UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 For the quarterly period ended: March 31, 2005
[_] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
Commission file number: 1-9263
DEFENSE TECHNOLOGY SYSTEMS, INC.
-------------------------------------------
(Exact name of small business issuer as specified in its charter)
Delaware 11-2816128
------------------------ ----------------
(State or other jurisdiction of incorporation or (I.R.S. Employer
organization) Identification No.)
275K Marcus
Blvd.
Hauppauge, NY 11788
------------------------------------------------------------
(Address of principal executive offices, including zip code)
Registrant's Telephone No., including area code: (631) 951-4000
Check 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 issuer's classes of common
stock, as of the last practicable date:
Common stock, $.001 par value 38,791,034
-------------------------------------------------------------------------------
Class Number of shares outstanding at May 23, 2005
Transitional Small Business Disclosure Format: Yes ____ No ___X___
1
DEFENSE TECHNOLOGY SYSTEMS, INC.
INDEX
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2005
and June 30, 2004............................................ 1
Condensed Consolidated Statements of Operations for the
three months ended March 31, 2005 and 2004................... 2
Condensed Consolidated Statements of Operations for the
nine months ended March 31, 2005 and 2004.................... 3
Condensed Consolidated Statements of Cash Flows for the
nine months ended March 31, 2005 and 2004.................... 4
Notes to Condensed Consolidated Financial Statements......... 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................... 16
Item 3. Controls and Procedures........................................... 22
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................ 23
Item 2. Changes in Securities ....................................... 23
Item 3. Defaults Upon Senior Securities.............................. 23
Item 4. Submission of Matters to a Vote of Security Holders.......... 23
Item 5. Other Information............................................ 23
Item 6. Exhibits and Reports on Form 8-K............................. 23
SIGNATURES ............................................................... 24
Exhibit 31 Section 302 Certifications
Exhibit 32 Section 906 Certifications
ITEM 1 FINANCIAL STATEMENTS
DEFENSE TECHNOLOGY SYSTEMS, INC.
Condensed Consolidated Balance Sheet
March 31, 2005
(Unaudited) June 30, 2004*
------------ --------------
ASSETS
CURRENT ASSETS:
Cash $ 17,232 $ 3,920
Accounts receivable 79,661 87,745
Prepaid expenses 2,152 1,500
------------ ------------
TOTAL CURRENT ASSETS 99,045 93,165
Property and equipment, net 12,035 15,202
Security deposits 12,119 12,119
Deferred acquisition costs 40,210 --
------------ ------------
TOTAL ASSETS $ 163,409 $ 120,486
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable $ 1,586,142 $ 2,932,351
Accrued expenses and other 1,118,775 1,008,417
Notes payable-related parties, current 1,025,025 160,738
Bankruptcy distributions payable 308,053 292,120
Secured subordinated debentures 92,633 92,633
------------ ------------
TOTAL CURRENT LIABILITIES 4,130,628 4,486,259
Note payable-related parties 95,850 381,087
Accrued dividends on preferred stock 119,411 62,189
------------ ------------
TOTAL LIABILITIES 4,345,889 4,929,535
------------ ------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' DEFICIT:
8% Series B Convertible Preferred
Stock, $.01 par value, stated value
$1,000 per share; Redeemable at
$1,250 per share; authorized, 3,000
a shares; 1,192 and 1,559 shares
issued and outstanding at March 31,
2005 and June 30, 2004,
respectively 1,192,000 1,559,000
Common stock, $.001 par value;
40,000,000 shares authorized,
38,791,034 and 34,781,755 issued
and outstanding at March 31, 2005
and June 30, 2004, respectively 38,791 34,782
Additional paid-in capital 8,574,743 8,028,629
Accumulated deficit (13,988,014) (14,431,460)
------------ ------------
TOTAL STOCKHOLDERS' DEFICIT (4,182,480) (4,809,049)
------------ ------------
TOTAL LIABILITIES AND
STOCKHOLDERS' DEFICIT $ 163,409 $ 120,486
============ ============
*Condensed from audited financial statements
See accompanying notes to condensed consolidated financial statements.
1
DEFENSE TECHNOLOGY SYSTEMS, INC.
Unaudited Condensed Consolidated Statements of Operations
Three Months Ended March 31,
2004
2005 (Restated)
------------ ------------
Net sales $ 145,270 $ 304,536
Cost of goods sold 90,259 237,554
------------ ------------
Gross profit 55,011 66,982
------------ ------------
Expenses:
Selling, general and administrative expenses 172,449 677,104
Interest expense 50,613 109,834
------------ ------------
223,062 786,938
------------ ------------
(168,051) (719,956)
------------ ------------
Other income (expense):
Commission income -- 6,019
Gain on settlement and write off of debt 447,564 244,857
Litigation loss (150,000) --
------------ ------------
Total other income, net 297,564 250,876
------------ ------------
Net income (loss) 129,513 (469,080)
Accrued dividends on preferred stock 23,512 31,095
------------ ------------
Net income (loss) attributable to common
shareholders $ 106,001 $ (500,175)
============ ============
Earnings (loss) per share attributable to
common shareholders:
Basic and diluted $ 0.00 $ (0.01)
============ ============
Weighted average common shares outstanding:
Basic 38,791,034 38,118,011
============ ============
Diluted 40,000,000 38,118,011
============ ============
2
See accompanying notes to condensed consolidated financial statements.
DEFENSE TECHNOLOGY SYSTEMS, INC.
Unaudited Condensed Consolidated Statements of Operations
Nine Months Ended March 31,
2004
2005 (Restated)
------------ ------------
Net sales $ 757,221 $ 542,538
Cost of goods sold 577,540 383,797
------------ ------------
Gross profit 179,681 158,741
------------ ------------
Expenses:
Selling, general and administrative expenses 524,344 3,536,375
Interest expense 294,128 356,729
------------ ------------
818,472 3,893,104
------------ ------------
(638,791) (3,734,363)
------------ ------------
Other income (expense):
Commission income 4,864 93,206
Gain on settlement and write off of debt 1,303,685 520,551
Other income 200 --
Litigation loss (150,000) --
------------ ------------
Total other income, net 1,158,749 613,757
------------ ------------
Net income (loss) 519,958 (3,120,606)
Accrued dividends on preferred stock 76,512 94,379
------------ ------------
Net income (loss) attributable to common
shareholders $ 443,446 $ (3,214,985)
============ ============
Earnings (loss) per share attributable to common shareholders:
Basic and diluted $ 0.01 $ (0.09)
============ ============
Weighted average common shares outstanding:
Basic 37,466,329 35,923,237
============ ============
Diluted 40,000,000 35,923,237
============ ============
See accompanying notes to condensed consolidated financial statements.
3
DEFENSE TECHNOLOGY SYSTEMS, INC.
