| • FORM 10-Q • EXHIBIT 31.1 • EXHIBIT 31.2 • EXHIBIT 32.1 • EXHIBIT 32.2 • EXHIBIT 99.1 • XBRL INSTANCE • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION • XBRL TAXONOMY EXTENSION DEFINITION • XBRL TAXONOMY EXTENSION LABELS • XBRL TAXONOMY EXTENSION PRESENTATION | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
______________
FORM 10-Q
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 2012
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: 0-32789
EMTEC, INC.
(Exact name of registrant as specified in its charter)
(973) 376-4242
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)
Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No x
As of July 9, 2012, there were outstanding 17,616,437 shares of the registrant’s common stock.
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EMTEC, INC.
FORM 10-Q FOR THE QUARTER ENDED MAY 31, 2012
Table of Contents
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PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
EMTEC, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except per Share and Share Data)
The Accompanying Notes are Integral Parts of these Consolidated Financial Statements.
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EMTEC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In Thousands, Except per Share and Share Data)
The Accompanying Notes are Integral Parts of these Consolidated Financial Statements.
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EMTEC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(In Thousands)
The Accompanying Notes are Integral Parts of these Consolidated Financial Statements.
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EMTEC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In Thousands)
Supplemental Disclosures of Non Cash Investing and Financing Activities
The Accompanying Notes are Integral Parts of these Consolidated Financial Statements.
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EMTEC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and note disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included in the accompanying unaudited consolidated financial statements. Quarterly results are not necessarily indicative of results for the full year. For further information, refer to the annual financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended August 31, 2011.
2. General
Description of Business
Emtec, Inc., a Delaware corporation (“Emtec”), is an information technology (“IT”) services provider delivering consulting, application services and infrastructure services to public sector and commercial clients. The Company’s client base is comprised of departments of the United States and Canada’s federal, state/provincial and local governments and schools and commercial businesses throughout the United States and Canada.
Principles of Consolidation
The consolidated financial statements in this report include the accounts of Emtec and its wholly-owned subsidiaries, Emtec, Inc., a New Jersey Corporation (“Emtec NJ”), Emtec Viasub LLC (“Emtec LLC”), Emtec LLC’s wholly-owned subsidiary Emtec Federal, Inc. (“Emtec Federal”), Emtec Global Services LLC (“EGS LLC”), EGS LLC’s wholly-owned subsidiaries Luceo, Inc. (“Luceo”), eBusiness Application Solutions, Inc. (“eBAS”), Aveeva, Inc. (“Aveeva”), Emtec Services Mauritius (“Emtec Mauritius”), Emtec Mauritius’s subsidiary Emtec Software India Private Limited (“Emtec India”) (formerly Aviance Software India Private Limited), Dinero Solutions, LLC (“Dinero”), Covelix, Inc. (“Covelix”), Covelix’s subsidiary Covelix Technologies Private Ltd. (“Covelix India”) and GNUCO, LLC d/b/a Emerging Solutions, LLC (“Emerging”), Emtec Infrastructure Services Corporation (“EIS-US”), and EIS-US’s wholly-owned subsidiaries Emtec Infrastructure Services Canada Corporation (“EIS-Canada”), which is referred to in this report as KOAN-IT, KOAN-IT (US) Corp. (“KOAN-IT (US)”) and Secure Data, Inc. (“SDI”), a subsidiary of Emtec Federal (collectively, the “Company”). Significant intercompany account balances and transactions have been eliminated in consolidation.
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Segment Reporting
The Company divides its operating activity into two operating segments for reporting purposes: Emtec Systems Integration (“ESI”) and Emtec Global Sourcing (“EGS”). The Company changed the names of these segments in 2010, however historical numbers associated with these segments remain the same. Our ESI segment provides clients a wide variety of services including outsourced consulting application services and infrastructure consulting and outsourcing. Our EGS segment provides our clients the opportunity to take advantage of our consulting resources and offshore resources when they are not specifically looking for us to manage their project. We will continue to reassess our segment reporting structure in accordance with Accounting Standards Codification Topic 280 Segment Reporting.
Reclassifications
Certain reclassifications have been made to prior period balances in order to conform to current presentations.
FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles
The Company identifies the Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC” or “ASC”) as the authoritative source of generally accepted accounting principles in the United States of America (“GAAP”). Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants.
Accounting Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 financial statements and the reported amounts of revenues and expenses during the reporting period, including, but not limited to, receivable valuations, impairment of goodwill and other long-lived assets, income taxes and valuations of put instruments and earnout obligations relating to acquisitions. Management’s estimates are based on historical experience, facts and circumstances available at the time and various other assumptions that are believed to be reasonable under the circumstances. The Company reviews these matters and reflects changes in estimates as appropriate. Actual results could differ materially from those estimates.
Fair Value of Financial Instruments
The fair value of cash and cash equivalents and trade receivables approximates their carrying values due to their short maturities. The fair value of non-current financial instrument assets and liabilities approximate their carrying value unless otherwise stated. The carrying value of the PNC Credit Facility approximated its fair value due to its variable interest rate. In addition, the carrying value of the subordinated debt approximates its fair value as the issuance dates, August 15, 2011 and December 30, 2011, are close in proximity to the May 31, 2012 date of the financial statements. Furthermore, there have been no changes to the credit markets or the Company’s financial position since the issuance dates that would impact the fair value of the subordinated debt in any material respect.
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In accordance with FASB ASC Topic 820 Fair Value Measurement, the estimated fair values of amounts reported in the consolidated financial statements have been determined using available market information and valuation methodologies, as applicable. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Entities are required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value based upon the following fair value hierarchy:
The following table summarizes the financial liabilities measured at fair value on a recurring basis as of May 31, 2012 and August 31, 2011 (in thousands):
The warrant liabilities were recorded at fair value based on upon valuation models that utilize relevant factors such as expected life, volatility of the Company’s stock price, and the risk free interest rate.
The following table summarizes the changes in earnout liabilities for the nine months ended May 31, 2012 (in thousands):
The earnout liabilities were recorded at fair value based on valuation models that utilize relevant factors such as expected life and estimated probabilities of the acquired companies achieving the performance targets throughout the earnout periods. Unobservable inputs used in the valuation of the earnout liabilities included discount rates, ranging from 19% to 21%, and probabilities, ranging from 10% to 95%, associated with the achievement of the earnout targets in future years.
