10-Q 1 a10-q.txt FORM 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10Q (X) Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 2000 or ( ) Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Commission File Number 0-12194 FORTEL INC. (formerly Zitel Corporation) (Exact name of Registrant as specified in its charter) California 94-2566313 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 46832 Lakeview Boulevard 94538-6543 Fremont, California (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (510) 440-9600 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or 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 _____ The number of shares of the Registrant's Common Stock outstanding as of June 30, 2000 was 26,706,967. FORTEL INC. AND SUBSIDIARIES INDEX Page Number PART I. Financial Information Item 1. Financial Statements Condensed Consolidated Balance Sheets June 30, 2000 (unaudited) and September 30, 1999 ...... 3 Condensed Consolidated Statements of Operations (unaudited) - Three and Nine Months Ended June 30, 2000 and 1999.......................... 4 Condensed Consolidated Statements of Cash Flows (unaudited) - Nine Months Ended June 30, 2000 and 1999 ................................ 5 Notes to Condensed Consolidated Financial Statements .................................. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................................. 14 Item 3. Quantitative and Qualitative Disclosures about Market Risk ................................. 17 PART II. Other Information Item 1. Legal Proceedings ................................. 19 Item 2. Changes in Securities ............................. 19 Item 3. Defaults Upon Senior Securities ................... 19 Item 4. Submission of Matters to a Vote of Security Holders .................................. 19 Item 5. Other Information ................................. 19 Item 6. Exhibits and Reports on Form 8-K .................. 26 Page 2 FORTEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS ($000's) (unaudited) (audited) June 30, September 30, 2000 1999 --------- ------------- ASSETS Current assets: Cash and cash equivalents $ 1,280 $ 1,670 Accounts receivable, net 4,717 3,719 Refundable taxes 204 205 Other current assets 1,296 1,218 ------- ------- Total current assets 7,497 6,812 Fixed assets, net 864 738 Other assets, net 3,729 4,102 ------- ------- Total assets $12,090 $11,652 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 3,408 $ 2,568 Accrued liabilities 1,314 1,114 Short-term debt 970 - Deferred revenue 3,491 2,073 ------- ------- Total current liabilities 9,183 5,755 Shareholders' equity: Preferred stock - 2,000 Common stock 74,281 71,340 Accumulated deficit (71,374) (67,443) ------- ------- Total shareholders' equity 2,907 5,897 ------- ------- Total liabilities and shareholders' equity $12,090 $11,652 ======= ======= The accompanying notes are an integral part of these condensed consolidated financial statements. Page 3 FORTEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (In thousands except per share data) Three Months Ended Nine Months Ended June 30, June 30, ------------------ ------------------ 2000 1999 2000 1999 ------- ------- -------- -------- Net product sales $ 5,123 $ 1,695 $ 10,156 $ 6,186 Services and other 2,668 4,623 7,246 10,271 ------- ------- -------- -------- Net sales 7,791 6,318 17,402 16,457 Cost and expenses: Cost of products sold 976 255 1,638 924 Cost of services and other 1,445 3,172 4,133 6,176 Research and development expenses 1,184 749 2,536 2,017 Selling, general & administrative expenses 5,138 3,920 13,895 11,470 Loss from unconsolidated company - - - 1,512 ------- ------- -------- -------- Operating loss (952) (1,778) (4,800) (5,642) Other (income) expense (1,009) 62 (869) 1,037 ------- ------- -------- -------- Net income (loss) $ 57 $(1,840) $ (3,931) $ (6,679) ======= ======= ======== ======== Basic income (loss) per share $ .00 $ (.08) $ (.15) $ (.31) ======= ======= ======== ======== Number of shares used in basic income (loss) per share calculations 26,386 21,930 25,760 21,739 ======= ======= ======== ======== Diluted income (loss) per share $ .00 $ (.08) $ (.15) $ (.31) ======= ======= ======== ======== Number of shares used in diluted income (loss) per share calculations 27,019 21,930 25,760 21,739 ======= ======= ======== ======== The accompanying notes are an integral part of these condensed consolidated financial statements. Page 4 FORTEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ($000's) (UNAUDITED) Nine Months Ended June 30, 2000 1999 -------- -------- Cash flows provided by (used in) operating activities: Net loss $ (3,931) $ (6,679) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Issuance of common stock in settlement of lawsuit 787 - Loss from unconsolidated company - 1,512 Discount on subordinated debenture - 555 Interest accrued on convertible subordinated debenture - 379 Amortization of capitalized financing costs - 362 Depreciation and amortization 1,628 1,673 Provision for doubtful accounts 217 166 Change in operating assets and liabilities: Increase in accounts receivable (1,215) (2,146) Decrease (increase) in refundable income taxes 1 (4) Increase in other current assets (78) (801) Increase (decrease) in accounts payable 