10QSB 1 d51590_10-q.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB (Mark One) |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from _________________ to _________________ Commission file number 001-15363 AdStar, Inc. (Exact name of small business issuer as specified in its charter) Delaware 22-3666899 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 4553 Glencoe Avenue, Suite 325, Marina del Rey, California 90292 (Address of principal executive offices) (310) 577-8255 (Issuer's telephone number) State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: As of August 12, 2002 the Issuer had outstanding 8,253,297 shares of its common stock, including 14,347 shares issuable pursuant to the vendor compensation plan. Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 |_| Transitional Small Business Disclosure Format (Check one): Yes |_| No |X| TABLE OF CONTENTS FORM 10-QSB REPORT June 30, 2002 PAGE PART I - FINANCIAL INFORMATION Item 1. Interim Condensed Financial Statements (Unaudited) Balance Sheet - June 30, 2002 3 Statements of Operations For the Three-Month and Six Month Periods Ended June 30, 2001 and 2002 4 Statements of Cash Flows For the Six-Month Periods Ended June 30, 2001 and 2002 5 Notes to Interim Financial Statements 6 Item 2. Management's Discussion and Analysis or Plan of Operation 12 PART II - OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds 18 Item 6. Exhibits and Reports on Form 8-K 19 SIGNATURES 20 2 AdStar, Inc. Balance Sheet June 30, 2002 (unaudited) Assets Current assets: Cash and cash equivalents $ 1,363,806 Restricted cash 5,535 Accounts receivable, net of allowance of $42,862 231,473 Prepaid and other current assets 180,825 ------------ Total current assets 1,781,639 Property and equipment, net 1,898,001 Deferred contract costs 268,406 Intangible assets, net 67,141 Other assets 28,376 ------------ Total assets $ 4,043,563 ============ Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 616,988 Accrued expenses 337,935 Deferred revenue 216,550 Capital lease obligations 14,710 ------------ Total current liabilities 1,186,183 Capital lease obligations 29,964 ------------ Total liabilities 1,216,147 Commitments and contingencies Stockholders' equity: Preferred stock, par value $0.0001; authorized 5,000,000 shares; 1,443,457 shares issued and outstanding; liquidation preference of $1,795,000 144 Common stock, par value $0.0001; authorized 20,000,000 shares; 8,253,297 shares issued and outstanding 825 Additional paid-in capital 12,742,482 Treasury stock, par value $0.0001; 67,796 shares (7) Stockholder receivable (39,566) Accumulated deficit (9,876,462) ------------ Total stockholders' equity 2,827,416 ------------ Total liabilities and stockholders' equity $ 4,043,563 ============
The accompanying notes are an integral part of these interim financial statements. 3 AdStar, Inc. Statements of Operations For the three-month and six month periods ended June 30, 2001 and 2002 (unaudited)
Three months ended Six months ended June 30, June 30, ---------------------------- ---------------------------- 2001 2002 2001 2002 ------------ ------------ ------------ ------------ Revenues $ 531,551 $ 541,636 $ 971,794 $ 1,041,845 Cost of revenues 196,495 260,407 371,647 486,121 ------------ ------------ ------------ ------------ Gross profit 335,056 281,229 600,147 555,724 Selling expenses 170,255 148,289 337,929 304,491 Administrative expenses 446,160 460,890 1,021,669 930,481 Development expenses 91,407 86,813 293,850 306,435 ------------ ------------ ------------ ------------ Loss from operations (372,766) (414,763) (1,053,301) (985,683) Other income -- 62,796 -- 62,796 Interest income (expense), net 15,564 6,813 18,965 10,487 ------------ ------------ ------------ ------------ Loss before taxes (357,202) (345,154) (1,034,336) (912,400) Provision for income taxes 518 1,866 2,050 3,630 ------------ ------------ ------------ ------------ Net loss $ (357,720) $ (347,020) $ (1,036,386) $ (916,030) ============ ============ ============ ============ Loss per share - basic and diluted $ (0.06) $ (0.04) $ (0.17) $ (0.11) Weighted average number of shares - basic and diluted 6,269,210 8,238,789 6,050,754 8,170,667
The accompanying notes are an integral part of these interim financial statements. 4 AdStar, Inc. Statements of Cash Flows For the six-month periods Ended June 30, 2001 and 2002 (unaudited)
2001 2002 ----------- ----------- Cash flows from operating activities: Net loss $(1,036,386) $ (916,030) Adjustments to reconcile net loss to net cash used in operating activities Depreciation and amortization 147,188 274,120 Stock returned from settlement -- (67,789) Stock based charges 54,520 24,802 Increase in reserve on accounts receivable -- 27,682 Loss on disposal of fixed assets 16,833 -- Changes in assets and liabilities: Accounts receivable (153,653) (48,785) Prepaid and other assets 35,548 (9,951) Deferred contract expenses -- (268,406) Accounts payable 88,791 262,722 Accrued expenses (206,758) (108,693) Deferred revenue 148,776 63,337 ----------- ----------- Net cash used in operating activities (905,141) (766,991) ----------- ----------- Cash flows from investing activities: Purchase of property and equipment (412,217) (234,649) Proceeds from disposal of fixed assets 25,661 -- Repayment of stockholder receivable 4,500 3,554 ----------- ----------- Net cash used in investing activities (382,056) (231,095) ----------- ----------- Cash flows from financing activities: Restricted cash -- 39,922 Proceeds from leasing of property and equipment -- 34,943 Net proceeds from sale of common stock 365,333 151,552 Net proceeds from sale of preferred stock -- 1,727,840 Principal repayments on capital leases (44,613) (3,904) ----------- ----------- Net cash provided by (used in) financing activities 2001 320,720 1,950,353 ----------- ----------- Net increase (decrease) in cash and cash equivalents (966,477) 952,267 Cash and cash equivalents at beginning of period 1,606,999 411,539 ----------- ----------- Cash and cash equivalents at end of period $ 640,522 $ 1,363,806 =========== =========== Supplemental cash flow disclosure: Taxes paid $ 4,565 $ 6,645 Interest paid $ 2,645 $ 2,129 Non cash investing and financing activities Conversion of note payable and accrued interest to common stock $ 1,186,966 $ -- Conversion of accounts payable to common stock $ -- $ 62,469
