10QSB 1 v06120_10-qsb.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-QSB (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter Ended June 30, 2004 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT Commission File Number: 000-1084047 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. (Exact name of small business issuer as specified in its charter) California 95-4691878 (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 204 NW Platte Valley Drive, Riverside, MO 64150 (Address of Principal Executive Offices) (Zip Code) (816) 584-8030 (Registrant's Telephone Number, Including Area Code) Securities Registered Pursuant to Section 12(b) of the Act: None Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, $.001 par value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ There were 53,112,424 shares of common stock, $0.001 par value, outstanding as of August 23, 2004. INNOVATIVE SOFTWARE TECHNOLOGIES, INC. FORM 10-QSB QUARTER ENDED JUNE 30, 2004 TABLE OF CONTENTS PAGE PART I - FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of June 30, 2004 (Unaudited) and December 31, 2003........................................3 Condensed Consolidated Statements of Operation (Unaudited) for the Three and Six Months Ended June 30, 2004 and 2003................4 Condensed Consolidated Statements of Cash Flow (Unaudited) for the Six Months Ended June 30, 2004 and 2003..........................5 Notes to the Condensed Consolidated Financial Statements (Unaudited)..............................................................6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................13 Item 3. Controls and Procedures.............................................18 PART II - OTHER INFORMATION Item 1. Legal Proceedings...................................................19 Item 3. Defaults upon Senior Securities.....................................20 Item 6. Exhibits and Reports on Form 8-K....................................20 Signatures ...............................................................21 Index to Exhibits............................................................22 PART I - FINANCIAL INFORMATION Item 1. Financial Statements INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED) JUNE 30, DECEMBER 31, 2004 2003 ------------ ------------ ASSETS CURRENT ASSETS Cash $ 4,959,208 $ 3,890,929 Accounts receivable: Merchant accounts receivable 1,159,882 1,104,051 Other receivables 15,215 101,590 Notes receivable, net of allowance for doubtful accounts of $359,018 and $454,529 respectively 1,315,964 949,891 Inventory 48,602 48,291 Prepaid expenses and other current assets 463,832 15,986 Deferred income taxes 457,890 457,890 ------------ ------------ TOTAL CURRENT ASSETS 8,420,593 6,568,628 ------------ ------------ PROPERTY AND EQUIPMENT, NET 597,934 574,291 GOODWILL 1,088,686 1,088,686 DEFERRED INCOME TAXES 17,688 17,688 DEPOSITS 53,965 43,965 ------------ ------------ TOTAL ASSETS $ 10,178,866 $ 8,293,258 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable and accrued expenses $ 5,129,534 $ 3,342,084 Deferred revenue 1,305,437 1,857,247 Accrued income taxes 1,088,795 822,533 Current maturities of capital lease obligations 58,689 67,049 ------------ ------------ TOTAL CURRENT LIABILITIES 7,582,455 6,088,913 CAPITAL LEASE OBLIGATIONS 110,585 126,336 ------------ ------------ TOTAL LIABILITIES 7,693,040 6,215,249 ------------ ------------ COMMITMENTS AND CONTINGENCIES (NOTE 5) -- -- STOCKHOLDERS' EQUITY Series A preferred stock; issued and outstanding, 1,650,500 shares 1,650,500 1,650,500 Series B preferred stock; issued and outstanding, 428,491 shares 448,491 448,491 Common stock - authorized, 100,000,000 shares of $.001 par value; issued and outstanding, 52,897,186 52,897 52,897 Additional paid-in capital 13,163,749 13,163,749 Accumulated deficit (12,829,811) (13,237,628) ------------ ------------ TOTAL STOCKHOLDERS' EQUITY 2,485,826 2,078,009 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 10,178,866 $ 8,293,258 ============ ============
See accompanying notes. 3 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED JUNE 30, JUNE 30, ----------------------------- ---------------------------- (RESTATED) (RESTATED) 2004 2003 2004 2003 ------------ ------------ ------------ ------------ REVENUE Services revenue $ 4,063,888 $ 7,565,830 Product sales 3,200,204 8,953,324 Other revenue 354,001 748,329 ------------ ------------ TOTAL REVENUE 7,618,093 $ 6,992,995 17,267,483 $ 12,572,203 COST OF REVENUE Cost of services revenue 1,995,586 3,492,050 Cost of product sales and other revenue 1,594,430 4,609,625 ------------ ------------ TOTAL COST OF REVENUE 3,590,016 3,515,533 8,101,675 6,062,425 ------------ ------------ ------------ ------------ GROSS PROFIT 4,028,077 3,477,462 9,165,808 6,509,778 ------------ ------------ ------------ ------------ OPERATING EXPENSES General and administrative 1,601,454 1,763,167 4,525,179 3,504,324 Commissions and other selling expenses 2,193,531 1,611,699 4,078,989 3,066,817 ------------ ------------ ------------ ------------ TOTAL OPERATING EXPENSES 3,794,985 3,374,866 8,604,168 6,571,141 ------------ ------------ ------------ ------------ INCOME FROM OPERATIONS 233,092 102,596 561,640 (61,363) ------------ ------------ ------------ ------------ OTHER INCOME (EXPENSES) Interest and penalties on late tax payments (23,340) (73,000) (45,088) (73,000) Other income 34,053 30,760 87,567 74,872 Interest income, deposits 5,485 18,444 10,969 35,831 Interest income, financing arrangements 31,879 -- 64,070 -- Interest expense (1,548) (13,668) (5,075) (13,668) ------------ ------------ ------------ ------------ TOTAL OTHER INCOME (EXPENSE) 46,529 (37,464) 112,443 24,035 ------------ ------------ ------------ ------------ INCOME BEFORE INCOME TAXES 279,620 65,132 674,083 (37,328) INCOME TAXES (110,449) (55,000) (266,262) 70,000 ------------ ------------ ------------ ------------ NET INCOME 169,171 10,132 407,821 32,672 UNDECLARED PREFERRED STOCK DIVIDENDS (20,790) -- (41,580) -- ------------ ------------ ------------ ------------ INCOME APPLICABLE TO COMMON STOCKHOLDERS $ 148,381 $ 10,132 $ 366,241 $ 32,672 ============ ============ ============ ============ BASIC INCOME PER COMMON SHARE $ 0.00 $ 0.00 $ 0.01 $ 0.00 ============ ============ ============ ============ DILUTED INCOME PER COMMON SHARE $ 0.00 $ 0.00 $ 0.01 $ 0.00 ============ ============ ============ ============ WEIGHTED AVERAGE NUMBER OF COMMON SHARES USED IN BASIC PER SHARE CALCULATION 52,897,186 52,870,136 52,897,186 52,821,170 ============ ============ ============ ============ WEIGHTED AVERAGE NUMBER OF COMMON SHARES USED IN DILUTED PER SHARE CALCULATION 57,188,189 52,870,136 57,188,189 52,821,170 ============ ============ ============ ============
See accompanying notes. 4 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)
FOR THE SIX MONTHS ENDED JUNE 30, -------------------------- (RESTATED) 2004 2003 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net Income (Loss) $ 407,820 $ 32,672 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 166,123 45,093 Prepaid non-cash compensation and expenses -- 62,250 Non-cash expenses -- 30,667 Net change in operating assets and liabilities Merchant account receivables (55,832) -- Other receivables 86,373 (28,308) Inventory (311) -- Prepaid expenses and other current assets (457,845) (225,103) Accounts payable and accrued expenses 1,787,449 221,684 Deferred revenue (551,810) 97,392 Accrued income taxes 266,262 -- ----------- ----------- NET CASH FLOWS FROM OPERATING ACTIVITIES 1,648,229 236,347 ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Change in notes receivable from financed sales (366,073) -- Capital expenditures (174,574) (104,181) ----------- ----------- NET CASH FLOWS FROM INVESTING ACTIVITIES (540,647) (104,181) ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from borrowing under note payable -- 8,085 Repayments under line of credit agreement -- (36,142) Payments on capital lease obligations (39,303) (46,859) ----------- ----------- NET CASH FLOWS FROM FINANCING ACTIVITIES (39,303) (74,916) ----------- ----------- NET INCREASE IN CASH 1,068,279 57,251 CASH AT BEGINNING OF PERIOD 3,890,929 1,338,345 ----------- ----------- CASH AT END OF PERIOD $ 4,959,208 $ 1,395,596 =========== =========== SUPPLEMENTAL CASH FLOW INFORMATION Issuance of Series B Preferred Stock as Compensation $ -- $ 20,000 =========== =========== Property and equipment acquired under capital leases $ 15,192 $ -- =========== ===========
See accompanying notes. 5 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (1) ORGANIZATION, BASIS OF PRESENTATION, AND CERTAIN INTERIM ACCOUNTING POLICIES (a) Organization and Description of Business: Innovative Software Technologies, Inc. (the "Company") was incorporated in the State of California in May 1998. The Company together with its wholly-owned subsidiaries is engaged in the development, marketing and delivery of business-type educational programs, generally to individuals, throughout the United States of America. The Company's educational programs combine both self-training and coaching by Company employees. During the quarterly period ended June 30, 2004, the Company's educational programs were concentrated in two product lines, Real Estate and Internet Marketing, which together comprised approximately 94% of second quarter 2004 revenues. (b) Basis of Presentation: The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-QSB and Regulation S-B. Accordingly, they do not contain all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the Company's financial condition as of June 30, 2004, and the results of their operations for the three and six months ended June 30, 2004 and June 30, 2003, and the cash flows for the six months ended June 30, 2004 and 2003. These unaudited condensed consolidated financial statements should be read in conjunction with the Company's audited 2003 consolidated financial statements, including the notes thereto, and the other information set forth therein, included in the Company's Annual Report on Form 10-KSB for the year ended December 31, 2003. Operating results for the three and six month periods ended June 30, 2004 are not necessarily indicative of the operating results that may be expected for the year ending December 31, 2004. (c) Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, EPMG, Inc. and Hackett Media, Inc. All significant intercompany balances and transactions have been eliminated in consolidation. (d) Income Taxes in Interim Periods: Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. For purposes of interim financial reporting, the Company projects its effective income tax rate for the entire fiscal year, taking into account all taxing jurisdictions, and applies such rate to interim pre-tax income. Changes in the projected effective tax rate in future quarters, if any, are accounted for prospectively in the period of change. 6 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (e) Earnings Per Common Share: Basic net income per common share is computed by dividing (i) the net income (loss), as adjusted for the effects of cumulative dividends on the Series A and B Preferred Stock by (ii) the weighted average common shares outstanding during the period. Diluted net income (loss) per share is computed similarly but includes the effects of dilutive securities in the denominator. The diluted income per common share for the quarterly period ended June 30, 2004 includes the effects of 6,712,919 common shares into which the Company's Series A and Series B Convertible Preferred Stock is convertible on an if-converted basis. The following table reflects the components of the basic and diluted income per common share for the quarterly and six month periods ended June 30, 2004 and 2003:
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------- ------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Basic: Income applicable to common stockholders $ 148,381 $ 10,132 $ 366,241 $ 32,672 =========== =========== =========== =========== Weighted average common shares outstanding 52,897,186 52,870,136 52,897,186 52,821,170 =========== =========== =========== =========== Basic income per common share $ 0.00 $ 0.00 $ 0.01 $ 0.00 =========== =========== =========== =========== Diluted: Income applicable to common stockholders $ 148,381 $ 10,132 $ 366,241 $ 32,672 Plus: Undeclared preferred stock dividends 20,790 0 41,580 0 ----------- ----------- ----------- ----------- Adjusted numerator $ 169,169 $ 10,132 $ 407,820 $ 32,672 =========== =========== =========== =========== Weighted average number of shares 52,897,186 52,870,136 52,897,186 52,821,170 Shares convertible from preferred stock 6,712,919 17,478,701 6,712,919 17,478,701 ----------- ----------- ----------- ----------- Adjusted denominator 59,610,105 70,348,837 59,610,105 70,299,871 =========== =========== =========== =========== Diluted income per common share $ 0.00 $ 0.00 $ 0.01 $ 0.00 =========== =========== =========== ===========
7 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (2) ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses consist of the following: JUNE 30, DECEMBER 31, 2004 2004 ----------- ----------- Accrued sales splits to lead providers $ 900,595 $ 1,255,770 Accrued wages and other 1,846,298 773,707 Reserves for returns and refunds 943,002 742,568 Accounts payable 1,177,194 351,089 Interest and penalties on late tax payments 262,446 218,950 Credit facility (a) -- 3,440 ----------- ----------- $ 5,129,534 $ 3,345,524 =========== =========== (a) The Company has a credit facility that provides for borrowings up to $50,000, with interest at Prime Rate, plus 2%. (3) STOCKHOLDERS' EQUITY (a) Convertible Preferred Stock: As of June 30, 2004, the Company had 25,000,000 shares of preferred stock authorized and has 1,650,500 shares of Series A Preferred issued and outstanding and 428,491 shares of Series B Preferred issued and outstanding. The Series A and Series B Preferred Stock (collectively "Preferred Stock") have the same terms and conditions. The Preferred Stock is (i) entitled to cumulative dividends at a rate of 4.0% of the liquidation value ($1.00 per share), (ii) convertible at any time into common stock at a rate of 95% of the average closing market price of the common stock for five days preceding conversion (6,712,919 and 8,105,228 common shares as of June 30, 2004 and December 31, 2003, respectively), (iii) redeemable at any time by the Company for $1.00 per share, and (iv) entitled to one vote per share. As of June 30, 2004 and December 31, 2003, the Company had cumulative, undeclared dividends in arrears on the Preferred Stock of $103,500 and $82,510, respectively. (4) RELATED PARTY TRANSACTIONS During the periods shown, the Company purchased sales leads from Education Success Institute, Inc. (ESI), which is owned by two individuals who were employees of the Company during such periods. The cost of sales leads purchased during the six months ended June 30, 2004, which is based upon a percentage of revenue, amounted to $3,927,171. In addition, during the periods shown, ESI subleases office space from the Company. Sub-rental receipts amounted to $700 each month during such periods. See Note 5. 8 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (5) COMMITMENTS AND CONTINGENCIES (a) Leases: Future minimum lease payments under noncancelable operating leases (with initial terms in excess of one year) and future minimum capital lease payments as of June 30, 2004 are as follows: CAPITAL OPERATING Year ending December 31: LEASES LEASES ----------- ----------- Six months ending December 31, 2004 43,268 152,931 2005 70,717 174,426 2006 48,066 37,467 2007 28,772 0 ----------- ----------- Total noncancelable lease payments 190,823 364,823 =========== Less amount representing interest 21,549 ----------- 169,274 =========== Principal amount due in one year 58,689 Principal amount due after one year 110,585 ----------- $ 169,274 =========== Rent expense under all operating leases for the quarter ended June 30, 2004 was $152,931. This amount was exclusive of $4,200 of sub-lease payments received from a related party. See Note 4. (b) Lead Arrangements: The Company is a party to several lead agreements with Education Success, Inc. and certain other lead generators. The continuous generation of sales leads is a critical element to the Company's continuing viability. The agreements provide for the transfer of sales leads to EPMG, Inc. for commissions of, generally, 34% of gross revenue, subject to certain adjustments. (c) Content Providers: The Company is a party to several agreements that provide for the educational content and multimedia materials used in the educational offerings. Generally, these agreements provide for a commission, generally 8% to 10% of actual sales. The maintenance of content agreements is a critical element to the Company's continuing viability. 