SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
COMMISSION FILE NUMBER: 0-19771
DATA SYSTEMS & SOFTWARE INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER)
DELAWARE 22-2786081
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
200 ROUTE 17, MAHWAH, NEW JERSEY 07430
(Address of principal executive offices) (Zip Code)
(201) 529-2026
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Registrant's telephone number, including area code
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
COMMON STOCK PURCHASE RIGHTS
(TITLE OF CLASS)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. / /
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes / / No / x /
The aggregate market value of the common stock held by non-affiliates of the registrant at March 29, 2004 was approximately $23.7 million. The aggregate market value was calculated by using the closing price of the stock on that date on the Nasdaq National Market.
Number of shares outstanding of the registrant's common stock, as of March 29, 2004: 7,902,025
DOCUMENTS INCORPORATED BY REFERENCE:
Certain sections of the registrant's Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 within 120 days of the end of the registrant's fiscal year are incorporated by reference into Part III of this Form 10-K.
TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business..................................................................................... 1
Item 2. Properties................................................................................... 10
Item 3. Legal Proceedings............................................................................ 10
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 10
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters........................ 11
Item 6. Selected Financial Data...................................................................... 11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................................................. 14
Item 7A. Quantitative and Qualitative Disclosures About Market Risk................................... 25
Item 8. Financial Statements and Supplementary Data.................................................. 25
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure...................................................................... 25
Item 9A. Controls and Procedures....................................................................... 26
PART III
Item 10. Directors and Executive Officers of the Registrant........................................... 27
Item 11. Executive Compensation....................................................................... 27
Item 12. Security Ownership of Certain Beneficial Owners
and Management............................................................................. 27
Item 13. Certain Relationships and Related Transactions............................................... 27
Item 14. Principal Accountant Fees and Services....................................................... 27
Part IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K............................. 28
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Certain statements contained in this report are forward-looking in nature. These statements can be identified by the use of forward-looking terminology such as "believes", "expects", "may", "will", "should" or "anticipates", or the negatives thereof, or comparable terminology, or by discussions of strategy. You are cautioned that our business and operations are subject to a variety of risks and uncertainties and, consequently, our actual results may materially differ from those projected by any forward-looking statements. Certain of such risks and uncertainties are discussed below under the heading "Item 1. Business-Factors That May Affect Future Results."
EASYBILL(TM) and ONCOPRO(TM) are trademarks of our Endan IT Solutions Ltd subsidiary. MAINGATE(R) is a registered trademark and POWERCAMP(TM) and SUPERSTAT(TM) are trademarks of our Comverge, Inc. investment.
PART I
ITEM 1. BUSINESS
OVERVIEW
We operate in three reportable segments: software consulting and development, energy intelligence solutions, and computer hardware. As we no longer have control over our formerly consolidated subsidiary Comverge Inc. (see Note 4 to the Consolidated Financial Statements), effective as of the second quarter of 2003, we account for our investment in Comverge by the equity method and no longer consolidate Comverge's balances and operating activity into our consolidated balance sheet and statement of operations.
o SOFTWARE CONSULTING AND DEVELOPMENT--Providing consulting and development services for computer software and systems, primarily through our dsIT subsidiary.
o ENERGY INTELLIGENCE SOLUTIONS--Developing and marketing load control, data communications and other energy intelligence solutions for electric utilities and their customers, through our Comverge investment.
o COMPUTER HARDWARE SALES--Serving as an authorized dealer and a value-added-reseller (VAR) of computer hardware, through our Databit subsidiary.
SALES BY ACTIVITY
The following table shows, for the years indicated, the dollar amount and the percentage of the sales attributable to each of the segments of our operations.
2001 2002 2003
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Amount % Amount % Amount %
------------------- ------------ ------ ------------ ------
Software consulting and development........................... $12,279 27 $14,202 25 $12,156 35
Energy intelligence solutions................................. 13,793 30 19,023 34 4,700 13
Computer hardware sales....................................... 19,794 43 22,605 41 18,139 52
Other......................................................... 58 -- 56 -- 39 --
------------------- ------------ ------ ------------ ------
Total Sales $45,924 100 $55,886 100 $35,034 100
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SOFTWARE CONSULTING AND DEVELOPMENT
SERVICES
Through dsIT Technologies Ltd. ("dsIT"), we provide computer software and systems consulting, development and integration services. dsIT is a systems and software house, with significant capabilities in a wide range of application areas, spanning military applications, security and public safety systems, telecom and datacom systems, and command and control principal systems. Our technological expertise includes state-of-the-art hardware with embedded real-time software systems in a wide variety of applications, primarily telecommunications, digital signal processing, image processing, software testing and validation, electronic warfare, simulation and electro-optics. In addition, we offer expertise and solutions products for billing, healthcare and other IT applications.
We provide our services either on a time-and-materials or fixed-price basis. When working on a time-and-materials basis, our engineers are generally sent to the customer's premises to perform design and development activities under the customer's direction. In these engagements, our personnel typically have no specific obligation for product delivery. During 2001, 2002 and 2003, sales attributable to services provided on a time-and-materials basis were $7.9 million, $10.3 million and $8.9 million, respectively, accounting for approximately 64%, 73% and 73% of segment sales for such years, respectively.
When working on a fixed-price basis, we undertake to deliver software or hardware/software solutions to a customer's specifications or requirements for a particular project, accounting for these services on the percentage-of-completion method. Since the profit margins on these projects are primarily determined by our success in controlling project costs, margins on these projects may vary substantially as a result of various factors, including underestimating costs, difficulties associated with implementing new technologies
and economic and other changes that may occur during the term of the contract. During 2001, 2002 and 2003, sales from fixed-price contracts were $4.4 million, $3.9 million and $3.2 million, respectively, accounting for approximately 36%, 27% and 27% of segment sales for such years, respectively. Included in our fixed price projects are sales and maintenance of our billing and healthcare proprietary software, totaling $0.6 million and $1.1 million, during 2002 and 2003, respectively.
CUSTOMERS AND MARKETS
Israel has historically been the primary area of this segment's operations, accounting for 88%, 95% and 98% of segment sales in 2001, 2002 and 2003, respectively. In the future, we expect virtually all of this segment's sales to continue to originate from Israel. We have created significant relationships with some of Israel's largest companies as well as its banking, healthcare and electronics industries, two of which account for 12% and 10% of segment sales in 2003. No other customer accounted for more than 10% of segment revenues.
COMPETITION
Our software consulting and development activity faces competition from numerous competitors, both large and small, operating in the Israeli and United States markets, some with substantially greater financial and marketing resources. We believe that our wide range of experience and long-term relationships with large corporations in Israel and the United States will enable us to compete successfully and obtain future business.
PROPRIETARY RIGHTS
We own two proprietary software packages: EASYBILL(TM), a comprehensive customer service and billing system aimed at the low to middle end application market; and ONCOPRO(TM), which manages hospital medical files and has advanced applications for oncology departments. The intellectual property rights resulting from our consulting and development services, are generally owned by the customer for whom the services are performed.
ENERGY INTELLIGENCE SOLUTIONS
OVERVIEW
Although we no longer have control over Comverge as of the second quarter of 2003, we continue to include Comverge's results in our financial statements by the equity method. Comverge continues to play a major role in our corporate strategy, and Comverge continues to have a material effect on our financial results.
Comverge designs, develops and markets a full spectrum of products, services and solutions to electric utilities and energy service companies and their residential and business customers that provide energy intelligence - the optimal transfer and usage of energy. Comverge's energy intelligence solutions bring to bear a combination of hardware development and manufacturing capabilities and a suite of software products which, together or separately, help investor-owned utilities, energy service companies and other providers of electricity, as well as their customers, address energy usage issues through load control, data communications and analysis, real-time pricing and integrated billing and reporting. Comverge's load control solutions allow its customers to reduce usage or "shed load" during peak usage periods, such as the summer air conditioning season, thereby reducing or eliminating the need to buy costly additional power on the spot market, or invest in new peaking generation capacity. This solution is both cost-effective and environmentally superior to building new generation capabilities. Comverge's two-way data communications solutions allow utilities to gather, transmit, verify and analyze real-time usage information, and can be used for automated meter reading, support time-of-use metering, theft detection, remote connect/disconnect and other value-added services.
In 2003, Comverge began two new initiatives. In March, Comverge began installation of its MainGate Home product for its largest customer, Gulf Power and then in June, Comverge signed a long term Virtual Peaking Capacity(TM) contract to provide significant peak load reduction to PacifiCorp, a subsidiary of ScottishPower.
HISTORY
Since 1992, we have been designing, developing and marketing two-way interactive communications solutions that provide real-time, remote automated meter reading and data management capabilities to utilities internationally. We developed state-of-the-art, high-speed, power line carrier technology and deployed pilot systems in Thailand, Taiwan, Venezuela, Argentina, Israel and Mexico.
In January 1998, Comverge acquired certain assets and licenses to intellectual property from Lucent Technologies' Utilities Solution business division. This licensed technology relates to a product which had been deployed by Lucent using a two-way cable TV system as well as an Internet-based wireless network. Comverge employs a number of the employees who were involved in developing this product.
In August 1999, Comverge purchased the assets and business of Scientific-Atlanta's Control Systems division, acquiring its load control and gateway product lines and hiring a number of employees from this division.
