U.S.SECURITIES AND EXCHANGE COMMISSION

                                                                  WASHINGTON,D.C.  20549

                                                                             FORM10-KSB

(MarkOne)[X] ANNUALREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

ForFiscal Year Ended: December 31, 2002

OR

[] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE 

ACT OF 1934.

Forthe transition period from ____________  to___________.

                                                             Commission file number       0-27580

                                                                  **NetLojixCommunications, Inc.**                                                                 -------------------------                                                   (ExactName of Small Business Issuer in Its Charter)

| **Delaware**                                                                      |   | **87-0378021**                        |
|-----------------------------------------------------------------------------------|--------|---------------------------------------|
| ----------                                                                        |   | ----------                            |
| (State  or Other Jurisdiction of    Incorporation or Organization) |   | (I.R.S.  Employer Identification No.) |
|                                                                                   |        |                                       |

 

| **501 Bath Street, Santa Barbara, CA   **            ----------------------------------   | **93101**      ----- |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------|
| (Address of Principal Executive Offices)                                                                                                              | (Zip Code)           |

**(805)884-6300**--------------(Issuer'sTelephone Number, Including Area Code)

Securitiesregistered under Section 12(b) of the Act: None.

Securitiesregistered under Section 12(g) of the Act: 

CommonStock, Par Value $0.01-----------------------------(Titleof class)

Checkwhether the issuer: (1) filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.   

Yes  X             No   -----            ----

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Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-B contained in this form, and no disclosure will be contained, tothe best of registrant's knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSB orany amendment to this Form 10-KSB.  [    ]

Stateissuer's revenues for its most recent fiscal year: $14,477,000.

Theaggregate market value of the registrant's Common Stock held by non-affiliatesof the registrant was approximately $207,252, computed at the last sale priceof such Common Stock on The OTC Bulletin Board as of March 20, 2003.

APPLICABLEONLY TO CORPORATE REGISTRANTS

Asof March 24, 2003, there were 14,695,149 shares of theRegistrant's Common Stock, par value $0.01, issued and outstanding, excludingtreasury stock. 

DOCUMENTSINCORPORATED BY REFERENCE

None

TransitionalSmall Business Disclosure Format (Check one): Yes          No   X                                                                                             -----           -----

 

 

 

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| TABLE OF CONTENTS  |
|--------------------|
|                    |  |  |  |
| Item Number        |   | Page Number |  |
|                    |  |  |  |
| PART I             |  |  |  |
|                    |  |  |  |
| 1.            | Description of Business |  3  |  |
|                    |  |  |  |
| 2.            | Description of Property | 13 |  |
|                    |  |  |  |
| 3.            | Legal Proceedings | 14 |  |
|                    |  |  |  |
| 4.            | Submission of Matters to a Vote of Security Holders | 14 |  |
|                    |  |  |  |
| PART II            |  |  |  |
|                    |  |  |  |
| 5.            | Market for Common Equity and Related Stockholder Matters | 14 |  |
|                    |  |  |  |
| 6.            | Management's Discussion and Analysis or Plan of Operation | 15 |  |
|                    |  |  |  |
| 7.            | Financial Statements | 24 |  |
|                    |  |  |  |
| 8.            | Changes in and Disagreements With Accountants on |  |  |
|     | Accounting and Financial Disclosure | 24 |  |
|                    |  |  |  |
| PART III           |  |  |  |
|                    |  |  |  |
| 9.                 | Directors, Executive Officers, Promoters and Control Persons;  Compliance with Section 16(a) of the Exchange Act | 25 |  |
|                    |  |   |  |
|               |  |  |  |
| 10.                | Executive Compensation | 28 |  |
|                    |  |  |  |
| 11.                | Security Ownership of Certain Beneficial Owners and |  |  |
|     | Management and Related Stockholder Matters | 31 |  |
|                    |  |  |  |
| 12.                | Certain Relationships and Related Transactions | 34 |  |
|                    |  |  |  |
| 13.                | Exhibits and Reports on Form 8-K  | 35 |  |
|                    |  |  |  |
| 14.                | Controls and Procedures | 35 |  |
|                    |  |  |  |

