10-Q 1 scanoptics10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q ( X ) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 -------------------------------------------------- OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to --------------------- --------------------- Commission File No. 0-5265 ----------------------------------------------------- SCAN-OPTICS, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 06-0851857 ----------------------------------- ---------------------------------------- (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) 179 Allyn Street, Suite 508, Hartford, CT 06103 -------------------------------------------------------------------------------- (Address of principal executive offices) Zip Code (860) 547-1761 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 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. ( X ) YES ( ) NO Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). ( ) YES ( X ) NO The number of shares of common stock, $.02 par value, outstanding as of July 29, 2005 was 41,451,577.

NOTE 1 - Basis of Presentation The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for interim periods are not necessarily indicative of the results that may be expected for the year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. The condensed consolidated balance sheet as of December 31, 2004 was derived from the audited financial statements for the year then ended. The pro forma balance sheet gives effect to the foreclosure described in Note 2 as if it had occurred as of June 30, 2005. NOTE 2 - Foreclosure and Cessation of Business During the quarter ended June 30, 2005, the Company violated certain covenants of its credit agreement (the Credit Agreement) with lenders affiliated with Patriarch Partners, LLC (collectively, the Lenders). The Lenders own about 80% of the Company's capital stock and all of its redeemable preferred stock. As a result of the covenant violations, on August 5, 2005, the Company entered into a Foreclosure Agreement with the Lenders. As such, the Company has classified all amounts due under the Credit Agreement as current as of June 30, 2005. Further, the Company wrote-off remaining unamortized deferred debt costs and accelerated accretion interest on debt. Under the Foreclosure Agreement the Company transferred substantially all of its assets to the Lenders to extinguish its obligations under the Credit Agreement (The outstanding principal under the Credit Agreement at the time of closing of the Foreclosure Agreement was $14,310,000). Further, the Company retained certain limited assets and the Lenders assume certain liabilities of the Company, including but not limited to, certain accrued obligations with respect to current employees and certain trade payables and accrued expenses. None of the assets retained by the Company can be liquidated for cash. The lenders also assumed certain employee benefit plans of the Company and certain of its insurance policies. Under the Foreclosure Agreement, the Company was permitted to obtain extended directors and officers insurance, and the lender agreed to assume or fund the defense of actions brought against the Company after the closing. At the closing the Company terminated all of its employees as of that time. Under the Foreclosure Agreement the lender agreed to fund certain expenses of the Company in its winding-down of its business, but the Company has no cash or other sources of liquidity and if the funds provided for in the wind-down budget are not used for the purposes specified in the budget, the Company is not entitled to receive any differential cash. The pro forma balance sheet as of June 30, 2005 gives effect to the Foreclosure Agreement as if the related transaction had occurred as of that date. Following the closing of the Foreclosure Agreement, the Company ceased doing business and is expected to be dissolved in accordance with the applicable provisions of the Delaware General Corporation Law. Following the closing of the Foreclosure Agreement, the Company's sole remaining executive officer is Scott Schooley who serves as President and Secretary of the Company. Following the closing of the Foreclosure Agreement, board of directors also voted to dissolve the Company, subject to requisite stockholder approval and compliance with the related SEC regulations. Because none of the assets retained by the Company can be liquidated for cash, there will be no residual value left to the holders of common stock of the Company following the closing of the Foreclosure Agreement and any winding-down of the Company's affairs. As of June 30, 2005, $3.4 million was outstanding under the revolving credit facility portion and $8.9 million was outstanding on the term loan portion of the Credit Agreement. Outstanding borrowings for the revolver and term loan bear interest at prime plus 2%. There is also $2.0 million under the term loan working capital facility portion of the Credit Agreement, including $500,000 of accretion. Such borrowings bear interest at prime. The Company's deteriorating financial condition resulted in the covenant violations referred to above. As such, the Company evaluated goodwill for impairment in connection with preparing the accompanying financial statements. Management considered goodwill impairment and recognized an impairment loss of $9,040,000 for the