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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended October 31, 2003
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ________________
Commission file number 0-24015
STEELCLOUD, INC.
(Exact name of registrant as specified in its charter)
COMMONWEALTH OF VIRGINIA 54-1890464
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1306 Squire Court
DULLES, VIRGINIA 20166
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(Address of principal executive offices) (Zip Code)
(703) 450-0400
--------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Exchange Act
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED None.
Securities registered pursuant to Section 12 (g) of the Act:
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED
- ------------------- ------------------------------------
Common Stock, $.001 par value per share Nasdaq SmallCap Market
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if there is disclosure of delinquent filers in
response to Item 405 of Regulation S-K contained herein and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. | |
The aggregate market value of the voting stock held by non-affiliates
of the issuer as of January 23, 2004 was $45,147,886.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes | | No |X|
The number of shares outstanding of the registrant's Common Stock,
$.001 par value per share, on January 23, 2004 was 13,343,690.
Documents incorporated by reference
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A for SteelCloud, Inc.'s annual meeting for 2003 are incorporated by reference
into Part III of this Form 10-K.
STEELCLOUD, INC
2003 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I PAGE NUMBER
Item 1. Business.......................................................... 4
Item 2. Properties........................................................ 9
Item 3. Legal Proceedings................................................. 9
Item 4. Submission of Matters to a Vote of Security Holders............... 9
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters .............................................. 10
Item 6. Selected Financial Data........................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations......................................... 13
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........ 22
Item 8. Financial Statements and Supplementary Data....................... 22
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosures.............................. 22
Item 9A. Controls and Procedures........................................... 23
PART III
Item 10. Directors and Executive Officers of the Registrant................ 24
Item 11. Executive Compensation............................................ 24
Item 12. Security Ownership of Certain Beneficial Owners and Management.... 24
Item 13. Certain Relationships and Related Transactions.................... 24
(Item 10 - Item 13 information is incorporated by reference
from portions of the Company's definitive Proxy Statement
to be filed pursuant to Regulation 14A)
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K... 24
Signatures........................................................ 26
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ITEM 1. BUSINESS
GENERAL
SteelCloud, Inc. (formerly Dunn Computer Corporation) or (the
"Company") was founded in 1987 as a company that manufactured and marketed
custom computers, primarily to the Federal government.
The Company is principally engaged in the design, development and
manufacturing of custom computer servers and network security appliances. The
Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. SteelCloud's network security appliances are developed in
collaboration with some of the world's premiere software companies. In addition,
SteelCloud develops proprietary software to optimize the performance of its
security appliances. SteelCloud's branded and co-branded appliances are
specially designed and optimized to deliver a dedicated network service such as
antivirus gateway protection, intrusion detection and secure content management.
The Company is focusing its efforts on the network security marketplace
and on the creation of additional SteelCloud intellectual property. The Company
is working toward the creation of its own family of hardened (highly secured)
appliances to be delivered as co-branded appliances with its software partners.
SteelCloud's primary business is to develop and manufacture products for
strategic software, technology, and managed services partners that develop,
implement and support Internet security and infrastructure solutions. With its
strategic partners, the Company can create and uniquely brand ready-to-use
turnkey network server appliance solutions combining both hardware and software.
The Company integrates either its own, its partner's, or other third-party
software into a custom designed server platform and manufactures the product
under a co-branded name or its partner's brand name allowing the partner to
deliver a complete turnkey solution. In addition to delivering computer
products, the Company develops and manufactures specialized servers and
infrastructure products for large commercial and government integrators as well
as certain governmental agencies. The Company enhances its product development
and manufacturing capability by providing custom supply chain and logistics
support services to its partners.
The Company's consulting services organization provides clients with a
seamless extension of their Information Technology ("IT") organizations. Expert
technical services include network analysis, security, design, troubleshooting
and implementation. SteelCloud provides IT support services to the public sector
as well as commercial customers. In addition, the Company is also a value-added
reseller for the software products of our strategic partners and certain other
software providers.
The Company was incorporated as Dunn Computer Corporation in Virginia
on February 26, 1998 in connection with the reorganization of Dunn Computer
Corporation, a Delaware Corporation, which was incorporated on April 22, 1997.
The Company's operating subsidiary, Dunn Computer Operating Company, was
incorporated in Virginia in July 1987. The Company's other subsidiaries are
International Data Products (IDP), acquired May 1998, STMS, Inc (STMS), acquired
September 1997, and Puerto Rico Industrial Manufacturing Operations Acquisition
Corporation (PRIMOA), incorporated in Puerto Rico in May 1998. In October 2002,
the Company determined to discontinue the PRIMOA subsidiary and thereby executed
a plan to dispose that operation. In September 2003, the Company sold the assets
of PRIMOA and contracted with a local Puerto Rican firm to provide its warranty
and support obligations for the duration of its contracts. Accordingly, the
operation has been classified as "discontinued" in the financials statements for
all years presented.
On September 25, 2000, the Company began doing business as ("d/b/a")
SteelCloud Company. On October 19, 2000, the Company changed its NASDAQ ticker
symbol from DNCC and began trading as SCLD. On May 15, 2001, the shareholders of
the Company approved the name change of the Company to SteelCloud, Inc.
effective on that date. In June 2003, the listing of the Company's shares of
common stock was transferred from the Nasdaq National Market to the Nasdaq Small
Cap Market. Unless the context otherwise requires, the "Company" or "Dunn
Computer Corporation" refers to SteelCloud Inc., its predecessor and its
subsidiaries. The principal executive offices are located at 1306 Squire Court,
Dulles, Virginia 20166. The Company's main telephone number is (703) 450-0400.
Inquiries may also be sent to SteelCloud at INFO@STEELCLOUD.COM for sales and
general information or IR@STEELCLOUD.COM for investor relations information.
-4-
PRODUCTS AND SERVICES
The Company offers network appliances, infrastructure server products,
and consulting services. The Company believes it operates in one segment,
information technology.
NETWORK SERVER APPLIANCES: SteelCloud partners with leading software
and technology companies to create uniquely branded, ready-to-use turnkey
network server appliance solutions combining both hardware and software.
SteelCloud integrates the partner's software onto a custom designed server
platform, running Linux, FreeBSD, or Microsoft NT/2000. This process results in
an optimized, tested, and certified appliance, unique to the partner, which is
ready to deploy and use when it arrives at the customer site. The company has
leveraged its years of experience developing and managing custom server
platforms for mission-critical Department of Defense ("DOD") and security
programs to create a unique model for its partners. The Company assembles a
package of design, support, and logistical services that are custom tailored for
each particular software company, thereby augmenting the partner's internal
capabilities. In essence, SteelCloud takes responsibility for those tasks
necessary to successfully bring an appliance to market, which are impractical
for its software partners to perform.
The Company believes that its unique approach to the server appliance
market (collaborating with leading software manufacturers and leveraging their
significant product marketing and sales efforts) enables it to realize economies
of scale in development, sales, and marketing far greater than its revenue would
indicate under a more traditional strategy. The Company also believes that risks
relating to R&D (research and development) and inventory are also greatly
reduced through this approach.
INFRASTRUCTURE PRODUCTS: The Company designs, develops and manufactures
specialized custom servers, which are configured with single, dual, or quad
Intel Pentium or Xeon processors. These servers are designed to give its
customers with unique requirements, the highest level of performance,
reliability, and manageability available in the market today. The company
combines its hardware offerings with specialized software integration and
logistics programs to give its custom server customers unique solutions
unavailable from the traditional hardware-only vendors.
The Company believes that its infrastructure/custom server products are
best suited to address the high volume needs of the federal government. The
Company teams with large federal integrators as its primary channel for
delivering its specialized servers.
CONSULTING SERVICES: SteelCloud provides an array of consulting
services surrounding the technologies addressed by its server appliances. The
Company's consulting services include network and security analysis, design and
implementation, as well as help desk consulting. These services are primarily
delivered in the form of short-term (less than three months) projects. The
Company's consulting services are performed for a fixed-fee or on an hourly
labor basis at pre-negotiated rates and estimated levels of effort. SteelCloud
is a value-added reseller for certain software products that are delivered in
conjunction with its consulting services. In some cases, SteelCloud provides its
appliance customers with additional technical services that complement their
appliance implementation.
Specific project-based services SteelCloud performs include network
analysis, network design, systems implementation, virus protection, network
security, software migrations, messaging system migrations and complete help
desk implementation and support. SteelCloud maintains expertise in specific
areas and technologies rather than general knowledge in many IT areas.
SteelCloud provides highly skilled professionals and services that leverage our
experience for maximum benefit to the client. Project management is the key
component of SteelCloud's operational strategy and success in project-based
engagements to ensure each project is delivered in accordance with the
customer's expectation and the Company's profitability objectives.
SteelCloud also provides network support services in the form of
fixed-rate hourly engineering services. Client contracts range in duration from
one month to three years. Staffing services consist of placing one or more
network engineers, user support technicians, or programmers on-site with a
client. These professionals perform work as a "virtual" employee for the client
and typically work under the direction of the client's management. Hourly rates
for staffing engagements are normally lower than for project-based engagements;
however, the contracts usually have substantially longer periods of performance.
SteelCloud's success in this area is achieved largely due to contract renewals
and increasing staffing requirements from existing customers.
-5-
E>
GOVERNMENT CONTRACTS
In fiscal 2003, the Company derived approximately 22% of its revenues
from sales of hardware and services to the U.S. Federal Government pursuant to
contracts with the General Services Administration (GSA) or other
agency-specific contracts. Certain Government customers reserve the right to
examine the Company's records as they relate to their contracts.
GSA CONTRACT. The Company has a multiple award schedule contract with
GSA (the "GSA" Contract). The Company's GSA contract was originally awarded in
April 1996. It was renewed in fiscal 2002 and is valid through March 31, 2007.
