ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Dunn Computer Corporation (together with its wholly-owned subsidiaries, the "Company" or "Dunn") manufactures custom computer systems and provides related services to departments, agencies and offices of the federal government (the "Government") and selected businesses. The Company provides its customers with single-source solutions by manufacturing its own brand of desktop and portable computers and high performance network client servers and offering services, which include network consulting, project implementation, and technical support. The Company currently derives most of its revenues from hardware sales to the Government, but also provides hardware and services to medium and large businesses. The Company sells its products and services to more than 300 customers, including entities within the Department of Defense, Administrative Office of the U.S. Courts, Lockheed Martin Corporation, Blue Cross and Blue Shield Association and the District of Columbia Government.
Dunn was founded in 1987 and initially resold third party computers to the Government. In 1991, Dunn began to manufacture and market its own line of computers to better serve the rapidly changing Government market. In April 1997, the Company sold 1,000,000 shares of common stock ("Common Stock") in an initial public offering for net proceeds of $3,917,664. In connection with the offering, warrants were issued to the underwriter for 100,000 shares of common stock at an exercise price of $6.00 per share. Beginning April 21, 1998, the warrants are exercisable for a period of four years.
In September 1997, Dunn completed the acquisition of STMS, Inc. a Virginia-based network services company ("STMS") which expanded Dunn's capabilities to provide a wide variety of services including network consulting, project implementation and technical support. The STMS acquisition provided the Company new opportunities to sell computer hardware into the commercial marketplace as part of a total package of information technology ("IT") hardware and services tailored to meet the commercial customers' needs. By manufacturing its own computer systems, the cost of which represents a significant portion of the cost of a total project, the Company believes it has a sustainable competitive advantage over other network service providers.
On May 1, 1998, Dunn acquired International Data Products, Corp. ("IDP Co.") and the net assets of IDP Co.'s Puerto Rican affiliate, Puerto Rico Industrial Manufacturing Operations, Corp. ("PRIMO" and together with IDP Co., "IDP"), for approximately $22 million, consisting of a combination of cash and Common Stock (the "IDP Acquisition"). When acquired, IDP was a leading supplier of portable and desktop computers to the Government. The IDP Acquisition tripled the Company's customer base within the Government to a total of 950 customers. In May 1998, in connection with the IDP Acquisition, the Company completed a public offering of 3,491,493 shares of common stock for net proceeds of $26,287,866.
The Company seeks to establish itself as a leading provider of network solutions to the Government and to increase sales of its hardware and services to the commercial market. One of the key elements of this strategy is integrating the Company's hardware and network services into a total solution for its Government customers. In the commercial market, management plans to leverage the Company's customer relationships developed through sales of its network services to expand sales of its hardware products. Consistent with its overall strategy, the Company may pursue strategic acquisitions that will complement its product or service capabilities.
INTEGRATION OF IDP
The Company has begun to integrate IDP's business with that of the Company's by implementing its plan of reducing overall expenses by eliminating duplicative operations and positions. Since May 1, 1998, the Company has terminated the production and warehouse functions at IDP's Gaithersburg, Maryland
facility and consolidated the manufacturing into its Sterling, Virginia and Puerto Rican facilities. The Company has fully integrated IDP's sales, marketing, accounting, personnel, customer service, and engineering departments of IDP into Dunn and has reduced its overall staff size by approximately 122 employees. The Company also plans to close the Gaithersburg facility by the end of February, 1999. The Company has incurred additional one-time costs associated with the integration of IDP. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The consolidation and integration of businesses following an acquisition involve a number of uncertainties. In connection with the IDP acquisition, there can be no assurance that the Company will: (i) achieve its operating and growth strategies with respect to these businesses; (ii) realize increased revenue opportunities from the anticipated synergies created by expanded product offerings; and (iii) acquire additional distribution channels or reduce the overall selling, general and administrative expenses associated with IDP. Additionally, the integration of any other business the Company may acquire in the future could involve unforeseen difficulties, which could have a material adverse effect on the Company's business, financial condition and results of operations and ultimately the market price of the Common Stock.
PRODUCTS AND SERVICES
COMPUTER HARDWARE PRODUCTS
DESKTOPS. The Company manufactures a high performance line of Pentium II desktop computers that may be used on a standalone basis or as part of a network. The desktops incorporate the newest Intel technology and can accommodate all the Intel Pentium processors, including the new high performance 450 Mhz Pentium II processor. The Company strives to keep ahead of the competition by constantly testing and incorporating the latest technology into its products.
FILESERVERS. The Company markets a single, dual and quad version of the Intel Pentium servers. All Dunn servers are Microsoft Windows NT, Novell, Banyan, and Token Ring compatible. The Company believes that its servers offer the latest or "best of the breed" technology that provides it with a price- performance advantage over major competition such as Hewlett Packard ("HP") and Compaq. The Company believes that the server market provides opportunities for higher profit margins compared to other sectors in the industry. In addition, because of the complexity of server installation and maintenance, server sales complement the Company's services business.
PORTABLES. The Company manufactures, on a brand name basis, a state-of-the-art portable line based on Intel's latest portable processors with a 13.3 inch or 14.1 inch display and many other advanced features. The system is assembled and configured in the United States by Dunn and meets the Federal Government's stringent Buy American and Trade Agreement Act requirements. The Company markets the portables in both the commercial and Government markets. At this time, the Company's portables business is a small portion of the business.
NETWORKING HARDWARE & SOFTWARE. The Company integrates, installs, and maintains major-brand networking hardware and software, which enables the Company to be a full solutions provider for its customers. A partial list of the manufacturers that the Company is authorized to sell include 3COM, Banyan, Cisco, Lotus, Microsoft, Novell and Santa Cruz Operation.
TECHNICAL SERVICES
CONSULTING. Dunn provides its clients with consulting services with respect to requirements analysis, network audits, security audits, security policy planning, network capacity planning, server capacity planning, and technology and feasibility studies. These services are generally provided on a fixed hourly fee basis with specific deliverables.
PROJECT IMPLEMENTATION. Dunn performs full life cycle project work for which it assumes responsibility for all deliverables and project completion. Providing project management is a key component of Dunn's strategy of being a full solutions provider.
RAPID RESPONSE. Dunn also offers clients that do not need full-time on-site support a family of support products all under the "SafetyNet" program. These products provide a wide range of support options and can be customized to each client's specific needs. For example, through "Block Services," clients may purchase blocks of Dunn's technical personnel hours for up to a period of three years from the purchase date, allowing clients to plan ahead and take advantage of volume discounts. Under its "Term Maintenance" program, Dunn also provides full service, term maintenance contracts on specific server and networking equipment. These contracts are based on a fixed price and term and include all parts and labor. Alternatively, under the "Extended Value Support" program, clients may opt for a labor-only product. Finally, the "ClockWork" program provides clients with standard technical resources on a recurring regular basis. One or two days per week or per month, clients can augment their existing staff with expertise they cannot afford to hire full-time. ClockWork provides an excellent alternative to hiring and full-time outsourcing.
STAFF AUGMENTATION. Dunn provides clients with service professionals whose full time personnel do not meet all of their service needs. The client generally assumes all responsibility for the management of Dunn's service personnel, who may work full time on a particular client account for varying lengths of time, generally between one week and one year. The Company's technical staff can get support twenty four hours a day, seven days a week from Novell, Microsoft, 3Com, Cisco, and others, allowing them to tap on resources beyond their own individual knowledge and capabilities. The Company believes the availability of this third-party support sets it apart from its competition.
SUPPORT SERVICES
The Company believes that its dedication to prompt, efficient customer service and technical support are important factors in customer retention and overall satisfaction. The Company provides toll-free technical support to its customers 365 days a year. Product support technicians assist customers with questions concerning compatibility, installation, determination of defects and general questions of product use. Company employees provide on-site service to its customers in the Washington, D.C. area and maintains arrangements with national service organizations to provide repair service on a world-wide basis.
CONTRACTS
In fiscal 1998, Dunn derived approximately 80% of its net revenues from sales of hardware and services to the federal Government pursuant to contracts with the General Services Administration ("GSA") or other agency-specific contracts. Most of these contracts are "indefinite delivery, indefinite quantity" or "IDIQ" contracts, meaning that an indefinite amount of product may be purchased at any time over the life of the contract. Government contracts, by their terms, generally can be terminated at any time, without cause, for the convenience of the Government. If a Government contract is so terminated, the contractor generally is entitled to receive compensation for the services provided or certain costs incurred at the time of termination and a reasonable profit on the contract work performed prior to the date of termination. In addition, all Government contracts require compliance with various contract provisions and procurement regulations and in certain cases, accounting requirements. If not cured, certain violations of these regulations could result in the termination of the contract, imposition of fines, and suspension or debarment from competing for or receiving awards of additional Government contracts. Exclusion of the Company from federal procurements, the termination of any of the Company's significant Government contracts or the imposition of such penalties could have a material adverse effect on the Company.
Substantially all of the Company's federal customers purchase equipment and services from the Company on a long-term contract basis. By contrast, most of the commercial customers purchase equipment and services by means of task and open purchase orders.
Set forth below is a description of some of the Company's more significant contracts as of October 31, 1998.
DESKTOP V CONTRACT. In May 1997, IDP was awarded a contract by the U.S. Air Force (the "Air Force") to provide high performance desktop computers, portable computers and network servers (the "Desktop V contract"). The Desktop V contract is a Government-wide acquisition contract that is open to all departments and agencies of the Government except for the Department of the Army and the Department of the Navy. For fiscal year ended October 31, 1998 ("fiscal 1998"), Dunn had revenues totaling approximately $18.0 million from the Desktop V contract, which represented approximately 26% of all of the Company's revenues for fiscal 1998. In connection with the Desktop V contract, a protestor has asserted that IDP is bound by a settlement agreement that calls for payments of 1.8% of its revenues derived from such contract. The Company contests this assertion and the matter is being litigated. See "Legal Proceedings." There can be no assurance that the Company will be successful in the litigation, and if not, it may be required to make such payments. The Desktop V contract was awarded to IDP pursuant to the Section 8(a) program of the U.S. Small Business Administration ("SBA") and, as such, contains a "termination for convenience" clause which provides that, in the event the program-eligible owners relinquish ownership of the business, the contract shall terminate unless the procuring agency requests a waiver from the SBA. At the time of the IDP acquisition, the Air Force had requested a waiver. Subsequently, the SBA has opposed the waiver. The Company has appealed the decision of the SBA. There can be no assurance that the Company will be successful in its appeal. The loss of the Desktop V contract could have a material adverse effect on the Company's business. Pending the outcome of the appeal, the Company is continuing to service orders under the Desktop V contract.
