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Form 10QSB for HOMELAND SECURITY CAPITAL CORP
14-Aug-2006
Quarterly Report
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
Introductory Statements
Forward-Looking Statements and Associated Risks. This Report contains forward-looking statements. Such forward-looking statements include statements regarding, among other things, (a) our projected sales and profitability, (b) our growth strategies, (c) anticipated trends in our industry, (d) our future financing plans, (e) our anticipated needs for working capital, (f) our lack of operational experience, and (g) the benefits related to ownership of our common stock. Forward-looking statements, which involve assumptions and describe our 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 of these words or other variations on these words or comparable terminology. These forward-looking statements are based largely on our company's expectations and are subject to a number of risks and uncertainties, including those described in "Business Risk Factors" of our Form 10-K for the year ended December 31, 2005. Actual results could differ materially from these forward-looking statements as a result of changes in trends in the economy and our company's industry, demand for our products, competition, reductions in the availability of financing and availability of raw materials, and other factors. In light of these risks and uncertainties, there can be no assurance that the forward-looking statements contained in this Report will in fact occur as projected.
Overview
Homeland Security Capital Corporation (together with any subsidiaries shall be referred to as the `Company,' `we,' `us' and `our') was incorporated in Delaware on August 12, 1997, and is located in Arlington, Virginia. The Company focuses on the acquisition and development of homeland security businesses.
The Company's original business was to develop and manufacture, at third party plants, digital set top boxes and digital video servers for the interactive television and high speed Internet markets.
On June 3, 2003, the Company elected to become a business development company ("BDC"), to be regulated pursuant to Section 54 of the Investment Company Act of 1940, as amended (the "Investment Company Act"). A business development company is an investment company designed to assist eligible portfolio companies with capital formation and management advice. The Company then changed its business plan to primarily seek investments in developing companies.
On December 30, 2005, at a special stockholders meeting (the "Special Meeting"), the stockholders of the Company voted to amend the Certificate of Incorporation of the Company to change the name to `Homeland Security Capital Corporation' and voted to withdraw the Company's election as a BDC. Accordingly, the Company has changed its business plan to primarily seek acquisition of companies that provide homeland security products and services.
The Company is seeking to build consolidated enterprises through the acquisition and integration of multiple businesses in the homeland security industry. We will seek to create long-term shareholder value by taking controlling interests in companies that provide homeland security products and services and helping them develop through superior operations, management and acquisitions. Our value creation strategy is designed to foster significant growth at our platform companies by providing leadership and counsel, capital support and financial expertise, strategic guidance and operating discipline, access to best practices and industry knowledge. We are targeting emerging companies in fragmented sectors of the homeland security industry. These target companies are generating revenues from promising security products and services but face challenges in scaling their businesses to capitalize on opportunities in the homeland security industry.
As part of the Company's new business strategy, the Company acquired a majority interest in Nexus Technologies Group, Inc. ("Nexus") on February 8, 2006 through the purchase of $3.4 million in preferred stock of Nexus. Nexus is a mid-Atlantic security integrator for the corporate and governmental security markets. Based in Hawthorne, N.Y., Nexus' subsidiaries began operations in 2001. Nexus specializes in non-proprietary integrated security solutions, including access control, alarm, video, communication, perimeter protection and bomb and metal detection security systems. Where applicable in this annual report, references to the `Company,' `we,' `us' and `our' shall include Nexus.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires our management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements, including the notes thereto, and related disclosures of commitments and contingencies, if any. We consider our critical accounting policies to be those that are complex and those that require significant judgments and estimates in the preparation of our financial statements, including valuation of our investments. Management relies on historical experience and on other assumptions believed to be reasonable under the circumstances in making its judgment and estimates. Actual results could differ materially from those estimates.
Revenue Recognition - Nexus recognizes revenues on its security system installation and integration contracts using the percentage of completion method.
Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Fair Value of Financial Instruments - The carrying amount of items included in working capital approximates fair value because of the short maturity of those instruments. The carrying value of the Company's debt approximates fair value because it bears interest at rates that are similar to current borrowing rates for loans of comparable terms, maturity and credit risk that are available to the Company.
Debt Offering Costs - Debt offering costs are related to private placements and are being amortized on a straight line basis over the term of the related debt, most of which is in the form of convertible debentures. Should conversion occur prior to the stated maturity date the remaining unamortized cost is expensed.
Investment Valuation - Investments in equity securities are recorded at fair value, represented as cost, plus or minus unrealized appreciation or depreciation, respectively. The fair value of investments that have no ready market, are determined in good faith by management, and approved by the Board of Directors, based upon assets and revenues of the underlying investee companies as well as general market trends for businesses in the same industry. Because of the inherent uncertainty of valuations, management's estimates of the values of the investments may differ significantly from the values that would have been used had a ready market for the investments existed and the differences could be material.