During 2003, Comverge completed private equity financing in the amount of $18.6 million and the finalization of terms for a new credit arrangement of $5 million with a leading financial institution. Included in the group of investors were Nth Power, EnerTech Capital Partners, Ridgewood Capital, E.ON Venture Partners, Shell Internet Ventures, Easton Hunt Capital Partners and Norsk Hydro Technology Ventures. In conjunction with the equity financing, Comverge acquired the fixed assets and iNET(TM) software platform from Sixth Dimension, Inc.
Comverge has an office in East Hanover, New Jersey from which its sales and marketing and PowerCAMP(TM) software groups operate aided by its iNET(TM) office in Newark, California. Comverge's administrative and engineering personnel and principal product manufacturing facility are located in Atlanta, Georgia. Comverge operates its installation program for Gulf Power from an office in Pensacola, Florida. Comverge also and maintains a small research and development center in Israel.
PRODUCTS AND SERVICES
Comverge offers data communications and load control product solutions that address the information and control needs of the global energy market through its power line technology and expertise it developed, combined with our strategic acquisitions of technology, personnel, contracts and customer base from Lucent, Scientific-Atlanta and Sixth Dimension. Comverge's technical expertise includes load control, broadband, wireless and powerline communications, as well as Internet and home networking and automation.
Comverge currently offers products and services in four product lines:
o Real-time usage information products;
o Load control products;
o Gateway products, which combine real-time information and control; and
o PowerCAMP(TM) Software products that allow utilities to conserve, analyze, monitor and price electric usage.
REAL-TIME USAGE INFORMATION PRODUCTS. Comverge markets the MainGate C&I, which is a meter-reading device for gathering and transmitting real-time usage information and providing distributed generation monitoring and control for commercial and industrial customers. The MainGate C&I uses Internet-based CDMA communications to transmit detailed information regarding patterns of energy consumption and is targeted at industrial and commercial customers, an important segment of the user market for energy companies. The use of CDMA for data communication makes our product easier to install and less expensive to run than products that require a dedicated telephone line. Comverge's alliances with Verizon Wireless, AT&T Wireless and GTE give us a national platform from which to market this product.
LOAD CONTROL PRODUCTS. Power distribution companies use load control products to reduce peak electrical demand, avoiding the need to buy costly electricity on the spot market or to build new generation facilities. Generators and energy marketers can use load control products to free capacity during high cost periods for resale to others. Comverge offers its customers two major load control products: digital control units, also known as DCUs, and SuperStats(TM). The DCU is a switch that can be connected to any appliance, such as an air conditioner or water heater, and that permits the user to turn appliances on and off from a remote location utilizing wireless communications. Comverge's SuperStat(TM) product combines a programmable thermostat with a wireless communication module to provide cooling systems direct load control, allowing customers to choose when and how much energy to use, while giving the utility the ability to control air conditioning systems through the thermostat during peak usage periods.
GATEWAY PRODUCTS. Maingate(TM), Comverge's gateway product, is a system designed around a communications "gateway," or bridge, which permits two-way real-time communications between a local area network (LAN) (such as a "network" of appliances and other devices within a home or a network of meters at multiple users) and a wide area network (WAN) (such as cable, telephone or CDPD). Maingate provides information and load control functionality to both the electricity provider and its customers and can significantly reduce the customer's electricity bills. When fully integrated with Comverge's PowerCAMP(TM) software, Maingate(TM) provides our customers with a comprehensive solution for their diverse energy management requirements.
Maingate(TM) provides two-way real time metering, time-of-use pricing, load control and whole house surge suppression for residential users. In the typical configuration, the central air conditioning system, controlled by a SuperStat(TM) thermostat, the water heater and up to one additional appliance within the home, are fitted with power line communication ("PLC") based load control devices. The load control devices and the SuperStat(TM) are networked, and linked via the Maingate gateway to the WAN. Maingate allows the customer to automatically respond to energy price variations to minimize their usage during high priced periods. Rollout of Maingate Home is being deployed for Florida's Gulf Power under a contract that provides for the installation of Maingate into 40,000 homes.
POWERCAMP(TM) SOFTWARE PRODUCTS. PowerCAMP(TM) is an extensive suite of software developed by our engineers and deployed in several countries. The software used in PowerCAMP(TM) has been subject to extensive field-testing and customer interaction and has been the backbone for monitoring and analyzing utility meter reading and load management programs using Comverge products. Comverge has taken this software and packaged and modularized it as a suite of stand-alone software editions for utilities and their residential, commercial and industrial customers. PowerCAMP(TM) can also serve those customers through a web-based Application Service Provider, or ASP, model. With the acquisition of the iNET(TM) software platform, Comverge has added technology for upstream monitoring and control of capital assets by offering comprehensive monitoring and control of power generation and substation assets.
CUSTOMERS AND MARKETS
Our energy intelligence solutions business has over 500 customers in eight countries and we have an installed base of approximately 5,000,000 end-point installations worldwide. The global market for energy intelligence solutions is immature and still emerging. Reliable information as to the current size of the market we serve or its rate of growth is not readily available. The anticipated growth in Comverge's market will be driven by the following factors:
o Increasing worldwide demand for electricity and volatility of electricity prices;
o Anticipated market and regulatory incentives to manage peak usage periods in an economically efficient and environmentally friendly manner; and
o Continued deregulation of the electric utility industry in the United States and resulting increased competition among electric service companies.
Although the effects of the current trend toward deregulation in the United States and overseas are not certain, we anticipate that the new, more competitive environment, combined with expected government incentives and mandates, will result in continued growth in the demand for products designed to gather information and manage electricity usage.
Comverge's customers are generally domestic electric utilities, electric service companies or prime contractors that serve electric utilities. Comverge's largest customer is Florida's Gulf Power, which purchased approximately $3 million in products and services in 2003. Comverge has demonstrated that its CDC and SuperStat(TM) products generally work well in small-scale deployments, and as its track record grows, Comverge expects to expand its sales to its existing customers to full-scale deployments. In addition to expanding relationships with existing customers, Comverge's strategy is to take advantage of the relationships with these customers to extend its sales to their affiliates, many of whom are owned by large utility holding companies with several owned utilities. Comverge's has also formed joint marketing partnerships with Verizon Wireless, Schlumberger and Honeywell, and continues to plan to expand on these relationships. In September, Comverge signed a five-year agreement with Landis+Gyr, a leading meter manufacturer, to jointly market and develop commercial and industrial metering solutions.
COMPETITION
Within the emerging energy intelligence solutions market, we face competition from a variety of companies and products, each of which is trying to garner a larger market share. Key competitors include Itron, ABB, Schlumberger and Mainstreet Networks with respect to Comverge's gateway products, CEPG with respect to Comverge's commercial and industrial AMR products, and Cannon Technologies and Itron with respect to Comerge's load control products. In addition to these companies, there are many other competitors and potential competitors vying for a portion of this as yet undefined market. Comverge believes that its products offer significant competitive advantages because they:
o have been proven in the field;
o offer significant technological advantages over competing products; and/or
o cost less than many of our competitors' products.
However, some of our competitors have more resources, better market recognition, a larger sales force or can offer features not offered by our products. In addition, certain of our competitors manufacture and sell electric meters or back-end billing or other software systems to utilities, possibly providing them an advantage in marketing their utility solution products. We cannot be certain that our products will win market acceptance or that we will be able to capture a significant segment of the market.
PROPRIETARY RIGHTS
Comverge holds 12 patents and has 13 patents pending. Comverge attempts to vigorously protect all of its proprietary rights. Certain products that Comverge has developed and is developing incorporate or are derived from intellectual property owned by third parties under license to Comverge.
In Comverge's product development activities, Comverge relies on a combination of nondisclosure agreements and technical measures to establish and protect its proprietary rights, if any, in its products. Comverge believes that as a result of the rapid pace of technological change in the software and real-time system industries, legal protection for its products, if any, will be less significant to its prospects than the knowledge, ability and expertise of its management and technical personnel.
COMPUTER HARDWARE SALES
PRODUCTS AND SERVICES
Through our Databit subsidiary, we sell and service PC-based computer hardware, software, data storage, client/server and networking solutions principally in the greater New York City metropolitan area. Databit is a value-added-reseller and an authorized service provider for equipment and software from such well-known industry leaders as Compaq, IBM, Microsoft, Oracle, 3Com, Compaq/Hewlett-Packard, NEC, Acer, Apple and Dell. We offer our customers a full range of systems integration services, including design, implementation, hardware and software selection, and implementation of local and wide area networks. In addition, we provide maintenance and service to customers under extended service agreements. Our equipment and software sales and other services are offered under separately negotiated and priced agreements.
CUSTOMERS AND MARKETS
Computer hardware segment sales include sales to two major customers, Montefiore Medical Center, which accounted for approximately 25%, 22% and 28% of segment sales in 2001, 2002 and 2003, respectively, and a large law firm, which accounted for approximately 21% in 2002. Another law firm customer accounted for 12% of segment sales in 2001. No other customer accounted for more than 10% of segment sales. We reduced our dependence on the New York metro market, which accounted for 71% and 70% of segment revenues in 2003 and 2002, respectively, compared 84% in 2001.
COMPETITION
The market for PCs and related peripheral hardware sales in which we operate is characterized by severe competition in price-performance, breadth of product line, financing capabilities, technical expertise, service and overall reputation. Manufacturers have been increasing their direct sales efforts on the Internet and otherwise, reducing prices to end-users, which reduces profit margins for distributors and value-added-resellers such as Databit. Our competitors include manufacturers, other VAR's, large equipment aggregators (some of whom sell to us) and systems integrators. Many of our competitors have longer operating histories, greater financial resources and buying power and larger, established customer bases. We compete by offering attractive prices and flexible payment terms, and by helping our customers evaluate their needs and tailoring solutions by offering other value-added services such as configuration and on-site service.
