10-Q 1 d10q.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001. [ ] 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 0-26392 LEVEL 8 SYSTEMS, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 11-2920559 -------------------------------------------------------------------------------- (State or other jurisdiction of incorporation (I.R.S Employer Identification Number) or organization) 8000 Regency Parkway, Cary, NC 275111 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (919) 380-5000 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15d 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 the number of shares outstanding in each of the issuer's classes of common stock, as of the latest practicable date. 16,174,825 common shares, $.001 par value, were outstanding as of November 9, 2001. Page 1 Level 8 Systems, Inc. Index
Page PART I. Financial Information ---- Number ------ Item 1. Financial Statements Consolidated balance sheets as of September 30, 2001 (unaudited) and December 31, 2000 3 Consolidated statements of operations for the three and nine months ended September 30, 2001 and 2000 (unaudited) 4 Consolidated statements of cash flows for the nine months ended September 30, 2001 and 2000 (unaudited) 5 Consolidated statements of comprehensive loss for the three and nine months ended September 30, 2001 and 2000 (unaudited) 6 Notes to consolidated financial statements (unaudited) 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Item 3. Quantitative and Qualitative Disclosures about Market Risk 24 PART II. Other Information 25 SIGNATURES 26
Page 2 PART I. Financial Information Item 1. Financial Statements Level 8 Systems, Inc. Consolidated Balance Sheets (in thousands) (unaudited)
September 30, December 31, 2001 2000 ---------------- ---------------- Assets Cash and cash equivalents $ 8,668 $ 23,856 Available-for-sale securities 235 588 Accounts receivable, less allowance for doubtful accounts of $738 and $1,735 at September 30, 2001 and December 31, 2000, respectively 4,070 20,760 Due from related party 155 306 Notes receivable 2,107 1,700 Notes receivable, related parties 80 104 Assets held for resale, net of liabilities 14,661 2,236 Prepaid expenses and other current assets 3,091 5,987 -------------- -------------- Total current assets 33,067 55,537 Property and equipment, net 1,439 3,309 Intangible assets, net 15,057 65,422 Software product technology, net 28,200 41,743 Note receivable -- 1,000 Notes receivable from related parties -- 396 Investment in Access International -- 1,600 Other assets 1,070 949 -------------- -------------- Total assets $ 78,833 $ 169,956 ============== ============== Liabilities and stockholders' equity Current maturities of long-term debt 15,000 2,133 Accounts payable 4,649 2,210 Accrued expenses: Salaries, wages and related items 1,098 4,175 Merger-related 104 311 Restructuring 1,615 210 Other 6,932 9,093 Due to related party -- 59 Deferred revenue 5,050 9,035 -------------- -------------- Total current liabilities 34,448 27,226 Long-term debt, net of current maturities 10,000 25,000 Stockholders' equity Preferred stock -- -- Common stock 16 16 Additional paid-in-capital 197,992 196,944 Accumulated other comprehensive income (678) (3,903) Accumulated deficit (162,945) (75,327) -------------- -------------- Total stockholders' equity 34,385 117,730 -------------- -------------- Total liabilities and stockholders' equity $ 78,833 $ 169,956 ============== ==============
The accompanying notes are an integral part of the consolidated financial statements. Page 3 Level 8 Systems, Inc. Consolidated Statements of Operations (in thousands, except per share amounts) (unaudited)
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 ------------- ------------ ------------- ------------- Revenue: Software $ 772 $ 14,422 $ 2,236 $ 34,324 Maintenance 3,091 4,015 10,848 11,493 2,026 3,881 7,914 17,246 ------------- ------------ ------------- ------------- Total operating revenue 5,889 22,318 20,998 63,063 Cost of revenue: Software 3,549 2,247 10,844 5,879 Maintenance 1,102 1,390 3,546 4,319 Services 2,234 3,443 6,920 14,745 ------------- ------------ ------------- ------------- Total cost of revenue 6,885 7,080 21,310 24,943 Gross profit (996) 15,238 (312) 38,120 Operating expenses: Sales and marketing 2,428 9,655 12,209 25,374 Research and development 1,341 2,196 5,952 6,957 General and administrative 1,955 3,503 10,738 9,704 Amortization of intangible assets 2,671 3,400 9,398 10,514 Restructuring -- 8,650 -- (Gain) loss on disposal of assets (341) 41 (1,371) 380 Impairment of intangible assets 10,898 -- 32,722 -- ------------- ------------ ------------- ------------- Total operating expenses 18,952 18,795 78,298 52,929 Loss from operations (19,948) (3,557) (78,610) (14,809) Other income (expense) Interest income 149 388 710 504 Unrealized loss on marketable securities (3,765) -- (3,765) -- Interest expense (1,049) (686) (3,934) (2,439) Net foreign currency gains (losses) 12 (174) (146) (290) ------------- ------------ ------------- ------------- Loss before provision for income taxes (24,601) (4,029) (85,745) (17,034) Income tax provision 357 470 631 1,020 ------------- ------------ ------------- ------------- Net loss $ (24,958) $ (4,499) $ (86,376) $ (18,054) Net loss per share - basic and diluted $ (1.58) $ (0.34) $ (5.51) $ (1.37) ============= ============ ============= ============= Weighted common shares outstanding - basic and diluted 16,056 14,298 15,916 13,646 ============= ============ ============= =============
The accompanying notes are an integral part of the consolidated financial statements. Page 4 Level 8 Systems, Inc. Consolidated Statements of Cash Flows (in thousands) (unaudited)
Nine Months Ended September 30, 2001 2000 --------- -------- Cash flows from operating activities: Net loss $(86,376) $(18,054) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 23,928 17,648 Impairment of intangible assets 32,722 -- Stock Compensation expense 1,045 Provision for doubtful accounts 3,793 421 Unrealized loss on Marketable Securities 3,765 Other (1,192) 42 Changes in assets and liabilities, net of assets acquired and liabilities assumed: Trade accounts receivable 9,493 (635) Prepaid expenses and other assets 198 877 Accounts payable, income taxes payable, and accrued expenses - excluding merger-related and restructuring (2,357) 1,278 Merger-related and restructuring 1,198 (2,733) Deferred revenue 188 (1,865) -------- -------- Net cash used in operating activities (13,595) (3,021) Cash flows from investing activities: Purchases of property and equipment (174) (816) Payments for acquisitions 526 Cash payments secured through notes receivable (80) (757) Proceeds from sale of assets 3,086 232 Purchases of Securities (4,000) Collection of note receivable 500 Purchased technology -- (150) Capitalization of software development costs (1,515) (576) -------- -------- Net cash provided by (used in) investing 1,817 (5,541) activities Cash flows from financing activities: Issuance of common shares -- 8,755 Issuance of preferred shares 29,840 Dividends on preferred shares (1,046) (437) Payments on borrowings from related company -- (4,519) Payments on capital leases (124) (69) Net borrowings on line of credit -- 5,175 Payments on debt (2,009) (20,645) ------- ------- Net cash provided by (used in) financing (3,179) 18,100 activities Effect of exchange rate changes on cash (231) (52) Net increase (decrease) in cash and cash equivalents (15,188) 9,486 Cash and cash equivalents: Beginning of period 23,856 6,509 -------- -------- End of period $ 8,668 $ 15,995 ======= ========
The accompanying notes are an integral part of the consolidated financial statements. Page 5 Level 8 Systems, Inc. Consolidated Statements of Comprehensive Loss (in thousands) (unaudited)
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 ------------- ------------ -------------- ------------ Net loss: $(24,958) $ (4,499) $ (86,376) $(18,054) Other comprehensive income, net of tax Foreign currency translation adjustment 101 (14) (186) (258) Unrealized loss on available-for-sale securities (353) Reclassification of unrealized loss included in income 3,765 -- 3,765 -- -------- -------- --------- -------- Comprehensive loss $(21,092) $ (4,513) $ (83,150) $(18,312) ======== ======== ========= ========
