10-K 1 scanoptics10k2004.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ( X ) Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2004 ( ) Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from __________________________ Commission File No. 0-5265 SCAN-OPTICS, INC. ----------------- (Exact name of registrant as specified in its charter) Delaware 06-0851857 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 169 Progress Drive, Manchester, CT 06040 -------------------------------------------------------------------------------- (Address of principal executive offices) Zip Code (860) 645-7878 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None --------------------- Securities registered pursuant to Section 12(g) of the Act: Common stock, $.02 par value --------------------------------------------------------------------- (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ( X ) YES ( ) NO Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) (__) YES (X) NO The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which common equity was last sold, or the average bid and asked price of such common equity, as of the last day of the registrant's most recently completed second fiscal quarter: $2,810,493 as of June 30, 2004. The number of shares of common stock, $.02 par value, outstanding as of March 22, 2005 was 41,451,577. 1 DOCUMENTS INCORPORATED BY REFERENCE ----------------------------------- Portions of the definitive Proxy Statement, relating to the 2005 Annual Meeting of Stockholders, which will be filed pursuant to Regulation 14A with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year, are incorporated by reference and included in the following: Part III-Item 10 - Directors and Executive Officers of the Registrant Part III-Item 11 - Executive Compensation Part III-Item 12 - Security Ownership of Certain Beneficial Owners and Management Part III-Item 13 - Certain Relationships and Related Transactions Part III-Item 14 - Principal Accountant Fees and Services 2 PART I ITEM 1 - BUSINESS Scan-Optics, Inc. (the "Company") was incorporated in Delaware in 1968 and has its principal office at 169 Progress Drive, Manchester, Connecticut 06040. The Company designs, develops and implements transaction and information management work processes. Adept with sophisticated recognition, image, workflow, network and data base technologies, the Company provides cost effective, high quality solutions that match the unique information processing requirements of its sophisticated client base. The Company is a leader in developing, applying and supporting technology for the conversion of analog information into digital. Historically the Company's research and development activity has focused on improving accuracy and performance of the high speed image and "OCR" (optical character recognition) scanning platforms. Microsoft development environments on Intel platforms have enhanced the Company's strength in developing and supporting complex system integration projects. With clarity of experience, Scan-Optics has consistently demonstrated the ability to maximize system performance while limiting investment requirements for its clients. By extending this capability to the Application Service Provider (ASP) environment we now provide our clients with the option to receive cost reduction and service benefits through an ASP model as well as through our traditional in-house solution. The Company's strategy is to expand into the larger market opportunities in Business Process Outsourcing (BPO) while utilizing the primary core competencies of the Company in vertical solution applications. The Company is applying its resources to provide customer solutions in four main areas: SO series image scanner platform and solution applications, the Test and Assessment Market, Business Process Outsourcing and Access Services. The Company has established these divisions to focus the Company's resources in a cost-effective manner on the clients that it serves. Although each activity is autonomous in pursuit of new business and revenue sources, they possess tremendous synergy for the end-user community that is searching for a "single-source" supplier. The Company's SO series scanner platform and solutions continues the Company's 36 year commitment to the very high end of the image capture market. Like its predecessor, the 9000 series scanner, this SO series scanner family integrates technology based on years of experience and expertise in the development of cost-effective, high quality solutions for applications in the government, insurance, assessment, transportation, order fulfillment and financial markets. Unlike its predecessor the SO series scanner opens significant new market opportunities in the "image only" world. The Company's ability to offer customized and integrated system solutions has helped customers all over the world to meet their productivity and profitability objectives. In the Assessment market, the Company follows an ISO9001:2000 documented quality process to define the customer requirements prior to proposing a value-based 3 information capture solution. The solution may be rich in Scan-Optics product and technology content or may integrate third-party technology to meet specific customer objectives. The company has continually invested in the skills and expertise within its development organization. Therefore, Scan-Optics is positioned to deliver quality solutions to this market in a timely manner. The Business Process Outsourcing (BPO) service is focused in four areas (1) document conversion services, (2) data capture, (3) business continuation services and (4) knowledge applications. These services provide a low-risk, cost-effective solution for customers with document imaging needs and will follow the disciplined ISO9001:2000 processes for quality control that have served the division in the past. The Access Services Division of the Company provides third party and proprietary product maintenance services nationwide, as well as in the UK and Canada. Access Services has been selected by over 28 companies to provide maintenance services for their products at customer sites or through the Access Services depot maintenance facility. In support of its many third-party contracts, the Company has adapted its logistics and dispatch center to support these high volume, low cost products. This business model demonstrates the flexibility of the Company to provide customized services to meet specific customer needs. Like the rest of the Company, this division depends on its ISO9001:2000 quality processes to assure high levels of customer satisfaction. Target Markets Scan-Optics' key values to the markets it serves are its customer relationships and commitment to customer satisfaction, expertise in data entry, forms processing, OCR/ICR/OMR and archive, storage and retrieval solutions and its experience in systems integration. Scan-Optics' focus on communicating these key values - Customer Satisfaction, Relationships, Quality, Experience and Expertise is an integral factor in all of its marketing activities. The Company's target markets for 2005 include its existing customer base and the vertical markets they represent, the Federal Government and the value-added Reseller/Channel market. Scan-Optics Technology The Company has been a leader of technological developments in the Optical Character Recognition (OCR), Intelligent Character Recognition (ICR), Optical Mark Read (OMR) and Imaging arena. Our most recent developments yielded patent applications for gray scale OMR recognition for assessment applications, software based endorsement of images, a patent for "detecting double documents" using acoustic sensors and a high performance image scanner based on a software design residing on Intel platforms in a Microsoft environment. Software Products Scan-Optics' AccuScore, for the automatic scoring of "bubble" forms, uses electronic image-capture technology in conjunction with patent pending gray scale OMR recognition software for performing the scoring with: o Inexpensive paper or printing 4 o Industry standard image scanners o Flexible, easy-to-use forms definition tool o Extremely high accuracy rates o Greater flexibility in forms design Scan-Optics' DocWise, provides a secure digital information archive utilizing sophisticated workflow processes. DocWise can store virtually any type of electronic file: E-mail, computer documents (Microsoft Excel and Word), digital photos, faxes, XML files and ERM reports. DocWise provides security under Windows NT, 2000 and XP security architecture with seven levels of access rights built in. DocWise is designed to work with the Microsoft suite of database products and Oracle's 8i Database product. DocWise has both an Internet client and a desktop client for optimum flexibility. DocWise has the capacity to import and index thousands of documents per hour in industry standard TIFF format. Scan-Optics' VistaCapture is a software solution suite for rapid development of data capture applications requiring character recognition, business rule oriented workflow and systems integration. SONAR (Scan-Optics Neural Auxiliary Recognition) is a software product released in 2001. SONAR incorporates the Company's patented Context Edit product and ICR recognition technology for lower volume forms/data capture applications. Applications such as enrollments with address changes are ideally suited for SONAR. Core Competencies Key product disciplines utilize integration expertise and experience that leverage the core competencies of the Company to provide specific solution alternatives. These core competencies include: High performance production level document scanning Image enhancement algorithms to create high levels of image quality Character recognition (OCR, ICR, Barcode, Mark Sense, OMR, etc.) Key-From-Image and Key-From-Paper data entry Document management, workflow and availability Test and Assessment domain knowledge Professional Services (design, development, installation and support) Value Added Engineering services and solutions ISO9001:2000 documented process controls in all business disciplines 5 Professional Services In order to provide a solution that meets the processing requirement of the client the Company provides a consultative approach to integrate solutions with proven professional services core competencies in the following areas: Application Expertise Industry Standards Open Systems Archival / Retrieval Installation Paper Handling Custom Engineering Microfilming Project Management Development Tools Networking Systems Engineering Forms Design Neural Technology System Integration Imaging OCR Technology Training Microsoft 2000 Database Performance Tuning The Company has provided software solutions to its customers since 1968. Utilizing Company developed products as well as third-party products, the professional services group provides solutions to address the customer's mission critical applications. The Company's image scanners provide the hardware platforms for delivering advanced high-volume forms processing, imaging, and document management system solutions, especially in its target markets. These targeted solutions are designed and developed by professional services and implemented on the customer's site or in the Scan-Optics BPO facility. The Company also provides ongoing change control with individual, custom software services as requested by the client. In this way, the Company can provide the entire solution of hardware and software with support for the length of the contract. Customer Satisfaction Customer satisfaction continues to be a key area of focus for the Company. Our quality processes focus on the delivery of quality products and services and we monitor, measure and internally report customer satisfaction levels in various surveys conducted throughout the year. The surveys also follow a documented quality process within our ISO9001:2000 certification program. ACCESS SERVICES DIVISION The Company has offered service and maintenance support to its customer base since 1968. This support, offered through our Access Services Division, is available with either leased or purchased systems in both domestic and international markets. In addition to supporting Company products, the Access Services Division provides service and maintenance support on a variety of electro-mechanical products for more than 28 different domestic and foreign manufacturers. Maintenance service is provided through a network of over 120 highly skilled service technicians, including employees and contractors. The Company provides on-site service with response times of 2 to 24 hours based on the service plan selected by the customer. In support of its third-party maintenance contracts Access Services has developed comprehensive depot maintenance capability with logistics and call center support. The Company focuses on comprehensive 6 diagnostic routines, modular designs, preventive maintenance procedures and customer surveys to provide its users high system availability to perform mission critical applications. BUSINESS PROCESS OUTSOURCING Beginning with the customer's needs, the Company can implement each outsourcing engagement/project from concept through production. The capabilities provided include: Project Management Networks/System Integration Systems Testing Professional Services and Training Scan-Optics has successfully utilized its manufacturing process disciplines in structuring an outsourcing service capability for image capture, data entry and knowledge management. The Company has gained significant experience, validating management's belief that significant customer value is achieved in terms of quality and efficiency when managing the BPO workflow under documented process and workflow controls. SIGNIFICANT CUSTOMERS In 2004 the Company derived 11% of its total revenue from one customer Mitsui & Co Ltd., one of the Company's distributors in Japan. In 2003, the Company derived 23% of its total revenue from one customer, Northrop Grumman, IT Inc. In 2002 no customers accounted for more than 10% of total revenue. CHANNELS OF DISTRIBUTION The Company sells to end-users, system integrators, value added resellers and independent distributors in both the domestic and international markets. QUALITY All aspects of the Company's business fall under the ISO9001:2000 certification requirements. Customer satisfaction is a driving priority and the chosen method of producing the measurable results is through the documented procedures defined in the Company's quality manual. BACKLOG The backlog for the Company's products and services as of December 31, 2004 was approximately $13.1 million. As of December 31, 2003, the backlog was approximately $15.2 million. Backlog as of March 11, 2005 was approximately $14.8 million. The backlog consists of firm orders for equipment, software and services, the majority of which are expected to be delivered within the next 12 months, and maintenance due on existing contracts expected to be provided during the next 12 months. The Company normally delivers a system within 30 to 180 days after receiving an order, depending upon the degree of professional services and software customization required. 7 COMPETITION The SO series scanner competes with the high end of the Kodak product line as well as other companies that serve niche markets. Our strategy is to compete in this $140M market based on price and performance. In the assessment market we compete with a "solution" focus that includes the integration of technologies that yield a product uniquely designed for the testing environment defined by the client. Our competition is typically in-house development, which would cause us to modify our approach to enter the opportunity with a technological component as a sub-contractor. Due to the No Child Left Behind Law this is currently a very active market where we are well positioned. Business Process Outsourcing is a $13 billion market and the competition is well established, however the expertise and experience at Scan-Optics allows us to provide a defined lower cost benefit for the client. Our client base has required improved efficiencies over the years that we have supplied. Our clients have generally received long term benefits based on short "payback" periods of 18 months to 2 years, which we can make our advantage as we market the solutions based on transaction based pricing versus integrated systems pricing. Over 50% of the revenue generated by the Access Services Division is derived from post installation hardware and software services on Scan-Optics integrated systems. Due to the proprietary nature of these integrated systems, this division faces little competition for this business. The majority of the remaining revenue is generated by the field repair of electro-mechanical devices manufactured by third-party equipment manufacturers, primarily of scanner products, that do not have there own field maintenance staff. The division competes with other third party maintenance providers for this revenue by using its reputation for quality, which has been generated from the strict adherence to its ISO9001:2000 quality process manual and its 35 years of experience in providing scanner repair. ISO9001 CERTIFICATION In 2000, the Company took the first step in expanding its quality program by bringing the Access Service Division into compliance with the already certified product development organization and manufacturing division. The Company also performed internal audits to test for compliance in the sales, design, manufacturing and service areas to continue to improve the quality management system. The registering body performed four surveillance audits on the Company's product development and manufacturing divisions, all of which were successful. In 2001, the Company maintained its quality systems and began to prepare for the transition to ISO9001:2000. During November 2002, the Company introduced the new quality scope, which encompasses all areas of the Company. The scope of the certification is for the design, manufacture, installation and service of scanning equipment; the contract manufacturing, installation and service of electro-mechanical devices; 8 the provision of related products and software services including the design, development, installation and support; and project management of integrated solutions for targeted lines of business. In 2003, we completed our transition to ISO9001:2000 and obtained certification in May 2003. We initially targeted October 2003 to complete our 2000 certification, but through teamwork and corporate commitment enterprise-wide, Scan-Optics achieved certification five months earlier than the target date. In 2004, we continued to monitor and maintain our Quality System through internal audits, corrective and preventive actions and continuous improvement initiatives. Our next third party surveillance audit is scheduled for April 2005. PATENTS The Company currently has nine United States patents in force, which expire between 2005 and 2022, and two patents pending. The patents are on mechanical systems, electronic circuits, electronic systems and software algorithms, which are used throughout the product lines. The Company values the investments made in new technology and attempts to protect its intellectual property. The Company expects to continue to apply for patents on its new technological developments when it believes they are significant. In November 1997, the Company licensed a patent to Imaging Business Machines, LLC for use in an image transport designed for processing airline tickets. In 1999, this same patent was licensed to Nale Corporation for use on its paper handling transports. In 2000, the Company filed for a patent for gray scale OMR used in test scoring applications. In 2001, the Company received the patent for the ultrasonic overlapping document detection system for our scanners. EMPLOYEES As of December 31, 2004 the Company employed 183 people, including 16 with administrative responsibilities, 12 in marketing and sales, 98 in software and service activities, 9 in engineering and 48 in manufacturing capacities. The Company considers its employee relations to be good. The Company has not experienced any work stoppages. FUNDED DEVELOPMENT AGREEMENTS During 2004, 2003 and 2002, the Company completed a number of small custom development contracts for specific customers resulting in revenue of approximately $79,000, $200,000 and $43,000, respectively. These revenues offset the related costs incurred for this development. The Company owns the technology developed under these contracts. No royalties or other consideration is required as part of these agreements. 9 EFFECTS OF ENVIRONMENTAL LAWS The effect of federal and state environmental regulations on the Company's operations is insignificant. BUSINESS SEGMENTS The Company views its business in three distinct operating segments: Solutions and Products, Access Services and Contract Manufacturing Services. Revenues are used by management as a guide to determine the effectiveness of the individual segment. The Company manages its operating expenses through a traditional functional perspective and, accordingly, does not report operating expenses on a segment basis.
