GSE SYSTEMS INC - Annual Report: 2006 (Form 10-K)
Conformed
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-K
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(Mark
One)
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[
X
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ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d)
OF
THE SECURITIES EXCHANGE ACT OF 1934
For
the fiscal year ended December 31, 2006
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OR
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[
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TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d)
OF
THE SECURITIES EXCHANGE ACT OF 1934
For
the transition period from _____
to
_____
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Commission
File Number 0-26494
GSE
Systems, Inc.
(Exact
name of registrant as specified in its charter)
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Delaware
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52-1868008
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(State
of incorporation)
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(I.R.S.
Employer Identification Number)
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7133
Rutherford Rd, Suite 200, Baltimore MD.
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21244
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(Address
of principal executive offices)
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(Zip
Code)
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Registrant's
telephone number, including area code: (410) 277-3740
SECURITIES
REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Title
of
each class Name
of each exchange on which registered
Common
Stock, $.01 par value American
Stock Exchange
SECURITIES
REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined
in
Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act. Yes [ ] No [X]
Indicate
by check mark whether the registrant (1) has filed all reports required to
be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements
for
the past 90 days. Yes [ X ] No [ ]
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this
Form 10-K. [ ]
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
(Check one):
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Large
accelerated filer [ ]
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Accelerated
filer [ ]
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Non-accelerated
filer [X]
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Indicate
by check mark whether the registrant is a shell company (as defined in rule
12(b)-2 of the Exchange Act). Yes [ ] No [X]
The
aggregate market value of Common Stock held by non-affiliates as of June 30,
2006 was $37,173,659 based on the closing price of such stock on that date
of
$4.10.
The
number of shares outstanding of each of the registrant’s Common Stock and Series
A Cumulative Convertible Preferred Stock as of March 31, 2007:
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Common
Stock, par value $.01 per share
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13,112,843
shares
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Series
A Cumulative Convertible Preferred Stock, par value $.01 per share
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0
shares
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DOCUMENTS
INCORPORATED BY REFERENCE
Portions
of the registrant's Proxy Statement for the 2007 Annual Meeting of Stockholders
to be filed pursuant to Regulation 14A under the Securities Exchange Act of
1934, as amended, are incorporated by reference into Part III.
GSE
SYSTEMS, INC.
FORM
10-K
For
the Year Ended December 31, 2006
TABLE
OF CONTENTS
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PART
I
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Page
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Item
1.
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Business
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4
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Item
1A.
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Risk
Factors
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19
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Item
1B.
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Unresolved
Staff Comments
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23
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Item
2.
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Properties
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23
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Item
3.
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Legal
Proceedings
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23
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Item
4.
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Submission
of Matters to a Vote of Security Holders
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24
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PART
II
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Item
5.
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Market
for Registrant’s Common Equity, Related
Stockholder
Matters, and Issuer Purchases of Equity Securities
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25
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Item
6.
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Selected
Consolidated Financial Data
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28
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Item
7.
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Management’s
Discussion and Analysis of Financial Condition
and
Results of Operations
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30
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Item
7A.
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Quantitative
and Qualitative Disclosures About Market Risk
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48
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Item
8.
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Financial
Statements and Supplementary Data
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49
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Item
9.
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Changes
in and Disagreements with Accountants
on
Accounting and Financial Disclosure
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50
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Item
9A.
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Controls
and Procedures
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50
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Item
9B.
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Other
Information
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51
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PART
III
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Item
10.
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Directors
and Executive Officers of the Registrant and Corporate Governance
Matters*
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51
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Item
11.
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Executive
Compensation*
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51
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Item
12.
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Security
Ownership of Certain Beneficial Owners
and
Management and Related Stockholder Matters*
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51
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Item
13.
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Certain
Relationships and Related Transactions and Director
Independence*
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52
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Item
14.
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Principal
Accountant Fees and Services*
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52
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PART
IV
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Item
15.
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Exhibits
and Financial Statement Schedules
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53
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SIGNATURES
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54
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Exhibits
Index
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55
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*
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to
be incorporated by reference from the Proxy Statement for the registrant’s
2007 Annual Meeting of
Shareholders.
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RETACT®,
GSE
Systems®, Thor®, OpenSim®, SmartTutor®, SimSuite Pro®, ESmart®, and GAARDS® are
registered trademarks and GFLOW+TM,
GLOGIC+TM,
GCONTROL+TM,
GPower+TM,
SimSuite PowerTM,
SimExecTM,
eXtreme
I/STM,
RACSTM,
PEGASUS
Plant Surveillance and Diagnosis SystemTM,
SIMONTM,
BRUS™,
SensBase™, Vista PINTM,
and
Java Applications & Development Environment (JADE)TM
are
trademarks of GSE Systems, Inc. All other trademarks used in this document
are
the property of their respective owners.
2
GSE
SYSTEMS, INC.
FORM
10-K
For
the Year Ended December 31, 2006
CAUTIONARY
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS.
This
report and the documents incorporated by reference herein contain
“forward-looking” statements within the meaning of Section 27A of the Securities
Act and Section 21E of the Exchange Act that
are
based on management’s assumptions, expectations and projections about us, and
the industry within which we operate,
that
have been made pursuant to the Private Securities Litigation Reform Act of
1995
which reflect our expectations regarding our future growth, results of
operations, performance and business prospects and opportunities. Wherever
possible, words such as “anticipate”, “believe”, “continue”, “estimate”,
“intend”, “may”, “plan”, “potential”, “predict”, “expect”, “should”,
“will” and similar expressions, or the negative of these terms or other
comparable terminology, have been used to identify these forward-looking
statements. These forward-looking statements may also use different phrases.
These statements regarding
our expectations reflect
our current beliefs and are based on information currently available to us.
Accordingly, these statements by their nature are subject to risks and
uncertainties, including those listed under Item 1A Risk Factors, which could
cause our actual growth, results, performance and business prospects and
opportunities to differ from those expressed in, or implied by, these
statements. We may not actually achieve the plans, intentions or
expectations disclosed in our forward-looking statements and you should not
place undue reliance on our forward-looking statements. Actual results or events
could differ materially from the plans, intentions and expectations disclosed
in
the forward-looking statements we make. Except as otherwise required by federal
securities law, we are not obligated to update or revise these forward-looking
statements to reflect new events or circumstances. We caution you that a variety
of factors, including but not limited to the factors described below under
Item
1A Risk Factors and the following, could cause our business conditions and
results to differ materially from what is contained in forward looking
statements:
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changes
in the rate of economic growth in the United States and other major
international economies;
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changes
in investment by the nuclear and fossil electric utility industry,
the
chemical and petrochemical industries and the U.S. military-industrial
complex;
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changes
in the financial condition of our
customers;
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changes
in regulatory environment;
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changes
in project design or schedules;
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contract
cancellations;
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changes
in our estimates of costs to complete
projects;
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changes
in trade, monetary and fiscal policies
worldwide;
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currency
fluctuations;
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war
and/or terrorist attacks on facilities either owned or where equipment
or
services are or may be provided;
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outcomes
of future litigation;
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protection
and validity of our patents and other intellectual property
rights;
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increasing
competition by foreign and domestic
companies;
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compliance
with our debt covenants;
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recoverability
of claims against our customers and others;
and
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changes
in estimates used in our critical accounting policies.
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Other
factors and assumptions not identified above were also involved in the formation
of these forward-looking statements and the failure of such other assumptions
to
be realized, as well as other factors, may also cause actual results to differ
materially from those projected. Most of these factors are difficult to predict
accurately and are generally beyond our control. You should consider the areas
of risk described above in connection with any forward-looking statements that
may be made by us.
You
should not place undue reliance on any forward-looking statements. New factors
emerge from time to time, and it is not possible for us to predict which factors
will arise.
3
We
undertake no obligation to publicly update any forward-looking statements,
whether as a result of new information, future events or otherwise. You are
advised, however, to consult any additional disclosures we make in proxy
statements, quarterly reports on Form 10-Q, and current reports on Form 8-K
filed with the SEC.
PART
I
ITEM
1. BUSINESS.
GSE
Systems, Inc. (“GSE Systems”, “GSE”, the “Company”, “our”, “we” or “us”), a
Delaware corporation organized in March 1994, is a world leader in real-time,
high fidelity simulation. The Company provides simulation and educational
solutions and services to the nuclear and fossil electric utility industry
and
the chemical and petrochemical industries. In addition, the Company provides
plant monitoring, and signal analysis monitoring and optimization software
primarily to the power industry. GSE is the parent company of GSE Power Systems,
Inc., a Delaware corporation; GSE Power Systems, AB, a Swedish corporation;
GSE
Engineering Systems (Beijing) Co. Ltd, a Chinese limited liability company;
and
has a 10% minority interest in Emirates Simulation Academy, LLC, a United
Arab
Emirates limited liability company.
The
Company’s annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and all amendments to those reports file or
furnished pursuant to Section 13(a) or 15(d) of the Exchange Act (15 U.S.C.
78m(a) or 78o(d) will be made available free of charge through the Investor
Relations section of the Company’s Internet website (http://www.gses.com) as
soon as practicable after such material is electronically filed with, or
furnished to, the SEC. In addition, the public may read and copy any materials
we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE,
Washington, DC 20549. The public may obtain information on the operation
of the
Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains
an
Internet site that contains reports, proxy and information statements, and
other
information regarding issuers that file electronically with the SEC at
http://www.sec.gov.
Recent
Developments.
On
June
21, 2005, the Board of Directors of GP Strategies Corporation (“GP Strategies”)
approved plans to spin-off its 57% interest in GSE through a special dividend
to
the GP Strategies’ stockholders. On September 30, 2005, the GP Strategies’
stockholders received 0.283075 share of GSE common stock for each share of
GP
Strategies common stock or Class B stock held on the record date of September
19, 2005. Following the spin-off, GP Strategies ceased to have any ownership
interest in GSE. GP Strategies continued to provide corporate support services
to GSE, including accounting, finance, human resources, legal, network support
and tax pursuant to a Management Services Agreement which expired on December
31, 2006.
4
In
order
to ensure that the Company had sufficient working capital in 2006, the Company
completed several financing transactions in early 2006. On February 28, 2006,
the Company and Dolphin Direct Equity Partners, LP (“Dolphin”) entered into a
Cancellation and Warrant Exchange Agreement (the “Cancellation Agreement ”)
under which Dolphin agreed to cancel its Senior Subordinated Secured Convertible
Promissory Note and cancel its outstanding warrant to purchase 380,952 shares
of
GSE common stock at an exercise price of $2.22 per share. In exchange for
Dolphin’s agreement to enter into the Cancellation Agreement and for the
participation of Dolphin Offshore Partners, LP in the Preferred Stock
transaction discussed below, the Company repaid the Dolphin Note and agreed
to
issue a new warrant to purchase 900,000 shares of GSE common stock at an
exercise price of $0.67 per share (the “Dolphin Warrant”). At the date of
issuance, the fair value of the Dolphin Warrant was $868,000, as established
using the Black-Scholes Model, and was recorded in paid-in capital with the
offset recorded as loss on extinguishment of debt. In accordance with the terms
of the warrant agreement, Dolphin exercised the Dolphin Warrant on November
8,
2006 upon the Company’s certification that, among other things, the underlying
shares of GSE common stock were registered with the Securities and Exchange
Commission on October 31, 2006, that the current stock price was greater than
$1.25 per share, and that the average of the current stock prices for each
trading day of the prior 30 calendar day period was not less than $1.25 per
share. The Company received cash proceeds of $603,000.
In
conjunction with the early payoff of the Dolphin Note and the cancellation
of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000, recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature
and
the related warrants, and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin. The total loss on extinguishment of the Dolphin
Note and the cancellation of the related warrants totaled $1.4 million.
On
February 28, 2006, the Company raised $3.9 million, net of associated fees
of
$395,000, through the sale of 42,500 shares of Series A Cumulative Convertible
Preferred Stock and Warrants by means of a private placement to “accredited
investors”, as that term is used in rules and regulations of the Securities and
Exchange Commission. The Convertible Preferred Stock was convertible at any
time
into a total of 2,401,133 shares of GSE common stock at a conversion price
of
$1.77 per share. The conversion price was equal to 110% of the closing price
of
the Company’s Common Stock on February 28, 2006, the date the sale of the
Convertible Preferred Stock was completed. Each investor received a five-year
warrant to purchase GSE common stock equal to 20% of the shares they would
receive from the conversion of the Convertible Preferred Stock, at an exercise
price of $1.77 per share. In aggregate, the Company issued warrants to purchase
a total of 480,226 shares of GSE common stock. The Convertible Preferred
Stockholders are entitled to an 8% cumulative dividend, payable on a semiannual
basis every June 30 and December 30. In 2006, the Company paid dividends
totaling $279,000 to the preferred stockholders. At the date of issuance, the
fair value of the warrants was $342,000 and the fair value of the preferred
stock was $3.9 million. The fair value of the warrants and the preferred stock
was determined by the use of the relative fair value method, in which the $4.25
million gross proceeds was allocated based upon the fair values of the warrants,
as determined by using the Black-Scholes Model, and the preferred stock, as
determined by an independent appraisal. At any time after March 1, 2007, the
Company had the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading
days
immediately prior to the date of such conversion exceeded 200% of the Series
A
Conversion Price. Prior to March 7, 2007, the holders of 22,500 shares of
Preferred Stock had already elected to convert their Preferred Stock into a
total of 1,271,187 shares of Common Stock; 8,580 shares of Preferred Stock
were
converted in 2006 and 13,920 shares of Preferred Stock in 2007. On March 7,
2007, the Company sent notice to the holders of the remaining 20,000 outstanding
shares of its Preferred Stock that the average current stock price for the
prior
twenty trading days had exceeded 200% of the Conversion Price, and that the
Company was converting the outstanding Preferred Stock into common stock. The
20,000 shares of Preferred Stock will convert to 1,129,946 shares of GSE common
stock. The holders of the Convertible Preferred Stock were entitled to vote
on
all matters submitted to the stockholders for a vote, together with the holders
of the voting common stock, all voting together as a single class. The holders
of the Convertible Preferred Stock were entitled to the number of votes equal
to
the number of GSE common stock that they would receive upon conversion of their
Convertible Preferred Stock.
5
The
Company paid the placement agent for the Convertible Preferred Stock and
Warrants 6% of the gross proceeds received by the Company from the offering
($255,000) plus five-year warrants to purchase 150,000 shares of the Company’s
common stock at an exercise price of $1.77 per share. In addition to the
placement agent fee, the Company paid $140,000 of other transaction fees related
to the offering. At the date of issuance, the fair value of the placement agent
warrants was $128,000, as established using the Black-Scholes Model, and was
recorded in paid-in capital, with the offset recognized as a reduction of the
preferred stock proceeds.
The
proceeds were used to payoff the Dolphin Note and the Company’s line of credit
balance and for other working capital purposes.
On
March
7, 2006, the Company entered into a new loan and security agreement with Laurus
Master Fund, Ltd and terminated its existing $1.5 million bank line of credit.
The new agreement established a $5.0 million line of credit for the Company.
The
line is collateralized by substantially all of the Company’s assets and provides
for borrowings up to 90% of eligible accounts receivable and 40% of eligible
unbilled receivables (up to a maximum of $1.0 million). The interest rate on
this line of credit is based on the prime rate plus 200-basis points (10.25%
as
of December 31, 2006), with interest only payments due monthly. There are no
financial covenant requirements under the new agreement and the credit facility
expires on March 6, 2008. On May 18, 2006, Laurus Master Fund agreed to
temporarily increase the Company’s borrowing capability by $2.0 million over and
above the funds that were available to the Company based upon its normal
borrowing base calculation. The over advance was used to collateralize a $2.1
million performance bond that the Company issued to the Emirates Simulation
Academy, LLC (“ESA”) in the form of a standby letter of credit. One half of the
increased borrowing capability expired on July 18, 2006, and the balance expires
on April 13, 2007. The Company’s borrowings over and above the normal borrowing
base calculation bear additional interest of 1.5% per month over and above
the
normal interest rate on the line of credit. At December 31, 2006, the Company’s
available borrowing base was $4.2 million of which $2.2 million had been
utilized. The Company issued to Laurus Master Fund, Ltd a warrant to purchase
up
to 367,647 shares of GSE common stock at an exercise price of $.01 per share.
At
the date of issuance, the fair value of the Laurus warrant, which was
established using the Black-Scholes Model, was $603,000 and was recorded as
paid-in capital with the offset recorded as deferred financing charges. Deferred
financing charges are classified as an other asset and are amortized over the
term of the credit facility through a charge to interest expense. On July 31,
2006, Laurus exercised the warrant through a cashless exercise procedure as
defined in the warrant. Laurus received 366,666 shares of GSE common
stock.
The
Company believes it is positioned to take advantage of emerging trends in the
power industry including a global nuclear power renaissance driven by the high
cost of oil coupled with environmental concerns caused by fossil fuels. In
the
U.S. alone, most operating units have applied for license extensions and/or
power upgrades. These license extensions and power upgrades lead to significant
upgrades to the physical equipment and control room technology. Both will result
in the need to modify or replace the existing plant control room simulators.
In
addition, eleven utility companies in the United States have already submitted,
or plan to submit shortly, construction and operating license applications
to
the Nuclear Regulatory Commission for the construction of 31 new nuclear plants.
Each of these plants will be required to have a full scope simulator ready
for
operator training and certification about two years prior to plant operation.
Similar nuclear plant construction programs are underway or planned in China,
Russia, Ukraine, Japan and Central Europe to meet growing energy demands.
Globally, industry sources indicate that over 180 new nuclear power plants
are
in the planning, pre-construction or construction phase. The Company, having
what it believes is the largest installed base of existing simulators, over
65%
on a global basis, is well positioned to capture a large portion of this
business, although no assurance can be given that it will be successful in
doing
so.
6
In
2005,
the Company completed an agreement with Westinghouse Electric Company LLC to
become their preferred vendor for the development of simulators for the AP1000
reactor design. As a result of this agreement, GSE is working closely with
Westinghouse to finalize the verification and validation of the AP1000 Reactor
Human-Machine Interface for the Main Control Room, and the Company’s simulation
models have been used to help Westinghouse successfully complete several phases
of Human-Machine Interface testing with US regulators. In turn, Westinghouse
and
GSE will collaborate on new opportunities both internationally and domestically.
Westinghouse announced on March 1, 2007 that it had successfully negotiated
a
framework agreement to provide four AP 1000 Nuclear Power Plants in the People’s
Republic of China. China's State Nuclear Power Technology Company (SNPTC)
selected Westinghouse's AP1000 passive Generation III technology as the basis
for the Sanmen and Haiyang plants. The framework agreement confirmed the basic
requirements and obligations of all involved parties, early engineering
activities and early funding for long-lead materials including early stage
work
on the two planned simulators. GSE received a small contract from Westinghouse
to begin work on the simulators. The Westinghouse agreement does not prevent
the
Company from working with other nuclear vendors anywhere in the
world.
In
2005,
the Company was awarded a $1.3 million contract to develop simulation models
for
the novel Pebble Bed Modular Reactor System (PBMR) being developed by a South
African company. The PBMR is a new high temperature gas cooled reactor that
is
inherently safe and reliable. Each reactor is designed to produce 165 MW, enough
to provide energy for 40,000 hours. The system is designed such that additional
reactors can easily be added as energy demand increases. The PBMR is ideally
suited for areas with current modest energy needs that are expected to grow.
In
July, 2006, the Company successfully completed the Site Acceptance Testing
for
recently delivered simulation models for the PBMR. GSE believes it is in an
excellent position to provide the simulators that will be required with each
PBMR installation, although there is no guarantee the Company will be awarded
additional contracts.
Throughout
the year, the Company continued its focus on the fossil power segment of the
power industry. In 2006, the Company logged fossil power orders of over $5.3
million. The Company expects continued growth in this market segment and is
focusing on second time simulation buyers that now demand the more sophisticated
and realistic simulation models offered by the Company.
While
GSE
simulators are primarily utilized for power plant operator certification and
training, the uses are expanding to include control system design, engineering
analysis, plant modification studies, and operation efficiency improvements
for
both nuclear and fossil utilities. During plant construction, simulators are
used to test control strategies and finalize control system displays and control
system layout. This helps to ensure on-time plant start-up. After commissioning,
the same tools can be used to increase plant availability and optimize plant
performance for the life of the facility.
Over
the
course of 2006, the Company has continued to develop its concept of integrating
simulation with broader training programs and educational initiatives giving
customers a turnkey alternative to operator and maintenance training. The
Company believes that this offering is unique. In late 2005, the Company
announced the formation of the Emirates Simulation Academy, LLC (ESA), a United
Arab Emirates company, to build and operate simulation training academies in
the
Arab Gulf Region. GSE is a 10% owner of ESA. These simulation training centers
will be designed to train and certify indigenous workers for deployment to
a
nation's critical infrastructure facilities including power plants, oil
refineries, petro-chemical plants, desalination units and other industrial
facilities. In January 2006, the Company announced the award of a contract
valued at over $15 million from ESA to supply five simulators and an integrated
training program. Similar simulation training center opportunities are in
development in a number of regions around the world.
7
Background.
GSE
Systems was formed on March 30, 1994 to consolidate the simulation and related
businesses of S3 Technologies, General Physics International Engineering &
Simulation and EuroSim, each separately owned and operated by ManTech
International Corporation, GP Strategies Corporation and Vattenfall AB,
respectively. On December 30, 1994, GSE Systems expanded into the process
control automation and supply chain management consulting industry through
its
acquisition of the process systems division of Texas Instruments Incorporated,
which the Company operated as GSE Process Solutions, Inc.
In
December 1997, the Company acquired 100% of the outstanding common stock of
J.L.
Ryan, Inc. (“Ryan”), a provider of engineering modifications and upgrade
services to the power plant simulation market. The combination of the Company’s
pre-existing technology with the technical staff of the acquired Ryan business
positioned the Company to be more competitive for modifications and upgrade
service projects within the nuclear simulation market.
In
October 2002, GSE purchased the stock of ManTech Automation Systems (Beijing)
Company Ltd, from ManTech International Corp. The Chinese company, which has
ten
employees, was renamed GSE Systems Engineering (Beijing) Company Ltd. This
acquisition gave the Company a much needed base in China to pursue and implement
simulation projects in that emerging market.
In
September 2003, the Company completed the sale of substantially all of the
assets of GSE Process Solutions, Inc. (“Process”) to Novatech, LLC (Novatech)
pursuant to an Asset Purchase Agreement, effective as of September 25, 2003,
by
and between the Company, Process and Novatech. The Company received $5.5 million
in cash.
Simulation
Business.
Power
Simulation.
Industry
History
The
real-time simulation industry grew from the need to train people on complex
and
potentially dangerous operations, without placing life or capital assets at
risk. Real-time simulation has been used for the training of plant operators
for
the power industry, including both nuclear power plants and conventional fossil
fuel power plants (i.e., coal, oil, and natural gas), since the early 1970s.
Real-time simulation usage has traditionally centered on initial training of
operators and follow-on training of operators in emergency conditions that
can
best be achieved through simulation replicating actual plant
operations.
8
In
the
nuclear power industry, use of a simulator that accurately reflects the current
actual plant design is mandated by the U.S. Nuclear Regulatory Commission.
This
mandate resulted from the investigation of the accident at the Three Mile Island
nuclear plant in 1979, which was attributed, at least in part, to operator
error. The NRC requires nuclear plant operators to earn their licenses through
simulator testing. Each nuclear plant simulator must pass a certification
program to ensure that the initial plant design and all subsequent changes
made
to the actual plant control room or plant operations are accurately reflected
in
the simulator. Plant operating licenses are tied to simulator
certification.
Full
scope power plant simulators are a physical representation of the entire plant
control room. The control panels are connected to an input/output (I/O) system,
which converts analog electrical signals to digital signals understood by the
simulation computer. The simulation computer houses the mathematical models,
which simulate the physical performance of the power plant’s systems such as the
reactor core, steam boiler, cooling water, steam turbine, electrical generator,
plant system controls and electrical distribution systems. Partial scope
simulators can be viewed as a subset of a full scope simulator. Instead of
simulating the entire performance of the power plant, a partial scope simulator
might represent one or two critical systems such as the steam turbine and/or
electrical generator operation.
In
the
past, training simulators had to strike a delicate balance between providing
an
accurate engineering representation of the plant, while still operating in
“real-time” in order to provide effective training. As computing power has
increased, so too has the capacity of simulators to provide more accurate plant
representations in real-time based upon simulation models developed from
engineering design codes.
Simulation
also is used to validate proposed plant equipment changes and to confirm the
results of such changes, prior to making the change in the plant, which can
save
time and money, as well as reduce the risk of unsafe designs, for the utility.
Demand
for new simulators in the nuclear power industry shifted to the international
market in the 1990s, as the domestic market was limited to upgrades and
replacement of existing simulators. However, the Company believes that the
economics and importance of nuclear power to the U.S. energy supply may result
in the extension of the useful lives of U.S. nuclear power plants. Any service
life extension of a nuclear power plant is likely to require major upgrades
to
the plant's equipment and technology, including its simulator.
Fossil
fuel plant simulators are not required by law or regulation, but are justified
as a cost-effective approach to train operators on new digital control systems
being implemented at many fossil fuel power plants. The size, complexity and
price of a fossil plant simulator are much lower than for simulators used for
nuclear plants. Fossil plant simulators have traditionally used lower fidelity
(less sophisticated) mathematical models to provide an approximate
representation of plant performance. The demand for highly accurate models
did
not exist in the early market for fossil simulators since the main use of the
simulator was to train operators on the functionality of distributed control
systems for plant start-up activities.
The
deregulation of the power industry has forced utilities to view their assets
differently. Power plants must now be profit centers, and gaining the maximum
efficiency from the plant to become, or remain, competitive is a paramount
issue. The mindset of the operator has shifted, as plant operators now must
perform within narrower and narrower performance margins while still maintaining
safe operations. GSE believes its fossil fuel plant customers are now
recognizing the benefits of high fidelity simulation models that provide highly
accurate representations of plant operations to help plant operators and
management determine optimal performance conditions.
9
Beyond
traditional operator training uses, the Company sees a significant shift in
the
use of its simulators to test plant automation systems before they are deployed
in the actual plant. Control strategies and equipment set points are validated
on the simulator prior to plant start up to ensure the control schemes work
properly and the expected plant performance is achieved. Performing these tests
on a high fidelity simulator saves days or weeks in the plant start up, thereby
reducing cost and ensuring quicker revenue generation by the utility.
Industry
Future
The
Company sees a renaissance in nuclear power generation both domestically and
internationally that will provide significant opportunities for expansion of
the
Company’s business. China has announced plans to build 40 new nuclear plants by
the year 2020. Russia has also announced plans for 40 new plants by 2030. New
plants are on the drawing board or under construction in Finland, Slovakia,
and
Bulgaria. Domestically, numerous utilities are preparing applications for
Construction and Operating Licenses under the Department of Energy 2010
incentive program, a joint government/industry cost-shared effort to identify
sites for new nuclear power plants, develop advanced nuclear plant technologies,
and demonstrate new regulatory processes leading to a private sector decision
to
order new nuclear power plants for deployment in the United States in the 2010
timeframe. Beyond new construction, numerous U.S. utilities are extending the
useful life of their current assets.
These
license extension processes in the nuclear industry will result in significant
changes in plant equipment and control room technology. Based upon U.S. Nuclear
Regulatory Commission regulations, each training simulator is required to
reflect all changes that are made in the actual plant, thus when changes in
plant equipment and control room technology are made, the nuclear power plants
must either upgrade existing simulators or purchase brand new
simulators.
The
second phenomena affecting the industry is the aging of the nuclear and fossil
plant operator workforce which will result in the need for simulation to train
the next generation of plant operators. The industry is faced with an aging
workforce at the same time new capacity is needed, thereby placing significant
pressure on the industry to find and train the next generation of operations
and
maintenance personnel. According to the Energy Central Research and Analysis
Division white paper entitled The High Cost of Losing Intellectual Capital,
the
U.S. Bureau of Labor Statistics predicts that 30% or more of the existing
workforce will be eligible for retirement in the next five years, and it is
believed that by 2012 there will be nearly 10,000 more utility industry jobs
then workers to fill them.
Therefore,
the Company believes that these trends, if they come to fruition in whole or
even in part, represent a market opportunity for its real-time simulation,
plant
optimization, asset management and condition monitoring products and
services.
GSE’s
Solution
The
Company’s Power Simulation business is a leader in the development, marketing
and support of high fidelity, real-time, dynamic simulation software for the
electric utility industry. The Company has built or modified about 65 of the
approximately 75 full-scope simulators serving about 103 operating nuclear
power
plants in the United States. Outside the United States, GSE has built or
modified about 73 of the approximately 167 full-scope simulators serving
approximately 329 operating nuclear power plants.
The
Company has developed integrated training solutions which combine the power
of
the Company’s simulation technology with training content to provide turn-key
training for the power and process industries. These training centers will
help
industry bridge the gap between college and university level training, and
real
world experience through simulation. The students that graduate from GSE’s
training centers will be eminently more valuable to the market
place.