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**PART I**

**ITEM 1. DESCRIPTION OF BUSINESS**

**INTRODUCTORY STATEMENT**

        THISANNUAL REPORT ON FORM 10-KSB CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THEMEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE"SECURITIES ACT") AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, ASAMENDED (THE "EXCHANGE ACT").  FORWARD-LOOKINGSTATEMENTS ARE STATEMENTS OTHER THAN HISTORICAL INFORMATION OR STATEMENTS OFCURRENT CONDITION AND RELATE TO FUTURE EVENTS OR THE FUTURE FINANCIALPERFORMANCE OF NETLOJIX COMMUNICATIONS, INC. ("NETLOJIX"). FORWARD-LOOKINGSTATEMENTS INVOLVE RISKS AND UNCERTAINTIES, SUCH AS STATEMENTS OF NETLOJIX'SSTRATEGIES, PLANS, OBJECTIVES, EXPECTATIONS, ESTIMATES AND INTENTIONS. SOMEFORWARD-LOOKING STATEMENTS MAY BE IDENTIFIED BY USE OF SUCH TERMS AS"BELIEVES," "ANTICIPATES," "INTENDS" OR "EXPECTS." NETLOJIX'S ACTUAL RESULTSMAY DIFFER SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKINGSTATEMENTS. NETLOJIX UNDERTAKES NO OBLIGATION TO PUBLICLY UPDATE OR REVISE ANYFORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION,FUTURE EVENTS OR OTHERWISE.   THECAUTIONARY STATEMENTS MADE IN THIS ANNUAL REPORT SHOULD BE READ AS BEINGAPPLICABLE TO ALL RELATED FORWARD-LOOKING STATEMENTS WHEREVER THEY APPEAR INTHIS ANNUAL REPORT.

**BACKGROUND**

General

        NetLojixis a provider of network and hosting infrastructure, web applicationdevelopment and technology support services. We provide single-source enterprise-wide solutions integrating ourcomplete portfolio of broadband connectivity, hosting, co-location, webapplication development, help desk services, system integration, maintenance and voice connectivity.  Our network infrastructure and Internet hostingplatform employ proprietary as well as existing technologies that enable ourcustomers to outsource their eBusiness initiatives including hosting,co-location, transaction management, bandwidth, data storage, and security.

        Oursupport teams provide design, implementation and management of wide areanetworks (WANs), local area networks (LANs) and electronic commerce oreBusiness solutions, including frame relay, digital subscriber line (DSL),Internet-based virtual private networks (iVPN), as well as managedinfrastructure services in our data center. We offer these services on a stand-alone basis or bundled as part of atotal, enterprise-wide solution.   Webelieve that businesses will continue to outsource more of their networkinfrastructure, systems, server management and system support to companies likeNetLojix.  Our strategy is to establishNetLojix as an industry leader of hosting and total network and technologymanagement for the business market by providing a complete, enterprise-widesolution and positioning NetLojix as our customers' "Technology Partner".  

 

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History

        Thecompany now known as NetLojix was incorporated on October 31, 1981.  Prior to October 23, 1996, NetLojix conductedoperations under the name "Hi, Tiger International, Inc."  On October 23, 1996, Hi, Tiger International,Inc. acquired AvTel Holdings, Inc., a California corporation. We changed ourname to "AvTel Communications, Inc." and changed our board of directors andexecutive management.  As a result of theacquisition, we began to change our focus and direction.  In the intervening years, we have developed asales and operational strategy to position us as an eBusiness enabler providingadvanced Internet, data and voice connectivity, technical support andapplication hosting services to the business market.  To reflect these changes, we changed our nameto NetLojix Communications, Inc. on September 15, 1999.  We now categorize our sources of revenue intothree areas: network connectivity, technical support and applicationdevelopment and hosting.  We have madeadditional acquisitions and dispositions in each of these areas.  These acquisitions are identified below:

*Network Connectivity*

- In November 1996, we acquired Silicon BeachCommunications, Inc., a provider of Internet services application developmentand hosting services based in Santa Barbara, California. 
-  In February 1997, we acquired WestNet Communications, Inc., a Ventura, CaliforniaInternet service provider. Following the completion of this acquisition, we beganto integrate the customer bases, network facilities and other operations ofSilicon Beach Communications and WestNetCommunications in order to achieve efficiencies and economies of scale. 
- On December 1, 1997, we acquired Matrix Telecom.At the time of the acquisition, Matrix Telecom was a provider of long distancetelephone services to both business and residential customers. This acquisitionprovided us with certain carrier agreements, regulatory approvals, licenses,provisioning capabilities and an expanded customer base.  Subsequent to the acquisition, we realignedMatrix Telecom to include only residential customers.  On November 30, 1999, we sold Matrix Telecomrepresenting our entire residential customer base. 

