10QSB 1 doc1.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB [X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2004 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 001-13869 ENVIRONMENTAL SAFEGUARDS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) NEVADA 87-0429198 (STATE OR OTHER JURISDICTION (IRS EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 2600 SOUTH LOOP WEST, SUITE 645 HOUSTON, TEXAS 77054 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE) (713) 641-3838 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) CHECK WHETHER THE ISSUER (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 or 15(d) OF THE EXCHANGE ACT DURING THE PAST 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 [ ] APPLICABLE ONLY TO CORPORATE ISSUERS AT AUGUST 16, 2004, APPROXIMATELY 10,745,091 SHARES OF COMMON STOCK, $.001 PAR VALUE, WERE OUTSTANDING. TRANSITIONAL SMALL BUSINESS DISCLOSURE FORMAT (CHECK ONE): Yes [ ] No [X] 1
ENVIRONMENTAL SAFEGUARDS, INC. CONTENTS PART I -- FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Condensed Balance Sheet as of June 30, 2004 (unaudited) and December 31, 2003. Unaudited Consolidated Condensed Statement of Operations for the three months and six months ended June 30, 2004 and 2003. Unaudited Consolidated Condensed Statement of Stockholders' Equity for the six months ended June 30, 2004. Unaudited Consolidated Condensed Statement of Cash Flows for the six months ended June 30, 2004 and 2003. Selected Notes to Unaudited Consolidated Condensed Financial Statements. Item 2. Management's Discussion and Analysis or Plan of Operation Item 3. Controls and Procedures PART II -- OTHER INFORMATION Item 1. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders Item 5. Other Information Item 6. Exhibits and Reports on Form 8-K SIGNATURES
2 PART I -- FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS 3
ENVIRONMENTAL SAFEGUARDS, INC. CONSOLIDATED CONDENSED BALANCE SHEET __________ (IN THOUSANDS, EXCEPT SHARE AMOUNTS) JUNE 30, 2004 DECEMBER 31, ASSETS (UNAUDITED) 2003 ------ ------------ -------------- Current assets: Cash and cash equivalents $ 146 $ 386 Accounts receivable 400 400 Prepaid expenses 121 61 ------------ -------------- Total current assets 667 847 Property and equipment, net 4,829 5,053 Intangible asset - acquired engineering design and technology, net 593 795 Other assets 2 2 ------------ -------------- Total assets $ 6,091 $ 6,697 ============ ============== LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current liabilities: Current Portion of notes payable to related parties $ 430 $ 420 Notes Payable 274 - Accounts payable 15 85 Dividends payable 954 845 Accrued interest 199 160 Damages payable 600 - Other accrued liabilities 973 862 ------------ -------------- Total current liabilities 3,445 2,372 Notes payable to related parties 691 786 Minority interest 1,901 1,912 Commitments and contingencies Stockholders' equity: Preferred stock; Series B convertible; voting, $.001 par value (aggregate liquidation value - $2,898); 5,000,000 shares authorized; 2,733,686 shares issued and outstanding 3 3 Preferred stock; Series D convertible, non-voting, cumulative $.001 par value (aggregate liquidation value $4,000); 400,000 shares authorized, issued and outstanding 1 1 Common stock; $.001 par value; 50,000,000 shares authorized; 10,745,091 shares issued and outstanding 10 10 Additional paid-in capital 15,332 15,332 Accumulated deficit (15,292) (13,719) ------------ -------------- Total stockholders' equity 54 1,627 ------------ -------------- Total liabilities and stockholders' equity $ 6,091 $ 6,697 ============ ==============
The accompanying notes are an integral part of these unaudited consolidated condensed financial statements. 4
ENVIRONMENTAL SAFEGUARDS, INC. UNAUDITED CONSOLIDATED CONDENSED STATEMENT OF OPERATIONS __________ (IN THOUSANDS, EXCEPT SHARE AMOUNTS) THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, -------------------- -------------------- 2004 2003 2004 2003 ---------- -------- ---------- -------- Revenue $ 600 $ 470 $ 1,200 $ 523 Cost of revenue 331 307 671 526 ---------- -------- ---------- -------- Gross margin 269 163 529 (3) Selling, general and administrative expenses 553 470 998 932 Amortization of intangible asset- acquired engineering design and technology 102 102 204 204 Research and development - 15 15 30 ---------- -------- ---------- -------- Loss from operations (386) (424) (688) (1,169) Interest income - - - - Interest expense (92) (45) (185) (63) Damages under lawsuit (600) - (600) -_ ---------- -------- ---------- -------- Loss before provision for income taxes and minority interest (1,078) (469) (1,473) (1,232) Benefit (provision) for income taxes - - - -_ ---------- -------- ---------- -------- Loss before minority interest (1,078) (469) (1,473) (1,232) Minority interest 6 7 11 13 ---------- -------- ---------- -------- Net loss $ (1,072) $ (462) $ (1,462) $(1,219) ========== ======== ========== ======== Net loss applicable to common stock- holders $ (1,127) $ (520) $ (1,573) $(1,335) ========== ======== ========== ======== Net loss per share-basic and diluted $ (0.10) $ (0.05) $ (0.15) $ (0.12) ========== ======== ========== ======== Weighted average shares outstanding-basic and diluted 10,745 10,745 10,745 10,745 ========== ======== ========== ========
The accompanying notes are an integral part of these unaudited consolidated condensed financial statements. 5
ENVIRONMENTAL SAFEGUARDS, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY __________ (IN THOUSANDS, EXCEPT SHARE AMOUNTS) TOTAL SERIES B SERIES D ADDITIONAL STOCK- PREFERRED PREFERRED COMMON PAID-IN ACCUMULATED HOLDERS' STOCK STOCK STOCK CAPITAL DEFICIT EQUITY ---------- ---------- ------- ----------- ------------- ---------- Balance as of December 31, 2003 $ 3 $ 1 $ 10 $ 15,332 $ (13,719) $ 1,627 Dividends on Series D Preferred stock - - - - (111) (111) Net loss - - - - (1,462) (1,462) ---------- ---------- ------- ----------- ------------- ---------- Balance as of June 30, 2004 $ - 3 $ 1 $ 10 $ 15,332 $ (15,292) $ 54 ========== ========== ======= =========== ============= ==========
The accompanying notes are an integral part of these consolidated financial statements. 6