10
In
addition to operator training, the Company’s simulation products and services
permit plant owners and operators to simulate the effects of changes in plant
configuration and performance conditions to optimize plant operation. These
features allow the Company’s customers to understand the cost implications of
replacing a piece of equipment, installing new technology or holding
out-of-service assets. GSE has also developed a suite of tools based on
sophisticated signal analysis and simulation techniques to help its customers
manage their assets by determining equipment degradation before it severely
impacts plant performance.
The
Company has also focused on upgrading older technology used in power plants
to
new technology upgrades for plant process computers and safety parameter display
systems. As nuclear plants in the U.S. continue to age, the Company will seek
more business in this upgrade market.
GSE
provides both turnkey solutions, including simulated hardware and proprietary
software, to match a specific plant, and discrete simulation technology for
specific uses throughout a plant. Its substantial investment in simulation
technology has led to the development of proprietary software tools. These
tools
significantly reduce the cost and time to implement simulation solutions and
support long-term maintenance. The Company’s high fidelity, real-time simulation
technology for power plant fluid, logic and control, electrical systems and
associated real time support software, JADE, is available for use primarily
on
UNIX, Linux and Windows computer platforms. The Company’s eXtreme
tools
were designed for the Windows environment. Both technologies were specifically
designed to provide user friendly graphic interfaces to the Company’s high
fidelity simulator.
In
addition to the simulator market, the Company offers products aimed at improving
performance of existing plants by reducing the number of unplanned outages
due
to equipment failure. Using advanced signal analysis techniques, the Company’s
tools can predict when certain plant equipment needs to be replaced. Replacement
of critical equipment prior to failure permits effective planning and efficient
use of maintenance time during scheduled off-line periods.
Products
of the Power Simulation business include:
| ¨ |
Java
Applications & Development Environment (JADE), a
Java-based application that provides a window into the simulation
instructor station and takes advantage of the web capabilities of
Java,
allowing customers to access the simulator and run simulation scenarios
from anywhere they have access to the web. JADE includes the following
software modeling tools:
|
| ¨ |
Jflow,
a
modeling tool that generates dynamic models for flow and pressure
networks.
|
| ¨ |
Jcontrol,
a
modeling tool that generates control logic models from logic
diagrams.
|
| ¨ |
Jlogic,
a
modeling tool that generates control logic models from schematic
diagrams.
|
| ¨ |
Jelectric,
a
modeling tool that generates electric system models from schematic
and
one-line diagrams.
|
| ¨ |
Jtopmeret,
a
modeling tool that generates two phase network dynamic models.
|
| ¨ |
Jdesigner,
a
JADE based intuitive graphic editor for all JADE tools.
|
| ¨ |
Jstation,
a
JADE based web-enabled Instructor
Station.
|
| ¨ |
eXtreme
Tools
is
a suite of software modeling tools developed under the Microsoft
Windows
environment. It includes:
|
| ¨ |
XtremeFlow,
a modeling
tool that generates dynamic models for flow and pressure
networks.
|
| ¨ |
XtremeControl,
a modeling
tool that generates control logic models from logic
diagrams.
|
| ¨ |
XtremeLogic,
a
modeling tool that generates control logic models from schematic
diagrams.
|
| ¨ |
Xtreme
Electric,
a
modeling tool that generates electric system models from schematic
and
one-line diagrams.
|
11
| ¨ |
SimExec
and OpenSim
are real-time simulation executive systems that control all real-time
simulation activities and allows for an off-line software development
environment in parallel with the training
environment.
|
OpenSim
is
targeted for users of Microsoft Windows operating systems, while SimExec
is
targeted for users of Microsoft Windows, UNIX and LINUX operating
systems.
| ¨ |
SmartTutor,
complementary software for instructor stations. It provides new
capabilities to help improve training methodologies and productivity.
Using Microsoft Smart Tag technology, SmartTutor allows the control
of the
simulator software directly from Microsoft Office products. The user
can
run training scenarios directly from a Microsoft Word document, or
he can
plot and show transients live within a Microsoft PowerPoint
slide.
|
| ¨ |
eXtreme
I/S,
a
Microsoft Windows based Instructor Station that allows the use of
Microsoft Word and PowerPoint to control the real-time simulation
environment. eXtreme I/S is a user-friendly tool for classroom training
and electronic report generation. It provides real-time plant performance
directly from the simulator during classroom training, which drastically
increases learning efficiency.
|
| ¨ |
Pegasus
Surveillance and Diagnosis System,
a
software package for semi-automatic plant surveillance and diagnostics,
incorporates sophisticated signal processing and simulation techniques
to
help operators evaluate the condition and performance of plant components.
Pegasus permits plant management to identify degraded performance
and
replace components before they
fail.
|
| ¨ |
SIMON,
a
computer workstation system used for monitoring stability of boiling
water
reactor plants. SIMON assists the operator in determining potential
instability events, enabling corrective action to be taken to prevent
unnecessary plant shutdowns.
|
The
Simulation business also provides consulting and engineering services to help
users plan, design, implement, and manage/support simulation and control
systems. Services include application engineering, project management, training,
site services, maintenance contracts and repair.
Strategy
The
goal
of the Power Simulation business is to expand its business on four
fronts:
| ¨ |
Continue
serving its traditional customer base.
|
| ¨ |
Combine
its simulation capability with training content to provide totally
integrated training solutions.
|
| ¨ |
Leverage
its existing engineering staff to provide additional services to
domestic
and international clients.
|
12
Traditional
Simulation Market. Nuclear power currently accounts for about 20% of the
electrical power grid capacity in the United States and this percentage will
likely remain the same even as total capacity increases. Any new nuclear power
plants will likely be of the advanced reactor designs created by Westinghouse,
General Electric and Areva. These new designs require new simulators and
training programs, as they are different from the nuclear power plant designs
currently in operation. In addition to new power plants, existing nuclear power
plants will likely be required to remain on-line for a longer period than
originally expected. In order to stay in operation, many plants will require
life extension modifications. Since all existing U.S. nuclear power plants
went
on-line before 1979, their designs and technology can also benefit from the
substantial advances in plant design and technology developed over the past
25
years. For example, several of the Company’s U.S. utility customers are
considering replacing their existing hard panel control rooms with modern
distributed control systems (DCS) as are common in fossil fuel plants, and
which
have been implemented in Europe for several years. Significant changes to
control room instrumentation and overall control strategy from hard panel to
DCS
generally require modification or replacement of the plant simulator. With
the
largest installed base of nuclear plant simulators in the world, the Company
believes it is uniquely positioned to serve this market segment with new
simulation products and services. GSE has received several projects in the
last
two years for implementing digital turbine control systems in U.S. plants.
As
plants
extend their useful life, many plan to “up-rate” the existing capacity to
increase electrical yield. By changing the capacity of certain equipment in
a
plant, the utility can gain upwards of a 10%-15% increase in output. Again,
any
such changes must be reflected in the control room simulator, and operators
must
be trained on the new equipment before implementation.
In
addition to the United States markets, several emerging regions of the world
are
expanding their electrical capacity with both nuclear and fossil fuel power
plants. This is particularly the case in China and the Gulf Region of the Middle
East. In 2006, the Company received its first contract for a fully
integrated training academy in the United Arab Emirates. The Emirates Simulation
Academy, LLC will use five simulators developed by the Company for gas turbine
plants, combined cycle power plants, oil refineries, oil platforms and
desalination plants. In addition, the Company is providing the training content
for both classroom and simulator training. The Company sees other opportunities
for similar academies in other regions of the world.
Classroom
Simulation. In
recent
years the Company has upgraded numerous training simulators to utilize standard
PC technology. As an extension of the PC-based simulator technology, the Company
has developed tools which will allow the training simulator to be used in a
classroom setting, replacing the actual control room panels with “soft-panel”
graphics.
Increased
training requirements and demands for performance improvement have resulted
in
simulator training time becoming scarce. By providing the actual training
simulator models in a classroom setting, the value of the simulator is increased
by allowing more personnel the training advantages of interactive, dynamic
real-time simulation.
The
Company pioneered the technology to run a simulator on a PC several years ago.
However, the technology remains complex, which prevented wide deployment of
the
simulator in classrooms. The Company has developed unique software which allows
simulator-based training lessons to be easily developed and deployed in a
classroom setting.
13
Simulation
Beyond Training. In
addition to operator training, the Company’s simulation products can meet this
increased need for efficiency by assisting plant operators in understanding
the
cost implications of replacing equipment, installing new technology and
maintaining out-of-service assets. In order to exploit this potential, the
Company has increased the fidelity of its simulation products and is marketing
its services to increase the fidelity of simulators that are already in
operation.
As
computing power and networking technologies improve, several of the Company’s
customers have started to migrate simulation technology from the training
organization to the engineering organization. The same full scope simulation
software that drives the simulated control room panels in a simulator can be
used with graphical representations of the panels so engineers can test design
changes and see how the balance of the plant will react to such changes. GSE
has
developed a Java-based application to allow customers easier access to, and
use
of, the simulation capabilities across the organization through network
communication.
Optimize
Existing Engineering Resources. GSE’s Power domestic service organization
focuses on simulator upgrades and retrofits. In addition to domestic resources,
GSE has developed a network of trained engineers in Russia, Ukraine, Czech
Republic, Bulgaria, and China. These foreign resources provide low cost
engineering and software development capabilities and are readily available
to
supplement the United States engineering staff as necessary.
Strategic
Alliances
Power’s
strategic alliances have enabled the Company to penetrate regions outside the
United States by combining the Company’s technological expertise with the
regional presence and knowledge of local market participants. These strategic
alliances have also permitted the reduction of research and development and
marketing costs by sharing such costs with other companies.
In
recent
years, a significant amount of the Company’s international business has come
from contracts in Eastern Europe, including the republics of the former Soviet
Union, and the Pacific Rim. In order to acquire and perform these contracts,
the
Company entered into strategic alliances with various entities including All
Russian Research Institute for Nuclear Power Plant Operation (Russia); Kurchatov
Institute (Russia); Risk Engineering Ltd. (Bulgaria); SAIC (US); Samsung
Electronics (Korea); and Toyo Engineering Corporation (Japan). In March
2006, GSE completed a strategic alliance with the University of Strathclyde
in
Glasgow, UK to develop a simulation training and plant diagnostics center to
serve the UK.
Competition
The
Power
Simulation business encounters intense competition. In the nuclear simulation
market, GSE competes directly with larger firms primarily from Canada and
Germany, such as L-3 Communications, MAPPS Inc. and STN Atlas. The fossil
simulation market is represented by smaller companies in the U.S. and overseas.
Several of the Company’s competitors have greater capital and other resources
than it has, including, among other advantages, more personnel and greater
marketing, financial, technical and research and development capabilities.
Customer purchasing decisions are generally based upon price, the quality of
the
technology, experience in related projects, and the financial stability of
the
supplier.
Customers
The
Power
Simulation business has provided approximately 200 simulation systems to an
installed base of over 75 customers worldwide. In 2006, approximately 74% of
the
Company’s revenue was generated from end users outside the United States.
Customers include, among others, ABB Inc., American Electric Power, Bernische
Kraftwerke AG (Switzerland), British Energy Generation (UK), Comission Federal
De Electricidad (Mexico), Emerson Process Management, Emirates Simulation
Academy, LLC (UAE), Honeywell Hi-Spec Solutions (Canada), Kapar Energry Ventures
SDN BHD (Malaysia), Karnkraftsakerhet och Utbildning AB (Sweden), Battelle’s
Pacific Northwest National Laboratory, Nuclear Engineering Ltd. (Japan), Pebble
Bed Modular Reactor (Pty) Ltd. (South Africa), PSEG Nuclear, Inc., and
Rosenergoatom Federal State Owned Enterprise (Russia).
14
For
the
year ended December 31, 2006, the Emirates Simulation Academy, LLC provided
21%
of the Company’s consolidated 2006 revenue (none in 2005 and 2004);
Rosenergoatom Federal State Owned Enterprise provided 12% of the Company’s
consolidated 2006 revenue (0% and 5% in 2005 and 2004, respectively), and
Battelle’s Pacific Northwest National Laboratory accounted for approximately 11%
of the Company’s 2006 consolidated revenue (25% and 24% in 2005 and 2004,
respectively). The Pacific Northwest National Laboratory is the purchasing
agent
for the Department of Energy and the numerous projects the Company performs
in
Eastern and Central Europe.
Sales
and Marketing
The
Company markets its Power Simulation products and services through a network
of
direct sales staff, agents and representatives, systems integrators and
strategic alliance partners. Market-oriented business and customer development
teams define and implement specific campaigns to pursue opportunities in the
power marketplace.
The
Company’s ability to support its multi-facility, international and/or
multinational Power Simulation clients is facilitated by its network of offices
and strategic partners in the U.S. and overseas. Power Simulation offices are
maintained in Maryland and Georgia, and outside the U.S., in Sweden and China.
In addition to the offices located overseas, the Company’s ability to conduct
international business is enhanced by its multilingual and multicultural work
force. GSE has strategic relationships with systems integrators and agents
representing its interests in:
|
¨ Brazil
¨ Czech
Republic
¨ India
¨ Mexico
¨ Russia
¨ South
Africa
¨ Taiwan
¨ United
Kingdom
|
¨ Bulgaria
¨ Germany
¨ Japan
¨ People's
Republic of China
¨ Spain
¨ South
Korea
¨ Ukraine
|
Process
Simulation.
Industry
Throughout
the process industries there is continuing competitive pressure, reduction
of
technical resources, and an aging workforce which is forcing process
manufacturers to turn to advanced technologies for real-time optimization,
training, and advanced process control. Operational efficiency is vital for
companies to remain competitive where many of the manufacturing industries
operate on very thin margins. There are only one or two advanced technology
companies that offer services fully across this spectrum, and GSE offers dynamic
real-time simulation capabilities for operator training into this segment.
15
GSE’s
Solution
The
SimSuite Pro product was developed by GSE specifically for operator training,
and the GSE culture and expertise is one of customized project execution and
delivery. This marketplace places a high value on experience, both company-wide
and for the individuals on the project teams, so GSE promotes its long history
in training simulators, while also seeking new applications. The SimSuite Pro
package continues to be enhanced with features applicable not just to the
execution of professional training techniques, but also to the recording and
validating of process operator performance for potential certification.
Strategy
The
core
concepts of process simulation make the technology a basis for other potential
process improvement activities, such as Advanced Process Control and Process
Optimization, which is where some of the major GSE competition has more business
focus than for operator training. GSE will continue to emphasize its operator
training focus and strengths, as well as the application of the process
simulator for change management, where changes in the process, control strategy,
or operating procedures can be evaluated in real time before they are applied
to
the actual process units. On-stream time is an important economic factor, and
there is recognizable value in avoiding the risk of unplanned process
disturbances from invalidated changes.
Competition
GSE’s
process simulation competitors are a varied group. There are major corporations
offering a wide range of products and services that include operator training
simulators. There are also companies focused on Process Technology and
manufacturing enhancement, such as Invensys and Honeywell who are Distributed
Control System ("DCS") distributors to the refining industry and provide
operator simulation as part of their DCS offering. There is a collection of
companies with specific industry niches that enables them to compete in operator
training simulation, such as Invensys and RSI. There are also the smaller
training companies that compete at the lower cost levels of Computer Based
Training (CBT) or simple simulations close to CBT.
The
GSE
focus on training simulation is a business strength, and its vendor
independence, with the ability to integrate to different vendor’s process
control systems, is also a value which is appreciated by customers. GSE can
be
seen as a best-of-breed type of supplier because it is not tied to a major
control system, nor is it providing simulation software for engineering and
business management with high annual license fees.
Sales
and Marketing
The
Company will market its Process Simulation technologies through a combination
of
techniques including its existing direct sales channel, sales agents, and
strategic alliance partners.
Competitive
Advantages.
The
Company believes that it is in a strong position to compete in the Simulation
markets based upon the following strengths:
16
| ¨ |
Technical
and Applications Expertise.
GSE is a leading innovator and developer of real-time software with
more
than 30 years of experience producing high fidelity real-time simulators.
As a result, the Company has acquired substantial applications expertise
in the energy and industrial process industries. The Company employs
a
highly educated and experienced multinational workforce of 135 employees,
including approximately 90 engineers and scientists. Approximately
60%
these engineers and scientists have advanced science and technical
degrees
in fields such as chemical, mechanical and electrical engineering,
applied
mathematics and computer sciences.
|
| ¨ |
Proprietary
Software Tools.
GSE has developed a library of proprietary software tools including
auto-code generators and system models that substantially facilitate
and
expedite the design, production and integration, testing and modification
of software and systems. These tools are used to automatically generate
the computer code and systems models required for specific functions
commonly used in simulation applications, thereby enabling it or
its
customers to develop high fidelity real-time software quickly, accurately
and at lower costs.
|
| ¨ |
Open
System Architecture. GSE’s
software products and tools are executed on standard operating systems
with third-party off-the-shelf hardware. The hardware and operating
system
independence of its software enhances the value of its products by
permitting customers to acquire less expensive hardware and operating
systems. The Company’s products work in the increasingly popular Microsoft
operating environment, allowing full utilization and integration
of
numerous off-the-shelf products for improved
performance.
|
| ¨ |
International
Strengths. Approximately
74% of the Company’s 2006 revenue was derived from international sales of
its products and services. GSE has a multinational sales force with
offices located in Beijing, China, and Nykoping, Sweden and agents
and
representatives in 22 other countries. To capitalize on international
opportunities and penetrate foreign markets, the Company has established
strategic alliances and partnerships with several foreign
entities.
|
Intellectual
Property.
The
Company depends upon its intellectual property rights in its proprietary
technology and information. GSE maintains a portfolio of patents, trademarks
(both registered and unregistered), copyrights (both registered and
unregistered), and licenses. While such patents, trademarks, copyrights and
licenses as a group are of material importance to the Company, it does not
consider any one patent, trademark, copyright, or license to be of such
importance that the loss or expiration thereof would materially affect any
segment or the Company as a whole. The Company relies upon a combination of
trade secrets, copyright, patent and trademark law, contractual arrangements
and
technical means to protect its intellectual property rights. GSE distributes
its
software products under software license agreements that grant customers
nonexclusive licenses for the use of its products, which are nontransferable.
Use of the licensed software is restricted to designated computers at specified
sites, unless the customer obtains a site license of its use of the software.
Software and hardware security measures are also employed to prevent
unauthorized use of the Company’s software, and the licensed software is subject
to terms and conditions prohibiting unauthorized reproduction of the software.
The
Company has several U.S. patents that were issued in the 1996 timeframe, none
of
which (individually or collectively) have a significant role in the Company’s
current business operations. In accordance with Title 35 U.S. Code Section
154,
these patents have a duration of 20 years from the filing date of the
application, subject to any statutory extension, provided they are properly
maintained. The Company believes that all of the Company’s trademarks
(especially those that use the phrase "GSE Systems") are valid and will have
an
unlimited duration as long as they are adequately protected and sufficiently
used. The Company’s licenses are perpetual in nature and will have an unlimited
duration as long as they are adequately protected and the parties adhere to
the
material terms and conditions.
17
GSE
has
eight registered U.S. trademarks: RETACT, GSE Systems, THOR, OpenSim, Smart
Tutor, SimSuite Pro, ESmart and GAARDS. Some of these trademarks have also
been
registered in foreign countries. The Company also claims trademark rights to
GLOW+, GLOGIC+, GCONTROL+, GPower+, SimSuite Power, SimExec, eXtreme I/S, RACS,
PEGASUS Plant Surveillance and Diagnosis System, SIMON, BRUS, Sens Base and
Vista PIN.
In
addition, the Company maintains federal statutory copyright protection with
respect to its software programs and products, has registered copyrights for
some of the documentation and manuals related to these programs, and maintains
trade secret protection on its software products.
Despite
these protections, the Company cannot be sure that it has protected or will
be
able to protect its intellectual property adequately, that the unauthorized
disclosure or use of its intellectual property will be prevented, that others
have not or will not develop similar technology independently, or, to the extent
it owns patents, that others have not or will not be able to design around
those
patents. Furthermore, the laws of certain countries in which the Company’s
products are sold do not protect its products and intellectual property rights
to the same extent as the laws of the United States.
Industries
Served.
The
following chart illustrates the approximate percentage of the Company's 2006,
2005, and 2004 consolidated revenue by industries served:
|
2006
|
2005
|
2004
|
|||||||
|
Nuclear
power industry
|
60%
|
83%
|
85%
|
||||||
|
Fossil
power industry
|
18%
|
14%
|
10%
|
||||||
|
Trainining
and education industry
|
21% | - | - | ||||||
|
Other
|
1%
|
3%
|
5%
|
||||||
|
Total
|
100%
|
100%
|
100%
|
||||||
Contract
Backlog.
The
Company does not reflect an order in backlog until it has received a contract
that specifies the terms and milestone delivery dates. As of December 31, 2006,
the Company’s aggregate contract backlog totaled approximately $18.5 million
(including $9.4 million for the ESA contract) of which approximately $17.8
million or 96% is expected to be converted to revenue by December 31, 2007.
As
of December 31, 2005, the Company’s aggregate contract backlog totaled
approximately $12.3 million.
Employees.
As
of
December 31, 2006, the Company had 135 employees as compared to 123 employees
at
December 31, 2005.
18
ITEM
1A. RISK FACTORS.
The
Company believes that the
following risk factors may cause the market price for its common stock to
fluctuate, perhaps significantly. In addition, in recent years the stock
market
in general, and the shares of technology companies in particular, have
experienced extreme price fluctuations. The Company’s common stock has also
experienced a relatively low trading volume, making it further susceptible
to
extreme price fluctuations.
The
Company has limited cash resources. If the Company is unable to generate
adequate cash flow from operations, it will need additional capital to fund
its
operations.
Based
on
the Company’s forecasted expenditures and cash flow, we believe we will need
$32.6 million to fund our consolidated operations for the twelve months ended
December 31, 2007. All of this funding is expected to be generated through
our
normal operations and the utilization of our current credit facility, and we
believe that we will have sufficient liquidity and working capital without
additional financing. We expect to generate $30.0 million of cash in the year
ended December 31, 2007 from the Company’s milestone billings backlog as of
December 31, 2006, including $12.8 million from the ESA Contract, plus the
orders logged by the Company in 2007 through March 15, 2007. The balance of
the
Company’s 2007 cash requirement is expected to be generated by future orders.
However, notwithstanding the foregoing, the Company may be required to look
for
additional capital to fund its operations if the Company is unable to operate
profitably and generate sufficient cash from operations. There can be no
assurance that the Company would be successful in raising such additional funds.
The
Company’s expense levels are based upon its expectations as to future revenue,
so it may be unable to adjust spending to compensate for a revenue shortfall.
Accordingly, any revenue shortfall would likely have a disproportionate effect
on the Company’s operating results.
The
Company’s revenue was $27.5 million, $22.0 million, and $29.5 million for the
years ended December 31, 2006, 2005 and 2004, respectively. The Company’s
operating income (loss) was $2.1 million, ($4.7 million), and $2,000 in 2006,
2005 and 2004, respectively. The Company’s operating results have fluctuated in
the past and may fluctuate significantly in the future as a result of a variety
of factors, including purchasing patterns, timing of new products and
enhancements by the Company and its competitors, and fluctuating foreign
economic conditions. Since the Company’s expense levels are based in part on its
expectations as to future revenue, the Company may be unable to adjust spending
in a timely manner to compensate for any revenue shortfall and such revenue
shortfalls would likely have a disproportionate adverse effect on operating
results.
Risk
of International Sales and Operations.
Sales
of
products and services to end users outside the United States accounted for
approximately 74% of the Company’s consolidated revenue in 2006, 63% of
consolidated revenue in 2005, and 65% of consolidated revenue in 2004. The
Company anticipates that international sales and services will continue to
account for a significant portion of its revenue in the foreseeable future.
As a
result, the Company may be subject to certain risks, including risks associated
with the application and imposition of protective legislation and regulations
relating to import or export (including export of high technology products)
or
otherwise resulting from trade or foreign policy and risks associated with
exchange rate fluctuations. Additional risks include potentially adverse tax
consequences, tariffs, quotas and other barriers, potential difficulties
involving the Company’s strategic alliances and managing foreign sales agents or
representatives and potential difficulties in accounts receivable collection.
The Company currently sells products and provides services to customers in
emerging market economies such as the United Arab Emirates (21% of the Company’s
consolidated revenue in 2006, but none in 2005 and 2004) and Russia (12%, 0%
and
5% of the Company’s consolidated revenue in 2006, 2005, and 2004, respectively)
Although end users in the Ukraine accounted for 8%, 18%, and 21% of the
Company’s consolidated revenue in 2006, 2005, and 2004, respectively, GSE’s
customer for these projects was Battelle’s Pacific Northwest National
Laboratory, which is the purchasing agent for the U.S. Department of Energy.
The
DOE provides funding for various projects in Eastern and Central Europe.
Accordingly, the Company is not subject to the political and financial risks
that are normally faced when doing business in the Ukraine. The Company has
taken steps designed to reduce the additional risks associated with doing
business in these countries, but the Company believes that such risks may still
exist and include, among others, general political and economic instability,
lack of currency convertibility, as well as uncertainty with respect to the
efficacy of applicable legal systems. There can be no assurance that these
and
other factors will not have a material adverse effect on the Company’s business,
financial condition or results of operations.
19
For
the year ended December 31, 2006, three customers provided a substantial portion
of the Company’s consolidated revenue. There is no guarantee that the Company
will be able to generate the same level of revenue from these customers in
future periods, nor that the Company could replace this revenue from other
customers. The loss of this revenue would cause a material adverse effect upon
the Company’s future revenue and results of operations.
For
the
year ended December 31, 2006, the Emirates Simulation Academy, LLC (UAE)
provided 21% of the Company’s consolidated 2006 revenue (none in 2005 and 2004);
Rosenergoatom Federal State Owned Enterprise (Russia) provided 12% of the
Company’s consolidated 2006 revenue (0% and 5% in 2005 and 2004, respectively),
and Battelle’s Pacific Northwest National Laboratory accounted for approximately
11% of the Company’s 2006 consolidated revenue (25% and 24% in 2005 and 2004,
respectively). The Pacific Northwest National Laboratory is the purchasing
agent
for the DOE and the numerous projects the Company performs in Eastern and
Central Europe. The Company may not generate comparable revenue from these
customers in future periods and may not be able to replace this revenue from
other customers, thus materially and adversely affecting the Company’s revenue
and results of operations.
The
Company’s business is substantially dependent on sales to the nuclear power
industry. Any disruption in this industry would have a material adverse effect
upon the Company’s revenue.
In
2006,
60% of GSE’s revenue was from customers in the nuclear power industry (83% in
2005 and 85% in 2004). The Company will continue to derive a significant portion
of its revenue from customers in the nuclear power industry for the foreseeable
future. The Company’s ability to supply nuclear power plant simulators and
related products and services is dependent on the continued operation of nuclear
power plants and, to a lesser extent, on the construction of new nuclear power
plants. A wide range of factors affect the continued operation and construction
of nuclear power plants, including the political and regulatory environment,
the
availability and cost of alternative means of power generation, the occurrence
of future nuclear incidents, and general economic conditions.
The
Company’s line
of credit agreement with Laurus Master Fund Ltd. imposes significant operating
and financial restrictions, which may prevent it from capitalizing on business
opportunities.
GSE’s
line of credit agreement with Laurus Master Fund Ltd. imposes significant
operating and financial restrictions. These restrictions affect, and in certain
cases limit, among other things, the Company’s ability to:
20
| ¨ |
incur
additional indebtedness and liens;
|
| ¨ |
make
capital expenditures;
|
| ¨ |
make
investments and acquisitions;
|
| ¨ |
consolidate,
merge or sell all or substantially all of its
assets.
|
There
can
be no assurance that these restrictions will not adversely affect the Company’s
ability to finance its future operations or capital needs or to engage in other
business activities that may be in the interest of stockholders.
The
Company is dependent on product innovation and research and development, which
costs are incurred prior to revenue for new products and improvements.
The
Company believes that its success will depend in large part on its ability
to
maintain and enhance its current product line, develop new products, maintain
technological competitiveness and meet an expanding range of customer needs.
The
Company's product development activities are aimed at the development and
expansion of its library of software modeling tools, the improvement of its
display systems and workstation technologies, and the advancement and upgrading
of its simulation technology. The life cycles for software modeling tools,
graphical user interfaces, and simulation technology are variable and largely
determined by competitive pressures. Consequently, the Company will need to
continue to make significant investments in research and development to enhance
and expand its capabilities in these areas and to maintain its competitive
advantage.
The
Company relies upon its intellectual property rights for the success of its
business; however, the steps it has taken to protect its intellectual property
may be inadequate.
Although
the Company believes that factors such as the technological and creative skills
of its personnel, new product developments, frequent product enhancements and
reliable product maintenance are important to establishing and maintaining
a
technological leadership position, the Company's business depends, in part,
on
its intellectual property rights in its proprietary technology and information.