The accompanying notes are an integral part of these interim financial statements. 5 AdStar, Inc. Notes To Interim Financial Statements (Unaudited) 1. General The interim financial statements for AdStar, Inc. (the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and with instructions to Form 10-QSB and Item 10 of Regulation S-B. Accordingly they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month period ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-KSB/A for the year ended December 31, 2001. For the six-month period ended June 30, 2002, the Company had incurred cash outflow from operations of approximately $767,000 and as of June 30, 2002, the Company had working capital of only $595,000. Based on the Company's current operating plans, management believes existing cash resources, including the proceeds from the sale of the preferred stock in March 2002, and cash forecasted by management to be generated by operations will be sufficient to meet working capital and capital requirements through June 30, 2003. Also, management's plans to attain profitability and generate additional cash flows include expansion of services under existing and new contracts, while containing any increase to operating expenditures necessary to accommodate this expansion. There is no assurance that management will be successful with these plans. However, if events and circumstances occur such that the Company does not meet its current operating plan as expected, and the Company is unable to raise additional financing, the Company may be required to further reduce certain discretionary spending, which could have a material adverse effect on the Company's ability to achieve its intended business objectives. 2. Summary of Significant Accounting Policies Concentration of Credit Risk and Major Customers Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of trade accounts receivable. Also, at times, cash balances held in financial institutions are in excess of FDIC insurance limits. For the three months ended June 30, 2002 and 2001, no customer accounted for 10% of the Company's revenues. At June 30, 2002 nine customers in the aggregate accounted for 61% of the Company's accounts receivable. The majority of the Company's customers have historically consisted of newspapers and publishers of classified advertisements. 6 Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition The Company derives revenue from several products and services as follows: Technology services revenue - The Company receives revenue from technology service contracts that generally contain multiple elements such as software customization services, monthly fees and post-contract customer support (PCS). Revenue from these arrangements is recognized in accordance with Statement of Position ("SOP") 97-2, "Software Revenue Recognition", and SOP 98-9, "Software Revenue Recognition with Respect to Certain Transactions". Accordingly, revenue is allocated to each element within the contract based on the relative fair values of those elements using vendor specific objective evidence. Revenue from monthly fees and PCS under software maintenance arrangements is based upon renewal rates and is recognized ratably over the term of the arrangement. Revenue from software customization services is recognized as the services are performed, using a percentage of completion methodology based on labor hours. The Company also provides customization services at the customers' request and recognizes revenue as the services are performed, using a percentage of completion methodology based on labor hours. Areas requiring management's judgment include revenue recognition and cost estimation on the fixed fee software customization element of the contracts. Revenue is recognized on these contracts using a percentage-of-completion methodology, based upon labor input measures and an estimate of time to completion. Monthly, technical management reviews the estimate of labor hours required to complete the customization and the effect of any change in estimate is reflected in the period in which the change is first known. Such changes in estimates have not been material to our quarterly results of operations. The corresponding cost of revenue charge is derived based upon the same labor input measurements and our existing cost structure. If the Company does not accurately estimate the resources required under the contract or the scope of the work to be performed, or if the Company does not manage its projects properly within the prescribed timeframe, future margins may be significantly and adversely affected. If increases in projected costs-to-complete are sufficient to create a loss contract, the entire estimated loss is charged to operations in the period the loss first becomes known. The complexity of the estimation process and uncertainties inherent in software customization activities may affect the percentages derived under the percentage-of-completion accounting method, which in turn may affect the amounts reported in the financial statements. ASP revenue - The Company receives revenue from providing an application service provider ("ASP") product that allows customers to use the Company's software applications on a "shared system" over the Internet. This technology is a publisher-specific ad-taking Web site service that offers visitors to a newspaper's Web page the opportunity to buy classified ads, for both the print and/or on-line editions of the newspaper, in real-time, on a 24/7 basis. The Company receives monthly fees for hosting 7 the transactions and providing customer support, and recognizes the fees ratably over the contract period. Web site revenue - The Company receives revenue from fees charged to customers who transact business on the Advertise123.com Web site. This site permits the general public to plan, schedule, compose and purchase advertising from many print and on-line publishers. Under the guidance provided by the Securities Exchange Commission Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition" and the Emerging Issues Task Force ("EITF") Abstract No. 99-19 "Reporting Revenue Gross as a Principal versus Net as an Agent" ("EITF 99-19"), the Company is, in substance, acting as an agent for the publishers and therefore recognizes as revenue only the net fees realized on the transactions. The Company recognizes revenues on a per-transaction basis when the ad is placed through their system and collection from the customer is probable. Development Costs Costs incurred in the development of products are expensed as incurred. Computation of Earnings Per Share Basic earnings (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted earnings (loss) per share is computed by dividing the net income (loss) by the weighted average number of common shares outstanding plus the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued. Potential common shares are excluded from the computation when their effect is antidilutive. For the three months ended June 30, 2001 and 2002, diluted loss per share does not include 1,788,164 and 3,380,476, respectively, of options and warrants to purchase common stock and 0 and 1,443,457, respectively, of shares issuable upon the conversion of Series A preferred stock to common stock, as their inclusion would be antidilutive. 