GSA CONTRACT. The Company has a contract with the GSA (the "GSA Contract"). The Company's GSA contract was awarded in April 1996 and is valid through March 31, 2002. The GSA Schedule enables Government IT purchasers to acquire all of their requirements from a particular vendor and largely limits the competition to selected vendors holding GSA contracts. For fiscal year 1998, the Company's GSA Contract had sales of $6.8 million, which accounted for approximately 10% of the Company's revenues.
LOCKHEED CONTRACT. Under the Company's contract with Lockheed Martin Corporation ("Lockheed"), the Company provides computer network servers to Lockheed for the Defense Department's Worldwide Defense Messaging System ("DMS"). DMS is expected to be the largest private messaging network in the world, supporting approximately 2,000,000 users. Lockheed is the prime contractor on the DMS contract. The Company's contract with Lockheed is on a year-to-year basis, has been renewed three times and can be renewed for up to two more years. In fiscal 1998, the Company generated revenues of $4.8 million from the Lockheed contract, which accounted for approximately 7% of the Company's revenues.
MANUFACTURING AND PRODUCTION
In fiscal 1998, Dunn assembled over 30,000 desktop and portable computers. The Company's production capacity is 100,000 units per year in the existing Sterling County facility on a three shift basis. The Company is currently in the process of having its Sterling County facility certified for the International Quality Standard ISO 9002, which requires it to meet certain stringent requirements to ensure that the facilities' manufacturing processes, equipment and associated quality control systems will satisfy specific customer requirements. The Company believes that the ISO 9002 quality standard is a significant factor in the both Government and the commercial market.
The Company also leases an approximately 34,000 square-foot facility in Guayama, Puerto Rico, which is used for manufacturing, technical support, and personal computer board level repair. The Guayama facility is ISO 9002 certified, and has the capability to manufacture 200,000 systems per year.
COMPETITION AND MARKETING
The markets for the Company's products and services are highly competitive. Many of the Company's competitors offer broader product lines, have substantially greater financial, technical, marketing and other resources than the Company and may benefit from component volume purchasing and product and process technology license arrangements that are more favorable in terms of pricing and availability than the Company's arrangements. Competitive pressures have intensified as large build-to-order multinational computer manufacturers have entered the Government market. The Company also competes with a large number of computer systems integrators and resellers. The Company believes that it is likely that these competitive conditions will continue in the future. There can be no assurance that the Company will continue to compete successfully against existing or new competitors that may enter markets in which the Company operates.
GOVERNMENT MARKET
The Information Technology Reform Act (the "ITRA"), which took effect on August 8, 1996, has had a profound effect on the way Government procures computers and related products and services. The most sweeping changes were (1) the repeal of the Brooks Act that had granted sole authority for purchasing IT to the GSA and, (2) the change in the GSA Schedule from a single-year small purchase contracting program to a multi-year, IDIQ contract with no limit on the value of purchases. Prior to the new legislation, the GSA was responsible for overseeing all IT purchases as well as assuring fair and open competition. The new legislation has expanded Dunn's ability to market and sell its products to Government users directly through its GSA contract and Basic Purchasing Agreements awarded under the GSA schedule. The Company has invested significantly to expand its marketing and sales efforts to take advantage of these changes in the federal market. The customer base acquired as part of IDP is a key element in its expanded sales and marketing effort.
Since the passage of the ITRA, the Government has increased the amount of information products acquired through the GSA Schedule. Although Dunn believes it has benefited from this reform, the emergence of the GSA Schedule as a significant procurement vehicle has also enabled traditional mass market commercial computer companies to be more responsive to Government requirements. The Company currently competes with national commercial computer manufacturers such as Dell Computer Corporation ("Dell") and Gateway 2000, Inc. ("Gateway") for a portion of the Government market.
The Government continues to rely on agency specific IDIQ contracts for its more complex computer requirements. The Company believes that national brand companies such as International Business Machine Corporation, Compaq Computer Corporation ("Compaq"), Dell Computer, AST Research, Inc. ("AST") and Apple Computer, Inc. often are dissuaded from bidding for these IDIQ contracts, which have complex terms and conditions and technical specifications. Some of these national brand companies have not focused on the Government market at all; however, there can be no assurance they will not do so in the future.
There has been a consolidation in the industry as a result of acquisitions and the failure of many firms. The competition has settled into a small group of competitors comprised of manufacturers and systems integrators. The Company believes that the Government's selection criteria for vendor selection consists of price, quality, familiarity with the vendor, and size and financial capability of the vendor.
The following companies are significant competitors of the Company in the Government market:
COMMERCIAL MARKET
The microcomputer products industry is highly competitive. Pricing is very aggressive in the industry and the Company expects pricing pressures to continue to intensify. The microcomputer products industry is also characterized by rapid changes in technology and consumer preferences, short product life cycles and evolving industry standards.
The commercial market for engineering services is a highly fragmented market served by thousands of small value-added resellers. These companies typically service a small geographic area and resell national brand computer hardware. The Company believes that its consulting division can compete effectively in the local market because it provides engineering services for Dunn products rather than desktop and server hardware provided by third parties. The Company believes that its ability to manufacture the hardware provides the technical services group a competitive advantage.
Microcomputers are marketed through several distribution channels including direct marketing, traditional microcomputer retailers, computer superstores, consumer electronic and office supply superstores and other resellers. There are many manufacturers of microcomputers, substantially all of which have greater financial, marketing and technological resources than the Company. The Company competes with manufacturers such as Compaq, Dell, Gateway, IBM and Packard Bell NEC, Inc.. The principal elements of competition are product reliability and quality, customization, price, customer service, technical support and product availability. There can be no assurance that the Company will in the future be able to compete effectively against existing competitors, especially companies who have historically focused their energies on the commercial market.
MARKETING
The Company markets to a wide array of Government organizations including agencies within the Department of Defense, civilian agencies and the judicial branch of the Government. The Company also views the commercial market, which represented 12% of its sales in fiscal 1998, as an increasingly important part of its business. The Company uses an in-house sales force and program managers to market its products and services. Although Dunn markets nationally, the Company's marketing efforts are concentrated in the Washington, D.C. metropolitan area, which accounts for 68% of Government computer procurement. In light of the new procurement legislation which gives different Government users the ability to purchase directly from vendors, the Company believes that marketing is becoming increasingly important to its Government as well as to its commercial business.
The Company strives to build a strong relationship with its customers. The Company believes that a key to building customer loyalty is a team of knowledgeable and responsive account executives and technical and support staff. The Company assigns each customer a trained account executive, to whom subsequent calls to the Company will be directed. The Company believes that these strong one-on-one relationships improve the likelihood that the customer may consider the Company for future purchases. Product support technicians are available 24 hours per day, seven days a week. The Company intends to continue to provide its customers with the latest technology at the lowest cost.
The Company attempts to maximize the use of emerging electronic commerce technologies and believes that both the Government and commercial customers will continue to expand and utilize these technologies. Internet and on-line computer services are being used by the Government and many companies to advertise opportunities as well as reference vendor information. The Company maintains a web site on the Internet wherein its GSA catalogue and products can be referenced. In addition, the Company provides the capability for customers to download updated software and drivers that become available. The Company believes that its targeted customer base will have a greater acceptance of these interactive services because its customers tend to have a greater familiarity with technology products and services.
SUPPLIERS
The Company devotes significant resources to establishing and maintaining relationships with its suppliers. The Company, where possible, purchases directly from component manufacturers such as Intel, Microsoft, Hitachi-Nissei Sanyo America, Ltd., Sony Electronics Corporation and Clevo Corporation ("Clevo"). The Company also purchases multiple products directly from large national and regional distributors such as TechData Corporation, Ingram Micro Incorporated and Decision Support Systems, Incorporated ("DSS").
Suppliers provide the Company with incentives in the form of discounts, rebates, credits, cooperative advertising and market development funds. In accordance with the terms of certain of the Company's Government contracts, the Company provides periodic reporting of pertinent supplier contract terms and conditions to contracting officials. As a product reseller, the Company must continue to obtain products at competitive prices from leading suppliers in order to provide competitively priced products for its customers. During fiscal 1997, Dunn purchased approximately 11% of its components from DSS. In the event that the Company is unable to continue to purchase components from these suppliers, the Company believes that alternative suppliers are readily available. The Company believes its relationships with its key suppliers to be good and believes that generally there are multiple sources of supply available should the need arise.
INVENTORY
Dunn has traditionally purchased inventory to fill orders received from our customers. IDP traditionally purchased inventory based on a weighted forecast. The Company is in the process of conforming IDP's inventory policies and practices to those of the Company.
PATENTS, TRADEMARKS AND LICENSES
The Company does not maintain a traditional research and development group, but works closely with computer product suppliers and other technology developers to stay abreast of the latest developments in computer technology. While the Company does not believe that its continued success will depend upon the rights to a patent portfolio, there can be no assurance that the Company will continue to have access to existing or new technology for use in its products.
The Company conducts its business under the trademarks and service marks of "Dunn", "Dunn Computer Corporation", "International Data Products," and "IDP." The Company believes its trademarks and service marks have significant value and are an important factor in the marketing of its products.
Because most software used on the Company's computers is not owned by the Company, the Company has entered into software licensing arrangements with several software manufacturers, including Microsoft.
EMPLOYEES
As of October 31, 1998, the Company employed 236 persons. Of such persons, 3 were employed in executive capacities, 38 in sales and marketing, 55 in administrative capacities, 32 in technical services and 108 in operations. As of January 22, 1999 the Company employed 209 persons. None of Dunn's employees are covered by a collective bargaining agreement. Dunn considers its relationships with its employees to be good.
The Company believes that its future success will depend in large part upon its continued ability to attract and retain highly qualified management, technical and sales personnel. The computer industry is currently undergoing a shortage of trained and experienced technicians. The Company endeavors to be attractive to current and prospective employees and has an in-house training program to produce its own supply of highly qualified technicians and service providers. However, there can be no assurance that the Company will be able to attract and retain the qualified personnel necessary for its business.
AVAILABLE INFORMATION
The Company is subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance therewith, files annual and quarterly reports on Forms 10-K and 10-Q, proxy statements and other information with the Securities and Exchange Commission (the "Commission"). The public may read and copy any such materials filed with the Commission at the Commission's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the Commission at 1-800-SEC-0330. In addition, the Commission maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers, such as the Company, that file such materials electronically with the Commission. The Commission's Internet address is http;//www.sec.gov.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
The Company leases an approximately 35,000 square foot facility in Sterling, Virginia which is used primarily for manufacturing and administrative services. The lease expires in October, 1999. The Company has an option to renew the Sterling lease for a period of five years at market rates. The Company is presently seeking ISO 9002 certification for its Sterling facility. The Sterling facility has obtained a top secret security clearance in connection with its performance of one of its government contracts. The facility is owned by C&T Partnership, an entity comprised of Thomas Dunne, the Company's President, and his wife Claudia Dunne, the Company's Vice President.
