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EX-31.2 - EXHIBIT 31.2 - EMTEC INC/NJex31-2.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
______________

FORM 10-Q

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

For the quarterly period ended May 31, 2011
 

Commission file number: 0-32789
 
EMTEC, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
(State or other jurisdiction of incorporation or organization)
87-0273300
(I.R.S. Employer Identification No.)
 
11 Diamond Road
Springfield, New Jersey 07081
 (Address of principal executive offices, including zip code)
 
(973) 376-4242
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15-(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  x    No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   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.  (Check one)
 
Large accelerated filer o  Accelerated filer  o  Non-accelerated filer  o  Smaller reporting company  x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
 
As of July 10, 2011, there were outstanding 16,507,313 shares of the registrant’s common stock.
 
 
 

 

EMTEC, INC.
FORM 10-Q FOR THE QUARTER ENDED MAY 31, 2011
 
Table of Contents
 

PART I – FINANCIAL INFORMATION
 
 
Item 1 - Financial Statements
 
     
 
Consolidated Balance Sheets
1
     
 
Consolidated Statements of Operations
2
     
 
Consolidated Statements of Cash Flows
3
     
 
Notes to Consolidated Financial Statements
4
     
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations 21
     
Item 3 - Quantitative and Qualitative Disclosures About Market Risk
45
     
Item 4 - Controls and Procedures
46
     
PART II – OTHER INFORMATION  
   
Item 1 – Legal Proceedings
47
     
Item 1A - Risk Factors
48
     
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds
50
     
Item 3 - Defaults upon Senior Securities
51
     
Item 4 – (Removed and Reserved)
52
     
Item 5 - Other Information
53
     
Item 6 – Exhibits
54
     
SIGNATURES
55
 
 
 

 
PART I – FINANCIAL INFORMATION
Item 1.  Financial Statements
EMTEC, INC. AND SUBSIDIARIES
 CONSOLIDATED BALANCE SHEETS
(In Thousands, Except per Share and Share Data)
             
   
May 31, 2011
       
 
(Unaudited)
   
August 31, 2010
 
             
Assets
           
             
Current Assets
           
Cash
  $ 2,883     $ 2,372  
Receivables:
               
Trade, less allowance for doubtful accounts
    23,528       36,262  
Other
    994       2,019  
Inventories, net
    1,639       1,515  
Prepaid expenses and other
    5,010       2,977  
Deferred tax asset - current
    961       898  
Total current assets
    35,015       46,043  
                 
Property and equipment, net
    4,284       2,211  
Intangible assets, net
    12,337       11,522  
Goodwill
    15,903       13,979  
Deferred tax asset- long term
    485       411  
Other assets
    205       106  
Total assets
  $ 68,229     $ 74,272  
                 
Liabilities, Put Options and Stockholders' Equity
               
                 
Current Liabilities
               
Line of credit
  $ 14,531     $ 16,023  
Current portion of capital lease obligation
    63       -  
Accounts payable
    17,535       24,666  
Warrant liability
    432       910  
Income taxes payable
    278       341  
Accrued liabilities
    7,798       8,027  
Due to former stockholders
    493       6  
Customer deposits
    108       202  
Current portion earn-out liabilities
    252       202  
Deferred revenue
    2,661       2,150  
Total current liabilities
    44,151       52,325  
                 
Deferred tax liability
    3,873       3,063  
Earn-out liabilities, net of current portion
    1,554       474  
Put option and restricted stock liability in connection with acquisition of Dinero
    52       -  
Capital lease obligation, net of current portion
    343       -  
Accrued liabilities
    179       183  
Total liabilities
    50,152       56,247  
                 
Commitments and contingencies (Note 12)
               
                 
Put options in connection with SDI and Covelix acquisitions
    1,114       738  
                 
Stockholders' Equity
               
Common stock $0.01 par value; 25,000,000 shares authorized; 19,471,902 and 18,984,520 shares issued and 16,607,313 and 16,119,931, outstanding at May 31, 2011 and August 31, 2010, respectively
    194       190  
Additional paid-in capital
    21,353       21,346  
Retained earnings
    645       1,158  
Accumulated other comprehensive income
    367       189  
      22,559       22,883  
Less: treasury stock, at cost, 2,864,589 shares
    (5,596 )     (5,596 )
Total stockholders' equity
    16,963       17,287  
                 
Total liabilities, put options and stockholders' equity
  $ 68,229     $ 74,272  
 
The Accompanying Notes are Integral Parts of these Consolidated Financial Statements.
 
 
1

 
 
EMTEC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In Thousands, Except per Share and Share Data)
                         
   
For the Three Months Ended May 31,
   
For the Nine Months Ended May 31,
 
   
2011
   
2010
   
2011
   
2010
 
Revenues
                       
                         
Procurement services
  $ 24,652     $ 39,536     $ 113,389     $ 122,193  
Service and consulting
    20,207       13,970       54,469       40,994  
                                 
Total Revenues
    44,859       53,506       167,858       163,187  
                                 
Cost of Sales
                               
                                 
Cost of procurement services
    21,980       35,140       101,742       109,348  
Cost of service and consulting
    15,072       10,285       40,013       29,310  
                                 
Total Cost of Sales
    37,052       45,425       141,755       138,658  
                                 
Gross Profit
                               
                                 
Procurement services
    2,672       4,396       11,647       12,845  
Service and consulting
    5,135       3,685       14,456       11,684  
                                 
Total Gross Profit
    7,807       8,081       26,103       24,529  
                                 
Operating expenses:
                               
                                 
Selling, general, and administrative expenses
    8,025       7,287       24,195       21,043  
Stock-based compensation
    144       118       437       392  
Warrant liability adjustment
    (49 )     -       (478 )     -  
Depreciation and amortization
    856       551       2,296       1,718  
Total operating expenses
    8,976       7,956       26,450       23,153  
                                 
Operating income (loss)
    (1,169 )     125       (347 )     1,376  
                                 
Other expense (income):
                               
Interest income – other
    (7 )     (3 )     (14 )     (18 )
Interest expense
    184       124       521       428  
Other
    (2 )     (4 )     14       (12 )
                                 
Income (loss) before income tax expense (benefit)
    (1,344 )     8       (868 )     978  
Income tax expense (benefit)
    (532 )     43       (355 )     456  
Net income (loss)
  $ (812 )   $ (35 )   $ (513 )   $ 522  
                                 
Net income (loss) per common share
                               
    Basic and Diluted
  $ (0.05 )   $ -     $ (0.03 )   $ 0.03  
                                 
Weighted Average Shares Outstanding
                               
    Basic
    15,824,147       15,071,515       15,701,185       15,071,515  
                                 
    Diluted
    15,824,147       15,071,515       15,701,185       15,258,822  
 
The Accompanying Notes are Integral Parts of these Consolidated Financial Statements.
 