Year Ended December 31 (thousands) 2004 2003 2002 --------------------------------------------------------------------------------------------------------- Revenues Solutions and products $ 15,886 $ 21,108 $ 16,376 Access services 10,933 10,563 11,499 Contract manufacturing services 1,922 410 1,466 --------------------------------------------------------------- Total revenues 28,741 32,081 29,341 Cost of solutions and products 12,528 13,407 10,715 Service expenses 8,980 8,813 8,539 --------------------------------------------------------------- Gross profit margin 7,233 9,861 10,087 Operating expenses, net 10,931 9,017 9,064 --------------------------------------------------------------- Income (loss) before income taxes $ (3,698) $ 844 $ 1,023 =============================================================== Total assets $ 24,338 $ 26,073 $ 26,406 =============================================================== Total expenditures for additions to long-lived assets $ 329 $ 173 $ 79 ===============================================================
The Solutions and Products Division includes the sale of hardware and software products as well as professional services. Contract Manufacturing Services provides assembly and test services under contracts with customers who develop and sell a variety of equipment. The Company has international distributors located in 13 countries and covering six continents. All international sales other than sales originating from the UK and Canadian subsidiaries are denominated in United States dollars. Changes in the economic climates of foreign markets could have an unfavorable impact on future international sales. 10 Export sales by geographic area (based on the location of the customer) were as follows:
(thousands) 2004 2003 2002 ----------------------------------------------------------------------------------------------- Latin America $ 82 2 % $ 124 12 % $ 72 24 % Europe 161 5 0 149 49 Pacific Rim 3,302 93 944 88 81 27 ------------------------------------------------------------------------------- $ 3,545 100 % $ 1,068 100 % $ 302 100 % ===============================================================================
Export sales represented 22%, 5%, and 2% of the Solutions and Products Segment revenues for the three years ended December 31, 2004, 2003, and 2002, respectively. There are no exports sales derived from the Company's Access Services Segment or Contract Manufacturing Services Segment. ITEM 2 - PROPERTIES The Company's world headquarters and manufacturing facility is located in an 84,000 square foot, one-story building in Manchester, Connecticut, leased for a term expiring in December 2006. The Company also leases 1,238 square feet of office space, under a lease expiring in July 2005, in Dallas, Texas for professional services and sales. Scan-Optics, Ltd., a wholly owned subsidiary in the United Kingdom, also leases office space for sales, service, and equipment demonstration. ITEM 3 - LEGAL PROCEEDINGS As of December 31, 2004, the Company had settled all outstanding claims and contingencies pending during 2004 with no significant effect on cash flows or operating results. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company did not submit any matters during the fourth quarter of 2004 to a vote of the stockholders. 11 PART II ITEM 5 - MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS COMMON STOCK MARKET PRICES AND DIVIDENDS The following is a two-year history of Common Stock prices for each quarter. The table sets forth the high and low closing quotations per share for the periods indicated of the Common Stock on the Over-the-Counter Bulletin Board based upon information provided by the National Association of Securities Dealers, Inc. The closing quotations represent prices between dealers and do not include retail markups, markdowns or commissions and may not represent actual transactions. There were 901 stockholders of record at December 31, 2004.
Quarter Ended March 31 June 30 September 30 December 31 High Low High Low High Low High Low ----------------------------------------------------------------------------------------------------------------- 2004 $ .80 $ .46 $ .70 $ .28 $ .43 $ .22 $ .30 $ .18 2003 $ .35 $ .25 $ .65 $ .27 $ .74 $ .50 $ .70 $ .45
The Company has not paid dividends on its Common Stock and the Board of Directors of the Company has no intention of declaring dividends in the foreseeable future. The Company's loan agreement does not allow dividend payments on common stock. See "Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters" for information about the Company's equity compensation plans. On August 6, 2004, the Company issued an aggregate of 34,425,345 shares of its common stock, $.02 par value (the "Shares") to lenders affiliated with Patriarch Partners, LLC (the Lenders), in a recapitalization pursuant to a Second Amended and Restated Subscription and Repurchase Agreement dated as of August 6, 2004 between the Company and the Lenders. The issuance of Shares to the Lenders is a key component of a comprehensive financial restructuring arrangement with the Lenders commenced as of March 30, 2004 pursuant to the terms of a Third Amended and Restated Credit Agreement between the Company and the Lenders. The terms of the purchase and sale are discussed under "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operation - Liquidity and Capital Resources." The transaction was made pursuant to the exemption from registration in Section 4(2) of the Securities Act of 1933, as amended. 12 ITEM 6 - SELECTED FINANCIAL DATA SCAN-OPTICS, INC. AND SUBSIDIARIES FIVE YEAR SUMMARY OF OPERATIONS
SELECTED FINANCIAL DATA (thousands, except share data) 2004 2003 2002 2001 2000 ---------------------------------------------------------- --------------- --------------- ---------------- --------------- Total Revenues $ 28,741 $ 32,081 $ 29,341 $ 30,740 $ 38,302 ================ =============== =============== ================ =============== Income (loss) before income taxes (3,698) 844 1,023 (6,280) (17,709) Income taxes (benefit) 71 (142) 81 33 61 ---------------- --------------- --------------- ---------------- --------------- Net Income (Loss) $ (3,769) $ 986 $ 942 $ (6,313) $ (17,770) ================ =============== =============== ================ =============== Basic earnings (loss) per share $ (.18) $ .14 $ .13 $ (.90) $ (2.53) ================ =============== =============== ================ =============== Basic weighted-average shares 20,890,686 7,026,232 7,026,232 7,026,232 7,025,064 ================ =============== =============== ================ =============== Diluted earnings (loss) per share $ (.18) $ .13 $ .13 $ (.90) $ (2.53) ================ =============== =============== ================ =============== Diluted weighted-average shares 20,890,686 7,806,491 7,317,437 7,026,232 7,025,064 ================ =============== =============== ================ =============== SELECTED BALANCE SHEET DATA Total assets $ 24,338 $ 26,073 $ 26,406 $ 27,380 $ 36,513 Working capital (deficit) 2,912 4,957 5,394 4,184 (9,833) Long term obligations 11,142 9,379 10,428 11,397 Mandatory redeemable preferred stock 855 4,286 4,054 3,800 Total stockholder's equity 2,314 2,443 1,383 360 4,307
The Company has not paid any dividends for the five-year period ended December 31, 2004. The above financial data should be read in conjunction with the related consolidated financial statements and notes thereto. Certain amounts have been reclassified to conform to the current year presentation. 13 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward Looking Information Certain statements contained in this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 and as such may involve known or unknown risks, uncertainties and other factors which may cause the Company's actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe the Company's future plans, strategies and expectations are generally identifiable by use of the words "may," "will," "should," "expect," "anticipate," "estimate," "believe," "intend" or "project" or the negative thereof or other variations thereon or comparable terminology. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to those set forth below. These risks and uncertainties should be considered in evaluating any forward-looking statements contained or incorporated by reference herein. The following list is not intended to be an exhaustive list of all the risks to which the Company's business is subject, but only to highlight certain substantial risks faced by the Company. Although the Company completed a debt restructuring effective March 30, 2004 (see "Liquidity and Capital Resources" for further information), the Company remains highly leveraged and could be adversely affected by a significant increase in interest rates. A one percent increase in the prime rate would increase the annual interest cost on the outstanding loan balance at December 31, 2004 of approximately $11.6 million by $.1 million. The Company completed a recapitalization on August 6, 2004 (see "-Liquidity and Capital Resources" and Note F to the Company's Consolidated Financial Statements for further details), and as a result the Company's lenders have acquired a significant voting control and accordingly have the right and the ability to influence the way in which the Company does business, including its strategy and tactics. The Company's business could be adversely affected by downturns in the domestic and international economy. The Company's international sales and operations are subject to various international business risks. The Company's revenues depend in part on contracts with various state or federal governmental agencies, and could be adversely affected by patterns in government spending. The Company faces competition from many sources, and its products and services may be replaced by alternative technologies. Further, the Company's business could be adversely affected by technological changes. Overview The Company reported net loss for the year of $3.8 million or $.18 per share, compared to a net income of $1 million, or $.13 per diluted share, for 2003. The Company's ability to effectively address these issues will have a direct impact on its operating results, its ability to generate sufficient cash to fund operations and its ability to comply with existing debt covenants. The Company's operating results for 2004 were significantly adversely affected compared to 2003 by certain non-recurring and transitional events, including the settlement of outstanding litigation, the phasing out of the sale of the Company's mature line of 9000 Series scanners, the phased market introduction of varied models of the Company's new generation of SO Series scanners, and the development of new channels of distribution for the Company's hardware and software. During 2004 the Company executed a financial restructuring and recapitalization that was approved at the annual meeting on July 15, 2004. See "Liquidity and Capital Resources" and Note F to the Company's Consolidated financial statements under 14 Item 8 of this Form 10-K. The Company continued its investment in research and development for a new image scanning platform in 2004 and introduced the first product in the SO series family during the AIIM trade show in March 2004. The SO product earned "Best in Show Award" for high-end image scanners. This success was followed by the installation of the in-line OCR version in the fourth quarter of 2004. This image scanner family was designed to satisfy the requirement of our very sophisticated customer base but is also scalable to provide excellent price performance in the competitive market space. The Company has three major initiatives currently underway to develop sources of revenue growth and profitability. The first is to capitalize on the SO series investment and generate significant sales revenues in the high-end image scanner market both domestically and internationally. In 2004 the Company introduced its entry into the Business Process Outsourcing marketplace with initial contracts in state tax processing, warranty registration forms processing, knowledge management and business continuation services. The Company is also focused on the assessment market with "solution" content. Currently on hold is activity to add long term value through the acquisition of key strategic services or enterprises. The inability of the Company to carry out these initiatives could have a material adverse effect on revenue growth and earnings. The first initiative is to provide cost effective solutions through the Company's development of its high-speed image transports. The Company has expanded its target market approach to include value-added resellers and distributors. It has also expanded its market coverage to include International distributors in Japan and other countries. The second initiative is Business Process Outsourcing ("BPO") Services that offer the market access to the Company's technology and systems on a transaction basis. The Company's' BPO Services provide a low-risk, cost-effective solution for customers with requirements for document conversion services, business continuation services, knowledge management or business process outsourcing. The BPO services offer customers a high quality, ISO9001 2000 certified, turnkey outsourcing solution utilizing the Company's proprietary hardware technology, and further leveraging software skills, resources and process controls. The third initiative is the solution focus in the assessment market. Fueled by the No Child Left Behind law, Scan-Optics has experienced significant success in this market adding significant value with our proprietary software solutions and high performance image and optical mark read (OMR) scanners. The Access Services Division continues to provide critical support capability to customers as well as other third parties where they provide services. Through the division's 120 technical service representatives, including employees and contractors, strategically located throughout the US, the Company believes that it can provide high quality, cost effective maintenance to its existing customer base as well as new accounts. While the Company is principally focused on achieving consistent profitability with its existing operations, the Company may consider acquiring key strategic products or enterprises. Acquisitions will be considered based upon their individual merit and benefit to the Company. 