Conformed
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Quarterly Period Ended June 30, 2005.
or
[ ] Transition
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934 for the Transition Period from __________ to __________.
Commission File Number: 0-26494
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GSE SYSTEMS, INC.
-----------------
(Exact name of registrant as specified in its charter)
Delaware 52-1868008
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9189 Red Branch Road, Columbia Maryland, 21045
-----------------------------------------------
(Address of principal executive office and zip code)
Registrant's telephone number, including area code: (410) 772-3500
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [ X ] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]
As of August 1, 2005, there were 8,999,706 shares of the Registrant's common
stock outstanding.
GSE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX
PAGE
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PART I. FINANCIAL INFORMATION 3
Item 1. Financial Statements:
Consolidated Balance Sheets as of June 30, 2005 and 3
December 31, 2004
Consolidated Statements of Operations for the Three and Six Months 4
Ended June 30, 2005 and June 30, 2004
Consolidated Statements of Comprehensive Income (Loss) for the 5
Three and Six Months Ended June 30, 2005 and June 30, 2004
Consolidated Statements of Cash Flows for the Six Months Ended 6
June 30, 2005 and June 30, 2004
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Results of Operations and 14
Financial Condition
Item 3. Quantitative and Qualitative Disclosures About Market Risk 24
Item 4. Controls and Procedures 24
PART II. OTHER INFORMATION 25
Item 1. Legal Proceedings 25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 25
Item 3. Defaults Upon Senior Securities 25
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 5. Other Information 26
Item 6. Exhibits 26
SIGNATURES 27
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
Unaudited
June 30, 2005 December 31, 2004
------------------- -------------------
ASSETS
Current assets:
Cash and cash equivalents $ 249 $ $ 868
Restricted cash 500 29
Contract receivables 9,177 8,723
Prepaid expenses and other current assets 820 819
------------------- -------------------
Total current assets 10,746 10,439
Equipment and leasehold improvements, net 528 596
Software development costs, net 838 909
Goodwill, net 1,739 1,739
Other assets 537 545
------------------- -------------------
Total assets $ 14,388 $ 14,228
=================== ===================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 675 $ 9
Accounts payable 2,674 2,998
Due to GP Strategies Corporation 473 291
Accrued expenses 1,694 1,608
Accrued compensation and payroll taxes 1,451 1,523
Billings in excess of revenue earned 618 1,079
Other current liabilities 187 273
------------------- -------------------
Total current liabilities 7,772 7,781
Long-term debt 676 -
Accrued warranty reserves, less current portion 482 483
Other liabilities 1,352 19
------------------- -------------------
Total liabilities 10,282 8,283
------------------- -------------------
Commitments and contingencies
Stockholders' equity:
Series A convertible preferred stock $.01 par value, 2,000,000 shares authorized,
no shares issued and outstanding - -
Common stock $.01 par value, 18,000,000 shares authorized, shares issued
and outstanding 8,999,706 and 8,949,706 in 2005 and 2004, respectively 90 89
Additional paid-in capital 30,915 30,815
Accumulated deficit - at formation (5,112) (5,112)
Accumulated deficit - since formation (20,642) (19,044)
Accumulated other comprehensive loss (1,145) (803)
------------------- -------------------
Total stockholders' equity 4,106 5,945
------------------- -------------------
Total liabilities and stockholders' equity $ 14,388 $ 14,228
=================== ===================
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
Three months ended Six months ended
June 30, June 30,
------------------------- ------------------------
2005 2004 2005 2004
------------ ----------- ------------ ----------
Contract revenue $ 6,717 $ 7,597 $ 13,010 $ 15,158
Cost of revenue 5,077 5,760 10,315 11,544
------------ ----------- ------------ ----------
Gross profit 1,640 1,837 2,695 3,614
------------ ----------- ------------ ----------
Operating expenses:
Selling, general and administrative 1,776 1,184 3,606 2,422
Administrative charges from GP Strategies 171 246 342 492
Depreciation and amortization 67 74 144 143
------------ ----------- ------------ ----------
Total operating expenses 2,014 1,504 4,092 3,057
------------ ----------- ------------ ----------
Operating income (loss) (374) 333 (1,397) 557
Interest expense, net (54) (16) (71) (159)
Other income (expense), net (103) 16 (154) 16
------------ ----------- ------------ ----------
Income (loss) before provision (benefit)
for income taxes (531) 333 (1,622) 414
Provision (benefit) for income taxes 25 57 (24) 74
------------ ----------- ------------ ----------
Net income (loss) $ (556) $ 276 $ (1,598) $ 340
============ =========== ============ ==========
Basic earnings (loss) per common share $ (0.06) $ 0.03 $ (0.18) $ 0.04
============ =========== ============ ==========
Diluted earnings (loss) per common share $ (0.06) $ 0.03 $ (0.18) $ 0.04
============ =========== ============ ==========
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(Unaudited)
Three months ended Six months ended
June 30, June 30,
------------------------- ------------------------
2005 2004 2005 2004
------------ ----------- ------------ ----------
Net income (loss) $ (556) $ 276 $ (1,598) $ 340
Foreign currency translation adjustment (184) (13) (342) (54)
------------ ----------- ------------ ----------
Comprehensive income (loss) $ (740) $ 263 $ (1,940) $ 286
============ =========== ============ ==========
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
Six months ended
June 30,
------------------------------
2005 2004
--------------- -------------
Cash flows from operating activities:
Net income (loss) $ (1,598) $ 340
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Depreciation and amortization 383 315
Changes in assets and liabilities:
Contract receivables (454) 497
Prepaid expenses and other assets 169 710
Accounts payable, accrued compensation and accrued expenses (627) 233
Due to GP Strategies Corporation 182 295
Billings in excess of revenues earned (461) (2,355)
Accrued warranty reserves (11) 113
Other liabilities (20) 27
--------------- -------------
Net cash provided by (used in) operating activities (2,437) 175
--------------- -------------
Cash flows from investing activities:
Capital expenditures (94) (68)
Capitalized software development costs (159) (239)
Releases of cash as collateral under letters of credit 29 301
--------------- -------------
Net cash used in investing activities (224) (6)
--------------- -------------
Cash flows from financing activities:
Borrowings under line of credit 675 -
Proceeds from issuance of common stock 100 -
Issuance of subordinated convertible note payable, net of
restrictions of cash placed in escrow 1,500 -
Deferred financing costs (182) -
Other financing activities, net (9) (17)
--------------- -------------
Net cash provided by (used in) financing activities 2,084 (17)
--------------- -------------
Effect of exchange rate changes on cash (42) (7)
--------------- -------------
Net decrease in cash and cash equivalents (619) 145
Cash and cash equivalents at beginning of year 868 1,388
--------------- -------------
Cash and cash equivalents at end of period $ 249 $ 1,533
============= =============
The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Three and Six Months ended June 30, 2005 and 2004
(Unaudited)
1. Basis of Presentation and Revenue Recognition
The consolidated financial statements included herein have been prepared by
GSE Systems, Inc. (the "Company") without independent audit. In the opinion of
the Company's management, all adjustments and reclassifications of a normal and
recurring nature necessary to present fairly the financial position, results of
operations and cash flows for the periods presented have been made. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with U.S. generally accepted accounting principles have
been condensed or omitted. These consolidated financial statements should be
read in conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the period ended
December 31, 2004 filed with the Securities and Exchange Commission on March 17,
2005.