 
2

 
 
EMTEC, INC. AND SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In Thousands)
   
   
For the Nine Months Ended May 31,
 
   
2011
   
2010
 
Cash Flows From Operating Activities
           
Net income (loss)
  $ (513 )   $ 522  
                 
Adjustments to Reconcile Net Income (loss) to Net Cash Provided By Operating Activities
               
Depreciation and amortization
    2,296       1,718  
Deferred income tax benefit
    68       (331 )
Stock-based compensation
    437       392  
Warrant liability adjustment
    (478 )     -  
                 
Changes In Operating Assets and Liabilities
               
Receivables
    14,701       (2,562 )
Inventories
    (124 )     196  
Prepaid expenses and other assets
    (1,808 )     (631 )
Accounts payable
    (7,308 )     (275 )
Customer deposits
    (93 )     312  
Income taxes payable
    (274 )     (548 )
Accrued liabilities
    (1,648 )     (1,781 )
Due to former stockholders
    2       -  
Deferred revenue
    454       183  
Net Cash Provided By (used in) Operating Activities
    5,712       (2,805 )
                 
Cash Flows From Investing Activities
               
Purchases of property and equipment
    (2,293 )     (563 )
Acquisition of businesses, net of cash acquired
    (1,463 )     (294 )
Net Cash Used In Investing Activities
    (3,756 )     (857 )
                 
Cash Flows From Financing Activities
               
Net increase (decrease) in line of credit
    (1,492 )     4,809  
Repayment of debt
    -       (1,146 )
Repayments under capital lease
    (63 )      -  
Net Cash Provided By (Used in) Financing Activities
    (1,555 )     3,663  
                 
Effect of exchange rates on cash
    109       59  
                 
Net Increase in Cash
    511       60  
Beginning Cash
    2,372       1,713  
                 
Ending Cash
  $ 2,883     $ 1,773  
Supplemental Disclosure of Cash Flow Information
               
Cash paid during the period for:
               
Income taxes
  $ 524     $ 2,094  
Interest
  $ 872     $ 713  
                 
 
Supplemental Disclosures of Non Cash Investing and Financing Activities
 
In January 2011, the Company entered into a capital lease for computer equipment and related hardware with a value of $468. See Note 10 for additional information.
 
In May 2011 and 2010, the Company increased goodwill by $380 and $606, respectively. These increases were related to earnout payments associated with the Luceo and KOAN-IT acquisitions. As of May 31, 2011 and 2010, these earnouts were not paid and were included in Accrued Liabilities of the Statements of Cash Flow.
 
In connection with the acquisition of Covelix, March 2011, the Company recorded a put option liability embedded in the stock issued as part of the purchase price consideration. As of May 31, 2011, this put option liability is included in Accrued Liabilities of the Statements of Cash Flow.
 
 
3

 
 
EMTEC, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and note disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included in the accompanying unaudited consolidated financial statements.  Quarterly results are not necessarily indicative of results for the full year. For further information, refer to the annual financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended August 31, 2010.

2.  General

Description of Business

Emtec, Inc., a Delaware corporation (the “Company”), is an information technology (“IT”)  services provider delivering consulting, application services, and infrastructure services to public sector and commercial clients.  The Company’s client base is comprised of departments of the United States and Canada’s federal, state/provincial and local governments, schools, and commercial businesses throughout the United States and Canada.
 
Principles of Consolidation
 
The consolidated financial statements in this report include the accounts of the Company and its wholly-owned subsidiaries, Emtec, Inc., a New Jersey Corporation (“Emtec NJ”), Emtec Viasub LLC (“Emtec LLC”), Emtec LLC’s wholly-owned subsidiary Emtec Federal, Inc. (“Emtec Federal”), Emtec Global Services LLC (“EGS LLC”), EGS LLC’s wholly-owned subsidiaries Luceo, Inc. (“Luceo”), eBusiness Application Solutions, Inc. (“eBAS”), Aveeva, Inc. (“Aveeva”), Emtec Services Mauritius (“Emtec Mauritius”), Emtec Mauritius’s subsidiary Emtec Software India Private Limited (“Emtec India”), formerly Aviance Software India Private Limited, Dinero Solutions, LLC (“Dinero”) (effective February 3, 2011), Covelix, Inc. (“Covelix”) and Covelix’s subsidiary Covelix Technologies Private Ltd. (“Covelix India”) (effective March 1, 2011), Emtec Infrastructure Services Corporation (“EIS-US”), and EIS-US’s wholly-owned subsidiaries Emtec Infrastructure Services Canada Corporation (“EIS-Canada”), which is referred to in this report as KOAN-IT, KOAN-IT (US) Corp. (“KOAN-IT (US)”) and Secure Data, Inc. (“SDI”) a subsidiary of Emtec Federal.  Significant intercompany account balances and transactions have been eliminated in consolidation.

On February 3, 2011, EGS LLC acquired all of the outstanding equity interests of Dinero. Dinero’s results of operations are included in the Company’s consolidated financial statements for the period February 3, 2011 through February 28, 2011.

 
4

 
 
On March 1, 2011, EGS LLC acquired all of the outstanding stock of Covelix. Covelix’s results of operations are included in the Company’s consolidated financial statements for the period March 1, 2011 through May 31, 2011.
 
Segment Reporting
 
The Company divides its operating activity into two operating segments for reporting purposes: Emtec Infrastructure Services Division (“EIS”) and Emtec Global Services Division (“EGS”).  EIS includes Emtec NJ, Emtec LLC, Emtec Federal, the Federal application services business from SDI, the business service management solutions offered by the Information Technology Service Management (“ITSM”) practice, Dinero, our Oracle Consulting Practice, effective February 3, 2011, and Covelix, our Offshore Development practice, effective March 1, 2011.  Because of our continued cross-selling of applications services into our EIS client base, in 2010, we redefined the services offered by our EGS segment as training and staffing business for enterprise applications services.  We may rename these segments in the future.
 
Reclassifications

Certain reclassifications have been made to prior year balances in order to conform to current presentations.
 
Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period, including, but not limited to, receivable and inventory valuations, impairment of goodwill and other long-lived assets, and income taxes.  Management’s estimates are based on historical experience, facts and circumstances available at the time and various other assumptions that are believed to be reasonable under the circumstances.  The Company reviews these matters and reflects changes in estimates as appropriate.  Actual results could differ materially from those estimates.

Goodwill

Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired companies.  The changes in the carrying amount of goodwill for the nine months ended May 31, 2011 by reportable segments are as follows (in thousands):
 
   
EIS
   
EGS
   
Total
 
Balance at August 31, 2010
  $ 11,685     $ 2,294     $ 13,979  
Foreign currency translation effect of Canadian and Indian goodwill
    75       12       87  
Increase in goodwill arising from to Luceo and Koan-IT acquisitions related earnout payments
    110       270       380  
Increase in goodwill due to Dinero and Covelix acquisitions
    1,458       -       1,458  
Balance at May 31, 2011
  $ 13,328     $ 2,575     $ 15,903  
 
 
5

 
 
In accordance with Accounting Standard Codification (“ASC”) Topic 350 “Intangibles- Goodwill and Other,” goodwill is not amortized but is tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired.  Goodwill is tested for impairment at one level below an operating segment (also known as a reporting unit) in accordance with the guidance of ASC Topic 350. These reporting units are comprised of Systems Division, KOAN-IT, Luceo, eBAS/Aveeva, SARK, SDI, Dinero (effective February 3, 2011) and Covelix (effective March 1, 2011.)  The Company has set an annual impairment testing date of June 1.

An impairment charge will be recognized only when the implied fair value of a reporting unit, including goodwill, is less than its carrying amount.  The impairment determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with ASC Topic 805 “Business Combinations.”  The residual fair value after this allocation is the implied fair value of the reporting unit goodwill.

At May 31, 2011, Emtec's market capitalization was less than its total stockholders’ equity.  However, the Company’s stock does not trade frequently and thus management believes the inherent value of the Company is not and has not been accurately reflected by the current or historical stock market valuation of the Company.  Accordingly, the Company continues to believe that the income and market-based approaches are the most appropriate valuation methods.
 
