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: September 30, 2004
[ ] 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 (I.R.S. Employer
incorporation or 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 37,770,854
--------------------------------------------------------------------------------
Class Number of shares outstanding at November 15, 2004
Transitional Small Business Disclosure Format: Yes _____ No __X__
DEFENSE TECHNOLOGY SYSTEMS, INC.
INDEX
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2004
and June 30, 2004............................................... 1
Condensed Consolidated Statements of Operations for the
three months ended September 30, 2004 and 2003.................. 2
Condensed Consolidated Statements of Cash Flows for the
three months ended September 30, 2004 and 2003.................. 3
Notes to Condensed Consolidated Financial Statements............ 4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 12
Item 3. Controls and Procedures......................................... 16
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................... 16
Item 2. Changes in Securities .......................................... 16
Item 3. Defaults Upon Senior Securities................................. 16
Item 4. Submission of Matters to a Vote of Security Holders............. 16
Item 5. Other Information............................................... 17
Item 6. Exhibits and Reports on Form 8-K................................ 17
SIGNATURES .............................................................. 17
Exhibit 31 Section 302 Certifications
Exhibit 32 Section 906 Certifications
ITEM 1 FINANCIAL STATEMENTS
DEFENSE TECHNOLOGY SYSTEMS, INC.
Condensed Consolidated Balance Sheet
September 30, 2004 June 30, 2004*
(Unaudited)
------------------ ------------------
ASSETS
CURRENT ASSETS:
Cash $ 1,846 $ 3,920
Accounts receivable 458,179 87,745
Other current assets 900 1,500
------------ ------------
TOTAL CURRENT ASSETS 460,925 93,165
Property and equipment, net 14,146 15,202
Security deposits 12,119 12,119
Patent, net 406,989 -
------------ ------------
TOTAL ASSETS $ 894,179 $ 120,486
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable 2,769,568 2,932,351
Accrued expenses and other 945,825 1,008,417
Notes payable-related parties, current 506,571 160,738
Bankruptcy distributions payable 297,431 292,120
Secured subordinated debentures 92,633 92,633
------------ ------------
TOTAL CURRENT LIABILITIES 4,612,028 4,486,259
Note payable-related parties 286,604 381,087
Accrued dividends on preferred stock 79,437 62,189
------------ ------------
TOTAL LIABILITIES 4,978,069 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 shares; 1,321 and 1,559
shares issued and outstanding at
September 30, 2004 and June 30, 2004,
respectively 1,321,000 1,559,000
Common stock, $.001 par value; 40,000,000
shares authorized, 37,770,854 and
34,781,755 issued and outstanding at
September 30, 2004 and June 30, 2004,
respectively 37,771 34,782
Additional paid-in capital 8,775,325 8,028,629
Accumulated deficit (14,217,986) (14,431,460)
------------ ------------
TOTAL STOCKHOLDERS' DEFICIT (4,083,890) (4,809,049)
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS'
DEFICIT $ 894,179 $ 120,486
============ ============
*Condensed from audited financial statements
See accompanying notes to condensed consolidated financial statements.
Page 1
DEFENSE TECHNOLOGY SYSTEMS, INC.
Unaudited Condensed Consolidated Statements of Operations
Three Months ended September 30,
2004 2003
(Restated)
------------ ------------
Net sales $ 494,177 $ 145,483
Cost of goods sold 403,149 84,714
------------ ------------
Gross profit 91,028 60,769
------------ ------------
Expenses:
Selling, general and administrative
expenses 163,691 127,644
Interest expense 143,356 134,911
Amortization of patent 6,261 -
------------ ------------
Total expenses 313,308 262,555
------------ ------------
(222,280) (201,786)
------------ ------------
Other income:
Commission income 4,864 55,160
Gain on settlement and write off of debt 458,436 165,998
Other income 54 -
------------ ------------
Total other income 463,354 221,158
------------ ------------
Net income 241,074 19,372
Accrued dividends on preferred stock 27,600 32,104
------------ ------------
Net income (loss) attributable to common
shareholders $ 213,474 $ (12,732)
============ ============
Earnings (loss) per share attributable to
common shareholders:
Basic $ 0.01 $ -
============ ============
Diluted $ 0.01 $ -
============ ============
Weighted average common shares outstanding:
Basic 36,951,121 33,554,646
============ ============
Diluted 40,000,000 33,554,646
============ ============
See accompanying notes to condensed consolidated financial statements.
