SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549-1004
___________________________
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2002
[ ] 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: 0-28403
___________________________
Avalon Digital Marketing Systems, Inc.
(Exact name of registrant as specified in its charter)
Delaware 77-0511097
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2120 Main Street, Suite 200, Huntington Beach, CA 92648
(Address of principal executive offices)
(714) 536-6200
(Registrant's telephone number, including area code)
MindArrow Systems, Inc.
Former fiscal year ended September 30
(Former name, former address and former fiscal year, if changed since last
report)
___________________________
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ X] No [ ]
The number of shares outstanding of each of the Registrant's classes of
common stock:
7,174,259
(Number of shares of common stock outstanding as of December 31, 2002)
Avalon Digital Marketing Systems, Inc.
Quarterly Report on Form 10-Q
For the three months ended December 31, 2002
INDEX
Part I. Financial Information
NOTE: Avalon Digital Marketing Systems, Inc. ("Avalon") was formed as a
result of a merger between MindArrow Systems, Inc. ("MindArrow") and Category 5
Technologies, Inc. ("Category 5") on September 30, 2002. MindArrow was the legal
acquirer of Category 5, but because Category 5's business was larger than
MindArrow's and because Category 5's former stockholders own the majority of
Avalon, generally accepted accounting principals require that Category 5 be
treated as the acquirer for accounting and reporting purposes. Accordingly, the
financial statements in this report reflect the following:
- Consolidated Balance Sheet as of December 31, 2002 - reflects post-merger
Avalon.
- Consolidated Balance Sheet as of June 30, 2002 - reflects Category 5 only.
- Statements of Operations for the Quarter and Six Months Ended December 31,
2001 - reflects Category 5 only. Statements of Operations for the Six
Months Ended December 31, 2002 - reflects one quarter of Category 5 only
and one quarter of post-merger Avalon. Statements of Operations for the
Quarter Ended December 31, 2002 reflects operations of post-merger Avalon.
- Statements of Cash Flows for the Six Months Ended December 31, 2001 -
reflects Category 5 only. Statements of Operations for the Six Months Ended
December 31, 2002 - reflects one quarter of Category 5 only and one quarter
of post-merger Avalon.
- Pro forma combined information as if the merger had taken place on July 1,
2002 is contained in the notes to financial statements.
In addition, references to the "Company" for periods prior to September 30, 2002
are intended to refer to Category 5 and its business.
Page
------
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets - December 31, 2002 (unaudited) and
June 30, 2002.................................................................. 4
Consolidated Statements of Operations (unaudited) - Three and Six Months
Ended December 31, 2002 and 2001............................................... 5
Consolidated Statement of Changes in Stockholders' Equity (unaudited) -
Six Months Ended December 31, 2002............................................. 6
Consolidated Statements of Cash Flows (unaudited) - Six Months
Ended December 31, 2002 and 2001............................................... 7
Notes to Consolidated Financial Statements (unaudited)......................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................... 19
Item 3. Quantitative and Qualitative Disclosures about Market Risk..................... 36
Item 4. Controls and Procedures........................................................ 36
2
Part II. Other Information
Page
Item 1. Legal Proceedings ............................................................. 38
Item 2. Changes in Securities and Use of Proceeds ..................................... 38
Item 3. Defaults Upon Senior Securities................................................ 39
Item 4. Submission of Matters to a Vote of Security Holders............................ 39
Item 5. Other Information.............................................................. 39
Item 6. Exhibits and Reports on Form 8-K............................................... 39
Signatures and certifications............................................................... 39
3
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
December 31, 2002 June 30, 2002
------------------- ----------------
(unaudited)
ASSETS
Current assets:
Cash $ 175,945 $ 298,272
Short term investments - 1,000,000
Receivables, net
Contract 439,996 1,751,701
Trade 1,117,990 597,035
Retainages 450,408 272,782
Prepaid expenses and other current assets 172,282 265,629
------------------ ----------------
Total current assets 2,356,621 4,185,419
Fixed assets, net 1,481,878 1,111,356
Identifiable intangible assets, net 8,020,821 1,962,356
Goodwill 16,735,421 2,187,947
Contract receivables - long term, net 846,701 3,400,363
Retainage receivables - long term, net - 1,664,548
Deposits 138,733 74,118
------------------ ----------------
Total assets $ 29,580,175 $ 14,586,107
================== ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities $ 7,392,695 $ 1,669,997
Deferred revenue 1,271,194 299,537
Notes payable, current portion 1,817,822 1,641,314
Fair value allowance 196,324 757,677
Due to related parties 155,498 198,867
Deferred taxes - 136,000
------------------ ----------------
Total current liabilities 10,833,533 4,703,392
------------------ ----------------
Long-term liabilities:
Capital lease obligation - 87,695
Deferred taxes - 1,008,000
------------------ ----------------
Total long-term liabilities - 1,095,695
------------------ ----------------
Stockholders' equity:
Common stock, $0.001 par value; 75,000,000 and 125,000,000 shares authorized,
7,174,259 and 1,659,286 shares issued and outstanding at
December 31 and June 30, 2002, respectively 7,174 1,659
Additional paid-in capital 25,781,258 6,960,164
Retained earnings (deficit) (7,041,790) 1,825,197
------------------ ----------------
Total stockholders' equity 18,746,642 8,787,020
------------------ ----------------
Total liabilities and stockholders' equity $ 29,580,175 $ 14,586,107
================== ================
The accompanying notes are an integral part of these statements.
4
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Statements of Operations
Three Months Ended Six Months Ended
December 31, December 31, December 31, December 31,
2002 2001 2002 2001
------------------------------- -------------- --------------
(unaudited) (unaudited)
Revenues $ 4,245,303 $ 7,079,812 $ 7,550,111 $ 11,436,017
Cost of revenues 1,112,433 2,132,086 1,239,891 3,860,021
-------------- --------------- -------------- --------------
Gross profit 3,132,870 4,947,726 6,310,220 7,575,996
-------------- --------------- -------------- --------------
Operating expenses:
Selling, general and administrative 5,560,335 2,925,031 9,874,833 5,120,942
Bad debt expense 3,416,964 - 4,360,175 378,068
Depreciation and amortization 899,657 16,843 1,273,455 32,237
-------------- --------------- -------------- --------------
Total operating expenses 9,876,956 2,941,874 15,508,463 5,531,247
-------------- --------------- -------------- --------------
Income (loss) from operations (6,744,086) 2,005,852 (9,198,243) 2,044,749
Write-down of short-term investment - - (1,021,135) -
Interest income 174,280 626 415,723 626
Interest expense (109,947) (25,101) (207,332) (29,151)
-------------- --------------- -------------- --------------
Net income (loss) before income taxes (6,679,753) 1,981,377 (10,010,987) 2,016,224
(Provision) benefit for income taxes
Current - (1,230,000) - (1,230,000)
Deferred - 530,000 1,144,000 530,000
-------------- --------------- -------------- --------------
Net income (loss) $ (6,679,753) $ 1,281,377 $ (8,866,987) $ 1,316,224
============== =============== ============== ==============
Basic earnings (loss) per share $ (0.95) $ 0.46 $ (1.63) $ 0.47
============== =============== ============== ==============
Diluted earnings (loss) per share $ (0.95) $ 0.37 $ (1.63) $ 0.39
============== =============== ============== ==============
Shares used in computation of basic earnings
(loss) per share 7,016,419 2,806,000 5,431,109 2,772,650
============== =============== ============== ==============
Shares used in computation of diluted
earnings (loss) per share 7,016,419 3,457,360 5,431,109 3,333,160
============== =============== ============== ==============
The accompanying notes are an integral part of these statements.
5
AVALON DIGITAL MARKETING SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2002 2001
------------ ------------
(UNAUDITED)
Cash flows from operating activities:
Net income (loss) $(8,866,987) $1,316,224
Adjustments to reconcile net income (loss) to net cash provided by (used in) operations:
Bad debt expense 4,360,175 378,068
Depreciation and amortization 1,273,455 32,235
Write-down of short-term investment 1,021,135 -
Fair value allowance (561,353) -
Amortization of debt discount and loan fees 77,508 6,667
Issuance of stock and options for services 59,675 225,000
Deferred tax benefit (1,144,000) (530,000)
Changes in operating assets and liabilities, net of effects of reverse
acquisition of MindArrow Systems, Inc. and acquisition of
AGEA Corporation
(Increase) decrease in contract receivables 873,605 (2,972,357)
(Increase) decrease in trade receivables 284,964 (24,583)
(Increase) decrease in retainages receivable 97,374 (601,787)
Decrease in prepaid expenses 197,570 133,170
Decrease in due from shareholder - (30,000)
(Increase) decrease in deposits 102,154 (62,500)
Increase in accounts payable and accrued expenses 2,009,919 1,453,749
Increase in deferred revenue 297,434 63,087
------------ ------------
Net cash provided by (used in) operations 82,628 (613,027)
------------ ------------
Cash flows from investing activities:
Purchases of fixed assets (42,835) (74,924)
Net cash acquired in acquisitions 426,485 -
------------ ------------
Net cash provided by (used in) investing activities 383,650 (74,924)
------------ ------------
Cash flows from financing activities:
Net borrowings (payments) on notes payable (651,000) 1,058,356
Net payments on shareholder loan (43,369) (12,200)
Proceeds from issuance of common stock 100,000 -
Proceeds from exercise of stock options 5,764 -
------------ ------------
Net cash provided by (used in) financing activities (588,605) 1,046,156
------------ ------------
Net increase (decrease) in cash (122,327) 358,205
Cash, beginning of period 298,272 215,866
------------ ------------
Cash, end of period $ 175,945 $ 574,071
============ ============
Cash paid for interest $ 85,425 $ -
============ ============
The accompanying notes are an integral part of these statements.
6
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Statement of Changes in Stockholders' Equity
Common Stock Additional
------------------------ Paid Retained
Shares Amount In Capital Earnings (Deficit) Total
------------- ---------- -------------- --------------- --------------
Balance, June 30, 2002 1,659,286 $ 1,659 $ 6,960,164 $ 1,825,197 $ 8,787,020
Recapitalization of the common stock of
Category 5 Technologies, Inc. 2,157,072 2,157 (2,157) - -
Issuance of common stock pursuant to
exercise of options and warrants 5,290 5 5,759 - 5,764
Common stock issued for services 18,975 19 59,656 - 59,675
Recapitalization and issuance of common
stock for reverse acquisition of MindArrow
Systems, Inc. 3,133,636 3,134 18,321,861 - 18,324,995
Sale of common stock, net of issuance costs 25,000 25 99,975 - 100,000
Common stock issued in acquisition of the
assets of AGEA Corporation 175,000 175 336,000 - 336,175
Net loss - - - (8,866,987) (8,866,987)
------------- ---------- -------------- --------------- --------------
Balance, December 31, 2002 (unaudited) 7,174,259 $ 7,174 $25,781,258 $ (7,041,790) $18,746,642
============= ========== ============== =============== ==============
The accompanying notes are an integral part of these statements.
7
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note A--The Company and Summary of Significant Accounting Policies
1. Basis of Presentation
Avalon Digital Marketing Systems, Inc. ("Avalon") was formed as a
result of a merger between MindArrow Systems, Inc. ("MindArrow") and Category 5
Technologies, Inc. ("Category 5") on September 30, 2002. MindArrow was the legal
acquirer of Category 5, but because Category 5's business was larger than
MindArrow's and because Category 5's former stockholders own the majority of
Avalon, generally accepted accounting principals require that Category 5 be
treated as the acquirer for accounting and reporting purposes. Accordingly, the
accompanying financial statements reflect the following:
o Consolidated Balance Sheet as of December 31, 2002 - reflects post-merger
Avalon.
o Consolidated Balance Sheet as of June 30, 2002 - reflects Category 5 only.
o Statements of Operations for the Quarter and Six Months Ended December 31,
2001 - reflects Category 5 only. Statements of Operations for the Six
Months Ended December 31, 2002 - reflects one quarter of Category 5 only
and one quarter of post-merger Avalon. Statements of Operations for the
Quarter Ended December 31, 2002 reflects operations of post-merger Avalon.
o Statements of Cash Flows for the Six Months Ended December 31, 2001 -
reflects Category 5 only. Statements of Operations for the Six Months Ended
December 31, 2002 - reflects one quarter of Category 5 only and one quarter
of post-merger Avalon.
o Pro forma combined information as if the merger had taken place on July 1,
2002 is contained in the notes to financial statements.
In addition, references to the "Company" for periods prior to September
30, 2002 are intended to refer to Category 5 and its business.