840 (788) Increase (decrease) in accrued liabilities 200 (496) Increase in deferred revenue 1,418 167 -------- ------- Net cash used in operating activities (133) (6,100) -------- ------- Cash flows provided by (used in) investing activities: Acquisition of fixed assets (676) (144) Investment in unconsolidated company - (1,512) Capitalized software development costs (680) (260) Purchased technology - (250) Decrease in (purchase of) other assets (25) 7 -------- ------- Net cash used in investing activities (1,381) (2,159) -------- ------- Page 5 FORTEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) ($000's) (UNAUDITED) Nine Months Ended June 30, 2000 1999 -------- ------- Cash flows provided by financing activities: Proceeds from short-term debt $ 970 $ - Issuance of common stock 154 156 Issuance of subordinated debentures - 4,782 ------- ------- Net cash provided by financing activities 1,124 4,938 ------- ------- Net decrease in cash and cash equivalents (390) (3,321) Cash and cash equivalents, beginning of year 1,670 6,589 ------- ------- Cash and cash equivalents, end of period $ 1,280 $ 3,268 ======= ======= Supplemental non-cash investing and financing activities: Capitalized financing costs $ - $ 218 ======= ======= Common stock purchase warrants $ - $ 128 ======= ======= Conversion of subordinated debentures and accrued interest $ - $ 4,912 ======= ======= Conversion of preferred stock $ 2,000 $ - ======= ======= The accompanying notes are an integral part of these condensed consolidated financial statements. Page 6 FORTEL INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Amounts in thousands except per share data) 1. The condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and should be read in conjunction with the audited financial statements of the Company. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted although the Company believes the disclosures which are made are adequate to make the information presented not misleading. Further, the condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary to present fairly the financial position and results of operations as of and for the periods indicated. The results of operations for the period ended June 30, 2000 are not necessarily indicative of the results expected for the full year. The balance sheet as of September 30, 1999 is derived from the audited financial statements as of and for the year then ended but does not include all notes and disclosures required by accounting principles generally accepted in the United States of America. 2. Recent Accounting Pronouncements: In March 2000, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 44 ("FIN 44"), Accounting for Certain Transactions involving Stock Compensation an interpretation of APB Opinion No. 25. FIN 44 clarifies the application of Opinion 25 for (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but certain conclusions cover specific events that occur after either December 15, 1998, or January 12, 2000. Management believes that the effects of the conclusions which are specific to events after December 15, 1998 and January 12, 2000 will not have a material effect on the Page 7 financial position and results of operation on adoption of FIN 44. In addition, management believes that the adoption of the other conclusions of FIN 44 will not have a material effect on the financial position or results of operations of the Company. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulleting No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements", which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosures related to revenue recognition policies. Management believes that, based on information currently available, the adoption of SAB 101 will not have a material effect on the financial position or results of operations of the Company. However, the guidance given in SAB 101 is still under discussion by the Securities and Exchange Commission and may be revised. Such revisions could have a material effect on the financial position or results of operations of the Company. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 is effective for the Company in fiscal year 2001 and will not require retroactive restatement of prior period financial statements. Management believes that the adoption of SFAS No. 133 will not have a material effect on the financial position or results of operations. Page 8 3. Other Assets: Other assets consist of the following: June 30, September 30, 2000 1999 -------- ------------- Goodwill $ 2,768 $ 2,768 Purchased technology 2,588 2,588 Other assets 2,487 1,782 Less accumulated amortization (4,114) (3,036) ------- ------- $ 3,729 $ 4,102 ======= ======= 4. Business Combinations: In October 1999, the Company acquired Telemetrics Systems AG, a company domiciled in Berne, Switzerland. The purchase price consisted of cash payments totaling $1.2 million in exchange for the net assets of the acquired company. No goodwill was generated by the transaction. The acquisition was accounted for using the purchase method of accounting; accordingly, the total purchase price of $1.2 million was allocated to the net assets acquired based upon their estimated fair values. The operating results of the acquired company from October 1999 through