3. Significant Contracts On March 18, 2002, the Company entered into a series of agreements with Tribune Company ("Tribune"). In accordance with these agreements, the Company sold 1,443,457 shares of Series A convertible preferred stock to the Tribune Company for approximately $1.8 million. The Company has recorded the $1.8 million investment in the Series A convertible preferred stock at cost which approximated fair value. The rights and preferences of the Series A preferred stock are described in Note 4 below. Additionally, the Company agreed to develop and customize a version of its Web software applications to Tribune specifications in exchange for earning volume-based transaction fees in the future by providing Web-based recruitment ad sales technology to all major market Tribune newspapers and on-line services. This customization will provide a platform that allows Tribune owned newspapers, together with a Tribune affiliated company, CareerBuilder, Inc. (www.careerbuilder.com), to receive recruitment advertising from agencies, corporate customers, and the general public. After the Company completes the development and customization effort, it will manage the related transactions and receive a volume-based ASP fee with a guaranteed monthly minimum. As the Company incurs cost associated with the customization effort, amounts will be 8 reflected as deferred contract costs in the balance sheet. Through June 30, 2002, $268,406 in development and customization costs have been deferred. The Company will amortize the cost of the development and customization effort over the expected period of the agreement, currently estimated to be five years from completion of the development and customization effort. The Company currently believes that the cost of the development and customization effort will not exceed the anticipated monthly minimum payments under the agreement totaling $450,000. Should it be determined that the costs to develop and customize the software applications under the agreement exceed estimated total revenues from the contract, the estimated loss will be charged to cost of revenues in the period the loss first becomes known. The Company will recognize in revenue the minimum monthly fees under the agreement on a straight-line basis commencing on the completion of the development and customization effort. To the extent that transaction based fees exceed the monthly minimum payments, the Company will record the excess in revenue when earned. 4. Series A Convertible Preferred Stock The Company has authorized 5,000,000 shares of preferred stock, par value $0.0001 per share, of which 1,443,457 shares have been designated as Series A convertible preferred stock ("Series A preferred stock"). The remaining authorized shares have not been designated. At June 30, 2002, the Company has reserved 1,443,457 shares of common stock for issuance upon the conversion of the Series A preferred stock. The Series A preferred stock has the following characteristics: Voting Rights - Each holder of the Series A preferred stock is entitled to the number of votes equal to the number of shares of common stock into which such holder's shares are convertible. The Company cannot amend its certificate of incorporation amending the rights of the Series A preferred stockholders, enter into any capital stock or equity agreements with rights ranking the same or above the rights of the Series A preferred stock or liquidate the Company without the approval of at least a majority of the holders of the Series A preferred stock then outstanding. Liquidation Preference - In the event of any liquidation, dissolution or winding up of the affairs of the Company, the holders of the Series A preferred stock will be entitled to receive in preference to the holders of the common stock, an amount per share equal to $1.244 plus accrued and unpaid dividends. After such payment, the Series A preferred stockholders share equally with the common stockholders in any remaining assets or funds of the Company. Conversion - Each share of the Series A preferred stock is convertible at anytime at the option of the holder into shares of common stock pursuant to a ratio of one share of common stock for each share of Series A preferred stock, subject to certain stock split and stock dividend adjustments. In addition, the conversion ratio is subject to adjustment, as defined in the agreement, in the event that the Company issues common stock at a per share price less than $1.244 per share. All Series A preferred stock will automatically convert to common stock on the first day after March 18, 2004 for which the market price of the Company's common stock exceeds $2.25 per share. 9 Dividends - Dividends on the Series A preferred stock shall accrue at 7% per annum through the date of liquidation or conversion. In the event of conversion all accrued and unpaid dividends will be waived. The Company is requesting stockholder approval and ratification of this transaction because the anti-dilution provisions associated with the Series A Preferred (described above under the paragraph beginning with "Conversion") can potentially result in the issuance of greater than 20% of our Common Stock outstanding on March 18, 2002 and at a price below its then market value of $1.15 (based on the closing bid price on March 15, 2002) upon conversion of all the Series A Preferred. As a result, the Nasdaq has advised us that approval of this transaction by holders of our Common Stock would be necessary to be in compliance with their shareholder approval requirement for such issuances and to avoid being subject to delisting proceedings. The annual proxy statement has been filed with this matter to be voted on by shareholders of record as of August 8, 2002. 5. Issuance of Common Stock In January 2002, the Company sold an additional 300,000 shares of common stock at a price of $0.50 per share. These shares were sold as part of a 1,300,000 share private placement made pursuant to Sections 4(2) and 4(6) of the Act, of which 1,000,000 shares were sold prior to December 31, 2001. In connection with this offering the Company issued warrants to purchase 130,000 shares of its common stock, at a per share price of $0.75, as part of the placement agent fees. The warrants expire on January 16, 2007. In January 2002, the Company issued 114,545 of its authorized but unregistered shares of common stock in full settlement of a $62,500 liability, payable to Morse, Zelnick, Rose & Lander, LLP. The shares were registered in June 2002. In February 2002, AdStar sold 100,000 shares of its common stock at $0.50 per share. In connection with this sale, the Company issued warrants to purchase 10,000 shares of its common stock, at a per share price of $0.75, as part of the placement agent fees. The warrants expire on January 31, 2007. 