The accompanying consolidated financial statements have been prepared
by Avalon Digital Marketing Systems, Inc. and subsidiaries (the "Company")
pursuant to the rules and regulations of the Securities and Exchange Commission
(the "SEC") for interim financial reporting. These consolidated financial
statements are unaudited and, in the opinion of management, include all
adjustments (consisting of normal recurring adjustments and accruals) necessary
for a fair presentation of the balance sheets, operating results, and cash flows
for the periods presented. Operating results for the three and six months ended
December 31, 2002 are not necessarily indicative of the results that may be
expected for the fiscal year ending June 30, 2003. Certain financial 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 omitted in accordance with the rules and regulations of the
SEC. These consolidated financial statements should be read in conjunction with
the audited consolidated financial statements, and accompanying notes, included
in the Annual Report on Form 10-KSB for the fiscal year ended June 30, 2002 of
Category 5, our predecessor company. The consolidated balance sheet at June 30,
2002 has been derived from the audited consolidated financial statements at that
date.
The Company was founded in 1998 as Executive Credit Services LLC and
incorporated under the name ePenzio, Inc. in May 2000. On May 29, 2001, Network
Investor Communications, Inc. ("NWIC") acquired all of the outstanding shares of
ePenzio, and effective July 23, 2001, NWIC changed its name to Category 5
Technologies, Inc. For accounting purposes the business combination with NWIC
was treated as a reverse merger or a recapitalization of ePenzio, with ePenzio
being treated as the accounting acquirer. On September 30, 2002, MindArrow
Systems, Inc., a Delaware corporation, acquired all of the outstanding shares of
Category 5 and changed its name to Avalon Digital Marketing Systems, Inc. For
accounting purposes, the business combination with MindArrow was treated as a
8
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
reverse acquisition, with Category 5 being the acquirer. The results of
operations of MindArrow Systems, Inc. are included in the consolidated financial
statements of the Company beginning October 1, 2002. Accordingly, the
accompanying consolidated statements of operations and cash flows reflect
information for Category 5 only from July 1, 2002 to September 30, 2002.
In addition, on September 30, 2002, the Company effected a reverse
stock split of the Company's common stock at a ratio of one-for-ten, causing
each outstanding share of common stock to convert automatically into one-tenth
of a share of common stock. In lieu of fractional shares, stockholders received
a cash payment based on the trading price of the common stock prior to the
effectiveness of the reverse split. Stockholders' equity has been restated to
give retroactive recognition to the reverse split for all periods presented by
reclassifying the excess par value resulting from the reduced number of shares
from common stock to paid-in capital. All references to common share and per
common share amounts for all periods presented have been retroactively restated
to reflect this reverse split.
Certain prior year amounts in the consolidated financial statements
have been reclassified to conform to the current year presentation.
The Company develops and provides software and services that enable its
clients to communicate and sell more effectively and efficiently over the web,
via email, and through other digital channels.
The business is divided between the Small Business and Large Enterprise
divisions. The Small Business division has been the primary source of our
historical revenues, and provides small businesses with merchant services and
digital marketing software, primarily marketed through seminars. The Small
Business division consists of Category 5's subsidiaries, ePenzio, Inc., Bring it
Home, Inc. and Olympus Financial, Inc.
The Large Enterprise division provides customized software and
professional services to large companies. The addition of MindArrow's
technology, personnel and customer base significantly increases the capabilities
and contribution of the Large Enterprise division. The Large Enterprise division
consists of the former MindArrow, MindArrow Asia, Ltd. and former Category 5
subsidiary, CaptureQuest, Inc.
2. Principles of Consolidation
The consolidated financial statements include the accounts of the
Company and its subsidiaries. All significant intercompany balances and
transactions have been eliminated.
3. Basic and Diluted Net Earnings (Loss) Per Share
Basic net earnings (loss) per share is computed using the weighted
average number of common shares outstanding during the period. Diluted net
earnings (loss) per share is computed using the weighted average number of
common shares during the period plus dilutive potential common shares. Dilutive
potential common shares include the incremental common shares issuable upon the
exercise of stock options and warrants (using the treasury stock method) and the
incremental common shares issuable upon conversion of convertible preferred
stock and notes payable (using the if-converted method). Potential common shares
in the diluted net earnings (loss) per share computation are excluded where
their effect would be antidilutive.
In periods where a net loss was incurred, potential common shares were
excluded because their effect would be antidilutive. In addition, for the three
and six months ended December 31, 2002, the following options were not included
in the computation of diluted EPS for the periods indicated because the options'
exercise price was greater than the average market price of the common shares:
Three Months Ended Six Months Ended
December 31, 2002 December 31, 2002
Options to purchase shares of common stock 512,325 512,325
Exercise prices $4 to $250 $4 to $250
Expiration dates through June 2012
9
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
4. Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the amounts of revenues and expenses during the reported period.
Actual results could differ from those estimates.
5. Concentration of Credit Risk
Financial instruments that potentially subject the Company to
significant concentration of credit risk consist primarily of cash, cash
equivalents, and accounts receivable. Substantially all of the Company's cash
and cash equivalents are held in two financial institutions. As of December 31
and June 30, 2002, the carrying amounts of cash were $175,945 and $298,272,
respectively, and the bank balances were $270,316 and $289,737, respectively, of
which $200,000 was FDIC insured.
Accounts receivable are typically unsecured and derived primarily from
customers located in the United States and Hong Kong. The Company performs
ongoing credit evaluations of its customers and will maintain reserves for
potential credit losses as the need arises.
In the normal course of business the Company sells certain of its
receivables to financing companies. The Company's sales of receivables to
financing companies include recourse provisions, which are deemed non-hedging
derivatives pursuant to the provisions of Statement of Financial Accounting
Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and
Hedging." The purpose of the limited recourse provisions are normal in the
course of business and are meant to facilitate the sale of receivables to
financing companies. The fair value of the recourse liability has been
determined using a best estimate method, and the fair value estimate was based
on historical recourse rates experience by the Company. The fair value of the
recourse obligation at December 31 and June 30, 2002 is $196,324 and $757,677,
respectively.
6. Segments
The Company has adopted Statement of Financial Accounting Standards No.
131 "Disclosures about Segments of an Enterprise and Related Information" ("SFAS
131"). SFAS 131 establishes standards for reporting information regarding
operating segments in annual financial statements and requires selected
financial information for those segments to be presented in interim financial
reports. SFAS 131 also establishes standards for related disclosures about
products and services, and geographic areas. Prior to the acquisition of
CaptureQuest in April 2002, the Company has viewed their operations as
principally one segment. The business of CaptureQuest and MindArrow constitute
the Large Enterprise segment, and the historical Category 5 businesses
constitute the Small Business segment. The following is a summary of these
segments:
Small Large
Business Enterprise
----------- -----------
For the six months ended December 31, 2002:
Net revenues, actual $5,393,675 $ 2,156,436
Net revenues, pro forma1 5,393,675 3,283,315
Long lived assets 2,107,012 24,131,108
10
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
MindArrow's Asia Pacific business adds a geographic segment to the
Company's business. The following is a summary of significant geographic
markets:
North Asia
America Pacific
------------- -------------
For the six months ended December 31, 2002:
Net revenues, actual $ 7,284,550 $ 265,561
Net revenues, pro forma(1) 8,231,907 445,083
Long lived assets 25,677,870 560,250
(1) Assumes the reverse acquisition of MindArrow, which occurred on September
30, 2002, had occurred on July 1, 2002.
7. Recent accounting pronouncements
SFAS No. 143, "Accounting for Asset Retirement Obligations," was issued
in June 2001. SFAS No. 143 addresses accounting and reporting for legal
obligations and related costs associated with the retirement of long-lived
assets. The Statement requires that the fair value of the liability for an asset
retirement obligation be recognized in the period incurred if a reasonable
estimate of fair value can be made. The estimated retirement costs are
capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143
is effective for financial statements issued for fiscal years beginning after
June 15, 2002. Adoption of this statement did not have a material effect.
In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" and the accounting and reporting provisions of APB
Opinion No. 30. SFAS No. 144 establishes accounting standards for the impairment
of long-lived assets, excluding goodwill, and for long-lived assets to be
disposed of. SFAS No. 144 requires that long-lived assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to future net cash flows expected to be generated by the asset. If such assets
are considered to be impaired, the impairment to be recognized is measured by
the amount by which the carrying amount of the assets exceeds the fair value of
the assets. Assets to be disposed of are reported at the lower of the carrying
amount or fair value less costs to sell. The statement retains the basic
provisions of APB Opinion No. 30 for the presentation of discontinued operations
in the statement of operations but broadens that presentation to include a
component of an entity (rather than a segment of a business). The Company is
currently evaluating the impact of the adoption of SFAS 144 but does not expect
its impact to be material.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This Statement, among other things, rescinds SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." The
Statement requires gains and losses from debt extinguishments that are used as
part of the Company's risk management strategy to be classified as part of
income from operations rather than as extraordinary items, net of tax. SFAS No.
145 is effective for fiscal years beginning after May 15, 2002 with earlier
adoption encouraged. Adoption of this statement did not have a material effect.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires
that a liability for costs associated with an exit or disposal activity be
recognized when the liability is incurred rather than when a company commits to
such an activity and also establishes fair value as the objective for initial
measurement of the liability. The Company will adopt SFAS No. 146 for exit or
disposal activities that are initiated after December 31, 2002.
11
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure," which amends SFAS No. 123, "Accounting
for Stock-Based Compensation". SFAS No. 148 provides alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation and is effective for fiscal years ending
after December 31, 2002. In addition, SFAS No. 148 amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in annual and
interim financial statements about the method of accounting for stock-based
compensation and the effect in measuring compensation expense. The disclosure
requirements of SFAS No. 148 are effective for interim periods beginning after
December 15, 2002. The Company has chosen to continue to account for stock-based
compensation using the intrinsic value method prescribed in APB Opinion No. 25
and related interpretations. Accordingly, compensation expense for stock options
is measured as the excess, if any, of the estimate of the market value of the
Company's stock at the date of the grant over the amount an employee must pay to
acquire the stock. The Company will adopt the annual disclosure provisions of
SFAS No. 148 in its financial reports for the year ended June 30, 2003 and will
adopt the interim disclosure provisions for its financial reports for the
quarter ended September 30, 2003. As the adoption of this standard involves
disclosures only, the Company does not expect a material impact on its results
of operations, financial position or liquidity.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." Interpretation No. 45 requires a
guarantor to include disclosure of certain obligations, and if applicable, at
the inception of the guarantee, recognize a liability for the fair value of
other certain obligations undertaken in issuing a guarantee. The recognition
requirement is effective for guarantees issued or modified after December 31,
2002 and based on current operations, the Company does not expect the adoption
of the recognition requirements of this statement to have a material effect on
its financial position or results of operations. The disclosure requirements are
effective for financial statements of interim and annual periods ending after
December 31, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities." Interpretation No. 46 clarifies the application
of Accounting Research Bulletin No. 51 and applies immediately to any variable
interest entities created after January 31, 2003 and to variable interest
entities in which an interest is obtained after that date. This Interpretation
is applicable for the Company in the fiscal year beginning July 1, 2003, for
interests acquired in variable interest entities prior to February 1, 2003.
Based on current operations, the Company does not expect the adoption of
Interpretation No. 46 to have a material effect on its financial position or
results of operations.
Note B--Liquidity
The Company's liquidity is significantly impacted by credit and
collections issues. Its Small Business division has generated large balances of
receivables and, depending on the quality of the credit and the cash needs, it
sells certain of the receivables, at a discount, to financing sources.
Receivables that have not been sold are retained and the billing and collecting
administration have been outsourced. A large portion of the Small Business
division's customers have sub-prime credit. Accordingly, many of the receivables
generated by these customers may have high credit risk.
At December 31, 2002, the Company's cash position required that it
actively seek additional sources of capital. As of December 31, 2002, the
Company had current assets of approximately $2.4 million and current liabilities
of approximately $10.8 million. This represents a working capital deficit of
approximately $8.4 million. The negative working capital balance includes as
current liabilities approximately $1.3 of deferred revenues and is mitigated by
approximately $0.8 million in net contracts receivable included in long-term
assets.
12
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The Company's line of credit facility with Zions Bank includes
covenants for tangible net worth and debt coverage ratios. As of December 31,
2002, the balance on the line was $247,822, and the Company was in violation of
these covenants, and has sought waivers. As of the date hereof, the bank has not
waived the violations, and if it were to demand payment of the entire balance,
the Company's liquidity would suffer. In January 2003, in exchange for an
advance of $250,000 on the line, the Company designated a recurring revenue
stream in the amount of approximately $40,000 per month for repayment of the
outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 was not made, and the Company is seeking an extension or
conversion into equity of some or all of the balance.
