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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-Q

 


 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2010

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 000-50464

 

LECG CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware

 

81-0569994

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

2000 Powell Street, Suite 600
Emeryville, California 94608

 

(510) 985-6700

(Address of principal executive offices including zip code)

 

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

As of July 30, 2010, there were 38,112,343 shares of the registrant’s common stock outstanding.

 

 

 



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES
FORM 10-Q
TABLE OF CONTENTS

 

PART I — FINANCIAL INFORMATION

3

Item 1.

Financial Statements (Unaudited)

3

 

Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2010 and 2009

3

 

Condensed Consolidated Balance Sheets as of June 30, 2010 and December 31, 2009

4

 

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2010 and 2009

5

 

Notes to Condensed Consolidated Financial Statements

6

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

19

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

35

Item 4.

Controls and Procedures

36

 

 

 

PART II — OTHER INFORMATION

37

Item 1.

Legal Proceedings

37

Item 1A.

Risk Factors

37

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

47

Item 3.

Defaults Upon Senior Securities

47

Item 4.

(Removed and Reserved)

47

Item 5.

Other Information

47

Item 6.

Exhibits

48

 

2



Table of Contents

 

PART I FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)
(unaudited)

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Fee-based revenues, net

 

$

79,684

 

$

65,464

 

$

146,968

 

$

129,386

 

Reimbursable revenues

 

3,925

 

2,405

 

6,648

 

4,788

 

Revenues

 

83,609

 

67,869

 

153,616

 

134,174

 

Direct costs

 

60,072

 

48,111

 

109,765

 

97,728

 

Reimbursable costs

 

3,876

 

2,651

 

6,530

 

5,191

 

Cost of services

 

63,948

 

50,762

 

116,295

 

102,919

 

Gross profit

 

19,661

 

17,107

 

37,321

 

31,255

 

Operating expenses:

 

 

 

 

 

 

 

 

 

General and administrative expenses

 

23,866

 

18,782

 

43,405

 

37,607

 

Depreciation and amortization

 

1,463

 

1,280

 

2,628

 

2,610

 

Restructuring charges and other impairments

 

3,188

 

2,624

 

10,108

 

2,680

 

Divestiture charges

 

 

1,725

 

 

1,739

 

Operating loss

 

(8,856

)

(7,304

)

(18,820

)

(13,381

)

Interest income

 

34

 

42

 

65

 

90

 

Interest expense

 

(1,501

)

(643

)

(4,100

)

(958

)

Other expense, net

 

(132

)

(356

)

(200

)

(446

)

Loss before income taxes

 

(10,455

)

(8,261

)

(23,055

)

(14,695

)

Income tax expense (benefit)

 

418

 

(1,807

)

889

 

(4,445

)

Net loss

 

(10,873

)

(6,454

)

(23,944

)

(10,250

)

 

 

 

 

 

 

 

 

 

 

Series A convertible redeemable preferred dividends

 

471

 

 

575

 

 

 

 

 

 

 

 

 

 

 

 

Net loss attributable to common shareholders

 

$

(11,344

)

$

(6,454

)

$

(24,519

)

$

(10,250

)

 

 

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.31

)

$

(0.25

)

$

(0.75

)

$

(0.40

)

Diluted

 

$

(0.31

)

$

(0.25

)

$

(0.75

)

$

(0.40

)

 

 

 

 

 

 

 

 

 

 

Shares used in calculating earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

36,888

 

25,515

 

32,644

 

25,451

 

Diluted

 

36,888

 

25,515

 

32,644

 

25,451

 

 

See notes to condensed consolidated financial statements

 

3



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)
(unaudited)

 

 

 

June 30,

 

December 31,

 

 

 

2010

 

2009

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

8,805

 

$

13,044

 

Accounts receivable, net

 

112,307

 

85,451

 

Prepaid expenses

 

4,167

 

4,981

 

Signing, retention and performance bonuses - current portion

 

12,112

 

14,046

 

Income taxes receivable

 

12,833

 

13,498

 

Other current assets

 

4,492

 

2,207

 

Total current assets

 

154,716

 

133,227

 

Property and equipment, net

 

10,493

 

7,814

 

Goodwill

 

48,927

 

1,800

 

Other intangible assets, net

 

7,628

 

3,078

 

Signing, retention and performance bonuses

 

19,288

 

20,293

 

Deferred compensation plan assets

 

8,400

 

10,017

 

Deferred tax assets, net

 

5,981

 

5,731

 

Other long-term assets

 

8,248

 

8,851

 

Total assets

 

$

263,681

 

$

190,811

 

 

 

 

 

 

 

Liabilities and stockholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accrued compensation

 

$

43,901

 

$

45,363

 

Accounts payable and other accrued liabilities

 

17,818

 

8,823

 

Payable for business acquisitions - current portion

 

1,155

 

1,055

 

Deferred revenue

 

4,444

 

3,052

 

Debt and subordinated notes

 

35,991

 

12,000

 

Deferred tax liabilities, net - current portion

 

6,163

 

5,731

 

Total current liabilities

 

109,472

 

76,024

 

Payable for business acquisitions

 

 

100

 

Deferred compensation plan obligations

 

9,630

 

10,163

 

Deferred rent

 

5,434

 

6,156

 

Other long-term liabilities

 

4,559

 

252

 

Total liabilities

 

129,095

 

92,695

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

Series A 7.5% convertible redeemable preferred stock, $0.01 par value, 15,000,000 shares authorized; 6,313,131 and 0 shares outstanding at June 30, 2010 and December 31, 2009, respectively (liquidation preference and redemption values at June 30, 2010 and December 31, 2009 of $25,575 and $0, including cumulative dividends of $575 and $0, respectively)

 

25,575

 

 

 

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

Common stock, $.001 par value, 200,000,000 shares authorized, 38,100,579 and 25,895,679 shares outstanding at June 30, 2010 and December 31, 2009, respectively

 

38

 

26

 

Additional paid-in capital

 

211,179

 

174,917

 

Accumulated other comprehensive loss

 

(1,550

)

(690

)

Accumulated deficit

 

(100,656

)

(76,137

)

Total stockholders’ equity

 

109,011

 

98,116

 

Total liabilities and stockholders’ equity

 

$

263,681

 

$

190,811

 

 

See notes to condensed consolidated financial statements

 

4



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)
(unaudited)

 

 

 

Six months ended June 30,

 

 

 

2010

 

2009

 

Cash flows from operating activities

 

 

 

 

 

Net loss

 

$

(23,944

)

$

(10,250

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Bad debt expense

 

967

 

66

 

Depreciation and amortization of property and equipment

 

2,063

 

2,254

 

Amortization of intangible assets

 

565

 

356

 

Amortization of signing, retention and performance bonuses

 

7,857

 

8,657

 

Deferred taxes

 

182

 

 

Equity-based compensation

 

2,906

 

3,216

 

Non cash restructuring charges and other impairments

 

3,609

 

1,519

 

Amortization of deferred financing costs

 

2,047

 

341

 

Divestiture charges

 

 

1,739

 

Other

 

140

 

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(6,977

)

(5,996

)

Signing, retention and performance bonuses paid

 

(9,976

)

(6,958

)

Prepaid and other current assets

 

1,866

 

948

 

Accounts payable and other accrued liabilities

 

4,997

 

(1,441

)

Income taxes receivable

 

697

 

(1,659

)

Accrued compensation

 

(6,068

)

(12,495

)

Deferred revenue

 

994

 

(187

)

Deferred compensation plan assets, net of liabilities

 

753

 

(128

)

Deferred rent

 

(539

)

(567

)

Other assets

 

(146

)

(132

)

Other liabilities

 

1,685

 

768

 

Net cash used in operating activities

 

(16,322

)

(19,949

)

Cash flows from investing activities

 

 

 

 

 

Cash acquired from Smart merger

 

9,242

 

 

Business acquisitions earn-out payments

 

 

(3,885

)

Divestiture payments

 

 

(3,210

)

Purchase of property and equipment

 

(897

)

(712

)

Proceeds from note receivable

 

295

 

279

 

Proceeds from divestiture

 

 

619

 

Restricted cash and deposits

 

(1,945

)

 

Other

 

(54

)

(30

)

Net cash provided by (used in) investing activities

 

6,641

 

(6,939

)

Cash flows from financing activities

 

 

 

 

 

Borrowings under revolving credit facility

 

7,000

 

30,000

 

Repayments under revolving credit facility

 

(19,000

)

(17,000

)

Repayments of long-term debt

 

(6,958

)

 

Payment of loan fees

 

(202

)

(2,243

)

Proceeds from issuance of series A convertible redeemable preferred stock

 

25,000

 

 

Proceeds from exercise or issuance of stock to employees and other

 

30

 

30

 

Net cash provided by financing activities

 

5,870

 

10,787

 

Effect of exchange rates on changes in cash

 

(428

)

19

 

Decrease in cash and cash equivalents

 

(4,239

)

(16,082

)

Cash and cash equivalents, beginning of year

 

13,044

 

19,510

 

Cash and cash equivalents, end of period

 

$

8,805

 

$

3,428

 

Supplemental disclosure

 

 

 

 

 

Cash paid for interest

 

$

1,793

 

$

593

 

Cash paid for income taxes, net

 

$

30

 

$

1,723

 

Non cash investing and financing activities

 

 

 

 

 

Fair value of common stock issued for acquisitions

 

$

33,330

 

$

 

Series A convertible redeemable preferred dividends

 

$

575

 

$

 

 

See notes to condensed consolidated financial statements

 

5



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.                                      Basis of presentation and operations

 

The accompanying Condensed Consolidated Financial Statements include the accounts of LECG Corporation and its wholly owned subsidiaries (collectively, the “Company” or “LECG”). The Company provides expert services, including economic and financial analysis, expert testimony, litigation support and strategic management consulting, and since the completion of its Merger with SMART, business advisory, corporate governance, assurance and tax services, to a broad range of public and private enterprises. Services are provided by academics, recognized industry leaders and former high-level government officials (collectively, “experts”), and seasoned consultants with the assistance of a professional support staff. The Company’s experts are comprised of employees of the Company as well as exclusive independent contractors. These services are provided primarily in the United States (U.S.). The Company also has international offices in Argentina, Australia, Belgium, China, France, Hong Kong, Italy, New Zealand, Spain and the United Kingdom. On March 10, 2010, the Company completed a merger (the “Merger”) with SMART Business Holdings, Inc. (“SMART”) which resulted in an expansion of services offered by the Company and in the number of its office locations from 19 to 24 offices across the country. SMART’s operating results have been included in the Company’s consolidated results from the acquisition date. In connection with the closing of the Merger, the Company announced the relocation and consolidation of its corporate headquarters to Devon, Pennsylvania, which is scheduled to be completed by the end of the third quarter of 2010. See Note 2 for more information regarding the Merger with SMART.