6. Settlement and return of Common Stock In November 2000, Adstar entered in a one-year strategic alliance agreement with Eastman Kodak Company (Kodak) whereby Adstar issued 67,796 shares of its common stock valued at $100,000. As of December 2001 the parties had not been able to complete the provisions of the agreement to both parties satisfaction, whereby Kodak notified Adstar of its intention to terminate the agreement as of February 28, 2002. After protracted settlement discussions the parties agreed to a mutual termination and release agreement entered into during May 2002. As part of the agreement Kodak returned Adstar's common stock, valued at $67,789 and Adstar agreed not to pursue any further actions for performance against Kodak. 7. Subsequent events In July 2002, AdStar entered into four-year employment agreements with each of Leslie Bernhard and Eli Rousso. Their prior agreements expired on June 30, 2002. Pursuant to 10 her employment agreement, Leslie Bernhard was retained as our Chief Executive Officer and her total annual compensation was reduced to $212,800. Pursuant to his employment agreement, Eli Rousso was retained as Executive Vice President and his total annual compensation was reduced to $212,800. Each agreement provides, among other things, for participation in an equitable manner in any profit-sharing or retirement, separation and disability plans for employees or executives and for participation in other employee benefits applicable to employees and executives of AdStar. Each agreement further provides for fringe benefits which commensurate with the executive's duties and responsibilities. Under each agreement, employment may be terminated by Adstar with cause or by the executive with good reason. Termination without cause, or by the executive for good reason, would subject Adstar to liability for liquidated damages in an amount equal to the terminated executive's base salary for the remaining term of his or her employment agreement or 12 months, whichever is greater. In July 2002, AdStar entered into a loan transaction with Leslie Bernhard and Eli Rousso for $110,434 and $100,000, respectively. As part of the transaction, Ms. Bernhard and Mr. Rousso each issued to AdStar an unsecured, non-negotiable promissory note bearing interest at 5.56% with monthly principal and interest payments of $763 and $691 payable on a monthly basis, with all remaining outstanding principal and interest amounts due on July 31, 2022. Concurrently, an outstanding note from Ms. Bernhard in the amount of $39,566 was restructured under the same terms and conditions as the aforementioned new note. In July 2002, for the six-month period ended June 30, 2002, 8,861 shares were issued to vendors under the AdStar Vendor Payment Plan relying upon the exemption under sections 4(2) and 4(6) of the Securities Act of 1933 and which represented compensation for the period of $7,500. The vendors have taken the shares for investment. In August 2002, AdStar was informed by Chase Merchant Services, L.L.C (Chase), AdStar's merchant bank providing credit card processing services, that it required the Company to maintain a restricted cash balance of $175,000. Chase indicated the primary reason for the reserve was the significant increase in dollar volume during the second quarter from AdStar's transactions. AdStar believes the reserve is unnecessary and has commenced negotiations to have the reserve significantly reduced or removed altogether. Should negotiations fail AdStar has identified another reputable credit card merchant services provider who has indicated it would not require a reserve. 11 Item 2. Management's Discussion and Analysis or Plan of Operation The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and related notes to the financial statements included elsewhere in this quarterly report. Certain statements in this discussion and elsewhere in this report constitute forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934 and are subject to the "Risk Factors" included in our Annual Report on Form 10-KSB/A for our fiscal year ended December 31, 2001 and in our registration statement on form S-3 filed with the Securities and Exchange Commission on January 24, 2002. Because this discussion involves risk and uncertainties, our actual results may differ materially from those anticipated in these forward-looking statements. Overview During the First quarter of 2002, we focused our efforts on raising equity capital and the development and customization arrangements with the Tribune Company. In January 2002, we completed the private placement that had been in process at year-end, raising an additional $150,000 in gross proceeds. In February 2002, we raised an additional $50,000 in gross proceeds from a subsequent private placement. Combined, these two transactions raised approximately $157,000 in net proceeds. In March 2002, we entered into a series of significant contracts with the Tribune Company. Under these agreements, we sold 1,443,457 shares of Series A preferred stock to the Tribune Company for net proceeds totaling approximately $1,728,000. Additionally, we agreed to develop and customize a version of our Web software applications to provide for Web-based technology for recruitment classified advertising sales to all major market Tribune newspapers and on-line services in exchange for earning volume-based ASP fees for ads placed through the Web using our customized software. This customization will provide a platform that allows Tribune owned newspapers, together with a Tribune affiliated company, CareerBuilder, Inc. (www.careerbuilder.com), to receive recruitment advertising from agencies, corporate customers, and the general public. From a practical standpoint, the customization work will need to be substantially completed before they will be able to begin processing the recruitment advertising and perform the related transactions. Therefore, we will incur significant expenditures to complete the customization effort prior to the point in time when we begin to earn the ASP fees from this arrangement. We believe that the value we will realize from these arrangements far exceeds the up-front expenditures required to complete the customization