ENVIRONMENTAL SAFEGUARDS, INC. UNAUDITED CONSOLIDATED CONDENSED STATEMENT OF CASH FLOWS __________ (IN THOUSANDS) SIX MONTHS ENDED JUNE 30, -------------------- 2004 2003 --------- --------- Cash flows from operating activities: Net loss $ (1,462) $ (1,219) Adjustment to reconcile net loss to net cash provided by operating activities 1,318 499 --------- --------- Net cash used by operating activities (144) (720) --------- --------- Cash flows from investing activities: Purchases of equipment (11) -_ --------- --------- Net cash used by investing activities (11) - --------- --------- Cash flows from financing activities: Net proceeds from notes payable - 920 Payments on notes payable (85) - Proceeds from sale of common stock upon exercise of warrants - 6 --------- --------- Net cash provided (used) by financing activities (85) 926 --------- --------- Net increase (decrease) in cash and cash equivalents (240) 206 Cash and cash equivalents, beginning of period 386 97 --------- --------- Cash and cash equivalents, end of period $ 146 $ 303 ========= =========
The accompanying notes are an integral part of these unaudited consolidated condensed financial statements. 7 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 1. GENERAL ------- The unaudited consolidated condensed financial statements included herein have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, pursuant to such rules and regulations. These unaudited consolidated condensed financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto of Environmental Safeguards, Inc. (the "Company") included in the Company's Annual Report on Form 10-KSB for the year ended December 31, 2003. In the opinion of management, the unaudited consolidated condensed financial information included herein reflect all adjustments, consisting only of normal, recurring adjustments, which are necessary for a fair presentation of the Company's financial position, results of operations and cash flows for the interim periods presented. The results of operations for the interim periods presented herein are not necessarily indicative of the results to be expected for a full year or any other interim period. 2. LIQUIDITY AND CAPITAL RESOURCES ---------------------------------- Since its inception, the Company has expended a significant portion of its resources to develop markets and industry awareness of the capabilities of its indirect thermal desorption recycling process. The Company's efforts have been focused on the development, production and sale of environmental recycling technologies and services to oil and gas industry participants, waste management companies and other industrial customers. The Company's efforts to develop markets and produce equipment have required significant amounts of capital including long-term debt secured by the Company's ITD units and related ITD technology. With the exception of the profitability impact from the Company's sale of three ITD units and certain licensing rights in late 2001, the Company has incurred recurring net losses and has been dependent on revenue from a limited customer base to provide cash flows. These factors raise substantial doubt about the Company's ability to continue as a going concern. The Company is currently seeking to obtain service contracts in the markets that it serves and is also considering strategic alternatives including a possible additional sale of certain of its assets. In December 2001, the Company completed the sale of three of its ITD units and certain licensing rights and the proceeds were used to pay off all the Company's senior debt. The Company's long-term viability as a going concern is dependent on the repositioning of its asset base and the achievement of a sustaining level of profitability. To the extent the Company's cash reserves and cash flows from operations are insufficient to meet future cash requirements, the Company will need to raise funds through the infusion of equity, the issuance of debt securities or the sale of ITD units. Such financing may not be available on terms acceptable to the Company or at all. Further, the sale of additional equity or convertible debt securities may result in dilution to the Company's stockholders. The accompanying financial statements do not include any adjustments that might be necessary if the company is unable to continue as a going concern. 8 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 3. IMPAIRMENT OF LONG-LIVED ASSETS ---------------------------------- Management has evaluated the carrying value of long-lived assets, including associated intangibles. An evaluation of recoverability is performed by comparing the estimated future undiscounted cash flows associated with the assets to their carrying amount to determine if a write-down to market value or discounted cash flow is required. Given the homogeneous nature and geographic deployment flexibility of such assets, and based upon this evaluation by management, impairment of the Company's long-lived assets has not been deemed necessary. 4. INCOME TAXES ------------- Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company has provided for a deferred tax valuation allowance for cumulative net operating tax losses to the extent that the net operating losses may not be realized. The difference between the federal statutory income tax rate and the Company's effective income tax rate is primarily attributed to foreign income taxes and changes in valuation allowances for deferred tax assets related to U.S. net operating losses. The differences between the Federal statutory income tax rates and the Company's effective income tax rates were as follows:
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ------------------ ------------------ 2004 2003 2004 2003 -------- -------- -------- -------- Federal statutory rate (34)% (34)% (34)% (34)% Change in valuation allowance 34 34 34 34 -------- -------- -------- -------- - % - % - % - % ======== ======== ======== ========