 

In connection with the Merger, the Company terminated its then existing credit facility and repaid in full the $19.0 million outstanding, and the Company became a co-borrower with SMART under a $40.8 million term loan (the “Amendment”) which matures on March 31, 2011. Through June 30, 2010, the Company has made principal payments of $7.0 million; and the outstanding balance of the term debt at June 30, 2010 was $33.8 million. Management believes that the Company’s cash and cash equivalents at June 30, 2010, and its federal and state tax refunds totaling approximately $13.3 million (of which $11.3 million was received in August 2010 and $2.0 million is pending receipt) will be sufficient to meet the Company’s operating needs and regularly scheduled quarterly debt service obligations through March 31, 2011, by which time the Company will need to refinance the remaining debt balance (approximately $27.8 million in principal amount at maturity). Given the relatively near-term maturity of this term debt facility, the Company has begun the process of seeking and evaluating alternatives to refinance the term debt through various banks and other financial institutions.  Until a refinancing is completed, it is not assured that the Company will be able to successfully implement any of the potential alternatives or that any such alternative will be on terms acceptable to the Company; and if unsuccessful, the Company does not anticipate that it will have sufficient liquidity at March 31, 2011 to repay the full $27.8 million then outstanding under the term debt. In that event, the Company’s ability to obtain the working capital required for its operations would be uncertain, and the Company’s results of operations, financial condition and cash flows could be materially adversely affected. The Condensed Consolidated Financial Statements do not include any adjustments that might result from the outcome of these uncertainties.

 

The Amendment contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum quarterly EBITDA and cash balance requirements. At June 30, 2010, the Company was in compliance with these covenants; however, due to a combination of accelerated and increased integration-related expenses, the inherent delays in realizing the related cost savings associated with these integration activities, and a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010, the Company estimates that it is likely to be non-compliant with one or more of the EBITDA-related covenants at September 30, 2010. In addition to the steps being taken to secure refinancing of the term debt maturing on March 31, 2011, the Company is currently evaluating alternatives to address the likely future covenant non-compliance, including the recent initiation of discussions with the current lenders to seek an amendment to reset the covenant ratios or to obtain a temporary waiver, as necessary, for any non-compliance in Q3 and Q4 of 2010. The breach of any such covenants, ratios or tests would result in a default under the Amendment which, if not cured or waived by the lenders, could permit the lenders to declare the full outstanding debt amount to be immediately due and payable, together with accrued and unpaid interest. As indicated above, the Company would have insufficient liquidity to satisfy full repayment of the outstanding balance in a timely manner, if the remaining payments were accelerated.

 

The Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2010 and 2009, the Condensed Consolidated Balance Sheets as of June 30, 2010 and the Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2010 and 2009 are unaudited. In the opinion of management, these Condensed Consolidated Financial Statements include all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of LECG’s consolidated financial position, results of operations and cash flows for the periods then ended. The December 31, 2009 Condensed Consolidated Balance Sheet is derived from LECG’s audited consolidated financial statements included in its Annual Report on Form 10-K for the year then ended. The results of operations for the three and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year. The Condensed Consolidated Financial Statements in this report should be read in conjunction with the consolidated financial statements and related notes contained in the Annual Report on Form 10-K for 2009.

 

The preparation of these Condensed Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the Condensed Consolidated Financial Statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

 

The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate their estimated fair values because of the short maturity of these financial instruments.

 

6



Table of Contents

 

2.                                      SMART merger

 

On March 10, 2010, the Company completed its Merger with SMART, a privately held provider of business advisory services, and received a $25.0 million cash investment from SMART’s majority shareholder, Great Hill Equity Partners III, LP (“Great Hill Partners”). In the Merger transaction, LECG acquired 100% of SMART’s outstanding stock in exchange for 10,927,869 shares of LECG common stock, which had a value of approximately $33.3 million based on the March 10, 2010 closing stock price of $3.05. The Company also assumed approximately $42.8 million of SMART debt. Simultaneously with the consummation of the Merger, Great Hill Partners made a $25.0 million cash investment into LECG in exchange for 6,313,131 shares of Series A Convertible Redeemable Preferred Stock. This stock is convertible share-for-share into LECG common stock and provides a 7.5% annual dividend payable in cash or Series A Convertible Redeemable Preferred Stock at the Company’s discretion. As a result of the issuance of the common stock and Series A Convertible Redeemable Preferred Stock, Great Hill Partners owns approximately 40% of the Company’s outstanding voting shares. The Company completed the Merger with SMART primarily to expand its services offered, gain market share, increase its talent pool of business consultants, and expand its client base to include SMART’s Fortune 200 customers. The combined company expects to generate improved financial performance, with incremental revenues from integrated service opportunities and SMART’s financial advisory and business consulting practices including technology, business process improvement, compensation and benefits, accounting, actuarial and tax, and cost reductions from synergies.

 

Purchase price allocation

 

The Merger was accounted for under Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 805, Business Combinations (“ASC 805”). Assets acquired and liabilities assumed were recorded at their estimated fair values as of the closing date of March 10, 2010 and represented management’s best estimate based on the data available at that time. The estimated purchase price totaled $76.2 million and was allocated to SMART’s net tangible assets acquired and liabilities assumed, and to identifiable intangible assets based on their estimated fair values. The excess of the purchase price over the net tangible assets acquired and liabilities assumed and identifiable intangible assets was recorded as goodwill (Note 8).

 

Total acquisition-related costs were approximately $6.5 million, and include fees for legal, financial advisory, accounting, due diligence, tax, valuation, printing and other various services in connection with the transaction. The Company recognized a total of $2.5 million of acquisition-related costs in the six months ended June 30, 2010 and $4.0 million prior to December 31, 2009.

 

The following table summarizes the adjusted purchase price allocation as of June 30, 2010 (in thousands):

 

Cash and cash equivalents

 

$

9,242

 

Accounts receivable

 

22,523

 

Prepaid expenses and other current assets

 

1,309

 

Property and equipment

 

4,415

 

Other assets

 

1,378

 

Accounts payable and other accrued liabilities

 

(11,760

)

Deferred compensation plan obligations and other liabilities

 

(3,138

)

Net tangible assets acquired

 

23,969

 

 

 

 

 

Identifiable intangible assets acquired

 

5,060

 

Goodwill

 

47,127

 

Debt assumed

 

(42,826

)

Total purchase price, net of debt assumed

 

$

33,330

 

 

Of the total estimated purchase price, approximately $24.0 million has been allocated to the net tangible assets acquired and liabilities assumed, which included a fair value of $2.0 million related to unfavorable leases, and $5.1 million has been allocated to the identifiable intangible assets acquired, which consist of the value assigned to SMART’s customer relationships of $4.9 million and trade name of $0.2 million. Approximately $47.1 million has been allocated to goodwill, and primarily represents the value of the acquired workforce and the expected synergies from combining operations. The goodwill recorded as a result of the SMART acquisition is not expected to be deductible for tax purposes.

 

7



Table of Contents

 

The following is a description of the methods used to determine the fair value of the intangible assets acquired from SMART:

 

·                                          The value assigned to SMART’s customer relationships was established based on the excess earnings methodology of the income approach in order to capture the subject customers’ expected contribution to future earnings. In this method, value is estimated as the present value of the benefits anticipated from ownership of the subject intangible asset in excess of the returns required on the investment in the contributory assets necessary to realize those benefits. The forecast of revenue from existing customer relationships was based on the recent year’s sales and assumptions regarding future customer attrition and expected volume and price changes. Management expects an average attrition rate of approximately 15% per year. Costs associated with the acquired customer revenue were based on specific margins and adjusted for the lower marketing expenses associated with sales to established customers. The excess earnings attributable to SMART’s customer relationships were discounted to present value using an estimated required rate of return. The Company will amortize the value of SMART’s customer relationships ratably over its economic life which is estimated to be ten years. Amortization of these customer relationships is not expected to be deductible for tax purposes.

 

·                                          The value assigned to SMART’s trade name was determined based on an income approach which assumes that the acquirer will not pay royalties or license fees to use the trade name. The approach is known as the relief-from-royalty method and is applied to the appropriate levels of net revenues to calculate the royalty savings attributable to the ownership of the trade name. The present value of the after-tax cost savings at an appropriate discount rate indicates the value of the trade name. The Company amortizes the trade name on a straight-line basis over ten months. Amortization of this trade name is not expected to be deductible for tax purposes.

 

The Company acquired SMART’s gross deferred tax assets of approximately $24.8 million ($5.8 million net deferred tax assets), which consisted mostly of U.S. and foreign net operating loss carryforwards and tax basis in intangible assets. In addition, the Company recorded a deferred tax liability of $2.0 million related to amortizable intangible assets from the Merger. A full valuation allowance was recorded against the net overall deferred tax assets for SMART, as a result of the Company’s current assessment of its recoverability.

