10-Q 1 f3q_sept01.txt 10QFILING -YR ENDING SEPT 30,2001 Conformed SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarterly Period Ended September 30, 2001. or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Transition Period from __________________to _____________ . Commission File Number: 0-26494 GSE SYSTEMS, INC. (Exact name of registrant as specified in its charter) Delaware 52-1868008 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 9189 Red Branch Road, Columbia Maryland, 21045 (Address of principal executive office and zip code) Registrant's telephone number, including area code: (410) 772-3500 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ As of November 2, 2001, there were 5,218,527 shares of the Registrant's common stock outstanding. GSE SYSTEMS, INC. QUARTERLY REPORT ON FORM 10-Q INDEX PAGE PART I. FINANCIAL INFORMATION 3 Item 1. Financial Statements: Consolidated Balance Sheets as of September 30, 2001 3 and December 31, 2000 Consolidated Statements of Operations for the Three and 4 Nine Months Ended September 30, 2001 and September 30, 2000 Consolidated Statements of Comprehensive Income for 5 the Three and Nine Months Ended September 30, 2001 and September 30, 2000 Consolidated Statements of Cash Flows for the Nine 6 Months Ended September 30, 2001 and September 30, 2000 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Results of Operations 14 and Financial Condition Item 3. Quantitative and Qualitative Disclosure About Market Risk 22 PART II. OTHER INFORMATION 22 Item 1. Legal Proceedings 22 Item 2. Changes in Securities and Use of Proceeds 22 Item 3. Defaults Upon Senior Securities 22 Item 4. Submission of Matters to a Vote of Security Holders 22 Item 5. Other Information 23 Item 6. Exhibits and Reports on Form 8-K 23 SIGNATURES 25 PART I - FINANCIAL INFORMATION Item 1. Financial Statements GSE SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data) Unaudited September 30, 2001 December 31, 2000 ASSETS Current assets: Cash and cash equivalents $ 977 $ 1,465 Restricted cash 164 30 Contract receivables 18,741 14,489 Inventories 1,274 1,587 Prepaid expenses and other current assets 1,905 2,520 Deferred income taxes 877 277 ----------------------------- ------------------------- Total current assets 23,938 20,368 Investment in Avantium Technologies B.V. 7,503 2,895 Property and equipment, net 1,782 2,299 Software development costs, net 4,030 5,067 Goodwill, net 2,554 2,996 Deferred income taxes 847 847 Restricted cash 340 503 Other assets 809 974 ----------------------------- ------------------------- Total assets $ 41,803 $ 35,949 ============================= ========================= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term debt $ 1,387 $ 2,347 Accounts payable 3,228 5,669 Accrued expenses 1,410 2,115 Accrued compensation and payroll taxes 1,749 1,940 Billings in excess of revenue earned 5,901 1,366 Accrued warranty reserves 580 462 Other current liabilities 1,821 947 ----------------------------- ------------------------- Total current liabilities 16,076 14,846 Long-term debt 13,701 11,840 Accrued warranty reserves 497 550 ----------------------------- ------------------------- Total liabilities 30,274 27,236 ----------------------------- ------------------------- Stockholders' equity: Common stock $.01 par value, 18,000,000 shares authorized, shares issued and outstanding 5,218,527 in 2001 and 5,193,527 in 2000 52 52 Additional paid-in capital 22,457 22,230 Retained earnings (deficit) - at formation (5,112) (5,112) Retained earnings (deficit) - since formation (4,772) (7,555) Accumulated other comprehensive loss (1,096) (902) ----------------------------- ------------------------- Total stockholders' equity 11,529 8,713 ----------------------------- ------------------------- Total liabilities and stockholders' equity $ 41,803 $ 35,949 ============================= ========================= The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (Unaudited) Three months Nine months ended September 30, ended September 30, 2001 2000 2001 2000 Contract revenue $ 13,823 $ 13,694 $ 38,146 $ 42,119 Cost of revenue 9,469 10,022 27,538 29,460 Gross profit 4,354 3,672 10,608 12,659 Operating expenses Selling, general and administrative 2,836 4,517 8,134 12,915 Depreciation and amortization 364 404 1,065 1,273 Total operating expenses 3,200 4,921 9,199 14,188 Operating income (loss) 1,154 (1,249) 1,409 (1,529) Gain on sale of assets - - 3,273 - Interest expense, net (235) (203) (687) (523) Other income (expense), net (15) 83 118 105 Income (loss) before income taxes 904 (1,369) 4,113 (1,947) Provision (benefit) for income taxes 303 (500) 1,330 (710) Net income (loss) $ 601 $ (869) $ 2,783 $ (1,237) ============= ============= ============= ============= Basic earnings (loss) per common share $0.12 $ (0.17) $ 0.54 $ (0.24) ============= ============= ============= ============= Diluted earnings (loss) per common share $0.11 $ (0.17) $ 0.53 $ (0.24) ============= ============= ============= ============= The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands) (Unaudited) Three months Nine months ended September 30, ended September 30, ------------------------- ------------------------ 2001 2000 2001 2000 ----------- ------------ ----------- ---------- Net income (loss) $ 601 $ (869) $ 2,783 $ (1,237) Foreign currency translation adjustment 45 (344) (194) (485) ----------- ------------ ----------- ----------- Comprehensive income (loss) $ 646 $ (1,213) $ 2,589 $ (1,722) =========== ============ =========== ========== The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited) Nine months ended September 30, ----------------------------- 2001 2000 ------------- ------------- Cash flows from operating activities: Net income (loss) $ 2,783 $ (1,237) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,635 2,943 Gain on sale of assets (3,273) - Non-monetary consideration received for software licensed to Avantium Technologies B.V. - (2,895) Deferred income taxes (600) (636) Changes in assets and liabilities: Contract receivables (4,252) 2,048 Inventories, prepaid expenses and other assets 56 1,398 Accounts payable, accrued compensation and accrued expenses (3,989) (1,428) Billings in excess of revenues earned 4,535 (767) Accrued warranty reserves 65 121 Other liabilities 581 (855) ------------- ------------ Net cash used in operating activities (1,459) (1,308) ------------- ------------- Cash flows from investing activities: Capital expenditures (342) (389) Capitalized software development costs (584) (1,580) ------------- ------------- Net cash used in investing activities (926) (1,969) ------------- ------------- Cash flows from financing activities: Proceeds from issuance of notes payable to stockholder 3,350 - (Restrictions) releases of cash as collateral under line of credit, net 29 - Increase (decrease) in borrowings under lines of credit (1,144) 2,247 Proceeds from issuance of common stock 33 541 Other financing activities, net (359) (406) ------------- ------------ Net cash provided by financing activities 1,909 2,382 ------------- ------------- Effect of exchange rate changes on cash (12) (106) ------------- ------------- Net decrease in cash and cash equivalents (488) (1,001) Cash and cash equivalents at beginning of period 1,465 2,695 ------------- ------------- Cash and cash equivalents at end of period $ 977 $ 1,694 ============= ============= The accompanying notes are an integral part of these consolidated financial statements.