9 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (d) Servicing Arrangements: The Company is a party to a servicing agreement with a third party financial institution for the servicing of the Company's financed sales. The agreement provides for the collection, servicing and remittance of notes receivable as an agent to the Company. The counterparty receives certain fees for this servicing arrangement, which is included as a reduction of the interest income on the notes receivable. (e) SEC Investigation: On June 24, 2003, the Securities and Exchange Commission issued a formal order of investigation authorizing subpoenas for documents and testimony in connection with the investigation of certain securities matters. The Company has and intends to continue to fully cooperate with the SEC in its investigation. (f) Litigation: None. (g) Income Tax Returns: The Company has not filed its 2003 and 2002 Federal and State of Utah income tax returns. Combined current income taxes payable for these periods are currently estimated to be $224,306 and $513,936, respectively. Interest and penalties through June 30, 2004 have been recorded in the amount of approximately $262,446. The Company has engaged an accountant who is in the process of preparing its past due returns. (6) UNAUDITED QUARTERLY RESTATEMENTS. The following table reflects the quarterly net income of the Company as previously reported by the Company in its quarterly report on Form 10-QSB for the quarter ended June 30, 2003 and as restated for the matters discussed below: JUNE 30, 2003 ------------------------- THREE MONTHS SIX MONTHS ENDED ENDED ----------- ----------- Net income (loss) before adjustments $ 252,711 $ 352,608 Reserve for notes receivable (a) (78,000) (308,000) Deferred revenue (b) (5,000) 81,000 Stock compensation (c) (31,579) (89,936) Penalties and interest (d) (73,000) (73,000) Income taxes (e) (55,000) 70,000 ----------- ----------- Net income (loss), adjusted $ 10,132 $ 32,672 =========== =========== 10 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (a) The Company changed its estimate of reserve for bad debts in the fourth quarter based upon historical performance. This adjustment gives effect to the estimate change for each quarter using that annual rate applied in the fourth quarter. (b) This adjustment adjusts the quarterly deferred revenue calculation for the following matter: Prior to February 2003, the Company outsourced coaching to a third party contractor who was responsible for delivery of the services and who provided the Company with records for accounting purposes. Since February 2003, the Company has employed its internal coaching staff and has developed internal operations databases to track coach-student encounters. During the fourth fiscal quarter of 2003, the Company began utilizing the populated operations databases to calculate the number of future coaching sessions for purposes of deferred revenue. Other estimates of future coaching sessions were used during the prior quarters. (c) This adjustment allocates certain stock based compensation that was recorded in the fourth fiscal quarter of 2003 to the quarters to which such compensation was earned. (d) There was no adjustment to reflect the allocation of the penalties and interest for non-payment of the Company's 2002 Federal and state income taxes. Amounts that were recorded in the fourth quarter were allocated to the second and third quarters of 2003. (e) This adjustment includes the tax effects for the aforementioned adjustments, plus the allocation of income taxes to the quarterly periods based upon the effective tax rate applicable to the year ended December 31, 2003. The Company intends to amend its previous filing on Form 10-QSB for the quarterly period ended June 30, 2003 for these matters. (7) SUBSEQUENT EVENTS. On July 2, 2004, Innovative Software Technologies, Inc. (the "Company") entered into a Settlement Agreement with James R. Garn, Ethan W. Willis, and Ethan and Randy, LC (the "Settlement Agreement") pursuant to which the parties agreed to settle all disputes between them, including all disputes relating to the Company's 2001 acquisition from Garn and Willis of the outstanding stock of Energy Professional Marketing Group, Inc. ("EPMG"). Under the terms of the Settlement Agreement, Garn and Willis (the "Principals") have surrendered to the Company all of their shares of capital stock of the Company, comprising 6,784,762 shares of common stock, 1,200,500 shares of Series A Preferred Stock, and 80,000 shares of Series B Preferred Stock, in exchange for certain assets of EPMG. These assets include EPMG's rights under certain credit card processing contracts (including receivables relating to reserves under those contracts in the amount of approximately $1,000,000), substantially all of the tangible fixed assets of EPMG's Utah facility, and certain intangible assets of EPMG, such as specified website domain names, software, and customer lead data. The Settlement Agreement also sets forth certain agreements and covenants relating to the relationship between the parties on a going-forward basis and the parties' respective businesses activities, including the following: o The Company and an entity controlled by the Principals have entered into agreements providing for the reciprocal supply of products and customer leads to each other on a going-forward basis. 