*Technical Support Services*

- In November 1998, we acquired Remote Lojix/PCSI, Inc., a privately held corporation based in NY, which provided systemintegration and local area network services to corporate customers primarily inthe eastern United States. This acquisition provided us with the necessarysales, technical resources and service capabilities to initiate our strategy toprovide technical support services to our existing and new customers.

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- In August 2000, we acquired Smith TechnologySolutions, Inc., a privately held corporation based in Northern California("STS"), which provided technical support services to corporate customers,primarily in California. Subsequent to December 31, 2002, we ceased operationsat STS and are negotiating the transfer of STS'scustomers and certain other assets to Dewayne Cornelious,the former general manager of STS.
- In September 2000, we acquired CW ElectronicEnterprises, Inc., a privately held corporation based in Chicago, whichprovides technical support services to corporate customers, primarily inIllinois.
- In September 2001, we sold a portion of the NewYork technical support services business (consisting of its New York Citycustomer list and related customer contracts) to Laser Printer Care CompanyLtd. We retained all of our help desk customers and contracts. 

*Application Developmentand Hosting*

- On September 25, 1998, we acquired Digital MediaInternational, Inc., a privately held corporation based in Santa Barbara,California, which developed software for educational, entertainment and other applications.  During 2000, we reduced our focus andcapabilities in this area. 

"GoingPrivate" Transaction

        On December 30, 2002, NetLojixannounced the signing of a definitive agreement for the merger of NetLojixAcquisitions Corporation ("NAC") with and into NetLojix. NAC is owned andcontrolled by Anthony E. Papa and James P. Pisani (NetLojix's Chief ExecutiveOfficer and President, respectively). Under the terms of this "going private" transaction, NAC will payapproximately $260,000 for all the outstanding shares of NetLojix's commonstock (other than those shares beneficially owned by Mr. Papa and Mr. Pisani orby any dissenting stockholders). Stockholders will receive $0.02 in cash, without interest, for eachoutstanding share of NetLojix's common stock (other than any shares owned byMr. Papa or Mr. Pisani or any dissenting stockholders).  Following the merger, NetLojix will no longerbe publicly traded and will continue operations as a privately held corporation.  The merger and the merger agreement have beenapproved by both an independent special committee and by the full Board ofDirectors of NetLojix.  However, theclosing of the merger is subject to a number of significant conditions,including approval by a majority of NetLojix stockholders.

        This Annual Report is not asolicitation of a proxy to vote in connection with the transaction.  In connection with obtaining stockholderapproval of the transaction, NetLojix will file a proxy statement with the Securitiesand Exchange Commission and distribute it to stockholders and will file anddistribute such other additional materials as required by applicable law.Stockholders should read the proxy statement and other materials carefully whenthey become available, because they will contain important information aboutthe transaction, including its various terms and conditions. Stockholders willalso be able to obtain the proxy statement at no charge at the SEC's website atwww.sec.gov.

 

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**BUSINESS OF NETLOJIX**

        We providetechnology and network management services that enable businesses toeffectively operate in the increasingly complex world of electronic commerceand communications.  The services weprovide include advanced Internet, data, and voice connectivity, technicalsupport and application development and hosting services.   We are a single-source provider ofenterprise network solutions integrating our complete portfolio of broadbandconnectivity; applications development and hosting; and technical help desk,system integration and maintenance. Our support teams provide design,implementation and management of LAN, WAN and eBusiness solutions, includingframe relay, DSL, iVPN, VOIP and Internet access.  We offer these services on a stand-alonebasis or bundled as part of a total solution. 

Services

        Wetarget the enterprise networking needs of corporate customers. Our objective isto become a leading single-source provider of technical support, applicationdevelopment and hosting and network connectivity. This includes Internetaccess, data transport and voice services; technical help desk services,systems integration, IT service and technical support; and web-centricapplication hosting. Through a value-added sales process, we design, installand manage our customers' networks. We also provide a host of additionalvalue-added services assisting our customers to create enhanced intranet andextranet applications. We believe this strategy of focusing on the corporatecustomer for enterprise-wide network solutions offers significant opportunity.We are able to cross-market to our customer base a variety of traditionaltelecommunications products and services such as long distance telephoneservice, executive calling cards and video/audio conferencing as well aseBusiness and IT maintenance and support services. 