 

The accounts receivable balance at March 10, 2010 consists of gross contractual amounts of $24.2 million. The contractual cash flows not expected to be collected totaled $1.7 million.

 

Pro forma financial information

 

The Company’s Condensed Consolidated Financial Statements include SMART’s results of operations beginning on March 11, 2010, the first business day after the effective date of the Merger. The following are SMART’s results included in the Company’s Condensed Consolidated Statements of Operations (in thousands):

 

 

 

UNAUDITED

 

 

 

April 1, 2010

 

March 11, 2010

 

 

 

June 30, 2010

 

June 30, 2010

 

Revenues

 

$

24,035

 

$

30,648

 

Net loss

 

$

(3,833

)

$

(6,136

)

Net loss attributable to common shareholders

 

$

(3,833

)

$

(6,136

)

 

The following summary of pro forma consolidated revenues, net loss and earnings per share is presented as if the Merger with SMART had occurred at the beginning of each period presented. These unaudited pro forma results are not necessarily indicative of future earnings or earnings that would have been reported had the Merger been completed as presented (in thousands, except per share data):

 

 

 

UNAUDITED

 

 

 

Supplemental pro forma

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Revenues

 

$

83,609

 

$

93,293

 

$

172,065

 

$

187,518

 

Net loss

 

$

(10,873

)

$

(6,325

)

$

(26,125

)

$

(9,962

)

Net loss attributable to common shareholders

 

$

(11,344

)

$

(6,803

)

$

(27,065

)

$

(10,908

)

Earnings per common share basic and diluted

 

$

(0.31

)

$

(0.19

)

$

(0.74

)

$

(0.30

)

 

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3.                                      Restricted cash

 

The Company had $1.9 million and $0 of restricted cash as of June 30, 2010 and December 31, 2009, respectively. The restricted cash balances consisted of pledged bank deposits to collateralize outstanding letters of credit and are included in Other long-term assets in the Condensed Consolidated Balance Sheets.

 

4.                                      Series A convertible redeemable preferred stock

 

As part of the Merger with SMART, the Company issued 6,313,131 shares of Series A Convertible Redeemable Preferred Stock in exchange for $25.0 million. This Series A Convertible Redeemable Preferred Stock is convertible share-for-share into the Company’s common stock and provides a cumulative 7.5% annual dividend. These dividends are payable in additional shares of Series A Convertible Redeemable Preferred Stock or, at the Company’s option, in cash so long as the Company has sufficient cash to make such distribution without breaching the terms of any contract for borrowed money indebtedness and such cash is legally available therefor. Dividends accrue from the date of issuance of the Series A Convertible Redeemable Preferred Stock and are payable quarterly, in arrears, on the last day of March, June, September and December. Any accrued but unpaid dividends shall compound quarterly. For the June 30, 2010 dividend, the Company recorded approximately $0.5 million of Series A convertible redeemable preferred stock and Additional paid-in capital.

 

See Note 4 of Notes to Condensed Consolidated Financial Statements included in the March 31, 2010 Report on Form 10-Q for a description of the liquidation preference and conversion and voting rights of the Series A convertible redeemable preferred stock.

 

5.                                      Earnings per common share

 

Basic earnings per common share is computed by dividing the net income (loss) attributable to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is computed by dividing the net income attributable to common stockholders for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares as determined by the treasury stock method are included in the diluted earnings per common share calculation to the extent these shares are dilutive. If the Company has a net loss for the period, common equivalent shares are excluded from the denominator because their effect on net loss would be antidilutive.

 

The following is a reconciliation of net loss and the number of shares used in the basic and diluted earnings per share computations (in thousands, except per share data):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Net loss

 

$

(10,873

)

$

(6,454

)

$

(23,944

)

$

(10,250

)

Less: series A convertible redeemable preferred share dividends

 

471

 

 

575

 

 

Net loss attributable to common shareholders

 

$

(11,344

)

$

(6,454

)

$

(24,519

)

$

(10,250

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

36,888

 

25,515

 

32,644

 

25,451

 

Effect of dilutive stock options, unvested restricted stock and preferred shares

 

 

 

 

 

Diluted

 

36,888

 

 

25,515

 

32,644

 

 

25,451

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.31

)

$

(0.25

)

$

(0.75

)

$

(0.40

)

Diluted

 

$

(0.31

)

$

(0.25

)

$

(0.75

)

$

(0.40

)

 

Approximately 4.3 million and 5.5 million of anti-dilutive securities for the three months ended June 30, 2010 and 2009, respectively, were excluded from the calculation of diluted earnings per share. For the six months ended June 30, 2010 and 2009, approximately 3.8 million and 5.6 million of anti-dilutive securities, respectively, were excluded from the calculation of diluted earnings per share.

 

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6.                                      Equity-based compensation

 

Stock option activity

 

Pursuant to the Merger agreement, the compensation committee of the Company’s board of directors approved the issuance of options to purchase 0.5 million shares of LECG’s common stock to employees of SMART. The options were granted effective April 1, 2010.

 

The weighted average grant date fair value for stock options awarded to employees of SMART was $1.85 per share, resulting in a total value of $0.9 million, which will be expensed on a straight-line basis over a five year vesting period. The weighted average exercise price of stock options granted to employees of SMART was $2.96 per share.

 

Black-Scholes assumptions

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that employs the assumptions and inputs appearing in the table below. Certain inputs are presented as the range of values for that input used throughout the periods presented. Expected volatility is measured using the historical volatility of LECG’s stock price over the historical period corresponding to the vesting period of the options. The expected term is calculated using FASB ASC 718, Compensation—Stock Compensation (“ASC 718”) (previously the Securities and Exchange Commission guidance in Staff Accounting Bulletin (‘SAB”) No. 110 amended SAB No. 107) that permits the application of a “simplified” method based on the average of the vesting term and the contractual term of the option. The risk-free interest rate is based on published yields on U.S. Treasury securities with maturities commensurate with the expected term of the option. The assumptions used in calculating the fair value of options granted to the SMART employees during three months ended June 30, 2010 are as follows:

 

Expected volatility

 

64.0

%

Expected dividend rate

 

0

%

Expected term (in years)

 

6.5

 

Risk-free interest rate

 

3.0

%

 

Restricted stock activity

 

The compensation committee of the Company’s board of directors approved the issuance of 1.0 million shares of restricted stock to the Company’s chief executive officer effective May 3, 2010. The award provides that the restricted stock will vest over five years of continuous service with annual cliff vesting on the anniversary date of the grant in the following percentages: 10%, 15%, 20%, 25% and 30%. The grant date fair value of this restricted stock award was $3.3 million which will be expensed on a straight-line basis over the five year vesting period.

 

Stock-based compensation expense

 

The following table summarizes equity-based compensation and its effect on direct costs, general and administrative expenses and earnings (in thousands):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

 

 

 

 

 

 

 

 

 

 

Direct costs

 

$

1,006

 

$

872

 

$

2,014

 

$

1,957

 

General and administrative expenses

 

495

 

613

 

892

 

1,259

 

Equity-based compensation effect on earnings before income tax

 

1,501

 

1,485

 

2,906

 

3,216

 

Income tax benefit

 

 

(593

)

 

(1,284

)

Equity-based compensation effect on earnings

 

$

1,501

 

$

892

 

$

2,906

 

$

1,932

 

 

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7.                                      Comprehensive loss

 

Comprehensive (loss) income represents net (loss) income plus other comprehensive (loss) income resulting from changes in foreign currency translation. The reconciliation of LECG’s comprehensive loss is as follows (in thousands):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Net loss

 

$

(10,873

)

$

(6,454

)

$

(23,944

)

$

(10,250

)

Foreign currency translation (loss) gain

 

(478

)

1,320

 

(860

)

504

 

Comprehensive loss

 

$

(11,351

)

$

(5,134

)

$

(24,804

)

$

(9,746

)

 

8.                                      Goodwill and other intangible assets

 

On March 10, 2010, the Company completed the Merger with SMART and accounted for the Merger in accordance with ASC 805. As a result, the Company recorded approximately $47.1 million of goodwill and $5.1 million of other identifiable intangible assets. For impairment testing purposes, the Company assigned all of the SMART goodwill to the new Consulting and Governance segment (Note 14), pending a final assessment of expected synergies and potential realignment between segments.

 

The changes in the carrying amount of consolidated goodwill during the period are as follows (in thousands):

 

 

 

June 30,

 

December 31,

 

 

 

2010

 

2009

 

Balance at beginning of year

 

$

1,800

 

$

 

Goodwill recorded in connection with merger

 

47,127

 

 

Additional acquisition related payments

 

 

1,800

 

Balance at end of period

 

$

48,927

 

$

1,800

 

 

Also as a result of the Merger with SMART, the Company acquired $4.9 million and $0.2 million of customer relationships and trade name intangible assets, respectively. The customer relationships will be amortized over an estimated ten year life and the trade name will be amortized over an estimated life of ten months. These values are reflected in the table below.

 

Other intangible assets related to the Company’s acquisitions were as follows (in thousands):

 

 

 

 

 

Accumulated

 

 

 

 

 

Gross (1)

 

amortization (1)

 

Net

 

As of December 31, 2009:

 

 

 

 

 

 

 

Customer relationships

 

$

6,495

 

$

(4,081

)

$

2,414

 

Other identifiable intangible assets

 

1,626

 

(962

)

664

 

Total

 

$

8,121

 

$

(5,043

)

$

3,078

 

 

 

 

 

 

 

 

 

As of June 30, 2010:

 

 

 

 

 

 

 

Customer relationships

 

$

11,450

 

$

(4,520

)

$

6,930

 

Other identifiable intangible assets

 

1,786

 

(1,088

)

698

 

Total

 

$

13,236

 

$

(5,608

)

$

7,628

 

 


(1)                                  Fully amortized intangible assets are eliminated from the gross and accumulated amortization amounts in the period the intangible asset fully amortized.