11 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) o A company controlled by the Principals has agreed to assume all of EPMG's outstanding service obligations to EPMG's coaching customers in consideration of the payment of service fees by the Company totaling $425,000. o A newly created company controlled and owned by the Principals has assumed the lease of EPMG's facility in Provo, Utah, and substantially all employees at such facility have transferred their employment to such newly created company. Pursuant to the Settlement Agreement, the Company has released all such employees from their non-compete obligations to the Company. o The Company has agreed to refrain from soliciting the services of certain lead providers for a six-month period of time and from marketing to current active coaching customers for 120 days following the Settlement Agreement. Pursuant to the Settlement Agreement, the Company, the Principals, and their respective affiliates have entered into mutual waivers and releases relating to any and all claims that they may have had against one another other at any time through the date of the Settlement Agreement. Subsequent to the settlement, EPMG will remain a wholly owned subsidiary of the Company and, together with the Company, will focus on growing its business through its traditional coaching and mentoring products, new software products relating to improving the efficiency of small businesses, and future planned software products targeting the IT departments of medium and large businesses. The Company recorded the settlement on the effective date of the settlement. No gain or loss arose from the settlement pursuant to generally accepted accounting principles which requires a company's receipt of its own securities in such transactions to be treated as transactions affecting only stockholders' equity. In addition, the Company has concluded that the transaction does not meet the conditions for treatment of EPMG as a discontinued operation due to the fact that continuing agreements between the Company and EPMG for cross selling of each others products and services rise to the level of the Company's significant continuing involvement in the operations of the disposed component. 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion includes statements that are forward looking in nature. The accuracy of such statements depends on a variety of factors that may affect the business and operations of the Company. When used in this discussion, the words "expect(s)", "feel(s)", "believe(s)", "will", "may", "anticipate(s)" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, and actual results could differ materially from those projected. These risks and uncertainties include, but are not limited to, the matters discussed under the caption "Factors Affecting Future Results" in the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2003 and other risks and uncertainties discussed in filings made with the Securities and Exchange Commission (including risks described in subsequent reports on Form 10-QSB, Form 10-KSB, Form 8-K and other filings). Readers are cautioned not to place undue reliance on these forward-looking statements, and are urged to carefully review and consider the various disclosures elsewhere in this Form 10-QSB. OVERVIEW The following discussion summarizes information about our accounting policies and practices and information about our operations in a comparative manner for the three and six months ended June 30, 2004 and 2003. Our management's discussion and analysis of financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere herein. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the Company's financial statements. Actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company believes that its critical accounting policies include those described below. Allowances for Doubtful Accounts Our net notes receivable amounted to $1,315,964 as of June 30, 2004 and relate to product financing arrangements entered into with our clients. These notes are unsecured, bear interest at 15% and have terms ranging between one and two years. The Company has not and does not intend to sell or otherwise transfer these receivables. The allowance for doubtful accounts is based upon our best estimate of the amount of probable credit losses in the existing notes based upon our historical loss rates experienced on such financing arrangements. A note is considered impaired pursuant to Financial Accounting Standards Board Statement 114, Accounting by Creditors for Impairment of a Loan. Pursuant to Statement 114, a note is impaired if it is probable that the Company will not collect all principal and interest contractually due. The impairment is measured based on the present value of expected future cash flows discounted at the note's 13 effective interest rate. The Company does not accrue interest when a note is considered impaired. When ultimate collectibility of the principal balance of the impaired note is in doubt, all cash receipts on impaired notes are applied to reduce the principal amount of such notes until the principal has been recovered and are recognized as interest income thereafter. Impairment losses are charged against the allowance when all possible means of collection have been exhausted and the potential for recovery is considered remote. Revenue Recognition and Returns and Allowances We have evaluated our product offerings in the context SAB 101 Revenue Recognition and EITF 00-21 Revenue Arrangements with Multiple Deliverables and have determined that revenues associated with the multimedia educational materials (product sales) require accounting separate from the educational and coaching services (services revenue). The fair value of these offerings is established through separate