A significant increase (decrease) in the discount rate, in isolation, would result in a significantly lower (higher) fair value measurement, and a significant increase (decrease) in any of the probabilities, in isolation, would result in a significantly higher (lower) fair value measurement.
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Financing Costs
Financing costs incurred are amortized over the life of the associated financing arrangements. Amortization expense totaled approximately $97,000 and $-0- for the three months ended May 31, 2012 and 2011, respectively. During the nine months ended May 31, 2012 and 2011, amortization expense totaled approximately $238,000 and $-0-, respectively.
Goodwill
Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired companies. The changes in the carrying amount of goodwill for the nine months ended May 31, 2012 by reportable segment are as follows (in thousands):
In accordance with ASC Topic 350 Intangibles - Goodwill and Other, goodwill is not amortized, but rather tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Goodwill is tested for impairment at one level below an operating segment (also known as a reporting unit) in accordance with the guidance of ASC Topic 350. These reporting units are comprised of Systems Division, KOAN-IT, Luceo, eBAS/Aveeva, SDI, Dinero, Covelix and Emerging. The Company has set an annual impairment testing date of June 1. However, the Company has not yet completed its annual impairment testing as of June 1, 2012.
An impairment charge will be recognized only when the implied fair value of a reporting unit, including goodwill, is less than its carrying amount. The impairment determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with ASC Topic 805 Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill.
The Company’s stock does not trade frequently and thus management believes the inherent value of the Company is not and has not been accurately reflected by the current or historical stock market valuation of the Company. Accordingly, the Company continues to believe that the income and market-based approaches are the most appropriate valuation methods.
In accordance with ASC Topic 350, the Company performed its annual impairment testing as of June 1, 2011. Based on this testing and its continued monitoring of market conditions and the operating performance of its reporting units, the Company does not currently believe that there is an indication of goodwill impairment at May 31, 2012. However, if current market conditions change and the Company’s estimated value(s) under the income and/or market-based approaches is/are affected, then it is possible that the Company could have to take a goodwill impairment charge against earnings in a future period.
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Identifiable Intangible Assets
At May 31, 2012 and August 31, 2011, the components of identifiable intangible assets are as follows (in thousands):
Customer relationships represent the fair value ascribed to customer relationships purchased from fiscal 2005 through fiscal 2011 through the Company’s acquisitions. The amounts ascribed to customer relationships are being amortized on a straight-line basis over 5-15 years.
Noncompete agreements represent the value ascribed to covenants not to compete in employment and acquisition agreements entered into with certain members or stockholders of acquired companies. The amounts ascribed to noncompete agreements are being amortized on a straight-line basis over 3-5 years.
Software technology represents the value ascribed to software developed by an acquired company. The amount ascribed to software technology is being amortized on a straight-line basis over 3 years.
Trademarks represent the value ascribed to trademarks owned by an acquired company. The amount ascribed to trademarks is being amortized on a straight-line basis over 5 years.
Trade names represent the value ascribed to trade names owned by various acquired companies. The amounts ascribed to trade names are being amortized on a straight-line basis over 5 years.
Amortization expense related to intangible assets was $911,000 and $593,000 for the three months ended May 31, 2012 and 2011, respectively. For the nine months ended May 31, 2012 and 2011, amortization expense was $2.8 million and $1.6 million, respectively. We currently expect future amortization to be as follows (in thousands):
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Long-lived assets, including customer relationships, noncompete agreements, software technology, trademarks and trade names, as well as property and equipment, are tested for recoverability in accordance with ASC Topic 350 Intangibles - Goodwill and Other and ASC Topic 360 Property, Plant and Equipment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable Recoverability of long-lived assets is assessed by a comparison of the carrying amount to the estimated undiscounted future net cash flows expected to result from the use of the assets and their eventual disposition. If estimated undiscounted future net cash flows are less than the carrying amount, the asset is considered impaired and a loss would be recognized based on the amount by which the carrying value exceeds the fair value of the asset. No impairment of long-lived assets occurred during the three or nine months ended May 31, 2012 or May 31, 2011.
Foreign Currency Translation and Other Comprehensive Income (loss)
The financial statements of the Company’s foreign subsidiaries are translated into U.S. dollars for consolidation and reporting purposes. The functional currency for the Company’s foreign operations is the local currency. Current rates of exchange are used to translate assets and liabilities. Adjustments to translate those statements into U.S. dollars are recorded in accumulated other comprehensive income (loss).
Earnings Per Share
Basic earnings per share amounts are computed by dividing net income available to common stockholders (the numerator) by the weighted average shares outstanding during the period (the denominator). Shares issued during the period are weighted for the portion of the period that they were outstanding.
The computation of diluted earnings per share is similar to the computation of basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive options, restricted stock awards and warrants had been exercised as of the end of the period and cash received from the exercise were used to repurchase shares in the open market (the “Treasury Share Method”). Potentially dilutive shares consist of stock options, restricted stock awards and warrants totaling 2,390,165 shares and 1,706,594 shares for the three month periods ended May 31, 2012 and 2011, respectively, and 3,038,836 shares and 1,382,879 shares for the nine month periods ended May 31, 2012 and 2011, respectively. Diluted shares for the three and nine month periods ended May 31, 2012 and 2011 were not included in the calculation of diluted net loss per share because the effect of the inclusion would be anti-dilutive. In addition, outstanding warrants to purchase 1,401,733 and 1,401,733 common shares as of May 31, 2012 and 2011, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the Company’s common shares over those periods.
Income Taxes
The Company conducts business in the United States, Canada and India. With respect to its U.S. operations, the Company files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. The Company accounts for income taxes in accordance with ASC Topic 740 Income Taxes. The Company files a federal consolidated tax return that includes all U.S. entities. The Company also files several combined/consolidated state tax returns and several separate state tax returns. Deferred taxes result from temporary differences, which are the differences between the financial reporting and tax bases of assets and liabilities. Deferred tax assets are recognized for tax loss carryforwards. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Deferred taxes result from timing differences primarily relating to net operating losses, bad debts, inventory reserves, deferred revenue, fixed asset depreciation, compensation expenses and intangible asset amortization.
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With a few exceptions, the Company is no longer subject to federal, state or local income tax examinations for tax returns filed for fiscal years 2008 and prior.