effort and also enhances our position in the marketplace. Our ASP business is continuing to demonstrate approval in the marketplace. During the quarter we experienced large increases in Web-based transaction volumes on behalf of our existing customers as well as substantial increases in volume from the new Knight-Ridder publications set up during the fourth quarter 2001. Revenue earned from our new ASP business improved substantially quarter over quarter, increasing 24% this quarter compared to the first quarter 2002 and 124% this quarter from the fourth quarter 2001. We expect this increase to continue throughout the year. During the second quarter 2002, on behalf of our customers we processed a total of 46,500 transactions through our web site generating gross billings in excess of $3,840,000. We recognized revenues of $221,000 on these transactions. For the same quarter in 2001 we processed a total of 25,000 transactions generating gross billings in excess of $1,992,000 for which we recognized $58,000 of revenues. For the six months ended June 30, 2002 we processed a total of 78,500 transactions generating gross billings in excess of $6,047,000 for which we recognized $399,000 of revenues. For the six months ended June 30, 2001 a total of 41,000 transactions were processed generating gross billings in excess of $3,310,000 for which we recognized $86,000 of revenues. We 12 are delighted with the level of incremental revenue our customers are able to generate using our software applications and we believe that this success gives us the opportunity to enter into arrangements to provide Web-based ad-taking technology for new customers. This success serves to confirm that we have developed a viable foundation that exploits our proprietary software products, extensive industry knowledge, and unique position within the marketplace. As we are early in the life cycle of our ASP business, we are continuing to critically evaluate all products, their profit contributions, and potential line extensions that may be of benefit to our existing customers as well as our potential customers. Customization services, which traditionally had been a large percentage of our revenue, were significantly down for the first two quarters of 2002 from the same quarters in 2001. This reflects reduced capital spending at newspapers resulting from lower advertising revenues caused by the general economic downturn since the fourth quarter of 2001. As we continue to add more newspapers as ASP customers, we will be better positioned to weather economic downturns. Description of Business Under our ASP business model we developed a new e-business application suite that is an enterprise class software solution allowing print and on-line publications to electronically receive completed classified advertising copy using the Internet as the communication channel. This new application suite was developed in conjunction with our existing customers, and in response to their need for a software solution supporting both business-to-business (B-to-B) operations and business-to-customer (B-to-C) operations. These software solutions enable our customers to expand the relationships with their customers using a single integrated platform, while increasing sales volumes at reduced costs. Our software allows newspapers to turn their on-line presence into an e-commerce-enabled, revenue generating Web site. We believe that our ASP product and services provide our customers an opportunity to generate incremental revenue from their on-line business while increasing the number of visitors to their Web site. Our new e-business application suite includes two main products that can be purchased separately or as a fully integrated software solution: o Professional software ("Professional Product") - This technology is designed for use by the professional marketplace. Specifically, our software allows publishers to receive transmissions from classified advertising agencies and corporations using advanced Web-based technology. The software includes sophisticated pricing algorithms to provide for maximum flexibility and intricate design resources to provide unlimited creative capabilities. The recently released Web version of this software has been favorably received. This software solution utilizes the Internet as the communication method, which significantly improves the intuitive nature of the application and allows the advertiser to increase the speed of each transmission by utilizing existing high-speed Internet connections. Should a high-speed Internet connection not be available, the advertiser can install a desktop version of this software that utilizes modem communication. o ASP Web site technology ("ASP Product") - This technology is a publisher-specific ad-taking Web site service designed to enhance a publication's Web site by allowing the general public to execute transactions to purchase classified advertising. Specifically, it is an integrated application suite that offers visitors to a newspaper's Web page the opportunity to buy classified ads, for both the print and/or on-line editions of the newspaper, in real-time, on a 24/7 basis. This product allows a publication to completely outsource the classified ad-taking power of their Web site whereby the publication receives incremental revenue at a very low incremental cost. We handle all functions associated with this revenue source. We furnish and host the application suite, run the technology, monitor the transactions throughout the session, handle the payment authorization and settlement process, electronically deliver 13 the ad text to the newspaper, and provide customer service support to the newspaper's customers. We provide all the technical and application expertise, customer support, and security measures that the publication needs to get an application up and running in a short time. Typically, we are able to process many more ads and do so much more quickly and affordably than the publisher could do internally. In addition, this software solution provides tools to evaluate performance, provide additional customer care, and increase future revenue opportunities. We provide the means to deliver highly personalized email communications to existing customers for the purpose of creating additional revenues and creating a profitable, long-term relationship. Both software products allow transactions to be executed through the Internet. Our application suite is designed to be quickly integrated into our customer's existing publishing software and readily expands as our customer's needs and business grows. Our products use a single platform to connect and integrate transmissions between