The accompanying notes are an integral part of the consolidated financial statements. Page 6 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) NOTE 1. INTERIM FINANCIAL STATEMENTS The accompanying financial statements are unaudited, and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles of the United States of America have been condensed or omitted pursuant to those rules and regulations. Accordingly, these interim financial statements should be read in conjunction with the audited financial statements and notes thereto contained in the Level 8 Systems, Inc.'s (the "Company") Annual Report on Form 10-K for the year ended December 31, 2000. The results of operations for the interim periods shown in this report are not necessarily indicative of results to be expected for other interim periods or for the full fiscal year. In the opinion of management, the information contained herein reflects all adjustments necessary for a fair statement of the interim results of operations. All such adjustments are of a normal, recurring nature, except for the impairment charges as discussed in Note 7 and the restructuring charge as discussed in Note 8. The year-end condensed balance sheet data was derived from audited financial statements in accordance with the rules and regulations of the SEC, but does not include all disclosures required for financial statements prepared in accordance with generally accepted accounting principles of the United States of America. The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All of the Company's subsidiaries are wholly owned for the periods presented. Certain prior year amounts in the accompanying financial statements have been reclassified to conform to the 2001 presentation. Such reclassifications had no effect on previously reported net loss or stockholders' equity. NOTE 2. LIQUIDITY The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As Level 8 Systems, Inc. has incurred a net loss of $86.4 million for the nine months ended September 30, 2001, has experienced negative cash flows from operations, had a significant working capital deficiency at September 30, 2001 and is relying on acceptance of a newly developed and marketed product, there may be doubt that Level 8 can continue as a going concern. To address these issues Level 8 Systems, Inc. is actively promoting and expanding its product line and has entered into preliminary sales negotiations with several significant new customers. Additionally, the working capital deficiency as noted above has been eliminated with the consummation of the asset sale to BluePhoenix Solutions. Management is pursuing additional financing and non-strategic asset sales with third parties. Management expects it will be able to attract additional capital to continue to fund operations and also expects that increased revenues will reduce its operating losses in future periods, however, there can be no assurance that management's plan will be executed as anticipated. The financial statements presented herein do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should Level 8 be unable to continue as a going concern. NOTE 3. USE OF ACCOUNTING ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles of the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual amounts could differ from these estimates. NOTE 4. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, ("SFAS 133"). In June 2000, further guidance related to accounting for derivative instruments and hedging activities was provided when the FASB issued SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities--an Amendment of FASB Statement No. 133. This standard, as amended, requires companies to record all derivatives on the balance sheet as either assets or liabilities and measure those instruments at fair value. The manner in which companies are to record gains or losses resulting from changes in the values of those derivatives depends on the use of the derivative and whether it qualifies for hedge accounting. As amended by SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities-- Page 7 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) Deferral of the Effective Date of FASB Statement No. 133, this standard is effective for the Company's financial statements beginning January 1, 2001, with early adoption permitted. These statements are effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The adoption of these statements had no material impact on the Company. In November of 1999, the SEC issued Staff Accounting Bulletin ("SAB") No. 100, Restructuring and Impairment Charges. SAB 100 provides guidance on the accounting for and disclosure of certain expenses and liabilities often reported in connection with exit activities and business combinations (restructuring activities), and the recognition and disclosure of asset impairment charges. The Company's accounting treatment for similar items, as discussed in Notes 7 and 8 to the consolidated financial statements, are consistent with the requirements of SAB 100. In September 2000, the Emerging Issues Task Force ("EITF") reached a consensus in EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company's Own Stock ("EITF 00-19") which provides specific guidance on the treatment of derivatives of a company's stock. The Company has applied the provisions of EITF 00-19 for the year ended December 31, 2000 and there is no financial statement impact. As of June 30, 2001, the Company has applied the implementation of additional provisions of EITF 00-19 and there is no financial statement impact. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, Business Combinations ("SFAS 141")which supersedes Accounting Principles Board (APB) Opinion No. 16, Business Combinations. SFAS 141 eliminates the pooling-of-interests method of accounting for business combinations for all transactions initiated after June 30, 2001 and modifies the application of the purchase accounting method. The provisions of SFAS 141 will be effective for transactions accounted for using the purchase method that are completed after June 30, 2001. Management does not expect this Statement will not have an impact on our consolidated financial statements. In July 2001, the FASB also issued Statement of Financial Accounting Standards No. 142, Goodwill and Intangible Assets ("SFAS 142") which supersedes APB Opinion No. 17, Intangible Assets. SFAS 142 eliminates the current requirement to amortize goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with a defined life and addresses the impairment testing for goodwill and intangible assets and the identification of reporting units for purposes of assessing potential future impairment of goodwill. SFAS 142 also requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. SFAS 142 will apply to goodwill and intangible assets arising from transactions completed before and after the Statement's effective date. SFAS 142 is effective for fiscal years beginning after December 15, 2001. Management is currently assessing the provisions of this Statement and has not yet made a determination of the impact adoption will have on the consolidated financial statements. At September 30, 2001, goodwill approximated $15,057. Goodwill and intangible assets amortization was $2,671 and $9,398 for the three and nine months ended September 30, 2001, respectively. In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets," which supercedes Statement of Financial Accounting Standards No. 121 ("SFAS 121"), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" and certain provisions of APB Opinion No. 30, "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." SFAS 144 requires that long-lived assets to be disposed of by sale, including discontinued operations, be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. SFAS 144 also broadens the reporting requirements of discontinued operations to include all components of an entity that have operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. The provisions of SFAS 144 are effective for fiscal years beginning after December 15, 2001. Management is evaluating the effect of this statement on the Company's results of operations and financial position. NOTE 5. AVAILABLE-FOR-SALE SECURITIES In September 2000, the Company purchased 500,000 shares of common stock and warrants to purchase and additional 500,000 shares of common stock in a publicly traded e-business service provider for $4,000. During the third quarter of 2001, the Company recorded a loss relating to an other than temporary decline in the market value of its shares. This loss of $3,765 has been recorded as an unrealized loss on marketable securities in the accompanying consolidated statement of operations. At September 30, 2001, the carrying value of the securities approximates their market value, with no unrealized gains or losses recorded in other comprehensive income. Page 8 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) NOTE 6. ALLOWANCE FOR DOUBTFUL ACCOUNTS On April 18, 2001, a significant customer voluntarily filed for protection under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court for the District of Delaware. Due to the uncertainty of collection of this debt, the Company recorded and allowance for doubtful accounts of $3,680 which was charged to general and administrative expenses in the consolidated statements of operations as of March 31, 2001. NOTE 7. IMPAIRMENT OF LONG-LIVED ASSETS In the first quarter of 2001, in connection with a restructuring of the Company's operations, management decided to conduct business and assess the performance of operations under a line-of-business approach. As such, the Company developed a business plan and forecast based on the line-of-business approach, including revenues, expenses, and profitability. The Company performed an assessment of the recoverability of its long-lived assets in accordance with SAB 100 and Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of ("SFAS 121"). The results of the Company's analysis of undiscounted cash flows indicated that impairment had occurred with regard to intangible assets related to the acquired Template Software, Inc. business, which is part of the Systems Integration segment. See Note 12 regarding discussions on the Company's segment disclosure. As a result, the Company estimated the fair market value of the related assets through a discounted future cash flow valuation technique. The results of this analysis indicated that the carrying values of these assets exceeded their fair market values. The Company has reduced the carrying value of these intangible assets by approximately $21,800 as of March 31, 2001. During the third quarter of 2001, the company was notified by one of its resellers that they would no longer engage in re-sales of the Company's CTRC products, a component of the Messaging and Application Engineering segment. This reseller accounted for substantially all of the CTRC product. As a result, the Company performed an assessment of the recoverability of those related long-lived in accordance with SAB 100 and SFAS No. 121. The results of the Company's analysis of undiscounted cash flows indicated that an