Unaudited Condensed Consolidated Statements of Cash Flows
Nine Months Ended March 31,
2005 2004
----------- -----------
(Restated)
Cash flows from operating activities:
Net income (loss) $ 519,958 $(3,120,606)
Adjustments to reconcile net income to cash
provided (used) by operating activities:
Depreciation and amortization 3,167 343
Amortization of note and bond discounts 4,050 1,530
Gain on settlement and write-off of debt (1,303,685) (520,551)
Interest component of beneficial conversion
feature of convertible loans 153,333 66,333
Common stock issued for consulting services -- 418,000
Stock options granted for consulting services -- 2,118,165
Common stock issued for officer compensation 236,500
Changes in current assets and liabilities:
Accounts receivable 8,084 (62,763)
Prepaid expenses and other current assets (652) (5,061)
Accrued interest on payable to
asset-based lender -- 36,407
Accounts payable and accrued liabilities 78,334 396,257
Accrued interest on bankruptcy liability 15,933 16,477
----------- -----------
Cash used by operating activities (521,478) (418,969)
----------- -----------
Cash flows from investing activities:
Fixed asset acquisitions -- (16,601)
Security deposits paid -- (12,119)
Deferred acquisition costs (40,210) --
----------- -----------
Cash used in investing activities (40,210) (28,720)
----------- -----------
Cash flows from financing activities:
Proceeds from notes and loans 650,000 215,000
Principal repayments on loans (75,000) (9,000)
Proceeds from stock subscriptions -- 100,000
Common stock sales -- 250,000
Borrowings from asset-based lender -- 203,565
Repayment of amounts due asset-based lender -- (312,572)
----------- -----------
Cash provided by financing activities 575,000 446,993
----------- -----------
Increase (decrease) in cash 13,312 (696)
Cash, beginning of period 3,920 11,888
----------- -----------
Cash, end of period $ 17,232 $ 11,192
=========== ===========
Supplemental disclosure of cash flow information:
Cash paid for income taxes $ 0 $ 0
=========== ===========
Cash paid for interest $ 6,504 $ 0
=========== ===========
Non-Cash Investing and Financing Activities:
Dividends accrued on preferred stock $ 76,512 $ 94,379
=========== ===========
Conversion of preferred stock and accrued
dividends to common stock $ 386,290 $ 45,505
=========== ===========
Conversion of notes payable and accrued
interest and dividends to common stock $ -- $ 677,555
=========== ===========
Conversion of trade payable (2005) and accrued
liability (2004) to shares of common stock $ 10,500 $ 183,423
=========== ===========
Accrued liabilities settled by cash payment
from shareholder $ -- $ 281,985
=========== ===========
See accompanying notes to condensed consolidated financial statements.
4
DEFENSE TECHNOLOGY SYSTEMS, INC.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1: Summary of Significant Accounting Policies
(A) - Unaudited Interim Financial Information
The unaudited condensed consolidated interim financial statements, and
accompanying notes included herein, have been prepared by Defense Technology
Systems, Inc., (the "Company"), pursuant to the rules and regulations of the
Securities and Exchange Commission ("SEC") and reflect all adjustments which are
of a normal recurring nature and which, in the opinion of management, are
necessary for the fair statement of the results of the three and nine months
ended March 31, 2005 and 2004. Certain information and footnote disclosures have
been condensed or omitted pursuant to such rules and regulations. The results
for the current interim periods are not necessarily indicative of the results
for the full year. These consolidated financial statements should be read in
conjunction with the consolidated financial statements and the notes thereto in
the Company's latest annual report filed with the SEC on Form 10-KSB for the
year ended June 30, 2004. The Company has restated the results for the three and
nine months ended March 31, 2004 as a result of a gain attributable to the
write-off of debt and a correction in the calculation of stock-based
compensation related to option grants.
The accompanying financial statements include the accounts of the Company and
its wholly-owned subsidiaries on a consolidated basis. All significant
intercompany accounts and transactions have been eliminated.
(B) - Nature of Business
The Company was incorporated in Delaware on January 7, 1998 as DataWorld
Solutions, Inc. and commenced operations on March 7, 1998. The Company became
publicly traded as a result of a reverse merger with Vertex Computer Cable &
Products, Inc. ("Vertex") in December 1998. Previously in January 1998, Vertex
secured certain financing that made effective Vertex's second amended plan of
organization under Chapter 11 of the U.S. Bankruptcy Act. In June 2004, the
Company changed its name to Defense Technology Systems. The Company consists of
two operating divisions: DWS Manufacturing is a specialty assembler of
electronic cable assemblies used in data systems and is also a distributor of
cabling systems, components and cable management solutions; DWS Defense Systems
is a distributor and integrator of specialized security products. Both divisions
operate in one business segment as contemplated by generally accepted accounting
principles.
(C) - Use of Estimates
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management makes estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements, as well as the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
5
(D) Adjustment of Previously Reported Quarterly Results
On July 2, 2004, the Company entered into an agreement to acquire a patent from
GEORAL International, Ltd. ("GEORAL"). In anticipation of acquiring the patent,
amortization expense of $6,261 was taken in each of the first two fiscal
quarters of 2005. As discussed in Note 3 below, consummation of the acquisition
of the patent never occurred; consequently, the amortization expense has been
reversed. Also, the cancellation of shares held in escrow related to such
transaction had no effect on previously reported earnings per share.
In addition, as previously reported, the results for the 2004 periods have been
restated. (See Notes 1-A and 1-I).
(E) - Revenue Recognition
Revenue from data and security product sales is recognized when the product is
shipped as title to the product passes at that point to the customer and the
Company has no further obligations with respect to the product.
(F) - Net Income (Loss) Per Basic and Diluted Common Shares
Net income (loss) per basic and diluted common shares is computed on the basis
of the weighted average number of basic and diluted common shares outstanding
during the period. Only the weighted average number of shares of common stock
actually outstanding is used to compute basic income (loss) per common share.
For the diluted amounts, the effect of outstanding options and warrants and
convertible stock and debt instruments is not considered during loss periods as
their effect would be anti-dilutive. The effect of outstanding options and
warrants is considered during periods when net income is earned when their
exercise price is below the average market price of the common stock during the
period. For the three and nine months ended March 31, 2005, options and warrants
to purchase 3,800,000 and 160,000 shares of common stock, respectively, have
been excluded from the calculation of diluted income per share for these
reasons. (See Note 1-J).
For the three and nine months ended March 31, 2005, outstanding convertible
preferred stock and debt enter into the calculation of diluted net income per
share on a limited basis due to two limitations as follows: (i) the convertible
stock agreement limits the preferred shareholder's common stock holdings to 9.9
percent of the total outstanding common shares; and (ii) the Company's current
common stock authorization is limited to 40 million shares. As a practical
matter, the amount of common shares issuable under outstanding convertible
instruments is so large, the applicable limitation is the 40 million share
authorization. For the three and nine months ended March 31, 2005, assuming
maximum dilution to 40 million shares, earnings per share would be unchanged at
$0.00 and $0.01, respectively.
6
Loss per share for the three and nine months ended March 31, 2004 was restated
due to the inclusion of gains of $14,622 and $194,078, respectively,
attributable to the write-off of certain statutorily barred liabilities, and an
additional expense of $153,000 related to the correction of an error in the
Black-Scholes formula application used to determine the value of stock options
granted to consultants. (See Note 1-H). Additionally, the weighted average
number of outstanding shares of common stock for such period was corrected for
the reduction of 1.2 million shares as disclosed in the Company's annual report
on Form 10-KSB for the year ended June 30, 2004. Such correction had no effect
on the per share results.