The Company has $820,000 of convertible notes payable that were due on
November 21, 2002. In November 2002, the note holders agreed to amend the
repayment terms of the notes to increase the interest rate to 14%, lower the
conversion price to $3 per share, establish payment terms calling for six equal
monthly principal payments beginning in January 2003 through June 2003. In
January 2003, $130,667 of the notes were converted into 43,570 shares of common
stock. As of February 10, 2003, the balance of the January payment that was not
converted into common stock amounted to $50,107 and had not been paid.
Since the closing of the reverse acquisition of MindArrow, the Company
has taken steps to reduce monthly cash operating expenses and identify new
sources of revenue. The Company is currently seeking additional debt and equity
financing and is currently evaluating proposals from investors under those
terms. However, no binding agreements have been signed and there is no certainty
that terms acceptable to the Company and investors can be reached.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the company as a going concern.
In the view of the Company, recoverability of a major portion of the
recorded asset amounts shown in the accompanying balance sheet is dependent upon
continued operations of the Company, which in turn is dependent upon the
Company's ability to meet obligations on a continuing basis. The consolidated
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence.
Note C--Receivables
1. Contracts Receivable
Contracts receivable consist of amounts due from customers of the Small
Business division. The customers have typically entered into 36-month
installment contracts and the portion of the balance that is due within one year
is included in the current balance. The allowance for doubtful accounts is
estimated using the Company's experience in collecting from these customers. At
December 31, 2002, contracts receivable consisted of the following:
Current Long-term
----------- ----------
Contracts receivable $1,121,255 $2,176,602
Allowance for uncollectible accounts ( 681,259) (1,329,901)
----------- ----------
Net $ 439,996 $ 846,701
========== ===========
13
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
2. Trade Accounts Receivable
Trade accounts receivable are comprised mainly of billings to customers
of the Large Enterprise division, and are all due within one year. The allowance
for doubtful accounts is provided based on a specific review of amounts due. At
December 31, 2002, trade receivables consisted of the following:
Trade accounts receivable $1,343,390
Allowance for uncollectible accounts (225,400)
-----------
Net $1,117,990
==========
3. Retainages Receivable
Current retainages receivable consist primarily of amounts held by the
Company's credit card merchant accounts and long-term retainage amounts held for
resale at their net realizable value. Long-term retainages receivable consist of
the reserves held by financing companies that have previously purchased financed
contracts. As the Company sells its financing contracts, the financing companies
retain portions of the funded amounts as reserves in the event of default by the
customer. These reserves are to be released to the Company as customers make
monthly payments. The amounts to be released are determined periodically by the
finance companies in accordance with the terms of the receivables purchase
agreements. At December 31, 2002, retainage receivable consisted of the
following:
Retainages receivable $ 470,727
Allowance for uncollectible accounts (295,319)
------------
Net 175,408
Long term retainage receivables -
held for resale at net realizable value(1) 275,000
------------
Total $ 450,408
============
(1) Held for resale and sold in January 2003.
Note D--Commitments and Contingencies
1. Legal Proceedings
From time to time the Company is subject to legal proceedings and
claims in the ordinary course of business, including claims of alleged
infringement of trademarks, copyrights and other intellectual property rights.
In May 2002, MindArrow moved its corporate offices from Aliso Viejo to
Huntington Beach, California and is currently in default on the Aliso Viejo
lease. The Company is in litigation with the landlord and has accordingly
accrued for back rent and estimated settlement costs totaling approximately
$803,000 included in "Accounts payable and accrued liabilities" on the
accompanying consolidated balance sheet.
In 1999 and 2000, MindArrow was a victim of a fraud perpetrated by its
former transfer agent and her accomplice, who were convicted of felonies arising
from the scheme. At sentencing hearings in April and July 2002, the perpetrators
were ordered to pay to the Company $10.9 million in restitution in addition to
amounts already received. In addition, the Company continues to pursue recovery
of the loss it incurred as a result of the fraud perpetrated against the
Company, and the Audit Committee of the Company's Board of Directors has
retained special counsel to assist it in pursuing potential sources of recovery.
Eight individuals and twelve entities have been named as defendants in lawsuits
initiated by the Company. The Company cannot predict whether or when it will
obtain any additional recovery. Because of the uncertainties surrounding
recoveries, the Company will not record the impact of recoveries until amounts
or assets are received.
14
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Note E--Notes Payable
1. Convertible Notes Payable
In November 2001, the Company issued $820,000 of convertible notes
payable to sixteen investors (the "Convertible Notes"). The Convertible Notes
bear interest at 8% per annum, were due on November 21, 2002, and were
convertible into shares of common stock at the option of the holders, for the
lower of $8.70 or the price of a private placement of the Company's common
stock. In November 2002, the note holders agreed to amend the repayment terms of
the notes to increase the interest rate to 14%, lower the conversion price to $3
per share, establish payment terms calling for six equal monthly principal
payments beginning in January 2003 through June 2003. The note holders also
received 179,170 additional warrants to purchase common stock at $3.00 per share
and an amendment to their original 179,170 warrants to reduce the exercise price
to $3 per share. In January 2003, $130,667 of the notes were converted into
43,570 shares of common stock. As of February 10, 2003, the balance of the
January payment that was not converted into common stock amounted to $50,107 and
had not been paid.
2. Line of Credit
In August 2002, the Company, through its wholly-owned subsidiary,
ePenzio, Inc., renewed its revolving line of credit with Zions First National
Bank (the "Zions Facility") and increased the amount of the credit facility to
$2 million. The annual interest rate applied to the unpaid principal balance of
the Zions Facility is 1% over Prime (4.25% at December 31, 2002). The Zions
Facility is secured by all inventory, chattel paper, accounts and general
intangibles owned by ePenzio on or after September 11, 2001. As of December 31,
2002, the Company had a balance of $247,822 under the Zions Facility. Pursuant
to the Zions Facility, ePenzio may borrow up to the lesser of (i) $2 million or
(ii) 50% of the aggregate amount of ePenzio's Eligible Accounts (as defined). In
addition to customary affirmative and negative covenants, ePenzio must maintain
a tangible net worth not less than $1 million, and a debt coverage ratio
(defined as total earnings before interest, taxes, depreciation and amortization
to total debt service coverage) of 1.5 to 1.0, measured on a quarterly basis.
The Company is not in compliance with such covenants, and is currently pursuing
waivers. In January 2003, in exchange for an advance of $250,000 on the line,
the Company designated a recurring revenue stream in the amount of approximately
$40,000 per month for repayment of the outstanding balance on the line.
3. Radical Communication, Inc.
In September 2001, MindArrow issued an unsecured subordinated note
payable in the amount of $1 million to Radical Communication, Inc. ("Radical"),
in connection with MindArrow's acquisition of substantially all of the assets of
Radical. In August 2002, $250,000 of the principal balance was converted into
62,500 shares of common stock and warrants to purchase 71,875 shares of common
stock. The note bears interest at 5% per annum and is due in two principal
installments; $250,000 on October 1, 2002 and $500,000 on October 1, 2003. The
initial payment was not made when due, and in February 2003, $150,000 of this
note was converted into 37,500 shares of common stock and warrants to purchase
43,125 shares of common stock at $2 per share. The Company is seeking an
extension or an agreement to convert some or all of the remaining balance.
Note F--Due to Related Parties
Two stockholders of the Company have advanced amounts to the Company.
The advances do not bear interest and are non-secured. Both of the stockholders
who advanced the amounts are employees of the Company, and one is a member of
the Board of Directors.
Note G--Stockholders' Equity
1. Common Stock
During the quarter ended September 30, 2002, 18,975 shares of common
stock were issued for services, resulting in compensation expense of $59,675. In
addition, 5,290 shares were issued during the six months ended December 31, 2002
upon exercise of stock options. Proceeds amounted to $5,764.
15
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
On September 30, 2002, 3,133,636 shares were issued in the reverse
acquisition of MindArrow. (see Note H - Reverse Acquisition of MindArrow
Systems, Inc.)
In June 2002, MindArrow obtained a commitment for between $3 million and up
to $4 million in financing by offering up to 1 million shares of common stock at
a price of $4.00 per share from a group of investors led by East-West Capital
Associates, Inc. ("East-West Capital") and its affiliate, East West Venture
Group, LLC . Through December 31, 2002, the Company had received $2.825 million
in proceeds towards the $3.0 million minimum commitment and $200,000 towards the
$1 million portion subject to a demand by the Company's board of directors.
During the quarter ended December 31, 2002, 25,000 shares of common stock were
issued pursuant to partial closings under this commitment. The stock purchase
agreement, as amended in February 2003 called for the remaining $175,000 of the
minimum commitment to be funded by providing $25,000 in cash and $150,000
through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. East-West Capital agreed to eliminate the
protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
To date, East-West Capital has otherwise satisfied all of their original
financing commitments to the Company.
On September 30, 2002, the Company effected a reverse stock split of
the Company's common stock at a ratio of one-for-ten, causing each outstanding
share of common stock to convert automatically into one-tenth of a share of
common stock. In lieu of fractional shares, stockholders will receive a cash
payment based on the trading price of the common stock prior to the
effectiveness of the reverse split. Stockholders' equity has been restated to
give retroactive recognition to the reverse split for all periods presented by
reclassifying the excess par value resulting from the reduced number of shares
from common stock to paid-in capital. All references to common share and per
common share amounts for all periods presented have been retroactively restated
to reflect this reverse split.
2. Warrants
In connection with the reverse acquisition of MindArrow on September
30, 2002, MindArrow's outstanding warrants remained outstanding and thus became
an obligation of Avalon. As of September 30, 2002, there were 1,511,002 warrants
outstanding with exercise prices ranging from $1 to $300 per share, and with
expiration dates ranging from January 2003 through April 2010.
In addition, in connection with the reverse acquisition of MindArrow on
September 30, 2002, Category 5's stockholders received warrants to purchase one
share of Avalon common stock for every twenty shares of Category 5 common stock
that they owned immediately prior to the transaction for a total of 833,918
warrants. The exercise price of the warrants is $0.10 per share, and are
exercisable if the Company's Small Business division achieves certain financial
targets for the twelve months ending September 30, 2003.
In October 2002, the Company issued 28,750 warrants to purchase common
stock at prices ranging from $5 to $12.50 per share in connection with common
stock issued for financing (Note G1). The Company recognized financing costs of
$22,863 during the quarter ended December 31, 2002 based on the fair value of
the vested warrants as computed using the Black-Scholes option pricing model.
In December 2002, the Company issued 179,170 warrants to purchase
common stock at $3 per share, and reduced the price of 179,170 previously issued
warrants to $3 per share, in connection with amendments made to bridge notes
(Note E1). The Company recognized financing costs of $336,840 during the quarter
ended December 31, 2002 based on the fair value of the vested warrants as
computed using the Black-Scholes option pricing model.
Additionally, the Company issued 17,500 warrants to purchase common
stock at $2.37 per share in December 2002 as partial consideration for the
acquisition of AGEA Corporation (Note K). The warrants were valued at $7,175
based on the fair value of the vested warrants as computed using the
Black-Scholes option pricing model.
3. Options
Following the completion of the reverse acquisition of MindArrow on
September 30, 2002, MindArrow's stock option plans became the stock option plans
of Avalon.
16
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
As amended, the 1999 Stock Option Plan (the "1999 Plan"), reserves
247,500 shares of common stock for option grants to employees, directors and
consultants to continue their service to the Company. At December 31, 2002,
there remained 75,100 shares available for grant under the 1999 Plan.
As amended, the 2000 Stock Incentive Plan (the "2000 Plan"), reserves
549,750 shares of common stock for option grants to employees, directors and
consultants to continue their service to the Company. At December 31, 2002,
there remained 408,400 shares available for grant under the 2000 Plan.
Options granted under Category 5's previous option plans, (the "C5
Plans") became obligations of Avalon, but the C5 Plans themselves were
discontinued. Accordingly, options granted under the C5 Plans to purchase
457,024 shares of common stock were outstanding as of December 31, 2002, all of
which became vested upon completion of the reverse acquisition of MindArrow.
During the quarter ended December 31, 2002, 100,138 options expired and
4,600 options were exercised.
Note H--Reverse Acquisition of MindArrow Systems, Inc.
On September 30, 2002, all of the outstanding shares of Category 5 were
acquired by MindArrow. The former shareholders of Category 5 received shares
equal to 55% of the issued and outstanding common stock of Avalon, plus warrants
to purchase an additional 5% should the Small Business division achieve certain
financial targets for the twelve month period ending September 30, 2003.