impairment had occurred with regard to the intangible assets related to the CTRC products. The Company estimated the fair market value of the related assets through a discounted future cash flow valuation technique. The results of this analysis indicated the carrying value of these intangible assets exceeded their fair market values. The Company has reduced the carrying value by approximately $10,900 as of September 30, 2001. NOTE 8. RESTRUCTURING CHARGES In the first quarter of 2001, the Company announced and began implementation of an operational restructuring to reduce its operating costs and streamline its organizational structure. As a result of this initiative, the Company recorded restructuring charges of $6,650 during the quarter ended March 31, 2001, and an additional charge of $2,000 for the quarter ending June 30, 2001. Additional charges for the quarter ended June 30, 2001 represent employee severance and benefits, relating to 41 employees and the former chief strategy officer, paid to terminated employees and includes the issuance of 250,000 shares of common stock valued at $1,045. Restructuring charges have been classified in "Restructuring" on the consolidated statements of operations. This operational restructuring involves the reduction of employee staff throughout the Company in all geographical regions in sales, marketing, services, development and administrative functions. The Company anticipates that each component of the restructuring plan will be completed by December 31, 2001. For the three months ended March 31, 2001, and June 30, 2001, the charges associated with the Company's restructuring were as follows:
Three Three months ended months ended March 31, 2001 June 30, 2001 Total ------------- ------------- ----------- Employee severance and benefits $ 3,319 $ 2,000 $ 5,319 Excess office facilities 2,110 -- 2,110 Marketing obligations 288 -- 288 Other 933 -- 933 -------- -------- -------- $ 6,650 $ 2,000 $ 8,650 ======== ======== ========
Page 9 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) The restructuring plan included the termination of 191 employees, all of whom were notified as of June 30, 2001. The plan included a reduction of 83 personnel in the European operations and 108 personnel in the US operations. Employee termination costs are comprised of severance-related payments for all employees terminated in connection with the operational restructuring. Termination benefits do not include any amounts for employment-related services prior to termination. Premises obligations primarily relate to the continuation of lease obligations, brokers commissions and leasehold improvements for approximately 60,000 square feet of facilities no longer deemed necessary and costs to exit short-term leases for various sales offices. Amounts expensed relating to lease obligations represent estimates of undiscounted future cash outflows, offset by anticipated third-party sub-lease payments. Marketing obligations relate to contracts and services relating to the prior focus of the Company and are no longer expected to be utilized. Other miscellaneous restructuring costs include professional fees, royalty commitments, recruiting fees, excess equipment and other miscellaneous expenses directly attributable to the restructuring. At September 30, 2001, the accrued liability associated with the restructuring charges and cash paid was $1,615 and $6,730 respectively. Non-cash restructuring items totaled $454 for the period ended September 30, 2001. The following table sets forth a reconciliation to accrued expenses and cash paid as of September 30, 2001: Accrued Cash Paid ------- --------- Employee termination $ 319 $ 5,000 Premises 1,108 1,151 Marketing obligations 53 235 Other miscellaneous restructuring costs 135 344 ------ ------- $1,615 $6,730 ====== ====== As of September 30, 2001, $149 of the restructuring accrual relates to expenses accrued for restructurings which occurred prior to fiscal 2001. NOTE 9. NOTES PAYABLE During the first quarter of 2001, the Company paid in full a $2,000 note payable assumed in the acquisition of StarQuest Software, Inc., in 2000. During the second quarter of 2001, the Company's $15,000 term loan with a commercial bank was amended to extend the due date to April 15, 2002. Subsequent to September 30, 2001, the Company completed the sale of its Geneva AppBuilder business (see Note 11). As a part of that transaction, the company repaid $12,000 of its $15,000 term borrowing with a commercial bank and extended the maturity on the remaining balance of $3,000 to November 15, 2003. The Company also repaid its entire $10,000 credit facility. The remaining $3,000 term loan is secured by the guarantee of Liraz Systems Ltd., a stockholder of the Company. NOTE 10. INCOME TAXES The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The Company's effective tax rate differs from the statutory rate primarily due to the fact that no income tax benefit was recorded for the net loss for the first quarter of fiscal year 2001 or 2000. Because of the Company's inconsistent earnings history, the deferred tax assets have been fully offset by a valuation allowance. The income tax provision for the fiscal years 2000 and 2001 is primarily related to income taxes from profitable foreign operations and foreign withholding taxes. NOTE 11. OTHER DISPOSITIONS Sale of Government Operations In connection with the acquisition of Template, the Company acquired certain classified government contracts and employees who performed services for such. As of May 1, 2000 the Company disposed of its government contracts and employees and certain other Page 10 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) related assets and obligations by selling them to a new company formed by certain of the Company's employees. The Company received a note for $1,000 to be paid in five annual payments beginning May 1, 2001 and 4.9% of the outstanding shares of the purchasing company. Due to the uncertainty of collection on the note and valuation of the new company, Level 8 fully reserved the value of the note and valued the investment at $0. During the first quarter of 2001, the Company renegotiated the note to $850, collected this amount and gave up the 4.9% ownership interest of the acquiring company. The gain was included in the gain on sale of assets. Asset Held for Resale During the third quarter of 2001, the Company entered into an agreement to sell its Geneva AppBuilder software business to BluePhoenix Solutions, a wholly owned subsidiary of Liraz Systems Ltd. Under the terms of the agreement, BluePhoenix Solutions will acquire substantially all of the assets associated with Geneva AppBuilder for approximately $19 million in cash and a $1 million note receivable due February 2003. Additionally the Company will receive approximately $469,000 for certain net assets of the Company, pending final audit of the transferred amounts. The Company will use approximately $12 million of the proceeds to retire certain short-term debt obligations. In conjunction with this agreement, the Purchaser has agreed to extend the Company's debt guaranty on the remaining $3,000 term loan to November 15, 2003. The sale closed on October 1, 2001. The components of asset and liability held for resale in the consolidated balance sheet are as follows: Accounts receivable $ 3,600 Prepaid expenses and other current assets 362 Property and equipment, net 957 Intangible assets, net 11,069 Software product technology, net 783 Investment in Access International 2,350 ------- Assets held for resale $19,121 Accrued salaries, wages and related items $ 203 Deferred revenue 4,257 ------- Liabilities held for resale $ 4,460 Net of assets/liabilities held for resale $14,661 ======= The Company owned a building in Windsor, England from the acquisition of Template Software, Inc. The Company determined that this facility was not needed for ongoing operations and was placed for sale. During the first quarter of 2001, the Company sold the building, fixtures, and certain equipment for approximately $2,350. NOTE 12. FUNDED RESEARCH AND DEVELOPMENT In July 2001, the Company and a significant customer entered into a multi-year agreement to fund the development of the next generation of Level 8's Geneva Enterprise Integrator and Geneva Business Process Automator software. The terms of the agreement provide $6.5 million in funding for research and development over the next 18 months. The Company and its significant customer will eliminate the proprietary code in existence and migrate the GEI and GBPA software to the Java 2 Enterprise Edition (J2EE) environment in order to provide customers with a flexible, common development environment. As of September 30, 2000, the Company has received $2,988 in funding payments. Payments are refundable upon cancelation of the contract prior to December 2001. Recognition of the payments has been deferred until the services have been performed and refund provisions of the have expired. Upon recognition the Company will reduce $1,567 in capitalized software development cost and record the remaining amounts as an offset to Research and development expenses. Page 11 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) NOTE 13. LOSS PER SHARE Basic loss per share is computed based upon the weighted average number of common shares outstanding. Diluted earnings/(loss) per share is computed based upon the weighted average number of common shares outstanding and any potentially dilutive securities. Potentially dilutive securities outstanding during the periods presented include stock options, warrants and preferred stock. Dividends of $315 and $117 were paid to the holders of the Company's preferred stock in the third quarter of 2001 and 2000, respectively. The following table sets forth the reconciliation of net loss to loss available to common stockholders:
Three months ended Nine months ended September 30, September 30, 2001 2000 2001 2000 ------------- ------------- -------------- ------------ Net loss $ (24,958) $ (4,499) $ (86,376) $ (18,054) Accrued preferred stock dividends (419) (352) (1,244) (617) --------- --------- --------- --------- Loss available to common stockholders $ (25,377) $ (4,851) $ (87,620) $ (18,671) ========= ========= ========= ========= Loss per common share: Net loss per share - basic and diluted $ (1.58) $ (0.34) $ (5.51) $ (1.37) ========= ========= ========= ========= Weighted common shares outstanding - basic and diluted 16,056 14,298 15,916 13,646 ========= ========= ========= =========
The following table sets forth the potential shares that are not included in the diluted net loss per share calculation because to do so would be anti-dilutive for the periods presented:
September 30, 2001 2000 ------ ------- Stock options, common share equivalent 3,606 3,708 Warrants, common share equivalent 2,662 1,946 Preferred stock, common share equivalent 2,354 2,354 ----- ----- 8,622 8,008 ===== =====
NOTE 14. RELATED PARTY TRANSACTIONS During the first quarter of 2001, the Company loaned an officer and director of the Company $75 which is due in full on January 31, 2002. The interest rate is ten percent (10%) per annum and the note is secured by shares of common stock owned by the officer and director. NOTE 15. SEGMENT INFORMATION During the first quarter of 2001, management reassessed how the Company would be managed and how resources would be allocated. Management now makes operating decisions and assesses performance of the Company's operations based on the following reportable segments: (1) Desktop Integration Products, (2) System Integration Products and (3) Messaging and Application Engineering Products. The principal product in the Desktop Integration segment is Cicero. Cicero is a business integration software product that maximizes end-user productivity, streamlines business operations and integrates disparate systems and applications. The products that make up Systems Integration are as follows: Geneva Enterprise Integrator and Geneva Business Process Automator. Geneva Enterprise Integrator is an integration tool that provides unified, real-time views of enterprise business information for eBusiness applications. Geneva Business Process Automator is a product designed to work with Geneva Enterprise Integrator for automating the many business processes that an organization uses to run its operations and enables the automation of information workflows spanning front and back office systems. Page 12 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) The products that comprise the Messaging and Application Engineering segment are Geneva Integration Broker, Geneva Message Queuing, Geneva XIPC and Geneva AppBuilder. Geneva Integration Broker is a transport independent message broker that enables an organization to rapidly integrate diverse business systems regardless of platform, transport, format or protocol. Geneva Message Queuing is an enterprise connectivity product for Microsoft and non-Microsoft applications. The primary use is for transactional, once and only once connectivity of Windows-based Web applications to back-office information resources like mainframes and other legacy systems. Geneva XIPC provides similar delivery of information between applications. While Geneva Message Queuing is based around a Microsoft standard, Geneva XIPC is for use with Linux and other brands of UNIX operating systems. Geneva AppBuilder is a set of application engineering tools that assists customers in developing, adapting and managing enterprise-wide computer applications for the Internet/intranets and client/server networks. For a more detailed discussion regarding these products, please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2000. Restatement of information prior to the first quarter of 2001 in the newly adopted format was not practicable as the Company did not differentiate on a product line basis. The 2001 information has been stated in the newly adopted format as well as the previous format in order to provide a comparative basis. Prior to the first quarter of 2001, management of the Company made operating decisions and assessed performance of its operations based on the following reportable segments: (1) Software, (2) Maintenance, (3) Services, and (4) Research and Development. The accounting policies of the segments are the same as those described in the "Summary of Significant Accounting Policies," included in the Company's Annual Report on Form 10-K for year ended December 31, 2000. Segment data includes a charge allocating all general and administrative expenses to each of its operating segments based on each segment's proportionate share of expenses. The Company evaluates the performance of its segments and allocates resources to them based on loss before interest, net foreign currency gains/(losses), taxes and amortization of goodwill and other intangible assets (EBITA). The table below presents information about reported segments for the three and nine months ended September 30, 2001:
Messaging/ Application Desktop Integration Systems Integration Engineering Total ------------------------- ------------------------- -------------------------- ------------------------- September 30, 2001 September 30, 2001 September 30, 2001 September 30, 2001 Three Nine Three Nine Three Nine Three Nine months months months months months months months months ended ended ended ended ended ended ended ended ---------- ----------- ---------- ----------- ----------- ----------- ----------- ---------- Total Revenue $ 53 $ 132 $ 1,023 $ 4.808 $ 4,813 $ 16,059 $ 5,889 $ 20,998 Total cost of revenue 2,247 7,248 972 4,142 3,666 9,920 6,885 21,310 ---------- ----------- ---------- ----------- ----------- ----------- ----------- ---------- Gross profit/(loss) (2,194) (7,116) 51 665 1,147 6,139 (996) (312) Total operating expenses 2,740 16,579 745 5,481 2,239 6,839 5,724 28,899 ---------- ----------- ---------- ----------- ----------- ----------- ----------- ---------- EBITA $ (4,934) $ (23,695) $ (694) $(4,816) $ (1,092) $ (700) $ (6,720) $(29,211) ========== =========== ========== =========== =========== =========== =========== ==========
The table below presents information about reported segments for the quarters ended September 30:
Three months ended Three months ended September 30, 2001 September 30, 2000 Total Revenue Total EBITA Total Revenue Total EBITA ---------------- --------------- --------------- --------------- Software $ 772 $ (6,315) $ 14,422 $ 248 Maintenance 3,091 1,787 4,015 2,359 Services 2,026 (605) 3,881 106 Research and Development -- (1,587) -- (2,616) -------- ---------- -------- --------- Total $ 5,889 $ (6,720) $ 22,318 $ (115) ======== ========== ======== =========
Page 13 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) The table below presents information about reported segments for the nine months ended September 30:
Nine months ended Nine months ended September 30, 2001 September 30, 2000 Total Revenue Total EBITA Total Revenue Total EBITA ---------------- --------------- --------------- --------------- Software $ 2,236 $ (27,102) $ 34,324 $ (2,285) Maintenance 10,848 6,379 11,493 6,433 Services 7,915 (848) 17,246 86 Research and Development -- (7,640) -- (8,149) --------- --------- --------- --------- Total $ 20,999 $ (29,211) $ 63,063 $ (3,915) ========= ========= ========= =========
A reconciliation of total segment EBITA to total consolidated loss before taxes for the three and nine months ended September 30 is as follows:
Three months ended Nine months ended September 30, September 30, 2001 2000 2001 2000 -------------- ------------ -------------- -------------- Total EBITA $ (6,720) $ (115) $ (29,211) $ (3,915) Amortization of goodwill (2,671) (9,398) (3,400) (10,514) Restructuring and impairment charges (10,898) -- (41,372) -- Gain (loss) on disposal of asset 341 (41) 1,371 (380) Interest and other income/(expense), net (4,653) (7,135) (473) (2,225) --------- -------- --------- --------- Total loss before income taxes $ (24,601) $ (4,029) $ (85,745) $ (17,034) ========= ======== ========= =========
The following table presents a summary of revenue by geographic region for the three and nine months period ended September 30:
Three months ended Nine months ended September 30, September 30, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Denmark 763 737 2,438 3,256 France 118 331 418 2,262 Germany 253 436 726 1,216 Greece 197 109 605 1,864 Italy 293 619 1,094 1,360 Israel 40 2,847 686 3,240 Norway 77 441 455 1,526 Switzerland 416 416 1,168 1,337 United Kingdom 895 1,389 3,529 8,172 USA 1,878 13,235 7,254 34,619 Other 959 1,758 2,626 4,211 ------ ------- ------- ------- Total revenue $5,889 $22,318 $20,999 $63,063 ====== ======= ======= =======