As of June 30, 2004, for U.S. federal income tax reporting purposes, the Company has approximately $8,900,000 of unused net operating losses ("NOLs") to future years. The Company's NOLs do not include the undistributed losses from certain controlled foreign corporations. The benefit from such NOLs will expire during the years ending December 31, 2017 to 2024. Because U.S. federal income tax laws limit the time during which NOLs may be applied against future taxable income, the Company may be unable to take full advantage of its NOLs for federal income tax purposes should the Company generate taxable income. Based on such limitation, the Company has significant NOLs for which realization of tax benefits is uncertain. The benefit from utilization of NOLs could be subject to limitations if material ownership changes occur in the Company. 9 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 5. NOTES PAYABLE AND NOTES PAYABLE TO RELATED PARTIES -------------------------------------------------- In July 2002, the Company obtained uncollateralized loans totaling $250,000 from Cahill Warnock Strategic Partners, L.P. and Strategic Associates, L.P. These loans bear interest of 12% per year and were originally due in January 2003 but have been extended to October 2004. David Warnock, a director of the Company, is a general partner of Cahill Warnock Strategic Partners, L.P. and a managing member of the general partner of Strategic Associates, L.P. In March 2003 the Company signed a $1,500,000 long-term loan agreement with Rineco Recycling, LLC ("Rineco"). The loan is collateralized by three ITD units and bears interest at a stated rate of 12% per year. Principal payments are due in 20 quarterly installments of $75,000 beginning in August 2003 with the final payment due in May 2008. In connection with this long-term loan, the Company issued 1,500,000 warrants to purchase shares of its common stock at an exercise price of $0.01 per share and these warrants were valued at $345,000. The loan origination fees and warrants results in an effective interest rate on the loan of approximately 35% per year. (See Note 11) The long-term debt has an original face value of $1,500,000 and is carried net of unamortized loan costs of approximately $311,000 as of June 30, 2004. Such loan costs are being amortized over the term of the long-term debt using the interest method. On June 28, 2004, the lender declared the Company in default on this loan and accelerated the maturity of the loan. The Company is contesting the declaration of default (see Footnote 10). In September 2003 the Company borrowed $8,000 from a financial institution to purchase a vehicle. The loan bears interest of 6.5% per year and is due in payments of $245 per month, including interest, through September 2006. The vehicle is collateral for the loan. In June 2004, the Company signed two loan agreements with Lundeen & Dickinson LLP, the law firm representing the Company in the lawsuit styled OnSite Technology LLC v Duratherm, Inc., Duratherm Group, Inc., Steven R. Heuer, and Victor R. Reynolds; Civil Action No. H-02-2624; in the United States District Court for the Southern District of Texas. The loan agreements are for $194,417 and $80,000. The loans bear interest at 7% per year and are due in February 2005. The loans are collateralized by one ITD unit Long-term debt as of June 30, 2004 consists of amounts due under the long-term debt agreements as described in the previous paragraphs.
Long-term debt, as of June 30, 2004, consists of the following (in thousands): Cahill Warnock Strategic Partners, L.P. $ 237 Strategic Associates, L.P. 13 Note payable to a related party 1,200 Lundeen & Dickinson LLP 274 Other note payable 6 ------- Contractual balance 1,730 Less unamortized loan costs (335) ------- Long-term debt 1,395 Less current maturities (430) Less trade note payable (274) ------- Long-term debt, net of current portion $ 691 =======
Continued 10 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 5. NOTES PAYABLE AND NOTES PAYABLE TO RELATED PARTIES (CONTINUED) -------------------------------------------------------------- The following is an analysis of future annual scheduled maturities of contractual balances of long-term debt (in thousands):
YEAR ENDED JUNE 30, -------------- 2005 $ 704 2006 426 2007 300 2008 300 ---------- Long-term debt $ 1,730 ==========
6. LOSS PER SHARE ---------------- The Company computes basic earnings per share based on the weighted average number of shares of common stock outstanding for the period, and includes common stock equivalents outstanding for the computation of diluted earnings per share. As a result of incurred net losses, for the three months and six months ended June 30, 2004 and 2003 all common stock equivalents have been excluded from the calculation of earnings per share as their effect is anti-dilutive. In future periods, the calculation of diluted earnings per share may require that the Company's common stock equivalents (totaling 24,236,449 shares at June 30, 2004) be included in the calculation of the weighted average shares outstanding for periods in which net income is reported. Following is a reconciliation of net loss to the net loss available to common stockholders:
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------ ---------------------- 2004 2003 2004 2003 ----------- ----------- ---------- ---------- (IN THOUSANDS) (IN THOUSANDS) Net loss $ (1,072) $ (462) $ (1,462) $ (1,219) Series D preferred stock dividends (55) (58) (111) (116) ----------- ----------- ---------- ---------- Net loss available to common stockholders $ (1,127) $ (520) $ (1,573) $ (1,335) =========== =========== ========== ==========
7. SEGMENT INFORMATION -------------------- The Company operates in the environmental remediation and hydrocarbon reclamation/recycling services industry. Substantially all revenue results from the sale of services using the Company's ITD units. The Company's reportable segments are based upon geographic area. All intercompany revenue and expenses have been eliminated. Continued 11 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 7. SEGMENT INFORMATION (CONTINUED) ------------------------------- Following is a summary of segment information:
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------ ---------------------- 2004 2003 2004 2003 ----------- ----------- ---------- ---------- (IN THOUSANDS) (IN THOUSANDS) Revenue: United States $ 600 $ 470 $ 1,200 $ 523 Latin America - - - -_ ----------- ----------- ---------- ---------- Total revenue $ 600 $ 470 $ 1,200 $ 523 =========== =========== ========== ========== Loss from operations: United States $ (328) $ (330) $ (580) $ (1,003) Latin America (5) (5) (5) (11) Middle East (11) (14) (21) (26) Corporate (42) (75) (82) (129) ----------- ----------- ---------- ---------- Total loss from operations $ (386) $ (424) $ (688) $ (1,169) =========== =========== ========== ==========
JUNE 30, DECEMBER 2004 31, 2003 --------- ---------- (IN THOUSANDS) Assets: United States $ 2,584 $ 3,202 Latin America 99 88 Middle East 3,393 3,393 Corporate 15 14 --------- ---------- Total assets $ 6,091 $ 6,697 ========= ==========
8. REVENUE ------- During the three months and six months ended June 30, 2004 and 2003, service revenue was derived from full-service contract utilization of ITD units owned by the Company. All revenue for the six months ended June 30, 2003 was derived from two customers. All revenue for the six months ended June 30, 2004 was derived from a single customer (See Note 11). 9. SUPPLEMENTAL NON-CASH TRANSACTIONS ------------------------------------