15 RESULTS OF OPERATIONS - 2004 VS. 2003 Total revenues decreased $3.3 million or 10% from 2003 to 2004. Hardware and software revenue decreased $4.2 million or 26% from the prior year. North American sales decreased $3.2 million or 28%. Total international sales increased to $3.5 million in 2004 compared to $1.1 million in 2003. International sales in the Pacific Rim increased to $3.3 million due to significant scanner systems orders and spare parts sold to the Company's distributor in Japan. Sales to Europe and Latin American increased to $.2 million in 2004 compared to $.1 million in the prior year. The Company has phased out the sale and production of its mature line of 9000 Series scanners, while introducing to the market, in phases, varied models of the Company's new generation of SO Series scanners and developing new channels of distribution for the Company's hardware and software, which concurrent activities accounted for a majority of the decreased hardware and software revenue. Professional services revenue increased to $5.9 million ($.5 million or 8% from 2003 to 2004) mainly due increased solution sales to the Company's target customer base. Access services revenue increased to $10.9 million ($.4 million or 4% from 2003 to 2004). Commencing in the fourth quarter of 2004, revenues on contracts that are not expected to be activated are recognized over the estimated final term for which the Company may possibly be required to perform. Under this change in accounting estimate, the Company recognized $.4 million revenues on contracts for which its obligation to perform is remote. Other increases in revenue from the Company's third party maintenance business were offset by a decline in proprietary maintenance contracts. Cost of hardware and software revenue gross margin for 2004 was 19% compared to 33% for 2003 and reflects the start up phase of the new SO Series scanners. The gross margin in 2004 included a provision of $.5 million for slow-moving inventory. Cost of professional services revenue gross margin in 2004 was 52%, as compared to 50% in 2003. The change was mainly due to increased sales volume which results in higher utilization rates for available resources. Cost of Access services revenue gross margin was 18% in 2004 compared to 17% in 2003 reflecting higher sales volume and a relatively fixed cost structure. Gross margin in 2004 was effected by a $.3 million provision for slow-moving inventory related to the United Kingdom. Sales and marketing expenses decreased $.1 million or 4% from 2003, principally due to lower salary and commission expenses partially offset by increased advertising expense. Research and development expenses increased $.7 million or 54% from 2003 mainly due to higher salary and external consulting costs in 2004. These costs were lower in 2003 due to the capitalization of certain software development costs. General and administrative expense increased $1.2 million or 34% from 2003. The increase reflects a $.5 million provision for accounts receivable as a result of the settlement of a legal action. The remaining portion of the increase is 16 mainly due to increased legal fees of $.2 million, stock option expense of $.2 million, health insurance claims expense of $.2 million and other expenses. Interest expense of $.9 million remained consistent with 2003. The weighted average interest rate was 7.3% in 2004 compared to 4.8% in 2003. The increase in the weighted average interest rate is due to accretion on the $1.5 million term loan working capital facility for which the Company is obligated to repay $2 million at maturity. Other income decreased $.1 million from 2003. In 2003, the Company recognized as other income on $.1 million for previously recorded liabilities that were no longer due or had been settled for amounts less than that previously recorded. Income tax expense increased $.2 million from 2003 mainly for state income and foreign taxes. RESULTS OF OPERATIONS - 2003 VS. 2002 The 2002 consolidated financial statements have been restated to reflect a change in the application of generally accepted accounting principles relating to the adjustment of certain liabilities. The Company identified certain liabilities relating to services and transactions dating back to 2002 and 2001. In 2003, the Company determined the amounts were no longer valid obligations of the Company. Further, it was determined that payment of the obligation or resolution of the circumstances originally creating the liability occurred in 2002. As a result, the liabilities should have been removed from the Company's books in 2002. The net impact of this change increased 2002 net income and earnings per share by $111,000 and $.02, respectively, representing a reduction of payables offset by required additional bonuses. The effect of income taxes was determined immaterial. Total revenues increased $2.7 million or 9% from 2002 to 2003. Hardware and software revenue increased $4.8 million or 42% from the prior year. North American sales increased $4.2 million or 38% due mainly to the replacement or upgrade of existing Series 9000 systems at current customer sites. The Company does not expect the replacement revenue to continue at the same level as 2003. Total international sales increased $.6 million or 189% from 2002. International sales in the Pacific Rim increased 849% or $.7 million due to spare parts orders and a scanner system sold to the Company's distributor in Japan. Sales to Europe and Latin American decreased $.1 million from the prior year. Professional services revenue decreased $1.1 million or 16% from 2002 to 2003 mainly due to the decrease in the service revenue component of certain hardware systems installations and difficulties in the current U.S. economy. Access services revenue decreased $.9 million or 8% from 2002 to 2003 due mainly to a decrease in revenue from the Company's proprietary maintenance contracts as a result of lower maintenance rates for the latest generation of the Series 9000 scanner, the 9000M, as compared to the earlier Series 9000 scanner. The Company was also impacted by a few customers discontinuing maintenance due to changes in their business or the use of other technologies. 17 Cost of hardware and software revenue increased $2.9 million or 37% from 2002. The increase in cost is mainly due to an increase in hardware and software sales volume. In 2003, the Company recorded approximately twice the number of Series 9000 scanners sales as compared to 2002, which accounted for more revenue and therefore increased manufacturing costs. Cost of hardware and software revenue as a percentage of revenue was 67% in 2003, as compared to 69% in 2002. Cost of professional services revenue decreased $.2 million or 6% in 2003 compared to the prior year mainly due to decreases in salaries and travel expenses. Cost of professional services revenue as a percentage of revenue was 50% in 2003, as compared to 44% in 2002, due mainly to a decline in new solutions sales, as well as fixed costs that exist to support a higher volume of business. Cost of Access services revenue increased $.3 million or 3% from 2002 to 2003. The increase is principally due to an increase in UK operating expenses. Cost of Access services revenue as a percentage of revenue was 83% in 2003, as compared to 74% in 2002, traceable to lower revenues in 2003 and a relatively fixed cost structure. Sales and marketing expenses increased $.2 million or 6% from 2002, principally due to an increased use of outside services related to the Company's new website as well as increases in consulting services related to an effort to expand into the federal government market, and increased trade show activity. Research and development expenses decreased $.5 million or 30% from 2002 mainly due to the capitalization of certain software development costs. General and administrative expenses remained consistent with the prior year. A reduction in legal expenses of $.2 million and $.1 million of bad debt recovery was offset by increased salary expense of $.2 million and increased group insurance expense of $.1 million. Interest expense of $.8 million remained consistent with 2002. The weighted average interest rate was 4.8% in 2003 compared to 5.5% in 2002. Other income decreased $.3 million from 2002 mainly due to a reduction in 2002 of $.4 million for certain amounts previously recorded as liabilities that were no longer due or have been settled for amounts less than previously recorded. Income tax benefit increased $.2 million from 2002 mainly due to the reduction of potential tax exposures associated with certain state and foreign exposure items. 18 LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents at December 31, 2004 of $.5 million decreased $0.1 million from December 31, 2003. Outstanding borrowings increased $3.6 million to $11.6 million at December 31, 2004 from $8.0 million at the end of 2003. The available balance on the line of credit was $1.5 million at December 31, 2004. As of December 31, 2004, the Company is in compliance with all financial covenants. The Company anticipates meeting its current obligations and other resource needs in 2005 with funds generated through operations and its available line of credit. However, Underachieved operating results could adversely effect the Company's ability to remain in compliance. On August 6, 2004, the Company completed a recapitalization with its lenders, Patriarch Partners LLC, (the Lenders) after obtaining stockholder approval at the Company's July 15, 2004 annual meeting. The recapitalization included, among other terms, the cancellation of $3.8 million of mandatorily redeemable Series B preferred stock, including accrued dividends, and warrants for 33.2% of the Company's outstanding common stock on a fully-diluted basis, both held by the Lenders, in exchange for the issuance of 34,425,345 shares of common stock of the Company (or 79.8% of the Company's outstanding common stock on a fully-diluted basis, subject to dilution for certain compensatory stock options granted by the Company) to the Lenders. In addition: * The Company's secured term and revolving debt was exchanged for a $9.0 million term loan and a $2.5 million revolving loan. The new term loan is payable in annual amounts of $90,000 beginning April 1, 2005 with the balance due at maturity. Borrowings accrue interest at a rate of prime plus 2%. * An additional $1.5 million term loan working capital facility was made available to the Company, with the Company obligated to repay $2 million at maturity. (Interest is being accreted such that the carrying amount of this loan at maturity will be $2 million.) This loan accrues interest at the prime rate. * The Company's financial covenants with respect to backlog, capital expenditure and EBITDA were modified. * Effective upon the closing of the recapitalization on August 6, 2004, the maturity date for all of the Company's secured indebtedness to the Lenders was extended through March 30, 2007. The Company believes that the 2004 loan restructuring will allow execution of the Company's business plan through the term of the credit agreement by reducing required short-term payments under the borrowing arrangements with the Lenders and increasing available funds through the working capital term loan facility, thereby enhancing the Company's ability to invest in its business, by lowering the thresholds of the financial covenants and by extending loan maturities through March 2007. 19 The Company's significant contractual obligations and commitments that impact its liquidity as of December 31, 2004 follow:
Contractual Obligations Payments Due by Period ----------------------------------------------------------------------------------------------------- Less than 1 1 - 3 4 - 5 After 5 (thousands) Total year years years years ------------------------------------------------ ------------ ------------- ------------ ------------ Notes payable $ 11,605 $ 1,000 $ 10,605 Redeemable preferred stock 855 855 Executive insurance agreement 359 50 100 $ 100 $ 109 Capital leases 225 84 141 Operating leases 1,262 450 552 104 156 -------------- ------------ ------------- ------------ ------------ Total contractual cash obligations $ 14,306 $ 1,584 $ 12,253 $ 204 $ 265 ============== ============ ============= ============ ============
Operating activities used $2.2 million of cash in 2004 compared to providing $3.0 million in 2003. Non-cash expenses in 2004 were $4.2 million compared to $2.6 million in 2003. The non-cash items relate to depreciation, amortization of customer service inventory and software license, and provisions for losses on accounts receivable and slow-moving inventory. These and other components of operating activities are discussed below. Net accounts receivable and unbilled receivables decreased $1.8 million from December 31, 2003 due principally to lower sales in the second half of 2004, $14.5 million, as compared to the second half of 2003, $15.8 million and provision for losses on accounts receivable of $.6 million. Total inventories increased $.2 million from 2003 levels. Manufacturing inventories increased $.8 million during the year due to an increase in materials and component parts of $1.2 million and a decrease in work-in-process inventory of $.4 million. Finished goods inventory remained consistent with prior year levels. The increase in materials and component parts is mainly due to the ongoing production schedule for the SO Series scanner in first quarter of 2005 as compared to the initial product launch schedule of the SO Series scanner in early 2004. Customer service inventory decreased for the year by $.6 million, which was mainly attributable to the amortization of spare parts. Net plant and equipment decreased $.1 million in 2004. This net decrease is due to depreciation of $.4 million, partially offset by additions of $.3 million. No significant additions are planned for 2005. Accounts payable increased $.5 million over December 31, 2003 relating to the timing of payments. Notes payable to bank increased $3.6 million as a result of borrowing against the Company's available line of credit to fund increased production schedules for the SO Series scanner and general corporate needs. Salaries and wages decreased $.8 million from 2003 mainly due to the absence of a bonus accrual at December 31, 2004. Deferred revenue increased $.6 million as a result of the increase in annual and quarterly maintenance billings that are subsequently recognized in revenue over the maintenance period covered by the billing. 20 Customer deposits decreased $.8 million due mainly to large orders in 2003 that contained deposit requirements as part of the contract which were not replicated in the fourth quarter of 2004. Other current liabilities decreased $.3 million due mainly to a $.3 million decrease in various accrued expenses. Other long term liabilities decreased $.9 million mainly due to the conversion of operating leases totaling $.8 million into preferred stock as part of the debt restructuring effective August 6, 2004. 