10-Q 1 c28365_10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-QSB (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended March 31, 2003 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______. Commission File Number 333-16031 FRONT PORCH DIGITAL INC. ------------------------ (Name of small business issuer as specified in its charter) NEVADA 86-0793960 ------ ---------- State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 20000 Horizon Way, Suite 120 MT. LAUREL, NEW JERSEY 08054 (Address of principal executive offices) (856) 439-9950 (Issuer's telephone number) Check whether the issuer (1) 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 [ ] No [X] As of May 22, 2003, 41,615,648 shares of the issuer's common stock, par value $.001, were outstanding. Transitional Small Business Disclosure Format (check one): Yes [ ] No [X] PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS - FRONT PORCH DIGITAL, INC. CONSOLIDATED BALANCE SHEETS [Unaudited]
ASSETS March 31, 2003 Current assets: Cash and cash equivalents $ 126,722 Accounts receivable - trade & other, net of allowance of $125,000: Non-affiliates 1,184,804 Affiliates 568,794 Deferred costs 35,237 Other current assets 419,568 ------------ Total current assets 2,335,125 Restricted cash 84,311 Property and equipment, net 1,000,471 Software development costs, net 273,784 Software and intellectual property, net of accumulated amortization of $701,709 1,688,845 Excess cost over fair value of net assets acquired, net of accumulated amortization of $949,778 4,364,439 Other assets 45,745 ------------ Total assets $ 9,792,720 ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of note payable $ 307,500 Current lease liability 18,845 Accounts payable 1,561,817 Accrued expenses 1,094,866 Accrued expenses - employees 696,312 Deferred revenue 581,046 ------------ Total current liabilities 4,260,386 Note payable, net of current portion 1,121,463 Other long-term obligations, net of current portion 438,337 Other long-term liabilities 48,082 Stockholders' equity: Preferred stock, nonvoting, $.001 par value, 5,000,000 shares authorized, none issued or outstanding Common stock, $.001 par value 50,000,000 shares authorized 32,329,937 shares issued and outstanding 32,330 Additional paid in capital 23,321,361 Accumulated other comprehensive income 66,144 Common stock to be issued 750,000 Accumulated deficit (20,245,383) ------------ Total stockholders' equity 3,924,452 ------------ Total liabilities and stockholders' equity $ 9,792,720 ============
SEE ACCOMPANYING NOTES. FRONT PORCH DIGITAL, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three months ended March 31, ---------------------------- 2003 2002 ---------------------------- Revenues: Products $ 869,188 $ 111,200 Services 510,529 138,986 Services - affiliate 1,048,982 - ----------- ----------- Total revenue 2,428,699 250,186 Cost of revenue: Products 140,312 44,735 Services 471,460 60,982 ----------- ----------- 611,772 105,717 ----------- ----------- Gross margin 1,816,927 144,469 Selling, general and administrative 1,403,364 766,234 Research and development 146,124 102,849 Depreciation 209,642 153,096 Amortization 149,492 58,929 ----------- ----------- 1,908,622 1,081,108 Loss from operations (91,695) (936,639) Other income (expense): Interest income 385 897 Interest expense (153,536) (4,500) Other expense 1,265 - Foreign currency transaction loss (702) - ----------- ----------- (152,588) (3,603) ----------- ----------- Net loss $ (244,283) $ (940,242) =========== =========== Weighted average number of common shares outstanding - basic and diluted 32,329,937 25,959,646 Loss per common share - basic and diluted $ (0.01) $ (0.04) ----------- ----------- SEE ACCOMPANYING NOTES. 3 FRONT PORCH DIGITAL, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Quarter Ended March 31, 2003 2002 ------------------------------------------ CASH FLOWS FROM OPERATING ACTIVITIES Net loss (244,283) $ (940,242) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation & amortization 359,134 212,025 Non-cash interest expense 138,750 - Non-cash issuance of common stock to employees and consultants - 83,774 Stock option compensation cost 9,259 68,987 Gain on sale of fixed assets (9,951) - Changes in operating assets and liabilities: Increase in accounts receivable (65,202) (86,655) Decrease in deferred costs 53,290 - Decrease (increase) in other current assets 175,065 (173,901) Decrease in other assets 63,600 - (Decrease) increase in accounts payable (115,944) 179,968 (Decrease) increase in accrued expenses (88,261) 7,332 Increase (decrease) in accrued expenses - employees 13,111 (13,355) (Decrease) increase in deferred revenue (709,253) 173,177 Other changes in operating activities - 83,381 ------------- ------------- Net cash used in operating activities (420,685) (405,509) ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (6,451) (13,506) Software development costs (62,180) (13,088) Proceeds from sale of fixed assets 31,354 - Other investing activities (7,539) - ------------- ------------- Net cash used in investing activities (44,816) (26,594) ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from note payable - 350,000 Repayment of note payable and capital leases (120,373) - Proceeds from issuance of common stock - 50,000 ------------- ------------- Net cash (used in) provided by financing activities (120,373) 400,000 ------------- ------------- Effect of exchange rate fluctuations on cash and cash equivalents (2,561) - - Net increase (decrease) in cash and cash equivalents (588,435) (32,103) Cash and cash equivalents (including restricted cash), beginning of period 799,468 393,439 ------------- ------------- Cash and cash equivalents (including restricted cash), end of period 211,033 361,336 ============= =============