BACKLOG
As of December 31, 2003, our backlog of work to be completed was $3.2 million, $3.1 million of which related to our software consulting and development segment (of which $2.2 million is related to our contracts with Clalit Health Services). We estimate that we will perform approximately $1.8 million of our backlog work in 2004.
EMPLOYEES
At December 31, 2003, we employed a total of 210 people, including 160 persons in engineering and technical support, 16 in marketing and sales, and 30 in management, administration and finance. A total of 183 of our employees are based in Israel. We consider our relationship with our employees to be satisfactory.
We have no collective bargaining agreements with any of our employees. However, with regard to our Israeli activities, certain provisions of the collective bargaining agreements between the Israeli Histadrut (General Federation of Labor in Israel) and the Israeli Coordination Bureau of Economic Organizations (including the Industrialists Association) are applicable by order of the Israeli Ministry of Labor. These provisions mainly concern the length of the workday, contributions to a pension fund, insurance for work-related accidents, procedures for dismissing employees, determination of severance pay and other conditions of employment. We generally provide our Israeli employees with benefits and working conditions beyond the required minimums. Israeli law generally requires severance pay upon the retirement or death of an employee or termination of employment without due cause. Furthermore, Israeli employees and employers are required to pay specified amounts to the National Insurance Institute, which administers Israel's social security programs. The payments to the National Insurance Institute include health tax and are approximately 17% of wages (up to a specified amount), of which the employee contributes approximately 60% and the employer approximately 40%.
SEGMENT INFORMATION
For additional financial information regarding our operating segments, foreign and domestic operations and sales, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 17 to our Consolidated Financial Statements included in this Annual Report.
FACTORS WHICH MAY AFFECT FUTURE RESULTS
We may from time to time make written or oral statements that contain forward-looking information. However, our actual results may differ materially from our expectations, statements or projections. The
following risks and uncertainties could cause actual results to differ from our expectations, statements or projections.
GENERAL FACTORS
WE HAVE A HISTORY OF OPERATING LOSSES AND DECREASING CASH AVAILABLE FOR OPERATIONS.
We have in the past, and continue to experience operating losses, although they have been decreasing over the years. In 2001, 2002 and 2003, we had operating losses of $10.4 million, $8.2 million and $3.6 million, respectively. Cash used in operations in 2001, 2002 and 2003 was $8.7 million, $6.2 million and $1.0 million, respectively.
Our Comverge investment was the primary source of operating losses, which amounted to losses of approximately $6.4 million, $2.2 million and $1.1 million in 2001, 2002, and 2003 (results consolidated in the first quarter of 2003), respectively. Of our net cash used in operating activities in 2003, approximately $0.3 million was used in the energy intelligence solutions segment, $0.6 million was provided by our Israeli software consulting and development segment operations, $0.3 million was provided by our computer hardware segment and $1.6 million was used by our corporate and other U.S. activities. As described under the caption "Recent Developments" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," throughout 2003, Comverge successfully completed private equity financing and new credit arrangements which should provide sufficient financing for Comverge to independently fund its activities.
We believe that as a result of Comverge's obtaining independent financing, the release of previously restricted cash and anticipated improvement in operating results in 2004 in our other U.S. and Israeli operating activities, we currently have sufficient liquidity to fund all our activities for at least the next 12 months. For additional discussion of our liquidity position and factors that may affect our future liquidity, see the discussion under the captions "Recent Developments" and "Liquidity and Capital resources" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
LOSS OF THE SERVICES OF A FEW KEY EMPLOYEES COULD HARM OUR OPERATIONS.
We depend on our key management and technical employees. The loss of certain managers could diminish our ability to develop and maintain relationships with customers and potential customers. The loss of certain technical personnel could harm our ability to meet development and implementation schedules. Most of our significant employees are bound by confidentiality and non-competition agreements. We do not maintain a "key man" life insurance policy on any of our executives or employees. Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. If we fail to attract or retain highly qualified technical and managerial personnel in the future, our business could be disrupted.
RISKS RELATED TO THE SOFTWARE CONSULTING AND DEVELOPMENT SEGMENT
FAILURE TO ACCURATELY FORECAST COSTS OF FIXED-PRICED CONTRACTS COULD REDUCE OUR MARGINS.
When working on a fixed-price basis, we undertake to deliver software or integrated hardware/software solutions to a customer's specifications or requirements for a particular project. The profits from these projects are primarily determined by our success in correctly estimating and thereafter controlling project costs. Costs may in fact vary substantially as a result of various factors, including underestimating costs, difficulties with new technologies and economic and other changes that may occur during the term of the contract. If, for any reason, our costs are substantially higher than expected, we may incur losses on fixed-price contracts.
HOSTILITIES IN THE MIDDLE EAST REGION MAY FURTHER DEEPEN THE WEAKNESS IN THE ISRAELI HI-TECH MARKET AND MAY HARM OUR ISRAELI OPERATIONS; OUR ISRAELI OPERATIONS MAY BE NEGATIVELY AFFECTED BY THE OBLIGATIONS OF OUR PERSONNEL TO PERFORM MILITARY SERVICE.
A substantial part of our software consulting and development services segment is conducted in Israel. Accordingly, political, economic and military conditions in Israel may directly affect this segment of our business. Over the past three years, the Israeli hi-tech market has experienced a significant downturn, particularly in the software consulting and development market. This weakness has been prolonged by the
increase in unrest, terrorist activity and military action in and around Israel, which began in September 2000 and which has continued with varying levels of intensity into 2004. Any increase in hostilities in the Middle East involving Israel could further weaken the Israeli hi-tech market, which may result in a significant deterioration of the results of our Israeli operations. In addition, an increase in hostilities in Israel could cause serious disruption to our Israeli operations if acts associated with such hostilities result in any serious damage to our offices or those of our customers or harm to our personnel.
Many of our employees in Israel are obligated to perform military reserve duty. In the event of severe unrest or other conflict, individuals could be required to serve in the military for extended periods of time. Over the past two years, there have been numerous call-ups of military reservists to active duty, and it is possible that there will be additional call-ups in the future.
Our Israeli operations could be disrupted by the absence for a significant period of time of one or more of our key employees or a significant number of our other employees due to military service. Such disruption could harm our Israeli operations.
EXCHANGE RATE FLUCTUATIONS COULD INCREASE THE COST OF OUR ISRAELI OPERATIONS.
Most of the sales in this segment stem from our Israeli operations and a significant portion of those sales are in New Israeli Shekels ("NIS") linked to the dollar. Such transactions are negotiated in dollars; however, for the convenience of the customer, they are settled in NIS. The dollar value of the revenues of our operations in Israel will decrease if the dollar is devalued in relation to the NIS during the period from the invoicing of a transaction to its settlement. In addition, significant portions of our expenses in those operations are in NIS, so that if the dollar is devalued in relation to the NIS, the dollar value of these expenses will increase.
FINANCIAL VIABILITY OF CLALIT HEALTH FUND.
In 2003, 12% of the software consulting and development segment's sales and 14% of its receivables at December 31, 2003 were related to the Clalit Health Fund. The Clalit Health Fund is the largest HMO in Israel and one of the largest in the world. The fund has a history of running at a deficit, which in the past has required numerous cost cutting plans and periodic assistance from the Israeli government. Should the fund have to institute additional cost cutting measures in the future, which may include restructuring of its terms of payment, this could have a material adverse effect on the performance of this segment.
RISKS RELATED TO THE ENERGY INTELLIGENCE SOLUTIONS SEGMENT
Although we no longer control Comverge and the business in our energy intelligence solutions segment, we have made a significant investment in this segment and it continues to have a material effect on our consolidated results. Comverge revenues have fluctuated significantly from quarter to quarter and Comverge continuously operates at a loss. The activities of this segment are subject to many risks, including the following:
THE MARKET FOR OUR ENERGY INTELLIGENCE SOLUTIONS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE; IF WE FAIL TO KEEP PACE, WE WILL HAVE DIFFICULTY DEVELOPING AND MAINTAINING A MARKET FOR OUR PRODUCTS AND SERVICES.
The market for our energy intelligence solutions segment is characterized by rapid technological change. Communications and networking technologies are continuously changing and we will need to invest in continued product development, both hardware and software, in order to keep pace with these changing technologies. Although Comverge has been successful in raising significant financing, over the long term, Comverge may not have adequate resources to invest in development and accordingly, its development efforts may not be successful.
THE PACE OF UTILITY DEREGULATION HAS BEEN SLOW; THE ULTIMATE REGULATORY STRUCTURE OF THE UTILITY INDUSTRY MAY NOT PROVIDE MANDATES OR INCENTIVES TO PURCHASE OUR PRODUCTS.
The electric utility industry is undergoing significant deregulation. The pace of deregulation appears to have slowed due to the uncertainty about deregulation in the wake of the energy crisis in California in 2000 and the Enron reorganization. Market observers expect deregulation to include energy choice and time-of-use pricing requirements, which will mandate, or favor implementation by utilities of, load control programs and the use of automated meter reading and data distribution. However, the pace of deregulation
has not been as rapid as expected and to date only a limited number of utilities have made purchase commitments for automated meter reading and data distribution systems. Many utilities have also deferred the purchase of load control systems, pending resolution of broader industry and regulatory developments. The results of deregulation are uncertain and may not result in the mandates or incentives for the types of services which require AMR systems. If state and federal regulation does not provide these requirements or incentives, the market for our products may not develop as we expect.