June 30, 2000, are included in the consolidated results of operations. The wholly-owned subsidiary of the Company is now named FORTEL A.G. 5. Common Stock: Common stock activity for the period from October 1, 1999 through June 30, 2000 is as follows: Common Stock Common Stock Shares Amount ------------ ------------ Balance at September 30, 1999 24,896 $71,340 Conversion of preferred stock 1,306 2,000 Issued in settlement of lawsuit 387 787 Exercise of stock options 24 64 Employee stock purchase 94 90 ------ ------- Balance at June 30, 2000 26,707 $74,281 ====== ======= 6. Legal Proceedings: During the quarter ended June 30, 2000, the Company's two outstanding legal proceedings were settled, resulting in a net gain of approximately $1.0 million, which was recorded in other income. In the first, the Company's suit against a vendor was Page 9 settled on May 15, 2000. The Company received $2.5 million in cash ($1.8 million after attorney fees) which was recorded in other income as a gain from settlement of a vendor lawsuit. In the second, a complaint for Breach of Contract, Declaratory Relief and Specific Performance, against the Company, was settled on May 31, 2000. The Company issued 387,500 shares of the Company's common stock, resulting in a charge of $787 thousand to other expense as a loss from settlement of litigation. 7. Income Taxes: The benefit for income taxes was fully offset by a valuation allowance due to the uncertainty surrounding the realization of the favorable tax attributes. 8. Earnings Per Share (EPS): A reconciliation of the numerator and denominator of basic and diluted EPS is provided as follow (in thousands, except per share amounts): Three Months Ended Nine Months Ended June 30, June 30, ------------------ ----------------- 2000 1999 2000 1999 ------- ------- ------- ------- (unaudited) (unaudited) Numerator - Basic and Diluted EPS Net income (loss) $ 57 $(1,840) $(3,931) $(6,679) ======= ======= ======= ======= Denominator - Basic EPS Common stock outstanding 26,386 21,930 25,760 21,739 Common equivalent stock - - - - ------- ------- ------- ------- 26,386 21,930 25,760 21,739 ------- ------- ------- ------- Basic income (loss) per share $ .00 $ (.08) $ (.15) $ (.31) ======= ======= ======= ======= Denominator - Diluted EPS Denominator - Basic EPS 26,386 21,930 25,760 21,739 Effect of Dilutive Securities: Common stock options 633 - - - ------- -------- ------- ------- 27,019 21,930 25,760 21,739 ------- ------- ------- ------- Diluted income (loss) per share $ .00 $ (.08) $ (.15) $ (.31) ======= ======= ======= ======= For the quarter and nine-month period ended June 30, 2000, options to purchase 633 thousand and 559 thousand shares, Page 10 respectively, were not included in the computation of diluted EPS because of the anti-dilutive effect of including these shares in the calculation for both periods. For the quarter and nine-month period ended June 30, 1999, options to purchase 3 thousand and 73 thousand shares, respectively, were not included in the computation of diluted EPS because of the anti-dilutive effect of including these shares in the calculation for both periods. 9. Segment Information: Through October 1999, the Company had two reportable segments - Datametrics and Year 2000 Services. The Datametrics business segment develops and markets E-business performance management software solutions. The Year 2000 segment provided service to review software code and identify areas within the code where Year 2000 problems might occur. Following completion of the remaining contract outstanding at September 30, 1999, the Company ceased providing these Year 2000 services in October 1999. The following table presents certain segment financial information (in thousands): Three Months Ended Nine Months Ended June June 2000 1999 2000 1999 ------- ------- ------- ------- Revenue: Datametrics $ 7,791 $ 3,662 $17,011 $13,035 Year 2000 - 2,656 391 3,422 ------- ------- ------- ------- Total $ 7,791 $ 6,318 $17,402 $16,457 ======= ======= ======= ======= Income (loss) from Operations: Datametrics $ (952) $(2,227) $(4,772) $(5,872) Year 2000 - 449 (28) 230 ------- ------- ------- ------- Total $ (952) $(1,778) $(4,800) $(5,642) ======= ======= ======= ======= Page 11 The table below presents net sales (in thousands) by geographic area for the periods ended June 30: Three Months Ended Nine Months Ended June June 2000 1999 2000 1999 ------- ------- ------- ------- North America $ 5,558 $ 1,987 $10,837 $ 7,596 U.K. 1,317 1,368 3,892 4,008 Australia 0 2,655 0 3,422 Other 916 308 2,673 1,431 ------- ------- ------- ------- Total $ 7,791 $ 6,318 $17,402 $16,457 ======= ======= ======= ======= The table below presents long-lived asset information (in thousands) by geographic area: June 30, September 30, 2000 1999 -------- ------------- Long-lived assets: U.S. $4,072 $4,178 International 521 662 ------ ------ Total $4,593 $4,840 ====== ====== Major Customers: Sales to one customer amounted to 44% and 20% of net sales for the quarter and nine-month period ended June 30, 2000, respectively. 10. Comprehensive Loss: The Company has adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income". There were no differences between comprehensive income (loss) and net income (loss) as reported for each of the periods presented in these condensed consolidated financial statements. 