21 OTHER MATTERS New Accounting Standards Refer to Note B of the Notes to Consolidated Financial Statements in Item 8 for a discussion of new accounting pronouncements and the potential impact on the Company's consolidated financial statements. Critical Accounting Policies The policies discussed below are considered by management to be critical to an understanding of the financial statements because their application places the most significant demands on management's judgement, with financial reporting results relying on estimations about the effect of matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. Revenue recognition - proportional performance: The Company recognizes revenue and profit on professional services engagements using the proportional performance method of accounting, which relies on estimates of total expected contract revenues and costs. The Company follows this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Since the financial reporting of these contracts depends on estimates, which are assessed continually during the term of the contract, recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are reflected in the period in which the facts that give rise to the revision become known. Accordingly, favorable changes in estimates result in additional profit recognition, and unfavorable changes in estimates result in the reversal of previously recognized revenue and profits. When estimates indicate a loss under a contract, the provision for such loss is recorded in that period. As work progresses under a loss contract, revenue continues to be recognized, and a portion of the contract costs incurred in each period is charged to the contract loss reserve. The estimated loss is calculated and adjusted each period. If estimates change, the professional services revenue, cost of revenue and gross margins will be impacted. Allowance for doubtful accounts: The Company evaluates the collectability of accounts receivable based on a combination of factors. In cases where the Company has knowledge of a specific customer's inability to meet its financial obligations (e.g., bankruptcy filings, substantial slow-down in recent payment history) or contract disputes, a specific reserve for uncollectable amounts will be recorded. For all other customers, the Company records a reserve for bad debts based on the age of the receivable balance. If circumstances change (i.e., higher than expected defaults, unexpected material adverse change in a significant customer's ability to meet its financial obligations to the Company or contract disputes), estimates of the collectability of amounts due could be reduced by a material amount. Inventories - slow-moving and obsolete: The Company performs regular reviews for excess and obsolete manufacturing inventories to determine if the inventory valuation allowances are adequate to cover the value of parts deemed excess or obsolete. The review is based upon current inventory levels, expected product sales over the next twelve to twenty four months and Access Services requirements for spare parts. Should the Company not achieve expected product sales or if Access Services parts requirements should change, future losses may occur through the requirement of additional reserves for excess and obsolete inventory. The spare parts are amortized over four years and the carrying amounts are reviewed periodically for appropriateness. 22 Long-lived assets: The Company records impairment losses on long-lived assets (including goodwill) used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than net book value. The Company also evaluates the amortization periods of long-lived assets, to determine whether events or circumstances warrant revised estimates of useful lives. If the business plan's operating results, the Company used to calculate the undiscounted cash flows are not achieved, a potential impairment could result with a write-down of the carrying value of long-lived assets required. 23 ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK On March 30, 2004, the Company completed a total debt restructuring (see "Liquidity and Capital Resources" for further information); however, the Company remains highly leveraged and could be adversely affected by a significant increase in interest rates. A one percent increase in the prime rate would increase the annual interest cost on the outstanding loan balance at December 31, 2004 of approximately $11.6 million by $.1 million. The Company has minimal foreign currency translation risk. All international sales other than sales originating from the UK and Canadian subsidiaries are denominated in United States dollars. Refer to the Overview section of Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations, and to Note A of the Notes to Consolidated Financial Statements. 24 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 25 REPORT of UHY LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Stockholders and Board of Directors Scan-Optics, Inc. We have audited the accompanying consolidated balance sheet of Scan-Optics, Inc. and subsidiaries as of December 31, 2004 and the related consolidated statements of operations, stockholders' equity, and cash flows for the year then ended. Our audit also included the financial statement schedule for 2004 listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scan-Optics, Inc. and subsidiaries at December 31, 2004 and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule for 2004, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ UHY LLP Hartford, Connecticut March 18, 2005 26 REPORT of ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Stockholders and Board of Directors Scan-Optics, Inc. We have audited the accompanying consolidated balance sheets of Scan-Optics, Inc. and subsidiaries as of December 31, 2003 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 2003. Our audits also included the financial statement schedule for 2003 and 2002 listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scan-Optics, Inc. and subsidiaries at December 31, 2003, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule for the years ended December 31, 2003 and 2002, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP Hartford, Connecticut March 26, 2004 27 SCAN-OPTICS, INC., AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
December 31 (thousands, except share data) 2004 2003 ------------------------------------------------------------------------------------------------- Assets Current Assets: Cash and cash equivalents $ 477 $ 585 Accounts receivable less allowance of $238 in 2004 and $1,134 in 2003 4,314 6,043 Unbilled receivables - contracts in progress 298 415 Inventories 7,461 7,282 Prepaid expenses and other 389 597 -------------------------------------- Total current assets 12,939 14,922 Equipment and Leasehold Improvements: Equipment 3,386 3,682 Leasehold improvements 4,089 4,010 Office furniture and fixtures 557 745 -------------------------------------- 8,032 8,437 Less accumulated depreciation and amortization 7,095 7,422 -------------------------------------- 937 1,015 Goodwill 9,040 9,040 Other assets 1,422 1,096 -------------------------------------- Total Assets $ 24,338 $ 26,073 ======================================
28
December 31 (thousands, except share data) 2004 2003 ----------------------------------------------------------------------------------------------------------------- Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 2,822 $ 2,323 Note payable 1,000 Salaries and wages 702 1,484 Taxes other than income taxes 641 758 Income taxes 68 189 Deferred revenue 3,408 2,787 Customer deposits 143 929 Other 1,243 1,495 ------------------------------------ Total current liabilities 10,027 9,965 Notes payable 10,605 7,989 Other liabilities 537 1,390 Mandatory redeemable preferred stock, at redemption value: Series B, 3,800,000 shares issued and outstanding 4,286 Series I, 420,857 shares issued and outstanding 855 ------------ ------------ Total Liabilities 22,024 23,630 Stockholders' Equity Preferred stock, par value $.02 per share, authorized 5,000,000 shares Common stock, par value $.02 per share: authorized 65,000,000 shares; 41,865,077 issued at December 31, 2004 and 7,439,732 issued at December 31, 2003, including treasury shares 837 149 Capital in excess of par value 41,651 38,354 Accumulated retained-earnings deficit (36,339) (32,570) Accumulated other comprehensive loss - currency translation adjustment (1,189) (844) ------------------------------------ 4,960 5,089 Cost of common stock in treasury, 413,500 shares (2,646) (2,646) ------------------------------------ Total stockholders' equity 2,314 2,443 ------------------------------------ Total Liabilities and Stockholders' Equity $ 24,338 $ 26,073 ==================================== See accompanying notes.
29 SCAN-OPTICS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended December 31 (thousands, except share data) 2004 2003 2002 ------------------------------------------------------------------------------------------------------ Revenues Hardware and software $ 11,883 $ 16,044 $ 11,292 Professional services 5,925 5,474 6,550 Access services 10,933 10,563 11,499 --------------- ------------- ----------------- Total revenues 28,741 32,081 29,341 Costs of Revenue Hardware and software 9,655 10,690 7,816 Professional services 2,873 2,717 2,899 Access services 8,980 8,813 8,539 --------------- ------------- ----------------- Total costs of revenues 21,508 22,220 19,254 Gross Profit 7,233 9,861 10,087 Operating Expenses Sales and marketing 3,327 3,455 3,273 Research and development 1,955 1,267 1,798 General and administrative 4,787 3,572 3,566 Interest 867 856 846 --------------- ------------- ----------------- Total costs and expenses 10,936 9,150 9,483 --------------- ------------- ----------------- Operating income (loss) (3,703) 711 604 Other income, net 5 133 419 --------------- ------------- ----------------- Income (loss) before income taxes (3,698) 844 1,023 Income taxes (benefit) 71 (142) 81 --------------- ------------- ----------------- Net Income (Loss) $ (3,769) $ 986 $ 942 =============== ============= ================= Basic earnings (loss) per share $ (.18) $ .14 $ .13 =============== ============= ================= Basic weighted-average shares 20,890,686 7,026,232 7,026,232 =============== ============= ================= Diluted earnings (loss) per share $ (.18) $ .13 $ .13 =============== ============= ================= Diluted weighted-average shares 20,890,686 7,806,491 7,317,437 =============== ============= =================
See accompanying notes. 30 SCAN-OPTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated Accumulated Common Stock Capital in Retained- Other (thousands, except share data) ----------------- Excess of Earnings Comprehensive Treasury Shares Amount Par Value Deficit Loss Stock Total ------------------------------------------------------------------------------------- -------------- ------------- ------------- Balance January 1, 2002 7,439,732 $ 149 $ 38,354 $ (34,498) $ (999) $ (2,646) $ 360 Net income 942 942 Currency translation 81 81 adjustments ------------- Comprehensive income 1,023 -------------------------------------------------------------------------------------------------------------------------------- Balance December 31, 2002 7,439,732 149 38,354 (33,556) (918) (2,646) 1,383 Net income 986 986 Currency translation adjustments 74 74 ------------- Comprehensive income 1,060 -------------------------------------------------------------------------------------------------------------------------------- Balance December 31, 2003 7,439,732 149 38,354 (32,570) (844) (2,646) 2,443 Net loss (3,769) (3,769) Currency translation adjustments (345) (345) ------------- Comprehensive loss (4,114) Exchange of common stock for debt 34,425,345 688 3,712 4,400 Common stock issuance costs (606) (606) Fair value of stock options issued to non-employees 191 191 -------------------------------------------------------------------------------------------------------------------------------- Balance December 31, 2004 41,865,077 $ 837 $ 41,651 $ (36,339) $(1,189) $ (2,646) $ 2,314 ================================================================================================================================
See accompanying notes. 31
SCAN-OPTICS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31 (thousands) 2004 2003 2002 ------------------------------------------------------------------------------------- --------------------- -------------------- Operating Activities Net income (loss) $ (3,769) $ 986 $ 942 Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Depreciation 404 426 425 Amortization of customer service inventory and development costs 2,134 1,885 2,355 Amortization of deferred debt costs 119 Accretion of interest on debt 105 Accretion of interest on preferred stock 128 486 254 Fair value of common stock options granted to non-employees 191 Provision for losses on accounts receivable 567 22 35 Provision for slow-moving inventory 527 50 Reversal of previously recorded liabilities (183) (369) Changes in operating assets and liabilities: Accounts receivable 1,279 (549) (668) Inventories (2,648) (28) (2,634) Prepaid expenses and other 208 (6) (87) Accounts payable 499 232 (819) Accrued salaries and wages (782) 457 (353) Taxes other than income taxes (117) 257 (23) Income taxes (121) 144 40 Deferred revenue 621 570 116 Customer deposits (786) (379) 801 Other (767) (1,283) (233) ------------------- --------------------- -------------------- Net cash provided (used) by operating activities (2,208) 3,037 (168) Investing Activities Acquisition related settlement 209 Purchases of plant and equipment, net (329) (173) (79) ------------------- --------------------- -------------------- Net cash provided (used) by investing activities (329) (173) 130 Financing Activities Debt and equity transaction costs (1,082) Proceeds from borrowings 5,711 7,650 4,376 Principal payments on borrowings (2,200) (10,203) (5,726) -------------------- -------------------- -------------------- Net cash provided (used) by financing activities 2,429 (2,553) (1,350) Increase (decrease) in cash and cash equivalents (108) 311 (1,388) Cash and cash equivalents at beginning of year 585 274 1,662 -------------------- -------------------- -------------------- Cash and Cash Equivalents at End of Year $ 477 $ 585 $ 274 ==================== ==================== ==================== Supplemental Cash Flow Information Interest paid $ 626 $ 732 $ 667 ==================== ==================== ==================== Income taxes paid $ 126 $ 24 $ 44 ==================== ==================== ==================== See accompanying notes.