The Company relies upon a combination of trade secret, copyright, patent and
trademark law, contractual arrangements and technical means to protect its
intellectual property rights. The Company enters into confidentiality agreements
with its employees, consultants, joint venture and alliance partners, customers
and other third parties that are granted access to its proprietary information,
and limits access to and distribution of its proprietary information. There
can
be no assurance, however, that the Company has protected or will be able to
protect its proprietary technology and information adequately, that the
unauthorized disclosure or use of the Company's proprietary information will
be
prevented, that others have not or will not develop similar technology or
information independently, or, to the extent the Company owns patents, that
others have not or will not be able to design around those patents. Furthermore,
the laws of certain countries in which the Company's products are sold do not
protect the Company's products and intellectual property rights to the same
extent as the laws of the United States.
The
industries in which GSE operates are highly competitive. This competition may
prevent the Company from raising prices at the same pace as its costs increase.
21
The
Company's businesses operate in highly competitive environments with both
domestic and foreign competitors, many of whom have substantially greater
financial, marketing and other resources than the Company. The principal factors
affecting competition include price, technological proficiency, ease of system
configuration, product reliability, applications expertise, engineering support,
local presence and financial stability. The Company believes that competition
in
the simulation fields may further intensify in the future as a result of
advances in technology, consolidations and/or strategic alliances among
competitors, increased costs required to develop new technology and the
increasing importance of software content in systems and products. The Company
believes that its technology leadership, experience, ability to provide a wide
variety of solutions, product support and related services, open architecture
and international alliances will allow it to compete effectively in these
markets. As the Company’s business has a significant international component,
changes in the value of the dollar could adversely affect the Company's ability
to compete internationally.
GSE
may
pursue new acquisitions and joint ventures, and any of these transactions could
adversely affect its operating results or result in increased costs or other
problems.
The
Company intends to pursue new acquisitions and joint ventures, a pursuit which
could consume substantial time and resources. Identifying appropriate
acquisition candidates and negotiating and consummating acquisitions can be
a
lengthy and costly process. The Company may also encounter substantial
unanticipated costs or other problems associated with the acquired businesses.
The risks inherent in this strategy could have an adverse impact on the
Company’s results of operation or financial condition.
The
nuclear power industry, the Company’s largest customer group, is associated with
a number of hazards which could create significant liabilities for the
Company.
The
Company’s business could expose it to third party claims with respect to
product, environmental and other similar liabilities. Although the Company
has
sought to protect itself from these potential liabilities through a variety
of
legal and contractual provisions as well as through liability insurance, the
effectiveness of such protections has not been fully tested. Certain of the
Company’s products and services are used by the nuclear power industry primarily
in operator training. Although the Company’s contracts for such products and
services typically contain provisions designed to protect the Company from
potential liabilities associated with such use, there can be no assurance that
the Company would not be materially adversely affected by claims or actions
which may potentially arise.
ITEM
1B. UNRESOLVED STAFF COMMENTS
None.
22
ITEM
2. PROPERTIES.
The
Company is headquartered in a facility in Baltimore, Maryland (approximately
21,000 square feet). The lease for this facility expires in 2008.
In
addition, the Company leases office space domestically in Georgia and
internationally in China and Sweden. The Company leases these facilities for
terms ending between 2007 and 2008.
In
October 2005, the Company relocated its Maryland operations from its facility
in
Columbia to the Baltimore facility and signed an “Assignment of Lease and
Amendment to Lease” that assigned and transferred to another tenant (the
“assignee”) the Company’s rights, title and interest in its Columbia, Maryland
facility lease. The assignee’s obligation to pay rent under the Lease began on
February 1, 2006. The Company remains fully liable for the payment of all rent
and for the performance of all obligations under the lease through the scheduled
expiration of the lease, May 31, 2008, should the assignee default on their
obligations.
ITEM
3. LEGAL
PROCEEDINGS.
The
Company and
our
subsidiaries are from time to time involved in ordinary routine litigation
incidental to the conduct of our business. The Company and our subsidiaries
are
not a party to, and our property is not the subject of, any material pending
legal proceedings that, in the opinion of management, are likely to have
a
material adverse effect on the Company’s business, financial condition or
results of operations.
23
ITEM
4. SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On
November 15, 2006, the Company held its annual meeting of shareholders. At
that
meeting, the following matters were voted upon:
|
Proposal
|
For
|
Withheld
|
Total
|
||||||||
|
1)
|
Election
of Directors for a three year term expiring in 2009:
|
||||||||||
|
Scott
N. Greenberg
|
8,953,174
|
543,619
|
9,496,793
|
||||||||
|
Joseph
W. Lewis
|
8,964,240
|
532,553
|
9,496,793
|
||||||||
|
O.
Lee Tawes, III
|
9,281,036
|
215,757
|
9,496,793
|
||||||||
|
The
following directors are serving terms until the annual meeting
in 2007 and
were not reelected at
the November 15, 2006 annual meeting:
|
|||||||||||
|
Jerome
I. Feldman
|
|||||||||||
|
John
V. Moran
|
|||||||||||
|
George
J. Pedersen
|
|||||||||||
|
|
|||||||||||
|
The
following directors are serving terms until the annual meeting
in 2008 and
were not reelected at
the November 15, 2006 annual meeting:
|
|||||||||||
|
Michael
D. Feldman
|
|||||||||||
|
Sheldon
L. Glashow
|
|||||||||||
|
Roger
L. Hagengruber
|
|||||||||||
|
|
|||||||||||
|
Proposal
|
For
|
Against
|
Abstain
|
Total
|
|||||||
|
2)
|
Ratification
of KPMG LLP as
|
||||||||||
|
the
Company's independent
|
|||||||||||
|
auditors
for the 2006 fiscal year
|
9,273,315
|
57,395
|
166,083
|
9,496,793
|
|||||||
24
PART
II
ITEM
5. MARKET
FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE
OF EQUITY SECURITIES.
The
Company’s common stock is listed on the American Stock Exchange, where it trades
under the symbol “GVP”. The following table sets forth, for the periods
indicated, the high and low sale prices for the Company’s common stock reported
by the American Stock Exchange for each full quarterly period within the
two
most recent fiscal years:
|
2006
|
||||||
|
Quarter
|
High
|
Low
|
||||
|
First
|
$
1.90
|
$
1.30
|
||||
|
Second
|
$
4.56
|
$
1.70
|
||||
|
Third
|
$
4.23
|
$
3.22
|
||||
|
Fourth
|
$
6.99
|
$
3.20
|
||||
|
2005
|
||||||
|
Quarter
|
High
|
Low
|
||||
|
First
|
$
2.76
|
$
1.75
|
||||
|
Second
|
$
2.20
|
$
1.70
|
||||
|
Third
|
$
1.80
|
$
1.25
|
||||
|
Fourth
|
$
1.58
|
$
1.06
|
||||
The
following table sets forth the equity compensation plan information for the
year
ended December 31, 2006:
25
|
Plan
category
|
Number
of securities to
be
issued upon exercise
of
outstanding options,
warrants
and rights
|
Weighted
average exercise
price
of outstanding
options,
warrants and
rights
|
Number
of securities
remaining
available for
future
issuance under
equity
compensation plans
|
|
Equity
compensation plan approved by security holders
|
1,892,702
|
$2.48
|
224,186
|
|
Equity
compensation plan not approved by security holders
|
--
|
$
--
|
--
|
|
Total
|
1,892,702
|
$2.48
|
224,186
|
There
were approximately 74 holders of record of the common stock as of March 15,
2007. The Company has never declared or paid a cash dividend on its common
stock. The Company currently intends to retain future earnings to finance the
growth and development of its business and, therefore, does not anticipate
paying any cash dividends in the foreseeable future on its common stock. In
December 2001,
the
Company issued to ManTech International Corp. 39,000 shares of convertible
preferred stock which accrued dividends at an annual rate of 6% payable
quarterly. ManTech elected to convert the preferred stock to common stock in
October 2003. At the date of the conversion, the Company’s credit facility
restricted the Company from paying any dividends on the preferred stock. At
December 31, 2006, the Company had accrued dividends payable to ManTech of
$316,000. The unpaid dividends accrue interest at 6% per annum. At December
31,
2006 the Company had an accrual for interest payable of $80,000.
The
Company believes factors such as quarterly fluctuations in results of operations
and announcements of new products by the Company or by its competitors may
cause
the market price of the common stock to fluctuate, perhaps significantly. In
addition, in recent years the stock market in general, and the shares of
technology companies in particular, have experienced extreme price fluctuations.
The Company’s common stock has also experienced a relatively low trading volume,
making it further susceptible to extreme price fluctuations. These factors
may
adversely affect the market price of the Company's common stock.
26
On
February 28, 2006, the Company raised $4.25 million through the sale of 42,500
shares of Series A Cumulative Convertible Preferred Stock and Warrants by means
of a private placement to “accredited investors”, as that term is used in rules
and regulations of the Securities and Exchange Commission. The Convertible
Preferred Stockholders were entitled to an 8% cumulative dividend, payable
on a
semiannual basis every June 30 and December 30. In 2006, the Company paid total
dividends of $279,000. At any time after March 1, 2007, the Company had the
right to convert the Preferred Stock into shares of GSE common stock when the
average of the current stock price during the twenty trading days immediately
prior to the date of such conversion exceeded 200% of the Series A Conversion
Price. Prior to March 7, 2007, the holders of 22,500 shares of Preferred Stock
had already elected to convert their Preferred Stock into a total of 1,271,187
shares of Common Stock; 8,580 shares of Preferred Stock were converted in 2006,
and 13,920 shares of Preferred Stock in 2007. On March 7, 2007, the Company
sent
notice to the holders of the remaining 20,000 outstanding shares of its
Preferred Stock that the average current stock price for the prior twenty
trading days had exceeded 200% of the Conversion Price, and that the Company
was
converting the outstanding Preferred Stock into common stock. The 20,000 shares
of Preferred Stock will convert to 1,129,946 shares of GSE common stock.
The
following graph compares the Company’s cumulative total shareholder return since
January 1, 2001 through December 31, 2006 with that of the American Stock
Exchange- US & Foreign Index and a peer group index. The Peer Group consists
of companies selected on a line-of-business basis and includes Aspen Technology,
Inc., GenSym Corporation and Honeywell International. The graph assumes an
initial investment of $100 on January 1, 2001 in our common stock and each
index
and that all dividends were reinvested. The Company has never paid a dividend
on
its common stock. The indices are re-weighted daily, using the market
capitalization on the previous tracking day. The comparisons shown in the
graph
below are based upon historical data. The stock price performance shown in
the
graph below is not necessarily indicative of, or intended to forecast, the
potential future performance of the Company’s common stock. The graph was
prepared for the Company by Ipreo, LLC.
27
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
|||
|
GSE
SYSTEMS, INC.
|
100.00
|
33.87
|
58.06
|
87.10
|
40.00
|
214.55
|
||
|
PEER
GROUP INDEX
|
100.00
|
71.66
|
103.38
|
111.37
|
119.82
|
148.86
|
||
|
AMEX
MARKET INDEX
|
100.00
|
96.01
|
130.68
|
149.65
|
165.03
|
184.77
|
Sales
of
Unregistered Securities
Except
as
described in Item 5 above, the Company has not made any sales of unregistered
securities during the past three years.
ITEM
6. SELECTED
CONSOLIDATED FINANCIAL DATA.
Historical
consolidated results of operations and balance sheet data presented below have
been derived from the historical financial statements of the Company. This
information should be read in connection with the Company’s consolidated
financial statements.
28
|
(in
thousands, except per share data)
|
Years
ended December 31,
|
|||||||||||||||
|
2006
|
2005
|
2004
|
2003
|
2002
|
||||||||||||
|
Statements
of Operations:
|
||||||||||||||||
|
Contract
revenue
|
$
|
27,502
|
$
|
21,950
|
$
|
29,514
|
$
|
25,019
|
$
|
20,220
|
||||||
|
Cost
of revenue
|
19,602
|
18,603
|
22,715
|
19,175
|
16,660
|
|||||||||||
|
Gross
profit
|
7,900
|
3,347
|
6,799
|
5,844
|
3,560
|
|||||||||||
|
Operating
expenses:
|
||||||||||||||||
|
Selling,
general and administrative
|
4,929
|
6,958
|
5,543
|
6,343
|
6,506
|
|||||||||||
|
Administrative
charges from GP Strategies
|
685
|
685
|
974
|
100
|
-
|
|||||||||||
|
Depreciation
and amortization
|
186
|
431
|
280
|
392
|
395
|
|||||||||||
|
Total
operating expenses
|
5,800
|
8,074
|
6,797
|
6,835
|
6,901
|
|||||||||||
|
Operating
income (loss)
|
2,100
|
(4,727
|
)
|
2
|
(991
|
)
|
(3,341
|
)
|
||||||||
|
Interest
expense, net
|
(764
|
)
|
(416
|
)
|
(176
|
)
|
(504
|
)
|
(55
|
)
|
||||||
|
Loss
on extinguishment of debt
|
(1,428
|
)
|
-
|
-
|
-
|
-
|
||||||||||
|
Other
income (expense), net
|
(105
|
)
|
497
|
316
|
(273
|
)
|
37
|
|||||||||
|
Income
(loss) from continuing operations
|
||||||||||||||||
|
before
income taxes
|
(197
|
)
|
(4,646
|
)
|
142
|
(1,768
|
)
|
(3,359
|
)
|
|||||||
|
Provision
(benefit) for income taxes
|
149
|
149
|
60
|
93
|
891
|
|||||||||||
|
Income
(loss) from continuing operations
|
(346
|
)
|
(4,795
|
)
|
82
|
(1,861
|
)
|
(4,250
|
)
|
|||||||
|
Loss
from discontinued operations,
|
||||||||||||||||
|
net
of income taxes
|
-
|
-
|
-
|
(1,409
|
)
|
(1,693
|
)
|
|||||||||
|
Income
(loss) on sale of discontinued operations,
|
||||||||||||||||
|
net
of income taxes
|
-
|
-
|
36
|
(262
|
)
|
-
|
||||||||||
|
Income
(loss) from discontinued operations
|
-
|
-
|
36
|
(1,671
|
)
|
(1,693
|
)
|
|||||||||
|
Net
income (loss)
|
$
|
(346
|
)
|
$
|
(4,795
|
)
|
$
|
118
|
$
|
(3,532
|
)
|
$
|
(5,943
|
)
|
||
|
Basic
income (loss) per common share (1) (2):
|
||||||||||||||||
|
Continuing
operations
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
$
|
(0.61
|
)
|
$
|
(0.76
|
)
|
||
|
Discontinued
operations
|
-
|
-
|
-
|
(0.26
|
)
|
(0.29
|
)
|
|||||||||
|
Net
income (loss)
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
$
|
(0.87
|
)
|
$
|
(1.05
|
)
|
||
|
Diluted
income (loss) per common share (1) (2):
|
||||||||||||||||
|
Continuing
operations
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
$
|
(0.61
|
)
|
$
|
(0.76
|
)
|
||
|
Discontinued
operations
|
-
|
-
|
-
|
(0.26
|
)
|
(0.29
|
)
|
|||||||||
|
Net
income (loss)
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
$
|
(0.87
|
)
|
$
|
(1.05
|
)
|
||
|
Weighted
average common shares outstanding:
|
||||||||||||||||
|
-Basic
|
9,539
|
8,999
|
8,950
|
6,542
|
5,863
|
|||||||||||
|
-Diluted
|
9,539
|
8,999
|
9,055
|
6,542
|
5,863
|
|||||||||||
|
|
As
of December 31,
|
|||||||||||||||
|
2006
|
2005
|
2004
|
2003
|
2002
|
||||||||||||
|
Balance
Sheet data:
|
||||||||||||||||
|
Working
capital (deficit)
|
$
|
1,463
|
$
|
(925
|
)
|
$
|
2,175
|
$
|
2,130
|
$
|
5,450
|
|||||
|
Total
assets
|
18,448
|
11,982
|
14,228
|
16,536
|
28,894
|
|||||||||||
|
Long-term
liabilities
|
251
|
1,567
|
19
|
34
|
9,031
|
|||||||||||
|
Stockholders'
equity
|
7,361
|
897
|
5,945
|
5,679
|
8,111
|
|||||||||||
29
ITEM
7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
On
June
21, 2005, the Board of Directors of GP Strategies Corporation (“GP Strategies”)
approved plans to spin-off its 57% interest in GSE through a special dividend
to
the GP Strategies’ stockholders. On September 30, 2005, the GP Strategies’
stockholders received 0.283075 share of GSE common stock for each share of
GP
Strategies common stock or Class B stock held on the record date of September
19, 2005. Following the spin-off, GP Strategies ceased to have any ownership
interest in GSE. GP Strategies continued to provide corporate support services
to GSE, including accounting, finance, human resources, legal, network support
and tax pursuant to a Management Services Agreement which expired on December
31, 2006.
In
order
to ensure that the Company had sufficient working capital in 2006, the Company
completed several financing transactions in early 2006. On February 28, 2006,
the Company and Dolphin entered into a Cancellation and Warrant Exchange
Agreement (the “Cancellation Agreement ”) under which Dolphin agreed to cancel
its Senior Subordinated Secured Convertible Promissory Note and cancel its
outstanding warrant to purchase 380,952 shares of GSE common stock at an
exercise price of $2.22 per share. In exchange for Dolphin’s agreement to enter
into the Cancellation Agreement and for the participation of Dolphin Offshore
Partners, LP in the Preferred Stock transaction discussed below, the Company
repaid the Dolphin Note and agreed to issue a new warrant to purchase 900,000
shares of GSE common stock at an exercise price of $0.67 per share (the “Dolphin
Warrant”). At the date of issuance, the fair value of the Dolphin Warrant was
$868,000, as established using the Black-Scholes Model, and was recorded in
paid-in capital with the offset recorded as loss on extinguishment of debt.
In
accordance with the terms of the warrant agreement, Dolphin exercised the
Dolphin Warrant on November 8, 2006 upon the Company’s certification that, among
other things, the underlying shares of GSE common stock were registered with
the
Securities and Exchange Commission on October 31, 2006, that the current stock
price was greater than $1.25 per share, and that the average of the current
stock prices for each trading day of the prior 30 calendar day period was not
less than $1.25 per share. The Company received cash proceeds of
$603,000.
In
conjunction with the early payoff of the Dolphin Note and the cancellation
of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000, recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature
and
the related warrants, and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin. The total loss on extinguishment of the Dolphin
Note and the cancellation of the related warrants totaled $1.4 million.
30
On
February 28, 2006, the Company raised $3.9 million, net of associated fees
of
$395,000, through the sale of 42,500 shares of Series A Cumulative Convertible
Preferred Stock and Warrants by means of a private placement to “accredited
investors”, as that term is used in rules and regulations of the Securities and
Exchange Commission. The Convertible Preferred Stock was convertible at any
time
into a total of 2,401,133 shares of GSE common stock at a conversion price
of
$1.77 per share. The conversion price was equal to 110% of the closing price
of
the Company’s Common Stock on February 28, 2006, the date the sale of the
Convertible Preferred Stock was completed. Each investor received a five-year
warrant to purchase GSE common stock equal to 20% of the shares they would
receive from the conversion of the Convertible Preferred Stock, at an exercise
price of $1.77 per share. In aggregate, the Company issued warrants to purchase
a total of 480,226 shares of GSE common stock. The Convertible Preferred
Stockholders are entitled to an 8% cumulative dividend, payable on a semiannual
basis every June 30 and December 30. In 2006, the Company paid dividends
totaling $279,000 to the preferred stockholders. At the date of issuance, the
fair value of the warrants was $342,000 and the fair value of the preferred
stock was $3.9 million. The fair value of the warrants and the preferred stock
was determined by the use of the relative fair value method, in which the $4.25
million gross proceeds was allocated based upon the fair values of the warrants,
as determined by using the Black-Scholes Model, and the preferred stock, as
determined by an independent appraisal. At any time after March 1, 2007, the
Company had the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading
days
immediately prior to the date of such conversion exceeds 200% of the Series
A
Conversion Price. Prior to March 7, 2007, the holders of 22,500 shares of
Preferred Stock had already elected to convert their Preferred Stock into a
total of 1,271,187 shares of Common Stock; 8,580 shares of Preferred Stock
were
converted in 2006, and 13,920 shares of Preferred Stock in 2007. On March 7,
2007, the Company sent notice to the holders of the remaining 20,000 outstanding
shares of its Preferred Stock that the average current stock price for the
prior
twenty trading days had exceeded 200% of the Conversion Price, and that the
Company was converting the outstanding Preferred Stock into common stock. The
20,000 shares of Preferred Stock will convert to 1,129,946 shares of GSE common
stock. The holders of the Convertible Preferred Stock were entitled to vote
on
all matters submitted to the stockholders for a vote, together with the holders
of the voting common stock, all voting together as a single class. The holders
of the Convertible Preferred Stock were entitled to the number of votes equal
to
the number of GSE common stock that they would receive upon conversion of their
Convertible Preferred Stock.
The
Company paid the placement agent for the Convertible Preferred Stock and
Warrants 6% of the gross proceeds received by the Company from the offering
($255,000) plus five-year warrants to purchase 150,000 shares of the Company’s
common stock at an exercise price of $1.77 per share. In addition to the
placement agent fee, the Company paid $140,000 of other transaction fees related
to the offering. At the date of issuance, the fair value of the placement agent
warrants was $128,000, as established using the Black-Scholes Model, and was
recorded in paid-in capital, with the offset recognized as a reduction of the
preferred stock proceeds.
The
proceeds were used to payoff the Dolphin Note and the Company’s line of credit
balance and for other working capital purposes.
On
March
7, 2006, the Company entered into a new loan and security agreement with Laurus
Master Fund, Ltd and terminated its existing $1.5 million bank line of credit.
The new agreement established a $5.0 million line of credit for the Company.
The
line is collateralized by substantially all of the Company’s assets and provides
for borrowings up to 90% of eligible accounts receivable and 40% of eligible
unbilled receivables (up to a maximum of $1.0 million). The interest rate on
this line of credit is based on the prime rate plus 200-basis points (10.25%
as
of December 31, 2006), with interest only payments due monthly. There are no
financial covenant requirements under the new agreement and the credit facility
expires on March 6, 2008. On May 18, 2006, Laurus Master Fund agreed to
temporarily increase the Company’s borrowing capability by $2.0 million over and
above the funds that were available to the Company based upon its normal
borrowing base calculation. The over advance was used to collateralize a $2.1
million performance bond that the Company issued to the Emirates Simulation
Academy, LLC in the form of a standby letter of credit. One half of the
increased borrowing capability expired on July 18, 2006, and the balance expires
on April 13, 2007. The Company’s borrowings over and above the normal borrowing
base calculation bear additional interest of 1.5% per month over and above
the
normal interest rate on the line of credit. At December 31, 2006, the Company’s
available borrowing base was $4.2 million of which $2.2 million had been
utilized. The Company issued to Laurus Master Fund, Ltd a warrant to purchase
up
to 367,647 shares of GSE common stock at an exercise price of $.01 per share.
At
the date of issuance, the fair value of the Laurus warrant, which was
established using the Black-Scholes Model, was $603,000 and was recorded as
paid-in capital with the offset recorded as deferred financing charges. Deferred
financing charges are classified as an other asset and are amortized over the
term of the credit facility through a charge to interest expense. On July 31,
2006, Laurus exercised the warrant through a cashless exercise procedure as
defined in the warrant. Laurus received 366,666 shares of GSE common
stock.
31
Based
on
the Company’s forecasted expenditures and cash flow, we believe we will need
$32.6 million to fund our operations for the twelve months ended December 31,
2007. All of this funding is expected to be generated through our normal
operations and the utilization of our current credit facility, and we believe
that we will have sufficient liquidity and working capital without additional
financing. We expect to generate $30.0 million of cash in the year ended
December 31, 2007 from the Company’s milestone billings backlog as of December
31, 2006, including $12.8 million from the ESA Contract, plus the orders logged
by the Company in 2007 through March 15, 2007. The balance of the Company’s 2007
cash requirement is expected to be generated by future orders. However,
notwithstanding the foregoing, the Company may be required to look for
additional capital to fund its operations if the Company is unable to operate
profitably and generate sufficient cash from operations. There can be no
assurance that the Company would be successful in raising such additional funds.
Critical
Accounting Policies and Estimates.
As
further discussed in Note 2 to the consolidated financial statements, in
preparing the Company’s financial statements, management makes several estimates
and assumptions that affect the Company’s reported amounts of assets,
liabilities, revenues and expenses. Those accounting estimates that have the
most significant impact on the Company’s operating results and place the most
significant demands on management's judgment are discussed below. For all of
these policies, management cautions that future events rarely develop exactly
as
forecast, and the best estimates may require adjustment.
Revenue
Recognition on Long-Term Contracts.
The
majority of the Company’s revenue is derived through the sale of uniquely
designed systems containing hardware, software and other materials under
fixed-price contracts. In accordance with Statement of Position 81-1,
Accounting
for Performance of Construction-Type and Certain Production-Type
Contracts,
the
revenue under these fixed-price contracts is accounted for on the
percentage-of-completion method. This methodology recognizes revenue and
earnings as work
progresses on the contract and is based on an estimate of the revenue and
earnings earned to date, less amounts recognized in prior periods. The Company
bases its estimate of the degree of completion of the contract by reviewing
the
relationship of costs incurred to date to the expected total costs that will
be
incurred on the project. Estimated contract earnings are reviewed and revised
periodically as the work progresses, and the cumulative effect of any change
in
estimate is recognized in the period in which the change is identified.
Estimated losses are charged against earnings in the period such losses are
identified. The Company recognizes revenue arising from contract claims either
as income or as an offset against a potential loss only when the amount of
the
claim can be estimated reliably and realization is probable and there is a
legal
basis of the claim.
Uncertainties
inherent in the performance of contracts include labor availability and
productivity, material costs, change order scope and pricing, software
modification and customer acceptance issues. The reliability of these cost
estimates is critical to the Company’s revenue recognition as a significant
change in the estimates can cause the Company’s revenue and related margins to
change significantly from the amounts estimated in the early stages of the
project.
32
As
the
Company recognizes revenue under the percentage-of-completion method, it
provides an accrual for estimated future warranty costs based on historical
and
projected claims experience. The Company’s long-term contracts generally provide
for a one-year warranty on parts, labor and any bug fixes as it relates to
software embedded in the systems.
The
Company’s system design contracts do not provide for “post customer support
service” (PCS) in terms of software upgrades, software enhancements or telephone
support. In order to obtain PCS, the customers must purchase a separate
contract. Such PCS arrangements are generally for a one-year period renewable
annually and include customer support, unspecified software upgrades, and
maintenance releases. The Company recognizes revenue from these contracts
ratably over the life of the agreements in accordance with Statement of Position
97-2 Software
Revenue Recognition.
Revenue
from the sale of software licenses which do not require significant
modifications or customization for the Company’s modeling tools are recognized
when the license agreement is signed, the license fee is fixed and determinable,
delivery has occurred, and collection is considered probable.
Revenue
for contracts with multiple elements are recognized in accordance with Emerging
Issues Task Force issue 00-21, Accounting
for Revenue Arrangements with Multiple Deliverables.
Revenues
from certain consulting or training contracts is recognized on a
time-and-material basis. For time-and-material type contracts, revenue is
recognized based on hours incurred at a contracted labor rate plus
expenses.
Capitalization
of Computer Software Development Costs.
In
accordance with Statement of Financial Accounting Standards (SFAS) No. 86,
Accounting
for the Costs of Computer Software to Be Sold, Leased, or Otherwise
Marketed,
the
Company capitalizes computer software development costs incurred after
technological feasibility has been established, but prior to the release of
the
software product for sale to customers. Once the product is available to be
sold, the Company amortizes the costs, on a straight line method, over the
estimated useful life of the product, which normally ranges from three to five
years. As of December 31, 2006, the Company has net capitalized software
development costs of $820,000. On an annual basis, and more frequently as
conditions indicate, the Company assesses the recovery of the unamortized
software computer costs by estimating the net undiscounted cash flows expected
to be generated by the sale of the product. If the undiscounted cash flows
are
not sufficient to recover the unamortized software costs the Company will
write-down the investment to its estimated fair value based on future discounted
cash flows. The excess of any unamortized computer software costs over the
related net realizable value is written down and charged to operations.
Significant changes in the sales projections could result in impairment with
respect to the capitalized software that is reported on the Company’s
consolidated balance sheet.
Deferred
Income Tax Valuation Allowance. Deferred
income taxes arise from temporary differences between the tax bases of assets
and liabilities and their reported amounts in the financial statements. As
required by SFAS No. 109 Accounting
for Income Taxes,
management makes a regular assessment of the realizability of the Company’s
deferred tax assets. In making this assessment, management considers whether
it
is more likely than not that some or all of the deferred tax assets will not
be
realized. The ultimate realization of deferred tax assets is dependent upon
the
generation of future taxable income during the periods in which those temporary
differences become deductible. Management considers the scheduled reversal
of
deferred tax liabilities and projected future taxable income of the Company
in
making this assessment. A valuation allowance is recorded to reduce the total
deferred income tax asset to its realizable value. As of December 31, 2006,
the
Company’s largest deferred tax asset related to a U.S. net operating loss
carryforward of $19.3 million which expires in various amounts over the
next nineteen years. The amount of loss carryforward which can be used by
the Company may be significantly limited due to changes in the Company's
ownership which have occurred subsequent to the spin-off of GSE by GP
Strategies, including equity transactions that occurred in 2006. Thus, a
portion of the Company's loss carryforward may expire unutilized. We
believe that the Company will achieve profitable operations in future years
that
will enable the Company to recover the benefit of its net deferred tax
assets. However, the Company presently does not have sufficient objective
evidence to support management's belief, and accordingly, the Company has
established a $10.2 million valuation allowance for its net deferred tax assets.