The Company has only one reportable segment. The Company has a wide range
of knowledge of simulation systems and the processes those systems are intended
to control and model. The Company's knowledge is concentrated heavily in
simulation technology and model development. The Company is primarily engaged in
simulation for the power generation industry, the process industries, and the US
Government. Contracts typically range from 18 months to three years.
At June 30, 2005, GP Strategies Corporation ("GP Strategies") owned 57% of
the Company's common stock. On June 20, 2005, the Board of Directors of GP
Strategies approved plans to spin-off its interest in GSE through a special
dividend to the GP Strategies' stockholders. The GP Strategies stockholders will
receive in the spin-off a pro-rata share of the Company's common stock based on
the number of shares of GP Strategies common stock and Class B stock held on the
record date, which will be determined on a future date. On July 8, 2005, the
Company filed a registration statement with the Securities and Exchange
Commission relating to the shares of the Company to be distributed by GP
Strategies in the spin-off. The Company anticipates that the record date will be
set and the spin-off will occur shortly after such registration statement is
declared effective.
For the three and six months ended June 30, 2005, one customer (Battelle's
Pacific Northwest National Laboratory) accounted for approximately 32.3% and
30.4%, respectively, of the Company's consolidated revenue. For the three and
six months ended June 30, 2004, this customer accounted for approximately 17.3%
and 21.1%, respectively, of the Company's consolidated revenue. The Pacific
Northwest National Laboratory is the purchasing agent for the Department of
Energy and the numerous projects the Company performs in Eastern and Central
Europe.
In the first six months of 2005, the Company incurred a significant
operating loss. The Company's revenue and profitability were impacted by the
lower volume of orders logged in 2004 coupled with the delay of two large
international simulator orders. In addition, the Company has continued to spend
heavily on business development activities in order to expand the Company's
simulation business into new sectors, such as the US military and homeland
security markets. Accordingly, the Company's cash position has weakened during
the six months ended June 30, 2005, with total cash decreasing from $868,000 at
December 31, 2004 to $294,000 at June 30, 2005. The Company has utilized
$725,000 of its $1.5 million credit facility at June 30, 2005, including $50,000
for letters of credit.
The Company's credit facility requires GSE to comply with certain financial
ratios. At June 30, 2005, GSE was not in compliance with its debt service
coverage ratio. The Company obtained a letter dated August 4, 2005 in which the
lender has agreed to forebear from exercising its rights under the credit
agreement against GSE with respect to this event of default until the Company
has delivered to the lender the Company's financial statements for the year
ending December 31, 2005.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant was $374,000 and the fair value of
the Conversion Option of the Dolphin Note was $959,000, both of which were
recorded as noncurrent liabilities, with the offset recorded as original issue
discount (OID). OID is accreted over the term of the Dolphin Note and charged to
interest expense, and the unamortized balance is netted against long-term debt
in the accompanying consolidated balance sheets. The GSE Warrant and Conversion
Option liabilities are marked to market through earnings on a quarterly basis in
accordance with EITF No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in a Company's Common Stock". In connection
with this transaction, GP Strategies' commitment to loan the Company up to
$1,000,000 has been terminated.
The majority of the Company's revenue is derived through the sale of
uniquely designed systems containing hardware, software and other materials
under fixed-price contracts. In accordance with Statement of Position 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts", the revenue under these fixed-price contracts is accounted for on
the percentage-of-completion method. This methodology recognizes income as work
progresses on the contract and is based on an estimate of the income earned to
date, less income recognized in earlier periods. The Company bases its estimate
of the degree of completion of the contract by reviewing the relationship of
costs incurred to date to the expected total costs that will be incurred on the
project. Estimated contract earnings are reviewed and revised periodically as
the work progresses, and the cumulative effect of any change is recognized in
the period in which the change is identified. Estimated losses are charged
against earnings in the period such losses are identified.
As the Company recognizes revenue under the percentage-of-completion
method, it provides an accrual for estimated future warranty costs based on
historical and projected claims experience. The Company's long-term contracts
generally provide for a one-year warranty on parts, labor and any bug fixes as
it relates to software embedded in the systems.
The Company's system design contracts do not provide for "post customer
support service" (PCS) in terms of software upgrades, software enhancements or
telephone support. In order to obtain PCS, the customers must purchase a
separate contract. Such PCS arrangements are generally for a one-year period
renewable annually and include customer support, unspecified software upgrades,
and maintenance releases. The Company recognizes revenue from these contracts
ratably over the life of the agreements in accordance with Statement of Position
97-2, "Software Revenue Recognition".
Revenues from certain consulting or training contracts are recognized on a
time-and-material basis. For time-and-material type contracts, revenue is
recognized based on hours incurred at a contracted labor rate plus expenses.
Contract receivables unbilled of $6.0 million and $4.3 million as of June
30, 2005 and December 31, 2004, respectively, are typically billed within sixty
days. In July, 2005 the Company billed $1.6 of the unbilled amounts.
2. Basic and Diluted Earnings (Loss) Per Common Share
Basic earnings (loss) per share is based on the weighted average number of
outstanding common shares for the period. Diluted earnings (loss) per share
adjusts the weighted average shares outstanding for the potential dilution that
could occur if stock options, warrants or convertible subordinated debt were
exercised or converted into common stock. The number of common shares and common
share equivalents used in the determination of basic and diluted earnings (loss)
per share were as follows:
(in thousands, except for share amounts) Three months ended Six months ended
June 30, June 30,
---------------------------- -----------------------------
2005 2004 2005 2004
------------ ----------- ------------ ------------
Numerator:
Net income (loss) $ (556) $ 276 $ (1,598) $ 340
============ =========== ============ ============
Denominator:
Weighted-average shares outstanding for basic
earnings per share 8,999,706 8,949,706 8,998,049 8,949,706
Effect of dilutive securities:
Employee stock options, warrants and
options outside the plan - 63,902 - 65,664
------------ ----------- ------------ ------------
Adjusted weighted-average shares outstanding
and assumed conversions for diluted
earnings per share 8,999,706 9,013,608 8,998,049 9,015,370
============ =========== ============ ============
Shares related to dilutive securities excluded
because inclusion would be anti-dilutive 2,208,289 1,694,776 1,625,798 1,694,776
============ =========== ============ ============
The difference between the basic and diluted number of weighted average
shares outstanding for the three and six months ended June 30, 2004 represents
dilutive stock options and warrants to purchase shares of common stock computed
under the treasury stock method, using the average market price during the
period. Conversion of the stock options, warrants and convertible subordinated
debt was not assumed for the three and six months ended June 30, 2005 because
the impact was anti-dilutive.
3. Stock Compensation
The Company applies the intrinsic-value-based method of accounting
prescribe by Accounting Principles Board (APB) Opinion No. 25, "Accounting for
Stock issued to Employees", and related interpretations including FASB
Interpretation No. 44, "Accounting for Certain Transactions involving Stock
Compensation, an interpretation of APB Opinion No. 25", issued in March 2000,
to account for its fixed-plan stock options. Under this method, compensation
expense is recorded on the date of grant only if the current market price of the
underlying stock exceeds the exercise price. SFAS No. 123, "Accounting for
Stock-Based Compensation", established accounting and disclosure requirements
using a fair-value-based method of accounting for stock based employee
compensation plans. As allowed by SFAS No. 123, the Company has elected to
continue to apply the intrinsic-value-based method of accounting described
above, and has adopted only the disclosure requirements of SFAS No. 123.
