February 16, 1999
INTERFACE SYSTEMS INC (INTF)
Quarterly Report (SEC form 10-Q)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
DISCONTINUED OPERATIONS
In May 1998, the Company sold substantially all assets and certain liabilities of its ISIL distribution business to Fayrewood plc for approximately $3.1 million cash. Accordingly, the operating results of ISIL and the loss on sale of $2.1 million have been segregated from continuing operations and reported as separate line items on the Company's consolidated statement of operations. In addition, the assets and liabilities of ISIL, excluding its cash and note payable, have been reclassified on the Company's consolidated balance sheet and reported as assets and liabilities of the discontinued operation. The Company has restated its prior financial statements to present the operating results of ISIL as a discontinued operation. Net revenues of the ISIL distribution business totaled $38.8 million, $62.8 million, and $56.3 million for fiscal 1998, 1997 and 1996, respectively.
RESULTS OF OPERATIONS
Net Revenues. Revenues for the first quarter ended December 31, 1998 were $5.2 million, a decrease of 7.3% over revenues of $5.6 million for the first quarter of fiscal 1998. The decrease was due primarily to decreased sales of the Company's Cleo Enterprise Networking products, which are impacted by large corporate orders, partially offset by increased sales of Document Server and e-Statement Direct software products.
Cost of Revenues. Cost of revenues were $2.1 million and $2.4 million, or 40.3% and 42.5% of net revenues for the quarters ended December 31, 1998 and 1997, respectively. During the first quarter of fiscal 1999, cost of revenues decreased as a percentage of net revenues primarily due to a decrease in non-recurring charges for inventory obsolescence and capitalized software development costs. Cost of revenues includes amortization of capitalized software development costs of $23,000 and $355,000 for the quarters ended December 31, 1998 and 1997, respectively. Cost of revenues also includes charges of $158,000 and $48,000 for inventory obsolescence during the quarter ended December, 1998 and 1997, respectively. Additionally, the decrease in cost of revenues as a percentage of net revenues resulted from increased sales of higher margin software products as a percentage of net revenue.
Product Development Costs. Product development costs were $913,000 and $903,000, or 17.5% and 16.1% of net revenues for the quarters ended December 31, 1998 and 1997, respectively.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $2.1 million and $2.2 million, or 40.2% and 38.7% of net revenues for the quarters ended December 31, 1998 and 1997, respectively. The absolute dollar decrease was primarily due to the Company's efforts to reduce its general and administrative expenses.
Income Taxes. The income tax provision for the quarter ended December 31, 1998 includes federal alternative minimum taxes and the utilization of approximately $380,000 of net operating loss carryforwards. The Company has net operating loss carryforwards of approximately $8.6 million available to offset future taxable income through fiscal year 2013.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1998, the Company's primary sources of liquidity included cash and cash equivalents of $1.3 million and a short-term credit facility with a bank providing for $3.5 million of borrowings, of which $3.5 million was available.
The Company met its liquidity needs during the first quarter of fiscal 1999 primarily through cash generated from operating activities of $2.6 million. Cash provided by operating activities was primarily the result of refunded income taxes, net income before depreciation and amortization expense and lower accounts receivable and inventories offset in part by decreases in accounts payable and accrued expenses.
Cash used in financing activities was $1.3 million in the first quarter of fiscal 1999 primarily due to repayment of borrowings under the Company's bank credit facility as a result of improved operating cash flow.
The Company has a $3.5 million bank credit facility that expires on February 28, 1999. As of December 31, 1998, there were no borrowings outstanding under this facility. Advances bear interest at the bank's prime rate (8.25% at December 31, 1998) plus 1%, are payable on demand and are collateralized by substantially all of the Company's assets. The amount available for borrowing at any time is based on borrowing base formulas relating to levels of accounts receivable, inventories and other bank covenants. Under such formulas, $3.5 million was available to the Company as of December 31, 1998.
Under the terms of the credit agreement, the Company is required to maintain certain minimum working capital, net worth and profitability levels and other specific financial ratios. In addition, the credit agreement prohibits the payment of cash dividends and contains certain restrictions on the Company's ability to borrow money or purchase assets or interests in other entities without the prior written consent of the bank. As of December 31, 1998, the Company was in compliance with the bank covenants.
The Company believes that its existing cash balances, available credit facility and future operating cash flows will be sufficient for near term operating needs. The Company believes it will renew its bank credit facility prior to expiration of the facility. The foregoing statements are "forward looking statements" within the meaning of the Securities Exchange Act of 1934. The extent to which such sources will be sufficient to meet the Company's anticipated cash requirements is subject to a number of uncertainties including the ability of the Company's operations to generate sufficient cash to support operations, and other uncertainties described in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Uncertainties Relating to Forward-Looking Statements."