32 SCAN-OPTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - DESCRIPTION OF BUSINESS Scan-Optics, Inc. and its subsidiaries (collectively, the Company) combine technology, experience and expertise to develop cost-effective solutions for applications that include government, insurance, assessment, transportation, financial and order entry. The Company's systems, software and services are marketed worldwide to commercial and government organizations either directly by the Company's sales organization or through distributors. The Company also markets with system integrators and specialized niche suppliers. The Company's business is vulnerable to a number of factors beyond its control. These factors include (1) the effect of a continued weakening in the domestic and international economies, which potentially impacts capital investments by customers, (2) the cyclical nature of funding within federal and state government agencies, (3) competition from similar products, (4) the implementation of other technologies, which may provide alternative solutions to customers, and (5) the stability of sole source suppliers. NOTE B - ACCOUNTING POLICIES Basis of Presentation: The consolidated financial statements include the accounts of Scan-Optics, Inc. and its subsidiaries, all wholly-owned. All intercompany accounts and transactions have been eliminated in the consolidated financial statements. Certain amounts have been reclassified to conform to the current year presentation. Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in them, including the accompanying notes. While management believes that the estimates and related assumptions used in the preparation of these financial statements are appropriate, actual results could differ from those estimates. Significant estimates included in the financial statements relate to asset valuation allowances for potentially uncollectible accounts receivable; slow-moving and obsolete inventories; and deferred income tax assets. Further, other significant estimates relate to revenue recognition Foreign Currency Translation: All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations accounts have been translated using the average exchange rate for the year. The gains and losses resulting from the changes in exchange rates from year to year have been reported in accumulated other comprehensive loss, a component of Stockholders' Equity. Cash Equivalents: Highly liquid investments purchased with maturities of three months or less when purchased are considered cash equivalents. Accounts Receivable and Revenue Recognition: Revenues relating to sales of certain equipment (principally optical character recognition equipment) are recognized upon acceptance, shipment, or 33 installation depending on the contract terms and conditions. When customers, under the terms of specific orders or contracts, request the Company to manufacture and invoice the equipment on a bill and hold basis, the Company recognizes revenue based on an acceptance test that is certified by the customer (Note O). When right of return exists, the Company recognizes revenue in accordance with SFAS 48, Revenue Recognition When Right of Return Exists. Returns were not significant for any period presented. At December 31, 2004 two customers represented 30% and 17%, respectively, of accounts receivable. At December 31, 2003 one customer represented 33% of accounts receivable. Revenues under systems integration and professional services contracts are recognized on a proportionate performance basis, based on the ratio of earned revenue to total contract price, after considering accumulated costs and estimated costs to complete each contract or when services have been performed and accepted, depending on the nature of the individual project. Under fixed price contracts, the Company may encounter, as has been the case with certain contracts in prior years, cost overruns caused by project management problems and the expense of hiring outside contractors to assist in project completions, as well as changes to previously agreed upon project designs. Adjustments to contract cost estimates are made in the periods in which the facts requiring such revisions become known. When the estimates indicate a loss on a particular contract, such a loss is provided for in the period it is identified. No significant losses were required to be provided for any period presented. The Company provides maintenance services under contracts with terms ranging from nine to 36 months. Revenues on activated contracts are recognized over the term of the contract as the Company fulfills its obligation for performance. Commencing in the fourth quarter of 2004, revenues on contracts that are not expected to be activated are recognized over the estimated final term for which the Company may possibly be required to perform. Under this change in accounting estimate, the Company recognized $405,000 of revenues on contracts for which its obligation to perform is remote. Accounts receivable are recognized when billed under the contract terms. Based on certain pre-negotiated contract terms billings may not coincide with revenue recognition. Revenues earned but not yet billable are shown as unbilled receivables until the customer is actually invoiced in accordance with the contract terms. An allowance for potentially uncollectible accounts receivable is provided based on management's assessment of each customer's current financial condition, general economic and industry conditions and past experience. Accounts receivable are charged to the allowance when deemed uncollectible. Inventories: Inventories of materials and component parts, and in-process and finished goods are stated at the lower of cost (first-in, first-out method) or market. The Company periodically provides for obsolete and slow-moving inventories based on historical usage, future requirements and anticipated demand. The fourth quarter of 2004 includes a provision of $527,000 for slow-moving inventory. As of December 31, 2004 allowances for obsolete and slow-moving inventories were $1,764,000 ($1,268,000 as of December 31, 2003). Service parts held and restricted primarily for customer use under maintenance contracts are amortized over four years. As such, service parts are stated at amortized cost which is reviewed periodically for reasonableness. Equipment and Leasehold Improvements: Equipment and leasehold improvements are stated on the basis of cost. Depreciation is computed principally using the straight-line method over the estimated 34 useful lives of the assets, which range from 3 to 10 years. Leasehold improvements are amortized over the useful life of the improvements or the life of the lease, whichever is shorter. Other Assets: Other assets consist primarily of capitalized software development costs and deferred debt costs. Certain internal and external software development costs are capitalized in accordance with FASB Statement No. 86, Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed. These costs are amortized on a straight-line basis over the estimated economic life of the software. Related amortization is greater than that computed on a units sold basis. Deferred debt costs are being amortized over the term of the debt. Asset Impairment: Goodwill and other long-lived assets are reviewed at least annually for impairment or whenever facts and circumstances suggest they may be impaired. There were no impairments for any of the years presented. Goodwill: Goodwill consists of the excess of cost over the fair value of identifiable net assets of businesses acquired. Goodwill is carried at cost, less amortization thereon to January 1, 2002; the carrying amount of goodwill is not in excess of its estimated recoverable amount. Fair Value of Financial Instruments: The carrying amounts reported in the balance sheets for accounts receivable, accounts payable, and accrued expenses and other liabilities approximate fair value due to the immediate to short-term maturity of these financial instruments. The fair values of the revolving credit facility and term loan are determined using current interest rates for similar instruments, as of December 31, 2004 and 2003 and approximate the carrying value of these financial instruments. Shipping Costs: Shipping costs are included in costs of revenue. Advertising Costs: The Company expenses the production costs of advertising the first time the advertising takes place. Advertising costs ($171,000 in 2004, $10,000 2003, and $12,000 in 2002) are included in selling, general and administrative expenses. Income Taxes: Deferred income taxes are provided for on differences between the income tax and the financial reporting bases of assets and liabilities at the statutory tax rates that will be in effect when the differences are expected to reverse. A valuation allowance for deferred tax assets is recorded to the extent the Company cannot determine that the ultimate realization of net deferred tax assets is more likely than not. In making such determination, the Company may consider estimated future reversals of existing temporary differences, estimated future earnings and available tax planning strategies. To the extent that the estimates of these items are reduced or not realized, the amount of the deferred tax assets considered realizable could be adversely affected. 35 Stock Based Compensation: The Company generally grants stock options to key employees and members of the Board of Directors with an exercise price equal to the fair value of the shares on the date of grant. The Company accounts for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees and, accordingly, recognizes no compensation expense for the stock option grants. Therefore, the Company has elected the disclosure provisions only of FASB Statement No. 123, Accounting for Stock-Based Compensation. Options granted to non-employees are recorded at fair value. The Company recognized compensation expense of $191,000 in 2004 associated with options granted to non-employees. Pro forma information regarding net income (loss) and earnings (loss) per share determined as if the Company granted stock options under the fair value method is required by FASB Statement No. 123. The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model. For the purpose of pro-forma disclosures, the estimated fair value of the stock options at the date of grant was determined using a Black-Scholes option pricing mode and is expensed ratably over the vesting period of the grant, which is 36 months for key employees and 6 months for nonemployee members of the Board of Directors. Options for senior management that were granted on December 31, 2001 as part of the previous debt restructuring vested over six months. The Company's pro-forma information is as follows:
Year Ended December 31 (thousands, except per share amounts) 2004 2003 2002 -------------------------------------------------------------- ---------------- --------------- ---------------- Net income (loss), as reported $ (3,769) $ 986 $ 942 Stock option expense (815) (93) (199) ---------------- --------------- ---------------- Pro forma net income (loss) $ (4,584) $ 893 $ 743 ================ =============== ================ Basic earnings (loss) per share, as reported $ (.18) $ .14 $ .13 Stock option expense (.04) (.01) (.03) ---------------- --------------- ---------------- Pro forma basic earnings (loss) per share $ (.22) $ .13 $ .10 ================ =============== ================ Diluted earnings (loss) per share, as reported $ (.18) $ .13 $ .13 Stock option expense (.04) (.01) (.03) ---------------- --------------- ---------------- Pro forma diluted earnings (loss) per share $ (.22) $ .12 $ .10 ================ =============== ================
The weighted-average fair value price of options granted was $.21, $.27 and $.34 for 2004, 2003, and 2002, respectively. Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. The assumptions used in the valuation model were: expected life-10 years; risk free interest rate of 4%, 3%, and 7% for 2004, 2003, and 2002, respectively and expected volatility of .786, 1.102, and 1.39 for 2004, 2003, and 2002, respectively. 36 Earnings (Loss) Per Share: The following table sets forth the computation of basic and diluted earnings (loss) per share:
Year Ended December 31 (thousands, except share data) 2004 2003 2002 ----------------------- ---------------------- ---------------------- Numerator: Net earnings (loss) $ (3,769) $ 986 $ 942 ======================= ====================== ====================== Denominator: Denominator for basic earnings (loss) per share (weighted-average shares) 20,890,686 7,026,232 7,026,232 Effect of dilutive securities: Employee stock options 780,259 291,205 ----------------------- ---------------------- ---------------------- Denominator for diluted earnings (loss) per share (adjusted weighted-average shares and assumed conversions) 20,890,686 7,806,491 7,317,437 ======================= ====================== ====================== Basic earnings (loss) per share $ (.18) $ .14 $ .13 ======================= ====================== ====================== Diluted earnings (loss) per share $ (.18) $ .13 $ .13 ======================= ====================== ======================