The Company also leases an approximately 55,000 square-foot facility in Gaithersburg, Maryland. The Company's plan is to vacate this space by February, 1999, and sublet the space. The existing lease expires in February 2000. The Company also leases a 34,000 square-foot facility in Guayama, Puerto Rico, which is used for manufacturing, technical support, and personal computer board level repair. The Company believes that its current facilities are adequate for its existing needs and that additional suitable space will be available as required.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
By letter dated April 15, 1998, DDI, a competitor of the Company asserted that IDP is bound by a settlement agreement entered into in connection with certain litigation, calling for payments to the competitor of 1.8% of the first $250 million of IDP's gross sales under the Desktop V contract. IDP and the Company dispute this claim. On June 1, 1998, the Company filed a Complaint for Declaratory Judgment in the U.S. District Court of the Eastern District of Virginia seeking a declaration that DDI is not entitled to receive payments under the settlement agreement. The defendant has counter-claimed against the Company claiming it did not breach the settlement agreement and is entitled to the payments. While the Company believes that it has a meritorious claim for declaratory judgment and meritorious
defenses to the counter-claim, there can be no assurance that the Company will be successful in this litigation and, if the court rules against the Company, it may be required to pay a percentage of its revenue under the Desktop V contract to the defendant.
On July 31, 1998, the Company received notice from the SBA that it was denying the request of the U.S. Air Force to waive the requirement to terminate IDP's Desktop V contract for the convenience of the Government upon the change in control of IDP to the Company. The Company has appealed the denial by the SBA to the SBA's Office of Hearings and Appeals. The appeal is currently pending. The loss of the Desktop V contract could have a material adverse effect on the Company's results of operations.
In November 1998, a former employee of the Company filed a demand for arbitration with the American Arbitration Association, alleging a breach of his employment agreement with the Company and seeking in excess of $2,350,000 in damages from the Company. The Company has filed an answer denying the claimant's allegations and stating a counterclaim against the former officer for breach of the employment agreement and for conversion of certain of the Company's property. The Company intends to defend the claimant's claim and pursue its out counterclaim vigorously.
On December 18, 1998, the Office of the United States Attorney for the District of Maryland, Northern Division (the "U.S. Attorney"), informed the Company that it was of the view that a civil False Claims Act violation was assessable against certain parties, including IDP, George and Oscar Fuster (the former principal owners of IDP) and the Company involving allegations of fraudulent misrepresentations by the Fusters in IDP's 1994 application for participation in the Section 8(a) program administered by the SBA. Remedies available to the Government, should such a case be brought, include treble damages, fines, and suspension and debarment. To date, no actual suit has been filed. The Company and the other parties are currently negotiating a settlement of this matter with the U. S. Attorney and, based on such negotiations, the Company believes this matter will be settled without determination of liability against or monetary payment by the Company.
There are routine legal claims pending against the Company, but in the opinion of management, liabilities, if any, arising from such claims will not have a material adverse effect on the financial condition and results of operation of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Prior to the quotation of the Company's Common Stock beginning on April 22, 1997, there was no established trading market for the Company's common stock. The Company's Common Stock is traded in the over-the-counter market and prices are quoted on The Nasdaq National Market under the symbol DNCC. The following table sets forth the high and low selling prices as reported by The Nasdaq National Market for the periods indicated. These quotations reflect inter-dealer prices without retail mark-up, mark-down or commission and may not represent actual transactions.
On January 22, 1999, the closing price of the Company's Common Stock as reported by The Nasdaq National Market was $5.25 per share. There were approximately 1,500 shareholders of the Common Stock of the Company as of such date.
The Company has not paid cash dividends on its Common Stock and does not intend to do so in the foreseeable future.
RECENT SALES OF UNREGISTERED STOCK
On May 1, 1998, in connection with the IDP acquisition, the Company acquired all of the issued and outstanding capital stock of IDP Co. and substantially all of the net assets of PRIMO. In consideration for the IDP acquisition, the Company paid the former owners an aggregate of $14.9 million in cash and an aggregate of 750,000 shares of Common Stock. In November 1998, the Company received 350,000 shares of the stock previously issued to the Fusters in connection with a Purchase Price Adjustment Agreement. The shares sold to the Fusters in the IDP acquisition were sold in reliance upon the exemption from registration afforded by Section 4(2) of the Securities Act of 1933, as amended.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
DUNN SELECTED CONSOLIDATED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA)
The following selected consolidated financial data of Dunn should be read in conjunction with the consolidated financial statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations". The consolidated statement of income data set forth below with respect to the fiscal years ended October 31, 1996, 1997 and 1998 and the consolidated balance sheet data as of October 31, 1997 and 1998 is derived from and is referenced to the audited consolidated financial statements of Dunn included elsewhere in this Prospectus. The consolidated statement of income
data set forth below with respect to the fiscal years ended October 31, 1994 and 1995 and the consolidated balance sheet data as of October 31, 1994 and 1995 is derived from audited consolidated financial statements of Dunn not included in this 10-K.
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(1) The earnings per share amounts prior to Fiscal 1998 have been restated as required to comply with Statement of Financial Accounting Standards No. 128, EARNINGS PER SHARE. For further discussion of earnings per share and the impact of Statement No. 128, see Note 2 to the Company's consolidated financial statements.
(2) Includes the activity of STMS from September 12, 1997 (date of acquisition).
(3) Includes the activity of IDP and PRIMO from May 1, 1998 (date of acquisition).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements contained in this section are forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995). Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, risks associated with the integration of businesses following an acquisition, competitors with broader product
lines and greater resources, the termination of any of the Company's significant contracts or the Company's inability to attract and retain highly qualified management, technical and sales personnel.
GENERAL
Over 85% of the Company's revenues are generated from the sale of hardware. Sales to customers within the Government accounted for 75% of Dunn's revenues in fiscal 1998. The Company's operating results are characterized by a number of factors resulting from its emphasis on the Government market. For example, the Company has historically experienced fluctuating quarterly results due to uneven purchasing patterns of Government customers relating to the Government's budgetary cycle. Consequently, sales for the first and fourth quarters typically account for the greatest proportions of revenues each year. In addition, the Company's Government contracts, which frequently provide for fixed prices, often have initially low gross margins which will increase over the term of a contract due to cost savings from technological improvements and shorter component life cycles. Since most of the Company's Government contracts have 30-day delivery terms, the Company attempts to limit its inventory risks by purchasing components to fill firm orders under fixed-price contracts.
The Company's most significant costs are components used in the manufacture of desktop, portable and server systems. With the combination of Dunn and IDP, the Company has been able to realize reduced component costs because of increased volume discounts.
The Company's business during fiscal 1998 was significantly impacted by the IDP acquisition which was consummated on May 1, 1998. As a result of the acquisition, the Company's revenues tripled as the Company benefited from the addition of the IDP customers. Offsetting this increase in revenue were relatively higher operational costs associated with integrating IDP's operations which were initially absorbed by the Company following the IDP Acquisition. The Company has taken a number of measures to consolidate and integrate the IDP operations with those of Dunn so as to reduce the Company's operating costs. Such steps have included a reduction in staff, the consolidation of manufacturing operations in the Sterling, Virginia facility, and the elimination or merger of duplicative operations.
The Company has recognized certain costs associated with its consolidation and integration plan as liabilities assumed in the IDP Acquisition. These costs were recorded as an adjustment to the purchase price of IDP and therefore are not reflected as expenses in the Company's results of operations. These liabilities totaled $1,376,000 and were comprised of employee severance costs of $615,000 and facilities-related costs of $761,000. The severance costs were recorded for IDP and PRIMO employees to be terminated due to the integration and consolidation of the Company's operations. The facilities-related costs include costs associated with the excess production and warehouse capacity at IDP's Gaithersburg, Maryland facility and an estimate of costs to be incurred once that facility is entirely vacated. To date, $232,000 of costs have been charged against these liabilities. The Company does not expect any significant adjustment to these liabilities as its consolidation and integration plan is substantially complete.
In addition, the Company incurred $565,000 in costs associated with the consolidation and integration plan which were recognized as expenses during fiscal 1998. These costs included compensation and severance costs of $295,000 and facilities-related costs of $270,000. The compensation and severance costs were for employees of the Company who were terminated as a result of the consolidation and integration plan. The facilities-related costs were costs of certain functions at IDP's Gaithersburg, Maryland facility that were relocated to the Company's Sterling facility subsequent to year-end.
Although the Company will incur certain costs associated with expanding its operations at its Sterling facility, the Company believes that the cost-cutting measures it has put in place will significantly reduce its operating costs and bring its gross profit margin closer to its level prior to the IDP acquisition. However, there can be no assurance that the Company will successfully implement its consolidation and integration plans or that profit levels will increase.
RESULTS OF OPERATIONS
The following table sets forth for the fiscal years ended October 31, 1994, 1995, 1996, 1997 and 1998, certain income and expense items of Dunn as a percentage of net revenues.
FISCAL YEAR ENDED OCTOBER 31, 1998 COMPARED TO FISCAL YEAR ENDED OCTOBER 31,
Net revenues of Dunn for fiscal year ended October 31, 1998 ("fiscal 1998") increased 206% to $66.9 million from $21.8 for fiscal year ended October 31, 1997 ("fiscal 1997"). This increase was primarily due to additional revenue resulting from the third quarter acquisition of International Data Products, Inc. Net revenues derived from IDP's operations for fiscal 1998 amounted to approximately $40.5 million.
Gross profit of Dunn for fiscal 1998 increased 183% to $11.9 million from $4.2 million for fiscal 1997. However, the gross profit as a percentage of net revenues during the same periods decreased to 17.8% from 19.4%. The decrease in gross profit margin is a result of an increase in the percentage of lower margin hardware sales by IDP and excess production capacity. The Company has closed the production facility in Gaithersburg, Maryland.
Selling and marketing expense of Dunn increased for fiscal 1997 by 336% to $3,672,000 from $842,000 for fiscal 1997. During the same periods, as a percentage of net revenues, selling and marketing expenses increased to 5.5% from 3.9%. The increase was primarily attributable to the acquisition of IDP, increased advertising in selected publications, increased attendance at trade shows and the development of a marketing campaign aimed at selected businesses.
General and administrative expense of Dunn for fiscal 1998 increased 365% to $6.3 million from $1.4 million for fiscal 1997. As a percentage of net revenues, general and administrative expense increased to 9.4% for fiscal 1998 from 6.2% for fiscal 1997. The Company charged $564,776 of IDP acquisition integration costs to G&A for the fiscal year. The Company also recognized approximately $545,000 in amortization expense for fiscal 1998 as compared to $22,000 for fiscal 1997. Dunn increased its costs in almost all aspects of general and administrative expenses as a result of the IDP acquisition. The Company has taken various actions to reduce general and administrative expenses in future periods. See Item 1 "Business."