 

The aggregate amortization expense for the six month period ended June 30, 2010 was $0.6 million. The estimated future amortization expense for other intangible assets as of June 30, 2010 is as follows (in thousands):

 

2010 (six months)

 

$

698

 

2011

 

1,162

 

2012

 

1,119

 

2013

 

1,023

 

2014

 

834

 

Thereafter

 

2,792

 

Total

 

$

7,628

 

 

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9.                                      Debt and subordinated notes

 

Credit facility

 

At December 31, 2009, the Company had $12.0 million in outstanding borrowings under its revolving credit facility (the “Facility”) and $1.6 million in outstanding standby letters of credit. On March 10, 2010, the Company received a $25.0 million cash investment from Great Hill Partners in connection with the SMART Merger, used the proceeds to repay $19.0 million outstanding under the Facility, and used $1.8 million to collateralize the outstanding letters of credit. This collateral is reflected as restricted cash in Other long-term assets in the Condensed Consolidated Balance Sheet. The Facility was terminated, and the unamortized portion of capitalized loan fees, totaling approximately $1.6 million, was expensed during the quarter ended March 31, 2010. Also in connection with the SMART Merger, the Company assumed approximately $40.8 million of term debt and $2.1 million of subordinated promissory notes which are discussed below.

 

Term debt

 

Concurrent with the closing of the SMART Merger, the Company entered into the Sixth Amendment to Credit Agreement and Consent (the “Amendment”) and became a co-borrower with SMART Business Advisory and Consulting, LLC under a Credit Agreement with the Bank of Montreal (“BMO”) and the syndicate bank members. The Amendment provides for a $40.8 million term loan which is guaranteed by LECG Corporation and its domestic subsidiaries. The Amendment also allows the Company to seek up to an additional $10.0 million of subordinated debt, subject to certain repayment and maturity restrictions. The term loan matures on March 31, 2011. The Amendment required a $4.0 million principal payment at closing, and subsequent quarterly principal payments of $3.0 million beginning on June 30, 2010 through December 31, 2010. Also, cash balances in excess of certain amounts at each quarter-end must be used to make additional principal payments. The remaining outstanding principal is due in full on March 31, 2011. On June 30, 2010, the Company made a principal payment of $3.0 million and an interest payment of $0.9 million. The outstanding balance of the term debt at June 30, 2010 was $33.8 million.

 

The Amendment contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum quarterly EBITDA and cash balance requirements. At June 30, 2010, the Company was in compliance with these covenants; however, due to a combination of accelerated and increased integration-related expenses, the inherent delays in realizing the related cost savings associated with these integration activities, and a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010, the Company estimates that it is likely to be non-compliant with one or more of the EBITDA-related covenants at September 30, 2010. See Note 1 for a discussion of the Company’s plans to address this likely future covenant non-compliance.

 

Under the current Amendment, interest is payable quarterly at a rate consisting of the Base Rate plus 6.5%. The Base Rate is defined as the greater of (i) 3.0%, (ii) BMO’s prevailing prime commercial rate, (iii) the Federal Funds rate plus 0.5%, or (iv) LIBOR plus 1.5%. The interest rate in effect as of June 30, 2010 was 9.75%. The Company paid approximately $0.2 million in fees related to this Amendment and will pay an additional $0.2 million on March 31, 2011. Also, if the Company achieves a trailing 12 month EBITDA of $15.0 million or greater, BMO is entitled to an additional payment of $1.0 million.

 

Subordinated promissory notes

 

Subordinated promissory notes are owed to certain active and former employees of SMART with an aggregate face amount of $2.1 million and a stated interest rate of 5.0%. These notes are payable on the earlier of the repayment of the BMO term facility or May 15, 2014.

 

10.                               Accrued compensation

 

Accrued compensation consists of the following (in thousands):

 

 

 

June 30,

 

December 31,

 

 

 

2010

 

2009

 

Expert compensation

 

$

24,091

 

$

23,734

 

Project origination fees

 

7,851

 

10,736

 

Vacation payable

 

4,585

 

2,098

 

Professional staff compensation

 

1,054

 

1,157

 

Administrative staff compensation

 

2,340

 

3,727

 

Signing, retention and performance bonuses payable

 

65

 

2,125

 

Other payroll liabilities

 

3,915

 

1,786

 

Total accrued compensation

 

$

43,901

 

$

45,363

 

 

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Table of Contents

 

11.                               Commitments and contingencies

 

Legal proceedings

 

The Company is party to certain legal proceedings arising out of the ordinary course of business, including proceedings that involve claims of wrongful termination by experts and professional staff who formerly worked for the Company, and claims for payment of disputed amounts relating to agreements in which the Company has acquired businesses. The outcomes of these matters are uncertain, and the Company’s management is not able to estimate the amount or range of amounts that may become payable as a result of a judgment or settlement in such proceedings. However, in the opinion of the Company’s management, the outcomes of these proceedings, individually and in the aggregate, would not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.

 

Business acquisitions and certain expert hires

 

The Company made commitments in connection with its historical business acquisitions that require the Company to pay additional purchase consideration to the sellers if specified performance targets are met over a number of years, as specified in the related purchase agreements. These amounts are generally calculated and payable at the end of a calendar or fiscal year or other interval. The maximum amount of additional purchase consideration that the Company may be required to pay (by no later than December 2010) is $1.5 million if and when future performance targets are met. See Note 3 of Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for 2009 for a description of the commitments and contingencies related to the acquisitions of Secura, Mack Barclay, and Neilson Elggren.

 

The accrued purchase price payable, and the total potential remaining purchase price payments at June 30, 2010, and the date of any final potential payment by acquisition are as follows (in thousands):

 

 

 

 

 

Accrued

 

 

 

 

 

 

 

 

 

purchase

 

 

 

Date

 

 

 

 

 

price

 

Potential

 

of final

 

 

 

Acquisition

 

payable at

 

remaining

 

or potential

 

 

 

Date

 

6/30/2010 (1)

 

payments (2)

 

payments (3)

 

 

 

 

 

 

 

 

 

 

 

Secura

 

Mar-07

 

$

100

 

$

 

Mar-11

 

Mack Barclay (4)

 

May-06

 

1,055

 

 

Jul-10

 

Neilson Elggren

 

Nov-05

 

 

1,500

 

Dec-10

 

Total additions

 

 

 

$

1,155

 

$

1,500

 

 

 

 


(1)                                 Included in “Payable for business acquisitions” on the Condensed Consolidated Balance Sheets.

(2)                                 Represents additional potential purchase price to be paid and goodwill to be recognized in the future if specified performance targets and conditions are met.

(3)                                 Represents final date of any payment or potential payment.

(4)                                 The Company paid the purchase price payable balance of $1.1 million to Mack Barclay on July 1, 2010.

 

In connection with the hiring of certain experts and professional staff in March 2004, the Company will pay additional performance bonuses of $2.5 million if specified performance targets are achieved prior to March 2011. Based on the current performance of this group, the Company does not expect these performance targets to be achieved before March 2011; however, performance bonus payments are subject to amortization from the time the bonus is earned through July 2014.

 

Significant expert retention and performance bonus contingencies

 

In the second half of 2009 and the first half of 2010, the Company entered into amended employment agreements with several experts and has made or is committed to make the following retention payments or performance-related payments if certain criteria are achieved at various measurement periods from 2010 to 2013. All such retention and performance payments will only be made if the expert is an employee of the Company on the payment date. Also, these payments are subject to amortization and potential repayment if the expert voluntarily terminates or is terminated for cause, generally from the time the payment is made through 2017. The table below presents the potential payments due by the years ending December 31 (in thousands):

 

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Table of Contents

 

Year

 

Retention

 

Performance

 

Total

 

 

 

 

 

 

 

 

 

2010 (six months)

 

$

1,590

 

$

125

 

$

1,715

 

2011

 

600

 

5,100

 

5,700

 

2012

 

500

 

1,725

 

2,225

 

2013

 

500

 

4,600

 

5,100

 

Total

 

$

3,190

 

$

11,550

 

$

14,740

 

 

Tax contingencies

 

In 2007 the Argentine taxing authority (“AFIP”) completed its audit of LECG Buenos Aires’ (“LECG BA”) income tax returns for 2003 and 2004, and its 2005 withholding tax return and issued a notice to disallow certain deductions claimed for those years as well as a proposal to impose a withholding tax on certain payments made by LECG BA to LECG LLC, its U.S. parent company. The AFIP proposed to limit the deductibility of costs charged by LECG LLC to LECG BA for expert and staff services performed by LECG personnel outside of Argentina on client related matters, and to require withholding tax on certain payments by LECG BA for services rendered by LECG personnel outside of LECG BA. In 2008, the Company elected to pay to the Argentine government $2.0 million for potential tax deficiencies and $1.3 million of potential interest in order to avoid the accrual of additional interest, while reserving its right to defend its position in Argentine tax court. The Company has recorded $3.3 million of payments to the Argentine taxing authority as Other long-term assets in the Condensed Consolidated Balance Sheets at June 30, 2010 and December 31, 2009.

 

On April 8, 2009, the Company was notified that the AFIP had terminated the penalty procedures relating to amounts previously paid for the 2003 and 2004 income tax and 2005 withholding tax deficiencies due to the passage of Argentine National Law No. 26.476 (Tax Moratorium). However, the Company may still be subject to penalties and interest on a potential underpayment of taxes related to the 2005 withholding tax return. Also, based on the results of the completed audit discussed above, the Company may receive additional notices for assessments of additional income taxes, penalties, and interest related to the Company’s 2005 and 2006 income tax returns and withholding taxes, penalties, and interest on payments made to the U.S. parent company to settle intercompany balances from June 2005 to December 2007.