Reconciliation of liabilities for unrecognized tax benefits for the nine months ended May 31, 2012 and 2011 (in thousands) are as follows:
3. Liquidity
The Company has incurred significant operating losses for fiscal 2011 as well as for the nine months ended May 31, 2012. In addition, the Company had a working capital deficit at August 31, 2011 and May 31, 2012, and is dependent on its line of credit to finance its working capital needs. The 2011 loss can be attributed primarily to reduced procurement revenues from the federal business associated with the federal debt and budget crisis in 2011 and certain non-cash charges including a warrant liability adjustment and an earnout liability adjustment. We believe the operating loss for the nine months ended May 31, 2012 was related primarily to timing delays with one of our education clients due to budgetary issues. We have managed our liquidity during this time through a cost reduction initiative that we implemented in the fourth quarter of fiscal 2011 and borrowings under our credit facility.
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The Company believes that its existing resources together with available borrowings under its credit facility, the annualized cost savings from the cost reduction initiative described above and expected cash flow from operations will provide sufficient liquidity for at least the next 12 months.
4. Acquisitions
Dinero Solutions, LLC and Covelix, Inc.
On February 3, 2011 and March 1, 2011, EGS LLC, a wholly-owned subsidiary of the Company, acquired all of the issued and outstanding equity interest or stock of Dinero and Covelix, respectively. The Company may be required to pay additional variable cash and stock consideration each year for the next three years on the anniversary of the respective acquisition dates that is contingent upon the achievement of certain performance milestones. The aggregate fair value of the contingent consideration arrangement at the respective acquisition dates was $1.1 million. The Company estimated the fair value of the contingent consideration using probability assessments of expected future cash flows over the period in which the obligation is expected to be settled, and applied a discount rate that appropriately captures a market participant’s view of the risk associated with the obligation. This fair value is based on significant inputs not observable in the market. As of May 31, 2012, the contingent consideration liability associated with these acquisitions was $1.2 million, net of a $500,000 earnout payment during the quarter ended May 31, 2012, based on valuation models that utilize relevant factors such as expected life and the estimated probabilities of Dinero and Covelix achieving the performance targets throughout the earnout periods. The Company recorded expense on its consolidated statements of operations of $130,000 and $-0- for the three months ended May 31, 2012 and 2011, respectively. For the nine months ended May 31, 2012 and 2011, the Company recorded expense on its consolidated statements of operations of $572,000 and $-0-, respectively.
The equity included in the reported aggregate consideration of one of the acquisitions consisted of the fair value of the “puttable” restricted common stock of the Company at the acquisition date. The “put” feature embedded in the restricted common stock allows each former shareholder a one-time election to put all of their restricted common stock to the Company at a fixed price on the third anniversary of the acquisition date. However, the exercise of the one-time put option is contingent upon the acquired company achieving a certain performance milestone measured over a three-year period. Management calculated the fair value of the put using a Black-Scholes valuation model. In accordance with SEC Accounting Series Release No. 268 Presentation in Financial Statements of Redeemable Preferred Stocks, the puttable stock is subject to equity accounting and is classified on the Company’s balance sheet as temporary equity.
As part of the purchase, the Company issued restricted common stock to a former sole member of one of the acquired companies. The shares vest over a three-year period contingent upon the acquired company achieving certain performance milestones and the continued employment of its former sole member. Pursuant to ASC Topic 805-10-55, Business Combinations – Overall – Implementation, the restricted stock is being treated as compensation rather than additional consideration since the vesting of the stock is linked to the continued employment at the Company of the former sole member of the acquired company. Furthermore, the restricted stock issued contains an embedded “put” feature that allows the former sole member of the acquired company a one-time election to put all of his restricted common stock to the Company at a fixed price on the third anniversary of the acquisition date. However, the exercise of the one-time put option is contingent upon the acquired company achieving a certain performance milestone measured over a three-year period. Management has determined that it is probable, as of May 31, 2012, that the acquired company will achieve the performance milestones for the vesting of the restricted stock and the put option and has calculated the fair value of the restricted stock and “put” using a Black-Scholes valuation model. In accordance with ASC Topic 718, Compensation – Stock Compensation, the puttable stock is subject to liability accounting. At May 31, 2012 and August 31, 2011, the Company recorded a net liability of $196,000 and $52,000 on its balance sheet, respectively. The Company recorded expense of $40,000 and $52,000 on its consolidated statements of operations associated with the fair value of the restricted stock and put for the three months ended May 31, 2012 and 2011, respectively. For the nine months ended May 31, 2012 and 2011, the Company recorded expense associated with the fair value of the restricted stock and put on its consolidated statements of operations of $107,000 and $52,000, respectively.
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GNUCO, LLC d/b/a Emerging Solutions, LLC
On August 15, 2011, EGS LLC, a wholly-owned subsidiary of the Company, acquired all of the outstanding membership interests of Emerging for cash, plus equity and the potential right to receive installments of additional cash consideration each year for the next three years if certain performance targets are met. The equity included in the reported consideration consisted of the fair value of “puttable” restricted common stock of the Company as of August 15, 2011. The “put” feature embedded in the restricted common stock allows each former shareholder of Emerging a one-time election to put all of their restricted common stock to the Company at a fixed price on the third anniversary of the acquisition date. However, the exercise of the one-time put option is contingent upon Emerging achieving a certain performance milestone measured over a three-year period. Management calculated the fair value of the put using a Black-Scholes valuation model. In accordance with SEC Accounting Series Release No. 268 Presentation in Financial Statements of Redeemable Preferred Stocks, the puttable stock is subject to equity accounting and is classified on the Company’s balance sheet as temporary equity.
In addition, the Company may be required to pay additional variable cash and stock consideration each year for the next three years on the anniversary of closing that is contingent upon the achievement of certain performance milestones. The fair value of the contingent consideration arrangement at the acquisition date was $3.0 million. The Company estimated the fair value of the contingent consideration using probability assessments of expected future cash flows over the period in which the obligation is expected to be settled, and applied a discount rate that appropriately captures a market participant’s view of the risk associated with the obligation. This fair value is based on significant inputs not observable in the market. As of May 31, 2012, the contingent consideration liability associated with this acquisition was $2.8 million based on valuation models that utilize relevant factors such as expected life and the estimated probabilities of Emerging achieving the performance targets throughout the earnout periods. The Company recorded income on its consolidated statements of operations of $192,000 and $-0- for the three months ended May 31, 2012 and 2011, respectively. For the nine months ended May 31, 2012 and 2011, the Company recorded income on its consolidated statements of operations of $163,000 and $-0-, respectively.
