ITEM 1. BUSINESS
INTRODUCTION
Digital Solutions, Inc. ("DSI" or "the Company"), was founded in 1969 as a payroll service company and has evolved into a leading provider of human resource management services to a wide variety of industries in 40 states.
DSI currently offers three general categories of services: (1) professional employer organization ("PEO") services, (2) employer administrative services, such as payroll processing, personnel and administration, benefits administration and tax filing; and, (3) contract staffing, or the placement of temporary and permanent employees. DSI currently furnishes PEO, payroll and contract staffing services to over 1,300 client organizations with approximately 5,100 worksite PEO and staffing employees, and believes that it currently ranks, in terms of revenues and worksite employee base, as one of the largest professional employer organizations in the United States. In addition, DSI places temporary help in hospitals and clinics throughout the United States through its Houston, Texas and Clearwater, Florida offices. The Company has three regional offices in South Plainfield, New Jersey; Houston, Texas; and Clearwater, Florida and six sales service centers in New York, New York; Ridgedale, Mississippi; El Paso and Houston, Texas; Clearwater, Florida; and South Plainfield, New Jersey.
Essentially, the Company provides services that function as the personnel department for small to medium sized companies. The Company believes that by offering services which relieve small and medium size businesses of the ever increasing burden of employee related record keeping, payroll processing, benefits administration, employment of temporary and permanent specialized employees and other human resource functions, the Company will position itself to take advantage of a major growth opportunity during this decade and the next.
Recognizing the desire by many small businesses to be relieved not only of the human resource administrative functions, but also of the responsibility to manage employees and oversee operational tasks ancillary to their core business, the Company has formulated a strategy of emphasizing PEO and "outsourcing" services. In PEO, a service provider becomes an employer of the client company's employees and provides these employees to the client to perform their intended functions at the worksite. In outsourcing, the service provider is not only responsible for human resource administration but also assumes ultimate responsibility for management of the employees and their job functions. For example, a provider of outsourcing services could be engaged by a hospital or clinic to manage the maintenance and operation of the facility. The medical staff would still be responsible for the medical functions but the physical plant would be managed by the provider.
DSI is focusing its future growth on the PEO and outsourcing industry. The Company's expansion program will focus on internal growth through the cross marketing of its PEO services to its entire client base and the acquisition of compatible businesses strategically situated in new areas
or with a client base serviceable from existing facilities.
DSI is now committed to focusing on the PEO and outsourcing industry for its future growth and to convert Staff-Rx, the Company's medical contract staffing subsidiary, into more than a staffing business by focusing on PEO, outsourcing and facilities management. While DSI will continue to sell stand-alone employer services, such as payroll and tax filing, it will emphasize the PEO component of its service offerings with a goal of becoming the leading provider of PEO services in the United States. A major component of the Company's growth strategy is the acquisition of well situated independent PEO companies whose business can be integrated into the Companies operations. However, there can be no assurance any such acquisition will be consummated by the Company.
Digital Solutions, Inc. was organized under the laws of the State of New Jersey on November 25, 1969 and maintains executive offices at 4041 Hadley Road, South Plainfield, New Jersey 07080 where its telephone number is (908) 561-1200.
GENERAL BUSINESS DEVELOPMENTS DURING THE LAST FISCAL YEAR
BANK CREDIT LINE
In February, 1995, the Company renewed its one year revolving credit line agreement with Summit Bank ("Summit"). The renewed line provides credit to the Company at the lesser of $3,500,000 or 70% of accounts receivable balances under 60 days. Interest on the loan is two and one-half percent over the bank's floating base rate payable monthly. The Company utilizes the proceeds to fund general working capital. The loan is collateralized by all of the Company's receivables and contains certain covenants which require the Company to maintain certain ratios on interest coverage, current ratio, total tangible capital funds and total non-subordinated liabilities to tangible net worth plus subordinated debt. The loan was not renewed in January 1996 and the Company has been negotiating with prospective lenders for a new line of credit. Summit has extended the loan periodically during the negotiations with new lenders and the last extension expired December 31, 1996. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
RECENT FINANCINGS
PRIVATE PLACEMENT
The Company offered and sold, in a private placement to "accredited investors", 2,293,929 Shares, at prices ranging from $1.20 to 4.00 per Share, for aggregate gross proceeds of approximately $5,100,000 during the period commencing November 1995 to June 15, 1996 (the "November 1995 Offering"). The Company paid selling commissions of 8% of the purchase price of the Shares sold in the November 1995 Offering and issued Selling Agent Warrants equal to 10% of the Shares sold by all selling agents authorized to accept such commissions. The Company issued
252,013 Selling Agent Warrants in the November 1995 Offering, of which 100,000 Selling Agent Warrants were issued to an investor purchasing 600,000 Shares in the November 1995 Offering. In addition, the Company paid the selling agents a nonaccountable expense allowance of 1% of the aggregate offering price of the Shares sold by such selling agent.
SERVICES
PROFESSIONAL EMPLOYER ORGANIZATION (PEO)
The Company's core business, and the area management intends to promote, is its PEO services. When a client utilizes the Company's PEO services, the client administratively transfers all or some of its employees to DSI which then provides them to the client. DSI thereby becomes the recognized legal co-employer and is responsible for all human resource functions, including payroll, benefits administration, tax reporting and personnel record keeping. The client still manages the employees and determines salary and duties in the same fashion as any employer. However, the client is relieved of reporting and tax filing requirements and other administrative tasks. Moreover, because of economies of scale, DSI is able to negotiate favorable terms on workers' compensation insurance, health benefits, retirement programs, and other valuable services. The client company benefits because it can now offer its employees the same or similar benefits as its larger competitors, and successfully compete in recruiting highly qualified personnel, as well as build the morale and loyalty of its staff.
The benefits DSI can offer include:
COMPREHENSIVE MAJOR MEDICAL PLANS -- DSI believes that medical insurance costs have forced small employers to reduce coverage provided to its employees and to increase employee contributions. DSI is able to leverage its large employee base and allow their clients to offer a variety of health coverage plans from traditional indemnity plans to Health Maintenance Organizations (HMO) or Preferred Provider Organizations (PPO).
DENTAL AND VISION COVERAGE -- Such coverage is generally beyond the reach of most small groups, but it is a cost effective option which can be provided by DSI.
LIFE INSURANCE -- Affordable basic coverage is available, plus optional supplemental life.
SECTION 125 PREMIUM CONVERSION PLAN -- Employees can pay for benefits with pre-tax earnings, reduce their taxable income and FICA payments, and increase their take-home pay.
401(K) RETIREMENT PLANS -- DSI believes that most small groups are not provided with any significant retirement benefits due to the administrative and regulatory requirements associated with the establishment and maintenance of retirement plans. DSI enables small business owners to offer their employees retirement programs comparable to those of major corporations. Such plans can be used to increase morale, productivity and promote employee loyalty.
CREDIT UNION -- An opportunity for employees to borrow money at lower interest than
offered at most banks.
PAYROLL SERVICES -- Although ancillary to the PEO services, clients no longer incur the expense of payroll processing either through in-house staff or outside service. DSI's PEO services include all payroll and payroll tax processing.
UNEMPLOYMENT COMPENSATION COST CONTROL -- DSI provides an unemployment compensation cost control program to aggressively manage unemployment claims.
HUMAN RESOURCES MANAGEMENT SERVICES -- DSI can provide clients with expertise in areas such as personnel policies and procedures, hiring and firing, training, compensation and performance evaluation.
WORKERS COMPENSATION PROGRAM -- DSI has a national workers compensation policy which can provide DSI with a significant advantage in marketing its services, particularly in jurisdictions where workers compensation policies are difficult to obtain at reasonable costs. DSI also provides its clients with independent safety analysis and risk management services to reduce worker's injuries and claims.
By relieving client companies of personnel administrative tasks, the client is able to focus on its core business. The client is also able to offer a broader benefits package for its employees, a competitive rate in workers' compensation insurance, and savings in time and paperwork previously required in connection with personnel administration.
PAYROLL SERVICES
DSI was established as a payroll service firm in 1969, and continues to provide basic payroll services to its clients. Historically, DSI provided these services primarily to the construction industry and currently 60% of the Company's approximately 1,000 payroll service clients are in the construction industry. DSI offers most, if not all, of what other payroll services provide, including the preparation of checks, government reports, W-2's (including magnetic tape filings), remote processing (via modem) directly to the clients offices, and service.