Other income (expense) including interest for fiscal 1998 decreased to an expense of $271,000 from an income of $98,000 for fiscal 1997. The decrease was a result of increased interest expense required to support the additional debt assumed as a result of the acquisition of IDP, and interest expense associated with certain operating leases. Dunn's effective tax rate increased to 41% for fiscal 1998 from 37.5% for fiscal 1997 as a result of the increase in the amortization of Goodwill which is not deductible for tax purposes. Dunn's net income declined by 26% for fiscal 1998 to $980,000 from $1.3 million for fiscal 1997. Net income as a percentage of net revenues during the same periods declined to 1.5% from 6.1%.
FISCAL YEAR ENDED OCTOBER 31, 1997 COMPARED TO FISCAL YEAR ENDED OCTOBER 31,
Net revenues of Dunn for the fiscal year ended October 31, 1997 ("fiscal 1997") increased 20.3% to $21.8 million from $18.1 million for fiscal year ended October 31, 1996 ("fiscal 1996"). This increase was primarily due to additional revenue resulting from the fourth quarter acquisition of STMS and increased revenues from Government contracts.
Gross profit of Dunn for fiscal 1997 increased 5.5% to $4.2 million from $4.0 million for fiscal 1996. However, the gross profit as a percentage of net revenues during the same periods decreased to 19.4% from 22.1%. The decrease in gross profit margin is a result of an increase in the percentage of lower margin third party hardware sales, initial lower margins realized on two new contracts and increased production costs.
Selling and marketing expense of Dunn increased for fiscal 1997 by 77.2% to $842,000 from $475,000 for fiscal 1996. During the same periods, as a percentage of net revenues, selling and marketing expenses increased to 3.9% from 2.6%. The increase was primarily attributable to increased advertising in selected publications, increased attendance at trade shows and the development of a marketing campaign aimed at selected businesses.
General and administrative expense of Dunn for fiscal 1997 declined 9.5% to $1.4 million from $1.5 million for fiscal 1996. As a percentage of net revenues, general and administrative expense declined to 6.2% for fiscal 1997 from 8.3% for fiscal 1996. Although Dunn increased its costs in almost all aspects of general and administrative expenses, the increased costs were offset by a decline in executive officers' incentive compensation.
Other income (expense) for fiscal 1997 increased to income of $98,000 from an expense of $9,000 for fiscal 1996. The increase was a result of use of proceeds from Dunn's initial public offering in April 1997 to reduce debt obligations and to invest in tax-exempt securities. Dunn's effective tax rate declined to 37.5% for fiscal 1997 from 38.5% for fiscal 1996 as a result of the non-taxable interest income. Dunn's net income grew by 6.7% for fiscal 1997 to $1.3 million from $1.2 million for fiscal 1996. Net income as a percentage of net revenues during the same periods declined to 6.1% from 6.8%.
LIQUIDITY AND CAPITAL RESOURCES
In fiscal 1998 Dunn generated $2.5 million in cash flow from operations. Dunn generated cash from its net income of $980,000, a reduction in accounts receivable of $2.1 million and a reduction of $7.0 million in inventories. The cash generated was used to reduce accounts payable by $9.5 million The Company used $14.2 million in its investing activities for the IDP Acquisition. The balance was used for property and equipment.
Dunn received approximately $26 million in net proceeds from its public offering in May 1998. Other significant financing activities were provided by Dunn's bank line of credit with First Union Bank (formerly Signet Bank). The line of credit expires on February 28, 1999 and currently bears interest at prime. As of January 25, 1999, Dunn had no outstanding balance on the line of credit.
Dunn's subsidiary, IDP has borrowing agreements with Deutsche Financial Services for an aggregate of $25.0 million, of which $13 million is secured by IDP's inventory and $12 million is secured by IDP's accounts receivable. Each of these facilities bears an annual interest rate of LIBOR plus 2.05%. Under the inventory financing facility, IDP normally receives 30 days free of interest when purchases are made from distributors, and 45 days free of interest when purchases are made from manufacturers. Under the accounts receivable financing facility, IDP can borrow against up to 85% of eligible receivables and is subject to various financial covenants. There is no formal expiration date on these facilities, although it is subject to annual re-evaluation. As of January 22, 1999 IDP had $8.2 million outstanding on its line of credit. Dunn is a guarantor of this credit facility. At October 31, 1998, IDP was in violation of its net worth convenant under this facility. The violation was subsequently cured through a waiver obtained from the
financial institution. The Company is currently negotiating for the consolidation of its borrowing arrangements. Any financial covenants associated with the renegotiated borrowing facilities will be based on the Company's consolidated financial position and results of operations.
As of October 31, 1998, IDP had notes payable to related parties of $906,000 bearing annual interest at rates ranging from 8.0% to 11.0% and are payable upon demand. The Company paid off these notes as part of the settlement with George and Oscar Fuster.
As of October 31, 1998, the Company had working capital of $5.8 million. The Company believes the bank facilities, together with cash on hand and the cash generated from operations, will provide sufficient financial resources to finance the current operations of the Company through fiscal 1999.
Dunn has obligations under its operating lease commitments of approximately $1.0 million and obligations under its existing employment contracts of approximately $1.0 million for fiscal 1999.
From time to time, the Company may pursue strategic acquisitions or mergers which may require significant additional capital and, in such event, the Company may seek additional financing of debt and/or equity.
YEAR 2000 ISSUES
Recently, national attention has focused on the potential problems and costs resulting from computer programs being written using two digits rather than four to define the applicable year. Any computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. While the Company believes that its internal software applications and the software in the systems it sells are Year 2000 compliant, there can be no assurance until the year 2000 that all systems will function adequately. Further, if the software applications of others on whose services the Company depends are not Year 2000 compliant, such noncompliance could have a material adverse effect on the Company. The Year 2000 problem can be corrected either through software programming or the application can be ported to a client/server network. The Company believes with its technical services and its client/server hardware product line, it provides Year 2000 solutions.
In response to the Year 2000 problem and the associated risks, the Company has developed a comprehensive compliance program to evaluate, address and remedy the date related problems with respect to the Company's internal systems, third party relationships, and Company products and services. The compliance program is managed by the Company's Director of Engineering, and is tailored after the guidance promulgated by the General Accounting Office (GAO) in their publication, Year 2000 Computing Crisis: An Assessment Guide and by the Department of the Navy Year 2000 Action Plan.
The Company has adopted the following five-phase approach that was endorsed by the GAO and recognized by the U.S. Congress:
AWARENESS PHASE. The Company's management is familiar with the scope of the Year 2000 impact, the problem is defined, compliance standards are established and an overall strategy is developed. A Year 2000 program team is organizing and implementing the Company's Year 2000 compliance program.
ASSESSMENT PHASE. The Year 2000 team determines the impact on the Company's systems, tools, products and contracts. The team creates an inventory and evaluation of systems that support the core business sectors. Third party service providers are contacted concerning their compliance with the Year 2000 problem with regard to the products and services they provide. The team then prioritizes the conversion or replacement of existing systems that are confirmed to be Year 2000 non-compliant.
RENOVATION PHASE. The Year 2000 program team rectifies the problems discovered in the assessment phase by modifying or replacing systems that are Year 2000 non-compliant.
VALIDATION PHASE. The renovated or replaced systems, applications and databases are tested and certified as Year 2000 compliant.
IMPLEMENTATION PHASE. The renovated or replaced systems are fully implemented and extensive testing is performed to insure coordination with other systems and databases. Backup and recovery plans are put in place. The Company anticipates that it will have all internal Year 2000 solutions in place by July 1, 1999. Internal solutions include information technology systems such as local and wide area network systems and non-IT systems such as embedded micro-controllers within facility, security, telephone and others systems. The Company is assessing the status of third parties with which it has a material relationship. Third parties include vendors and suppliers of essential hardware, software and services and Company customers who may fund Year 2000 compliance efforts in lieu of contracting services to the Company. The Company is assessing the status of its products and Year 2000-related services. All products sold via the GSA schedule are Year 2000 compliant. Other products developed and sold by the Company are being assessed for Year 2000 compliance. The Company also performs Year 2000-related services for both government and industry and is assessing the potential risk to the Company of performing these services and is taking action to mitigate these risks as they are identified.
CONTINGENCY PLANS. The Company currently is developing contingency plans. The Company anticipates that its internal systems will be Year 2000 compliant by July 1, 1999. The Year 2000 readiness of third parties with which the Company has a material relationship and their products and services are being assessed. The Company will continue to develop contingency plans as required to mitigate the effects of delays, if any, in internal systems compliance, third party business interruption, non-compliant Company products and risks associated with providing Year 2000-related services.
COST FOR YEAR 2000 COMPLIANCE. The Company estimates that the total cost for Year 2000 compliance will be approximately $75,000. As of January 29, 1999, the Company has spent approximately $55,000 on Year 2000 compliance.
YEAR 2000 RISKS. The Company expects to fund the remaining aspects of its program with cash on hand or internally generated cash. The Company believes that its Year 2000 compliance plan is a comprehensive one and that all internal systems, including both information technology systems and non-information technology systems, will be compliant by the end of calendar 1999. The Company, however, may not be able to identify or remedy all Year 2000 compliance issues with respect to its internal systems, suppliers, customers, products and services. As a result, the Year 2000 problem could have a materially adverse effect on the Company's financial condition or results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL ISSUES
None.
PART III
The Notice and Proxy Statement for the 1998 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A under the Securities Exchange Act of1934, as amended, which is incorporated by reference in this Annual Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K, will provide the information required under Part III, including Item 10
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report
1. Financial Statements
Dunn Computer Corporation Report of Ernst & Young LLP, Independent Auditors Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements International Data Production Corporation and combined company Report of KPMG Peat Marwick, LLP, Independent Auditor Combined Balance Sheets as of September 30, 1996 and 1997 Combined Statements of Income and Retained Earnings for the three years in the period ended September 30, 1997 Combined Statements of Cash Flows for the three years in the period ended September 30, 1997 Notes to Combined Financial Statements
2. Financial Statement Schedules
Statements not listed above have been omitted because they are not applicable or the information required to be set forth therein is included in the Consolidated Financial Statements or the notes thereto under Item 8.
3. Exhibits.
- ------------------------
* Filed herewith
(b) Reports on Form 8-K
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DUNN COMPUTER CORPORATION
By: /s/ THOMAS P. DUNNE ----------------------------------------- Thomas P. Dunne PRESIDENT AND CHIEF EXECUTIVE OFFICER
Date: February 12, 1999
Pursuant to and in accordance with the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
NAME TITLE DATE - ------------------------------ -------------------------- -------------------
/s/ THOMAS P. DUNNE - ------------------------------ President, Chief Executive February 12, 1999 Thomas P. Dunne Officer and Director
Executive Vice President, /s/ JOHN D. VAZZANA Chief Financial Officer - ------------------------------ (and principal February 12, 1999 John D. Vazzana accounting officer) and Director
/s/ CLAUDIA N. DUNNE - ------------------------------ Vice President and February 12, 1999 Claudia N. Dunne Director
/s/ VADM E. A. BURKHALTER USN (RET.) - ------------------------------ Director February 12, 1999 VADM E. A. Burkhalter USN (Ret.)