(G) - Income Taxes
The Company records its income taxes in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", which
requires the recognition of deferred tax assets and liabilities for the future
tax consequences of temporary differences between the financial statement and
tax basis carrying amounts of assets and liabilities. For interim periods, the
estimated effective annual tax rate is applied to year-to-date income or loss.
(H) - Property, Equipment and Depreciation
Property and equipment at March 31, 2005, are stated at cost less accumulated
depreciation and amortization computed on a straight-line basis over the
estimated useful lives of the respective assets, which range from three to five
years. Leasehold improvements are amortized over the useful life of the
improvement, or the lease term, whichever is less. Expenditures for maintenance,
repairs and betterments, which do not materially extend the useful lives of the
assets, are charged to operations as incurred. The cost and related accumulated
depreciation of assets retired or sold are removed from the respective accounts
and any gain or loss is recognized in operations.
(I) - Write-Off of Statutorily Barred Liabilities
In the fourth quarter of fiscal 2004 the Company was advised by its counsel that
pursuant to applicable law, certain of its trade obligations are statutorily
unenforceable after periods of four or six years, as applicable, from the date
of their incurrence. Accordingly the Company has written off $447,564 and
$1,303,685 of accounts payable which amount is reported as gain on settlement
and write-off of debt for the three and nine months ended March 31, 2005,
respectively. Also, the Company has restated the results for the three and nine
months ended March 31, 2004 to reflect $14,622 and $194,078, respectively, of
additional write-offs applicable to such periods.
(J) - Stock-Based Compensation
The Company accounts for stock-based compensation pursuant to SFAS Nos. 123 and
148. These pronouncements allow companies to either expense the estimated fair
value of all stock options or, as the Company has elected with respect to
options granted to employees and directors, to continue to follow the intrinsic
value method previously set forth in Accounting Principles Board ("APB") Opinion
No. 25, but disclose the pro forma effects on net income (loss) had the fair
value of those options been expensed. (See Note 1-L).
7
In October 2004, the Board of Directors of the Company granted the Company's CEO
and CFO options to purchase 500,000 shares of common stock each at an exercise
price of $0.154 per share, which was calculated at 125 percent of the
weighted-average closing price of the stock for the four weeks following the
grant date. The options vest six months from the grant date and expire five
years from the grant date. The fair value of these options at the grant date
using the Black-Scholes pricing model was $139,400, or $0.1394 per share.
The determination of the fair value of these options was based on the following
elements:
Stock price volatility: 328%
Annual interest rate: 2.07%
Dividends paid on common stock: $ 0.00
Estimated useful life of options: 3 years
On March 15, 2005, the Board of Directors of the Company granted the Company's
CEO and CFO options to purchase 500,000 shares of common stock each at an
exercise price of $0.143 per share, which was calculated at 125 percent of the
weighted-average closing price of the stock for the four weeks following the
grant date. The options vest six months from the grant date and expire five
years from the date of the grant. The fair value of these options at the grant
date using the Black-Scholes pricing model was $123,700, or $0.1237 per share.
(See Note 9).
The determination of the fair value of these options was based on the following
elements:
Stock price volatility: 297%
Annual interest rate: 2.55%
Dividends paid on common stock: $0.00
Estimated useful life of options: 3 years
The following is the pro forma effect of these option grants on the results for
the three and nine months ended March 31, 2005:
Three months Nine months
ended ended
March 31, 2005 March 31, 2005
-------------- --------------
Net income as reported: $ 129,513 $ 519,958
---------- ----------
Pro forma net income: $ 53,103 $ 386,103
========== ==========
Earnings per share as reported: $ 0.00 $ 0.01
------ ------
Pro forma earnings per share $ 0.00 $ 0.01
====== ======
8
Both sets of options in 2005 were freestanding grants awarded by the Board of
Directors. They were not part of any stock option plan. There were no
employee options which vested or were outstanding during the 2004 periods.
(K)- Fair Value of Financial Instruments
The Company has estimated the fair value for financial instruments using
available market information and other valuation methodologies in accordance
with Financial Accounting Standards No. 107, "Disclosures about Fair Value of
Financial Instruments." Management of the Company believes that the fair value
of financial instruments, consisting of cash, accounts receivable, accounts
payable, notes payable, long-term debt and subordinated debentures approximate
carrying value for assets and is undeterminable for liabilities.
(L) - Recent Accounting Pronouncements
In September 2004, the Financial Accounting Standards Board (FASB) issued FASB
Staff Position (FSP) Emerging Issues Task Force (EITF) Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments",
which delays the effective date for the recognition and measurement guidance in
EITF Issue No. 03-1. In addition, the FASB has issued a proposed FSP to consider
whether further application guidance is necessary for securities analyzed for
impairment under EITF Issue No. 03-1. We do not believe the adoption of EITF
Issue 03-1, when it does become effective, will have a material impact on our
financial statements.
In November 2004, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 151, Inventory Costs, which clarifies the accounting for abnormal
amounts of idle facility expense, freight, handling costs, and wasted material.
SFAS No. 151 will be effective for inventory costs incurred during fiscal years
beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151
will have a material impact on our financial statements.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary
Assets, which eliminates the exception for non-monetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
non-monetary assets that do not have commercial substance. SFAS No. 153 will be
effective for non-monetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a
material impact on our financial statements.
In December 2004, the Financial Accounting Standards Board ("FASB") issued a
revised SFAS No. 123, "Share-Based Payment". The revised Statement requires
companies to expense the value of employee stock options and similar awards and
applies to all non-vested awards granted prior to the effective date, all awards
granted after the required effective date and to awards modified, repurchased or
cancelled after that date. This Statement, as modified by an SEC rule in April
2005, will be effective for the Company beginning in fiscal 2007, with
application expected to be prospective; adoption of SFAS 123(R) will have an
effect on the Company's financial statements, the effect of which cannot be
presently estimated as it will depend on many factors, including future option
grants.
9
In March 2005, the SEC issued Staff Accounting Bulletin (SAB) 107, Share-Based
Payment, which expresses views of the SEC staff about the application of SFAS
123(R). The Company cannot presently determine how the guidance in SAB 107 will
affect its application of SFAS 123(R).
NOTE 2: GOING CONCERN
The Company has current assets of $99,045 (including $17,232 in cash) compared
with current liabilities of $4,130,628, resulting in a working capital deficit
of $4,031,583 as of March 31, 2005. Although the Company had net income of
$129,513 and $519,958 for the three and nine months ended March 31, 2005,
respectively, the income was entirely attributable to debt settlements and
write-offs. Additionally, the Company has incurred significant net losses in
each of the three preceding fiscal years and has a stockholder's equity deficit
of $4,182,480 at March 31, 2005. Such deficits and recurring losses raise
questions about the Company's ability to continue as a going concern.