11. Subsequent Event: On July 18, 2000, the Company closed a private placement of the Company's common stock with two institutional investors. The Company received gross proceeds of $5,000,000 in the transaction in exchange for the issuance of 2,191,781 shares of common stock. The purchase price per share of $2.28 was equal to the average Page 12 closing bid price of the common stock as reported by Bloomberg Information Services, Inc. on the five trading days prior to the transaction. The purchasers also received repricing warrants for each share of common stock purchased which expire (1) automatically after eighteen months from the date of issuance, (2) on the sale of the common stock by the investors and (3) on any date, after the effective date of the registration of shares, when the closing price of the Company's stock has been above $4.5625 for a period of twenty-two consecutive trading days. The repricing warrant may be exercised at an exercise price of $.001 on any date which the average of the two lowest closing prices in the previous ten trading days is lower than $2.7375. The earliest that a repricing notice may be submitted is twenty-two trading days after the closing date. The number of shares that the warrant may be exercised for is calculated by the product of the number of shares of the original issuance subject to the repricing warrant and the difference between $2.7375 and the average calculated above. Page 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Result of Operations The Company recorded net income of $57,000 ($0.00 per share) for the quarter ended June 30, 2000 compared with a net loss of $1,840,000 ($0.08 per share) for the same quarter of the prior year. Weighted average shares outstanding for the current quarter were 27,019,000 compared to 21,930,000 for the same quarter of the prior year. For the nine months ended June 30, 2000, the net loss was $3,931,000 ($0.15 per share) compared with a net loss of $6,679,000 ($0.31 per share) for the same period a year earlier. Year-to-date weighted average shares were 25,760,000 versus 21,739,000 in the prior year. Total net sales for the current quarter was $7,791,000 versus total net sales of $6,318,000 for the same quarter of the prior year, an increase of $1,473,000 or 23%. The prior year included revenue of $2,656,000 from the sale of Year 2000 services, which the Company ceased providing in October 1999. Net sales of software licenses and related services increased 113% versus the same quarter of the prior year. For the nine months ended June 30, 2000, total net sales was $17,402,000 versus $16,457,000 for the same period of the prior year, an increase of $945,000 or 6%. Included in the prior year was revenue of $3,422,000 from the sale of Year 2000 services. Net sales of software licenses and related services increased 31% versus the same period of the prior year. Sales to one customer amounted to 44% and 20% of net sales for the quarter and nine-month period ended June 30, 2000, respectively. Gross margin as a percent of net sales was 69% for the quarter ended June 30, 2000 compared to 46% for the same quarter of the prior year. For the nine-month period ended June 30, 2000, gross margin was 67% versus 57% for the same period of the prior year. The improvement in gross margin percentage during the current quarter and nine-month period is primarily attributable to product mix. Future gross margins may be affected by several factors including mix of products sold, the price of products sold and price competition. Research and development expenses for the quarter ended June 30, 2000 were $1,184,000 or 15% of total net sales compared with $749,000 or 12% of total net sales for the same quarter of the Page 14 prior year. Actual spending increased $435,000. For the nine-month period ended June 30, 2000, research and development expense was $2,536,000 or 15% of total net sales compared with $2,017,000 or 12% of total net sales for the same period of the prior year. Actual spending increased $519,000. The increase in spending during both periods was attributable to increased development costs. Selling, general and administrative (SG&A) expenses were $5,138,000 or 66% of total net sales versus $3,920,000 or 62% of total net sales for the same quarter of the prior year. Actual spending increased $1,218,000. For the nine-month period ended June 30, 2000, SG&A was $13,895,000 or 80% of total net sales versus $11,470,000 or 70% of total net sales for the same period of the prior year. Actual spending increased $2,425,000. The increased spending in both periods is attributable to increased salaries and related benefits related to additional sales and marketing personnel, increased travel and entertainment, increased consulting and professional services and higher commission costs. In addition, during the current quarter, approximately $520,000 was incurred related to the re-launch of the Company and its new SightLine product. A loss of approximately $371,000, related to the sublease of the Company's facility in Fremont (CA), was incurred during the second quarter of the current fiscal year. Additional legal expense of approximately $175,000 was incurred