third party sales of each of these products and services. Product Sales: We recognize product sales upon delivery to our students, as evidenced by third party shipping providers, which is the point where the student assumes ownership and risk of loss. Shipping costs are billed to students and are included as a component of revenue and cost of product sales. Returns are provided for based upon the Company's historical return experience. Services Revenues: The Company's educational offering includes multiple sessions with a Company employed coach. We recognize services revenue pro rata as coaching/training sessions are rendered. Deferred revenue represents the price of future coaching sessions that students have paid for ($3,150,600), less the applicable commissions to lead generators and content providers ($1,228,739) and sales commissions ($616,424). Our obligation to provide coaching and training ceases one year following the sale. Refunds for unused courses are not provided for in the sales arrangement with the student. However, the Company offers refunds in certain circumstances for which a history has been developed to estimate and reserve such amounts. RESULTS OF OPERATIONS Three and six month periods ended June 30, 2004 and June 30, 2003. Revenues Revenues for the three months ended June 30, 2004 and 2003 were $7,618,093 and $6,992,995, respectively, which represents a 9% increase. Revenues for the six months ended June 30, 2004 were $17,267,483, and $12,572,203, respectively, which represents a 37% increase. The Company's principal source of revenue for the three months ended June 30, 2004 and 2003 consisted of business education and coaching services. Revenues increased substantially in the first quarter 2004 (73% over the first quarter of 2003) as a result of increasing the sales staff and focusing on the offerings that, based upon our accumulated experience, have the higher sales rate among our targeted customer base. The slow down in sales during the second quarter 2004 resulted from operations being hampered by the continued negotiations between the former principals of EPMG and the Company and the efforts to split the Utah operations of our EPMG subsidiary. We record revenues for multimedia education materials (product sales) upon delivery of the material to our students. We record revenues for coaching sessions rendered and we defer revenue for coaching sessions that are paid for but have not yet been rendered. Our total services revenue deferral as of June 14 30, 2004 was $3,150,600 compared to $4,461,883 as of December 31, 2003. These deferred revenues are partially offset by lead splits and sales commissions paid when funds are received. Our deferral as of June 30, 2004 was less than the amount deferred as of December 31, 2003 as the number of open coaching sessions decreased. Substantially all of our revenues through June 30, 2004 were derived from our EPMG subsidiary. On September 26, 2003, legal counsel representing the former principals of EPMG, who are currently employees of our EPMG subsidiary, notified us with an allegation that they were entitled to rescind the 2001 acquisition of EPMG. The notification alleged that the former principals were defrauded in connection with our acquisition of EPMG, Inc. and that they would seek litigation to effect a rescission of the 2001 purchase. On July 2, 2004, the Company entered into a Settlement Agreement with the former principals of EPMG pursuant to which the parties agreed to settle all disputes between them. Under the terms of the Settlement Agreement, the former principals have surrendered to the Company all of their shares of capital stock of the Company, comprising 6,784,762 shares of common stock, 1,200,500 shares of Series A Preferred Stock, and 80,000 shares of Series B Preferred Stock, in exchange for certain assets of EPMG. These assets include EPMG's rights under certain credit card processing contracts (including receivables relating to reserves under those contracts in the amount of approximately $1,000,000), substantially all of the tangible fixed assets of EPMG's Utah facility, and certain intangible assets of EPMG, such as specified website domain names, software, and customer lead data. (See Form 8-K report filed on July 19, 2004.) Cost of Sales and Margins Cost of sales for the three months ended June 30, 2004 and 2003 were $3,590,016 and $3,515,533, respectively, representing gross margins of 52.9% and 49.7%, respectively. For the six months ended June 30, 2004 and 2003, cost of sales were $8,101,675 and $6,062,425 respectively, representing gross margins of 53.1% and 51.8%, respectively. Cost of sales include (i) the cost of the multimedia educational materials that we ship to our students, (ii) the wages paid to our coaches and (iii) the commissions that we pay to lead sources. Our increased gross profit margins reflect slight decreases in our lead split and fulfillment costs. Selling Expenses Selling expenses for the three months ended June 30, 2004 and 2003 were $2,193,531 (28.8% of revenue) and $1,611,699 (23.0% of revenue), respectively. Selling expenses for the six months ended June 30, 2004 and 2003 were $4,078,989 (23.6% of revenue) and $3,066,817 (24.4% of revenue), respectively. Selling expenses consisted primarily of commissions paid to sales associates as well as marketing and advertising expenses associated with key products and services. The overall increase in selling expenses is attributed to the increase in sales of products and services. General and Administrative Expenses General and administrative expenses for the three months ended June 30, 