SEE ACCOMPANYING NOTES. 4 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BASIS OF PRESENTATION Front Porch Digital Inc. (the "Company") enables the conversion, preservation and management of analog and digital content, including text, images, audio, graphics, video and rich media. The Company develops proprietary software products and performs services that convert content into digital formats for subsequent storage and on-demand delivery in the same or other formats or digital platforms. The software, based on proprietary and patent-pending technology, enables a new paradigm in the way broadcasters, content owners, education and law enforcement personnel manage their workflow - a shift from tape-oriented warehousing to a fully-digital, instant access automated archive. The Company's customers are located in the United States, Europe and Asia. The consolidated financial statements of the Company have been prepared on a going-concern basis, which contemplates the realization of assets and liabilities in the normal course of business. Accordingly, the consolidated financial statements do not include any adjustments that might be necessary should the Company be unable to continue in existence. The Company has incurred losses since commencement of operations in its current line of business. Although the Company's operating results have improved in 2002 and the first quarter of 2003, the Company has made certain progress toward financial stability as described in Note 8 Subsequent Events, and the Company expects its results of operations to continue to improve throughout 2003, there can be no assurance that the Company will not continue to sustain operating losses. Further, for the three months ended March 31, 2003, the Company incurred net losses and negative cash flows from operating activities of $0.2 million and $0.4 million, respectively. For the three months ended March 31, 2003, the Company incurred a loss from operations of $92,000. In addition, at March 31, 2003, the Company had a working capital deficit of $1.9 million. These factors create significant uncertainty about the Company's ability to continue as a going concern. During the first quarter of 2003, management continued implementing a restructuring of the operations of the Company that included reorganizing the personnel of the Company, reducing headcount, reducing non-essential operating costs and refocusing the Company's business strategy, products and services. The Company has also undertaken an aggressive cash management program that includes deferral of payment of certain expenses and the accelerated collection of cash payments on contracted revenues. Management of the Company recognizes that additional resources will be required to continue as a going concern and, in April 2003, secured additional capital and restructured certain liabilities as described in Note 8 -- Subsequent Events. Management believes these actions will enable the Company to obtain sufficient cash to continue as a going concern. However, there can be no assurance that the additional capital and improved liquidity will be adequate to enable the Company to continue as a going concern. The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. Management of the Company believes the disclosures are adequate to make the information presented not misleading. In the opinion of management, all adjustments considered necessary for a fair presentation have been included and such adjustments are of a normal and recurring nature. For further information, refer to 5 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) the financial statements and footnotes included in the Company's Annual Report on Form 10-KSB for the year ended December 31, 2002. Operating results for the three months ended March 31, 2003 are not necessarily indicative of the operating results expected for the year ending December 31, 2003. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Front Porch Digital, Inc. and its wholly-owned subsidiary (the "Company"). All significant intercompany transactions and balances have been eliminated in consolidation. REVENUE RECOGNITION The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery and acceptance has occurred, the fee is fixed or determinable, and collection is reasonably assured. The Company licenses software under license agreements and provides professional services, including training, installation, consulting and maintenance. License fee revenues are recognized when a license agreement has been signed, the software product has been shipped, the fees are fixed and determinable, collection is considered probable and no significant vendor obligations remain. The Company allocates revenue to each component of the contract based on objective evidence of its fair value, as established by management. Because licensing of the software generally is not dependent on the professional services portion of the contract, the software revenue is recognized upon delivery. Fees for maintenance agreements are recognized ratably over the term of the agreement. Maintenance is generally billed in advance resulting in deferred revenues. The Company provides software-related professional services. Services are generally provided on a time and materials basis and revenue is recognized as the services are provided. Revenue under service contracts is recognized when services have been performed and accepted, or on the proportional-performance method of accounting, depending on the nature of the project. The extent of progress toward completion under the proportional-performance method of accounting is measured by using the number of sites and/or units under the contract that have been completed and the progress towards completion of batches in progress at period end. STOCK-BASED COMPENSATION The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its employee stock options because the alternative fair value accounting provided for under Financial Accounting Standards Board Statement of Financial Accounting Standard (SFAS) No. 123, "Accounting for Stock Based Compensation," requires the use of option valuation models that were not developed for use in valuing employee stock options. The effect of applying SFAS No. 123's fair value method to the Company's stock-based award results in pro forma net loss that is not materially different from the amounts reported for the three months ended March 31, 2002 and 2003 and loss per share that is the same as the amounts reported for the three months ended March 31, 2002 and 2003. Pro forma results of operations may not be representative of the effects on reported or pro forma results of operations for future years. For the three months ended March 31, 2003 and 2002, $10,000 and 69,000 of compensation cost was recorded, respectively. 6 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The Company accounts for equity instruments issued to non-employees in exchange for goods or services using the fair value method and records expense based on the values determined. USE OF ESTIMATES The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECLASSIFICATIONS Certain reclassifications have been made to prior year amounts and balances to conform with the 2003 presentation. 2. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In December 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure -- an amendment of FASB Statement No. 123." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 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 Company has not adopted SFAS No. 148 in its accounting for stock-based compensation. However it has updated its disclosure to conform to the pronouncement. 3. ACQUISITION On July 31, 2002, the Company acquired all of the outstanding stock of ManagedStorage International France, a French SOCIETE PAR ACTIONS SIMPLIFEE("MSI France"), and certain assets of ManagedStorage International, Inc., a Delaware corporation ("ManagedStorage"), pursuant to a Stock and Asset Purchase Agreement dated as of July 31, 2002 (the "Purchase Agreement"), between the Company and ManagedStorage. The consideration paid by the Company pursuant to the Purchase Agreement consisted of (a) 5,000,000 shares of common stock, par value $.001 per share, of the Company (the "Company Common Stock"), which were valued at $1.5 million; (ii) a warrant for the purchase of up to 1,750,000 shares of Company Common Stock at a price of $2.00 per share, exercisable immediately and expiring on July 31, 2012; and (iii) a warrant for the purchase of up to 1,750,000 shares of Company Common Stock at a price of $4.00 per share, exercisable immediately and expiring on July 31, 2012. In December 2002, an additional $750,000 of consideration became payable to the seller as certain earn-out targets were achieved. This amount was recorded as common stock to be issued at March 31, 2003 and, in April 2003, 2.5 million shares of common stock of the Company were issued in satisfaction of this earn-out consideration. Pursuant to the terms of the Purchase Agreement, the Company acquired from ManagedStorage (i) all of the issued and outstanding shares of capital stock of MSI 7 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) France and (ii) certain software and related intellectual property rights, including DIVArchive, a software solution designed to assist media, entertainment and medical companies in the preservation, management and accessing of digital content consisting of large digital data files. Pursuant to the Purchase Agreement, ManagedStorage entered into a Lock-Up Agreement with the Company whereby, subject to certain exceptions, ManagedStorage agreed not to sell, assign, transfer, pledge or otherwise dispose of any Company Common Stock owned or acquired by it or any interest therein prior to July 31, 2003, except as expressly permitted by the Lock-Up Agreement. In connection with the transaction, ManagedStorage was granted certain demand registration rights with respect to the shares of Company Common Stock acquired by ManagedStorage pursuant to the terms of the Purchase Agreement. The acquisition has been accounted for as a purchase. Results of operations for the acquired entity are included in the consolidated statement of operations for the three months ended March 31, 2003. Intellectual property, which represents the DIVArchive software, is amortized over a three-year period. Total amortization expense related to the intellectual property acquired was $60,000 for the three months ended March 31, 2003. The following pro forma results of operations of the Company for the three months ended March 31, 2003 and 2002 are presented to reflect the acquisition as if it had occurred as of the beginning of the periods presented. PRO FORMA RESULTS OF OPERATIONS: 2003 2002 ---- ---- Revenues $ 2,428,000 $ 1,000,000 Loss from continuing operations (92,000) (1,616,000) Net loss (244,000) (1,653,000) Basic and diluted loss per share (.01) (.05) Weighted average shares outstanding 32,329,937 33,459,646 4. NOTES PAYABLE At March 31, 2003, notes payable consisted of: $150,000 unsecured note payable that bore interest at 9% per annum. In September 2002, the Company recapitalized the outstanding balance and accrued interest of an existing unsecured note payable. The new principal amount of $246,500 included the original principal balance of $200,000 plus accrued interest of $46,500. The note was payable in an initial payment of $45,000, and equal monthly installments of $25,000 through 8 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) June 1, 2003, with a final payment of $8,647 on July 1, 2003. At March 31, 2002, the remaining principle balance on this note was $150,000. During April 2003, the Company restructured this note payable as described in Note 8 -- Subsequent Events; $744,000 of an unsecured non-interest bearing note payable to an employee. This note is payable based on a percentage of revenue of certain operations of the Company, ranging between 2% and 3% per year, to be payable in full no later than December 31, 2004. In the event the Company exits the media conversion business prior to December 31, 2004, the remaining balance of this note is payable on demand. The Company has estimated that $170,000 will be payable in the next 12 months; and $500,000 aggregate principal amount of convertible secured notes to two investors that were issued on March 27, 2002. The notes contained a beneficial conversion feature as the notes included certain anti-dilution protection and rights, and they were convertible into common stock at a price significantly below the then current market price. The Company allocated $500,000 of the value received to this beneficial conversion feature, which has been recorded as a debt discount and has been amortized to interest expense over the term of the debt. The Company recorded non-cash interest expense related to debt discount of $125,000 during the three months ended March 31, 2003. The notes matured on March 27, 2003, bore interest at the rate of 7% per annum, which was payable on a quarterly basis, and were secured by all of the assets of the Company. The notes were convertible at any time at the option of the note holders into a number of shares of common stock of the Company equal to 14% of the outstanding shares of common stock, subject to certain anti-dilution adjustments. The note holders were granted certain rights for the registration of these shares under the Securities Act of 1933, as amended, which requires the Company to register these shares on the earlier of April 2003, or upon the filing of certain registration statements by the Company. The notes contained restrictions that, among others, prohibited the Company from issuing new debt, paying creditors in excess of specified amounts, or prepaying the notes without the consent of the note holders. In the event the Company raised $2.5 million of equity capital, the Company could have deposited into an escrow account an amount equal to the outstanding principal and interest on the notes, at which time all restrictions and liens on the assets of the Company would have been released. Upon the sale or liquidation of substantially all of the assets of the Company, or a business combination in which a majority of the issued and outstanding shares of common stock of the Company is transferred, the note holders were entitled to receive all outstanding principal and interest on the notes and a liquidation preference equal to three times the amount of such outstanding principal and interest. During April 2003, the Company converted and restructured these notes as detailed in Note 8 -- Subsequent Events. Based on the refinancing described in Note 8, at March 31, 2003, the Company classified $307,500 of these notes payable as a current liability and $1,121,463 as a long-term liability, which included accrued interest of $35,000 and will be due in 2004. 