        NetLojixis organized into three primary business segments: network connectivity,technical support services and application development and hosting (See"Segment Reporting", Notes to the Consolidated Financial Statements).  The network connectivity segment, whichaccounted for 54.5% of NetLojix's revenue for the year ended December 31, 2002,includes traditional long distance services, calling card, dedicated voice anddata access and numerous Internet service options.  The technical support services segmentaccounted for 34.8% of NetLojix's revenues in 2002.  This segment's services include flat-feemaintenance contracts, prepaid time block retainers, help desk managementcontracts, LAN installations, warranty repairs and a small amount of hardwaresales. The final segment is applications development and hosting services,which contributed 10.7% of 2002 revenue. Its services include producing, designing, and programming creativemultimedia applications that can be produced as a web application or a standalone application as well as web hosting services.

*        Strategy. *Theimplementation of our strategy involves the marketing of products and servicesintegrated into enterprise-wide network and technology solutions for businesscustomers. These enterprise-wide solutions include network design, systemintegration and technical support, wide area network connectivity, voiceconnectivity, Internet access and Web development, hosting and co-location.NetLojix's sales and marketing activities result in monthly, recurring revenuesfrom enterprise customers under term agreements. Our sales strategy includesin-house direct sales professionals and, on a limited basis, an agent programthrough which we distribute our services through value-added resellers ("VARs")of information technology products. We leverage the existing customerrelationships of these VARs gaining more immediate access to a wider group ofprospective customers and greater credibility in the sales process. 

 

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Customers

        Ourcustomers are primarily owners of small to mid-size businesses (50-500employees) and are located in many geographic regions of the UnitedStates.  There are slight concentrationsaround NetLojix's offices in New York, Chicago, Fort Worth, Texas andCalifornia.  For the twelve months endedDecember 31, 2002, one customer (SG Cowen Securities Corporation) in theTechnical Support Services segment represented approximately 16.2% of ourrevenue.  That customer reduced its usageof our services in 2002, and has indicated that it will further reduce oreliminate its usage of our services in 2003. We currently do not know if that customer will continue to utilize ourservices in the remainder of 2003. 

        Forthe year ended December 31, 2002 revenue from related parties as a percentageof total revenue increased 7 percentage points, to 27%, with the increasegrowing throughout the year.  However,UICI (a public company affiliated with  certain stockholders of NetLojix) terminated NetLojix as its long distance services provider as ofDecember 2002.  For the twelve monthsended December 31, 2002, UICI accounted for approximately $2,084,000 ofNetLojix's $3,929,000 affiliated revenue and 14.4% of NetLojix's total revenue

Regulation

        Theservices, which NetLojix provides, either directly or through our subsidiaries,are subject to varying degrees of federal, state and local regulation.  The Federal Communications Commissionexercises jurisdiction over all facilities of, and services offered by,telecommunications common carriers to the extent that they involve theprovision, origination or termination of jurisdictionally interstate orinternational communications.  The statepublic service commissions retain jurisdiction over jurisdictionally intrastatecommunications.  The FederalCommunications Commission and relevant public service commissions have theauthority to regulate interstate and intrastate rates, respectively, ownershipof transmission facilities and the terms and conditions under which ourservices are provided.  

        Ingeneral, neither the Federal Communications Commission nor the relevant statepublic service commissions exercise direct oversight over cost justificationfor our services or profit levels, but either or both may do so in the future.  However, we are required by federal and statelaw and regulations to file tariffs listing the rates, terms and conditions ofservices provided.  We are also generallyrequired to obtain certification from the relevant state public servicecommission prior to the initiation of certain intrastate service, and arerequired to maintain a certificate issued by the Federal CommunicationsCommission in connection with the provision of certain internationalservices.  Any failure to maintain properfederal and state tariffs or certification or any difficulties or delays inobtaining required authorization could have a material adverse effect on ourbusiness.

 

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Competition

        The telecommunications and information technology industriesare highly competitive and affected by rapid regulatory and technologicalchange.  We face intense competition ineach of our individual product and service offerings. 

        Our network connectivity services offerings compete directlywith traditional long distance carriers, facilitiesbased carriers as well as Internet and web service providers.  Our technical support services competes bothdirectly and indirectly with IT consulting firms and computer equipmentresellers.

        Webelieve that the principal competitive factors in our business include pricing,customer service, network quality, service offerings and the flexibility toadapt to changing market conditions. Our future success depends in part uponour ability to compete with national and local telecommunications providers,national and local Internet service providers, and small to large networkservices providers, many of which have considerably greater financial and otherresources than we do. 