If the computed values of all the Company's stock based awards were
calculated and expensed (over the vesting period of the awards) using the fair
value method specified under SFAS 123, net income (loss) would have been as
follows:
(in thousands, except per share data) Three months ended Six months ended
June 30, June 30,
----------------------------- ---------------------------------
2005 2004 2005 2004
------------ ----------- ------------ ------------
Net income (loss), as reported $ (556) $ 276 $ (1,598) $ 340
Add stock-based employee compensation expense
included in reported net income (loss) - - - -
Deduct total stock-based employee compensation
expense determined under fair-value-method
for all awards - (15) (672) (30)
------------ ----------- ------------ ------------
Pro forma net income (loss) $ (556) $ 261 $ (2,270) $ 310
============ =========== ============ ============
Net income (loss) per share, as reported:
Basic $ (0.06) $ 0.03 $ (0.18) $ 0.04
Diluted $ (0.06) $ 0.03 $ (0.18) $ 0.04
Net income (loss) per share, proforma:
Basic $ (0.06) $ 0.03 $ (0.25) $ 0.03
Diluted $ (0.06) $ 0.03 $ (0.25) $ 0.03
The fair value of each option is estimated on the date of grant using a
Black-Scholes option-pricing model with the following weighted-average
assumptions:
Six months ended
June 30,
------------------------
2005 2004
----------- -----------
Risk- free interest rates 4.04% 2.40%
Dividend yield 0% 0%
Expected life 4.43 4.54
Volatility 74.57% 83.72%
Options with an average exercise price of $1.85 covering a total of 600,000
shares of common stock were granted to 47 employees in March 2005, all of which
immediately vested. No employee stock options were issued in the first six
months of 2004 or in the quarter ended June 30, 2005.
4. Long-term Debt
The Company's long-term debt consists of the following:
(in thousands) June 30, December 31,
2005 2004
----------------- ------------------
Line of credit with bank $ 675 $ -
Senior convertible secured subordinated note payable 2,000 -
Note payable, other - 9
----------------- ------------------
2,675 9
Less warrant related discount (365) -
Less convertible option discount (959) -
----------------- ------------------
1,351 9
Less current portion (675) (9)
----------------- ------------------
Long-term debt, less current portion $ 676 $ -
================= ==================
Line of Credit
General Physics Corporation ("General Physics") is a wholly owned
subsidiary of GP Strategies. On March 30, 2004, the Company was added as an
additional borrower under the Financing and Security Agreement between General
Physics Corporation and a financial institution. Under the terms of the
agreement, $1.5 million of General Physics' available credit facility has been
carved out for use by GSE. The line is collateralized by substantially all of
the Company's assets and provides for borrowings up to 80% of eligible accounts
receivable and 80% of eligible unbilled receivables. The interest rate on this
line of credit is based upon the Daily LIBOR Market Index Rate plus 3% (6.32% as
of June 30, 2005), with interest only payments due monthly. At June 30, 2005,
the Company's available borrowing base was $1.5 million, of which $725,000 had
been utilized, including $50,000 for letters of credit. The credit facility
expires on August 12, 2006.
The Company's credit facility requires GSE to comply with certain financial
ratios. At June 30, 2005, GSE was not in compliance with its debt service
coverage ratio. The Company obtained a letter dated August 4, 2005 in which the
lender has agreed to forebear from exercising its rights under the credit
agreement against GSE with respect to this event of default until the Company
has delivered to the lender the Company's financial statements for the year
ending December 31, 2005.
Senior Convertible Secured Subordinated Note Payable
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant was $374,000 and the fair value of
the Conversion Option of the Dolphin Note was $959,000, both of which were
recorded as noncurrent liabilities, with the offset recorded as original issue
discount (OID). OID is accreted over the term of the Dolphin Note and charged to
interest expense, and the unamortized balance is netted against long-term debt
in the accompanying consolidated balance sheets. The GSE Warrant and Conversion
Option liabilities are marked to market through earnings on a quarterly basis in
accordance with EITF No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in a Company's Common Stock".
In connection with this transaction, GP Strategies' commitment to loan the
Company up to $1,000,000 has been terminated.
Note Payable, Other
The Company had an unsecured promissory note payable to a former employee.
The final payment on the note was made in April 2005.
5. Series A Convertible Preferred Stock
The Series A convertible preferred stock had no voting rights and required
dividends at the rate of 6% per annum payable quarterly. Dividends accumulated
if not paid quarterly and compounded interest accrued on any unpaid dividends.
On October 23, 2003, ManTech International Corp. elected to convert all of its
39,000 shares of preferred stock to common stock in conjunction with the sale of
its ownership in the Company to GP Strategies. Thus, as of June 30, 2005 and
December 31, 2004 there are no shares of preferred stock outstanding. The
Company had accrued dividends payable of $366,000 as of June 30, 2005 and
December 31, 2004. Such amount accrues interest at the rate of 6% until paid.
6. Letters of Credit and Performance Bonds
As of June 30, 2005, the Company was contingently liable for one $50,000
letter of credit. The letter of credit represents a payment bond on a contract.
In addition, the Company was contingently liable at June 30, 2005 for
approximately $30,000 under a performance bond on one contract, which was
secured by a bank guarantee of the Company's foreign subsidiary.
7. Income Taxes
The Company's effective tax rate was 1.5% and 17.9% for the six months
ended June 30, 2005 and June 30, 2004, respectively. The decrease in the
effective tax rate is attributable primarily to lower taxable income in Sweden.
For 2005, the Company's combined U.S. federal and state effective tax rate is
projected to be 2% and the Swedish effective tax rate is projected to be 9%. The
Company has an $8.7 million valuation allowance for all of the deferred tax
assets that are not related to its Swedish subsidiary.
8. Administrative Charges from GP Strategies and Other Related Party
Transactions
On January 1, 2004, the Company entered into a Management Services
Agreement with GP Strategies in which GP Strategies agreed to provide corporate
support services to GSE, including accounting, finance, human resources, legal,
network support and tax. In addition, GSE uses the financial system of General
Physics, a subsidiary of GP Strategies. In 2004, GSE was charged $685,000
($171,250 per quarter) for GP Strategies' services. The agreement has been
extended through December 31, 2005 without an increase in the fee. The agreement
can be renewed for successive one-year terms.
In December 2003, GSE's Board of Directors elected John Moran, a GP
Strategies executive with experience in the power industry and simulation
technology, as Chief Executive Officer. Mr. Moran continued as a GP Strategies
employee throughout most of 2004, however, Mr. Moran devoted 100% of his time to
the performance of his duties as CEO of GSE. On December 16, 2004, Mr. Moran
became an employee of GSE. For the six months ended June 30, 2004, GSE was
charged $150,000 by GP Strategies for Mr. Moran's compensation and benefits.
9. Commitments and Contingencies
In conjunction with the move of its Process Automation business to its
Columbia, Maryland facility in May 2003, the Company subleased most of its
vacated facility in Baltimore, Maryland to Alpharma USPD Inc. for a five-year
period, although Alpharma could terminate the lease at the end of the second
year provided a six-month notice was given. Alpharma elected to terminate the
sublease on April 30, 2005. In May, 2005, the Company's lease for the Baltimore
facility was amended to release the Company from its rental obligation for
14,000 sq. ft. of the total 29,000 sq. ft. being leased effective October 1,
2005, as the landlord had entered into a new lease with another tenant for this
space. The Company's broker is actively seeking another subtenant for the
remaining space, and management believes that a subtenant will be found.
However, if a subtenant is not found, the Company may be required to record an
additional charge related to the lease for the vacated facility. The Company's
lease expires in July 2008; the annual rent is approximately $372,000 (after the
reduction of the space), of which the Company currently has a loss accrual of
$214,000.