In addition, DSI offers a wide array of tax reporting services including accrual of tax summaries, timely deposit of taxes, impounding of tax refunds, filing of returns, distribution of quarterly and year-end statements and responding to agency inquiries.
CONTRACT STAFFING SERVICES
DSI's staffing subsidiaries have, in the aggregate, more than 26 years of experience in placing permanent and temporary employees with specialized skills and talents with regional, national and international employers. Contract Staffing enables clients to attain management and productivity goals by matching highly trained professionals and technical personnel to specific project requirements. DSI works in two specific markets where it places people on a temporary long term assignment, or on a
permanent basis: (1) technical employees such as engineers, information systems specialists and project managers primarily with Fortune 100 companies for specific projects, and, (2) radiologists, therapists, nurses, doctors with hospitals, clinics and therapy centers throughout approximately 40 states. Clients whose staff requirements vary depending on the level of current projects or business are able to secure the services of highly qualified individuals on an interim basis.
DSI's staffing services provide clients with the ability to "rightsize"; that is, expand or reduce its workforce in response to changing business conditions. DSI provides numerous benefits to the client, such as saving the costs of salary and benefits of a permanent employee whose services are not needed throughout the year. The client also avoids the costs, uncertainty and delays associated with searches for qualified interim employees. The Company also provides insurance bonding where necessary and assumes all responsibility for payroll tax filing and reporting functions, thereby saving the client administrative responsibility for all payroll, workers' compensation, unemployment and medical benefits.
DSI also increases the pool of qualified applicants for the client since contract staffing employees have access to a wide array of benefits such as health and life insurance, Section 125 premium conversion plans, and 401(k) retirement plans. These benefits provide interim employees with the motivation of full-time workers without additional benefit costs to the client. A client is also able to temporarily rehire a retired employee for short-term or specialized projects without jeopardizing their pension plan.
ACQUISITION STRATEGY
A key component of the Company's growth strategy has been, and will continue to be, the acquisition of compatible businesses to expand its operations and customer base. Currently, the human resource service industry includes numerous small companies seeking to develop services, operations and customer base similar to those developed by the Company. The Company has actively acquired companies in the human resource industry during the last four years. However, with the business and strategy of the Company further developed, acquisitions in the future will be concentrated in the PEO and outsourcing business. The Company believes that with a limited number of key acquisitions of regional PEO companies who possess a strong customer base and regional reputation, the Company will be able to grow into an industry leader, in not only revenue size, but in scope of services offered.
A prospective acquisition candidate may be either a public or private company, but will be required to meet certain financial criteria and growth potential established by the Company. The Company evaluates acquisition candidates by analyzing the company's management, operations and customer base, which must complement or expand the Company's operations; financial stability, including the company's profitability and cash flow. The Company's long term plan is to expand sales and income potential by achieving economies of scale as it expands and regionalizes its revenue base. However, there can be no assurance that the Company will be able to successfully identify, acquire and integrate into the Company operations, compatible PEO companies.
CUSTOMERS
The Company's customer base consists of over 1,300 client companies, representing approximately 29,000 employees (including payroll services) as of September 30, 1996. The Company's client base is broadly distributed throughout a wide variety of industries; however, approximately 60% of the customers in the payroll processing area are in the construction industry and substantially all of Staff-RX customers are in the healthcare industry.
The Company intends to maintain diversity within its client base to lower its exposure to downturns or volatility in any particular industry and help insulate the Company to some extent from general economic cycles. All prospective customers are also evaluated individually on the basis of workers' compensation risk, group medical history, unemployment history and operating stability.
SALES AND MARKETING
The Company has established sales teams in all of its locations.
Sales personnel offer a full array of DSI services, professional employment, payroll and contract staffing, which supports the cross-marketing of DSI's products and enables the sales representative to employ a professional consultative approach to satisfying clients needs rather than forcing a single solution.
All sales personnel have quotas and are held accountable on a weekly basis with a sales meeting held in each location where the activity for the week is discussed.
The Company has also implemented several focused marketing activities to increase sales opportunities. DSI has been licensed by the various state Boards of Accountancy to hold continuing professional education seminars for CPAs. In addition, the Company has become an active participant in many trade and community associations and chambers of commerce.
Finally, the Company has signed an agreement as the exclusive professional employment provider for a natonal buying group, the American Gem Society. The Company will attempt to expand these relationships in the future.
COMPETITION
The PEO industry consists of approximately 2,200 companies, most of which serve a single market or region. The Company believes that there are several PEOs with annual revenue exceeding $500 million. The largest PEO is Staff Leasing of Bradenton, Florida with revenue in excess of $1 billion. While there are several other large PEOs among the approximately 2,200 companies, many are located in Florida and other states in the Sunbelt. The Company considers its primary competition to be these large national and regional PEO providers, as well as the traditional form of employment of employees.
The payroll services industry is characterized by intense competition. The principal competitive factors are price and service. Management believes that Automatic Data Processing, Inc., and Paychex, Inc. which each purchased PEOs in Florida, will be major competitors in the future. The Company also competes with manual payroll systems sold by numerous companies, as well as other providers of computerized payroll services including banks, and smaller independent companies. Some companies have in-house computer capability to generate their own payroll documents and reports. The increasing availability of personal computers at low cost may result in additional businesses acquiring such capabilities. In the area of providing temporary technical and medical personnel, the Company competes with companies such as Volt Information Services, Butler Arde and Tech Aid, Inc., among others. Many of these competitors have longer operating histories and greater financial resources than the Company.
The Company competes with these companies by offering customized products, personalized service, competitive prices and specialized personnel to satisfy a client's particular employee requirements.
DSI believes that its broad scope of human resource management services and its commitment to quality service will differentiate it from its competition. Many companies compete in the various segments of the human resource and financial services marketplace. However, the Company believes there are none which compete in all of them and offer the broad range of services which the Company offers. DSI believes that its concentration on providing comprehensive services and moving into facilities management or outsourcing of human resource management services will set it apart from its competitors. While many of the PEOs entered the industry as a result of workers' compensation or health insurance problems, DSI is establishing itself as a professional employer organization which will assist companies, small and large, with all of their human resource management challenges.
INDUSTRY REGULATION
INTRODUCTION
The Company's operations are affected by numerous federal and state laws relating to labor, tax and employment matters. By entering into a co-employer relationship with employees who are assigned to work at client company locations (sometimes referred to as "worksite employees"), the Company assumes certain obligations and responsibilities of an employer under these federal and state laws. Many of these federal and state laws were enacted prior to the development of nontraditional employment relationships, such as professional employer organizations, temporary employment, and outsourcing arrangements, and do not specifically address the obligations and responsibilities of nontraditional employers. In addition, the definition of "employer" under these laws is not uniform. Accordingly, the application of these laws to the Company's business cannot be assured.
Some governmental agencies that regulate employment and labor laws have developed rules that specifically address labor and employment issues raised by the relationship among clients and PEOs. Existing regulations are relatively new and, therefore, their interpretation and application by administrative agencies and federal and state courts is limited or non-existent. The development of
additional regulations and interpretation of existing regulations can be expected to evolve over time. The Company cannot predict with certainty the nature or direction of the development of federal, state and local regulations.
As an employer, the Company is subject to all federal statutes and regulations governing its employer-employee relationships.
FEDERAL EMPLOYMENT TAXES
The Company assumes the sole responsibility and liability for the payment of federal and state employment taxes with respect to wages and salaries paid to its employees, including worksite employees. There are essentially three types of federal employment tax obligations: (i) withholding of income tax requirements governed by Code Section 3401, et seq.; (ii) obligations under FICA, governed by Code Section 3401, et seq.; and, (iii) obligations under the Federal Unemployment Tax Act (FUTA), governed by Code Section 3301, et seq.
Under these Code sections, employers have the obligation to withhold and remit the employer portion and, where applicable, the employee portion of these taxes. There is still considerable uncertainty as to the status of leased employees in relation to these statutes. While the Company believes that it can assume the client company's withholding obligations, in the event the Company fails to meet these obligations, the client company may be held jointly and severally liable for these payments. These interpretive uncertainties may have an impact on the Company's PEO business.
