10-Q 1 d10q.txt HLM DESIGN U. S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended February 1, 2002 OR ( ) TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from ____________ to ____________ Commission file Number 001-14137 --------- HLM Design, Inc. (Exact Name of Registrant as Specified in Its Charter) Delaware 56-2018819 (State or Other Jurisdiction (I.R.S Employer Identification No.) of Incorporation or Organization) 121 West Trade Street, Suite 2950 Charlotte, North Carolina 28202 (Address of principal executive offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (704) 358-0779 Indicate by 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 ____ ---- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Title of Each Class Outstanding at March 4, 2002 ------------------- ---------------------------- Common stock, par value $.001 per share 2,297,586 shares HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES INDEX TO FORM 10-Q

PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES CONDENSED CONSOLIDATED BALANCE SHEETS

See notes to unaudited condensed consolidated financial statements. 3 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES CONDENSED CONSOLIDATED BALANCE SHEETS

See notes to unaudited condensed consolidated financial statements. 4 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES CONDENDSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

See notes to unaudited condensed consolidated financial statements. 5 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (Unaudited)

See notes to unaudited condensed consolidated financial statements. 6 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See notes to unaudited condensed consolidated financial statements. 7 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Business-HLM Design, Inc. ("HLM Design") and Subsidiaries and Affiliates ("the Company") is a professional consultancy that provides management services to architectural, engineering and planning design entities ("Managed Firms") under long-term management and services agreements ("MSAs"). As of February 1, 2002, the Company had wholly-owned affiliates and subsidiaries as follows: Affiliates: . HLM Design of North America, Inc. ("HLMNA"); . HLM Design USA, Inc. ("HLMUSA"); . HLM Design Architecture, Engineering and Planning, P.C. ("HLMAEP"); Subsidiaries: . JPJ Architects, Inc. ("JPJ"); . G.A. Design International Holdings, Ltd. ("GAIH"); and . BL&P Engineers, Inc. ("BL&P"). Financial Statement Presentation - The accompanying unaudited financial information for the three and nine month periods ended January 26, 2001 and February 1, 2002 has been prepared in accordance with accounting principles generally accepted in the United States of America. All significant intercompany accounts and transactions have been eliminated. These unaudited consolidated financial statements reflect, in the opinion of management, all material adjustments (which include only normal recurring adjustments) necessary to fairly state the financial position and the results of operations for the interim periods presented. The results for interim periods are not necessarily indicative of the results to be expected for the entire fiscal year. These interim financial statements should be read in conjunction with the Company's audited consolidated financial statements for the year ended April 27, 2001. New Accounting Standards -In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. This new standard requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. As of April 28, 2001, the Company adopted SFAS No. 133. The adoption of this statement did not have a material impact on the Company's consolidated financial statements. 8 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-continued In June 2001, the FASB issued SFAS 141, "Business Combinations", which requires all business combinations initiated after June 30, 2001 to be accounted for under the purchase method. SFAS 141 also sets forth guidelines for applying the purchase method of accounting in the determination of intangible assets, including goodwill acquired in a business combination, and expands financial disclosures concerning business combinations consummated after June 30, 2001. The application of SFAS 141 did not affect any of the previously reported amounts included in goodwill or other intangible assets. Effective April 28, 2001, the Company early adopted SFAS 142, "Goodwill and Other Intangible Assets", which establishes new accounting and reporting requirements for goodwill and other intangible assets. Under SFAS 142, all goodwill amortization ceased effective April 28, 2001. The Company identified reporting units based on the current reporting structure, assigned all goodwill to the reporting units, as well as other assets and liabilities, to the extent that they related to the reporting unit. The Company has completed the first step of the transitional goodwill impairment