In accordance with ASC Topic 350, the Company performed its annual impairment testing as of June 1, 2010.  Based on its annual impairment testing at June 1, 2010 and continued monitoring of market conditions and the operating performance of its reporting units, the Company does not currently believe that there is an indication of goodwill impairment at May 31, 2011.  However, if current market conditions change and the Company’s estimated value(s) under the income and/or market-based approaches is/are affected, then it is possible that the Company would have to take a goodwill impairment charge against earnings in a future period.

Identifiable Intangible Assets

At May 31, 2011 and August 31, 2010, the components of identifiable intangible assets are as follows (in thousands):
 
   
May 31, 2011
   
August 31, 2010
 
Customer relationships
  $ 17,158     $ 15,768  
Noncompete agreements
    938       449  
Software technology
    14       14  
Trademarks
    169       169  
Trade names
    623       203  
Foreign currency translation adjustment
    169       52  
      19,071       16,655  
Accumulated amortization
    (6,718 )     (5,128 )
Foreign currency translation adjustment
    (16 )     (5 )
Balance, ending
  $ 12,337     $ 11,522  
 
 
6

 
 
Customer relationships represent the fair value ascribed to customer relationships purchased in 2005, the acquisitions of Luceo and eBAS/Aveeva in fiscal 2008, the acquisition of KOAN-IT in fiscal 2009, the acquisition of SDI in fiscal 2010, the acquisition of Dinero in February 2011 and Covelix in March 2011. The amounts ascribed to customer relationships are being amortized on a straight-line basis over 5-15 years.
 
Noncompete agreements represent the value ascribed to covenants not to compete in employment and acquisition agreements with certain members of Luceo, eBAS/Aveeva, KOAN-IT, SDI, Dinero and Covelix’s management entered into at the time of the respective acquisitions. The amounts ascribed to noncompete agreements are being amortized on a straight-line basis over 3-5 years.
 
Software technology represents the value ascribed to software developed by SARK that was acquired in fiscal 2010. The amount ascribed to software technology is being amortized on a straight-line basis over 3 years.
 
Trademarks represent the value ascribed to trademarks owned by KOAN-IT. The amount ascribed to trademarks is being amortized on a straight-line basis over 5 years.
 
Trade names represent the value ascribed to trade names owned by SDI, Dinero and Covelix. The amount ascribed to trade name is being amortized on a straight-line basis over 5 years.
 
Amortization expense related to intangible assets was $593,000 and $410,000 for the three months ended May 31, 2011 and 2010, respectively. For the nine months ended May 31, 2011 and 2010, amortization expense related to intangible assets was $1.6 million and $1.2 million, respectively. We currently expect future amortization of definite lived intangible assets to be as follows (in thousands):
 
Years ending August 31,        
2011
  $ 2,138  
2012
  $ 2,344  
2013
  $ 2,296  
2014
  $ 1,647  
2015
  $ 1,516  

Long-lived assets, including customer relationships, noncompete agreements, software technology, trademarks and trade names as well as property and equipment, are tested for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable in accordance with ASC Topic 360 “Property, Plant and Equipment.”  Recoverability of long-lived assets is assessed by a comparison of the carrying amount to the estimated undiscounted future net cash flows expected to result from the use of the assets and their eventual disposition.  If estimated undiscounted future net cash flows are less than the carrying amount, the asset is considered impaired and a loss would be recognized based on the amount by which the carrying value exceeds the fair value of the asset.  No impairment of long-lived assets occurred during the three or nine-month periods ended May 31, 2011 or 2010.

Foreign Currency Translation and Other Comprehensive Income (loss)

The financial statements of the Company’s foreign subsidiaries are remeasured into U.S. dollars for consolidation and reporting purposes.  The functional currency for the Company’s foreign operations is the local currency.  Current rates of exchange are used to remeasure assets and liabilities.  Adjustments to translate those statements into U.S. dollars are recorded in accumulated other comprehensive income (loss).

 
7

 
 
The Company’s comprehensive income (in thousands) is presented in the following table:
 
   
For the Three Months Ended May 31,
   
For the Nine Months Ended May 31,
 
   
2011
   
2010
   
2011
   
2010
 
Net Income (loss)
  $ (812 )   $ (35 )   $ (513 )   $ 522  
Translation adjustment, net of taxes
    105       12       178       66  
Total comprehensive income (loss)
  $ (707 )   $ (23 )   $ (335 )   $ 588  

Earnings Per Share

Basic earnings (loss) per share amounts are computed by dividing net income (loss) available to common stockholders (the numerator) by the weighted average shares outstanding (the denominator), during the period. Shares issued during the period are weighted for the portion of the period that they were outstanding.

The computation of diluted earnings per share is similar to the computation of basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive options, restricted stock awards and warrants had been exercised as of the end of the period. Potentially dilutive shares consist of stock options, restricted stock awards and warrants totaling 1,706,594 shares and 378,916 shares, for the three month periods ended May 31, 2011 and 2010, respectively, and 1,382,879 shares and 187,307 shares for the nine month periods ended May 31, 2011 and 2010, respectively. Diluted shares for the three month periods ended May 31, 2011 and 2010, and nine months ended May 31, 2011 were not included in the calculation of diluted net loss per share because the effect of the inclusion would be anti-dilutive. In addition, outstanding warrants to purchase 1,401,733 and 1,764,437 common shares as of and for the periods ended May 31, 2011 and 2010, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the Company’s common shares over those periods.

Income Taxes

The Company conducts business nationally and in Canada and India. With respect to its U.S. operations, the Company files income tax returns in the U.S federal jurisdiction and various state and local jurisdictions.  The Company accounts for income taxes in accordance with ASC Topic 740 “Income Taxes.”  The Company files a federal consolidated income tax return that includes all U.S. entities.  The Company also files several combined/consolidated (unitary) state income tax returns and several separate state income tax returns.  Deferred taxes are provided based upon a review of the tax basis of assets and liabilities, whereby deferred tax assets and liabilities are recognized for temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis.  Deferred tax assets are recognized for tax loss carryforwards.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.  Deferred taxes result from timing differences primarily relating to bad debts, inventory reserves, deferred revenue, fixed asset depreciation, compensation expenses and intangible amortization.

 
8

 
 
With a few exceptions, the Company is no longer subject to federal, state or local income tax examinations for tax returns filed for fiscal years ended August 31, 2006 and prior.

Reconciliation of Liabilities for Unrecognized Tax Benefits for the nine months ended May 31, 2011 and 2010 (in thousands) are as follows:

   
2011
   
2010
 
             
Balance at September 1, 2010 and 2009
  $ 212     $ 202  
                 
Unrecognized tax positions of prior periods:
               
     Increase
    -       -  
     Decrease
    -       -  
                 
Unrecognized tax positions for the nine months:
         
     Increase
    1       1  
     Decrease
    -       -  
                 
Decrease in Unrecognized tax benefits due to settlements
    -          
                 
Decrease in Unrecognized tax benefits due to lapse of statute of limitations
    -       -  
                 
Balance at May 31, 2011 and 2010
  $ 213     $ 203  

   
For the Nine Months Ended May 31,
 
   
2011
   
2010
 
             
Total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate
  $ 97     $ 91  
                 
Accrued interest and penalties for unrecognized tax benefits
  $ 117     $ 94  
                 
Interest and penalties classified as income tax expense
  $ 17     $ 16  

3. Acquisitions

Secure Data, Inc.
 
On June 4, 2010, Emtec Federal, a wholly-owned subsidiary of the Company, acquired all of the outstanding shares of SDI for cash and equity.  The equity included in the reported consideration consisted of the fair value of the “puttable” restricted common stock of the Company as of June 4, 2010.  The “put” feature embedded in the restricted common stock allows each former shareholder of SDI a one-time election to put all of their restricted common stock to the Company at a fixed price on the third anniversary of the acquisition date.  Management calculated the fair value of the put using a Black-Scholes valuation model.  In accordance with SEC Accounting Series Release No. 268 “Presentation in Financial Statements of Redeemable Preferred Stocks,” the puttable stock is subject to equity accounting and is classified on the Company’s balance sheet as temporary equity.
 