10. New Accounting Standards
In December 2004, the FASB issued SFAS No. 123 - Revised (SFAS No. 123R),
"Share-Based Payment", which revises SFAS No. 123, "Accounting for Stock-Based
Compensation", and supercedes APB No. 25, "Accounting for Stock Issued to
Employees." Currently, the Company does not record compensation expense for
certain stock-based compensation. Under SFAS No. 123R, the Company will measure
the cost of employee services received in exchange for stock, based on the
grant-date fair value (with limited exceptions) of the stock award. Such cost
will be recognized over the period during which the employee is required to
provide service in exchange for the stock award (usually the vesting period).
The fair value of the stock award will be estimated using an option-pricing
model, with excess tax benefits, as defined in SFAS No. 123R, being recognized
as an addition to paid in capital. SFAS No. 123R was to be effective as of July
1, 2005. However, on April 14, 2005, the Securities and Exchange Commission
announced that the effective date of SFAS 123R will be postponed until January
1, 2006, for calendar year companies. The Company is currently in the process of
evaluating the impact of SFAS No. 123R on its consolidated financial statements.
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition
GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") is a leader in
real-time high fidelity simulation technology and model development. The Company
provides simulation solutions and services to the power generation industry, the
process industries, and the US Government. In addition, the Company provides
plant monitoring and signal analysis monitoring and optimization software
primarily to the power industry, and develops specialized software applications
for emerging technologies. The Company has only one reportable segment.
At June 30, 2005, GP Strategies Corporation ("GP Strategies") owned 57% of
the Company's common stock. On June 20, 2005, the Board of Directors of GP
Strategies approved a plan to spin-off its interest in GSE through a special
dividend to the GP Strategies' stockholders. The GP Strategies stockholders will
receive in the spin-off a pro-rata share of the Company's common stock based on
the number of shares of GP Strategies common stock and Class B stock held on the
record date, which will be determined on a future date. On July 8, 2005, the
Company filed with the Securities and Exchange Commission a registration
statement relating to the shares of the Company to be distributed by GP
Strategies in the spin-off. The Company anticipates that the record date will be
set and the spin-off will occur shortly after such registration statement is
declared effective.
In the first six months of 2005, the Company incurred a significant
operating loss. The Company's revenue and profitability were impacted by the
lower volume of orders logged in 2004 coupled with the delay of two large
international simulator orders. In addition, the Company has continued to spend
heavily on business development activities in order to expand the Company's
simulation business into new sectors, such as the US military and homeland
security markets. Accordingly, the Company's cash position has weakened during
the six months ended June 30, 2005, with total cash decreasing from $868,000 at
December 31, 2004 to $294,000 at June 30, 2005. The Company has utilized
$725,000 of its $1.5 million credit facility at June 30, 2005, inclusive of
$50,000 for letters of credit. On March 30, 2004, the Company was added as an
additional borrower under the Financing and Security Agreement between General
Physics Corporation and a financial institution. Under the terms of the
agreement, $1.5 million of General Physics' available credit facility has been
carved out for use by GSE.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant was $374,000 and the fair value of
the Conversion Option of the Dolphin Note was $959,000, both of which were
recorded as noncurrent liabilities, with the offset recorded as original issue
discount (OID). OID is accreted over the term of the Dolphin Note and charged to
interest expense, and the unamortized balance is netted against long-term debt
in the accompanying consolidated balance sheets. The GSE Warrant and Conversion
Option liabilities are marked to market through earnings on a quarterly basis in
accordance with EITF No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in a Company's Common Stock". In connection
with this transaction, GP Strategies' commitment to loan the Company up to
$1,000,000 has been terminated.
The Company's credit facility requires GSE to comply with certain financial
ratios. At June 30, 2005, GSE was not in compliance with its debt service
coverage ratio. The Company obtained a letter dated August 4, 2005 in which the
lender has agreed to forebear from exercising its rights under the credit
agreement against GSE with respect to this event of default until the Company
has delivered to the lender the Company's financial statements for the year
ending December 31, 2005.
On January 1, 2004, the Company entered into a Management Services
Agreement with GP Strategies Corporation in which GP Strategies agreed to
provide corporate support services to GSE, including accounting, finance, human
resources, legal, network support and tax. In addition, GSE uses the financial
system of General Physics, a subsidiary of GP Strategies. In 2004, GSE was
charged $685,000 ($171,250 per quarter) for GP Strategies' services. The
agreement has been extended through December 31, 2005 without an increase in the
fee. The agreement can be renewed for successive one-year terms.
In conjunction with the move of its Process Automation business to its
Columbia, Maryland facility in May 2003, the Company subleased most of its
vacated facility in Baltimore, Maryland to Alpharma USPD Inc. for a five-year
period, although Alpharma could terminate the lease at the end of the second
year provided a six-month notice was given. Alpharma elected to terminate the
sublease on April 30, 2005. In May, 2005, the Company's lease for the Baltimore
facility was amended to release the Company from its rental obligation for
14,000 sq. ft. of the total 34,000 sq. ft. being leased effective October 1,
2005, as the landlord had entered into a new lease with another tenant for this
space. The Company's broker is actively seeking another subtenant for the
remaining space, and management believes that a subtenant will be found.
However, if a subtenant is not found, the Company may be required to record an
additional charge related to the lease for the vacated facility. The Company's
lease expires in July 2008; the annual rent is approximately $372,000 (after the
reduction of the space), of which the Company currently has a loss accrual of
$214,000.
Cautionary Statement Regarding Forward-Looking Statements
This report contains certain forward-looking statements. Any statements
contained herein that are not statements of historical facts may be deemed
forward-looking statements. These statements are based on management's current
beliefs and expectations and are subject to numerous risks and uncertainties and
changes in circumstances. Actual results may differ materially from these
forward-looking statements due to changes in global, economic, business,
governmental, technical, competitive, market and regulatory factors.
General Business Environment
The Company is positioned to take advantage of emerging trends in the power
industry. The operating licenses for numerous nuclear power plants will expire
over the next several years. Thirty plants received license extensions before
the end of 2004 and eighteen more have applications under review. Many of these
plants are planning significant upgrades to the physical equipment and control
room technology in conjunction with the license extensions. Both will result in
the need to modify or replace the existing plant control room simulators. The
Company, having what the Company believes is the largest installed base of
existing simulators, is well positioned to capture a large portion of this
business.
In the first quarter 2005, the Company completed an agreement with
Westinghouse Electric Company LLC to become their preferred vendor for the
development of simulators for the AP1000 reactor design. As a result of this
agreement, GSE will work closely with Westinghouse to finalize the verification
and validation of the AP1000 Reactor Human-Machine Interface for the Main
Control Room. GSE expects to spend $250,000 in 2005 on developing simulation
models for the AP1000 reactor. In turn, Westinghouse and GSE will collaborate on
new opportunities both internationally and domestically. In the second quarter
2005, the first of these opportunities has developed in China. Recent reports
indicate that the Chinese government expects to build 30 new nuclear plants over
the next 10 years utilizing Western technology. Most of these new plants will
require a stand alone simulator for which the Company believes it is best
qualified to supply.