5. CONCENTRATION OF CREDIT RISK The Company sells its products and services throughout the United States, Europe and Asia. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. Credit losses have been within management's expectations. For the three months ended March 31, 2003, revenues from two customers, each exceeding 10% of total revenue, aggregated 43% and 11%, respectively. At March 31, 2003, accounts receivable from the largest customer was $568,794, or 37% of total trade receivables. This customer is also a stockholder of the Company. In addition, accounts receivable from two other customers aggregated 28% and 12% of accounts receivable at March 31, 2003. For the three months ended March 31, 2002, revenues from two customers, each exceeding 10% of total revenue, aggregated 42% 9 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) and 39%, respectively. The Company was a subcontractor for this customer/stockholder during 2002 and 2003, which beneficially owned approximately 13.5% of the Company's outstanding common stock as of May 22, 2003. 6. PER SHARE DATA The Company reports its earnings (loss) per share in accordance with the SFAS No. 128, "Accounting for Earnings Per Share". Basic loss per share is calculated using the net loss divided by the weighted average common shares outstanding. Shares from the assumed conversion of outstanding warrants and options are omitted from the computations of diluted loss per share because the effect would be antidilutive. 7. SEGMENT INFORMATION SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," establishes standards for reporting information about operating segments and related disclosures about products and services, geographic areas and major customers. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company's operations are segregated into two lines of business: media conversion services and software and related services. The Company operates these lines of business across the geographic areas of the United States, Europe, Canada and Asia-Pacific. Offices and facilities are located in Mount Laurel, New Jersey, Houston, Texas and Toulouse, France. The Company's lines of business are not completely integrated into all locations and therefore the Company does not currently offer all solutions in all markets in which it is present. Current efforts are underway to integrate products and services across all markets served. The media conversion business segment offers a comprehensive, integrated suite of enterprise data media solutions ("EDMS") that can help customers ensure information preservation, reduce cost and improve productivity without compromising the security and integrity of their stored information. The Company's EDMS group has performed professional services for over 600 customers worldwide in industries that include banking and finance, power utility, petroleum, pharmaceutical and government. All services offered by the EDMS group are performed offline utilizing the Company's proprietary software and stand-alone hardware devices, at either the customer site or one of the Company's secure delivery facilities. These services can be performed for any applicable optical and/or tape media type and format. Components of the currently available offerings include tape copy and conversion, tape volume management, tape data assurance, and archive generation and conversion. The software and related services business segment offers an integrated suite of digital media solutions that facilitate the capture, management and distribution of digital content. Components of these offerings include a desktop encoding system, automated video indexing and a real-time format transcoder. In addition, the Company offers a distributed storage and archive management solution for the entertainment industry that simplifies the process of preserving, managing and accessing digital content. Revenues, margins and operating expenses of the Company's lines of business are evaluated by management. The Company does not measure assets by lines of business as assets are generally not distinctive to a particular line of business and they are not fundamental in assessing segment performance. Capital expenditures are managed by segment, but only for purposes of budgeting and cash flow management. General overhead expenses are included completely in the software and services business segment as the media conversion segment has been and continues to be an easily definable, separate, 10 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) stand-alone business - no allocations of such costs are made as allocated indirect costs are not considered in the management of the business segments. All direct and indirect costs associated with a segment are reported within that segment. Summarized operations of each of the Company's operating segments in the aggregate for the three months ended March 31, 2003 and 2002, are as follows: MEDIA CONVERSION SOFTWARE AND SERVICES Three Months Ended March 31, Three Months Ended March 31, 2003 2002 2003 2002 Revenues $1,375,204 $ 123,536 $1,053,495 $ 126,650 Gross margin 1,138,519 35,319 678,408 109,150 Gross margin % 83% 29% 64% 86% Income (Loss) from continuing operations 943,891 (253,835) (1,035,586) (682,803) 8. SUBSEQUENT EVENTS Subsequent to March 31, 2003, the following transactions were consummated: In April 2003, the Company issued $645,000 aggregate principal amount of unsecured convertible promissory notes that bear interest at the rate of 8% per annum and mature on September 30, 2004. Principle and accrued interest are payable at maturity. The convertible notes are convertible