test by comparing the fair value of each reporting unit to its carrying value and has determined that no impairment exists at the effective date of the implementation of the new standard. Fair value of each reporting unit was measured using a valuation by an independent third party as of April 28, 2001 which was based on the market multiples, comparable transactions and discounted cash flow methodologies. This valuation indicated an aggregate fair value of the reporting units significantly in excess of the Company's market capitalization as of April 28, 2001. The Company believes the market capitalization is not representative of the fair value of the Company because the common stock of the Company is not actively traded. On an ongoing basis, the Company will obtain an independent valuation and perform an annual goodwill impairment test. The Company's operations have improved significantly for the months of October 2001 through January 2002. At least quarterly, management will evaluate to determine if an event has occurred that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company, if appropriate, will perform a goodwill impairment test between the annual dates. Impairment adjustments recognized after adoption, if any, will be recognized as operating expenses. Impairment indicators which may be considered include, but are not limited to, the following: . A significant adverse change on legal factors or in the business climate . Unanticipated competition . A significant decline in the operating performance . Adverse action or assessment by a regulator 9 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES- continued The following financial information is presented as if SFAS No. 142 was adopted at the beginning of the fiscal year ended April 27, 2001:

The financial information for acquired intangible assets included in other non-current assets is as follows:

The non-compete intangible assets are amortized over their contractual life ranging from four to nine years. Amortization expense for the three months and nine months ended February 1, 2002 was $14,585 and $43,750, respectively, and annual estimated amortization for the non-compete agreements are as follows: Estimated Amortization Expense ------------------------------ Fiscal 2002 $58,333 Fiscal 2003 $58,333 Fiscal 2004 $43,749 Fiscal 2005 $33,336 Fiscal 2006 $33,336 10 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES- continued The changes in carrying amount of goodwill for the nine months ended February 1, 2002 is as follows: Total ----- Balance, April 27, 2001 $ 12,166,149 Goodwill acquired during the period 110,719 ------------ Balance, February 1, 2002 $ 12,276,868 ============ Newly Issued Accounting Standards-In October 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets," which supercedes SFAS No. 121, "Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," but retains many of its fundamental provisions. Additionally, this statement expands the scope of discontinued operations to include more disposal transactions. The Company is currently assessing the impact of this statement, which will be effective for the Company for fiscal year 2003. In November 2001, the FASB issued Topic D-103, "Income Statement Characterization of Reimbursements Received for "Out-of-Pocket" Expenses Incurred". Topic D-103 requires reimbursements for out-of-pocket expenses incurred to be characterized as revenue in the income statement. Currently, the Company accounts for out-of-pocket expenses as reimbursable income. Topic D-103 is effective for periods beginning after December 1, 2001. Topic D-103 will not have an impact on the condensed consolidated financial statements. 2. CONTRACTS IN PROGRESS Information relative to contracts in progress is as follows:

11 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 2. CONTRACTS IN PROGRESS-continued Net underbillings are included in the accompanying balance sheets as follows:

3. FINANCING ARRANGEMENTS Effective December 18, 2001, the Company entered into an amendment to its revolving credit, term loan and capital expenditure loan with IBJ Whitehall Business Credit Corporation ("IBJ"). The amendment is summarized as follows: a. Revolving credit-The maximum revolving advance amount is $10,500,000. b. Revolving credit-Waiver of the leverage and senior leverage financial covenants as of quarter ended November 2, 2001. c. Revolving credit-Modification of certain future financial covenants. On March 15, 2002, the Company obtained a Waiver and Consent Letter to its revolving credit, term loan, capital expenditure loan with IBJ. This Waiver and Consent Letter is summarized as follows: a. Revolving credit-Waiver of the leverage and senior leverage financial covenants as of the quarter ended February 1, 2002 waiving compliance through February 2003. b. Revolving credit-Modification of calculation of the leverage and senior leverage ratio as of the quarter ended May 