In addition, in the second quarter 2005, the Company was awarded a contract
to develop simulation models for the novel Pebble Bed Modular Reactor System
(PBMR) being developed by a South African company. The PBMR is a new high
temperature gas cooled reactor that is inherently safe and reliable. Each
reactor is designed to produce 165 MW, enough to provide energy for 40,000
hours. The system is designed such that additional reactors can easily be added
as energy demand increases. The PBMR is ideally suited for areas with current
modest energy needs that are expected to grow. GSE believes it is in an
excellent position to provide the simulators that will be required with each
PBMR installation, although there is no guarantee the Company will be awarded
additional contracts.
The Company continues to focus on the fossil power segment of the power
industry. In the second quarter 2005, the Company logged additional fossil power
orders of approximately $1.8 million. The Company expects continued growth in
this market segment and is focusing on second time simulation buyers that now
demand the more sophisticated and realistic simulation models offered by the
Company.
While GSE simulators are primarily utilized for power plant operator
training, the uses are expanding to include engineering analysis, plant
modification studies, and operation efficiency improvements for both nuclear and
fossil utilities. During plant construction, simulators are used to test control
strategies and ensure on-time start-up. After commissioning, the same tools can
be used to increase plant availability and optimize plant performance for the
life of the facility. In partnership with an industry leading optimization
company, GSE will be participating in DOE grant programs to utilize simulation
and optimization for DOE's clean coal power initiative.
The Company continues to invest heavily in developing business with the US
government and in particular its military component. There are two areas of
emphasis in this market - Homeland Security and Military Defense simulation. In
Homeland Security, the Company has turned its attention to opportunities for
simulation in disaster recovery and terrorist threat response. In the second
quarter 2005, the Company continued development of its REMITS product used to
simulate the operation of Emergency Operations Centers (EOC) run by municipal
and state governments. REMITS is a Real-time Emergency Management Interactive
Training System designed to simulate emergency situations and enable EOC staffs
to train without requiring human participation in the field. REMITS enables the
EOC staff to stay current with the technology and enables instructors to
introduce new problems and challenges during the exercise to test the EOC staff
response to changing situations. As the Federal Government spends billions in
first responder training, the Company believes its REMITS product will find a
large market in the developing field of training for disaster recovery and
terrorist threat response. The Company is currently in final negotiations with a
provider of command and control software that is installed in over 150 Homeland
Security EOC's. REMITS will be integrated with their software. There is no
certainty that REMITS will have a materially positive impact upon the Company's
future performance.
With regard to military defense simulation, the Company continues to
execute its plan to capitalize on what is clearly recognized as the biggest
simulation spender in the world, the US Military. In the second quarter 2005,
the Company executed approximately $580,000 in simulation work for the US Navy
on their nuclear propulsion program. The Navy selected GSE's technology for this
program which is expected to extend through the year 2025. In the second quarter
2005, the Company has qualified as a prime contractor under the Navy's Seaport-e
procurement program. This allows the Company to bid on a broad range of
simulation task orders as they are released by the Navy.
Results of Operations
The following table sets forth the results of operations for the
periods presented expressed in thousands of dollars and as a percentage of
revenues:
(in thousands) Three months ended June 30, Six Months Ended June 30,
2005 % 2004 % 2005 % 2004 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Contract revenue $ 6,717 100.0 % $ 7,597 100.0 % $ 13,010 100.0 % $ 15,158 100.0 %
Cost of revenue 5,077 75.6 % 5,760 75.8 % 10,315 79.3 % 11,544 76.2 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Gross profit 1,640 24.4 % 1,837 24.2 % 2,695 20.7 % 3,614 23.8 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Operating expenses:
Selling, general and administrative 1,776 26.4 % 1,184 15.6 % 3,606 27.8 % 2,422 16.0 %
Administrative charges from GP Strategies 171 2.6 % 246 3.2 % 342 2.6 % 492 3.3 %
Depreciation and amortization 67 1.0 % 74 1.0 % 144 1.1 % 143 0.9 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total operating expenses 2,014 30.0 % 1,504 19.8 % 4,092 31.5 % 3,057 20.2 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Operating income (loss) (374) (5.6)% 333 4.4 % (1,397) (10.8)% 557 3.6 %
Interest expense, net (54) (0.8)% (16) (0.2)% (71) (0.5)% (159) (1.0)%
Other expense, net (103) (1.5)% 16 0.2 % (154) (1.2)% 16 0.1 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Income (loss) before provision
(benefit) for income taxes (531) (7.9)% 333 4.4 % (1,622) (12.5)% 414 2.7 %
Provision (benefit) for income taxes 25 0.4 % 57 0.8 % (24) (0.2)% 74 0.5 %
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss) $ (556) (8.3)% $ 276 3.6 % $ (1,598) (12.3)% $ 340 2.2 %
========== ========== ========== ========== =========== ========== ========== ==========
Critical Accounting Policies and Estimates
In preparing the Company's financial statements, management makes several
estimates and assumptions that affect the Company's reported amounts of assets,
liabilities, revenue and expenses. Those accounting estimates that have the most
significant impact on the Company's operating results and place the most
significant demands on management's judgment are discussed below. For all of
these policies, management cautions that future events rarely develop exactly as
forecast, and the best estimates may require adjustment.
Revenue Recognition on Long-Term Contracts. The Company uses the
percentage-of-completion revenue recognition methodology to record revenue under
its long-term fixed-price contracts in accordance with the AICPA Statement of
Position 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts". This methodology recognizes income as work
progresses on the contract and is based on an estimate of the income earned to
date, less income recognized in earlier periods. The Company bases its estimate
of the degree of completion of the contract by reviewing the relationship of
costs incurred to date to the expected total costs that will be incurred on the
project. The Company's project managers are responsible for estimating the costs
to be incurred at the beginning of each project and are responsible for updating
the estimate monthly as the project progresses. Management reviews the status of
each project monthly with the project managers and determines whether the cost
estimates are reasonable. If changes in the estimated costs to complete the
projects are required, the cumulative impact on the percentage of completion
revenue calculation is recognized in the period identified. Whenever evidence
indicates that the estimated total cost of a contract will exceed its total
contract value, the Company's operating results are charged for the full amount
of the estimated losses immediately. Uncertainties inherent in the performance
of contracts include labor availability and productivity, material costs, change
order scope and pricing, software modification issues and customer acceptance
issues. The reliability of these cost estimates is critical to the Company's
revenue recognition as a significant change in the estimates can cause the
Company's revenue and related margins to change significantly from the amounts
estimated in the early stages of the project.
Capitalization of Computer Software Development Costs. In accordance with
Statement of Financial Accounting Standards (SFAS) No. 86, "Accounting for the
Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed", the
Company capitalizes computer software development costs incurred after
technological feasibility has been established, but prior to the release of the
software product for sale to customers. Once the product is available to be
sold, the Company begins to amortize the costs over the estimated useful life of
the product, which normally ranges from three to five years. At June 30, 2005,
the Company has net capitalized software development costs of $838,000. On an
annual basis, and more frequently as conditions indicate, the Company assesses
the recovery of the unamortized software computer costs by estimating the net
undiscounted cash flows expected to be generated by the sale of the product. If
the undiscounted cash flows are not sufficient to recover the unamortized
software costs the Company will write-down the investment to its estimated fair
value based on future discounted cash flows. The excess of any unamortized
computer software costs over the related net realizable value is written down
and charged to operations. Significant changes in the sales projections could
result in an impairment with respect to the capitalized software that is
reported on the Company's balance sheet.