Page 2
DEFENSE TECHNOLOGY SYSTEMS, INC.
Unaudited Condensed Consolidated Statements of Cash Flows
Three Months ended September 30,
2004 2003
---- ----
(Restated)
Cash flows from operating activities:
Net income $ 241,074 $ 19,372
Adjustments to reconcile net income to
cash provided (used) by operating
activities:
Depreciation and amortization 7,317 -
Amortization of note and bond
discounts 1,350 360
Gain on settlement and write-off of
debt (458,436) (165,998)
Interest component of beneficial
conversion feature of convertible loans 108,333 40,000
Changes in current assets and
liabilities:
Accounts receivable (370,434) 59,556
Prepaid expenses 600 -
Accounts payable and accrued
liabilities 233,061 43,810
Accrued interest on bankruptcy
liability 5,311 5,527
------------ ------------
Cash provided (used) by
operating activities (231,824) 2,627
------------ ------------
Cash flows from investing activities:
Patent acquisition costs (20,250) -
------------ ------------
Cash flows from financing activities:
Proceeds from notes and loans 325,000 46,000
Principal repayments on loans (75,000) (3,000)
Borrowings from asset-based lender - 152,382
Repayment of amounts due asset-based lender - (205,038)
------------ ------------
Cash provided (used) by
financing activities 250,000 (9,656)
------------ ------------
Decrease in cash (2,074) (7,029)
Cash, beginning of period 3,920 11,888
------------ ------------
Cash, end of period $ 1,846 $ 4,859
============ ============
Supplemental disclosure of cash flow
information:
Cash paid for income taxes $ 0 $ 0
============ ============
Cash paid for interest $ 1,300 $ 0
============ ============
Non-Cash Investing and Financing Activities:
Dividends accrued on preferred stock $ 27,600 $ 32,104
============ ============
Conversion of preferred stock and accrued
dividends to common stock $ 248,352 $ 45,505
============ ============
Acquisition of patent for shares of common
stock $ 393,000 $ -
============ ============
See accompanying notes to condensed consolidated financial statements.
Page 3
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 months ended
September 30, 2004 and 2003. Certain information and footnote disclosures have
been condensed or omitted pursuant to such rules and regulations. The results
for the current interim period 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-months ended September 30, 2003 as a result of a gain attributable to the
write-off of debt.
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. The preparation of
consolidated financial statements in accordance with accounting principles
generally accepted in the United States of America requires the Company to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingencies as of the date of the consolidated
financial statements and the reported amount of revenues and expenses during the
period. Actual results could differ from those estimates.
(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, installer and integrator of specialized security products.
Both divisions operate in one business segment as contemplated by generally
accepted accounting principles.
Page 4
(C) - Revenue Recognition
The Company records sales on its long-term contracts on a
percentage-of-completion basis, based upon current estimates of costs to
complete such contracts. Contract costs include all direct materials, labor and
subcontractor costs. General and administrative expenses are accounted for as
period charges and, therefore, are not included in the calculation of the
estimates to complete. Anticipated losses are provided for in their entirety
without reference to the percentage-of-completion.
Revenue from data and security product sales is recognized when the product is
shipped. Revenue from installation contracts is recognized under the percentage
of completion method.
(D) - Net Income (Loss) Per Basic and Diluted Common Share
Net income (loss) per basic and diluted common share 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 months ended September 30, 2004 and 2003, options and
warrants to purchase 3,000,000 and 160,000 shares of common stock, respectively,
have been excluded from the calculation of diluted income (loss) per share for
these reasons. (See Note 9).
For the three months ended September 30, 2004, outstanding convertible preferred
stock and debt enter into the calculation of 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 September 30, 2004, assuming maximum dilution to 40 million shares,
earnings per share would be unchanged at $0.01.
Loss per share for the three months ended September 30, 2003 was restated due to
the inclusion of a $165,998 gain attributable to the write-off of certain
statutorily barred liabilities. (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.