YEAR 2000
The "year 2000" problem is pervasive and complex, with the potential to cause systems failures and business process interruption resulting from the use of 2-digit date formats as the year changes from 1999 to 2000. The Company has been addressing the risks associated with its information technology ("IT") and non-information technology ("non-IT") systems as the year 2000 approaches. In addition to the Company's own systems, the Company relies, directly and indirectly, on external systems of its customers, suppliers, financial organizations, utilities providers and government entities (collectively, "Third Parties"). Consequently, the Company could be affected by disruptions in the operations of Third Parties with which the Company interacts. Furthermore,
the purchasing frequency and volume of customers or potential customers may be affected by Year 2000 correction efforts as companies expend significant efforts to make their systems Year 2000 compliant.
The Company is using both internal and external resources to (a) assess the Company's state of readiness (including the readiness of Third Parties with which the Company interacts) with respect to the year 2000 problem; (b) estimate the cost to correct and/or replace non-compliant internal IT and non-IT systems; (c) assess the known risks and consequences related to failure to correct any Year 2000 problems identified; and (d) develop a contingency plan, if advisable, to address the Company's Year 2000 exposure. The Company's Board of Directors has established a committee to review the Company's efforts to address its Year 2000 issues and report back to the Board at each Board meeting.
The Company has tested all current versions of its products to determine whether such products are Year 2000 compliant. The Company believes that all of its current products are Year 2000 compliant. Earlier versions of the Company's products can be classified as either (a) known to be Year 2000 compliant, (b) known to not be Year 2000 compliant, or (c) not tested for Year 2000 compliance. The Company has no plans to make earlier versions of its products Year 2000 compliant and, in cases where the end user of a non-compliant product is known, has made attempts to contact the customer. In cases where the product has been sold through a reseller, the end user is not known and therefore, cannot be contacted.
If any of the Company's customers are unable to make their IT systems Year 2000 compliant in a timely fashion, they may suspend further product purchases from the Company until their systems are Year 2000 compliant. Because most of the Company's customers are Fortune 500 companies and banking and finance institutions, the Company expects most of its customers will become Year 2000 compliant in a timely fashion, although the Company is not in a position to monitor their progress.
All of the Company's critical vendors have been queried as to their Year 2000 preparedness. For the few that have not responded satisfactorily, alternative sources are being sought and will be in place by June 1999.
The Company has completed the assessment of its principal internal IT software systems and its personal computer and network hardware and software for Year 2000 compliance. The Company is in process of replacing its accounting software and IGK's customer order tracking system with third party products. The Company believes that these systems will be replaced by June 1999 and that its principal internal IT software systems and its personal computer and network hardware and software will be Year 2000 compliant by June 1999.
The Company has incurred costs of approximately $85,000 to date and presently expects to incur an additional $115,000 in the future to address Year 2000 compliance issues. Such costs consist primarily of the cost of replacing non-compliant internal IT system software and upgrading or replacing non-compliant personal computer and network hardware and software, but do not include internal staff costs, which the Company has not separately tracked. The Company would have incurred many of the costs for these efforts in any event because of the normal process of internal IT system upgrades. These cost estimates are subject to a number of uncertainties, which could result in actual costs exceeding the estimated amounts including, but not limited to, undetected errors or defects discovered in the remediation process or unanticipated difficulties in completing the remediation in a timely fashion.
While the Company believes that its efforts to address Year 2000 issues for which it is responsible should be successful, a description of its most reasonably likely worse case Year 2000 scenarios have been described above. In addition, it is possible that there will be undetected errors or defects associated with Year 2000 in the Company's current products and internal systems or those of its principal vendors. If any of the foregoing scenarios should occur, it is possible that the Company could be involved in litigation. In addition, although the Company does not believe that it has any obligation to make prior versions of its products Year 2000 compliant, it is possible that its customers may take a contrary position and initiate litigation. Because of the relative lack of litigation concerning the Year 2000 issue, it is uncertain how such issues may affect the Company. In the event of litigation or one or more of the worst case Year 2000 scenarios described above, the Company's financial condition and results of operation could be materially adversely affected.
UNCERTAINTIES RELATING TO FORWARD-LOOKING STATEMENTS
"Management's Discussion and Analysis of Results of Operations" contain "forward-looking statements" within the meaning of the Securities Exchange Act of 1934, as amended, based on current management expectations. Actual results could differ materially from those in the forward-looking statements due to a number of uncertainties, including, but not limited to, those discussed in this section. Factors that could cause future results to differ from these expectations include general economic conditions particularly related to demand for the Company's products and services; changes in Company strategy; product life cycles; competitive factors (including the introduction or enhancement of competitive products); pricing pressures; the Company's success in and expense associated with developing, introducing and shipping new products; software defects and latent technological deficiencies in new products; changes in operating expenses; inability to attract or retain consulting, sales and/or engineering talent; changes in customer requirements; evolving industry standards; and the impact of undetected errors or defects associated with the Year 2000 date function on the Company's current products and internal systems.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has no material market risk exposure.
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