EMPLOYEE BENEFIT PLANS
The Company offers various employee benefit plans to its employees, including its worksite employees. These plans include the 401(k) Plan (a profit-sharing plan with a cash or deferred arrangement ("CODA") under Code Section 401(k), a Section 125 plan, a group health plan, a group life insurance plan and a group disability insurance plan. Generally, employee benefit plans are subject to provisions of both the Code and the Employee Retirement Income Security Act ("ERISA").
In order to qualify for favorable tax treatment under the Code, the plans must be established and maintained by an employer for the exclusive benefit of its employees. In addition to the employer/employee threshold, pension and profit-sharing plans, including plans that offer CODAs under Code Section 401(k) and matching contributions under Code Section 401(m), must satisfy certain other requirements under the Code. These other requirements are generally designed to prevent discrimination in favor of highly compensated employees to the detriment of non-highly compensated employees with respect to both the availability of, and the benefits, rights and features offered, in qualified employee benefit plans.
Employee pension and welfare benefit plans are also governed by ERISA. ERISA defines "employer" as "any person acting directly as an employer, or indirectly in the interest of an employer, in relation to an employee benefit plan." ERISA defines the term "employee" as "any individual employed by an employer." A definitive judicial interpretation of "employer" in the context of a PEO
arrangement has not been established. If the Company were found not to be an employer for ERISA purposes, its plans would not comply with ERISA,and, the level of services the Company could offer may be adversely affected. Further, as a result of such finding, the Company and its plans would not enjoy the preemption of state laws provided by ERISA and could be subject to varying state laws and regulations, as well as to claims based upon state common laws.
In addition to ERISA and the Code provisions discussed herein, issues related to the relationship between the Company and its worksite employees may also arise under other federal laws, including other federal income tax laws.
STATE REGULATION
As an employer, the Company is subject to all statutes and regulations governing the employer-employee relationship. The Staff Leasing Services Licensing Act (the "Act") now regulates PEOs in Texas. The Act, which became effective on September 1, 1993, established a mandatory licensing scheme for PEOs and expressly recognizes a licensee as the employer of the assigned employee for purposes of the Texas Unemployment Compensation Act. The Company possesses a license to offer PEO services in the state of Texas.
While many states do not explicitly regulate PEOs, approximately 16 states have passed laws that have licensing or registration requirements for PEOs and other states are considering such regulation. Such laws vary from state to state, but generally provide for monitoring the fiscal responsibility of PEOs. Whether or not a state has licensing, registration or certification requirements, the Company faces a number of other state and local regulations that could impact its operations. The Company is currently licensed in Florida and New Mexico as well as Texas.
EMPLOYEES
As of January 10, 1997, the Company employed 133 employees, both full-time and part-time, including executive officers, a reduction from 149 during the previous fiscal year. The Company also employs approximately 5,100 leased employees and 200 temporary employees on client assignments. The Company believes its relationship with its employees is satisfactory.
ITEM 2.
ITEM 2. PROPERTIES
OPERATIONS AND FACILITIES
The Company currently has three processing centers in South Plainfield, New Jersey, Houston, Texas and Clearwater, Florida. The Company also has six sales service centers which are located in New York City, South Plainfield, New Jersey, Clearwater, Florida, Houston, and El Paso, Texas and Ridgeland, Mississippi. A sales service center is an office used primarily for sales efforts and client services. The Company's short term strategy is to target acquisitions in the current areas of operation, whereby the Company will acquire a business or business accounts and absorb these accounts into the current operations with minimal additional overhead. The Company's strategic plan
calls for limited amount of acquisitions over the next year, and, again, targeted acquisitions in the current areas of operation. The Company intends to continue its national expansion efforts in fiscal years 1997-1998, most likely through additional acquisitions.
DSI leases its 17,000 square foot corporate headquarters in South Plainfield, New Jersey, as well as offices in Clearwater, Florida and Houston, Texas. The Company also leases sales offices in New York City, Ridgeland, Mississippi, and El Paso, Texas. The facilities provide sufficient capacity to meet demands for the foreseeable future. However, the Company anticipates entering into additional leases as a result of planned acquisitions. In fiscal year 1996, the Company's total lease expenses were $626,688.
Although DSI's offices are equipped with software and computer systems, the Company is currently evaluating all systems including hardware and will upgrade accordingly. At the Company's headquarters in South Plainfield, New Jersey, two high speed Xerox printers produce 200,000 plus checks monthly for its client base. These machines, which are integrated with the software system, do all of the printing on the checks, including the client name, the employee, dates, as well as the "Micro Encoding".
The following is summary information on DSI's facilities:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In March 1996, the Company commenced an action against LNB Investment Corporation ("LNB"), Donaldson, Lufkin & Jenrette Securities Corporation and other individuals to recover damages on account of the wrongful sale of the Company's common stock. The Company seeks to recover 525,000 shares which were not returned and damages against all of the defendants. The Company is currently engaged in discovery proceedings in the action.
In October 1995, the Company entered into a note and finance agreement with LNB providing for the loan to the Company of up to $3,000,000. The loan was for a term of 15 months and was to be secured by shares of the Company's common stock having a market value of no less than four times the outstanding balance of the loan. LNB agreed not to sell or otherwise liquidate the shares unless the Company were to default under the loan agreement and failed to cure such default after notice. A total of 7,500,000 shares to be pledged as collateral were registered under a registration statement filed under the Securities Act of 1933, as amended.
The Company issued 1,783,334 shares (the "Shares") in the name of LNB and delivered the Shares to a depository to secure the first portion of the loan of $1,000,000.
In January, 1996, the Company determined that the Shares the Company pledged as collateral had been transferred and sold in violation of the loan and finance agreement. Through the efforts of the Company, the Company recovered 1,258,334 Shares.
During the last fiscal year, the Company also settled litigation commenced by a former landlord of the Company.
The Company is engaged in no other litigation, the effect of which is anticipated to have a material adverse impact on the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
NOT APPLICABLE
PART II
ITEM 5.
ITEM 5. MARKET OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
A. Principal Market
The Company's Common Stock is traded in the over-the-counter market and included in the Automated Quotation System of the National Association of Securities Dealers, Inc. ("NASDAQ") under the symbol "DGSI".
B. Market Information
The Company's common stock commenced trading in the over-the-counter market on May 15, 1986. The range of high and low bid prices for such securities for the periods indicated below, are:
Common Stock
The above quotations, reported by NASDAQ, represent prices between dealers and do not include retail mark-ups, mark-downs or commissions. Such quotations do not necessarily represent actual transactions.
C. Dividends
The payment by the Company of cash dividends, if any, rests within the discretion of its Board of Directors and, among other things, will depend upon the Company's earnings, capital requirements and financial condition, as well as other relevant factors. The Company has not declared any cash dividends on its common stock since inception, and has no present intention of paying any cash dividends on its common stock in the foreseeable future, and it intends to use earnings, if any, to generate increased growth.
D. Approximated Number of Equity Security Holders
The approximate number of record holders of the Company's common stock as of January 7, 1997 was 336. Such number of record holders was determined from the Company's stockholder records, and does not include beneficial owners of the Company's common stock whose shares are held in the names of various security holders, dealers and clearing agencies. The Company believes there are in excess of 500 beneficial holders of the Company's common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Fiscal Year 1996 as Compared to Fiscal Year 1995
Operating Revenues for the fiscal year 1996 were $100,927,000 as compared to fiscal year 1995 of $73,821,000 which represents an increase of 36.7%. This increase is attributable to the increased sales efforts of the internal sales force as well as the full year impact of the acquisition of Turnkey Services which was acquired in May 1995.
Direct Operating Costs as a percentage of revenue for fiscal year 1996 was 91.6% as compared to 92.8% for fiscal 1995 and Gross Profit for the fiscal year 1996 increased to 8.4% as compared to 7.2% for the prior fiscal year. These changes are attributable to the increased margins in the PEO business due to reduced costs of the Company's workers' compensation programs and the full year effect of the acquisition of Turnkey Services. The Company provides management personnel services to certain clients of Turnkey Services which generate higher than average administrative fees. The reduction in workers' compensation costs was achieved through better managed claims experience.