WE MUST COMPETE WITH OTHER UTILITY SOLUTION PROVIDERS FOR MARKET ACCEPTANCE AND CUSTOMERS.
While we believe that the systems offered by our energy intelligence solutions segment offer advantages over competing load control and data communications solutions, there are alternative solutions, and we cannot predict what share of the market we will obtain. In addition, some of our competitors have more sales and marketing resources, better brand recognition and/or technologies that offer alternative advantages. If our potential customers do not adopt our solutions or do so less rapidly than we expect, our future financial results and our ability to achieve positive cash flow or profitability will be harmed.
WE MAY ENCOUNTER DIFFICULTIES IN IMPLEMENTING OUR TECHNOLOGY, PRODUCTS AND SERVICES.
Problems may occur in the implementation of our technology, products or services, and we may not successfully complete the commercial implementation of our technology on a wide scale. Future advances may render our technology obsolete or less cost effective than competitive systems. Consequently, we may be unable to offer competitive services or offer appropriate new technologies on a timely basis or on satisfactory terms.
DELAYS, QUALITY CONTROL AND PRICE PROBLEMS COULD ARISE DUE TO OUR RELIANCE ON THIRD-PARTY MANUFACTURERS OF CERTAIN COMPONENTS.
We use a limited number of outside parties to manufacture components of some of our products. Our reliance on third party manufacturers exposes us to risks relating to timeliness, quality control and pricing. We have experienced certain delays and quality control problems from third-party manufacturers in the past and we may experience such problems with our current manufacturers. Implementing these new product offerings could cause some transitional delays and the diversification could have a negative impact on price and quality control. Such delays, price increases and/or quality control problems at our third-party manufacturers could harm our relationships with our customers, our operating results and cash flow.
RISKS RELATED TO THE COMPUTER HARDWARE SEGMENT
WE FACE LOW MARGIN, MASS MARKETING COMPETITION.
The market for PCs and related peripheral hardware sales in which we operate is characterized by severe competition in price-performance and financing capabilities. Manufacturers and on-line Internet vendors have been increasing their direct sales efforts on the Internet and otherwise, reducing prices to end-users, which reduce profit margins for distributors and value added resellers such as our Databit subsidiary. Should this trend continue, it could make our method of sales uneconomical and bring into question the long-term viability of the business model used by Databit.
A LARGE PORTION OF OUR SALES ARE CONCENTRATED IN THE GREATER NEW YORK CITY METROPOLITAN AREA.
Computer hardware sales to the greater New York City metropolitan area represented 84%, 70% and 71% of the total segment sales for the years ended December 31, 2001, 2002 and 2003, respectively. Furthermore, most of the sales force for the segment is based in Manhattan and northern New Jersey. The decrease in percentage of sales centered in the New York City metropolitan area is partially attributable to the sales office we opened on the West Coast, which we enhanced in 2003. There can be no assurance business will continue to grow outside the New York City metropolitan area, and if the region suffers from an economic downturn similar to that of 2001, our operating results could be materially adversely affected.
ITEM 2. PROPERTIES
Our corporate headquarters and the principal offices for our U.S. software consulting and development and hardware sales segments are located in Mahwah, New Jersey in approximately 5,000 square feet of office space, at a rate of $85,000 per annum, under a lease that expired in September 2003, although we continue to rent these premises on a month-to-month basis. We also rent offices of approximately 4,600 square feet in New York City, at a current rate of $185,000 per annum, under a lease which expires in October 2005. Our West Coast sales office for our hardware sales segment consists of 500 square feet located in Los Angeles, California at a rate of $11,000 per annum, under a lease that expires in March 2004. We also lease a 600 square foot sales office in southern New Jersey at a current rent of $8,000 per annum.
Our Israeli activities are conducted in approximately 18,000 square feet of office space in the Tel Aviv metropolitan area under a lease that expires in August 2009. The annual rent is approximately $289,000. These facilities are used for the Israeli operations of the software consulting and development segment and the energy intelligence solutions segment. In addition, as part of our acquisition of Endan, we acquired Endan's leased office space located in the Tel Aviv metropolitan area and are subleasing this space. The leases expire in October 2004 and the annual net rent expense is approximately $19,000.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On December 8, 2003, we conducted our annual meeting of stockholders. At this meeting, the stockholders elected the following persons to serve as our directors: George Morgenstern, Shane Yurman, Avi Kerbs and Elihu Levine. The stockholders did not vote on any other matters.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our Common Stock is currently traded on the Nasdaq SmallCap Market under the symbol "DSSCE". Prior to March 3, 2003, our Common Stock traded on the Nasdaq National Market System (NASDAQ/NNM). The following table sets forth, for the periods indicated, the high and low reported sales prices per share of our Common Stock on both the Nasdaq SmallCap Market and the Nasdaq National Market System.
High Low
------- -------
2002:
First Quarter............................... $5.62 $3.83
Second Quarter.............................. 3.96 2.74
Third Quarter............................... 3.04 1.04
Fourth Quarter.............................. 1.93 0.84
2003:
First Quarter............................... $2.79 $0.91
Second Quarter.............................. 2.79 1.80
Third Quarter............................... 3.39 2.25
Fourth Quarter.............................. 3.45 2.45
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As of March 23, 2004, the last reported sales price of our common stock on the Nasdaq SmallCap Market was $23.7, there were 81 record holders of our common stock and we estimate that there were 1,456 beneficial owners of our common stock.
We paid no dividends in 2002 or 2003 and we presently do not intend to pay any dividends in 2004.
The following table provides information about our equity compensation plans as of December 31, 2003, including both stockholder approved plans and non-stockholder approved plans. The section entitled "Compensation of Directors" in our proxy statement for the annual meeting of stockholders held on December 8, 2003 contains a summary explanation of the Non-Employee Director's Stock Option Plan, which has been adopted without the approval of stockholders, and is incorporated herein by reference.
NUMBER OF SECURITIES
REMAINING AVAILABLE FOR
NUMBER OF SECURITIES TO WEIGHTED-AVERAGE FUTURE ISSUANCE UNDER
BE ISSUED UPON EXERCISE PRICE OF EQUITY COMPENSATION
EXERCISE OF OUTSTANDING PLANS (EXCLUDING
OUTSTANDING OPTIONS, OPTIONS, WARRANTS SECURITIES REFLECTED IN
WARRANTS AND RIGHTS AND RIGHTS COLUMN (a))
(a) (b) (c)
PLAN CATEGORY -------------------------------------------------------------------
Equity Compensation Plans Approved by Security Holders 817,750 $5.32 2,421,325
Equity Compensation Plans Not Approved by Security Holders 488,301 $4.00 929,616
------- ----- ---------
Total 1,308,051 $4.83 3,350,941
========= ===== =========
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ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated statement of operations data for the years ended December 31, 2001, 2002 and 2003 and consolidated balance sheet data as of December 31, 2002 and 2003 have been derived from our audited Consolidated Financial Statements included in this Annual Report. The selected consolidated statement of operations data for the years ended December 31, 1999 and 2000 and the consolidated balance sheet data as of December 31, 1999, 2000 and 2001 have been derived from our audited Consolidated Financial Statements not included herein.
This data should be read in conjunction with our Consolidated Financial Statements and related notes and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
SELECTED CONSOLIDATED STATEMENT OF OPERATIONS DATA
For the Years Ended December 31,
---------------------------------
1999 2000 2001 2002 2003
---------------------- -------- -------- --------
(in thousands, except per share data)
Sales $ 39,708 $ 57,839 $ 45,924 $ 55,886 $ 35,034
Cost of sales ........................................... 31,615 45,606 37,612 42,971 27,976
-------- -------- -------- -------- --------
Gross profit ............................................ 8,093 12,233 8,312 12,915 7,058
Research and development expenses ............................ 1,269 928 2,284 1,526 153
Selling, general and administrative expenses ................. 12,471 16,340 16,617 16,689 10,498
Impairment of goodwill and investment ........................ -- -- 227 2,850 --
Gain on sale of subsidiary/division .......................... -- 1,144 397 -- --
-------- -------- -------- -------- --------
Operating loss .......................................... (5,647) (3,891) (10,419) (8,150) (3,593)
Interest income .............................................. 61 1,758 1,104 253 61
Interest expense ............................................. (910) (709) (459) (1,212) (788)
Loss on early redemption of debt ............................. -- (943) -- -- --
Other income (loss), net ..................................... (306) (50) (32) 113 (475)
-------- -------- -------- -------- --------
Loss from operations before taxes on income .............. (6,802) (3,835) (9,806) (8,996) (4,795)
Taxes on income .............................................. 62 171 (11) 28 (1)
-------- -------- -------- -------- --------
Loss from operations of the Company and its ............. (6,864) (4,006) (9,795) (9,024) (4,794)
consolidated subsidiaries
Share of losses in Comverge .................................. -- -- -- -- (1,752)
Minority interests, net of tax ............................... (275) -- -- 880 264
-------- -------- -------- -------- --------
Loss from continuing operations ......................... (7,139) .(4,006) (9,795) (8,144) (6,282)
Loss from discontinued operations, net of income taxes ....... (8,728) (104) -- -- --
Gain on sale of discontinued operations, net of income
taxes ...................................................... -- 4,222 -- -- --
-------- -------- -------- -------- --------
Net income (loss) ........................................ $(15,867) $ 112 $ (9,795) $ (8,144) $ (6,282)
======== ======== ======== ======== ========
Basic and diluted net income (loss) per share:
Loss from continuing operations ...................... $ (0.96) $ (0.54) $ (1.41) $ (1.11) $ (0.81)
Discontinued operations ................................... (1.17) 0.56 -- -- --
-------- -------- -------- -------- --------
Net income (loss) per share (basic and diluted) ......... $ (2.13) $ 0.02 $ (1.41) $ (1.11) $ (0.81)
======== ======== ======== ======== ========
Weighted average number of shares
outstanding - basic and diluted ................ 7,433 7,422 6,970 7,349 7,738
======== ======== ======== ======== ========
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SELECTED CONSOLIDATED BALANCE SHEET DATA:
As of December 31,
------------------
1999 2000 2001 2002 2003
------------------------- ------- ------- -------
(in thousands)
Working capital ............................... $20,030 $18,178 $ 6,809 $ 2,845 $ 729
Total assets .................................. 50,458 42,157 39,244 3,347 17,674
Short-term and long-term ...................... 9,007 6,606 8,681 10,033 2,149
debt
Minority interests ............................ 10 40 2,530 1,609 1,367
Total shareholders' equity .................... 24,850 22,581 14,362 7,128 3,200
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(1) Results for 1999 include the gain on the sale of our help desk segment. See Notes 3 and 4 to the Consolidated Financial Statements included in this Annual Report for a description of our various acquisitions and dispositions of business operations and segments during the period from 2001 to 2003.