 

Amounts paid in connection with the potential income and withholding tax deficiency would qualify for a foreign tax credit on LECG’s U.S. tax return and would result in a deferred tax asset on LECG’s Condensed Consolidated Balance Sheets, the realization of which would be dependent upon the ability to utilize the foreign tax credit within the ten-year expiration period. The Company believes that it properly reported these transactions in its Argentine tax returns and has assessed that its position in this matter will be sustained. Accordingly, the Company has not recognized any additional tax liability in connection with this matter at June 30, 2010.

 

12.                              Income taxes

 

As a result of the Company’s Merger with SMART, the Company acquired SMART’s gross deferred tax assets of approximately $24.8 million, which consisted mostly of U.S. and foreign net operating loss carryforwards and tax basis in intangible assets. In addition, the Company recorded a deferred tax liability of $2.0 million related to amortizable intangibles from the Merger. A full valuation allowance was recorded against the net overall deferred tax assets for SMART, as a result of the Company’s current assessment of its recoverability.

 

The Company’s deferred tax assets are generally projected to reverse over the next one to thirty-three years. The extended reversal period is the result of significant income tax basis in intangible assets which were impaired for financial statement purposes during 2008. Tax amortization from these assets, if not offset with current taxable income, creates a net operating loss with a 20-year carryforward period for federal tax purposes. During the second quarter of 2010, the Company reviewed its deferred tax assets, as well as projected taxable income, for recovery using the “more likely than not” approach by assessing the available evidence surrounding its recoverability. The Company considered all available evidence, both positive and negative, including forecasts of future taxable income, tax planning strategies and past operating results which includes the net loss for the six months ended June 30, 2010 and the years-ended 2009 and 2008. Even though the Company projects income in future years, based on the current economic environment and the difficulty of accurately projecting taxable income, the Company determined it was still “more likely than not” that its net deferred tax assets may not be realized. Consequently, as of June 30, 2010, the Company has retained a full valuation allowance against its net overall deferred tax assets, including those acquired in the SMART Merger. However, SMART’s historical goodwill had a carryover tax basis as of the Merger date that brought about an increase in the Company’s deferred tax liability in the amount of $0.2 million, which represents the tax amortization of such goodwill through June 30, 2010 for which there is no book deduction. The Company is precluded from considering this as a source of taxable income in the future which could then be offset by the Company’s deferred tax assets because there is no scheduled reversal of the deferred tax liability. In future periods, if the Company begins to

 

14



Table of Contents

 

generate taxable income and management determines that the deferred tax asset is recoverable, the valuation allowance will be reversed. Any such reversal will result in a tax benefit in the period of reversal. The income tax expense for the six months ended June 30, 2010 represents the amount of tax that the Company expects to pay on taxable income generated in foreign jurisdictions during the period and the deferred tax expense from the amortization of goodwill whose tax basis was carried over from SMART as a result of the Merger.

 

13.                               Restructuring and other impairments charges

 

As a result of the Merger with SMART, the Company has identified and begun pursuing opportunities for cost savings through office consolidations and workforce reductions to improve operating efficiencies across the Company’s combined businesses. Part of the anticipated cost savings will result from the relocation of the combined company’s corporate headquarters to Devon, Pennsylvania, where SMART is currently based. The move, which is scheduled to be completed by the end of the third quarter of 2010, is intended to position the combined company for future growth by creating a unified platform from which to build common practices and capitalize on growth opportunities, while streamlining and leveraging its infrastructure. During the six months ended June 30, 2010, the Company moved forward with several initiatives, including: (i) the consolidation of six office locations; (ii) the closure of two other offices; (iii) the closure of two additional offices expected to be completed in the third quarter of 2010; and (iv) a workforce reduction of 62 administrative staff in the Emeryville office, partly offset by approximately 33 replacement hires in Devon, Pennsylvania.

 

Net restructuring charges in the three months ended June 30, 2010 totaled $3.0 million, which consisted of $2.5 million of severance benefits and $0.5 million of lease termination costs. In addition, the Company recorded impairment charges related to fixed assets and unearned signing bonuses in the amount of $0.2 million.

 

For the three months ended March 31, 2010, net restructuring and impairment charges totaled $6.9 million, consisting of $2.8 million of lease termination charges, $0.6 million of severance benefits and $3.5 million of non-cash impairment charges related to the write-off of certain property, plant and equipment and non-trade receivables. The Company determined that recovery of the non-trade receivable was not reasonably assured at March 31, 2010, which had been recorded in Other assets in the Condensed Consolidated Balance Sheet.

 

Of the total $10.1 million restructuring and impairment charge in the six months ended June 30, 2010, $6.5 million require current and future cash outlays and $3.6 million is non-cash related. Cash-related items during the first six months of 2010 included severance benefits pertaining to the terminated Emeryville Corporate employees totaling $2.3 million. The Company estimates it will incur an additional $0.8 million through the end of the final retention period in January 2011.

 

The table below summarizes the liabilities incurred which are recorded in Other liabilities on the Condensed Consolidated Balance Sheets and the activity during the period related to these restructuring and other impairment actions (in thousands):

 

 

 

One-time

 

Lease

 

Asset

 

 

 

 

 

termination

 

termination

 

impairments

 

 

 

 

 

benefits

 

costs

 

and other

 

Total

 

Liability at December 31, 2009

 

$

 

$

1,605

 

$

 

$

1,605

 

Restructuring and impairment charges

 

3,200

 

3,220

 

3,688

 

10,108

 

Cash payments

 

(711

)

(1,420

)

 

(2,131

)

Write-off of assets

 

 

 

(3,688

)

(3,688

)

Other adjustments

 

(51

)

326

 

 

275

 

Liability at June 30, 2010

 

$

2,438

 

$

3,731

 

$

 

$

6,169

 

 

14.                               Segment reporting

 

Prior to the Merger with SMART, the Company managed its business in two operating segments: Litigation, Forensics and Finance (formerly known as Finance and Accounting Services) and Economics and Dispute Resolution (formerly known as Economics Services). As a result of the Merger, the Company formed the Consulting and Governance segment composed of the historical SMART consulting, business advisory, governance, assurance and tax practices. Below is a description of the Company’s three operating segments and their components:

 

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Table of Contents

 

Litigation, Forensics and Finance segment is composed of electronic discovery, financial services, forensic accounting, healthcare, higher education, intellectual property, and international finance and accounting services sectors as follows:

 

·                  Electronic discovery—provides direct collaboration with outside counsel, general counsel, corporate executives, bank examiners, bankruptcy trustees, forensic accountants, fraud examiners, and damages experts to deliver objective advice and testimony in all phases of the electronic discovery process including litigation preparedness, computer forensics and data analytics.

 

·                  Financial services—provides banking advisory services to leading financial service firms worldwide, addressing regulatory compliance, tax, and dispute resolution, and provides representation before applicable regulatory authorities and assists clients in regulatory compliance and SEC investigations and litigation.

 

·                  Forensic accounting—provides a broad range of expertise in accounting, auditing, computer forensics, regulatory (SEC), valuation, tax, and securities litigation, and offers a comprehensive mix of forensic accounting services, including internal investigations, fraud investigations, and when necessary, expert witness testimony.

 

·                  Healthcare—provides analyses and insight to clients confronting the uncertain healthcare environment by advising clients in the development of strategies, designing and understanding policies, and responding to legal and regulatory challenges, and offers a broad range of litigation support, management advisory, compliance, and expert testimony services.

 

·                  Higher education—provides strategic advice and management consulting to companies, universities, governments, and non-profit organizations with a focus on research and development and higher education.

 

·                  Intellectual property—provides expertise in areas such as capturing value from technological innovation and knowledge assets, estimating damages due to infringement or misappropriation, definition of markets and analyses of non-infringing alternatives, transfer pricing valuation studies, and valuation of businesses, opportunities, and intangible assets.

 

·                  International finance and accounting services—provides expert finance and accounting services to clients outside the United States, with particular emphasis on investigations, damages analysis and expert testimony in international arbitrations.

 

Economics and Dispute Resolution segment is composed of energy and environment, global competition, labor and employment, regulated industries, and securities sectors as follows:

 

·                  Energy and environment—provides expertise in the regulated energy, environment and natural resources industries.

 

·                  Global competition—offers a complete range of services on antitrust matters, including mergers and acquisitions, before courts and regulatory authorities around the world. The services involve the use of economic and statistical techniques to develop independent and objective analyses concerning issues related to merger reviews, monopolization claims, cartels, and quantification of damages. Experts in this area frequently testify before courts and appear before competition authorities in many jurisdictions around the world.

 

·                  Labor and employment—provides litigation support, independent expert testimony, and business advisory services, including issues of statistical liability in discrimination, wrongful termination, and wage and hour claims.

 

·                  Regulated industries—provides expertise in a broad range of regulated industries, such as telecommunications, transportation and financial claims.

 

·                  Securities—specializes in the study of capital markets. These leading financial economists conduct independent analyses in disputes involving allegations of securities fraud, valuation of complex securities, and capital market transactions such as mergers and acquisitions.

 

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Table of Contents

 

Consulting and Governance segment is composed of consulting and business advisory sector, and governance, assurance and tax sector as follows:

 

·                  Consulting and Business Advisory provides financial, operational and technology solutions, which improve business processes, leverage enabling technology and addresses human capital issues for corporate clients and government agencies in a broad range of industries including commercial services, healthcare, higher education, insurance, life sciences, and manufacturing.