SIX MONTHS ENDED JUNE 30, --------------------- 2004 2003 --------- ---------- (IN THOUSANDS) Dividends declared but not yet paid $ 111 $ 116 Stock warrants issued to obtain long-term debt $ - $ 345
12 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 10. LITIGATION ---------- In July 2002, OnSite filed a lawsuit styled OnSite Technology LLC v. Duratherm, Inc., Duratherm Group, Inc., Steven R. Heuer and Victor R. Reynolds; Civil Action No. H-02-2624; in the United States District Court for the Southern District of Texas against Duratherm, Inc. and Duratherm Group, Inc., Steven R. Heuer and Victor R. Reynolds. OnSite alleged that Duratherm's remediation operations at its Galveston County, Texas facility infringe on OnSite's U.S. Patent No. 5,738,031 and requested a declaratory judgment that OnSite's operation of its remediation process does not infringe either of Heuer and Reynolds' U.S. Patent Nos. 4,990,237 and 5,269,906 over which Duratherm alleges control. OnSite also sought damages for patent infringement, injunctive relief to prevent further patent infringement, and other relief that the court might find appropriate. Defendants filed an answer asserting that they do not infringe on OnSite's patent or alternatively, that such patent is invalid. Defendants' denial that there is any controversy between the parties regarding the Heuer and Reynolds' patents has been rejected by the court. Defendants further alleged in their pleadings that OnSite infringed on the above patents along with U.S. Patent No. 5,523,060, all of which OnSite denied. Defendants, although originally asserting that OnSite infringed each of the patents in suit, have announced in open court that they are no longer claiming infringement of U.S. Patent No. 4,990,237 against OnSite. Discovery closed, and the case was tried commencing on June 7, 2004. Pre-trial rulings precluded OnSite from challenging the validity of the patents in suit, and a jury found that OnSite infringed both United States Patent No. 5,269,906 and 5,523,060. The jury found damages of $2,118,197. Both sides filed post-trial motions which remain pending. The ultimate monetary impact of the lawsuit is still pending the ruling of the judge in the proceedings. Based on discussions with legal counsel in the matter, if the judge enters a judgment based upon the jury verdict finding infringement, the damages are not expected to be less than $600,000 even though substantial grounds exist for an appeal of the damage issue, as well as all liability issues. Accordingly, the Company has recorded an accrual for damages in the matter of $600,000. In July 2002, OnSite also initiated litigation styled OnSite Technology, LLC v. Duratherm, Inc. et al.; Cause No. 02CV0801; In the 56th Judicial District Court of Galveston County, Texas, against Duratherm, Inc., Duratherm Group, Inc., Barry Hogan and Jim Hogan. This lawsuit alleges that in November 1999, OnSite and Waste Control Specialists, L.L.C. ("WCS") entered into a contract wherein OnSite would, among other things, provide the necessary services, supplies and equipment to perform recycling and remediation services utilizing an indirect thermal desorption unit as specified therein. OnSite alleges that, in late July or early August 2000, Defendants, acting in concert through Duratherm, Inc., sent or caused to be sent a letter(s) and/or other communication(s) to WCS, which OnSite alleges contained statements that were false and intended to deceive WCS, as to OnSite and OnSite's technology and indirect thermal desorption unit. OnSite also alleges that a suit filed by Duratherm in August 2000 for patent infringement against OnSite and WCS in the United States District Court for the Southern District of Texas under Civil Action No. H-00-2727, which suit was subsequently dismissed with prejudice by the United States District Judge, was malicious and contained false statements and allegations about OnSite and OnSite's technology and indirect thermal desorption unit. OnSite alleges that as a result of such false, deceptive and malicious statements, WCS terminated its contract with OnSite. In February, 2003 OnSite amended its petition to add John C. Hilliard as a defendant and to add as a claim against the defendants, the loss of a prospective contract with ExxonMobil. OnSite has also amended its petition to include as a defendant Duratherm's counsel, Conley Rose P.C. The causes of action alleged by OnSite against the Defendants are (i) interference with contract and prospective business relations; (ii) unfair competition and business disparagement; (iii) unjust enrichment; and (iv) injury to OnSite's business reputation. OnSite is seeking actual, consequential, incidental and compensatory damages, including, but not limited to, disgorgement, pre- and post-judgment interest, attorney's fees and costs and exemplary and punitive damages. OnSite is also seeking to enjoin these defendants and Duratherm's counsel, Conley Rose P.C., from interfering with the current and prospective business relationships of Continued 13 ENVIRONMENTAL SAFEGUARDS, INC. SELECTED NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS __________ 10. LITIGATION (CONTINUED) ----------------------- OnSite with regard to the indirect thermal desorption units. The Defendants in this litigation have filed an answer denying the allegations contained in OnSite's petition. Certain of the Defendants in this law suit have filed a counterclaim against OnSite alleging that OnSite sent out letters which tortuously interfered with their businesses. This case is in the discovery stage and is set for trial in October 2004. In July 2004 OnSite initiated litigation styled OnSite Technology LLC, Environmental Safeguards, Inc., and National Fuel & Energy, Inc. vs Rineco Recycling, LLC; Cause No. 2004-42635 in the 164th District Court of Harris County, Texas. OnSite alleges that Rineco improperly accelerated a promissory note which OnSite gave to Rineco in March of 2003. There has been no discovery in the case and no trial date set. 11. RELATED PARTY TRANSACTIONS ---------------------------- In July 2002, the Company obtained uncollateralized loans totaling $250,000 from Cahill Warnock Strategic Partners, L.P. and Strategic Associates, L.P. These loans bear interest of 12% per year and were originally due in January 2003 but have been extended to October 2004. David L. Warnock, one of the Directors of the Company, is a general partner of Cahill Warnock Strategic Partners, L.P. and a managing member of the general partner of Strategic Associates, L.P. In March 2003 the Company obtained a loan of $1,500,000 (See Footnote 5). The Company issued 1,500,000 warrants to purchase shares of its common stock at an exercise price of $0.01 per share in connection with this loan. This transaction resulted in the lender becoming a related party and the beneficial owner of 12% of the Company's common stock, although none of the warrants have been exercised as of June 30, 2004. In January 2003, the Company signed a contract to process various waste streams with an entity affiliated with the lender described in the previous paragraph. 