IntellectualProperty

        Weuse several unregistered trademarks in our marketing materials. These includeNetLojix CommunicationsTM, mPOPTM, Silicon BeachTM, WestNetCommunicationsTM,Remote LojixTM,Addictive MediaTM,Digital MeteorTM,ShopLojixTM, SiteLojixTMHostCareTM, AppCareTM, SecureCareTM and StorageCareTM,which we have not sought to register. While these trademarks are important toour business, we do not believe that failure to register these trademarks posesany material risk of infringement on our rights to use such trademarks. 

Employees

        Asof March 24, 2003, NetLojix and our subsidiaries had 83 full-timeemployees.  None of the employees arerepresented by unions. We supplement our work force from time to time withcontractors, administrative personnel employed through agencies, and part-timeemployees. We believe that we have good relations with our employees.

**RISK FACTORS**

        INEVALUATING NETLOJIX, ITS BUSINESS, OPERATIONS AND FINANCIAL POSITION, THEFOLLOWING RISK FACTORS SHOULD BE CONSIDERED CAREFULLY, IN ADDITION TO THE OTHERINFORMATION CONTAINED IN THIS FORM 10-KSB. THE FOLLOWING FACTORS, AMONG OTHERS,COULD AFFECT NETLOJIX'S ACTUAL FUTURE OPERATING RESULTS AND COULD CAUSE SUCHRESULTS TO DIFFER FROM THE RESULTS DISCUSSED IN ANY FORWARD-LOOKINGSTATEMENTS MADE BY OR ON BEHALF OF NETLOJIX. 

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We may not be able to continue asa going concern

        Wehave incurred significant losses from operations in each of the last fiveyears, and we may continue to lose money for the foreseeable future.  As a result of our recurring operating lossesand our working capital deficiency, our auditors have indicated that they havesubstantial doubt about our ability to continue as a going concern.

Wewill need to raise additional capital

        Inthe last two years, we have reduced our operating expenses and attempted toconserve cash.  During that time, ourcash flow from operations and our secured borrowings have been sufficient tomeet our reduced working capital and capital expenditure requirements.  However, we have reached the borrowing limitunder our secured credit facility and are currently in default under it.  Our secured lender has not yet exercised itsright to accelerate the required repayment of the amounts due under thefacility, but it has notified us that it does not intend to renew the facility.We are continuing to explore other possible sources of cash.  However, our current low stock price anddelisting from The Nasdaq SmallCap Market in June 2001present substantial obstacles to any equity financing.  It may be difficult or impossible for us toraise additional capital when we need it. 

The"going private" transaction could limit investors' gains on NetLojix commonstock.

        Ifthe "going private" transaction is consummated on the terms currentlycontemplated, stockholders (other than Mr. Papa and Mr. Pisani or anydissenting stockholders) will receive $0.02 in cash, without interest, for eachoutstanding share of NetLojix's common stock they own. This could limit thegains realized by investors currently purchasingNetLojix common stock.

The stock price is volatile

        Thetrading volume of the common stock has been variable, but often low. As aresult, relatively small trades may significantly affect the market price ofthe common stock.  While the tradingprice of our common stock has been extremely low for more than a year, therehave been significant changes in the price on a percentage basis.  This volatility may be significantly affectedby factors such as actual or anticipated fluctuations in our operating results,developments in the proposed "going private" transaction, announcements ofpotential acquisitions, changes in regulations, industry consolidation andmergers, conditions and trends in the market, adoption of new accountingstandards affecting the industry, general market conditions and otherfactors.  In addition, the stock markethas from time to time experienced significant price and volume fluctuationsthat have particularly affected the market prices for the shares of companieslike NetLojix. Many of these factors are beyond our control.

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Wemay not be able to compete successfully

        The industries in which we compete are intensely competitiveand subject to rapid change.  We competewith telecommunications services providers, technical support providers, webdevelopment companies and other Internet service providers.  Within the telecommunications industry,competitors include facilities-based and non-facilities-based providers,many of which have substantially more resources than us. Providers compete onthe basis of price, customer service, transmission quality, breadth of serviceofferings and value-added services. 

        The technical support industry is characterized by numerouscompetitors offering one or more services that we provide. We compete with PCvendors and PC resellers for maintenance and extended warranty services andlarge IT consulting firms for our "help" desk and IT facilities managementservices. In addition, there are numerous small companies that competeeffectively for technical support services within one or more industry specificniche markets or geographic areas.  Manycompetitors are substantially larger than we are and have greater financial,technical, service and marketing resources.