/s/ DANIEL SINNOTT - ------------------------------ Director February 12, 1999 Daniel Sinnott
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors
We have audited the accompanying consolidated balance sheets of Dunn Computer Corporation (a Virginia Corporation) as of October 31, 1997 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for the three years in the period ended October 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Dunn Computer Corporation as of October 31, 1997 and 1998, and the consolidated results of its operations and its cash flows for the three years in the period ended October 31, 1998 in conformity with generally accepted accounting principles.
DUNN COMPUTER CORPORATION
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
DUNN COMPUTER CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes.
DUNN COMPUTER CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes.
DUNN COMPUTER CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION
Dunn Computer Corporation (the "Corporation") was incorporated on July 27, 1987 under the laws of the Commonwealth of Virginia. On January 3, 1997, Dunn Computer Corporation ("Dunn"), a Delaware corporation, was formed as a holding company for the stock of Dunn Computer Corporation, the Virginia corporation. On January 6, 1997, the Board of Directors and stockholders of the Corporation approved and effected a 2,799.160251 for 1 stock exchange with Dunn whereby the holders of the Corporation's common stock would receive 2,799.160251 shares of common stock in Dunn for each share of common stock in the Corporation.
On September 12, 1997, Dunn acquired all of the outstanding stock of STMS, Inc. ("STMS"), a Virginia Corporation.
On February 26, 1998, Dunn Computer Corporation (the "Company") was incorporated in the Commonwealth of Virginia to become a holding company for Dunn and International Data Products Corp. ("IDP"), as provided for in the Acquisition Agreement. The Acquisition Agreement provides for the acquisition of all of the stock of IDP by the Company and the acquisition of substantially all of the net assets of Puerto Rico Industrial Manufacturing Operations, Corp. ("PRIMO"), an affiliate of IDP, by a newly formed subsidiary of the Company (collectively, the "IDP Acquisition"). Effective May 1, 1998, the Company's acquisitions of IDP and PRIMO were consummated. Simultaneously, a subsidiary of the Company merged into Dunn, whereby each outstanding share of common stock of Dunn was exchanged on a one-for-one basis for a share of common stock of the Company and each outstanding option and warrant of Dunn was converted into an option or warrant, respectively, of the Company on substantially the same terms as applied to each option or warrant of Dunn immediately prior to the merger. Dunn became a wholly-owned subsidiary of the Company. All references in the accompanying consolidated financial statements as to the number of shares of common stock and per-share amounts have been restated to reflect the stock exchanges described above. Also, the Company has authorized 2,000,000 shares of preferred stock with rights and preferences to be determined by the Board of Directors at a later date.
The Company is engaged in the business of selling build-to-order computer systems and related equipment and providing computer training and maintenance service to business and government agencies. The Company operates in a competitive environment subject to technological change and the emergence of new technologies, although the Company believes that its products and services are, or would be, upgradable to new technologies.
2. SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CASH AND CASH EQUIVALENTS
The Company maintains demand deposits with several financial institutions. At times, deposits exceed federally insured limits, but management does not consider this a significant concentration of credit risk. The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. At October 31, 1998, the Company's cash management process resulted in an overdraft of $741,000 included in accounts payable.
OTHER RECEIVABLES
In connection with the acquisition of STMS, the Company purchased a 47.5% interest in Glacier Corporation ("Glacier"). This investment was recorded at its fair value of $125,000 on the STMS acquisition date. During fiscal 1998, the Company relinquished its voting rights with respect to its investment in Glacier in exchange for a promissory note equivalent to $125,000. The Company reduced the carrying value of its investment in Glacier by the amount of the promissory note. The balance of the promissory note is included in other receivables and will be reduced as payments are received. The Company believes that the carrying amount of its investment ($0) in Glacier (which only includes equity rights) represents the lower of cost or market at October 31, 1998. The Company is accounting for its investment in Glacier using the cost method since the Company has no voting rights with respect to its investment.
INVESTMENTS
At October 31, 1997 and 1998, investments consisted of shares of common stock of a privately-held internet company, Worldwide Internet Solutions Network, Inc. ("WIZnet"), with a cost basis of approximately $150,000. The Company believes that this carrying amount represents the lower of cost or market. The Company is accounting for this investment using the cost method since the Company's investment represents less than 20% of the privately-held internet company's outstanding stock. The President and Chief Executive Officer of WIZnet is a member of the Company's Board of Directors.
INVENTORY
Inventory is stated at the lower of cost or market as determined by the first-in first-out (FIFO) method. The Company periodically evaluates its inventory obsolescence reserve to ensure inventory is recorded at net realizable value.
IMPAIRMENT OF LONG-LIVED ASSETS
Each year, management determines whether any property and equipment or any other assets have been impaired based on the criteria established in Statement of Financial Accounting Standards No. 121 ("SFAS 121"), "ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF." The Company made no adjustments to the carrying values of the assets during the years ended October 31, 1996, 1997 and 1998.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangibles represent the unamortized excess of the cost of acquiring subsidiary companies over the fair values of such companies' net tangible assets at the dates of acquisition. Goodwill related to the Company's acquisitions as described in Note 5 is being amortized on a straight-line basis over periods ranging from twenty to forty years. Other intangibles, including contracts, are being amortized on a straight-line basis over a five year period.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ACQUISITION-RELATED LIABILITIES
During fiscal year 1998, the Company recorded $1,376,000 of acquisition-related liabilities in connection with the IDP Acquisition. These liabilities were recorded after certain actions had been identified, quantified and approved by management of the Company having authority to commit the Company to the plan. Those certain actions included closing the IDP facility in Maryland, integrating IDP and the Company's production, warehouse, sales, marketing and administrative functions, eliminating duplicative jobs and expanding space in the Company's office space in Virginia. The Company vacated the production and warehouse space in the IDP facility in June 1998 and intends to vacate the remaining space in the facility in February, 1999. During fiscal 1998, $232,000 of costs were charged against the liability. The acquisition-related liabilities at October 31, 1998 consisted of the following:
Workforce-related charges, consisting principally of severance costs, were recorded based on specific identification of employees to be terminated, along with their job classifications or functions and their locations. The facilities-related charges include the cost of the Company's excess facilities (Maryland facility) and an estimate of the costs to be incurred once the facility is entirely vacated. This estimate represents the lower of the amount of the remaining lease obligations, net of any sublease rentals, or the expected lease settlement costs. These costs have been estimated from the time when the space is expected to be vacated and when there are no plans to utilize the facility in the future. Costs incurred prior to vacating the facilities will be charged to operations. Periodically, the accruals related to the acquisition- related charges are reviewed and compared to their respective cash requirements. As a result of those reviews, the accruals are adjusted for changes in cost and timing assumptions of previously approved and recorded initiatives.
STOCK COMPENSATION
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "ACCOUNTING FOR STOCK-BASED COMPENSATION". SFAS 123 allows companies to account for stock-based compensation under either the new provisions of SFAS 123 or the provisions of Accounting Principles Board Opinion No. 25 ("APB 25"), "ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES," but requires pro forma disclosure in the footnotes to the consolidated financial statements as if the measurement provisions of SFAS 123 had been adopted. The Company continues accounting for its stock-based compensation in accordance with the provisions of APB 25.
REVENUE RECOGNITION
The Company generally recognizes revenues from computer sales and sales-type leases at the time of shipment. Revenues are earned principally pursuant to various contracts with agencies of the Federal government and commercial customers. The length of the Company's contracts generally range from one to three years.
Service revenues are recognized over the contractual period as the services are provided. Revenues from operating leases are recognized over the contract term. The Company has assigned payments from one of its operating leases to a financing company in exchange for the present value of the minimum lease payments. This amount is nonrefundable by the Company. The Company has recorded this amount as
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED) unearned revenues and will recognize revenues over the lease term as payments are received by the Company and remitted to the financing company. The agreement is cancelable by the lessee upon thirty days notice.
The products sold are generally covered by a warranty for periods ranging from two to three years. The Company accrues a warranty reserve for revenues recognized during the year to record estimated costs to provide warranty services.
Unearned revenue also relates to cash received from credit card sales as of year end for which the related inventory was shipped subsequent to year end.
During the year ended October 31, 1996, the Company had revenues from two agencies of the Federal government which represented 22% and 14% of total revenues. In addition, during 1996, the Company had revenues from one Federal government contractor and one commercial customer which represented 17% and 16% of total revenues, respectively. During the year ended October 31, 1997, the Company had revenues from one agency of the Federal government and one Federal government contractor which represented 21% and 11% of total revenues, respectively. As of October 31, 1997, accounts receivable from agencies of the Federal government represented 64% of total accounts receivable. During the year ended October 31, 1998, the Company had revenues from one agency of the Federal government which represented 40% of total revenues. As of October 31, 1998, accounts receivable from agencies of the Federal government represented 67% of total accounts receivable.
For the year ended October 31, 1998, approximately 27% of the Company's revenues were from Federal contracts that were awarded under Section 8(a) of the Small Business Act.
ADVERTISING EXPENSES
The Company expenses advertising costs as incurred. Advertising costs amounted to approximately $61,000 and $468,000 during fiscal 1997 and 1998, respectively. Advertising costs for fiscal 1996 were immaterial to the financial statements.
ACQUISITION INTEGRATION COSTS
The Company expenses acquisition integration costs as incurred. Acquisition integration costs consist of compensation costs for employees whose jobs will be terminated in fiscal 1998 or 1999 and costs for facilities that will be closed in fiscal 1999. Severance and facility closing costs related to the Company's decision to exit certain activities of the acquired business have been accounted for as acquisition-related liabilities.
INCOME TAXES
The Company provides for income taxes in accordance with the liability method.
EARNINGS PER SHARE
In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128 ("SFAS 128"), EARNINGS PER SHARE. SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. The definition of diluted earnings per share is very similar to the previous definition of fully diluted
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EARNINGS PER SHARE (CONTINUED) earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the SFAS 128 requirements.
FINANCIAL INSTRUMENTS AND CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, investments and accounts receivable. The cash is held by high credit quality financial institutions. For accounts receivable, the Company performs ongoing credit evaluations of its customers' financial condition and generally does not require collateral. The Company maintains reserves for credit losses, and such losses have been within management's expectations. The concentration of credit risk is mitigated by the diverse customer base and the amount of receivables due by the Federal government. The carrying amount of the receivables approximates their fair value.