12. SUBSEQUENT EVENTS ------------------ In August 2004 OnSite Technology, LLC. ("OnSite"), a subsidiary of the Company filed for chapter 11 bankruptcy protection in the U.S. Bankruptcy Court, Southern District of Texas, Houston Division. In August 2004 OnSite declared Rineco Chemical Industries, Inc. in breach of the services contract between the two parties and ceased operations under the contract. OnSite has requested that its claim for damages due to the breach of the contract be submitted to binding arbitration as contemplated by the contract. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion should be read in conjunction with our consolidated condensed financials statements and related notes included elsewhere in this report, and with our Annual Report on Form 10-KSB for the year ended December 31, 2003. INFORMATION REGARDING AND FACTORS AFFECTING FORWARD-LOOKING STATEMENTS We are including the following cautionary statement in this Form 10-QSB to make applicable and take advantage of the safe harbor provision of the Private Securities Litigation Reform Act of 1995 for any forward-looking statements made by us, or on behalf of us. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements which are other than statements of historical facts. Certain statements in this Form 10-QSB are forward-looking statements. Words such as "expects", "anticipates", "estimates" and similar expressions are intended to identify forward-looking statements. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties are set forth below. Our expectations, beliefs and projections are expressed in good faith and are believed to have a reasonable basis, including without limitation, our examination of historical operating trends, data contained in our records and other data available from third parties. There can be no assurance, however, that our expectations, beliefs or projections will result, be achieved, or be accomplished. In addition to other factors and matters discussed elsewhere herein, the following are important factors that, in our view, could cause material adverse affects on our financial condition and results of operations: our ability to secure contracts for our ITD units; our ability to attain widespread market acceptance of our technology; our ability to obtain acceptable forms and amounts of financing; the demand for, and price level of, our services; competitive factors; the actual useful life of our ITD Units; ability to mitigate concentration of business in a small number of customers; the evolving industry and technology standards; the ability to protect proprietary technology; the dependence on key personnel; the effect of business interruption due to political unrest; and our ability to maintain acceptable utilization rates on our equipment. We are not obligated to update or revise these forward-looking statements to reflect the occurrence of future events or circumstances. OVERVIEW We are engaged in the development, production and sale of environmental recycling technologies and services to waste management companies, oil and gas companies and other industrial customers through our wholly owned subsidiary, OnSite Technology, L.L.C. ("OnSite"). We are devoting substantially all of our efforts to the development of markets for OnSite's services. We are currently marketing our recycling services to companies engaged in waste management, refining, and other industrial applications. Refining and other types of industrial activities, often produce significant quantities of petroleum-contaminated waste, from which our Indirect Thermal Desorption ("ITD") process can extract and recover the hydrocarbons as re-useable or re-saleable liquids, and produce recycled solids compliant with environmental regulations. The activities of OnSite include use of ITD technology to address hydrocarbon contamination problems and hydrocarbon recycling and reclamation opportunities at heavy industrial, refining, petrochemical and waste management sites, as well as at Superfund, DOD and DOE sites. We are currently concentrating our marketing efforts and resources on domestic downstream plants, manufacturing facilities and waste management facilities, where our proprietary equipment and process have a competitive advantage in waste minimization, and recycling/reuse of hazardous waste markets, including industrial, petroleum and petro-chemical waste streams. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of its financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. These estimates and assumptions provide a basis for our judgments about the carrying values of 15 assets and liabilities that are not readily apparent from other sources. Actual results may differ from our estimates under different assumptions or conditions, and these differences may be material. We believe that the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: - We recognize revenue at the time services are performed, or in the event of the sale of an ITD unit, when the equipment is shipped. - We record property and equipment at cost and compute depreciation using the straight-line method over an estimated useful life of 8 years on our ITD Units and 3 to 5 years on our office furniture and equipment and transportation and other equipment. Effective October 1, 2002, we changed the estimated useful lives of our ITD units from 5 years to 8 years to more accurately reflect our experience with the useful lives of the units and to conform to industry practices for equipment used in similar applications. Any additions or improvements that increase the value or extend the life of our assets are capitalized and expenditures for normal maintenance and repairs are expensed as incurred. Disposals are removed from the accounts at