10QSB 1 v050603_10qsb.txt 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, 2006 [_] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT FOR THE TRANSITION PERIOD FROM __________ TO __________ COMMISSION FILE NUMBER ________________________________ SCIENCE DYNAMICS CORPORATION ---------------------------- (Exact name of small business issuer as specified in its charter) DELAWARE 22-2011859 -------- ---------- (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 7150 N. PENNSAUKEN, NEW JERSEY 08109 ------------------------------------ (Address of principal executive offices) Issuer's telephone Number: (856) 910-1166 WITH COPIES TO: Gregory Sichenzia, Esq. Sichenzia Ross Friedman Ference LLP 1065 Avenue of the Americas New York, New York 10018 (212) 930-9700 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 [_] No [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X] APPLICABLE ONLY TO CORPORATE ISSUERS 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 15, 2006, the issuer had 113,980,767 outstanding shares of Common Stock. Transitional Small Business Disclosure Format (check one): Yes [_] No [X] TABLE OF CONTENTS PAGE ---- PART I - FINANCIAL INFORMATION Item 1. Financial Statements.............................................. 1 Consolidated Balance Sheets.............................. 1 Consolidated Statements of Operations.................... 2 Consolidated Statements of Cash Flows.................... 3 Notes to Consolidated Financial Statements............... 4 Item 2. Management's Discussion and Analysis or Plan of Operation......... 11 Item 3. Controls and Procedures........................................... 15 PART II - OTHER INFORMATION Item 1. Legal Proceedings................................................. 15 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds....... 15 Item 3. Defaults Upon Senior Securities................................... 15 Item 4. Submission of Matters to a Vote of Security Holders............... 15 Item 5. Other Information................................................. 15 Item 6. Exhibits.......................................................... 15 SIGNATURES................................................................... 16 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. SCIENCE DYNAMICS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS June 30, December 31, 2006 2005 Unaudited Audited ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 813,895 $ 53,997 Accounts receivable - trade 875,904 706,255 Inventories 1,943 6,049 Other current assets 230,077 190,581 ------------ ------------ Total current assets 1,921,819 956,882 ------------ ------------ Property and equipment, net -- 35,279 Goodwill 2,063,833 2,063,833 Other Intangibles, net 963,730 1,077,110 Other assets 21,313 19,213 -- ------------ ------------ Total assets $ 4,970,695 $ 4,152,317 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) Current liabilities: Customer deposits $ 15,000 $ 150,199 Accounts payable 706,068 986,505 Accrued expenses 1,010,663 1,084,555 Current maturities notes payable 2,638,149 2,667,942 Derivative Liability 449,017 462,462 ------------ ------------ Total current liabilities 4,818,897 5,351,663 Minority Interest 92,337 78,316 Shareholders' equity - (Deficit) Preferred stock - .01 par value 10,000,000 shares authorized -- -- No shares issued Common stock - .01 par value, 200,000,000 shares authorized, 113,106,567 and 89,841,498 issued 112,980,767 and 89,715,698 outstanding in 2006 and 2005 respectively 1,131,066 898,415 Additional paid-in capital 19,962,235 18,800,980 (Deficit) (20,636,007) (20,579,224) ------------ ------------ 457,294 (879,829) Common stock held in treasury, at cost (397,833) (397,833) ------------ ------------ Total shareholders' equity (Deficit) 59,461 (1,277,662) ------------ ------------ Total liabilities and shareholders' Equity $ 4,970,695 $ 4,152,317 ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 1 SCIENCE DYNAMICS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Six Month's Three Month's Ended Ended June 30, June 30, 2006 2005 2006 2005 "As Restated" "As Restated" Sales - Technology Products $ 801,886 $ 755,214 $ 377,996 $ 321,767 Sales - Technology Services 1,882,675 1,374,350 964,758 933,227 ------------ ------------ ------------ ------------ Total Sales 2,684,561 2,129,564 1,342,754 1,254,994 Cost of Sales - Technology Products 269,820 214,006 115,700 104,397 Cost of Sales - Technology Services 923,924 760,242 445,676 524,759 ------------ ------------ ------------ ------------ Total Cost of Sales: 1,193,744 974,248 561,376 629,156 Total Gross Profit 1,490,817 1,155,316 781,378 625,838 Operating Expenses: Research and development 218,269 195,966 109,135 100,819 Selling, general and administrative 1,061,197 1,283,180 556,590 697,307 ------------ ------------ ------------ ------------ 1,279.466 1,479,146 665,725 798,126 Operating Income (Loss) before other income 211,351 (323,830) 115,653 (172,288) (expenses) Other income (expenses): Interest Expense (264,753) (367,795) (134,864) (262,609) Other income 13,506 13,505 -- Derivative income (expense) 13,445 (239,692) 13,445 298,871 Finance Expense (16,309) -- (8,266) -- Minority interest (14,021) 13,717 (6,579) 13,717 ------------ ------------ ------------ ------------ Total Other Expense (268,133) (593,770) (122,759) 49,979 ------------ ------------ ------------ ------------ Net(Loss) $ (56,782) $ (917,600) $ (7,106) $ (122,309) ------------ ------------ ------------ ------------ Net Loss per Common Share -Basic $ (0.00) $ (0.01) $ (0.00) $ (0.00) Net Loss per Common Share -Diluted $ (0.00) $ (0.01) $ (0.00) $ (0.00) Weighted average shares outstanding -Basic 93,719,010 78,908,206 97,596,521 87,334,473 Weighted average shares outstanding -Diluted 93,719,010 78,908,206 97,596,521 87,334,473