2004 and 2003 were $1,601,454 (21.0% of revenue) and $1,763,167 (25.2% of revenue), respectively. General and administrative expenses for the six months ended June 30, 2004 and 2003 were $4,525,179 (26.2% of revenue) and $3,504,324 (27.9% of revenue), respectively. General and administration expenses consisted primarily of salaries and wages, professional fees, rent, travel expenses, payroll taxes, 15 telephone expenses and other general and administrative expenses necessary to support the operations of the Company. The decrease in general and administrative expenses was attributable to lower legal fees. Other Income (Expense) Other income, net of other expenses for the three months ended June 30, 2004 and 2003 was $46,529 and $(37,464), respectively. For the six months ended June 30, 2004 and 2003, other income, net of other expenses was $112,443 and $24,035, respectively. The increase is principally attributable to the increase in interest on our financing notes receivable of $64,070 offset by the recognition of $45,088 in interest and penalties on late tax payments, for the six months ended June 30, 2004. Income Taxes Our income tax provision amounted to $266,262 for the period ended June 30, 2004 and a benefit of $70,000 for the period ended June 30, 2003. For purposes of interim financial reporting, the Company projects its effective income tax rate for the entire fiscal year (39.5% for the six month period ended June 30, 2004), taking into account all taxing jurisdictions, and applies such rate to interim pre-tax income. Changes in the projected effective tax rate in future quarters, if any, are accounted for prospectively in the period of change. Our income tax for the quarterly period ended June 30, 2003 was different than the statutory rates applicable to our taxing jurisdictions because of valuation allowances and non-deductible permanent differences (primarily income tax penalties). Net Income Our net income for the three and six months ended June 30, 2004 amounted to $169,171 and $407,821, respectively, compared to $10,132 and $32,672 for the three and six months ended June 30, 2003. These increases were attributable to the matters discussed above. LIQUIDITY AND CAPITAL RESOURCES At June 30, 2004 we had current assets of $8,420,593, which represents an increase of $1,851,964 over current assets as of December 31, 2003. Much of the increase is attributable to an increase in cash. At June 30, 2004 we had cash on hand of $4,959,208, which represents an increase of $1,068,279 over the balances as of December 31, 2003. Other material increases in current assets resulted from notes receivable and deferred income taxes. Notes receivable of $1,315,964, as of June 30, 2004 is net of our estimated reserve of $359,018 for bad debts. Gross notes receivable were $1,602,982 as of June 30, 2004 compared to $1,507,358 as of June 30, 2003. At June 30, 2004 we had current liabilities of $7,582,455, which represents an increase of $1,493,542 over current liabilities as of December 31, 2003. Our current liabilities include significant amounts associated with deferred revenue, commissions and reserves for returns. These accounts require complex subjective estimates. Our net deferred revenue of $1,305,437, which will not require cash outlays, decreased $551,810 from the balance as of December 31, 2003. This decrease is attributable to our increase in our number of coaches and associated coaching sessions completed. We are liable for commissions to our sales force and to lead providers. These commissions payable, included as a component of accounts payable and accrued liabilities, are $1,746,892 as of June 30, 2004. As June 30, 2004 our working capital increased to $838,139 from $479,176 as of December 31, 2003. We believe that our operating activities in 2004 will be sufficient to fulfill our obligations as they become due in the normal course of business. 16 We have no material commitments for capital expenditures. Capital expenditures in the quarter and six months ended June 30, 2004 were $119,934 and $189,766, respectively. We may require additional facilities and support equipment if our growth rate continues at the current rate. We have not filed our 2003 and 2002 Federal and State of Utah income tax returns. Combined current income taxes payable for these periods are currently estimated to be $224,306 and $513,936, respectively. Interest and penalties have been recorded in the amount of approximately $262,446. The Company has engaged an accountant who is in the process of preparing its past due returns. We currently do not have a stock option or stock purchase plan. We also currently do not have any employee benefit plans that would require the use of our securities. EPMG TRANSACTION AND POSSIBLE FUTURE EFFECTS On September 26, 2003, counsel representing the former principals of EPMG, Inc., who were then employees of EPMG, Inc., notified the Company that they were allegedly entitled to rescind the Company's 2001 acquisition of EPMG, Inc., which was accomplished in a stock-for-stock exchange, accounted for as a purchase business combination. The notification alleged that the former principals were defrauded in connection with the Company's acquisition of EPMG, Inc. and that they would seek litigation to effect a rescission of the 2001 purchase. On July 2, 2004, the Company entered into a Settlement Agreement with the former principals pursuant to which the parties agreed to settle all disputes between them. Under the terms of the Settlement Agreement, the former principals have surrendered to the Company all of their shares of capital stock of the Company, comprising 6,784,762 shares of common stock, 1,200,500 shares of Series A Preferred Stock, and 80,000 shares of Series B Preferred Stock, in exchange for certain assets of EPMG. These assets include EPMG's rights under certain credit card processing contracts (including receivables relating to reserves under those contracts in the amount of approximately $1,000,000), substantially all of the tangible fixed assets of EPMG's Utah facility, and certain intangible assets of EPMG, such as specified website domain names, software, and customer lead data. (See Form 8-K report filed on July 19, 2004.) OFF BALANCE-SHEET ARRANGEMENTS The Company has no material off-balance sheet arrangements as of June 30, 2004. 