 

·                  Governance, Assurance and Taxprovides broad-based accounting services to a broad range of clients in many industries, with a focus on insurance and financial services, commercial services, healthcare, higher education, life sciences and manufacturing. Tax solutions include a full range of federal, state and local, sales and use, personal property, real estate and international tax services. Other services include internal and external audit, compliance advisory, compensation and benefits services and actuarial services.

 

All segment revenues are generated from external clients and there are no intersegment revenues or expenses. The Company does not allocate general and administrative operating expenses to its segments.

 

Summarized financial information by segment for the three and six months ended June 30, 2010 and 2009 is as follows (in thousands, except percentages):

 

 

 

Three months ended June 30,

 

 

 

2010

 

2009

 

 

 

Litigation,
Forensics
and
Finance

 

Economics
and Dispute
Resolution

 

Consulting
and
Governance
(1)

 

Total

 

Litigation,
Forensics
and
Finance

 

Economics
and Dispute
Resolution

 

Total

 

Fee-based revenues, net

 

$

31,990

 

$

25,081

 

$

22,613

 

$

79,684

 

$

37,251

 

$

28,213

 

$

65,464

 

Reimbursable revenues

 

1,381

 

1,122

 

1,422

 

3,925

 

1,618

 

787

 

2,405

 

Revenues

 

33,371

 

26,203

 

24,035

 

83,609

 

38,869

 

29,000

 

67,869

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct costs

 

24,916

 

19,383

 

15,773

 

60,072

 

28,609

 

19,502

 

48,111

 

Reimbursable costs

 

1,374

 

1,023

 

1,479

 

3,876

 

1,715

 

936

 

2,651

 

Cost of services

 

26,290

 

20,406

 

17,252

 

63,948

 

30,324

 

20,438

 

50,762

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

7,081

 

$

5,797

 

$

6,783

 

19,661

 

$

8,545

 

$

8,562

 

17,107

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

21.2

%

22.1

%

28.2

%

23.5

%

22.0

%

29.5

%

25.2

%

Charges not allocated at the segment level:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative expenses

 

 

 

 

 

 

 

23,866

 

 

 

 

 

18,782

 

Depreciation and amortization

 

 

 

 

 

 

 

1,463

 

 

 

 

 

1,280

 

Restructuring charges and other impairments

 

 

 

 

 

 

 

3,188

 

 

 

 

 

2,624

 

Divestiture charges

 

 

 

 

 

 

 

 

 

 

 

 

1,725

 

Interest income

 

 

 

 

 

 

 

(34

)

 

 

 

 

(42

)

Interest expense

 

 

 

 

 

 

 

1,501

 

 

 

 

 

643

 

Other expense, net

 

 

 

 

 

 

 

132

 

 

 

 

 

356

 

Loss before income taxes

 

 

 

 

 

 

 

$

(10,455

)

 

 

 

 

$

(8,261

)

 

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Table of Contents

 

 

 

Six months ended June 30,

 

 

 

2010

 

2009

 

 

 

Litigation,
Forensics
and
Finance

 

Economics
and Dispute
Resolution

 

Consulting
and
Governance
(1)

 

Total

 

Litigation,
Forensics
and
Finance

 

Economics
and Dispute
Resolution

 

Total

 

Fee-based revenues, net

 

$

69,808

 

$

48,243

 

$

28,917

 

$

146,968

 

$

73,094

 

$

56,292

 

$

129,386

 

Reimbursable revenues

 

3,165

 

1,752

 

1,731

 

6,648

 

3,174

 

1,614

 

4,788

 

Revenues

 

72,973

 

49,995

 

30,648

 

153,616

 

76,268

 

57,906

 

134,174

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct costs

 

53,559

 

36,905

 

19,301

 

109,765

 

57,933

 

39,795

 

97,728

 

Reimbursable costs

 

3,121

 

1,619

 

1,790

 

6,530

 

3,336

 

1,855

 

5,191

 

Cost of services

 

56,680

 

38,524

 

21,091

 

116,295

 

61,269

 

41,650

 

102,919

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

16,293

 

$

11,471

 

$

9,557

 

37,321

 

$

14,999

 

$

16,256

 

31,255

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

22.3

%

22.9

%

31.2

%

24.3

%

19.7

%

28.1

%

23.3

%

Charges not allocated at the segment level:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative expenses

 

 

 

 

 

 

 

43,405

 

 

 

 

 

37,607

 

Depreciation and amortization

 

 

 

 

 

 

 

2,628

 

 

 

 

 

2,610

 

Restructuring charges and other impairments

 

 

 

 

 

 

 

10,108

 

 

 

 

 

2,680

 

Divestiture charges

 

 

 

 

 

 

 

 

 

 

 

 

1,739

 

Interest income

 

 

 

 

 

 

 

(65

)

 

 

 

 

(90

)

Interest expense

 

 

 

 

 

 

 

4,100

 

 

 

 

 

958

 

Other expense, net

 

 

 

 

 

 

 

200

 

 

 

 

 

446

 

Loss before income taxes

 

 

 

 

 

 

 

$

(23,055

)

 

 

 

 

$

(14,695

)

 


(1)                                 Results for the Consulting and Governance segment in the six months ended June 30, 2010 represent activity from March 11, 2010 to June 30, 2010. Also, since the Merger with SMART was completed on March 10, 2010, no prior period comparative results are presented for this segment.

 

15.                               Subsequent event

 

On July 2, 2010, the Company acquired certain assets and assumed the lease related liabilities of Bourne Business Consulting LLP and Bourne Business Consulting Limited (“Bourne Partners”), a London-based independent business consultancy practice focusing on disputes, valuation, intellectual property and international tax matters. The purchase price is £2.8 million, of which £2.0 million will be paid on or before April 1, 2011 and £0.8 million will be paid on or before July 1, 2011. Also certain contingent consideration may be payable at regular intervals if certain performance targets are achieved over the measurement period which runs through June 30, 2014.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and other parts of this Quarterly Report on Form 10-Q concerning our future business, operating and financial condition and statements using the terms “believes”, “expects”, “will”, “could”, “plans”, “anticipates”, “estimates”, “predicts”, “intends”, “potential”, “continue”, “should”, “may”, or the negative of these terms or similar expressions are “forward-looking” statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based upon our current expectations as of the date of this Report. There may be events in the future that we are not able to accurately predict or control that may cause actual results to differ materially from expectations. Information contained in these forward-looking statements is inherently uncertain, and actual performance is subject to a number of risks, including but not limited to, (1) our ability to successfully attract, integrate and retain our experts and professional staff, (2) dependence on key personnel, (3) successful management and utilization of professional staff, (4) dependence on growth of our service offerings, (5) our ability to maintain and attract new business, (6) our ability to maintain and comply with the covenants under our new credit facility, (7) the cost and contribution of additional hires and acquisitions, (8) risks relating to the recent closing of our Merger with SMART and our ability to successfully integrate the service offerings, professional staff, facilities and culture of the predecessor organizations, (9) successful administration of our business and financial reporting capabilities including maintaining effective internal control over financial reporting, (10) potential professional liability, (11) intense competition, (12) risks inherent in international operations, and,(13) risks inherent in successfully transitioning and managing our restructured business. Further information on these and other potential risk factors that could affect our financial results may be described from time to time in our periodic filings with the Securities and Exchange Commission and include those set forth in this Report under Item 1A. “Risk Factors.” We cannot guarantee any future results, levels of activity, performance or achievement. We undertake no obligation to update any of these forward-looking statements after the date of this Report.

 

Overview

 

We provide expert services through our highly credentialed experts and professional staff, whose skills and qualifications provide us the opportunity to address complex, unstructured business and public policy problems. We also provide business advisory, consulting, technology, accounting, compensation and benefits, tax, and transaction advisory services. We deliver independent expert testimony and original authoritative studies in both adversarial and non-adversarial situations. We conduct economic, financial, accounting and statistical analyses to provide objective opinions and strategic advice to legislative, judicial, regulatory and business decision makers. Our skills include electronic discovery, forensic accounting, data collection, econometric modeling and other types of statistical analyses, report preparation and oral presentation at depositions. Our experts are renowned academics, former senior government officials, experienced industry leaders, technical analysts and seasoned consultants. Our clients include Fortune Global 500 corporations, major law firms, and local, state and federal governments and agencies in the United States and other countries throughout the world. Many of consulting and advisory services professionals have either come from national or international consulting and accounting firms or industry, and have held senior-level executive or director positions prior to joining our firm.

 

Certain business developments

 

On March 10, 2010, we completed our merger (which we refer to as the “Merger”) with SMART Business Holdings, Inc. (“SMART”), a privately held provider of business advisory services, and we received a $25.0 million cash investment from SMART’s majority shareholder, Great Hill Equity Partners III, LP (“Great Hill Partners”) (which we refer to as the investment). In the Merger transaction, we acquired 100% of SMART’s outstanding stock, in exchange for 10,927,869 shares of LECG common stock, and we assumed approximately $42.8 million of SMART debt as of March 10, 2010. Simultaneously with the consummation of the Merger, Great Hill Partners, made a $25.0 million cash investment into LECG in exchange for 6,313,131 shares of Series A Convertible Redeemable Preferred Stock. This stock is convertible share-for-share into LECG’s common stock (equivalent to a price of $3.96 per share), and provides a 7.5% annual dividend payable in cash or Series A Convertible Redeemable Preferred Stock at our discretion. As a result of the issuance of the common stock and Series A Convertible Redeemable Preferred Stock, Great Hill Partners owns approximately 40% of our outstanding voting shares.