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5. Stock-Based Compensation
The second amendment to the Company’s 2006 Stock-Based Incentive Compensation Plan (the “2006 Plan”) was approved by the Company’s stockholders on January 20, 2011. The 2006 Plan authorizes the granting of stock options, restricted stock, deferred stock, stock appreciation rights and other stock-based awards to directors and eligible associates. The second amendment increased the aggregate number of shares of Common Stock available for issuance under the 2006 Plan from 2,543,207 shares to 9,543,207 shares. Options under the 2006 Plan may not be granted with an exercise price that is less than 100% of the fair value of the Company’s common stock on the date of grant (110% in the case of an incentive stock option granted to a stockholder owning more than 10% of the common stock of the Company or any of its subsidiaries). Options under the 2006 Plan have terms from 7 to 10 years. Certain options vest immediately and others vest over a term of up to 4 to 5 years.
The Company measures the fair value of options on the grant date using the Black-Scholes option valuation model. The Company estimated the expected volatility using the Company’s historical stock price data over the expected term of the stock options. The Company also used historical exercise patterns and forfeiture behaviors to estimate the options, expected term and our forfeiture rate. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve in effect on the grant date. Both expected volatility and the risk-free interest rate are based on a period that approximates the expected term. Since our stock is thinly traded, the stock price used on the date of vesting for the Black-Scholes model is the last trade that occurred.
A summary of stock options for the nine months ended May 31, 2012 is as follows:
* Represents the total pre-tax intrinsic value based on the Company’s average closing stock prices for the nine months ended May 31, 2012.
A summary of stock options for the nine months ended May 31, 2011 is as follows:
* Represents the total pre-tax intrinsic value based on the Company’s average closing stock prices for the nine months ended May 31, 2011.
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Non-vested Stock (Restricted Stock)
The following table summarizes the Company’s restricted stock activity during the nine months ended May 31, 2012:
The following table summarizes the Company’s restricted stock activity during the nine months ended May 31, 2011:
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The Company recognizes compensation expense associated with the issuance of such shares using the closing price of the Company’s common stock on the Over-the-Counter Pink Sheet market on the date of grant over the vesting period on a straight-line basis.
Stock Options and Non-vested Stock
Stock-based compensation costs related to the 2006 Plan totaled $52,000 and $104,000 for the three months ended May 31, 2012 and 2011, respectively, and $226,000 and $385,000 for the nine months ended May 31, 2012 and 2011, respectively. As of May 31, 2012, the Company had $223,000 of unrecognized compensation cost related to the 2006 Plan. The unrecognized compensation cost is expected to be recognized over a remaining period of 4 years.
Stock Appreciation Rights
On May 21, 2012, the Company granted Mr. Gregory P. Chandler, the Company's Chief Financial Officer, a stock appreciation right award under the 2006 Plan covering 657,542 shares of the Common Stock, with a per share base price of $1.75 (the “Award”). The purpose of the Company’s stock appreciation right program, pursuant to which the Award was granted, is to motivate the Company’s management team to substantially increase the value of the Company in a manner that will allow all stockholders to realize such increase in value. Mr. Chandler’s Award will have no value unless our Common Stock value exceeds $1.75 per share in a liquidity event, which is substantially higher than the trading price of our Common Stock as of the grant date.
Subject to Mr. Chandler’s continued employment with the Company from the grant date through the applicable vesting date, 10% of the Award will become vested on each of August 31, 2012, August 31, 2013, August 31, 2014, August 31, 2015 and August 31, 2016. The remaining 50% of the Award, as well as any other portion of the Award that is then unvested, will become vested upon the occurrence of a liquidity event if one of the two following conditions is satisfied: (i) Mr. Chandler is employed by the Company on the date of such liquidity event; or (ii) if such liquidity event is a change in control, Mr. Chandler’s employment is terminated without cause or for good reason, in either case, after the date on which a letter of intent relating to the change in control that is binding with respect to exclusivity has been executed and the change in control that is the subject of such letter of intent is consummated within 180 days after the date of such termination of employment. Notwithstanding the foregoing, in the event that the per share equity value upon the occurrence of a liquidity event is not greater than $1.75, then no portion of the Award shall become vested in connection with such liquidity event and the entire Award (whether or not vested) will be immediately forfeited. In the event that a liquidity event does not occur on or before August 31, 2017, then the entire Award, whether or not vested, will be immediately forfeited.
To the extent vested, the Award will become exercisable immediately prior to the occurrence of a liquidity event. Upon the exercise of the Award, Mr. Chandler is entitled to receive a number of shares of Common Stock having a fair market value on the date of exercise equal to the product of (x) the difference between the fair market value of one share of Common Stock on the date of exercise and the base price and (y) the number of shares of Common Stock with respect to which the Award is then being exercised.
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In the event of Mr. Chandler’s termination of employment for cause, the entire Award, whether or not vested, will be immediately forfeited. In the event of Mr. Chandler’s termination of employment for any reason other than for cause, the unvested portion of the Award will generally be immediately forfeited and the vested portion of the Award will remain outstanding and, to the extent not then exercisable, will be eligible to become exercisable upon the occurrence of a liquidity event.
FASB ASC 718 "Compensation - Stock Compensation" prescribes accounting and reporting standards for all stock-based payments awarded to employees, including stock appreciation rights. Under ASC 718, accruals of compensation cost for an award with a performance condition should be based on the probable outcome of that performance condition—compensation cost should be accrued if it is probable that the performance condition will be achieved and should not be accrued if it is not probable that the performance condition will be achieved. If an award has multiple performance conditions (for example, if the number of options or shares an employee earns varies depending on which, if any, of two or more performance conditions is satisfied), compensation cost should be accrued if it is probable that a performance condition will be satisfied. In making that assessment, it may be necessary to take into account the interrelationship of those performance conditions.
As of May 31, 2012, the Company has not recorded compensation expense associated with Mr. Chandler’s Award as of May 31, 2012. However, if the Company determines that a liquidity event is probable, compensation expense associated with Mr. Chandler’s Award will be recorded at that time.