New Accounting Pronouncements: Statement of Financial Accounting Standards (FAS) No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 requires that abnormal amounts of idle capacity and spoilage costs should be excluded from the cost of inventories and expensed when incurred. FAS No. 151 is effective for fiscal periods beginning after June 15, 2005. The Company does not expect this standard to have a material effect on its financial statements upon adoption. FAS No. 123R, Share-Based Payment requires that a public entity measure the cost of equity based service awards based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the vesting period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. A public entity will initially measure the cost of liability based service awards based on current fair value. The fair value of those awards will be re-measured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite period be recognized as compensation cost over that period. FAS 123R is required for fiscal periods beginning after June 15, 2005. The Company has not yet attempted to evaluate the likely effects on its financial statements. 37 NOTE C - UNBILLED RECEIVABLES - CONTRACTS IN PROGRESS Unbilled amounts in accounts receivable under contracts in progress were $.3 million and $.4 million at December 31, 2004 and 2003, respectively, and are recoverable from the customer upon completion of the phase or milestone. The Company estimates that substantially all unbilled amounts will be collected in 2005. NOTE D - INVENTORIES The components of inventories were as follows: December 31 (thousands) 2004 2003 -------------------------------------------------------------------------------- Finished goods $ 57 $ 57 Work-in-process 644 1,066 Service parts 2,713 3,291 Materials and component parts 4,047 2,868 -------------------------- $ 7,461 $ 7,282 ========================== NOTE E - OTHER ASSETS The following table summarizes other assets: December 31, 2004 2003 ------------------------- Software development cost $ 1,120 $ 960 Deferred debt costs 476 - Cash surrender value of life insurance policy 137 136 ------------------------- 1,733 1,096 Accumulated amortization (311) - ------------------------- $ 1,422 $ 1,096 ========================= The Company capitalized software development costs of $160,000 and $960,000 in 2004 and 2003, respectively. The Company commenced amortizing these costs in 2004 over a five year period. Total amortization of software development costs was $192,000 in 2004. In connection with the new credit agreement disclosed in Note F, the Company incurred $1,082,000 of transaction costs of which $476,000 were allocated to debt. These costs were deferred and are being recognized in expense over the three year term of the credit agreement. Total amortization of deferred debt costs was $119,000 in 2004. The estimated aggregate amortization expense for each of the next five succeeding years follows: 2005 - $384,000, 2006 - $384,000, 2007 - $264,000, 2008 - $225,000, and 2009 - $28,000. 38 NOTE F - CREDIT ARRANGEMENTS Effective March 30, 2004, the Company entered into a new credit agreement (the Credit Agreement) with lenders affiliated with Patriarch Partners, LLC. (the Lenders). Among other things, under the Credit Agreement the Company's existing revolving and term loans with outstanding amounts of $9.0 million were exchanged for a $9.0 million term loan, a $2.5 million revolving credit facility and a $1.5 million term loan working capital facility. The $9.0 million term loan bears interest at prime plus 2% and is payable in two annual installments of $90,000 on April 1, 2005 and 2006 with the balance of $8,820,000 due on March 30, 2007. In the second quarter of 2004, the Company borrowed $1.5 million under the term loan working capital facility of the Credit Agreement. Such borrowings bear interest at prime. The Credit Agreement requires the Company to repay the borrowed amount plus $500,000 at March 30, 2007. The additional $500,000 is being expensed as interest and accreted to debt over the term of the loan. As of December 31, 2004, $1 million was outstanding under the $2.5 million revolving credit facility portion of the Credit Agreement. Outstanding borrowings bear interest at prime plus 2% and are due March 30, 2007. As part of the Credit Agreement the Company is required to meet financial covenants with respect to backlog, capital expenditures and EBITDA. The Company is in compliance with the modified covenants. On August 6, 2004, the Company completed a recapitalization with its Lenders, which had been approved by the Company's shareholders on July 15, 2004. The recapitalization included, among other terms, the cancellation of the $3.8 million of Mandatorily Redeemable Series B Preferred Stock, including dividends of $0.6 million and outstanding warrants held by the Lenders, in exchange for 34,425,345 shares of Common Stock. As such, the Lenders own 79.8% of the fully-diluted Common Stock of the Company at the date of issuance, subject to dilution for certain current and future compensatory stock options granted by the Company. Due to the compensatory stock options, 6,470,929 shares are redeemable if the 2001 executive options are exercised. The Company also issued an aggregate of 420,857 shares of 4% Series I Preferred Stock with a mandatory redemption on March 30, 2007 for $841,714 plus unpaid dividends at 4%. Effective upon the closing of the recapitalization on August 6, 2004, the maturity date for all of the Company's secured indebtedness to the Lenders was extended through March 30, 2007. Borrowings under the Credit Agreement are secured by all of the Company's assets. NOTE G - CAPITAL STOCK An amended and restated certificate of incorporation was approved by the shareholders at the Company's annual meeting held July 15, 2004. As such, the total authorized capital stock of the Corporation is 70,000,000 shares consisting of 65,000,000 shares of Common Stock, par value $.02 per 39 share and 5,000,000 shares of Preferred Stock, par value $.02 per share. As of December 31, 2004 420,857 shares of Preferred Stock have been designated as Series I, with dividends at 4%, and are outstanding. On August 6, 2004, the Company issued 420,857 shares of Series I Preferred Stock in exchange for cancellation of lease obligations aggregating $842,000 that the Lenders acquired from the lessor. The Series I Preferred Stock and accrued 4% annual dividends are redeemable March 30, 2007. As of December 31, 2004 the carrying value of Preferred Stock is $855,000. Accumulated deferred dividends were $13,000 as of December 31, 2004. The recapitalization which was effective August 6, 2004 included, among other terms, the cancellation of the 380,000 shares of $3.8 million mandatorily redeemable Series B Redeemable Preferred Stock, par value $.02, the cancellation of existing warrants exercisable for Common Stock held by the Lenders, and the issuance of 34,425,345 shares of Common Stock of the Company to the Lenders. There are 41,451,577 shares issued and outstanding as of December 31, 2004. There are also 413,500 shares of treasury stock. At December 31, 2004, the Company had reserved 1,292,983 shares of common stock for the issuance or exercise of stock options. 40 NOTE H - STOCK OPTION PLANS The Company has six stock option plans for key employees and board members. Options granted under the plans are for a period of ten years and at prices not less than 85% of the fair market value of the shares at date of grant. Options for employees are not exercisable for one year following the date of grant and then are exercisable in such installments during the period prior to expiration, as the Stock Option and Executive Compensation Committee shall determine. Options for senior management that were granted on December 31, 2001 as part of the total debt restructuring are not exercisable until six months after the grant thereof and certain other options granted in 2004 under the senior executive stock option plan were exercisable in full upon grant of such option. Options for Directors are also not exercisable until six months after the grant thereof. Options may be exercised from time to time, in part or as a whole, on a cumulative basis as determined by the Stock Option and Executive Compensation Committee under all stock option plans. The following schedule summarizes the changes in stock options for each of the three years in the period ended December 31, 2004:
Number of Weighted Option Price Shares Average Price Per Share ----------------------------------------------------------- ---------------------- ----------------- ------------------------------ Outstanding January 1, 2002 (782,261 exercisable) 2,198,083 $ 1.41 $ .24 to $9.19 Granted 30,000 .34 .34 to .34 Canceled (236,800) 1.65 .24 to 9.19 ---------------------- ----------------- ------------------------------ Outstanding December 31, 2002 (1,869,142 exercisable) 1,991,283 1.37 .24 to 9.19 2003 Activity ------------- Granted 717,500 .29 .28 to .55 Canceled (56,100) 2.67 .31 to 3.88 ---------------------- ----------------- ------------------------------ Outstanding December 31, 2003 (1,970,183 exercisable) 2,652,683 1.05 .24 to 9.19 2004 Activity ------------- Granted 5,485,929 .25 .25 to .66 Canceled (1,153,608) .90 .24 to 7.50 ---------------------- ----------------- ------------------------------ Outstanding December 31, 2004 (6,579,984 exercisable) 6,985,004 $ .45 $ .24 to $9.19 ====================== ================= ==============================
The weighted-average price of options exercisable was $.46, $1.31 and $1.43 at December 31, 2004, 2003, and 2002, respectively. The weighted-average remaining contractual life of the options outstanding at December 31, 2004 was 9 years. 41
Options Outstanding Options Exercisable ------------------------------------------------------------------------- ------------------------------------------------------ Weighted Average Remaining Weighted Weighted Number Contractual Average Number Average Range of Exercise Prices Outstanding Life (Years) Exercise Price Exercisable Exercise Price ---------------------------- ------------------- ------------------- ------------------ ------------------- ---------------------- $ .24 to $ .60 6,540,671 9 $ .25 6,135,651 $ .25 $ .61 to $1.50 122,500 7 .88 122,500 .88 $1.51 to $3.75 246,333 3 3.39 246,333 3.39 $3.76 to $9.19 75,500 2 6.98 75,500 6.98 ---------------------------- ------------------- ------------------- ------------------ ------------------- ---------------------- 6,985,004 6,579,984 =================== ===================
At December 31, 2004 there were 3,470,511 options available for grant of which 261,500 were reserved for the Directors. NOTE I - RESEARCH AND DEVELOPMENT AGREEMENTS During 2004, 2003 and 2002, the Company completed a number of small custom development contracts for specific customers resulting in revenue of approximately $79,000, $200,000 and $43,000, respectively. These revenues offset the related costs incurred for this development. The ownership of these technologies remains with the Company. No royalties or other considerations are required as part of these agreements. NOTE J - EMPLOYEE BENEFITS The Company maintains a Retirement Savings Plan for United States employees. Under this plan, all employees may contribute up to 15% of their salary to a retirement account up to the maximum amount allowed by law. Starting in 1997, the Company contributed an amount equal to 50% of the first 6% contributed by the participant; in 2001, the employer match was increased to 67% of the first 6%. The Company's contributions to this plan were $378,000, $346,000 and $346,000, in 2004, 2003 and 2002, respectively. Effective January 15, 2005 the Company suspended its matching contribution. The Company sponsors an Employee Stock Ownership Plan (the "Plan") covering substantially all full-time employees. The Plan, which is a tax qualified employee benefit plan, was adopted by the Board of Directors of the Company in 1988 to provide retirement benefits for employees. The Plan borrowed $1,325,000 to purchase 260,000 shares of the Company's stock to be allocated to participants ratably over a ten year period. The ESOP loan was guaranteed by the Company and the outstanding balance of the loan was repaid in 1991. At December 31, 1998, all shares had been allocated. The Company did 42 not allocate any additional shares to the Plan in 2004, 2003 or 2002. The Company, at its discretion, may make annual allocations to the Plan in the future. There were no expenses related to the Plan in 2004, 2003 and 2002. The Company terminated the Plan effective December 31, 2003; its assets are expected to be distributed in 2005. There will be no significant financial impact to the Company. NOTE K - INCOME TAXES At December 31, 2004, the Company has U.S. federal and state operating loss carry forwards of approximately $32,400,000 and $29,900,000 respectively. The U.S. federal and state net operating loss carry forwards expire from 2005 through 2024. In 2004 the Company's ability for utilization of net operating loss carry forwards was significantly restricted due to the change in control as a result of the recapitalization (see Note F for further details). At December 31, 2004, the Company has approximately $3,500,000 and $800,000 of net operating loss carry forwards for the United Kingdom and Germany, respectively. These loss carry forwards expire from 2005 through 2014. There are no net operating loss carry forwards for Canada. A summary of income (loss) before income taxes follows: Year Ended December 31 (thousands) 2004 2003 2002 -------------------------------------------------------------------------------- Domestic $ (3,739) $ 708 $ 811 Foreign 41 136 212 -------------------------------------------- Income (loss) before income taxes $ (3,698) $ 844 $ 1,023 ============================================ Income taxes (benefit) follow: Year Ended December 31 (thousands) 2004 2003 2002 -------------------------------------------------------------------------------- Current : State $ 30 $ 40 $ 80 Federal benefit (321) Foreign 41 139 1 ------------------------------------------ Total current 71 (142) 81 Deferred - - - ------------------------------------------ Total $ 71 $ (142) $ 81 ========================================== 43 Significant components of deferred income tax assets and (liabilities) follow:
December 31 (thousands) 2004 2003 ----------------------------------------------------------------------------------------------------------- Deferred income tax assets: Net operating loss carry forward $ 13,890 $ 12,109 Alternative minimum tax credit carry forward 168 168 Foreign equipment 92 92 Inventories 807 584 Bonus accrual 26 Accounts receivable allowance 81 354 Vacation accrual 202 183 Other 110 109 --------------------------- Total deferred income tax assets 15,350 13,625 Deferred income tax liabilities: Goodwill (511) (175) Plant and equipment (215) (151) --------------------------- Total deferred income tax liabilities (726) (326) Valuation allowance (14,624) (13,299) --------------------------- Net deferred income tax $ - $ - ===========================
A reconciliation of income taxes computed using the U.S. statutory rate to the provision (benefit) for income taxes follows:
Year Ended December 31 2004 2003 2002 ------------------------------------------------------------- ---------------------- --------------------- ---------------------- Federal income taxes at statutory rate $ (1,271) $ 287 $ 348 State income taxes, net of federal benefit 30 66 80 Foreign income taxes 41 93 Valuation allowance, net of deferred income tax adjustments 1,271 (382) (348) Adjustment of tax reserves (206) Other 1 ---------------------- --------------------- ---------------------- Provision (benefit) for income taxes $ 71 $ (142) $ 81 ====================== ===================== ======================
The tax reserve decrease in 2003 of $206,000 or $.03 per diluted share is directly related to the reduction of potential tax exposures associated with certain state and foreign items. 44 NOTE L - LEASE COMMITMENTS The Company's principal lease commitment is for its corporate office and manufacturing facility in Manchester, Connecticut. This lease expires on December 31, 2006. The Company also has capital leases for office equipment. Minimum rental payments for these noncancelable leases, with terms of one year or more as of December 31, 2004, follow: (thousands) Operating Leases Capital Lease 2005 $ 450 $ 84 2006 448 74 2007 52 67 2008 52 2009 52 Thereafter 208 -------------------------------- Total minimum lease payments $ 1,262 225 Amounts representing interest ======= (35) --------- Present value of net minimum lease payments $ 190 ========= Rental expense for 2004, 2003, and 2002 was $445,000, $470,000, and $681,000, respectively. The cost of assets recorded under capital leases and accumulated depreciation thereon was $322,000 and $125,000 as of December 31, 2004 ($322,000 and $43,000, at December 31, 2003). All assets under capital leases are classified as equipment. Amortization of assets recorded under capital leases is included in depreciation expense. Long term capital leases are included in other long term liabilities on the balance sheet. NOTE M - CONTINGENCIES As of December 31, 2004, the Company had settled all outstanding claims and contingencies pending during 2004 with no significant effect on cash flows or operating results. 45 NOTE N - SEGMENT INFORMATION The Company views its business in three distinct operating segments: Solutions and Products, Access Services and Contract Manufacturing Services. Revenues are used by management as a guide to determine the effectiveness of the individual segment. The Company manages its operating expenses through a traditional functional perspective and accordingly does not report operating expenses on a segment basis.