quarter ended June 30, 2005. NOTE 3 - Stock Based Compensation The Company grants stock options to key employees and members of the Board of Directors with an exercise price equal to the fair value of the shares on the date of grant. The Company accounts for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, recognizes no compensation expense for the stock option grants. Therefore, the Company has elected the disclosure provisions only of FASB Statement No. 123, "Accounting for Stock-Based Compensation". For the purpose of pro forma disclosures, the estimated fair value of the stock options is expensed ratably over the vesting period, which is generally 36 months for key employees and 6 months for the Board of Directors. In December 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") 148, "Accounting for Stock-Based Compensation--Transition and Disclosure". SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The following table illustrates the effect on net loss and loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123:

NOTE 4 - Inventories The components of inventories were as follows: June 30 December 31 (thousands) 2005 2004 ------------------------------------------------------------------- Finished goods $ 58 $ 57 Work-in-process 775 644 Service parts 2,701 2,713 Materials and component parts 4,180 4,047 ----------------------------- $7,714 $7,461 ============================= NOTE 5 - Income Taxes Income tax expense relates to minimum tax requirements in certain states and Canadian income taxes. A valuation allowance has been provided for U.S. income tax benefits applicable to the operating losses since it is not more likely than not that the Company will benefit from their future utilization. The Company's future ability to utilize the available net operating loss carryforwards may be restricted due to limitations effected by a prior change in control. NOTE 6 - Comprehensive Income The components of comprehensive loss follow:

NOTE 8 - Contingencies On March 9, 2005, the Company received from attorneys representing James C. Mavel, the Company's former Chief Executive Officer and President, a "notice of termination" pursuant to his Employment Agreement and asserting entitlement to severance compensation under the agreement. On or about August 3, 2005 the Company was notified that Mr. Mavel had filed a demand for arbitration with the American Arbitration Association, but the Company did not receive a copy of the demand until on or about August 9, 2005. The demand, among other things claims that Mr. Mavel is entitled to $2.5 million from the Company. Although the Company does not believe that Mr. Mavel's claim to severance compensation or the amount claimed is supported by the Employment Agreement or the facts, should Mr. Mavel's claim be supported, any material award of severance compensation to Mr. Mavel would have a material adverse effect on the financial condition of the Company following the closing of the Foreclosure Agreement with its secured lender on August 5, 2005. Item 2. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations. Forward Looking Information Certain statements contained in this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 and as such may involve known or unknown risks, uncertainties and other factors which may cause the Company's actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe the Company's future plans, strategies and expectations are generally identifiable by use of the words "may," "will," "should," "expect," "anticipate," "estimate," "believe," "intend" or "project" or the negative thereof or other variations thereon or comparable terminology. Foreclosure and Cessation of Business The Company entered into a foreclosure agreement on August 5, 2005 pursuant to which it transferred substantially all of its assets to its secured lender and ceased operations (see "-Liquidity and Capital Resources" below and Note 2 to the Company's Consolidated Financial Statements for further details). Results of Operations for the Three and Six Months Ended June 30, 2005 vs. 2004 Total revenues decreased $1.6 million or 11% from the first six months of 2004 to the first six months of 2005 and decreased $1.1 million or 16% from the second quarter of 2004 to the second quarter of 2005. Hardware and software revenues decreased $2.0 million or 33% in the first six months of 2005 compared with the same period in 2004 and decreased $1.3 million or 51% in the second quarter of 2005 compared to 2004. Compared to the first six months of 2004, North American sales decreased $1.3 million or 56% and decreased $.6 million or 16% during the second quarter of 2005 compared to the second quarter of 2004. International sales decreased $1.4 million during the first six months of 2005 as compared with the first six months of 2004 and remained consistent with the second quarter of 2005 compared to 2004. The decrease in revenue is mainly due to the phased out sale and production of its mature line of 9000 Series scanners in 2004 and the Company launching the new generation of SO Series scanners which has had slower than anticipated establishment of new distribution channels and delayed market acceptance. Professional services revenues decreased $0.1 million or 4% in the first six months of 2005 compared with the first six months of 2004 and increased $0.1 million or 5% during