at any time at the option of the note holders into shares of common stock of the Company at a conversion price of $.042 per share, subject to certain anti-dilution adjustments. The convertible notes may be prepaid by the Company at any time without penalty. In the event of a prepayment by the Company, or upon payment of principal and interest at maturity, the Company will be required to issue to the holders of such notes five-year common stock purchase warrants pursuant to which the holders of the warrants will have the right to purchase a number of shares of common stock of the Company equal to 5,500 shares for each $1,000 of principal balance repaid, at a purchase price of $0.10 per share, subject to certain anti-dilution adjustments. The purchase agreement relating to the convertible notes contains restrictions that, among others, prohibit the Company from issuing new debt, making capital expenditures in excess of specified amounts, paying dividends on the common stock or granting security interests in assets without the consent of note holders owning a majority in principal amount of the outstanding notes. In April 2003, the holders of the $500,000 aggregate principal amount of convertible secured notes converted $250,000 of the outstanding principle and 100% of the accrued interest into 6,785,715 shares of common stock of the Company pursuant to the conversion terms of the convertible secured notes discussed in Note 4. The holders of these notes also converted the remaining $250,000 principal balance on the notes into the convertible notes described in the preceding paragraph. During April 2003 and in connection with the $645,000 funding and secured note conversion above, the Company restructured certain other current liabilities including: (i) restructuring $530,000 of current liabilities to a single vendor to be payable over a five-year period, with interest at the rate of 5% per annum. Principal payments under the agreement are fixed for the first year at $100,000 per year. Remaining payments are subject to certain acceleration clauses based upon working capital levels and capital raised. In connection with this agreement, the Company issued warrants to purchase up to 500,000 shares of common stock at a price per share of $0.10 to the vendor and (ii) restructuring a $150,000 note payable and accrued interest which was due in full on June 30, 2003 into a new note that is payable over 12 months and matures on May 1, 2004. The note is payable in equal monthly installments beginning May 1, 2003 and carries an annual interest rate of 9% per 11 FRONT PORCH DIGITAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) annum. Accrued interest is payable at maturity. In connection with this agreement, the Company issued to the noteholder warrants to purchase up to 100,000 shares of common stock at a price per share of $0.10. On April 23, 2003, the Company sold to Eastman Kodak Company ("Kodak") the Company's intellectual property rights relating to the DIVArchive product applications for the medical imaging and information management market. In connection with such sale, Kodak paid the Company $800,000, will pay the Company a final payment of $50,000 upon completion of certain post-closing matters, has offered employment to substantially all of the Company's personnel associated with the transferred assets and assumed certain software support obligations to the Company's existing DIVArchive customers in the medical industry. 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND PLAN OF OPERATIONS GENERAL When used in this discussion, the words "believes", "anticipates", "expects" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. The Company's business and results of operations are affected by a wide variety of factors that could materially and adversely affect the Company and its actual results, including, but not limited to: (1) the availability of additional funds to enable the Company to successfully pursue its business plan; (2) the uncertainties related to the effectiveness of the Company's technologies and the development of its products and services; (3) the Company's ability to maintain, attract and integrate management personnel; (4) the ability of the Company to complete the development and continued enhancement of its products in a timely manner; (5) the Company's ability to effectively market and sell its products and services to current and new customers; (6) the Company's ability to negotiate and maintain suitable strategic partnerships and corporate relationships; (7) the intensity of competition; and (8) general economic conditions. As a result of these and other factors, the Company may experience material fluctuations in future operating results on a quarterly or annual basis, which could materially and adversely affect its business, financial condition, operating results and stock price. Any forward-looking statements herein speak only as of the date hereof. The Company undertakes no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. OVERVIEW The Company enables the conversion, preservation and management of analog and digital content, including text, images, audio, graphics, video and rich media. The Company develops proprietary software products and performs services that convert content into digital formats for subsequent storage and on-demand delivery in the same or other formats or digital platforms. The software, which is based on proprietary and patent-pending technology, enables a new paradigm in the way broadcasters, content owners and education and law enforcement personnel manage their workflow - a shift from tape-oriented warehousing to a fully-digital, instant access automated archive. With additional expertise in providing onsite, offline data management services for tape and optical assets, the Company believes it is uniquely positioned to enable clients to preserve, protect and manage information assets. The Company's customers are located in the United States, Europe and Asia. The Company is in the early stages of executing its business strategy and anticipates generating significant revenues from the sale of its data conversion and software products during the next 12 months. This expansion is contingent upon several factors, including the availability of adequate cash resources, the price of its products and services relative to its competitors, and general economic and business conditions, among other factors. In the fourth quarter of 2002, the Company initiated a restructuring plan in an effort to position itself to raise the necessary working