Page 5
(E) - Income Taxes
The Company records its income taxes in accordance with Statement of Financial
Accounting Standards 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.
(F) - Property and Equipment
Property and equipment at September 30, 2004, 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.
(G) Amortization of Patent
During the quarter ended September 30, 2004, the Company acquired a patent from
GEORAL International, Ltd. (US Patent No. 6,472,984) for the GIL 2001 Security
Doors. The patent was valued at $413,250 which represents the value of the
common stock given in consideration of the purchase as well as $20,250 of
related professional fees incurred in the transaction. The patent expires on
January 30, 2021; the Company is amortizing the value of the patent over the
remaining 16 1/2 years of its useful life in accordance with the provisions of
Statement of Financial Accounting Standards ("SFAS") 142. (See Note 3).
(H) - 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 $78,488 of accounts
payable which amount is included in gain on settlement and write-off of debt for
the three months ended September 30, 2004. Additionally, the Company has
restated the results for the three months ended September 30, 2003 to reflect
$165,998 of write-offs applicable to that period.
(I) - 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. Such pro forma disclosures are not
applicable for the periods presented herein since there are no employee stock
options outstanding nor have any options been granted, vested, exercised, or
cancelled during such periods. (See Note 9).
Page 6
(J)- 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.
(K) - Recent Accounting Pronouncements
FASB Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest
Entities," was issued in January 2003, and a revised interpretation of FIN 46
(FIN 46-R) was issued in December 2003. FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary of the entity if
the equity investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. The provisions of FIN 46 were effective immediately
for all arrangements entered into after January 31, 2003, and application of FIN
46 was required through the end of the Company's second quarter of fiscal 2004.
The Company was required to adopt the provisions of FIN 46-R for those
arrangements in the third quarter of fiscal 2004. For arrangements entered into
prior to February 1, 2003, the Company was required to adopt the provisions of
FIN 46-R in the fourth quarter of fiscal 2004. Adoption of both of these
standards did not have a material impact on the Company's financial position,
results of operations or cash flows.
Note 2: Going Concern
-------------
The Company has current assets of $460,925 (including $1,846 in cash) compared
with current liabilities of $4,612,028, resulting in a working capital deficit
of $4,151,103 as of September 30, 2004. Although the Company had net income of
$241,074 for the three months ended September 30, 2004, 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 $4,083,890 at September 30, 2004. 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 Note
8).
Page 7
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 three months ended September 30, 2004, the Company settled a total of
$436,948 in exchange for a series of cash payments totaling $57,000 resulting in
a gain of $379,948. The Company continues to seek settlements of outstanding
debt.
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 $78,488 of accounts
payable which amount is included in gain on settlement and write-off of debt for
the three months ended September 30, 2004. Additionally, the Company has
restated its results for the three months ended September 30, 2003 to reflect a
gain of $165,998 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.
Note 3: Acquisition of Patent
---------------------
In July, 2004, the Company acquired a patent from GEORAL International, Ltd. (US
Patent No. 6,472,984) for the GIL 2001 Security Doors. The patent was valued at
$413,250 which represents the value of the common stock given in consideration
of the purchase plus the professional fees incurred in the transaction. The
patent expires on January 30, 2021. The acquisition agreement includes 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 received in consideration
of the purchase ($393,000) or by returning to the Company one million shares of
common stock.
Note 4: Notes Payable - Related Parties
-------------------------------
Notes payable-related parties, as of September, 2004, consists of the
following:
Current Long-Term Total
Augustine-revolving credit line $400,000 $ - $400,000
Augustine-note payable - 93,150 93,150
Rosenthal & Rosenthal 56,546 193,454 250,000
Shareholder loan 50,025 - 50,025
-------- -------- --------
$506,571 $286,604 $793,175
======== ======== ========
Page 8
For the three months ended September 30, 2004, the Company's borrowings from
Augustine Capital Management ("Augustine") required the recognition of
approximately $108,000 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 July 2004, the Company borrowed
$300,000 under the terms of this convertible note facility, and in September
2004 borrowed an additional $25,000, bringing the total amount outstanding under
this facility to $400,000 as of September 30, 2004. Total outstanding borrowings
under the revolving credit line are limited to $500,000. Any future borrowings
under this agreement will result in the recognition of additional interest
expense related to this beneficial conversion feature. The balance of the
unamortized discount on the Augustine-note payable was $7,650 as of September
30, 2004.