Deferred Income Tax Valuation Allowance. Deferred income taxes arise from
temporary differences between the tax bases of assets and liabilities and their
reported amounts in the financial statements. As required by SFAS No. 109,
"Accounting for Income Taxes", management makes a regular assessment of the
realizability of the Company's deferred tax assets. In making this assessment,
management considers whether it is more likely than not that some or all of the
deferred tax assets will not be realized. The ultimate realization of deferred
tax assets is dependent upon the generation of future taxable income during the
periods in which those temporary differences become deductible. Management
considers the scheduled reversal of deferred tax liabilities and projected
future taxable income of the Company in making this assessment. A valuation
allowance is recorded to reduce the total deferred income tax asset to its
realizable value. At June 30, 2005, the Company's largest deferred tax asset
related to a U.S. net operating loss carryforward of $16.1 million which expires
in various amounts over the next twenty years. The amount of loss carryforward
which can be used by the Company may be limited to approximately $500,000
annually. Other than the net deferred tax assets that are related to the
Company's Swedish subsidiary, the recovery of the net deferred tax asset could
not be substantiated by currently available objective evidence. Accordingly, the
Company has established an $8.7 million valuation allowance for the deferred tax
assets that are not related to the Swedish subsidiary. The valuation allowance
will be reduced if the Company's US operations are able to realize taxable
income in the future.
Results of Operations - Three and Six Months ended June 30, 2005 versus Three
and Six Months ended June 30, 2004.
Contract Revenue. Total contract revenue for the quarter ended June 30,
2005 totaled $6.7 million, which was 11.6% lower than the $7.6 million total
revenue for the quarter ended June 30, 2004. Revenue for the six months ended
June 30, 2005 was $13.0 million versus $15.2 million in the same period of 2004,
a 14.2% decrease. The decreases reflect the low order volume logged in 2004
coupled with the delay of two large international simulator contracts. At June
30, 2005, the Company's backlog was $14.7 million of which the Company believes
approximately $8.0 million will be recognized as revenue in the next six months.
Gross Profit. Gross profit totaled $1.6 million (24.4% of revenue) for the
quarter ended June 30, 2005, as compared with $1.8 million (24.2% of revenue)
for the quarter ended June 30, 2004. For the six months ended June 30, 2005,
gross profit decreased from $3.6 million (23.8% of revenue) for the six months
ended June 30, 2004 to $2.7 million (20.7% of revenue). The decrease in gross
profit percentage is mainly attributable to the lower revenue base to cover the
Company's relatively fixed overhead.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses totaled $1.8 million in the quarter ended June
30, 2005, a 50.0% increase from the $1.2 million for the same period in 2004.
SG&A expenses for the six months ended June 30, 2005 increased 48.9%, from $2.4
million for the six months ended June 30, 2004 to $3.6 million. Business
development costs increased from $560,000 in the second quarter 2004 to $661,000
in the second quarter 2005 and increased from $1.1 million for the six months
ended June 30, 2004 to $1.6 million in the same period of 2005. The Company
expanded its business development organization throughout 2004 into the first
quarter of 2005, adding an additional five employees between the first quarter
2004 and the first quarter 2005. In addition, the Company incurred higher
bidding and proposal costs in the pursuit of new orders. The Company's corporate
and G&A expenses increased from $621,000 in the second quarter 2004 to $1.0
million in the second quarter 2005. Likewise, for the six months ended June 30,
2005, corporate and G&A expenses increased from $1.3 million for the first six
months of 2004 to $1.7 million in 2005. The increase is due to (a) an adjustment
to the Company's loss reserve for the unutilized Baltimore facility (b) the
payment of $50,000 to the landlord in the second quarter 2005 for a revision to
the Company's Baltimore facility lease reducing the Company's leased space by
14,000 sq. ft, (c) an increase in the reserve for doubtful accounts and (c)
salary and benefit costs of John Moran, the Company's CEO, who became a GSE
employee in December 2004. Prior to December 2004, the Company was charged for
Mr. Moran's services by GP Strategies and his costs were classified as GP
Strategies administration fees. Also included in SG&A in 2005 is $138,000 of
severance costs, of which $88,000 had not been paid at June 30, 2005. Gross
spending on software product development ("development") totaled $147,000 in the
quarter ended March 31, 2005 as compared to $145,000 in the same period of
2005. For the six months ended June 30, 2005, gross development spending totaled
$291,000 versus $239,000 in the same period of 2004. The Company anticipates
that its total gross development spending in 2005 will approximate the same
total level as 2004.
The Company capitalized $68,000 of software development costs in the three
months ended June 30, 2005 as compared to $142,000 in the same period of 2004.
For the six months ended June 30, 2005 and 2004, the Company capitalized
$158,000 and $239,000, respectively. The reduction in capitalized costs reflects
the release of JTool 2.0, the Company's software modeling tools, in June 2004.
The Company's R&D expenditures in the first half of 2005 were related to:
* Additional enhancements to JADE (Java Applications & Development
Environment), a Java-based application that provides a window into the
simulation station and takes advantage of the web capabilities of
Java, allowing customers to access the simulator and run scenarios
from anywhere they have access to the web. JADE 3.0 was released in
April 2005.
* The continued development of the Company's REMITS product used to
simulate the operation of Emergency Operations Centers (EOC) run by
municipal and state governments.
* The development of generic simulation models representing the
Westinghouse Electric Company LLC AP1000 nuclear plant design.
Administrative Charges from GP Strategies. On January 1, 2004, the Company
entered into a Management Services Agreement with GP Strategies Corporation in
which GP Strategies agreed to provide corporate support services to GSE,
including accounting, finance, human resources, legal, network support and tax.
GSE will pay an annual fee of $685,000 ($171,250 per quarter) for these
services. The agreement has been extended through December 31, 2005 without an
increase in the fee. The agreement can be renewed for successive on-year terms.
In December 2003, GSE's Board of Directors elected John Moran, a GP
Strategies executive with experience in the power industry and simulation
technology, as Chief Executive Officer. Mr. Moran continued as a GP Strategies
employee until December 15, 2004 when he became a GSE employee. In the first six
months of 2004, GSE was charged $150,000 by GP Strategies for Mr. Moran's
compensation and benefits.
Depreciation and Amortization. Depreciation expense totaled $67,000 and
$74,000 during the quarters ended June 30, 2005 and 2004, respectively. For the
six months ended June 30, 2005 and 2004 depreciation expense totaled $144,000
and $143,000, respectively.
Operating Income (Loss). The Company had an operating loss of $374,000
(5.6% of revenue) in the second quarter 2005, as compared with operating income
of $333,000 (4.4% of revenue) for the same period in 2004. For the six months
ended June 30, 2005 and 2004, the Company had an operating loss of $1.4 million
(10.8% of revenue) and operating income of $557,000 (3.6% of revenue),
respectively. The decrease was due to the factors outlined above.
Interest Expense, Net. Net interest expense increased from $16,000 in the
quarter ended June 30, 2004 to $54,000 for the same quarter in 2005. For the six
months ended June 30, 2005 and 2004, net interest expense totaled $71,000 and
$159,000, respectively. The Company expects interest expense to increase
significantly during the third and fourth quarters of 2005.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant was $374,000 and the fair value of
the Conversion Option of the Dolphin Note was $959,000, both of which were
recorded as noncurrent liabilities, with the offset recorded as original issue
discount (OID). OID is accreted over the term of the Dolphin Note and charged to
interest expense, and the unamortized balance is netted against long-term debt
in the accompanying consolidated balance sheets. The GSE Warrant and Conversion
Option liabilities are marked to market through earnings on a quarterly basis in
accordance with EITF No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in a Company's Common Stock". In connection
with this transaction, GP Strategies' commitment to loan the Company up to
$1,000,000 has been terminated.