capital to capitalize on its product and service portfolio, which has been gaining widespread acceptance in the marketplace. The restructuring plan included: 13 o Implementing cost reductions and cost control measures to limit new spending, including reducing headcount in the United States and Europe, reducing salaries and benefits costs, reducing consulting fees, controlling and reducing travel and entertainment costs, reducing facility size and costs and reducing overall general operating costs. o Securing additional resources in executive management and operations to develop and implement the restructuring plan. o Reducing short-term liabilities by renegotiating with its key vendors and other short-term creditors to settle outstanding obligations for reduced amounts or extending payment terms, in some cases beyond one year. o Implementing aggressive cash flow management, including accelerating significant cash receipts from customers in advance of due dates and deferring vendor payables to minimize the actual cash outflows of the business. o Re-aligning existing personnel and operations to better match the costs of the business with the business focus and expected results of operations. o Improving operational management, effectiveness and efficiency to enable the Company to deliver on its existing customer contracts in a timely and predictable manner. The following discussion and analysis of financial condition and results of operations are based upon the Company's financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. RESULTS OF OPERATIONS - Three Months Ended March 31, 2003 Compared to the Three Months Ended March 31, 2002 REVENUE. Total revenue for the three months ended March 31, 2003 increased $2.2 million, to $2.4 million compared to total revenue of $250,000 for the three months ended March 31, 2002. This increase was attributable to the additional revenue generated in both the media conversion and software and related services business segments. Service revenues totaled $1,560,000, or 64% of total revenues, for the three months ended March 31, 2003 as compared to $139,000, or 56% of total revenues, for the three months ended March 31, 2002. For the three months ended March 31, 2003, $869,000, or 36% of total revenue, was attributable to sales of software and related products as compared to $111,000, or 44% of total revenue, for the three months ended March 31, 2002. GROSS MARGIN. Total gross margin was $1,817,000, or 75% of total revenue, for the three months ended March 31, 2003 compared to $144,000, or 58% of total revenue, for the three months ended March 31, 2002. This increase was attributable to increased revenue from these services and the timely delivery of these services to customers. In addition, revenues scaled to a level whereby the direct costs of operations can be supported, unlike in the prior year periods during which revenue was marginally able to cover cost of sales. For the three months ended March 31, 2003, sales of software and related products resulted in gross margins of 83% and the provision of data and video conversion services resulted in gross margins of 69%. For the three months ended March 31, 2002, sales of software and related products resulted 14 in gross margins of 60% and the provision of data and video conversion services resulted in gross margins of 56%. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses for the three months ended March 31, 2003 were $1,403,000, as compared to $766,000 for the three months ended March 31, 2002. Selling, general and administrative expenses for the three months ended March 31, 2003 consisted primarily of $695,000 for salaries and related benefits for employees not directly related to the production of revenue, $245,000 in professional and consulting fees, $95,000 for travel, $131,000 of facilities costs, and $237,000 for general office expenses. Selling, general and administrative expenses for the three months ended March 31, 2002 consisted primarily of $550,000 for salaries and related benefits for employees not directly related to the production of revenue, $77,000 in professional fees, $39,000 for travel, $59,000 of facilities costs, and $41,000 for general office expenses. As a result of the restructuring, the Company's selling, general and administrative expenses are expected to decrease in subsequent quarters. RESEARCH AND DEVELOPMENT. The Company maintains a software development staff that designs and develops the Company's new products and services. The Company believes that by performing most of its own software development, it can more quickly and cost-effectively introduce new and innovative technologies and services. In addition, the Company believes it will be better equipped to incorporate customer preferences into its development plans. The Company continues to devote more resources to the development of software tools and products that facilitate the conversion and migration of data from legacy media to current technology, convert analog content to multiple digital formats, manage and reformat digital content on demand and archiving technologies. Research and development expenses for the three months ended March 31, 2003 were $146,000 compared to $103,000 for the three months ended March 31, 2002. DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense was $359,000 for the three months ended March 31, 2003 compared to $212,000 for the three months ended March 31, 2002. Amortization expense primarily consisted of amortization of intangible assets. Depreciation expense consists of depreciation of furniture, equipment, software and improvements. The increase in depreciation and amortization expenses is the result of the inclusion of such expenses for MSI France, which was acquired in August 2002. The Company will perform an ongoing annual impairment test, as required under SFAS No. 142, "Goodwill and Other Intangible Assets" by the Financial Accounting Standards Board, at the end of the third quarter of each year. LOSS FROM OPERATIONS. For the three months ended March 31, 2003, the Company reported a loss from operations of $92,000 compared to a loss from operations of $0.9 million for the three months ended March 31, 2002. INTEREST EXPENSE. Interest expense was $154,000 for the three months ended March 31, 2003 compared to $5,000 for the three months ended March 31, 2002. Interest expense for the three months ended March 31, 2003 included non-cash interest charges aggregating $139,000, including a non-cash interest charge of $125,000 related to the amortization of debt discount on the