Form 10-Q

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

The number of shares of registrant's Common Stock outstanding on September 8, 2003 was 48,055,556.

The Company¾

Datatec Systems, Inc. and its subsidiaries (the "Company") are in the business of providing rapid and accurate technology deployment services and licensing software tools to support enterprises in the delivery and management of complex IT solutions.

During the fiscal year ended April 30, 2000, the Company changed the name of its subsidiary CASI, Inc. to eDeploy.com Inc., ("eDeploy.com"). During the fiscal year ended April 30, 2002, the Company integrated eDeploy.com's activities into Datatec Systems, Inc. eDeploy's activities include developing, marketing and managing the licensing of software tools to support enterprises in the delivery of complex IT solutions.

The net loss of $19.4 million for the fiscal year ended April 30, 2001 and the net loss of $2.7 million for the fiscal year ended April 30, 2002 resulted in a strain on the Company's cash resources. Although the Company realized net income of $1.4 million for fiscal year ended April 30, 2003 and took dramatic measures to cut costs and to manage cash, it is still experiencing a significant strain on cash resources. The primary reason for the strain on resources is the increased requirements for expenditures for field personnel, job expenses and materials related to the increased revenue. As a result, the working capital financing line regularly remains at or close to its maximum allowable levels and the average days outstanding on trade payables have extended beyond normal credit terms granted by vendors.

Achievement of the Company's fiscal 2004 operating plan, including maintaining adequate capital resources, depends upon the timing of work performed on existing projects, ability to gain and perform work on new projects, ability to maintain positive relations with key vendors and the ability to raise permanent capital and replace the current working capital financing line within the timeframe required to meet spending requirements. Multiple project cancellations, job performance related losses, delays in the timing of work performed on existing projects, inability to gain and perform work on new projects, or inability to raise permanent capital and replace the current working capital financing line in a timely fashion could have an adverse impact on the Company's liquidity and on the ability to execute its operating plan.

Basis of Presentation---

The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The Company's July 31, 2003 financial statements include the results of its subsidiary Millennium Care, Inc. from May 1, 2003, the date of acquisition. All intercompany accounts and transactions have been eliminated.

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles applicable to interim financial information and with the instructions to Form 10-Q and Article 10 of the Securities and Exchange Commission ("SEC") Regulation S-X. Accordingly, they do not include all of the information and footnotes 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 fair presentation have been included. Operating results for the three months ended July 31, 2003 are not necessarily indicative of the results that may be expected for a full year. The accompanying financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in Datatec's annual report on Form 10-K for the year ended Ap ril 30, 2003.

Use of Estimates¾

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 the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates underlying the accompanying consolidated financial statements include estimated revenues under long-term contracts, estimated costs to complete long-term contracts, recoverability of intangibles and other long-lived assets, allowance for doubtful accounts and inventory carrying values. Actual results could differ from those estimates.

(2) Recent Developments:

Acquisition of Millennium Care, Inc. On May 1, 2003, the Company acquired 100% of a privately-held provider of help desk outsourcing and related technologies. Pursuant to the stock purchase agreement, the Company issued 1,546,247 shares of common stock, warrants to purchase 200,000 shares of common stock and employee stock options to purchase 56,490 shares of common stock in exchange for all of the outstanding equity of Millennium. In addition, the Company has agreed to issue to the sellers of Millennium additional shares of common stock in the event certain revenue targets are met by Millennium during calendar years 2003 and 2004. If Millennium achieves qualified (as defined) revenue of over $6 million (Canadian) in calendar 2003 or $10 million (Canadian) in calendar year 2004, the Company would be required to issue additional shares of common stock in an amount equal to 40% of any such excess for calendar year 2003 and 35% of any such excess for calendar year 2004. The warra nts are exercisable at $1.82 per share and are not exercisable before January 31, 2004 or after May 1, 2008. These warrants also require Millennium to achieve a revenue target of $5.4 million (Canadian) for calendar year 2003 in order to become exercisable. The Company may redeem the warrants at any time after January 31, 2005 at a price of $0.10 per warrant if the closing price of the common stock is at least 180% of the exercise price for 20 out of 30 consecutive trading days and the average daily trading volume during this period is greater than 100,000 shares per day. The exercise price of the warrants is subject to adjustment upon certain events, including stock splits, stock dividends, reorganizations, reclassifications, mergers, consolidations and dispositions of assets. The stock options are exercisable at $1.40 per share and were issued to replace Millennium employee options, which were canceled as a result of the acquisition.