17 ITEM 3. CONTROLS AND PROCEDURES (a) As of June 30, 2004, the Chief Executive Officer and Chief Financial Officer of the Company, with the participation of the Company's management, carried out an evaluation of the effectiveness of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer believe that, as of the date of the evaluation, the Company's disclosure controls and procedures are effective in making known to them material information relating to the Company (including its consolidated subsidiaries) required to be included in this report. (b) There were no changes in the Company's internal controls or in other factors that could significantly affect internal controls, known to the Chief Executive Officer or the Chief Financial Officer, subsequent to the date of the evaluation. 18 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS SEC Investigation On June 24, 2003 the Securities and Exchange Commission ("SEC") issued a formal order of investigation with respect to the Company, authorizing the investigation of certain securities matters relating to the Company. The SEC staff has taken the testimony of certain officers of the Company and has informed the Company that it intends to take additional testimony. The SEC staff has also issued additional requests for the voluntary production of documents. Prior to the issuance of the order, the Company had voluntarily provided documents and information to the SEC staff in response to informal, non-public inquiries by the staff. The Company intends to fully cooperate with the SEC in its investigation. Garn & Willis Settlement On September 26, 2003, counsel representing the former principals of EPMG, Inc., who were then employees of EPMG, Inc., notified the Company that they were allegedly entitled to rescind the Company's 2001 acquisition of EPMG, Inc., which was accomplished in a stock-for-stock exchange. The notification alleged that the former principals were defrauded in connection with the Company's acquisition of EPMG, Inc. and that they would seek litigation to effect a rescission of the 2001 purchase. On July 2, 2004, the Company entered into a Settlement Agreement with the former principals pursuant to which the parties agreed to settle all disputes between them. Under the terms of the Settlement Agreement, the former principals have surrendered to the Company all of their shares of capital stock of the Company, comprising 6,784,762 shares of common stock, 1,200,500 shares of Series A Preferred Stock, and 80,000 shares of Series B Preferred Stock, in exchange for certain assets of EPMG. These assets include EPMG's rights under certain credit card processing contracts (including receivables relating to reserves under those contracts in the amount of approximately $1,000,000), substantially all of the tangible fixed assets of EPMG's Utah facility, and certain intangible assets of EPMG, such as specified website domain names, software, and customer lead data. (See Form 8-K report filed on July 19, 2004.) 19 ITEM 3. DEFAULTS UPON SENIOR SECURITIES (b) There has not been any material arrearage in the payment of dividends on any preferred stock. The Company has withheld a dividend payment of 137,942 shares of common stock payable on Series A Preferred Stock to two stockholders in connection with a dispute with such stockholders. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. a. Exhibits The exhibits required by this item are listed in the Index to Exhibits set forth at the end of this Form 10-QSB. b. Reports on Form 8-K During the period covered by this report, the Company did not file any reports on Form 8-K. 20 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INNOVATIVE SOFTWARE TECHNOLOGIES, INC. Date: August 23, 2004 /s/ Peter M. Peterson -------------------------------------- Peter M. Peterson Chief Executive Officer /s/ Christopher J. Floyd -------------------------------------- Christopher J. Floyd Chief Financial Officer 21 INDEX TO EXHIBITS EXHIBIT NUMBER DESCRIPTION ------- ---------------------------------------------------------------------- 10.1 Employment Contract for Peter M. Peterson, Chief Executive Officer of Innovative Software Technologies, Inc. 10.2 Employment Contract for Christopher J. Floyd, Chief Financial Officer, Vice President Finance, and Corporate Secretary of Innovative Software Technologies, Inc. 31.1 Certification of Chief Executive Officer of Innovative Software Technologies, Inc. pursuant to Rule 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended. 31.2 Certification of Chief Financial Officer of Innovative Software Technologies, Inc. pursuant to Rule 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended. 32.1 Certification of Chief Executive Officer of Innovative Software Technologies, Inc. pursuant to 18 U.S.C. 1350. 32.2 Certification of Chief Financial Officer of Innovative Software Technologies, Inc. pursuant to 18 U.S.C. 1350. 22