6. Warrants
DARR Westwood LLC
On August 2, 2010, the Company entered into a letter agreement (the “Letter Agreement”) with DARR Westwood LLC (the “Investor”), pursuant to which, among other things, (a) the Investor agreed (i) to certain transfer restrictions on shares of common stock, par value $0.01 per share, of the Company (“Common Stock”) owned by the Investor, which are described below, and (ii) to transfer to the Company for cancellation the existing warrant owned by the Investor to purchase 8% of the outstanding Common Stock on a fully diluted basis, and (b) the Company issued to the Investor a warrant (the “DARR Warrant”) to purchase up to an aggregate of 1,401,733 shares of Common Stock at an exercise price of $2.11 per share. The Investor’s sole member is Dinesh R. Desai, the Company’s Chairman, Chief Executive Officer and President.
Under the terms of the Letter Agreement, the Investor is prohibited during the specified restricted period from transferring or publicly announcing any intention to transfer, in either case without the unanimous approval of the disinterested members of the Company’s board of directors, (a) all or any portion of the DARR Warrant or the Investor’s rights under the DARR Warrant or (b) any shares of Common Stock currently or in the future owned by the Investor. However, this prohibition does not apply to any transfer of shares of Common Stock pursuant to which both (x) the transferee is an independent third party and (y) the price paid by the transferee is equal to or greater than $5.00 per share in cash. The restricted period specified in the Letter Agreement commenced on August 2, 2010 and terminates on the earlier to occur of (a) August 2, 2015 or (b) the date on which both (i) the average of the daily volume weighted average price per share of Common Stock over the immediately preceding 45 trading days that at least one share of Common Stock was traded is $5.00 or more, and (ii) the average daily trading volume of shares of Common Stock over the 45 consecutive trading days (regardless of whether any shares of Common Stock were traded on any such trading day) immediately preceding such date is 10,000 or more.
The Letter Agreement also requires that if the Company causes its Common Stock to become listed on a national securities exchange, the Company will also list and maintain the listing of the shares of Common Stock underlying the DARR Warrant on such national securities exchange. In addition, subject to certain conditions, the Company is required under the Letter Agreement to provide prior notice to the Investor if, at any time before the DARR Warrant has been exercised in full, the Company effects certain specified corporate actions, including selecting a record date for dividends or distributions or effecting a reorganization, reclassification, merger, consolidation, sale, transfer, disposition, dissolution, liquidation or winding up involving the Company.
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The DARR Warrant entitles the Investor to purchase 1,401,733 shares of Common Stock at $2.11 per share and expires on August 2, 2015. The DARR Warrant also contains provisions for cashless exercise and weighted average anti-dilution protection for subsequent issuances or deemed issuances of Common Stock by the Company for consideration per share less than the per share exercise price of the DARR Warrant in effect immediately prior to such issuance or deemed issuance. In connection with the issuance of the DARR Warrant and in compliance with ASC Topic 815 Derivatives and Hedging, the Company recorded a liability on August 2, 2010 of $916,000. At May 31, 2012 and August 31, 2011, the liability related to the DARR Warrant recorded on the Company’s balance sheet was $1.0 million and $732,000, respectively. The Company recorded (income) expense on its consolidated statements of operations of $105,000 and $(49,000) for the three months ended May 31, 2012 and 2011, respectively, and $283,000 and $(478,000) for the nine months ended May 31, 2012 and 2011, respectively, as a result of adjusting the warrant liability to fair value. Because the Company’s stock is thinly traded, there may continue to be adjustments associated with determining the fair value of the liability related to the DARR Warrant in future periods.
NewSpring
In connection with the entry into a Subordinated Credit Facility with NewSpring SBIC Mezzanine Capital II, L.P., a Delaware limited partnership (“NewSpring”), which is described in more detail in Note 8 – Subordinated Debt below, on August 15, 2011 the Company issued to NewSpring a Common Stock Purchase Warrant (the “NewSpring Warrant”) to purchase the number of shares of Common Stock equal to 5.0% of the Common Stock outstanding at the time of, and after giving effect to, the exercise of the NewSpringWarrant. On December 30, 2011, in connection with the entry into a Revolving Credit and Security Agreement with PNC Bank and Peachtree II, L.P. (“Peachtree”) becoming a lender under the Subordinated Credit Facility, the Company amended and restated the NewSpring Warrant (as so amended and restated, the “Amended and Restated NewSpring Warrant”) and granted a warrant (the “Peachtree Warrant,” and together with the Amended and Restated NewSpring Warrant, the “Warrants”) to Peachtree.
In connection with the issuance of the NewSpring Warrant and in compliance with ASC Topic 470-20 Debt with Conversion and Other Options, the subordinated note issued to NewSpring under the Subordinated Loan Agreement (as defined below) has been discounted by the fair value of the NewSpring Warrant, calculated to be $484,000 at time of issuance. This amount is being amortized as additional interest expense and accretes the note to face value on the Company’s balance sheet at maturity. The Company determined the fair value of the NewSpring Warrant by using the Black-Scholes pricing model. At May 31, 2012 and August 31, 2011, the liability recorded on the Company’s balance sheet was $972,000 and $719,000, respectively. The Company recorded expense on its consolidated statements of operations of $153,000 and $-0- for the three months ended May 31, 2012 and 2011, respectively, and $255,000 and $-0- for the nine months ended May 31, 2012 and 2011, respectively, as a result of adjusting the warrant liability to fair value. Because the Company’s stock is thinly traded, there may continue to be adjustments associated with determining the fair value of the liability related to the NewSpring Warrant in future periods.
Peachtree
In connection with the Amended and Restated Subordinated Credit Facility (as defined below), on December 30, 2011, the Registrant issued to Peachtree the Peachtree Warrant, which allows Peachtree to purchase the number of shares of Common Stock equal to 1.5% of the Common Stock outstanding at the time of, and after giving effect to, the exercise of the Peachtree Warrant (based on the “treasury stock method”) in accordance with the generally accepted accounting principles applicable in the United States of America and determined using the same principles, assumptions and estimates that are used by the Company in the preparation of its financial statements and assuming the exercise or conversion of all securities that are directly or indirectly exercisable for or convertible into Common Stock). The exercise price for the Common Stock is $0.01 per share, which may be paid through a cashless exercise. The Peachtree Warrant expires on December 30, 2021.