(2) Effective July 1, 2002, we adopted Statement of Financial Standards (SFAS) No. 141, "Business Combinations" and effective January 1, 2002, adopted SFAS No. 142, "Goodwill and Other Intangibles". As a result, we have ceased amortization of all goodwill beginning January 1, 2002. Had SFAS No. 142 been adopted by us effective January 1, 2001, net loss and net loss per share, basic and diluted, would have been as follows (in thousands, except per share data):
Year ended
December 31,
2001
------------
Net loss as reported ...................................... $(9,795)
Plus: Goodwill amortization, net of income taxes .......... 502
------------
Adjusted net loss ......................................... $(9,293)
============
Net loss per share:
Basic and diluted - as reported ........................ $(1.41)
============
Basic and diluted - as adjusted ........................ $(1.33)
============
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW AND TREND INFORMATION
The following discussion includes statements that are forward-looking in nature. Whether such statements ultimately prove to be accurate depends upon a variety of factors that may affect our business and operations. Certain of these factors are discussed in "Item 1. Description of Business-Factors That May Influence Future Results."
We operate in three reportable segments: software consulting and development, energy intelligence solutions, and computer hardware. As we no longer have control over our formerly consolidated subsidiary Comverge (see Note 4 to the Consolidated Financial Statements), effective as of the second quarter of 2003, we account for our investment in Comverge by the equity method and no longer consolidate Comverge's balances and operating activity into our consolidated balance sheet and statement of operations. The following analysis should be read together with the segment information provided in Note 17 to our Consolidated Financial Statements included in this report.
SOFTWARE CONSULTING AND DEVELOPMENT
Segment revenues decreased in 2003 compared to 2002, causing continuing losses despite the significant cost cutting measures instituted during the past two years. The decrease resulted primarily from the continued general weakness in the global hi-tech markets and in the software consulting and development market in particular. We currently expect segment revenues to increase in 2004; this increase, coupled with the improved cost structure achieved, lead us to believe that this segment will return to profitability in 2004.
Beginning in the fourth quarter of 2003, we started recognizing revenues from the contract signed with Clalit Health Services, Israel's largest HMO and one of the largest HMOs in the world, which awarded our dsIT subsidiary, together with Yael Software, a $4 million contract, of which dsIT's portion is approximately 50%. The contract includes the development and implementation of a new Customer Care and Billing system, based entirely on dsIT's e-asyBillTM billing system. The system, to be implemented over a one-year period with a seven-year maintenance contract, is expected to generate revenues in the years 2004 through 2011. In the future, we expect that this product, as well as our OncoProTM product and sonar technology systems, will have increased impact on our results of operations.
In addition, the consulting market seems to be stabilizing and even showing certain signs of growth that leave us optimistic regarding revenues from this activity in 2004.
Finally, dsIT has been successful in bidding (together with Databit from our Computer Hardware segment) for certain Israeli Ministry of Defense (MoD) contracts and we expect this cooperation to produce increased revenues in the future.
ENERGY INTELLIGENCE SOLUTIONS
During 2003, Comverge signed and closed on agreements (see Note 4 to our Consolidated Financial Statements) for private equity financing totaling $18.7 million. We invested $3.35 million in these financings, and $15.35 million was invested by a group of leading energy venture capital investors, in exchange for Series A Convertible Preferred Stock of Comverge.
Comverge's operating results for the period from January 1, 2003 to March 31, 2003 have been consolidated and are included in our consolidated statements of operations. Our share of Comverge's operating results for the period from April 1, 2003 to December 31, 2003 (effective April 1, 2003) is reflected in "Share of losses in Comverge" in our consolidated statements of operations.
In 2003, Comverge saw a decrease in the market for its DCU and Superstat families of products, causing a general decrease in sales. In addition, in 2003 Comverge devoted significant attention to the capital raising process mentioned above. However, during this period, Comverge signed its first two major, long-term Virtual Peaking CapacityTM contracts to provide significant peak load reduction to PacifiCorp, a subsidiary of Scottish Power, and to San Diego Gas and Electric, a subsidiary of Sampora Energy. Although little revenue was recognized with respect to these contracts in 2003, we expect them to have a positive effect on revenues in future periods. Comverge signed a 10-year contract extension modifying the contract with
Gulf Power for Price Responsive Load Management. Although this modification is expected to bring the contract's total revenues to an excess of $50 million, it will reduce revenues from this contract in the short term. However, it is not expected to negatively impact overall operating results of Comverge. Over the longer term, the contract modification is expected to improve this project's profitability, due to product improvements and reductions in component costs.
COMPUTER HARDWARE
Sales in 2003 were lower than sales in 2002, primarily due to the extraordinarily high amount of sales in the fourth quarter of 2002. We currently expect to maintain average sales in 2004 at a level similar to that of the fourth quarter of 2003, by further expanding our new offices in southern New Jersey and on the West Coast. In addition, to offset the weakness in the hardware resale market, we are attempting to diversify our revenue base and have initiated efforts toward alternatives adding more value added software products and services. These activities, together with continuing joint marketing efforts with dsIT for Israeli Ministry of Defense projects, are intended to reduce Databit's dependency on the computer hardware markets in the future.
CORPORATE
Comverge has been successful in raising approximately $18.6 million and establishing bank credit lines of $5 million, so that although we no longer have control over Comverge activities, we do not need to further fund Comverge operations. George Morgenstern, our Chairman and Chief Executive Officer, has retired from full-time employment, initiating his consulting contract as of January 1, 2004, and has agreed to make himself available to fill other appropriate positions the Board may desire. In light of our reduced involvement with Comverge, the independent management in place at our dsIT and Databit subsidiaries and our CEO's semi-retirement, we continue to evaluate our corporate activities and structure. This evaluation includes exploration of restructuring, acquisitions or mergers and/or other strategic alternatives. To assist us in this effort, we have retained Foresight, a strategic and financial consulting and research firm, to perform a valuation of our subsidiaries and Comverge, as well as perform other analysis to be utilized by our Board of Directors in its exploration of possible strategic alternatives. We expect to continue this process and complete it within the next few months.
CRITICAL ACCOUNTING POLICIES
The Securities and Exchange Commission ("SEC") defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.
The following discussion of critical accounting policies represents our attempt to report on those accounting policies which we believe are critical to our consolidated financial statements and other financial disclosure. It is not intended to be a comprehensive list of all of our significant accounting policies, which are more fully described in Note 2 of the Notes to the Consolidated Financial Statements included in this Annual Report. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management's judgment in their application. There are also areas in which the selection of an available alternative policy would not produce a materially different result.
We have identified the following as critical accounting policies affecting our company: principles of consolidation and investments in associated companies, revenue recognition; foreign currency transactions; inventory; income taxes; and goodwill and other long-lived assets.
PRINCIPLES OF CONSOLIDATION AND INVESTMENTS IN ASSOCIATED COMPANIES
Our consolidated financial statements include the accounts of all majority-owned subsidiaries. All intercompany balances and transactions have been eliminated. Minority interests in net losses are limited to the extent of their equity capital. Losses in excess of minority interest equity capital are charged against us in our consolidated statements of operations. Investments in associated companies are accounted for by the equity method.
In April 2003, we, together with our then consolidated subsidiary, Comverge, signed and closed on a definitive agreement with a syndicate of venture capital firms raising an aggregate of $13,000 in capital funding. We purchased $3,250 of Series A Convertible Preferred Stock issued by Comverge in the equity financing and incurred transaction costs of an additional $294. In December 2003, we invested an additional $100 in Series A-2 Convertible Preferred Stock. A syndicate of venture capital firms purchased $7,750 of Series A Convertible Preferred Stock issued by Comverge, and one member of the syndicate also purchased $2,000 of Series A-1 Convertible Preferred Stock of Comverge. In connection with the transaction, we also converted to equity intercompany balances of $9,673. As a result of Comverge securing its equity investments, we no longer control Comverge's activity and we are no longer required to nor have any intention to fund Comverge's activity.