The GSA contract enables Government IT purchasers to acquire all of their
requirements from a particular vendor and largely limits the competition to
selected vendors holding GSA contracts. For fiscal year 2003, the Company's GSA
contract had sales of $7.4 million, which accounted for approximately 22% of the
Company's revenues.
COMMERCIAL CONTRACTS
In fiscal year 2003, SteelCloud derived approximately 78% of its
revenues from sales of hardware and services to the commercial marketplace and
state and local government. The Company's commercial customer base consists of
several Fortune 500 companies as well as medium-size commercial customers. The
Company generated approximately $8.1 million or 25% of its total net revenues
from contracts and awards with Lockheed Martin during fiscal year 2003. The
Company intends to continue to increase its commercial customer base in the
upcoming fiscal year. The Company's Appliance Partner program and its own sales
and marketing activities are concentrated on expanding the Company's commercial
customer base. Strategic partnerships with industry leading companies such as
Microsoft, Intel and Seagate enable the Company to further diversify its product
mix and attract high quality customers.
In June 2003, the Company entered into an OEM agreement with Computer
Associates International, Inc. to deliver a family of hardened, ready-to-deploy
enterprise-class security appliance based on Computer Associates' eTrust
technology which provides comprehensive threat management, identity management
and access management across the full range of platforms and applications. The
first set of appliances delivered under this agreement featured eTrust
Antivirus, a powerful and cost-effective solutions for protecting enterprise
environments from viruses and malicious code. The anti-virus gateway (AVG)
appliance models 3000 and 5000 were available as of October 31, 2003. The
anti-virus gateway (AVG) appliance model 1000, which is aimed at small to medium
sized businesses, is scheduled for availability in early fiscal 2004. In
addition, the Company is currently developing a family of intrusion detection
system (IDS) appliances using Computer Associates' eTrust Intrusion Detection,
which can identify attacks directed at customers' businesses and automatically
mount effective defenses. The IDS appliances are scheduled for general
availability in early 2004. The resulting products are different from previous
SteelCloud appliances in that they are branded solutions integrated with the
proprietary SteelCloud Secure Console (SC2) software.
In July 2003, the Company was selected by Lockheed Martin to supply
specialized servers to the Automated Package Processing System (APPS) program
that will upgrade the existing parcel processing capability of the U.S. Postal
Service. The servers will be installed in more than 74 postal service locations.
The contract has an initial estimated value of more than $2.8 million with
contract options for an additional $3.2 million. The Company has shipped initial
delivery orders for more than 100 systems and full production is expected to
begin in fiscal year 2004. In addition, two of Lockheed Martin's subcontractors
on the APPS program have placed initial orders with the Company in excess of
$250,000 with plans to order additional systems.
In July 2003, the Company signed an OEM agreement with Microsoft
Corporation under which the Company's new line of branded security appliances
developed around the Company's proprietary SC2 software which will utilize a
special embedded version of Microsoft's Windows server. SteelCloud's contract
with Microsoft protects its intellectual property interest in the SC2 software.
In September 2003, the Company entered into a distribution agreement to
sell its hardened security appliances to value added resellers as well as end
users in North America through Arrow Electronics, Inc. Arrow Electronics is one
of the world's largest electronic distributors with approximately $7.4 billion
in worldwide sales.
-6-
The Company anticipates that Arrow will provide its US Channel Partners with an
efficient and effective means to purchase SteelCloud security appliances.
Additionally, the Company anticipates that Arrow's supply-chain services will
provide its reseller organizations in North America with the tools needed to
market SteelCloud security appliances such as online ordering and reporting,
financial services and product launch support.
MANUFACTURING AND PRODUCTION
SteelCloud's production operations are capable of assembling 100,000
systems per year in its existing Dulles, Virginia facility on a three-shift
basis. The Company is currently operating on a single shift basis.
COMPETITION AND MARKETING
The markets for the Company's products and services are highly
competitive. Many of the Company's competitors offer broader product lines and
may have greater financial, technical, marketing and other resources. These
competitors may benefit from component volume purchasing and product and process
technology license arrangements that are more favorable in terms of pricing and
availability than the Company's arrangements.
The Company competes with a large number of computer systems
integrators, custom computer manufacturers, resellers, and IT services
companies. The Company believes it is likely that these competitive conditions
will continue in the future. There can be no assurance the Company will continue
to compete successfully against existing or new competitors that may enter
markets in which the Company operates.
The Company's principal competitors are general-purpose server
manufacturers including Nokia, Sun Microsystems and Dell. The Company also
competes with system integrators such as Avnet and Pioneer Standard Electronics
as well as smaller companies such as Network Engines that specialize in building
server products and providing some level of integration services.
FEDERAL GOVERNMENT MARKET - The emergence of the GSA Schedule, which is
a list of pre-approved vendors from which the Government and/or federal agencies
may purchase goods and services, as a significant procurement vehicle has
enabled traditional mass-market commercial computer companies to be more
responsive to government requirements and become more competitive with the
Company in the Federal Government Market. The Company believes that the
Government's selection criteria for vendor selection consist of price, quality,
familiarity with the vendor, and size and financial capability of the vendor.
The government has increased the amount of information technology products
acquired through the GSA Schedule. Because the Company primarily targets custom
computer procurements, it rarely competes with national commercial computer
manufacturers such as Dell Computer Corporation and Hewlett-Packard in the
federal market.
COMMERCIAL MARKET - The information technology industry is highly
competitive. Pricing is very aggressive in the industry and the Company expects
pricing pressures to continue. The industry is also characterized by rapid
changes in technology and customer preferences, short product life cycles and
evolving industry standards.
The commercial market for the Company's IT products and services is a
highly fragmented market served by thousands of small value-added resellers and
specialized manufacturers. These companies typically service a small geographic
area and resell national brand computer and/or network hardware. The Company
believes its consulting services group can compete effectively in the
Washington, DC metropolitan market because it provides engineering services in
conjunction with its turnkey server appliances and products from its strategic
partners; e.g., Cisco, Microsoft, and Intel. The Company believes that its
ability to integrate its server systems with networking products also gives its
consulting services group a competitive advantage.
In the OEM server appliance market, the principal elements of
competition are product reliability, quality, customization, price, customer
service, technical support, value-added services, and product availability.
There can be no assurance that the Company will, in the future, be able to
compete effectively against existing and future competitors.
MARKETING - The Company markets its products and services to software
manufacturers, their channel partners, select commercial accounts, and the
federal government. The Company uses an in-house sales force and program
managers to market its products and services. SteelCloud markets its products
and services worldwide, either directly through its own sales personnel, or
through the marketing organizations of its appliance partners. The Company
believes that marketing is important for all of its target markets, although
less so in its appliance business because its success relies on the partner's
sales and marketing capabilities.
-7-
The Company strives to build a strong relationship with its customers.
The Company believes that a key to building customer loyalty is a team of
knowledgeable and responsive account executives and a knowledgeable technical
and support staff. The Company assigns each customer a trained account
executive, to which subsequent calls to the Company will be directed. The
account executive is augmented with a program manager for SteelCloud's larger
customers. The Company believes that these strong one-on-one relationships
improve the likelihood that the customer may consider the Company for future
purchases. The Company intends to continue to provide its customers with
products and technical services that offer the customer the best value.
The Company uses electronic commerce technologies in its marketing
efforts and believes that its customers will continue to expand and utilize
these technologies. The Internet is being used by customers to advertise
opportunities and to reference vendor information. The Company maintains a web
site on the Internet referencing its GSA catalogue and product offerings. The
Company is capable of accepting sales and processing payments over the Internet.
SUPPLIERS
The Company devotes significant resources to establishing and
maintaining relationships with its key suppliers. The Company, where possible,
purchases directly from component manufacturers such as Intel, Microsoft and
Cisco among others. The Company also purchases multiple products directly from
large national and regional distributors such as Arrow Electronics, TechData
Corporation and Ingram Micro.
Certain suppliers provide the Company with incentives in the form of
discounts, rebates, credits, and cooperative advertising, and market development
funds. The Company must continue to obtain products at competitive prices from
leading suppliers in order to provide competitively priced products for its
customers. In the event the Company is unable to purchase components from
existing suppliers, the Company has alternative suppliers it can rely upon. The
Company believes its relationships with its key suppliers to be good and
believes that generally, there are multiple sources of supply available should
the need arise.
PATENTS, TRADEMARKS AND LICENSES
The Company works closely with computer product suppliers and other
technology developers to stay abreast of the latest developments in computer
technology. While the Company does not believe its continued success depends
upon the rights to a patent portfolio, there can be no assurance that the
Company will continue to have access to existing or new technology for use in
its products.
The Company conducts its business under the trademarks and service
marks of "SteelCloud", "SteelCloud Company" and "Dunn Computer Corporation,".
The Company believes its trademarks and service marks have significant value and
are an important factor in the marketing of its products.
Because most software used on the Company's computers is not owned by
the Company, the Company has entered into software licensing arrangements with
several software manufacturers.
EMPLOYEES
As of October 31, 2003, the Company had 88 employees. Of this total, 4
were employed in an executive capacity, 10 in sales and marketing, 11 in
administrative capacities, 47 in technical and/or services and 16 in operations.
As of January 20, 2004, the Company had 91 employees. None of the Company's
employees are covered by a collective bargaining agreement. The Company
considers its relationships with its employees to be good.
The Company believes that its future success depends in large part upon
its continued ability to attract and retain highly qualified management,
technical, and sales personnel. The computer industry's shortage of trained and
experienced technicians has eased over the past twelve months. The company has
an in-house training and mentoring program to develop its own supply of highly
qualified technical support specialists. There can be no assurance, however,
that the Company will be able to attract and retain the qualified personnel
necessary for its business.