during the current quarter related to a lawsuit settled during the quarter. Other income was $1,009,000 and $869,000 for the quarter and nine-month period ended June 30, 2000, respectively. Included in other income in the current quarter was a gain of approximately $1,800,000 related to the favorable settlement of a vendor lawsuit. In addition, a charge of approximately $800,000 related to the issuance of 387,500 shares of the Company's common stock, in settlement of a lawsuit filed against the Company, is also included in other income in the current quarter. For the same quarter and nine-month period of the prior year, other expense was $62,000 and $1,037,000, respectively. Included in other expense in the quarter and nine-month period of the prior year was primarily interest expense related to a convertible subordinated debenture. Liquidity and Capital Resources During the nine-month period ended June 30, 2000, working capital decreased $2,743,000 and cash flow utilized by operating Page 15 activities totaled $133,000. Cash utilized by operating activities resulted primarily from the net loss of $3,931,000 and an increase in accounts receivable of $1,215,000, offset by an increase in deferred revenue of $1,418,000, an increase in accounts payable and accrued liabilities of $1,040,000 and depreciation and amortization charges of $1,628,000. Net cash used in investing activities of $1,381,000 consists of $680,000 in capitalized software development costs and $676,000 in acquisition of fixed assets. Net cash provided by financing activities was $154,000, resulting primarily from the sale of stock under the Company's employee stock purchase plan. Management believes that the Company will be able to meet its cash requirement needs for the next twelve months from cash on hand, other working capital, cash flow from operations augmented by an available accounts receivable factoring arrangement. In addition, on July 18, 2000, the Company closed a private placement of the Company's common stock and received gross proceeds of $5,000,000. Recent Accounting Pronouncements In March 2000, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 44 ("FIN 44"), Accounting for Certain Transactions involving Stock Compensation an interpretation of APB Opinion No. 25. FIN 44 clarifies the application of Opinion 25 for (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but certain conclusions cover specific events that occur after either December 15, 1998, or January 12, 2000. Management believes that the effects of the conclusions which are specific to events after December 15, 1998 and January 12, 2000 will not have a material effect on the financial position and results of operation on adoption of FIN 44. In addition, management believes that the adoption of the other conclusions of FIN 44 will not have a material effect on the financial position or results of operations of the Company. In December 1999, the Securities and Exchange Commission ("SEC") Page 16 issued Staff Accounting Bulleting No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements", which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosures related to revenue recognition policies. Management believes that, based on information currently available, the adoption of SAB 101 will not have a material effect on the financial position or results of operations of the Company. However, the guidance given in SAB 101 is still under discussion by the Securities and Exchange Commission and may be revised. Such revisions could have a material effect on the financial position or results of operations of the Company. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 is effective for the Company in fiscal year 2001 and will not require retroactive restatement of prior period financial statements. Management believes that the adoption of SFAS No. 133 will not have a material effect on the financial position or results of operations. Item 3. Quantitative and Qualitative Disclosures about Market Risk The Company considered the provision of Financial Reporting Release No. 48, "Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments". The Company had no holdings of derivative financial or commodity instruments at June 30, 2000. A review of other financial Page 17 instruments and risk exposures at that date revealed the Company did not have exposure to interest rate risk. ======================================================= This Report on Form 10-Q contains forward-looking statements which are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act. Readers are cautioned that such forward-looking statements are subject to risks and uncertainties and actual results could differ materially. Certain of these risks and uncertainties are discussed herein under the section "Risk Factors" and elsewhere in this Report as well in the Company's other filings with the Securities and Exchange Commission. ------------------------------------------------------------- Fortel and SightLine are trademarks of Fortel Inc. All other product names and brand names are trademarks or registered trademarks of their respective holders. Page 18 PART II. OTHER INFORMATION Item 1. Legal Proceedings During the quarter ended June 30, 2000, the Company's two outstanding legal proceedings were settled, resulting in a net gain of approximately $1.0 million, which was recorded in other income. In the first, the Company's suit against a vendor was settled on May 15, 2000. The Company received $2.5 million in cash ($1.8 million after attorney fees) which was recorded in other income as a gain from settlement of a vendor lawsuit. In the second, a complaint for Breach of Contract, Declaratory Relief and Specific Performance, against the Company, was settled on May 31, 2000. The Company issued 387,500 shares of the Company's common stock, resulting in a charge of $787 thousand to other expense as a loss from settlement of litigation. Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information Risk Factors Recent Levels of Net Sales Have Been Insufficient Fortel has not generated net sales sufficient to produce an operating profit in recent years. The Company has relied on significant financings to support its activities. Fortel sustained substantial operating losses and net losses in fiscal years 1997 through 1999 and the nine months ended June 30, 2000. The Company must generate substantial additional net sales and gross margins on its products and services and must continue to successfully implement programs to manage cost and expense level in order to remain a viable operating entity. There is no assurance that Fortel can achieve these objectives. Page 19 Significant Losses For the first nine months of fiscal year 2000, the Company reported a net loss of $3,931,000. The Company reported a total net loss of $13,103,000 and $43,205,000 for fiscal years 1999 and 1998, respectively. The Company has taken a number of steps to attempt to return to profitability, although there is no assurance that it will be successful. A significant portion of the cumulative losses were caused by the funding of MatriDigm, and operations of the Company's former storage systems business, which was sold in July 1998. MatriDigm filed Chapter 7 bankruptcy in October 1999 so there will be no additional funding. The Company has subleased its Fremont (CA) headquarters and, in April 2000, moved to substantially smaller and less costly premises. The Company continues to consider options and take actions necessary to bring costs into line with anticipated revenues. There can be no assurance that the Company will be successful in this effort and remain a viable operating entity. Fluctuations in Quarterly Results Fortel's quarterly operating results have in the past varied and may in the future vary significantly depending on a number of factors, including: .The level of competition, the size, timing, cancellation or rescheduling of significant orders; .Market acceptance of new products and product enhancements; .New product announcements or introductions by Fortel's competitors; .Deferrals of customer orders in anticipation of new products or product enhancements; .Changes in pricing by Fortel or its competitors; .The ability of Fortel to develop, introduce and market new products and product enhancements on a timely basis; .Fortel's success in expanding its sales and marketing programs; Page 20 .Technological changes in the market for Fortel's products; .Product mix and the mix of sales among Fortel's sales channels; .Levels of expenditures on research and development; .Changes in Fortel's strategy; personnel changes; and, .General economic trends and other factors. Due to all of the foregoing factors, Fortel believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indicator of future performance. It is possible that in some future quarter the Company's operating results may be below the expectations of public market analysts and investors. Fortel Stock Price Has Been Volatile The price of Fortel's Common Stock has been subject to extreme volatility during fiscal year 1998, as the closing bid price has ranged between a low of 2 7/32 and a high of 23 5/8. Fortel feels that one of the reasons for this volatility was rumored progress of and rumored problems in the product development program and marketing efforts of MatriDigm. The price of Fortel's Common Stock during fiscal year 1999 demonstrated significantly less volatility, ranging from the low closing bid price of 1 7/32 to the high closing bid price of 6 15/32. During the first nine months of fiscal year 2000, such price ranged between a low of 21/32 and a high of 6 5/8. Competition The market for system management tools in which the Company's software products business unit competes is intensely competitive. Many of the companies with which the Company competes, such as TeamQuest Corporation, Computer Associates International, Inc., Hewlett-Packard Company, and BMC Software, Inc. have substantially larger installed bases and greater financial resources than the Company. There can be no assurance that the Company's competitors will not develop products comparable or superior to those developed by the Company or adapt more quickly than the Company to new technologies, evolving industry standards, new product introductions, or changing customer requirements. Page 21 Dependence on New Products; Rapid Technological Change The markets in which the Company operates are characterized by rapid technological change, changing customer needs, frequent new