3, 2002 which the Company expects to meet for the fiscal year ended May 3, 2002. The amount available to borrow is calculated based on the aging of certain assets. As of February 1, 2002 the Company had borrowings outstanding under the revolver of $8,842,609. Substantially all assets are pledged under this financing arrangement. This financing arrangement requires that certain financial requirements be maintained such as minimum net worth, minimum EBITDA, maximum leverage and senior leverage ratios, maximum fixed charge coverage and senior fixed charge coverage ratios and maximum capital expenditure commitments. All covenants are determined quarterly and the leverage and senior leverage covenants are based on a trailing four quarters ending on each determination date. At February 1, 2002, the Company was in compliance with the minimum net worth, maximum capital expenditure commitments and maximum fixed charge coverage and senior fixed charge coverage ratios; however, the Company was not in compliance with the maximum leverage and senior leverage ratios. The Company has obtained a waiver from IBJ as of February 1, 2002 as discussed above. The Company expects to meet the covenants at future determination dates. Due to lower than anticipated cash flow during the six months ended November 2, 2001 of fiscal year ended May 3, 2002, the Company extended its current year payment obligations under certain note agreements with former acquired company shareholders (the subordinated notes payable) as follows: 12 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 3. FINANCING ARRANGEMENTS-continued Notes payable to former JPJ Architect, Inc. shareholders: The current year installment due October 2001 of $348,000 plus interest has been modified to agreed upon payments of $31,628 plus interest, $40,953 plus interest, $63,274 plus interest, $94,911 plus interest, $94,911 plus interest and $22,323 plus interest for the quarters ending November 2, 2001, February 1, 2002, May 3, 2002, August 2, 2002, November 1, 2002, and January 4, 2003, respectively. In addition, 72,001 shares scheduled to be delivered October 2001 were delayed until January 2002. Notes payable to former ESS Architects, Inc. shareholders: The current year installment due September 2001 of $125,000 plus interest has been modified to agreed upon payments of $31,285 plus interest and $93,715 plus interest for the quarters ending November 2, 2001 and May 3, 2002, respectively. Notes payable to former BL&P shareholder: The current year installment due October 2001 of $612,000 plus interest has been modified to agreed upon payments of $61,200 plus interest, $122,400 plus interest, $183,600 plus interest, $183,600 plus interest, and $61,200 plus interest for the quarters ending February 1, 2002, May 3, 2002, August 2, 2002, November 1, 2002, and January 4, 2003, respectively. In addition, in October 2001, the Company negotiated approximately $237,000 reduction in this note payable in exchange for a like amount of the Company's trade accounts receivable. The Company has obtained approval from IBJ (as required by The Revolving Credit, Term Loan and Capital Expenditure Loan Agreement) for the modification of the repayment dates of the subordinated notes payable discussed above. 4. STOCKHOLDERS' EQUITY In June 2001, 7,480 shares of common stock were issued under the HLM Design, Inc. Employee Stock Purchase Plan. In September 2001, 6,604 shares of common stock were issued under the HLM Design, Inc. Employee Stock Purchase Plan. In December 2001, 3,171 shares of common stock were issued under the HLM Design, Inc. Employee Stock Purchase Plan. 13 HLM DESIGN, INC. AND SUBSIDIARIES AND AFFILIATES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 6. SUBSEQUENT EVENT HLM Design Ltd. ("HLM Ltd.")-not previously affiliated with the Company Effective February 26, 2002, the Company purchased all of the issued and outstanding common stock for $3.0 million in cash, subordinated promissory notes bearing interest at 7 percent in the aggregate amount of $3.6 million (the "Notes") and 400,000 shares of common stock. IBJ reviewed and approved the transaction, including the issuance of the subordinated promissory notes, prior to entering into this transaction. The Stock Purchase Agreement ("Agreement") provides for, among other things, the delivery to HLM Ltd.'s former stockholders of 25% of the shares of common stock on each of February 26, 2003, February 26, 2004, February 26, 2005 and February 26, 2006. Notes totaling $3.1 million provide for payment of 42.2% of the principal amount on each of February 26, 2003 and February 26, 2004 and 7.8% of the principal amount on February 26, 2005 and February 26, 2006. A note for $0.2 million provides for six-month installments beginning August 26, 2002 with final payment on February 26, 2006. A note for $0.3 million provides for payment on August 26, 2002. Note payments will be made provided there exists sufficient cash flow in HLM Ltd. as defined in the subordinated promissory notes. Following the consummation of the Agreement, the Company and HLM Ltd. will enter into a Management and Services Agreement, whereby the Company will manage all aspects of HLM Ltd. other than the provision of professional architecture and engineering services. The acquisition will be accounted for using the purchase method of accounting. The purchase price will be allocated to the assets and liabilities acquired based on their estimated fair value at the acquisition date of which amounts have not been determined. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the results of operations and financial condition of the Company should be read in conjunction with the financial statements and related notes thereto included elsewhere in this report. RESULTS OF OPERATIONS

15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED RESULTS OF OPERATIONS For the three months ended February 1, 2002 and January 26, 2001 Revenues were $15.2 million for the three-month period ended February 1, 2002 as compared to $15.4 million for the three-month period ended January 26, 2001. This decrease of 1% is due to the (a) economic downturn in the United States economy resulting in certain clients delaying project start dates which has delayed related revenue recognition, and (b) lack of new projects of certain clients in markets affected by the nation's economic downturn, principally in the commercial segment. Management believes that clients may continue to delay project start dates through the remainder of fiscal year ending May 3, 2002. Direct costs, which include consultant costs and reimbursable project expenses, total $6.2 million, or 41% of revenues, for the three month period ended February 1, 2002 as compared to $5.5 million, or 35% of revenues, for the three month period ended January 26, 2001. This increase is due to an increased use of consultants to meet certain project requirements. Direct labor cost was $2.7 million, or 30% of net production income, for the three month period ended February 1, 2002 as compared to $3.1 million, or 31% of net production income, for the three-month period ended January 26, 2001. This decrease as a percentage of net production income is due to management's reduction of salary costs during the second quarter ended November 2, 2001 in an effort to offset the economic downturn which is partially offset by: (a) tightening of project profit margins (b) certain clients delaying project start dates, (c) lack of new projects of certain clients and the time required to adjust to these changes, and (d) increase in salary and salary related costs which has not been passed through to the clients in all cases. The Company is continuing to work with the project managers of the Managed Firms to improve the effectiveness and efficiency of each project and ultimately decrease direct labor cost as a percentage of net production income. Operating costs were $5.5 million, or 62 % of net production income, for the three-month period ended February 1, 2002 as compared to $6.0 million, or 61% of net production income, for the three-month period ended January 26, 2001. This increase as a percentage of net production income is principally due to an increase in rent and occupancy costs, professional liability insurance, and equipment rentals. This increase as a percentage of net production income is partially offset by a decrease in indirect labor due in part to management's reduction of salary costs during the second quarter ended November 2, 2001 and, to a lesser extent, a decrease in travel expenses. 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED Amortization of intangible assets was $ 14,585 for the three months ended February 1, 2002 as compared to $ 165,973 for the three months ended January 26, 2001. This decrease is due to the Company's adoption of SFAS 142, Goodwill and Other Intangible Assets. In June 2001, the FASB issued SFAS 141, "Business Combinations", which requires all business combinations initiated after June 30, 2001 to be accounted for under the purchase method. SFAS 141 also sets forth guidelines for applying the purchase method of accounting in the determination of intangible assets, including goodwill acquired in a business combination, and expands financial disclosures concerning business combinations consummated after June 30, 2001. The application of SFAS 141 did not affect any of the previously reported amounts included in goodwill or other intangible assets. Effective April 28, 2001, the Company early adopted SFAS 142, "Goodwill and Other Intangible Assets", which establishes new accounting and reporting requirements for goodwill and other intangible assets. Under SFAS 142, all goodwill amortization ceased effective April 28, 2001. The Company identified reporting units based on the current reporting structure, assigned all goodwill to the reporting