Note 5: Other Related Party Transactions
--------------------------------
As of September 30, 2004, approximately $232,000 of accrued compensation due the
Company's President and Chief Executive Officer was included in accrued expenses
on the Condensed Consolidated Balance Sheet.
Note 6: Income Taxes
------------
No income taxes were provided since the Company has loss carry-forwards. As
of September 30, 2004, the Company has net operating loss carry-forwards
totaling approximately $18,200,000, expiring at various dates through fiscal
2023. The Company estimates an effective tax rate of zero for fiscal 2005 based
on utilization of its net operating loss carry-forwards.
Note 7: Capital Stock Transactions
--------------------------
In July 2004, pursuant to the terms of the Patent Acquisition Agreement, the
Company issued one million shares of common stock to GEORAL International, Ltd.
for the purchase of a patent. The shares were valued at $393,000 or $0.393 per
share, the weighted-average closing market price of the stock for the two days
before and after the date of this transaction. (See Note 3).
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.
Additionally, 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.
Following is a schedule of changes in shareholders' deficit for the three months
ended September 30, 2004:
Page 9
8% Retained
Preferred Common Additional Earnings Stock-
Stock Common Stock Paid in (accumulated holder's
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 (238,000) 1,989,099 1,989 246,363 10,352
Value of beneficial conversion
feature of convertible loans 108,333 108,333
Purchase of patent 1,000,000 1,000 392,000 393,000
Accrued dividends on 8%
preferred stock (27,600) (27,600)
Net income for three months
ended September 30, 2004 - - - - 241,074 241,074
---------- ---------- ------- ---------- ------------ -----------
Balance September 30, 2004 $1,321,000 37,770,854 $37,771 $8,775,325 $(14,217,986) $(4,083,890)
========== ========== ======= ========== ============ ===========
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 September 30, 2004, 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 has filed a counter suit
against AAT alleging wrongful termination. The matter is currently set for trial
in December, 2004. The ultimate outcome of this matter is not expected to have a
material adverse effect on the Company's results of operations or financial
position.
(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.
Page 10
Additionally, 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.
(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 September, 2004, approximately $326,000 was
due these states (inclusive of estimated penalties and interest). The Company is
presently negotiating a settlement of its approximately $268,000 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 part of the
negotiations, the Company is continuing to make $5,000 monthly good faith
payments toward this obligation.
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 September 2004,
approximately $42,000 remained outstanding, which due to the nature of the
obligation is classified as a current liability.
(D) Sales and purchase concentrations
For the three months ended September 30, 2004, two customers accounted for 66
percent and 12 percent of sales, respectively, and two vendors accounted for 77
percent and 21 percent of purchases, respectively. Loss of either the major
customer or supplier would have a significant negative effect on the Company's
business.
Note 9: Subsequent Events
-----------------
On October 20, 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 equal to 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. As the
exercise price of the options could not be determined as of the date of this
report, the fair value of the options utilizing the Black-Scholes pricing model
could not be determined. Under APB No. 25 the option grants have no intrinsic
value.
Page 11
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
months ended September 30, 2004, as compared to the same period in 2003. The
Company has restated the results for the three-months ended September 30, 2003
as a result of a gain attributable to the write-off of debt. 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.
Special note regarding forward-looking statements
-------------------------------------------------
This report contains forward-looking statements within the meaning of 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, these are factors that could cause actual results to differ
materially from those expressed or implied.
Results of Operations
Three Months Ended September 30, 2004, vs. Three Months Ended September 30, 2003
Sales revenue increased approximately 240 percent, to $494,177 for the three
months ended September 30, 2004, from $145,483 for the comparative period in the
prior year due to a combination of increased sales in the Company's Data
division as well as a $326,078 sales order received by the DWS Defense
subsidiary. As this subsidiary was formed in October 2003, there were no sales
attributable to DWS Defense during the three months ended September 30, 2003.