cost less accumulated depreciation and any gain or loss from disposition is reflected in operations currently. As of August 2004, we own five ITD units, and our 50%-owned subsidiary Onsite Arabia, Inc., owns two additional units. Of the five fully-owned units, one is in operation and four are available for contract operations. The two 50%-owned units are available for contract operations in the Arabian Gulf region. QUARTERLY FLUCTUATIONS Our revenue may be affected by the timing and deployment of ITD Units to customer sites under existing contracts, and by the timing of obtaining new contracts. Accordingly, our quarterly results may fluctuate and the results of one fiscal quarter should not be deemed to be indicative of the results of any other quarter, or for the full fiscal year. RESULTS OF OPERATIONS COMPARISON OF OPERATING RESULTS - THREE MONTHS ENDED JUNE 30, 2004 AND 2003 Summary. During the second quarter of 2004, we incurred a net loss of $1,072,000 as compared to a 2003 second quarter net loss of $462,000. The increase in loss for the second quarter of 2004 was principally due to the damages from the patent infringement case and related litigation costs. Revenue and Gross Margin. Revenue of $600,000 during the second quarter of 2004 generated $269,000 of gross margin as compared to revenue of $470,000 and gross margin of $163,000 in the comparable 2003 quarter. The increase in revenue and gross margin was mainly due to improved equipment utilization in 2004 and is attributable to our contract to process various waste streams at a facility in Arkansas. Selling, General and Administrative ("SGA") Expenses. SGA expenses during the second quarter of 2004 were $553,000 compared to $470,000 for the second quarter of 2003. The difference is primarily due to litigation costs for legal proceedings described in Part II. Amortization of Engineering Design and Technology. This calculation represents the amortization of Acquired Engineering Design and Technology costs, an intangible asset related to the December 1997 acquisition of the remaining 50% interest in OnSite from Parker Drilling. The intangible asset is being amortized over an 8-year estimated economic life. This expense was $ 102,000 for the second quarter of both 2003 and 2004. Other. Other Expenses for the second quarter of 2004 of $600,000 are a provision for the damages from the patent infringement lawsuit (see Footnote 10 to the financial statements). There was no other expense in the comparable 2003 quarter. 16 Interest Expense. During the second quarter of 2004, interest expense of $92,000 compares to interest expense of $45,000 for the second quarter of 2003. The interest expense for both periods relates to deferred preferred stock dividends and notes payable to related parties. The increased interest expense in the second quarter of 2004 is primarily due to interest on the $1.5 million loan which was fully outstanding for the entire second quarter of 2004. This loan was only partially funded until the third quarter of 2003. Income Taxes. There were no tax provision effects in the second quarter of 2004 or 2003. During both comparative quarters we incurred net operating losses ("NOLs") primarily in the U.S., which may be used to offset taxable income reported in future periods. The NOLs have generated deferred tax assets, but due to uncertainties regarding the future realization of these assets, a valuation allowance has been provided for the full amount of the deferred tax assets. Minority Interest. Minority interest for the second quarter of 2004 and 2003 relates to our 50% minority partner's interest in the net loss of OnSite Arabia. COMPARISON OF OPERATING RESULTS - SIX MONTHS ENDED JUNE 30, 2004 AND 2003 Summary. During the six months ended June 30, 2004, we incurred a net loss of $1,462,000 as compared to a 2003 net loss of $1,219,000. The increase in loss for the six months ended June 30, 2004 was principally due to the damages from the patent infringement case and related litigation costs. Revenue and Gross Margin. Revenue of $1,200,000 during the first six months of 2004 generated $529,000 of gross margin as compared to revenue of $523,000 and negative gross margin of $3,000 in the comparable 2003 period. The increase in revenue and the improvement in gross margin were mainly due to the fact that in the first six months of 2004 an average of 1.0 units under full-service contract operations versus an average of 0.6 units in the first six months of 2003. Selling, General and Administrative ("SGA") Expenses. SGA expenses during the first six months of 2004 were $998,000 as compared to $932,000 for the first six months of 2003. The difference primarily due to litigation costs incurred in 2004. Amortization of Engineering Design and Technology. This represents the amortization of Acquired Engineering Design and Technology costs, an intangible asset related to the December 1997 acquisition of the remaining 50% interest in OnSite from Parker Drilling. The intangible asset is being amortized over an 8-year estimated economic life. This expense was $ 204,000 for the first six months of both 2003 and 2004. Other. Other Expenses for the first six months of 2004 of $600,000 are a provision for the damages from the patent infringement lawsuit (see Footnote 10 to the financial statements). There was no other expense in the comparable 2003 period. Interest Expense. During the first six months of 2004, interest expense of $185,000 relating to deferred preferred stock dividend, our long term debt, and note payable to related parties compares to interest expense of $63,000 for the first six months of 2003 The increased interest expense in the first six months of 2004 is primarily due to interest on the $1.5 million loan which was fully outstanding during the first six months of 2004, but only partially funded during the first six months of 2003. Income Taxes. There were no tax provision effects in the first six months of 2004 or 2003. During both comparative six month periods we incurred net operating losses ("NOLs") primarily in the U.S., which may be used to offset taxable income reported in future periods. The NOLs have generated deferred tax assets, but due to uncertainties regarding the future realization of these assets, a valuation allowance has been provided for the full amount of the deferred tax assets. Minority Interest. Minority interest for the first six months of 2004 and 2003 relates to our 50% minority partner's interest in the net loss of OnSite Arabia. 