Selling, general and administrative costs ("SG&A") increased $1,254,000. This growth in expenses includes $195,000 in charges for intangibles associated with acquisitions that were not consummated during the year, $210,000 in charges for severance payments for employees terminated in fiscal 1996, and $178,000 in an increase in the allowance for doubtful accounts attributable to accounts that have aged beyond acceptable limits but which the Company continues to pursue. Approximately $500,000 is attributable to the full year impact of Turnkey Services which was acquired May 1, 1995. Additionally, the Company reversed $515,000 in previously established reserves for claims which the Company resolved in its favor. As a percentage of Gross Profit, SG&A expenses are 104.3% in fiscal 1996 as compared to 126.7% in fiscal 1995 and 88.1% in fiscal 1994. Management believes that although there is improvement from 1995, it will continue to attempt to improve this margin in the future.
Net loss before taxes was ($563,000) in fiscal 1996 as compared to a loss of ($3,453,000) in fiscal 1995. This decrease in net loss is primarily attributable to the increase in gross profit and the decrease in SG&A as a percentage of gross profit, explained above.
Fiscal Year 1995 as Compared to Fiscal Year 1994
Operating revenues for the fiscal year 1995 were $73,821,000 as compared to fiscal year 1994 of $37,998,000. This represents an increase of $35,823,000 or 94%. This increase is attributable to the increased sales efforts of the internal sales force $15,700,000, as well as the acquisition of Staff RX $8,400,000, Turnkey Services, Inc. $6,200,000 and the full year effect of the other PEO companies which were acquired in the second quarter of fiscal year 1994 $5,500,000.
Cost of sales for fiscal year 1995 was 92.8% as compared to 92.0% in fiscal year 1994. This increase is due to the continued growth in the PEO business which has a higher direct cost than any other segment, as a percentage of revenues.
Selling, general and administrative costs (SG&A) increased $4,007,000 from fiscal year 1994 and was primarily due to: (i) increased selling and marketing expenses including direct mail, the addition of 15 senior account managers (sales force); (ii) additions at the corporate level needed to help position and transform the Company into a national firm; (iii) the establishment of a Houston processing center to support client and sales activities in the Southwest and Florida; and, (iv) establishment of certain necessary reserves and balances at year end.
Net loss before tax benefits was $3,453,000 for fiscal year 1995 as compared to a net gain of $720,000 the prior year. In accordance with Statement of Financial Accounting Standards 109 (SFAS 109), the Company has recorded an additional tax asset of $160,000 in the current fiscal year of 1994, representing the expected future utilization of existing net operating loss carryforwards against operating income. As of September 30, 1995, the Company has recorded total deferred assets of $760,000, which it believes, based on the current level of sales activity and the positive impacts of recent acquisitions, will more likely than not be realized in accordance with SFAS 109.
With the increase in sales volume in the fiscal year ended September 30, 1995 combined with anticipated growth, management believes that the recognition of the $760,000 of deferred tax assets is more likely than not, in accordance with SFAS 109. Management's tax planning strategy is consistent with its goal of continued maximization of shareholder value through revenue growth by producing improved employee benefits coverage, arranging sales representation alliances and acquiring existing bases of business, mostly in the employee leasing area. Finally, the Company's current processing operations has enough capacity for this growth with minimal capital expenditures or operating costs.
Fiscal Year 1994 as Compared to Fiscal Year 1993
Operating revenues for the fiscal year 1994 were $37,998,000 compared to fiscal year 1993 of $14,681,000. This is an increase of $23,317,000 or 159%. The increase was attributable to the acquisition of Staff Leasing of Mississippi, Inc., ($8,611,000) and the acquisition of certain other leasing companies and the associated staff contracting companies ($6,508,000) during fiscal year 1994. Revenues from DSI's operations, other than newly acquired companies mentioned previously, were up approximately 50%. Payroll services increased $67,000; DSI Staff Connxions increased $7,700,000 and DSI Contract Staffing increased $387,000.
Cost of sales for fiscal year 1994 was 92% of total revenue as compared to 85% in fiscal year 1993. This ratio increased because of the incremental impact of increased sales of employee leasing, which carries a lower margin than the Company's other product lines.
Selling, general and administrative (SG&A) costs increased $733,000 from fiscal 1993 and was primarily due to; (1) additions at the corporate level needed to coordinate and control the functions
of the acquired companies as the Company transforms into a national firm; and (2) the associated overhead of these acquired companies in the area of selling and client services especially in the Texas acquisition which created the Company's processing center in the southwest.
Net income before tax benefits increased $227,000 or 225% over prior fiscal year 1993.
Liquidity and Capital Resources
Working capital increased in fiscal year 1996 to $286,000 from a deficit in fiscal year 1995 of $(4,771,000). This increase of $5,057,000 in working capital is due primarily to a successful private offering of 1,800,000 shares of common stock that produced $4,700,000 in net proceeds. In addition, the Company raised $437,500 through the issuance of convertible preferred stock at a dividend rate of 6% and convertible into common stock at a conversion price equal to a 20% discount to market at the date of conversion. This capital was used to retire a short term note of $1,887,500 in March 1996, provide $1,200,000 in additional cash collateral for the Company's workers' compensation program, and 3) working capital.
Although the PEO clients generally pay when their payroll is delivered, certain large clients have extended payment terms that the Company is actively trying to reduce or eliminate. These clients have increased the Company's need for capital to support the growth in their businesses. Additionally, as the Company's contract staffing business grows, additional capital is needed to fund the receivables.
Current Assets increased $1,622,000 which is primarily due to an increase in restricted cash of $1,155,000 as well as an increase in accounts receivable of $1,409,000 offset by a decrease in loans receivable from officers of $562,000 and a decrease in other assets of $360,000.
In addressing the capital needs of the Company, management is presently in negotiating with a bank to provide an $7,000,000 line of credit to replace the matured line. This facility will be secured by substantially all assets of the Company and will be available based on a percentage of eligible receivables. Management believes that this facility, if obtained, will be sufficient to cover its cash needs for the foreseeable future.
In December 1996, due to the favorable trends in losses in its Workers' Compensation program, the Company's carrier reduced its letter of credit requirement from $1,600,000 to $1,150,000 which resulted in $450,000 in additional cash available. These funds were contributed to working capital.
Inflation and changing prices have not had a material effect on the Company's net revenues and results of operations in the last three fiscal years, as the Company has been able to modify its prices to respond to inflation and changing prices.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
See Attached Financial Statements appearing at pages through.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The executive officers and directors of the Company are as follows:
Each director is elected for a period of one year at the Company's annual meeting of shareholders and will serve until his successor is duly elected by the shareholders.
Karl W. Dieckmann, Director of the Company since April, 1990, has been Chairman of the Board since November, 1991. From 1980 to 1988, Mr. Dieckmann was the Executive Vice President of Science Management Corporation and managed the Engineering, Technology and Management Services Groups. From 1948 to 1980, Mr. Dieckmann was employed by the Allied Corporation (now Allied Signal Corporation) in various capacities including President, Semet Solvay Division;
Executive Vice President, Industrial Chemicals Division; Vice President Technical -- Fibers Division; Group General Manager -- Fabricated Products Division; and General Manager -- Plastics Division, as well as various positions with the Chemicals Division.
George J. Eklund was President and Chief Operating Officer of the Company since September 21, 1994, and President and Chief Executive Officer from March 13, 1996. From 1992 to 1994, Mr. Eklund was President of the Human Resource Information Services division of Fiserv, Inc., which provides outsourcing services. From 1977 to 1992, Mr. Eklund was employed by ADP (Automatic Data Processing) in various positions eventually serving as Corporate Vice President and Eastern Division President. His eastern division served the northeast area of the country.
Kenneth P. Brice, has been Chief Financial Officer since July 1, 1995 and was Vice President of Finance since he started at DSI on February 8, 1995. From 1993 until 1995, he was vice-president of Mergers and Acquisitions for Interim Services, Inc., a national provider of temporary help services. His other industry experience includes 15 years with Automatic Data Processing where he reached the position of Vice President and Group Controller of the Employer Services division, ADP's largest operating unit.
Louis J. Monari is Vice-President of DSI Staff ConnXions NE, Risk Management and Corporate Secretary. His experience includes 16 years with Nabisco Brands in human resources positions based in manufacturing, research and development and corporate headquarters. This includes 7 years in Nabisco's international division. Prior to joining DSI, he was with Goodrich and Sherwood, a major human resources consulting firm headquartered in New York City. From 1988-1993, he served as co-Founder and President of Holgate Associates, Inc., a human resources consulting firm.