SUPPLEMENTAL INFORMATION OF NON-CASH INVESTING AND FINANCING ACTIVITIES
RECENT PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130 ("SFAS 130"), "REPORTING COMPREHENSIVE INCOME", which establishes standards for reporting the components of comprehensive income and requires that all items that are required to be recognized under accounting standards as components of comprehensive income be included in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income includes net income as well as certain non-owners items that are reported directly within a separate component of stockholders' equity. The provisions of SFAS 130 are effective for fiscal years beginning after December 15, 1997. The Company has adopted SFAS 130 on November 1, 1998. The adoption did not have a material impact on the Company's consolidated financial position or results of operations.
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION", which is required to be adopted for companies with fiscal years beginning after December 15, 1997. SFAS 131 changes the way public companies report segment information in annual financial statements and also requires those companies to report selected segment information in interim financial reports to stockholders. SFAS 131 supersedes Statement of Financial Accounting Standards No. 14, "FINANCIAL REPORTING FOR SEGMENTS OF A BUSINESS ENTERPRISE." The Company adopted SFAS 131 on November 1, 1998. The adoption did not have a material impact on the disclosure for segment information on the financial statements.
In February 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 132 ("SFAS 132"), "EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECENT PRONOUNCEMENTS (CONTINUED) BENEFITS," which is required to be adopted for companies with fiscal years beginning after December 15, 1997. SFAS 132 amends Statements of Financial Accounting Standards No. 87 "EMPLOYERS' ACCOUNTING FOR PENSIONS,"No. 88. EMPLOYERS' ACCOUNTING FOR SETTLEMENTS AND CURTAILMENTS OF DEFINED BENEFIT PENSION PLANS AND FOR TERMINATION BENEFITS" and No. 106 "EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS," by revising employers' disclosures about pension and other postretirement benefit plans. SFAS 132 doesn't change the measurement or recognition of those plans. The disclosure requirements of SFAS 132 will not have a material impact on the Company's consolidated financial position or results of operations.
In March 1998, AcSEC issued Statement of Position 98-1 ("SOP 98-1"), "ACCOUNTING FOR THE COSTS OF COMPUTER SOFTWARE DEVELOPED FOR OR OBTAINED FOR INTERNAL USE." SOP 98-1 is effective for fiscal years beginning after December 15, 1998. SOP 98-1 will require the capitalization of certain costs incurred after the date of adoption in connection with developing or obtaining software for internal use. The Company currently expenses such costs as incurred. The Company has not yet assessed what the impact of SOP 98-1 will be on the Company's future earnings or financial position.
3. PROPERTY AND EQUIPMENT AND EQUIPMENT ON LEASE
Property and equipment, including leasehold improvements, are stated at cost. Property and equipment are depreciated and amortized using the straight-line method over the estimated useful lives of five years. Leasehold improvements are amortized over the lesser of the related lease term or the useful life.
Property and equipment consisted of the following:
The Company owns equipment that is currently at a customer's site under an operating lease agreement (See Note 2--Revenue Recognition). The cost and related accumulated depreciation for the equipment on lease amounted to $4,763,671, and $667,188, respectively, at October 31, 1998.
4. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets were comprised of:
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. ACQUISITIONS
STMS
On September 12, 1997, the Company acquired all of the outstanding stock of STMS, Inc., a Virginia corporation ("STMS"), for 150,000 shares of the Company's common stock, options to purchase 25,000 shares of the Company's common stock, and $1,044,500 in cash used specifically to repay certain debt of STMS. The transaction was accounted for using the purchase method. The 150,000 shares of common stock were valued at the market price of Company's common stock or $975,000 on the date of the transaction. The options to purchase 25,000 shares of common stock were issued to a stockholder/creditor of STMS and were valued at fair value of $84,000 using the Black-Scholes option-pricing model. The purchase price was allocated to the assets and liabilities acquired based on their estimated fair values. In conjunction with the acquisition, the Company recorded goodwill in the amount of $2,397,287 and other intangible assets (contracts) in the amount of $600,000. The operations of STMS are included in the consolidated financial statements of the Company beginning September 12, 1997 (date of acquisition).
The Company granted options to purchase an aggregate of 1,330,000 shares of the Company's common stock, at an exercise price equivalent to its fair market value at the date of grant, to the former stockholders of STMS in conjunction with their three-year employment agreements. The options vest over a three-year period.
During February 1998, the Company repurchased an aggregate of 50,000 shares of common stock and the option to purchase 25,000 shares of common stock originally issued in connection with the STMS acquisition (see Note 10).
IDP AND PRIMO
On May 1, 1998, the Company acquired all of the outstanding stock of IDP and substantially all of the net assets of PRIMO for $14.9 million in cash and 750,000 shares of common stock of the Company, both subject to adjustment in the event that the combined net assets of IDP and PRIMO fell below a certain level stipulated in the Acquisition Agreement (See Note 10). The transaction was accounted for using the purchase method. The 750,000 shares of common stock were valued at the market price of the Company's common stock ($8.50 per share) on the date of the transaction. The purchase price was preliminarily allocated to the assets and liabilities acquired based on their estimated fair values. In conjunction with the acquisition, the Company recorded goodwill (as adjusted) in the amount of $21,801,699. The operations of IDP, including PRIMO, are included in the consolidated financial statements of the Company beginning May 1, 1998 (date of acquisition).
In connection with the IDP acquisition, two of the IDP sellers entered into employment agreements with the Company pursuant to which they each received options to purchase 300,000 shares of the Company's common stock. The grant price of the options was equivalent to the fair market value of the underlying common stock on the grant date and the options vested immediately.
During November 1998, the Company entered into an Employment Agreement Termination Agreement and a Purchase Price Adjustment Agreement with the two former stockholders of IDP whereby employment of the former stockholders of IDP was terminated and the former IDP stockholders agreed to return 350,000 shares of the Company's common stock originally issued in connection with the IDP Acquisition. See Note 10 for additional information.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. ACQUISITIONS (CONTINUED)
IDP AND PRIMO (CONTINUED) The selected unaudited pro forma information for the years ended October 31, 1997 and 1998 includes the operating results of the Company as if the Company acquired STMS, IDP, and PRIMO on November 1, 1996.
6. BANK LINES OF CREDIT AND NOTES PAYABLE
In April 1996, the Company entered into a line of credit agreement with a bank that was subsequently amended in December 1997 to allow the Company to borrow an amount limited to the minimum of its borrowing base or $4,000,000. As of October 31, 1998, the Company's borrowing base, which is based on certain percentages of total accounts receivable less overdue accounts, is $959,843. Outstanding borrowings bear interest at the prime rate. As of October 31, 1997, there were no outstanding borrowings under this line of credit facility. As of October 31, 1998, the Company had borrowed $201,000 against this line of credit facility and had an unused borrowing capacity of $758,843. The Company pays a commitment fee equivalent to a certain percentage (approximately . 3/8%) of the unused borrowings under the line of credit facility. The line of credit is secured by all assets of Dunn, a subsidiary of the Company. Under the line of credit agreement, the Company is required to maintain a net worth of $1,250,000 as well as to submit periodic financial statements. For the years ended October 31, 1996, 1997 and 1998, the Company is in compliance with the covenants. The line of credit agreement expires February 28, 1999.
Notes payable consisted of the following:
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. BANK LINES OF CREDIT AND NOTES PAYABLE (CONTINUED) Principal payments on the long-term debt for each of the fiscal years from 1999 to 2003 and thereafter are due as follows:
Notes payable to related parties are payable to certain stockholders and their relatives, and employees. These notes payable were assumed by the Company in the IDP Acquisition. All notes payable to related parties are classified as current liabilities as the outstanding balances are due upon demand. Notes payable to related parties bear interest at annual interest rates ranging from 8 to 11%. The total amounts outstanding on these related parties' notes payable were approximately $905,960 at October 31, 1998. Interest expense on these notes payable amounted to $58,297 during the period from May 1, 1998 through October 31, 1998. The total amounts outstanding on these notes payable were repaid subsequent to October 31, 1998 (See Note 10).
The Company has a line of credit facility of $25,000,000, of which $13,000,000 is secured by IDP's inventory and $12,000,000 is secured by IDP's accounts receivable. This line of credit facility was assumed by the Company in the IDP Acquisition. The outstanding balance on this line of credit at October 31, 1998 was approximately $3,055,060. The interest rate applicable to this line of credit as of October 31, 1998 was 7.33% (LIBOR rate plus 2.05%). There is no formal expiration date on this facility although it is subject to annual re-evaluation by the financial institution. The Company was in violation of its net worth financial covenant at October 31, 1998. This violation at October 31, 1998, and any subsequent violations through January 31, 1999, were subsequently cured through a waiver obtained from the financial institution. The Company has classified all outstanding balances as current.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. RELATED PARTY TRANSACTION
Thomas Dunne, the Company's President, and his wife, Claudia Dunne, the Company's Vice President, acquired a building for the purpose of leasing office space to the Company. In connection with the acquisition of the building, the Company guaranteed the building's $1 million mortgage. The term of the mortgage is 25 years. The Company subsequently executed a noncancelable operating lease with Mr. and Mrs. Dunne. The Company believes that the lease agreement is on terms no less favorable to the Company than could be obtained from unaffiliated third parties (see Note 8).
8. COMMITMENTS
OPERATING LEASES
The Company leases office space under a noncancelable operating lease agreement with two stockholders (see Note 7). The lease agreement terminates in October 1999, but provides for a five year renewal at the Company's option. Additionally, the Company leases various office equipment and other office space under non-cancelable operating leases. Rent expense under these leases was $154,000, $175,000 and $499,100 for the years ended October 31, 1996, 1997, and 1998, respectively.
Future minimum lease payments under noncancelable operating leases, including the leases assumed in the STMS and IDP acquisitions, at October 31, 1998 are as follows:
The Company will receive $1,898,436 in aggregate sublease income through fiscal 2003.
EMPLOYMENT AGREEMENTS
The Company has employment agreements with certain key executives under which the Company is required to pay the following base salaries annually over the next two years.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. INVESTMENT IN SALES-TYPE LEASES
During 1998, the Company leased equipment to certain customers under sales-type leases. The components of the Company's net investment in sales-type leases are as follows:
Future minimum lease payments due under noncancelable leases as of October 31, 1998 are as follows:
10. STOCKHOLDERS' EQUITY
EQUITY TRANSACTIONS
On April 21, 1997, the Company sold 1,000,000 shares of common stock in an initial public offering for net proceeds of $3,917,664. In connection with the offering, warrants were issued to the underwriter for 100,000 shares of common stock at an exercise price of $6.00 per share. Beginning April 21, 1998, the warrants are exercisable for a period of four years.
