,230
Actual return on assets (95,523) (81,840)
Net amortization and deferral 90,219 57,880
----------------------------
Total net periodic pension cost $ 69,925 $ 52,465
============================
Key assumptions used in the actuarial valuation were:
[Download Table]
Years ended October 31,
-------------------------------
1998 1999
-------------------------------
Weighted average discount rate 7.5% 6.5%
Rate of return on assets:
Pre-retirement 8.0% 8.0%
Post-retirement 8.0% 8.0%
F-26
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:
[Enlarge/Download Table]
Years ended October 31,
-------------------------------------------------------
1998 1999 2000
-------------------------------------------------------
Numerator:
Net income (loss) before extraordinary gain $979,921 $(33,607,145) $50,665
Preferred Stock dividends - - (624,828)
-------------------------------------------------------
Net income (loss) available to common
shareholders before extraordinary gain 979,921 (33,607,145) (574,163)
Denominator:
Denominator for basic earnings per share-
weighted-average shares 7,231,397 9,403,775 9,580,112
Effect of dilutive securities:
Employee stock options 251,132 - -
Warrants 9,722 - -
-------------------------------------------------------
Dilutive potential common shares 260,854 - -
-------------------------------------------------------
Denominator for diluted earnings per share -
adjusted weighted-average shares and assumed
conversions 7,492,251 9,403,775 9,580,112
-------------------------------------------------------
Earnings (loss) per share $ 0.14 $ (3.57) $ (.06)
=======================================================
Diluted earnings per share $ 0.13 $ (3.57) $ (.06)
=======================================================
F-27
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.
F-28
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:
[Enlarge/Download Table]
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
2000
Revenue $7,128,063 $10,602,548 $10,328,950 $11,706,832
Gross Profit 1,481,318 2,007,347 1,797,071 1,844,247
(Loss) income after preferred dividends,
before extraordinary item (589,298) (288,667) 190,565 113,237
Extraordianry item 750,000 - - -
Net income (loss) 160,702 (288,667) 190,565 113,237
Per Share Data
--------------
Income loss before extraordinary item (0.06) (0.03) 0.02 0.01
Net income (loss) 0.02 (0.03) 0.02 0.01
1999
Revenue $11,711,620 $ 9,440,804 $ 7,255,482 $ 6,067,391
Gross Profit 2,026,627 2,649,771 349,555 1,467,653
Net (loss) income (547,673) (45,586) (22,856,018) (10,157,868)
Per Share Data
--------------
Net income (loss) (.06) (0.01) (2.56) (0.94)
F-29
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
[Enlarge/Download Table]
Classification Balance at Additions Deductions Balance
Beginning of at End of
Year Year
Allowance for doubtful accounts:
Year ended October 31, 1998............................. $77,000 $59,000 $90,000(1) $46,000
Year ended October 31, 1999............................. $46,000 $1,400,000 $1,346,000(1) $100,000
Year ended October 31, 2000............................. $100,000 $o $o $100,000
Inventory reserve:
Year ended October 31, 1998............................. $250,000 $o $o $250,000
Year ended October 31, 1999............................. $250,000 $2,241,000 $362,000(2) $2,129,000
Year ended October 31, 2000............................. $2,129,000 $o $575,000(2) $1,554,000
-----------
(1) Write-offs of accounts receivable
(2) Write-offs of inventory
S-2
Dates Referenced Herein and Documents Incorporated by Reference
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