Additionally, the Company's continuation is also threatened by the existence of
numerous judgments on trade payables, defaults on various secured indebtedness
and delinquencies on certain tax obligations. These conditions could result in
the seizure of Company assets and/or its being forced into bankruptcy. (See
Notes 4 and 8).
The Company is currently implementing a business plan that it believes will
strengthen the balance sheet, increase revenue and return it to profitability.
The plan involves a series of initiatives. The Company is seeking to restructure
its liabilities by negotiating with secured and unsecured creditors and vendors
for forgiveness of certain outstanding debt, or to exchange debt for equity. The
Company has also acquired a majority interest of a company in its industry. (See
Note 9).
In the fourth quarter of fiscal 2004 the Company was advised by its counsel that
pursuant to applicable law, certain of its trade obligations are statutorily
unenforceable after periods of four or six years, as applicable, from the date
of their incurrence. Accordingly the Company has written off $447,564 and
$1,303,685 of accounts payable which amount is reported as settlement and
write-off of debt for the three and nine months ended March 31, 2005,
respectively. Additionally, the Company has restated its results for the three
and nine months ended March 31, 2004 to reflect gains of $14,622 and $194,078,
respectively, attributable to the write-off of debt.
If management is not successful in implementing the initiatives discussed in the
preceding paragraphs, it could result in the severe curtailment of the Company's
operations and/or the seizure of its assets and/or its being forced into
bankruptcy. There is no assurance that the Company will be successful in
accomplishing its objectives. The accompanying financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
10
NOTE 3: TERMINATION OF AGREEMENT TO ACQUIRE PATENT AND RELATED ACCOUNTING
ADJUSTMENTS
On July 2, 2004, the Company entered into an agreement with GEORAL to acquire a
patent (US Patent No. 6,472,984) for the GIL 2001 Security Doors. The patent was
valued at $413,250 representing the value of the one million shares of common
stock placed in escrow in consideration of the purchase price plus the
professional fees incurred in the transaction. The patent expires on January 30,
2021. The acquisition agreement included an option for the seller to re-purchase
the patent on the fifth anniversary of the agreement at a cost equal to the
value of common stock to be received in consideration of the purchase ($393,000)
or by returning to the Company one million shares of common stock.
In anticipation of acquiring the patent and based on an interpretation of the
agreement that its effective date was July 2, 2004, the Company commenced
amortization of the patent over its remaining useful life. Accordingly, the
Company had recorded amortization expense of $6,261 in each of the first two
quarters of this fiscal year. During this period, the documents necessary to
affect a transfer of the patent were never delivered to the Company despite
attempts to obtain them from GEORAL. In the third quarter, additional attempts
by the Company's counsel to obtain the patent were also unsuccessful.
As a result, the Company determined that GEORAL's failure to perform pursuant to
the agreement constituted a material breach, effectively voiding the agreement
and the one million shares of common stock previously held in escrow were
returned to the Company and cancelled. The Company has made the following
adjustments to the previously reported quarterly results for fiscal 2005:
o Amortization expense of $6,261 per quarter has been reversed for
the periods ended September 30, 2004 and December 31, 2004. Total
amortization expense reversed for the six months was $12,522.
o Previously capitalized legal fees of $20,250 have been expensed
in the current quarter ended March 31, 2005.
None of these changes had any effect on previously reported per share results.
NOTE 4: NOTES PAYABLE - RELATED PARTIES
Notes payable-related parties, as of March 31, 2005, consists of the
following:
Current Long-Term Total
---------- --------- ----------
Augustine-revolving credit line $ 535,000 $ -- $ 535,000
Augustine-term note payable - 95,850 95,850
Rosenthal & Rosenthal 250,000 250,000
NewMarket Technology 190,000 -- 190,000
Shareholder loan 50,025 -- 50,025
---------- --------- ----------
$1,025,025 $ 95,850 $1,120,875
========== ========= ==========
11
For the nine months ended March 31, 2005, the Company's borrowings from
Augustine Capital Management ("Augustine") required the recognition of
approximately $153,333 of additional interest expense related to the lender's
right to convert the outstanding balance of their note payable into shares of
common stock at a 25% discount from market. In November 2004, the Company
borrowed $35,000 under the terms of this convertible note facility, and in
December 2004 borrowed an additional $100,000, bringing the total amount
outstanding under this facility to $535,000 as of March 31, 2005, all of which
is due on August 28, 2005. With the lender's permission, the Company has
exceeded the stated credit limit of $500,000 applicable to this facility. Any
future borrowings under this agreement either allowed in excess of the line or
subsequent to repayments of outstanding amounts will result in the recognition
of additional interest expense related to this beneficial conversion feature.
The balance of the unamortized discount on the Augustine term note payable, due
March 1, 2006, was $4,950 as of March 31, 2005.
The note payable to Rosenthal & Rosenthal ("R & R") was executed in June 2004
and restructured existing secured debt. The new note, also secured by
receivables and other assets, initially called for payment of interest only at
prime plus two percent through December 2004, and repayment of principal in 42
equal payments plus interest commencing in January 2005. In April 2005, the
terms of the note were amended. As amended, the note requires payment of
interest only through June 2005, and repayment of principal in 42 equal payments
plus interest commencing in July 2005. As consideration for the extension, the
Company agreed to issue to R & R 300,000 shares of common stock by April 30,
2005. The Company is in the process of issuing such shares and has received a
verbal waiver from R & R applicable to such delay. However, the Company is
currently in default on the interest payments due in calendar 2005 under this
note. Under such default, Rosenthal & Rosenthal's security interest, which
constitutes a priority over other liens, allows them to proceed upon the
collateral. As a result of the interest default, the entire principal balance
has been classified as current at March 31, 2005.
In January 2005, the Company borrowed $95,000 from NewMarket Technology, Inc.,
("NewMarket"), pursuant to a promissory term note, bearing interest at 6% per
annum. Principal and interest are due in one year. In February 2005, the Company
borrowed an additional $95,000 from NewMarket, pursuant to a second promissory
term note, bearing interest at 6% per annum. Principal and interest are due in
one year. (See Note 9).
As of March 31, 2005, interest accrued on all notes payable and included in
accrued expenses was $50,222. Related party interest expense for the three and
nine month period ended March 31, 2005 was $21,163 and $194,885, respectively.
Related party interest expense for the three and nine month periods ended
March 31, 2004 was $16,758 and $88,104, respectively.
NOTE 5: OTHER RELATED PARTY TRANSACTIONS
As of March 31, 2005, approximately $209,000 of accrued compensation, due the
Company's Chief Executive Officer and Chief Financial Officer, was included in
accrued expenses on the Condensed Consolidated Balance Sheet.
NOTE 6: INCOME TAXES
For the 2004 periods, no income taxes were provided due to losses incurred. For
the 2005 periods, no income taxes were provided due to the Company's tax loss
carry-forwards. As of March 31, 2005, the Company has net operating loss
carry-forwards totaling approximately $18,000,000, expiring at various dates
through fiscal 2023. The Company estimates an effective tax rate of zero for the
fiscal year ending June 30, 2005, based on utilization of its net operating loss
carry-forwards.