-8-
ITEM 2. PROPERTIES
The Company leases approximately 35,000 square feet at its facility in
Dulles, Virginia, which is used as its principal executive offices, for
manufacturing and administrative services. Pursuant to the lease, which expires
in February 2005, the Company pays approximately $29,000 per month in rent.
SteelCloud believes that its facilities are adequate for its current and future
operations.
In addition, we maintain sales offices in California and Massachusetts.
We do not lease any space for these offices as our salespersons are based out of
their respective residences.
ITEM 3. LEGAL PROCEEDINGS
On July 31, 1998, the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial of the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. Prior to this ruling by the SBA, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract on May 1, 1999. In October 1999, the U.S. Air Force issued a
termination-for-convenience letter to the Company. Under a
termination-for-convenience, the government is required generally to reimburse a
contractor for all costs incurred in the performance of the contract. The
Company is in the process of attempting to recover from the government a portion
or all of unreimbursed costs associated with the Desktop V Contract. No
assurances can be given that the Company will be successful in recovering any
costs associated with this matter.
Other than the above, there are no material claims pending against the
Company.
There are routine legal claims pending against the Company, but in the
opinion of management, liabilities, if any, arising from such claims will not
have a material adverse effect on the financial condition and results of
operation of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during
the fourth quarter of the fiscal year covered by this report.
-9-
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Prior to the quotation of the Company's Common Stock beginning on April
22, 1997, there was no established trading market for the Company's common
stock. The Company's Common Stock is listed on The Nasdaq Stock Market, Inc.'s
SmallCap Market. The Company changed its symbol from "DNCC" to "SCLD" on October
19, 2000. The following table sets forth the high and low selling prices as
reported by The Nasdaq National Market System through June 30, 2003 and on the
Nasdaq SmallCap Market from July 1, 2003 to January 23, 2004, for each fiscal
quarter during the fiscal years ended October 31, 2003 and 2002, as well as for
the first quarter of fiscal 2004 through January 23, 2004. These quotations
reflect inter-dealer prices without retail mark-up, mark-down or commission and
may not represent actual transactions.
FISCAL 2002
HIGH LOW
----------------------
First Quarter.......................................... $3.89 $0.78
Second Quarter......................................... $3.34 $2.32
Third Quarter.......................................... $3.50 $1.62
Fourth Quarter......................................... $2.15 $0.87
FISCAL 2003
HIGH LOW
----------------------
First Quarter.......................................... $1.40 $1.01
Second Quarter......................................... $1.68 $0.97
Third Quarter.......................................... $3.47 $1.26
Fourth Quarter......................................... $5.36 $3.14
FISCAL 2004
HIGH LOW
----------------------
First Quarter (through January 23, 2004)............... $5.12 $3.87
On January 23, 2004 the closing price of the Company's Common Stock as
reported on The Nasdaq SmallCap Market was $3.98 per share. There were
approximately 5,100 shareholders of the Common Stock of the Company as of such
date.
The Company has not paid cash dividends on its Common Stock and does
not intend to do so in the foreseeable future.
-10-
RECENT SALES OF UNREGISTERED STOCK
In March 2000, the Company sold 3,000 shares of its Series A
Convertible Preferred Stock to one investor. In connection with the sale, the
Company received an aggregate of $3,000,000. The shares of preferred stock were
sold in reliance upon the exemption from registration provided by Regulation D
Rule 506 of the Securities Act of 1933, as amended. In August 2001, the Company
redeemed 2,620 shares of the Series A Convertible Preferred Stock which
represented all of the then outstanding Preferred Stock.
In March 2000, the Company issued 225,000 shares of its common stock in
connection with the settlement of a lawsuit with a former employee. The shares
of common stock were issued in reliance upon the exemption from registration
afforded by Section 4(2) of the Securities Act of 1933, as amended.
On October 24, 2003, SteelCloud, Inc. sold 1,887,500 shares of its
common stock to private and institutional investors in a private placement
transaction at a price of $4.00 per share. SteelCloud, Inc. received gross
proceeds of $7,550,000 in connection with this transaction. Brean Murray & Co.,
Inc. and Ferris, Baker Watts, Incorporated acted as co-placement agents in
connection with this private offering. The co-placement agents received an
aggregate of $437,500 and 107,422 warrants to purchase shares of our common
stock as commissions in connection with this offering. Additionally, in
connection with this transaction SteelCloud, Inc. issued an aggregate of 493,359
and 85,938 warrants at an exercise price of $5.81 and $4.00 per share,
respectively, which are exercisable until October 24, 2008. The securities were
sold pursuant to an exemption from registration provided by section 4(2) of the
Securities Act.
-11-
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following selected consolidated financial data of SteelCloud should
be read in conjunction with the consolidated financial statements and the notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations". The consolidated statement of operations data set forth
below with respect to the fiscal years ended October 31, 2001, 2002 and 2003 and
the consolidated balance sheet data as of October 31, 2002 and 2003 is derived
from and is referenced to the audited consolidated financial statements of
SteelCloud included elsewhere in this Annual Report on Form 10-K. The
consolidated statement of income data set forth below with respect to the fiscal
years ended October 31, 1999, 2000 and 2001 and the consolidated balance sheet
data as of October 31, 1999, 2000 and 2001 is derived from audited consolidated
financial statements of SteelCloud not included in this annual report.
YEAR ENDED OCTOBER 31,
1999 2000 2001 2002 2003
---------------------------------------------------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA: (2)
Net revenues ............................................... $ 28,749 $ 22,509 $ 25,791 $ 29,157 $ 33,043
Costs of revenues .......................................... 23,021 17,481 19,407 22,163 26,353
Gross profit ............................................... 5,729 5,028 6,384 6,994 6,690
Selling, general and administrative,
and amortization ......................................... 36,062 5,510 5,075 6,481 6,321
(Loss) income from operations .............................. (30,333) (482) 1,309 513 369
Other (expense) income, net ................................ (2,908) (123) (184) (222) (5)
(Loss) income from continuing operations
before income taxes and extraordinary gain ............... (33,241) (606) 1,125 291 364
(Benefit from) provision for income taxes .................. (559) 65 102 (280) --
(Loss) income before extraordinary gain and
discontinued operations .................................. (32,683) (671) 1,023 571 364
Extraordinary gain ......................................... -- 750 -- -- --
Cumulative effect of change in accounting principle ........ -- -- (576) -- --
Preferred stock dividends .................................. -- (625) (112) -- --
Increase to income available to common stockholders from
repurchase of preferred stock ............................ -- -- 721 -- --
Net (loss) income from discontinued operations ............. (924) 721 (9) (1,686) (144)
Net (loss) income available to common stockholders ......... $(33,607) $ 176 $ 1,047 $ (1,115) $ 220
Basic (loss) income per share (1) .......................... $ (3.57) $ 0.02 $ 0.10 $ (0.11) $ 0.04
(Loss) income per share assuming dilution (1) .............. $ (3.57) $ 0.02 $ 0.08 $ (0.10) $ 0.03
Weighted average shares outstanding (1) .................... 9,404 9,581 10,111 9,948 10,241
Weighted average shares outstanding assuming dilution (1) .. 9,404 9,581 12,463 10,812 10,962
Pro forma basic (loss) earnings per share
assuming the accounting change is applied retroactively .. $ (3.57) $ (0.04) $ 0.16 $ (0.11) $ 0.04
Pro forma (loss) earnings per share assuming the accounting
change is applied retroactively, assuming dilution ....... $ (3.57) $ (0.04) $ 0.08 $ (0.10) $ 0.03
AT OCTOBER 31,
1999 2000 2001 2002 2003
---------------------------------------------------------
CONSOLIDATED BALANCE SHEET DATA: (2)
Working (deficit) capital .................................. $ (1,239) $ 5,839 $ 7,349 $ 3,856 $ 11,883
Total assets ............................................... 22,287 23,005 17,134 17,633 19,761
Long-term debt ............................................. 2,845 2,598 3,837 60 60
Total liabilities .......................................... 17,470 14,149 9,736 10,876 5,027
Stockholders' equity ....................................... 4,817 8,856 7,398 6,757 14,734
- ------------
(1) Includes the activity of IDP from May 1, 1998 (date of acquisition).
(2) The selected financial data for each year presented has been restated
to reflect the Company's PRIMO operations as a discontinued operation.
-12-
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION
Certain statements contained herein may constitute forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. Because such statements include risks and uncertainties, actual results
may differ materially from those expressed or implied by such forward-looking
statements. Factors that could cause actual results to differ materially
include, but are not limited to, risks associated with the integration of
businesses following an acquisition, competitors with broader product lines and
greater resources, emergence into new markets, the termination of any of the
Company's significant contracts, the Company's inability to maintain working
capital requirements to fund future operations or the Company's inability to
attract and retain highly qualified management, technical and sales personnel.
OVERVIEW
Founded in 1987, SteelCloud, Inc, based in Dulles, Virginia, designs,
develops and manufactures customized computer servers and network appliances.
The Company's custom computer servers are designed to meet the precise needs of
volume customers to reduce the customer's investments in logistics, integration
capacity and support. The Company's network security appliances are developed in
collaboration with some of the world's premiere software companies. In addition,
the Company develops proprietary software to optimize the performance of its
security appliances. The Company's appliances are specially designed and
optimized to deliver a dedicated network service such as antivirus gateway
protection, intrusion detection and secure content management.