Income Taxes - The Company accounts for income taxes using the asset and liability method, whereby deferred tax assets and liabilities are determined based upon the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance related to the deferred tax assets is also recorded when it is more likely than not that some or all of the deferred tax asset will not be realized.
Results of Operations
Three Months Ended June 30, 2006 Compared With the Three Months Ended June 30, 2005
Revenues
For the three months ended June 30, 2006, the Company had sales of $2,053,707 consisting of fees earned by Nexus on security systems installation and integration contracts. The Company had no sales for the three month period ended June 30, 2005. The increase in sales is due to the implementation of the Company's new business strategy of acquiring and integrating businesses that provide homeland security products and services.
Cost of goods sold
For the three months ended June 30, 2006, cost of sales was $1,166,315 consisting of materials, labor and other costs incurred by Nexus associated with security systems installation and integration contracts. The Company had no cost of sales for the three months ended June 30, 2005. The increase in cost of sales is due to the implementation of the Company's new business strategy of acquiring and integrating businesses that provide homeland security products and services.
General and administrative expenses
General and administrative expenses for the three months ended June 30, 2006 were $1,273,635 compared to $192,239 for the three months ended June 30, 2005. The increase of $1,081,396 or 562% in general and administrative expenses is primarily due to general and administrative expenses that were incurred in the acquisition of Nexus. The increase consisted of additional professional fees of $38,125 for the acquisition of Nexus, additional personnel costs of $701,138, increases in facility and insurance expenses of $188,085 and general administrative costs of $154,048. These costs and other expenses were incurred in connection with the Company's change in business strategy for the three month period.
Other income and expense
The Company had net other income of $860,016 for the three months ended June 30, 2006 compared to net other expenses of $(179,547) for the three months ended June 30, 2005 for an increase of $1,039,563 or 579%. Income was increased by a positive change in the derivative valuation of $1,194,955, settlement of trade payables of $169,684 and interest income of $5,761. Other income and expense was decreased by increases in interest expense of $42,560, amortization of debt discounts of $236,291, amortization of debt offering costs of $43,332 and recording of minority interest in the consolidated Nexus subsidiaries of $8,654.
Net income (loss)
As a result of the foregoing, the Company recorded a net income of $473,773 for the three months ended June 30, 2006 compared to a net loss of $371,786 for the three months ended June 30, 2005. This represents an increase in the net income of $845,559 or 227%.
Six Months Ended June 30, 2006 Compared With the Six Months Ended June 30, 2005
Revenues
For the six months ended June 30, 2006, the Company had sales of $2,741,737, consisting of fees earned by Nexus on security systems installation and integration contracts. The Company had no sales for the six month period ended June 30, 2005. The increase in sales is due to the implementation of the Company's new business strategy of acquiring and integrating businesses that provide homeland security products and services.
Cost of goods sold
For the six months ended June 30, 2006, cost of sales was $1,931,386, consisting of materials, labor and other costs incurred by Nexus associated with security systems installation and integration contracts. The Company had no cost of sales for the six months ended June 30, 2005. The increase in cost of sales is due to the implementation of the Company's new business strategy of acquiring and integrating businesses that provide homeland security products and services.
General and administrative expenses
General and administrative expenses for the six months ended June 30, 2006 were $2,329,966 compared to $392,920 for the six months ended June 30, 2005. The increase of $1,937,046 or 493% in general and administrative expenses is primarily due to general and administrative expenses that were incurred in the acquisition of Nexus. The increase consisted of additional professional fees of $242,089 for the acquisition of Nexus, additional personnel costs of $1,255,457, increases in facility and insurance expenses of $184,604 and general administrative costs of $254,896. These costs and other expenses were incurred in connection with the Company's change in business strategy for the six month period.
Other income and expense
The Company had net other income of $248,044 for the six months ended June 30, 2006 compared to net other expenses of $(279,647) for the six months ended June 30, 2005 for an increase of $527,691 or 189%. Income was increased by a positive change in the derivative valuation of $805,077, recording a minority interest in the loss of the consolidated Nexus subsidiary of $60,225, and interest income of $15,554. Other income and expense was decreased by increases in interest expense of $22,423, amortization of debt discounts of $240,345, amortization of debt offering costs of $31,691, a reduction in the settlement of trade payables of $18,762 and a reduction in investment income of $39,944.
Net loss
As a result of the foregoing, the Company recorded a net loss of $1,271,571 for the six months ended June 30, 2006 and a net loss of $672,567 for the six months ended June 30, 2005. This represents an increase in the net loss of $599,004 or 89%.
Liquidity and Capital Resources
The primary source of financing for the Company since its inception has been through the issuance of common and preferred stock and debt. The Company had cash on hand of $646,280 at June 30, 2006 and $1,094,061 at December 31, 2005. Our primary needs for cash are to fund our ongoing operations until such time as they begin to generate sufficient cash to fund operations and to have cash available to make additional acquisitions of businesses that provide homeland security products and services. While we believe that we have sufficient cash on hand to satisfy our current operating commitments, we will require significant additional funding in order to make additional acquisitions.