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In connection with the issuance of the Peachtree Warrant and in compliance with ASC Topic 470-20 Debt with Conversion and Other Options, the subordinated note issued to Peachtree under the Subordinated Loan Agreement (as defined below) has been discounted by the fair value of the Peachtree Warrant, calculated to be $73,000 at time of issuance. This amount is being amortized as additional interest expense and accretes the note to face value on the Company’s balance sheet at maturity. The Company determined the fair value of the Peachtree Warrant by using the Black-Scholes pricing model. At May 31, 2012 and August 31, 2011, the liability recorded on the Company’s balance sheet was $292,000 and $-0-, respectively. The Company recorded expense on its consolidated statements of operations of $46,000 and $-0- for the three months ended May 31, 2012 and 2011, respectively, and $219,000 and $-0- for the nine months ended May 31, 2012 and 2011, respectively, as a result of adjusting the warrant liability to fair value. Because the Company’s stock is thinly traded, there may continue to be adjustments associated with determining the fair value of the liability related to the Peachtree Warrant in future periods.
7. Line of Credit
On December 30, 2011, Emtec NJ, Emtec LLC, Emtec Federal, EGS LLC, Luceo, eBAS, Aveeva, EIS-US, KOAN-IT US, SDI, Dinero, Covelix and Emerging. (collectively the “Borrower”) entered into a Revolving Credit and Security Agreement (the “PNC Loan Agreement”) with PNC Bank, National Association, as lender and agent (“PNC”). The PNC Loan Agreement provides for a senior secured revolving credit facility in an amount not to exceed (i) $30.0 million for the period from February 1 through August 31 each year during the term of the facility and (ii) $45.0 million for the period from September 1 through January 31 each year during the term of the facility (the “PNC Credit Facility”). The PNC Credit Facility also includes a $7.0 million sublimit for the issuance of letters of credit. The proceeds of the PNC Credit Facility were used to refinance all of the Borrower’s outstanding indebtedness under a Loan and Security Agreement with De Lage Landen Financial Services, Inc. (“DLL”) pursuant to which DLL provided a revolving credit loan and floorplan loan (the “DLL Credit Facility”), to pay off all indebtedness under a Loan Agreement with De Lage Landen Financial Services Canada Inc. (“DLL Canada”) pursuant to which DLL Canada provided EIS-Canada with a revolving credit line of C$5 million (the “Canadian Credit Facility”), to pay related costs and expenses and for working capital and other general corporate purposes. The PNC Loan Agreement will remain in effect until December 29, 2014, unless sooner terminated by the Borrower or PNC.
Borrowings under the PNC Loan Agreement will bear regular interest at a rate equal to the Alternate Base Rate (as defined in the PNC Loan Agreement) plus 1.0% or the Eurodollar Rate (as defined in the PNC Loan Agreement) plus 3.0% on the outstanding principal amount.
The PNC Loan Agreement contains certain customary affirmative and negative covenants, including, among other things: (i) affirmative covenants requiring the Borrower to provide certain financial statements and schedules to PNC, maintain their legal existence, keep their collateral in good condition, and provide certain notices to PNC; and (ii) negative covenants that provide for limitations on other indebtedness, liens, amendments of organizational documents, asset sales, capital expenditures, issuance of capital stock, investments, and transactions with affiliates.
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The PNC Loan Agreement also contains certain customary representations and warranties and events of default, including, among other things, failure to pay interest, principal or fees due under the PNC Loan Agreement, any material inaccuracy of any representation and warranty, any default having occurred under any Subordinated Debt (as such term is defined in the PNC Loan Agreement), and the occurrence of bankruptcy or other insolvency events. Certain of the events of default are subject to exceptions and materiality qualifiers. If an event of default shall occur and be continuing under the PNC Loan Agreement, PNC may, among other things, accelerate the repayment of the Borrower’s obligations under the PNC Credit Facility.
To secure the payment of the obligations under the PNC Loan Agreement, the Borrower granted to PNC a security interest in, and a lien upon, all of its respective interests in its respective assets, including receivables, equipment, general intangibles, inventory, investment property, subsidiary stock, leasehold interests, goods, deposit accounts, letter of credit rights, commercial tort claims and insurance proceeds. All such security interests are subject to the terms of a Subordination Agreement, dated December 30, 2011 among PNC, NewSpring, Peachtree (NewSpring and Peachtree, collectively, the “Investors”) and the Borrower, as amended on March 20, 2012 (the “Subordination Agreement”).
On March 20, 2012, the Borrower and EIS Canada entered into a First Amendment and Joinder to Loan Documents (the “First Amendment”) with PNC, pursuant to which PNC agreed to make certain amendments to the PNC Loan Agreement and the Other Documents (as such term is defined in the PNC Loan Agreement and together with the PNC Loan Agreement, the “PNC Loan Documents”), including (1) joining EIS Canada to the PNC Loan Documents, (2) amending the definition of EBITDA to revise certain add-backs and deductions thereto and (3) revising the covenants and representations and warranties included in the PNC Loan Agreement to include certain customary covenants and representations and warranties relating to EIS Canada.
To secure the payment of the obligations of EIS Canada under the PNC Loan Agreement, EIS Canada granted to PNC a security interest in, and a lien upon, all of its interests in its assets, including accounts, securities entitlements, securities accounts, futures accounts, futures contracts and investment property, deposit accounts, instruments, documents, chattel paper, inventory, goods, equipment, fixtures, agricultural liens, as-extracted collateral, letter of credit rights and intangibles of every kind. All such security interests are subject to the terms of the Subordination Agreement.
The Company had a balance of $13.7 million outstanding under the revolving portion of the PNC Credit Facility at May 31, 2012. At August 31, 2011, the Company had a balance of $17.2 million outstanding under the revolving portion of the DLL Credit Facility, and a balance of $1.0 million (included in the Company’s accounts payable) outstanding plus $2.2 million in open approvals under the floorplan portion of the DLL Credit Facility. Net availability was $5.1 million under the revolving portion of the PNC Credit Facility as of May 31, 2012 and $4.9 million under the revolving portion of the DLL Credit Facility as of August 31, 2011.
As of May 31, 2012, the Company determined it was in compliance with its financial covenants under the PNC Credit Facility.