In fiscal 2003, SteelCloud began focusing its efforts on the network
security marketplace and on the creation of additional SteelCloud intellectual
property. The Company is in the process of creating its own family of hardened
(highly secured) appliances to be delivered as co-branded appliances with its
software partners. With its strategic partners, SteelCloud creates and uniquely
brands ready-to-use turnkey network server appliance solutions combining both
hardware and software. The Company integrates its own, its partner's, or other
third-party software, into a custom designed server platform. The Company
manufactures the resulting product either under a co-branded name or its
partner's brand name allowing the partner to deliver a complete turnkey
solution. The Company enhances its product development and manufacturing
capability by providing custom supply chain and logistics support services to
its partners.
SteelCloud's consulting services organization provides clients with a
seamless extension of their own IT organizations. Expert technical services
include network analysis, security, design, troubleshooting and implementation.
The Company provides Information Technology (IT) support services to the public
sector as well as commercial customers. The Company is also a value-added
reseller for the software products of its strategic partners and certain other
software providers.
FISCAL 2003
PRODUCT DEVELOPMENT
In fiscal 2003, the Company undertook initiatives to enhance its
product offerings and improve its margins. SteelCloud is developing a family of
hardened (highly secured operating system) security appliances that will be
offered as SteelCloud product or as co-branded appliances with its software
partners. Accordingly, the Company commenced its research and development
("R&D") activities associated with these new product offerings in the second
quarter of fiscal 2003. The result of this work has been new appliance platforms
that can be easily tailored to the needs of a particular software package or
technology and SC2, SteelCloud's new proprietary secure management software.
With the Company's goal of increasing margins, the Company expanded its
appliance business model to encompass more direct control in the development and
marketing of its appliances. Product packaging, including the appliance chassis,
has become a major differentiating factor in the marketing of an appliance
server. SteelCloud has increased its capability to develop both custom and
standard chassis offerings for its clients. The Company believes that the
intellectual property that it has developed will enable SteelCloud to be more
competitive from a packaging perspective while decreasing the costs necessary to
bring a product to market. During fiscal 2003, the Company incurred research and
development costs of approximately $494,087 in support of its new business
strategy. SteelCloud will continue to incur these costs as these products are
brought to market. These products are different from previous SteelCloud
appliances in that they are branded solutions integrated with its proprietary
SteelCloud Secure Console (SC2) software.
-13-
In June 2003, the Company entered into an agreement with Computer
Associates International, Inc. to deliver a family of hardened, ready-to-deploy
enterprise-class security appliance for intrusion detection and antivirus
gateway protection based on Computer Associates' eTrust technology. Computer
Associates is one of the largest software companies in the world and delivers
software and services that enable organizations to manage their IT environments.
In July 2003, SteelCloud announced its first co-branded, anti-virus gateway
(AVG, network security product in collaboration with Computer Associates
International, Inc (CA) which was made available in September 2003. In August
2003, SteelCloud expanded its agreement with Computer Associates to include the
marketing of its security appliances in Europe, Asia Pacific, Africa and the
Middle East.
DISCONTINUED OPERATIONS
The Company continually evaluates operating facilities with regard to
the Company's long-term strategic goals established by management and the Board
of Directors. Operating facilities, which are not expected to contribute to the
Company's future operations are either closed or sold. On October 25, 2002, the
Company's management, with the approval of the Board of Directors, determined
that the Puerto Rico Industrial Manufacturing Operation Acquisition, Corp
("PRIMOA") would no longer contribute to future operations and therefore adopted
a plan to dispose of that operation effective on that date. In September 2003,
the Company sold the assets of the operation and contracted with a local firm to
fulfill its warranty obligations through the end of the fiscal year.
Accordingly, the Company has reflected PRIMO as discontinued operations in the
current financial statements. As a result, prior year amounts have been
reclassified to segregate the continuing operations from the discontinued
operations. The loss associated with the discontinued operation was
approximately $48,000 and $134,000 for the three and twelve-month periods ended
October 31, 2003. The loss associated with the sale of PRIMO was approximately
$10,000. The Company does not anticipate additional losses associated with this
operation in future periods. We believe that given the current environment of
that market, discontinuing the operation was the best alternative.
SIGNIFICANT CONTRACTS
In January 2002, the Company was awarded several contracts by Lockheed
Martin valued at more than $10.5 million for customized servers. The Company
commenced work under the contracts in March 2002 and completed the contracts in
October 2003. For the three and twelve month periods ended October 31, 2003, the
Company recognized revenue of approximately $1.2 million and $8.1 million under
these contracts, respectively (or approximately 13% and 24%, respectively, of
total net revenues). In addition, for the year ended October 31, 2003, the
Company had other contracts with this same customer totaling approximately
$663,000 or 2% of its net revenues.
In July 2003, SteelCloud was selected by Lockheed Martin to supply
specialized servers to the Automated Package Processing System (APPS) program
that will upgrade the existing parcel processing capability of the U.S. Postal
Service. The servers will be installed in more than 74 postal service locations.
SteelCloud's contract has an initial estimated value of more than $2.8 million
with contract options for an additional $3.2 million. The Company has shipped
initial delivery orders for more than 100 systems and full production is
expected to begin in fiscal 2004. Two of Lockheed Martin's subcontractors on the
APPS program have also ordered approximately $250,000 in systems and have
indicated plans to order additional systems.
In July 2003, SteelCloud signed an OEM agreement with Microsoft
Corporation under which its new line of branded security appliances developed
around its proprietary SC2 software will utilize a special embedded version of
Microsoft's Windows server. SteelCloud's contract with Microsoft protects our
intellectual property interest in the SC2 software.
In September 2003, the Company entered into an agreement to sell its
hardened security appliances to reseller customers in North America through a
distributor, Arrow Electronics, Inc. The Company anticipates that Arrow will
provide its US Channel Partners with an efficient and effective means to
purchase our security appliances. Additionally, the Company anticipates that
Arrow's supply-chain services will provide its reseller organizations in North
America with all the tools they need to market our security appliances, from
online ordering and reporting to financial services to product launch support.
-14-
SALES OFFICE EXPANSION
The Company continues to maintain sales offices in California and
Boston in order to meet the Company's growing demands. These office locations
allow SteelCloud to expand its customer base and to develop and deploy new
products for its customers to promote future revenue growth.
IMPAIRMENT OF GOODWILL AND OTHER ASSETS
In fiscal 2003, the Company evaluated its acquired goodwill in
accordance with Financial Accounting Standards Board (FASB) Statement No. 142
for possible permanent impairment. As a result of the evaluation, the Company
determined that no impairment charge was warranted.
Fiscal 1999 Termination of a Significant Contract
On July 31, 1998, the Company received notice from the SBA that it was
denying the request of the U.S. Air Force to waive the requirement to terminate
IDP's Desktop V contract for the convenience of the Government upon the change
in control of IDP to the Company. The Company appealed the denial of the SBA to
the SBA's Office of Hearings and Appeals. On August 31, 1999, the SBA denied the
appeal and ruled that the U.S. Air Force must terminate-for-convenience the
Desktop V contract. On May 1, 1999, prior to the SBA ruling, the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract and terminated the contract for all participating vendors. Initially
awarded to IDP, the Desktop V contract was the Company's largest contract.
Management believed at the date of the IDP acquisition, the contract would be
renewed by the government through fiscal year 2003 and would generate over $100
million in revenues during that period. As a result of the termination of this
contract, the recoverability of the Company's goodwill associated with the IDP
acquisition was significantly impaired. Accordingly, management recorded an
impairment charge of approximately $21 million during fiscal 1999.
In October 1999, the U.S. Air Force issued a termination-for-
convenience letter to the Company. Under a termination-for-convenience, the
government is required generally to reimburse a contractor for all costs
incurred in the performance of the contract. The Company is in the process of
attempting to recover from the government a portion or all of unreimbursed costs
associated with the Desktop V Contract.
CRITICAL ACCOUNTING POLICIES
The Company believes the following represent its critical accounting
policies:
REVENUE RECOGNITION
The Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL STATEMENTS (SAB 101), as
amended by SAB 101A and 101B. SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and
determinable: and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management's judgments regarding the fixed
nature of the fee charged for services rendered and products delivered and the
collectibility of those fees. Should changes in conditions cause management to
determine these criteria are not met for certain future transactions, revenue
recognized for any reporting period could be adversely affected.
Hardware products sold are generally covered by a warranty for periods
ranging from one to three years. The Company accrues a warranty reserve for
estimated costs to provide warranty services. The Company's estimate of costs to
service its warranty obligations is based on historical experience and
expectation of future conditions. To the extent the Company experiences
increased warranty claim activity or increased costs associated with servicing
those claims, its warranty accrual will increase resulting in decreased gross
profit.
For technology support services under time and material contracts, the
Company recognizes revenue as services are provided based on contracted rates
and materials are delivered.
-15-
SEGMENT REPORTING
The company operates as one segment. The chief operating decision maker
reviews the operations of the company as a whole in deciding how to allocate
resources, and assess performance. In accordance with Financial Accounting
Standards (SFAS No. 131) "Disclosures about Segments of an Enterprise and
Related Information", the Company does not disclose segment information.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued Interpretation Number 46,
Consolidation of Variable Interest Entities ("FIN 46"). This interpretation of
Accounting Research Bulletin No. 51, Consolidated Financial Statements,
addresses consolidation by business enterprises of variable interest entities.
Under current practice, two enterprises generally have been included in
consolidated financial statements because one enterprise controls the other
through voting interests. FIN 46 defines the concept of "variable interests" and
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse risks
among the parties involved. This interpretation applies immediately to variable
interest entities created after January 31, 2003. It applies in the first fiscal
year or interim period beginning after June 15, 2003, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. The interpretation may be applied prospectively with a
cumulative-effect adjustment as of the date on which it is first applied or by
restating previously issued financial statements for one or more years with a
cumulative-effect adjustment as of the beginning of the first year restated.