The accompanying notes are an integral part of these consolidated financial statements. 2 SCIENCE DYNAMICS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended June 30, 2006 2005 ----------- ----------- Cash flows from operating activities: Net (Loss) $ (56,782) $ (917,600) ----------- ----------- Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 148,659 60,977 Non-Cash items -- Financing expense non cash 16,309 -- Minority interest 14,021 (13,717) Derivative income & expense including interest expense attributed to Derivatives 65,887 325,604 Changes in operating assets and liabilities: (Increase) decrease in: Accounts receivable (169,650) 46,201 Inventories 4,106 24,000 Other assets (57,905) (16,808) Increase (decrease) in: Accounts Payable and accrued expenses (254,328) 448,438 Deferred Income -- Customer Deposits (135,199) 50,000 ----------- ----------- Total adjustments (368,100) 924,695 ----------- Net cash (used in )provided by operating activities (424,882) 7,095 ----------- ----------- Cash flows used in investing activities: Investment in SMEI -- (1,655,325) Acquired Cash SMEI -- 5,159 Purchase of property and equipment -- (7,875) ----------- ----------- Net cash (used) in investing activities -- (1,658,041) ----------- ----------- Cash flows from financing activities: Loans from Stockholders /Officers -- (86,240) Bank note UB term Loan -- (15,000) Issuance of Convertible Debt net of fees -- 1,868,896 Issuance of Common shares, net of fees 1,293,906 -- Short term notes payable (209,000) (100,000) Revolving AR Credit facility 99,875 (197,000) ----------- ----------- Net cash provided by (used in) financing activities 1,184,781 1,470,656 ----------- ----------- Net increase (decrease) in 759,899 (180,290) cash and cash equivalents Cash and cash equivalents - 53,997 192,681 ----------- ----------- beginning of period Cash and cash equivalents - end of period $ 813,895 $ 12,391 =========== =========== Supplemental Information: Interest paid 100,875
The accompanying notes are an integral part of these consolidated financial statements. 3 SCIENCE DYNAMICS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) NOTE 1- ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A) ORGANIZATION Science Dynamics Corporation (the "Company", "SciDyn" or "Science Dynamics") was incorporated in the State of Delaware May 1973 and commenced operations in July 1977. The Company began as a provider of specialized solutions to the telecom industry. Throughout its history SciDyn has adapted to the changes in this industry by reinventing itself to be more responsive and open to the dynamic pace of change experienced in the broader converged communications industry of today. Currently SciDyn provides advanced solutions for several vertical markets. The greatest change in operations is in the shift from being a component manufacturer to a solution provider focused on developing applications through software on its core platform technology. To further its strategy of becoming a solutions provider, the Company acquired a majority interest in "SMEI" in February 2005. With the SMEI acquisition, approximately 70% of the Company's revenues are derived from solution services. B) BASIS OF FINANCIAL STATEMENT PRESENTATION The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has generated significant losses and is unable to predict profitability for the future. These factors indicate that the Company's continuation, as a going concern is dependent upon its ability to obtain adequate financing. The Company plans to address the going concern by replacing debt with equity and continuing to grow the company with profitable sales both organically and through acquisitions. Management believes successfully executing these tasks will lead to the removal of the going concern comment from our audited financials. The accompanying financial statements include the operating results of Systems Management Engineering Systems, Inc. (SMEI), a majority owned (86%) subsidiary of Science Dynamics acquired February 14, 2005. On February 14, 2005 the Company recorded on its Balance Sheet a Minority Interest Liability of $171,995 representing the net asset value not acquired by the Company. The carrying value of the minority interest of $171,995 has since been reduced by $79,658 at June 30, 2006 giving effect to the SMEI's net operating results. The carrying value increased by $14,021 in the six months ended June 30, 2006 giving effect to the portion of SMEI's net operating profit allocable to minority shareholders. C) PRINCIPLES OF CONSOLIDATION: The consolidated financial statements included the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained. All significant inter-company accounts and transactions have been eliminated in consolidation. For those consolidated subsidiaries where Company ownership is less than 100%, the outside stockholders' interests are shown as minority interests. D) USE OF ESTIMATES: The financial statements have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. These estimates form the basis for judgments made about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments are based on historical experience and on various other assumptions that the Company believes are reasonable under the circumstances. However, future events are subject to change and the best estimates and judgments routinely require adjustment. US GAAP requires estimates and judgments in several areas, including those related to impairment of goodwill and equity investments, revenue recognition, recoverability of inventory and receivables, the useful lives long lived assets such as property and equipment, the future realization of deferred income tax benefits and the recording of various accruals. The ultimate outcome and actual results could differ from the estimates and assumptions used. 4 NOTE 2- SEGMENT REPORTING Management views its business as two operating units, Technology Products and Technology Services. Six Months Ended Six Months Ended June 30, 2006 June 30, 2005 ---------- ---------- Revenue Technology Products $ 801,886 755,214 Technology Services 1,882,675 1,374,350 (a) ---------- ---------- Total Consolidated Revenue $2,684,561 $2,129,564 (a) ---------- ---------- Gross Profit Technology Products 532,066 541,208 Technology Services 958,751 614,108 (a) ---------- ---------- Total Gross Profit 1,490,817 1,155,316 (a) ---------- ---------- (a) - Gross Profit for the six months ended June 30, 2005 reflects SMEI's operating results for the period from February 14, 2005, the date of the SMEI acquisition, to June 30, 2005 NOTE 3 - EMPLOYMENT CONTRACTS Mr. Paul Burgess CEO & President of the Company has waived his right to the base salary of $112,500 of his compensation as described in his employment agreement for the six month's ended June 30, 2006. Mr. Burgess and the board are presently renegotiating his contract going forward. 5 NOTE 4 - NOTES PAYABLE Notes payable consists of the following as of June 30, 2006 and December 31, 2005:
2006 2005 --------------------------- Face value $2,000,000, variable rate (8.0% at December 31, 2005) Secured Convertible Term Note, due in monthly payments of $60,606 commencing June 30, 2005 (A) $ 1,521,794 $ 1,442,462 -- $400,000, 8.0% Secured Convertible Keshet Term Note (B) 400,000 400,000 8% Secured Convertible Laurus Term Note, originally due May 21, 2003 (B) -- -- Revolving credit facility (C) 302,726 202,851 Notes Payable - Stockholders/Officers (D) 213,629 388,629 Short term notes payable (E) 200,000 234,000 --------------------------- Total notes payable 2,638,149 2,667,942 Less current maturities, associated with notes payable (2,638,149) (2,667,942) --------------------------- Long-term debt $ -- $ -- ===========================
(A) 2005 LAURUS AGREEMENTS: On February 14, 2005, the Company entered into a Securities Purchase Agreement, dated February 11, 2005, with Laurus Master Fund, Ltd. ("Laurus") for the sale of a $2,000,000 principal amount Secured Convertible Term Note (the "Note") convertible at $0.10 per share and a Common Stock Purchase Warrant to purchase 6,000,000 shares of the Company's common stock at $0.11 that expire February 11, 2012. The sale of the Note and the Warrant were made pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act"), and Regulation D under the Securities Act. The Company received net proceeds of $1,867,500 from the sale of the Note and the Warrant. The Company may only use such proceeds for (i) general working capital purposes, (ii) no less than 80% of the equity interests of Systems Management Engineering, Inc. ("SMEI") pursuant to the Stock Purchase Agreement, as amended, dated as of December 16, 2004 by and among the Company, SMEI and the shareholders of SMEI identified therein, and (iii) the acquisition of 100% of the remaining equity interests of SMEI pursuant to a transaction in form and substance reasonably satisfactory to Laurus. The Note bears interest at a rate per annum equal to the prime rate published in The Wall Street Journal from time to time, plus 3%, but shall not be less than 8%. The interest terms include a monthly reset feature that provides for decreases in interest rates pro-rata for certain increases in the Company's common stock above the conversion rate; such feature does not become effective until the underlying common shares are registered. Otherwise, interest is payable monthly in arrears commencing March 1, 2005 and on the first business day of each consecutive calendar month thereafter until the maturity date, February 11, 2008 (each a "Repayment Date"). Amortizing payments of the aggregate principal amount outstanding under the Note must begin on June 1, 2005 and recur on the first business day of each succeeding month thereafter until the maturity date (each an "Amortization Date"). Beginning on the first Amortization Date, the Company must make monthly payments to Laurus on each Repayment Date, each in the amount of $60,606.06, together with any accrued and unpaid interest to date on such portion of the principal amount plus any and all other amounts which are then owing under the Note, the Purchase Agreement or any other related agreement but have not been paid (collectively, the "Monthly Amount"). Any principal amount that remains outstanding on the maturity date is due and payable on the maturity date. 6 In order to secure payment of all amounts due under the Note, as well as the Company's other obligations to Laurus: (i) the Company granted Laurus a lien on all of the Company's assets and also on all assets of the Company's subsidiaries; (ii) the Company pledged all of the capital stock that it owns of each of its subsidiaries; and (iii) each of the Company's subsidiaries executed a Subsidiary Guaranty of such obligations. Pursuant to the terms of a registration rights agreement, the Company agreed to include the shares of common stock to be issued upon conversion of the Note and Warrants in a registration statement to be filed not later than March 13, 2005 and to use its reasonable commercial efforts to cause such registration statement to be declared effective no later than May 12, 2005. Failure to file or become effective results in liquidating damages penalties of 2% per month of the face value of the Note. The Company has been in default on the note by not becoming effective on the registration statement by the required date and by not making the required monthly principal payments to Laurus since June 1, 2005. On November 21, 2005, the Company signed an amendment and waiver with Laurus waiving each Event of Default for our failure to pay accrued interest, and principal through November 1, 2005 and the failure to timely file a Registration Statement with the SEC. As consideration of the waiver, the Company issued to Laurus a seven year warrant to purchase 3,000,000 shares of the common stock of the Company with an exercise price of $0.075 per share. The Company further agreed to file a Registration Statement to register the shares of Common Stock that may be issued upon exercise of the Additional Warrant within 90 days of the date of the waiver. The Amendment and Waiver agreement was effective November 22, 2005 when the Company paid Laurus $32,236.25 of overdue interest under the secured convertible term note and issued Laurus the Additional Warrant. The Company allocated the fair value of the Additional Warrant to deferred finance costs ($42,275) and derivative expense ($5,725) on a relative fair value basis. The additional deferred finance costs is being amortized through periodic charges to interest expense using the effective interest method which commenced in the fourth fiscal quarter of 2005. In accordance with EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock," the basis from the 2005 Laurus Agreements was allocated to embedded derivative features indexed to the Company's common stock (consisting of the conversion and interest reset features) in