12
NOTE 7: CAPITAL STOCK TRANSACTIONS
(A) Preferred Stock Conversions
In July 2004, as per the terms of the 8% Convertible Preferred Stock agreement,
Augustine converted 200 shares of preferred stock with a stated value of
$200,000 plus accrued dividends of $8,153 into 1,200,883 shares of common stock
based on a conversion price of $0.173 per share.
In September 2004, Augustine, converted 38 shares of preferred stock with a
stated value of $38,000 plus accrued dividends of $2,199, into 788,216 shares of
common stock based on a conversion price of $0.051 per share.
In November 2004, Augustine converted 105 shares of preferred stock with a
stated value of $105,000 plus accrued dividends of $7,249 into 2,200,961 shares
of common stock based on a conversion price of $0.051 per share.
Additionally, in November 2004, Augustine, converted 24 shares of preferred
stock with a stated value of $24,000 plus accrued dividends of $1,689, into
508,693 shares of common stock based on a conversion price of $0.051 per share.
(B) Return of Shares by Consultant; Cancellation of Option/Consulting Agreement
In October 2004, a former consultant to the Company returned 400,000 shares of
common stock acquired pursuant to a consulting agreement together with 400,000
shares he had personally acquired to the Company's treasury. These shares were
valued at $88,800 or $0.111 per share, the weighted-average closing market price
for the two days before and after the date of the transaction. By resolution of
the Board of Directors, these shares were cancelled and became equivalent to
unissued shares.
Additionally, as a result of the termination of the above-referenced consulting
agreement, options to purchase 1,200,000 shares of common stock at various
prices were cancelled.
(C) Other Capital Stock Transactions
In November 2004, a vendor converted a trade payable in the amount of $10,500
into 110,526 shares of common stock valued at $10,500 or $0.095 per share.
13
Following is a schedule of changes in shareholders' deficit for the nine months
ended March 31, 2005:
Preferred Common Treasury Add'l
Stock Common Stock Treasury Stock Paid-In Accumulated Stockholder's
Amount Shares Amount Shares Amount Capital Deficit Deficit
---------- ----------- ----------- ---------- -------- ----------- ------------- --------------
Balance July 1, 2004 $1,559,000 34,781,755 $34,782 $ 8,028,629 ($14,431,460) ($4,809,049)
Conversion of
preferred stock
to common stock (367,000) 4,698,753 4,699 381,591 19,290
Value of beneficial
conversion
feature of convertible
loans 153,333 153,333
Return of common
shares to treasury by
consultant 800,000 (88,800) 88,800 --
Cancellation of
treasury stock (800,000) (800) (800,000) 88,800 (88,000) --
Conversion of trade
payable
to common stock 110,526 110 10,390 10,500
Accrued dividends on 8%
preferred stock (76,512) (76,512)
Net income for nine
months
ended March 31, 2005 519,958 519,958
---------- ----------- ----------- ---------- --------- ----------- ------------ --------------
Balance March 31, 2005 $1,192,000 38,791,034 $38,791 -- $ 0 $ 8,574,743 ($13,988,014) ($4,182,480)
========== =========== =========== ========== ========= =========== ============ ==============
NOTE 8: COMMITMENTS AND CONTINGENCIES
(A) Litigation matters
The Company is a party to legal matters arising in the general course of
business. During fiscal 2001 and subsequently, the Company decided not to
dispute litigation with suppliers and other creditors for collection of amounts
owed to them. As a result, as of March 31, 2005, the Company had outstanding
judgments amounting to $527,051. This balance is included in accounts payable in
the accompanying condensed consolidated financial statements.
In September 2000, the Company began to negotiate a potential merger with
American Access Technologies ("AAT"), which resulted in a merger agreement being
signed in April 2001. In June 2001, the Company was notified by AAT that they
were unilaterally terminating the agreement claiming that the Company had
suffered material and adverse changes and that such change entitled AAT to
terminate the agreement. AAT then filed suit against the Company seeking
reimbursement of various incurred costs. The Company filed a counter suit
against AAT alleging wrongful termination. A non-jury trial took place in
February, 2005 and as a result, AAT was awarded approximately $94,000 plus
interest and legal fees. The Company has estimated the total of such amounts at
approximately $150,000, which total is included in accrued expenses in the
accompanying balance sheet at March 31, 2005. The Company is currently
negotiating with AAT in settlement of this matter.
14
(B) Default on debt obligations
The Company is currently in default on payments owed on its bankruptcy
distributions payable. This could result in the Company's creditors requesting
that the Company's Chapter 11 bankruptcy proceedings be re-opened. The Company
is presently accruing interest on this obligation at a rate of 8 percent
annually.
The Company has not made payments on its Secured Subordinated Debentures since
January, 2001, and may be declared in default. This obligation is secured by all
of the Company's assets, but is subordinate to all current and future loan
facilities. The Company is presently accruing interest on this obligation at a
rate of 8 percent annually.
The Company is currently in default on the interest payments due under the note
payable to Rosenthal & Rosenthal. Under such default, Rosenthal & Rosenthal's
security interest, which constitutes a priority over other liens, allows them to
proceed upon the collateral. (See Note 4)
(C) Sales and payroll tax delinquencies
As of August 2001, the Company failed to remit sales taxes that it collected
from customers in four states. As of March, 2005, approximately $317,000 was due
(inclusive of estimated penalties and interest). The Company is presently
negotiating a settlement of its approximately $296,000 liability with the State
of New York. Should negotiations not be successful, the Company could be forced
by the State of New York to cease operations.
As of March 2002, the Company failed to remit federal payroll taxes that it had
collected. In March 2004, the Company settled its federal payroll tax liability
which resulted in a forbearance installment plan whereby the Company is
obligated to make monthly payments of $3,000 plus a final payment of accrued
interest in full settlement of this liability. As of March 2005, approximately
$33,000 remained outstanding, which due to the nature of the obligation is
classified as a current liability.
(D) Customer and vendor concentrations
For the three and nine months ended March 31, 2005, two customers accounted for
42% and 14% of sales, and 43% and 22% of sales, respectively, and two vendors
accounted for 74% and 12% of purchases, and 55% and 32% of purchases,
respectively. For the three and nine months ended March 31, 2004, two customers
accounted for 54% and 26% of sales, and 39% and 27% of sales, respectively, and
one vendor accounted for 98% of purchases, and 87% of purchases, respectively.
Additionally, as of March 31, 2005, two customers accounted for 34% and 21%,
respectively, of accounts receivable. Loss of any of these major customers or
vendors would have a significant negative effect on the Company's business.
15
NOTE 9: ACQUISITION OF A MAJORITY INTEREST IN DIGITAL
COMPUTER INTEGRATION CORPORATION
In December 2004, the Company executed a letter of intent with NewMarket
Technology, Inc. ("NewMarket") to purchase NewMarket's 51 percent interest in
Digital Computer Integration Corp. ("DCI"). DCI is a security and defense
products manufacturer. In February 2005, the parties executed a definitive
agreement for this acquisition. The Company closed on this transaction in April
2005. The Company purchased the 51 percent interest by issuance to NewMarket of
a newly created Series C Preferred Stock with certain conversion features and a
newly created Series D Preferred Stock. The Series C and D shares are subject to
certain proxy rights held by the Company's two executive officers. Additionally,
Philip Verges, the CEO of NewMarket, has joined the Company's Board of
Directors, effective April 2005.