The large sales order referred to above constituted 66 percent of sales for the
three months ended September 30, 2004, and such sale represented the first
significant business related to a new distributorship agreement with the
Company's major supplier. The Company anticipates additional sales as a result
of this distributorship agreement but cannot predict the amount and/or timing of
such future sales. (See Note 8-D to the condensed consolidated financial
statements).
Page 12
Costs of revenue increased approximately 376 percent, to $403,149 for the three
months ended September 30, 2004, from $84,714 for the three months ended
September 30, 2003 as a result of increased revenue during the three month
period ended September 30, 2004.
Gross profit increased approximately 49.8 percent, to $91,028 for the three
months ended September 30, 2004, from $60,769 for the three months ended
September 30, 2003. The gross profit attributable to the Company's data and
security divisions were $59,387 and $31,641, respectively. Gross profit margin
decreased to 18.4 percent for the three months ended September 30, 2004,
compared to 41.8 percent for the three months ended September 30, 2003. The
gross profit margin of Company's data and security divisions were 37.2 percent
and 9.5 percent 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 increased approximately 28.2
percent, to $163,691 for the three months ended September 30, 2004, from
$127,644 for the three months ended September 30, 2003. The increase is
primarily related to substantially higher professional fees resulting from the
completion of the Company's fiscal 2004 audit, offset in part by 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 September 30, 2004, by
approximately $8,000; and (ii) the CFO agreed to reduce his annual salary
resulting in annual savings of $30,000.
In consideration of the aforementioned revision to the compensation structure of
the Company's officers, in October 2004 the Board of Directors granted each
officer 500,000 options to purchase shares of common stock. (See Note 9 to the
condensed consolidated financial statements).
Interest expense increased 6.3 percent, to $143,356 for the three months ended
September 30, 2004, from $134,911 for the three months ended September 30, 2003.
This was primarily related to interest expense incurred as a result of the
beneficial conversion feature of the Augustine revolving credit facility. (See
Note 4 to the condensed consolidated financial statements).
Amortization expense for the three months ended September 30, 2004 related to
the acquisition of a patent was $6,261 versus zero for the three months ended
September 30, 2003. The patent was acquired in July, 2004. (See Note 1-G to the
condensed consolidated financial statements).
Gain on settlement and write-off of debt increased $292,438, or 176 percent, to
$458,436 for the three months ended September 30, 2004, from $165,998 for the
three months ended September 30, 2003. The increase was attributable to a
$379,948 gain on the settlement of outstanding debt due one vendor, offset by a
decrease in the write-off of statutorily-barred liabilities of $87,510.
The Company earned net income of $241,074 for the three months ended September
30, 2004, as compared to net income of $19,372 for the three months ended
September 30, 2003, entirely due to debt settlements and write-offs.
Page 13
The net income applicable to common shareholders for the three months ended
September 30, 2004 was $213,474, compared to a loss of $12,732 for the three
months ended September 30, 2003. Dividends accrued on convertible preferred
stock were $27,600 and $32,104 for the three months ended September 30, 2004 and
2003, respectively.
Basic and diluted earnings per share were $0.01 and nil for the three months
ended September 30, 2004 and 2003, respectively. The 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 September 30,
2004, options and warrants to purchase 3,000,000 and 160,000 shares of common
stock, respectively, have been excluded from the calculation of diluted income
per share for this reason. Additionally, for the three months ended September
30, 2004, outstanding convertible preferred stock and debt enter into the
calculation of 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 September 30,
2004, assuming maximum dilution to 40 million shares, earnings per share are
unchanged at $0.01.
Significant Accounting Estimate
In July, 2004, the Company acquired a patent from GEORAL International, Ltd. (US
Patent No. 6,472,984) for the GIL 2001 Security Doors. (See Note 3). The patent
was valued at $413,250 which represents the value of the common stock given in
consideration of the purchase as well as the cost of professional fees incurred
in the transaction. The patent expires on January 30, 2021. The Company has
identified the accounting for this patent as a significant accounting estimate
which, due to the existence of an option for the seller to reacquire the patent
at an amount subject to future determination, may become more significant as the
option date approaches. The Company cannot presently evaluate the likelihood of
the exercise of this option or the amount of consideration it would receive if
the option were exercised. As a result of the range of possible accounting and
related economic consequences of the potential exercise of this option, the
Company will critically evaluate the carrying value of this asset on not less
than a semi-annual basis.