 
9

 
 
In addition, the Company may be required to pay additional variable cash and stock consideration each year for each of the first three years after closing that is contingent upon the achievement of certain performance milestones. The fair value of the contingent consideration arrangement at the acquisition date was $676,000. The Company estimated the fair value of the contingent consideration using probability assessments of expected future cash flows over the period in which the obligation is expected to be settled, and applied a discount rate that appropriately captures a market participant’s view of the risk associated with the obligation. This fair value is based on significant inputs not observable in the market. As of May 31, 2011, there were no significant changes in the range of outcomes for the contingent consideration.

The Company applied ASC Topic 805, “Business Combinations,” to this acquisition whereby amounts were assigned to assets acquired and liabilities assumed based on their fair values, on the date of the acquisition. Management determined the fair value of SDI’s net assets on June 4, 2010 that resulted in an excess purchase price over fair value of net assets acquired that was recognized as goodwill and recorded on the Company’s balance sheet.

Unaudited pro forma results of operations are not included in this report because the effect of the business combination is not significant.

Dinero Solutions, LLC
 
On February 3, 2011, EGS LLC, a wholly-owned subsidiary of the Company, acquired all of the issued and outstanding stock of Dinero for cash plus future contingent earnout payments with a fair value as of February 3, 2011 of $653,000.  The Company may be required to pay additional variable cash consideration in the future that is contingent upon the achievement of certain performance milestones.  We estimated the fair value of the contingent consideration using probability assessments of expected future cash flows over the period in which the obligation is expected to be settled, and applied a discount rate that appropriately captures a market participant’s view of the risk associated with the obligation. This fair value is based on significant inputs not observable in the market. As of May 31, 2011, there were no significant changes in the range of outcomes for the contingent consideration.
 
The Company applied ASC Topic 805, “Business Combinations,” whereby, amounts were assigned to assets acquired and liabilities assumed based on their fair values, on the date of the acquisition. Management determined the fair value of Dinero’s net assets on February 3, 2011 that resulted in excess purchase price over fair value of net assets acquired of $191,000 which was recognized as goodwill.  It should be noted that the purchase allocation is preliminary and has not yet been finalized.

Unaudited pro forma results of operations are not included in this report because the effect of the acquisition is not significant.
 
As part of the purchase, the Company issued restricted common stock to the former sole member of Dinero.  The shares vest over a three-year period contingent upon Dinero achieving certain performance milestones as well as continued employment of its former sole member.  Pursuant to ASC Topic 805-10-55, “Business Combinations – Overall – Implementation,” the restricted stock is being treated as compensation rather than additional consideration since the vesting of the stock is linked to the continued employment at the Company of the former sole member of Dinero.  Furthermore, the restricted stock issued contains an embedded “put” feature that allows the former sole member of Dinero a one-time election to put all of his restricted common stock to the Company at a fixed price on the third anniversary of the acquisition date.  However, the exercise of the one-time put option is contingent upon Dinero achieving a certain performance milestone measured over a three-year period.  Management has determined that it is probable, as of May 31, 2011, that Dinero will achieve the performance milestones for the vesting of the restricted stock and the put option and has calculated the fair value of the restricted stock and “put” using a Black-Scholes valuation model. In accordance with ASC Topic 718, “Compensation – Stock Compensation,” the puttable stock is subject to liability accounting.  At May 31, 2011, the Company recorded a net liability of $52,000 on its balance sheet.  The Company recorded expense of $52,000 on its consolidated statement of operations associated with the fair value of the restricted stock and put from the date of acquisition through May 31, 2011.
 
 
10

 

Covelix, Inc.
 
On March 1, 2011, EGS LLC, a wholly-owned subsidiary of the Company, acquired all of the outstanding shares of Covelix for cash and equity.  The equity included in the reported consideration consisted of the fair value of the “puttable” restricted common stock of the Company as of March 1, 2011.  The “put” feature embedded in the restricted common stock allows each former shareholder of Covelix a one-time election to put all of their restricted common stock to the Company at a fixed price on the third anniversary of the acquisition date.  However, the exercise of the one-time put option is contingent upon Covelix achieving a certain performance milestone measured over a three-year period.  Management calculated the fair value of the put using a Black-Scholes valuation model.  In accordance with SEC Accounting Series Release No. 268 “Presentation in Financial Statements of Redeemable Preferred Stocks,” the puttable stock is subject to equity accounting and is classified on the Company’s balance sheet as temporary equity.
 
In addition, the Company may be required to pay additional variable cash and stock consideration each year for the next three years on the anniversary of closing that is contingent upon the achievement of certain performance milestones. The fair value of the contingent consideration arrangement at the acquisition date was $477,000. The Company estimated the fair value of the contingent consideration using probability assessments of expected future cash flows over the period in which the obligation is expected to be settled, and applied a discount rate that appropriately captures a market participant’s view of the risk associated with the obligation. This fair value is based on significant inputs not observable in the market. As of May 31, 2011, there were no significant changes in the range of outcomes for the contingent consideration.

The Company applied ASC Topic 805, “Business Combinations,” to this acquisition whereby amounts were assigned to assets acquired and liabilities assumed based on their fair values, on the date of the acquisition. Management determined the fair value of Covelix’s net assets on March 1, 2011 that resulted in an excess purchase price over fair value of net assets acquired that was recognized as goodwill and recorded on the Company’s balance sheet.

Unaudited pro forma results of operations are not included in this report because the effect of the business combination is not significant.

 
11

 
 
The Company allocated $590,000 to client relationships at the acquisition date.  This asset is being amortized on a straight-line method over a period of five years.  The Company also allocated $60,000 and $170,000 to a non-compete asset and trade name, respectively.  These assets are being amortized on a straight-line method over a period of five years.  It should be noted that the purchase allocation is preliminary and has not yet been finalized.
 
4.  Stock-Based Compensation
 
Stock Options 
 
The second amendment to the Company’s 2006 Stock-Based Incentive Compensation Plan (the “2006 Plan”) was approved by the Company’s stockholders on January 20, 2011. The 2006 Plan authorizes the granting of stock options, restricted stock, deferred stock, stock appreciation rights and other stock-based awards to directors and eligible employees. The second amendment increased the aggregate number of shares of Common Stock available for issuance under the 2006 Plan from 2,543,207 shares to 9,543,207 shares.  Options under the 2006 Plan may not be granted with an exercise price that is less than 100% of the fair value of the Company’s common stock on the date of grant (110% in the case of an incentive stock option granted to a stockholder owning more than 10% of the common stock of the Company or any of its subsidiaries). Options under the 2006 Plan have terms from 7 to 10 years.  Certain options vest immediately and others vest over a term up to 4 to 5 years.
 
The Company measures the fair value of options on the grant date using the Black-Scholes option valuation model.  The Company estimated the expected volatility using the Company’s historical stock price data over the expected term of the stock options.  The Company also used historical exercise patterns and forfeiture behaviors to estimate the options, expected term and our forfeiture rate.  The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve in effect on the grant date.  Both expected volatility and the risk-free interest rate are based on a period that approximates the expected term.
 