Company's senior secured convertible notes (which have since been retired) and non-cash interest expense of $14,000 related to amortization of non-cash financing costs. NET LOSS. For the three months ended March 31, 2003, the Company reported a net loss of $0.2 million, or ($.01) per share, compared to a net loss of $0.9 million, or ($.04) per share, for the three months ended March 31, 2002. FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS. The Company conducts business in various countries outside the United States in which the functional currency of the country is not the U.S. dollar. As a result, the Company has foreign currency exchange translation exposure as the results of these foreign operations are translated into U.S. dollars in its consolidated financial statements. The effect of changes in value of the U.S. dollar compared to other currencies, primarily the euro, has been to increase reported revenues and operating profit when the U.S. dollar 15 weakens and reduce these amounts when the dollar strengthens. While the Company looks for opportunities to reduce its exposure to foreign currency fluctuations against the U.S. dollar, at this point the Company has not had adequate financial resources to pursue hedging opportunities generally. At March 31, 2003, the Company reported a cumulative translation gain of $66,144 as a component of Comprehensive Loss. The Company is also subject to foreign exchange transaction exposure when its subsidiaries transact business in a currency other than its own functional currency. These transactions are infrequent and have not had a significant effect on the consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES In April 2003, the Company issued $645,000 aggregate principal amount of unsecured convertible promissory notes that bear interest at the rate of 8% per annum and mature on September 30, 2004. Principle and accrued interest are payable at maturity. The convertible notes are convertible at any time at the option of the note holders into shares of common stock of the Company at a conversion price of $.042 per share, subject to certain anti-dilution adjustments. The convertible notes may be prepaid by the Company at any time without penalty. In the event of a prepayment by the Company, or upon payment of principal and interest at maturity, the Company will be required to issue to the holders of such notes five-year common stock purchase warrants pursuant to which the holders of the warrants will have the right to purchase a number of shares of common stock of the Company equal to 5,500 shares for each $1,000 of principal balance repaid, at a purchase price of $0.10 per share, subject to certain anti-dilution adjustments. The purchase agreement relating to the convertible notes contains restrictions that, among others, prohibit the Company from issuing new debt, making capital expenditures in excess of specified amounts, paying dividends on the common stock or granting security interests in assets without the consent of note holders owning a majority in principal amount of the outstanding notes. In April 2003, the holders of the $500,000 aggregate principal amount of convertible secured notes converted $250,000 of the outstanding principle and 100% of the accrued interest into 6,785,715 shares of common stock of the Company pursuant to the conversion terms of the convertible secured notes discussed in Note 4. The holders of these notes also converted the remaining $250,000 principal balance on the notes into the convertible notes described in the preceding paragraph. During April 2003 and in connection with the $645,000 funding and secured note conversion above, the Company restructured certain other current liabilities including: (i) restructuring $530,000 of current liabilities to a single vendor to be payable over a five-year period, with interest at the rate of 5% per annum. Principal payments under the agreement are fixed for the first year at $100,000 per year. Remaining payments are subject to certain acceleration clauses based upon working capital levels and capital raised. In connection with this agreement, the Company issued warrants to purchase up to 500,000 shares of common stock at a price per share of $0.10 to the vendor and (ii) restructuring a $150,000 note payable and accrued interest which was due in full on June 30, 2003 into a new note that is payable over 12 months and matures on May 1, 2004. The note is payable in equal monthly installments beginning May 1, 2003 and carries an annual interest rate of 9% per annum. Accrued interest is payable at maturity. In connection with this agreement, the Company issued to the noteholder warrants to purchase up to 100,000 shares of common stock at a price per share of $0.10. On April 23, 2003, the Company sold to Eastman Kodak Company ("Kodak") the Company's intellectual property rights relating to the DIVArchive product applications for the medical imaging and information management market. In connection with such sale, Kodak paid the Company $800,000, will pay the Company a final payment of $50,000 upon completion of the transition process and has offered employment to substantially all of the Company's personnel associated with the transferred assets and assumed 16 certain software support obligations to the Company's existing DIVArchive customers in the medical industry. As of March 31, 2003, the Company had liquid assets (unrestricted cash and cash equivalents and accounts receivable) of $1.9 million and current assets of $2.3 million. Current liabilities of $4.3 million at March 31, 2003 consisted of $1.6 million of accounts payable; $1.1 million of accrued expenses; $696,000 of accrued expenses to employees; $581,000 of deferred revenue, which consisted of progress payments received on engagements currently in progress; $308,000 of current portion of notes payable and $19,000 of current lease liability. The Company's working capital deficit was $1.9 million as of March 31, 2003 for the reasons described above. The Company used net cash of $0.4 million in operating activities during the three months ended March 31, 2003 and used net cash of $0.4 million in operating activities during the three months ended March 31, 2002, primarily as a result of the net losses incurred during the periods. During the three months ended March 31, 2003, the Company used $45,000 in investing activities, of which $6,000 was used for capital expenditures, $62,000 was used for the development of the Company's suite of video software solutions, and $8,000 was used in other investing activities, offset