GSE SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Nine Months ended September 30, 2001 and 2000 (Unaudited) 1. Basis of Presentation The consolidated financial statements included herein have been prepared by GSE Systems, Inc. (the "Company") without independent audit. In the opinion of the Company's management, all adjustments and reclassifications of a normal and recurring nature necessary to present fairly the financial position, results of operations and cash flows for the periods presented have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000 filed with the Securities and Exchange Commission on April 2, 2001. 2. Basic and Diluted Earnings (Loss) Per Common Share Basic earnings (loss) per share is based on the weighted average number of outstanding common shares for the period. Diluted earnings (loss) per share adjusts the weighted average shares outstanding for the potential dilution that could occur if stock options or warrants were exercised or converted into common stock. The number of common shares and common share equivalents used in the determination of basic and diluted earnings (loss) per share were as follows: Three months Nine months ended September 30, ended September 30, ------------------------------ ------------------------------ 2001 2000 2001 2000 -------------- -------------- ------------- -------------- Weighted average shares outstanding - Basic 5,206,944 5,193,527 5,197,999 5,190,198 ============== ============== ============= ============== Weighted average shares outstanding - Diluted 5,288,752 5,193,527 5,235,330 5,190,198 ============== ============== ============= ==============
The difference between the basic and diluted number of weighted average shares outstanding for the quarters ended September 30, 2001 represents dilutive stock options and warrants to purchase shares of common stock computed under the treasury stock method, using the average market price during the period. Common stock equivalents are not considered if their effect is anti-dilutive. 3. Inventories Inventories are stated at the lower of cost, as determined by the average cost method, or market. Obsolete or unsaleable inventory is reflected at its estimated net realizable value. Inventories consist of the following: Note 3 - Inventories (in thousands) September 30, December 31, 2001 2000 ----------------- --------------- Raw materials $ 866 $ 1,084 Service parts 408 503 ----------------- --------------- Total inventories $ 1,274 $ 1,587 ================= ===============
4. Software Development Costs Certain computer software development costs are capitalized in the accompanying consolidated balance sheets. Capitalization of computer software development costs begins upon the establishment of technological feasibility. Capitalization ceases and amortization of capitalized costs begins when the software product is commercially available for general release to customers. Amortization of capitalized computer software development costs is included in cost of revenue and is determined using the straight-line method over the remaining estimated economic life of the product, not to exceed five years. Software development costs capitalized were $282,000 and $564,000 for the three months ended September 30, 2001 and 2000, respectively. Total amortization expense was $492,000 and $589,000 for the three months ended September 30, 2001 and 2000, respectively. For the nine months ended September 30, 2001 and 2000, software development costs capitalized were $584,000 and $1,580,000, respectively. Total amortization expense was $1,570,000 and $1,700,000 for the nine months ended September 30, 2001 and 2000, respectively. 5. Investment in Avantium International B.V. On February 24, 2000, the Company licensed certain of its simulation software products to Avantium International B.V. ("Avantium") in exchange for 251,501 shares of Avantium preferred stock, valued at $2.5 million, and 352,102 shares of Avantium common stock, valued at $349,000. The software license, which is perpetual in nature, gives Avantium the right to use the software in the development of new software products. Each share of preferred stock is convertible into common stock. Subject to certain restrictions, in the event that Avantium has not conducted an initial public offering (or been purchased) within five years, the Company and certain other holders of preferred shares may, at their option, have their shares redeemed by Avantium, for the greater of (i) the original purchase price plus 8% interest compounded annually plus any accrued and unpaid dividends whether or not declared, or (ii) the fair market value of the shares on an as-if-converted-into-common-shares-basis plus any accrued and unpaid dividends. Avantium was formed to develop high-speed experimentation and simulation ("HSE&S") technologies for application in new product and process development in pharmaceutical, petrochemical, fine chemical, biotechnology and polymers industries. Avantium expects to develop HSE&S technologies through in-house development and contract research at leading universities, hardware developers and informatics companies. Avantium has various investors, including Shell International Chemical, SmithKline Beecham, W.R. Grace, three major European universities and two venture capital firms. During the year ended December 31, 2000, the Company recognized software-licensing revenue of $2.9 million based on the fair value of the consideration received from Avantium. The fair value was established based on cash paid by other investors for their respective preferred and common stock interests in Avantium. The Company has delivered all elements of the software and has no other obligations to Avantium, other than standard warranty. The Company will account for its investment in Avantium using the cost method of accounting based on management's conclusion that the Company does not have significant influence with respect to the operations of Avantium. During the year ended December 31, 2000, the Company also received and completed an additional $2.9 million contract to make certain improvements and enhancements to the software on a best efforts basis for Avantium. The rates and margins in the contract were comparable to those the Company earns performing services for its existing customers. As a result of the experience with Avantium in 2000, the Company concluded that a combination of the relevant interests of the two companies would significantly increase the potential of both organizations. In addition, focusing the technical and marketing resources of Avantium and the GSE VirtualPlant team would produce significant cost savings. Accordingly, on March 6, 2001, the Company sold its VirtualPlant business to Avantium. Avantium purchased certain fixed assets and intellectual property (including BatchCAD and BatchWizard software products), obtained perpetual licenses to certain GSE Process software products, and employed certain personnel in both the US and the UK. GSE received 8% of Avantium's stock, thus increasing its holdings in Avantium to approximately 19%. Avantium and GSE will continue to work together in the marketplace and in product development so that common clients will be able to use Avantium's VirtualPlant technology to develop scalable products that will fit together at the manufacturing level with GSE's process control and simulation products. However, GSE is not obligated to provide any further support to Avantium. During the first quarter of 2001, the Company recognized a gain on the sale of its VirtualPlant business of $3.3 million, before income taxes. This gain was determined based on the estimated fair value of the Avantium stock received, based on an independent appraisal, net of the book value of the assets sold and the estimated costs to settle severance with employees terminated from GSE and other transaction expenses. GSE retains one seat on the supervisory board of Avantium. However, management has concluded that such seat does not provide the Company with significant influence. Accordingly, the Company will account for its investment in Avantium using the cost method. If a decline in fair value below cost is judged by management to be other than temporary, the cost basis will be written down to fair value as a new cost basis and the amount of the write-down will be included in earnings as a realized loss. Any new cost basis derived in this manner will not be changed for subsequent recoveries in fair value. 