In March 2003, GP Strategies extended their $1.8 million limited guarantee
of the Company's bank facility for a one-year period. In consideration for the
extension of the guarantee, the Company issued 150,000 shares of its common
stock to GP Strategies. The number of shares was calculated based upon a 10% fee
divided by the closing price of GSE's common shares on March 21, 2003. The cost
of the guarantee was amortized over the one year period; GSE recognized $45,000
of interest expense in the first quarter 2004 which completed the amortization
of these costs.
The fees paid to the Company's financial institution as consideration for
the extension of the Company's credit facility for a one-year period beginning
March 23, 2003 were amortized over the one year extension. In the first quarter
2004, the Company recognized $94,000 of interest expense which completed the
amortization of these costs.
Other income (expense), net. At June 30, 2005, the Company had foreign
currency contracts for sale of approximately $2.8 million Japanese Yen at fixed
rates. The contracts expire on various dates through May 2007. The Company has
not designated the contracts as hedges and, accordingly, has recorded the
reduction in estimated fair value of the contracts during the second quarter
2005 of $102,000, and for the first six months of 2005 of $157,000, in other
expense. The estimated fair value of the contracts was $42,000 at June 30, 2005.
Provision (Benefit) for Income Taxes. The Company's effective tax rate was
1.5% and 17.9% for the six months ended June 30, 2005 and June 30, 2004,
respectively. The decrease in the effective tax rate is attributable primarily
to lower taxable income in Sweden. For 2005, the Company's combined U.S. federal
and state effective tax rate is projected to be 2% and the Swedish effective tax
rate is projected to be 9%. The Company has an $8.7 million valuation allowance
for all of the deferred tax assets that are not related to its Swedish
subsidiary.
Liquidity and Capital Resources
As of June 30, 2005, the Company's cash and cash equivalents totaled
$249,000 compared to $868,000 at December 31, 2004.
Cash provided by (used in) operating activities. For the six months ended
June 30, 2005, net cash used in operating activities was $2.4 million.
Significant changes in the Company's assets and liabilities in 2005 included:
* a $454,000 increase in contract receivables. The increase mainly
reflects an increase in the Company's unbilled receivable balance due
to the timing of contract payment milestones,
* a $627,000 decrease in accounts payable, accrued compensation and
accrued expenses. The reduction mainly reflects the payment of vendor
invoices due to the infusion of cash from the Dolphin Note, and
* a decrease in billings in excess of revenues earned of $461,000. In
2003, the Company had entered into a $6.0 million contract with a
Mexican customer for a full scope simulator that allowed the Company
to invoice the customer for 20% of the contract upon the receipt of
the purchase order as an advance payment. The reduction in billings in
excess of revenues earned mainly reflects the completion of work which
has reduced the Company's liability to the customer for the advance
payment.
Net cash provided by operating activities was $175,000 for the six months
ended June 30, 2004. Significant changes in the Company's assets and liabilities
in 2004 included:
* a $710,000 reduction in prepaid expenses and other assets. The
reduction reflects (1) lower prepaid insurance expense due to the
participation of the Company in some of GP Strategies' insurance
programs, and (2) the collection from Novatech of expenses paid by the
Company on behalf of Novatech after the sale of the Process business
in 2003, and
* a decrease in billings in excess of revenues earned by $2.4 million.
The reduction in billings in excess of revenues earned mainly reflects
the completion of work on the Company's $6.0 million contract with a
Mexican customer mentioned above, which reduced the Company's
liability to the customer for the advance payment.
Cash used in investing activities. Net cash used in investing activities
for the six months ended June 30, 2005 totaled $224,000. Capital expenditures
totaled $94,000 and capitalized software development costs totaled $159,000. A
$29,000 cash collateralized stand-by letter of credit expired in June 2005 and
the cash collateral was released.
Net cash used in investing activities was $6,000 for the six months ended
June 30, 2004, consisting of $239,000 of capitalized software development costs
and $68,000 of capital expenditures, offset by the expiration of $301,000 of
cash collateralized stand-by letters of credit for which the cash collateral was
released.
Cash used in financing activities. During the six months ended June 30,
2005, the Company generated $2.1 million in cash from financing activities. The
Company borrowed $675,000 from its bank line of credit and generated $100,000
from the conversion of employee stock options. The Company also paid down a note
payable by $9,000.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. Under the terms of the
Note, the number of shares of GSE common stock actually issued on conversion of
the Note, when aggregated with the number of shares of GSE common stock actually
issued upon exercise of the Warrant, could not exceed 19.99% of the outstanding
shares of GSE common stock on May 26, 2005. This limitation was the "Conversion
Share Limit". Of the $2 million proceeds from the sale of the Note, $500,000 was
placed in escrow until the termination of the Conversion Share Limit. The Note
provided that the Conversion Share Limit would terminate upon the effectiveness
of the consent to the transaction by stockholders holding a majority of the
outstanding shares of GSE common stock, in compliance with the stockholder
approval requirements of the American Stock Exchange. On May 19, 2005, the
Company obtained the written consent of GP Strategies Corporation as holder of a
majority of the outstanding shares of GSE common stock. An information statement
regarding the Dolphin transaction was mailed to all GSE stockholders on June 9,
2005. Accordingly, the Conversion Share Limit expired on June 29, 2005, and the
$500,000 in escrow was released to GSE on July 5, 2005
In conjunction with the Dolphin note, the Company incurred $182,000 of
deferred financing costs which will be amortized over the term of the note.
In the six months ended June 30, 2004, the Company used $17,000 in
financing activities related to the pay down of a note payable.
Credit Facilities
General Physics Corporation ("General Physics") is a wholly owned
subsidiary of GP Strategies. On March 30, 2004, the Company was added as an
additional borrower under the Financing and Security Agreement between General
Physics Corporation and a financial institution. Under the terms of the
agreement, $1.5 million of General Physics' available credit facility has been
carved out for use by GSE. The line is collateralized by substantially all of
the Company's assets and provides for borrowings up to 80% of eligible accounts
receivable and 80% of eligible unbilled receivables. The interest rate on this
line of credit is based upon the daily LIBOR Market Index Rate plus 3% (6.32% as
of June 30, 2005), with interest only payments due monthly. At June 30, 2005,
the Company's available borrowing base was $1.5 million, of which $725,000 had
been utilized, inclusive of $50,000 for letters of credit. The credit facility
expires on August 12, 2006.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009 (the "Dolphin Note"), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the "GSE Warrant"). The Dolphin Note is convertible
into 1,038,961 shares of GSE common stock at a conversion price of $1.925 per
share and accrues interest at 8% payable quarterly. Both the convertible note
and the warrant are subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant was $374,000 and the fair value of
the Conversion Option of the Dolphin Note was $959,000, both of which were
recorded as noncurrent liabilities, with the offset recorded as original issue
discount (OID). OID is accreted over the term of the Dolphin Note and charged to
interest expense, and the unamortized balance is netted against long-term debt
in the accompanying consolidated balance sheets. The GSE Warrant and Conversion
Option liabilities are marked to market through earnings on a quarterly basis in
accordance with EITF No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in a Company's Common Stock". In connection
with this transaction, GP Strategies' commitment to loan the Company up to
$1,000,000 has been terminated.
The Company's credit facility requires GSE to comply with certain financial
ratios. At June 30, 2005, GSE was not in compliance with its debt service
coverage ratio. The Company obtained a letter dated August 4, 2005 in which the
lender has agreed to forebear from exercising its rights under the credit
agreement against GSE with respect to this event of default Company has
delivered to the lender the Company's financial statements for the year ending
December 31, 2005.