At the time of closing, certain due diligence disclosure information required to
be provided by the Company in the schedules to the acquisition agreement was
omitted and/or misstated. The incorrect/omitted information related to the
number of outstanding vested and unvested stock options, including the options
recently granted to the Company's Chief Executive Officer and Chief Financial
Officer. Upon discovery of the error/omission in the schedules, the Company
amended the schedules and obtained the consent of the counterparty to the
agreement, with the disclosure information as amended. At the same time, the
newly expanded Board of Directors ratified the previous grant of one million
stock options to the Company's two executive officers.
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis covers material changes in the financial
condition of Defense Technology Systems, Inc., (the "Company") since June 30,
2004 and material changes in the Company's results of operations for the three
and nine months ended March 31, 2005, as compared to the same periods in 2004.
As discussed in Note 3 to the condensed consolidated financial statements, the
Company has reversed $6,261 of amortization expense previously recorded in each
of the first two quarters of 2005, applicable to a patent under an acquisition
agreement, which agreement was determined to have been materially breached and
voided by the counter-party. The Company has restated the results for the three
and nine months ended March 31, 2004 as a result of a gain attributable to the
write-off of debt and a correction in the expense related to the granting of
stock options to consultants. This discussion and analysis should be read in
conjunction with "Management's Discussion and Analysis" included in the
Company's Annual Report on Form 10-KSB for the year ended June 30, 2004,
including audited financial statements contained therein, as filed with the
Securities and Exchange Commission.
16
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements within the meaning of the
federal securities laws. These statements plan for or anticipate the future.
Forward-looking statements include statements about the Company's future
business plans and strategies, statements about its need for working capital,
future revenues, results of operations and most other statements that are not
historical in nature. In this report, forward-looking statements are generally
identified by the words "intend", "plan", "believe", "expect", "estimate", and
the like. Investors are cautioned not to put undue reliance on forward-looking
statements. Except as otherwise required by applicable securities statutes or
regulations, the Company disclaims any intent or obligation to update publicly
these forward-looking statements, whether as a result of new information, future
events or otherwise. Because forward-looking statements involve future risks and
uncertainties, there are factors that could cause actual results to differ
materially from those expressed or implied.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2005, VS. THREE MONTHS ENDED MARCH 31, 2004
Sales revenue decreased approximately 52%, to $145,270 for the three months
ended March 31, 2005, from $304,536 for the comparative period in the prior
year. Sales in the Company's Data division decreased from $149,623 to $136,770
for the three months ended March 31, 2005. Sales in the Company's DWS Defense
Systems subsidiary decreased from $154,913 to $8,500 for the three months ended
March 31, 2005 due to the completion of a large project in March, 2004.
Costs of revenue decreased approximately 62%, to $90,259 for the three months
ended March 31, 2005, from $237,554 for the three months ended March 31, 2004 as
a result of decreased revenue during the three month period ended March 31,
2005.
Gross profit decreased approximately 18%, to $55,011 for the three months ended
March 31, 2005, from $66,982 for the three months ended March 31, 2004. The
gross profit attributable to the Company's Data and Security divisions were
$53,443 and $1,568, respectively. Gross profit margin increased to 38% for the
three months ended March 31, 2005, compared to 22% for the three months ended
March 31, 2004. The gross profit margin of the Company's Data and Security
divisions were 39% and 18%, respectively. The overall decrease was due to
decreased revenue during the three month period ended March 31, 2005. The gross
profit margin increase was attributable to the increase in higher-margin data
product sales relative to lower-margin security product sales.
Selling, general and administrative expenses decreased approximately 75%, to
$172,449 for the three months ended March 31, 2005, from $677,104 for the three
months ended March 31, 2004. The decrease is primarily related to the
non-recurrence of a $236,500 non-cash charge to compensation expense related to
the granting of common stock to an officer of the Company during the three
months ended March 31, 2004, the elimination of consulting expenses, as well as
a reduction in officers' salaries related to revisions in their compensation
structure as follows: (i) the CEO is being compensated on a commission-only
basis, which reduced his compensation for the three months ended March 31, 2005
by approximately $23,000; and (ii) the CFO agreed to reduce his annual salary
resulting in annual savings of $30,000.
Interest expense decreased 54%, to $50,613 for the three months ended March 31,
2005, from $109,834 for the three months ended March 2004. This decrease was
primarily related to the elimination of interest expense related to the
Compnay's former asset-based lender, offset by an increase in interest expense
accrued on the Augustine notes and new debt to NewMarket.
17
Gain on settlement and write-off of debt increased 83%, to $447,564 for the
three months ended March 31, 2005, from $244,857 for the three months ended
March 31, 2004. The increase was attributable to the write-off of
statutorily-barred liabilities. The Company anticipates continuing the write-off
of these liabilities in future quarters.
The Company incurred a one-time litigation loss of $150,000 for the three months
ended March 31, 2005, related to a judgment against the Company in the AAT case.
(See Note 8-A). The Company is currently negotiating with the judgment holder in
settlement of this obligation. Such negotiations may result in the reduction of
the amount owed and/or satisfaction of the obligation with the issuance of a
debt or equity security.
The Company earned net income of $129,513 for the three months ended March 31,
2005, as compared to a loss of $469,080 for the three months ended March 31,
2004, due to a significant increase in debt write-offs and the non-recurrence of
the non-cash compensation charge incurred for the three months ended March 31,
2004, partially offset by the afore-mentioned litigation loss.
The net income applicable to common shareholders for the three months ended
March 31, 2005 was $106,001, compared to a loss of $500,175 for the three months
ended March 31, 2004. Dividends accrued on convertible preferred stock were
$23,512 and $31,095 for the three months ended March 31, 2005 and 2004,
respectively.
Basic and diluted earnings (loss) per share were nil and $(0.01) for the three
months ended March 31, 2005 and 2004, respectively. The dilutive effect of
outstanding options and warrants on earnings per share is considered during
periods when net income is earned when their exercise price is below the average
market price of the common stock during the period. For the three months ended
March 31, 2005, options and warrants to purchase 3,800,000 and 160,000 shares of
common stock, respectively, have been excluded from the calculation of diluted
income per share as their exercise price exceeded the average market price
during the period. Additionally, for the three months ended March 31, 2005,
outstanding convertible preferred stock and debt enter into the calculation of
diluted net income per share on a limited basis due to two limitations as
follows: (i) the convertible stock agreement limits the preferred shareholder's
common stock holdings to 9.9 percent of the total outstanding common shares; and
(ii) the Company's current common stock authorization is limited to 40 million
shares. As a practical matter, the amount of common shares issuable under
outstanding convertible instruments is so large, the applicable limitation is
the 40 million share authorization. For the three months ended March 31, 2005,
assuming maximum dilution to 40 million shares, earnings per share are unchanged
at $0.00.