the amount of $444,920, and the Warrant, in the amount, in the amount of $270,000. See Derivative Financial Instruments, below. These discounts resulted in an initial carrying value of the Secured Convertible Term Note of $1,285,080. The debt is being amortized through charges to interest expense over the debt term using the effective method. Amortization during the six months ended June 30, 2006 amounted to $79,332. (B) 2001 LAURUS AND KESHET FINANCING AGREEMENTS On May 21, 2001, the Company entered into concurrent financing arrangements, each bearing similar terms and conditions, with Laurus and Keshet Capital for $1,000,000 and $400,000, respectively. The notes bore interest at 8% and were due and payable in May 2003. The notes were convertible into the Company's common stock at 85% of the average trading market price over a period of twenty days preceding conversion. In addition, the notes were issued with detachable warrants to purchase 727,273 (relative to the Laurus arrangement) and 290,908 (relative to the Keshet Arrangement) shares of common stock. The warrants had terms of five years and fixed strike prices of $1.43. The Keshet notes, which remain outstanding as of June 30, 2006 are in default. In accordance with EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock," the basis from the 2001 Laurus Agreements was allocated to embedded derivative feature indexed to the Company's common stock (consisting of the conversion feature) in the amount of $634,501, and the Warrant, in the amount, in the amount of $334,546. These discounts resulted in an initial carrying value of the Secured Convertible Term Note of $30,953. The debt discount was amortized through charges to interest expense over the term using the effective method at effective interest rate of 99.07%. The basis from the 2001 Keshet Agreements was allocated to embedded derivative features indexed to the Company's common stock (consisting of the conversion feature) in the amount of $253,800, and the Warrant, in the amount, in the amount of $133,818. These discounts resulted in an initial carrying value of the Secured Convertible Term Note of $12,382. The debt discount was amortized through charges to interest expense over the term using the effective method at effective interest rate of 99.07%. (C) REVOLVING LINE OF CREDIT On November 7, 2005 the Company opened a Line of Credit with Presidential Financial Group. The Line of Credit with Presidential is for a period of 12 months and is a credit facility up to $1,000,000 and is secured by SMEI's accounts receivables. The Advance Rate on the Company's government receivables is 85%. Interest on the line will be charged at the rate of prime plus 2% on the average daily loan balance with a minimum monthly loan balance requirement of $200,000. Additionally, a monthly service charge will be charged at a rate of 1.00% of the average daily loan balance. The total outstanding balance on this facility as of June 30, 2006 was $302,726. 7 (D) NOTES PAYABLE STOCKHOLDERS/OFFICERS The Company has other short-term loans payable to various stockholders and officers of the Company amounting to $213,629, these notes bear interest ranging from 8% to 18% per annum. The notes are unsecured demand notes. (E) SHORT TERM NOTES At June 30, 2006 the Company has $200,,000 in short term notes. These loans are collateralized by the future sale of the New Jersey Net Operating Loss in 2006. These notes bear interest at 20% per annum. NOTE 5 - DERIVATIVE FINANCIAL INSTRUMENTS The balance sheet caption derivative liabilities consist of (i) embedded conversion features and (ii) the Warrants, issued in connection with the 2005 Laurus Financing Arrangement and the 2001 Keshet Financing Arrangement. These derivative financial instruments are indexed to an aggregate of 59,711,076 and 32,821,172 shares of the Company's common stock as of June 30, 2006 and 2005, respectively, and are carried at fair value. The following tabular presentation sets forth information about the derivative instruments for the six months ended June 30, 2006 and 2005: June 30, 2006: Conversion Features Warrants Total ---------------------------------------- Net liabilities $(242,017) $ (207,000) $(449,017) ======================================= Derivative income (loss): $ 13,445 $ -- $ 13,445 ======================================= June 30, 2005: Conversion Features Warrants Total ----------------------------------------- Net liabilities $ (670,179) $ (354,000) $(1,024,179) ========================================= Derivative income (loss): $ 236,726 $ 8,145 $ 244,871 ========================================= Freestanding derivative instruments, consisting of warrants and options that arose from the Laurus financing are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in the Black Scholes models included: conversion or strike prices ranging from $0.06--$0.11; volatility factors ranging from 35.50% - 41.88% based upon forward terms of instruments; terms-remaining term for all instruments; and a risk free rate of 4.88%. Fair value for forward-based features (principally the interest reset feature) is determined using the income approach; generally discounted cash flows. Embedded derivative instruments consist of multiple individual features that were embedded in the convertible debt instruments. The Company evaluated all significant features of the hybrid instruments and, where required under current accounting standards, bifurcated features for separate report classification. These features were, as attributable to each convertible note, aggregated into one compound derivative financial instrument for financial reporting purposes. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and Company-controlled redemption privileges) that are necessary to value these complex derivatives. Significant assumptions included in the Flexible Monte Carlo included: conversion or strike prices ranging from $0.06--$0.10; volatility factors ranging from 40.70% to 41.88% based upon forward terms of instruments; terms-remaining term for all instruments; equivalent interest rate risk ranging from 3.10% to 3.41% and equivalent yield rate ranging from 12.15% to 13.15% 8 Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. NOTE 6 - RESTATEMENTS -------------------------------------------------------------------------------- For the For the ------- ------- six months three months ---------- ------------ ended ended ----- ----- June 30, 2005 June 30, 2005 ------------- ------------- -------------------------------------------------------------------------------- Net Loss Applicable to Stockholders, as previously reported ($591,996) ($363,180) --------- --------- -------------------------------------------------------------------------------- Adjustments: -------------------------------------------------------------------------------- Derivative income (expense) ($325,604) 240,871 --------- --------- -------------------------------------------------------------------------------- Net Loss Applicable to Stockholders, as restated ($917,600) (122,309) --------- --------- -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- Basic and Diluted Loss per Common Share (as previously reported) ($ 0.01) ($ 0.00) --------- --------- -------------------------------------------------------------------------------- Basic and Diluted Loss per Common Share (as Restated) ($ 0.01) ($ 0.00) --------- --------- -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- The Company corrected its accounting for derivative financial instruments to conform to the requirements of Statements of Financial Accounting Standards No. 133, as amended. Embedded conversion features that meet the definition of derivative financial instruments have, where applicable, been bifurcated from host instruments and, in all instances; derivative financial instruments have been recorded as liabilities and are carried at fair value. Other instruments, such as warrants, where physical or net-share settlement is not within the Company's control are recorded as liabilities and carried at fair value. Finally, instruments that were initially recorded as equity were reclassified to liabilities at the time that the Company no longer possessed the ability to settle the instruments on a physical or net-share basis. The Fair Value adjustments included in the restated consolidated statement of operations for the six and three month's ended June 30, 2005 are as follows: --------------------------------------------------------------------------- For the six For the three months ended months ended June 30, 2005 June 30, 2005 --------------------------------------------------------------------------- Interest expense ($ 85,912) ($ 58,000) --------------------------------------------------------------------------- Derivative income (expense) ($239,692) $ 298,871 --------------------------------------------------------------------------- Net Adjustment ($325,604) $ 240,871 --------------------------------------------------------------------------- The interest expense adjustment is included under the caption interest expense and the derivative expense is reflected as a separate caption on the 2005 restated consolidated statement of operations. 9 NOTE 7 - PRIVATE PLACEMENT - EQUITY FINANCING Between April 14, 2006 and May 11, 2006 the Company sold 23,231,733 shares of common stock and 11,615,867 warrants to purchase additional shares of common stock to various accredited investors in a private placement The Company received $1,293,906 and converted $100,000 of accrued expenses for a total of $1,393,906.. Each unit is comprised of 100 shares and 50 warrants to purchase one shares of common stock with an exercise price of $0.12 per share exercisable for five years. Each 100 shares of common stock and one common stock purchase warrant were sold for a per-unit price of $6.00, or $0.06 per share. NOTE 8 - RECENT ACCOUNTING PRONOUNCEMENTS. The Company believes that any new accounting pronouncements since December 31, 2005, will not have an affect on the Company's financial statements. NOTE 9 - SUBSEQUENT EVENTS RENEGOTIATION OF LAURUS DEBENTURE On July 21, 2006, the Company entered into a forbearance agreement with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, Laurus waived certain Events of Default under the Secured Term Note dated February 11, 2005 (the "Term Note") and the related documents executed in connection with the Term Note and forebear from enforcing its remedies as a result of the occurrence of the events of default. The Company paid $500,000 and issued 1,000,000 shares of its common stock to Laurus upon execution of the Forbearance Agreement. In addition, pursuant to the terms of the Forbearance Agreement, the Company agreed to pay $250,000 in cash and issue 8,333,333 shares of its common stock by August 1, 2006 or pay at least $2,000,000 of the Principal Amount of the term Note through conversion or cash payment on or before August 31, 2006. In addition the Company agreed to change the conversion price from $0.10 to $0.06 on the first $500,000 converted. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION. FORWARD LOOKING STATEMENTS This Form 10-QSB includes forward-looking statements relating to the business of Science Dynamics Corporation (the "Company" or "Science Dynamics"). Forward-looking statements contained herein or in other statements made by Science Dynamics are made based on management's expectations and beliefs concerning future events impacting the Company and are subject to uncertainties and factors relating to the Company's operations and business environment, all of which are difficult to predict and many of which are beyond the control of the Company, that could cause actual results of the Company to differ materially from those matters expressed in or implied by forward-looking statements. The Company believes that the following factors, among others, could affect its future performance and cause actual results of the Company to differ materially from those expressed in or implied by forward-looking statements made by or on behalf of the Company: (a) the effect of technological changes; (b) increases in or unexpected losses; (c) increased competition; (d) fluctuations in the costs to operate the business; (e) uninsurable risks; and (f) general economic conditions. GENERAL OVERVIEW Science Dynamics Corporation was incorporated in the State of Delaware in May 1973 and commenced operations in July 1977. We have been