The Company has accounted for the acquisition of Millennium using the purchase method of accounting under Statement of Financial Accountant Standards (SFAS) No. 141, "Business Combinations". The inclusion of Millennium for the quarter ended July 31, 2002 would have no material impact on the Company's July 31, 2002 consolidated financial statements. The Company has performed a preliminary assessment of the fair values of the assets acquired and liabilities assumed. The purchase price for Millennium was allocated to assets and liabilities based on Management's estimates of fair value based upon projected discounted cash flows. The following table sets forth the allocation of the purchase price (dollars U.S. in thousands):

In accordance with SFAS No.142 "Goodwill and Other Intangible Assets", the goodwill will not be amortized, but will be tested for impairment using a fair value approach at least annually.

Issuance of Subordinated Secured Convertible Notes and Warrants. On July 3, 2003, the Company issued an aggregate of $4.9 million principal amount of subordinated secured convertible notes and warrants to purchase an aggregate of 875,000 shares of common stock, pursuant to a Note Purchase Agreement by and among the Company and the investors signatory thereto. The investors are six funds managed by the Palladin Group L.P., which also manages two funds that were among the Company's current lenders. Under the original Note Purchase Agreement, the notes are to be repaid in sixteen equal monthly installments beginning on January 1, 2004 and ending on April 1, 2005 and bear interest at a rate of 2% per annum. The monthly installments of principal and interest are payable in cash or common stock at our option, subject to certain listing and registration requirements relating to the common stock. If the Company elects to pay the monthly installments in common stock, the conversion rat e is the lower of: (a) $1.40 or (b) a 10% discount to the then fair market value of the common stock. The holder of each note is entitled, at its option, to convert at any time the principal amount of the note or any portion thereof, together with accrued but unpaid interest, into shares of common stock at a conversion price for each share of common stock equal to $1.40. In connection with the financing, we issued to the investors four-year warrants to purchase an aggregate of 875,000 shares of common stock at an exercise price of $1.3224 per share. The warrants have been valued at approximately $384,000, based on the Black Scholes Pricing Model utilizing the following assumptions: expected life of 4.0 years; volatility of 66 percent; risk free borrowing rate of 2.120 percent. This amount has been recorded as a discount against the debt and will be accreted as interest expense over the remaining life of the debt. In addition, in accordance with Emerging Issues Task Force No. 98-5, an embedded beneficia l conversion feature of approximately $384,000 has been recognized as additional paid-in-capital and will be accreted as additional interest expense over the remaining life of the debt. Through July 31, 2003, $40,000 of the above discounts has been accreted. The warrants are exercisable at any time from July 3, 2003 to July 3, 2007, and are not redeemable. The exercise price of the warrants is subject to adjustment upon certain events, including stock splits, stock dividends, reorganizations, reclassifications, mergers, consolidations and dispositions of assets and issuances, other than certain permitted issuances, of common stock and securities convertible into common stock at prices less than the exercise price.

The Company agreed to prepare and file a registration statement covering the resale of the shares of common stock issuable upon the redemption or conversion of the notes and the exercise of the warrants. The registration statement was required to be filed with the Securities and Exchange Commission ("SEC") not later than August 3, 2003. The Company filed such registration statement on July 31, 2003. The Company will incur a 2% penalty on the value of the shares of common stock underlying the notes and the warrants if the SEC does not declare such registration statement effective by November 1, 2003.

On July 28, 2003, the Company agreed to issue to the investors an aggregate of 700,000 four-year warrants to purchase shares of the Company's common stock at an exercise price of $0.9441 per share in exchange for the following: (i) a waiver of the investors' rights of first refusal in connection with the July 28, 2003 private placement (described below); (ii) a waiver of the investors' right to a redemption price adjustment to their notes which would cause an increased number of shares to be issuable upon redemption of their notes as a result of the July 28, 2003 private placement; and (iii) an extension of the maturity date of the notes from October 1, 2004 to April 3, 2005. These warrants have been valued at approximately $483,000 using Black Scholes Pricing Model. The value has been accounted for as a cost of the July 28, 2003 private placement of common stock. The Company determined the fair value of the warrants based on the Black Scholes Pricing Model to be approximately $449,000 and included such costs in the issuance costs attributable to the Company's July 28, 2003 private placement of common stock.