The transaction has been accounted for as a reverse acquisition, with
Category 5 the acquirer. The total purchase price of the acquisition was
$18,324,995, which gives effect to the 3,133,636 outstanding shares of common
stock and all outstanding options and warrants of MindArrow. The purchase price
was allocated to the assets acquired and the liabilities assumed based on their
estimated fair values. Goodwill has resulted from the excess costs over fair
value of the net assets acquired.
Intangibles $20,876,507
Tangible assets acquired 2,418,383
Liabilities assumed (4,969,895)
------------
$18,324,995
============
The Company performed an evaluation of the intangible assets arising
from the transaction, and identified the following:
Existing technology $ 2,800,000
Patents 1,200,000
Customer relationships 2,900,000
Goodwill 13,976,507
------------
$20,876,507
============
The Company will evaluate goodwill for impairment annually, at June 30,
2003, and whenever there is an impairment indicator. The identifiable intangible
assets will be amortized over their estimated economic lives, which range from
three to seven years.
The following unaudited pro forma results of operations for the six
months ended December 31, 2002, assume the acquisition discussed above occurred
on July 1, 2002:
Revenues $ 8,676,990
Net loss (10,861,057)
Basic and diluted loss per share $ (1.55)
The above pro forma financial information does not purport to be
indicative of the results of operations had the acquisition of MindArrow
actually had taken place on July 1, 2002, nor is it intended to be a projection
of future results or trends.
17
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Note I--Income Taxes
Components of income tax benefit (expense) reflected in the
consolidated statements of operations for the six months ended December 31, 2002
are as follows:
Three Months Ended Six Months Ended
December 31, December 31,
2002 2001 2002 2001
----------- ------------- ---------- -------------
Expected tax benefit (expense) at federal rate $2,270,000 $ (670,000) $ 3,400,000 $(690,000)
Nondeductible expenses - (30,000) (94,000) (10,000)
Net operating loss producing no current benefit (2,270,000) - (2,162,000) -
----------- ------------- ----------- ------------
$ - $ (700,000) $1,144,000 $ (700,000)
=========== ============= =========== ============
The components of deferred taxes included in the accompanying
consolidated balance sheet as of December 31, 2002, are as follows:
Deferral of revenue related to contracts receivable $ (437,000)
Accrued vacation 94,000
Net operating loss carryforwards 15,436,000
------------
Deferred tax asset 15,093,000
Valuation allowance (15,093,000)
------------
Net $ -
============
As of December 31, 2002, the Company has approximately $45.4 million in
net operating loss carryforwards which are available to offset future taxable
income. These losses begin to expire in 2019. Utilization of these losses will
likely be significantly limited due to the impact of Internal Revenue Code
Section 382 and the regulations thereunder.
Note J--Supplemental Disclosure of Cash Flow Information
Noncash investing and financing activities included the reverse
acquisition of MindArrow described above, in exchange for 3,133,636 shares of
common stock and the acquisition of AGEA Corporation (Note K).
Note K--Acquisition of AGEA Corporation
On December 22, 2002 the Company acquired the assets of AGEA
Corporation in exchange for 175,000 shares of common stock valued at $1.88 per
share and warrants to purchase 17,500 shares of common stock at $2.37 per share
(Note G2). The consideration was valued at $336,175 and allocated to the assets
acquired and the liabilities assumed as follows:
Cash acquired $ 390,000
Liabilities assumed (53,825)
-----------
$ 336,175
===========
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read together with our consolidated
financial statements and related notes included elsewhere in this quarterly
report on Form 10-Q. All references to "pro forma" results for prior periods in
this Item 2 assume that the merger between MindArrow and Category 5 occurred in
such prior periods.
OVERVIEW
Avalon Digital Marketing Systems, Inc. was formed as a result of a merger
between MindArrow Systems, Inc. and Category 5 Technologies, Inc. on September
30, 2002. MindArrow was the legal acquirer or Category 5, but because Category
5's business was larger than MindArrow's and because Category 5's former
stockholders owned the majority of the combined company at the time of the
merger, generally accepted accounting principals require that Category 5 be
treated as the acquirer for accounting and reporting purposes. Accordingly, the
financial statements included in this report reflect the following:
- Consolidated Balance Sheet as of December 31, 2002 - reflects post-merger
Avalon.
- Consolidated Balance Sheet as of June 30, 2002 - reflects Category 5 only.
- Statements of Operations for the Quarter and Six Months Ended December 31,
2001 - reflects Category 5 only. Statement of Operations for the Six Months
Ended December 31, 2002 - reflects one quarter of Category 5 only and one
quarter of post-merger Avalon.
- Statement of Operations for the Quarter Ended December 31, 2002 reflects
operations of post-merger Avalon.
- Statement of Cash Flows for the Six Months Ended December 31, 2001 -
reflects Category 5 only. Statement of Operations for the Six Months Ended
December 31, 2002 - reflects one quarter of Category 5 only and one quarter
of post-merger Avalon.
- Pro forma combined information as if the merger had taken place on July 1,
2002 is contained in the notes to financial statements.
In addition, references to the "Company" for periods prior to September 30,
2002 are intended to refer to Category 5 and its business, except for
information provided on a "pro forma" basis.
Category 5 was founded in 1998 as Executive Credit Services LLC and
incorporated under the name ePenzio, Inc. in May 2000. On May 29, 2001, Network
Investor Communications, Inc. ("NWIC") acquired all of the outstanding shares of
ePenzio, and effective July 23, 2001, NWIC changed its name to Category 5
Technologies, Inc. ("Category 5"). For accounting purposes the business
combination with NWIC was treated as a reverse merger or a recapitalization of
ePenzio, with ePenzio being treated as the accounting acquirer. On September 30,
2002, MindArrow Systems, Inc., a Delaware corporation, acquired all of the
outstanding shares of Category 5 and changed its name to Avalon Digital
Marketing Systems, Inc. For accounting purposes, the business combination with
MindArrow was treated as a reverse acquisition, with Category 5 being the
acquirer.
Avalon develops and provides software and services that enable our clients
to communicate and sell more effectively and efficiently over the web, via
email, and through other digital channels.
The business is divided between the Small Business and Large Enterprise
sales channels. The Small Business channel has been the primary source of our
historical revenues, and provides small businesses with merchant services and
digital marketing software, primarily marketed through workshops. Small Business
operations consist primarily of Category 5's subsidiaries, ePenzio, Inc., Bring
it Home, Inc. and Olympus Financial, Inc.
We also provide customized software and professional services to large
companies. The addition of MindArrow's technology, personnel and customer base
significantly increases the capabilities and contribution of the Large
Enterprise sales channel. Large Enterprise operations consist primarily of the
former MindArrow, MindArrow Asia, Ltd. and former Category 5 subsidiary,
CaptureQuest, Inc.
19
Our revenues were derived from the production and delivery of rich media
messages and software license fees. Production services include theme
development, design and layout, video production, special effects, hyperlink
recommendations, hyperlink page design and creation, reporting and sales cycle
consultation.
We currently sell our products and services through a direct sales force,
small business workshops, and a small network of sales affiliates.
CRITICAL ACCOUNTING POLICIES
Revenues are recognized when the consulting or production services are
rendered and messages are delivered. We recognize software license fee revenue
when persuasive evidence of an agreement exists, the product has been delivered,
we have no remaining significant obligations with regard to implementation, the
license fee is fixed or determinable and collection of the fee is probable.
Revenue from media sales is recognized upon placing advertisements. Revenue from
consulting is recognized as the services are rendered.
We record cash receipts from clients and billed amounts due from clients in
excess of revenue recognized as deferred revenue. The timing and amount of cash
receipts from clients can vary significantly depending on specific contract
terms and can therefore have a significant impact on the amount of deferred
revenue in any given period.
Identifiable intangible assets acquired in a business combination are
recorded separately from goodwill if they arise from contractual or other legal
rights or are separable from the acquired entity and can be sold, transferred,
licensed, rented or exchanged, either individually or as part of a related
contract, asset or liability. Goodwill, as well as other intangible assets with
indefinite lives, are not amortized and will be tested for impairment annually
and whenever there is an impairment indicator. All acquired goodwill is assigned
to reporting units for purposes of impairment testing and segment reporting.
RECENT ACCOUNTING PRONOUNCEMENTS
SFAS No. 143, "Accounting for Asset Retirement Obligations," was issued in
June 2001. SFAS No. 143 addresses accounting and reporting for legal obligations
and related costs associated with the retirement of long-lived assets. The
Statement requires that the fair value of the liability for an asset retirement
obligation be recognized in the period incurred if a reasonable estimate of fair
value can be made. The estimated retirement costs are capitalized as part of the
carrying amount of the long-lived asset. SFAS No. 143 is effective for financial
statements issued for fiscal years beginning after June 15, 2002. Adoption of
this statement did not have a material effect.
In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" and the accounting and reporting provisions of APB
Opinion No. 30. SFAS No. 144 establishes accounting standards for the impairment
of long-lived assets, excluding goodwill, and for long-lived assets to be
disposed of. SFAS No. 144 requires that long-lived assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to future net cash flows expected to be generated by the asset. If such assets
are considered to be impaired, the impairment to be recognized is measured by
the amount by which the carrying amount of the assets exceeds the fair value of
the assets. Assets to be disposed of are reported at the lower of the carrying
amount or fair value less costs to sell. The statement retains the basic
provisions of APB Opinion No. 30 for the presentation of discontinued operations
in the statement of operations but broadens that presentation to include a
component of an entity (rather than a segment of a business). The Company is
currently evaluating the impact of the adoption of SFAS 144 but does not expect
its impact to be material.
20
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This Statement, among other things, rescinds SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." The
Statement requires gains and losses from debt extinguishments that are used as
part of the Company's risk management strategy to be classified as part of
income from operations rather than as extraordinary items, net of tax. SFAS No.
145 is effective for fiscal years beginning after May 15, 2002 with earlier
adoption encouraged. Adoption of this statement did not have a material effect.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires
that a liability for costs associated with an exit or disposal activity be
recognized when the liability is incurred rather than when a company commits to
such an activity and also establishes fair value as the objective for initial
measurement of the liability. The Company will adopt SFAS No. 146 for exit or
disposal activities that are initiated after December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure," which amends SFAS No. 123, "Accounting
for Stock-Based Compensation". SFAS No. 148 provides alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation and is effective for fiscal years ending
after December 31, 2002. In addition, SFAS No. 148 amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in annual and
interim financial statements about the method of accounting for stock-based
compensation and the effect in measuring compensation expense. The disclosure
requirements of SFAS No. 148 are effective for interim periods beginning after
December 15, 2002. The Company has chosen to continue to account for stock-based
compensation using the intrinsic value method prescribed in APB Opinion No. 25
and related interpretations. Accordingly, compensation expense for stock options
is measured as the excess, if any, of the estimate of the market value of the
Company's stock at the date of the grant over the amount an employee must pay to
acquire the stock. The Company will adopt the annual disclosure provisions of
SFAS No. 148 in its financial reports for the year ended June 30, 2003 and will
adopt the interim disclosure provisions for its financial reports for the
quarter ended September 30, 2003. As the adoption of this standard involves
disclosures only, the Company does not expect a material impact on its results
of operations, financial position or liquidity.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." Interpretation No. 45 requires a
guarantor to include disclosure of certain obligations, and if applicable, at
the inception of the guarantee, recognize a liability for the fair value of
other certain obligations undertaken in issuing a guarantee. The recognition
requirement is effective for guarantees issued or modified after December 31,
2002 and based on current operations, the Company does not expect the adoption
of the recognition requirements of this statement to have a material effect on
its financial position or results of operations. The disclosure requirements are
effective for financial statements of interim and annual periods ending after
December 31, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities." Interpretation No. 46 clarifies the application of
Accounting Research Bulletin No. 51 and applies immediately to any variable
interest entities created after January 31, 2003 and to variable interest
entities in which an interest is obtained after that date. This Interpretation
is applicable for the Company in the second quarter of fiscal year 2004, which
ends September 30, 2003, for interests acquired in variable interest entities
prior to February 1, 2003. Based on current operations, the Company does not
expect the adoption of Interpretation No. 46 to have a material effect on its
financial position or results of operations.
21
WE NEED ADDITIONAL FINANCING
Our liquidity is significantly impacted by credit and collections issues.
Our Small Business channel has generated large balances of receivables and,
depending on the quality of the credit and cash needs, we sell certain of the
receivables, at a discount, to financing sources. Receivables that have not been
sold are retained and billing and collecting administration have been
outsourced. A large portion of the Small Business customers have historically
had sub-prime credit. Accordingly, many of the receivables generated by these
customers may have high credit risk.