17 LIQUIDITY AND CAPITAL RESOURCES We currently have no significant commitments for capital expenditures. Since our inception, we have expended a significant portion of our resources to develop markets and industry awareness of our ITD remediation and recycling/reclamation process technology. Our efforts have been focused primarily on hydrocarbon soil contamination inherent in oil and gas exploration activities. Our efforts to develop markets and produce equipment have required significant amounts of capital. In December 2001 we completed the sale of three of our ITD units along with certain licensing rights, and utilized the bulk of the proceeds from the sale to retire our senior debt. With the exception of this sale, we have incurred recurring net losses and have been dependent on revenue from a limited customer base to provide cash flows. During 2003 and 2004 we have been exploring ways to expand our revenue. In January 2003, we signed a contract to process various waste streams at a facility in Arkansas. We are currently seeking to obtain additional service contracts in our served markets and are considering strategic alternatives including the possible sale of certain assets. The company does not expect that its existing cash reserves and cash flows from operations will be sufficient to cover the Company's cash requirements for 2004. We will need to successfully raise funds through an equity infusion, the issuance of debt securities or the sale of ITD units. Financing may not be available on terms acceptable to us, or at all. Further, the sale of additional equity or convertible debt securities may result in dilution to our stockholders. Our independent accountants have provided us their report for the two years ended December 31, 2003 and 2002, which sets forth factors that raise substantial doubt about our ability to continue as a going concern. Our viability as a going concern remains dependent on our ability to raise short-term cash funds as noted above, increased utilization of our ITD units and the achievement of a sustaining level of profitability. There can be no assurances, however, that we will successfully increase ITD utilization or become sufficiently profitable. During July 2002, the Company obtained uncollateralized loans totaling $250,000 from Cahill Warnock Strategic Partners, L. P. and Strategic Associates, L.P. These loans bear interest at 12% per year and are due in October 2004. During March 2003, the Company obtained a loan of $1,500,000 from Rineco Recycling, LLC. The loan is collateralized by three ITD units and bears interest at 12% per year. Principal payments are due in 20 quarterly installments of $75,000 beginning in August 2003 with the final payment due in May 2008. Warrants to purchase 1,500,000 shares of our common stock at a price of $0.01 were issued in connection with this loan. If we default on the $1,500,000 loan and if the lender forecloses on the collateral, we would be left with only two ITD Units in the U.S. The loss of the three ITD Units would (i) greatly reduce our capacity to serve customers in the U.S., (ii) would put a limit on the potential revenue we could achieve in the U.S., and (iii) would create an additional competitor in the U.S. On June 28, 2004, Rineco declared the Company in default on this loan and accelerated the maturity of the loan. The Company is contesting the declaration of default and has initiated litigation against Rineco alleging that Rineco improperly accelerated this loan. On August 10, 2004, OnSite Technology, LLC ("OnSite"), one of our subsidiaries, filed for Chapter 11 bankruptcy protection in the U.S. Bankruptcy Court, Southern District of Texas, Houston Division. OnSite plans to timely submit a plan of reorganization to the Bankruptcy Court. ITEM 3. CONTROLS AND PROCEDURES James S. Percell, our Chief Executive Officer, and Michael D. Thompson, our Chief Financial Officer, have concluded that that our disclosure controls and procedures are appropriate and effective. They have evaluated these controls and procedures as of a date within 90 days of the filing date of this report on Form 10-QSB. There were no significant changes in the our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. There have been no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-14(b) or Rule 15d-14(b) that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 18 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In July 2002, OnSite filed a lawsuit styled OnSite Technology LLC v. Duratherm, Inc., Duratherm Group, Inc., Steven R. Heuer and Victor R. Reynolds; Civil Action No. H-02-2624; in the United States District Court for the Southern District of Texas against Duratherm, Inc. and Duratherm Group, Inc., Steven R. Heuer and Victor R. Reynolds. OnSite alleged that Duratherm's remediation operations at its Galveston County, Texas facility infringe on OnSite's U.S. Patent No. 5,738,031 and requested a declaratory judgment that OnSite's operation of its remediation process does not infringe either of Heuer and Reynolds' U.S. Patent Nos. 4,990,237 and 5,269,906 over which Duratherm alleges control. OnSite also sought damages for patent infringement, injunctive relief to prevent further patent infringement, and other relief that the court might find appropriate. Defendants filed an answer asserting that they do not infringe on OnSite's patent or alternatively, that such patent is invalid. Defendants' denial that there is any controversy between the parties regarding the Heuer and Reynolds' patents has been rejected by the court. Defendants further alleged in their pleadings that OnSite infringed on the above patents along with U.S. Patent No. 5,523,060, all of which OnSite denied. Defendants, although originally asserting that OnSite infringed each of the patents in suit, have announced in open court that they are no longer claiming infringement of U.S. Patent No. 4,990,237 against OnSite. Discovery closed, and the case was tried commencing on June 7, 2004. Pre-trial rulings precluded OnSite from challenging the validity of the patents in suit, and a jury found that OnSite infringed both United States Patent No. 5,269,906 and 5,523,060. The jury found damages of $2,118,197. Both sides filed post-trial motions which remain pending. The ultimate monetary impact of the lawsuit is still pending the ruling of the judge in the proceedings. Based on discussions with legal counsel in the matter, if the judge enters a judgment based upon the jury verdict finding infringement, the damages are not expected to be less than $600,000 even