33
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 contract
revenue.
|
(in
thousands)
|
Years
ended December 31,
|
|||||||||||||||||||||||||||
|
|
|
|
|
2006
|
|
|
|
|
%
|
|
|
2005
|
|
|
|
|
%
|
|
|
2004
|
|
|
|
|
%
|
|||
|
Contract
revenue
|
$
|
27,502
|
100.0
|
%
|
$
|
21,950
|
100.0
|
%
|
$
|
29,514
|
100.0
|
%
|
||||||||||||||||
|
Cost
of revenue
|
19,602
|
71.3
|
%
|
18,603
|
84.7
|
%
|
22,715
|
76.9
|
%
|
|||||||||||||||||||
|
Gross
profit
|
7,900
|
28.7
|
%
|
3,347
|
15.3
|
%
|
6,799
|
23.1
|
%
|
|||||||||||||||||||
|
Operating
expenses:
|
||||||||||||||||||||||||||||
|
Selling,
general and administrative
|
4,929
|
17.9
|
%
|
6,958
|
31.7
|
%
|
5,543
|
18.8
|
%
|
|||||||||||||||||||
|
Administrative
charges from GP Strategies
|
685
|
2.5
|
%
|
685
|
3.1
|
%
|
974
|
3.3
|
%
|
|||||||||||||||||||
|
Depreciation
and amortization
|
186
|
0.7
|
%
|
431
|
2.0
|
%
|
280
|
1.0
|
%
|
|||||||||||||||||||
|
Total
operating expenses
|
5,800
|
21.1
|
%
|
8,074
|
36.8
|
%
|
6,797
|
23.1
|
%
|
|||||||||||||||||||
|
Operating
income (loss)
|
2,100
|
7.6
|
%
|
(4,727
|
)
|
(21.5
|
)%
|
2
|
0.0
|
%
|
||||||||||||||||||
|
Interest
expense, net
|
(764
|
)
|
(2.8
|
)%
|
(416
|
)
|
(1.9
|
)%
|
(176
|
)
|
(0.6
|
)%
|
||||||||||||||||
|
Loss
on extinguishment of debt
|
(1,428
|
)
|
(5.2
|
)%
|
-
|
0.0
|
%
|
-
|
0.0
|
%
|
||||||||||||||||||
|
Other
income (expense), net
|
(105
|
)
|
(0.4
|
)%
|
497
|
2.3
|
%
|
316
|
1.1
|
%
|
||||||||||||||||||
|
Income
(loss) from continuing operations
|
||||||||||||||||||||||||||||
|
before
income taxes
|
(197
|
)
|
(0.7
|
)%
|
(4,646
|
)
|
(21.1
|
)%
|
142
|
0.5
|
%
|
|||||||||||||||||
|
Provision
for income taxes
|
149
|
0.5
|
%
|
149
|
0.7
|
%
|
60
|
0.2
|
%
|
|||||||||||||||||||
|
Income
(loss) from continuing operations
|
(346
|
)
|
(1.3
|
)%
|
(4,795
|
)
|
(21.8
|
)%
|
82
|
0.3
|
%
|
|||||||||||||||||
|
Income
on sale of discontinued operations,
|
||||||||||||||||||||||||||||
|
net
of income taxes
|
-
|
0.0
|
%
|
-
|
0.0
|
%
|
36
|
0.1
|
%
|
|||||||||||||||||||
|
Income
from discontinued operations
|
-
|
0.0
|
%
|
-
|
0.0
|
%
|
36
|
0.1
|
%
|
|||||||||||||||||||
|
Net
income (loss)
|
$
|
(346
|
)
|
(1.3
|
)%
|
$
|
(4,795
|
)
|
(21.8
|
)%
|
$
|
118
|
0.4
|
%
|
||||||||||||||
Comparison
of the Years Ended December 31, 2006 to December 31, 2005.
Contract
Revenue. Revenue
for the year ended December 31, 2006 was $27.5 million versus $22.0 million
for
the year ended December 31, 2005, a 25.0% increase. The increase reflects an
increase in orders and higher volume in 2006. Total orders logged in 2006
totaled $33.5 million (including a $15.1 million contract received from ESA)
as
compared to $15.3 million in 2005. For the twelve months ended December 31,
2006, the Company recognized $5.7 million of contract revenue on the ESA
project, which accounted for 20.7% of the Company’s consolidated revenue. The
Company settled an outstanding claim with a customer for work performed through
December 31, 2005 of approximately $265,000, of which $120,000 was recognized
as
revenue in 2005 and the balance was recognized as revenue in 2006. License
revenue totaled $1.2 million for the twelve months ended December 31, 2006
versus only $472,000 in 2005. At December 31, 2006, the Company’s backlog was
$18.5 million.
34
Gross
Profit. Gross
profit increased from $3.3 million (15.3% of revenue) for the year ended
December 31, 2005 to $7.9 million (28.7% of revenue) for the year ended December
31, 2006. 2006 gross margin was favorably impacted by the ESA contract, the
increase in license revenue and the settlement of the outstanding claim
discussed above. In 2005, the Company had made certain adjustments to the
estimated costs to complete several of its long-term contracts which resulted
in
a net reduction of the contract-to-date gross profit recognized on the contracts
of approximately $895,000 or 4% of revenue.
Selling,
General and Administrative Expenses.
Selling,
general and administrative (“SG&A”) expenses totaled $5.0 million in the
year ended December 31, 2006, a 27.9% decrease from the $7.0 million for 2005.
The reduction reflects the following spending variances:
| ¨ |
Business
development and marketing costs decreased from $3.0 million for the
year
ended December 31, 2005 to $2.1 million in 2006. In order to reduce
operating expenses, the Company terminated several of its business
development personnel in mid-2005 and reassigned others to operating
positions.
|
| ¨ |
The
Company’s general and administrative expenses totaled $2.4 million in the
year ended December 31, 2006, which was 16.2% lower than the $2.9
million
incurred in 2005. The reduction reflects lower facility costs in
2006 due
to the restructuring of the Company’s leased facilities in late 2005 (the
assignment of the Columbia, Maryland facility and the move of the
Company’s headquarters to the Baltimore, Maryland facility) plus the
reassignment of one executive from corporate to an operating position.
|
| ¨ |
Gross
spending on software product development (“development”) totaled $871,000
for the twelve months ended December 31, 2006 versus $758,000 in
the same
period of 2005. For the year ended December 31, 2006, the Company
expensed
$538,000 and capitalized $333,000 of its development spending while
in the
year ended December 31, 2005, the Company expensed $275,000 and
capitalized $483,000 of its development spending. The Company’s
capitalized development expenditures in 2006 were related to the
development of new features for the Xflow modeling tool for modeling
power
plant buildings and the development of new features for the THEATRe
thermo-hydraulic and REMARK core models. The Company anticipates
that its
total gross development spending in 2007 will approximate
$800,000.
|
| ¨ |
In
2005, the Company implemented staff reductions; 2005 SG&A expense
reflected $301,000 of accrued severance.
|
| ¨ |
The
Company increased its reserve for bad debts by $496,000 for the twelve
months ended December 31, 2005.
|
35
Administrative
Charges from GP Strategies. The
Company extended its Management Services Agreement with GP Strategies
Corporation through December 31, 2006. Under the agreement, GP Strategies
provided corporate support services to GSE, including accounting, finance,
human
resources, legal, network support and tax. In addition, GSE used the financial
system of General Physics, a subsidiary of GP Strategies. The Company was
charged $685,000 in both the twelve months ended December 31, 2006 and 2005.
The
Company terminated the agreement on December 31, 2006.
Depreciation
and Amortization. For
the
years ended December 31, 2006 and 2005, depreciation expense totaled $186,000
and $431,000, respectively. Due to the relocation of the Company’s Maryland
operations from Columbia, Maryland to Baltimore, Maryland, the Company
accelerated the depreciation of certain leasehold improvements in 2005 which
has
resulted in lower depreciation expense in 2006.
Operating
Income (Loss). The
Company had an operating income of $2.0 million (7.3% of revenue) for the year
ended December 31, 2006, as compared with an operating loss of $4.7 million
(21.5% of revenue) for the prior year. The variances were due to the factors
outlined above.
Interest
Expense, Net. Net
interest expense increased from $416,000 in the year ended December 31, 2005
to
$764,000 for the year ended December 31, 2006.
The
Company incurred interest expense of $264,000 and $57,000 on borrowings against
its credit facilities in the twelve months ended December 31, 2006 and 2005,
respectively.
Amortization
of deferred financing costs related to the Company’s lines of credit totaled
$200,000 in 2006 versus only $37,000 in 2005. The increase reflects the
replacement of the Wachovia Bank credit facility with one from Laurus Master
Fund, Ltd in early 2006.
Amortization
of the cost of the warrants issued to Laurus in conjunction with the new credit
facility totaled $251,000 in 2006.
The
Company incurred interest expense of $26,000 and $96,000 on the Dolphin Note
in
2006 and 2005, respectively. Also included in interest expense was original
issue discount accretion related to the Dolphin Note and GSE Warrant of $58,000
and $203,000, in the twelve months ended December 31, 2006 and 2005,
respectively.
Interest
accrued on the preferred dividends payable to ManTech was $20,000 for the year
ended December 31, 2006 and $21,000 for the same period of 2005. Other interest
expense totaled $11,000 in both years.
The
Company earned interest income of $66,000 in the twelve months ended December
31, 2006 versus only $9,000 in the twelve months ended December 31, 2005. The
increase reflects the increase in cash deposited into certificates of deposit
as
collateral for performance bonds. This cash is classified on the balance sheet
as restricted cash.
Loss
on Extinguishment of Debt.
On
February 28, 2006, the Company and Dolphin entered into a Cancellation and
Warrant Exchange Agreement (the “Cancellation Agreement ”) under which Dolphin
agreed to cancel its Senior Subordinated Secured Convertible Promissory Note
and
cancel its outstanding warrant to purchase 380,952 shares of GSE common stock
at
an exercise price of $2.22 per share. In exchange for Dolphin’s agreement to
enter into the Cancellation Agreement and for the participation of Dolphin
Offshore Partners, LP in the Preferred Stock transaction, the Company repaid
the
Dolphin Note and agreed to issue a new warrant to purchase 900,000 shares of
GSE
common stock at an exercise price of $0.67 per share.
36
In
conjunction with the early payoff of the Dolphin Note and the cancellation
of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000, recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature
and
the related warrants, and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin.
Other
Income (Expense), Net.
Other
Income (Expense), net was ($105,000) in 2006 versus $497,000 in 2005.
At
December 31, 2006, the Company had contracts for sale of approximately 142
million Japanese Yen at fixed rates. The contracts expire on various dates
through August 2007. The Company has not designated the contracts as hedges
and has recorded the estimated change in the fair value of the contracts of
($24,000) in other income (expense). The estimated fair value of the contracts
was $12,000 at December 31, 2006 and is recorded on the balance sheet under
other current assets.
At
December 31, 2005, the Company had contracts for the sale of approximately
247
million Japanese Yen at fixed rates. The Company had not designated the
contracts as hedges and has recorded the change in the estimated fair value
of
the contracts during 2005 of ($170,000) in other income (expense), net. The
estimated fair value of the contracts was $31,000 as of December 31, 2005.
$20,000 of the fair value is recorded on the balance sheet under other current
assets, and the balance is classified under other assets.
The
Company accounts for its investment in ESA using the equity method. In
accordance with the equity method, the Company has eliminated 10% of the profit
from this contract as the training simulators are assets that will be recorded
on the books of ESA, and the Company is thus required to eliminate its
proportionate share of the profit included in the asset value. The profit
elimination totaled $251,000 for the year ended December 31, 2006, respectively,
and has been recorded as an other expense in the income statement and as an
other liability on the balance sheet. Once ESA begins to amortize the training
simulators on their books, GSE will begin to amortize the other liability to
other income.
The
Company incurred foreign currency transaction gains of $128,000 in the twelve
months ended December 31, 2006 versus currency transaction losses of $35,000
in
2005.
In
conjunction with the Dolphin Note and GSE Warrants, the fair value of the GSE
Warrant was $375,000 and the fair value of the Conversion Option of the Dolphin
Note was $959,000. The GSE Warrant and Conversion Option liabilities were marked
to market through earnings on a quarterly basis in accordance with EITF No.
00-19, Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in
a
Company’s Common Stock. In
2005,
the Company recognized a gain of $636,000 from the change in fair market value
of these liabilities as of December 31, 2005.
Provision
for Income Taxes. The
Company’s tax provision in 2006 was $149,000 and consisted of foreign income
taxes of $17,000 and state income taxes of $29,000 and federal income taxes
of
$103,000. The Company has a full valuation allowance on its deferred tax
assets.
In
2005,
the Company’s tax provision was $149,000 and consisted of foreign income taxes
of $103,000, deferred income taxes of $50,000 and state income taxes of
($4,000).
37
Comparison
of the Year Ended December 31, 2005 to December 31, 2004
Contract
Revenue. Contract revenue decreased 25.6% from $29.5 million in 2004 to
$22.0 million in 2005 primarily as a result of a decline in orders and lower
volumes. In addition, the Company had an outstanding claim with a customer
for
work performed through December 31, 2005 of approximately $265,000, for which
$120,000 was recognized in 2005. Total orders logged in 2005 totaled $15.3
million as compared to $18.9 million in 2004.
Gross
Profit. Gross profit totaled $3.3 million (15.3% of revenue) for the year
ended December 31, 2005 as compared with $6.8 million (23.1% of revenue)
for the
year ended December 31, 2004. The decline in gross profit was directly related
to a decrease in contract revenue and certain adjustments made by the Company
during 2005 to the estimated costs to complete several of its long-term
contracts, which resulted in a net reduction of the contract-to-date gross
profit recognized of approximately $895,000 or 4% of revenue.
Selling,
General and Administrative Expenses. Selling, general and administrative
(“SG&A”) expenses for the year ended December 31, 2005 increased 25.5% from
the prior year; from $5.5 million in 2004 to $7.0 million in 2005. Business
development costs increased from $2.8 million for the year ended December
31,
2004 to $3.0 million in 2005, an 8.0% increase. The Company expanded its
business development organization throughout 2004 into the first quarter
of
2005, adding an additional five employees between the first quarter 2004
and the
first quarter 2005. In addition, the Company incurred higher bidding and
proposal costs in the pursuit of new orders. In order to reduce operating
expenses, the Company terminated several of its business development personnel
in mid-2005 and reassigned others to operating positions. The Company’s
corporate and G&A expenses increased 43.4% in 2005, from $2.5 million in
2004 to $3.7 million in 2005. The increase reflects severance costs of $301,000
in 2005, bad debt expense of $496,000, and the salary and benefit costs of
the
Company’s CEO who became a GSE employee in December 2004. Prior to December
2004, the Company was charged for the CEO’s services by GP Strategies and his
costs were classified as GP Strategies administration fees.
Software
and other development expenditures were $758,000 in 2005 and $552,000 in
2004 of
which $275,000 and $191,000 was expensed in 2005 and 2004, respectively.
The
Company capitalized $483,000 of software development costs in 2005 as compared
to $361,000 in 2004. The Company’s capitalized costs in 2005 were related
to:
| ¨ |
Enhancements
to JADE (Java Applications & Development Environment), a Java-based
application that provides a window into the simulation station and
takes
advantage of the web capabilities of Java, allowing customers to
access
the simulator and run scenarios from anywhere they have access to
the web.
JADE 3.0 was released in April 2005.
|
| ¨ |
The
continued development of the Company’s REMITS product used to simulate the
operation of Emergency Operations Centers (EOC) run by municipal
and state
governments.
|
| ¨ |
The
development of generic simulation models representing the Westinghouse
Electric Company LLC AP1000 nuclear plant
design.
|
| ¨ |
The
development of new features for the Xflow modeling tool for modeling
power
plant buildings.
|
Administrative
Charges from GP Strategies. On January 1, 2004, the Company entered into a
Management Services Agreement with GP Strategies Corporation in which GP
Strategies agreed to provide corporate support services to GSE, including
accounting, finance, human resources, legal, network support and tax. Expense
for these services was $685,000 in both 2005 and 2004. On September 30, 2005,
GP
Strategies spun-off its 57% interest in GSE through a special dividend to
the GP
Strategies’ stockholders. Despite the spin-off, the Management Services
Agreement was extended through December 31, 2006 without an increase. In
2004,
the Company was also charged $298,000 for salary and benefits of its CEO
who was
a GP Strategies employee until December 16, 2004.
38
Depreciation
and Amortization. Depreciation
expense totaled $431,000 and $280,000 for 2005 and 2004, respectively. Due
to
the relocation of the Company’s Maryland operations from Columbia, Maryland to
Baltimore, Maryland, the Company accelerated the depreciation of certain
leasehold improvements in 2005.
Operating
Income (Loss). The
Company had an operating loss of $4.7 million (21.5% of revenue) in 2005
as
compared with operating income of $2,000 in 2004. The 2005 operating loss
was
due to the factors outlined above.
Interest
Expense, Net. Net
interest expense increased from $176,000 in 2004 to $416,000 in 2005. The
Company incurred interest expense of $96,000 on the Dolphin Note in 2005.
Also
included in 2005 interest expense was original issue discount accretion related
to the Dolphin Note and GSE Warrant of $203,000.
The
Company incurred interest expense of $58,000 on borrowings against its $1.5
million credit facility. In 2004, the Company had no borrowings against the
credit facility.
Amortization
of deferred financing costs totaled $37,000 in 2005 and $111,000 in
2004.
Other
Income (Expense), Net. Other
income (expense), net was $497,000 and $316,000 in 2005 and 2004, respectively.
In
conjunction with the Dolphin Note and GSE Warrants, the fair value of the
GSE
Warrant was $375,000 and the fair value of the Conversion Option of the Dolphin
Note was $959,000. The GSE Warrant and Conversion Option liabilities are
marked
to market through earnings on a quarterly basis in accordance with EITF No.
00-19, Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in a Company’s Common Stock. In 2005, the Company recognized
a gain of $636,000 from the change in fair market value of these liabilities
as
of December 31, 2005.
At
December 31, 2005, the Company had contracts for the sale of approximately
247
million Japanese Yen at fixed rates. The contracts expire on various dates
through May 2007. The Company had not designated the contracts as hedges
and
recorded the change in the estimated fair value of the contracts during 2005
of
($170,000) in other income (expense), net. The estimated fair value of the
contracts was $31,000 as of December 31, 2005.
At
December 31, 2004, the Company had contracts for the sale of approximately
435
million Japanese Yen at fixed rates. The Company had not designated the
contracts as hedges and recorded the change in the estimated fair value of
the
contracts of $203,000 in other income (expense).
Provision
for Income Taxes. In
2005,
the Company’s tax provision was $149,000 and consisted of foreign taxes of
$103,000, deferred taxes of $50,000 and state taxes of ($4,000). The Company
had
a full valuation allowance on its net deferred tax assets.
39
The
Company’s tax provision in 2004 was $90,000; $60,000 related to continuing
operations and $30,000 related to discontinued operations. The provision
consisted of state income taxes of $18,000, U.S. alternative minimum tax of
$1,000, foreign income taxes of $121,000 and deferred income taxes of ($50,000).
Income
on Sale of Discontinued Operations. Income
from discontinued operations was $36,000 in 2004 related to the Company’s
Process Simulation business sold in 2003.
Liquidity
and Capital Resources.
As
of
December 31, 2006, GSE had cash and cash equivalents of $1.1 million versus
$1.3
million at December 31, 2005.
Cash
from operating activities. Net
cash
used in operating activities was $832,000 for the year ended December 31, 2006.
The loss on early extinguishment of debt of $1.4 million was a non-cash expense
that had no impact on the Company’s operating cash flow. Significant changes in
the Company’s assets and liabilities in 2006 included:
| ¨ |
A
$3.8 million increase in contracts receivable. An invoice for $1.7
million
was issued to ESA in August 2006 and was still outstanding at December
31,
2006. In March 2007, ESA established a line of credit with a bank.
Payment
will be made to GSE as soon as all required documents have been received
by the bank. No bad debt reserve has been established for the outstanding
ESA receivable at December 31, 2006. In addition, the Company had
an
unbilled receivable of $1.9 million for the ESA contract at December
31,
2006.
|
| ¨ |
A
$690,000 increase in billings in excess of revenues earned. The increase
is related to the timing of milestone billings on several projects.
|
| ¨ |
A
$536,000 decrease in the amount due to GP Strategies Corporation.
The
reduction reflects the utilization of a portion of the funds received
through the Company’s convertible preferred stock transaction to pay down
the balance due to GP Strategies. The Company paid off the balance
due to
GP Strategies prior to the termination of the Management Services
Agreement on December 31, 2006.
|
For
the
year ended December 31, 2005, net cash used in operating activities was $1.9
million compared with $393,000 in 2004. The increase of $1.5 million was
primarily attributed to the change in net loss of $4.8 million offset by
significant changes in the Company’s assets and liabilities, which in 2005
included:
| ¨ |
A
$1.8 decrease in contracts receivable. The decrease reflected the
combination of (a) a decrease in outstanding trade receivables of
$1.0
million due to the lower project activity in 2005, (b) a decrease
in
unbilled receivables of $560,000 due to the timing of contract invoicing
milestones, and (c) an increase in the bad debt reserve of $220,000.
|
| ¨ |
An
$810 decrease in prepaid expenses and other assets. The decrease
mainly
reflected the following items: (a) the amortization of fees incurred
in
2004 related to the issuance of project advance payment and performance
bonds, (b) the reduction of an advance payment to a subcontractor
in 2004
as the subcontractor performed the related work, and (c) the reduction
in
the fair value of the Company’s hedging contracts.
|
40
For
the
year ended December 31, 2004, net cash used in operating activities was
$393,000; $357,000 was used by continuing operations and $36,000 was used by
discontinued operations. Significant changes in the Company’s assets and
liabilities in 2004 included:
| ¨ |
A
$734,000 decrease in contracts receivable. The Company invoices customers
upon the completion of contract-specified milestones; milestone billings
were lower in the fourth quarter 2004 compared to the fourth quarter
2003
due to lower contract activity.
|
| ¨ |
A
$547,000 reduction in prepaid expenses and other assets. The reduction
reflects (1) lower prepaid insurance expense due to the participation
of
the Company in some of GP Strategies’ insurance programs, (2) the
collection from Novatech of expenses paid by the Company on behalf
of
Novatech after the sale of the Process business in 2003 and (3)
amortization of capitalized bank commitment fees.
|
| ¨ |
An
increase in accounts payable, accrued compensation and accrued expenses
of
$200,000. The increase reflects the increase in project activity
in 2004
as compared to the prior year and the related increase in obligations
to
the Company’s subcontractors.
|
| ¨ |
A
decrease in billings in excess of revenues earned by $2.8 million.
In
2003, the Company had entered into a $6.6 million contract with a
Mexican
customer for a full scope simulator that allowed the Company to invoice
the customer for 20% of the contract upon the receipt of the purchase
order as an advance payment. The reduction in billings in excess
of
revenues earned largely reflects the completion of work which has
reduced
the Company’s liability to the customer for the advance payment.
|
Cash
provided by (used in) investing activities. For
the
year ended December 31, 2006, net cash used in investing activities was $2.8
million consisting of $333,000 of capitalized software development costs,
$185,000 of capital expenditures, and the restriction of $2.3 million of cash
as
collateral for five performance bonds issued by the Company and backed by
standby letters of credit. The largest is a $2.1 million performance bond issued
to ESA which expires on October 31, 2008 at the completion of the one-year
warranty period.
Net
cash
used in investing activities was $692,000 for the year ended December 31, 2005.
The Company made capital expenditures of $182,000 and capitalized software
development costs of $483,000.
Net
cash
used in investing activities was $110,000 for the year ended December 31, 2004,
consisting of $361,000 of capitalized software development costs and $222,000
of
capital expenditures, offset by the expiration of stand-by letters of credit
for
which the $473,000 of cash collateral was released. Standby letters of credit
are issued by the Company in the ordinary course of business through banks
as
required by certain contracts and proposal requirements.
Cash
provided by (used in) financing activities. The
Company generated $3.4 million from financing activities in the twelve months
ended December 31, 2006. The Company generated net proceeds of $3.9 million
from
the issuance of 42,500 shares of Series A Cumulative Convertible Preferred
Stock
and Warrants which were used to pay off the $2.0 million Dolphin Note and the
outstanding borrowings under the Company’s bank line of credit. In conjunction
with the establishment of a new line of credit with Laurus Master Fund, Ltd,
the
Company incurred cash financing costs of $448,000.
The
Company entered into a new credit facility with Laurus Master Fund on March
7,
2006 and had outstanding borrowings under the credit facility on December
31,
2006 of $2.2 million. On May 18, 2006, Laurus Master Fund agreed to
temporarily increase the Company’s borrowing capability by $2.0 million over and
above the funds that were available to the Company based upon its normal
borrowing base calculation. The over advance was used to collateralize a
$2.1
million performance bond that the Company issued to the Emirates Simulation
Academy, LLC in the form of a standby letter of credit. One half of the
increased borrowing capability expired on July 18, 2006, and the balance
expires
on April 13, 2007. The Company’s borrowings over and above the normal borrowing
base calculation bear additional interest of 1.5% per month over and above
the
normal interest rate on the line of credit.
41
The
Company received $409,000 through the issuance of common stock due to the
exercise of employee stock options, and $730,000 through the issuance of common
stock due to the exercise of warrants. The
Company recognized a tax benefit of $124,000 related to the employee stock
option exercises.
In
2006,
the Company paid dividends of $279,000 to the preferred stockholders.
For
the
year ended December 31, 2005, the Company generated $3.0 million in cash from
financing activities. The Company borrowed $1,182,000 from its bank line of
credit, generated $100,000 from the exercise of employee stock options, and
issued to Dolphin Direct Equity Partners, LP a Senior Subordinated Secured
Convertible Note in the aggregate principle amount of $2,000,000. The Company
incurred $197,000 of deferred financing costs related to the Dolphin Note and
paid down a note payable of $9,000.
For
the
year ended December 31, 2004, the Company used $33,000 in financing activities
related to the pay down of a note payable.
Credit
Facilities.
The
Company had a line of credit with a bank through General Physics Corporation,
a
wholly owned subsidiary of GP Strategies. Under the terms of the agreement,
$1.5
million of General Physics’ available credit facility was carved out for use by
GSE. The line was collateralized by substantially all of the Company’s assets
and provided for borrowings up to 80% of eligible accounts receivable and 80%
of
eligible unbilled receivables. GP Strategies guaranteed GSE’s borrowings under
the credit facility, which continued in place after the spin-off from GP
Strategies in 2003. The interest rate on the line of credit was based upon
the
Daily LIBOR Market Index Rate plus 3%, with interest only payments due monthly.
A portion of the proceeds from the Company’s sale of Series A Cumulative
Convertible Preferred Stock on February 28, 2006 (see discussion below) was
used
to pay off the outstanding balance of the line of credit, $1.2 million.
On
March
7, 2006, the Company entered into a new loan and security agreement with Laurus
Master Fund, Ltd and terminated its existing $1.5 million bank line of credit.
The new agreement established a $5.0 million line of credit for the Company.
The
line is collateralized by substantially all of the Company’s assets and provides
for borrowings up to 90% of eligible accounts receivable and 40% of eligible
unbilled receivables (up to a maximum of $1.0 million). The interest rate on
this line of credit is based on the prime rate plus 200-basis points (10.25%
as
of December 31, 2006), with interest only payments due monthly. There are no
financial covenant requirements under the new agreement, and the credit facility
expires on March 6, 2008. On May 18, 2006, Laurus Master Fund agreed to
temporarily increase the Company’s borrowing capability by $2.0 million over and
above the funds that were available to the Company based upon its normal
borrowing base calculation. The over advance was used to collateralize a $2.1
million performance bond that the Company issued to the Emirates Simulation
Academy, LLC (“ESA”) in the form of a standby letter of credit. One half of the
increased borrowing capability expired on July 18, 2006, and the balance expires
on April 13, 2007. The Company’s borrowings over and above the normal borrowing
base calculation bear additional interest of 1.5% per month over and above
the
normal interest rate on the line of credit. The Company issued to Laurus Master
Fund, Ltd a warrant to purchase up to 367,647 shares of GSE common stock at
an
exercise price of $.01 per share. At the date of issuance, the fair value of
the
Laurus warrant, which was established using the Black-Scholes Model, was
$603,000 and was recorded as paid-in capital with the offset recorded as
deferred financing charges. Deferred financing charges are classified as an
other asset and are amortized over the term of the credit facility through
a
charge to interest expense. On July 31, 2006, Laurus exercised the warrant
through a cashless exercise procedure as defined in the warrant. Laurus received
366,666 shares of GSE common stock.