Senator John H. Ewing, has been a Director of the Company since April, 1990. Senator Ewing has been a State Senator for the state of New Jersey from 1978 to the present. From 1968 to 1977, Senator Ewing was a New Jersey State Assemblyman. From 1940 to 1968, he was employed by Abercrombie and Fitch Co., New York City, and eventually rose to the position of Chairman of the Board. Senator Ewing is also currently Chairman of the New Jersey Senate Education Committee.
Alfred C. Koeppe, from October, 1995 to the present, is the Senior Vice President of Corporate Services & External Affairs of Public Service Electric and Gas Company and a graduate of Rutgers University and Seton Hall Law School. In 1975, he served as clerk for U.S. District Judge Vincent Biunno and has served as a trial attorney for the NJ Department of the Public Defender, the American Electric Power Company in NY, and was a trial attorney with A.T. & T. in the Department of Justice antitrust case. He was elected President and CEO of NJ Bell on February 1, 1993. He holds memberships in various associations, among them the NJ, American and Essex County Bar, the Board of Governors of the National Conference of Christians and Jews .
William J. Marino, President and Chief Executive Officer of Blue Cross and Blue Shield of New Jersey, joined the Board of Directors in October, 1995. He joined Blue Cross and Blue Shield
in 1992 and was named to his present post in 1994. From 1968 to 1991, Mr. Marino held a variety of sales, marketing and management positions with the Prudential Insurance Company of America. He is Chairman of the Board of Trustees of the United Way of Essex and West Hudson (NJ) and is Chairman of the Board of Directors and Executive Committee of the Regional Business Partnership, and a Trustee of the New Jersey Network Foundation, St. Peter's College and the Newark Museum.
Steven B. Sands was elected to the Board of Directors on April 25, 1994. Mr. Sands has been engaged in the investment banking business since 1980. From 1987 to 1990, Mr. Sands was employed at Rodman & Renshaw, New York, NY, an investment banking firm. Since 1990, Mr. Sands has been co-Chairman and Chief Executive Officer of Sands Brothers & Co., Ltd., an investment banking firm. Mr. Sands is a director of Semi-Conductor Packaging Materials Co. (semi-conductor components manufacturer), Air Methods Corporation (emergency air medical transport), The National Registry Inc. (fingerprint database technology), Financing for Science International, Inc. (leasing of healthcare related equipment), The Village Green Bookstore, Inc. (bookstore owner and operator), Command Security Corp. (security guards) and Wholesale Cellular USA Inc. (cellular telephone distributor), each a publicly-held company.
Raymond J. Skiptunis, has been a Director of the Company since October, 1985 and President and Chief Executive Officer from February, 1989 to October, 1989, and Chief Executive Officer from April, 1990 to March, 1996. Since March, 1984, Mr. Skiptunis has been a Partner of Venray Capital Management Partners, a limited partnership providing financial consulting and managerial support to companies in which it invests. He was the Chairman and President of Venray Capital Management Corp., a financial management consulting firm from November, 1982 to March, 1984 and has held similar offices in Venray Capital Corp., both of which are predecessors to Venray Capital Management Partners.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISIONS
Karl W. Dieckmann, John H. Ewing, William J. Marino and Stephen B. Sands served on the Company's Compensation Committee during the last fiscal year.
See "Certain Relationships and Related Transactions" for transactions between the Company and members of the Compensation Committee.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following provides certain summary information concerning compensation paid or accrued by the Company during the years ended September 30, 1996, 1995 and 1994 to the Company's Chief Executive Officer and each of the executive officers of the Company who received in excess of $100,000 in compensation during the last fiscal year.
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(1) 1996 Bonuses are still to be determined.
(2)Mr. Skiptunis was replaced as Chief Executive Officer by Mr. Eklund in March 1996.
(3)Mr. Eklund's employment with the Company commenced on September 19, 1994. He assumed the position of Chief Executive Officer in March 1996.
The Corporation provides normal and customary life and health insurance benefits to all of its employees including executive officers. The Corporation has no retirement or pension plan other than a 401(k), which is voluntary.
Compensation of Directors
Directors who are employees of the Company are not compensated for services in such capacity except under the Director Plan, as defined below. Non-Employee Directors receive $400 per meeting, $50 in travel expenses, and $250 for each committee meeting.
Employment Agreement
Effective March 12, 1996, the Company entered into a new employment agreement with Mr. Eklund for a three year term. The employment agreement provides for (i) annual compensation of $210,000 for the first year of the agreement increasing at the discretion of the Company; (ii) a bonus in accordance with a plan to be established by the Company; (iii) the award of stock options to purchase 300,000 shares of the Company's common stock, subject to vesting requirements; (iv) certain insurance and severance benefits; and (v) a $700 per month automobile allowance.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
OPTION/SAR GRANTS IN LAST FISCAL YEAR (INDIVIDUAL GRANTS)
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES
The following table sets forth information with respect to the named executive officers concerning exercise of stock options and SARs during the last fiscal year and the value of unexercised options and SARs held as of the year ended September 30, 1995.
- ---------------------------- (1) Based upon a closing bid price of the Common Stock at $6.0625 per share on September 30, 1996.
1990 STOCK OPTION PLANS
In April, 1990, the Board of Directors adopted the 1990 Employees Stock Option Plan (the "1990 Plan") which was approved by shareholders in August, 1990. The 1990 Plan provides for the
grant of options to purchase up to 1,000,000 shares of the Company's common stock. Under the terms of the 1990 Plan, options granted thereunder may be designated as options which qualify for incentive stock option treatment ("ISOs") under Section 422A of the Code, or options which do not so qualify ("Non-ISO's").
The 1990 Plan is administered by a Stock Option Committee designated by the Board of Directors. The Stock Option Committee has the discretion to determine the eligible employees to whom, and the times and the price at which, options will be granted; whether such options shall be ISOs or Non-ISOs; the periods during which each option will be exercisable; and the number of shares subject to each option. The Committee has full authority to interpret the 1990 Plan and to establish and amend rules and regulations relating thereto.
Under the 1990 Plan, the exercise price of an option designated as an ISO shall not be less than the fair market value of the common stock on the date the option is granted. However, in the event an option designated as an ISO is granted to a ten percent (10%) shareholder (as defined in the 1988 Plan), such exercise price shall be at least 110% of such fair market value. Exercise prices of Non-ISO options may be less than such fair market value.
The aggregate fair market value of shares subject to options granted to a participant, which are designated as ISOs and which become exercisable in any calendar year, shall not exceed $100,000.
The Stock Option Committee may, in its sole discretion, grant bonuses or authorize loans to or guarantee loans obtained by an optionee to enable such optionee to pay any taxes that may arise in connection with the exercise or cancellation of an option.
Unless sooner terminated, the 1990 Plan will expire in April 2000.
In April 1990, the Board of Directors adopted the Non-Executive Director Stock Option Plan (the "Director Plan") which was approved by shareholders in August, 1991 and amended in March 1996. The Director Plan provides for issuance of a maximum of 500,000 shares of common stock upon the exercise of stock options arising under the Director Plan. Options may be granted under the Director Plan until April, 2000 to: (i) non-executive directors as defined and, (ii) members of any advisory board established by the Company who are not full-time employees of the Company or any of its subsidiaries. The Director Plan provides that each non-executive director is automatically granted an option to purchase 5,000 shares upon joining the Board and each September lst, pro rata, based on the time the director has served in such capacity during the previously year. Similarly, each eligible director of an advisory board will receive on each September lst an option to purchase 5,000 shares of the Company's common stock each September lst. The Directors' Plan also provides that directors, upon joining the Board, and for one (1) year thereafter, will be entitled to purchase restricted stock from the Company at a price equal to 80% of the closing bid price on the date of purchase up to an aggregate purchase price of $50,000.