        We also compete with all Internet service providers thatprovide web hosting and design.  Many ofour competitors are substantially larger than we are and have substantiallygreater financial, infrastructure and personnel resources than we have.Furthermore, many of our competitors have well established and experiencedmarketing and sales capabilities and greater name recognition.

Wemust keep pace with technological change to remain competitive

        Ourbusiness is in a period of rapid technological evolution, marked by theintroduction of competitive product and service offerings, such as the use ofthe Internet for international voice and data communications, the use of theweb for business connectivity and rapidly changing commercial uses of theInternet.  Our future success depends, inpart, on our ability to use leading technologies effectively, to developtechnological expertise, to enhance existing services and to develop newservices that meet changing customer needs on a timely and cost-effectivebasis.  We are unable to predict whichtechnological development will challenge its competitive position or the amountof expenditures that will be required to respond to a rapidly changingtechnological environment.  If we fail torespond in a timely and effective manner to new and evolving technologies, itcould have a negative impact on our operating results and financial condition.

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Weare dependent on telecommunications carriers and other suppliers

        We rely on traditional telecommunications carriers totransmit our traffic over local and long distance networks.  These networks may experience disruptionsthat are not easily remedied. In addition, we depend on certain suppliers ofhardware and software.  If the suppliersfail to provide network services, equipment or software in the quantities, atthe quality levels or at the times we require, it will be difficult for us toprovide services.

Regulatory and legaluncertainties could harm our business

        Ourbusiness is subject to various federal, state and local laws, regulations,agency actions and court decisions, some of which impose prior certification,notification, registration and/or tariff requirements. NetLojix Telecom, asubsidiary of NetLojix, has Section 214 authority from the FederalCommunications Commission and operating authority from 49 states.  Certificates of authority can generally be conditioned,modified or revoked by state regulatory authorities for failure to comply withstate laws and regulations. Fines and other penalties may be imposed.  The loss of a certificate of authority or theimposition of fines or other penalties could have a material effect on ourbusiness, operating results and financial condition.  In addition, future changes in any of thesesources of regulation could have a material adverse effect on our business,operating results and financial condition. 

Our executive officers, directors and existing stockholderswill have the ability to exercise significant control 

        Executiveofficers, directors and members of their families beneficially own, in theaggregate, approximately 36% of our outstanding common stock.  In addition, as of January 31, 2002, an entityaffiliated with director Jeffrey J. Jensen became NetLojix's securedlender.  These stockholders will be ableto exercise effective control over all matters requiring approval by ourstockholders, including the election of directors and the approval ofsignificant corporate transactions. This concentration of ownership may alsohave the effect of delaying or preventing a change of control, which couldnegatively affect the stock price. 

Future sales of common stock may negatively affect ourstock price

        Ifrequested by certain shareholders, we are required to register for resaleapproximately 3,200,000 shares of common stock that are held by executiveofficers and directors of NetLojix, members of their families and certaincharitable foundations, pursuant to a registration rights and lockup agreement.The market price of our common stock could decline as a result of sales of alarge number of shares of NetLojix common stock in the market, or theperception that such sales could occur. These sales might also make it more difficult for us to sell equitysecurities in the future at a time that we consider appropriate.

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We are dependent on key management personnel for ourfuture success 

        Oursuccess depends to a significant degree upon the efforts of senior managementpersonnel, in particular, Anthony E. Papa, Chairman and Chief ExecutiveOfficer, and James P. Pisani, President and Chief Operating Officer.  The departure of any officers or keyemployees could materially adversely affect our ability to implement ourbusiness plan.

We may not be able to hire and retain qualified employees

        Webelieve that our future success will depend in large part upon our continuingability to attract and retain highly skilled personnel. Competition forqualified, high-level technology and telecommunications personnel isintense and there can be no assurance that we will be successful in attractingand retaining qualified personnel. The loss of the services of one or more ofour key individuals, or failure to attract and retain other key personnel,could materially adversely affect our business, operating results and financialcondition. 

Wehave a secured credit facility with a newly-formed lender

        On January 31, 2002, our securedcredit facility with Coast Business Credit expired.  We entered into a new secured credit facilitywith DTL One, LLC ("DTL"), a newly-formed entity owned by director Jeffrey J.Jensen. See "Management's Discussion and Analysis of Financial Condition andResults of Operations - Liquidity and Capital Resources."  As of March 24, 2003, approximately $1.2million is outstanding under the DTL credit facility and we are currently indefault.  NetLojix has been notified byDTL One that it does not intend to renew the agreement.