6. Long-term Debt The Company has a $10.0 million bank line of credit (the "Credit Facility") under which the Company and its subsidiaries, GSE Process Solutions, Inc. and GSE Power Systems, Inc., are jointly and severally liable as co-borrowers. The Credit Facility provides for borrowings to support working capital needs and foreign letters of credit ($2.0 million sublimit). The line is collateralized by substantially all of the Company's assets and provides for borrowings up to 85% of eligible accounts receivable, 50% of eligible unbilled receivables and 40% of eligible inventory (up to a maximum of $1.2 million). GP Strategies Corporation, one of the Company's major stockholders, has provided a limited guarantee totaling $1.8 million. The interest rate on this line of credit is based on the bank's prime rate plus 0.75% (6.75% as of September 30, 2001), with interest only payments due monthly. At September 30, 2001, the Company's available borrowing base was approximately $10 million, of which approximately $8.1 million had been utilized. The Credit Facility expires on March 23, 2003. The Credit Facility requires the Company to comply with certain financial ratios and precludes the Company from paying dividends and making acquisitions beyond certain limits without the bank's consent. At September 30, 2001, the Company was in compliance with the covenants. In the fourth quarter of 2000, the Company issued a demand promissory note to ManTech International Corporation ("ManTech"), one of the Company's major stockholders, that allowed the Company to borrow up to $1.8 million at an interest rate of prime plus one percent. The promissory note was secured by the Company's pledge of its equity interest in Avantium, but such security interest was subordinate to the first lien thereon by the Company's bank. In the first quarter of 2001, the Company borrowed an additional $550,000 from ManTech and the promissory note was amended to increase the principal amount to $2.1 million. Subsequently, in the first quarter of 2001, and with ManTech's approval, the Company issued a replacement promissory note in the amount of $2.1 million to ManTech pursuant to which the Company's obligations to ManTech became unsecured and the principal is payable over a two-year period, in equal installments, commencing April 1, 2004, with interest payments to commence monthly on July 1, 2001. The note permits ManTech to convert the principal into GSE convertible preferred stock at a conversion rate of $100 per share. ManTech agreed to subordinate the note to the Company's Credit Facility. In 2000, ManTech had provided $1.8 million in standby letters of credit to the bank as additional collateral for the Company's credit facility. On April 6, 2001, ManTech agreed to allow the Company's bank to draw upon the letters of credit, thus paying down a portion of the Company's bank debt in exchange for additional subordinated debt in the Company. Accordingly, the Company's promissory note to ManTech was amended to increase the amount to $3.9 million. As permitted by the note, ManTech elected to convert its debt into equity in the form of convertible preferred stock at the conversion rate of $100 per share. Thus, the Company expects to issue 39,000 shares of Series A preferred stock to ManTech in the fourth quarter 2001. The Company has determined that the conversion of this debt into preferred stock does not constitute a beneficial conversion. The Series A convertible preferred stock has no voting rights and will have a stated dividend rate of 6% per annum payable quarterly. Dividends will accumulate if not paid quarterly and interest will accrue at the stated rate on any unpaid dividends. ManTech at its discretion shall have the right to convert each share of Series A convertible preferred stock into GSE common stock at a purchase price of $2.645 per share at any time after a one-year holding period from the date of issuance. At the end of the third year from the date of issuance, the Series A convertible preferred stock automatically converts into GSE common stock. Prior to ManTech's conversion of the Series A convertible preferred stock to common stock, GP Strategies has the option to acquire 50% of the Series A convertible preferred stock for $1,950,000. On June 25, 2001, the Company issued an additional unsecured promissory note to ManTech that allowed the Company to borrow up to $1.0 million at an interest rate of prime plus one percent. The note is subordinated to the Company's Credit Facility. The note and accrued interest may be repaid from the cash receipts of a public equity offering (see Note 12, Subsequent Events). If the offering is not completed, or does not provide sufficient cash to pay off the entire promissory note and accrued interest, the principal is payable over a two-year period, in equal installments, commencing April 1, 2004, with interest payments to commence monthly on January 1, 2002. 7. Letters of Credit As of September 30, 2001, the Company was contingently liable for approximately $503,000 under four letters of credit used as payment bonds on contracts, all of which were secured by cash deposits classified as restricted cash in the consolidated balance sheet. 8. Authorized Common Stock At a special shareholder's meeting on August 2, 2001, the Company's shareholders approved an amendment to the Certificate of Incorporation increasing GSE's authorized common stock by 10 million shares to a total of 18 million shares. With this new allocation of common stock, the Company intends to issue approximately 3.7 million shares of common as follows: (a) 1,474,480 shares to cover the exchange of $3.9 million of the ManTech subordinated debt into convertible preferred stock as discussed in Note 6, Long-term Debt, and (b) 2,219,701 shares for a rights offering to non-affiliated stockholders (see Note 12, Subsequent Events). 9. Income Taxes The Company's effective tax rate is based on its best current estimate of its expected annual effective tax rate. The difference between the statutory U.S. tax rate and the Company's effective tax rate for the quarters ended September 30, 2001 and 2000 is primarily due to the effects of foreign operations being taxed at different rates, state income taxes and in 2001 the impact of deferred tax assets expected to be realized in the current year which previously had not been recognized by the Company as a result of a valuation allowance. As of September 30, 2001 and December 31, 2000, the aggregate deferred tax assets are recorded net of valuation allowances of approximately $4.8 million and $5.4 million, respectively. For the nine months ended September 30, 2001, the Company reduced its valuation allowance by approximately $600,000. The Company continues to evaluate the likelihood of realizing its remaining deferred tax assets. However, management currently believes that the remaining amounts of the Company's deferred tax assets are more likely than not to be realized. 10. Segment Information The Company's two reportable segments are its core business units Process and Power. (The Company's VirtualPlant business was reported under the Process segment.) The Company is primarily organized on the basis of these two business units. The Company has a wide range of knowledge of control and simulation systems and the processes those systems are intended to improve, control and model. The Company's knowledge is concentrated heavily in the process industries, which include the chemicals, food & beverage, and pharmaceuticals fields, as well as in the power generation industry. The Process business unit is primarily engaged in process control and simulation in a variety of commercial industries. Contracts typically range from three to nine months. The Power business unit is primarily engaged in simulation for the power generation industry, with the vast majority of customers being in the nuclear power industry. Contracts typically range from 18 months to three years. The Company evaluates the performance of its business units utilizing "Business Unit Contribution", which is substantially equivalent to earnings before interest and taxes before allocating any corporate expenses. The table below presents information about the reportable segments: (in thousands) Three months ended September 30, 2001 Nine months ended September 30, 2001 -------------------------------------------- -------------------------------------------- Process Power Consolidated Process Power Consolidated Contract revenue $ 8,268 $ 5,555 $ 13,823 $ 17,744 $ 20,402 $ 38,146 ============ ============= =============== ============ ============= =============== Business unit contribution $ 2,159 $ (21) $ 2,138 $ 2,434 $ 1,920 $ 4,354 ============ ============= =============== ============ ============= =============== Three months ended September 30, 2000 Nine months ended September 30, 2000 -------------------------------------------- -------------------------------------------- Process Power Consolidated Process Power Consolidated Contract revenue $ 6,694 $ 7,000 $ 13,694 $ 19,899 $ 22,220 $ 42,119 ============ ============= =============== ============ ============= =============== Business unit contribution $ (974) $ 860 $ (114) $ (1,721) $ 3,646 $ 1,925 ============ ============= =============== ============ ============= ===============