Year Ended December 31 (thousands) 2004 2003 2002 ---------------------------------------------------------------------------------------------------------------------- Revenues Solutions and products $ 15,886 $ 21,108 $ 16,376 Access services 10,933 10,563 11,499 Contract manufacturing services 1,922 410 1,466 -------------- ----------------- --------------- Total revenues 28,741 32,081 29,341 Cost of solutions and products 12,528 13,407 10,715 Service expenses 8,980 8,813 8,539 -------------- ----------------- --------------- Gross profit margin 7,233 9,861 10,087 Operating expenses, net 10,931 9,017 9,064 -------------- ----------------- --------------- Income (loss) before income taxes $ (3,698) $ 844 $ 1,023 ============== ================= =============== Total assets $ 24,338 $ 26,073 $ 26,406 ============== ================= =============== Total expenditures for additions to long-lived assets $ 329 $ 173 $ 79 ============== ================= ===============
The Solutions and Products Division includes the sale of hardware and software products as well as professional services. Contract Manufacturing Services provides assembly and test services under contracts with customers who develop and sell a variety of equipment. In 2004 the Company derived 11% of its total revenue from Mitsui & Co Ltd., one of the Company's distributors in Japan. In 2003, the Company derived 23% of its total revenue from Northrop Grumman, IT Inc. No other customer accounted for more than 10% of total revenue for any year presented. The Company has international distributors located in 13 countries and covering six continents. All international sales other than sales originating from the UK and Canadian subsidiaries are denominated in United States dollars. Changes in the economic climates of foreign markets could have an unfavorable impact on future international sales. 46 Export sales by geographic area (based on the location of the customer) were as follows:
Year Ended December 31 (thousands) 2004 2003 2002 ---------------------------------------------------------------------------------------------------------------------- Latin America $ 82 2% $ 124 12% $ 72 24% Europe 161 5 0 149 49 Pacific Rim 3,302 93 944 88 81 27 ------------------------------------------------------------------------- $ 3,545 100% $ 1,068 100% $ 302 100% =========================================================================
Export sales represented 22%, 5%, and 2% of the Solutions and Products Segment revenues for 2004, 2003, and 2002, respectively. There are no exports sales derived from the Company's Access Services Segment or Contract Manufacturing Services Segment. NOTE O - BILL AND HOLD TRANSACTIONS Revenues relating to sales of certain equipment (principally optical character recognition equipment) are recognized upon acceptance, shipment, or installation depending on the contract specifications. When customers, under the terms of specific orders or contracts, request that the Company manufacture and invoice the equipment on a bill and hold basis, the Company recognizes revenue based upon an acceptance test that is certified by the customer. Revenues recorded during 2004, 2003, and 2002 included bill and hold transactions of $.1 million, $2.3 million and $1.3 million, respectively. Accounts receivable included bill and hold receivables of $.1 million at December 31, 2004. There were no accounts receivable associated with bill and hold transactions at December 31, 2003. 47 NOTE P - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Following is a summary of quarterly results of operations.
(thousands, except per share amounts) March June September December ------------------------------------------------------------------------------------------------------------------- 2004 ---- Revenues $ 7,333 $ 6,878 $ 6,187 $ 8,343 Cost of product sales and service expenses 5,816 5,178 4,327 6,187 Net loss (712) (1,619) (663) (775) Basic earnings (loss) per share (.10) (.23) (.02) (.02) Diluted earnings (loss) per share (.10) (.23) (.02) (.02) 2003 ---- Revenues 8,110 8,107 7,365 8,499 Cost of product sales and service expenses 5,527 5,374 5,227 6,092 Net income 196 214 12 564 Basic earnings per share .03 .03 .00 .08 Diluted earnings per share .03 .03 .00 .07
Fourth quarter 2004 net loss of $775,000 includes a provision for slow moving inventory adjustment of $527,000 or $.01 per share. In addition, the Company recognized $405,000 or $.01 per share of revenue applicable to a change in accounting estimate for revenues on maintenance service contracts for which the Company's obligation to perform is remote. The second quarter 2004 net loss of $1,619,000 includes a $543,000 provision or $.07 per share for an account receivable as a result of the settlement of a legal action. Fourth quarter 2003 net income of $564,000 includes a tax benefit of $206,000 or $.03 per share due to a reduction in the tax reserves. NOTE Q - SUBSEQUENT EVENTS On March 9, 2005, the Company received from attorneys representing James C. Mavel, the former Chief Executive Officer and President, a "notice of termination" pursuant to his Employment Agreement and asserting entitlement to severance compensation under the agreement. The Company intends to investigate the assertions promptly and raise all available defenses. While, based on currently available information, the Company does not believe that Mr. Mavel's claim to severance compensation is supported by the Employment Agreement or the facts, should Mr. Mavel's claim be supported, the Company believes that severance compensation would not exceed $1.3 million. 48 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND -------------------------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- Previously reported on Form 8-K filed October 13, 2004. ITEM 9A - DISCLOSURE CONTROLS AND PROCEDURES -------------------------------------------- The Company evaluated the design and operation of its disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is timely made in accordance with the Exchange Act and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision and with the participation of management, including the Company's principal executive officer and principal financial officer, as of the end of the period covered by this Annual Report on Form 10-K. The principal executive officer and principal financial officer have concluded, based on their review, that the Company's disclosure controls and procedures, as defined at Exchange Act Rules 13a-15(e) and 15d-15(e), are effective to ensure that information required to be disclosed by the Company in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. No significant changes were made during any fiscal quarter in 2004 to the Company's internal controls or other factors that has materially affected, or is reasonably likely to materially affect, the Company's internal controls and financial reporting. 49 PART III ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------------------------------ Information pertaining to Directors and additional information pertaining to Executive Officers is included under the captions "Governance of the Company" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's definitive proxy statement to be filed under Regulation 14A for the 2005 Annual Meeting of Stockholders and is incorporated herein by reference and made a part hereof. EXECUTIVE AND OTHER OFFICERS OF THE REGISTRANT Officers of the Company as of March 22, 2005 are set forth in the schedule below.
Officer Name Age Principal Occupation: Since ---------------------------------------------------------------------------------------------------- Logan Clarke, Jr. 77 Acting Chief Executive Officer and President 2005 Joseph P. Crouch 42 Vice President - Manufacturing Services Division 1999 Richard C. Goyette 53 Vice President - Sales and Marketing 1996 Richard D. Harris 44 Corporate Secretary 2001 Joel K. Howser 57 Vice President - Software Development 1998 Peter H. Stelling 54 Chief Financial Officer, Vice President, Treasurer and 2004 Assistant Corporate Secretary Paul M. Yantus 43 Chief Operating Officer 2005
50 Mr. Clarke has been a Director of Scan-Optics since 1981 and was appointed Acting Chief Executive Officer and President in March 2005. He had previously served as Interim Executive Director of Southeast Area Technology Center, a business incubator and revolving loan fund from 1995 to 1996, independent management consultant from 1990 to 1995, as Executive Vice President of Society for Savings, a savings bank, from 1986 to 1990, as Dean of the School of Management at The Hartford Graduate Center from 1983-1986 and a lecturer in management from 1979-1983. Prior to 1979, Mr. Clarke served in multiple senior management positions in the banking industry. Mr. Crouch joined the Company in March 1999 and was appointed to the position of Vice President - Manufacturing Services Division in November 1999. Prior to joining the Company, Mr. Crouch was Director of Manufacturing Operations for CalComp's Input Technologies Division. Mr. Crouch had over ten years of contract manufacturing experience before joining the Company. Mr. Goyette joined the Company in March 1996 as Vice President - Sales and Marketing. Prior to joining the Company, from 1993 through 1995, Mr. Goyette was Vice President of the Imaging Systems Division of Unisys. From 1992 to 1993, he was Vice President of the Software Products Group of Unisys. From 1990 to 1992 he was Vice President of Corporate Information Productivity Systems of Unisys. He is currently Vice President - Sales and Marketing. Mr. Harris joined the law firm of Day, Berry and Howard LLP in 1990 and became partner in 1998. He was appointed to the position of Corporate Secretary in January 2001. Mr. Howser joined the Company in February 1997 as Vice President - Marketing. In December of 1997, Mr. Howser assumed the responsibility of Vice President - Product Development. Prior to joining the Company, from 1989 through 1996, he was director of development for Unisys in its image program. Mr. Howser had twenty years of experience in transaction processing and OCR/image development prior to joining Unisys. He is currently Vice President - Software Development. Mr. Stelling joined the Company in 2003 as Vice President of Finance and in 2004 was named Chief Financial Officer, Vice President, Treasurer and Assistant Corporate Secretary. In his prior assignment, he was Senior Vice president of Finance and Chief Financial Officer of Gale Group, an operating unit of the Thomson Corporation. Prior to Gale, Mr. Stelling served as Vice President of Finance at Chambers Engraving Group, a unit of Dyson-Kissner-Moran, Inc, a New York based investment firm. Mr. Yantus, joined the Company in 2005 as Chief Operating Officer. Prior to joining the Company, Mr. Yantus was a founder and President of Espire Marketing, Inc., a web-based solutions provider. Prior to founding Espire, Mr. Yantus served in various positions at MSX International, a company specializing in business process outsourcing and staffing, including Senior Vice President--Business Process Outsourcing and IT (2002-2003), Vice President--Business and Technology Services (2001-2002), and General Manager--Integrated Information Solutions (1999-2001). Prior to his employment with MSX International Mr. Yantus held senior positions at Danka and Lason Systems. The executive officers are elected for a one year term effective at the conclusion of the Annual Meeting of Stockholders each year. There are no family relationships between any of the listed officers. 51 ITEM 11 - EXECUTIVE COMPENSATION -------------------------------- This information is included in the Company's definitive proxy statement to be filed under Regulation 14A for the 2005 Annual Meeting of Stockholders and is incorporated herein by reference. 52 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND -------------------------------------------------------------------------------- RELATED STOCKHOLDER MATTERS --------------------------- For information with respect to the security ownership of the Directors and Executive Officers and related stockholders matters, see the Proxy Statement to be filed under Regulation 14A for the Company's 2005 Annual Meeting of Shareholders, which is incorporated by reference herein. The Company has six equity compensation plans as of December 31, 2004. See Note H to the Notes to Consolidated Financial Statements of the Company included in this report for additional information regarding these plans. The following table gives information about the Company's equity compensation plans as of December 31, 2004.