        DTL is not an established bank orother institutional lender.  ToNetLojix's knowledge, DTL is not regulated by state or federal bankingregulators, and its financial statements are not a matter of public record.  We believe that, to date, NetLojix is DTL's only borrower. Mr. Jensen, the sole owner of DTL, hasrepresented that he will advance sufficient capital to DTL to enable it tohonor its obligations under the credit facility, and he has provided NetLojixwith evidence of his personal financial resources that would allow him to doso.  

        NetLojix believes that DTL will meetits obligations under the credit facility in the event that NetLojix is able todraw additional funds. NetLojix also believes that the DTL credit facility ismore favorable to NetLojix than the other alternatives that were available toNetLojix upon the expiration of the Coast facility.  However, because DTL is not an establishedinstitutional lender, NetLojix has less of a track record upon which to predictDTL's performance. If DTL is unable or unwilling tohonor a borrowing request in a timely fashion, our cash flow could be seriouslyimpaired, and this would have a material adverse effect on our operations andfinancial condition.

We will not be able to make acquisitions of othercompanies

        Animportant component of our past growth has been to develop our business throughacquisitions. Given NetLojix's current cash position and low stock price, itwill be very difficult for us to acquire new companies or businesses.  So we are not likely to be able to continueto grow by acquisitions.

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Forward-looking Statements

        Certainstatements contained in this Form 10-KSB, including without limitation,statements containing the words "believes," "anticipates," "intends," "expects"and words of similar import, constitute "forward-looking statements"within the meaning of Section 27A of the Securities Act and Section 21E of theExchange Act. Such forward-looking statements involve known and unknownrisks, uncertainties and other factors that may cause the actual results,performance or achievements of NetLojix to be materially different from anyfuture results, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others, those setforth above. GIVEN THESE UNCERTAINTIES, THE STOCKHOLDERS OF NETLOJIX ARECAUTIONED NOT TO PLACE UNDUE RELIANCE ON SUCH FORWARD-LOOKING STATEMENTS.

**ITEM 2. DESCRIPTION OF PROPERTY**

        Wedo not own any real property.  The tablebelow sets forth certain information with respect to the material propertiesthat we lease, including the executive offices in Santa Barbara, California.All of such properties consist of office space and data centers.

| **Location**                                                   | **Square feet** | **Expiration date (1)** | **Current monthly   rent (2)** |
|----------------------------------------------------------------|-----------------|-------------------------|--------------------------------|
| 501  Bath Street  Santa  Barbara, CA                           | 6,978           | March  2003 (3)         | $18,565                        |
|                                                           |            |                    |                           |
| 104  West Anapamu   Suites  C, D, & E  Santa  Barbara, CA  | 6,693           | November  2006 (4)      | $8,590                         |
|                                                           |            |                    |                           |
| 1024 Serpentine Lane  Suite 107  Pleasanton, CA                | 2,862           | July 2003               | $5,572                         |
|                                                           |            |                    |                           |
| 519 W. Golf Road  Arlington Heights, IL                        | 5,850           | October  2006           | $4,266                         |
|                                                           |            |                    |                           |
| 7001  Grapevine Highway  Suite  525  North  Richland Hills, TX | 3,183           | May 2005                | $3,643                         |
|                                                           |            |                    |                           |
| 1495 Palma Dr.  Suite D  Ventura, CA                           | 1,000           | May  2004               | $630                           |

(1)                  Subjectto certain renewal options held by NetLojix.(2)                All amounts shownare on a triple net basis.(3)                NetLojix iscurrently attempting to negotiate a one-year extension on a smaller space inthis building.(4)                Expires as to themajority of the space in November 2006. Expires as to other portions of the space in May 2005.

 

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        Weexpect that our current facilities will be more than sufficient to meet ourneeds at least for the next twelve months and that additional facilities willbe available at competitive rates if needed. 

**ITEM 3. LEGAL PROCEEDINGS**

        Weare involved in various claims and legal actions arising in the ordinary courseof business. In the opinion of management, the ultimate disposition of thesematters will not have a material adverse effect on our financial position, resultsof operations or liquidity.   NetLojix isnot aware of any proceedings against it contemplated by any governmentalauthority.

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

        Notapplicable.