Adoption of this standard is not expected to have a material effect on the
Company's financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting and reporting for derivative instruments and hedging
activities under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS No. 149 is effective for derivative instruments and
hedging activities entered into or modified after June 30, 2003, except for
certain forward purchase and sale securities. For these forward purchase and
sale securities, SFAS No. 149 is effective for both new and existing securities
after June 30, 2003. Adoption is not expected to have a material impact on the
Company's financial statements.
In May 2003, the Financial Accounting Standards Board (FASB) issued
SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics
of both Liabilities and Equity." SFAS No. 150 establishes standards for issuer
classification and measurement of certain financial instruments with
characteristics of both liabilities and equity. Instruments that fall within the
scope of SFAS No. 150 must be classified as a liability. Most of the guidance in
SFAS 150 is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. On November 7, 2003, the provisions of
SFAS 150, relating to mandatorily redeemable non-controlling interest, were
deferred indefinitely. Adoption of this standard is not expected to have a
material effect on the Company's financial statements.
In December 2002, the EITF issued EITF 00-21, Revenue Arrangements with
Multiple Deliverables. This Issue addresses certain aspects of the accounting by
a vendor for arrangements under which it will perform multiple
revenue-generating activities. In some arrangements, the different
revenue-generating activities (deliverables) are sufficiently separable, and
there exists sufficient evidence of their fair values to separately account for
some or all of the deliverables (that is, there are separate units of
accounting). In other arrangements, some or all of the deliverables are not
independently functional, or there is not sufficient evidence of their fair
values to account for them separately. This Issue addresses when and, if so, how
an arrangement involving multiple deliverables should be divided into separate
units of accounting. This Issue does not change otherwise applicable revenue
recognition criteria. The provisions of EITF 00-21 are effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
Management is currently assessing the impact of the adoption of EITF 00-21 on
the Company's financial statements.
-16-
ACCOUNTING FOR INCOME TAXES
The Company accounts for income taxes using the liability method. In
doing so, the future tax consequences of temporary differences and net operating
losses result in deferred tax assets and liabilities, subject to a valuation
allowance against deferred tax assets when realization is uncertain. As of
October 31, 2003, the Company has recorded a valuation allowance of
approximately $13 million against the total deferred tax asset of $13.4 million,
based upon its evaluation of future estimates of taxable income. The Company's
evaluation included consideration of historical earnings (excluding
non-recurring charges) as well as projected near-term earnings based on its
backlog, customer relationships and operating environment.
-17-
RESULTS OF OPERATIONS
The following table sets forth for the fiscal years ended October 31,
1999, 2000, 2001, 2002 and 2003, certain income and expense items of SteelCloud
as a percentage of net revenues.
1999 2000 2001 2002 2003
---------------------------------------------------------
Net revenues........................................ 100.00% 100.00% 100.00% 100.00% 100.00%
Costs of revenues................................... 80.08% 77.66% 75.25% 76.01% 79.76%
Gross profit........................................ 19.93% 22.34% 24.75% 23.99% 20.24%
Selling, general and administrative and amortization 125.43% 24.48% 19.68% 22.23% 19.13%
(Loss) income from operations....................... (105.51)% (2.14)% 5.08% 1.76% 1.11%
Other (expense) income.............................. (10.12)% (0.55)% (0.71)% (0.76)% 0.01%
(Loss) income before income taxes................... (115.62)% (2.69)% 4.36% 1.00% 1.00%
(Benefit from) provision for income taxes........... (1.94)% 0.29% 0.40% (0.96)% 0.00%
(Loss) income from discontinued operations.......... (3.21%) 3.20% (0.03)% (5.78)% (0.44)%
Net (Loss) income to common stockholders............ (116.90)% 0.78% 4.06% (3.82)% 0.67%
FISCAL YEAR ENDED OCTOBER 31, 2003 COMPARED TO FISCAL YEAR ENDED
OCTOBER 31, 2002
Net revenues of SteelCloud for fiscal year ended October 31, 2003
("fiscal 2003") increased approximately 13% to $33.0 million from $29.2 million
for fiscal year ended October 31, 2002 ("fiscal 2002"). The increase was
primarily the result of increased deliveries on the Company's $10 million server
appliance contract with Lockheed Martin. Revenues under this contract were
approximately $8.1 million in fiscal 2003 compared to $2.4 million in fiscal
2002. This contract was completed in October 2003. The Company is anticipating
additional orders under this contract in fiscal 2004; however, no assurances can
be given that the Company will receive such orders. During fiscal 2003, the
Company derived approximately 24% of its revenues from Lockheed Martin. In
addition, revenues under the Company's GSA schedule increased by approximately
$3.8 million in fiscal 2003. The Company also experienced revenue growth in its
OEM products, reselling activities and consulting services during fiscal 2003.
These increases offset the decrease in revenue from one of the Company's
significant customers in the previous fiscal year, Network Associates, for which
its supply agreement expired on December 31, 2002. Revenues from this agreement
were approximately $10 million in fiscal 2002 compared to $527,000 in fiscal
2003. The increase in revenues was the result of the Company's efforts to expand
its sales force and diversify its revenue sources.
Gross profit for fiscal 2003 decreased by approximately 4% to
approximately $6.7 million from $7.0 million in fiscal 2002. The decrease was
primarily the result of the Company's increase in its reselling activities
during fiscal 2003, which yield lower margins. Gross profit as a percentage of
net revenues during the same periods decreased to 20.2% from 24.0%, which was
also primarily attributable to the increase in the Company's reselling
activities.
Selling and marketing expense increased moderately in fiscal 2003 by 7%
to approximately $1.28 million from approximately $1.2 million for fiscal 2002.
The increase reflects additional marketing and advertising expenditures
associated with the Company's new branded products. Selling and marketing
expense as a percentage of net revenues was unchanged, at 4% in fiscal 2003 and
fiscal 2002 respectively.
General and administrative expense for fiscal 2003 decreased 5% to
$4.55 million from $4.77 million for fiscal 2002. As a percentage of net
revenues, general and administrative expense slightly decreased to 14% for
fiscal 2003 from 16% for fiscal 2002. This decrease was a result of the
Company's revenue growth in fiscal 2003. The general and administrative expense
decrease during fiscal 2003 was attributable to the reversal of a previously
accrued contingency of approximately $250,000. The Company continues to manage
general and administrative costs relative to its net revenue and gross margin.
In fiscal 2002 the Company recorded an impairment charge of
approximately $132,000 related to its remaining goodwill of International Data
Products ("IDP") as the Company had determined that it was permanently impaired.
The remaining intangible assets related to certain contract rights, which have
been fully amortized. The useful life of those contracts has expired. In
addition, the Company recorded an impairment charge of
-18-
approximately $165,000 related to its goodwill acquired in the purchase of
Puerto Rico Industrial Manufacturing Operations ("PRIMO") as that operation was
discontinued in October 2002. The impairment charge for PRIMO goodwill was
included in discontinued operations. In fiscal 2003, the Company did not record
any impairment charges related to its remaining goodwill.
Other expense, including interest, for fiscal 2003 decreased to
approximately $4,700 from approximately $222,000 for fiscal 2002. The decrease
was a result of the Company's ability to fund operations through cash generated
from operations, and not from utilizing the Company's line of credit. In fiscal
2002, the Company recorded a one-time charge of $150,000, to reflect the
permanent decline in market value of its investment in WIZnet, a private entity,
based on its performance.
Net income available to common shareholders increased in fiscal 2003 to
$219,988 from $(1,115,186) in fiscal 2002. Fiscal 2002 net income included a
loss from discontinued operations of approximately $1.7 million, and
approximately $279,800 of income tax benefit. The Company currently has
approximately $32.6 million in Net Operating Loss ("NOL") carryforwards, which
may be used to offset future income. The $13.4 million deferred tax asset was
fully reserved prior to October 31, 2003. As of October 31, 2003, a deferred tax
asset of $400,000 was recognized based on fiscal 2004 estimated taxable income
for which it may offset. Approximately $32.6 million of NOLs remain fully
reserved as of October 31, 2003. This reserve will be released in future periods
if and when the Company determines it is more likely than not that additional
deferred tax assets will be recovered.
FISCAL YEAR ENDED OCTOBER 31, 2002 COMPARED TO FISCAL YEAR ENDED
OCTOBER 31, 2001
Net revenues of SteelCloud for fiscal year ended October 31, 2002
("fiscal 2002") increased approximately 13% to $29.2 million from $25.8 million
for fiscal year ended October 31, 2001 ("fiscal 2001"). The increase was due to
the commencement of a significant contract with Lockheed Martin in January 2002.
The Company recognized approximately $2.5 million under the $10.5 million
contract. The Company anticipates completion of this contract in July 2003;
however, the Company is discussing other contracts with this customer, which
could result in additional orders. No assurances can be given that such
discussions will result in follow-on orders from this customer. As of October
31, 2002, the Company had unearned revenue of approximately $4.5 million, which
primarily consisted of goods associated with the Lockheed Martin contract for
which the Company received milestone payments. In addition, the Company
experienced growth in its OEM sales, consulting services sales and Federal
Government sales in fiscal 2002 as a result of its focus on those markets.
During Fiscal 2002, the Company derived approximately 64% of its revenues from
two customers.
During fiscal 2002, the Company's revenues from its reselling
activities increased to approximately $2.4 million from approximately $2.1
million in fiscal 2001. The increase is a result of the Company's partnerships
with certain software companies.
Gross profit for fiscal 2002 increased by approximately 10% to $7.0
million from $6.4 million in fiscal 2001. The increase is the result of the
Company's revenue growth as both sales and gross profit had double digit
increases in fiscal 2002. Gross profit as a percentage of net revenues during
the same periods decreased slightly to 24.0% from 24.8%, which was the result of
a downward economy and the Company's effort to be more aggressive in its
margins. In addition, gross margin in fiscal 2002 was negatively impacted by
$526,000 for inventory obsolescence and shrinkage.