The Company sold its Belgian business in November 2000 and its VirtualPlant business in March 2001 (see Note 5, Investment in Avantium International B.V.). Whereas the Process segment contract revenue for the three months ended September 30, 2001 included no revenue from these divested businesses, the Process revenue for the three months ended September 30, 2000 included revenue of $1.5 million. For the nine months ended September 30, 2001 and 2000, Process revenue included $507,000 and $6.6 million, respectively, for these two divested businesses. The Process 2000 revenue also includes $2.9 million from a software-license sold to Avantium (see Note 5, Investment in Avantium International B.V.). Process business unit contribution for the three and nine months ended September 30, 2000 included losses of $1.7 million and $1.6 million, respectively, from the two divested businesses. In 2001, the Process business unit contribution included a loss for VirtualPlant of $471,000 prior to its sale in March 2001. A reconciliation of segment business unit contribution to consolidated income (loss) before taxes is as follows: (in thousands) Three months Nine months ended September 30, ended September 30, ------------------------- --------------------------- 2001 2000 2001 2000 ----------- ----------- ----------- ------------ Segment business unit contribution $ 2,138 $ (114) $ 4,354 $ 1,925 Corporate expenses (999) (1,052) (2,827) (3,349) Gain on disposition of assets - - 3,273 - Interest expense, net (235) (203) (687) (523) ----------- ----------- ----------- ------------ Income (loss) before income taxes $ 904 $ (1,369) $ 4,113 $ (1,947) =========== =========== =========== ============
11. New Accounting Standards Effective January 1, 2001, the Company adopted Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," and No. 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities." These statements require that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The adoption of these standards, including the valuation of derivative instruments outstanding on the effective date, did not have a material impact on the Company's consolidated financial statements. On July 20, 2001, the FASB issued Statement No. 141, "Business Combinations," and Statement No. 142, "Goodwill and Other Intangible Assets." Statement 141 requires that all business combinations be accounted for under a single method -- the purchase method. Use of the pooling-of-interests method no longer is permitted. Statement 141 requires that the purchase method be used for business combinations initiated after June 30, 2001. Statement 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed for impairment at least annually. The amortization of goodwill ceases upon adoption of the Statement, which for calendar year-end companies, will be January 1, 2002. In October 2001, The FASB issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The provisions of this statement are effective for fiscal years beginning after December 15, 2001. The Company does not expect the adoption of this standard to have a material impact on the Company's consolidated financial statements. 12. Subsequent Events On October 25, 2001, the Company filed a final registration statement with the SEC for a fixed price rights offering which became effective on October 29, 2001. In early November, the Company distributed to non-affiliated holders of its common stock, based on an October 26, 2001 record date, subscription rights to purchase additional shares of common stock at a subscription price of $2.53 per share. Each non-affiliated holder of its common stock received .711 subscription rights for each share held as of the record date. Shareholders have until the expiration date of December 14, 2001 to subscribe to the offering. Rights holders who exercise their rights in full will also have the opportunity to subscribe for additional shares of common stock that are not purchased by other eligible rights holders. The pricing for the rights offering was approved by the Company's board of directors on May 30, 2001 at 10% above the market price on June 15, 2001. The market price on June 15, 2001 was $2.30 per share. A 10% premium equals a rights offering price of $2.53 per share, 5% below the price per share of common stock issuable upon conversion of the preferred stock to be issued to ManTech. If all shares offered are sold, the estimated proceeds to GSE would be approximately $5.6 million before the fees and expenses related to the offering. The principal purposes of the offering are for repayment of a $1 million loan from ManTech (see Note 6, Long-term Debt), working capital, strategic acquisitions, capital expenditures and general corporate purposes. Avantium International BV, of which GSE owns approximately 19% (see Note 5, Investment in Avantium BV) requires a significant amount of additional capital to continue its business operations. We have been advised that, under the terms of a pending financing, GSE's ownership will be diluted. GSE SYSTEMS, INC. AND SUBSIDIARIES FORM 10-Q Nine Months ended September 30, 2001 and 2000 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition Cautionary Statement Regarding Forward-Looking Statements This Form 10-Q contains certain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the safe harbors created by those Acts. These statements include the plans and objectives of management for future operations, including plans and objectives relating to the development of the Company's business in the domestic and international marketplace. All forward-looking statements involve risks and uncertainties, including, without limitation, risks relating to the Company's ability to enhance existing software products and to introduce new products in a timely and cost-effective manner, reduced development of nuclear power plants that may utilize the Company's products, a long pay-back cycle from the investment in software development, uncertainties regarding the ability of the Company to grow its revenues and successfully integrate operations through expansion of its existing business and strategic acquisitions, the ability of the Company to respond adequately to rapid technological changes in the markets for process control and simulation software and systems, significant quarter-to-quarter volatility in revenues and earnings as a result of customer purchasing cycles and other factors, dependence upon key personnel, the ability of the Company to meet bank financial covenants and manage cash needs, and general market conditions and competition. See "Risk Factors," in Part I of the Company's Form 10-K for the year-ended December 31, 2000. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties as set forth herein, the failure of any one of which could materially adversely affect the operations of the Company. The Company's plans and objectives are also based on the assumptions that market conditions and competitive conditions within the Company's business areas will not change materially or adversely and that there will be no material adverse change in the Company's operations or business. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and there can, therefore, be no assurance that the forward-looking statements included in this Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in forward-looking statements, any such information included herein should not be regarded as a representation by the Company or any other person that the objectives and plans of the Company will be achieved. General Business Environment GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") develops and delivers business and technology solutions by applying process control, simulation software, systems and services to the energy, process and manufacturing industries worldwide. The Company's solutions and services assist customers in improving quality, safety and throughput; reducing operating expenses; and enhancing overall productivity. Power Simulation Business The Company's Power Simulation Business Unit ("Power") is continuing its efforts to expand its leadership in nuclear simulation technology to the fossil simulation marketplace. In the past year, GSE has released its "G-Suite" software tools which target fossil simulation applications. These new tools elevate the level of simulation beyond traditional training to allow the operator to optimize plant performance. Following a concerted global marketing effort, GSE has been awarded over $9 million of new orders for six fossil simulators in the United States and India in the last twelve months, including an award from American Electric Power in 2001 for two full-scope fossil training simulators. The deregulation of the electric power industry and the California energy crisis have underscored the importance of efficient and reliable operations of power stations. The use of simulation to address these issues has resulted in new opportunities for GSE to improve the simulation fidelity of existing simulators and the supply of new simulators around the world. While GSE simulators are primarily utilized for power plant operator training, the uses are expanding to include engineering, plant modification studies, and operation efficiency improvements for both nuclear and fossil utilities. During plant construction, simulators are used to test control strategies and ensure on-time start-up. After commissioning, the same tools can be used to increase plant availability and optimize plant performance for the life of the facility. President Bush's National Energy Policy encourages the improvement of nuclear plant operating performance from 90%, the current level, to 92%. In the second quarter of 2001, GSE released several products using advanced signal analysis techniques to help nuclear plants achieve this increase in operating performance. GSE's Pegasus Plant Surveillance and Diagnosis System(TM) helps improve plant availability, safety and economy. Pegasus is a software package for semi-automatic plant surveillance and diagnostics and enables site engineers to perform detailed analysis for specified component faults, allowing the identification of degraded performance and replacement of components before they fail. SensBase(TM) provides comprehensive sensor test services, thus ensuring that changes in transmitters and other instruments do not jeopardize the function of the nuclear plant protection systems. BRUS(TM), a noise analysis program package, is a collection of signal analysis tools which allow users to detect developing abnormalities in the plant. The Company recently entered into two strategic marketing alliances which are expected to help expand the Power business. The first alliance is with General Physics Corporation, the leading supplier of operator instructional training programs for the Power industry. Whereas GSE is the leading manufacturer of operating training simulators for the Power industry, the alliance with General Physics Corporation will allow a more encompassing solution to both companies' client base and strengthen their respective product lines. In addition to cooperating in marketing of individual products, the companies will combine some of General Physics' extensive training materials and programs with GSE's power plant simulation models to provide truly interactive and adaptive total training solutions. GSE will also help sell and distribute General Physics' GFE product to GSE's customer base. The second alliance is with Powergen's Simulator Training Systems Group, a premier supplier of simulation systems and technology for Combined Cycle Gas Turbine (CCGT) power plants. The Simulator Training Systems Group has developed a range of distributed control system emulation tools necessary to effectively simulate the control systems for fossil and nuclear power plants. Power has the extensive knowledge, models and tools necessary to simulate the functionality of power plant systems. By combining the tool sets and jointly marketing this capability worldwide, the companies believe they can both significantly expand their offering and provide greater value to users in the nuclear, fossil and CCGT power industry. The Company is also looking to leverage the technology it acquired a few years ago for plant access control and intrusion detection in light of recent security concerns at nuclear plants and other sensitive locations. The Company has implemented its software at various nuclear power plants in the US, and sees applications at other facilities. The system is the command and control center that ties together card readers, retinal scanners, closed circuit TV and other field devices used for intrusion detection and personnel access control. Process Control Business In order to return the Company's Process Control Business Unit ("Process") to profitability, the Company implemented a restructuring plan in 2000 that included personnel reductions, the outsourcing of Process' manufacturing and assembly operations, and the November, 2000 sale of Process' unprofitable European operations based in Belgium. The restructuring was completed in the first quarter 2001 with the sale of the Business Unit's VirtualPlant technology and assets to Avantium International BV ("Avantium") in exchange for Avantium stock. Avantium and GSE expect to continue to work together in the marketplace and in product development so that common clients will be able to use Avantium's VirtualPlant technology to develop scalable products that will fit together at the manufacturing level with GSE's process control and simulation products, thus speeding up market introduction and reducing the overall life cycle costs. Process released the latest version, 10.2, of its D/3 Distributed Control System(TM) software in December 2000. The new release furthers GSE's strategy of providing an open system able to seamlessly communicate with a variety of third-party hardware and software. By allowing maximum flexibility in selection of Input-Output systems, customers can take advantage of the latest control technology without costly replacement of their plant hardware. In September 2001, the Company received a $2.8 million contract from Archer Daniels Midland (ADM) to purchase upgrades for all of ADM's 24 D/3 systems worldwide to version 10.2. In addition, the Company received a $6.7 million three-year contract from Westinghouse Savannah River Company for D/3 version 10.2 hardware, licenses and services for a new Tritium Extraction processing facility. To expand within its traditional customer base, and gain new customers, Process embarked upon a program to modify its process control module (PCM) to increase its operating speed and reduce its manufacturing costs. This will allow the Company to bridge the cost gap between programmable logic controllers (PLCs) and the distributed control systems while providing the increased performance of a full-function distributed control system. Products based upon these modifications will start to be released in the fourth quarter of 2001 and continue into 2002. The Company has also initiated a campaign to find expanded distribution channels for its new products. Results of Operations The following table sets forth the results of operations for the periods presented expressed in thousands of dollars and as a percentage of revenues: (in thousands) Three months ended September 30, Nine months ended September 30, 2001 % 2000 % 2001 % 2000 % --------- ------- --------- -------- --------- -------- --------- ------- Contract revenue $13,823 100.0% $13,694 100.0% $38,146 100.0% $42,119 100.0% Cost of revenue 9,469 68.5 % 10,022 73.2% 27,538 72.2 % 29,460 69.9 % --------- ------- --------- -------- --------- -------- --------- ------- Gross profit 4,354 31.5 % 3,672 26.8 % 10,608 27.8 % 12,659 30.1 % --------- ------- --------- -------- --------- -------- --------- ------- Operating expenses: Selling, general and administrative 2,836 20.5 % 4,517 33.0 % 8,134 21.3 % 12,915 30.7 % Depreciation and amortization 364 2.6 % 404 3.0 % 1,065 2.8 % 1,273 3.0 % --------- ------- --------- -------- --------- -------- --------- ------- Total operating expenses 3,200 23.1 % 4,921 35.9 % 9,199 24.1 % 14,188 33.7 % --------- ------- --------- -------- --------- -------- --------- ------- Operating income (loss) 1,154 8.3 % (1,249) (9.1)% 1,409 3.7 % (1,529) (3.6)% Gain on sale of assets - 0.0 % - 0.0 % 3,273 8.6 % - 0.0 % Interest expense, net (235) (1.7)% (203) (1.5)% (687) (1.8)% (523) (1.2)% Other income (expense), net (15) (0.1)% 83 0.6 % 118 0.3 % 105 0.2 % --------- ------- --------- -------- --------- -------- --------- ------- Income(loss)before income taxes 904 6.5 % (1,369) 100.0% 4,113 10.8 % (1,947) (4.6)% Provision(benefit)for income taxes 303 2.2 % (500) (3.7)% 1,330 3.5 % (710) (1.7)% --------- ------- --------- -------- --------- -------- --------- ------- Net income (loss) $ 601 4.3 % $ (869) (6.3)% $2,783 7.3 % $(1,237) (2.9)% ========= ======= ========= ======== ========= ======== ========= =======