the second quarter of 2005 compared to the second quarter of 2004. Access services revenues decreased $0.5 million or 9% in the first six months of 2005 compared with the first six months of 2004 and decreased $0.2 million or 6% during the second quarter of 2005 compared to the second quarter of 2004. The Company was impacted by a few customers discontinuing maintenance contracts due to changes in their businesses or replacement of lower cost SO Series replacing the 9000 Series. Cost of hardware and software margin for the first six months of 2005 was 1% compared to 24% for the first six months of 2004. The gross margin was a negative 32% during the second quarter of 2005, compared to a positive margin of 25% in the second quarter of the prior year. The decreases in gross margin are mainly due to the composition of the sales mix and increased production costs. Cost of professional services gross margin for the first six months of 2005 was 39% compared to 46% for the same period in 2004. The gross margin for the second quarter of 2005 was 37% as compared to 49% in the second quarter of 2004. The decrease in gross margin was mainly due to decreased solution sales. Cost of Access Services gross margin for the first six months of 2005 was 20% compared to 7% for the same period in 2004. The gross margin for the second quarter of 2005 was 23% as compared to 12% in the second quarter of 2004. The increase in gross margin during the first six months of 2005 as compared to 2004 is due to recording a $.3 million inventory provision related to operations in the United Kingdom in 2004. Sales and marketing expenses decreased $.2 million or 11% in the first six months of 2005 compared to the first six months of 2004 and decreased $.2 million or 22% in the second quarter of 2005 compared to the second quarter of 2004 mainly due to lower salary and benefit costs and outside consulting services. Research and development expenses decreased $.3 million or 25% in the first six months of 2005 compared to the first six months of 2004 and decreased $.1 million or 22% in the second quarter of 2005 compared to the second quarter of 2004. The decrease is mainly due to lower external consulting costs related to the SO series scanner. General and administrative expenses decreased $.3 million or 13% in the first six months of 2005 compared to the first six months of 2004 and decreased $.3 million or 19% in the second quarter of 2005 compared to the second quarter of 2004. The decrease is mainly due to the 2004 recording of a $.5 million provision for accounts receivable as a result of the settlement of a legal action, offset by the recording of $.3 million of deferred debt costs to expense as a result of the default on the Credit Agreement. Goodwill impairment of $9 million was recorded in the second quarter of 2005 as discussed in Note 2 to the Company's Condensed Consolidated Financial Statements. Interest expense increased $.5 million or 143% from the first six months of 2005 and increased $.4 million or 222% from the second quarter of 2004 due to higher average interest rates and increased borrowings. Additional interest of $0.3 million was also recorded for working capital term loan due to the Company's default on the loan. The weighted average interest rate for the first six months of 2005 was 14.8% compared to 5.4% in 2004. Liquidity and Capital Resources Please refer to Note 2 Foreclosure and Cessation of Business as part of the Liquidity and Capital Resources. Cash and cash equivalents at June 30, 2005 increased 1.2 million from December 31, 2004 levels. Outstanding borrowings increased $2.7 million to $14.3 million at June 30, 2005 from $11.6 million at the end of 2004. As a means of attempting to alleviate the Company's liquidity problems previously disclosed in the company's Form 10-Q for the fiscal quarter ended March 30, 2005, on June 29, 2005 the Company entered into a First Amendment to the Credit Agreement (described below) pursuant to which, among other things, an additional $900,000 was made available to the Company through July 1, 2005 as part of the Credit Agreement's revolving credit facility. Subsequently, the Company failed to repay such amounts by July 1, 2005, which was a default under Section 2.9 of the Credit Agreement. The Company was also in default of certain financial covenants under Section 6.2(c) of the Credit Agreement regarding Consolidated Earnings Before Interest, Taxes, Depreciation and Amortization. On July 8, 2005 Patriarch Partners Agency Services, LLC as agent to the lenders under the Credit Agreement, submitted to the Company a draft foreclosure agreement. On August 3, 2005, Patriarch, on behalf of the secured lender, delivered a notice of default to the company, accelerating all of the outstanding debt under the Credit Agreement. As a result of the covenant violations, on August 5, 2005, the Company entered into a Foreclosure Agreement with the Lenders. As such, the Company has classified all amounts due under the Credit Agreement as current as of June 30, 2005. Further, the Company wrote-off remaining unamortized deferred debt costs and accelerated accretion interest on debt. Under the Foreclosure Agreement the Company transferred substantially all of its assets to the Lenders to extinguish its obligations under the Credit Agreement. (The outstanding principal under the Credit Agreement