42
Senior
Subordinated Secured Convertible Note Payable
On
May
26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP a Senior
Subordinated Secured Convertible Note in the aggregate principal amount of
$2,000,000, which had a maturity date of March 31, 2009, and a seven-year
warrant to purchase 380,952 shares of GSE common stock at an exercise price
of
$2.22 per share. The Dolphin Note was convertible into 1,038,961 shares of
GSE
common stock at a conversion price of $1.925 per share and accrued interest
at
8% payable quarterly. The aggregate purchase price for the Dolphin Note and
GSE
Warrant was $2,000,000. At the date of issuance, the fair value of the GSE
Warrant was $375,000 and the fair value of the Conversion Option of the Dolphin
Note was $959,000, both of which were recorded as noncurrent liabilities, with
the offset recorded as original issue discount (OID). OID was accreted over
the
term of the Dolphin Note and charged to interest expense, and the unamortized
balance was netted against long-term debt in the accompanying consolidated
balance sheets. The GSE Warrant and Conversion Option liabilities were marked
to
market through earnings on a quarterly basis in accordance with EITF NO. 00-19,
Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in
a
Company’s Common Stock.
On
February 28, 2006, the Company and Dolphin entered into a Cancellation and
Warrant Exchange Agreement (the “Cancellation Agreement”) under which Dolphin
agreed to cancel its Senior Subordinated Secured Convertible Promissory Note
and
cancel its outstanding warrant to purchase 380,952 shares of GSE common stock
at
an exercise price of $2.22 per share. In exchange for Dolphin’s agreement to
enter into the Cancellation Agreement and for the participation of Dolphin
Offshore Partners, LP in the Preferred Stock transaction discussed below, the
Company repaid the Dolphin Note and agreed to issue a new warrant to purchase
900,000 shares of GSE common stock at an exercise price of $0.67 per share.
At
the date of issuance, the fair value of the Dolphin Warrant was $868,000, as
established using the Black-Scholes Model, and was recorded in paid-in capital
with the offset recorded as loss on extinguishment of debt. In accordance with
the terms of the warrant agreement, Dolphin exercised the Dolphin Warrant on
November 8, 2006 upon the Company’s certification that, among other things, the
underlying shares of GSE common stock were registered with the Securities and
Exchange Commission on October 31, 2006, that the current stock price was
greater than $1.25 per share, and that the average of the current stock prices
for each trading day of the prior 30 calendar day period was not less than
$1.25
per share. The Company received cash proceeds of $603,000.
In
conjunction with the early payoff of the Dolphin Note and the cancellation
of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000, recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature
and
the related warrants, and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin. The total loss on extinguishment of the Dolphin
Note and the cancellation of the related warrants totaled $1.4 million.
43
Series
A Cumulative Preferred Stock
On
February 28, 2006, the Company raised $3.9 million, net of associated fees
of
$395,000, through the sale of 42,500 shares of Series A Cumulative Convertible
Preferred Stock and Warrants by means of a private placement to “accredited
investors”, as that term is used in rules and regulations of the Securities and
Exchange Commission. The Convertible Preferred Stock is convertible at any
time
into a total of 2,401,130 shares of GSE common stock at a conversion price
of
$1.77 per share. The conversion price was equal to 110% of the closing price
of
the Company’s Common Stock on February 28, 2006, the date the sale of the
Convertible Preferred Stock was completed. Each investor received a five-year
warrant to purchase GSE common stock equal to 20% of the shares they would
receive from the conversion of the Convertible Preferred Stock, at an exercise
price of $1.77. In aggregate, the Company issued warrants to purchase a total
of
480,226 shares of GSE common stock. At the date of issuance, the fair value
of
the warrants was $342,000 and the fair value of the preferred stock was $3.9
million. The fair value of the warrants and the preferred stock was determined
by the use of the relative fair value method, in which the $4.25 million gross
proceeds was allocated based upon the fair values of the warrants, as determined
by using the Black-Scholes Model, and the preferred stock, as determined by
an
independent appraisal. The Convertible Preferred Stock holders are entitled
to
an 8% cumulative dividend, payable on a semiannual basis every June 30 and
December 30. In 2006, the Company paid dividends totaling $279,000 to the
preferred stockholders. At the date of issuance, the fair value of the warrants
was $342,000 and the fair value of the preferred stock was $3.9 million. The
fair value of the warrants and the preferred stock was determined by the use
of
the relative fair value method, in which the $4.25 million gross proceeds was
allocated based upon the fair values of the warrants, as determined by using
the
Black-Scholes Model, and the preferred stock, as determined by an independent
appraisal. At any time after March 1, 2007, the Company had the right to convert
the Preferred Stock into shares of GSE common stock when the average of the
current stock price during the twenty trading days immediately prior to the
date
of such conversion exceeds 200% of the Series A Conversion Price. Prior to
March
7, 2007, the holders of 22,500 shares of Preferred Stock had already elected
to
convert their Preferred Stock into a total of 1,271,187 shares of Common Stock;
8,580 shares of Preferred Stock were converted in 2006, and 13,920 shares of
Preferred Stock in 2007. On March 7, 2007, the Company sent notice to the
holders of the remaining 20,000 outstanding shares of its Preferred Stock that
the average current stock price for the prior twenty trading days had exceeded
200% of the Conversion Price, and that the Company was converting the
outstanding Preferred Stock into common stock. The 20,000 shares of Preferred
Stock will convert to 1,129,946 shares of GSE common stock. The holders of
the
Convertible Preferred Stock were entitled to vote on all matters submitted
to
the stockholders for a vote, together with the holders of the voting common
stock, all voting together as a single class. The holders of the Convertible
Preferred Stock were entitled to the number of votes equal to the number of
GSE
common stock that they would receive upon conversion of their Convertible
Preferred Stock.
The
Company paid the placement agent 6% of the gross proceeds received by the
Company from the offering ($255,000) plus five-year warrants to purchase 150,000
shares of the Company’s common stock at an exercise price of $1.77 per share. In
addition to the placement agent fee, the Company paid $140,000 of other
transaction fees related to the offering. At the date of issuance, the fair
value of the placement agent warrants was $128,000, as established using the
Black-Scholes Model, and was recorded in paid-in capital, with the offset
recognized as a reduction of the preferred stock proceeds.
The
proceeds were used to payoff the Dolphin Note and the Company’s bank line of
credit balance and for other working capital purposes.
44
Contractual
Cash Commitments
The
following summarizes the Company’s contractual cash obligations as of December
31, 2006, and the effect these obligations are expected to have on its liquidity
and cash flow in future periods:
|
Payments
Due by Period
(in
thousands)
|
||||||||||||||||||||
|
Contractual
Cash Obligations
|
Total
|
Less
than 1 year
|
1-3
Years
|
4-5
Years
|
After
5 Years
|
|||||||||||||||
|
Long
Term Debt
|
$
|
2,155
|
$
|
2,155
|
$
|
-
|
$
|
-
|
$
|
-
|
||||||||||
|
Subcontractor
and Purchase Commitments
|
$
|
4,970
|
$
|
4,872
|
$
|
98
|
$
|
-
|
$
|
-
|
||||||||||
|
Net
future minimum lease payments
|
$
|
1,137
|
$
|
804
|
$
|
333
|
$
|
-
|
$
|
-
|
||||||||||
|
Total
|
$
|
8,262
|
$
|
7,831
|
$
|
431
|
$
|
-
|
$
|
-
|
||||||||||
In
October 2005, the Company signed an “Assignment of Lease and Amendment to Lease”
that assigns and transfers to another tenant (the “assignee”) the Company’s
rights, title and interest in its Columbia, Maryland facility lease. The
assignee’s obligation to pay rent under the Lease began on February 1, 2006. The
Company remains fully liable for the payment of all rent and for the performance
of all obligations under the lease through the scheduled expiration of the
lease, May 31, 2008, should the assignee default on their obligations. At
December 31, 2006, the remaining rental payments under the lease totaled $1.1
million. The Company relocated its Maryland operations from its Columbia
facility to its Baltimore facility in October 2005.
As
of
December 31, 2006, the Company was contingently liable for five letters of
credit totaling $2.3 million. The letters of credit represent performance bonds
on five contracts and have been cash collateralized.
2007
Liquidity Outlook
Based
on
the Company’s forecasted expenditures and cash flow, we believe we will need
gross cash inflows of $32.6 million to fund our operations for the twelve
months ended December 31, 2007. All of this funding is expected to be generated
through our normal operations and the utilization of our current credit
facility, and we believe that we will have sufficient liquidity and working
capital without additional financing. We expect to generate $30.0 million of
cash in the year ended December 31, 2007 from the Company’s milestone billings
backlog as of December 31, 2006, including $12.8 million from the ESA Contract,
plus the orders logged by the Company in 2007 through March 30, 2007. The
balance of the Company’s 2007 cash requirement is expected to be generated by
future orders. However, notwithstanding the foregoing, the Company may be
required to look for additional capital to fund its operations if the Company
is
unable to operate profitably and generate sufficient cash from operations.
There
can be no assurance that the Company would be successful in raising such
additional funds.
45
Foreign
Exchange.
A
portion
of the Company's international sales revenue has been and may be received in
a
currency other than the currency in which the expenses relating to such revenue
are paid. When necessary, the Company enters into forward exchange contracts,
options and swap agreements as hedges against certain foreign currency
commitments to hedge its foreign currency risk.
Off-balance
Sheet Obligations.
The
Company has no off-balance sheet obligations as of December 31, 2006, except
for
its operating lease commitments and outstanding letters of credit. See
Contractual
Cash Commitments
above.
New
Accounting Standards.
On
July
13, 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in
Income Taxes- an Interpretation of FASB Statement No. 109 (“FIN 48”) was
issued. The provisions of FIN 48 are effective for fiscal years beginning after
December 15, 2006. FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in an enterprise’s financial statements in accordance with FASB
Statement No. 109, Accounting for Income Taxes. It also prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken
in a
tax return. The Company is currently evaluating the impact of FIN 48 on its
operations, financial condition and cash flows.
In
September 2006, the FASB issued Statement No. 157, Fair Value
Measurements. Statement No. 157 defines fair value, establishes a
framework for measuring fair value and expands disclosure requirements regarding
fair value measurements. Statement No. 157 does not require any new fair
value measurements. We are required to adopt the provisions of Statement
No. 157 effective January 1, 2008 although earlier adoption is
permitted. We do not believe the adoption of this standard will have a material
effect on our financial position, results of operations or cash flows.
In
September 2006, the Securities and Exchange Commission issued Staff Accounting
Bulletin, or SAB, No. 108, Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements, which provides interpretive guidance on the consideration of
the effects of prior year misstatements in quantifying current year
misstatements for the purpose of a materiality assessment. SAB No. 108
requires registrants to quantify misstatements using both the balance sheet
and
income statement approaches and to evaluate whether either approach results
in
quantifying an error that is material based on relevant quantitative and
qualitative factors. The Company adopted SAB No. 108 for the year ended December
31, 2006; the adoption did not have a material impact on the Company’s financial
statements.
In
February 2007, the FASB issued Statement No. 159 (SFAS159), The Fair Value
Option for Financial Assets and Liabilities
---
Including an Amendment of FASB Statement No.115, which permits
entities to measure eligible items at fair value. For items where the fair
value
election is made, the Company will be required to report unrealized gains or
losses in earnings. SFAS 159 is effective for fiscal years beginning after
November 15, 2007. At this time, we are assessing the impact the adoption of
SFAS 159 will have on our consolidated financial statements.
46
Other
Matters.
Management
believes inflation has not had a material impact on the Company's
operations.
47
ITEM
7A. QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The
Company’s market risk is principally confined to changes in foreign currency
exchange rates. During the year ended December 31, 2006, 18% of the Company’s
revenue was from contracts which required payments in a currency other than
U.S.
Dollars, principally Swedish Krona (9%), Japanese Yen (4%), Malaysian Ringgitt
(4%) and British Pounds Sterling (1%). For the years ended December 31, 2005
and
2004, a portion of the Company’s revenue was denominated in Swedish Krona (6%
and 3%, respectively) and Japanese Yen (8% and 13%, respectively). In addition,
during the years ended December 31, 2006, 2005 and 2004, 15%, 13% and 16%,
respectively, of the Company’s expenses were incurred in Swedish Krona. 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 utilizes forward foreign currency financial instruments to manage market
risks associated with the fluctuations in foreign currency exchange rates.
It is
the Company's policy to use derivative financial instruments to protect against
market risk arising in the normal course of business. The criteria the Company
uses for designating an instrument as a hedge include the instrument's
effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions. The Company monitors its foreign
currency exposures to maximize the overall effectiveness of its foreign currency
hedge positions. The principal currency hedged is the Japanese yen. The
Company's objectives for holding derivatives are to minimize the risks using
the
most effective methods to reduce the impact of these exposures. The Company
minimizes credit exposure by limiting counterparties to nationally recognized
financial institutions.
At
December 31, 2006, the Company had contracts for sale of approximately 142
million Japanese Yen at fixed rates. The contracts expire on various dates
through August 2007. The Company has not designated the contracts as hedges
and has recorded the estimated change in the fair value of the contracts of
($24,000) in other income (expense). The estimated fair value of the contracts
was $12,000 at December 31, 2006. The Company recognized unrealized gains
(losses) of approximately ($170,000) and $203,000 in 2005 and 2004,
respectively, on these contracts.
The
Company is also subject to market risk related to the interest rate on its
existing line of credit. As of December 31, 2006, such interest rate is based
on
the Prime Rate plus 200 basis-points. A 100 basis-point change in such rate
during the year ended December 31, 2006 would have increased or decreased the
Company’s annual interest expense by approximately $21,000.
48
ITEM
8. FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA.
INDEX
TO FINANCIAL STATEMENTS
|
Page
|
|
|
GSE
Systems, Inc. and Subsidiaries
|
|
|
Report
of Independent Registered Public Accounting Firm
|
F-1
|
|
Consolidated
Balance Sheets as of December 31, 2006 and 2005
|
F-2
|
|
Consolidated
Statements of Operations for the years ended
December
31, 2006, 2005, and 2004
|
F-3
|
|
Consolidated
Statements of Comprehensive Income (Loss) for the years ended
December
31, 2006, 2005, and 2004
|
F-4
|
|
Consolidated
Statements of Changes in Stockholders’ Equity for the years
ended
December
31, 2006, 2005, and 2004
|
F-5
|
|
Consolidated
Statements of Cash Flows for the years ended
December
31, 2006, 2005, and 2004
|
F-6
|
|
Notes
to Consolidated Financial Statements
|
F-7
|
49
Report
of
Independent Registered Public Accounting Firm
The
Board
of Directors and Stockholders
GSE
Systems, Inc.:
We
have
audited the accompanying consolidated
balance sheets of GSE Systems, Inc. and subsidiaries as of December 31, 2006
and
2005, and the related consolidated statements of operations, comprehensive
income (loss), changes in stockholders’ equity and cash flows for each of the
years in the three-year period ended December 31, 2006. These consolidated
financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining,
on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In
our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of GSE Systems, Inc. and
subsidiaries as of December 31, 2006 and 2005, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2006 in conformity with U.S. generally accepted accounting
principles.
As
discussed in Note 2 to the consolidated financial statements, effective January
1, 2006, the Company adopted Statement of Financial Accounting Standards No.
123(R), Share-Based
Payment.
/s/
KPMG
LLP
Baltimore,
Maryland
April
2,
2007
F-1
|
PART
I - FINANCIAL INFORMATION
|
|||||||||
|
Item
1. Financial Statements
|
|||||||||
|
GSE
SYSTEMS, INC. AND SUBSIDIARIES
|
|||||||||
|
CONSOLIDATED
BALANCE SHEETS
|
|||||||||
|
(in
thousands, except share data)
|
|||||||||
|
|
December
31,
|
||||||||
|
2006
|
2005
|
||||||||
|
ASSETS
|
|||||||||
|
Current
assets:
|
|||||||||
|
Cash
and cash equivalents
|
$
|
1,073
|
$
|
1,321
|
|||||
|
Restricted
cash
|
63
|
-
|
|||||||
|
Contract
receivables
|
10,669
|
6,896
|
|||||||
|
Prepaid
expenses and other current assets
|
494
|
376
|
|||||||
|
Total
current assets
|
12,299
|
8,593
|
|||||||
|
Equipment
and leasehold improvements, net
|
354
|
329
|
|||||||
|
Software
development costs, net
|
820
|
940
|
|||||||
|
Goodwill,
net
|
1,739
|
1,739
|
|||||||
|
Long-term
restricted cash
|
2,291
|
56
|
|||||||
|
Other
assets
|
945
|
325
|
|||||||
|
Total
assets
|
$
|
18,448
|
$
|
11,982
|
|||||
|
LIABILITIES
AND STOCKHOLDERS' EQUITY
|
|||||||||
|
Current
liabilities:
|
|||||||||
|
Current
portion of long-term debt
|
$
|
2,155
|
$
|
1,182
|
|||||
|
Accounts
payable
|
2,455
|
3,019
|
|||||||
|
Due
to GP Strategies Corporation
|
6
|
542
|
|||||||
|
Accrued
expenses
|
2,072
|
1,612
|
|||||||
|
Accrued
compensation and payroll taxes
|
1,535
|
1,226
|
|||||||
|
Billings
in excess of revenue earned
|
1,867
|
1,177
|
|||||||
|
Accrued
warranty
|
746
|
754
|
|||||||
|
Other
current liabilities
|
-
|
6
|
|||||||
|
Total
current liabilities
|
10,836
|
9,518
|
|||||||
|
Long-term
debt
|
-
|
869
|
|||||||
|
Other
liabilities
|
251
|
698
|
|||||||
|
Total
liabilities
|
11,087
|
11,085
|
|||||||
|
Commitments
and contingencies
|
|||||||||
|
Stockholders'
equity:
|
|||||||||
|
Preferred
stock $.01 par value, 2,000,000 shares authorized, shares issued
and
|
|||||||||
|
outstanding
33,920 in 2006 and none issued in 2005
|
-
|
-
|
|||||||
|
Common
stock $.01 par value, 18,000,000 shares authorized, shares issued
and
|
|||||||||
|
outstanding
11,013,822 in 2006 and 8,999,706 in 2005
|
110
|
90
|
|||||||
|
Additional
paid-in capital
|
37,504
|
30,915
|
|||||||
|
Accumulated
deficit - at formation
|
(5,112
|
)
|
(5,112
|
)
|
|||||
|
Accumulated
deficit - since formation
|
(24,185
|
)
|
(23,839
|
)
|
|||||
|
Accumulated
other comprehensive loss
|
(956
|
)
|
(1,157
|
)
|
|||||
|
Total
stockholders' equity
|
7,361
|
897
|
|||||||
|
Total
liabilities and stockholders' equity
|
$
|
18,448
|
$
|
11,982
|
|||||
|
The
accompanying notes are an integral part of these consolidated financial
statements.
|
|||||||||
F-2
|
GSE
SYSTEMS, INC. AND SUBSIDIARIES
|
||||||||||||
|
CONSOLIDATED
STATEMENTS OF OPERATIONS
|
||||||||||||
|
(in
thousands, except per share data)
|
||||||||||||
|
|
Years
ended December 31,
|
|||||||||||
|
2006
|
2005
|
2004
|
||||||||||
|
Contract
revenue
|
$
|
27,502
|
$
|
21,950
|
$
|
29,514
|
||||||
|
Cost
of revenue
|
19,602
|
18,603
|
22,715
|
|||||||||
|
Gross
profit
|
7,900
|
3,347
|
6,799
|
|||||||||
|
|
||||||||||||
|
Operating
expenses
|
||||||||||||
|
Selling,
general and administrative
|
4,929
|
6,958
|
5,543
|
|||||||||
|
Administrative
charges from GP Strategies
|
685
|
685
|
974
|
|||||||||
|
Depreciation
|
186
|
431
|
280
|
|||||||||
|
Total
operating expenses
|
5,800
|
8,074
|
6,797
|
|||||||||
|
|
||||||||||||
|
Operating
income (loss)
|
2,100
|
(4,727
|
)
|
2
|
||||||||
|
|
||||||||||||
|
Interest
expense, net
|
(764
|
)
|
(416
|
)
|
(176
|
)
|
||||||
|
Loss
on extinguishment of debt
|
(1,428
|
)
|
-
|
-
|
||||||||
|
Other
income (expense), net
|
(105
|
)
|
497
|
316
|
||||||||
|
|
||||||||||||
|
Income
(loss) from continuing operations before income taxes
|
(197
|
)
|
(4,646
|
)
|
142
|
|||||||
|
|
||||||||||||
|
Provision
for income taxes
|
149
|
149
|
60
|
|||||||||
|
|
||||||||||||
|
Income
(loss) from continuing operations
|
(346
|
)
|
(4,795
|
)
|
82
|
|||||||
|
|
||||||||||||
|
Income
on sale of discontinued operations, net
|
||||||||||||
|
of
income taxes
|
-
|
-
|
36
|
|||||||||
|
|
||||||||||||
|
Income
from discontinued operations
|
-
|
-
|
36
|
|||||||||
|
Net
income (loss)
|
(346
|
)
|
(4,795
|
)
|
118
|
|||||||
|
Preferred
stock dividends
|
(279
|
)
|
-
|
-
|
||||||||
|
Net
income (loss) attributed to common shareholders
|
$
|
(625
|
)
|
$
|
(4,795
|
)
|
$
|
118
|
||||
|
Basic
income (loss) per common share
|
||||||||||||
|
Continuing
operations
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
||||
|
Discontinued
operations
|
-
|
-
|
-
|
|||||||||
|
Net
income (loss)
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
||||
|
Diluted
income (loss) per common share
|
||||||||||||
|
Continuing
operations
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
||||
|
Discontinued
operations
|
-
|
-
|
-
|
|||||||||
|
Net
income (loss)
|
$
|
(0.07
|
)
|
$
|
(0.53
|
)
|
$
|
0.01
|
||||
|
The
accompanying notes are an integral part of these consolidated financial
statements.
|
||||||||||||
F-3
|
GSE
SYSTEMS, INC. AND SUBSIDIARIES
|
||||||||||||
|
CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
|
||||||||||||
|
(in
thousands)
|
||||||||||||
|
|
Years
ended December 31,
|
|||||||||||
|
2006
|
2005
|
2004
|
||||||||||
|
Net
income (loss)
|
$
|
(346
|
)
|
$
|
(4,795
|
)
|
$
|
118
|
||||
|
Foreign
currency translation adjustment
|
201
|
(354
|
)
|
148
|
||||||||
|
Comprehensive
income (loss)
|
$
|
(145
|
)
|
$
|
(5,149
|
)
|
$
|
266
|
||||
|
The
accompanying notes are an integral part of these consolidated financial
statements.
|
||||||||||||
F-4
|
GSE
SYSTEMS, INC, AND SUBSIDIARIES
|
|||||||||||||||||||||||||||||
|
CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
|
|||||||||||||||||||||||||||||
|
(in
thousands)
|
|||||||||||||||||||||||||||||
|
|
|||||||||||||||||||||||||||||
|
|
|
|
|||||||||||||||||||||||||||
|
Preferred
Stock
|
Common
Stock
|
Additional
|
Accumulated
Deficit
|
Accumulated
Other
|
|||||||||||||||||||||||||
|
|
Shares
|
Amount
|
Shares
|
Amount
|
Paid-in Capital |
At
Formation
|
Since Formation |
Comprehensive Loss |
Total
|
||||||||||||||||||||
|
Balance,
January 1, 2004
|
-
|
$
|
-
|
8,950
|
$
|
89
|
$
|
30,815
|
$
|
(5,112
|
)
|
$
|
(19,162
|
)
|
$
|
(951
|
)
|
$
|
5,679
|
||||||||||
|
Foreign
currency translation
|
|||||||||||||||||||||||||||||
|
adjustment
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
148
|
148
|
||||||||||||||||||||
|
Net
income
|
-
|
-
|
-
|
-
|
-
|
-
|
118
|
-
|
118
|
||||||||||||||||||||
|
Balance,
December 31, 2004
|
-
|
-
|
8,950
|
89
|
30,815
|
(5,112
|
)
|
(19,044
|
)
|
(803
|
)
|
5,945
|
|||||||||||||||||
|
Common
stock issued for
|
|||||||||||||||||||||||||||||
|
options
exercised
|
-
|
-
|
50
|
1
|
100
|
-
|
-
|
-
|
101
|
||||||||||||||||||||
|
Foreign
currency translation
|
|||||||||||||||||||||||||||||
|
adjustment
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
(354
|
)
|
(354
|
)
|
||||||||||||||||||
|
Net
loss
|
-
|
-
|
-
|
-
|
-
|
-
|
(4,795
|
)
|
-
|
(4,795
|
)
|
||||||||||||||||||
|
Balance,
December 31, 2005
|
-
|
-
|
9,000
|
90
|
30,915
|
(5,112
|
)
|
(23,839
|
)
|
(1,157
|
)
|
897
|
|||||||||||||||||
|
Issuance
of preferred stock
|
43
|
-
|
-
|
-
|
3,386
|
-
|
-
|
-
|
3,386
|
||||||||||||||||||||
|
Conversion
of preferred
|
-
|
||||||||||||||||||||||||||||
|
stock
to common stock
|
(9
|
)
|
-
|
485
|
5
|
(5
|
)
|
-
|
-
|
-
|
-
|
||||||||||||||||||
|
Preferred
stock dividends paid
|
-
|
-
|
-
|
-
|
(279
|
)
|
-
|
-
|
-
|
(279
|
)
|
||||||||||||||||||
|
Stock-based
compensation
|
|||||||||||||||||||||||||||||
|
expense
|
-
|
-
|
-
|
-
|
202
|
-
|
-
|
-
|
202
|
||||||||||||||||||||
|
Common
stock issued for
|
|||||||||||||||||||||||||||||
|
options
exercised
|
-
|
-
|
169
|
2
|
407
|
-
|
-
|
-
|
409
|
||||||||||||||||||||
|
Tax
benefit of options exercised
|
-
|
-
|
-
|
-
|
124
|
-
|
-
|
-
|
124
|
||||||||||||||||||||
|
Issuance
of restricted common stock
|
-
|
-
|
22
|
-
|
96
|
-
|
-
|
-
|
96
|
||||||||||||||||||||
|
Issuance
of warrants
|
-
|
-
|
-
|
-
|
1,941
|
-
|
-
|
-
|
1,941
|
||||||||||||||||||||
|
Common
stock issued for
|
-
|
||||||||||||||||||||||||||||
|
warrants
exercised
|
-
|
-
|
1,338
|
13
|
717
|
-
|
-
|
-
|
730
|
||||||||||||||||||||
|
Foreign
currency translation
|
-
|
||||||||||||||||||||||||||||
|
adjustment
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
201
|
201
|
||||||||||||||||||||
|
Net
loss
|
-
|
-
|
-
|
-
|
-
|
-
|
(346
|
)
|
-
|
(346
|
)
|
||||||||||||||||||
|
Balance,
December 31, 2006
|
34
|
$
|
-
|
11,014
|
$
|
110
|
$
|
37,504
|
$
|
(5,112
|
)
|
$
|
(24,185
|
)
|
$
|
(956
|
)
|
$
|
7,361
|
||||||||||
|
The
accompanying notes are an integral part of these consolidated financial
statements.
|
|||||||||||||||||||||||||||||
F-5
|
GSE
SYSTEMS, INC. AND SUBSIDIARIES
|
|||||||||||
|
CONSOLIDATED
STATEMENTS OF CASH FLOWS
|
|||||||||||
|
(in
thousands)
|
|||||||||||
|
Years
ended December 31,
|
|||||||||||
|
|
|||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Cash
flows from operating activities:
|
|||||||||||
|
Net
income (loss)
|
$
|
(346
|
)
|
$
|
(4,795
|
)
|
$
|
118
|
|||
|
Income
on sale of discontinued operations
|
-
|
-
|
36
|
||||||||
|
Income
(loss) from continuing operations
|
(346
|
)
|
(4,795
|
)
|
82
|
||||||
|
Adjustments
to reconcile income (loss) from continuing operations to
|
|||||||||||
|
net
cash used in operating activities:
|
|||||||||||
|
Depreciation
and amortization
|
697
|
1,121
|
678
|
||||||||
|
Change
in fair market value of liabilities for conversion option and
warrants
|
-
|
(636
|
)
|
-
|
|||||||
|
Loss
on extinguishment of debt
|
1,428
|
-
|
-
|
||||||||
|
Foreign
currency transaction (gain) loss
|
(128
|
)
|
35
|
(52
|
)
|
||||||
|
Deferred
income taxes
|
-
|
50
|
(50
|
)
|
|||||||
|
Employee
stock based compensation expense
|
202
|
-
|
-
|
||||||||
|
Non-employee
stock based compensation expense
|
96
|
-
|
-
|
||||||||
|
Elimination
of profit on Emirates Simulation Academy LLC contract
|
251
|
-
|
-
|
||||||||
|
Changes
in assets and liabilities:
|
|||||||||||
|
Contract
receivables
|
(3,773
|
)
|
1,827
|
734
|
|||||||
|
Prepaid
expenses and other assets
|
128
|
810
|
547
|
||||||||
|
Accounts
payable, accrued compensation and accrued expenses
|
473
|
(597
|
)
|
200
|
|||||||
|
Due
to GP Strategies Corporation
|
(536
|
)
|
251
|
191
|
|||||||
|
Billings
in excess of revenue earned
|
690
|
79
|
(2,829
|
)
|
|||||||
|
Accrued
warranty reserves
|
(8
|
)
|
87
|
158
|
|||||||
|
Other
liabilities
|
(6
|
)
|
(25
|
)
|
(50
|
)
|
|||||
|
Income
taxes payable
|
-
|
(58
|
)
|
34
|
|||||||
|
Net
cash used in continuing operations
|
(832
|
)
|
(1,851
|
)
|
(357
|
)
|
|||||
|
Net
cash used in discontinued operations
|
-
|
-
|
(36
|
)
|
|||||||
|
Net
cash used in operating activities
|
(832
|
)
|
(1,851
|
)
|
(393
|
)
|
|||||
|
Cash
flows from investing activities:
|
|||||||||||
|
Capital
expenditures
|
(185
|
)
|
(182
|
)
|
(222
|
)
|
|||||
|
Capitalized
software development costs
|
(333
|
)
|
(483
|
)
|
(361
|
)
|
|||||
|
Releases
(restrictions) of cash as collateral under letters of credit,
net
|
(2,298
|
)
|
(27
|
)
|
473
|
||||||
|
Net
cash used in investing activities
|
(2,816
|
)
|
(692
|
)
|
(110
|
)
|
|||||
|
Cash
flows from financing activities:
|
|||||||||||
|
Increase
in borrowings under lines of credit
|
2,155
|
1,182
|
-
|
||||||||
|
Payoff
of line of credit with bank
|
(1,182
|
)
|
-
|
-
|
|||||||
|
Net
proceeds from issuance of preferred stock and warrants
|
3,856
|
-
|
-
|
||||||||
|
Proceeds
from issuance of common stock
|
1,139
|
100
|
-
|
||||||||
|
Tax
benefit from option exercises
|
124
|
-
|
-
|
||||||||
|
Deferred
financing costs
|
(448
|
)
|
(232
|
)
|
-
|
||||||
|
Payment
of preferred stock dividends
|
(279
|
)
|
-
|
-
|
|||||||
|
Issuance
(paydown) of subordinated convertible note payable
|
(2,000
|
)
|
2,000
|
-
|
|||||||
|
Other
financing activities, net
|
-
|
(9
|
)
|
(33
|
)
|
||||||
|
Net
cash provided by (used in) financing activities
|
3,365
|
3,041
|
(33
|
)
|
|||||||
|
Effect
of exchange rate changes on cash
|
35
|
(45
|
)
|
16
|
|||||||
|
Net
increase (decrease) in cash and cash equivalents
|
(248
|
)
|
453
|
(520
|
)
|
||||||
|
Cash
and cash equivalents at beginning of year
|
1,321
|
868
|
1,388
|
||||||||
|
Cash
and cash equivalents at end of year
|
$
|
1,073
|
$
|
1,321
|
$
|
868
|
|||||
|
The
accompanying notes are an integral part of these consolidated financial
statements.
|
|||||||||||
F-6
1.