18
NINE MONTHS ENDED MARCH 31, 2005, VS. NINE MONTHS ENDED MARCH 31, 2004
Sales revenue increased approximately 40% to $757,221 for the nine months ended
March 31, 2005, from $542,538 for the comparative period in the prior year. A
slight decrease in sales in the Company's Data division from $387,625 to
$353,743 for the nine months ended March 31, 2005 was offset by a significant
increase in sales attributed to the Company's DWS Defense Systems subsidiary
from $154,913 to $403,478 for the nine months ended March 31, 2005 as a result
of a large sales order received in the first quarter of 2005.
Costs of revenue increased approximately 50%, to $577,540 for the nine months
ended March 31, 2005, from $383,797 for the nine months ended March 31, 2004 as
a result of increased revenue during the nine month period ended March 31, 2005.
Gross profit increased approximately 13%, to $179,681 for the nine months ended
March 31, 2005, from $158,741 for the nine months ended March 31, 2004. The
gross profit attributable to the Company's Data and Security divisions were
$133,312 and $46,369, respectively. Gross profit margin decreased to 24% for the
nine months ended March 31, 2005, compared to 29% for the nine months ended
March 31, 2004. The gross profit margin of the Company's Data and Security
divisions were 38% and 11%, respectively. The overall decrease was due to the
significant increase in distribution of security products which are at a lower
margin than the Company's data cable assembly business.
Selling, general and administrative expenses decreased approximately 85%, to
$524,344 for the nine months ended March 31, 2005, from $3,536,375 for the nine
months ended March 31, 2004. The decrease is primarily attributable to the
non-recurrence of a $2,772,665 non-cash charge to consulting expenses and
officer's compensation related to the granting of common stock and options to
certain individuals during the nine months ended March 31, 2004, as well as a
previously described reduction in officers' salaries.
Interest expense decreased 18%, to $294,128 for the nine months ended March 31,
2005, from $356,729 for the nine months ended March 31, 2004 This decrease was
primarily related to the elimination of interest expense related to the
Company's former asset-based lender, offset principally by an increase in
interest expense accrued on the Augustine notes.
The Company incurred a one-time litigation loss of $150,000 for the nine months
ended March 31, 2005, related to a judgment against the Company in the AAT case.
(See Note 8-A). The Company is currently negotiating with the judgment holder in
settlement of this obligation. Such negotiations may result in the reduction of
the amount owed and/or satisfaction of the obligation with the issuance of a
debt or equity security.
Gain on settlement and write-off of debt increased 150%, to $1,303,685 for the
nine months ended March 31, 2005, from $520,551 for the nine months ended March
31, 2004. The increase was attributable an increase in the write-off of
statutorily-barred liabilities.
The Company earned net income of $519,958 for the nine months ended March 31,
2005, as compared to a loss of $3,120,606 for the nine months ended March 31,
2004, due to debt settlements and write-offs and the non-recurrence of the
non-cash charge incurred for the nine months ended March 31, 2004, partially
offset by the afore-mentioned litigation loss.
19
The net income applicable to common shareholders for the nine months ended March
31, 2005 was $443,446, compared to a loss of $3,214,985 for the nine months
ended March 31, 2004. Dividends accrued on convertible preferred stock were
$76,512 and $94,379 for the nine months ended March 31, 2005 and 2004,
respectively.
Basic and diluted earnings (loss) per share were $0.01 and $(0.09) for the nine
months ended March 31, 2005 and 2004, respectively. The dilutive effect of
outstanding options and warrants on earnings per share is considered during
periods when net income is earned when their exercise price is below the average
market price of the common stock during the period. For the nine months ended
March 31, 2005, options and warrants to purchase 3,800,000 and 160,000 shares of
common stock, respectively, have been excluded from the calculation of diluted
income per share as such options were out of the money. Additionally, for the
nine months ended March 31, 2005, outstanding convertible preferred stock and
debt enter into the calculation of diluted net income per share on a limited
basis due to two limitations as follows: (i) the convertible stock agreement
limits the preferred shareholder's common stock holdings to 9.9 percent of the
total outstanding common shares; and (ii) the Company's current common stock
authorization is limited to 40 million shares. As a practical matter, the amount
of common shares issuable under outstanding convertible instruments is so large,
the applicable limitation is the 40 million share authorization. For the nine
months ended March 31, 2005, assuming maximum dilution to 40 million shares,
earnings per share are unchanged at $0.01.
ACQUISITION OF A MAJORITY INTEREST IN DIGITAL COMPUTER INTEGRATION CORPORATION
In December 2004, the Company executed a letter of intent with NewMarket
Technology, Inc. ("NewMarket") to purchase NewMarket's 51 percent interest in
Digital Computer Integration Corp. ("DCI"). DCI is a security and defense
products manufacturer. In February 2005, the parties executed a definitive
agreement for this acquisition. The Company closed on this transaction in April
2005. The Company purchased the 51 percent interest by issuance to NewMarket of
a newly created Series C Preferred Stock with certain conversion features and a
newly created Series D Preferred Stock. The Series C and D shares are subject to
certain proxy rights held by the Company's two executive officers. Additionally,
Philip Verges, the CEO of NewMarket, has joined the Company's Board of
Directors, effective April 2005.
At the time of closing, certain due diligence disclosure information required to
be provided by the Company in the schedules to the acquisition agreement was
omitted and/or misstated. The incorrect/omitted information related to the
number of outstanding vested and unvested stock options, including the options
recently granted to the Company's Chief Executive Officer and Chief Financial
Officer. Upon discovery of the error/omission in the schedules, the Company
amended the schedules and obtained the consent of the counterparty to the
agreement, with the disclosure information as amended. At the same time, the
newly expanded Board of Directors ratified the previous grant of one million
stock options to the Company's two executive officers.
20
The Company is currently analyzing the accounting effects of this transaction
including the resulting goodwill. Audited financial statements of the acquired
company and pro-forma combined financial statements reflecting the acquisition
by the Company will be provided in an amended Form 8-K filing by June 20, 2005.
LIQUIDITY AND CAPITAL RESOURCES
The Company has current assets of $99,045 (including $17,232 in cash) compared
with current liabilities of $4,130,628, resulting in a working capital deficit
of $4,031,583 as of March 31, 2005. Although the Company had net income of
$129,513 and $519,958 for the three and nine months ended March 31, 2005, the
income was entirely attributable to debt settlements and write-offs.
Additionally, the Company has incurred significant net losses in each of the
three preceding fiscal years and has a stockholder's equity deficit of
$4,182,480 at March 31, 2005. Such deficits and recurring losses raise questions
about the Company's ability to continue as a going concern.
Additionally, the Company's continuation is also threatened by the existence of
numerous judgments on trade payables, defaults on various secured indebtedness,
including a debt with a priority security lien, and delinquencies on certain tax
obligations. As a result of a default in calendar year 2005 interest payments to
Rosenthal & Rosenthal, the entire principal balance of $250,000 owed to them has
been classified as current at March 31, 2005. These conditions could result in
the seizure of Company assets and/or its being forced into bankruptcy. (See
Notes 4 and 8 to the Condensed Consolidated Financial Statements).