The exercise price for options granted under the Director Plan shall be 100% of the fair
market value of the common stock on the date of grant. Until otherwise provided in the Stock Option Plan, the exercise price of options granted under the Director Plan must be paid at the time of exercise, either in cash, by delivery of shares of common stock of the Company or by a combination of each. The term of each option commences on the date it is granted and unless terminated sooner as provided in the Director Plan, expires five (5) years from the date of grant. The Director Plan shall be administered by a committee of the board of directors composed of not fewer than three persons who are officers of the Company (the "Committee"). The Committee has no discretion to determine which non-executive director or advisory board member will receive options or the number of shares subject to the option, the term of the option or the exercisability of the option. However, the Committee will make all determinations of the interpretation of the Director Plan. Options granted under the Director Plan are not qualified for incentive stock option treatment.
In April 1990, the Board of Directors adopted and in August, 1990, the Company's shareholders approved the Senior Management Incentive Plan (the "Management Plan") for use in connection with the issuance of stock, options and other stock purchase rights to executive officers and other key employees and consultants who render significant services to the Company and its subsidiaries. It is contemplated that only those executive management employees (generally the Chairman of the Board, Chief Executive Officer, Chief Operating Officer, President and Vice Presidents of the Company or Presidents of the Company's subsidiaries) who perform services of special importance to the Company will be eligible to participate under the Management Plan. A total of 5,000,000 shares of common stock will be reserved for issuance under the Management Plan. Awards made under the Management Plan will be subject to three-(3) year vesting periods, although the vesting periods are subject to the discretion of the Administrator.
Unless otherwise indicated, the Management Plan is to be administered by the Board of Directors or a committee of the Board, if one is appointed for this purpose (the Board or such committee, as the case may be, shall be referred to in the following description as the "Administrator"). The Management Plan generally provides that, unless the Administrator determines otherwise, each option or right granted under a plan shall become exercisable in full upon certain "change of control" events as described in the Management Plan. If any change is made in the stock subject to the Management Plan, or subject to any right or option granted under the Management Plan (through merger, consolidation, reorganization, recapitalization, stock dividend, dividend in property other than cash, stock split, liquidating dividend, combination of shares, exchange of shares, change in corporate structure or otherwise), the Administrator will make appropriate adjustments to such plans and the classes, number of shares and price per share of stock subject to outstanding rights or options. The Management Plan permits awards until April, 2000.
Directors who are not otherwise employed by the Company will not be eligible for participation in the Management Plan.
The Management Plan provides four types of awards: stock options, incentive stock rights, stock appreciation rights (including limited stock appreciation rights) and restricted stock purchase agreements, as described below.
Options granted under the Management Plan may be either incentive stock options ("ISOs") or options which do not qualify as ISOs ("non-ISOs") similar to the options granted under the 1990 Plan.
Incentive stock rights consist of incentive stock units equivalent to one share of common stock in consideration for services performed for the Company. If the employment or consulting services of the holder with the Company terminate prior to the end of the incentive period relating to the units awarded, the rights shall thereupon be null and void, except that if termination is caused by death or permanent disability, the holder or his heirs, as the case may be, shall be entitled to receive a pro-rata portion of the shares represented by the units, based upon that portion of the incentive period which shall have elapsed prior to the death or disability.
Restricted stock purchase agreements provide for the sale by the Company of shares of common stock at a price to be determined by the Board of Directors, which shares shall be subject to restrictions on disposition for a stated period during which the purchaser must continue employment with the Company in order to retain the shares. Payment can be made in cash, a promissory note or a combination of both. If termination of employment occurs for any reason within six months after the date of purchase, or for any reason other than death or by retirement with the consent of the Company after the six month period, but prior to the time that the restrictions on disposition lapse, the Company shall have the option to reacquire the shares at the original purchase price.
Restricted shares awarded under the Management Plan will be subject to a period of time designated by the Administrator (the "restricted period") during which the recipient must continue to render services to the Company before the restricted shares will become vested. The Administrator may also impose other restrictions, terms and conditions that must be fulfilled before the restricted shares may vest.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information as of January 9, 1997 with respect to each director, each of the named executive officers as defined in Item 402(a)(3), and directors and executive officers of the Company as a group, and to the persons known by the Company to be the beneficial owner of more than five percent of any class of the Company's voting securities.
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* Less than 1 percent.
(1) Ownership consists of sole voting and investment power except as otherwise noted.
(2) Includes options to purchase 50,000 shares of the Company's common stock, and excludes unvested options to purchase 25,000 shares of common stock.
(3) Includes options to purchase 5,000 shares of the Company's common stock, and warrants to purchase 10,000 shares of common stock, and excludes unvested options to purchase 5,000 shares of common stock.
(4) Includes options to purchase 200,000 shares of the Company's common stock, and excludes unvested options to purchase 300,000 shares of common stock.
(5) Includes options to purchase 30,000 shares of common stock, and excludes unvested options to purchase 5,000 shares of common stock.
(6) Does not include unvested options to purchase 6,250 shares.
(7) Includes options to purchase 5,000 shares of the Company's common stock, and excludes unvested options to purchase 5,000 shares in 1996.
(8) Includes options to purchase 30,000 shares of common stock, and excludes unvested options to purchase 20,000 shares of common stock.
(9) Includes options to purchase 5,000 shares of common stock, and excludes unvested options to purchase 5,000 shares of common stock.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information concerning employment agreements with and compensation of the Corporation's executive officers and directors, see "Executive Compensation".
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
The financial statements and schedules of the Company are included in Part II, Item 8 of this report and appear as pages through and includes page S-1.
2. All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements or the notes thereto.
3. Exhibit List
The exhibits designated with an asterisk (*) are filed herewith. All other exhibits have been previously filed with the Commission and, pursuant to 17 C.F.R. Secs. 20l.24 and 240.12b-32, are incorporated by reference to the document referenced in brackets following the descriptions of such exhibits.
EXHIBIT
(b) Reports on Form 8-K No 8-K reports were filed in the last fiscal quarter.
(c) See Item (a)(3) above.
(d) See Schedule II annexed hereto and appearing at page S-1.
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of
Digital Solutions, Inc.:
We have audited the accompanying consolidated balance sheets of Digital Solutions, Inc. and subsidiaries as of September 30, 1996 and 1995, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended September 30, 1996. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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 financial statements referred to above present fairly, in all material respects, the financial position of Digital Solutions, Inc. and subsidiaries as of September 30, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1996 in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed in the index to the financial statements is the responsibility of the management of Digital Solutions, Inc. and subsidiaries and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in our audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Roseland, New Jersey December 30, 1996
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 1996 AND 1995
LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------
The accompanying notes to the consolidated financial statements are an integral part of these consolidated balance sheets.
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) ORGANIZATION AND BUSINESS:
Digital Solutions, Inc. (the Company) was incorporated under the laws of the State of New Jersey on November 25, 1969. The Company, with its subsidiaries, provides a broad spectrum of human resource services including professional employer services, payroll processing, human resource administration and placement of temporary and permanent employees.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of Presentation-
The accompanying consolidated financial statements include those of DSI, a New Jersey Corporation and its wholly-owned subsidiaries; DSI Contract Staffing, DSI Staff ConnXions, Digital Insurance Services, Inc., DSI Staff ConnXions of Mississippi, DSI Staff ConnXions - Southwest, MLB Medical Staffing, Inc., Ram Technical Services, Inc. and DSI Staff Rx, Inc. The results of operations of acquired companies (see Note 3) have been included in the consolidated financial statements from the date of acquisition. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
Use of Estimates-
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Revenue Policy-
The Company recognizes revenue in connection with its professional employer organization program (PEO) and its temporary placement service program when the services have been provided. Revenues are recorded based on the Company's billings to customers, with the corresponding cost of providing those services reflected as direct operating expenses. Payroll services, commissions and other fees for administrative services are recognized as revenue as the related service is provided.
Equipment and Improvements-
Equipment and improvements are stated at cost. Depreciation and amortization are provided using straight-line and accelerated methods over the estimated useful asset lives (3 to 5 years) and the shorter of the lease term or estimated useful life for leasehold improvements.
Goodwill-
Goodwill represents the excess of the cost of companies acquired over the fair value of their net assets at the acquisition date and is being amortized on a straight line basis over 20 years for substantially all of the Company's acquisitions (see Note 3). Amortization expense charged to operations was approximately $415,000 for 1996, $327,000 for 1995 and $74,000 for 1994. Amortization expense for 1996 and 1995, includes a provision for goodwill impairment, as described below.