Selling and marketing expense significantly increased in fiscal 2002 by
64% to approximately $1.2 million from approximately $725,000 for fiscal 2001.
During fiscal 2002, the Company opened regional sales offices in California and
Massachusetts in its efforts to expand markets and produce revenue growth.
Selling and marketing expense as a percentage of net revenues, increased 1% in
fiscal 2002 to 4% from 3% in fiscal 2001.
General and administrative expense for fiscal 2002 increased 21% to
$4.8 million from $4.0 million for fiscal 2001. As a percentage of net revenues,
general and administrative expense slightly increased to 16% for fiscal 2002
from 15% for fiscal 2001. This increase was a result of the Company's revenue
growth in fiscal 2002. In addition, fiscal 2001 general and administrative
expenses were significantly reduced as the Company settled certain liabilities
for amounts less than previously recorded. Accordingly, all previously recorded
accruals were reversed as a result of the settlement, which reduced general and
administrative expenses. The Company will continue to manage general and
administrative costs relative to its net revenue and gross margin.
-19-
In fiscal 2002 the Company recorded an impairment charge of
approximately $132,000 related to its remaining goodwill of International Data
Products ("IDP") as the Company had determined that it was permanently impaired.
The remaining goodwill related to certain contracts, which had matured/expired
in fiscal 2002. In addition, the Company recorded an impairment charge of
approximately $165,000 related to its goodwill acquired in the purchase of
Puerto Rico Industrial Manufacturing Operations ("PRIMO") as that operation was
discontinued in October 2002. The impairment charge for PRIMO goodwill was
included in discontinued operations.
Other expense, including interest, for fiscal 2002 increased to
approximately $222,000 from approximately $184,000 for fiscal 2001. Interest
expense, net decreased by approximately 54% to $73,000 in fiscal 2002 from
$158,000 in fiscal 2001. This was a result of the Company's significant
reduction in its outstanding debt as well as a continual decline in short-term
borrowing rates throughout fiscal 2002. In fiscal 2002, the Company recorded a
one-time charge of $150,000, to reflect the permanent decline in market value
for its investment in WIZnet, a private entity, based on its current
performance.
Net income available to common shareholders decreased approximately
207% in fiscal 2002 to $(1,115,185) from $1,047,041 in fiscal 2001. Included in
net income is approximately $279,800 of income tax benefit. The Company has
approximately $11 million in Net Operating Loss ("NOL") carryforwards, which may
be used to offset future income. The $11 million deferred tax asset was fully
reserved prior to October 31, 2002. As of October 31, 2002, a deferred tax asset
of $400,000 was recognized based on fiscal 2003 estimated taxable income for
which it may offset. A portion of the resulting tax benefit associated with the
tax deductions relating to stock options exercised were credited to stockholders
equity. Approximately $10.6 million of NOLs remain fully reserved as of October
31, 2002. This reserve will be released in future periods as the company
continues to generate taxable income for which the asset will be used to offset.
Fiscal 2001 net income available to common shareholders includes
certain one-time and non-recurring increases to income available to common
stockholders of $721,816 relating to the Series A Convertible Preferred Stock
private placement with Briarcliff Investors LLC, which closed in March 2000 and
the redemption of those preferred shares in August 2001 for $2.5 million. Net
income available to common shareholders is also comprised of the accumulating 5%
dividends on the Series A Convertible Preferred Stock for the period those
shares were outstanding.
LIQUIDITY AND CAPITAL RESOURCES
As of October 31, 2003, the Company had cash and cash equivalents of
approximately $8.1 million and working capital of approximately $11.9 million.
The Company believes cash on hand together with cash generated from operations
will provide sufficient financial resources to finance current operations of the
Company through fiscal 2004.
In fiscal 2003, the Company generated approximately $140,000 in cash
flow from operating activities of continuing operations. The Company generated
net income from continuing operations of approximately $364,000 collected
accounts receivable of approximately $750,000, sold inventory of approximately
$1.4 million and recognized deferred contract costs of approximately $2.0
million. The cash generated was used primarily to pay accounts payable and
accrued expenses of approximately $488,000. In addition, the Company recognized
deferred revenue of approximately $4.2 million.
The Company's investing activities consisted of the purchases of
approximately $228,000 for property and equipment.
The Company's financing activities during fiscal 2003 were provided
primarily by the Company's issuance of common stock, and proceeds from the
exercise of common stock options. Issuance of the Company's common stock
generated approximately $7.4 million, net of expenses. Proceeds from the
exercise of common stock options generated approximately $366,000. The Company
did not materially rely on its bank line of credit during fiscal 2003. The line
of credit expires on March 31, 2004 and currently bears interest at the lower of
(a) prime or (b) the LIBOR Market Index Rate plus two and one-half percent. As
of December 31, 2003, the Company had an outstanding balance on the line of
credit of approximately $0 and available borrowing capacity of approximately
$3.5 million.
-20-
In February 2002, the Company executed a promissory note in conjunction
with its line of credit in the amount of $725,000. The note's interest was at
the lower of (a) the Lender's Prime Rate per annum or (b) the LIBOR Market Index
Rate plus 2.5% and matured on July 5, 2003. The Company made monthly principal
payments of approximately $43,000. In July 2003, the Company extinguished its
debt and repaid the loan in its entirety.
On October 24, 2003, the Company sold 1,887,500 shares of its common
stock to private and institutional investors in a private placement transaction
at a price of $4.00 per share. SteelCloud, Inc. received gross proceeds of
$7,550,000 in connection with this transaction. Brean Murray & Co., Inc. and
Ferris, Baker Watts, Incorporated acted as co-placement agents in connection
with this private offering. The co-placement agents received an aggregate of
$437,500 and 107,422 warrants to purchase shares of our common stock as
commissions in connection with this offering. Additionally, in connection with
this transaction the Company issued an aggregate of 493,359 and 85,938 warrants
at an exercise price of $5.81 and $4.00 per share, respectively, which are
exercisable until October 24, 2008. The securities were sold pursuant to an
exemption from registration provided by section 4(2) of the Securities Act.
In fiscal 2003, the Company received proceeds from the exercise of
stock options of approximately $366,000. Approximately 570,000 shares of common
stock were issued upon the exercise of these stock options.
The Company has obligations under its operating lease commitments of
approximately $363,549 for fiscal 2004.
From time to time, the Company may pursue strategic acquisitions or
mergers, which may require significant additional capital. In such event, the
Company may seek additional financing of debt and/or equity.
OFF-BALANCE SHEET ARRANGEMENTS
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The Company's significant contractual obligations as of October 31,
2003 are for debt and operating leases. Debt by year of maturity and future
rental payments under operating lease agreements are presented below. As of
October 31, 2003, the Company does not have an outstanding balance on its line
of credit and does not have any purchase obligations. The Company has not
engaged in off-balance sheet financing, commodity contract trading or
significant related party transactions.
- -------------------------- ------------------------------------------------------------------------------
CONTRACTUAL OBLIGATIONS PAYMENTS DUE BY PERIOD
- -------------------------- ------------------------------------------------------------------------------
Total Less than 1 1-3 years 4-5 years After 5
year years
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - current $ 96,133 $ 96,133 - - -
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
Notes payable - long term 59,922 - 45,224 14,698 -
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
Operating lease 455,103 363,549 91,554 - -
- -------------------------- ----------------- ---------------- --------------- ------------- -------------
-21-
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk related to fluctuations in
interest rates on its debt. Increase in prevailing interest rates could increase
the Company's interest payment obligations relating to variable rate debt. For
example, a 100 basis point increase in interest rates would increase annual
interest expense by $38,000.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS OF STEELCLOUD, INC.
PAGE
Report of Grant Thornton LLP, Independent Auditors...................... F-1
Report of Ernst & Young LLP, Independent Auditors....................... F-2
Consolidated Balance Sheets............................................. F-3
Consolidated Statements of Operations................................... F-4
Consolidated Statements of Stockholders' Equity......................... F-5
Consolidated Statements of Cash Flows................................... F-6
Notes to the Consolidated Financial Statements.......................... F-7
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL ISSUES
On October 10, 2002, SteelCloud, Inc. (the "Company") dismissed Ernst &
Young LLP ("E&Y") as its independent certified public accountants. During the
fiscal years ended October 31, 2001 and 2000 the reports by Ernst & Young LLP on
the financial statements of the Company did not contain an adverse opinion or a
disclaimer of opinion, or was qualified or modified as to uncertainty, audit
scope, or accounting principles. During the Company's two most recent fiscal
years and subsequent period up to October 10, 2002, there were no disagreements
with the former accountant on any matter of accounting principles or practices,
financial statement disclosure, or auditing scope or procedure, which
disagreements if not resolved to their satisfaction would have caused them to
make reference in connection with their opinion to the subject matter of the
disagreement, other than the matter discussed below.
As discussed on the Company's quarterly financial conference call held
on June 6, 2002, during the quarter ended April 30, 2002, the Company and Ernst
& Young LLP had a difference of opinion with respect to revenue recognition
relating to a contractual arrangement between the Company and one of its
customers for the delivery of assembled computer units. The arrangement provides
the customer with the ability to order and pay for certain components to be
included in the units prior to delivery of the completed units. Ernst & Young
LLP concluded that the payments received from the customer relating to such
components should be deferred and recognized as revenue concurrent with the
delivery of the completed units as delivery of the components had not yet
occurred, and there remained services to be rendered and obligations to be
satisfied. Ernst & Young LLP discussed this matter with members of the Audit
Committee and members of the Board of Directors. After management discussed
Ernst & Young LLP's opinion with members of the Company's Audit Committee, the
Company accepted Ernst & Young LLP's opinion and adopted the accounting
treatment suggested by Ernst & Young LLP with respect to revenue recognition in
connection with this matter and does not continue to have a difference of
opinion with Ernst & Young with respect to this matter.