During February 1998, the Company repurchased 50,000 shares of its common stock held by former stockholders of STMS. The shares were repurchased at the current market price of $9.15 per share. The Company accounted for the repurchase as a treasury stock transaction. The Company also repurchased options to purchase 25,000 shares of the Company's common stock that were originally issued in connection with the STMS acquisition. The repurchase price of $75,750 represents the difference between the fair market value of the underlying common stock on the repurchase date and the grant price multiplied by the 25,000 options. The Company accounted for the repurchase as a reduction of additional paid-in capital.
The IDP Acquisition Agreement provided for an adjustment of the purchase price if the combined net worth of IDP and PRIMO exceeded or was below a specified level. Since the net worth on the closing balance sheet of IDP and PRIMO was below the specified level, the Company and the former IDP stockholders agreed to adjust the purchase price. In November 1998, the Company entered into a Purchase Price Adjustment Agreement with the two former stockholders of IDP whereby 350,000 shares of the Company's common stock originally issued in connection with the IDP acquisition were returned to the Company. The Company accounted for the return as a treasury stock transaction and valued such shares at the fair market value of the Company's common stock on the date of acquisition. In connection with the
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. STOCKHOLDERS' EQUITY (CONTINUED)
EQUITY TRANSACTIONS (CONTINUED)
transaction, the Company and the two former stockholders also agreed to cancel the employment agreements in exchange for payments totaling $500,000, for which the Company recorded an adjustment to its purchase price allocation. In addition, the Company agreed to pay the balance of the notes payable to related parties of $905,960 in full by November 25, 1998. The two former stockholders retained their options to purchase the Company's common stock subject to all original terms and conditions. (See Note 5)
In connection with the acquisitions of IDP and PRIMO, the Company completed a public offering of 3,491,493 shares of common stock for net proceeds of $26,287,866.
STOCK OPTIONS
On January 6, 1997, the Company adopted the 1997 Stock Option Plan (the "Option Plan") which permits the Company to grant up to 600,000 options to officers, directors and employees who contribute materially to the success of the Company. In September 1997, the Company increased the number of options available for grant under the plan to 2,200,000. Stock options are generally granted at prices which the Company's Board of Directors believes approximates the fair market value of its common stock at the date of grant. The options vest over a stated period of time not to exceed four years. The contractual term of the options is five years.
Common stock option activity was as follows:
The total options outstanding include 600,000 options granted to the former IDP stockholders that are not included in the Option Plan.
As of October 31, 1998, there were 304,183 options available for future grants under the Option Plan.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTIONS (CONTINUED)
The following table summarizes information about fixed-price stock options outstanding at October 31, 1998:
Had compensation expense related to the stock options been determined based on the fair value at the grant date for options granted during the years ended October 31, 1996, 1997, and 1998 consistent with the provisions of SFAS 123, the Company's net income and earnings per share would have been as follows:
The effect of applying SFAS 123 on pro forma net income as stated above is not necessarily representative of the effects on reported net income for future years due to, among other things, the vesting period of the stock options and the fair value of additional options in the future years.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing fair value model with the following weighted-average assumptions used for grants in 1997 and 1998: dividend yield of 0%, expected volatility of 46%, and 84%, respectively; risk-free interest rates of 5.75% and 5.50%, respectively; and expected life of the option term of five years. The weighted average fair values of the options granted in 1997 and 1998 with a stock price equal to the exercise price is $6.18 and $5.21, respectively. The weighted average fair value of options granted in 1998 with a stock price greater than the exercise price is $7.36.
11. INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. INCOME TAXES (CONTINUED) Components of the Company's net deferred tax asset (credit) balance are as follows:
As of October 31, 1998, the Company had approximately $2,500,000 in net operating loss carryforwards related to STMS and IDP which expire between 2012 and 2017. These carryforwards may be significantly limited under Section 382 of the Internal Revenue Service Code and the SRLY rules. The Company has recorded a valuation allowance for a portion of the deferred tax assets because realizability of those assets is uncertain.
The components of the provision for income taxes are as follows:
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. INCOME TAXES (CONTINUED) The reconciliation of income tax from the Federal statutory rate of 34% is:
In September 1997 and in May 1998, respectively, the Company acquired the stock of STMS and IDP in tax-free exchanges. The stock acquisitions were accounted for using the purchase method. Included in the Company's deferred tax assets at October 31, 1998 is approximately $3,800,000 representing the differences between the assigned values and tax bases of the assets and liabilities acquired, as well as net operating loss carry forwards acquired. These deferred tax assets were fully reserved at the dates of acquisition. To the extent these deferred tax assets are subsequently realized, the resulting tax benefit will be applied to reduce goodwill recorded in connection with the acquisitions and there will be no impact on income tax expense.
12. RETIREMENT PLANS
401(K) PLANS
Effective April 1, 1995, the Company adopted a 401(k) (the "Plan"). Employees are eligible to participate after completing six months of services and attaining age 18. Employees can defer up to 15% of compensation. Employee contributions are subject to Internal Revenue Service limitations. All employees who contribute to the Plan are eligible to share in discretionary Company matching contributions. During the years ended October 31, 1996, 1997 and 1998, the Company contributed $3,300, $11,855 and $0, respectively, to the Plan.
In connection with the IDP Acquisition, the Company assumed IDP's tax-deferred savings plan under Section 401(k) of the Internal Revenue Code which is offered to all employees who have attained the age of 21. The plan provides for contributions by employees as well as matching and discretionary contributions by the Company. The Company made contributions of approximately $123,000 during the period from May 1, 1998 through October 31, 1998.
DEFINED BENEFIT PLAN
The Company has a defined benefit plan (the "Pension Plan") covering substantially all salaried employees. The Pension Plan benefits are based on years of service and the employee's compensation. The Company's funding policy is to annually contribute amounts sufficient to meet minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974 ("ERISA"). Contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. The assets of the Pension Plan are invested in money market and corporate debt and equity instruments. The Company contributed, in the aggregate, approximately $135,000 for the Pension Plan years ending October 31, 1995 and 1996 and $63,777 for the Pension Plan year ending October 31, 1997. Such amounts met the minimum funding requirements under ERISA. The Company has accrued,
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. RETIREMENT PLANS (CONTINUED)
DEFINED BENEFIT PLAN (CONTINUED) but not yet paid, $70,063, which amount represents its minimum funding requirements under ERISA for fiscal 1998.
On January 6, 1997, the Company amended the Pension Plan to change the benefits to be paid out after retirement from 100% to 40% of its initial liability. This will result in a reduction of the projected benefit obligation by $150,000.
The following table sets forth the Pension Plan's funded status as reported on activity, and amounts recognized in the Company's consolidated financial statements:
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. RETIREMENT PLANS (CONTINUED)
DEFINED BENEFIT PLAN (CONTINUED) Key assumptions used in the actuarial valuation were:
13. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share:
14. CONTINGENCIES
EMPLOYEE TERMINATION
In November 1998, a former employee of the Company (who had previously been an employee and stockholder of STMS) filed a demand for arbitration with the American Arbitration Association, alleging a breach of his employment agreement with the Company and seeking "in excess of $2,350,000" in damages from the Company. The Company has filed an answer denying the former employee's allegations and a counterclaim for this former employee's breach of the employment agreement and for conversion of certain of the Company's property, and intends to defend the former employee's claim and to pursue its own claim, vigorously. The Company believes that it has meritorious defenses to the former employee's claim. The Company can't estimate at this time the amount of the liability to be incurred, if any, but doesn't believe that this matter will have a material adverse effect upon the Company's financial position
DUNN COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. CONTINGENCIES (CONTINUED) or results of operations and, as such, the Company has not recorded any amount relating to this matter in the accompanying consolidated financial statements.
IDP ACQUISITION
On December 18, 1998, the Company became aware of a threatened action by the Office of the United States Attorney for the District of Maryland, Northern Division (U.S. Attorney), against parties including IDP, the former stockholders of IDP, and the Company, in which the U.S. Attorney may allege fraudulent misrepresentations by the former stockholders of IDP in a 1994 application by IDP for participation in the Section 8(a) program administered by the United States Small Business Administration. To date, no actual suit has been filed. The Company is currently negotiating a resolution to this matter with the U.S. Attorney and the other parties. The Company believes that it has meritorious defenses to each of these allegations and intends to vigorously defend itself if a suit is filed. The Company can't estimate at this time the amount of the liability to be incurred, if any, but doesn't believe that this matter will have a material adverse effect upon the Company's financial position or results of operations and as such, the Company has not recorded any amount relating to this matter in the accompanying consolidated financial statements.
In May 1997, the U.S. Air Force awarded a contract to IDP. Dynamic Decisions, Inc. ("DDI"), a competitor for this contract, protested the contract award to the Small Business Administration ("SBA"), which protest was denied. DDI filed suit against the SBA and Air Force seeking review of the award decision. IDP intervened in the litigation and the litigation was subsequently settled. Based on the terms of the settlement, IDP agreed to pay DDI 1.8% of the first $250 million of IDP's gross sales under the contract. On June 1, 1998, the Company filed a Complaint for Declaratory Judgment in U.S. District Court for the Eastern District of Virginia seeking a declaration that DDI is not entitled to receive payments under the settlement agreement. This filing is based on the Company's position that DDI breached the settlement agreement. DDI has counter-claimed against the Company denying it breached the settlement agreement and seeking the payments. The Company believes that it has meritorious defenses to the claim and intends to vigorously defend itself. The Company can't estimate at this time the amount of the liability to be incurred, if any, but doesn't believe that this matter will have a material adverse effect upon the Company's financial position or results of operations and as such, the Company has not recorded any amount relating to this matter in the accompanying consolidated financial statements.
REPORT OF KPMG PEAT MARWICK LLP, INDEPENDENT AUDITORS
The Boards of Directors International Data Products, Corp. and Puerto Rico Industrial Manufacturing Operations, Corp.:
We have audited the accompanying combined balance sheets of International Data Products, Corp. and combined company as of September 30, 1996 and 1997, and the related combined statements of income and retained earnings and cash flows for each of the years in the three-year period ended September 30, 1997. These combined financial statements are the responsibility of the Companies' management. Our responsibility is to express an opinion on these combined financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of International Data Products, Corp. and combined company as of September 30, 1996 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 1997 in conformity with generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP
McLean, Virginia November 7, 1997
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
COMBINED BALANCE SHEETS
See accompanying notes to combined financial statements.
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
COMBINED STATEMENTS OF INCOME AND RETAINED EARNINGS
See accompanying notes to combined financial statements.
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
COMBINED STATEMENTS OF CASH FLOWS
Supplemental Cash Flow Information:
The Company paid income taxes of approximately $26,000, $224,000 and $713,000, and paid interest of approximately $365,000, $629,000 and $496,000, during the years ended September 30, 1995, 1996, and 1997, respectively.
See accompanying notes to combined financial statements.