at the time of closing of the Foreclosure Agreement was $14,310,000). Further, the Company retained certain limited assets and the Lenders assume certain liabilities of the Company, including but not limited to, certain accrued obligations with respect to current employees and certain trade payables and accrued expenses. None of the assets retained by the Company can be liquidated for cash. The Lenders also assumed certain employee benefit plans of the Company and certain of its insurance policies. Under the Foreclosure Agreement, the Company was permitted to obtain extended directors and officers insurance, and the Lenders agreed to assume or fund the defense of actions brought against the Company after the closing. At the closing the Company terminated all of its employees as of that time. Under the Foreclosure Agreement the Lenders agreed to fund certain expenses of the Company winding-down its business. However, the Company has no cash or other sources of liquidity and if the funds provided for in the wind-down budget are not used for the purposes specified in the budget, the Company is not entitled to receive any differential cash. The pro forma balance sheet as of June 30, 2005 gives effect to the Foreclosure Agreement as if the related transaction had occurred as of that date. Following the closing of the Foreclosure Agreement, the Company ceased doing business and is expected to be dissolved in accordance with the applicable provisions of the Delaware General Corporation Law. Following the closing of the Foreclosure Agreement, the Company's sole remaining executive officer is Scott Schooley who serves as President and Secretary of the Company. Following the closing of the Foreclosure Agreement, board of directors also voted to dissolve the Company, subject to requisite stockholder approval and compliance with the related SEC regulations. Because none of the assets retained by the Company can be liquidated for cash, there will be no residual value left to the holders of common stock of the Company following the closing of the Foreclosure Agreement and any winding-down of the Company's affairs. As of June 30, 2005, $3.4 million was outstanding under the revolving credit facility portion and $8.9 million was outstanding on the term loan portion of the Credit Agreement. Outstanding borrowings for the revolver and term loan bear interest at prime plus 2%. There is also $2.0 million under the term loan working capital facility portion of the Credit Agreement, including $500,000 of accretion. Such borrowings bear interest at prime. The Company's deteriorating financial condition resulted in the covenant violations referred to above. As such, the Company evaluated goodwill for impairment in connection with preparing the accompanying financial statements. Management considered goodwill impairment and recognized an impairment loss of $9,040,000 for the quarter ended June 30, 2005. Operating activities used $1.0 million of cash in the first six months of 2005, as compared to the using $2.0 million in the first six months of 2004. The decrease is partly due to the lack of a bonus accrual in 2005 as compared to the same period in 2004. Non-cash expenses were $10.7 million for the first six months of 2005 and $1.1 million for the same period in 2004. As shown in the statements of cash flows these expenses relate to depreciation, amortization and accretion. The non-cash expenses for the first six months of 2005 include a goodwill impairment of $9.0 million. Net accounts receivable and unbilled receivables at June 30, 2005 decreased $1.5 million from December 31, 2004 due to the timing of collections and lower sales in the second quarter of 2005 compared to the fourth quarter of 2004. Total inventories at June 30, 2005 increased $0.3 million from December 31, 2004. Manufacturing inventory increased $0.2 million from the beginning of the year. Customer service inventory remained consistent as compared to December 31, 2004. Net equipment and leasehold improvements at March 31, 2005 decreased $0.2 million due to depreciation and amortization recorded during the quarter. Other current assets increased $0.5 million from December 31, 2004 mainly due to a vendor deposit placed in the second quarter for $0.5 million. Accounts payable remained consistent with December 31, 2004. Salaries and wages remained consistent with December 31, 2004. Taxes other than income taxes decreased $0.1 million from December 31, 2004 due to payments made for state sales and use taxes. Customer deposits remained consistent with December 31, 2004. Deferred revenues increased $0.4 million from December 31, 2004 due to the timing of invoicing and maintenance contracts. Other current liabilities decreased $0.1 million mainly due to reduced accruals for consulting fees and other miscellaneous items. Contractual Obligation Under the terms of an agreement for goods and services with Columbia Tech, the Company issued purchase orders in the aggregate amount of $3.1 million in the second quarter of 2005. The delivery of these goods and services and subsequent payment is scheduled over the next nine to twelve months. This agreement has been assigned to SO Acquisition as part of the Foreclosure Agreement. Critical Accounting Policies Our critical accounting policies are discussed in Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2004. There have been no significant changes in our critical accounting policies since then through June 30, 2005. The preparation of our financial statements requires us to make estimates that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures of contingent assets and liabilities. We base our accounting estimates on historical experience and other factors that are believed to be reasonable under the circumstances. However, actual results may vary from these estimates under different assumptions or conditions. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Through June 30, 2005 there were no substantial changes in our market risks. As disclosed elsewhere, the Company's board of directors voted to dissolve the Company in conjunction with the Foreclosure Agreement. Item 4. Controls and Procedures. The Company evaluated the design and operation of its disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is timely made in accordance with the Securities Exchange Act of 1934 (the "Exchange Act") and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision and with the participation of management, including the Company's principal executive and financial officer as of the end of the period covered by this Quarterly Report on Form 10-Q. The principal executive officer and principal financial officer has concluded, based on his review, that the Company's disclosure controls and procedures, as defined at Exchange Act Rules 13a-14(c) and 15d-14(c), are effective to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There were no changes in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II - OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders (a) Scan-Optics, Inc. held its 2005 annual meeting of stockholders on July 15, 2005, after the originally scheduled meeting had to be adjourned on June 15, 2005 for failure to have a sufficient quorum present in person or by proxy. (b) Kevin S. Flannery was elected as a Class I director of the Company with a term expiring in 2008. Scott Schooley continued as a Class II director. Logan Clarke, Jr. and Ralph Takala continued as Class III directors. (c) The following matters were voted on at the meeting: o The election of Mr. Flannery as a Class I director, in which not less than 40,255,857 votes were cast for his election. There were 152,875 abstentions and no broker non-votes. o The ratification of UHY LLP as the Company's independent auditors for the fiscal year ending December 31, 2005, in which 40,357,312 votes were cast for the ratification, 35,061 votes were cast against, and none withheld. There were 16,359 abstentions and no broker non-votes. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. Exhibit Number Description Exhibit 10.1 Employment Letter Agreement (incorporated by reference to Exhibit 10.1 to Form 8-K filed on April 22, 2005). Exhibit 10.2 First Amendment to Third Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.1 to Form 8-K filed on June 29, 2005). Exhibit 10.3 Foreclosure Agreement (incorporated by reference to Exhibit 10.1 to Form 8-K filed on August 5, 2005). Exhibit 31.1* Chief Executive and Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Exhibit 32.1* Chief Executive and Chief Financial Officer Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith. (b) Reports on Form 8-K. Report on Form 8-K filed April 22, 2005 for entry in to a Material Definitive Agreement with Logan Clarke, Jr. regarding employment as Acting President and Chief Executive Officer. Report on Form 8-K filed May 18, 2005 for termination of a Material Definitive Agreement with Logan Clarke Jr. and the Appointment of a Principal Officer for the appointment of Paul M. Yantus as President and Chief Executive Officer. Report on Form 8-K filed May 18, 2005 for the release of the Results of Operations and Financial Condition for the first quarter of 2005. Report on Form 8-K filed on June 6, 2005 for the Departure of Directors or Principal Officers due to the departure of Joel K. Howser as Vice President of Software Development. Report on Form 8-K filed on June 10, 2005 for the Departure of Directors or Principal Officers due the resignation of Lynn Tilton from the Board of Directors. Report on Form 8-K on June 29, 2005 for the entry in a Material Definitive Agreement for additional revolving credit. Report on Form 8-K on July 11, 2005 for the Departure of Directors or Principal Officers for resignation of Michael Scinto from the Board of Directors. Report on Form 8-K on July 14, 2005 for Other Events including the receipt of a Draft Foreclosure Agreement. Report on Form 8-K on August 5, 2005 for the entry in to Material Definitive Agreement and the Completion of Acquisition or Disposition of Assets for the entering of a Foreclosure Agreement and the transfer of substantially all assets to SO Acquisition, LLC. This filing also disclosed a proposed amendment to the Certificate of Incorporation to permit the board of directors to consist of one director. Report on Form 8-K/A on August 11, 2005 to amend the filing for the Foreclosure Agreement and the Completion of Acquisition or Disposition of Assets to indicate that a proxy statement will be filed. SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SCAN-OPTICS, INC. Date August 22, 2005 /s/ Scott Schooley ----------------------------------- -------------------------------- Scott Schooley President

SCAN OPTICS INC 10-Q