product introductions and evolving industry standards. The introduction of products embodying new technologies and/or the emergence of new industry standards could render the Company's existing products and services obsolete and unmarketable. The Company's future success will depend upon its ability to develop and to introduce new products and services on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. There can be no assurance that the Company will be successful in developing and marketing products or services that respond to technological changes or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products or services, or that its new products or services will adequately meet the requirements of the marketplace and achieve market acceptance. If the Company is unable, for technological or other reasons, to develop and introduce new products or services in a timely manner in response to changing market conditions or customer requirements, the Company's business, operating results and financial condition will be materially and adversely affected. Product Liability The Company's agreements with its customers typically contain provisions intended to limit the Company's exposure to potential product liability claims. It is possible that the limitation of liability provisions contained in the Company's agreements may not be effective. Although the Company has not received any product liability claims to date, the sale and support of products by the Company and the incorporation of products from other companies may entail the risk of such claims. A successful product liability claim against the Company could have a material adverse effect on the Company's business, operating results and financial condition. Dependence on Proprietary Technology The Company's success depends significantly upon its proprietary technology. The Company currently relies on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect Page 22 its proprietary rights. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. The Company has registered its Fortel trademarks and will continue to evaluate the registration of additional trademarks as appropriate. The Company generally enters into confidentiality agreements with its employees and with key vendors and suppliers. The Company currently holds a United States patent on one of its software technologies. There can be no assurance that this patent will provide the Company with any competitive advantages or will not be challenged by third parties, or that the patents of others will not have a material adverse effect on the Company's ability to do business. The Company believes that the rapidly changing technology in the computer industry makes the Company's success depend more on the technical competence and creative skills of its personnel than on patents. There has also been substantial litigation in the computer industry regarding intellectual property rights, and litigation may be necessary to protect the Company's proprietary technology. The Company has not received significant claims that it is infringing third parties' intellectual property rights, but there can be no assurance that third parties will not in the future claim infringement by the Company with respect to current or future products, trademarks or other proprietary rights. The Company expects that companies in its markets will increasingly be subject to infringement claims as the number of products and competitors in the Company's target markets grows. Any such claims or litigation may be time-consuming and costly, cause product shipment delays, require the Company to redesign its products or require the Company to enter into royalty or licensing agreements, any of which could have a material adverse effect on the Company's business, operating results or financial condition. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that the Company regards as proprietary. There can be no assurance that the Company's means of protecting its proprietary rights will be adequate or that the Company's competitors will not independently develop similar technology, duplicate the Company's products or design around patents issued to the Company or other intellectual property rights of the Company. Page 23 International Sales and Operations Sales to customers outside the United States have accounted for significant portions of the Company's net sales, and the Company expects that operations in the United Kingdom, The Netherlands, Germany, Switzerland, and France, respectively, will result in international sales representing an increasingly significant portion of the Company's net sales. International sales pose certain risks not faced by companies that limit themselves to domestic sales. Fluctuations in the value of foreign currencies relative to the U.S. dollar, for example, could make the Company's products less price competitive. If the Company, in the future, denominates any of its sales in foreign currencies, this could result in losses from foreign currency transactions. International sales also could be adversely affected by factors beyond the Company's control, including the imposition of government controls, export license requirements, restrictions on technology exports, changes in tariffs and taxes and general economic