by proceeds from the sale of fixed assets of $31,000. During the three months ended March 31, 2002, the Company used $27,000 in investing activities, of which $14,000 was used for capital expenditures and $13,000 was used for the development of the Company's suite of video software solutions. The Company used $120,000 in financing activities during the three months ended March 31, 2003, which consisted solely of principal repayments made on notes payable and capital leases. During the three months ended March 31, 2002, financing activities provided $400,000, which consisted of $350,000 of borrowings on notes payable and $50,000 of proceeds from the issuance of 400,000 shares of unregistered common stock to an individual investor. The Company expects capital expenditures to be approximately $0.5 million during the next twelve months. It is expected that the Company's principal uses of cash will be to provide working capital and to finance capital expenditures and for other general corporate purposes, including financing its sales and marketing strategy. The amount of spending in each respective area is dependent upon the total capital available to the Company. The Company expects that anticipated cash flow from operations combined with its cash and cash equivalents at May 22, 2003 will be sufficient to operate for at least the next 12 months. However, continued operating losses and the early stage of the Company's business, as well as potential changes in the business and competitive environment, continue to present a significant risk to the Company's long-term success. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The Company's actual financial results may differ materially from the stated plan of operations. Factors which may cause a change from the Company's plan of operations vary, but include, without limitation, decisions of the Company's management and board of directors not to pursue the stated plan of operations based on its reassessment of the plan, and general economic conditions. Additionally, there can be no assurance that the Company's business will generate cash flows at or above current levels. Accordingly, the Company may choose to defer capital expenditure plans and extend vendor payments for additional cash flow flexibility. ITEM 3. CONTROLS AND PROCEDURES (a) Based upon an evaluation performed within 90 days of this Report, our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO") have each concluded that our disclosure controls and procedures are effective to ensure that 17 material information relating to our Company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our internal controls are effective to provide reasonable assurances that our financial condition, results of operations and cash flows are fairly presented in all material respects. (b) The CEO and CFO each note that, since the date of his evaluation until the date of this Report, there have been no significant changes in internal controls or in other factors that could significantly affect internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses. 18 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS: On or about March 21, 2003, Giancarlo Gaggero, a former employee of the Company, and Data Strategies International, Inc., a company owned and controlled by Mr. Gaggero, filed a suit against the Company in the District Court of Harris County, Texas alleging breach by the Company of an asset purchase and related agreements between Data Strategies and the Company and breach by the Company of an employment agreement between Mr. Gaggero and the Company. Mr. Gaggero's employment with the Company was terminated on March 5, 2003. The plaintiffs seek monetary damages of approximately $253,000 plus interest and costs and a declaration that they are excused from performance under the agreements from and after January 2001. The Company responded to the complaint on April 17, 2003 and requested that the case be moved from state court to federal court jurisdiction. The Company believes certain of the claims are without merit, with respect to which the Company intends to defend the action vigorously, and is considering certain counterclaims against the plaintiffs. An outcome in this litigation that is adverse to the Company, cost associated with defending the lawsuit and the diversion of management's time and resources to defend the lawsuit could seriously harm the Company's business and its financial condition. In addition to the proceeding described above, the Company is involved in certain other disputes that arise in the ordinary course of business. The Company believes that no current dispute will have a material adverse effect on its financial condition or results of operations. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K: The following exhibits are filed herewith: (a) Exhibits 99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Current Reports on Form 8-K or 8-K/A The Company filed a Current Report on Form 8-K dated January 8, 2003 reporting several executive officer changes. The changes announced included the resignation of Paul McKnight as Chief Financial Officer, the election of Matthew Richman as Chief Financial Officer and the appointment of Michael Knaisch as Chief Operating Officer of the Company. The Company filed a Current Report on Form 8-K dated March 1, 2003 announcing the resignation of David Cohen as a director of the Company. 19 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: May 27, 2003 FRONT PORCH DIGITAL INC. By: /s/ DONALD MAGGI ------------------- Donald Maggi Chief Executive Officer (principal executive officer) By: /s/ MATTHEW RICHMAN ------------------- Matthew Richman Chief Financial Officer and Treasurer (principal financial and accounting officer) 20 Certification of Principal Executive Officer Pursuant to 18 U.S.C. 1350 (SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002) I, Donald Maggi, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Front Porch Digital Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. By: /s/ Donald Maggi ------------------------- Name: Donald Maggi Title: Chief Executive Officer May 27, 2003 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER Pursuant to 18 U.S.C. 1350 (SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002) I, Matthew Richman, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Front Porch Digital Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. By: /s/ Matthew Richman -------------------------------- Name: Matthew Richman Title: Chief Financial Officer and Treasurer May 27, 2003