developing and delivering secure technologically advanced communication solutions for over twenty-five years and recently expanded our product offering to include IT solutions with the acquisition of 86% of Systems Management Engineering, Inc. ("SMEI") on February 14, 2005. During 2006 the company has continued to demonstrate improved bottom line performance. The positive EBITDA (earnings before interest, taxes, depreciation and amortization) of $186,681 in the second quarter of 2006 is the second consecutive quarter the company has been EBITDA positive. These results are especially encouraging when compared to the same period a year ago at which time the company had an EBITDA loss of ($136,630). The company's improved results are a direct reflection of the company's efforts to manage our costs effectively and continue to build on our existing contracts. We intend to continue the expansion of our sales efforts both within the federal government secure software solutions space and commercial accounts. We continue to build upon our recent success in these markets by expanding our marketing efforts through our direct sales strategy. Our strong contract backlog has given us an opportunity to expand our existing revenue base. Our team is driven to increase shareholder value through both organic growth and acquisitions throughout the year. With regards to our acquisition strategy, we will continue to pursue profitable companies with proprietary products and services we can sell to our existing customers and which have synergies with our existing business. Between April 14, 2006 and May 11, 2006 the Company sold 23,231,733 shares of common stock and 11,615,867 warrants to purchase additional shares of common stock to various accredited investors in a private placement. The Company received $1,293,906 and converted $100,000 of accrued expenses for a total of $1,393,906. Each unit is comprised of 100 shares and 50 warrants to purchase one shares of common stock with an exercise price of $0.12 per share exercisable for five years. Each 100 shares of common stock and one common stock purchase warrant were sold for a per-unit price of $6.00, or $0.06 per share. On July 21, 2006, the Company entered into a forbearance agreement with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, Laurus waived certain Events of Default under the Secured Term Note dated February 11, 2005 (the "Term Note") and the related documents executed in connection with the Term Note and forebear from enforcing its remedies as a result of the occurrence of the events of default. The Company paid $500,000 and issued 1,000,000 shares of its common stock to Laurus upon execution of the Forbearance Agreement. In addition, pursuant to the terms of the Forbearance Agreement, the Company agreed to pay $250,000 in cash and issue 8,333,333 shares of its common stock by August 1, 2006 or pay at least $2,000,000 of the Principal Amount of the term Note through conversion or cash payment on or before August 31, 2006. In addition the Company agreed to change the conversion price from $0.10 to $0.06 on the first $500,000 converted. 11 RESULTS OF OPERATIONS - THREE AND SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 SALES: Total sales for the three months ended June 30, 2006 increased by $87,760 or 7.0% to $1,342,754 compared to $1,254,994 for the three months ended June 30, 2005. This consisted of technology product revenues of $377,996 or 28.2% of total sales and technology service revenues of $964,758 or 71.8% of the total. Total sales for the six months ended June 30, 2006 were $2,684,561 compared to $2,129,564 for the six months ended June 30, 2005, representing an increase of $554,997 or 26.1% in sales for the six months period ended June 30, 2006. The increase in the period attributable to the SMEI acquisition on February 14, 2005 was $400,379. Excluding the revenue growth attributable to the SMEI acquisition, revenues increased from prior year by $154,618 or 7.3%. Service revenues as a percent of total revenues increased to 70.1% from 64.5% a year ago. GROSS MARGIN: Gross margin for the three months ended June 30, 2006 was $781,378, an increase of $155,540 or 24.9% compared to three months ended June 30, 2005. Our overall gross margin percentage increased to 58.2% from 49.9% for the same period in 2005. The overall gross margin percentage was positively affected by a higher gross margin percentage for technology services. The gross margin percentage for services increased to 53.8% from 43.7% in 2005. The factors driving higher service margin percentage included a shift towards in-house labor as opposed to outside subcontractors and a shift towards flat rate service contracts from time and material based contracts. The gross margin percentage for technology products increased to 69.4% from 66.6% for the same period in 2005. The higher margin percentage for products was driven by an increase in the application or engineering services component of overall product revenues. Application development or engineering services carry high margins when coupled with a product sale. Gross margin for the six months ended June 30 was $1,490,817, an increase of $335,501 or 29% compared to same period in 2005. Our overall gross margin percentage increased to 55.5% from 54.3% in 2005. The overall gross margin percentages were impacted by the stronger margins realized in the second quarter discussed above and as a result of the SMEI acquisition in February 14, 2005. RESEARCH AND DEVELOPMENT EXPENSES: Research and development expenses consist primarily of salaries and related personnel costs, consulting fees associated with product development. For the three months ended June 30, 2006, research and development expenses increased to $109,135 compared to $100,819 for the three months ended June 30, 2005. Research and development expenses increased slightly to $218,269 for the six months ended June 30, 2006 compared to $195,966 for the six months ended June 30, 2005. Management believes that continual enhancements of the Company's products will be required to enable the Company to maintain its competitive position. The Company will have to focus its principal future product development and resources on developing new, innovative, technical products and updating existing products. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES: Selling, General and administrative ("SG&A") expenses consist primarily of expenses for management, finance and administrative personnel, legal, accounting, consulting fees, sales commissions and marketing, and facilities costs. For the three months ended June 30, 2006 SG&A expenses decreased to $556,590 compared to $697,307 for the comparative three months ended June 30, 2005. The decrease was primarily due to headcount reductions as part of cost reduction initiatives undertaken in the latter part of 2005, a reduction in executive salaries in 2006 and synergy savings by combining administrative functions of SMEI with the Company. 12 For the six months ended June 30, 2006 SG&A decreased to $1,061,197, a reduction of $221,983 from $1,283,180 for the comparative six months ended June 30, 2005. The decrease as discussed above was primarily due to headcount reductions as part of cost reduction initiatives undertaken in the latter part of 2005, a reduction in executive salaries in 2006 and synergy savings by combining the administrative functions of SMEI with that of Science Dynamics. INTEREST EXPENSE: Interest Expense decreased to $134,864 for the three months ended June 30, 2006 compared to $262,609 for the three months ended June 30, 2005. Interest expense for the six months ended June 30, 2005 included a default interest accrual of $120,000 related to default on the Laurus convertible note. Interest Expense decreased to $264,754 for the six months ended June 30, 2006 compared to $367,795 for the six months ended June 30, 2006. Interest expense for the six months ended June 30, 2005 included a default interest accrual of $120,000 related to default on the Laurus convertible note. NET LOSS: As a result of the factors discussed above, the Company's net loss for the three months ended June 30, 2006 decreased significantly to $7,106 compared to a net loss of $122,309 for the three months ended March 31, 2005 and from $917,600 for the six months ended June 30, 2005 to $56,782 for the six months ended June 30, 2006. LIQUIDITY AND CAPITAL RESOURCES For the six months period ended June 30, 2006, cash and cash equivalents increased to $813,895 from $53,997 at December 31, 2005. Net cash used by operating activities was $424,882 for the three months ended June 30, 2006 compared to net cash provided by operating activities of $7,095 in the corresponding three month period ended June 30, 2005. This consisted of a net loss of $56,782, an increase in our accounts receivable of $169,650, an increase in other assets of $57,905, a decrease in customer deposits of $135,199, a decrease in the Company's accounts payable and accrued expenses of $254,328, partially offset by non-cash items (depreciation, amortization of intangibles, derivative interest and financing cost) amounting to $244,876. Net cash provided by financing activities was $1,184,781 for the six months ended June 30, 2006 compared to $1,470,656 in the corresponding six months ended June 30, 2005. For the six months ended June 30, 2006, the Company increased the outstanding balance on its Revolving Credit facility by $99,875. The revolving credit facility is based on the accounts receivable of the Company's software consulting division. The outstanding balance on the revolving credit facility as of June 30, 2006 was $302,726. During the six months ended June 30, 2006, the Company sold 23,231,733 shares of common stock and 11,615,867 warrants to purchase additional shares of common stock to various accredited investors in a private placement The Company received $1,293,904 and convert $100,000 of accrued expenses for a total of $1,393,904.. Each unit is comprised of 100 shares and 50 warrants to purchase one shares of common stock with an exercise price of $0.12 per share exercisable for five years. Each 100 shares of common stock and one common stock purchase warrant were sold for a per-unit price of $6.00, or $0.06 per share. On July 21, 2006, the Company entered into a forbearance agreement with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, Laurus waived certain Events of Default under the Secured Term Note dated February 11, 2005 (the "Term Note") and the related documents executed in connection with the Term Note and forebear from enforcing its remedies as a result of the occurrence of the events of default. The Company paid $500,000 and issued 1,000,000 shares of its common stock to Laurus upon execution of the Forbearance Agreement. In addition, , pursuant to the terms of the Forbearance Agreement, the Company agreed to pay $250,000 in cash and issue 8,333,333 shares of its common stock by August 1, 2006 or pay at least $2,000,000 of the Principal Amount of the term Note through conversion or cash payment on or before August 31, 2006. In addition, the Company agreed to change the conversion price from $0.10 to $0.06 on the first $500,000 converted. 13 By August 31, 2006 we have a significant cash requirement of at least $1,000,000 to be repaid to Laurus Funds in accordance with the July 21, 2006 Forbearance Agreement. At June 30, 2006, the Company had a cash position of $813,895 and availability on its credit facility of approximately $300,000. On July 21, the Company repaid to Laurus $500,000, with a remaining cash balance due of $1,000,000 to be paid to Laurus As a result, the Company lacks the sufficient near-term liquidity to satisfy the remaining payments due to Laurus by the August 31, 2006. In this regard, the Company is actively engaged in financing activities and renegotiations with Laurus to satisfy these requirements. Excluding the Laurus repayments, the Company believes that its current operating cash flows together with its availability on its credit facility are sufficient to provide the necessary liquidity to support operations and any payments coming due in the next twelve months. If the Company is not successful raising the additional financing needed, Laurus will, among other things, have the right to declare all sums owing to it under the secured convertible term note immediately due and payable and it may take immediate possession of all of our assets and all of the assets of our