A summary of stock options for the nine months ended May 31, 2011 is as follows:
 
For the Nine Months Ended May 31, 2011
   
Weighted Average
Exercise Price
 
Weighted Average
Remaining Term
 
Aggregate Intrinsic Value (a)
 
   
Shares
               
Options Outstanding -September 1, 2010
    413,333     $ 1.13          
Options Granted
    20,000     $ 1.04          
Options Exercised
    -       -          
Options Forfeited or Expired
    (1,000 )   $ 1.31          
                     
Options Outstanding - May 31, 2011
    432,333     $ 1.13   5.31 years   $ 23,525  
                           
Options Exercisable -May 31, 2011
    382,533     $ 1.13   5.18 years     23,525  
 
 
(a)
Represents the total pre-tax intrinsic value based on the Company’s average closing stock prices for the three or nine months ended May 31, 2011.
 
 
12

 
 
For the three and nine month periods ended May 31, 2011, the Company issued -0- and 20,000 stock options, respectively.  There were no stock options issued during the three month periods ended May 31, 2011 and November 30, 2010, and 20,000 stock options were issued during the three months ended February 28, 2011. The following assumptions were used to value stock options issued during the three months ended February 28, 2011:
 
   
2011
 
Weighted-Average Fair Value
  $ 0.70
Assumptions
       
Expected Volatility
    90.26%
Expected Term
 
5 years
Expected Forfeiture Rate
    0%
Dividend Yield
    0%
Risk-Free Interest Rate
    1.53%
 
Non-vested Stock (Restricted Stock)
 
The following table summarizes the Company’s restricted stock activity during the nine months ended May 31, 2011:
 
 
For the Nine Months Ended May 31, 2011
   
Shares
     
Weighted Average Grant Date Fair Value
    Fair Value    
Nonvested - September 1, 2010
    870,916     $ 1.06          
Granted
    199,882     $ 0.99          
Vested
    (389,666 )   $ 1.06     $ 404,326  
(a)
Forfeited
    -       -            
Nonvested - May 31, 2011
    681,132     $ 1.04     $ 408,679  
(b)
 
 
(a)
The fair value of vested restricted stock shares represents the total pre-tax fair value, based on the closing stock price on the day of vesting,  which would have been received by holders of restricted stock shares had all such holders sold their underlying shares on that date.
 
 
(b)
The aggregate fair value of the non-vested restricted stock shares expected to vest represents the total pre-tax fair value, based on the Company’s closing stock price as of May 31, 2011, which would have been received by holders of restricted stock shares had all such holders sold their underlying shares on that date.
 
The Company recognizes compensation expense associated with the issuance of such shares using the closing price of the Company’s common stock on the date of grant over the vesting period on a straight-line basis.
 
Stock Options and Non-vested Stock
 
Stock-based compensation costs related to the 2006 Plan totaled $104,000 and $118,000 for the three months ended May 31, 2011 and 2010, respectively, and $385,000 and $392,000 for the nine months ended May 31, 2011 and 2010, respectively.  As of May 31, 2011, the Company had $374,000 of unrecognized compensation cost related to the 2006 Plan.  The unrecognized compensation cost is expected to be recognized over a remaining period of 4 years.
 
 
13

 
 
 5.  Warrants
 
On August 2, 2010, the Company entered into a letter agreement (the “Letter Agreement”) with DARR Westwood LLC (the “Investor”), pursuant to which, among other things, (a) the Investor agreed (i) to certain transfer restrictions on shares of Common Stock owned by the Investor, which are described below, and (ii) to transfer to the Company for cancellation the existing warrant owned by the Investor to purchase 8% of the outstanding Common Stock on a fully diluted basis, and (b) the Company issued to the Investor a warrant (the “Warrant”) to purchase up to an aggregate of 1,401,733  shares of common stock, par value $.01 per share, of the Company (“Common Stock”) at an exercise price of $2.11 per share. The Investor’s sole member is Dinesh R. Desai, the Company’s Chairman, Chief Executive Officer and President.  For further information on Warrants, refer to the annual financial statements and notes thereto included in the Company’s Quarterly Report on Form 10-K for the year ended August 31, 2010.
 
The Warrant entitles the Investor to purchase 1,401,733 shares of Common Stock at $2.11 per share and expires on August 2, 2015. The Warrant also contains provisions for cashless exercise and weighted average anti-dilution protection for subsequent issuances or deemed issuances of Common Stock by the Company for consideration per share less than the per share exercise price of the Warrant in effect immediately prior to such issuance or deemed issuance. In connection with this issuance of warrants and compliance with ASC Topic 815, “Derivates and Hedging,” the Company recorded a liability on August 2, 2010 of $916,000. At May 31, 2011 and August 31, 2010, the net liability recorded on the balance sheet was $432,000 and $910,000, respectively.  The Company recorded (income) expense on its consolidated results of operations of ($49,000) and $-0- for three months ended May 31, 2011 and 2010 and ($478,000) and $-0- for the nine months ended May 31, 2011 and 2010, respectively, as a result of adjusting the warrant liability to fair value.  As a result of the Company’s stock being thinly traded, there may continue to be adjustments associated with fair valuing the warrant liability in future periods.
 
6.  Line of Credit
 
The Company, Emtec NJ, Emtec LLC, Emtec Federal, EGS LLC, Luceo, eBAS, Aveeva EIS-US, KOAN-IT US, SDI, Dinero and Covelix (collectively, the “Borrower”), have a Loan and Security Agreement with De Lage Landen Financial Services, Inc. (the “Lender”) pursuant to which the Lender provides the Borrower with a revolving credit loan and floor plan loan (the “Credit Facility”). The Credit Facility provides for aggregate borrowings of the lesser of $32.0 million or 85% of Borrower’s eligible accounts receivable, plus 100% of unsold inventory financed by the Lender and 40% of all other unsold inventory. The floor plan loan portion of the Credit Facility is for the purchase of inventory from approved vendors and for other business purposes. The Credit Facility subjects the Borrower to mandatory repayments upon the occurrence of certain events as set forth in the Credit Facility.
 
 
14

 
 
On December 5, 2008, the Borrower entered into a First Amendment and Joinder to Loan and Security Agreement and Schedule to Loan and Security Agreement (the “First Amendment”) with the Lender, pursuant to which the Lender extended the term of the loans issued to the Borrower under the Loan and Security Agreement from December 7, 2008 until December 7, 2010 and made certain other amendments to the Loan and Security Agreement, including the following:
 
 
·
The First Amendment changed the base rate of interest to the three month (90 day) LIBOR rate from the previous base rate of the “Prime Rate.”

 
·
The First Amendment changed the interest rate for revolving credit loans to the base rate plus 3.25% from the previous interest rate for revolving credit loans which was the base rate minus 0.5%, and changed the interest rate for floorplan loans, if applicable, to 6.25% in excess of the base rate from the previous interest rate for floorplan loans of 2.5% in excess of the base rate.

 
·
The First Amendment amended the Schedule to Loan and Security Agreement to provide that the Borrower must pay the Lender a floorplan annual volume commitment fee if the aggregate amount of all floorplan loans does not equal or exceed $60.0 million in a 12-month period from December 1st through November 30th.  The floorplan commitment fee is equal to the amount that the floorplan usage during such 12-month period is less than $60.0 million multiplied by 1%.  If the Borrower terminates the Credit Facility during a 12-month period, the Borrower shall be required to pay the Lender a prorated portion of the annual volume commitment fee.
 
On December 7, 2010, the Borrower entered into a Second Amendment and Joinder to Loan and Security Agreement and Schedule to Loan and Security Agreement (the “Second Amendment”) with the Lender, pursuant to which the Lender has agreed to extend the term of the Credit Facility from December 7, 2010 until December 7, 2012 and to make certain other amendments to the Credit Facility, including the following:
 
 
·
The Second Amendment changed the total facility amount by temporarily increasing it to $40.6 million.  This amendment was effective until January 31, 2011, at which time the total facility amount returned to its previous level of $32.0 million.