multiple browsers and multiple technology standards. In continually ensuring that our AdStar software solution works with all available technology standards, we solve the problems created for our customers because advertisers create and deliver content using ever changing technology with multiple standards, multiple browsers and evolving network infrastructures. By bridging disparate technologies in a way that seamlessly allows for communication and transmission of advertising copy, we alleviate this obstacle for our customers, freeing them to focus on their business. Both lines of business require fees to customize the AdStar software solution to the technical specifications for each publication. In addition, we charge ongoing monthly fees to manage the ad-taking process, provide technical support, supply a customer service phone room, and manage the entire e-commerce function. The monthly fees include a small hosting fee plus a fee based on transaction volumes and structured in such a way that we are, in essence partnering with our customers. Therefore, when our customer's revenue volume increases, our revenue will also increase. With this structure, we are able to offer superior service in a manner that is cost effective for publishers of all sizes. In developing our Web-based system we began to incur expenses in 1998 that could not be offset by the revenues generated by our historical business. These expenses caused us to incur losses in 1998, 1999, 2000, 2001 and first two quarters of 2002. Our future success is dependent upon our ability to substantially grow revenues to the point where we can fund the current level of operations. To this end, our plans include expanding the products and services offered to our customers by building on our (i) proprietary software processes, (ii) established customer relationships, and (iii) unique position within the industry. We feel that there is significant opportunity to increase revenues by offering the Web software and customer support services that we had initially developed for our Web-based national portal, "Advertise123.com," to print publications under the ASP business model. In addition to the AdStar software solution, we have also developed Advertise123.com, a one-stop marketplace on the Web for the general public to buy classified ads. Through Advertise123.com, the general public can compose professional looking classified ads using one of several pre-programmed templates, schedule the ad to run in one or several of over 200 newspapers and 50 state newspaper associations, and purchase the ad using a credit card, all on a 24/7 basis. We receive a small fee for this service. During July 2002 AdStar and DynAccSys entered a strategic Marketing Agreement whereby Adstar will incorporate DynAccSys's Virtual AdTaker into its existing E-Commerce Product Suite. With Virtual AdTaker, AdStar's publishing customers can accept several types of display ads via the Web, including in-column ads with photos, obituary, funeral and legal notices, and gallery ads. 14 Results of Operations The following table sets forth the results of operations expressed as a percentage of revenues: Three months ended Six months ended June 30, June 30, ------------------------------------------- 2001 2002 2001 2002 ---- ---- ---- ---- Revenues 100% 100% 100% 100% Cost of revenues 37% 48% 38% 47% ---- ---- ---- ---- Gross profit 63% 52% 62% 53% Selling expense 32% 27% 35% 29% Administrative expenses 84% 85% 105% 89% Development expenses 17% 16% 30% 29% ---- ---- ---- ---- Loss from operations -70% -76% -108% -94% Interest income (expense) 3% 13% 2% 7% ---- ---- ---- ---- Loss before taxes -67% -63% -106% -87% Provision for income taxes -- -- -- -- ---- ---- ---- ---- Net loss -67% -64% -106% -87% Three-and six Month Periods Ended June 30, 2002 and 2001 Revenues. - Net revenues for the second quarter 2002 increased 2% to $542,000 compared to second quarter 2001 net revenues of $532,000. Fees from our ASP Product increased 282% to $221,000 during the second quarter 2002 from $58,000 in the second quarter 2001. Revenue from software customization services decreased 70% during the second quarter 2002 to $37,000 from $123,000 in the second quarter 2001. Revenues from miscellaneous and non-recurring items decreased 77% during the second quarter 2002 to $14,000 from $60,000 in the second quarter 2001. Fees from our Professional Product decreased 7% to $269,000 during the second quarter 2002 from $290,000 during the second quarter 2001. Net revenues for the six months ended June 30, 2002 increased 7% to $1,042,000 compared to $972,000 for the six months ended June 30, 2001. ASP fees for the six months ended June 30, 2002 increased 362% to $399,000 from $86,000 for the six months ended June 30, 2001. Customization revenue for the six months ended June 30, 2002 decreased 81% to $39,000 from $205,000 for the six months ended June 30, 2001. Revenue from miscellaneous and non-recurring items for the six months ended June 30, 2002 decreased 49% to $60,000 from $118,000 for the six months ended June 30, 2001. Fees from our Professional Product decreased to 3% $543,000 during the second quarter 2002 from $562,000 during the second quarter 2001. The decrease in software customization is a by-product of the trend to defer capital expenditures in the publishing industry due to the general economic climate, we anticipate the deferral to continue through the rest of the year. The decrease in Professional Product is primarily due to the transition of existing customers from the Professional Product line to our ASP Product; this trend is expected to continue. We expect that revenue from our ASP Product will continue to increase as we increase both the number of customers and the transaction volume we process on behalf of those customers. Cost of Revenues - Cost of revenue consists primarily of the costs to customize and install the AdStar software applications, configure end-user software, install Web-based ad-taking software, 15 provide customer training and end-user support, amortization of internally developed application modules, royalties, and Co-location costs. These costs increased to approximately $260,000 for the second quarter of 2002 compared with $196,000 for the second quarter 2001. Our gross profit margin decreased to 52% during the second quarter 2002, from 63% during the second quarter 2001. This increase in cost of revenues primarily resulted from an increase in the amortization of software development costs to $88,000 in the second quarter 2002 from $35,000 in the second quarter 2001. Cost of revenues for the six months ended June 30, 2002 increased to $486,000 from $372,000 for the