While we currently do not have any commitments in place for additional funding, on August 29, 2005, the Company entered into term sheet agreement with Cornell Capital Partners to enter into a $50 million standby equity distribution agreement (the "SEDA Financing"). Based on the SEDA term sheet, Cornell Capital Partners shall commit to purchase up to $50 million of Common Stock of the Company over the course of 24 months after an effective registration of the Company's common stock, par value $.001 per share (the "Common Stock"). The Company shall have the right, but not the obligation, to sell Common Stock to Cornell Capital Partners, in advances up to $1,000,000 each. Upon closing, the Company shall issue to Cornell restricted shares and/or warrants of the Company's Common Stock in an amount equal to 2% of the commitment amount based on a share price of $0.001 per share. The number of restricted shares issued shall be limited to less than 4.9% of the total outstanding shares of the Company at closing. Upon each advance, Cornell Capital Partners shall receive directly from escrow cash compensation equal to 5% of the gross proceeds of such advance. The Company shall sell to Cornell Capital Partners the Common Stock at a purchase price equal to 98% of the market price, which is defined as the lowest closing bid price of the Common Stock during the five consecutive trading days after the date an advance notice is given to Cornell Capital Partners. As of August 14, 2006, the Company has not received any definitive documents in connection with the SEDA Financing. The final terms and conditions of the SEDA Financing may be subject to modification as mutually agreed upon by the Company and Cornell Capital Partners at the time of entering into definitive agreements.
The Company entered into a Securities Purchase Agreement with Cornell Capital Partners, dated as of February 6, 2006, which provided for the purchase by Cornell Capital Partners of a Convertible Debenture (the "Debenture") in the amount of $4,000,000, which debenture is convertible into Common Stock. The conversion price of the Debenture shall be equal to the lesser of (1) $0.01 or
(2) a ten percent discount to the lowest daily volume weighted average price of the Common Stock for the thirty days preceding conversion. Cornell Capital Partners will be entitled to convert the Debenture at a conversion price into Common Stock, provided that Cornell Capital Partners cannot convert into shares of Common Stock that would cause Cornell Capital to own more than 4.9% of the issued and outstanding Common Stock. The Debenture will bear interest at 5% per annum and the principal amount will be payable on the third anniversary of the effective date of the Debenture. If the Common Stock is trading below the conversion price, the Company may redeem the Debenture at any time upon the payment of a redemption premium equal to twenty percent of the amounts redeemed.
On February 6, 2006, the Company entered into an Investment Agreement with Cornell Capital Partners, pursuant to which the Company exchanged with Cornell Capital Partners 1,000,000 shares of Series G Convertible Preferred Stock (the "Series G Preferred Shares") for 450,000,000 shares of the Company's Common Stock owned by Cornell Capital Partners. Each share of Series G Preferred Shares may be converted, at Cornell Capital Partners' discretion, into 450 shares of the Common Stock. The Series G Preferred Shares are senior to all Common Stock and all series of preferred stock of the Company. Each share of Series G Preferred Share has a liquidation preference of $0.10 plus any accrued and unpaid dividends. The holders of Series G Preferred Shares are not entitled to receive any dividends. The Company paid a $10,000 structuring fee to Yorkville Advisors Management, LLC in connection with the transaction.
During the six months ended June 30, 2006, we had a net decrease in cash of $(447,781). Our sources and uses of funds were as follows:
Cash Flows from Operating Activities
We used net cash of $(3,788,018) in our operating activities during the six month period ended June 30, 2006. Our net cash used in operating activities resulted primarily from the Company's net loss of $(1,271,571) for the six months ended June 30, 2006, a use of $(2,547,690) from net changes in operating assets and liabilities for the six months ended June 30, 2006 and the net change in derivative and debt discounts of $321,744. These uses have been offset by $271,216 from the use of stock issued as compensation and for payment of expenses, $21,065 in depreciation and amortization and $72,220 in amortization of debt offering costs for the six months ended June 30, 2006.
Cash Flows from Investing Activities
We used net cash of $(237,492) in our investing activities during the six month period ended June 30, 2006, consisting primarily $202,991 in purchases of fixed assets and an increase of $240,000 in other assets, offset by an increase of $205,499 in minority interest in consolidated subsidiaries.
Cash Flows from Financing Activities
We provided cash of $3,577,729 from financing activities during the six month period ended June 30, 2006, consisting of $4,000,000 in proceeds from convertible debentures issued less $430,000 in costs associated with the issuance of those debentures. We also converted debentures and received net proceeds of $7,729 in cash.
As of June 30, 2006, we had positive net working capital of $176,914.