In connection with Comverge's April equity financing transactions, Comverge acquired Sixth Dimension, Inc. in a purchase business combination, valued at approximately $510, in exchange for 877,000 of Comverge's common shares. In connection with this transaction, as a result of our dilution and the new valuation of Comverge's common stock, we recorded an increase of $1,085 to our common stock investment in Comverge. The adjustment was recorded to additional-paid-in-capital.
Following Comverge's first equity transaction of the year, we held approximately 50.6% of the outstanding capital voting stock of Comverge (approximately 76% of Comverge's common stock and approximately 26% of Comverge's Preferred Stock). As a result of the transaction, we are no longer obligated to fund Comverge. Additionally, as a result of the April equity transactions, we have a negative investment balance in Comverge's common stock of $1,824. Due to our commitment to no longer fund Comverge, we have ceased to record equity losses against our common stock investment. Our negative common investment will only be adjusted upon disposition of the our common stock investment or when we realize equity income from Comverge in excess of any accumulated equity losses recorded on our Preferred Stock investment. Our Preferred Stock investment of $3,644 (which was primarily financed by the release of $3,000 of previously restricted cash) has been reduced by equity losses in Comverge for the period of April 1, 2003 to December 31, 2003 of $1,752.
In September 2003, Comverge completed an agreement raising an additional $2,000 in capital funding in exchange for additional Series A Convertible Preferred Stock issued by Comverge. Comverge utilized these funds to repurchase the Series A-1 Convertible Preferred Stock previously issued by Comverge. In October 2003, Comverge completed an agreement raising an additional $5,600 in capital funding in exchange for additional Series A Convertible Preferred Stock issued by Comverge.
Following the equity transactions in 2003, we remained Comverge's largest shareholder, owning approximately 40.9% of the outstanding capital voting stock of Comverge, which is comprised of approximately 17% of the Preferred Stock and approximately 76% of Comverge's common stock.
As a result of the private equity financing transactions, Comverge is no longer a controlled subsidiary of ours. Thus, effective April 1, 2003, we no longer consolidated Comverge's balance sheet and results of operations, and from that date, accounted for our investment in Comverge on the equity method.
As a result of Comverge's net loss during the nine months ended December 31, 2003, we recognized $1,752 as equity loss representing 26% of Comverge's losses for the period from April 1 to September 30, 2003 and 17% of Comverge's losses for the period from October 1 to December 31, 2003 against our Preferred Stock investment.
REVENUE RECOGNITION
Our revenue recognition policies are significant because our revenue is a key component of our results of operations. Revenue from time-and-materials service contracts, maintenance agreements and other services are recognized as services are provided. Revenue on the sale of products and software are recognized when substantial evidence of an arrangement exists, the price is fixed and determinable, delivery or shipment has occurred and there is reasonable assurance of collection of the sales proceeds. Such revenues generally do not involve difficult, subjective or complex judgments.
In 2003, we derived $3.2 million of revenues from fixed-price contracts, all of which are attributable to our software and consulting development segment, representing approximately 9% of consolidated sales in
2003 ($3.9 million and 7%, and $4.4 million and 10%, in 2002 and 2001, respectively), which require the accurate estimation of the cost, scope and duration of each engagement. Revenue and the related costs for these projects are recognized using the percentage-of-completion method as costs (primarily direct labor) are incurred, with revisions to estimates reflected in the period in which changes become known. If we do not accurately estimate the resources required or the scope of work to be performed, or do not manage our projects properly within the planned periods of time or satisfy our obligations under the contracts, then future revenue and consulting margins may be significantly and negatively affected or losses on existing contracts may need to be recognized. Any such resulting changes in revenues and reductions in margins or contract losses could be material to our results of operations.
FOREIGN CURRENCY TRANSACTIONS
The currency of the primary economic environment in which our corporate headquarters and our U.S. subsidiaries operate is the United States dollar ("dollar"). Accordingly, the Company and all of its U.S. subsidiaries use the dollar as their functional currency. We have several Israeli subsidiaries which together account for approximately 34% of our net revenues for the year ended December 31, 2003 (24% for the year ended December 31, 2002), and 55% of our assets and 53% of our total liabilities as of December 31, 2003 (31% of our assets and 23% of our total liabilities as of December 31, 2002).
The financial statements of the Company's Israeli subsidiaries whose functional currency is the New Israeli Shekel ("NIS") have been translated using the exchange rates in effect at the balance sheet date. Statements of operations amounts have been translated using the exchange rate at date of transaction. In 2001, 2002 and 2003 the resulting translation adjustments are not reported, since the effect is immaterial All exchange gains and losses denominated in non-dollar currencies are reflected in other income (loss), net in the consolidated statement of operations when they arise. Such foreign currency gains (losses), net amounted to $(3), $154 and $(124) for the years ended December 31, 2001, 2002 and 2003, respectively.
INVENTORIES
Inventories are stated at the lower of cost or market. Inventories have been reduced by an allowance for excess and obsolete inventories to establish a new cost basis. The allowance for excess and obsolete inventories at December 31, 2002 and 2003 was $43 and $13, respectively. The estimated allowance is based on management's review of inventories on hand compared to estimated future usage and sales. We evaluate the adequacy of these reserves quarterly.
INCOME TAXES
We have a history of unprofitable operations from losses incurred in a number of our operations. These losses generated sizeable state, federal and foreign tax net operating loss ("NOL") carryforwards as of December 31, 2003 of approximately $5.9 million, $8.7 million and $10.0 million, respectively.
Generally accepted accounting principles require that we record a valuation allowance against the deferred income tax asset associated with these NOL carryforwards and other deferred tax assets if it is "more likely than not" that we will not be able to utilize them to offset future income taxes. Due to our history of unprofitable operations, we only recognize net deferred tax assets in those subsidiaries in which we believe that it is "more likely than not" that we will be able to utilize them to offset future income taxes in the future. We currently provide for income taxes only to the extent that we expect to pay cash taxes on current income.
It is possible, however, that we could be profitable in the future at levels which cause management to conclude that it is more likely than not that we will realize all or a portion of the NOL carryforwards and other deferred tax assets. Upon reaching such a conclusion, we would immediately record the estimated net realizable value of the deferred tax assets at that time and would then provide for income taxes at a rate equal to our combined federal and state effective rates or foreign rates. Subsequent revisions to the estimated net realizable value of the deferred tax assets could cause our provision for income taxes to vary significantly from period to period.
GOODWILL AND OTHER LONG-LIVED ASSETS
We review the carrying value of our long-lived assets held for use whenever circumstances indicate there may be an impairment. For all assets excluding goodwill, the carrying value of a long-lived asset is
considered impaired if the sum of the undiscounted cash flows is less than the carrying value of the asset. If this occurs, an impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value. The fair value is determined by applying a market- rate multiple to the estimated near-term future revenue stream expected to be produced by the segment. Effective July 1, 2001 and January 1, 2002, we adopted SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." Under these accounting standards, we no longer amortize our goodwill and are required to complete an annual impairment test. For the purpose of implementing SFAS No. 142, we have designated the fourth quarter as the period of the annual test and determined that we have three reporting units, which are the same as our three reportable segments. In 2002 we came to the conclusion that due to the slow down in the hi-tech markets, we recognize an expense for the impairment of goodwill and acquired software of $3.0 million ($2.4 million net of minority interests). No impairment was found in the annual assessment for the year ended December 31, 2003.
As of December 31, 2003, we had an aggregate of $4.4 million of goodwill, all of which relates to our software consulting and development segment. Additionally, at December 31, 2003, we had $0.1 million net book value of other identifiable intangible assets.
STOCK-BASED COMPENSATION
The Company accounts for stock-based compensation issued to non-employees on a fair value basis in accordance with SFAS No. 123 and EITF Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in conjunction with Selling, Goods or Services" and related interpretations. The Company uses the Black-Scholes valuation method to estimate the fair value of the warrants. For warrants granted in 2003 the Company used a risk free interest rate of 1.75%, their contractual life of two years, an annual volatility of 88% and no expected dividends. The Company estimated the fair value of these warrants to be approximately $97, which has been charged to selling, general and administrative expense.
RESULTS OF OPERATIONS
The following table sets forth selected consolidated statement of operations data as a percentage of our total sales:
Year Ended December 31,
-----------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
Sales .................................................................. 100% 100% 100% 100% 100%
Cost of sales .......................................................... 80 79 82 77 80
---- ---- ---- ---- ----
20 21 18 23 20
Gross profit
Research and development expenses ...................................... 3 2 5 3 --
Selling, general and administrative expenses ........................... 31 28 36 30 30
Impairment of goodwill and investment .................................. -- -- -- 5 --
Gain on sale of subsidiary/division .................................... -- 2 1 -- --
---- ---- ---- ---- ----
Operating loss .................................................... (14) (7) (23) (15) (10)
Interest income (expense), net ......................................... (2) 2 2 (1) (2)
Loss on early redemption of debt ....................................... -- (2) -- -- --
Other income (loss), net ............................................... (1) -- -- -- (1)
---- ---- ---- ---- ----
Loss from operations before taxes on income ........................ (17) (7) (21) (16) (14)
Taxes on income ........................................................ -- -- -- -- --
---- ---- ---- ---- ----
Loss from operations of the Company and its consolidated
subsidiaries ................................................... (17) (7) (21) (16) (14)
Share of losses in Comverge ............................................ -- -- -- -- (5)
Minority interests, net of tax ......................................... (1) -- -- 1 1
---- ---- ---- ---- ----
Loss from continuing operations ................................... (18) (7) (21) (15) (18)
Loss from discontinued operations, net of income taxes ................. (22) -- -- -- --
Gain on sale of discontinued operations, net of income taxes ........... -- 7 -- -- --
---- ---- ---- ---- ----
Net income (loss) .................................................. (40)% --% (21)% (15)% (18)%
==== ==== ==== ==== ====
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The following table sets forth certain information with respect to revenues and profits of our three reportable business segments for the years ended December 31, 2001, 2002 and 2003, including the percentages of revenues attributable to such segments. The column marked "Other" aggregates information relating to miscellaneous operating segments, which may be combined for reporting under applicable accounting principles.