six months ended June 30, 2001. Our gross profit margin for the six months ended June 30, 2002 decreased to 53% from 62% for the six months ended June 30, 2001. This increase primarily resulted from an increase in the amortization of software development costs to $174,000 for the six months ended June 30, 2002 from $67,000 for the six months ended June 30, 2001. Given our current level of Web automation, we will be able to manage significantly greater transaction volumes with limited increases to our current staffing levels. Accordingly, we expect a corresponding increase in cash to be generated from our gross profits. Selling Expense. - Selling expense consists primarily of direct charges for advertising, sales promotion, marketing, and trade shows, as well as the cost for business development. Selling expense decreased 13% during the second quarter 2002 to $148,000 from $170,000 during the second quarter 2001. The 13% decrease primarily resulted from the reduction of personnel related expenses to $110,000 during the second quarter 2001 from $134,000 for the second quarter 2001. Selling expense for the six months ended June 30, 2002 decreased 10% to $304,000 from $338,000 for the six months ended June 30, 2001. Personnel related expenses for the six months ended June 30, 2002 decreased 7% to $261,000 from $280,000 for the six months ended June 30, 2001. Direct charges for the six months ended June 30, 2002 decreased 26% to $43,000 from $58,000 for the six months ended June 30, 2001. In future quarters, we can expect to see some incremental increase in selling expenses as compared to the last two quarters as we continue the development of our strategic relationships with Tribune Company, Knight-Ridder, Inc., CareerBuilder, Inc., DynAccSys, and other potential strategic partners. Administrative Expenses. - Administrative expense consists primarily of the cost of executive, administrative, professional fees, accounting, finance and information technology personnel. Administrative expenses increased 3% during the second quarter 2002 to $461,000 from $446,000 during the second quarter 2001. The increase was primarily related to professional fees and other non-personnel related expenses. Administrative expenses for the six months ended June 30, 2002 decreased 9% to $930,000 from $1,022,000 for the six months ended June 30, 2001. Personnel related expenses for the six months ended June 30, 2002 decreased to $258,000 from $461,000 for the six months ended June 30, 2001. Legal fees for the six months ended June 30, 2002 increased to $155,000 from $21,000 for the six months ended June 30, 2002. This is primarily due to a significant increase in outside legal expenses during the first quarter 2002 related to financing negotiations and general corporate advise. Although we expect that quarterly administrative expenses overall will be lower in comparison to the prior year, during the remainder of 2002, personnel related expenses may increase incrementally from the first two quarters, as we have added some additional administrative headcount, and anticipate increases in Directors & Officers insurance and health care costs as dictated by current market conditions. Development Expenses. - Development expenses consist of expenses to identify functional requirements, to plan, identify and conceptually design the required technical infrastructure, and to 16 perform Web-site maintenance and other general routine fixes. The costs consist primarily of personnel related expenses for technical and design personnel and consultants. Development expense for the second quarter 2002 decreased 5% to $87,000 from $91,000 during the second quarter 2001. Personnel related expenses decreased to $62,000 in the second quarter 2002, as compared to $86,000 for the second quarter 2001. Development expense for the six months ended June 30, 2002 increased to $306,000 from $294,000 for the six months ended June 30, 2001. The increase was due to approximately $44,000 in one-time costs for outside consultants to create the conceptual design and feasibility study for the Tribune Company product prior to execution of our agreement with them during the first quarter of 2002, offset by a decrease in personnel related expenses for the six months ended June 30, 2002 to $262,000 from $286,000 for the six months ended June 30, 2001. Other Income (Expense) - Other income expense has historically been comprised of net interest income (expense). During the second quarter 2002 AdStar finalized a settlement with Kodak, Inc. whereby Kodak returned 67,796 shares of AdStar common stock resulting in a non-cash gain of approximately $63,000. Net interest income decreased 56% during the second quarter 2002 to $7,000 from $16,000 during the second quarter 2001. This decrease is attributable to a general reduction of interest rates available in short-term time deposits and money market accounts at commercial banks, as well as an increase in interest expense during the quarter relating to the addition of capital leases. Net interest income for the six months ended June 30, 2002 decreased to $10,000 from $19,000 for the six months ended June 30, 2001. Liquidity and Capital Resources As of June 30, 2002, we had cash and cash equivalents of approximately $1,364,000. Net cash used in operations was approximately $766,000 for the six months ending June 30, 2002 compared with $905,000 for the comparable 2001 period. The favorable $138,000 difference is due primarily to a $120,000 smaller net loss, an increase in depreciation and amortization of $127,000, a decrease in other non-cash items totaling $87,000, decrease in accounts receivable of $105,000, and increase in deferred contract costs of 268,000, an increase in accounts payable and accrued expenses of $272,000, a decrease in deferred revenue of $87,000, and a decrease in prepaid expenses of $46,000 for the six months ended June 30, 2002 as compared to the six months ended June 30, 2001. Net cash used in investing activities decreased to $231,000 in the second quarter 2002 compared with $382,000 in the same period in 2001. This is a result of reduced spending on capitalized software in general and the shifting of resources to deferred contract expenditures primarily related to the CareerBuilder project. Net cash provided by financing activities increased by $1,630,000 in the second quarter 2002 compared with $321,000 in the same period in 2001. The increase is primarily due to the net proceeds of $1,727,000 from the issuance of Series A preferred stock to Tribune Company as compared to the comparable period in 2001. As a result of the equity raised during the first quarter 2002, we expect our available