Number of shares of Common Stock remaining available Number of shares of for future issuance under Common Stock to be Weighted -average equity compensation plans issued upon exercise of exercise price of (excluding shares outstanding options, outstanding options, reflected in the first Plan Category warrants and rights warrants and rights column) ------------------------------------------------------------------------------------------------------------------------------ Equity compensation plans approved by stockholders 1,292,983 $ 1.32 2,654,472 Equity compensation plans not approved by stockholders: Senior management options 5,692,021 .25 816,039 -------------------------------------------------------------------------- 6,985,004 $ .45 3,470,511 ==========================================================================
The Company's equity compensation plan that was not approved by stockholders is the Senior Executive Stock Option Plan. Under the Plan, individuals who were senior executive officers of the Company as of December 31, 2001 were eligible to receive a grant of a non-qualified stock option to purchase one share of common stock for each dollar of such individual's annual salary as of December 31, 2001; provided, however, that the individual was required to remain employed until June 30, 2002 before the right to exercise the option accrued. The exercise price for such options was $0.24, the closing price of the common stock on December 31, 2001. This plan was amended and restated by our Board of Directors on April 26, 2004 to permit option grants to executive officers who were employed by Scan-Optics after December 31, 2001 and to make other certain changes to the plan and, effective upon the consummation of the recapitalization, to increase the number of shares available thereunder to 6,815,114 shares. Options were granted on April 26, 2004 to two individuals for an aggregate of 55,000 shares of common stock at $0.66, the closing price of the common stock on such date. In connection with the recapitalization, each holder of options ("Old Options") was granted additional options 53 exercisable for 5.30 shares for each share issuable under the Old Options. When any options are exercised under the Senior Executive Stock Option Plan, the Lenders will transfer a like number of shares to the Company for their par value to cover the option exercise. In this way, only the Lenders, and none of the stockholders, will suffer dilution upon the exercise of such options. All options granted under the plan on December 31, 2001 were exercisable on the six month anniversary of the date of grant and all options granted thereafter were immediately exercisable in full as of the date of grant. See Note H to the Notes to Consolidated Financial Statements of the Company included in this report for additional information. 54 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS -------------------------------------------------------- This information is included under the caption "Certain Transactions" in the Company's definitive proxy statement to be filed under Regulation 14A for the 2005 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES ------------------------------------------------ This information is included under the caption "Principal Accountant Fees and Services" in the Company's definitive proxy statement to be filed pursuant to Regulation 14A for the 2005 Annual Meeting of Stockholders and is incorporated by reference. 55 PART IV ITEM 15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K ------------------------------------------------------------------------ (a) The following consolidated financial statements and report of independent auditors of the Company and its subsidiaries are included in Item 8: (1) Report of UHY LLP, Independent Registered Public Accounting Firm Report of Ernst & Young LLP, Independent Registered Public Accounting Firm Consolidated Balance Sheets at December 31, 2004 and 2003 Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2004, 2003 and 2002 Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002 Notes to Consolidated Financial Statements - December 31, 2004 (2) The following consolidated financial statement schedule is included in Item 14(a): Schedule II -- Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (3) Listing of Exhibits ------------------- *3.1(a) Amended and Restated Certificate of Incorporation dated July 16, 2004 filed as Exhibit 10.1 to the Company's quarterly report on Form 10-Q filed November 12, 2004. 3.1(b) Certificate of Designations, Preferences, Rights and Restrictions for 4% Series I Redeemable Preferred Stock dated July 16, 2004. 56 *3.2 Restated By-laws of the Company, as amended is filed as Exhibit 3.2 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 2002. *+10.2 The Scan-Optics, Inc. 1984 Incentive and Non-Qualified Stock Option Plan included in Exhibit E in the Company's Proxy Statement dated April 19, 1984 for the Annual Meeting of Stockholders held on May 17, 1984. *+10.3 The Scan-Optics, Inc. 1987 Incentive and Non-Qualified Stock Option Plan included in Exhibit B in the Company's Proxy Statement dated April 16, 1987 for the Annual Meeting of Stockholders held on May 19, 1987. *+10.4 The Scan-Optics, Inc. 1990 Incentive and Non-Qualified Stock Option Plan included in Exhibit A in the Company's Proxy Statement dated April 30, 1990 for the Annual Meeting of Stockholders held on June 12, 1990. *+10.5 The Scan-Optics, Inc. 1990 Stock Option Plan for Outside Directors included in Exhibit B in the Company's Proxy Statement dated April 30, 1990 for the Annual Meeting of Stockholders held on June 12, 1990. *+10.6 The Scan-Optics, Inc. 1990 Incentive and Non-Qualified Stock Option Plan amendment included as Item 2 in the Company's Proxy Statement dated April 14, 1994 for the Annual Meeting of Stockholders held on May 18, 1994. *+10.7 The Scan-Optics, Inc. 1990 Stock Option Plan for Outside Directors amendment included as Item 2 in the Company's Proxy Statement dated April 15, 1996 for the Annual Meeting of Stockholders held on May 15, 1996. *+10.8 The Scan-Optics, Inc. 1999 Incentive and Non-Qualified Stock Option Plan included in Exhibit A in the Company's Proxy Statement dated April 8, 1999 for the Annual Meeting of Stockholders held on May 20, 1999. *+10.9 Employment agreement, effective as of December 31, 1996, between Scan-Optics, Inc. and James C. Mavel, included as Exhibit 10.9 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 1996. *+10.10 Executive severance agreement between Joseph P. Crouch and Scan-Optics, Inc. dated November 15, 1999, is filed as Exhibit 10.10 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 1999. *+10.12 Executive severance agreement between Richard C. Goyette and Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit 10.12 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 1999. *+10.13 Executive severance agreement between Joel K. Howser and Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit 10.13 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 1999. 57 *+10.14 Executive severance agreement between Clarence W. Rife and Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit 10.14 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 1999. *+10.15 The Scan-Optics, Inc. Amended and Restated Senior Executive Stock Option Plan is filed as Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q. *+10.16 The Scan-Optics, Inc. 2002 Incentive and Non-Qualified Stock Option Plan. *10.17 Third Amended and Restated Credit Agreement dated as of March 30, 2004 among Scan-Optics, Inc., the subsidiaries of Scan-Optics, the lenders parties thereto and Patriarch Partners Agency Services, LLC, as agent, filed as Exhibit 10.20 to the Company's Annual Report on Form 10-K filed for the year ended December 31, 2003. *+10.18 Executive Severance Agreement dated as of April 1, 2004, by and between the Company and Peter H. Stelling, filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q filed August 16, 2004. *+10.19 Scan-Optics, Inc. 2004 Incentive and Non-Qualified Stock Option Plan filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q filed August 16, 2004. *+10.20 Employment Agreement effective as of March 7, 2005 between the Company and Paul Yantus, filed as Exhibit 10.1 to a report on Form 8-K filed by the Company on March 10, 2005. *10.21 Second Amended and Restated Subscription Agreement and Repurchase Agreement dated as of August 6, 2004, between the Company and ARK CLO 2000-1, LIMITED, filed as Exhibit 99.1 to the Company's report on Form 8-K filed on August 6, 2004. *22. List of subsidiaries of the Company, included as Exhibit 10.8 in the Company's Annual Report on Form 10-K filed for the year ended December 31, 1999. 23.1 Consent of UHY LLP, Independent Registered Public Accounting Firm. 23.2 Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 31.1 Certificate of the Acting Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certificate of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 58 32.1 Certification of Acting Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act. 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act. * Exhibits so marked have heretofore been filed by the Company with the Securities and Exchange Commission and are incorporated herein by reference. + Management contract for compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. (b) Reports on Form 8-K -------------------- Report on Form 8-K was filed October 13, 2004 for Changes in Registrant's Certifying Accountant. Report on Form 8-K was filed November 10, 2004 regarding third quarter of 2004 earnings. Report on Form 8-K was filed November 12, 2004 and November 24, 2004 for the Election of Directors. (c) Exhibits -------- The exhibits required by this item are included herein. (d) Financial Statement Schedule ---------------------------- The response to this portion of Item 15 is submitted as a separate section of this report. 59 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. SCAN-OPTICS, INC. ----------------- Registrant By: /s/ Logan Clarke, Jr. --------------------------------- Logan Clarke, Jr. Acting Chief Executive Officer and President Date: March 25, 2005 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. /s/ Logan Clarke Jr. --------------------------- Logan Clarke Jr. Acting Chief Executive Officer, President and a Director (Principal Executive Officer) Date: March 25, 2005 /s/ Peter H. Stelling --------------------------- Peter H. Stelling Chief Financial Officer, Vice President and Treasurer (Principal Financial and Accounting Officer) Date: March 25, 2005 /s/ John J. Holton --------------------------- John J. Holton Director March 25, 2005 /s/ Kevin Flannery --------------------------- Kevin Flannery Director March 25, 2005 /s/ Scott Schooley --------------------------- Scott Schooley Director March 25, 2005 /s/ Michael Scinto --------------------------- Michael Scinto Director March 25, 2005 /s/ Ralph J. Takala --------------------------- Ralph J. Takala Director March 25, 2005 /s/ Lynn Tilton --------------------------- Lynn Tilton Director March 25, 2005 60
SCHEDULE II SCAN-OPTICS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 (thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Additions --------------------------------- Balance at Charged to Charged to Balance at Beginning Costs and Other End of Description Of Period Expenses Accounts Deductions Period ---------------------------------------------- --------------- ---------------- ---------------- --------------- ---------------- Year ended December 31, 2004 Allowance for doubtful accounts (billed and unbilled) $ 1,134 $ 567 $ 1,463(1) $ 238 Year ended December 31, 2003: Allowance for doubtful accounts (billed and unbilled) $ 1,574 $ 22 $ 462(1) $ 1,134 Year ended December 31, 2002: Allowance for doubtful accounts (billed and unbilled) $ 1,936 $ 35 $ 397(1) $ 1,574 (1) Uncollectible accounts written off, net of recoveries.
The required information regarding the valuation allowance for deferred income tax assets is included in Note K. 61