Private Placement of Common Stock. On July 28, 2003, the Company raised $3.49 million in private equity financing (less out-of-pocket transaction costs of approximately $0.48 million) for working capital purposes and to reduce outstanding indebtedness by selling 3,696,621 shares of the Company's common stock and warrants to purchase an additional 1,848,306 shares of the Company's common stock at an exercise price of $1.3637 per share. The warrants are exercisable at any time from July 28, 2003 to July 28, 2008. The Company may redeem the warrants at any time after July 28, 2004 at a price of $0.10 per warrant if the closing price of the common stock is at least 180% of the exercise price for 20 out of 30 consecutive trading days and the average daily trading volume during this period is greater than 100,000 shares per day. The Company also issued a five-year warrant to purchase 554,492 shares of common stock at an exercise price of $1.3637 per share to the placement agent for the f inancing. These warrants are exercisable at any time from July 28, 2003 to July 28, 2008 and are not redeemable by the Company. The exercise price on both the warrants issued to investors in the private placement and the warrants issued to the placement agent is subject to adjustment upon certain events, including stock dividends, reclassifications, recapitalizations, reorganizations and mergers. In addition, the exercise price of the warrants issued to the investors in the private placement is subject to adjustment upon issuances, other than certain permitted issuances, of common stock and securities convertible into common stock at prices less than the exercise price. The agreement with the investors in the private placement requires the Company to file a registration statement for the resale of the shares of common stock issued in the private placement and the shares of common stock underlying the warrants, with the SEC immediately following the closing on July 28, 2003.

In addition, we issued to the placement agent 127,168 shares of our common stock to cancel $133,400 in fees the Company owed to them.

Amendment of debt due to related party. On August 29, 2003, the Company entered into an agreement with Christopher J. Carey, by which it agreed to pay down amounts owed to Mr. Carey in equal monthly amounts of $316,666.67, plus interest, beginning September 2003 and ending February 2004. At its option, the Company may pay such monthly amounts in cash or in shares of the Company's common stock determined using a five-day average closing price prior to the monthly payment date. The agreement with Mr. Carey also requires the Company to register the shares of common stock issuable to Mr. Carey.

Litigation. On September 4, 2003, a jury found in favor of the Company with respect to a lawsuit filed against it by Petsmart, Inc. in the Superior Court of Maricopa County, Arizona.

The jury verdict rejected Petsmart's claims against the Company and accepted the Company's counterclaim for unpaid invoices of approximately $172,000. The Company intends to seek reimbursement of legal costs against Petsmart in connection with the litigation. 

(3) Critical Accounting Policies:

Revenue Recognition¾

The Company generates revenue from: (1) providing technology deployment services, including configuring Internetworking and computing devices to meet the specific needs of its customers, integrating these devices as well as operational and application software with a customer's existing hardware and software, and physically installing the technology on the customer's network and (2) from licensing its software to third parties.

Services from deployment activities are performed primarily under long-term contracts, but may be performed under short-term workorders or time and material arrangements. The Company's typical long-term contract contains multiple elements designed to track the various services required under the arrangement with the customer. These elements are used to identify components of progress billings, but are combined for revenue recognition purposes. The Company recognizes revenue earned under long-term contracts utilizing the percentage of completion method of accounting by measuring total costs incurred to total estimated costs. Under the percentage of completion method of accounting, revenue, costs and gross margin are recognized as work is performed based on the relationship between total costs incurred and total estimated costs.

Contracts are reviewed at least quarterly and, if necessary, revenue, costs and gross margin are adjusted prospectively for revisions in estimated total contract value and total estimated contract costs. Estimated losses are recognized when identified.

Payment milestones differ according to the customer and the type of work performed. Generally, the Company invoices customers and payments are received throughout the deployment process and, in certain cases, in advance of work performed if a substantial amount of up front costs is required. In certain cases payments are received from customers after the completion of site installation. However, revenue and costs are only recognized on long-term contracts to the extent of the contracts' percentage of completion. Costs and estimated earnings in excess of billings, which is classified as a current asset, is recorded for the amount of revenue earned in excess of billings to customers. Accrued costs or deferred revenue is recorded as a current liability for the amount of billings in excess of revenue earned.