On October 11, 2002, upon receipt of approval of the Audit Committee of
the Company's Board of Directors, the Company engaged Grant Thornton LLP to
serve as the Company's independent certified public accountants. Prior to
October 11, 2002, the Company did not consult with Grant Thornton LLP on any
accounting or auditing issues.
-22-
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Our management, with
the participation of our principal executive officer and principal financial
officer, has evaluated the effectiveness of our disclosure controls and
procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the "Exchange Act")) pursuant to
Rule 13a-15(c) under the Exchange Act as of the end of the period covered by
this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that, as of such date, our
disclosure controls and procedures are effective to provide reasonable assurance
that information required to be disclosed by us in reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in applicable SEC rules and forms.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. There was no
change in our internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period
covered by this Annual Report on Form 10-K that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
-23-
PART III
The Notice and Proxy Statement for the 2003 Annual Meeting of
Stockholders to be filed pursuant to Regulation 14A under the Securities and
Exchange Act of 1934, as amended, which is incorporated by reference in this
Annual Report on Form 10-K pursuant to General Instruction G (3) of Form 10-K,
will provide the information required under Part III, including Item 10
(directors and executive officers of the Company), Item 11 (Executive
Compensation), Item 12 (security ownership of certain beneficial owners and
management), and Item 13 (certain relationships and related transactions), which
will be filed within 120 days after the end of the fiscal year covered by this
Form 10-K.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report
1. Financial Statements SteelCloud, Inc.
Report of Grant Thornton LLP, Independent Auditors
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets as of October 31, 2002 and 2003
Consolidated Statements of Operations for the three years ended
October 31, 2003
Consolidated Statements of Stockholders' Equity for the three
years ended October 31, 2003
Consolidated Statements of Cash Flows for the three years ended
October 31, 2003
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II Valuation and Qualifying Accounts
Statements not listed above have been omitted because they are not
applicable or the information required to be set forth therein is
included in the Consolidated Financial Statements or the notes thereto
under Item 8.
(b) Reports on Form 8-K
On September 11, 2003, the Company filed a report on Form 8-K pursuant
to Items 7 and 12. On October 28, 2003, the Company filed a report on
Form 8-K pursuant to Items 5 and 7. On October 29, 2003, the Company
filed a report on Form 8-K pursuant to Item 7.
(c) Exhibits.
EXHIBIT DESCRIPTION
NUMBER
**3.1 Articles of Incorporation of the Company, dated February 25, 1998, and
effective as of February 26, 1998. (Filed as Exhibit 3.1 to the
Company's Registration Statement on Form S-1, Amendment No. 1, dated
April 23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
**3.2 By-laws of the Company, effective as of March 5, 1998. (Filed as
Exhibit 3.2 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby
incorporated by reference.)
**4.1 Specimen common stock certificate for the Company. (Filed as Exhibit
4.1 to the Company's Registration Statement on Form S-1, Amendment No.
2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated
by reference.)
**10.8 Employment Agreement by and between Dunn and Thomas P. Dunne (Filed as
Exhibit 99.2 to Dunn's Registration Statement on Form SB-2, Amendment
2, dated April 4, 1997 (File No. 333-19635) and hereby incorporated by
reference).
-24-
**10.10 Deed of Lease, dated February 7, 1997, between APA Properties No. 6
L.P. and STMS, Inc. and First Amendment thereto, dated July 23, 1997
(Filed as Exhibit 10.10 to Dunn's Form 10-KSB, dated January 30, 1998
(File No. 0-22263) and hereby incorporated by reference).
**10.11 1997 Stock Option Plan, as amended. (Filed as Exhibit 10.11 to the
Company's Registration Statement on Form S-1, Amendment No. 2, dated
April 23, 1998 (File No. 333-47631) and hereby incorporated by
reference.)
**10.13 Agreement, dated May 5, 1997, by and between International Data
Products, Corp. and the U.S. Air Force, the Desktop V Contract. (Filed
as Exhibit 10.13 to the Company's Registration Statement on Form S-1,
Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby
incorporated by reference.)
**10.16 Deed of Lease, dated July 15, 1994, between Puerto Rico Industrial
Development Company and Puerto Rico Industrial Manufacturing
Operations, Corp. (Filed as Exhibit 10.16 to the Company's
Registration Statement on Form S-1, Amendment No. 2, dated April 23,
1998 (File No. 333-47631) and hereby incorporated by reference.)
**10.22 Employee Stock Purchase Plan.
**10.25 Termination agreement, Promissory Note, dated December 29, 1999 by and
between Dunn and Deutsche Financial Services.
**10.26 Loan and Security Agreement, dated May 27, 1999 by and between Dunn
and First Union Commercial Corporation.
**10.27 Modification Agreement dated February 11, 2000 by and between Dunn and
First Union National Bank.
**10.29 Modification Agreement dated January 18, 2002 by and between
SteelCloud, Inc. and First Union National Bank.
**10.30 Second Modification Agreement dated March 31, 2003, by and between
Steel Cloud, Inc., a Virginia Corporation, Dunn Computer Corporation,
a Delaware corporation, International Data Products, Corp., STMS,
Inc., Puerto Rico Industrial Manufacturing Operations Acquisition,
Corp. and Dunn Computer Operating Company (collectively, the
"Borrower") and Wachovia Bank, National Association, formerly known as
First Union National Bank.
*11.1 Statement of Computation of Earnings Per Share.
*21.1 List of Subsidiaries.
*23.1 Consent of Grant Thornton LLP, Independent Auditors.
*23.2 Consent of Ernst & Young LLP, Independent Auditors.
*31.1 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
*31.2 Certification of Vice President, Finance Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
*32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes - Oxley Act of 2002
*32.2 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes - Oxley Act of 2002
- -----------
* Filed herewith
** Previously filed.
-25-
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
STEELCLOUD, INC.
Date: January 29, 2004 By: /S/ THOMAS P. DUNNE
-------------------
Thomas P. Dunne
CHIEF EXECUTIVE OFFICER
Pursuant to and in accordance with the requirements of the Securities
Exchange Act of 1934, this report has been signed by the following persons on
behalf of the registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
/S/ THOMAS DUNNE Chief Executive Officer
Thomas P. Dunne and Director January 29, 2004
/S/KEVIN MURPHY
Kevin Murphy Chief Financial Officer January 29, 2004
/S/ VADM E.A. BURKHALTER
VADM E. A. Burkhalter USN (Ret.) Director January 29, 2004
/S/JAMES BRUNO
James Bruno Director January 29, 2004
/S/ JAY KAPLOWITZ
Jay Kaplowitz Director January 29, 2004
/S/BENJAMIN KRIEGER
Benjamin Krieger Director January 29, 2004
/S/ RICHARD PRINS
Richard Prins Director January 29, 2004
-26-
INDEX TO FINANCIAL STATEMENTS
STEELCLOUD, INC (A VIRGINIA CORPORATION)
Report of Grant Thornton LLP, Independent Auditors ....................... F-1
Report of Ernst & Young LLP, Independent Auditors ........................ F-2
Consolidated Balance Sheets as of October 31, 2002 and 2003 .............. F-3
Consolidated Statements of Operations for the
three years ended October 31, 2003 .................................... F-4
Consolidated Statements of Stockholders' Equity
for the three years ended October 31, 2003 ............................ F-5
Consolidated Statements of Cash Flows for the
three years ended October 31, 2003 .................................... F-6
Notes to Consolidated Financial Statements ............................... F-7
-27-
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders
SteelCloud, Inc.
We have audited the accompanying consolidated balance sheets of
SteelCloud, Inc. as of October 31, 2003 and 2002, and the related consolidated
statements of operations, stockholders' equity, and cash flows for the years
then ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SteelCloud,
Inc. as of October 31, 2003 and 2002, and the results of its operations and its
cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States of America.
As discussed in note 5 to the consolidated financial statements the
Company adopted Statement of Financial Accounting Standards No. 142, GOODWILL
AND OTHER INTANGIBLE ASSET on November 1, 2002
/s/ Grant Thornton LLP
- -----------------------
Vienna, VA
December 19, 2003
F-1
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors
SteelCloud, Inc.
We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of SteelCloud, Inc. (a Virginia Corporation)
for the year ended October 31, 2001. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated results of operations
of SteelCloud, Inc. and its cash flows for the year ended October 31, 2001, in
conformity with accounting principles generally accepted in the United States.
As discussed in Note 2 of the Notes to the Consolidated Financial
Statements, in 2001 the Company changed its method of accounting for convertible
securities with beneficial conversion features.