and political conditions. The laws of some countries do not protect the Company's intellectual property rights to the same extent as the laws of the United States. The Company does not believe these additional risks are significant in the United Kingdom, The Netherlands, Germany, Switzerland, or France. Dependence on Key Personnel The Company's future performance depends significantly upon the continued service of its key technical and senior management personnel. The Company provides incentives such as salary, benefits and option grants (which are typically subject to vesting over four years) to attract and retain qualified employees. The loss of the services of one or more of the Company's officers or other key employees could have a material adverse effect on the Company's business, operating results and financial condition. The Company's future success also depends on its continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain its key technical and management employees or that it can attract, assimilate and retain other highly qualified technical and management personnel in the future. The Company believes there is significant competition for the few software development professionals with the advanced Page 24 technological skills necessary to perform the services offered by the Company's business. The Company's ability to maintain or renew existing relationships and obtain new business depends, in large part, on its ability to hire and retain technical personnel. An inability to hire such additional qualified personnel could impair the ability of the business to manage and complete its existing projects and to bid for and obtain new projects. Anti-Takeover Provisions Certain provisions of the Company's Certificate of Incorporation, as amended and restated, and Bylaws, as amended, California law and the Company's indemnification agreements with certain officers and directors of the Company may be deemed to have an anti-takeover effect. Such provisions may delay, defer or prevent a tender offer or takeover attempt that a stockholder might consider to be in that stockholder's best interests, including attempts that might result in a premium over the market price for the shares held by stockholders. The Company's Board of Directors may issue additional shares of Common Stock or establish one or more classes or series of Preferred Stock, having the number of shares designations, relative voting rights, dividend rates, liquidation and other rights, preferences and limitations as determined by the Board of Directors without stockholder approval. The Board of Directors of the Company has approved the adoption of a Preferred Share Purchase Rights Plan (the "Rights Plan"). Terms of the Rights Plan provide for a dividend distribution of one preferred share purchase right (a "Right") for each outstanding share of common stock, no par value per share (the "Common Shares"), of the Company. Each Right entitles the registered holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, no par value (the "Preferred Stock"), at an exercise price of $69.50 per one one-hundredth of a Preferred Share (the "Purchase Price"), subject to adjustment, and a redemption price of $.01 per Right. Each one one-hundredth of a share of Preferred Stock has designations and the powers, preferences and rights, and the qualifications, limitations and restrictions which make its value approximately equal to the value of a Common Share. The Rights are not exercisable until the earlier to occur of (i) 10 days following a public announcement that a person, entity Page 25 or group of affiliated or associated persons (an "Acquiring Person") have acquired beneficial ownership of 15% or more of the outstanding Common Shares or (ii) 10 business days (or such later date as may be determined by action of the Board of Directors prior to such time as any person or entity becomes an Acquiring Person) following the commencement of, or announcement of an intention to make, a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person or group of 15% or more of such outstanding Common Shares. The Rights have certain anti-takeover effects, as they would cause substantial dilution to a person or group that attempted to acquire the Company on terms not approved by the Company's Board of Directors. The Rights should not interfere with any merger or other business combination approved by the Board of Directors, since the Rights may be redeemed by the Company at $.01 per Right prior to the earliest of (i) the twentieth day following the time that a person or group has acquired beneficial ownership of 15% or more of the Common Shares (unless extended for one or more 10 day periods by the Board of Directors), (ii) a change of control, or (iii) the final expiration date of the rights. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 27 - Financial Data Schedule (b) Reports on Form 8-K During the period from April 1, 2000 through June 30, 2000, the Company filed the following current report on Form 8-K: Date of Report - Item(s) Reported: June 29, 2000 Certificate of Ownership and Name Change Page 26 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FORTEL INC. Date: August 10, 2000 Anna M. McCann Anna M. McCann Chief Financial Officer Page 27