Revenue earned under short-term workorders and time and material arrangements is recognized as the work is completed. Billings under these arrangements are typically done when the work is completed.

Revenue from software licensing arrangements is recognized in accordance with Statement of Position ("SOP") No. 97-2, as amended, "Software Revenue Recognition". Revenue from license fees is recognized when an agreement has been signed, delivery of the product has occurred, the fee is fixed or determinable and collectibility is not probable. Revenue is deferred if such criteria are not met. If the fee due from the customer is not fixed or determinable, revenue is recognized as payments become due from the customer. If collectibility is not reasonably assured, revenue is recognized when the fee is collected. Maintenance revenue, if applicable, is negotiated separately and the contract identifies the specific charges related to this service. This revenue is recognized ratably over the contract maintenance period. The Company also recognizes revenue as an Application Service Provider ("ASP"). Under this scenario, the Company does not license the software, but provides access to the so ftware through its hosting activities. For this access, the Company bills its customers and recognizes this revenue over the period of access. Revenue from licensing, maintenance and hosting activities remain immaterial in amount.

Cash and Cash Equivalents¾

The Company considers cash equivalents to be all highly liquid investments purchased with an original maturity of three months or less.

Inventory¾

Inventory, which is comprised of parts and materials to be installed as part of the Company's deployment services, is stated at the lower of average cost or market.

Property and Equipment, Net¾

Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives or lease terms of the related assets, whichever is shorter.

Goodwill and Intangible Assets-

In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, "Business Combinations" and SFAS 142, "Goodwill and Other Intangible Assets" (collectively "the Standards"). The Standards require all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, that goodwill is no longer subject to amortization but rather be reviewed periodically for impairment and that other identifiable intangibles be separated and those with finite lives be amortized over their useful lives. Goodwill and intangible assets with indefinite lives must be assessed once a year for impairment, and more frequently if circumstances indicate a possible impairment. The first step of the two-step impairment assessment identifies potential impairment and compares the fair value of the applicable reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying value, goodwill of the rep orting unit is not considered impaired, and the second step of the impairment test is not necessary. If the carrying value of the reporting unit exceeds its fair value, the second step of the impairment test shall be performed to measure the amount of impairment loss, if any. The Company elected to early adopt these standards as of May 1, 2001 as permitted and evaluated the carrying value of its goodwill and other intangible assets. Based on its evaluation, the Company determined that there was no impairment to its Goodwill and other intangible assets. Subsequent impairment tests will be performed, at a minimum, in the fourth quarter of each fiscal year, in conjunction with the Company's annual planning process.

The Company determined the estimated fair values of goodwill and certain intangible assets with definitive lives based on purchase price allocations determined by performing fair value analyses. In addition, the Company capitalizes certain computer software costs, including product enhancements, after technological feasibility has been established, in accordance with SFAS No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed." These costs are amortized using the greater of the ratio that current gross revenue for a product bears to the total of current and anticipated future gross revenues for the product, or a maximum of three years using the straight-line method beginning when the products are available for general release to customers. Approximately $1,274,000 and $1,183,000 of net capitalized software costs are included in intangible assets in the accompanying consolidated balance sheets as of April 30, 2003 and July 31, 2003, respectively . Amortization expense of capitalized software costs for the three months ended July 31, 2002 and 2003 was $397,000 and $223,000, respectively, and is included in project costs. Costs incurred prior to technological feasibility and those incurred for minor enhancements and maintenance have been charged to general and administrative expense as incurred.

Goodwill is not amortized, but tested at least annually for impairment using a fair value approach. Intangible assets with definitive lives are capitalized and amortized over their useful lives.

Long-Lived Assets¾

In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supercedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of", and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for the disposal of a segment of a business. This Statement also amends ARB No. 51, "Consolidated Financial Statements", to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. The provisions of this Statement are required to be applied starting with fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 in f iscal 2003, with no material impact on its consolidated financial position or consolidated results of operations.

Prior to adopting SFAS No. 144, SFAS No. 121, required, among other things, that an entity review its long-lived assets and certain related intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. The amount of impairment of goodwill would be determined as part of the long-lived asset grouping being evaluated. Impairment losses are recognized when a long-lived asset's carrying amount may not be recoverable. Impairment losses are recognized when a long-lived asset's carrying value exceeds the expected undiscounted future cash flows related to that asset. The amount of the impairment loss is the difference between the carrying value and the fair market value of the asset. The fair market value of the asset is determined based upon discounted cash flows. Due to the losses incurred for the fiscal years ended April 30, 2001 and 2002, the Company has assessed its long-lived assets for impairment. Based on estim ated undiscounted future cash flows, the Company believes that there was no impairment of its long-lived assets as of July 31, 2003.