units, as well as other assets and liabilities, to the extent that they related to the reporting unit. The Company has completed the first step of the transitional goodwill impairment test by comparing the fair value of each reporting unit to its carrying value and has determined that no impairment exists at the effective date of the implementation of the new standard. Fair value of each reporting unit was measured using a valuation by an independent third party as of April 28, 2001 which was based on the market multiples, comparable transactions and discounted cash flow methodologies. This valuation indicated an aggregate fair value of the reporting units slightly higher than the recorded book value as of April 28, 2001. The Company believes the market capitalization is not representative of the fair value of the Company because the common stock of the Company is not actively traded. On an ongoing basis, the Company will obtain an independent valuation and perform an annual goodwill impairment test. The Company's operations have improved significantly for the months of October 2001 through January 2002. At least quarterly, management will evaluate if an event has occurred that would more likely than not reduce the fair value of a reporting unit below its carrying value. The Company, if appropriate, will perform a goodwill impairment test between the annual dates. Impairment adjustments recognized after adoption, if any, will be recognized as operating expenses. Impairment indicators which may be considered include, but are not limited to, the following: [X] A significant adverse change on legal factors or in the business climate [X] Unanticipated competition [X] A significant decline in the operating performance [X] Adverse action or assessment by a regulator 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED The following financial information is presented as if SFAS No. 142 was adopted at the beginning of the fiscal year ended April 27, 2001: Nine Months Three Months January 26, January 26, 2001 2001 ---- ---- Reported net income $ 569,115 $ 62,233 Goodwill amortization 477,525 159,724 ----------- -------------- Adjusted net income $ 1,046,640 $ 221,957 =========== ============== Goodwill $12,314,407 $ 12,314,407 =========== ============== Basic income per share: Reported net income $ 0.24 $ 0.03 Goodwill amortization 0.19 0.06 ------------ -------------- Adjusted net income $ 0.43 $ 0.09 ============ ============== Reported diluted income per share: Reported net income $ 0.24 $ 0.03 Goodwill amortization 0.19 0.06 ----------- -------------- Adjusted net income $ 0.43 $ 0.09 =========== ============== The financial information for acquired intangible assets included in other non-current assets is as follows: April 27, February 1, 2001 2002 ---- ---- Amortized intangible assets-non compete agreements: Original Cost $100,000 $400,000 Accumulated Amortization $ 39,583 $ 83,333 The non-compete intangible assets are amortized over their contractual life ranging from four to nine years. Amortization expense for the three months and the nine months ended February 1, 2002 was $14,585 and $43,750, respectively, and annual estimated amortization for the non-compete agreements are as follows: Estimated Amortization ---------------------- Expense ------- Fiscal 2002 $58,333 Fiscal 2003 $58,333 Fiscal 2004 $43,749 Fiscal 2005 $33,336 Fiscal 2006 $33,336 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED The changes in carrying amount of goodwill for the nine months ended February 1, 2002 is as follows:

Interest expense was $0.2 million for the three-month period ended February 1, 2002 as compared to $0.4 million for the three-month period ended January 26, 2001. This decrease is principally due to: (a) a decrease in the Company's effective interest rate in the current year and (b) a decrease in the borrowings under the Company's revolving credit facility with IBJ Whitehall Business Credit Corporation ("IBJ"). Income tax expense was $0.3 million for the three-month period ended February 1, 2002 as compared to $0.1 million expense for the three-month period ended January 26, 2001. The effective income tax rate was 49 % and 69% for the three-month periods ended February 1, 2002 and January 26, 2001, respectively. This effective rate is lower principally due to the decrease in non-deductible goodwill amortization resulting from the adoption of SFAS No. 142 for the fiscal year beginning April 28, 2001. For the nine months ended February 1, 2002 and January 26, 2001 Revenues were $45.1 million for the nine-month period ended February 1, 2002 as compared to $47.3 million for the nine-month period ended January 26, 2001. This decrease of 5% is due to the: (a) economic downturn in the United States economy resulting in certain clients delaying project start dates which has delayed related revenue recognition, (b) impact of the September 11, 2001 terrorist attacks as the Company's