Presentation of revenue by region is based on the country in which the customer is domiciled. Page 14 Level 8 Systems, Inc. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except share and per share data) NOTE 16. CONTINGENCIES Litigation. During the quarter ended September 30, 2001, in response to an action brought by the Company, the Company was named as a defendant in an action that claimed the Company had breached a contract relating to the sale of certain assets. The plaintiff is seeking damages in excess of $100 million. The Company believes that there is no basis for this complaint and will vigorously defend it's position. Accordingly, the Company has not recorded any liability associated with this claim. NOTE 17. SUBSEQUENT EVENTS In October 2001, the Company entered into an exchange agreement with its existing preferred shareholders. Under the terms of the agreement, the holders of the Series A and Series B 4% convertible redeemable preferred stock and related common stock warrants will receive an equal number of preferred shares of the new Series A1 and Series B1 convertible redeemable preferred stock and related warrants. The conversion price of both the Series A1 and Series B1 preferred stock has been reduced by 16.7% and 50% respectively, which increases the number of shares of common stock to be issued upon conversion of the preferred shares by approximately 1.4 million shares. Additionally, the exercise price for the warrants received in the exchange has been reduced to $1.77 per share and the call prices have been reduced accordingly to $5.00 per share for the Series A1 warrants and $7.50 per share for the Series B1 warrants. The difference in the fair value of the instruments prior to the exchange and subsequent to the change will be recorded as a dividend to preferred shareholders. In return, the preferred shareholders have agreed to waive all future dividend payments which approximates $1.7 million per year and modify the anti-dilution provisions that existed under the Series A and Series B preferred stock offerings. The Company may issue up to 3 million shares of common stock, warrants, preferred stock or other securities without triggering any anti-dilution provisions. Page 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ----------------------------------------------------------------------- RESULTS OF OPERATIONS. --------------------- GENERAL INFORMATION ------------------- Level 8 Systems is a global provider of business integration software that enables organizations to integrate new and existing information and processes at the desktop with Cicero and at the server level with the Geneva Integration Suite of products. Business integration software addresses the emerging need for a company's information systems to deliver enterprise-wide views of the company's business information processes. In addition to software products, Level 8 also provides technical support, training and consulting services as part of its commitment to providing its customers industry-leading integration solutions. Level 8's worldwide consulting team has in-depth experience in developing successful enterprise-class solutions as well as valuable insight into the business information needs of customers in the Global 5000. Level 8 offers services around its integration software products. This discussion contains forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities, liquidity and capital resources and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause its actual results to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. See "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations--Forward Looking and Cautionary Statements." The Company's results of operations include the operations of the Company and its subsidiaries. Operations for the subsidiaries acquired during 2001 and 2000 are included from the date of acquisition. Accordingly, the 2000 results of operations presented do not include the operations of StarQuest Software, Inc. ("StarQuest") as it was acquired November 28, 2000. All subsidiaries are wholly owned for the periods presented. Due to the Company's acquisition and divestiture activities, year-to-year comparisons of results of operations are not necessarily meaningful. Additionally, as a result of the Company's pursuit of a growth strategy focusing on its software product sales and synergies gained as a result of eliminating duplicative functions, the results of operations are significantly different than the result of combining the previous operations of each acquired company into Level 8. Pro forma comparisons are therefore not necessarily meaningful either. In 2001, the Company has shifted its primary focus from selling multiple Enterprise Application Integration ("EAI") products to a seller of Cicero, a desktop integration package, to the financial services industry with a decreased focus on services. Further, on October 1, 2001, the Company sold its remaining Application Engineering products and thus will have no significant future revenue streams within that segment. BUSINESS STRATEGY ----------------- During the first quarter of 2001, management reassessed how the Company would be managed and how resources would be allocated. Management now makes operating decisions and assesses performance of the Company's operations based on the following reportable segments: (1) Desktop Integration Products, (2) System Integration Products and (3) The Messaging and Application Engineering Products. The principal product in the Desktop Integration segment is Cicero. Cicero is a business integration software product that maximizes end-user productivity, streamlines business operations and integrates disparate systems and applications. The products that make up the Systems Integration segment are as follows: Geneva Enterprise Integrator and Geneva Business Process Automator. Geneva Enterprise Integrator is an integration tool that provides unified, real-time views of enterprise business information for eBusiness applications. Geneva Business Process Automator is a product designed to work with Geneva Enterprise Integrator for automating the many business processes that an organization uses to run its operations and enables the automation of information workflows spanning front and back office systems. The products that comprise the Messaging and Application Engineering segment are Geneva Integration Broker, Geneva Message Queuing, Geneva XIPC and Geneva AppBuilder. Geneva Integration Broker is a transport independent message broker that enables an organization to rapidly integrate diverse business systems regardless of platform, transport, format or protocol. Geneva Message Queuing is an enterprise connectivity product for Microsoft and non-Microsoft applications. The primary use is for transactional, once and only once connectivity of Windows-based Web applications to back-office information resources like mainframes and other legacy systems. Geneva XIPC provides similar delivery of information between applications. While Geneva Message Queuing is based around a Microsoft standard, Geneva XIPC is for use with Linux and other brands of UNIX operating systems. Geneva AppBuilder is a set of application engineering tools that assists customers in developing, adapting and managing enterprise-wide computer applications for the Internet/intranets and client/server networks. Page 16 On October 1, 2001, the Company completed the sale of its Geneva AppBuilder product. Under the terms of the agreement, the Company sold the rights, title and interest in the Geneva AppBuilder product along with all receivables, unbilled and deferred revenues as well as all maintenance contracts. The Geneva AppBuilder product currently accounts for approximately 83% of total revenue within the Messaging and Application Engineering segment and approximately 63% of total revenue for all segments. See Notes 11 and 16 in the Notes to the Consolidated Financial Statements. Also during the quarter ended September 30, 2001, the Company sold two of its messaging products - Geneva Message Queuing and Geneva XIPC to Envoy Technologies, Inc. Under the terms of the agreement, Envoy acquired all rights, title and interest to the products along with all customer and maintenance contracts. For a more detailed discussion regarding these products, please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2000. RESULTS OF OPERATIONS --------------------- The following table sets forth, for the periods indicated, the Company's unaudited results of operations expressed as a percentage of revenue:
Three months ended Nine months ended September 30, September 30, 2001 2000 2001 2000 ------------- ------------- ------------- ------------- Revenue: Software products 13.1 % 64.6 % 10.6 % 54.4 % Maintenance 52.5 % 18.0 % 51.7 % 18.2 % Services 34.4 % 17.4 % 37.7 % 27.4 % ------ ------ ------ ------ Total 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenue: Software products 60.3 % 10.1 % 51.6 % 9.3 % Maintenance 18.7 % 6.2 % 16.9 % 6.8 % Services 37.9 % 15.4 % 33.0 % 23.4 % ------ ------ ------ ------ Total 116.9 % 31.7 % 101.5 % 39.5 % Gross profit (16.9)% 68.3 % (1.5)% 60.5 % Operating expenses: Sales and marketing 41.2 % 43.3 % 58.1 % 40.3 % Research and product development 22.8 % 9.8 % 28.3 % 11.0 % General and administrative 33.2 % 15.7 % 51.1 % 15.4 % Amortization of goodwill and intangibles 45.4 % 15.2 % 44.7 % 16.7 % Restructuring charges % -- % 41.2 % -- % Impairment of intangible assets 185.1 % -- % 155.8 % -- % Gain on disposal of asset (5.7)% 0.2 % (6.5)% 0.6 % ------ ------ ------ ------- Total 322.0 % 84.2 % 372.7 % 84.0 % Loss from operations (338.9)% (15.9)% (374.2)% (23.5)% Other income (expense), net (79.0)% (2.1)% (27.5)% (3.5)% ------ ------ ----- ---- Loss before taxes (417.9)% (18.0)% (401.7)% (27.0)% Income tax provision 6.1 % 2.1 % 3.0 % 1.6 % ------ ------ ------ ----- Net loss (424.0)% (20.1)% (404.7)% (28.6)% ====== ===== ====== =====
Page 17 The following table sets forth unaudited data for total revenue by geographic origin as a percentage of total revenue for the periods indicated:
Three months ended Nine months ended September 30, September 30, 2001 2000 2001 2000 ---------- --------- --------- -------- United States 32% 59% 31% 55% Europe 64% 26% 61% 38% Asia Pacific 3% 2% 3% 2% Other 1% 13% 5% 5% --- --- --- --- Total 100% 100% 100% 100% === === === ===