At December 31, 2002, our cash position required that we actively seek
additional capital. As of December 31, 2002, we had current assets of
approximately $2.4 million and current liabilities of approximately $10.8
million. This represents a working capital deficit of approximately $8.4
million. The negative working capital balance includes as current liabilities
approximately $1.3 of deferred revenues and is mitigated by approximately $0.8
million in net contracts receivables included in long-term assets.
The Company's line of credit facility with Zions Bank includes covenants
for tangible net worth and debt coverage ratios. As of December 31, 2002, the
balance on the line was $247,822, and the Company was in violation of these
covenants, and has sought waivers. As of the date hereof, the bank has not
waived the violations, and if it were to demand payment of the entire balance,
the Company's liquidity would suffer. In January 2003, in exchange for an
advance of $250,000 on the line, the Company designated a recurring revenue
stream in the amount of approximately $40,000 per month for repayment of the
outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 has not been made, and in February 2003, $50,000 of the past
due amount was converted into common stock at $4 per share. We are seeking an
extension or conversion into equity of some or all of the balance.
We have $820,000 of convertible notes payable that were due on November 21,
2002. The notes were convertible into common stock at the options of the
holders, for the lower of $8.70 or the price of a private placement of our
common stock, but not converted. In November 2002, the note holders agreed to
amend the repayment terms of the notes to increase the interest rate to 14%,
lower the conversion price to $3 per share, establish payment terms calling for
six equal monthly principal payments beginning in January 2003 through June
2003. In January 2003, $130,667 of the notes were converted into 43,570 shares
of common stock. As of February 10, 2003, the balance of the January payment
that was not converted into common stock amounted to $50,107 and had not been
paid.
In February 2003, a group of investors led by East-West Capital Associates,
Inc. ("East-West Capital") and its affiliate, East West Venture Group, LLC
agreed to fund the $175,000 remainder of its $3 million obligation to purchase
our common stock at $4 per share, by providing $25,000 in cash and $150,000
through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. East-West Capital agreed to eliminate the
protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
To date, East-West Capital has otherwise satisfied all of their original
financing commitments to the Company.
Since the closing of the reverse acquisition of MindArrow, the Company has
taken steps to reduce monthly cash operating expenses and identify new sources
of revenue. We are currently seeking additional debt and equity financing and
are currently evaluating proposals from investors under those terms. However, no
binding agreements have been signed and there is no certainty that terms
acceptable to the Company and investors can be reached.
The accompanying consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States of
America, which contemplate continuation of the company as a going concern.
In our view, recoverability of a major portion of the recorded asset
amounts shown in the accompanying balance sheet is dependent upon our continued
operations, which in turn is dependent upon our ability to meet obligations on a
continuing basis. The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary
should we be unable to continue in existence.
22
RESULTS OF OPERATIONS
Revenues from the Large Enterprise sales channel increased to $1.7 million,
a 54% increase over pro forma combined revenues of MindArrow and CaptureQuest
for the same period for the previous year.
In recent months, we have shifted our Small Business focus to selling our
own software through our direct seminar channels, operated by our subsidiary
Bring it Home, Inc., ("BiH") and away from selling third-party products through
the third-party seminar channel, operated by our subsidiary, ePenzio, Inc.
("ePenzio") Revenues from BiH increased to $2.0 million in the quarter ended
December 31, 2002, from $1.2 million in the same period of the prior year, an
increase of 67%.
At third-party workshops, known as "lead sources," ePenzio customers
generally entered into long-term installment contracts to pay for the products
and services they purchased, and we have experienced high rates of payment
default in these contracts in the past three quarters. Accordingly, we have
significantly reduced the number of installment contracts we are accepting, and
have begun to seek new lead sources and other third-party sales channels.
Quarterly revenues from our ePenzio subsidiary have decreased from $6.1 million
for the quarter ended December 31, 2001 to $0.5 million in the current quarter.
Quarterly revenues totaled $4.2 million, a 40% decrease from the same
quarter in the previous year. Revenues for the six months ended December 31,
2002 decreased to $7.6 million from $11.4 million for the six months ended
December 31, 2001, a 34% decrease. The decreases are primarily the result of
management's plan to reduce our focus on ePenzio revenues and increase our focus
on revenues from our BiH and Large Enterprise channel sales, as discussed above.
Gross profit decreased from $4.9 million for the three months ended
December 31, 2001 to $3.1 million for the three months ended December 31, 2002.
However, gross profit margin increased from 70% to 74%. Gross profit decreased
from $7.6 million, or 66% of revenues, to $6.3 million, or 84% of revenues, for
the six months ended December 31, 2002. Since the merger, we have taken steps to
decrease the direct costs associated with hosting the seminars in addition to
adding to the product offering, in order to improve margins in future periods.
Selling, general and administrative expenses increased from $2.9 million,
or 41% of revenues, and $5.1 million, or 45% of revenues, for the quarter and
six months ended December 31, 2001, respectively, to $5.6 million, or 131% of
revenues, and $9.9 million, or 131% of revenues, for the quarter and six months
ended December 31, 2002, respectively. These increases were associated with
additional costs of integrating previously acquired companies and professional
service and other costs associated with the combination of MindArrow and
Category 5. During the quarter ended December 31, 2002, we completed cost
reductions which will reduce costs in subsequent quarters.
Bad debt expense increased to $3.4 million and $4.3 million for the quarter
and six months ended December, 31, 2002, respectively, compared to $0 and $0.4
million for the same periods from 2001. The increase resulted primarily from
defaults on ePenzio's contracts receivable. We have decreased our use of
long-term contracts receivable for revenues generated by ePenzio, and therefore
expect bad debt expense to decrease on both an absolute and relative basis in
future quarters.
We incurred a loss from operations of $6.7 million and $9.2 million for the
quarter and six months ended December 31, 2002, respectively, compared to income
from operations of $2.0 million and $2.0 million for the same periods from 2001.
The loss resulted from a number of factors, including the factors discussed in
the foregoing paragraphs and the following factors:
- The decrease in lead-source revenues and significant bad debt expense.
- Costs associated with organizing and marketing Bring It Home seminars;
- Increases in costs related to the acquisitions completed during the year;
and
23
Certain of these costs are nonrecurring, such as the costs associated with
integrating acquired companies, and the curtailing of entering into installment
contracts will significantly reduce bad debt expense in future quarters.
The write-down of short-term investment of $1.0 million relates to a
certificate of deposit account in the name of our CaptureQuest subsidiary that
arose from an investment in CaptureQuest by Omnicorp Bank. The account was held
at Omnicorp, which was declared insolvent by regulators in October 2002.
Omnicorp has asked account holders to convert their certificates of deposit into
an investment in preferred shares of Solara Ventures, Inc. a Canadian-based
investment company. We have not yet accepted Omnicorp's request and are
evaluating our options. As of December 31, 2002, the entire balance was written
down due to the uncertainty surrounding any recovery.
We incurred a net loss of $6.7 million or $0.95 per share, and $8.9
million, or $1.63 per share, for the quarter and six months ended December 31,
2002, respectively, compared to net income of $1.3 million, or $0.46 per share,
and $1.3 million, or $0.47 per share, for the same periods in 2001.
LIQUIDITY AND SOURCES OF CAPITAL
At December 31, 2002, our cash position required that we actively seek
additional sources of capital. As of December 31, 2002, we had current assets of
approximately $2.4 million and current liabilities of approximately $10.8
million. This represents a working capital deficit of approximately $8.4
million. The negative working capital balance includes as current liabilities
approximately $1.3 of deferred revenues and is mitigated by approximately $0.8
million in net contracts receivables included in long-term assets.
The Company's line of credit facility with Zions Bank includes covenants
for tangible net worth and debt coverage ratios. As of December 31, 2002, the
balance on the line was $247,822, and the Company was in violation of these
covenants, and has sought waivers. As of the date hereof, the bank has not
waived the violations, and if it were to demand payment of the entire balance,
the Company's liquidity would suffer. In January 2003, in exchange for an
advance of $250,000 on the line, the Company designated a recurring revenue
stream in the amount of approximately $40,000 per month for repayment of the
outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 has not been made, and in February 2003, $50,000 of the past
due amount was converted into common stock at $4 per share. We are seeking an
extension or conversion into equity of some or all of the balance.
We have $820,000 of convertible notes payable that were due on November 21,
2002. The notes were convertible into common stock at the options of the
holders, for the lower of $8.70 or the price of a private placement of our
common stock, but not converted. In November 2002, the note holders agreed to
amend the repayment terms of the notes to increase the interest rate to 14%,
lower the conversion price to $3 per share, establish payment terms calling for
six equal monthly principal payments beginning in January 2003 through June
2003. In January 2003, $130,667 of the notes were converted into 43,570 shares
of common stock. As of February 10, 2003, the balance of the January payment
that was not converted into common stock amounted to $50,107 and had not been
paid.
In February 2003, a group of investors led by East-West Capital Associates,
Inc. ("East-West Capital") and its affiliate, East West Venture Group, LLC
agreed to fund the $175,000 remainder of its $3 million obligation to purchase
our common stock at $4 per share, by providing $25,000 in cash and $150,000
through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. East-West Capital agreed to eliminate the
protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
To date, East-West Capital has otherwise satisfied all of their original
financing commitments to the Company.
Since the closing of the reverse acquisition of MindArrow, the Company has
taken steps to reduce monthly cash operating expenses and identify new sources
of revenue. We are currently seeking additional debt and equity financing and
are currently evaluating proposals from investors under those terms. However, no
binding agreements have been signed and there is no certainty that terms
acceptable to the Company and investors can be reached.
During the six months ended December 31, 2002, we generated $82,628 of cash
from operating activities, generated $383,650 of cash in investing activities
and used $588,605 of cash in financing activities. During the six months ended
December 31, 2001, we used $613,027 of cash in operating activities, used
$74,924 of cash in investing activities and generated cash in financing
activities of $1,046,156.
24
Our liquidity is significantly impacted by credit and collections issues.
Our business generates large balances of receivables and, depending on the
quality of the credit and the cash needs, we sell certain of the receivables, at
a discount, to financing sources. We retain receivables that we do not sell. A
large portion of our customer base is made up of small businesses with sub-prime
credit. Accordingly, many of the receivables generated by these customers may
have high credit risk. We have recently undertaken steps designed to improve
collectibility and attempt to reclaim accounts that have been fully reserved or
written off.
We maintain trade credit arrangements with certain of its suppliers. The
unavailability of a significant portion of, or the loss of, the Zions Facility
and trade credit from suppliers would have a material adverse effect on the
Company's financial condition and operations. In the event of the termination of
contracts with all or most of the finance companies with which the Company has
developed such relationship, the Company may be unable to meet its anticipated
working capital needs or routine capital expenditures on a short-term and
long-term basis.
25
Certain of the matters and subject areas discussed in this quarterly report
on Form 10-Q contain "forward-looking statements" that are subject to a number
of risks and uncertainties, many of which are beyond our control. All
statements, other than statements of historical fact included in this report
regarding our business strategy, future operations, financial position,
estimated revenues, projected costs, prospects, plans and objectives of
management as well as third parties are forward-looking statements. Generally,
when used in this report, the words "anticipate," "intend," "estimate,"
"expect," "project," and similar expressions are intended to identify
forward-looking statements, although not all forward-looking statements contain
such identifying words. All forward-looking statements speak only as of the date
of this report. Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we can give no assurance that such
expectations will prove to be correct. Important factors that could cause our
actual results to differ materially from our expectations are described below
and in our other filings with the SEC.
RISK FACTORS
WE NEED ADDITIONAL FINANCING
Our liquidity is significantly impacted by credit and collections issues.
Our Small Business division has generated large balances of receivables and,
depending on the quality of the credit and the cash needs, we sell certain of
the receivables, at a discount, to financing sources. Receivables that have not
been sold are retained and the billing and collecting administration have been
outsourced. A large portion of the Small Business division's customers have
sub-prime credit. Accordingly, many of the receivables generated by these
customers may have high credit risk.
At December 31, 2002, our cash position required that we actively seek
additional sources of capital. As of December 31, 2002, we had current assets of
approximately $2.4 million and current liabilities of approximately $10.8
million. This represents a working capital deficit of approximately $8.4
million. The negative working capital balance includes as current liabilities
approximately $1.3 of deferred revenues and is mitigated by approximately $0.8
million in net contracts receivables included in long-term assets.
The Company's line of credit facility with Zions Bank includes covenants
for tangible net worth and debt coverage ratios. As of December 31, 2002, the
balance on the line was $247,822, and the Company was in violation of these
covenants, and has sought waivers. As of the date hereof, the bank has not
waived the violations, and if it were to demand payment of the entire balance,
the Company's liquidity would suffer. In January 2003, in exchange for an
advance of $250,000 on the line, the Company designated a recurring revenue
stream in the amount of approximately $40,000 per month for repayment of the
outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 has not been made, and in February 2003, $50,000 of the past due
amount was converted into common stock at $4 per share. We are seeking an
extension or conversion into equity of some or all of the balance.