 

As a result of our Merger with SMART, we increased our revenue base and expanded our areas of practice. We also significantly increased our cost structure and we assumed additional debt, including a term loan which matures on March 31, 2011 and which had an outstanding principal balance of $33.8 million at June 30, 2010. We believe that our cash and cash equivalents at June 30, 2010, and our federal and state tax refunds totaling approximately $13.3 million (of which $11.3 million was received in August 2010 and $2.0 million is pending receipt), will be sufficient to meet our operating cash needs and our regularly scheduled quarterly debt service obligations through March 31, 2011, by which time we will need to refinance the remaining debt balance (approximately $27.8 million in principal amount at maturity). The term loan agreement contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum quarterly EBITDA and cash balance requirements. At June 30, 2010, we were in compliance with these covenants, however due to a combination of accelerated and increased integration-related expenses, the inherent delays in realizing the related cost savings associated with these integration activities, and a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010, we estimate that it is likely to be non-compliant with one or more of the existing EBITDA-related covenants at September 30, 2010. Additional information regarding our term debt and our plans for addressing this situation can be found under the caption “Liquidity and Capital Resources” below, and in Note 1 of Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

 

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During the first quarter of 2010, we announced the move of our corporate headquarters to Devon, Pennsylvania. We also implemented plans to consolidate or close eight other offices as a result of the Merger. Further financial information regarding our Merger and restructuring charges is included in Note 2 and Note 13 of Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. Also see our risk factors related to the assumed additional debt, our Merger with SMART and SMART’s Sarbanes-Oxley compliance beginning on page 37 of this Form 10-Q.

 

2010 Billable headcount

 

The following table summarizes the changes in the period-end billable headcount since December 31, 2009 and June 30, 2009.

 

 

 

 

 

 

 

 

 

Change since

 

 

 

June 30,

 

December 31,

 

June 30,

 

December 31, 2009

 

June 30, 2009

 

 

 

2010

 

2009

 

2009

 

Number

 

%

 

Number

 

%

 

Litigation, Forensics and Finance

 

375

 

415

 

461

 

(40

)

-10

%

(86

)

-19

%

Economics and Dispute Resolution

 

188

 

227

 

257

 

(39

)

-17

%

(69

)

-27

%

Consulting and Governance

 

416

 

 

 

416

 

100

%

416

 

100

%

Consolidated

 

979

 

642

 

718

 

337

 

52

%

261

 

36

%

 

The increase in consolidated billable headcount since December 31, 2009 is due to the addition of 416 billable headcount as a result of the Merger with SMART, offset by 79 terminations due primarily to voluntary attrition, net of new hires.

 

The increase in consolidated billable headcount from June 30, 2009 to June 30, 2010 is due to the addition of 416 billable headcount as a result of the Merger with SMART, primarily offset by 79 voluntary terminations, net of new hires during 2010; and 71 terminations as a result of our third quarter 2009 restructuring actions and five terminations as a result of our divestiture activities, including 35 terminations in our Economics and Dispute Resolution segment and 41 terminations in our Litigation, Forensics and Finance segment.

 

The retention of key experts and consultants, and the recruitment and hiring of additional experts, consultants and professional staff, both through direct hiring and through acquisitions, contributes to the success of our business. Our retention and hiring strategy is designed to promote our competitive advantage, to deepen our existing service offerings and to enter into new service areas when strategic opportunities arise. In connection with our retention and hiring efforts in the six months ended June 30, 2010 and 2009, we paid signing, retention and performance bonuses of $10.0 million and $7.0 million, respectively, which will be amortized over periods ranging from one to seven years. Amortization of signing, retention and performance bonuses expense related to our billable headcount was $7.3 million and $8.5 million in the six months ended June 30, 2010 and 2009, respectively.

 

Operations

 

Revenues

 

We derive our revenue primarily from professional service fees that are billed at hourly rates on a time and expense basis. Revenue related to these services is recognized when the earnings process is complete and collection is reasonably assured. Revenues are recognized net of amounts estimated to be unrealizable based on several factors, including the historical percentage of write-offs due to fee adjustments for both unbilled and billed receivables.

 

Fee-based revenues, net are comprised of:

 

·              fees for the services of our professional staff and subcontractors;

 

·              fees for the services of our experts and affiliates; and

 

·              realization allowance.

 

Reimbursable revenues are comprised of costs that are reimbursable by clients, including travel, document reproduction, subscription data services and other costs, and amounts we charge for services provided by others.

 

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Table of Contents

 

Cost of services

 

Direct costs are comprised of:

 

·              salary, bonuses, employer taxes and benefits of all professional staff and salaried experts;

 

·              compensation to experts based on a percentage of their individual professional fees;

 

·              compensation to experts based on specified revenue and gross margin performance targets;

 

·              compensation to subcontractors and affiliates;

 

·              fees earned by experts and other business generators as project origination fees;

 

·              amortization of signing, retention and performance bonuses that are subject to vesting over time; and

 

·              equity-based compensation.

 

Reimbursable costs are costs that are reimbursable by clients, including travel, document reproduction, subscription data services, and costs incurred for services provided by others.

 

Hourly fees charged by the professional staff that support our experts, rather than the hourly fees charged by our experts, generate a majority of our gross profit. Most of our experts are compensated based on a percentage of their billings from 30% to 100%, and averaging approximately 73% of their individual billings on particular projects in the six months ended June 30, 2010 and 2009. Such experts are paid when we have received payment from our clients. We refer to these experts as at-risk experts. Some of our experts are compensated based on a percentage of performance targets such as revenue or gross margin associated with engagements generated by an expert or a group of experts. Experts not on either of these compensation models are compensated under a salary plus performance-based bonus model. Managing Directors acquired in the SMART Merger are compensated on a salary plus performance-based bonus model, which is dictated by the underlying performance of their respective business sectors. We make advance payments, or draws, to many of our non-salaried experts, and any outstanding draws previously paid to experts are deducted from the experts’ fee payments. We recognize an estimate of compensation expense for expert advances that we consider may ultimately be unrecoverable. In some cases, we guarantee an expert’s draw at the inception of their employment for a period of time, which is typically one year or less. In such cases, if the expert’s earnings do not exceed their draws within a reasonable period of time prior to the end of the guarantee period, we recognize an estimate of the compensation expense we will ultimately incur by the end of the guarantee period.

 

Because of the manner in which we pay our experts, our gross profit is significantly dependent on the margin on our professional staff services. The number of professional staff and the level of experience of professional staff assigned to a project will vary depending on the size, nature and duration of each engagement. We manage our personnel costs by monitoring engagement requirements and utilization of the professional staff. As an inducement to encourage experts to utilize our professional staff, experts generally receive project origination fees. Such fees are based primarily on a percentage of the collected professional staff fees. Project origination fees can also include a percentage of the collected expert fees for those experts acting in a support role on an engagement. These fees have averaged 11% and 10% of professional staff revenues in the six months ended June 30, 2010 and 2009, respectively. Experts are generally required to use our professional staff unless the skills required to perform the work are not available through us. In these instances we engage outside individual or firm-based consultants, who are typically compensated on an hourly basis. Both the revenue and the cost resulting from the services provided by these outside consultants are recognized in the period in which the services are performed.

 

Hiring and/or retaining experts sometimes involves the payment of upfront cash amounts. In some cases, the payment of a portion of an upfront amount is due at a future date. These types of upfront payments are recognized when the payment is made, the obligation to pay such amount is incurred, or on the execution date of the retention agreement, and are generally amortized over the period for which they are recoverable from the individual expert up to a maximum period of seven years.

 

We have also paid or are obligated to pay certain performance bonuses that are subject to recovery of unearned amounts if the expert were to voluntarily leave us, be terminated for cause, or fail to meet certain performance criteria prior to a specified date. Like signing and retention bonuses, these performance bonuses are amortized over the period for which unearned amounts are recoverable from the individual expert up to a maximum period of seven years, and we recognize such performance bonuses at the time we determine it to be more likely than not that the performance criteria will be met.

 

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Most of our agreements allow us to recover signing, retention and performance bonuses from the employee if he or she were to voluntarily leave us or be terminated for cause prior to a specified date. However, for the purpose of recognizing expense, we amortize such signing, retention and performance bonuses over the shorter of the contractual recovery period or seven years. If an employee is involuntarily terminated, we generally cannot recover the unearned amount and we write off the unearned amount at the time of termination.

 

CRITICAL ACCOUNTING POLICIES

 

Revenue recognition

 

Revenues include all amounts earned that are billed or billable to clients, including reimbursable expenses, and are reduced for amounts related to work performed that are estimated to be unrealizable. Expert revenues consist of revenues generated by experts who are our employees as well as revenues generated by experts who are independent contractors. There is no operating, business or other substantive distinction between our employee experts and our exclusive independent contractor experts.

 

Revenues primarily arise from time and expense contracts, which are recognized in the period in which the services are performed. We also enter into certain performance-based contracts for which performance fees are dependent upon a successful outcome, as defined by the consulting engagement. Revenues related to performance-based fee contracts are recognized in the period when the earnings process is complete and we have received payment for the services performed under the contract. Revenues are also generated from fixed price contracts, which are recognized as the agreed upon services are performed. Fixed price and performance-based contracts revenues are not a material component of total revenues.

 

We recognize revenue net of an estimate for amounts that will not be collected from the client due to fee adjustments. This estimate is based on several factors, including our historical percentage of fee adjustments and review of unbilled and billed receivables. These estimates are reviewed by management on a quarterly basis.

 

Accounts receivable, reserves for unrealizable revenue and allowance for bad debts

 

Accounts receivable consist of unbilled and billed amounts due from clients, which are recognized net of reserves for unrealizable revenue and allowances for bad debts. We maintain reserves for unrealizable revenue and allowance for bad debts based on several factors, including the length of time receivables are past due, economic trends and conditions affecting our client base, specific knowledge of a client’s inability to meet its financial obligations, significant one-time events and historical write-off experience. We review the adequacy of our reserves on a quarterly basis. These estimates may be significantly different from actual results. If the financial condition of a client deteriorates in the future, impacting the client’s ability to make payments, an increase to our allowance might be required or our allowance may not be sufficient to cover actual write-offs.