In the fourth quarter of fiscal 2004 the Company was advised by its counsel that
pursuant to applicable commercial law, certain of its trade obligations are
statutorily unenforceable after periods of four or six years, as applicable,
from the date of their incurrence. Accordingly the Company has written off
$447,564 and $1,303,685 of accounts payable which amount is included in gain on
settlement and write-off of debt for the three and nine months ended March 31,
2005, respectively. Additional amounts will likely be written off in subsequent
periods as the applicable statutory periods are exceeded.
The Company is currently implementing a business plan that it believes will
strengthen the balance sheet, increase revenue and return it to profitability.
The plan involves a series of initiatives. The Company is seeking to restructure
its liabilities by negotiating with secured and unsecured creditors and vendors
for forgiveness of certain outstanding debt, or to exchange debt for equity. For
the nine months ended March 31, 2005, the Company settled a total of
approximately $437,000 in exchange for a series of cash payments totaling
$57,000 resulting in a gain of approximately $380,000. The Company continues to
seek settlements of outstanding debt, including the recent judgment as a result
of a one-time litigation loss. (See Note 8-A).
The Company may also pursue strategic acquisitions that provide it with growth
and vertical integration within the security business. The acquisition of a 51%
interest in DCI is an example of the type of growth that is being sought. There
is no assurance that the Company will be successful in accomplishing its
objectives. If the Company is not successful in these initiatives, it may be
forced to severely curtail operations or seek protection under the bankruptcy
laws.
21
In May 2005, the Company announced that the Board of Directors would seek a new
Chief Executive Officer as part of the new direction the Company is taking, and
evidencing this direction, its new DCI subsidiary announced it had signed a
$605,000 contract with a major defense industry contractor.
The Company's cash balance at June 30, 2004 increased $13,312 from $3,920 to
$17,232 as of March 31, 2005. The increase was the result of cash proceeds from
notes totaling $650,000, offset by a combination of cash used for the repayment
of stockholder loans totaling $75,000, and operating and investing activities
requiring $521,478, and $40,210, respectively. Operating activities exclusive of
changes in current assets and liabilities required $623,177, offset by the
combination of a decrease in receivables and other current assets of $7,432 and
an increase in accounts payable and accrued liabilities of $94,267.
Historically, the Company's capital resources have been private stock sales and
loans and advances from principal shareholders. In January 2005, the Company
received a loan of $95,000 from NewMarket Technology, Inc., and an additional
loan of $95,000 in February 2005. In addition, in April 2005 the Company
negotiated a six-month deferral of the principal repayments on its note payable
to Rosenthal & Rosenthal.
The Company recognizes that its current capitalization structure does not
presently facilitate raising additional equity capital due to the limitation of
40 million authorized shares of common stock and the large number of shares
issuable upon conversion of its various convertible instruments. Therefore in
order to facilitate raising capital in the future, the Company will likely
explore various means of restructuring its capitalization. This may include a
shareholder proxy to increase share authorization.
ITEM 3. CONTROLS AND PROCEDURES
The Company's Chief Executive Officer and Chief Financial Officer have evaluated
the effectiveness of the Company's disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended) as of the end of the three-month and nine-month periods ended
March 31, 2005. Based on this evaluation, the Company's Chief Executive Officer
and Chief Financial Officer have concluded that the Company's controls and
procedures are effective in providing reasonable assurance that the information
required to be disclosed in this report is accurate and complete and has been
recorded, processed, summarized and reported within the time period required for
the filing of this report. Subsequent to the period covered by this report,
there have not been any significant changes in the Company's internal controls
or other factors that could significantly affect the Company's internal
controls.
22
PART II. OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS:
In September 2000, the Company began to negotiate a potential merger with
American Access Technologies ("AAT"), which resulted in a merger agreement being
signed in April 2001. In June 2001, the Company was notified by AAT that they
were unilaterally terminating the agreement claiming that the Company had
suffered material and adverse changes and that such change entitled AAT to
terminate the agreement. AAT then filed suit against the Company seeking
reimbursement of various incurred costs. The Company filed a counter suit
against AAT alleging wrongful termination. A non-jury trial took place in
February, 2005 and as a result, AAT was awarded approximately $94,000 plus
interest and legal fees. The Company has estimated the total of such amounts at
approximately $150,000. The Company is currently negotiating with AAT in
settlement of this matter.
ITEM 2 - CHANGES IN SECURITIES:
One million shares of the Company's common stock, which were held in escrow
since July 2004 and deemed outstanding, have been returned to the Company by the
escrow holder and cancelled. Such action resulted from the breach of the related
patent acquisition agreement by the counterparty. (See Note 3 to the condensed
consolidated financial statements).
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES:
As of March 31, 2005, the Company is in default on the following obligations, as
disclosed in Note 8B to the Condensed Consolidated Financial Statements: the
Secured Subordinated Debentures, and the Class 7 Bankruptcy Distributions. Also,
as disclosed in Notes 8A and 8C, the Company has approximately $527,000 in
judgments entered against it for unpaid trade payables and is delinquent on
payment of certain sales and payroll tax obligations. Additionally, as disclosed
in Note 4, the Company is currently in default on the interest payments due
under the note payable to Rosenthal & Rosenthal. Under such default, Rosenthal &
Rosenthal's security interest, which constitutes a priority over other liens,
allows them to proceed upon the collateral.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS:
None.
ITEM 5 - OTHER INFORMATION:
The Company is in the process of adopting a formal Code of Ethics,
pursuant to Section 406 of the Sarbanes-Oxley Act of 2002.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Exhibit No. Description
----------- -----------
31 Section 302 Certifications
32 Section 906 Certifications
23
(b) Reports on Form 8-K:
During the three-month period ended March 31, 2005, the Company
filed the following Current Reports on Form 8-K:
Current Report of Form 8-K filed on March 3, 2005, which included
disclosure under Item 1 related to the execution of a definitive
agreement for the acquisition of a majority interest in Digital
Computer Integration Corporation.
Additionally, in April and May, 2005, the Company the filed the
following three Current Reports on Form 8-K relating to matters
discussed in this quarterly report:
Current Report of Form 8-K filed on April 13, 2005, which
included disclosure under Items 2 and 5 related to the completion
of the acquisition of a majority interest in Digital Computer
Integration Corporation, and the appointment of Philip Verges to
the Company's Board of Directors
Current Report of Form 8-K filed on April 19, 2005, which
included disclosure under Item 1 related to the Company
rescinding the agreement with Georal International. Ltd. based on
their failure to perform.
Current Report of Form 8-K/A filed on May 20, 2005, which
included disclosure under Item 2 related to the Company amending
certain schedules to the agreement to acquire a majority interest
in Digital Computer Integration Corporation.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DEFENSE TECHNOLOGY SYSTEMS, INC.
Date: May 23, 2005 By: /s/ Daniel McPhee
-------------------- -------------------
Daniel McPhee
President and Chief Executive Officer
Date: May 23, 2005 By: /s/ Philip J. Rauch
-------------------- ---------------------
Philip J. Rauch,
Chief Financial Officer
24