REVENUE AND GROSS MARGIN. The Company has three categories of revenue: software products, maintenance and services. Software products revenue is comprised primarily of fees from licensing the Company's proprietary software products. Maintenance revenue is comprised of fees for maintaining, supporting and providing periodic upgrades to the Company's software products. Services revenue is comprised of fees for consulting and training services related to the Company's software products. The Company's revenues may vary from quarter to quarter due to market conditions, the budgeting and purchasing cycles of customers and the effectiveness of its sales force. The Company typically does not have any material backlog of unfilled software orders, and product revenue in any quarter is substantially dependent upon orders received in that quarter. Because the Company's operating expenses are based on anticipated revenue levels and are relatively fixed over the short term, variations in the timing of recognition revenue can cause significant variations in operating results from quarter to quarter. Fluctuations in operating results may result in volatility in the price of the Company's common stock. Total revenues decreased significantly for the three months and nine months ended September 30, 2001 as compared to the same periods of 2000 due to the Company's new focus on its Cicero product, the development of Geneva Enterprise Integrator under the J2EE platform and to a general slowing of the economy. Gross margins on software products decreased from a margin of 68.3% and 60.5% for the three and nine months ended September 30, 2000, respectively, to a negative 16.9% and 1.5% for the same periods in 2001, primarily due to an increase in software technology amortization and the decrease in the Company's software product revenue discussed above. Cost of revenues for fiscal 2001 reflect the amortization of the technology purchased from Merrill Lynch in August 2000. For the three and nine months ended September 30, 2001, these costs amounted to $1,896 and $5,687. SOFTWARE PRODUCTS. For the three and nine months ended September 30, 2001, the Systems Integration segment accounted for approximately 12% and 41%, respectively, of the software revenue while the Messaging and Application Engineering segment accounted for approximately 88% and 59% of software revenue. The formal launch date of the Cicero product was late in the second quarter of 2001, so there was no significant revenue associated with this segment in either the three or six month period ended September 30, 2001. Gross margins on software products decreased from a margin of 84.5% for the three months ended September 30, 2000, and 82.9% for the nine months ended September 30, 2000, to (360%) and (385%), respectively, for the same periods in 2001 primarily due to an increase in software technology amortization and the decrease in the Company's software product revenue. Cost of software is composed primarily of amortization of purchased technology, amortization of capitalized software costs for internally developed software and royalties to third parties for the Company's Geneva Message Queuing product and to a lesser extent production and distribution costs. The increase in cost of software was primarily due to amortization of capitalized software from the acquisition of StarQuest and the Cicero developed technology purchased in 2000. The software product gross margin for the Systems Integration segment was (311%) and (38%) for the three and nine months ended September 30, 2001, respectively, and the Messaging and Application Engineering segment were approximately (90%) and (68%) for the three and nine months ended September 30, 2001, respectively. These costs were primarily attributable to the royalties and the amortization of capitalized software. The Company expects to see significant increases in software sales related to the Desktop Integration segment coupled with improving margins on software products as Cicero was formally launched late in the second quarter of 2001. The Systems Integration segment revenue is anticipated to increase slightly from fiscal 2001 levels with the gross margin remaining relatively consistent. The Messaging and Application Engineering segment revenue is expected to a decrease significantly along with related expenses as these products have been sold. Page 18 MAINTENANCE. Maintenance revenue during the three and nine months ended September 30, 2001 decreased over the same periods for 2000 as several customers have not yet renewed their maintenance contracts. The Desktop Integration segment accounted for approximately 0% and 1% of total maintenance revenue for the three and nine month periods ended September 30, 2001, as that particular segment was only recently launched. The Systems Integration segment accounted for 15% and 16% for the three and nine months ended September 30, 2001, and the Messaging and Application Engineering segment accounted for approximately 85% and 83% of total maintenance revenue, respectively, for the three and nine months ended September 30, 2001. Cost of maintenance is comprised of personnel costs and related overhead and the cost of third-party contracts for the maintenance and support of the Company's software products. Gross margins on maintenance decreased for the current quarter to 64%, down from 66% last year but increased for the nine months ending September 30, 2001 to 67%, up from 62% last year. The Desktop Integration segment had a negative gross margin on maintenance as this product is still in its infancy. The Systems Integration segment had a gross margin on maintenance of approximately 92% and 76% for the three and nine months ended September 30, 2001, while the Messaging and Application Engineering segment had a gross margin on maintenance of approximately 63% and 69% for the three and nine months ended September 30, 2001, both of which are attributable to the increases in installed customer base and the Company realizing economies of scale. Maintenance revenues are expected to increase, primarily in the Desktop Integration segment and the System Integration segment. The Messaging and Application Engineering segment revenues are expected to significantly decrease as these products have been sold. Cost of maintenance is expected to increase slightly for the Desktop Integration segment, while remaining constant for the System Integration segment. SERVICES. Services revenue for the three and nine months ended September 30, 2001 decreased (23%) and (32%), respectively, over the same period last year, primarily due to the overall decline in software sales as well as a reduction in capacity. In addition, revenues in the nine months ended September 30, 2000 reflect revenues from the now ceased government services group. For the three and months ended September 30, 2001, the Systems Integration segment comprised of approximately 23% of the services revenue and for the nine month period, the Systems Integration segment comprised 30% of the total services revenue. The Messaging and Application Engineering segment accounted for approximately 76% of services revenue in the quarter and 70% of all services revenue realized to date. Cost of services primarily includes personnel and travel costs related to the delivery of services. Services gross margins decreased to a negative 10% for the three months ended September 30, 2001 and to 12.5% for the nine months then ended. In the same period in 2000, service gross margins were approximately 13%. Services revenues are expected to increase for the Desktop Integration segment now that its Cicero product has been released. The Messaging and Application Engineering segment revenues are expected to significantly decrease along with its gross margin as a key component of this segment has been sold. The revenues for the Systems Integration segment are expected to remain constant while its gross margin increases from more efficient utilization of personnel. SALES AND MARKETING. Sales and marketing expenses primarily include personnel costs for salespeople, travel, and related overhead, as well as trade show participation and the Messaging and Application Engineering promotional expenses. Sales and marketing expenses decreased significantly from the three and nine months ended September 30, 2000 to the same periods of 2001 due to a decrease in the size of the Company's sales and marketing workforce, and through decreased promotional activities. Sales and marketing expenses are expected to decrease along all product lines, primarily due to the restructuring efforts done in the first and second quarters of 2001. Because of the disposition of the Messaging and AppBuilder products, the key emphasis for the sales and marketing groups going forward will be on the Desktop Integration segment. RESEARCH AND DEVELOPMENT. Research and development expenses primarily include personnel costs for product authors, product developers and product documentation and related overhead. Research and development expense decreased 38.9% and 14.5% for three and nine months, respectively, over the three and six months ended June 30, 2000 due to restructuring efforts done primarily in the second quarter of 2001 and the ability of the Company to capitalize certain research and development costs. The Company intends to continue making a significant investment in research and development while also improving efficiencies in this area. Page 19 GENERAL AND ADMINISTRATIVE. General and administrative expenses consist of personnel costs for the executive, legal, financial, human resources, and administrative staff, related overhead, and all non-allocable corporate costs of operating the Company. General and administrative expenses for the three months ended September 30, 2001, decreased by 