work was virtually stopped for ten days which resulted in a revenue loss through inefficiency and loss of productivity of more than $750,000, and (c) lack of new projects of certain clients in markets affected by the nation's economic downturn, principally in the commercial segment. The firm returned to profitability in October. Management believes that clients may continue to delay project start dates through the remainder of fiscal year ending May 3, 2002. Direct costs, which include consultant costs and reimbursable project expenses, total $17.7 million, or 39% of revenues, for the nine-month period ended February 1, 2002 as compared to $16.3 million, or 35% of revenues, for the nine-month period ended January 26, 2001. This increase is due to an increased use of consultants to meet certain project requirements. 19 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED Direct labor cost was $9.2 million, or 34% of net production income, for the nine-month period ended February 1, 2002 as compared to $9.8 million, or 32% of net production income, for the nine-month period ended January 26, 2001. This increase as a percentage of net production income is due to the: (a) over-utilization of personnel on projects, (b) tightening of project profit margins, (c) certain clients delaying project start dates, (d) lack of new projects of certain clients and the time required to adjust to these changes, and (e) increase in salary and salary related costs which has not been passed through to the clients in all cases. This increase as a percentage of net production income is partially offset by management's reduction of salary costs during the second quarter ended November 2, 2001 in an effort to offset the economic downturn. The Company is continuing to work with the project managers of the Managed Firms to improve the effectiveness and efficiency of each project and ultimately decrease direct labor cost as a percentage of net production income. Operating costs were $17.5 million, or 64% of net production income, for the nine-month period ended February 1, 2002 as compared to $18.0 million, or 58% of net production income, for the nine-month period ended January 26, 2001. This increase as a percentage of net production income is principally due to an increase in indirect labor due in part to the effects of September 11, 2001 and related fringe benefits, professional liability insurance, and rent and occupancy expenses. This increase as a percentage of net production income is partially offset by a decrease in indirect labor due in part to management's reduction of salary costs during the second quarter ended November 2, 2001, and, to a lesser extent, a decrease in travel expenses. Amortization of intangible assets was $43,750 for the nine months ended February 1, 2002 as compared to $496,275 for the nine months ended January 26, 2001. This decrease is due to the Company's adoption of SFAS 142, Goodwill and Other Intangible Assets as discussed in the three months ended February 1, 2002 section beginning on page 16 in Management's Discussion and Analysis of Financial Condition and Results of Operations. Interest expense was $0.9 million for the nine-month period ended February 1, 2002 as compared to $1.4 million for the nine-month period ended January 26, 2001. This decrease is principally due to: (a) a decrease in the Company's effective interest rate in the current year and (b) a decrease in the borrowings under the Company's revolving credit facility with IBJ. Income tax expense (benefit) was ($0.1) million for the nine-month period ended February 1, 2002 as compared to $0.7 million expense for the nine-month period ended January 26, 2001. The effective income tax rate was 29 % and 55% for the nine-month periods ended February 1, 2002 and January 26, 2001, respectively. This effective rate is lower principally due to the decrease in non-deductible goodwill amortization resulting from the adoption of SFAS No. 142 for the fiscal year beginning April 28, 2001. 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has met working capital and capital expenditure needs through cash from operations and bank financing. At February 1, 2002, the Company's current assets of $23.9 million exceeded current liabilities of $19.2 million, resulting in net working capital of $4.7 million. During the nine month period ended February 1, 2002, the Company's operating activities provided $1.6 million cash from operations primarily from a decrease in costs and estimated earnings in excess of billings on uncompleted projects and an increase in accounts payable which is partially offset by an increase in trade and other accounts receivable. The Company used $0.5 million primarily for capital expenditures, and to a lesser extent, acquisition activities. The Company provided cash of $0.5 million from financing activities primarily on borrowings under the Company's revolving credit facility with IBJ and