During 1995, the Company adopted the provisions of Statement of Financial Accounting Standard No. 121, "Accounting for the Impairment of Long-Lived Assets" ("SFAS 121"). SFAS 121 requires, among other things, that an entity review its long-lived assets and certain related intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. As a result of certain of the acquisitions described in Note 3 experiencing operating cash flow losses for the current period, the Company, utilizing the present value of estimated future cash flows from these operations discounted at a rate of return (15%), determined that some impairment had occurred in certain of these acquisitions. As a result, the Company charged approximately $195,000 and $180,000 of additional amortization to depreciation and amortization for the year ended September 30, 1996 and 1995, respectively. Had the Company applied the measurement criteria prescribed by SFAS 121 in prior years, the effect would not have been material.
Insurance Programs-
The Company maintains a variety of large deductible insurance policies (see Note 9) to cover its exposure to claims for medical, workers' compensation and general liability on both a per occurrence and aggregate basis. Provisions have been made in the financial statements which represent the expected future payments based on individual case reserves plus an estimate for claims that have been incurred but not reported as of the balance sheet date.
Net Income (Loss) Per Common Share-
Net income (loss) per common share is based upon the weighted average number of shares outstanding as well as the dilutive effect of stock options and warrants (see Note 10). Dividends on preferred stock of approximately $98,000 were declared and paid in 1994 and deducted from earnings available for common shares. Outstanding stock options and warrants have not been considered in the computations of net loss per common share in 1996 and 1995 since their effect was antidilutive.
Statement of Cash Flows-
For purposes of the statements of cash flows, the Company considers all liquid investments purchased with a maturity of three months or less to be cash equivalents.
Reclassifications-
Certain reclassifications have been made to the prior year financial statements to conform them to the 1996 presentation.
(3) ACQUISITIONS:
The following acquisitions have been accounted for under the purchase method of accounting. Accordingly, the results of operations of these entities have been included in the consolidated financial statements of the Company since the date of acquisition.
Turnkey Services, Inc.-
In May 1995, the Company, through its subsidiary, DSI Staff ConnXions-Southwest, purchased certain assets of a PEO company located in El Paso, Texas, Turnkey Services, Inc. The assets acquired included the customer lists and all owned and leased assets utilized by Turnkey in its business operations, subject to interest of equipment lessors. In consideration for the assets, the Company paid to Turnkey $784,000 in cash and a note payable (see Note 8) and issued common stock in the amount of $166,000. In addition, the Company incurred approximately $200,000 in transaction costs and recorded goodwill of approximately $989,000 associated with this acquisition.
If this acquisition had been included in the consolidated financial statements for the entire year ended September 30, 1995, the effect would not have been significant.
Staff Rx, Inc.-
In November 1994, the Company acquired certain assets of several affiliated contract staffing firms through the Company's wholly-owned subsidiary DSI-Staff Rx, Inc. in exchange for $200,000 in cash and a promissory note for $1,300,000. In addition, the Company incurred approximately $266,000 in transaction costs and recorded goodwill of approximately $1,766,000, associated with this acquisition.
In March 1995, the Company issued 360,000 shares of its common stock which was valued at $743,000. This was used to satisfy part of the aforementioned promissory note. The balance was paid in cash.
If this acquisition had been included in the consolidated financial statements for the entire year ended September 30, 1995, the effect would not have been significant.
M & B Staff Management, Inc.-
In September 1994, the Company completed the acquisition of certain assets of an employee leasing business, M & B Staff Management, Inc. ("M & B"). Pursuant to the terms of the acquisition, the Company also entered into noncompete agreements with certain shareholders and employees of M & B. The business assets of M & B and the noncompete agreements were acquired for 205,128 shares of the Company's common stock. The Company recorded goodwill of approximately $740,000 associated with this acquisition.
If this acquisition had been included in the consolidated financial statements for the entire year ended September 30, 1994, the effect would not have been significant.
The Alternative Source, Inc., MLB Medical Staffing, Inc., and RAM Technical Services, Inc.-
In January 1994, the Company through its wholly-owned subsidiary corporations, acquired the assets of The Alternative Source, Inc. ("TAS") and the shares of MLB Medical Staffing, Inc. ("MLB") and RAM Technical Services, Inc., three affiliated companies based in Houston, Texas. TAS is engaged in the PEO business, MLB is engaged in the nurse staffing business and RAM is engaged in contract employee staff leasing business. In consideration of the foregoing, DSI paid the sellers $200,000 in cash, issued a note for $25,000 and issued an aggregate of 416,221 shares of the Company's stock, of which a portion was held in escrow pending the fulfillment of certain sales and performance criteria by the sellers.
As of the closing date of acquisition, the Company recorded goodwill of approximately $1,201,000. In accordance with the earn-out provisions of the purchase agreement, in May 1995, the Company retired 112,714 shares held in escrow and reduced the purchase price and amount of goodwill by $254,000.
If this acquisition had been included in the consolidated financial statements for the entire year ended September 30, 1994, the effect would not have been significant.
DSI Staff Leasing of Mississippi, Inc.-
In November 1993, the Company purchased certain assets of Staff Leasing of Mississippi, Inc., a PEO company, in exchange for cash, a two-year promissory note and 50,000 shares of the Company's common stock. In connection with this acquisition, the Company recorded goodwill of approximately $244,000 and a covenant not to compete in the amount of $25,000.
If this acquisition had been included in the consolidated financial statements for the entire year ended September 30, 1994, the effect would not have been significant.
(4) NOTES DUE FROM OFFICERS:
(A) During 1996, notes due from officers amounting to $679,000, including accrued interest, were settled through the officers' remittance of 107,130 shares of the Company's common stock to the Company. The number of shares exchanged was based upon the fair market value of the shares remitted on the date of the settlement.
(5) INCOME TAXES:
At September 30, 1996, the Company had available net operating loss carryforwards of approximately $4,827,000 to reduce future periods' taxable income. The Company's deductible temporary differences are not significant. The carryforwards expire in various years beginning in 2005 and extending through 2011.
The Company has recorded a $760,000 deferred tax asset at September 30, 1996 and 1995. This represents management's estimate of the income tax benefits to be realized upon utilization of a portion of its net operating losses for which management believes utilization to be more likely than not. In order for the Company to realize a $760,000 tax benefit, the Company would have to generate approximately $2,000,000 in future taxable income. Management believes the Company's operations can generate sufficient taxable income to realize this tax asset as a result of recent business developments, its ability to meet its operating plan as well as the resolution of significant past problems which had adversely affected the Company in prior years.
The income tax benefit reflected in the consolidated statement of operations for 1995 and 1994 represents a portion of the recorded deferred tax asset described above.
At September 30, 1996 an analysis of the Company's deferred income tax asset is as follows-
(6) SHORT-TERM BORROWINGS:
In February 1995, the Company entered into a one year revolving line facility (the "Line") with a bank which was subsequently extended and modified. Under the terms of the current agreement, the Company may borrow up to the lesser of $3,500,000 (including letters of credit -- see Note 9), or 75% of eligible accounts receivable, as defined. The Company is obligated to make monthly payments of interest on the outstanding amounts at the bank's floating base rate plus two and one-half percent (13.25% at September 30, 1996). As of September 30, 1996, the Company had $138,000 available under this facility based upon the borrowing base calculation.
The Line is collateralized by substantially all of the Company's accounts receivable and contains certain covenants, including an interest coverage ratio, current ratio, total liabilities (as defined) to tangible net worth (as defined) ratio and total tangible capital funds (as defined). As of September 30, 1996, the Company was in compliance with these financial covenants, however, the line has matured. The Company is presently negotiating with the bank to develop mutually agreeable terms
and conditions in response to the Company's request for extending the line. While the Company believes it will be able to negotiate such terms and renew the line, in the event that this does not occur, the Company is pursuing other financing alternatives.
During 1995, the Company issued approximately $1,975,000 of Subordinated Bridge Notes to various investors. The notes bore interest at a rate of 12% per annum (which was increased to 16% in November, 1995 in consideration for extending the maturity date) and were repaid in full in 1996. In connection with the issuance of these notes, the Company also granted these investors warrants to purchase the Company's common stock (see Note 10).