Contract Revenue. Revenue for the three and nine months ended September 30, 2001 amounted to $13.8 million and $38.1 million, respectively, as compared with revenue of $13.7 million and $42.1 million for the three and nine months ended September 30, 2000. The Process business unit's revenue was $8.3 million for the third quarter 2001, compared with $6.7 million for the third quarter 2000; revenue for the nine months ended September 30, 2001 and 2000 was $17.7 million and $19.9 million, respectively. The Company sold its unprofitable Belgian subsidiary, GSE Process Solutions N.V., on November 30, 2000 to Newton Integrated Services B.V. of the Netherlands, and sold its VirtualPlant technology and assets on March 6, 2001 to Avantium. Whereas revenues for the three months ended September 30, 2001 included no revenues from these divested businesses, the revenues for the three months ended September 30, 2000 included revenues of $1.5 million. For the nine months ended September 30, 2001 and 2000, Process revenues included $507,000 and $6.6 million, respectively, for these two divested businesses. Included in the 2000 revenues was $2.9 million from the sale of licenses for five of GSE's software products to Avantium International B.V., in exchange for an equity interest in Avantium (see Note 5, Investment in Avantium International B.V. in the Notes to Consolidated Financial Statements). Excluding the revenue for these divested businesses, the Process business unit's revenue increased $3.1 million, or 60%, in the third quarter 2001 as compared with the prior year, and increased $3.9 million , or 29%, for the nine months ended September 30, 2001 as compared to the same period in the prior year. The increase in Process' continuing business revenue is mainly attributable to two significant orders received from Westinghouse Savannah River Corporation in the third quarter 2001. The Power business unit revenue decreased 20.6% in the third quarter, from $7.0 million in 2000 to $5.6 million in 2001. Revenue for the nine months ended September 30, 2001 and 2000 was $20.4 million and $22.2 million, respectively. The decrease in revenue is attributable to the completion of several large international projects in 2001 and fewer upgrades for simulators in the United States in 2001 as compared to 2000. Gross Profit. Gross profit totaled $4.4 million (31.5% of revenue) for the quarter ended September 30, 2001, as compared with $3.7 million (26.8% of revenue) for the same period in 2000. The increase in gross margin as a percentage of revenue is largely due to the restructuring of the Process business unit, including the sale of the Belgian subsidiary and VirtualPlant businesses, the outsourcing of the Process manufacturing/assembly operation in November 2000, and personnel reductions. For the nine months ended September 30, 2001 and 2000, gross profit decreased from $12.7 million (30.1%) in 2000 to $10.6 million (27.8%) in 2001. The gross profit and gross profit margins for 2000 reflect the software licenses sold to Avantium in the first quarter 2000. Excluding the gross profit from sale of software licenses to Avantium the gross profit margin for 2000 was 24.9%. Selling, General and Administrative Expenses. Selling, general and administrative ("SG&A") expenses totaled $2.8 million in the quarter ended September 30, 2001, a 37.2% decrease from the $4.5 million for the same period in 2000. SG&A expenses for the nine months ended September 30, 2001 decreased 37.0% to $8.1 million as compared to $12.9 million for the same period in the prior year. The decreases in SG&A reflect reduced sales, marketing and corporate administration headcount, and lower net research and product development expenditures ("R&D"), as discussed below. Gross R&D totaled $499,000 in the third quarter of 2001, as compared with $1.1 million in the same period of 2000. Capitalized software development costs totaled $282,000 and $564,000 for the third quarter of 2001 and 2000, respectively. Accordingly, net R&D, expensed and included in SG&A, was $217,000 and $536,000 for the third quarters of 2001 and 2000, respectively. The Company's R&D expenditures were reduced significantly in 2001 due to the completion of three major development projects: VPbatch(TM), the Windows NT version of its FlexBatch(R) Recipe and Process Management software; initiatives to improve product ease of use of SimSuite Pro(TM), its process simulation product; and the release of version 10.2 of the D/3 Distributed Control System in December 2000. Similar reductions in R&D spending have occurred in the nine months ending September 30, 2001 versus September 30, 2000. Gross R&D spending in 2001 totaled $1.2 million versus $3.3 million in 2000; capitalized software development costs totaled $584,000 in 2001 versus $1.6 million in 2000; and net R&D, expensed and included in SG&A, was $624,000 in 2001 versus $1.7 million in 2000. R&D expenditures in 2001 are mainly related to improvements in the process control module for the Process D/3 system and the development of a high availability server system. Depreciation and Amortization. Depreciation expense totaled $197,000 and $267,000 during the quarters ended September 30, 2001 and 2000, respectively. For the nine months ended September 30, 2001 and 2000, depreciation expense was $562,000 and $888,000, respectively. The decrease in depreciation in 2001 is primarily due to disposals of fixed assets as the Company restructured its operations and divested certain businesses. Amortization of goodwill was $167,000 and $137,000 during the three months ended September 30, 2001 and 2000, respectively. During the nine months ended September 30, 2001 and September 30, 2000, amortization expense was $503,000 and $394,000, respectively. The increase in amortization in 2001 reflects the increase in goodwill due to payments made for contingent consideration for prior year acquisitions. Operating Income (Loss). The Company had operating income of $1.2 million (8.3% of revenue) in the third quarter 2001, compared with an operating loss of $1.2 million (9.1% of revenue) for the same period in 2000. For the nine months ended September 30, 2001 and September 30, 2000, operating income (loss) was $1.4 million or 3.7% of revenue and ($1.5) million or (3.6)% of revenue, respectively. Excluding the operating results of the divested businesses, the Company's operating income for the third quarter 2001 was $1.2 million compared with $722,000 for the third quarter 2000 and for the nine months ended September 30, 2001 was $1.9 million compared with $810,000. The Company attributes its business restructuring initiatives for the improvement in operating income of its remaining businesses. Gain on Sale of Assets. On March 6, 2001, the Company sold its VirtualPlant business technology and assets to Avantium. GSE received 8% of Avantium's stock, thus increasing its holdings in Avantium to approximately 19%, and recognized a gain on the sale of $3.3 million, before income taxes. This gain was determined based on the estimated fair market value of the Avantium stock received, based on an independent appraisal, less the book value of the assets sold, approximately $700,000 in severance costs payable to certain former employees of VirtualPlant that were not hired by Avantium (these amounts will be paid during the balance of 2001), and other transaction expenses. Interest Expense, Net. Net interest expense increased to $235,000 for the quarter ended September 30, 2001, from $203,000 for the same period in 2000. For the nine months ended