Software Energy
Consulting and Intelligence Computer
Development Solutions Hardware Other Total
----------- --------- --------
(dollars in thousands)
Year ended December 31, 2003:
Revenues from external customers .................... $ 12,156 $ 4,700 $ 18,139 $ 39 $ 35,034
Percentage of total revenues from external
customers ......................................... 35% 13% 52% -- 100%
Gross profit ........................................ 2,581 1,313 3,125 39 7,058
Share of losses in Comverge ......................... -- (1,752) -- -- (1,752)
Net loss ............................................ (849) (3,174) (199) (17) (4,239)
Year ended December 31, 2002:
Revenues from external customers .................... $ 14,202 $ 19,023 $ 22,605 $ 56 $ 55,886
Percentage of total revenues from external
customers ......................................... 25% 34% 41% -- 100%
Gross profit ........................................ $ 2,674 $ 6,087 $ 4,098 $ 56 $ 12,915
Impairment of goodwill and investments .............. $ 2,850 -- -- -- $ 2,850
Segment income (loss) ............................... (4,503) $ (2,161) $ 15 $ (2) $ (6,651)
Year ended December 31, 2001:
Revenues from external customers .................... $ 12,279 $ 13,793 $ 19,794 $ 58 $ 45,924
Percentage of total revenues from external
customers ......................................... 27% 30% 43% -- 100%
Gross profit ........................................ $ 2,104 $ 2,652 $ 3,498 $ 58 $ 8,312
Impairment of goodwill and investments .............. $ 227 -- -- -- $ 227
Segment income (loss) ............................... $ (2,052) $ (6,447) $ 1,006 $(217) $ (7,710)
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2003 COMPARED TO 2002
SALES. Of the $20.9 million decrease in sales in 2003 compared to 2002, $14.3 million was due to Comverge, which, since the second quarter of 2002, is no longer fully consolidated. Sales decreased in the computer hardware sales segment by $4.5 million, primarily due to the non-recurrence of the extraordinarily high segment sales in the fourth quarter of 2002. In the software consulting and development segment, sales decreased by $2.0 million, primarily due to the decrease in the number of consultants and development projects in 2003. This decrease is primarily attributable to the downturn in the high-tech market in general and the software consulting and development market in particular.
GROSS PROFIT. The decrease in gross profits and gross profit margins in 2003 as compared to 2002 was also primarily due to our company no longer fully consolidating Comverge's operations since the second quarter of 2003. This accounted for $4.8 million of the $5.9 million decrease. In addition, as Comverge's gross profit margin was higher than the average in the group, ceasing to consolidate its operations caused a decrease in our consolidated gross profit margin. Gross profit in the computer hardware segment decreased in 2003 by $1.0 million, primarily due to the aforementioned decrease in sales. In the software consulting and development segment, despite the significant decrease in sales, gross profits remained relatively stable, with gross profit margins improving from 19% in 2002 to 21% in 2003, due to the improved cost structure achieved as a result of cost cutting measures implemented over the last two years, and the completion of most of the projects running at lower profit margins in previous periods.
RESEARCH AND DEVELOPMENT EXPENSES ("R&D"). The decrease in R&D expenses was primarily due to our company no longer consolidating Comverge's operations since the second quarter of 2003.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES ("SG&A"). The discontinued full consolidation of Comverge's operations since the second quarter of 2003 accounted for $4.3 million of the $6.2 million decrease in SG&A expenses in 2003 as compared to 2002. However, SG&A decreased in all our other activities as well. In the software consulting and development segment, SG&A decreased by $0.6 million, or 17%, as a result of cost cutting measures begun in 2002 and continuing through 2003. SG&A in our computer hardware sales segment also decreased by $0.5 million, primarily due to reduced commissions on reduced sales. Finally, corporate SG&A also decreased primarily due to reduced professional fees and compensation expenses. We presently expect to be able to maintain the current level of expenses in the software consulting and development segment and further reduce corporate SG&A as we reduce compensation expenses as a result of our CEO retiring and the implementation of his consulting agreement.
INTEREST INCOME (EXPENSE). The decrease in net finance expenses is attributable to completing the accretion of discounts and the amortization of related costs in connection with convertible debt and warrants in 2002 and the first few months of 2003, which accounted for approximately half the interest expense in 2002.
OTHER LOSS, NET. The other loss in 2003 was primarily attributable to the write-off of a stockholder's note received from Comverge's CEO.
EQUITY LOSS IN UNCONSOLIDATED SUBSIDIARY. The equity loss in 2003 was attributable to Comverge, whose results we account for on an equity basis as of the second quarter of 2003 (see Note 4 of our consolidated Financial Statements). Our share of Comverge's $7.9 million net losses during the period from April 1, 2003 to December 31, 2003 was $1.8 million. Comverge's increased losses in 2003 of $9.3 million, compared to $2.2 million in 2002, was primarily attributable to a decrease in sales, particularly those related to Comverge's family of DCU and SuperstatTM products as well as those stemming from its Gulf Power contract, where shipments have been suspended. Sales from the VPN contracts will primarily effect future periods. In addition, SG&A in Comverge has increased primarily due to increased advertising and marketing expenses, particularly those related to marketing and advertising its new Utah - PacifiCorp program.
MINORITY INTERESTS. Minority interests reflect the minority interests in losses generated by our dsIT subsidiary.
2002 COMPARED TO 2001
SALES. Sales in 2002 were $55.9 million, increasing by $10.0 million, or 22%, from $45.9 million in 2001, due to sales increases in all segments.
Energy intelligence solution sales increased by $5.2 million, or 38%, from $13.8 million in 2001, to $19.0 million in 2002. The increase in this segment's sales was primarily attributable to fulfillment of a large contract to sell our Maingate C&I and PowerCAMP systems to a major utility and to a generally higher level of business.
Sales in the computer hardware segment continued to improve, increasing by $2.8 million, or 14%, from $19.8 million in 2001, to $22.6 million in 2002. Although sales in this segment were improving through the year, the increase was primarily attributable to the $9.2 million in sales in the fourth quarter of 2002. The increase in the fourth quarter of 2002 was primarily attributable to sales of $4.5 million to a single customer.
Software consulting and development sales increased by $1.9 million, or 16%, from $12.3 million in 2001, to $14.2 million in 2002. This improvement in sales was entirely attributable to the expanded revenue base achieved as a result of the Endan acquisition by dsIT in December 2001, which more than offset the general weakness in the global hi-tech markets and in the software consulting and development market in particular.
GROSS PROFIT. Gross profit in 2002 was $12.9 million, increasing by $4.6 million, or 55%, compared to 2001, with gross profit margins improving from 18% in 2001 to 23% in 2002. The increase in gross profits was attributable to improvements in all segments, particularly in the energy intelligence solutions segment.
Gross profit in the energy intelligence solution segment increased by $3.4 million, or 130%, from $2.7 million, or 19% of sales, in 2001 to $6.1 million, or 32% of sales, in 2002. The increase in gross profit margin is primarily attributable to a $0.7 million settlement with a former contract manufacturer and an increase of approximately $2.7 million in sales of products of higher margin products.
In the computer hardware segment, gross profit increased by $0.6 million, or 17%, primarily due to the increase in sales.
Gross profit in the software consulting and development segment also increased by $0.6 million, or 27%, from $2.1 million, or 17% of sales, in 2001, to $2.7 million, or 19% of sales, in 2002. The increase in gross profits was primarily attributable to the increase in sales, as well as improved cost structure.
RESEARCH AND DEVELOPMENT EXPENSES ("R&D"). R&D expenses decreased from $2.3 million in 2001 to $1.5 million in 2002. This decrease was due to a decrease in R&D expenditures in the energy intelligence solution segment, as it shifted its emphasis from R&D in 2001 to marketing and sales in 2002.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES ("SG&A"). Despite the significant increase in sales, SG&A remained relatively stable, increasing by $0.1 million, from $16.6 million in 2001, to $16.7 million in 2002.
IMPAIRMENT OF GOODWILL AND INVESTMENT. The entire expense recorded was due to our software consulting and development segment. With the acquisition of Endan by our dsIT subsidiary in December 2001, we recognized goodwill and acquired software valued at a total of $6.4 million. This value was supported by third party valuations prepared at the time of the acquisition, based on sales and business projections made at that time. Since then, the hi-tech market in general and that of software consulting in particular have continued to deteriorate. As a result, we recorded in 2002 a goodwill impairment charge of $2.8 million. In addition, we recorded a write down of $90,000 with respect to an investment in a start-up company.