 
·
The Second Amendment added and clarified certain covenants in the Credit Facility including the following:

 
o
Changing the Positive Net Income covenant to add back to Net Income certain non-cash charges;

 
o
Providing that Borrower shall maintain a ratio of EBITDA to Interest Paid (as such terms are defined in the Credit Facility) of 3.50 to 1.00 as of the end of each fiscal quarter measured on a trailing twelve month basis; and

 
o
Changing the Capital Expense covenant to increase the limitation on capital expenditures to $2,750,000 in any rolling four fiscal quarter period and to provide that business acquisition costs are not considered capital expenditures for this purpose.

In addition, by executing the Second Amendment, EIS-US, KOAN-IT US and SDI each joined the Credit Documents as a Borrower and granted the Lender a security interest in all of their respective assets, including inventory, equipment, fixtures, accounts, chattel paper, instruments, deposit accounts, documents, general intangibles, letter of credits rights, and all judgments, claims and insurance policies.  EIS-US pledged 100% of the outstanding shares of its domestic subsidiary, KOAN-IT US, and 65% of the outstanding shares of the Company’s Canadian subsidiary, Emtec Infrastructure Services Canada Corporation.  Emtec Federal, Inc. pledged 100% of the outstanding shares of its domestic subsidiary, SDI, and the Company pledged 100% of the outstanding shares of its domestic subsidiary, EIS-US.

 
15

 
 
On March 11, 2011, the Borrower entered into a Third Amendment and Joinder to Loan and Security Agreement and Schedule to Loan and Security Agreement (the “Third Amendment”) with the Lender, pursuant to which Dinero and Covelix each joined the Credit Documents as a Borrower and granted the Lender a security interest in all of their respective assets, including inventory, equipment, fixtures, accounts, chattel paper, instruments, deposit accounts, documents, general intangibles, letter of credits rights, and all judgments, claims and insurance policies.

On June 23, 2011, EIS-Canada and De Lage Landen Financial Services Canada Inc. (the “Canadian Lender”) entered into a Loan Agreement (the “Canadian Loan Agreement”) and Schedule to Loan Agreement (the “Canadian Schedule,” together with the Canadian Loan Agreement, the “Canadian Credit Documents”) pursuant to which the Canadian Lender has agreed to provide EIS-Canada with a revolving credit line of $5 million (Canadian dollars) (the “Canadian Credit Facility”).  The Canadian Credit Facility is subject to certain mandatory repayments upon the occurrence of certain events as set forth in the Canadian Credit Documents.

Borrowings under the Canadian Credit Facility will bear interest at an annual rate equal to the rate of interest announced by The Toronto-Dominion Bank as the Canadian prime rate plus 1.75% for revolving credit loans.

To secure the payment of the obligations under the Canadian Credit Facility, EIS-Canada entered into a General Security Agreement, dated June 23, 2011, with the Canadian Lender (the “Canadian Security Agreement”), pursuant to which EIS-Canada granted to the Canadian Lender a security interest in all of EIS-Canada’s interests in certain of its undertakings, personal property and real property.

The Canadian Credit Documents contain certain customary covenants, including among other things:

 
·
Affirmative covenants requiring EIS-Canada to maintain its legal existence and provide certain notices to the Canadian Lender; and

 
·
Restrictive covenants including limitations on other indebtedness, liens, fundamental changes, asset sales, capital expenditures, the issuance of capital stock, investments, and transactions with affiliates.

The Canadian Credit Documents contain certain customary representations and warranties and events of default, including failure to pay interest, principal or fees, any material inaccuracy of any representation and warranty, bankruptcy and insolvency events. Certain of the events of default are subject to exceptions and materiality qualifiers.

The Company had balances of $14.5 million and $16.0 million outstanding under the revolving portion of the Credit Facility, and balances of $974,000 and $3.4 million (included in the Company’s accounts payable) outstanding plus $723,000 and $723,000 in open approvals under the floor plan portion of the Credit Facility at  May 31, 2011 and August 31, 2010, respectively. Net availability per our Lender was $1.3 million and $6.8 million under the revolving portion of the Credit Facility as of May 31, 2011 and August 31, 2010, respectively.

On June 23, 2011, the Borrower entered into a Fourth Amendment to Loan and Security Agreement and Schedule to Loan and Security Agreement (the “Fourth Amendment”) with the Lender, pursuant to which the Lender has agreed to make certain amendments to the Loan and Security Agreement and the Schedules to the Loan and Security Agreement including (1) recognizing the Canadian Credit Facility and acknowledging the Borrowers’ agreement to guarantee EIS-Canada’s obligations under that facility and (2) amending the total facility amount under the Credit Documents to provide that the total facility plus the aggregate amount outstanding under the Canadian Credit Facility shall not exceed $32,000,000 (US dollars).
 
As of May 31, 2011, the Company determined that it was in compliance with its financial covenants under the Facility.

 
16

 

7.  Concentration of Credit Risk
 
Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of accounts receivable.
 
The Company’s revenues, by client type, consist of the following (in thousands):
 
   
For the Three Months Ended
 
   
May 31, 2011
   
May 31, 2010
 
Departments of the U.S. Government
  $ 12,036       26.8 %   $ 22,457       42.0 %
Canadian Government Agencies
    991       2.2 %     760       1.4 %
State and Local Governments
    2,465       5.5 %     1,026       1.9 %
Commercial Companies
    14,673       32.7 %     12,977       24.3 %
Education and other
    14,694       32.8 %     16,287       30.4 %
Total Revenues
  $ 44,859       100.0 %   $ 53,506       100.0 %
 
   
For the Nine Months Ended
 
   
May 31, 2011
   
May 31, 2010
 
Departments of the U.S. Government
  $ 72,124       43.0 %   $ 79,373       48.6 %
Canadian Government Agencies
    2,301       1.4 %     1,480       0.9 %
State and Local Governments
    4,720       2.8 %     3,162       1.9 %
Commercial Companies
    40,921       24.4 %     38,462       23.6 %
Education and other
    47,792       28.4 %     40,710       24.9 %
Total Revenues
  $ 167,858       100.0 %   $ 163,187       100.0 %
 
The Company reviews a client’s credit history before extending credit.  The Company does not require collateral or other security to support credit sales. The Company provides an allowance for doubtful accounts based on the credit risk of specific clients, historical experience and other identified risks. Trade receivables are carried at original invoice less an estimate made for doubtful receivables, based on review by management of all outstanding amounts on a periodic basis.  Trade receivables are considered delinquent when payment is not received within standard terms of sale, and are charged-off against the allowance for doubtful accounts when management determines that recovery is unlikely and ceases its collection efforts.
 
The trade account receivables consist of the following (in thousands):
 
   
May 31,
   
August 31,
 
   
2011
   
2010
 
Trade receivables
  $ 24,032     $ 36,628  
Allowance for doubtful accounts
    (504 )     (366 )
Trade receivables, net
  $ 23,528     $ 36,262  

Trade receivables include $2.4 million and $2.2 million of unbilled revenue as of May 31, 2011 and August 31, 2010, respectively.