borrowings under the term loan agreement with IBJ, which was partially offset by payment on other long-term borrowings. The Company's growth and operating strategy will require substantial capital and may result in the Company from time to time incurring additional debt, issuing equity securities or obtaining additional bank financing. As a management company, HLM Design is responsible for the financing of working capital growth, capital growth and other cash needs of its managed firms. During fiscal year end April 27, 2001, the Company entered into a revolving credit, term loan and capital expenditure loan for a total of $20 million. Effective June 2001, the Company entered into an amendment to (a) reduce the maximum revolving advance amount; (b) cancel the capital expenditure loan commitment and (c) increase the unpaid principal of the term loan to repay amounts under the revolving credit facility, which was based on an evaluation of the Company's revolving advance, term loan and capital expenditure loan needs. The amendment is summarized as follows: a. Revolving credit--The maximum revolving advance amount is $12,500,000 b. Term loan--The unpaid principal balance was increased to $1.6 million. c. Capital expenditure loan--The Capital Expenditure Loan commitment has been cancelled. Effective December 18, 2001, the Company entered into an amendment to its revolving credit, term loan and capital expenditure loan with IBJ. The amendment is summarized as follows: a. Revolving credit-The maximum revolving advance amount is $10,500,000. b. Revolving credit-Waiver of the leverage and senior leverage financial covenants as of quarter ended November 2, 2001. c. Revolving credit-Modification of certain future financial covenants. On March 15, 2002, the Company obtained a Waiver and Consent Letter to its revolving credit, term loan, capital expenditure loan with IBJ. This Waiver and Consent Letter is summarized as follows: a. Revolving credit-Waiver of the leverage and senior leverage financial covenants as of the quarter ended February 1, 2002 waiving compliance through February 2003. b. Revolving credit-Modification of calculation of the leverage and senior leverage ratio as of the quarter ended May 3, 2002 which the Company expects to meet for the fiscal year ended May 3, 2002. At February 1, 2002, the Company had borrowings outstanding under the revolver of $8.8 million. The amount available to borrow is calculated based on the aging of certain assets and generally, the Company borrows the maximum amount available under the terms of this agreement. At February 1, 2002, the Company had borrowings outstanding under the term loan of $1.0 million. 21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED Substantially all assets are pledged under this financing arrangement. This financing arrangement requires that certain financial requirements be maintained such as minimum net worth, minimum EBITDA, maximum leverage and senior leverage ratios, maximum fixed charge coverage and senior fixed charge coverage ratios and maximum capital expenditure commitments All covenants are determined quarterly and the leverage and senior leverage covenants are based on a trailing four quarters ending on each determination date. At February 1, 2002, the Company was in compliance with the minimum net worth, maximum capital expenditure commitments and maximum fixed charge coverage and senior fixed charge coverage ratios; however, the Company was not in compliance with the maximum leverage and senior leverage ratios. The Company has obtained a waiver from IBJ as of February 1, 2002, as discussed above. The Company expects to meet the covenants at future determination dates. Due to lower than anticipated cash flow during the six months ended November 2, 2001 of fiscal year ending May 3, 2002, the Company extended its current year payment obligations under certain note agreements with former acquired company shareholders (the subordinated notes payable) as discussed in Note 3 in Notes to Unaudited Condensed Consolidated Financial Statements. The Company has obtained approval from IBJ (as required by The Revolving Credit, Term Loan and Capital Expenditure Loan Agreement) for the modification of the repayment dates of the subordinated notes payable. The Company expects to continue expanding the operations through internal growth and strategic acquisitions. The Company believes that its revolving line of credit, anticipated funds from future operations coupled with the modification of repayment terms on certain notes payable discussed above will be sufficient to meet the Company's operating needs for the next twelve months, but offers no assurances. However, in order to continue its expansion program through acquisitions, the Company will require additional capital. If the Company is unable to obtain additional capital, its acquisition strategy will be adversely affected. This discussion contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those forward-looking statements. Factors that may cause actual results to differ materially include the Company's ability to contract with architectural engineering and planning firms, the limited number of management services agreements with such firms, the ability to receive payments from the managed firms, dependence on key personnel, dependence on the managed firms, the risks inherent in the provision of professional services, competition, the uncertainties concerning additional financings by the Company and government regulation, as described in Exhibit 99.1 to this Form 10-Q. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates impacting the condensed consolidated financial statements relate to revenue recognition under the percentage of completion method and the allowance for doubtful accounts. 22 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-CONTINUED The majority of the Company's revenues are recorded from fixed fee contracts on a percentage of completion basis based on assumptions regarding estimated direct labor costs to complete. Each month actual labor costs incurred to date are accumulated on each project and estimated labor cost to complete is forecasted for each project. Actual labor costs incurred to date and estimated labor costs to complete are added together to determine projected final labor cost. The percentage complete is determined by dividing the actual labor cost incurred to date by the projected final labor cost. This percentage complete is multiplied by the contract value, net of direct costs, which may include direct subconsultants, travel, printing, etc. to determine the amounts of revenue that can be recognized. Under this method, any projected loss would be immediately recognized in the consolidated condensed financial statements. Historically, the majority of the Company's estimates to complete have been materially correct, but these estimates might not continue to be accurate. Included in accounts receivable and costs and estimated earnings in excess of billings on uncompleted projects on the condensed consolidated balance sheets are reserves for doubtful accounts. Generally, before the Company does business with a new client, the Company reviews their creditworthiness. Senior management reviews the accounts receivable aging on a monthly basis to determine if any receivables will be potentially uncollectible. Based on the information available to the Company, we believe the reserve for doubtful accounts as of February 1, 2002 was adequate. However, no assurances can be given that actual write-offs will not exceed the recorded reserve. In the normal course of business, the Company is party to various claims and legal proceedings. The Company records a reserve for these matters when an adverse outcome is probable and the amount of the potential liability is reasonable estimable. Although the ultimate outcome of these matters is currently not determinable, the Company does not believe that the resolution of these matters will have a material effect upon the financial condition, results of operations or cash flows for an interim or annual period. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risk from changes in interest rates affecting the credit arrangements, including a variable rate revolving credit arrangement and term loan agreement, which may adversely affect the results of operations and cash flows. We seek to minimize the interest rate risk through the Company's day-to-day operating and financing activities. We do not engage in speculative or derivative financial or trading activities. A hypothetical 100 basis point adverse change (increase) in interest rates relating to the revolving credit arrangement and term loan agreement would have decreased pre-tax income for the nine-month period ended February 1, 2002 by approximately $61,000. The Company has no other material exposure to market risk sensitive instruments. 23 PART II. OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS The Company's Revolving Credit, Term Loan, Capital Expenditure Loan, Guaranty and Security Agreement, as amended as of June 29, 2001, provide that the Company may not pay cash dividends on its common stock. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits Exhibit No. Description ----------- ----------- 99.1 Cautionary Statement under Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. (b) Reports on Form 8-K None. Items 1, 3, 4 and 5 are not applicable and have been omitted. 24 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. HLM DESIGN, INC. (Registrant) Date: March 18, 2002 By: /s/ Joseph M. Harris -------------- --------------------- Joseph M. Harris President, Chairman and Director Date: March 18, 2002 By: /s/ Vernon B. Brannon -------------- --------------------- Vernon B. Brannon Senior Vice President, Chief Operating Officer and Chief Financial Officer 25

HLM DESIGN INC 10-Q