/s/ ERNST & YOUNG LLP
---------------------
December 21, 2001
McLean, Virginia
F-2
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEETS
OCTOBER 31,
----------------------------
2002 2003
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents .................................................. $ 751,323 $ 8,098,221
Accounts receivable, net of allowance for
doubtful accounts of $293,000 as of
October 31, 2002 and 2003 ............................................. 6,082,340 5,332,549
Inventory, net ............................................................. 4,180,812 2,880,944
Deferred tax asset ......................................................... 400,000 400,000
Income tax receivable ...................................................... 55,392 55,392
Prepaid expenses and other current assets .................................. 208,892 184,420
Deferred contract costs .................................................... 2,039,339 7,053
Assets held for sale ....................................................... 953,320 --
------------ ------------
Total current assets .......................................................... 14,671,418 16,958,579
Property and equipment, net ................................................... 304,081 477,111
Equipment on lease, net ....................................................... 574,272 335,935
Goodwill and other intangible assets, net ..................................... 1,778,059 1,778,059
Other assets .................................................................. 304,922 211,155
------------ ------------
Total assets .................................................................. $ 17,632,752 $ 19,760,839
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................... $ 3,620,580 $ 3,202,195
Accrued expenses ........................................................... 1,542,277 1,369,145
Notes payable, current portion ............................................. 503,823 96,133
Liabilities held for sale .................................................. 641,145 --
Unearned revenue ........................................................... 4,507,859 293,363
------------ ------------
Total current liabilities ..................................................... 10,815,684 4,960,836
Notes payable, long-term portion .......................................... 60,000 59,952
Other ..................................................................... -- 6,415
------------ ------------
Total long-term liabilities ................................................... 60,000 66,367
Stockholders' equity:
Common stock, $.001 par value;
50,000,000 shares authorized,
10,447,611 and 13,008,553 shares issued
and outstanding at October 31, 2002 and 2003,
respectively ............................................................... 10,448 13,009
Additional paid-in capital .................................................... 39,553,017 47,307,036
Treasury stock, 400,000 shares at October 31, 2002
and 2003, respectively ..................................................... (3,432,500) (3,432,500)
Accumulated deficit ........................................................... (29,373,897) (29,153,909)
------------ ------------
Total stockholders' equity .................................................... 6,757,068 14,733,636
------------ ------------
Total liabilities and stockholders' equity .................................... $ 17,632,752 $ 19,760,839
============ ============
SEE ACCOMPANYING NOTES
F-3
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED OCTOBER 31,
--------------------------------------------
2001 2002 2003
------------ ------------ ------------
Net revenues ...................................... $ 25,791,082 $ 29,157,368 $ 33,042,999
Costs of revenues ................................. 19,406,836 22,163,435 26,353,462
------------ ------------ ------------
Gross profit ...................................... 6,384,246 6,993,933 6,689,537
Selling and marketing ............................. 724,337 1,184,406 1,276,386
General and administrative ........................ 3,956,293 4,769,552 4,550,414
Research and product development .................. -- -- 494,087
Impairment of goodwill ............................ -- 132,644 --
Amortization of goodwill .......................... 394,216 394,216 --
------------ ------------ ------------
Income from operations ............................ 1,309,400 513,115 368,650
Other income (expense):
Interest income ................................ 87,961 5,525 5,661
Interest expense ............................... (245,532) (78,734) (22,800)
Other, net ..................................... (26,396) (149,183) 12,421
------------ ------------ ------------
Income from continuing operations before income tax 1,125,433 290,723 363,932
Provision for (benefit from) income taxes ......... 102,276 (279,800) --
------------ ------------ ------------
Income from continuing operations ................. 1,023,157 570,523 363,932
(Loss) from discontinued operations, net of tax ... (9,431) (1,685,708) (134,367)
(Loss) on disposal of discontinued operations,
net of tax ..................................... -- -- (9,577)
------------ ------------ ------------
Income (loss) before cumulative effect of ......... $ 1,013,726 $ (1,115,185) $ 219,988
accounting change
Cumulative effect of change in accounting principle (576,001) -- --
------------ ------------ ------------
Net income (loss) ................................. $ 437,725 $ (1,115,185) $ 219,988
Dividends to preferred stockholders ............... (112,500) -- --
Increase to income available to common stockholders
from repurchase of preferred stock ........... 721,816 -- --
------------ ------------ ------------
Net income (loss) available to common stockholders $ 1,047,041 $ (1,115,185) $ 219,988
============ ============ ============
Earnings (loss) per share, basic
Earnings from continuing operations ............... $ 0.10 $ 0.06 $ 0.04
(Loss) from discontinued operations ............... -- (0.17) (0.01)
------------ ------------ ------------
Net earnings (loss) per share ..................... $ 0.10 $ (0.11) $ 0.03
============ ============ ============
Earnings (loss) per share, fully diluted
Earnings (loss) from continuing operations ........ $ 0.08 $ 0.05 $ 0.03
(Loss) from discontinued operations ............... -- (0.15) (0.01)
------------ ------------ ------------
Net earnings (loss) per share ..................... $ 0.08 $ (0.10) $ 0.02
============ ============ ============
Pro forma amounts assuming the
accounting change is applied retroactively:
Net income (loss) to common stockholders .......... $ 1,623,042 $ (1,115,185) $ 219,988
============ ============ ============
Net earnings (loss) per share, basic .............. $ 0.16 $ (0.11) $ 0.03
============ ============ ============
Net earnings (loss) per share, fully diluted ...... $ 0.08 $ (0.10) $ 0.02
============ ============ ============
SEE ACCOMPANYING NOTES.
F-4
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
ADDITIONAL
PREFERRED STOCK COMMON STOCK PAID-IN
SHARES AMOUNT SHARES AMOUNT CAPITAL
-------------------------------------------------------------------------
BALANCE AT
OCTOBER 31, 2000 ..... 2,850 3 9,806,962 9,807 41,584,844
Conversion of
Series A Convertible
Preferred Stock ...... (230) -- 390,267 391 (391)
Conversion of
Preferred Stock
dividends to shares
of Common Stock ...... -- -- 17,316 17 10,019
Dividend Declared on
Series A Convertible
Preferred Stock ...... -- -- -- -- --
Cumulative effect of
change in accounting
principle ............ -- -- -- -- 576,001
Redemption of
preferred Stock ...... (2,620) (3) -- (3,091,076) --
Net Income ........... -- -- -- -- --
-------------------------------------------------------------------------
BALANCE AT ........... 10,214,545 $ 10,215 $ 39,079,397
OCTOBER 31, 2001
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 227,826 228 272,465
Issuance of
common stock
for services ......... -- -- 5,240 5 17,495
Tax benefit associated
with exercise of
employee
stock options ........ -- -- -- -- 119,000
Compensation expense
associated with the
issuance of stock
options .............. -- -- -- -- 64,660
Net Income ........... -- -- -- -- --
-------------------------------------------------------------------------
BALANCE AT ........... 10,447,611 $ 10,448 $ 39,553,017
OCTOBER 31, 2002
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 673,442 673 789,882
Issuance of
common stock ......... 6,966,025
under private
placement ............ -- -- 1,887,500 1,888 6,964,137
Net Income ........... -- -- -- -- --
-------------------------------------------------------------------------
BALANCE AT ........... 13,008,553 $ 13,009 $ 47,307,036
OCTOBER 31, 2003
=========================================================================
RETAINED
TREASURY EARNINGS
STOCK (ACCUMULATED TOTAL
DEFICIT)
-------------------------------------------
BALANCE AT
OCTOBER 31, 2000 ..... (3,432,500) (29,305,753) 8,856,401
Conversion of
Series A Convertible
Preferred Stock ...... -- -- --
Conversion of
Preferred Stock
dividends to shares
of Common Stock ...... -- -- 10,036
Dividend Declared on
Series A Convertible
Preferred Stock ...... -- (112,500) (112,500)
Cumulative effect of
change in accounting
principle ............ -- (576,001) --
Redemption of
preferred Stock ...... 721,816 (2,369,263)
Net Income ........... -- 1,013,726 1,013,726
-------------------------------------------
BALANCE AT ........... $ (3,432,500) $(28,258,712) $ 7,398,400
OCTOBER 31, 2001
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 272,693
Issuance of
common stock
for services ......... -- -- 17,500
Tax benefit associated
with exercise of
employee
stock options ........ -- -- 119,000
Compensation expense
associated with the
issuance of stock
options .............. -- -- 64,660
Net Income ........... -- (1,115,185) (1,115,185)
-------------------------------------------
BALANCE AT ........... $ (3,432,500) $(29,373,897) $ 6,757,068
OCTOBER 31, 2002
Issuance of
common stock
in connection
with exercise
of employee
incentive
stock option
plan ................. -- -- 790,555
Issuance of
common stock .........
under private
placement ............ -- --
Net Income ........... -- 219,988 219,988
-------------------------------------------
BALANCE AT ........... $ (3,432,500) $(29,153,909) 14,733,636
OCTOBER 31, 2003
===========================================
SEE ACCOMPANYING NOTES.
F-5
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED OCTOBER 31,
-----------------------------------------
2001 2002 2003
----------- ----------- -----------
OPERATING ACTIVITIES
Net income (loss) .............................. $ 437,725 $(1,115,185) $ 219,988
Cumulative change in accounting principle ...... 576,001 -- --
Loss from discontinued operations, net ......... 9,431 1,685,708 143,944
----------- ----------- -----------
Income applicable from continuing operations ... 1,023,157 570,523 363,932
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization of property and 1,301,588 683,860 331,553
equipment
Amortization of goodwill and other .......... 394,216 394,216 --
intangibles
Impairment of goodwill ...................... -- 132,644 --
Impairment charge - investment .............. -- 150,000 --
Provision for bad debt ...................... -- 161,030 --
(Gain) loss on sale of assets ............... -- 4,196 --
(Gain) on settlement of litigation .......... (343,087) -- --
Stock compensation expense .................. -- 82,160 --
Changes in operating assets and liabilities:
Accounts receivable, net .................. (2,258,763) (586,275) 749,791
Income tax receivable ..................... (1,169,743) 1,345,032 --
Inventory ................................. (267,972) 117,458 1,336,334
Prepaid expenses and other assets ......... 38,236 41,688 29,394
Deferred contract costs ................... -- (2,039,339) 2,032,286
Deferred tax asset (credit) ............... 1,282,695 (279,800) --
Accounts payable .......................... 600,954 454,159 (321,574)
Accrued expenses .......................... 213,513 53,462 (166,718)
Unearned revenue and other liabilities .... 77,695 4,294,474 (4,214,496)
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Net cash provided by operating
activities of continuing operations ............ 892,489 5,579,488 140,502
INVESTING