44% over the three months ended September 30, 2000, due primarily to restructuring. For the nine months ended period September 30, 2001, expenses increased by $1.0 million over the same period last year. The increase was primarily the result of a provision for bad debt of approximately $3.7 million from a significant customer who filed for Chapter 11 Bankruptcy. General and administrative expenses are expected to decrease going forward primarily due to the restructuring plan implemented in the first two quarters of 2001. AMORTIZATION OF GOODWILL AND OTHER INTANGIBLE ASSETS. Amortization of goodwill and other intangible assets was $2.67 million for the three months ended September 30, 2001 and $3.4 million for the same period of 2000. The amortization of goodwill in the three months ended September 30, 2000 was related to the purchases of Template Software, Inc ("Template"), Seer Technologies, Inc. ("Seer"), Momentum Software Corporation ("Momentum"), and Level 8 Technologies ("Level 8"). For the three months ended September 30, 2001, amortization of goodwill and other intangibles also included the amortization of intangible assets related to the acquisition of StarQuest. The decrease in amortization expense in the current quarter reflects the reduction in goodwill as a result of an impairment that had occurred with regard to the intangible assets acquired from Template. The impairment charge was recognized in the first quarter of 2001. Amortization of goodwill and other intangible assets was $10.5 million for the nine months ended June 30, 2001 and $9.4 million same period of 2000. The Company will continue to assess the recoverability of its intangible assets on a quarterly basis based on the net present value of the expected future cash flows. RESTRUCTURING. In the first quarter of 2001, the Company announced and began implementation of an operational restructuring to reduce its operating costs and streamline its organizational structure. As a result of this initiative, the Company recorded restructuring charges of $6,650 during the quarter ended March 31, 2001, and an additional charge of $2,000 for the quarter ending June 30, 2001. Additional charges for the quarter ended June 30, 2001 represents employee severance and benefits, relating to 41 employees and the former chief strategy officer, paid to terminated employees and includes the issuance of 250,000 shares of common stock valued at $1,045. Restructuring charges have been classified in "Restructuring" on the consolidated statements of operations. This operational restructuring involves the reduction of employee staff throughout the Company in all geographical regions in sales, marketing, services, development and administrative functions. The Company anticipates that each component of the restructuring plan will be completed by December 31, 2001. For the three months ended March 31, 2001, and June 30, 2001, the charges associated with the Company's restructuring were as follows:
Three Three Six months ended months ended months ended March 31, 2001 June 30, 2001 June 30, 2001 -------------------- -------------------- -------------------- Employee severance and benefits $ 3,319 $ 2,000 $ 5,319 Excess office facilities 2,110 -- 2,110 Marketing obligations 288 -- 288 Other 933 -- 933 -------- -------- -------- $ 6,650 $ 2,000 $ 8,650 ======== ======== ========
The restructuring plan included the termination of 191 employees, all of whom have been notified as of June 30, 2001. The plan includes a reduction of 83 personnel in the European operations and 108 personnel in the US operations. Employee termination costs are comprised of severance-related payments for all employees terminated in connection with the operational restructuring. Termination benefits do not include any amounts for employment-related services prior to termination. Premises obligations primarily relate to the continuation of lease obligations, brokers commissions and leasehold improvements for approximately 60,000 square feet of facilities no longer deemed necessary and costs to exit short-term leases for various sales offices. Amounts expensed relating to lease obligations represent estimates of undiscounted future cash outflows, offset by anticipated third-party sub-lease payments. Marketing obligations relate to contracts and services relating to the prior focus of the Company and are no longer expected to be utilized. Other miscellaneous restructuring costs include professional fees, royalty commitments, recruiting fees, excess equipment and other miscellaneous expenses directly attributable to the restructuring. At September 30, 2001, the accrued liability associated with the restructuring charges and cash paid was $1,615 and $6,730, respectively. Non-cash restructuring items totaled $454 for the period ended September 30, 2001. Page 20 The following table sets forth a reconciliation to accrued expenses and cash paid as of September 30, 2001: Accrued Cash Paid ------- --------- Employee termination $ 319 $ 5,000 Premises 1,108 1,151 Marketing obligations 53 235 Other miscellaneous restructuring costs 135 344 -------- -------- $ 1,615 $ 6,730 ======== ======== IMPAIRMENT OF INTANGIBLE ASSETS. In the first quarter of 2001, management reevaluated and modified its approach to managing the business and decided to conduct business and assess the efficiency of operations under a line-of-business approach. As such, the Company performed an assessment of the recoverability of its long-lived assets under a line of business approach. The results of its analysis of undiscounted cash flows indicated that an impairment had occurred with regard to intangible assets acquired from Template. The Company estimated the fair market value of the related assets through a discounted future cash flow valuation technique. The results of this analysis indicated that the carrying values of these assets exceeded their fair market values. The Company has reduced the carrying value of these intangible assets by approximately $21,824 as of March 31, 2001. During the third quarter of 2001, the Company was notified by one of its resellers that they would no longer engage in re-sales of the Company's CTRC products, a component of the Messaging and Application Engineering segment. This reseller accounted for substantially all of the CRTC product sales. As a result, the Company performed an assessment of the recoverability of those related long-lived in accordance with SAB 100 and SFAS 121. The results of the Company's analysis of undiscounted cash flows indicated that an impairment had occurred with regard to the intangible assets related to the CRTC products. The Company estimated the fair market value of the related assets through a discounted future cash flow valuation technique. The results of this analysis indicated the carrying value of these intangible assets exceeded their fair market values. The Company has reduced the carrying value by this amount by approximately $10,900 as of September 30, 2001. PROVISION FOR INCOME TAXES. The Company's effective income tax rate for continuing operations differs from the statutory rate primarily because an income tax benefit was not recorded for the net loss incurred in 2001 or 2000. Because of the Company's inconsistent earnings history, the deferred tax assets have been fully offset by a valuation allowance. The income tax provision for the first and second quarters of fiscal year 2001 is primarily related to income taxes from profitable foreign operations and foreign withholding taxes. IMPACT OF INFLATION. Inflation has not had a significant effect on the Company's operating results during the periods presented. LIQUIDITY AND CAPITAL RESOURCES ---------------------------------- Operating and Investing Activities The Company utilized $15.2 million of cash during the first nine months of 2001. Operating activities utilized approximately $13.6 million, which is comprised primarily of the loss from operations of $86.4 million, offset by non-cash charges for depreciation and amortization of approximately $23.4 million and non-cash charges for impairment of $32.7 million as well as a reduction in accounts receivable of $9.0 million and a provision for bad debts in the amount of $3.9 million. The Company generated approximately $1.8 million in cash from investing activities primarily from the sale of property and utilized approximately $3.4 million in cash for financing activities by repaying a portion of its debt. On April 18, 2001, a significant customer voluntarily filed for protection under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court for the District of Delaware. Due to the uncertainty of collection of this debt, the Company recorded and allowance for doubtful accounts of $3,680 which was charged to general and administrative expenses in the consolidated statements of operations. As of September 30, 2001, the Company did not have any material commitments for capital expenditures. Page 21 Financing Activities The Company funded its cash needs during the first nine months of 2001 with cash on hand at December 31, 2000 and through operations. At September 30, 2001, the Company has an outstanding term loan with a commercial bank for $15,000. This loan bears interest at LIBOR plus 1% (approximately 4.8% at June 30, 2001), which is payable quarterly. On October 1, 2001, using the proceeds from the sale of the AppBuilder product, the Company reduced the outstanding term loan to $3,000 and extended the maturity date to November 15, 2003. There are no financial covenants. This loan is guaranteed by Liraz, the Company's principal shareholder. During 2000, the loan and guarantee were amended to extend the due date from May 31, 2001 to November 30, 2001 and to provide the