 

Equity-based compensation

 

We account for equity-based compensation under the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 718, Compensation—Stock Compensation (“ASC 718”). ASC 718 requires the recognition of the fair value of equity-based compensation in operations. The fair value of our stock option awards are estimated using a Black-Scholes option valuation model. This model requires the input of highly subjective assumptions and elections including expected stock price volatility and the estimated life of each award. In addition, the calculation of equity-based compensation costs requires that we estimate the number of awards that will be forfeited during the vesting period. Our forfeiture rate is based upon historical experience as well as anticipated employee turnover considering certain qualitative factors. The fair value of equity-based awards is amortized over the vesting period of the award and we elected to use the straight-line method for awards granted after the adoption of ASC 718.

 

Income taxes

 

We account for income taxes in accordance with FASB ASC 740, Income Taxes (“ASC 740”). The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. Judgment is required in assessing the future tax consequences of events that have been recognized in our Condensed Consolidated Financial Statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations or cash flows.

 

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We account for uncertainty in income taxes recognized in our financial statements using a two-step approach. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is “more likely than not” that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely to be realized upon ultimate settlement.

 

Our deferred tax assets are generally projected to reverse over the next one to thirty-three years. The extended reversal period is the result of significant income tax basis in intangible assets which were impaired for financial statement purposes during 2008. Tax amortization from these assets, if not offset with current taxable income, creates a net operating loss with a 20-year carryforward period for federal tax purposes. During the second quarter of 2010, we reviewed our deferred tax assets, as well as future projected taxable income, for recovery using the “more likely than not” approach by assessing the available evidence surrounding recoverability. We considered all available evidence, both positive and negative, including forecasts of future taxable income, tax planning strategies and past operating results which includes a net loss for the six months ended June 30, 2010 and years-ended 2009 and 2008. Even though we project income in future years, based upon the current economic environment and the difficulty of accurately projecting taxable income, we determined that it was still “more likely than not” that our net deferred tax assets may not be realized. Consequently, as of June 30, 2010, we retained a full valuation allowance against our net overall deferred tax assets, including those acquired in the SMART Merger. However, SMART’s historical goodwill had a carryover tax basis as of the Merger date that brought about an increase in our deferred tax liability in the amount of $0.2 million, which represents the tax amortization of such goodwill through June 30, 2010 for which there is no book deduction. We are precluded from considering this as a source of taxable income in the future which could then be offset by our deferred tax assets because there is no scheduled reversal of the deferred tax liability. In future years, if we begin to generate taxable income and our management determines that the net deferred tax asset is recoverable, the valuation allowance will be reversed. Any such reversal will result in a tax benefit in the period of reversal. The income tax expense for the six months ended June 30, 2010 represents the amount of tax that we expect to pay on taxable income generated in foreign jurisdictions during the period and the deferred tax expense from the amortization of goodwill whose tax basis was carried over from SMART as a result of the Merger.

 

Goodwill and other intangible assets

 

Goodwill relates to our business acquisitions, reflecting the excess of purchase price over fair value of identifiable net assets acquired. FASB ASC 350, Goodwill and Other Intangible Assets (“ASC 350”) requires that goodwill and intangible assets with indefinite lives not be amortized, but rather tested for impairment at least annually, or whenever events or changes in circumstances indicate the carrying amounts of these assets may not be recoverable. Our annual impairment test is performed during the fourth quarter of each year using an October 1st measurement date.

 

Factors that we consider important in determining whether to perform an impairment review on a date other than October 1st, include significant underperformance relative to forecasted operating results, significant negative industry or economic trends, and permanent declines in our stock price and related market capitalization. If we determine that the carrying value of goodwill may not be recoverable, we will assess impairment based on a projection of discounted future cash flows for each reporting unit, or some other fair value measurement such as the quoted market price of our stock and the resulting market capitalization, and then measure the amount of impairment, if necessary, based on the difference between the carrying value of our reporting units’ assigned goodwill and its implied fair value. Determining the fair value of our reporting units and the implied fair value of a reporting units’ assigned goodwill requires the use of estimates and assumptions and significant management judgments, all of which could materially effect our determination and measurement of impairment.

 

Other intangible assets that are separable from goodwill and have determinable useful lives are valued separately and amortized over their expected useful lives. Other intangible assets consist principally of customer relationships, contract rights, non-compete agreements and trade processes and are generally amortized over ten months to ten years. We evaluate the recoverability of our other intangible assets over their remaining useful life when changes in events or circumstances warrant an impairment review. If the carrying value of an intangible asset is determined to be impaired and unrecoverable over its originally estimated useful life, we will record an impairment charge to reduce the asset’s carrying value to its fair value and then amortize the remaining value prospectively over the revised remaining useful life. We generally determine the fair value of our intangible asset using a discounted cash flow model as quoted market prices for these types of assets are not readily available.

 

RESULTS OF OPERATIONS

 

Prior to our acquisition of SMART on March 10, 2010, we managed our business in two operating segments: Economics and Dispute Resolution (formerly known as Economics Services) and Litigation, Forensics and Finance (formerly known as Finance and Accounting Services). As a result of the Merger with SMART, we formed a new Consulting and Governance segment composed of the historical SMART consulting and business advisory sector, and the governance, assurance and tax sector (see Note 14 of Notes to Condensed Consolidated Financial Statements included with this Quarterly Report on Form 10-Q for a description of these sectors). The Chief Operating Decision Maker (our CEO) considers the key profit/loss measurement of these segments to be gross profit and gross margin. As such, only revenue, costs of services and gross margin are presented and discussed at the segment level.

 

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Table of Contents

 

Three and six months ended June 30, 2010 and 2009

 

The following table sets forth the percentage of revenues represented by certain line items in our Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2010 and 2009, respectively.

 

Results of operations for the three months ended June 30, 2010 include a full quarter of operating activities of SMART. Results of operations for the six months ended June 30, 2010 include the operating activities of SMART from March 11, 2010 to June 30, 2010. Also, since the Merger with SMART was completed on March 10, 2010, no prior period comparative data is presented for the Consulting and Governance segment.

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

 

 

 

 

 

 

 

 

 

 

Fee-based revenues, net

 

95.3

%

96.5

%

95.7

%

96.4

%

Reimbursable revenues

 

4.7

%

3.5

%

4.3

%

3.6

%

Revenues

 

100.0

%

100.0

%

100.0

%

100.0

%

Direct costs

 

71.9

%

71.0

%

71.4

%

72.8

%

Reimbursable costs

 

4.6

%

3.9

%

4.3

%

3.9

%

Cost of services

 

76.5

%

74.9

%

75.7

%

76.7

%

Gross profit

 

23.5

%

25.1

%

24.3

%

23.3

%

Operating expenses:

 

 

 

 

 

 

 

 

 

General and administrative expenses

 

28.5

%

27.7

%

28.3

%

28.0

%

Depreciation and amortization

 

1.7

%

1.9

%

1.8

%

2.0

%

Restructuring charges and other impairments

 

3.8

%

3.9

%

6.6

%

2.0

%

Divestiture charges

 

0.0

%

2.5

%

0.0

%

1.3

%

Operating loss

 

-10.5

%

-10.9

%

-12.4

%

-10.0

%

Interest income

 

0.0

%

0.1

%

0.0

%

0.1

%

Interest expense

 

-1.8

%

-0.9

%

-2.7

%

-0.7

%

Other expense, net

 

-0.2

%

-0.5

%

-0.1

%

-0.3

%

Loss before income taxes

 

-12.5

%

-12.2

%

-15.2

%

-10.9

%

Income tax expense (benefit)

 

0.5

%

-2.7

%

0.6

%

-3.3

%

Net loss

 

-13.0

%

-9.5

%

-15.8

%

-7.6

%

 

Revenues and cost of services

 

The following table sets forth the consolidated revenues, cost of services, gross profit and gross margin and certain operating metrics for LECG for the three and six months ended June 30, 2010 and 2009, respectively.

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands, except rate amounts)

 

Fee-based revenues, net

 

$

79,684

 

$

65,464

 

$

14,220

 

21.7

%

$

146,968

 

$

129,386

 

$

17,582

 

13.6

%

Reimbursable revenues

 

3,925

 

2,405

 

1,520

 

63.2

%

6,648

 

4,788

 

1,860

 

38.8

%

Revenues

 

83,609

 

67,869

 

15,740

 

23.2

%

153,616

 

134,174

 

19,442

 

14.5

%

Direct costs

 

60,072

 

48,111

 

11,961

 

24.9

%

109,765

 

97,728

 

12,037

 

12.3

%

Reimbursable costs

 

3,876

 

2,651

 

1,225

 

46.2

%

6,530

 

5,191

 

1,339

 

25.8

%

Cost of services

 

63,948

 

50,762

 

13,186

 

26.0

%

116,295

 

102,919

 

13,376

 

13.0

%

Gross profit

 

$

19,661

 

$

17,107

 

$

2,554

 

14.9

%

$

37,321

 

$

31,255

 

$

6,066

 

19.4

%

Gross margin

 

23.5

%

25.2

%

 

 

-1.7

%

24.3

%

23.3

%

 

 

1.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Billable headcount, period average

 

985

 

727

 

258

 

35.5

%

871

 

750

 

121

 

16.1

%

Average billable rate

 

$

265

 

$

316

 

$

(51

)

-16.1

%

$

280

 

$

312

 

$

(32

)

-10.3

%

Jr./Sr. staff paid utilization rate

 

67.0

%

68.5

%

 

 

-1.5

%

69.5

%

67.8

%