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8. Subordinated Debt
On August 15, 2011, the Borrower entered into a Subordinated Loan Agreement (the “Subordinated Loan Agreement”) with NewSpring. The Subordinated Loan Agreement provided for a subordinated term loan in an original principal amount of $10.0 million (the “Subordinated Credit Facility”). The proceeds of the Subordinated Credit Facility were used to pay a portion of the purchase price for the acquisition of Emerging, to pay down a portion of the amount outstanding under the DLL Credit Facility and to pay related costs and expenses. Borrowings under the Subordinated Loan Agreement will bear regular interest at a rate equal to 12.0% per annum on the outstanding principal amount. Accrued and unpaid regular interest is payable on the last business day of each fiscal quarter beginning with November 30, 2011. Borrowings under the Subordinated Loan Agreement will bear additional interest at a rate equal to 2.0% per annum and this accrued and unpaid additional interest of 2.0% can be, at the Borrower’s option, paid in cash, or added to the principal amount outstanding on the last business day of each fiscal quarter beginning with November 30, 2011.
On December 30, 2011, the Borrower entered into an Amended and Restated Subordinated Loan Agreement (the “Amended and Restated Subordinated Loan Agreement”) with the Investors pursuant to which: (i) Peachtree provided an additional subordinated term loan in an original principal amount of $3.0 million (together with the existing subordinated term loan from NewSpring in the original principal amount of $10.0 million, the “Amended and Restated Subordinated Credit Facility”), (ii) NewSpring was appointed as collateral agent, (iii) the Investors waived any event of default arising from (a) the Borrower failing to meet the Total Funded Senior Debt to Pro Forma Adjusted EBITDA Ratio covenant (as set forth in the Subordinated Loan Agreement) for the trailing twelve months ending November 30, 2011 and (b) the Borrower failing to comply with the covenant in the Subordinated Loan Agreement prohibiting a Borrower name change without notice to, or the consent of, NewSpring, and (iv) the Investors agreed to make certain other amendments to the Subordinated Loan Agreement, including amending the Total Funded Senior Debt to Pro Forma Adjusted EBITDA Ratio covenant to provide that the Company and its consolidated subsidiaries shall maintain as of the last business day of the fiscal quarters ending on February 28, 2012 and May 31, 2012, a ratio of Total Funded Senior Debt on such date to Pro Forma Adjusted EBITDA (as such terms are defined in the Amended and Restated Subordinated Loan Agreement) on a trailing twelve months basis for such period of not less 4.0 to 1.0 for the fiscal quarter ending on February 28, 2012 and of not less than 3.75 to 1.0 for the fiscal quarter ending on May 31, 2012.
The Amended and Restated Subordinated Loan Agreement contains certain customary affirmative and negative covenants, including, among other things: (i) affirmative covenants requiring the Borrower to provide certain financial statements and schedules to the Investors, maintain their legal existence, keep their collateral in good condition, and provide certain notices to the Investors; and (ii) negative covenants that provide for limitations on other indebtedness, liens, amendments of organizational documents, asset sales, capital expenditures, issuance of capital stock, investments, and transactions with affiliates. The Amended and Restated Subordinated Loan Agreement also entitles the Investors to have up to two representatives attend every meeting of the Board of Directors of the Company until the date that the obligations of the Borrower under the Amended and Restated Subordinated Loan Agreement have been irrevocably paid in full and discharged, subject to certain exceptions relating to confidentiality and conflict of interest requirements.
The Amended and Restated Subordinated Loan Agreement also contains certain customary representations and warranties and events of default, including, among other things, failure to pay interest, principal or fees due under the Amended and Restated Subordinated Loan Agreement, any material inaccuracy of any representation and warranty, any default having occurred under any Senior Debt (as such term is defined in the Amended and Restated Subordinated Loan Agreement), and the occurrence of bankruptcy or other insolvency events. Certain of the events of default are subject to exceptions and materiality qualifiers. If an event of default shall occur and be continuing under the Amended and Restated Subordinated Loan Agreement, the Investors may, among other things, accelerate the maturity of the Amended and Restated Subordinated Credit Facility.
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As of May 31, 2012, the Company has determined it was in compliance with its financial covenants under the Amended and Restated Subordinated Loan Agreement with NewSpring and Peachtree. NewSpring and Peachtree have agreed that the total funded senior debt to pro forma adjusted EBITDA financial covenant under the Amended and Restated Subordinated Loan Agreement would not be applicable for the quarter ended May 31, 2012.
9. Concentration of Credit Risk
Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of accounts receivable.
The Company’s revenues, by client type, consist of the following (in thousands):
The Company reviews a client’s credit history before extending credit. The Company does not require collateral or other security to support credit sales. The Company provides an allowance for doubtful accounts based on the credit risk of specific clients, historical experience and other identified risks. Trade receivables are carried at original invoice less an estimate made for doubtful receivables, based on review by management of all outstanding amounts on a periodic basis. Trade receivables are considered delinquent when payment is not received within standard terms of sale, and are charged-off against the allowance for doubtful accounts when management determines that recovery is unlikely and ceases its collection efforts.
The trade account receivables consist of the following (in thousands):
Trade receivables include $3.9 million and $3.0 million of unbilled revenue as of May 31, 2012 and August 31, 2011, respectively.
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Major Customers
Sales to major customers, representing at least 10% of total revenue for a period consist of the following (in thousands):
Trade receivables due from an education client in the southeastern United States and one of the departments of the U.S. Government accounted for approximately 9.2% and 11.3%, respectively, of the Company’s trade receivables as of May 31, 2012. The same clients accounted for approximately 14.9% and 2.4%, respectively of the Company’s trade receivable as of August 31, 2011.
10. Inventories
Inventories are stated at the lower of average cost or market. Inventories consist of finished goods purchased for resale, including computer hardware, computer software, computer peripherals and related supplies. At May 31, 2012 and August 31, 2011, inventories consisted of the following (in thousands):
11. Accrued Liabilities
At May 31, 2012 and August 31, 2011, accrued liabilities consisted of the following (in thousands):
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12. Related Party Transactions
The Company leases warehouse and office space from related parties. The aggregate expense for these lease arrangements during the three months ended May 31, 2012 and 2011 was $146,000 and $194,000, respectively. During the nine months ended May 31, 2012 and 2011, the aggregate expense for these lease arrangements was $413,000 and $582,000, respectively.
13. Legal Proceedings
In September 2011, the Company learned that it had been named as a defendant in a qui tam case alleging violations of the Trade Agreements Act. This case, designated United States ex rel. Sandager v. Dell Marketing, L.P., et al., was filed under seal in the United States District Court for the District of Minnesota on July 31, 2008. The United States declined to intervene in the matter on September 30, 2009. On April 25, 2012, the case was dismissed with prejudice.