September 30, 2001 and September 30, 2000, net interest expense totaled $687,000 and $523,000, respectively. These increases are primarily attributable to an increase in the Company's average debt outstanding during the 2001 period in order to fund working capital requirements. Other Income (Expense), Net. Other income (expense) mainly reflects the receipt of $147,000 equity distribution from the Company's liquidated Joint Venture in China (this investment was written off in a prior year) offset by net foreign currency transaction losses. Provision for Income Taxes. The Company's effective tax rate is based on the best current estimate of its expected annual effective tax rate. The difference between the statutory U.S. tax rate and the Company's effective tax rate for the quarters ended September 30, 2001 and 2000 is primarily due to the effects of foreign operations being taxed at different rates, state income taxes and in 2001 the impact of deferred tax assets expected to be realized in the current year which previously had not been recognized by the Company as a result of a valuation allowance. As of September 30, 2001 and December 31, 2000, the aggregate deferred tax assets are recorded net of valuation allowances of approximately $4.8 million and $5.4 million, respectively. For the nine months ended September 30, 2001, the Company reduced its valuation allowance by approximately $600,000. The Company continues to evaluate the likelihood of realizing its remaining deferred tax assets. Liquidity and Capital Resources As of September 30, 2001, the Company's cash and cash equivalents totaled $977,000, compared to $1,694,000 at September 30, 2001. The decrease in cash from September 30, 2000 to September 30, 2001 was mainly attributable to cash used in operating activities and investing activities partially offset by cash provided by financing activities. Cash from operating activities. Net cash used in operating activities was $1.5 million and $1.3 million for the nine months ended September 30, 2001 and 2000, respectively. The gain on the Company's sale of its VirtualPlant technology and assets to Avantium International B.V. in March 2001 ($3.3 million) was a non-monetary exchange that had no impact on the Company's operating cash flow in 2001. Likewise, the Company's $2.9 million licensing of software to Avantium in the first quarter 2000 for an equity stake in Avantium was also a non-monetary transaction. Significant changes in the Company's assets and liabilities in 2001 included an increase in contract receivables of $4.3 million, a $4.2 million reduction in accounts payable and accrued expenses, and a $4.5 million increase in billings in excess of revenues earned. Cash used in investing activities. Net cash used in investing activities for the first nine months of 2001 was $914,000, including $584,000 of capitalized software development costs and $330,000 for capital expenditures. For the comparable period of 2000, net cash used in investing activities was $1,969,000, comprised of $1,580,000 of capitalized software development costs and $389,000 of capital expenditures. The decrease in capitalized software costs was due to the completion of several development projects. Cash used in financing activities. Cash used in financing activities was $1.9 million in the nine month period ended September 30, 2001 as compared to cash generated from financing activities of $2.4 million in the nine month period ended September 30, 2000. In 2001, the Company reduced its borrowings under its bank line of credit by $1.1 million to a total of $8.1 million (versus an increase in the Company's bank line of credit of $2.2 million in 2000), but increased its borrowings from ManTech by $3.4 million to a total of $4.9 million.In 2000, GSE generated $500,000 from the sale of stock to ManTech. Other. The Company has a $10.0 million bank line of credit (the "Credit Facility") under which the Company and its subsidiaries, GSE Process Solutions, Inc. and GSE Power Systems, Inc., are jointly and severally liable as co-borrowers. The Credit Facility provides for borrowings to support working capital needs and foreign letters of credit ($2.0 million sublimit). The line is collateralized by substantially all of the Company's assets and provides for borrowings up to 85% of eligible accounts receivable, 50% of eligible unbilled receivables and 40% of eligible inventory (up to a maximum of $1.2 million). GP Strategies Corporation, a major stockholder, has provided a limited guarantee totaling $1.8 million. The interest rate on this line of credit is based on the bank's prime rate plus 0.75% (6.75% as of September 30, 2001), with interest only payments due monthly. At September 30, 2001, the Company's available borrowing base was approximately $10 million, of which approximately $8.1 million had been utilized. The Credit Facility requires the Company to comply with certain financial ratios and precludes the Company from paying dividends and making acquisitions beyond certain limits without the bank's consent. At September 30, 2001, the Company was in compliance with the bank covenants. In the fourth quarter of 2000, the Company had issued a demand promissory note to ManTech that allowed the Company to borrow up to $1.8 million at an interest rate of prime plus one percent. The promissory note was secured by the Company's pledge of its equity interest in Avantium, but such security interest was subordinate to the first lien thereon by the Company's bank. In the first quarter of 2001, the Company borrowed an additional $550,000 from ManTech and the promissory note was amended to increase the principal amount to $2.1 million. Subsequently, in the first quarter of 2001, and with ManTech's approval, the Company issued a replacement promissory note in the amount of $2.1 million to ManTech pursuant to which the Company's obligations to ManTech became unsecured and the principal is payable over a two-year period, in equal installments, commencing April 1, 2004, with interest payments to commence monthly on July 1, 2001. The note permits ManTech to convert the principal into GSE convertible preferred stock at a conversion rate of $100 per share. ManTech agreed to subordinate the note to the Company's credit facility. In 2000, ManTech provided $1.8 million in standby letters of credit to the bank as additional collateral for the Company's Credit Facility. On April 6, 2001, ManTech agreed to allow the Company's bank to draw upon ManTech's $1.8 million letter of credit which supported the Company's credit facility, thus paying down a portion of the Company's bank debt in exchange for additional subordinated debt in the Company. Accordingly, the Company's promissory note to ManTech was amended to increase the amount to $3.9 million. As permitted by the note, ManTech has elected to convert its debt into equity in the form of Series A convertible preferred stock at the conversion rate of $100 per share. Thus, the Company expects to issue 39,000 shares of Series A preferred stock to ManTech in the fourth quarter 2001. The Company has determined that the conversion of this debt into preferred stock does not constitute a beneficial conversion. The Series A convertible preferred stock has no voting rights and will bear dividends at the rate of 6% per annum payable quarterly. Dividends will accumulate if not paid quarterly and compounded interest will accrue on any unpaid dividends. ManTech at its discretion shall have the right to convert each share of Series A convertible preferred stock into GSE common stock at a purchase price of $2.645 per share at any time after a one-year holding period from the date of issuance. At the end of the third year from the date of issuance, the Series A convertible preferred stock automatically converts into GSE common stock. Prior to ManTech's conversion of the Series A convertible preferred stock to common stock, GP Strategies has the option to acquire 50% of the Series A convertible preferred stock for $1,950,000. At a special shareholder's meeting on August 2, 2001, the Company's shareholders approved an amendment to the Certificate of Incorporation increasing GSE's authorized common stock by 10 millions shares to a total of 18 million shares. With this new allocation of common stock, the Company intends to issue approximately 3.7 million shares of common as follows: (a) 1,474,480 shares to cover the exchange of $3.9 million of the ManTech subordinated debt into convertible