Liquidity and Capital Resources
The Company has current assets of $460,925 (including $1,846 in cash) compared
with current liabilities of $4,612,028, resulting in a working capital deficit
of $4,151,103 as of September 30, 2004. Although the Company had net income of
$241,074 for the three months ended September 30, 2004, 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 $4,083,890 at September 30, 2004. Such
deficits and recurring losses raise questions about the Company's ability to
continue as a going concern.
Page 14
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 Note
8 to the Condensed Consolidated Financial Statements).
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 three months ended September 30, 2004, 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.
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
$78,488 of accounts payable which amount is included in gain on settlement and
write-off of debt for the three months ended September 30, 2004. Additional
amounts will likely be written off in subsequent periods as the applicable
statutory periods are exceeded.
The Company may also pursue strategic acquisitions that provide it with growth
and vertical integration within the security business. 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.
The Company's cash balance at June 30, 2004 decreased $2,074 from $3,920 to
$1,846 as of September 30, 2004. The decrease was the result of a combination of
cash used for the repayment of stockholder loans totaling $75,000, and operating
and investing activities requiring $231,824, and $20,250, respectively, offset
by cash proceeds from notes totaling $325,000. Operating activities exclusive of
changes in current assets and liabilities required $100,362, offset by an
increase in receivables and other current assets of $369,834, and an increase in
accounts payable and accrued liabilities of $238,372.
The Company's capital resources include private stock sales and loans and
advances from principal shareholders. During the three month period ended
September 30, 2004, the Company borrowed $325,000 under the terms of its
convertible loan agreements with Augustine. The agreements provide for
additional borrowings of $100,000, all of which may be converted to common stock
at a 25 percent discount to the market price of the stock at the time of
conversion, subject to the lender's holdings not exceeding 9.9 percent of the
total outstanding shares of common stock. Amounts converted by the lender may be
re-borrowed by the Company to the extent that the total outstanding balance
under the revolving line of credit cannot exceed $500,000. 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.
Page 15
ITEM 3. CONTROLS AND PROCEDURES
Daniel McPhee, Chief Executive Officer and Philip J. Rauch, Chief Financial
Officer of Defense Technology Systems, Inc. have established and are currently
maintaining disclosure controls and procedures for the Company. The disclosure
controls and procedures have been designed to ensure that material information
relating to the Company is made known to them as soon as it is known by others
within the Company.
The Company's Chief Executive Officer and Chief Financial Officer conduct an
update and a review and evaluation of the effectiveness of the Company's
disclosure controls and procedures and have concluded, based on their evaluation
within 90 days of the filing of this Report, that the Company's disclosure
controls and procedures are effective for gathering, analyzing and disclosing
the information it is required to disclose in its reports filed under the
Securities Exchange Act of 1934. There have been no significant changes in the
Company's internal controls or in other factors that could significantly affect
these controls subsequent to the date of the previously mentioned evaluation.
PART II. OTHER INFORMATION
-------- -----------------
Item 1 - Legal Proceedings:
There were no new legal proceedings or significant developments in existing
proceedings that occurred during the three months ended September 30, 2004.
Item 2 - Changes in Securities:
As a result of three transactions, the Company issued 2,989,099 shares of common
stock during the three month period ended September 30, 2004, as disclosed in
Note 7 to the Condensed Consolidated Financial Statements.
Item 3 - Defaults Upon Senior Securities:
As of September 30, 2004, 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. Additionally, 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.
Item 4 - Submission of Matters to a Vote of Security Holders:
None.
Page 16
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 Description
No.
31 Section 302 Certifications
32 Section 906 Certifications
(b) Reports on Form 8-K:
--------------------
None.
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: November 14, 2004 By: /s/ Daniel McPhee
--------------------- -------------------------------------
Daniel McPhee
President and Chief Executive Officer
Date: November 14, 2004 By: /s/ Philip J. Rauch
--------------------- -------------------------------------
Philip J. Rauch,
Chief Financial Officer
Page 17