Income Taxes¾

The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". Certain transactions are recorded in the accounts in a period different from that in which these transactions are reported for income tax purposes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and the tax effect of net operating loss carry-forwards. A valuation allowance is recorded against deferred tax assets if it is more likely than not that such assets will not be realized.

Fair Value of Financial Instruments¾

The carrying value of cash and cash equivalents, accounts receivable, costs and estimated earnings in excess of billings, accounts payable, deferred income and the current portion of long-term debt approximate fair value due to the short-term maturities of these instruments. The carrying value of the long-term debt obligations approximate fair value based on current rates offered to the Company for debt with similar collateral and guarantees, if any, and maturities.

Foreign Currency Translation¾

The local currency of the Company's foreign (Canada) subsidiary is its functional currency. Assets and liabilities of the Company's foreign subsidiary are translated into U.S. dollars at the current exchange rate. Statement of operations accounts are translated at the average rate of exchange prevailing during the year. Translation adjustments arising from the use of differing exchange rates from period to period are a component of accumulated comprehensive loss included in stockholders' equity.

Stock Based Compensation¾

SFAS No. 123, "Accounting for Stock-Based Compensation", requires that an entity account for employee stock-based compensation under a fair value based method. However, SFAS No.123 also allows an entity to continue to measure compensation cost for employee stock-based compensation arrangements using the intrinsic value based method of accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees". The Company continues to account for employee stock-based compensation using the intrinsic value based method.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation- Transition and Disclosure". SFAS No. 148 amends SFAS No. 123, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for financial statements for fiscal years and interim periods ending after December 15, 2002. The Company has adopted the disclosure provisions of SFAS No. 148. SFAS No. 148 did not require the Company to change to the fair value based method of accounting for stock based compensation.

The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation.

Internal Use Software¾

In accordance with SOP No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," the Company capitalizes certain costs of computer software developed or obtained for internal use. Approximately $205,000 and $85,000 of amortization expense were incurred during the three months ended July 31, 2002 and 2003, respectively, and is included in general, administrative and selling expense. The Company has expensed costs incurred during the preliminary and post implementation phases in the periods in which these costs were incurred.

Comprehensive Income---

SFAS No. 130, "Reporting Comprehensive Income", establishes standards for reporting and displaying of comprehensive income and its components (revenue, expenses, gains and losses) in a full set of general-purpose financial statements. The Company's sole component of other comprehensive income is foreign currency translation adjustments generated from the Company's Canadian subsidiary.

Recent Accounting Pronouncements¾

In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This Statement eliminates the automatic classification of gain or loss on extinguishment of debt as an extraordinary item of income and requires that such gain or loss be evaluated for extraordinary classification under the criteria of APB No. 30. This Statement also requires sales-leaseback accounting for certain lease modifications that have economic effects that are similar to sales-leaseback transactions, and makes various other technical corrections to existing pronouncements. This Statement will be effective for the Company for the fiscal year ending April 30, 2004. This standard, which the Company adopted during the first quarter of fiscal 2004 did not have a material effect on the Company's consolidated financial position or consolidated results of operations.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This standard amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, collectively referred to as derivatives, and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Relationships." SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships after June 30, 2003. The Company does not believe that the implementation of this standard will materially impact its consolidated financial position or consolidated results of operations.

Segments of an Enterprise¾

SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information" established standards for reporting of financial information in Company's Financial Statements.

The Company's management considers its business to be a single business entity.

(4) Net Income Per Share:

SFAS No. 128, "Earnings Per Share" requires the presentation of basic earnings per share ("Basic EPS") and diluted earnings per share ("Diluted EPS"). Basic EPS is calculated by dividing income or loss applicable to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted EPS is calculated by dividing income available to common stockholders by the weighted average number of common and potentially dilutive common shares outstanding during the period.

In accordance with SFAS No. 128, the following table reconciles net loss and per share amounts used to calculate basic and diluted earnings per share (in thousands):

Outstanding options and warrants totaling 10,407,479 for the three months ended July 31, 2003 have been excluded from the computation of Diluted EPS, as their inclusion would have been anti-dilutive.