We have $820,000 of convertible notes payable that were due on November 21,
2002. The notes were convertible into common stock at the options of the
holders, for the lower of $8.70 or the price of a private placement of our
common stock, but not converted. In November 2002, the note holders agreed to
amend the repayment terms of the notes to increase the interest rate to 14%,
lower the conversion price to $3 per share, establish payment terms calling for
six equal monthly principal payments beginning in January 2003 through June
2003. In January 2003, $130,667 of the notes were converted into 43,570 shares
of common stock. As of February 10, 2003, the balance of the January payment
that was not converted into common stock amounted to $50,107 and had not been
paid.
In February 2003, a group of investors led by East-West Capital Associates,
Inc. ("East-West Capital") and its affiliate, East West Venture Group, LLC
agreed to fund the $175,000 remainder of its $3 million obligation to purchase
our common stock at $4 per share, by providing $25,000 in cash and $150,000
through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. East-West Capital agreed to eliminate the
protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
To date, East-West Capital has otherwise satisfied all of their original
financing commitments to the Company.
Since the closing of the reverse acquisition of MindArrow, the Company has
taken steps to reduce monthly cash operating expenses and identify new sources
of revenue. We are currently seeking additional debt and equity financing and
are currently evaluating proposals from investors under those terms. However, no
binding agreements have been signed and there is no certainty that terms
acceptable to the Company and investors can be reached.
26
THERE CAN BE NO ASSURANCE THAT ANY ADDITIONAL FINANCING WILL BE AVAILABLE
ON ACCEPTABLE TERMS, IF AT ALL. IF WE ARE UNSUCCESSFUL IN RAISING ADDITIONAL
FUNDS, OUR LIQUIDITY POSITION WILL BE MATERIALLY AND ADVERSELY AFFECTED AND WE
COULD BE REQUIRED TO MAKE DRASTIC COST REDUCTIONS, WHICH WOULD NEGATIVELY IMPACT
OUR OPERATIONS.
Although we believe our assumptions underlying our operating plan to be
reasonable, we lack the operating history of a more seasoned company and there
can be no assurance that our forecasts will prove accurate. In the event that
our plans change, our assumptions change or prove inaccurate, if the committed
financing falls through, or if future private placements, other capital
resources and projected cash flow otherwise prove to be insufficient to fund
operations, we could be required to seek additional financing sooner than
currently anticipated. To the extent that we are able to raise additional funds
and it involves the sale of our equity securities, the interests of our
shareholders could be substantially diluted.
RECENT ACTIONS THAT WE HAVE TAKEN MAY NEGATIVELY IMPACT OUR ABILITY TO ACHIEVE
OUR BUSINESS OBJECTIVES
In order to manage our liquidity and cash position, over the past year we
have had to implement certain cost cutting measures, including significant
reductions in force. After these staff reductions, as of December 31, 2002, we
had 122 full time employees worldwide. Although these cost cutting measures have
improved our short-term cash requirements, they may negatively impact our
ability to grow our business and achieve our business objectives.
OUR LIMITED OPERATING HISTORY MAKES EVALUATION OF OUR BUSINESS DIFFICULT
We have a limited operating history on which to base our evaluation of
current business and prospects. Our short operating history makes it difficult
to predict future results, and there are no assurances that our revenues will
increase, or that we will achieve or maintain profitability or generate
sufficient cash from operations in future periods.
Our ability to achieve and sustain profitability would be adversely
affected if we:
- fail to effectively market and sell our services;
- fail to develop new and maintain existing relationships with clients;
- fail to continue to develop and upgrade our technology and network
infrastructure;
- fail to respond to competitive developments;
- fail to introduce enhancements to our existing products and services to
address new technologies and standards; or
- fail to attract and retain qualified personnel.
Our operating results are also dependent on factors outside of our control,
such as strength of competition and the growth of the market for our services.
There is no assurance that we will be successful in addressing these risks, and
failure to do so could have a material adverse effect on our financial
performance.
We expect to incur losses in the near term, and if we are unable to
generate sufficient cash flow or raise the capital necessary to allow us to
continue to meet all of our obligations as they come due, our business could
suffer.
OUR FUTURE REVENUES ARE NOT PREDICTABLE, AND OUR RESULTS COULD VARY
SIGNIFICANTLY
Because of our limited operating history and the emerging nature of our
markets, we are unable to reliably forecast our revenues.
27
Our operating results may fluctuate significantly in the future as a result
of a variety of factors. These factors include:
- the demand for our services;
- the addition or loss of individual clients;
- the amount and timing of capital expenditures and other costs relating to
the expansion of our operations;
- the introduction of new products or services by us or our competitors; and
- general economic conditions and economic conditions specific to the
Internet, such as electronic commerce and online media.
Any one of these factors could cause our revenues and operating results to
vary significantly. In addition, as a strategic response to changes in the
competitive environment, we may from time to time make certain pricing, service
or marketing decisions or acquisitions that could significantly hurt our
operating results in a given period.
Due to all of the foregoing factors, we believe that period-to-period
comparisons of our results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance. Furthermore, it
is possible that our operating results in one or more quarters will fail to meet
the expectations of investors. In such event, the market price of our common
stock could drop.
IF WE ARE UNABLE TO OBTAIN FUNDING, OUR CUSTOMERS AND VENDORS MAY DECIDE NOT TO
DO BUSINESS WITH US
If we are unable to continue funding our operations at our current levels,
and if customers and vendors become concerned about our business prospects, they
may decide not to conduct business with us, or may conduct business with us on
terms that are less favorable than those customarily extended by them. In that
event, our revenues would decrease and our business will suffer significantly.
WE ARE NOT SURE IF THE MARKET WILL ACCEPT OUR PRODUCT OFFERINGS
Our ability to succeed will depend on the following, none of which can be
assured: - the effectiveness of our marketing and sales efforts; - market
acceptance of our current and future offerings; and - the reliability of our
networks and services.
We operate in a market that is in the early stage of development, is
rapidly evolving, and is characterized by an increasing number of competitors
and risk surrounding market acceptance of new technologies and services.
Potential customers must view our technologies as a viable alternative to
traditional commercial advertising and brochure distribution. Because this
market is so new, it is difficult to predict its size and growth rate. If the
market fails to develop as we expect, our growth will be slower than expected.
WE MAY MAKE ACQUISITIONS OF COMPLEMENTARY TECHNOLOGIES OR BUSINESSES, WHICH MAY
DISRUPT OUR BUSINESS AND BE DILUTIVE TO OUR EXISTING STOCKHOLDERS.
We intend to consider acquisitions of businesses and technologies on an
opportunistic basis. Acquisitions of businesses and technologies involve
numerous risks, including the diversion of management attention, difficulties in
assimilating the acquired operations, loss of key employees from the acquired
company, and difficulties in transitioning key customer relationships. In
addition, these acquisitions may result in dilutive issuances of equity
securities, the incurrence of additional debt, large one-time expenses and the
creation of goodwill or other intangible assets that result in significant
amortization expense and impairment charges. Any acquisition may not provide the
benefits originally anticipated, and there may be difficulty in integrating the
service offerings and customer and supplier relationships gained through
acquisitions with our own. Although we attempt to minimize the risk of
unexpected liabilities and contingencies associated with acquired businesses
through planning, investigation and negotiation, such unexpected liabilities
28
nevertheless may accompany such acquisitions. We cannot guarantee that we will
successfully identify attractive acquisition candidates, complete and finance
additional acquisitions on favorable terms, or integrate the acquired businesses
or assets into our own. Any of these factors could materially harm our business
or our operating results in a given period.
NETWORK AND SYSTEM FAILURES COULD ADVERSELY IMPACT OUR BUSINESS The performance,
reliability and availability of our Web sites and network
infrastructure is critical to our reputation and ability to attract and retain
clients. Our systems and operations are vulnerable to damage or interruption
from earthquake, fire, flood, power loss, telecommunications failure, Internet
breakdowns, break-ins, tornadoes and similar events. We carry business
interruption insurance to compensate for losses that may occur, but insurance is
not guaranteed to remove all risk of loss. Services based on sophisticated
software and computer systems often encounter development delays and the
underlying software may contain errors that could cause system failures. Any
system failure that causes an interruption could result in a loss of clients and
could reduce the attractiveness of our services.
We are also dependent upon Web browsers, Internet service providers and
online service providers to provide Internet users access to our clients, users
and Web sites. Users may experience difficulties due to system failures or
delays unrelated to our systems. These difficulties may hurt audio and video
quality or result in intermittent interruptions in broadcasting and thereby slow
our growth.
CIRCUMVENTION OF OUR SECURITY MEASURES AND VIRUSES COULD DISRUPT OUR BUSINESS
Despite the implementation of security measures, our networks may be
vulnerable to unauthorized access, computer viruses and other disruptive
problems. Anyone who is able to circumvent security measures could steal
proprietary information or cause interruptions in our operations. Service
providers have occasionally experienced interruptions in service as a result of
the accidental actions of users or intentional actions of hackers. We may have
to spend significant capital to protect against security breaches or to fix
problems caused by such breaches. Although we have implemented security
measures, there can be no assurance that such measures will not be circumvented
in the future. Eliminating computer viruses and alleviating other security
problems may require interruptions, delays or cessation of service to users,
which could hurt our business.
WE DEPEND ON CONTINUED GROWTH IN USE OF THE INTERNET
Rapid growth in use of the Internet is a recent phenomenon and there can be
no assurance that use of the Internet will continue to grow or that a sufficient
base of users will emerge to support our business. The Internet may not be
accepted as a viable medium for broadcasting advertising and brochure
distribution, for a number of reasons, including:
- inadequate development of the necessary infrastructure;
- inadequate development of enabling technologies;
- lack of acceptance of the Internet as a medium for distributing rich media
advertising; and
- inadequate commercial support for Web-based advertising.
To the extent that Internet use continues to increase, there can be no
assurance that the Internet infrastructure will be able to support the demands
placed upon it, and especially the demands of delivering high-quality video
content.
Furthermore, user experiences on the Internet are affected by access speed.
There is no assurance that broadband access technologies will become widely
adopted. In addition, the Internet could lose its viability as a commercial
medium due to delays in the development or adoption of new standards and
protocols required to handle increased levels of Internet activity, or due to
increased government regulation. Our business could suffer if use of the
Internet grows more slowly than expected, or if the Internet infrastructure does
not effectively support the growth that does occur.
29
WE MAY BE UNABLE TO COLLECT OUR RECEIVABLES AND RETAINAGES IN AMOUNTS PREVIOUSLY
ESTIMATED.
In accordance with United States generally accepted accounting principles,
we have established reserves against our retainages and receivables. We believe
that the established reserves adequately allow for the estimated uncollectible
portion of the retainages and receivables. However, we may experience collection
rates below established reserves, which could reduce the amount of available
funds and require additional reserves. Reduced available funds could adversely
affect our ability to successfully implement the objectives of our business
plan. There can be no assurance that we will be able to collect retainages and
receivables in sufficient amounts. Failure to collect adequate amounts of
retainages and receivables could materially adversely affect our business and
results of operations.
THERE ARE LOW BARRIERS TO ENTRY IN OUR SMALL BUSINESS MARKET, WHICH COULD RESULT
IN INCREASED COMPETITION IN THE FUTURE.
The market for Internet-based services is relatively new, intensely
competitive and rapidly evolving. There are minimal barriers to entry, and
current and new competitors can launch new Internet products and services at a
relatively low cost within relatively short time periods. We expect competition
to persist and intensify and the number of competitors to increase significantly
in the future. Should we seek in the future to attempt to expand the scope of
our Internet services and product offerings, we will compete with a greater
number of Internet companies. Because the operations and strategic plans of
existing and future competitors are undergoing rapid change, it is difficult for
us to anticipate which companies are likely to offer competitive products and
services in the future.
OUR SMALL BUSINESS DIVISION WILL RELY ON CERTAIN KEY CO-MARKETING ALLIANCES TO
GENERATE CLIENTS, END-USERS, AND REVENUE.
We have entered into certain key co-marketing arrangements with strategic
partners in order to leverage the industry and marketing expertise of such
partners. We expect that revenues generated from the sale of products and
services through such strategic co-marketing arrangements will account for a
significant portion of our revenues for the foreseeable future. Some of these
arrangements provide, for the co-marketing partner, certain exclusive rights to
co-market our services in a particular industry, which might hinder us from
directly contacting potential clients in such industry. Our arrangements with
these co-marketing partners are relatively new and have not yet generated
material revenues. There can be no assurance that such arrangements will be
successful in generating such revenues. Further, if a co-marketing relationship
is terminated, we may be unable to replace such relationship with other
alliances that have comparable customer bases and user demographics.