preferred stock as discussed above, and (b) 2,219,701 shares for a rights offering to non-affiliated stockholders. On October 25, 2001, the Company filed a final registration statement with the SEC for a fixed price rights offering which became effective on October 29, 2001. In early November, the Company distributed to non-affiliated holders of its common stock, based on an October 26, 2001 record date, subscription rights to purchase additional shares of common stock at a subscription price of $2.53 per share. Each non-affiliated holder of its common stock received .711 subscription rights for each share held as of the record date. Shareholders have until the expiration date of December 14, 2001 to subscribe to the offering. Rights holders who exercise their rights in full will also have the opportunity to subscribe for additional shares of common stock that are not purchased by other eligible rights holders. The pricing for the rights offering was approved by the Company's board of directors on May 30, 2001 at 10% above the market price on June 15, 2001. The market price on June 15, 2001 was $2.30 per share. A 10% premium equals a rights offering price of $2.53 per share, 5% below the price per share of common stock issuable upon conversion of the preferred stock to be issued to ManTech. If all shares offered are sold, the estimated proceeds to GSE would be approximately $5.6 million before the fees and expenses related to the offering. The principal purposes of the offering are for repayment of a $1 million loan from ManTech (see below), working capital, strategic acquisitions, capital expenditures and general corporate purposes. On June 25, 2001, the Company issued an additional unsecured promissory note to ManTech that allowed the Company to borrow up to $1.0 million at an interest rate of prime plus one percent. The Company used the loan proceeds for working capital purposes. The note is subordinated to the Company's credit facility. The note and accrued interest may be repaid from the cash receipts of the contemplated rights offering. If the rights offer is not completed, or does not provide sufficient cash to pay off the entire promissory note and accrued interest, the principal is payable over a two period, in equal installments, commencing April 1, 2004, with interest payments to commence monthly on January 1, 2002. The Company has undertaken a number of initiatives during 2000 and 2001 to improve operating results and cash flows. Management believes the initiatives undertaken will enable the Company to maintain compliance with the bank financial covenants as well as provide sufficient cash flow to meet the Company's obligations as they become due. Item 3. Quantitative and Qualitative Disclosure about Market Risk The Company's market risk is principally confined to changes in foreign currency exchange rates and potentially adverse effects of differing tax structures. The Company's exposure to foreign exchange rate fluctuations arises in part from inter-company accounts in which costs incurred in one entity are charged to other entities in different foreign jurisdictions. The Company is also exposed to foreign exchange rate fluctuations as the financial results of all foreign subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, those results when translated may vary from expectations and adversely impact overall expected profitability. The Company is also subject to market risk related to the interest rates on its existing line of credit. As of September 30, 2001, such interest rates are based on the bank's prime rate plus 75 basis-points. As of September 30, 2001, $13 million of the Company's debt was subject to variable interest rates. A 100 basis-point change in such rates during the quarter and nine months ended September 30, 2001 would have increased the Company's interest expense by approximately $28,000 and $82,000, respectively. PART II - OTHER INFORMATION Item 1. Legal Proceedings In accordance with its conduct in the ordinary course of business, certain actions and proceedings are pending to which the Company is a party. In the opinion of management, the aggregate liabilities, if any, arising from such actions are not expected to have a material adverse effect on the financial condition of the Company. Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders Proposal For Against Abstain Votes Withheld ------------------------------------------------------ ------------ ----------- ----------- ------------- 1) Amendment to the Company's Certificate 3,807,790 418,645 300 -- of Incorporation increasing the Company's authorized common stock from 8,000,000 shares to 18,000,000 shares 2) Approve an amendment to the Company's 2,667,591 472,774 485 1,085,885 1995 Long-Term Incentive Plan
Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits None (b) Reports on Form 8-K The Company filed a report on Form 8-K effective July 31, 2001 regarding the following transactions: (a) On January 1, 1999, GSE Systems, Inc. entered into employment agreements with Directors Jerome I. Feldman, George J. Pedersen, Scott N. Greenberg, and John A. Moore, Jr. to serve as executive employees, providing strategic planning in acquisitions and divestitures, management of financing arrangements, and customer and other business development activities. (b) On March 10, 2000, GSE Systems, Inc. entered into certain change of control agreements with the following current employees: Jerry Jen, President and COO, Jeffery G. Hough, Senior Vice President and Chief Financial Officer, Gill R. Grady, Senior Vice President, and Dion Freedman, Vice President (Process Business). (c) On May 3, 2001, GSE Systems, Inc. established an Executive Compensation Plan for Jerry Jen, who was appointed President on March 27, 2001. This report on Form 8-K included the Executive Compensation Plan between GSE Systems, Inc. and Jerry Jen filed as an exhibit. (d) On June 25, 2001, GSE Systems, Inc. issued a promissory note to ManTech International Corporation, one of its largest stockholders, in the amount of $1 million at an interest rate of prime plus 1% and used the loan proceeds for working capital purposes. This report on Form 8-K included the Promissory Note issued by GSE Systems, Inc. to ManTech International Corporation dated June 25, 2001 filed as an exhibit. The Company filed a report on Form 8-K effective August 15, 2001 regarding the following transactions: (a) On September 13, 1999, GSE Systems, Inc. issued Warrant Agreements to stockholders GP Strategies Corporation and ManTech International Corporation in consideration for their respective guarantees/support services in connection with Registrant's credit facilities. The essential terms and conditions of each Warrant Agreement are as follows: (1) number of warrants: 150,000 shares of GSE common stock; (2) warrant price: exercise price of $2.375 per share (reflecting the market price as of the date the board of directors approved the granting of the warrants); and (3) term of warrant: through August 16, 2003. This report on Form 8-K included the Warrant Agreement No. 1 dated September 13, 1999 between GSE Systems, Inc. and ManTech International Corporation; Warrant Agreement No. 2 dated September 13, 1999 between GSE Systems, Inc. and GP Strategies Corporation filed as exhibits. (b) On April 6, 2001, GSE Systems, Inc. entered into the Allonge and First Modification to Replacement Promissory Note with ManTech International Corporation. The essential terms and conditions of this Allonge are as follows: (1) ManTech had previously guaranteed the Registrant's credit facility up to $1.8 million, in the form of two separate letters of credit; (2) ManTech agreed to allow the Registrant's bank to draw down the full amount of the letters of credit, thereby reducing Registrant's debt level with the bank; and (3) as a result, the principal amount of the loan from ManTech increased by $1.8 million, from $2.1 million to $3.9 million. This report on Form 8-K included the Allonge and First Modification to Replacement Promissory Note dated April 6, 2001 between GSE Systems, Inc. and ManTech International Corporation filed as an exhibit. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: November 14, 2001 GSE SYSTEMS, INC. /S/ CHIN-OUR JERRY JEN Chin-Our Jerry Jen Chief Operating Officer and President (Principal Executive Officer) /S/ JEFFERY G. HOUGH Jeffery G. Hough Senior Vice President and Chief Financial Officer (Prinipal Financial and Accounting Officer)