Business and basis
of presentation
GSE
Systems, Inc. ("GSE Systems", “GSE” or the "Company") develops and delivers
business and technology solutions by applying simulation software, systems
and
services to the energy industry worldwide.
On
June
21, 2005, the Board of Directors of GP Strategies Corporation (“GP Strategies”)
approved plans to spin-off its 57% interest in GSE through a special dividend
to
the GP Strategies’ stockholders. On September 30, 2005, the GP Strategies’
stockholders received 0.283075 share of GSE common stock for each share of
GP
Strategies common stock or Class B stock held on the record date of September
19, 2005. Following the spin-off, GP Strategies ceased to have any ownership
interest in GSE. GP Strategies continued to provide corporate support services
to GSE, including accounting, finance, human resources, legal, network support
and tax pursuant to a Management Services Agreement which expired on December
31, 2006.
The
Company’s operations are subject to certain risks and uncertainties including,
among others, rapid technological changes, success of the Company’s product
development, marketing and distribution strategies, the need to manage growth,
the need to retain key personnel and protect intellectual property, and the
availability of additional financing on terms acceptable to the
Company.
Based
on
the Company’s forecasted expenditures and cash flow, we believe we will need
$32.6
million to fund our operations for the twelve months ended December 31, 2007.
All of this funding is expected to be generated through our normal operations
and the utilization of our current credit facility, and we believe that we
will
have sufficient liquidity and working capital without additional financing.
We
expect to generate $30.0 million of cash in the year ended December 31, 2007
from the Company’s milestone billings backlog as of December 31, 2006, including
$12.8 million from the ESA Contract, plus the orders logged by the Company
in
2007 through March 30, 2007. The balance of the Company’s 2007 cash requirement
is expected to be generated by future orders. However, notwithstanding the
foregoing, the Company may be required to look for additional capital to
fund
its operations if the Company is unable to operate profitably and generate
sufficient cash from operations. There can be no assurance that the Company
would be successful in raising such additional funds.
2.
Summary of significant accounting policies
Principles
of consolidation
The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All intercompany balances and
transactions have been eliminated.
Accounting
estimates
The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the 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. The Company’s most significant estimates relate to
revenue recognition, capitalization of software development costs, and the
recoverability of deferred tax assets. Actual results could differ from those
estimates.
Revenue
recognition
The
majority of the Company’s revenue is derived through the sale of uniquely
designed systems containing hardware, software and other materials under
fixed-price contracts. In accordance with Statement of Position 81-1,
Accounting
for Performance of Construction-Type and Certain Production-Type
Contracts,
the
revenue under these fixed-price contracts is accounted for on the
percentage-of-completion method. This methodology recognizes revenue and
earnings as work
progresses on the contract and is based on an estimate of the revenue and
earnings earned to date, less amounts recognized in prior periods. The Company
bases its estimate of the degree of completion of the contract by reviewing
the
relationship of costs incurred to date to the expected total costs that will
be
incurred on the project. Estimated contract earnings are reviewed and revised
periodically as the work progresses, and the cumulative effect of any change
in
estimate is recognized in the period in which the change is identified.
Estimated losses are charged against earnings in the period such losses are
identified. The Company recognizes revenue arising from contract claims either
as income or as an offset against a potential loss only when the amount of
the
claim can be estimated reliably and realization is probable and there is a
legal
basis of the claim. In 2006, the Company settled an outstanding claim with
a
customer for work performed through December 31, 2005 of approximately $265,000,
of which $120,000 was recognized as revenue in 2005 and the balance was
recognized as revenue in 2006. There are no claims outstanding as of December
31, 2006.
F-7
As
the
Company recognizes revenue under the percentage-of-completion method, it
provides an accrual for estimated future warranty costs based on historical
and
projected claims experience. The Company’s long-term contracts generally provide
for a one-year warranty on parts, labor and any bug fixes as it relates to
software embedded in the systems.
The
Company’s system design contracts do not provide for “post customer support
service” (PCS) in terms of software upgrades, software enhancements or telephone
support. In order to obtain PCS, the customers must purchase a separate
contract. Such PCS arrangements are generally for a one-year period renewable
annually and include customer support, unspecified software upgrades, and
maintenance releases. The Company recognizes revenue from these contracts
ratably over the life of the agreements in accordance with Statement of Position
97-2 Software
Revenue Recognition.
Revenue
from the sale of software licenses which do not require significant
modifications or customization for the Company’s modeling tools are recognized
when the license agreement is signed, the license fee is fixed and determinable,
delivery has occurred, and collection is considered probable.
Revenue
for contracts with multiple elements are recognized in accordance with Emerging
Issues Task Force Issue 00-21, Accounting
for Revenue Arrangements with Multiple Deliverables.
Revenues
from certain consulting or training contracts are recognized on a
time-and-material basis. For time-and-material type contracts, revenue is
recognized based on hours incurred at a contracted labor rate plus
expenses.
Cash
and cash equivalents
Cash
and
cash equivalents consist of cash on hand and overnight sweep investments with
maturities of three months or less at the date of purchase.
Contract
Receivables
Contract
receivables include recoverable costs and accrued profit not billed which
represents revenue recognized in excess of amounts billed. The liability,
“Billings in excess of revenue earned,” represents billings in excess of revenue
recognized.
F-8
Billed
receivables are recorded at invoiced amounts. The allowance for doubtful
accounts is based on historical trends of past due accounts, write-offs, and
specific identification and review of past due accounts. The activity in the
allowance for doubtful accounts is as follows:
|
(in
thousands)
|
|
As
of and for the
|
||||||||||||
|
Years
ended December 31,
|
||||||||||||||
|
2006
|
2005
|
2004
|
||||||||||||
|
Beginning
balance
|
$
|
245
|
$
|
24
|
$
|
7
|
||||||||
|
Current
year provision
|
3
|
496
|
35
|
|||||||||||
|
Current
year write-offs
|
(245
|
)
|
(275
|
)
|
(18
|
)
|
||||||||
|
Ending
balance
|
$
|
3
|
$
|
245
|
$
|
24
|
||||||||
Equipment
and leasehold improvements, net
Equipment
is recorded at cost and depreciated using the straight-line method with
estimated useful lives ranging from three to ten years. Leasehold improvements
are amortized over the life of the lease or the estimated useful life, whichever
is shorter, using the straight-line method. Upon sale or retirement, the cost
and related amortization are eliminated from the respective accounts and any
resulting gain or loss is included in operations. Maintenance and repairs are
charged to expense as incurred.
Software
development costs
Certain
computer software development costs are capitalized in the accompanying
consolidated balance sheets in accordance with SFAS No. 86, Accounting
for the Costs of Computer Software to be Sold, Leased, or Otherwise
Marketed.
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 provided using the straight-line method over the remaining estimated
economic life of the product, not to exceed five years.
Development
expenditures
Development
expenditures incurred to meet customer specifications under contracts are
charged to contract costs. Company sponsored development expenditures are
charged to operations as incurred and are included in selling, general and
administrative expenses. The amounts incurred for Company sponsored development
activities relating to the development of new products and services or the
improvement of existing products and services, were
approximately $871,000, $758,000, and $552,000, for the years ended December
31,
2006, 2005, and 2004, respectively. Certain of these expenditures were
capitalized as software development costs. See Note 7, Software development
costs.
F-9
Impairment
of long-Lived Assets
In
accordance with SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, property and equipment are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an
asset
may not be recoverable. Recoverability of assets to be held and used is measured
by a comparison of the carrying amount of an asset to estimated undiscounted
future cash flows, an impairment charge is recognized by the amount by which
the
carrying amount of the asset exceeds the fair value of the asset. Assets to
be
disposed of would be separately presented in the balance sheet and reported
at
the lower of the carrying amount or fair value less costs to sell, and are
no
longer depreciated. The assets and liabilities of a disposal group classified
as
held for sale would be presented separately in the appropriate asset and
liability sections of the balance sheet.
Goodwill
is tested annually, on November 30, for impairment, or more frequently if events
and circumstances indicate that the asset might be impaired. An impairment
loss
is recognized to the extent that the carrying amount exceeds the asset’s fair
value. For goodwill, the impairment determination is made at the reporting
unit
level and consists of two steps. First, the Company determines the fair value
of
a reporting unit and compares it to its carrying amount. Second, if the carrying
amount of a reporting unit exceeds its fair value, an impairment loss is
recognized for any excess of the carrying amount of the reporting unit’s
goodwill over the implied fair value of that goodwill. The implied fair value
of
goodwill is determined by allocating the fair value of the reporting unit in
a
manner similar to a purchase price allocation, in accordance with SFAS No.
141,
Business Combinations. The residual fair value after this allocation is the
implied fair value of the reporting unit goodwill. No impairment losses were
recognized in 2006, 2005 and 2004.
Foreign
currency translation
Balance
sheet accounts for foreign operations are translated at the exchange rate at
the
balance sheet date, and income statement accounts are translated at the average
exchange rate for the period. The resulting translation adjustments are included
in other comprehensive income (loss). Transaction gains and losses, resulting
from changes in exchange rates, are included in other income (expense) in the
Consolidated Statements of Operations in the period in which they occur. For
the
years ended December 31, 2006, 2005, and 2004, foreign currency transaction
gains (losses) were approximately $128,000, ($35,000), and $52,000,
respectively.
F-10
Warranty
As
the
Company recognizes revenue under the percentage-of-completion method, it
provides an accrual for estimated future warranty costs based on historical
experience and projected claims. The activity in the warranty accounts is as
follows:
|
(in
thousands)
|
As
of and for the
|
||||||||||
|
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Beginning
balance
|
$
|
754
|
$
|
667
|
$
|
509
|
|||||
|
Current
year provision
|
568
|
286
|
312
|
||||||||
|
Current
year claims
|
(599
|
)
|
(166
|
)
|
(154
|
)
|
|||||
|
Currency
adjustment
|
23
|
(33
|
)
|
-
|
|||||||
|
Ending
balance
|
$
|
746
|
$
|
754
|
$
|
667
|
|||||
Income
taxes
Deferred
income taxes are provided under the asset and liability method. Under this
method, deferred income taxes are determined based on the differences between
the financial statement and tax bases of assets and liabilities using enacted
tax rates in effect for the year in which the differences are expected to
reverse. Valuation allowances are established when necessary to reduce deferred
tax assets to the amounts expected to be realized. Provision is made for the
Company's current liability for federal, state and foreign income taxes and
the
change in the Company's deferred income tax assets and liabilities. No provision
has been made for the undistributed earnings of the Company's foreign
subsidiaries as they are considered permanently invested.
Stock
Compensation
In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 123R, Share-Based
Payment
(SFAS
No. 123R), which revises SFAS No. 123, Accounting
for Stock-Based Compensation (SFAS
No.
123), and supersedes Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees
(APB
No. 25), and requires companies to recognize compensation expense for all
equity-based compensation awards issued to employees that are expected to vest.
The Company adopted SFAS No. 123R on January 1, 2006, using the Modified
Prospective Application method without restatement of prior periods. Under
this
method, the Company would begin to amortize compensation cost for the remaining
portion of its outstanding awards for which the requisite service was not yet
rendered as of January 1, 2006. However, at January 1, 2006, all of the
Company’s outstanding options were fully vested and thus there is no
compensation expense in 2006 related to the adoption of SFAS No. 123R on these
outstanding options. The Company determines the fair value of and accounts
for
awards that are granted, modified, or settled after January 1, 2006 in
accordance with SFAS No. 123R.
Compensation
expense related to share based awards is recognized on a straight-line basis
based on the value of share awards that are scheduled to vest during the
requisite service period. During the twelve months ended December 31, 2006,
the
Company recognized $202,000 of pre-tax stock-based compensation expense under
the fair value method in accordance with SFAS No. 123R. As of December 31,
2006,
the Company had $374,000 of unrecognized compensation related to the unvested
portion of outstanding stock option awards expected to be recognized through
May
2009.
F-11
Prior
to
2006, the Company applied the intrinsic-value-based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting
for stock issued to Employees,
and
related interpretations including FASB Interpretation No. 44, Accounting
for Certain Transactions involving Stock Compensation, and interpretation of
APB
Opinion No. 25, issued
in
March 2000, to account for its fixed-plan stock options. Under this method,
compensation expense was recorded on the date of grant only if the current
market price of the underlying stock exceeded the exercise price. SFAS No.
123,
Accounting
for Stock-Based Compensation,
established accounting and disclosure requirements using a fair-value-based
method of accounting for stock based employee compensation plans. As allowed
by
SFAS No. 123, the Company elected to continue to apply the intrinsic-value-based
method of accounting describe above, and had adopted only the disclosure
requirements of SFAS No. 123. See Note 13, Stock-Based compensation.
Income
(loss) per share
Basic
income (loss) per share is based on the weighted average number of outstanding
common shares for the period. Diluted income (loss) per share adjusts the
weighted average shares outstanding for the potential dilution that could occur
if stock options, warrants, convertible subordinated debt or convertible
preferred stock were exercised or converted into common stock. The number of
common shares and common share equivalents used in the determination of basic
and diluted income (loss) per share was as follows:
F-12
[
|
(in
thousands, except for share and per share amounts)
|
|||||||||||
|
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Numerator:
|
|||||||||||
|
Net
income (loss)
|
$
|
(346
|
)
|
$
|
(4,795
|
)
|
$
|
118
|
|||
|
Preferred
stock dividends
|
(279
|
)
|
-
|
-
|
|||||||
|
Net
income (loss) attributed to
|
|||||||||||
|
common
stockholders
|
$
|
(625
|
)
|
$
|
(4,795
|
)
|
$
|
118
|
|||
|
Denominator:
|
|||||||||||
|
Weighted-average
shares outstanding for basic
|
|||||||||||
|
earnings
per share
|
9,539,142
|
8,999,021
|
8,949,706
|
||||||||
|
Effect
of dilutive securities:
|
|||||||||||
|
Employee
stock options, warrants and
|
|||||||||||
|
convertible
preferred stock
|
-
|
-
|
105,736
|
||||||||
|
Adjusted
weighted-average shares outstanding
|
|||||||||||
|
and
assumed conversions for diluted
|
|||||||||||
|
earnings
per share
|
9,539,142
|
8,999,021
|
9,055,442
|
||||||||
|
Shares
related to dilutive securities excluded
|
|||||||||||
|
because
inclusion would be anti-dilutive:
|
3,755,457
|
2,753,213
|
1,294,826
|
||||||||
Conversion
of the stock options, warrants, convertible preferred stock and convertible
subordinated debt was not assumed for the years ended December 31, 2006 and
2005
because the impact was anti-dilutive. The difference between the basic and
diluted number of weighted average shares outstanding for the year ended
December 31, 2004 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. The net loss for the year ended December
31, 2006 was decreased by preferred stock dividends of $279,000 in calculating
the per share amounts.
F-13
Concentration
of credit risk
The
Company is subject to concentration of credit risk with respect to contract
receivables. Credit risk on contract receivables is mitigated by the nature
of
the Company's worldwide customer base and its credit policies. The Company's
customers are not concentrated in any specific geographic region, but are
concentrated in the energy industry. For
the
year ended December 31, 2006, the Emirates Simulation Academy LLC (UAE) provided
21% of the Company’s consolidated 2006 revenue (none in 2005 and 2004);
Rosenergoatom Federal State Owned Enterprise (Russia) provided 12% of the
Company’s consolidated 2006 revenue (0% and 5% in 2005 and 2004, respectively),
and Battelle’s Pacific Northwest National Laboratory accounted for approximately
11% of the Company’s consolidated revenue (25% and 24% in 2005 and 2004,
respectively). The Pacific Northwest National Laboratory is the purchasing
agent
for the Department of Energy and the numerous projects the Company performs
in
Eastern and Central Europe. As
of
December 31, 2006, the contracts receivable balance related to these three
significant customers was approximately $5.6 million, or 52% of contract
receivables, of which $2.4 million was unbilled at year-end.
Fair
values of financial instruments
The
carrying amounts of current assets, current liabilities, and long-term debt
reported in the Consolidated Balance Sheets approximate fair value.
Deferred
Financing Fees
The
Company amortizes the cost incurred to obtain debt financing over the term
of
the underlying obligations using the effective interest method. The amortization
of deferred financing costs is included in interest expense. Unamortized
deferred financing costs are classified within other assets in the consolidated
balance sheets.
Derivative
Instruments
The
Company utilizes foreign
currency forward financial instruments to manage market risks associated with
the fluctuations in foreign currency exchange rates. It is the Company's policy
to use derivative financial instruments to protect against market risk arising
in the normal course of business. The criteria the Company uses for designating
an instrument as a hedge include the instrument's effectiveness in risk
reduction and one-to-one matching of derivative instruments to underlying
transactions. The Company monitors its foreign currency exposures to maximize
the overall effectiveness of its foreign currency hedge positions. Principal
currencies hedged include the Euro and the Japanese Yen. The Company's
objectives for holding derivatives are to minimize the risks using the most
effective methods to reduce the impact of these exposures. The Company minimizes
credit exposure by limiting counterparties to nationally recognized financial
institutions.
F-14
All
derivatives, whether designated as hedging relationships or not, are recorded
on
the balance sheet at fair value. If the derivative is designated as a fair
value
hedge, the changes in the fair value of the derivative and of the hedged item
attributable to the hedged risk are recognized in earnings. If the derivative
is
designated as a cash flow hedge, the change in the fair value of the derivative
and of the hedged item are recognized as an element of other comprehensive
income.
As
of
December 31, 2006 and 2005, the Company had contracts for sale of approximately
124 million and 247 million Japanese Yen, respectively, at fixed rates. The
contracts expire on various dates through May 2007. The Company has not
designated the contracts as hedges and has recorded the estimated fair value
of
the contracts of $11,000 and $31,000 as of December 31, 2006 and 2005,
respectively, as an other asset in the consolidated balance sheet. The change
in
the estimated fair value of the contracts for the years ended December 31,
2006,
2005 and 2004 was approximately ($23,000), ($170,000) and $203,000,
respectively, and was recorded in other income (expense) in the consolidated
statements of operations.
New
Accounting Standards
On
July
13, 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income
Taxes- an Interpretation of FASB Statement No. 109 (“FIN 48”) was issued. The
provisions of FIN 48 are effective for fiscal years beginning after December
15,
2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized
in an enterprise’s financial statements in accordance with FASB Statement No.
109, Accounting for Income Taxes. It also prescribes a recognition threshold
and
measurement attribute for the financial statement recognition and measurement
of
a tax position taken or expected to be taken in a tax return. The Company is
currently evaluating the impact of FIN 48 on its operations, financial condition
and cash flows.
In
September 2006, the FASB issued Statement No. 157, Fair
Value Measurements.
Statement No. 157 defines fair value, establishes a framework for measuring
fair value and expands disclosure requirements regarding fair value
measurements. Statement No. 157 does not require any new fair value
measurements. We are required to adopt the provisions of Statement No. 157
effective January 1, 2008 although earlier adoption is permitted. We do not
believe the adoption of this standard will have a material effect on our
consolidated financial statements.
In
September 2006, the Securities and Exchange Commission issued Staff Accounting
Bulletin, or SAB, No. 108, Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements, which provides interpretive guidance on the consideration of
the effects of prior year misstatements in quantifying current year
misstatements for the purpose of a materiality assessment. SAB No. 108
requires registrants to quantify misstatements using both the balance sheet
and
income statement approaches and to evaluate whether either approach results
in
quantifying an error that is material based on relevant quantitative and
qualitative factors. The Company adopted SAB No. 108 for the year ended December
31, 2006; the adoption did not have a material impact on the Company’s financial
statements.
In
February
2007, the FASB issued Statement No. 159, The
Fair Value Option for Financial Assets and Liabilities ---
Including an amendment of FASB Statement No. 115,
which
permits entities to measure eligible items at fair value. For items where the
fair value election is made, the Company will be required to report unrealized
gains or losses in earnings. Statement 159 is effective for fiscal years
beginning after November 15, 2007. The Company is currently assessing the impact
the adoption of this statement will have on our consolidated financial
statements.
F-15
3.
Discontinued operations
In
September 2003, the Company completed the sale of substantially all of the
assets of Process to Novatech pursuant to an Asset Purchase Agreement, effective
as of September 25, 2003. The Company received $5.5 million in cash, subject
to
certain adjustments. The Company recognized a loss on this transaction of
$262,000. In conjunction with the transaction, Novatech purchased certain assets
with a book value of $11.7 million and assumed certain operating liabilities
totaling approximately $6.8 million. The Company incurred approximately $865,000
of closing costs associated with the transaction.
The
$36,000 of income from discontinued operations in 2004 relates to the favorable
resolution of certain contingencies which the Company had provided for at the
date of sale net of income taxes.
4.
Contract receivables
Contract
receivables represent balances due from a broad base of both domestic and
international customers. All contract receivables are considered to be
collectible within twelve months. Recoverable costs and accrued profit not
billed represent costs incurred and associated profit accrued on contracts
that
will become billable upon future milestones or completion of contracts. The
components of contract receivables are as follows:
|
(in
thousands)
|
December
31,
|
|||||||
|
2006
|
2005
|
|||||||
|
Billed
receivables
|
$
|
6,066
|
$
|
3,445
|
||||
|
Recoverable
costs and accrued profit not billed
|
4,606
|
3,696
|
||||||
|
Allowance
for doubtful accounts
|
(3
|
)
|
(245
|
)
|
||||
|
Total
contract receivables
|
$
|
10,669
|
$
|
6,896
|
||||
5.
Prepaid expenses and other current assets
Prepaid
expenses and other current assets consist of the following:
|
(in
thousands)
|
December
31,
|
|||||||
|
2006
|
2005
|
|||||||
|
Prepaid
expenses
|
$
|
218
|
$
|
228
|
||||
|
Employee
advances
|
26
|
40
|
||||||
|
Other
current assets
|
250
|
108
|
||||||
|
Total
|
$
|
494
|
$
|
376
|
||||
F-16
6.
Equipment and leasehold improvements
Equipment
and leasehold improvements consist of the following:
|
(in
thousands)
|
December
31,
|
|||||||
|
2006
|
2005
|
|||||||
|
Computer
equipment
|
$
|
2,422
|
$
|
2,039
|
||||
|
Leasehold
improvements
|
4
|
-
|
||||||
|
Furniture
and fixtures
|
446
|
388
|
||||||
|
2,872
|
2,427
|
|||||||
|
Accumulated
depreciation
|
(2,518
|
)
|
(2,098
|
)
|
||||
|
Equipment
and leasehold improvements, net
|
$
|
354
|
$
|
329
|
||||
Depreciation
expense was approximately $186,000, $431,000, and $280,000 for the years ended
December 31, 2006, 2005, and 2004, respectively. Due to the relocation of the
Company’s Maryland operations from Columbia, Maryland to Baltimore, Maryland in
October 2005, the Company accelerated the depreciation of certain leasehold
improvements in 2005.
7.
Software development costs
Software
development costs, net, consist of the following:
|
(in
thousands)
|
December
31,
|
|||||||
|
2006
|
2005
|
|||||||
|
Capitalized
software development costs
|
$
|
1,600
|
$
|
1,896
|
||||
|
Accumulated
amortization
|
(780
|
)
|
(956
|
)
|
||||
|
Software
development costs, net
|
$
|
820
|
$
|
940
|
||||
Software
development costs capitalized were approximately $333,000, $483,000, and
$361,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Amortization of software development costs capitalized was approximately
$453,000, $452,000, and $398,000 for the years ended December 31, 2006,
2005 and 2004, respectively, and were included in cost of revenue.
8.
Investment in Emirates Simulation Academy, LLC
On
November 8, 2005, the Emirates Simulation Academy, LLC (“ESA”), headquartered in
Abu Dhabi, United Arab Emirates, was formed to build and operate simulation
training academies in the Arab Gulf Region. These simulation training centers
will be designed to train and certify indigenous workers for deployment to
critical infrastructure facilities including power plants, oil refineries,
petro-chemical plants, desalination units and other industrial facilities.
The
members of the limited liability company include Al Qudra Holding PJSC of the
United Arab Emirates (60% ownership), the Centre of Excellence for Applied
Research and Training of the United Arab Emirates (30% ownership) and GSE (10%
ownership). At December 31, 2006, GSE’s investment in ESA totaled $238,000 and
was classified on the balance sheet as an other asset. The Company accounts
for
its investment in ESA using the equity method.
F-17
In
January 2006, GSE received a $15.1 million contract from ESA to supply five
simulators and an integrated training program. For the year ended December
31,
2006, the Company recognized $5.7 million of contract revenue on this project
using the percentage-of-completion method, which accounted for 20.7% of the
Company’s consolidated revenue.
In
accordance with the equity method, the Company has eliminated 10% of the profit
from this contract as the training simulators are assets that will be recorded
on the books of ESA, and the Company is thus required to eliminate its
proportionate share of the profit included in the asset value. The profit
elimination totaled $251,000 for the year ended December 31, 2006, respectively,
and has been recorded as an other expense in the income statement and as an
other liability on the balance sheet. Once ESA begins to amortize the training
simulators on their books, GSE will begin to amortize the other liability to
other income.
The
Company issued an invoice for $1.7 million to ESA in August 2006 which is still
outstanding at December 31, 2006. In March 2007, ESA established a line of
credit with a bank. Payment will be made to GSE as soon as all required
documents have been received by the bank. No bad debt reserve has been
established for the outstanding receivable at December 31, 2006. In addition,
the Company had an unbilled receivable of $1.9 million for the ESA contract
at
December 31, 2006. Under the terms of the contract, the Company provided a
$2.1
million performance bond to ESA that will remain outstanding until the end
of
the warranty period on October 31, 2008.
See
Note
20, Subsequent Events.
9.