In addition, the Company is occasionally involved in various lawsuits, claims, and administrative proceedings arising in the normal course of business. Except as set forth above, the Company believes that any liability or loss associated with such matters, individually or in the aggregate, will not have a material adverse effect on the Company’s financial condition or results of operations.
14. Segment Information
The Company provides segment financial information in accordance with ASC Topic 280 Segment Reporting. The Company divides its operating activity into two operating segments for reporting purposes: Emtec Systems Integration (“ESI”) and Emtec Global Sourcing (“EGS”). In 2011, Management changed the names of these segments, however, the historical numbers associated with these segments remains the same. Our ESI segment provides clients a wide variety of services including outsourced consulting application services and infrastructure consulting and outsourcing. Our EGS segment provides our clients the opportunity to take advantage of our consulting resources and offshore resources when they are not specifically looking for us to manage their project. The accounting policies of our segments are the same as those described in Note 2, and there are no material intersegment transactions.
Summarized financial information relating to the Company’s operating segments is as follows (in thousands):
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with, and is qualified in its entirety by, the unaudited financial statements, including the notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q.
Cautionary Statement Regarding Forward-Looking Statements
You should carefully review the information contained in this Quarterly Report on Form 10-Q and in other reports or documents that we file from time to time with the Securities and Exchange Commission (the “SEC”). In addition to historical information, this Quarterly Report on Form 10-Q contains our beliefs regarding future events and our future financial performance. In some cases, you can identify those so-called “forward-looking statements” by words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of those words and other comparable words. You should be aware that those statements are only our predictions. Actual events or results may differ materially. We undertake no obligation to publicly release any revisions to forward-looking statements after the date of this report. In evaluating those statements, you should specifically consider various factors, including the risk factors discussed in our Annual Report on Form 10-K for the year ended August 31, 2011 and other reports or documents that we file from time to time with the SEC. All forward-looking statements attributable to us or a person acting on our behalf are expressly qualified in their entirety by this cautionary statement.
Assumptions relating to budgeting, marketing, and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our business, financial position, results of operations and cash flows.
Overview of Emtec
Emtec, Inc., a Delaware corporation, formed on January 17, 2001, is an information technology (“IT”) services provider. We provide consulting, application services and infrastructure services to commercial and public sector clients. The Company’s client base is comprised of commercial businesses, school districts throughout the United States and Canada and departments of the United States and Canada’s federal, state/provincial and local governments.
Consolidated Statements of Operations for the Three Months Ended May 31, 2012 compared with the Three Months Ended May 31, 2011.
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EMTEC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
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Consolidated Results of Operations Overview
Management examines numerous measures when analyzing the results of our operations. Our objective is to grow the overall revenues, gross profit margins and operating profits of the Company.
As we diversify our business and grow our consulting and outsourcing services revenues, and in particular our applications services revenues, we expect gross margins to increase. However, due to changes in types of services, we may occasionally see a decline in our services gross margin, which may lead to a decline in our overall gross margin.
We measure our selling costs as a percentage of gross profits, and commissions compensation for our sales associates is calculated based on gross profit. We expect that our growth will lead to selling costs increasing, but as our revenues grow, we expect our selling costs to grow less quickly than our gross profit, thereby decreasing selling costs as a percentage of total gross profits. As we grow, we expect that our general and administrative costs will decrease as a percentage of revenue. In the past, we have invested, from time to time, in additional general and administrative costs in order to be able to grow our revenue more quickly based on market conditions. In addition, we may experience an increase in our overall selling, general and administrative costs prior to being able to reduce some of the costs (for example, after an acquisition, we may not experience overhead synergies immediately).
As we grow our consulting and outsourcing revenues, we expect to focus increasingly on measures such as average billing rates, utilization rates, hours billed and hourly consulting costs. While we do not publicly report these metrics, we analyze these figures to monitor trends that will enable us to make more effective decisions. We are improving our internal systems (including our ERP implementation during the fourth quarter of fiscal 2011) in order to be able to provide these metrics more quickly to our management.
We currently categorize our revenues and costs of sales into “Procurement Services” and “Consulting and Outsourcing.” We have made these categorizations in order to analyze our growth in IT professional services as a percentage of overall revenues. We have divided our business into two segments: Emtec Systems Integration (“ESI”) and Emtec Global Sourcing (“EGS”). ESI provides clients with a wide variety of services including outsourced consulting application services and infrastructure consulting and outsourcing. EGS provides clients the opportunity to take advantage of our consulting resources when they are not specifically looking for us to manage their project.
For the three months ended May 31, 2012 compared with the three months ended May 31, 2011, total revenues increased by $5.8 million or 13.0% to $50.7 million. This increase was comprised of a $6.5 million increase in consulting and outsourcing revenue offset by a $726,000 decrease in procurement services revenue. Further, total gross profit increased by $1.3 million and overall gross profit margin increased from 17.4% for the three months ended May 31, 2011 to 17.9% for the three months ended May 31, 2012. The increases in consulting and outsourcing revenue and gross profit are consistent with our strategy of shifting towards services that generate higher margin revenue. Additionally, the increased total gross profit helped to reduce our operating loss by $747,000 to $422,000 for the three months ended May 31, 2012 as compared to $1.2 million for the three months ended May 31, 2011. There are several non-cash expenses included in our operating costs. These include depreciation and amortization, stock-based compensation expenses and mark-to-market adjustments for certain stock based and acquisition based liabilities for the three months ended May 31, 2012 and 2011 which total $1.7 million and $1.0 million, respectively. Excluding non-cash items, the improvement in our business is the result of several factors including an improvement in revenues from our Education Business, improved margins and lower selling costs in our Federal Business, and a cost-cutting initiative undertaken by the Company in 2011 with projected annual savings of approximately $4.5 million. In addition, our capital expenditures for the three months ended May 31, 2012 decreased $1.4 million from $1.6 million for the three months ended May 31, 2012 to $164,000 for the three months ended May 31, 2012. The increase in capital expenditures during the three months ended May 31, 2011 related to the Company’s ERP implementation during the third and fourth quarters of fiscal 2011.
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We discuss the results of each segment below.
Results of Operations -ESI
The following discussion and analysis provides information that management believes is relevant to an assessment and understanding of our ESI results of operations for the three months ended May 31, 2012 and 2011.
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