 
17

 
 
Sales to major customers, representing at least 10% of total revenue for a period, of the Company, consist of the following (in thousands):
 
   
For the Three Months Ended
 
   
May 31, 2011
   
May 31, 2010
 
School District #1
  $ 10,005       22.3 %   $ 11,062       20.7 %
School District #2
    4,403       9.8 %     5,814       10.9 %
All Other Customers
    30,451       67.9 %     36,630       68.4 %
Total Revenues
  $ 44,859       100.0 %   $ 53,506       100.0 %

   
For the Nine Months Ended
 
   
May 31, 2011
   
May 31, 2010
 
School District #1
  $ 37,409       22.3 %   $ 26,715       16.4 %
Department of the U.S. Government
    17,286       10.3 %     6,132       3.8 %
All Other Customers
    113,163       67.4 %     130,340       79.8 %
Total Revenues
  $ 167,858       100.0 %   $ 163,187       100.0 %
 
Trade receivables due from an education client in the southeastern United States and one of the departments of the U.S. Government accounted for approximately 11.6% and 0.1%, respectively, of the Company’s trade receivables as of May 31, 2011. The same clients accounted for approximately 18.2% and 1.3%, respectively of the Company’s trade receivable as of August 31, 2010.
 
8.  Inventories
 
Inventories are stated at the lower of average cost or market. Inventories consist of finished goods purchased for resale, including computer hardware, computer software, computer peripherals and related supplies. At May 31, 2011 and August 31, 2010, inventories consisted of the following (in thousands):
 
   
May 31,
   
August 31,
 
   
2011
   
2010
 
Hardware, software, accessories and parts
  $ 1,851     $ 1,759  
Inventory reserve
    (212  )     (244 )
Net inventories
  $ 1,639     $ 1,515  

9. Accrued Liabilities
 
At May 31, 2011 and August 31, 2010, accrued liabilities consisted of the following (in thousands):
 
   
May 31, 2011
   
August 31, 2010
 
Accrued payroll
  $ 2,822     $ 4,156  
Accrued commissions
    220       389  
Accrued state sales taxes
    68       84  
Accrued third-party service fees
    12       181  
Other accrued expenses
    4,676       3,217  
    $ 7,798     $ 8,027  
 
 
18

 
 
10.         Related Party Transactions

The Company leases warehouse and office space from related parties.  The aggregate expense for these lease arrangements during the three months ended May 31, 2011 and 2010 was $194,000 and $162,000, respectively.  During the nine months ended May 31, 2011 and 2010, the aggregate expense for these lease arrangements was $582,000 and $473,000, respectively.
 
11.         Legal Proceedings

In December 2007, the Company received a subpoena issued by the General Services Administration Office of Inspector General (“OIG”), as part of an ongoing, industry-wide investigation.  The Company produced documents and data in response to the subpoena to the OIG during 2008.  In October 2010, the Company learned that it had been named as a defendant in a qui tam case alleging violations of the Trade Agreements Act.  This case, designated United States ex rel. Folliard v. Synnex Corporation et al., was filed under seal in the United States District Court for the District of Columbia.  Qui tam lawsuits typically remain under seal (hence, usually unknown to the defendant) for some time while the government decides whether or not to intervene on behalf of a private qui tam plaintiff (known as a relator) and take the lead in the litigation.  These lawsuits can involve significant monetary damages and penalties and award bounties to private plaintiffs who successfully bring the suits.  The United States government declined to intervene in the matter on May 27, 2010.  Nonetheless, the Company can provide no assurance that the government will not intervene in this case in the future or in any other qui tam suit against the Company in the future.   The Company filed a motion to dismiss the lawsuit on December 10, 2010.  At this time, the Company is unable to predict the timing and outcome of this matter.

In addition, the Company is occasionally involved in various lawsuits, claims, and administrative proceedings arising in the normal course of business.  Except as set forth above, the Company believes that any liability or loss associated with such matters, individually or in the aggregate, will not have a material adverse effect on the Company’s financial condition or results of operations.

12.         Segment Information

The Company provides segment financial information in accordance with ASC Topic 280, “Segment Reporting.”  The Company’s business activities are divided into two business segments, EIS and EGS. EIS consists of the Systems Division, which includes Emtec NJ, Emtec LLC, Emtec Federal and the business service management solutions offered by the ITSM practice, the Oracle practice, and the Federal applications business. EGS is the Company’s enterprise applications services solutions and training business including its ERP and Application Development practice and its Business Analysis and Quality Assurance Practice.  The accounting policies of our segments are the same as those described in Note 2 and there are no material intersegment transactions.
 
Summarized financial information relating to the Company’s operating segments is as follows (in thousands):
 
   
(Unaudited)
       
   
May 31 ,
   
August 31,
 
   
2011
   
2010
 
Identifiable Assets:
           
EIS
  $ 56,336     $ 61,501  
EGS
    11,893       12,771  
Total Assets
  $ 68,229     $ 74,272  
 
 
19

 
 
   
For the Three Months Ended
   
For the Nine Months Ended
 
   
May 31,
   
May 31,
 
   
(Unaudited)
   
(Unaudited)
 
                         
   
2011
   
2010
   
2011
   
2010
 
Revenues
                       
EIS
  $ 37,136     $ 45,791     $ 145,647     $ 140,800  
EGS
    7,723       7,715       22,211       22,387  
Total Revenue
  $ 44,859     $ 53,506     $ 167,858     $ 163,187  
                                 
Gross profit
                               
EIS
  $ 6,661     $ 6,736     $ 22,320     $ 20,619  
EGS
    1,146       1,345       3,783       3,910  
Gross profit
  $ 7,807     $ 8,081     $ 26,103     $ 24,529  
                                 
Depreciation and amortization
                               
EIS
  $ 620     $ 371     $ 1,602     $ 1,082  
EGS
    236       180       694       636  
Depreciation and amortization
  $ 856     $ 551     $ 2,296     $ 1,718  
                                 
Operating income (loss)
                               
EIS
  $ (997 )   $ 371     $ (284 )   $ 1,609  
EGS
    (172 )     (246 )     (63 )     (233 )
Operating income (loss)
  $ (1,169 )   $ 125     $ (347 )   $ 1,376  
                                 
Interest and other expense
                               
EIS
  $ 120     $ 66     $ 361     $ 238  
EGS
    55       51       160       160  
Interest and other expense
  $ 175     $ 117     $ 521     $ 398  
                                 
Income tax expense (benefit)
                               
EIS
  $ (480 )   $ 138     $ (398 )   $ 573  
EGS
    (52 )     (95 )     43       (117 )
Income tax expense (benefit)
  $ (532 )   $ 43     $ (355 )   $ 456  
                                 
Net income (loss)
                               
EIS
  $ (637 )   $ 167     $ (247 )   $ 798  
EGS
    (175 )     (202 )     (266 )     (276 )
Net income (loss)
  $ (812 )   $ (35 )   $ (513 )   $ 522  
                                 
Capital expenditures
                               
EIS
  $ 1,499     $ 296     $ 2,192     $ 502  
EGS
    94       16       101       61  
Capital expenditures
  $ 1,593     $ 312     $ 2,293     $ 563  
 
 
20

 
 
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis should be read in conjunction with, and is qualified in its entirety by, the unaudited financial statements, including the notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q.
 
Cautionary Statement Regarding Forward-Looking Statements
 
You should carefully review the information contained in this Quarterly Report on Form 10-Q and in other reports or documents that we file from time to time with the Securities and Exchange Commission (the “SEC”).  In addition to historical information, this Quarterly Report on Form 10-Q contains our beliefs regarding future events and our future financial performance.  In some cases, you can identify those so-called “forward-looking statements” by words such as “may,” “will,” “should,” expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of those words and other comparable words.  You should be aware that those statements are only our predictions.  Actual events or results may differ materially.  We undertake no obligation to publicly release any revisions to forward-looking statements after the date of this report. In evaluating those statements, you should specifically consider various factors, including the risk factors discussed in our Annual Report on Form 10-K for the year ended August 31, 2010 and other reports or documents that we file from time to time with the SEC.  All forward-looking statements attributable to us or a person acting on our behalf are expressly qualified in their entirety by this cautionary statement.
 