Long-term debt
The
Company’s long-term debt consists of the following:
|
(in
thousands)
|
December
31,
|
|||||||
|
2006
|
2005
|
|||||||
|
Line
of credit with bank
|
$
|
-
|
$
|
1,182
|
||||
|
Line
of credit with Laurus Master Fund, Ltd.
|
2,155
|
-
|
||||||
|
Senior
convertible secured subordinated note payable
|
-
|
2,000
|
||||||
|
Total
notes payable and financing arrangements
|
2,155
|
3,182
|
||||||
|
Less
warrant related discount, net of accretion
|
-
|
(318
|
)
|
|||||
|
Less
convertible option discount, net of accretion
|
-
|
(813
|
)
|
|||||
|
2,155
|
2,051
|
|||||||
|
Less
current portion
|
(2,155
|
)
|
(1,182
|
)
|
||||
|
Long-term
debt, less current portion
|
$
|
-
|
$
|
869
|
||||
Line
of Credit
The
Company had a line of credit with a bank through General Physics Corporation,
a
wholly owned subsidiary of GP Strategies. Under the terms of the agreement,
$1.5
million of General Physics’ available credit facility was carved out for use by
GSE. The line was collateralized by substantially all of the Company’s assets
and provided for borrowings up to 80% of eligible accounts receivable and 80%
of
eligible unbilled receivables. GP Strategies guaranteed GSE’s borrowings under
the credit facility, which continued in place after the spin-off from GP
Strategies. The interest rate on the line of credit was based upon the Daily
LIBOR Market Index Rate plus 3%, with interest only payments due monthly. A
portion of the proceeds from the Company’s sale of Series A Cumulative
Convertible Preferred Stock on February 28, 2006 (see Note 12) was used to
pay
off the outstanding balance of the line of credit, $1.2 million.
F-18
On
March
7, 2006, the Company entered into a new loan and security agreement with Laurus
Master Fund, Ltd (“Laurus”) and terminated its existing $1.5 million bank line
of credit. The new agreement established a $5.0 million line of credit for
the
Company. The line is collateralized by substantially all of the Company’s assets
and provides for borrowings up to 90% of eligible accounts receivable and 40%
of
eligible unbilled receivables (up to a maximum of $1.0 million). The interest
rate on this line of credit is based on the prime rate plus 200-basis points
(10.25% as of December 31, 2006), with interest only payments due monthly.
The
credit facility does not require the Company to comply with any financial ratios
and expires on March 6, 2008. Because the Laurus line of credit agreement
includes both a subjective acceleration clause and a requirement to maintain
a
lock-box arrangement whereby remittances for GSE’s customers reduce the
outstanding debt, the borrowings under the line of credit have been classified
as short-term obligations on the balance sheet. On May 18, 2006, Laurus Master
Fund agreed to temporarily increase the Company’s borrowing capability by $2.0
million over and above the funds that were available to the Company based upon
its normal borrowing base calculation. The over advance was used to
collateralize a $2.1 million performance bond that the Company issued to ESA
in
the form of a standby letter of credit. One half of the increased borrowing
capability expired on July 18, 2006, and the balance expires on April 13, 2007.
The Company’s borrowings over and above the normal borrowing base calculation
bear additional interest of 1.5% per month over and above the normal interest
rate on the line of credit. At December 31, 2006, the Company’s available
borrowing base was $4.2 million of which $2.2 million had been utilized. The
Company issued to Laurus a warrant to purchase up to 367,647 shares of GSE
common stock at an exercise price of $.01 per share. At the date of issuance,
the fair value of the Laurus warrant, which was established using the
Black-Scholes Model, was $603,000 and was recorded as paid-in capital with
the
offset recorded as deferred financing charges. Deferred financing charges are
classified as an other asset and are amortized over the term of the credit
facility through a charge to interest expense. On July 31, 2006, Laurus
exercised the warrant through a cashless exercise procedure as defined in the
warrant. Laurus received 366,666 shares of GSE common stock.
Senior
Convertible Secured Subordinated Note Payable
On
May
26, 2005, GSE issued and sold to Dolphin Direct Equity Partners, LP (“Dolphin”)
a Senior Subordinated Secured Convertible Note in the aggregate principal amount
of $2,000,000 which was to mature on March 31, 2009 (the “Dolphin Note”), and a
seven-year warrant to purchase 380,952 shares of GSE common stock at an exercise
price of $2.22 per share (the “GSE Warrant”). The Dolphin Note was convertible
into 1,038,961 shares of GSE common stock at an exercise price of $1.925 per
share and accrued interest at 8% payable quarterly. Both the Convertible Note
and the Warrant were subject to anti-dilution provisions. The aggregate purchase
price for the Dolphin Note and GSE Warrant was $2,000,000. At the date of
issuance, the fair value of the GSE Warrant and Conversion Option, which was
established using the Black-Scholes Model, was $375,000 and $959,000,
respectively, both of which were recorded as noncurrent liabilities, with the
offset recorded as original issue discount (OID). OID was accreted over the
term
of the Dolphin Note and charged to interest expense, and the unamortized balance
was netted against long-term debt in the accompanying consolidated balance
sheets. The GSE Warrant and Conversion Option liabilities were marked to market
through earnings on a quarterly basis in accordance with EITF No. 00-19,
Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in
a
Company’s Common Stock.
F-19
On
February 28, 2006, the Company and Dolphin entered into a Cancellation and
Warrant Exchange Agreement (the “Cancellation Agreement”) under which Dolphin
agreed to cancel its Senior Subordinated Secured Convertible Promissory Note
and
cancel its outstanding warrant to purchase 380,952 shares of GSE common stock
at
an exercise price of $2.22 per share. In exchange for Dolphin’s agreement to
enter into the Cancellation Agreement and for the participation of Dolphin
Offshore Partners, LP in the Preferred Stock transaction discussed in Note
12,
the Company repaid the Dolphin Note and agreed to issue a new warrant to
purchase 900,000 shares of GSE common stock at an exercise price of $0.67 per
share (the “Dolphin Warrant”). At the date of issuance, the fair value of the
Dolphin Warrant was $868,000, as established using the Black-Scholes Model,
and
was recorded in paid-in capital with the offset recorded as loss on
extinguishment of debt. In accordance with the terms of the warrant agreement,
Dolphin exercised the Dolphin Warrant on November 8, 2006 upon the Company’s
certification that, among other things, the underlying shares of GSE common
stock were registered with the Securities and Exchange Commission on October
31,
2006, that the current stock price was greater than $1.25 per share, and that
the average of the current stock prices for each trading day of the prior 30
calendar day period was not less than $1.25 per share. The Company received
cash
proceeds of $603,000.
In
conjunction with the early payoff of the Dolphin Note and the cancellation
of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000, recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature
and
the related warrants, and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin. The total loss on extinguishment of the Dolphin
Note and the cancellation of the related warrants totaled $1.4 million.
10.
Income taxes
The
consolidated income (loss) before income taxes, by domestic and foreign sources,
is as follows:
|
(in
thousands)
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Domestic
|
$
|
(466
|
)
|
$
|
(3,733
|
)
|
$
|
42
|
|||
|
Foreign
|
269
|
(913
|
)
|
166
|
|||||||
|
Total
|
$
|
(197
|
)
|
$
|
(4,646
|
)
|
$
|
208
|
|||
F-20
The
provision
for income taxes is as follows:
|
(in
thousands)
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Current:
|
|||||||||||
|
Federal
|
$
|
103
|
$
|
-
|
$
|
1
|
|||||
|
State
|
29
|
(4
|
)
|
18
|
|||||||
|
Foreign
|
17
|
103
|
121
|
||||||||
|
Subtotal
|
149
|
99
|
140
|
||||||||
|
Deferred:
|
|||||||||||
|
Federal
and state
|
-
|
-
|
-
|
||||||||
|
Foreign
|
-
|
50
|
(50
|
)
|
|||||||
|
Subtotal
|
-
|
50
|
(50
|
)
|
|||||||
|
Total
|
$
|
149
|
$
|
149
|
$
|
90
|
|||||
|
The
allocation of the provision for income taxes to continuing and
discontinued operations is as
|
|||||||||||
|
follows:
|
|||||||||||
|
Continuing
operations
|
$
|
149
|
$
|
149
|
$
|
60
|
|||||
|
Discontinued
operations
|
-
|
-
|
30
|
||||||||
|
$
|
149
|
$
|
149
|
$
|
90
|
||||||
The
difference between the provision for income taxes included in income (loss)
from
continuing operations computed at the applicable U.S. statutory rate and the
reported provision for income taxes is as follows:
|
|
|||||||||||
|
Effective
tax rate percentage (%)
|
|||||||||||
|
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Statutory
U.S. tax rate
|
(34.0
|
)%
|
(34.0
|
)%
|
34.0
|
%
|
|||||
|
State
income tax, net of federal tax benefit
|
9.8
|
-
|
5.7
|
||||||||
|
Effect
of foreign operations
|
(2.3
|
)
|
3.1
|
(6.0
|
)
|
||||||
|
Change
in valuation allowance
|
(95.2
|
)
|
34.0
|
1.0
|
|||||||
|
Other,
principally permanent differences
|
197.6
|
0.1
|
7.6
|
||||||||
|
Effective
tax rate
|
75.9
|
%
|
3.2
|
%
|
42.3
|
%
|
|||||
F-21
Included
within permanent differences are certain elements of the loss on extinguishment
of debt (see Note 9) that are not tax deductible.
Deferred
income taxes arise from temporary differences between the tax bases of assets
and liabilities and their reported amounts in the financial statements. A
summary of the tax effect of the significant components of the deferred income
tax assets (liabilities) is as follows:
|
(in
thousands)
|
December
31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Deferred
tax assets:
|
|||||||||||
|
Net
operating loss carryforwards
|
$
|
7,611
|
$
|
8,035
|
$
|
6,246
|
|||||
|
Investments
|
1,658
|
1,658
|
1,658
|
||||||||
|
Foreign
tax credits
|
378
|
378
|
378
|
||||||||
|
Accrued
expenses
|
192
|
138
|
260
|
||||||||
|
Expenses
not currently deductible for tax purposes
|
300
|
449
|
285
|
||||||||
|
Alternative
minimum tax credit caryforwards
|
162
|
162
|
162
|
||||||||
|
Other
|
179
|
(107
|
)
|
145
|
|||||||
|
Total
deferred tax asset
|
10,480
|
10,713
|
9,134
|
||||||||
|
Valuation
allowance
|
(10,173
|
)
|
(10,361
|
)
|
(8,733
|
)
|
|||||
|
Total
deferred tax asset less valuation allowance
|
307
|
352
|
401
|
||||||||
|
Deferred
tax liabilities:
|
|||||||||||
|
Tax
in excess of book depreciation
|
(6
|
)
|
(7
|
)
|
(29
|
)
|
|||||
|
Software
development costs
|
(301
|
)
|
(345
|
)
|
(322
|
)
|
|||||
|
Total
deferred tax liabilities:
|
(307
|
)
|
(352
|
)
|
(351
|
)
|
|||||
|
Net
deferred tax asset
|
$
|
-
|
$
|
-
|
$
|
50
|
|||||
In
assessing the realizability of deferred tax assets, management considers whether
it is more likely than not that some or all of the deferred tax assets will
not
be realized. The ultimate realization of deferred tax assets is dependent upon
the generation of future taxable income during the periods in which those
temporary differences become deductible. Management considers the scheduled
reversal of deferred tax liabilities and projected future income in making
this
assessment. Management believes that the Company will achieve profitable
operations in future years that will enable the Company to recover the benefit
of its net deferred tax assets. However, the Company presently does not
have sufficient objective evidence to support management's belief, and
accordingly, the Company has established a $10,173,000 valuation allowance
for
the deferred tax assets as of December 31, 2006. The valuation allowance for
deferred tax assets decreased by $188,000 in 2006, and increased by $1,628,000
in 2005 and by $152,000 in 2004.
At
December 31, 2006, the Company had available $19,325,000 and $1,708,000 of
domestic and foreign net operating loss carryforwards, respectively, which
expire between 2007 and 2026. The amount of loss carryforward which can be
used
by the Company may be significantly limited due to changes in the Company's
ownership which have occurred subsequent to the spin-off of GSE by GP
Strategies, including the equity transactions that occurred in 2006. Thus,
a portion of the Company's loss carryforward may expire unutilized.
11.
Capital stock
The
Company’s Board of Directors has authorized 20,000,000 total shares of capital
stock, of which 18,000,000 are designated as common stock and 2,000,000 are
designated as preferred stock. The Board of Directors has the authority to
establish one or more classes of preferred stock and to determine, within any
class of preferred stock, the preferences, rights and other terms of such
class.
As
of
December 31, 2006, the Company has reserved 4,762,529 shares of common stock
for
issuance upon exercise of stock options and warrants and the conversion of
the
Series A Convertible Preferred Stock.
F-22
12.
Series A Convertible Preferred Stock
On
February 28, 2006, the Company raised $3.9 million, net of associated fees
of
$395,000, through the sale of 42,500 shares of Series A Cumulative Convertible
Preferred Stock and Warrants by means of a private placement to “accredited
investors”, as that term is used in rules and regulations of the Securities and
Exchange Commission. The Convertible Preferred Stock was convertible at any
time
into a total of 2,401,133 shares of GSE common stock at a conversion price
of
$1.77 per share. The conversion price was equal to 110% of the closing price
of
the Company’s Common Stock on February 28, 2006, the date the sale of the
Convertible Preferred Stock was completed. Each investor received a five-year
warrant to purchase GSE common stock equal to 20% of the shares they would
receive from the conversion of the Convertible Preferred Stock, at an exercise
price of $1.77 per share. In aggregate, the Company issued warrants to purchase
a total of 480,226 shares of GSE common stock. The Convertible Preferred
Stockholders are entitled to an 8% cumulative dividend, payable on a semiannual
basis every June 30 and December 30. In 2006, the Company paid dividends
totaling $279,000 to the preferred stockholders. At the date of issuance, the
fair value of the warrants was $342,000 and the fair value of the preferred
stock was $3.9 million. The fair value of the warrants and the preferred stock
was determined by the use of the relative fair value method, in which the $4.25
million gross proceeds was allocated based upon the fair values of the warrants,
as determined by using the Black-Scholes Model, and the preferred stock, as
determined by an independent appraisal. At any time after March 1, 2007, the
Company has the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading
days
immediately prior to the date of such conversion exceeds 200% of the Series
A
Conversion Price. See Note 20, Subsequent events. The holders of the Convertible
Preferred Stock are entitled to vote on all matters submitted to the
stockholders for a vote, together with the holders of the voting common stock,
all voting together as a single class. The holders of the Convertible Preferred
Stock are entitled to the number of votes equal to the number of GSE common
stock that they would receive upon conversion of their Convertible Preferred
Stock.
The
Company paid the placement agent for the Convertible Preferred Stock and
Warrants 6% of the gross proceeds received by the Company from the offering
($255,000) plus five-year warrants to purchase 150,000 shares of the Company’s
common stock at an exercise price of $1.77 per share. In addition to the
placement agent fee, the Company paid $140,000 of other transaction fees related
to the offering. At the date of issuance, the fair value of the placement agent
warrants was $128,000, as established using the Black-Scholes Model, and was
recorded in paid-in capital, with the offset recognized as a reduction of the
preferred stock proceeds.
The
proceeds were used to payoff the Dolphin Note and the Company’s line of credit
balance and for other working capital purposes.
At
December 31, 2006, 33,920 shares of the Series A Convertible Preferred Stock
were still outstanding.
On
October 23, 2003, ManTech International, Inc. converted all of its preferred
stock to common stock in conjunction with the sale of its ownership in GSE
to GP
Strategies. The Company had accrued dividends payable to ManTech of $316,000
and
$366,000 as of December 31, 2006 and December 31, 2005, respectively. The unpaid
dividends accrue interest at 6% per annum. At December 31, 2006 and December
31,
2005, the Company had an accrual for interest payable of $80,000 and $60,000,
respectively.
F-23
13.
Stock-Based compensation
Accounting
Standard Adopted
In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 123R, Share-Based
Payment
(SFAS
No. 123R), which revises SFAS No. 123, Accounting
for Stock-Based Compensation (SFAS
No.
123), and supersedes Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees
(APB
No. 25), and requires companies to recognize compensation expense for all
equity-based compensation awards issued to employees that are expected to vest.
The Company adopted SFAS No. 123R on January 1, 2006, using the Modified
Prospective Application method without restatement of prior periods. Under
this
method, the Company would begin to amortize compensation cost for the remaining
portion of its outstanding awards for which the requisite service was not yet
rendered as of January 1, 2006. However, at January 1, 2006, all of the
Company’s outstanding options were fully vested and thus there is no
compensation expense in 2006 related to the adoption of SFAS No. 123R on these
outstanding options. The Company determines the fair value of and accounts
for
awards that are granted, modified, or settled after January 1, 2006 in
accordance with SFAS No. 123R.
The
following table presents the impact of SFAS No. 123R on operating income, loss
before income tax expense, net loss, basic and diluted loss per share, and
cash
flows from operating and financing activities:
|
(In
thousands, except per share data)
|
|
As
Reported
|
||||||||||||
|
Including
|
Excluding
|
|||||||||||||
|
|
SFAS
No. 123R
|
SFAS
No. 123R
|
||||||||||||
|
Year
Ended December 31, 2006
|
Adoption
|
Adoption
|
Impact
|
|||||||||||
|
Operating
income
|
$
|
2,100
|
$
|
2,302
|
$
|
(202
|
)
|
|||||||
|
Loss
before income tax expense
|
(197
|
)
|
5
|
(202
|
)
|
|||||||||
|
Net
loss
|
(346
|
)
|
(144
|
)
|
(202
|
)
|
||||||||
|
Basic
loss per common share
|
(0.07
|
)
|
(0.04
|
)
|
(0.02
|
)
|
||||||||
|
Diluted
loss per common share
|
(0.07
|
)
|
(0.04
|
)
|
(0.02
|
)
|
||||||||
|
Net
cash used in operating activities
|
(832
|
)
|
(832
|
)
|
-
|
|||||||||
|
Net
cash provided by financing activities
|
3,365
|
3,365
|
-
|
|||||||||||
Long-term
incentive plan
During
1995, the Company established the 1995 Long-Term Incentive Stock Option Plan
(the “Plan”), which includes all officers, key employees and non-employee
members of the Company’s Board of Directors. All options to purchase shares of
the Company’s common stock under the Plan expire seven years from the date of
grant and generally become exercisable in three installments with 40% vesting
on
the first anniversary of the grant date and 30% vesting on each of the second
and third anniversaries of the grant date, subject to acceleration under certain
circumstances. As of December 31, 2006, the Company had 224,186 shares of common
stock reserved for future grants under the Plan.
Under
SFAS No. 123R, the Company recognizes compensation expense on a straight-line
basis over the requisite service period for stock-based compensation awards
with
both graded and cliff vesting terms. The Company applies a forfeiture estimate
to compensation expense recognized for awards that are expected to vest during
the requisite service period, and revises that estimate if subsequent
information indicates that the actual forfeitures will differ from the estimate.
The Company recognizes the cumulative effect of a change in the number of awards
expected to vest in compensation expense in the period of change. The Company
has not capitalized any portion of its stock-based compensation.
F-24
During
the year ended December 31, 2006, the Company recognized $202,000 of pre-tax
stock-based compensation expense under the fair value method in accordance
with
SFAS No. 123R.
Stock
option and warrant activity
During
the year ended December 31, 2006, the Company granted stock options to purchase
660,000 shares of common stock to GSE directors, officers, and employees. In
addition, the Company granted the following warrants:
| ¨ |
In
conjunction with the establishment of a new credit facility on March
7,
2006 (See Note 9), the Company issued a five-year warrant to purchase
up
to 367,647 shares of GSE common stock at an exercise price of $.01
per
share to Laurus Master Fund, Ltd. The warrant vested immediately.
|
| ¨ |
Each
investor in the Preferred Stock transaction discussed in Note 12
received
a five-year warrant to purchase GSE common stock equal to 20% of
the
shares they would receive from the conversion of the Convertible
Preferred
Stock, at an exercise price of $1.77 per share. In aggregate, the
Company
issued warrants to purchase a total of 480,226 shares of GSE common
stock.
The warrants vested immediately.
|
| ¨ |
In
exchange for Dolphin’s agreement to enter into the Cancellation Agreement
and for the participation of Dolphin Offshore Partners, LP in the
Preferred Stock transaction discussed in Note 12, the Company issue
a
five-year warrant to purchase 900,000 shares of GSE common stock
at an
exercise price of $0.67 per share to Dolphin Offshore Partners, LP.
The
warrant vested immediately.
|
| ¨ |
The
Company issued to the placement agent for the Preferred Stock transaction
discussed in Note 12 five-year warrants to purchase 150,000 shares
of the
Company’s common stock at an exercise price of $1.77 per share. The
warrants vested immediately.
|
F-25
Information
with respect to stock option and warrant activity and stock options and warrants
outstanding at December 31, 2006, 2005 and 2004 is as follows:
|
|
Aggregate
|
||||||||||
|
Number
|
Weighted
|
Intrinsic
|
|||||||||
|
|
of
|
Average
|
Value
|
||||||||
|
Shares
|
Exercise
Price
|
(in
thousands)
|
|
||||||||
|
Shares
under option and warrant, January 1, 2004
|
1,903,976
|
$
|
3.95
|
||||||||
|
Options
and warrants granted
|
-
|
-
|
|||||||||
|
Options
and warrants exercised
|
-
|
-
|
-
|
||||||||
|
Options
and warrants canceled
|
(37,200
|
)
|
3.79
|
||||||||
|
Shares
under option and warrant, December 31, 2004
|
1,866,776
|
$
|
3.96
|
||||||||
|
Options
and warrants granted
|
980,952
|
1.99
|
|||||||||
|
Options
and warrants exercised
|
(50,000
|
)
|
2.00
|
$
|
37
|
||||||
|
Options
and warrants canceled
|
(281,598
|
)
|
6.91
|
||||||||
|
Shares
under option and warrant, December 31, 2005
|
2,516,130
|
$
|
2.90
|
||||||||
|
Options
and warrants granted
|
2,557,873
|
1.13
|
|||||||||
|
Options
and warrants exercised
|
(1,507,146
|
)
|
0.76
|
$
|
4,285
|
||||||
|
Options
and warrants canceled
|
(972,677
|
)
|
3.06
|
||||||||
|
Shares
under option and warrant, December 31, 2006
|
2,594,180
|
$
|
2.34
|
$
|
6,075
|
||||||
|
Options
and warrants exercisable at December 31, 2006
|
1,934,180
|
$
|
2.53
|
$
|
4,902
|
||||||
A
summary
of the status of the Company’s nonvested options and warrants as of and for the
year ended December 31, 2006 is presented below:
|
|
Number
|
Weighted
|
||||||
|
of
|
Average
|
|||||||
|
Shares
|
Fair
Value
|
|||||||
|
Nonvested
options and warrants at January 1, 2006
|
-
|
$
|
-
|
|||||
|
Options
and warrants granted
|
2,557,873
|
1.05
|
||||||
|
Options
and warrants vested during the period
|
(1,897,873
|
)
|
1.02
|
|||||
|
Options
and warrants cancelled and expired
|
-
|
-
|
||||||
|
Nonvested
options and warrants at December 31, 2006
|
660,000
|
$
|
1.13
|
|||||
F-26
The
weighted average fair value of stock options and warrants granted in 2005
was
$1.15 per share. There were no options or warrants issued in 2004.
Information
concerning shares under stock options and warrants exercisable and shares under
stock options expected to vest at December 31, 2006:
|
Weighted
|
||||||||||||||
|
Average
|
Aggregate
|
|||||||||||||
|
Remaining
|
Weighted
|
Intrinsic
|
||||||||||||
|
|
Options
|
Contractual
Life
|
Average
|
Value
|
||||||||||
|
|
Exercisable
|
(Years)
|
|
Exercise
Price
|
(in
thousands)
|
|
||||||||
|
Stock
options and warrants exercisable
|
1,934,180
|
2.88
|
2.53
|
$
|
4,902
|
|||||||||
|
Stock
options expected to vest
|
660,000
|
6.22
|
1.78
|
$
|
1,173
|
|||||||||
|
Shares
under options and warrants exercisable
|
||||||||||||||
|
and
expected to vest
|
2,594,180
|
|||||||||||||
The
fair
value of the options and warrants granted in 2006 was estimated on the date
of
grant using a Black-Scholes option-pricing model with the following assumptions:
|
Year
ended
|
|||
|
December
31, 2006
|
|||
|
Risk-
free interest rates
|
4.73%
- 4.99%
|
||
|
Dividend
yield
|
0%
|
||
|
Expected
life
|
5.0
years
|
||
|
Volatility
|
72.88%
- 73.97%
|
||
|
Weighted
Average Volatility
|
73.90%
|
As
of
December 31, 2006, the Company had $374,000 of unrecognized compensation expense
related to the unvested portion of outstanding stock options expected to be
recognized through May 2009.
Pro-Forma
Information
F-27
The
following table presents the pro-forma effect on net income and earnings per
share for all outstanding stock-based compensation awards for the years ended
December 31, 2005 and 2004 in which the fair value provisions of SFAS No. 123R
were not in effect:
|
(in
thousands, except per share data)
|
Years
ended December 31,
|
|||||||
|
2005
|
2004
|
|||||||
|
Net
income (loss) attributed to
|
||||||||
|
common
stockholders, as reported
|
$
|
(4,795
|
)
|
$
|
118
|
|||
|
Add
stock-based employee compensation expense
|
||||||||
|
included
in reported net loss
|
-
|
-
|
||||||
|
Deduct
total stock-based employee compensation
|
||||||||
|
expense
determined under fair-value-method
|
||||||||
|
for
all awards, net of tax
|
(672
|
)
|
(51
|
)
|
||||
|
Pro
forma net loss
|
$
|
(5,467
|
)
|
$
|
67
|
|||
|
Net
loss per share, as reported:
|
||||||||
|
Basic
|
$
|
(0.53
|
)
|
$
|
0.01
|
|||
|
Diluted
|
$
|
(0.53
|
)
|
$
|
0.01
|
|||
|
Net
loss per share, proforma:
|
||||||||
|
Basic
|
$
|
(0.61
|
)
|
$
|
0.01
|
|||
|
Diluted
|
$
|
(0.61
|
)
|
$
|
0.01
|
|||
The
fair
value of each option was estimated on the date of grant using a Black-Scholes
option-pricing model with the following weighted-average assumptions:
|
Year
ended December 31,
|
|||||
|
2005
|
2004
|
||||
|
Risk-
free interest rate
|
4.0%
|
3.4%
|
|||
|
Dividend
yield
|
0.0%
|
0%
|
|||
|
Expected
life
|
4.4
years
|
4.2
years
|
|||
|
Volatility
|
74.6%
|
73.6%
|
|||
Common
Stock Issued for Services Provided
On
April
20, 2006, the Company entered into an Investor Relations Consulting Agreement
(the “Consulting Agreement”) with Feagans Consulting, Inc. As compensation
for services rendered pursuant to the Consulting Agreement, the Company agreed
to issue 50,000 shares of Common Stock (the “Feagans Shares”). The Feagans
Shares vest in monthly increments of 2,778 shares month commencing May 2006
and ending October 2007. As of December 31, 2006, 22,224 shares had vested.
The
price per share is based on the price per share on the last day of each month
and corresponds to the shares vested on the last day of the month. For the
eight
months ending December 31, 2006, the average price per share was $4.34; the
total compensation expense recognized by the Company was $96,000 in the twelve
months ended December 31, 2006. The Company will deliver the 50,000 common
shares to Feagans Consulting, Inc. on October 31, 2007.
F-28
14.
Commitments and contingencies
Leases
The
Company is obligated under certain noncancelable operating leases for office
facilities and equipment. Future minimum lease payments under noncancelable
operating leases as of December 31, 2006 are as follows:
|
(in
thousands)
|
Gross
future
|
Assignment
|
Net
future
|
||||||||
|
minimum
lease
|
of
|
minimum
lease
|
|||||||||
|
payments
|
lease
|
payments
|
|||||||||
|
2007
|
$
|
1,470
|
$
|
(666
|
)
|
$
|
804
|
||||
|
2008
|
790
|
(457
|
)
|
333
|
|||||||
|
$
|
2,260
|
$
|
(1,123
|
)
|
$
|
1,137
|
|||||
Total
rent expense under operating leases for the years ended December 31, 2006,
2005,
and 2004 was approximately $856,000, $1.3 million, and $1.2 million,
respectively.
The
Company subleased 3520 sq. ft. of space in the Columbia, Maryland facility
which
sublease terminated in October 2005. For the years ended December 31, 2005
and
2004, such sublease rentals amounted to $71,000 and $80,000,
respectively.
In
October 2005, the Company signed an “Assignment of Lease and Amendment to Lease”
that assigns and transfers to another tenant (the “assignee”) the Company’s
rights, title and interest in its Columbia, Maryland facility lease. The
assignee’s obligation to pay rent under the Lease began on February 1, 2006. The
Company remains fully liable for the payment of all rent and for the performance
of all obligations under the lease through the scheduled expiration of the
lease, May 31, 2008, should the assignee default on their obligations. The
Company relocated its Maryland operations from its Columbia facility to its
Baltimore facility in October 2005.
Letters
of credit and performance bonds
As
of
December 31, 2006, the Company was contingently liable for approximately $2.3
million under five letters of credit used as performance bonds on
contracts, which were secured by a cash deposit classified as restricted cash
in
the consolidated balance sheet.
Contingencies
Various
actions and proceedings are presently 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
position, results of operations or cash flows of the Company.
15.
Related party transactions
Prior
to
the spin-off discussed in Note 1, Business and basis of presentation, GP
Strategies owned 57% of the Company.