WE ARE DEPENDENT UPON CERTAIN RELATIONSHIPS WITH THIRD PARTIES, THE LOSS OF
WHICH MAY BE DETRIMENTAL TO OUR OPERATIONS.
We are dependent on certain banking relationships as well as strategic
relationships with third parties who provide payment gateways to our customers.
We must comply with certain bank covenants to maintain our banking
relationships. Failure of these financial institutions and third parties to
continue their relationships with us or to continue to provide services in a
satisfactory way to our customers could adversely impact our financial viability
and result in the loss of the business of the merchants to whom we sell products
and services.
WE MAY BECOME SUBJECT TO ADDITIONAL U.S. STATE TAXES THAT CANNOT BE PASSED
THROUGH TO OUR MERCHANT CUSTOMERS, IN WHICH CASE OUR PROFITABILITY COULD BE
ADVERSELY AFFECTED.
Transaction processing companies may be subject to taxation by various U.S.
states on certain portions of our fees charged to customers for our services.
Application of this tax is an emerging issue in our industry and the states have
not yet adopted uniform regulations on this topic. If we are required to pay
such taxes and are not able to pass the tax expense through to our merchant
customers, our operating costs will increase, reducing our profit margin.
30
IF WE DO NOT RESPOND TO TECHNOLOGICAL CHANGE, WE COULD LOSE OR FAIL TO DEVELOP
CUSTOMERS.
The development of our business entails significant technical and business
risks. To remain competitive, we must continue to enhance and improve the
functionality and features of our technology. The Internet and the ecommerce
industry are characterized by:
- rapid technological change;
- changes in client requirements and preferences;
- frequent new product and service introductions embodying new technologies;
and
- the emergence of new industry standards and practices.
THE EVOLVING NATURE OF THE INTERNET COULD RENDER OUR EXISTING SYSTEMS OBSOLETE.
Our success will depend, in part, on our ability to:
- develop and enhance technologies useful in our business;
- develop new services and technology that address the increasingly
sophisticated and varied needs of our current and prospective clients; and
- adapt to technological advances and emerging industry and regulatory
standards and practices in a cost-effective and timely manner.
Future advances in technology may not be beneficial to, or compatible with,
our business. Furthermore, we may not use new technologies effectively or adapt
our systems to client requirements or emerging industry standards on a timely
basis. Our ability to remain technologically competitive may require substantial
expenditures and lead time. If we are unable to adapt to changing market
conditions or user requirements in a timely manner, we will lose clients.
WE COULD FACE LIABILITY FOR INTERNET CONTENT
As a distributor of Internet content, we face potential liability for
negligence, copyright, patent or trademark infringement, defamation, indecency
and other claims based on the content of our broadcasts. Such claims have been
brought, and sometimes successfully pressed, against Internet content
distributors. Our general liability insurance may not be adequate to indemnify
us for all liability that may be imposed. Although we generally require our
clients to indemnify us for such liability, such indemnification may be
inadequate. Any imposition of liability that is not covered by insurance or by
an indemnification by a client could harm our business.
OUR OPERATING RESULTS COULD BE IMPAIRED IF WE BECOME SUBJECT TO BURDENSOME
GOVERNMENT REGULATIONS AND LEGAL UNCERTAINTIES CONCERNING THE INTERNET
Due to the increasing popularity and use of the Internet, it is
possible that a number of laws and regulations may be adopted with respect to
the Internet, relating to:
- user privacy;
- pricing, usage fees and taxes;
- content;
- copyrights;
- distribution;
- characteristics and quality of products and services; and
- online advertising and marketing.
The adoption of any additional laws or regulations may decrease the
popularity or impede the expansion of the Internet and could seriously harm our
business. A decline in the popularity or growth of the Internet could decrease
demand for our products and services, reduce our revenues and margins and
31
increase our cost of doing business. Moreover, the applicability of existing
laws to the Internet is uncertain with regard to many important issues,
including property ownership, intellectual property, export of encryption
technology, libel and personal privacy. The application of laws and regulations
from jurisdictions whose laws do not currently apply to our business, or the
application of existing laws and regulations to the Internet and other online
services, could also harm our business.
OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VOLATILE
The trading
price of our common stock has been and is likely to continue to be highly
volatile. For example, on February 10, 2003, our common stock closed at $1.20
per share, and on November 12, 2002, our common stock closed at $4.70 per share.
Our stock price could be subject to wide fluctuations in response to factors
such as:
- the average daily trading volume of our common stock;
- actual or anticipated variations in quarterly operating results and
our need for additional financing to fund our continuing operations;
- announcements of technological innovations, new products or services
by us or our competitors; - the addition or loss of strategic
relationships or relationships with our key customers;
- conditions or trends in the Internet, streaming media, media delivery,
and online commerce markets;
- changes in the market valuations of other Internet, online service, or
software companies;
- announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures, or capital commitments;
- sales of our common stock and legal or regulatory developments;
- additions or departures of key personnel;
- our failure to obtain additional financing on satisfactory terms, or
at all; and
- general market conditions.
The historical volatility of our stock price may make it more difficult for
investors in our securities to resell shares at prices they find attractive.
In addition, the stock market in general, the Nasdaq SmallCap Market, the
market for Internet and technology companies in particular, have experienced
extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of these companies. These broad
market and industry factors may reduce our stock price, regardless of our
operating performance.
INSIDERS OWN APPROXIMATELY 42% OF OUR OUTSTANDING COMMON STOCK AND THEIR
INTERESTS COULD CONFLICT WITH THOSE OF OTHER STOCKHOLDERS.
Our current directors and senior employees own approximately 42% of our
outstanding common stock. As a result, the directors and executive officers
collectively may be able to substantially influence all matters requiring
stockholder approval, including the election of directors and approval of
significant corporate transactions. Such concentration of ownership may also
have the effect of delaying or preventing a change in control.
FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE
Sales of a substantial number of shares of our common stock in the public
market, or the appearance that such shares are available for sale, could
adversely affect the market price for our common stock. As of December 31, 2002,
32
we had 7,174,259 shares of common stock outstanding. A significant number of
these shares are not publicly traded but are available for immediate resale to
the public. We also have reserved shares of our common stock as follows:
- 3,018,358 shares are reserved for issuance upon the exercise of
warrants;
- 1,254,274 shares are reserved for issuance upon the exercise of stock
options.
Shares underlying vested options are generally eligible for immediate
resale in the public market.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS MAY NOT SUFFICIENTLY
PROTECT US AND WE MAY INCUR COSTLY LITIGATION TO PROTECT OUR RIGHTS
We have filed nineteen patent applications and we plan to file additional
patent applications in the future with respect to various additional aspects of
our technologies. In addition, we have received patents on technology we
obtained in the Control Commerce and Radical Communication acquisitions. We mark
our software with copyright notices, and intend to file copyright registration
applications where appropriate. We have also filed several federal trademark
registration applications for trademarks and service marks we use. There can,
however, be no assurance that any patents, copyright registrations, or trademark
registrations applied for by us will be issued, or if issued, will sufficiently
protect our proprietary rights.
We also rely substantially on certain technologies that are not patentable
or proprietary and are therefore available to our competitors. In addition, many
of the processes and much of our technology are dependent upon our technical
personnel, whose skill, knowledge and experience are not patentable. To protect
our rights in these areas, we require all employees, significant consultants and
advisors to enter into confidentiality agreements under which they agree not to
use or disclose our confidential information as long as that information remains
proprietary. We also require that our employees agree to assign to us all rights
to any inventions made during their employment relating to our activities, and
not engage in activities similar to ours during the term of their employment.
There can be no assurance, however, that these agreements will provide
meaningful protection for our trade secrets, know-how or other proprietary
information in the event of any unauthorized use or disclosure of such trade
secrets, know-how or proprietary information. Further, in the absence of patent
protection, we may be exposed to competitors who independently develop
substantially equivalent technology or otherwise gain access to our trade
secrets, knowledge or other proprietary information.
Despite our efforts to protect our intellectual property, a third party or
a former employee could copy, reverse-engineer or otherwise obtain and use our
intellectual property or trade secrets without authorization or could develop
technology competitive to ours.
Our intellectual property may be misappropriated or infringed upon.
Consequently, litigation may be necessary in the future to enforce our
intellectual property rights, to protect our confidential information or trade
secrets, or to determine the validity or scope of the rights of others.
Litigation could result in substantial costs and diversion of management and
other resources and may not successfully protect our intellectual property.
Additionally, we may deem it advisable to enter into royalty or licensing
agreements to resolve such claims. Such agreements, if required, may not be
available on commercially reasonable or desirable terms or at all.
OUR TECHNOLOGY MAY INFRINGE ON THE RIGHTS OF OTHERS
Even if the patents, copyrights and trademarks we apply for are granted,
they do not confer on us the right to manufacture or market products or services
if such products or services infringe on intellectual property rights held by
others. If any third parties hold conflicting rights, we may be required to stop
making, using, or marketing one or more of our products or to obtain licenses
from and pay royalties to others, which could have a significant and material
adverse effect on us. There can be no assurance that we will be able to obtain
or maintain any such license on acceptable terms or at all.
We may also be subject to litigation to defend against claims of
infringement of the rights of others or to determine the scope and validity of
the intellectual property rights of others. If third parties hold trademark,
copyright or patent rights that conflict with our business, then we may be
33
forced to litigate infringement claims that could result in substantial costs to
us. In addition, if we were unsuccessful in defending such a claim, it could
have a negative financial impact. If third parties prepare and file applications
in the United States that claim trademarks used or registered by us, we may
oppose those applications and be required to participate in proceedings before
the United States Patent and Trademark Office to determine priority of rights to
the trademark, which could result in substantial costs to us. An adverse outcome
in litigation or privity proceedings could require us to license disputed rights
from third parties or to cease using such rights. Any litigation regarding our
proprietary rights could be costly, divert management's attention, result in the
loss of certain of our proprietary rights, require us to seek licenses from
third parties and prevent us from selling our services, any one of which could
have a negative financial impact. In addition, inasmuch as we broadcast content
developed by third parties, our exposure to copyright infringement actions may
increase because we must rely upon such third parties for information as to the
origin and ownership of such licensed content. We generally obtain
representations as to the origin and ownership of such licensed content and
generally obtain indemnification to cover any breach of such representations;
however, there can be no assurance that such representations will be accurate or
given, or that such indemnification will adequately protect us.
THE LENGTH OF OUR SALES CYCLE INCREASES OUR COSTS
Many of our potential customers conduct extensive and lengthy evaluations
before deciding whether to purchase or license our products. In our experience
to date we've seen the sales cycle range from a few days up to six months. While
the potential customer is making this decision, we continue to incur salary,
travel and other similar costs of following up with these accounts. Therefore,
the risk associated with our lengthy sales cycle is that we may expend
substantial time and resources over the course of the sales cycle only to
realize no revenue from such efforts if the customer decides not to purchase
from us. Any significant change in customer buying decisions or sales cycles for
our products could have a material adverse effect on our business, results of
operations, and financial conditions.
THERE ARE RISKS INHERENT IN CONDUCTING INTERNATIONAL OPERATIONS
There are many risks associated
with our international operations in eastern Asia, including, but not limited
to:
- difficulties in collecting accounts receivable and longer collection
periods;
- changing and conflicting regulatory requirements;
- potentially adverse tax consequences;
- tariffs and general export and customs restrictions;
- difficulties in staffing and managing foreign operations;
- political instability;
- fluctuations in currency exchange rates;
- the need to develop localized versions of our products;
- national standardization and certification requirements;
- seasonal reductions of business activity; and
- the impact of local economic conditions and practices.
Any of the above-listed risks could have a material adverse effect on our
future business, financial condition, or results of operations.
INTERNATIONAL MARKETS FOR ONLINE MARKETING ARE IN THEIR VERY EARLY STAGES OF
DEVELOPMENT
We distribute email messages globally. To date, we have developed or
modified into foreign language text and delivered eBrochures to recipients in
the United Kingdom, France, Switzerland, Austria, Norway, Sweden, Iceland,
Finland, Denmark, Greece, Lebanon, Mexico, Panama, Peru, Philippines, Australia,
34
Singapore, Hong Kong, China, and Taiwan. The markets for online advertising and
direct marketing in these countries are generally in earlier stages of
development than in the United States, and we cannot assure you that the market
for, and use of online advertising and direct marketing in international markets
such as these and others will be significant in the future. Factors that may
account for slower growth in the online advertising and direct marketing markets
include, but are not limited to:
- slower growth in the number of individuals using the Internet
internationally;
- privacy concerns;
- a lower rate of advertising spending internationally than in the United
States; and
- a greater reluctance to use the Internet for advertising and direct
marketing.