INTEREST INCOME (EXPENSE). To finance our operations, we utilized our investments, raised capital by issuing convertible debentures, and obtained lines of credit. The utilization of our investments caused the decrease in interest income and we expect interest income to further decrease in future periods. We incurred finance expenses in connection with the capital raised including interest and amortization of costs associated with the convertible debt and warrants issued. Although the interest associated with the utilization of lines of credit is expected to continue at the current level, the amortization expenses are expected to decrease over the future quarters. Of the $1.2 million of interest expense during the year ended December 31, 2002, $0.7 million was related to the accretion of discounts and the amortization of related costs in connection with convertible debt and warrants.
MINORITY INTERESTS. Minority interests reflect the minority interests in losses generated by our dsIT subsidiary, primarily due to the impairment of goodwill and acquired software in this segment as described above.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 2003, we had working capital of $0.7 million, including $1.2 million in cash and cash equivalents. Net cash used in operating activities in 2003 was $1.0 million, all of which was used to finance corporate expenses, which totaled $2.1 million. Our controlled operating entities had positive cash flow from operations.
We believe that the proceeds of the financing and new credit arrangements acquired by Comverge provide sufficient financing for Comverge to independently fund its operations. Due to significant interest in Comverge held by others and other restrictions, working capital and cash flows of Comverge will not be available to finance other U.S. activities.
Of the total working capital at December 31, 2003, $0.2 million was in our majority-owned dsIT subsidiary. Due to Israeli tax and company law constraints as well as the significant minority interest in dsIT, such working capital and cash flows from dsIT's operations are not available to finance U.S. activities. As at December 31, 2003, dsIT was utilizing $0.9 million of its $1.1 million line of credit. dsIT's line of credit is denominated in NIS and bears interest at a rate equal to the Israeli prime rate plus 1.4% per annum. The Israeli prime rate fluctuates and as of December 31, 2003, was 6.7%. We believe that dsIT will have sufficient liquidity to finance its activities from cash flow from its own operations over the next 12 months. This is based on continued utilization of its line of credit and improved operating results stemming from continued cost reductions as well as growth in sales.
We believe that we have sufficient liquidity to finance our US-based operating activities and our corporate activities for at least the 12 months following the date of this report, utilizing the cash on hand of
$0.8 million as of March 22, 2004 and operating cash flow from expected
profitable operations of the computer hardware segment. However, due to our
liquidity, successful implementation of our plans is subject to risk and
uncertainties, including those associated with (i) maintaining and further
increasing the level of revenues obtained in the fourth quarter of 2003, and
(ii) effective and timely implementation of cost reductions already begun. Our
long-term liquidity is contingent on our ability to increase our revenue and
profit base, become cash flow neutral in our US based activities and attracting
equity investments to the extent required.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Our contractual obligations and commitments at December 31, 2003, excluding certain severance arrangements described below, principally include obligations associated with our outstanding indebtedness, future minimum operating lease obligations and contractual obligations to our CEO for payments for his post-retirement consulting services to us, and are as set forth in the following table:
Cash Payments Due During Year Ending December 31,
--------------------------------------------------------
(In Thousands)
After
Contractual Obligations Total 2004 2005 2006 2006
----------------------- ----- ---- ---- ---- ----
Long-term debt related to Israeli operations $1,291 $659 $435 $172 $25
Guarantees 558 558 -- -- --
Operating leases 3,208 1,298 803 335 771
Consulting agreement with CEO 1,304 -- 1,304 -- --
----- ----- ---------- ---- ----
Total contractual cash obligations $6,361 $2,515 $2,542 $507 $796
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We expect to finance these contractual commitments from cash on hand and cash generated from operations.
We also have obligations under various agreements and other arrangements with officers and other employees with respect to severance arrangements and multiyear employment agreements.
Previously, we accrued a loss for contingent performance of bank guarantees, the balance of which was $558,000 at December 31, 2003. A portion of these guarantees was collateralized by means of a deposit of $241,000 as of December 31, 2003. Although we've accrued this loss, we contested this liability and expect an Israeli Supreme Court decision in this regard within the next few months.
Under Israeli law and labor agreements, dsIT is required to make severance payments to dismissed employees and to employees leaving employment under certain other circumstances. The obligation for severance pay benefits, as determined by the Israeli Severance Pay Law, is based upon length of service and last salary. These obligations are substantially covered by regular deposits with recognized severance pay and pension funds and by the purchase of insurance policies. As of December 31, 2003, we accrued a total of $3.7 million for potential severance obligations, of which approximately $2.4 million was funded with cash to insurance companies.
Under the terms of his employment agreement with us, we have an obligation to pay our Chief Executive Officer consulting fees over a seven-year period starting January 1, 2004. During the first four years of the consulting period, we have to pay our CEO $237,000 per year, equal to 50% of his salary in effect as of December 31, 2003. During the last three years of the consulting period, we must pay $119,000 per year, equal to 25% of that salary. In addition, we must pay contributions to a non-qualified defined contribution retirement plan equal to 25% of the consulting fee. In accordance with the employment contract, we are obliged to fund amounts payable for the term of the consulting period by the purchase of an annuity or similar investment product at the beginning of the consulting period. The CEO has agreed to forgo the commitment of immediate funding for the next twelve months or until we acquire additional funding.
We also have a severance arrangement under an employment agreement with our Chief Financial Officer to pay severance under certain circumstances. If our CFO employment agreement is terminated by us or by him for reasons other than for cause, we must pay him (i) an amount equal to 150% of his last month's salary multiplied by the number of years (including partial years) that the CFO worked for us, plus (ii) an amount equal to six times his last month's salary. Our severance obligation would be reduced by the
amount contributed by us to certain Israeli pension and severance funds pursuant to the CFO's employment agreement. As of December 31, 2003, the unfunded portion of such severance obligation was $84,000.
We also have a severance arrangement under an employment agreement with the Chief Executive Officer of dsIT to pay severance under certain circumstances. If his employment agreement is terminated by us or by him for reasons other than for cause, we must pay him (i) an amount equal to his last month's salary multiplied by the number of years (including partial years) that he worked for Endan and dsIT. Our severance obligation would be reduced by the amount contributed by us to certain Israeli pension and severance funds pursuant to his employment agreement. As of December 31, 2003, the unfunded portion of such severance obligation was $117,000.
IMPACT OF INFLATION AND CURRENCY FLUCTUATIONS
A majority of our sales are denominated in dollars. The remaining portion is primarily denominated in NIS, linked to the dollar. Such sales transactions are negotiated in dollars; however, for the convenience of the customer they are settled in NIS. These transaction amounts are linked to the dollar between the date the transactions are entered into until the date they are effected and billed. From the time these transactions are effected and billed through the date of settlement, amounts are primarily unlinked. The majority of our expenses in Israel are in NIS, while a portion is in dollars or dollar-linked NIS.
The dollar cost of our operations in Israel may be adversely affected in the future by a revaluation of the NIS in relation to the dollar, should it be significantly different from the rate of inflation. In 2003 the appreciation of the NIS against the dollar was 7.6%, whereas in 2002 the devaluation of the NIS against the dollar was 7.3%. Inflation in Israel was -1.9% in 2003 and 6.5% during 2002. During the first two months of 2004, the NIS was devalued against the dollar by 2.4% and inflation during this period was 0.0%.
As of December 31, 2003, virtually all of our monetary assets and liabilities that were not denominated in dollars or dollar-linked NIS were denominated in NIS. In the event that in the future we have material net monetary assets or liabilities that are not denominated in dollar-linked NIS, such net assets or liabilities would be subject to the risk of currency fluctuations.
PAYMENTS TO RELATED PARTIES
We paid an individual as a director and vice president, who is the son of our Chief Executive Officer, approximately $197,000, $230,000 and $273,000 for the years ending December 31, 2001, 2002 and 2003, respectively. We also have engaged certain of our directors and former directors to render professional services to us. One of our former directors, who is also the son-in-law of our Chief Executive Officer, is principal of a law firm that we engage to perform legal services for us. We paid to this firm legal fees and out-of-pocket disbursements (which includes fees and expenses of special counsel hired on our behalf) of approximately $575,000, $630,000 and $403,000 for the years ended December 31, 2001, 2002 and 2003, respectively. The chief executive officer of the Company's Israeli subsidiary has a loan from the subsidiary that was acquired in 2001. The loan balance and accrued interest at December 31, 2002 and 2003 was $48,000 and $52,000, respectively. The loan has no defined maturity date, is denominated in NIS, is linked to the Index and bears interest at 4% per annum. Comverge has made loans of $10,000 each to both our Chief Executive Officer and Chief Financial Officer. The loans had an initial maturity date of January 3, 2002 and were extended at that time to mature on January 3, 2004. The loans bear interest at 4.25% per annum. The balance of the loans and accrued interest at December 31, 2002 and 2003 was $25,000 and $26,000, respectively.
SUMMARY QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table sets forth certain of our unaudited quarterly consolidated financial information for the years ended December 31, 2002 and 2003. This information should be read in conjunction with our Consolidated Financial Statements and the notes thereto.
2002 2003
-------------------------------------------- -----------------------------------------
First Second Third Fourth First Second Third Fourth
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
-------- -------- -------- -------- -------- ------- ------- -------
(Restated)
(in thousands, except per share amounts)
Sales ................................. $ 12,808 $ 12,783 $ 11,269 $ 19,026 $ 12,868 $ 7,285 $ 6,684 $ 8,197
Cost of sales ......................... 9,830 10,191 8,906 14,044 9,799 5,994 5,481 6,702
-------- -------- -------- -------- -------- ------- ------- -------
Gross profit .......................... 2,978 2,592 2,363 4,982 3,069 1,291 1,203 1,495
Research and development expenses ..... 460 550 256 260 |