At June 30, 2005, the Company had foreign currency contracts for sale of
approximately $2.8 million Japanese Yen at fixed rates. The contracts expire on
various dates through May 2007. The Company has not designated the contracts as
hedges and, accordingly, has recorded the reduction in estimated fair value of
the contracts during the second quarter 2005 of $102,000, and for the first six
months of 2005 of $157,000, in other expense. The estimated fair value of the
contracts was $42,000 at June 30, 2005.
New Accounting Standards
In December 2004, the FASB issued SFAS No. 123 - Revised (SFAS No. 123R),
"Share-Based Payment", which revises SFAS No. 123, "Accounting for Stock-Based
Compensation", and supercedes APB No. 25, "Accounting for Stock Issued to
Employees." Currently, the Company does not record compensation expense for
certain stock-based compensation. Under SFAS No. 123R, the Company will measure
the cost of employee services received in exchange for stock, based on the
grant-date fair value (with limited exceptions) of the stock award. Such cost
will be recognized over the period during which the employee is required to
provide service in exchange for the stock award (usually the vesting period).
The fair value of the stock award will be estimated using an option-pricing
model, with excess tax benefits, as defined in SFAS No. 123R, being recognized
as an addition to paid in capital. SFAS No. 123R was to be effective as of July
1, 2005. However, on April 14, 2005, the Securities and Exchange Commission
announced that the effective date of SFAS 123R will be postponed until January
1, 2006, for calendar year companies. The Company is currently in the process of
evaluating the impact of SFAS No. 123R on its consolidated financial statements.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
The Company's most significant market risk is changes in foreign currency
exchange rates. The Company's exposure to foreign exchange rate fluctuations
arises in part from inter-company accounts in which costs incurred in one entity
are charged to other entities in different foreign jurisdictions. The Company is
also exposed to foreign exchange rate fluctuations as the financial results of
all foreign subsidiaries are translated into U.S. dollars in consolidation. As
exchange rates vary, those results when translated may vary from expectations
and adversely impact overall expected profitability.
The Company utilizes various derivative financial instruments to manage
market risks associated with the fluctuations in foreign currency exchange
rates. It is the Company's policy to use derivative financial instruments to
protect against market risk arising in the normal course of business. The
Company monitors its foreign currency exposures to maximize the overall
effectiveness of its foreign currency positions. Principal currencies hedged
include the Euro and the Japanese yen. The Company's objectives for holding
derivatives are to minimize the risks using the most effective methods to reduce
the impact of these exposures. The Company minimizes credit exposure by limiting
counterparties to nationally recognized financial institutions.
At June 30, 2005, the Company had foreign currency contracts for sale of
approximately $2.8 million Japanese Yen at fixed rates. The contracts expire on
various dates through May 2007. The Company has not designated the contracts as
hedges and, accordingly, has recorded the reduction in estimated fair value of
the contracts during the second quarter 2005 of $102,000, and for the first six
months of 2005 of $157,000, in other expense. The estimated fair value of the
contracts was $42,000 at June 30, 2005.
The Company is also subject to market risk related to the interest rate on
its existing line of credit. As of June 30, 2005, such interest rate is based on
the Libor Market Index Rate plus 300 basis-points. A 100 basis-point change in
such rates during the three and six months ended June 30, 2005 would have
changed the Company's interest expense by approximately $1,000 and $3,000,
respectively.
On May 26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP
a Senior Subordinated Secured Convertible Note in the aggregate principle amount
of $2,000,000, which matures March 31, 2009, and a seven-year warrant to
purchase 380,952 shares of GSE common stock at an exercise price of $2.22 per
share. The Dolphin Note is convertible into 1,038,961 shares of GSE common
stock at a conversion price of $1.925 per share and accrues interest at 8%
payable quarterly. Both the convertible note and the warrant are subject to
anti-dilution provisions. The aggregate purchase price for the Dolphin Note and
GSE Warrant was $2,000,000. At the date of issuance, the fair value of the GSE
Warrant was $374,000 and the fair value of the Conversion Option of the Dolphin
Note was $959,000, both of which were recorded as noncurrent liabilities, with
the offset recorded as original issue discount (OID). The GSE Warrant and
Conversion Option liabilities are marked to market through earnings on a
quarterly basis in accordance with EITF No. 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in a Company's Common
Stock.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures. Based on their
evaluation as of the end of the period covered by this Form 10-Q, the Company's
principal executive officer and principal financial officer have concluded that
the Company's disclosure controls and procedures (as defined in Rules 13a-15(e)
under the Securities Exchange Act of 1934 (the "Exchange Act") are effective to
ensure that information required to be disclosed by the Company in reports that
it files or submits under the Exchange Act is recorded, processed, and
summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms".
(b) Changes in internal control. There were no changes in the Company's
internal control over financial reporting that occurred during the most recent
fiscal quarter that have materially affected, or are reasonably likely to
materially affect, the Company's internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In accordance with its conduct in the ordinary course of business, certain
actions and proceedings are pending to which the Company is a party. In the
opinion of management, the aggregate liabilities, if any, arising from such
actions are not expected to have a material adverse effect on the financial
condition of the Company.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
The Company's credit facility requires GSE to comply with certain financial
ratios. At June 30, 2005, GSE was not in compliance with its debt service
coverage ratio. The Company obtained a letter dated August 4, 2005 in which
the lender has agreed to forebear from exercising its rights under the credit
agreement against GSE with respect to this event of default Company has
delivered to the lender the Company's financial statements for the period ending
December 31, 2005.
Item 4. Submission of Matters to a Vote of Security Holders
On June 16, 2005, the Company held its annual meeting of shareholders. At
that meeting, the following matters were voted upon:
Proposal For Against Abstain Withheld
--------------------------------------------- ------------- ------------ ------------- --------------
1) Election of Directors for a two year term expiring in 2007:
Jerome I. Feldman 5,356,285 - - 1,641,034
John V. Moran 5,381,785 - - 1,615,534
George J. Pedersen 5,381,785 - - 1,615,534
Election of Directors for a three year term expiring in 2008:
Sheldon L. Glashow 6,897,019 - - 100,300
Roger L Hagengruber 6,897,019 - - 100,300
Chin-Our Jerry Jen 5,356,285 - - 1,641,034
The following directors are serving terms until the annual meeting in 2006 and were not reelected
at the June 16, 2005 annual meeting:
Scott N. Greenberg
Andrea D. Kantor
Joseph W. Lewis
2) Approval of an amendment to
the Company's 1995 Long-Term
Incentive Plan (as Amended and
Restated Effective June 25, 2001)
to extend the Plan until June 30, 2008 6,826,132 170,187 1,000 -
2) Ratification of KPMG LLP as
the Company's independent
auditors for the 2005 fiscal year 6,997,319 - - -
Item 5. Other Information
None
Item 6. Exhibits
(a) Exhibits
10.1 Forbearance letter dated August 4, 2005.*
31.1 Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.*
31.2 Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.*
32.1 Certification of the Chief Executive Officer and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.*
---------------
*Filed herewith
SIGNATURES
Pursuant to the requirements 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.
Date: August 15, 2005 GSE SYSTEMS, INC.
/S/ JOHN V. MORAN
-------------------
John V. Moran
Chief Executive Officer
(Principal Executive Officer)
/S/ JEFFERY G. HOUGH
---------------------
Jeffery G. Hough
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)