Any of the above-listed risks could have a material adverse effect on our
future business, financial condition, or results of operations.
WE ARE SUBJECT TO RISKS ASSOCIATED WITH GOVERNMENTAL REGULATION AND LEGAL
UNCERTAINTIES
We are subject to general business laws and regulations. These laws and
regulations, as well as new laws and regulations that may be adopted in the
United States and other countries with respect to the Internet, may impede the
growth of the Internet. These laws may relate to areas such as advertising,
taxation, personal privacy, content issues (such as obscenity, indecency, and
defamation), copyright and other intellectual property rights, encryption,
electronic contracts and "digital signatures," electronic commerce liability,
email, network and information security, and the convergence of traditional
communication services with Internet communications, including the future
availability of broadband transmission capability. Other countries and political
organizations are likely to impose or favor more and different regulation than
that which has been proposed in the United States, thus furthering the
complexity of regulation. In addition, state and local governments may impose
regulations in addition to, inconsistent with, or stricter than, federal
regulations. The adoption of such laws or regulations, and uncertainties
associated with their validity, applicability, and enforcement, may affect the
available distribution channels for and costs associated with our products and
services, and may affect the growth of the Internet. Such laws or regulations
may therefore harm our business.
We do not know for certain how existing laws governing issues such as
privacy, property ownership, copyright and other intellectual property issues,
taxation, illegal or obscene content, retransmission of media, and data
protection, apply to the Internet. The vast majority of such laws were adopted
before the advent of the Internet and related technologies and do not address
the unique issues associated with the Internet and related technologies. Most of
the laws that relate to the Internet have not yet been interpreted. Changes to
or the interpretation of these laws could:
- limit the growth of the Internet;
- create uncertainty in the marketplace that could reduce demand for our
products and services;
- increase our cost of doing business;
- expose us to significant liabilities associated with content distributed or
accessed through our products or services, and with our provision of
products and services, and with the features or performance of our
products;
- lead to increased product development costs, or otherwise harm our
business; or
- decrease the rate of growth of our user base and limit our ability to
effectively communicate with and market to our user base.
Any of the above-listed consequences could have a material adverse effect
on our future business, financial condition, or results of operations.
35
WE MAY BE SUBJECT TO LEGAL LIABILITY IN CONNECTION WITH THE DATA COLLECTION
CAPABILITIES OF OUR PRODUCTS AND SERVICES
Our products are interactive Internet applications that by their very
nature require communication between a client and server to operate. To provide
better consumer experiences and to operate effectively, our products
occasionally send information to servers at MindArrow. Many of the services we
provide also require that users provide information to us. We post privacy
policies concerning the use and disclosure of our user data. Any failure by us
to comply with our posted privacy policies could impact the market for our
products and services, subject us to litigation, and harm our business.
In addition, the Child Online Privacy Protection Act ("COPPA") became
effective as of April 21, 2000. COPPA requires operators of commercial Web sites
and online services directed to children (under 13), and general audience sites
that know that they are collecting personal information from a child, to:
- provide parents notice of their information practices;
- obtain verifiable parental consent before collecting a child's personal
information, with certain limited exceptions;
- give parents a choice as to whether their child's information will be
disclosed to third parties;
- provide parents access to their child's personal information and allow them
to review it and/or have it deleted;
- give parents the opportunity to prevent further use or collection of
information; not require a child to provide more information than is
reasonably necessary to participate in an activity; and
- maintain the confidentiality, security, and integrity of information
collected from children.
We do not knowingly collect and disclose personal information from such
minors, and therefore believe that we are fully compliant with COPPA. However,
the manner in which COPPA may be interpreted and enforced cannot be fully
determined, and thus COPPA and future legislation such as COPPA could subject us
to potential liability, which in turn would harm our business.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not believe that we currently have material exposure to interest
rate, foreign currency exchange rate or other relevant market risks.
Interest Rate and Market Risk. Our exposure to market risk for changes in
interest rates relates primarily to our investment profile. As of December 31,
2002, our investment portfolio consisted primarily of cash and cash equivalents,
substantially all of which were held at two financial institutions. We do not
use derivative financial instruments in our investment portfolio.
Foreign Currency Exchange Risk. We do not believe that we currently have
material exposure to foreign currency exchange risk because of the relative
insignificance of our foreign subsidiaries. We intend to assess the need to use
financial instruments to hedge currency exposures on an ongoing basis.
We do not use derivative financial instruments for speculative trading
purposes.
ITEM 4. CONTROLS AND PROCEDURES
(a.) Our Chief Executive Officer and Chief Financial Officer have evaluated the
effectiveness of our disclosure controls and procedures (as defined in
Rules 13(a) or 15(d), as applicable, of the Securities Exchange Act of
1934) as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"). Based on such evaluation, such
officers have concluded that, as of the Evaluation Date, our disclosure
controls and procedures are effective in alerting our management on a
timely basis to material information required to be disclosed in our
reports filed under the Exchange Act.
36
(b.) There have been no significant changes in our internal controls or in other
factors that could significantly affect such controls since the Evaluation
Date.
37
PART II-OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time the Company is subject to legal proceedings and claims in
the ordinary course of business, including claims of alleged infringement of
trademarks, copyrights and other intellectual property rights.
In May 2002, MindArrow moved its corporate offices from Aliso Viejo to
Huntington Beach, California and is currently in default on the Aliso Viejo
lease. The Company is in litigation with the landlord and has accordingly
accrued for back rent and estimated settlement costs totaling approximately
$803,000 included in "Accounts payable and accrued liabilities" on the
accompanying consolidated balance sheet.
The Company is also a defendant in a lawsuit filed by Sunrise International
Leasing Corporation with the District Court, Fourth Judicial District, in the
County of Hennepin, Minnesota, on May 6, 2002, for default of payment and breach
of lease on two equipment leases. This dispute has been settled, the equipment
has been returned and we agreed to pay a net of $137,000 to Sunrise in
settlement, the full amount of which has been included in accounts payable and
accrued liabilities at December 31, 2002.
The Company is also a defendant in a lawsuit filed by EMC Corporation with
the Orange County Superior Court on July 11, 2002, for failure of payment on
equipment. The plaintiff is seeking monetary damages in the amount of
$117,526. The Company anticipates settling for damages, the full amount of
which have been included with accounts payable and accrued liabilities at
December 31, 2002
In 1999 and 2000, MindArrow was a victim of a fraud perpetrated by its
former transfer agent and her accomplice, who were convicted of felonies arising
from the scheme. At sentencing hearings in April and July 2002, the perpetrators
were ordered to pay to the Company $10.9 million in restitution in addition to
amounts already received. In addition, the Company continues to pursue recovery
of the loss it incurred as a result of the fraud perpetrated against the
Company, and the Audit Committee of the Company's Board of Directors has
retained special counsel to assist it in pursuing potential sources of recovery.
Eight individuals and twelve entities have been named as defendants in lawsuits
initiated by the Company. The Company cannot predict whether or when it will
obtain any additional recovery. Because of the uncertainties surrounding
recoveries, the Company will not record the impact of recoveries until amounts
or assets are received.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the quarter ended December 31, 2002, the Company issued the
following equity securities in transactions not registered under the Securities
Act:
In December 2002 the Company issued 175,000 shares of Common Stock and
performance warrants to acquire up to 17,500 additional shares of Common Stock
in connection with the acquisition of AGEA Corp. The securities were issued to
the shareholders of AGEA. The performance warrants will vest if sales of AGEA
products by the Company fulfill certain net revenue targets through December 31,
2003.
In December 2002, the Company issued 179,170 warrants to purchase common
stock at $3 per share, and reduced the price of 179,170 previously issued
warrants to $3 per share, in connection with amendments made to bridge notes.
In October 2002, the Company issued 25,000 shares of Common Stock and
aggregate warrants to purchase up to 28,750 shares of Common Stock for an
aggregate cash amount of $100,000, pursuant to financing commitments previously
entered into by the Company with East-West Capital Associates, Inc. and
East-West Venture Group, LLC.
38
All of the foregoing issuances were without registration under the
Securities Act in reliance upon the exemption from the registration requirements
of the Securities Act set forth in Section 4(2) of the Securities Act and
Regulation D thereunder.
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 October 15, 2002, the Registrant filed a Report on Form 8-K disclosing
under Item 2 the combination of MindArrow Systems, Inc. and Category 5
Technologies, Inc. pursuant to an Agreement and Plan of Merger dated as of July
12, 2002. The following financial statements were filed as part of such Report:
1. Consolidated combined balance sheets of Category 5 and subsidiaries as of
June 30, 2002 and 2001 and related consolidated combined statements of
operations, equity, and cash flows for the year ended June 30, 2002, the six
months ended June 30, 2001 and the year ended December 31, 2000.
2. Pro forma combined balance sheet of MindArrow and Category 5 as of June
30, 2002, and pro forma combined statement of operations for the twelve months
ended June 30, 2002.
SIGNATURES, AND CERTIFICATIONS OF THE CHIEF EXECUTIVE OFFICER AND THE CHIEF
FINANCIAL OFFICER OF THE COMPANY.
The following pages include the Signatures page for this Form 10-Q, and two
separate Certifications of the Chief Executive Officer (CEO) and the Chief
Financial Officer (CFO) of the company.
The first form of Certification is required by Rule 13a-14 under the Securities
Exchange Act of 1934 (the Exchange Act) in accord with Section 302 of the
Sarbanes-Oxley Act of 2002 (the Section 302 Certification). The Section 302
Certification includes references to an evaluation of the effectiveness of the
design and operation of the company's "disclosure controls and procedures" and
its "internal controls and procedures for financial reporting". Item 4 of Part I
of this Quarterly Report presents the conclusions of the CEO and the CFO about
the effectiveness of such controls based on and as of the date of such
evaluation (relating to Item 4 of the Section 302 Certification), and contains
additional information concerning disclosures to the company's Audit Committee
and independent auditors with regard to deficiencies in internal controls and
fraud (Item 5 of the Section 302 Certification) and related matters (Item 6 of
the Section 302 Certification).
The second form of Certification is required by section 1350 of chapter 63 of
title 18 of the United States Code.
39
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.
Avalon Digital Marketing Systems, Inc.
--------------------------------------
(Registrant)
Date: February 19, 2003 /s/ ROBERT I. WEBBER
-------------------------------------
Robert I. Webber
Chief Executive Officer and President
(Principal Executive Officer)
Date: February 19, 2003 /s/ MICHAEL R. FRIEDL
--------------------------------------
Michael R. Friedl
Chief Financial Officer, Secretary,
and Treasurer (Principal Financial
and Accounting Officer)
40
CERTIFICATION
I, Robert I. Webber, certify that:
1) I have reviewed this quarterly report on Form 10-Q of Avalon Digital
Marketing Systems, Inc.;
2) Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4) The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5) The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6) The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Dated: February 19, 2003, by /s/ ROBERT I. WEBBER
-------------------------------
Robert I. Webber
Chief Executive Officer and
President (Principal Executive
Officer)
41
CERTIFICATION
I, Michael R. Friedl, certify that:
1) I have reviewed this quarterly report on Form 10-Q of Avalon Digital
Marketing Systems, Inc.;
2) Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4) The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5) The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6) The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Dated: February 19, 2003, by /s/ MICHAEL R. FRIEDL
--------------------------------------
Michael R. Friedl
Chief Financial Officer, Secretary,
and Treasurer (Principal Financial
and Accounting Officer)
42
CERTIFICATION (continued)
Each of the undersigned hereby certifies, for the purposes of section 1350 of
chapter 63 of title 18 of the United States Code, in his capacity as an officer
of Avalon Digital Marketing Systems, Inc. ("Avalon"), that, to his knowledge,
the Quarterly Report of Avalon on Form 10-Q for the period ended December 31,
2002, fully complies with the requirements of Section 13(a) or 15(d), as
applicable, of the Securities Exchange Act of 1934 and that the information
contained in such report fairly presents, in all material respects, the
financial condition and results of operation of Avalon.
Date: February 19, 2003 /s/ ROBERT I. WEBBER
-------------------------------------
Robert I. Webber
Chief Executive Officer and President (Principal
Executive Officer)
Date: February 19, 2003 /s/ MICHAEL R. FRIEDL
--------------------------------------
Michael R. Friedl
Chief Financial Officer, Secretary, and
Treasurer (Principal Financial and Accounting
Officer)
43