Other information with respect to short term borrowings for 1996 and 1995 is as follows-
(7) ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES:
Accrued expenses and other current liabilities at September 30, 1996 and 1995 consist of the following-
(8) LONG-TERM DEBT:
Long-term debt at September 30, 1996 and 1995 consists of the following-
Maturities of long-term debt as of September 30, 1996 are as follows-
(9) COMMITMENTS AND CONTINGENCIES:
Leases-
In November 1991, the Company entered into a lease for its corporate headquarters facility. The lease term extends 69 months with fixed monthly payments of $18,000. The Company recognized rent expense of $253,000 under this lease in 1996, 1995 and 1994. Rent expense under all operating leases was $627,000 in 1996, $384,000 in 1995 and $290,000 in 1994.
Minimum payments under noncancellable lease obligations at September 30, 1996 are as follows-
Workers' Compensation Policy-
The Company maintains a large deductible insurance policy with a national insurance carrier for claims under its workers' compensation plan. In addition to administering all the claims for the Company, the insurance carrier also develops reserve factors on each claim (that may or may not materialize after the claim is fully investigated). As of September 30, 1996, the Company had reserved approximately $631,000 for the settlement of future claims as well as $97,000 for current claims and recognized approximately $1,332,000 as its share of premiums collected in excess of claims and fees paid and established reserves for the year ended September 30, 1996.
Currently, the Company establishes its reserves for workers compensation claims in accordance with generally accepted accounting principles (GAAP). Under GAAP, there are two acceptable methods of establishing reserves. A company may establish reserves based upon all incurred, but not reported claims, as well as an estimate for claims incurred, but not reported (IBNR), or the Company may establish reserves based upon an actuarial determination of the ultimate cost of settling those claims (fully developed claims). The Company currently establishes its
reserves using an IBNR methodology. Based upon an actuarial assumption of fully developed claims, if the Company were to establish its reserves under that methodology, the Company's reserves at September 30, 1996 would have amounted to approximately $1,260,000.
The Company has outstanding letters of credit as of September 30, 1996 amounting to approximately $1,600,000. These letters of credit are required to collateralize unpaid claims in connection with the workers compensation insurance policy and can only be drawn upon by the beneficiary if the Company does not perform according to the terms of the related agreement. The Company has collateralized these letters of credit by maintaining compensating restricted cash balances amounting to $1,155,000 and utilizing approximately $445,000 of amounts available under its line of credit.
Legal Proceedings-
In October 1995, the Company entered into a note and finance agreement with LNB Investment Corporation (LNB) providing for the loan to the Company of up to $3,000,000. The loan was for a term of 15 months and was to be secured by shares of the Company's common stock having a market value of no less than four times the outstanding balance of the loan. LNB agreed not to sell or otherwise liquidate the shares unless the Company were to default under the loan agreement and failed to cure such default after notice. A total of 7,500,000 shares to be pledged as collateral were registered under a registration statement filed under the Securities Act of 1933, as amended.
The Company issued 1,783,334 shares in the name of LNB and delivered the shares to a depository to secure the first portion of the loan of $1,000,000. In January 1996, the Company determined that the shares pledged as collateral had been transferred and sold in violation of the loan and finance agreement. As a result, the financing agreement was terminated and never funded. Through the efforts of the Company, 1,258,334 of these shares were recovered and the Company received proceeds of $229,000 for a portion of the 525,000 shares not recovered.
In March 1996, the Company commenced action against LNB, Donaldson, Lufkin & Jenrette Securities Corporation and other individuals to recover damages on account of the wrongful sale of the Company's common stock. The Company seeks to recover 525,000 shares which were not returned and damages against all of the defendants. The Company is engaged in preliminary discovery and the defendants have not yet answered the complaint.
At September 30, 1996 the Company is involved in various other legal proceedings incurred in the normal course of business. In the opinion of management and its counsel, none of these proceedings would have a material effect, if adversely decided, on the consolidated financial position or results of operations of the Company.
During 1996, the Company resolved several matters in its favor. As a result, approximately $515,000 in reserves established in prior years were reversed and reflected as a reduction of selling, general and administrative expenses.
(10) SHAREHOLDERS' EQUITY
Private Placements-
In November, 1995, the Company issued in a private placement 500 Shares of $.10 par value Series B Convertible Preferred Stock. Holders of the preferred stock were entitled to dividends of $60 per annum, payable semiannually and had the right to convert up to 50% of their shares at any time after 41 days from the date of issuance of the Series B Preferred Stock and 100% after 60 days after issuance into the Company's common stock at a conversion price equaled to 75% of the average closing price at the date of conversion. In January 1996, holders of the Company's preferred stock exercised their conversion privilege and received 421,792 shares of the Company's common stock. The Company realized net proceeds of $437,000 from the proceeds of this offering.
Additionally, during 1996 the Company raised an additional $4,089,000, net of expenses through a private placement of 1,882,228 shares of its common stock. The proceeds from these offerings were used in part to pay down the balance on the Subordinated Bridge Notes, collateralize letters of credit issued to secure the Company's workers' compensation program (see Note 9) and for working capital needs.
Stock Warrants -
The following is a summary of the outstanding warrants to purchase the Company's common stock at September 30, 1996 as a result of various debt and equity offerings that have occurred since the Company's inception:
Stock Option Plans -
In April 1990 the Company adopted three stock option plans, the 1990 Employees Stock Option Plan, the Non-Executive Director Stock Option Plan, and the Senior Management Incentive Plan (collectively the "1990 Plans"). The 1990 Plans will remain in effect until April 2000 or unless terminated sooner by the Board of Directors.
The 1990 Employees Stock Option Plan (the "Employee Plan") provides for options to be granted to employees, including certain officers of the Company, for the purchase of up to 1,000,000 shares of common stock. Some of the options granted under the 1990 Plan are intended to qualify as incentive stock options under the Internal Revenue Code. The exercise price of incentive stock options granted may not be less than the fair market value of the shares on the date of grant, or in certain circumstances, an option price at least equal to 110% of the fair market value of the stock at the time the option is granted. Options granted under the plan may not be exercised more than ten years from the date of the grant (or in certain circumstances, five years from the date of grant).
The Non-Executive Director Stock Option Plan (the "Director Plan"), provides for the issuance of options for the purchase of up to 500,000 shares of common stock. Eligible participants are directors of the Company who are also not employees of the Company and nonemployee directors of any advisory board established by the Company. Under the terms of the Director Plan, the exercise price of options granted will equal 100% of the fair market value of the common stock at the date the options are granted. Options will be granted to eligible participants as follows: 5,000 upon becoming nonexecutive directors and 5,000 each September 1, commencing September 1, 1990 provided such person had been eligible for the preceding 12 months. Directors of advisory boards will receive on each September 1 an option to purchase 10,000 shares of common stock, providing such director has served as a director of the advisory board for the previous 12 month period. The term of each option commences on the date it is granted and expires five years from grant date unless terminated sooner as provided in the Director Plan.
The Senior Management Incentive Plan (the "Management Plan") provides for the issuance of stock, options and other stock rights to executive officers and other key employees who render significant services to the Company. Under the terms of the Management Plan, the exercise price of options granted will equal 100% of the fair market value of the common stock at the date the options are granted. A total of 5,000,000 shares of common stock have been reserved for issuance under the Management Plan. Awards made under the Management Plan are generally subject to three-year vesting periods (subject to the discretion of the Board of Directors), but may become exercisable in full upon certain "change of control" events as defined in the Management Plan.
The following tables summarizes the activity in the Company's stock option plans for the year ended September 30, 1996 and 1995.
During 1996, certain individuals exercised options by delivering to the Company shares previously purchased in consideration for the option price. The amounts reflected in additional paid in capital are net of the value of the shares redeemed by the Company.
Options outstanding as of September 30, 1996 become exercisable as follows-
In 1995, the Financial Accounting Standard Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation." The new standard specifies permissible methods for valuing compensation attributable to stock options, as well as certain required disclosures. The Company is required to adopt the new standard no later than October 1, 1996. The Company intends to continue to follow the current method used to measure compensation cost attributable to stock options which is one of the permissible methods under the new standard. A result, while additional disclosures will be required in subsequent years, adoption of the new standard will not have an effect on the consolidated financial statements.
SCHEDULE II
DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
S-1 SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
DIGITAL SOLUTIONS, INC.
/s/George J. Eklund ------------------------------------ George J. Eklund Chief Executive Officer and Director
Dated: January 13, 1997
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 and in the capacities and on the dates indicated.
EXHIBIT INDEX