subsidiaries, including SMEI. If this were to occur, we most likely would be forced to discontinue operations. OFF-BALANCE SHEET ARRANGEMENTS The Company does not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, results of operations, liquidity or capital expenditures. CRITICAL ACCOUNTING POLICIES The financial statements have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. These estimates form the basis for judgments made about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments are based on historical experience and on various other assumptions that the Company believes are reasonable under the circumstances. However, future events are subject to change and the best estimates and judgments routinely require adjustment. US GAAP requires estimates and judgments in several areas, including those related to impairment of goodwill and equity investments, revenue recognition, recoverability of inventory and receivables, the useful lives long lived assets such as property and equipment, the future realization of deferred income tax benefits and the recording of various accruals. The ultimate outcome and actual results could differ from the estimates and assumptions used. BASIS OF FINANCIAL STATEMENT PRESENTATION -The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has generated significant losses and is unable to predict profitability for the future. These factors indicate that the Company's continuation, as a going concern is dependent upon its ability to obtain adequate financing. The Company plans to address the going concern by replacing debt with equity and continuing to grow the company with profitable sales both organically and through acquisitions. Management believes successfully executing these tasks will lead to the removal of the going concern comment from our audited financials. PRINCIPLES OF CONSOLIDATION- The consolidated financial statements included the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained. All significant inter-company accounts and transactions have been eliminated in consolidation. For those consolidated subsidiaries where Company ownership is less than 100%, the outside stockholders' interests are shown as minority interests. 14 ITEM 3. CONTROLS AND PROCEDURES. As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of its Chief Executive Officer and Chief Financial Officer of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act). Based upon this evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is: (1) accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure; and (2) recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. There was no change to the Company's internal controls or in other factors that could affect these controls during the Company's last fiscal quarter that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. The Company is not a party to any pending legal proceeding, nor is the Company's property the subject of a pending legal proceeding, that is not in the ordinary course of business or otherwise material to the financial condition of its business. None of the Company's directors, officers or affiliates is involved in a proceeding adverse to the Company's business or has a material interest adverse to the Company's business. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. On May 21, 2001, the Company entered into concurrent debt financing arrangements, each bearing similar terms and conditions, with Laurus Master Fund, Ltd. and Keshet Capital for proceeds of $1,000,000 and $400,000, respectively. The notes bore interest at 8% and were due and payable in May 2003. The notes were convertible into the Company's common stock at 85% of the average trading market price over a period of twenty days preceding conversion. In addition, the notes were issued with detachable warrants to purchase 727,273 (relative to the Laurus arrangement) and 290,908 (relative to the Keshet arrangement) shares of common stock. The warrants had terms of five years and fixed strike prices of $1.43. The Keshet notes, which remain outstanding as of June 30, 2006 are in default. As of June 30, 2006, the Company was in default on the Secured Term Note dated February 11, 2005 (the "Term Note") with Laurus Master Fund, due to its failure to pay accrued interest and principal on the Note when due and the Company's failure to comply with certain registration requirements of its Registration Rights Agreement with Laurus. On July 21, 2006, the Company entered into a forbearance agreement with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, Laurus waived certain Events of Default under the Secured Term Note dated February 11, 2005 (the "Term Note") and the related documents executed in connection with the Term Note and forebear from enforcing its remedies as a result of the occurrence of the events of default. The Company paid $500,000 and issued 1,000,000 shares of its common stock to Laurus upon execution of the Forbearance Agreement. In addition, , pursuant to the terms of the Forbearance Agreement, the Company agreed to pay $250,000 in cash and issue 8,333,333 shares of its common stock by August 1, 2006 or pay at least $2,000,000 of the Principal Amount of the term Note through conversion or cash payment on or before August 31, 2006. In addition, the Company agreed to change the conversion price from $0.10 to $0.06 on the first $500,000 converted. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. ITEM 5. OTHER INFORMATION. Not applicable. ITEM 6. EXHIBITS. EXHIBIT NUMBER DESCRIPTION -------------------------------------------------------------------------------- 31.1 Certification by Chief Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act. 31.2 Certification by Chief Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act. 32.1 Certification by Chief Executive Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code. 32.2 Certification by Chief Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code. 15 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. SCIENCE DYNAMICS CORPORATION Date: August 16, 2006 By: /s/ Paul Burgess ---------------------------- Paul Burgess Chief Executive Officer Date: August 16, 2006 By: /s/ Joe Noto ---------------------------- Joe Noto Chief Financial Officer 16