though substantial grounds exist for an appeal of the issue, as well as all liability issues. Accordingly, the Company has recorded an accrual for damages in the matter of $600,000. In July 2002, OnSite also initiated litigation styled OnSite Technology, LLC v. Duratherm, Inc. et al.; Cause No. 02CV0801; In the 56th Judicial District Court of Galveston County, Texas, against Duratherm, Inc., Duratherm Group, Inc., Barry Hogan and Jim Hogan. This lawsuit alleges that in November 1999, OnSite and Waste Control Specialists, L.L.C. ("WCS") entered into a contract wherein OnSite would, among other things, provide the necessary services, supplies and equipment to perform recycling and remediation services utilizing an indirect thermal desorption unit as specified therein. OnSite alleges that, in late July or early August 2000, Defendants, acting in concert through Duratherm, Inc., sent or caused to be sent a letter(s) and/or other communication(s) to WCS, which OnSite alleges contained statements that were false and intended to deceive WCS, as to OnSite and OnSite's technology and indirect thermal desorption unit. OnSite also alleges that a suit filed by Duratherm in August 2000 for patent infringement against OnSite and WCS in the United States District Court for the Southern District of Texas under Civil Action No. H-00-2727, which suit was subsequently dismissed with prejudice by the United States District Judge, was malicious and contained false statements and allegations about OnSite and OnSite's technology and indirect thermal desorption unit. OnSite alleges that as a result of such false, deceptive and malicious statements, WCS terminated its contract with OnSite. In February, 2003 OnSite amended its petition to add John C. Hilliard as a defendant and to add as a claim against the defendants, the loss of a prospective contract with ExxonMobil. OnSite has also amended its petition to include as a defendant Duratherm's counsel, Conley Rose P.C. The causes of action alleged by OnSite against the Defendants are (i) interference with contract and prospective business relations; (ii) unfair competition and business disparagement; (iii) unjust enrichment; and (iv) injury to OnSite's business reputation. OnSite is seeking actual, consequential, incidental and compensatory damages, including, but not limited to, disgorgement, pre- and post-judgment interest, attorney's fees and costs and exemplary and punitive damages. OnSite is also seeking to enjoin these defendants and Duratherm's counsel, Conley Rose P.C., from interfering with the current and prospective business relationships of OnSite with regard to the indirect thermal desorption units. The Defendants in this litigation have filed an answer denying the allegations contained in OnSite's petition. Certain of the Defendants in this law suit have filed a counterclaim against OnSite alleging that OnSite sent out letters which tortuously interfered with their businesses. This case is in the discovery stage and is set for trial in October 2004. In July 2004 OnSite initiated litigation styled OnSite Technology LLC, Environmental Safeguards, Inc., and National Fuel & Energy, Inc. vs Rineco Recycling, LLC; Cause No. 2004-42635 in the 164th District Court of Harris County, Texas. OnSite alleges that Rineco Recycling, LLC improperly accelerated a promissory note which OnSite gave to Rineco Recycling, LLC in March of 2003. There has been no discovery in the case and no trial date set. 19 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our annual meeting of stockholders was held in Houston, Texas on May 19, 2004 for the purpose of voting on the proposals described below. Proxies for the meeting were solicited pursuant to Regulation 14A under the Securities Exchange Act of 1934 and there were no solicitations in opposition to our solicitation. The holders of common stock approved the election of the following four directors, each to serve for a term of one year by the following vote: Votes For Votes Against Abstaining James S. Percell 9,050,658 0 167,956 Bryan Sharp 9,074,958 0 143,656 Albert M. Wolford 9,069,958 0 148,656 Thomas R. Bray 9,141,858 0 75,656 The holders of Series B Convertible Stock approved the election of the following director, to serve for a term of one year by the following vote: Votes For Votes Against Abstaining David L. Warnock 2,733,686 0 0 The holders of voting stock ratified the appointment of Ham, Langston & Brezina, LLP as our independent accountants for the fiscal year ending December 31, 2004 by the following vote: Votes For 11,667,601 Votes Against 67,486 Abstaining 138,195 The holders of voting stock approve the amendment to The 1998 Stock Option Plan by the following vote: Votes For 5,870,225 Votes Against 566,345 Abstaining 82,875 ITEM 5. OTHER INFORMATION During March 2003, the Company obtained a loan from Rineco Recycling, LLC in the amount of $1,500,000. On June 28, 2004 Rineco declared the Company in default on this loan and accelerated its maturity. The alleged default was based on an adverse jury verdict rendered in June 2004 in the Duratherm litigation which Rineco alleges resulted in a material adverse change in the financial condition of the Company. We are contesting the declaration of default and have initiated litigation against Rineco alleging that Rineco improperly accelerated the loan. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) Exhibits Exhibit 31.1 - Certification of Chief Executive Officer of Environmental Safeguards, Inc. required by Rule 13a - 14(1) or Rule 15d - 14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Exhibit 31.2 - Certification of Chief Financial Officer of Environmental Safeguards, Inc. required by Rule 13a - 14(1) or Rule 15d - 14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Exhibit 32.1 -- Certification of Chief Executive Officer of Environmental Safeguards, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and Section 1350 of 18 U.S.C. 63. Exhibit 32.2 -- Certification of Chief Financial Officer of Environmental Safeguards, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and Section 1350 of 18 U.S.C. 63. 20 (B) Reports on Form 8-K On June 21, 2004 we filed a report on Form 8-K which included information under Item 5 " Other Events and Regulation FD Disclosure". 21 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. ENVIRONMENTAL SAFEGUARDS, INC. Date: August 23, 2004 By: /s/ James S. Percell James S. Percell, President Date: August 23, 2004 By: /s/ Michael D. Thompson Michael D. Thompson, Chief Financial Officer 22