(5) Short-term Borrowings:

The Company maintains a credit facility with IBM Credit. At the beginning of fiscal 2003, the credit facility consisted of: (i) a $16 million, three-year revolving credit facility and (ii) a $3 million, three-year term loan, payable in monthly installments of principal and interest. During fiscal 2003, the credit facility was amended several times.

On April 14, 2003, the credit facility was amended to: (i) extend the credit facility to August 1, 2004 from August 1, 2003; (ii) provide for a maximum availability of $29 million until May 31, 2003, $25 million from June 1, 2003 until December 31, 2003, $20 million from January 1, 2004 until March 31, 2004 and $15 million from April 1, 2004 until August 1, 2004; (iii) lower the interest rate on the facility from prime plus 4.25% to prime rate plus 1.75% effective May 1, 2003; (iv) amend certain finance charges and financial covenants (described below); and (v) require the Company to pay off the remaining balance of the $3 million term loan with IBM Credit after the closing of an equity financing. The Company repaid the term loan after closing on the $5 million private equity placement in April 2003.

On June 3, 2003, the credit facility was further amended to provide for a maximum availability as follows: (i) $25 million from June 1, 2003 until January 14, 2004; (ii) $23 million from January 15, 2004 until March 31, 2004; and (iii) $20 million from April 1, 2004 until August 1, 2004. In addition, IBM Credit agreed to increase the Company's maximum availability from $25,000,000 to $28,000,000 until August 31, 2003, at which time the maximum borrowings under the credit facility available must be reduced to $25,000,000. The Company is required to pay interest at the rate of prime rate plus 4% on any amounts borrowed over $25 million, instead of prime rate plus 1.75%.

The borrowings under the revolving line of credit are based on a formula of 85% of eligible receivables and 25-35% of eligible inventory. The amounts outstanding under the credit facility as of April 30, 2003 and July 31, 2003 were $28.8 million and $24.6 million, respectively. At times, IBM Credit has allowed the Company to borrow amounts in excess of our maximum allowable.

As set forth in the table below, the Company has failed to comply with one or more of the financial covenants of its credit facility for each fiscal quarter beginning in the fiscal quarter ended as of January 31, 2001, through and including the fiscal quarter ended as of July 31, 2003. The Company and IBM Credit Corporation entered into an Acknowledgment, Waiver and Amendment to the Inventory and Working Capital Financing Agreement as of the end of each of these quarters by which IBM Credit has waived the Company's defaults. The amounts outstanding under the revolving credit facility and term loan as of April 30, 2002 and 2003 have been classified as current in the Company's consolidated balance sheets. The following is a summary of the covenant violations for each of the quarters referred to above.

IBM Credit, the Company's working capital lender, has notified the Company that it does not intend to renew its working capital line beyond August 2004. As a result, the Company is seeking replacement financing for its credit facility.

(6) Issuances of Subordinated Secured Convertible Debentures and Common Stock

On April 3, 2002, the Company raised $2.0 million (less transaction costs of $0.170 million) to be used for working capital purposes by issuing an aggregate of $2.0 million principal amount of Subordinated Secured Convertible Debentures and Warrants to purchase an aggregate of 270,000 shares of the Company's common stock at $1.416 per share. The debentures matured on July 2, 2003 and had an interest rate of 5% per annum. Interest was due quarterly on March 31, June 30, September 30 and December 31 of each year (with the first interest payment due and payable on September 30, 2002) and was paid in cash and Common Stock. The Company recorded a discount of $582,000 in connection with the issuance of the Debentures. The warrants have been valued at approximately $291,000, based on the Black Scholes Pricing Model utilizing the following assumptions: expected life of 5.0 years; volatility of 119 percent; risk free borrowing rate of 4.405 percent. This amount has been recorded as a discount against the debt and will be accreted as interest expense over the remaining life of the debt. In addition, in accordance with Emerging Issues Task Force No. 98-5, an embedded beneficial conversion feature of approximately $291,000 has been recognized as additional paid-in-capital and was accreted as additional interest expense over the life of the debt. Through July 31, 2003, the total discount of $582,000 had been accreted.

The warrants are exercisable at any time from April 3, 2002 to April 3, 2007 and are not redeemable by the Company. The exercise price of the warra