F-29
On
January 1, 2004, the Company entered into a Management Services Agreement with
GP Strategies Corporation in which GP Strategies agreed to provide corporate
support services to GSE, including accounting, finance, human resources, legal,
network support and tax. GSE was charged $685,000 for GP Strategies’ services in
2006, 2005 and 2004. The agreement terminated on December 31, 2006. In addition,
in 2004 GSE was charged $289,000 by GP Strategies for compensation and benefits
of the Company’s CEO who was an employee of GP Strategies until December 16,
2004.
16.
Employee benefits
The
Company has a qualified defined contribution plan that covers substantially
all
U.S. employees under Section 401(k) of the Internal Revenue Code. Under this
plan, the Company's stipulated basic contribution matches a portion of the
participants' contributions based upon a defined schedule. The Company's
contributions to the plan were approximately $124,000, $93,000, and $110,000
for
the years ended December 31, 2006, 2005, and 2004, respectively.
17.
Segment information
The
Company has one reportable business segment
that
provides simulation solutions and services to the nuclear and fossil electric
utility industry, and to the chemical and petrochemical industries. Contracts
typically range from 10 months to three years.
For
the
years ended December 31, 2006, 2005, and 2004, 60%, 83%, and 85% of the
Company’s consolidated revenue was from customers in the nuclear power industry,
respectively. The Company designs, develops and delivers business and technology
solutions to the energy industry worldwide. Revenue, operating income (loss)
and
total assets for the Company’s United States, European, and Asian subsidiaries
as of and for the years ended December 31, 2006, 2005, and 2004 are as follows:
F-30
|
(in
thousands)
|
Year
ended December 31, 2006
|
||||||||||||||||
|
|
United
States
|
Europe
|
Asia
|
Eliminations
|
Consolidated
|
||||||||||||
|
Contract
revenue
|
$
|
23,975
|
$
|
3,527
|
$
|
-
|
$
|
-
|
$
|
27,502
|
|||||||
|
Transfers
between geographic locations
|
329
|
70
|
166
|
(565
|
)
|
-
|
|||||||||||
|
Total
contract revenue
|
$
|
24,304
|
$
|
3,597
|
$
|
166
|
$
|
(565
|
)
|
$
|
27,502
|
||||||
|
Operating
income (loss)
|
$
|
1,928
|
$
|
184
|
$
|
(12
|
)
|
$
|
-
|
$
|
2,100
|
||||||
|
Total
assets, at December 31
|
$
|
37,827
|
$
|
2,583
|
$
|
80
|
$
|
(22,042
|
)
|
$
|
18,448
|
||||||
|
(in
thousands)
|
Year
ended December 31, 2005
|
||||||||||||||||
|
|
United
States
|
Europe
|
Asia
|
Eliminations
|
Consolidated
|
||||||||||||
|
Contract
revenue
|
$
|
19,045
|
$
|
2,899
|
$
|
6
|
$
|
-
|
$
|
21,950
|
|||||||
|
Transfers
between geographic locations
|
34
|
57
|
56
|
(147
|
)
|
-
|
|||||||||||
|
Total
contract revenue
|
$
|
19,079
|
$
|
2,956
|
$
|
62
|
$
|
(147
|
)
|
$
|
21,950
|
||||||
|
Operating
loss
|
$
|
(3,995
|
)
|
$
|
(647
|
)
|
$
|
(85
|
)
|
$
|
-
|
$
|
(4,727
|
)
|
|||
|
Total
assets, at December 31
|
$
|
37,803
|
$
|
2,282
|
$
|
31
|
$
|
(28,134
|
)
|
$
|
11,982
|
||||||
|
(in
thousands)
|
Year
ended December 31, 2004
|
||||||||||||||||
|
|
United
States
|
Europe
|
Asia
|
Eliminations
|
Consolidated
|
||||||||||||
|
Contract
revenue
|
$
|
24,774
|
$
|
4,724
|
$
|
16
|
$
|
-
|
$
|
29,514
|
|||||||
|
Transfers
between geographic locations
|
132
|
10
|
70
|
(212
|
)
|
-
|
|||||||||||
|
Total
contract revenue
|
$
|
24,906
|
$
|
4,734
|
$
|
86
|
$
|
(212
|
)
|
$
|
29,514
|
||||||
|
Operating
income (loss)
|
$
|
89
|
$
|
(7
|
)
|
$
|
(80
|
)
|
$
|
-
|
$
|
2
|
|||||
|
Total
assets, at December 31
|
$
|
38,711
|
$
|
3,618
|
$
|
33
|
$
|
(28,134
|
)
|
$
|
14,228
|
||||||
Approximately
74%, 63%, and 65% of the Company’s 2006, 2005 and 2004 revenue, respectively,
was derived from international sales of its products and services from all
of
its subsidiaries.
18.
Supplemental disclosure of cash flow information
|
(in
thousands)
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
|||||||||
|
Cash
paid:
|
|||||||||||
|
Interest
|
$
|
312
|
$
|
156
|
$
|
96
|
|||||
|
Income
taxes
|
$
|
194
|
$
|
157
|
$
|
94
|
|||||
F-31
19.
Quarterly financial data (unaudited)
The
Company’s quarterly financial information has not been audited but, in
management’s opinion, includes all adjustments necessary for a fair
presentation.
[
|
(in
thousands, except per share data)
|
Year
ended December 31, 2006 Quarterly Data
|
|||||||||||||
|
First
|
Second
|
Third
|
Fourth
|
|||||||||||
|
|
Quarter
|
Quarter
|
Quarter
|
Quarter
|
||||||||||
|
Contract
revenue
|
$
|
5,584
|
$
|
6,556
|
$
|
7,292
|
$
|
8,070
|
||||||
|
Operating
income
|
212
|
439
|
686
|
763
|
||||||||||
|
Net
income (loss)
|
$
|
(1,322
|
)
|
$
|
124
|
$
|
422
|
$
|
430
|
|||||
|
|
||||||||||||||
|
Basic
income (loss) per common share:
|
$
|
(0.12
|
)
|
$
|
-
|
$
|
0.04
|
$
|
0.03
|
|||||
|
Diluted
income (loss) per common share:
|
$
|
(0.12
|
)
|
$
|
-
|
$
|
0.03
|
$
|
0.03
|
|||||
|
(in
thousands, except per share data)
|
Year
ended December 31, 2005 Quarterly Data
|
|||||||||||||
|
First
|
Second
|
Third
|
Fourth
|
|||||||||||
|
Quarter
|
Quarter
|
Quarter
|
Quarter
|
|||||||||||
|
Contract
revenue
|
$
|
6,293
|
$
|
6,717
|
$
|
4,607
|
$
|
4,333
|
||||||
|
Operating
loss
|
(1,023
|
)
|
(374
|
)
|
(1,430
|
)
|
(1,900
|
)
|
||||||
|
Net
income (loss)
|
$
|
(1,042
|
)
|
$
|
(556
|
)
|
$
|
(1,047
|
)
|
$
|
(2,150
|
)
|
||
|
|
||||||||||||||
|
Basic
income (loss) per common share:
|
$
|
(0.12
|
)
|
$
|
(0.06
|
)
|
$
|
(0.12
|
)
|
$
|
(0.24
|
)
|
||
|
Diluted
income (loss) per common share:
|
$
|
(0.12
|
)
|
$
|
(0.06
|
)
|
$
|
(0.12
|
)
|
$
|
(0.24
|
)
|
||
20.
Subsequent events
Prior
to
March 7, 2007, the holders of 22,500 shares of Preferred Stock had already
elected to convert their Preferred Stock into a total of 1,271,187 shares of
Common Stock; 8,580 shares of Preferred Stock were converted in 2006, and 13,920
shares of Preferred Stock in 2007. On March 7, 2007, the Company sent notice
to
the holders of the remaining 20,000 outstanding shares of its Preferred Stock
that the average current stock price for the prior twenty trading days had
exceeded 200% of the Conversion Price, and that the Company was converting
the
outstanding Preferred Stock into common stock. The 20,000 shares of Preferred
Stock convert to 1,129,946 shares of GSE common stock.
On
March
18, 2007, the Company agreed to deposit $1,180,000 in a restricted,
interest-bearing account at the Union National Bank (“UNB”) in the United Arab
Emirates as a partial guarantee for the $11.8 million credit facility that
UNB
has extended to ESA. The guarantee will be in place until the expiration of
the
ESA credit facility on December 31, 2014 or earlier if ESA pays down and
terminates the credit facility.
F-32
ITEM
9. CHANGES
IN AND DISAGREEMENTS WITH ACCOUTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
None.
ITEM
9A. CONTROLS AND PROCEDURES.
Evaluation
of Disclosure Controls and Procedures
The
Company maintains disclosure controls and procedures
that are
designed to ensure that information required to be disclosed by it in its
reports filed or submitted pursuant to the Securities Exchange Act of 1934,
as
amended (the “Exchange Act”), is recorded, processed, summarized and reported
within the time periods specified in the Securities and Exchange Commission’s
rules and forms and that information required to be disclosed by the Company
in
its Exchange Act reports is accumulated and communicated to management,
including the Company’s Chief Executive Officer (“CEO”), who is its principal
executive officer, and Chief Financial Officer (“CFO”), who is its principal
financial officer, to allow timely decisions regarding required
disclosure.
The
Company’s CEO and CFO are responsible for establishing and maintaining adequate
internal control over the Company’s financial reporting. They have reviewed the
Company’s disclosure controls and procedures as of December 31, 2006 in order to
comply with the SEC’s requirements for certification of this Form 10-K.
Throughout
2006, the Company relied on the advice of an outside tax consultant; however,
this tax consultant died unexpectedly in early 2007. Based upon the impact
of
the death of the Company's outside tax consultant, and their evaluation as
of
the end of the period covered by this Form 10-K, the Company's CEO and CFO
identified a material weakness in that the Company's accounting department
does
not currently have sufficient expertise to analyze the accounting for complex
tax matters. (A
material weakness is a significant deficiency, or combination of significant
deficiencies, that result in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected.)
The
Company is seeking a new outside tax consultant to ensure that it has access
to
an expert that can handle complex tax matters and analyze the related
accounting.
Until
such time as the Company successfully retains a new outside tax consultant,
the
Company’s principal executive officer and principal financial officer have
concluded that the Company’s disclosure controls and procedures (as defined in
Rules 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”))
presently
are
not
effective to ensure that information required to be disclosed by the Company
in
reports that it files or submits under the Exchange Act is recorded, processed,
and summarized and reported within the time periods specified in Securities
and
Exchange Commission rules and forms.
The
Company is not an accelerated
filer and, accordingly, it is required to comply with the SEC’s enhance
requirements for certification and attestation of internal control over
financial reporting for its Form 10-K for its fiscal year ending December
31,
2007.
Limitation
of Effectiveness of Controls
It
should
be noted that any system of controls, however well designed and operated, can
provide only reasonable, and not absolute, assurance that the objectives of
the
system will be met. The design of any control system is based, in part, upon
the
benefits of the control system relative to its costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision making can be faulty, and that controls
can
be circumvented by the individual acts of some persons, by collusion of two
or
more people or by management override of control. In addition, over time,
controls may become inadequate because of changes in conditions, or the degree
of compliance with the policies or procedures may deteriorate. In addition,
the
design of any control system is based in part upon certain assumptions about
the
likelihood of future events. Because of inherent limitation in a cost-effective
control system, misstatements due to error or fraud may occur and not be
detected. The Company’s controls and procedures are designed to provide a
reasonable level of assurance of achieving their objectives.
50
ITEM
9B. OTHER INFORMATION.
None.
PART
III
ITEM
10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The
information required by this item, including items 401, 405 406 and 407 of
Regulation S-K, is incorporated by reference to the sections captioned
“Directors
and Executive Officers”
and
“Section
16(A) Beneficial Ownership Reporting Compliance”
in
the
definitive Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
to be held June 6, 2007 and incorporated herein by reference or will be provided
in an amendment to this Form 10-K.
The
Company has adopted a Code of Business Ethics and Policy that applies to
its
directors, officers and employees, including its principal executive officer,
and principal financial officer. The code of Business Ethics and Policy is
available on our website at www.gses.com.
The
Company will post on its website information about any amendment to, or waiver
from, any provision of the Code of Business Ethics and Policy that applies
to
its principal executive officer, principal financial officer, or principal
accounting officer.
ITEM
11. EXECUTIVE COMPENSATION.
The
information required by this item will either be set forth under the
“Compensation
of Directors and Executive Officers”
or
“Employment
Contracts and Termination of Employment and Change-in-Control”
sections in the definitive Proxy Statement for the 2007 Annual Meeting of
Shareholders to be held June 6, 2007 and incorporated herein by reference
or
will be provided in an amendment to this Form 10-K.
ITEM
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS.
The
information required by this item will be either set forth under the sections
captioned “Voting
Securities and Principal Holders Thereof”, “Grants of Plan Based Awards During
2006”, and“Outstanding
Equity Awards at December 31, 2006”
in the
definitive Proxy Statement for the 2007 Annual Meeting of Shareholders to
be
held June 6, 2007 and incorporated herein by reference or will be provided
in an
amendment to this Form 10-K.
51
ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The
information required by this item will be either set forth under the
“Directors
and Executive Officers”,“Related
Party Transactions”
or
“Director
Independence”
sections in the definitive Proxy Statement for the 2007 Annual Meeting of
Shareholders to be held June 6, 2007 and incorporated herein by reference
or
will be provided in an amendment to this Form 10-K.
ITEM
14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The
information required by this item will be either set forth under the
“Audit
Committee Pre-Approval of Audit and Non-Audit Services” or “Principal Accounting
Fees and Services” sections
in the definitive Proxy Statement for the 2007 Annual Meeting of Shareholders
to
be held June 6, 2007 and incorporated herein by reference or will be provided
in
an amendment to this Form 10-K.
52
PART
IV
ITEM
15. EXHIBITS
AND FINANCIAL STATEMENT SCHEDULES
(a)
(1)
List of Financial Statements
The
following financial statements are included in Item 8:
|
GSE
Systems, Inc. and Subsidiaries
|
|
Report
of Independent Registered Public Accounting Firm
|
|
Consolidated
Balance Sheets as of December 31, 2006 and 2005
|
|
Consolidated
Statements of Operations for the years ended December 31, 2006, 2005,
and
2004
|
|
Consolidated
Statements of Comprehensive Income (Loss) for the years ended December
31,
2006, 2005, and 2004
|
|
Consolidated
Statements of Changes in Stockholders' Equity for the years ended
December
31, 2006, 2005, and 2004
|
|
Consolidated
Statements of Cash Flows for the years ended December 31, 2006, 2005,
and
2004
|
|
Notes
to Consolidated Financial
Statements
|
(a)
(2)
List of Schedules
All
other
schedules to the consolidated financial statements are omitted as the required
information is either inapplicable or presented in the consolidated financial
statements or related notes.
(a)
(3)
List of Exhibits
The
Exhibits which are filed with this report or which are incorporated by reference
are set forth in the Exhibit Index hereto.
53
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.
GSE
Systems, Inc.
By: /
s
/
JOHN
MORAN
John
Moran
Chief
Executive
Officer
Pursuant
to the requirements of the Securities Act, this report has been signed by the
following persons in the capacities and on the dates indicated.
Date:
April 2, 2007
/
s
/
JOHN
MORAN
John
Moran, Chief Executive Officer
(Principal
Executive Officer)
Date:
April 2, 2007
/
s
/
JEFFERY G. HOUGH
Jeffery
G. Hough, Senior Vice President
and
Chief
Financial Officer
(Principal
Financial and Accounting Officer)
Date:
April 2, 2007 (Jerome
I. Feldman, Chairman of the Board) By:
/
s
/
JEFFERY G. HOUGH
(Michael
D. Feldman, Director)
Jeffery
G. Hough
(Dr.
Sheldon L. Glashow, Director)
Attorney-in-Fact
(Scott
N.
Greenberg, Director)
(Dr.
Roger Hagengruber, Director)
(Joseph
W. Lewis, Director)
(George
J. Pedersen, Director)
(Orrie
Lee Tawes III, Director)
A
Power
of Attorney, dated February 28, 2007 authorizing Jeffery G. Hough to sign this
Annual Report on Form 10-K for the fiscal year ended December 31, 2006 on behalf
of certain of the directors of the Registrant is filed as Exhibit 24 to this
Annual Report.
54
|
Exhibit
|
Description
of Exhibit
|
|
3
|
Articles
of Incorporation and Bylaws
|
|
3(i)
|
Third
Amended and Restated Certificate of Incorporation of the Company.
Previously filed in connection with the GSE Systems, Inc. Form 8-K
as
filed with the Securities and Exchange Commission on October 24,
2001 and
incorporated herein by reference.
|
|
3(ii)
|
Form
of Amended and Restated Bylaws of the Company. Previously filed in
connection with Amendment No. 1 to the GSE Systems, Inc. Form S-1
Registration Statement as filed with the Securities and Exchange
Commission on June 14, 1995 and incorporated herein by reference.
|
|
4.
|
Instruments
Defining Rights of Security Holders, including
Indenture.
|
|
4.1
|
Specimen
Common Stock Certificate of the Company. Previously filed in connection
with Amendment No. 3 to the GSE Systems, Inc. Form S-1 Registration
Statement as filed with the Securities and Exchange Commission on
July 24,
1995 and incorporated herein by reference.
|
|
4.2
|
Preferred
Stock Issuance Agreement by and between GSE Systems, Inc. and ManTech
International Corporation (dated December 5, 2001). Previously filed
in
connection with the GSE Systems, Inc. Form 8-K as filed with the
Securities and Exchange Commission on December 12, 2001 and incorporated
herein by reference.
|
|
4.3
|
Cancellation
and Warrant Exchange Agreement dated February 28, 2006 by and among
GSE
Systems, Inc. and Dolphin Direct Equity Partners, LP. Previously
filed in
connection with the GSE Systems, Inc. Form 8-K filed with the Securities
and Exchange Commission on March 6, 2006 and incorporated herein
by
reference.
|
|
4.4
|
Registration
Rights Agreement dated February 28, 2006 by and among GSE Systems,
Inc.
and Dolphin Direct Equity Partners, LP. Previously filed in connection
with the GSE Systems, Inc. Form 8-K filed with the Securities and
Exchange
Commission on March 6, 2006 and incorporated herein by reference.
|
55
|
Exhibit
|
Description
of Exhibit
|
|
4.5
|
Senior
Subordinated Secured Convertible Note and Warrant Purchase Agreement
dated
as of May 26, 2005 by and among GSE Systems, Inc. and Dolphin Direct
Equity Partners, LP. Previously filed in connection with the GSE
Systems,
Inc. Form 8-K filed with the Securities and Exchange Commission on
March
6, 2006 and incorporated herein by reference.
|
|
4.6
|
Form
of Senior Subordinated Secured Convertible Promissory Note dated
as of May
26, 2005 issued by and among GSE Systems, Inc. and Dolphin Direct
Equity
Partners, LP in the aggregate principal amount of $2,000,000. Previously
filed in connection with the GSE Systems, Inc. Form 8-K filed with
the
Securities and Exchange Commission on March 6, 2006 and incorporated
herein by reference.
|
|
4.7
|
Form
of Warrant to Purchase 900,000 shares of Common Stock of GSE Systems,
Inc.
dated as of February 28, 2006. Previously filed in connection with
the GSE
Systems, Inc. Form 8-K filed with the Securities and Exchange Commission
on March 6, 2006 and incorporated herein by reference.
|
|
4.8
|
Form
of Warrant to Purchase 380,952 shares of Common Stock of GSE Systems,
Inc.
dated as of May 26, 2005. Previously filed in connection with the
GSE
Systems, Inc. Form 8-K filed with the Securities and Exchange Commission
on March 6, 2006 and incorporated herein by reference.
|
|
4.9
|
Form
of Warrant to Purchase 150,000 shares of Common Stock of GSE Systems,
Inc.
dated as of February 28, 2006. Previously filed in connection with
the GSE
Systems, Inc. Form 8-K filed with the Securities and Exchange Commission
on March 6, 2006 and incorporated herein by reference.
|
|
4.10
|
Certificate
of Designation, Preferences and Rights of Series A Cumulative Preferred
Stock dated as of February 28, 2006 providing for the issuance of
a series
of 42,500 shares of Series A Cumulative Convertible Preferred Stock,
par
value $0.01 per share. Previously filed in connection with the GSE
Systems, Inc. Form 8-K filed with the Securities and Exchange Commission
on March 6, 2006 and incorporated herein by reference.
|
|
4.11
|
Form
of Warrant to Purchase 367,647 shares of the Company’s Common Stock dated
as of March 7, 2006. Previously filed in connection with the GSE
Systems,
Inc. Form 8-K filed with the Securities and Exchange Commission on
March
13, 2006 and incorporated herein by reference.
|
56
|
Exhibit
|
Description
of Exhibit
|
|
4.12
|
Grant
of Security Interest in Patents and Trademarks by and among GSE Systems,
GSE Power Systems, Inc. and Laurus Master Fund, Ltd. dated March
7, 2006.
Previously filed in connection with the GSE Systems, Inc. Form 8-K
filed
with the Securities and Exchange Commission on March 13, 2006 and
incorporated herein by reference.
|
|
4.13
|
Subsidiary
Guaranty by and among GSE Company Services LLC, MSHI, Inc., GSE Power
Systems, Inc., GSE Erudite Software Inc., GSE Government & Military
Simulation Systems, Inc., and GSE Process Solutions, Inc. and Laurus
Master Fund, Ltd. dated as of March 7, 2006. Previously filed in
connection with the GSE Systems, Inc. Form 8-K filed with the Securities
and Exchange Commission on March 13, 2006 and incorporated herein
by
reference.
|
|
4.14
|
Control
Agreement by and among GSE Systems, Inc., Laurus Master Fund Ltd.
and GSE
Services Company LLC dated as of March 7, 2006. Previously filed
in
connection with the GSE Systems, Inc. Form 8-K filed with the Securities
and Exchange Commission on March 13, 2006 and incorporated herein
by
reference.
|
|
4.15
|
Security
Agreement by and among GSE Systems, Inc., GSE Power Systems, Inc.
and
Laurus Master Fund, Ltd. dated as of March 7, 2006. Previously filed
in
connection with the GSE Systems, Inc. Form 8-K filed with the Securities
and Exchange Commission on March 13, 2006 and incorporated herein
by
reference.
|
|
4.16
|
Registration
Rights Agreement by and among GSE Systems, Inc. and Laurus Master
Fund,
Ltd. dated as of March 7, 2006. Previously filed in connection with
the
GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
Commission on March 13, 2006 and incorporated herein by reference.
|
|
4.17
|
Stock
Pledge Agreement by and among the Company, MSHI, Inc., GSE Power
Systems,
Inc., GSE Process Solutions, Inc. and Laurus Master Fund, Ltd. dated
as of
March 7, 2006. Previously filed in connection with the GSE Systems,
Inc.
Form 8-K filed with the Securities and Exchange Commission on March
13,
2006 and incorporated herein by reference.
|
|
4.18
|
Secured
Non-Convertible Revolving Note dated as of March 7, 2006. Previously
filed
in connection with the GSE Systems, Inc. Form 8-K filed with the
Securities and Exchange Commission on March 13, 2006 and incorporated
herein by reference.
|
57
|
Exhibit
|
Description
of Exhibit
|
|
10.
|
Material
Contracts
|
|
10.1
|
Agreement
among ManTech International Corporation, National Patent Development
Corporation, GPS Technologies, Inc., General Physics Corporation,
Vattenfall Engineering AB and GSE Systems, Inc. (dated as of April
13,
1994). Previously filed in connection with the GSE Systems, Inc.
Form S-1
Registration Statement as filed with the Securities and Exchange
Commission on April 24, 1995 and incorporated herein by
reference.
|
|
10.2
|
GSE
Systems, Inc. 1995 Long-Term Incentive Plan, amended as of April
28, 2005.
Previously filed in connection with the GSE Systems, Inc. Form DEF
14A as
filed with the Securities and Exchange Commission on May 31, 2005
and
incorporated herein by reference. *
|
|
10.3
|
Form
of Option Agreement Under the GSE Systems, Inc. 1995 Long-Term Incentive
Plan. Previously filed in connection with the GSE Systems, Inc. Form
10-K
as filed with the Securities and Exchange Commission on March 22,
1996 and
incorporated herein by reference. *
|
|
10.4
|
Office
Lease Agreement between Sterling Rutherford Plaza, LLC and GSE Systems,
Inc. (dated as of February 10, 1998). Previously filed in connection
with
the GSE Systems, Inc. Form 10-K as filed with the Securities and
Exchange
Commission on March 21, 1998 and incorporated herein by reference.
|
|
10.5
|
Office
Lease Agreement between Red Branch Road, LLC and GSE Systems, Inc.
(dated
February 10, 1998). Previously filed in connection with the GSE Systems,
Inc. Form 10-K as filed with the Securities and Exchange Commission
on
March 21, 1998 and incorporated herein by reference.
|
|
10.6
|
Assignment
of Lease and Amendment of Lease between GSEM, LLC and GSE Systems,
Inc.
Previously filed in connection with the GSE Systems, Inc. Form 10-K
as
filed with the Securities and Exchange Commission on March 31, 2006
and
incorporated herein by reference.
|
|
10.7
|
Preferred
Stock Issuance Agreement by and between GSE Systems, Inc. and ManTech
International Corporation (dated December 5, 2001). Previously filed
in
connection with the GSE Systems, Inc. Form 8-K as filed with the
Securities and Exchange Commission on December 12, 2001 and incorporated
herein by reference.
|
|
10.8
|
Asset
Sale and Purchase Agreement between GSE Systems, Inc. and Novatech
LLC
dated September 25, 2003. Previously filed in connection with the
GSE
Systems, Inc. Form 8-K as filed with the Securities and Exchange
Commission on October 10, 2003 and incorporated herein by reference.
|
58
|
Exhibit
|
Description
of Exhibit
|
|
10.9
|
Management
Services Agreement between GSE Systems, Inc. and GP Strategies Corporation
dated January 1, 2004. Previously filed in connection with the GSE
Systems, Inc. Form 10-K filed with the Securities and Exchange Commission
on April 14, 2004 and incorporated herein by reference.
|
|
10.10
|
Memorandum
of Association of Limited Liability Company dated November 8, 2005
by and
between Al Qudra Holding PJSC, Centre of Excellence for Applied Research
and Training, and GSE Systems, Inc. Previously filed in connection
with
the GSE Systems, Inc. Form 10-Q/A filed with the Securities and Exchange
Commission on October 4, 2006 and incorporated herein by reference.
|
|
10.11
|
Supply
Agreement Contract by and between Emirates Simulation Academy, LLC
and GSE
Power Systems, Inc. dated January 3, 2006. Previously filed in connection
with the GSE Systems, Inc. Form 10-Q/A filed with the Securities
and
Exchange Commission on October 4, 2006 and incorporated herein by
reference.
|
|
10.12
|
License
and Technology Transfer Agreement by and Between GSE Power Systems,
Inc.
and Emirates Simulation Academy, LLC dated January 3, 2006. Previously
filed in connection with the GSE Systems, Inc. Form 10-Q/A filed
with the
Securities and Exchange Commission on October 4, 2006 and incorporated
herein by reference.
|
|
14.
|
Code
of Ethics
|
|
14.1
|
Code
of Ethics for Principal Executive Officer and Senior Financial Officers.
Previously filed in connection with the GSE Systems, Inc. Form 10-K
file
with the Securities and Exchange Commission on March 31, 2006 and
incorporated herein by reference.
|
|
21.
|
Subsidiaries.
|
|
21.1
|
List
of Subsidiaries of Registrant at December 31, 2006, filed herewith.
|
|
23.
|
Consents
of Experts and Counsel
|
|
23.1.
|
Consent
of KPMG LLP, filed herewith.
|
|
24.
|
Power
of Attorney
|
|
24.1
|
Power
of Attorney for Directors’ and Officers’ Signatures on SEC Form 10-K,
filed herewith.
|
59
|
Exhibit
|
Description
of Exhibit
|
|
31.
|
Certifications
|
|
31.1
|
Certification
of Chief Executive Officer of the Company pursuant to Securities
and
Exchange Act Rule 13d-14(a)/15(d-14(a), as adopted pursuant to Section
302
and 404 of the Sarbanes-Oxley Act of 2002, filed herewith.
|
|
31.2
|
Certification
of Chief Financial Officer of the Company pursuant to Securities
and
Exchange Act Rule 13d-14(a)/15(d-14(a), as adopted pursuant to Section
302
and 404 of the Sarbanes-Oxley Act of 2002, filed herewith.
|
|
32.
|
Section
1350 Certifications
|
|
32.1
|
Certification
of Chief Executive Officer and Chief Financial Officer of the Company
pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section
906 of
the Sarbanes-Oxley Act of 2002, file herewith.
|
|
99.
|
Additional
Exhibits
|
|
a.
|
Form
of Right of First Refusal Agreement. Previously filed in connection
with
Amendment No. 3 to the GSE Systems, Inc. Form S-1 Registration Statement
as filed with the Securities and Exchange Commission on July 24,
1995 and
incorporated herein by reference.
|
|
*
Management contracts or compensatory plans required to be filed as
exhibits pursuant to Item 14 (c) of this
report.
|
60