funds, combined with the cash generated from existing operations and new customers, and the flexibility to cut back our work-force should anticipated significant customization projects be delayed or terminated, will be sufficient to meet our anticipated working capital needs through June 30, 2003. We have generated operating losses during the past four years, and we cannot guarantee that the assumed increases in revenue will occur in a timely manner, that we will be able to contain our costs in accordance with our plans, nor that we have accurately estimated the resources required to fulfill our obligations to the Tribune Company. Although we are optimistic that our new ASP business will be accepted in the marketplace and we will fulfill our obligations to the Tribune Company in a timely manner, the timing is not assured. Our ability to sell ASP business products and service offerings 17 during the current year may be hampered by the current downturn in the advertising market and state of the economy in general. These factors, coupled with the extended time frame required for software sales, customization, and implementation, could delay our ability to increase revenue to a level sufficient to cover our expenses. In August 2002, AdStar was informed by Chase Merchant Services, L.L.C (Chase), AdStar's merchant bank providing credit card processing services, that it requires us to maintain a restricted cash balance of $175,000. Chase indicated the primary reason for the reserve was the significant increase in dollar volume during the second quarter from AdStar's transactions. AdStar believes the reserve is unnecessary and has commenced negotiations to have the reserve significantly reduced or removed altogether. Should negotiations fail Adstar has identified another reputable credit card merchant services provider who has indicated it would not require a reserve. We currently have no additional borrowings available to us under any credit arrangement, and we are continuing to look for additional debt and equity financing. Adequate funds may not be available or may not be available on terms favorable to us. If additional funds are raised through the issuance of equity securities, dilution to existing stockholders may result. If funding is insufficient at any time in the future, we may be unable to develop or enhance our products or services, take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our financial position, results of operations and cash flows. PART II Item 2. Changes in Securities and Use of Proceeds Recent Sales of Unregistered Securities. AdStar established a vendor payment plan whereby it may compensate vendors in shares of its common stock in lieu of cash. Under the plan, 400,000 shares are available for issuance. In the six-month period ended June 30, 2002, 8,861 shares were issued to vendors under the plan relying upon the exemption under sections 4(2) and 4(6) of the Securities Act of 1933 and which represented compensation for the period of $7,500. The vendors have taken the shares for investment. In January 2002, AdStar completed a private placement of 1,300,000 shares of its common stock at a price of $0.50 per share, through the sale of the remaining 300,000 shares. 1,000,000 shares were sold during the period of October 2001 through December 2001. These shares were sold to accredited investors, as defined under Rule 215 of the Securities Act of 1933, and required a minimum investment of $25,000. In connection with this offering AdStar issued warrants to purchase 130,000 shares of its common stock, at $0.75 per share, as part of the placement agent fees. The warrants expire on January 16, 2007 and have anti-dilution protection against capital changes. In addition, AdStar issued to Morse, Zelnick, Rose and Lander LLP, AdStar's legal counsel, 114,545 shares of restricted common stock, issued at fair market value in full settlement of a $62,500 liability. These offerings were exempt from registration made pursuant to Sections 4(2) and 4(6) of the Act. In February 2002, AdStar sold to an accredited investor (as previously defined) 100,000 shares of its common stock at a price per share equal to 85% of its per share closing price on January 31, 2002 ($0.50). In connection with this sale AdStar issued warrants to purchase 10,000 shares of its Common Stock, at $0.75 per share, as part of the placement agent fees. The warrants expire on January 31, 2007 and have anti-dilution protection against capital changes. This sale was exempt from registration made pursuant to Sections 4(2) and 4(6) of the Act. 18 In March 2002, AdStar sold 1,443,457 shares of its Series A Preferred Stock to Tribune Company for an aggregate purchase price of $1.8 million. These shares currently convert on a 1:1 basis. Shareholders of Series A Preferred Stock are entitled to vote on all matters submitted to the stockholders for vote and as a single class with the common stock. The holders of Series A Preferred Stock are entitled to one vote for each share of common stock issuable upon conversion. We are requesting shareholder approval and ratification of this transaction. We are requesting shareholder approval and ratification of the Tribune Company transaction because the anti-dilution provisions associated with the Series A Preferred can potentially result in the issuance of greater than 20% of our Common Stock outstanding on March 18, 2002 and at a price below its then market value of $1.15 (based on the closing bid price on March 15, 2002) upon conversion of all the Series A Preferred. As a result, the Nasdaq has advised us that approval of this transaction by holders of our Common Stock would be necessary to be in compliance with their shareholder approval requirement for such issuances and to avoid being subject to delisting proceedings. The annual proxy statement has been filed with this matter to be voted on by shareholders of record as of August 8, 2002. Item 6. Exhibits and Reports on Form 8-K a. Exhibits: Exhibit No. Description ----------- ----------- 99.1 Chief Executive Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, filed with the Securities and Exchange Commission on the date hereof. 99.2 Chief Financial Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, filed with the Securities and Exchange Commission on the date hereof. b. Reports on Form 8-K: None 19 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. AdStar, Inc ----------- (Registrant) Date August 14, 2002 /s/ Leslie Bernhard ---------------------------------- ----------------------- President & CEO Date August 14, 2002 /s/ Anthony J. Fidaleo ---------------------------------- ----------------------- Chief Financial Officer 20