Company with additional borrowings. In exchange for the initial and amended guarantees, the Company issued Liraz a total of 170,000 shares of the Company's common stock. Based upon the fair market value of the stock issued, the Company has recorded total deferred costs of $4,013 related to the guaranty. These costs are being amortized in the Consolidated Statement of Operations as a component of interest expense over the term of the guaranty. On December 15, 2000, the Company entered into a credit facility with a commercial bank to provide for borrowings up to the lesser of $10,000 or the sum of 50% of eligible receivables plus cash pledged with this commercial bank. At September 30, 2001, the Company is in compliance with all financial covenants. On October 1, 2001, as part of the sale of the AppBuilder product and using proceeds therefrom, the Company liquidated the entire credit facility and obtained a release on all secured assets. As a result, the Company has no credit facility in place. During the first quarter of 2001, the Company paid a $2.0 million note payable it assumed from the acquisition of StarQuest to one of StarQuest's strategic partners. For the nine months ended September 30, 2001, the Company incurred a net loss of $86.3 million and has a working capital deficit of $1.4 million and an accumulated deficit of $160.2 million. As noted above, on October 1, 2001, the Company completed the sale of its AppBuilder product for approximately $20,000 plus certain net assets. The Company believes that existing cash on hand, cash generated through the disposition of the AppBuilder assets and cash provided by future operations should be sufficient to finance its operations and expected working capital and capital expenditure requirements for approximately the next twelve months so long as the Company continues to perform according to its operating plan and cost reduction program. The Company's future capital needs will depend on the Company's ability to meet its current operating forecast, the ability to successfully bring Cicero to market and market demand for the Company's products. As Cicero is a brand new product in a newly emerging product category, the Company's forecasted sales may be delayed or postponed and the anticipated sales cycle may take longer than anticipated. As such, there can be no assurance that the Company will continue to be able to meet its cash requirements through operations or obtain additional financing on acceptable terms, and the failure to do so may have an additional adverse impact on the Company's business and operations. The Company may explore additional debt or equity financing to sustain operations during the product acceptance stage. Euro Conversion Several European countries adopted a Single European Currency (the "Euro") as of January 1, 1999 with a transition period continuing through January 1, 2002. The Company is reviewing the anticipated impact the Euro may have on its internal systems and on its competitive environment. The Company believes its internal systems will be Euro capable without material modification cost. Further, the Company does not presently expect the introduction of the Euro currency to have material adverse impact on the Company's financial condition, cash flows, or results of operations. Page 22 FORWARD LOOKING AND CAUTIONARY STATEMENTS ----------------------------------------- Certain statements contained in this Quarterly Report may constitute "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 ("Reform Act"). We may also make forward looking statements in other reports filed with the Securities and Exchange Commission, in materials delivered to shareholders, in press releases and in other public statements. In addition, our representatives may from time to time make oral forward looking statements. Forward looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as "anticipates," "believes," "expects," "estimates," "intends," "plans," "projects," and similar expressions, may identify such forward looking statements. In accordance with the Reform Act, set forth below are cautionary statements that accompany those forward looking statements. Readers should carefully review these cautionary statements as they identify certain important factors that could cause actual results to differ materially from those in the forward looking statements and from historical trends. The following cautionary statements are not exclusive and are in addition to other factors discussed elsewhere in our filings with the Securities and Exchange Commission and in materials incorporated therein by reference: our future success depends on the market acceptance of the Cicero product and successful execution of the new strategic direction; general economic or business conditions may be less favorable than expected, resulting in, among other things, lower than expected revenues; an unexpected revenue shortfall may adversely affect our business because our expenses are largely fixed; our quarterly operating results may vary significantly because we are not able to accurately predict the amount and timing of individual sales and this may adversely impact our stock price; trends in sales of our products and general economic conditions may affect investors' expectations regarding our financial performance and may adversely affect our stock price; our future results may depend upon the continued growth and business use of the Internet; we may lose market share and be required to reduce prices as a result of competition from its existing competitors, other vendors and information systems departments of customers; we may not have the ability to recruit, train and retain qualified personnel; our future results may depend upon the successful integration of future acquisitions; we may not have the resources to successfully manage additional growth; rapid technological change could render our products obsolete; loss of any one of our major customers could adversely affect our business; our business is subject to a number of risks associated with doing business abroad including the effect of foreign currency exchange fluctuations on our results of operations; our products may contain undetected software errors, which could adversely affect our business; because our technology is complex, we may be exposed to liability claims; we may be unable to enforce or defend our ownership and use of proprietary technology; our license to market and sell the Cicero technology may become non-exclusive in August 2002; because we are a technology company, our common stock may be subject to erratic price fluctuations; and we may not have sufficient liquidity and capital resources to meet changing business conditions. Page 23 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ------------------------------------------------------------------ Approximately 68% and 70% of the Company's revenues for the three and nine month periods ended September 30, 2001, respectively, were generated by sales outside the United States. The Company is exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and is subject to transaction gains and losses, which are recorded as a component in determining net income. Additionally, the assets and liabilities of the Company's non-U.S. operations are translated into U.S. dollars at exchange rates in effect as of the applicable balance sheet dates, and revenue and expense accounts of these operations are translated at average exchange rates during the month the transactions occur. Unrealized translation gains and losses are included as a component of accumulated other comprehensive income or loss in shareholders' equity. In an effort to reduce its exposure to currency fluctuations on its foreign currency receivables, the Company began hedging these receivables by purchasing forward contracts during 1999. However, as a matter of procedure, the Company will not invest in speculative financial instruments as a means of hedging against such risk. Gains and losses on forward foreign exchange contracts are marked to market and are included in the consolidated statement of operations for each period. In addition, since the Company enters into forward contracts only as a hedge, any change in currency rates would not result in any material net gain or loss, as any gain or loss on the underlying foreign currency denominated balance would be offset by the gain or loss on the forward contract. Page 24 PART II. Other Information Item 1. Legal Proceedings From time to time, the Company is a party to routine litigation incidental to its business. As of the date of this report, the Company has been named in an action claiming material breach of a contract. While the Company believes the claims are without merit and fully intends to vigorously defend its position, if the plaintiff were to be successful, the result may have a material adverse impact on the Company's future. Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits None (b) Reports on Form 8-K On August 14, 2001, Level 8 filed a Form 8-K reporting its August 8, 2001 asset purchase agreement between Level 8 Systems, Inc. and AppBuilder Solution B.V., a wholly owned subsidiary of Liraz Systems Ltd. On October 16, 2001 Level 8 Systems filed Form 8-K reporting the completion of its asset sale agreement between BluePhoenix Solutions (formerly AppBuilder Solutions B.V.), a wholly owned subsidiary of Liraz Systems Ltd and the Company. Page 25 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. Level 8 Systems, Inc. Date: November 14, 2001 /s/ Paul Rampel ................................... Paul Rampel President Date: November 14, 2001 /s/ John Broderick ................................... John Broderick Chief Financial Officer Page 26