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS
SEPTEMBER 30, 1995, 1996, AND 1997
(1) BASIS OF PRESENTATION AND RELATED MATTERS
ORGANIZATION
The International Data Products, Corp. combined financial statements include the accounts of International Data Products, Corp. ("IDP") and Puerto Rico Industrial Manufacturing Operations, Corp. ("PRIMO"). IDP and PRIMO are under common family ownership control. All material intercompany accounts and transactions have been eliminated in combination. IDP and PRIMO combined is hereinafter referred to as the "Company".
IDP was incorporated in Maryland on February 27, 1984. The Company sells computer equipment and provides computer training and maintenance service primarily to agencies and suppliers of the federal government. For each of the three years ended September 30, 1995, 1996 and 1997, approximately 1 percent, 8 percent and 6 percent, respectively, of the Company's revenue was from federal contracts that were awarded under section 8(a) of the Small Business Act.
Puerto Rico Industrial Manufacturing Operations, Corp. is incorporated under the laws of the Commonwealth of Puerto Rico. PRIMO manufactures computers and peripheral equipment for IDP. Substantially all of PRIMO's sales are to IDP, which have been eliminated in the accompanying combined financial statements.
The Company operates in a competitive environment subject to technological change and the emergence of new technologies, although the Company believes that its products and services are, or would be, upgradable to new technologies.
CASH AND CASH EQUIVALENTS
The Company maintains demand deposits with several financial institutions. At times, deposits exceed federally insured limits, but management does not consider this a significant concentration of credit risk. Cash equivalents consist of highly liquid investments with original maturities of 90 days or less. The fair market value of such instruments approximates cost.
INVENTORY
Inventory consists of parts and material and is stated at the lower of cost, using weighted average cost method, or market. The Company has established reserves for obsolete and excess inventory at $0 and $796,404 as of September 30, 1996 and 1997, respectively.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and depreciated using the straight-line method based on estimated useful lives of three to seven years. Maintenance and repair costs are charged to expense as incurred. Leasehold improvements are capitalized and amortized over the lesser of the life of the improvement or the remaining term of the lease.
REVENUE RECOGNITION
The Company recognizes revenues from hardware and software sales at time of receipt by the customer. Service revenues are recognized over the contractual period as the service is provided.
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(1) BASIS OF PRESENTATION AND RELATED MATTERS (CONTINUED) ADVERTISING
The Company expenses the production costs of advertising the first time the advertising is published, except for direct response advertising, which is capitalized and amortized over its expected period of future benefit (generally three months) based on the ratio of current direct response revenue to estimated total direct response revenue. Direct response advertising consists primarily of magazine advertisements which include item order numbers unique to the advertising campaign.
At September 30, 1996, approximately $246,000 of advertising costs were reported as prepaid expenses. There were no advertising costs reported as prepaid expenses at September 30, 1997. For the years ended September 30, 1995, 1996 and 1997, total advertising expense was approximately $252,000, $255,000, and $535,000, respectively.
WARRANTY EXPENSE
The Company reserves for estimated future warranty costs that may be required to satisfy contractual requirements. Such provisions are accrued as the related revenue is recognized. The typical warranty period ranges from one to three years.
INCOME TAXES
The Company applies the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts and income tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The income tax provisions for IDP and PRIMO are prepared separately and combined for financial reporting purposes.
PRIMO has been granted a tax exemption, with certain normal reservations, from Puerto Rico income (90%), property (90%), and municipal license taxes (60%) on its manufacturing operations under the Puerto Rico Tax Incentives Act of 1987, Act No. 8, as amended. This tax exemption is for a period of 20 years ending on September 12, 2014.
CHANGE IN REPORTING PERIODS
PRIMO's reporting periods, as previously audited, were the year ended December 31, 1995 and the nine months ended September 30, 1996. For purposes of presenting the combined financial statements of the Company, PRIMO's financial statements were conformed to reflect each of the years ended September 30, 1995 and 1996, respectively.
USE OF ESTIMATES
The preparation of the combined financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported assets
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(1) BASIS OF PRESENTATION AND RELATED MATTERS (CONTINUED) and liabilities and disclosures of contingent assets and liabilities. Actual results may differ from those estimates.
(2) ACCOUNTS RECEIVABLE
Accounts receivable, which are substantially all billed or billable, at September 30, 1996 and 1997 consist of the following:
Management of the Company believes that substantially all of the outstanding accounts receivable will be collected within one year.
Revenues from several U.S. government agencies totaled approximately $72,820,000, $69,111,000 and $57,871,000, for the years ended September 30, 1995, 1996 and 1997, respectively, including approximately $22,298,000, $22,117,000 and $15,282,000 from the JTP Joint Venture in 1995, 1996 and 1997, respectively (see note 3).
(3) INVESTMENT IN JOINT VENTURE
In November 1993, IDP formed a joint venture entity, Justice Technology Partners Joint Venture ("JTP") with two other companies for the purpose of obtaining and performing under a certain contract. JTP has a contract with a federal government agency involving the sale and maintenance of computer equipment. IDP provides the computer equipment to the joint venture and records sales at cost plus its estimated share of the joint venture profits.
IDP has a 24 percent interest in JTP and the initial investment of $31,200 is recorded at cost. IDP's equity in the estimated earnings of the joint venture is included in accounts receivable.
Summarized financial information for this unconsolidated joint venture entity, as of and for the years ended December 31, 1995 and 1996, is as follows:
Distributions received in excess of profit recognized, amounting to approximately $59,000 is included as a reduction of accounts receivable at September 30, 1996; and profits recognized in excess of
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(3) INVESTMENT IN JOINT VENTURE (CONTINUED) distributions received, amounting to approximately $116,000 is included in accounts receivable at September 30, 1997.
(4) FIXED ASSETS
Fixed assets as of September 30, 1996 and 1997 consist of the following:
(5) INDEBTEDNESS
Notes payable consists of the following:
Principal payments on the long-term debt for each of the fiscal years from 1998 to 2002 and thereafter are due as follows:
Other notes payable consist of automobile loans and a demand bank loan. The automobile loans are secured by the respective automobile, and the demand loan is secured by the Company's accounts at the
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(5) INDEBTEDNESS (CONTINUED) respective bank. The notes mature at intervals between November 1997 and September 2001. Interest rates on the notes range from 3.7 percent to 11.5 percent.
Notes payable to related parties are payable to certain stockholders and their relatives, and employees. All notes payable to related parties are classified as current liabilities as they are callable by the holder at any time. Notes payable to related parties bear interest at rates ranging from 8 to 11 percent. The total amounts outstanding on these related party notes payable were approximately $1,604,000 and $1,498,000 at September 30, 1996 and 1997, respectively.
The Company has a line of credit facility of $15,000,000, of which $5,000,000 is secured by the Company's inventory and $10,000,000 is secured by accounts receivable. The outstanding balance on this line of credit at September 30, 1996 and 1997 was approximately $6,586,000 and $5,635,000, respectively. The interest rates applicable to this line of credit as of September 30, 1996 and 1997 were 8.25 percent and 8.5 percent, respectively. Subsequent to year-end, the amounts available under this credit facility were increased to $25,000,000 with an additional temporary overline of $7,000,000 available through January 31, 1998. There is no formal expiration date on this facility although it is subject to annual re-evaluation by the financial institution.
(6) INCOME TAXES
For combined financial reporting purposes, income (loss) before income taxes for the years ended September 30, 1995, 1996 and 1997 include the following components:
As discussed in Note 2, PRIMO has been granted a 90 percent exemption, with certain reservations, for income taxes on its manufacturing operations under the Tax Incentives Act of Puerto Rico of 1987, Act No. 8, as amended. This exemption is for a period of twenty years and ends in September 2014. Further, PRIMO has no temporary differences that would create deferred tax assets or liabilities as of September 30, 1996 or 1997.
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(6) INCOME TAXES (CONTINUED) The components of income tax expense (benefit) for the Company for the years ended September 30, 1995, 1996 and 1997 are as follows:
Income tax expense (benefit) amounted to $278,305 for 1995, an effective rate of 13 percent; ($17,708) for 1996, an effective rate of (2) percent; and ($417,447) for 1997, an effective rate of (55) percent. The actual expense (benefit) differs from the "expected expense (benefit)" for those years, computed by applying the U.S. federal corporate tax rate of 34 percent in 1995, 1996 and 1997 to earnings (loss) before income tax expense, as follows:
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(6) INCOME TAXES (CONTINUED) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at September 30, 1996 and 1997 are presented below:
The net deferred tax asset (liability) is reflected in the accompanying balance sheets as:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax asset will be realized. The ultimate realization of the deferred tax asset is dependent upon the generation of future taxable income during the periods in which temporary differences become deductible. Management considers scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies that can be implemented by IDP in making this assessment. Management has established a valuation allowance of $122,690 in 1997 to reduce the deferred tax asset to a level where based upon the level of historical taxable income, scheduled reversal of deferred tax liabilities, and projections of future taxable income over the periods in which the temporary differences become deductible based on available tax planning strategies, management presently believes that it is more likely than not that IDP will realize the benefits of these deductible differences.
INTERNATIONAL DATA PRODUCTS, CORP. AND COMBINED COMPANY
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1995, 1996, AND 1997
(7) COMMITMENTS AND CONTINGENCIES
LEASES
The Company is obligated under various noncancelable operating leases for office/warehouse space and office equipment. The future minimum lease obligations under these noncancelable operating leases as of September 30, 1997 are approximately as follows:
Rent expense under these operating leases amounted to approximately $453,000, $556,000, and $538,000 for the periods ended September 30, 1995, 1996, and 1997, respectively. Rent payments are being expensed on a straight-line basis over the life of the lease, with the difference recorded as deferred rent.
BID PROTEST SETTLEMENT
During the year ended September 30, 1996, IDP settled a contract award dispute with a third party and recorded a $750,000 gain on settlement. Costs relating to the bid protest were expensed in the period incurred and recorded as operating expenses.
(8) RETIREMENT PLAN
IDP maintains a tax-deferred savings plan under Section 401(k) of the Internal Revenue Code which is offered to all employees who have attained the age of 21. The plan provides for contributions by employees as well as matching and discretionary contributions by IDP. IDP made contributions of approximately $150,000, $210,000, and $261,000 to the plan during the years ended September 30, 1995, 1996, and 1997.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors
We have audited the consolidated financial statements of Dunn Computer Corporation (a Virginia corporation) as of October 31, 1997 and 1998, and for each of the three years in the period ended October 31, 1998 and have issued our report thereon dated February 3, 1999 (included elsewhere in this Form 10-K). Our audits also included the financial statement schedule listed in Item 14 of this Form 10-K. The schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole presents fairly, in all material respect, the information set forth herein.
/s/ Ernst & Young LLP
Vienna, Virginia February 3, 1999
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SCHEDULE II-VALUATION AND QUALIFYING ACCOUNT AND RESERVE DUNN COMPUTER CORPORATION
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(1) Write-offs of accounts receivable
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