Assumptions relating to budgeting, marketing, and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our business, financial position, results of operations and cash flows.
 
Overview of Emtec
 
We are an IT services provider and we deliver consulting, application services, and infrastructure services to public sector and commercial clients.  The Company’s client base is comprised of departments of the United States and Canada’s federal, state/provincial and local governments, schools, and commercial businesses throughout the United States and Canada.
 
 
21

 
 
Consolidated Statements of Operations for the Three Months Ended May 31, 2011 compared with the Three Months Ended May 31, 2010.

EMTEC, INC.
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
(In thousands)
 
                         
   
Three Months Ended May 31,
             
   
2011
   
2010
   
Change
   
%
 
Revenues
                       
Procurement services
  $ 24,652     $ 39,536     $ (14,884 )     (37.6 )%
Service and consulting
    20,207       13,970       6,237       44.6 %
Total Revenues
    44,859       53,506       (8,647 )     (16.2 )%
                                 
Cost of Sales
                               
Cost of procurement services
    21,980       35,140       (13,160 )     (37.5 )%
Cost of service and consulting
    15,072       10,285       4,787       46.5 %
Total Cost of Sales
    37,052       45,425       (8,373 )     (18.4 )%
                                 
Gross Profit
                               
Procurement services
    2,672       4,396       (1,724 )     (39.2 )%
Procurement services %
    10.8 %     11.1 %                
                                 
Service and consulting
    5,135       3,685       1,450       39.3 %
Service and consulting %
    25.4 %     26.4 %                
                                 
Total Gross Profit
    7,807       8,081       (274 )     (3.4 )%
Total Gross Profit %
    17.4 %     15.1 %                
                                 
Operating expenses:
                               
Selling, general, and administrative expenses
    8,025       7,287       738       10.1 %
Stock-based compensation
    144       118       26       22.0 %
Warrant liability adjustment
    (49 )     -       (49 )     N/A  
Depreciation and amortization
    856       551       305       55.4 %
Total operating expenses
    8,976       7,956       1,020       12.8 %
Percent of revenues
    20.0 %     14.9 %                
                                 
Operating income (loss)
    (1,169 )     125       (1,294 )     (1035.2 )%
Percent of revenues
    -2.6 %     0.2 %                
                                 
Other expense (income):
                               
Interest income – other
    (7 )     (3 )     (4 )     (133.3 )%
Interest expense
    184       124       60       48.4 %
Other
    (2 )     (4 )     2    
NM
 
                                 
Income (loss) before income tax expense (benefit)
    (1,344 )     8       (1,352 )     (16900.0 )%
Income tax expense (benefit)
    (532 )     43       (575 )     (1337.2 )%
Net loss
  $ (812 )   $ (35 )   $ (777 )     2220.0 %
Percent of revenues
    -1.8 %     -0.1 %                
 
 
22

 
 
Consolidated Results of Operations Overview
 
Management examines numerous measures when analyzing the results of our operations.  Our objective is to grow the overall revenues, gross profit margins and operating profits of the Company.
 
We have diversified our business and attempted to grow our consulting services revenues, and in particular our applications services revenues, with the goal of causing our overall gross profits to increase.  However, from time to time, we may invest in additional staff to deliver services and may have a change in the mix of services we provide, causing gross profits to fluctuate.  We pay our sales employees a base salary, commissions and bonuses.  Typically, our incentives to sales people are based on gross profit.  If we hire new sales personnel, we could see temporary increases in selling costs as a percentage of gross profit.  However, over the long-term, we expect our selling costs to grow less quickly than gross profit, thereby decreasing selling costs as a percentage of total gross profits.  From time to time, we may incur additional general and administrative costs to enable us to grow our revenue more quickly as market conditions improve, but as we grow, we expect our general and administrative costs to decrease as a percentage of revenue and gross profit.
 
As the Company increases its consulting services revenues, we expect to focus increasingly on measures such as average billing rates, utilization rates, hours billed and hourly consulting costs.  While we do not publicly report these metrics, we analyze these figures to monitor trends that will enable us to make more effective decisions.  We are investing in internal systems in order to be able to provide these metrics more quickly to our management.
 
We currently categorize our revenues and costs of sales into “Procurement Services” and “Services and Consulting.”  We have made the categorizations in order to analyze our growth in consulting and other services as a percentage of overall revenues.  Traditionally, we have divided our business into two segments. Emtec Infrastructure Services (“EIS”) provides a broad range of IT solutions for our clients.  Emtec Global Services (“EGS”) was originally formed to provide IT application consulting and other services.  However, as cross-selling has increased and our existing clients have purchased many of our consulting services, we have decided to change EGS’s role to training our consultants, providing a resource pool for our project teams, and staffing services, primarily in our application services practices.  Therefore, we are seeing an increase in consulting and other services in our EIS segment that include services previously performed by EGS.  In addition to being proficient in a wide array of technologies, our application services consultants are skilled in business process improvement through the use of technology.
 
For the three months ended May 31, 2011 compared with the three months ended May 31, 2010, total revenue decreased by $8.6 million or 16.2% to $44.9 million which can be attributed to a decline in spending by U.S. governmental agencies. See Item 1A-Risk Factors. Similarly, total gross profit decreased by $274,000 or 3.4% to $7.8 million.  However, overall, gross margin percentage increased to 17.4% from 15.1% for the same period in the prior year.  Procurement services gross margin decreased by 0.3% from 11.1% to 10.8%.  Furthermore, service and consulting gross margin decreased by 1.0% from 26.4% to 25.4%.  The operating loss increased by $1.3 million to $1.2 million and the net loss similarly increased by $777,000 to $812,000.

We discuss the results of each segment below.

Results of Operations -EIS

EIS serves departments of the U.S. government, Canadian government agencies, state and local governments, education markets and commercial companies.

The following discussion and analysis provides information that management believes is relevant to an assessment and understanding of our EIS Results of Operations for the three months ended May 31, 2011 and 2010.
 
 
23

 
 
EIS
STATEMENTS OF OPERATIONS
(In thousands)
 
 
   
Three Months Ended May 31,
             
   
2011
   
2010
   
Change
   
%
 
Revenues
                       
Procurement services
  $ 24,652     $ 39,536     $ (14,884 )     (37.6 )%
Service and consulting
    12,484     $ 6,255       6,229       99.6 %
Total Revenues
    37,136       45,791       (8,655 )     (18.9 )%
                                 
Cost of Sales
                               
Cost of procurement services
    21,980       35,140       (13,160 )     (37.5 )%
Cost of service and consulting
    8,495       3,915       4,580       117.0 %
Total Cost of Sales
    30,475       39,055       (8,580 )     (22.0 )%
                                 
Gross Profit
                               
Procurement services
    2,672       4,396       (1,724 )     (39.2 )%
Procurement services %
    10.8 %     11.1 %                
                                 
Service and consulting
    3,989       2,340       1,649       70.5 %
Service and consulting %
    32.0 %     37.4 %                
                                 
Total Gross Profit
    6,661       6,736       (75 )     (1.1 )%
Total Gross Profit %
    17.9 %     14.7 %                
                                 
Operating expenses:
                               
Selling, general, and administrative expenses
    6,943       5,876       1,067       18.2 %
Stock-based compensation
    144       118       26       22.0 %
Warrant liability adjustment