**PART II**

**ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

        SinceJune 6, 2001, our common stock has been traded on The OTC Bulletin Board. Priorto that time NetLojix was traded on The NasdaqSmallCap Market.  Effective June 6, 2001,our common stock was delisted from The Nasdaq SmallCapMarket for failure to meet the net tangible asset and $1.00 minimum bid pricerequirements.  The trading symbol is"NETX." There is no established public trading market for NetLojix's preferredstock. The following table sets forth, for the indicated periods, high and lowsales prices for NetLojix's common stock. Such information was provided by Nasdaq, variousmarket makers and on-line quote reporting services. The quotations providedreflect inter-dealer prices, without retail mark-up, mark-downor commission and may not represent actual transactions.

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| Year   ending December 31, 2001          | High   | Low    |
|------------------------------------------|--------|--------|
|      First  Quarter  | $0.81  | $0.13  |
|      Second  Quarter | $0.47  | $0.09  |
|      Third  Quarter  | $0.23  | $0.10  |
|      Fourth  Quarter | $0.30  | $0.10  |
| Year  ending December 31, 2002           |   |   |
|      First  Quarter  | $0.20  | $0.13  |
|      Second  Quarter | $0.18  | $0.07  |
|      Third  Quarter  | $0.09  | $0.02  |
|      Fourth  Quarter | $0.05  | $0.01  |

        Thenumber of shareholders of record of NetLojix common stock as of March 17, 2002,was 706.  At that date there were tworecord holders of NetLojix preferred stock.

        Wehave not paid any cash dividends on our common stock to date and we do notanticipate paying dividends in the foreseeable future.  We intend to utilize all available funds forthe development of our business.  Theterms of NetLojix's Series A Convertible PreferredStock prevent the payment of any dividend on the common stock unless (1) all cumulativedividends on the Series A Convertible Preferred Stock have been fully paid, and(2) the holders of at least 50% of the outstanding shares of the Series AConvertible Preferred Stock have approved such dividend. In addition, the termsof our secured credit agreement provide that NetLojix cannot declare a dividendon any of its ownership interests without the secured lender's approval. 

**ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

        The following discussion should beread in connection with the consolidated financial statements and theaccompanying footnotes included later in this Form 10-KSB.  This discussion includes "forward-looking"statements, which are based on current expectations and judgments ofmanagement, which involve risks and uncertainties.   There are risks that what we expect may nothappen in the future.  Because of theserisks and uncertainties, what happens in the future may be very different fromwhat we contemplate in our forward-looking statements.

**BACKGROUND**

Description of Our Revenue Segments

        We classify our business into three segments:network connectivity, technical support services and application developmentand hosting.  The segmentation of ourcompany is how we manage the day-to-day operations of our business and is basedon the types of services we provide.

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*Network Connectivity*

        The network connectivity segment includes services for thetransfer of data or voice traffic.  Weprovide numerous Internet service options, data and voice access and traditionallong distance services. Our Internet product offerings within the networkconnectivity segment include dial-up access, DSL, and dedicated access.  Our telecommunications product offeringsinclude dedicated or leased lines, switched long distance, frame relay, ATM,calling cards, and "1-800" services. This segment includes the Internetconnectivity portion of our Internet service provider business.  Within this segment, our networking andcommunications professionals will design, build and maintain a flexible,cost-effective package of data networking and voice communication services tomeet our customers' needs.

*Technical SupportServices*

        Technicalsupport services encompasses a broad array of solutions including systemintegration, desktop and network support, asset management and help desksolutions aimed at keeping our customers' IT systems operational and theirnetworks running smoothly. Service options within this segment include systemsand network installations, flat-fee maintenance contracts, prepaid time blockretainers, help desk management contracts, warranty repairs and a small amountof hardware sales.

*Application Developmentand Hosting*

        Theapplications development and hosting services segment includes producing,designing, and programming creative multimedia and commerce applications thatcan be produced as a web application or a stand alone application.  Once a web site has been designed we can alsoprovide site maintenance services, host the web site on our own web servers orprovide co-location space within one of our data centers. 

Critical Accounting Policies

        Our discussion and analysis of our financial condition andresults of operations are based upon our consolidated statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States.  The preparation ofthese financial statements  requires usto make estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses.  Inconsultation with our Board of Directors and Audit Committee, we haveidentified three accounting policies that we believe are keyto an understanding of our financial statements. These are important accountingpolicies that require management's most difficult, subjective judgments. 

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        The first policy relates to revenue recognition.  In most cases, we recognize revenue when theservices are rendered.  For prepaidmaintenance contracts, we recognize revenue ratably over the serviceperiod.  For contracts that containcustomer acceptance provisions, we recognize revenue only after a customer hasindicated acceptance. 

        The second policy relates to accounts receivable. Interestis not accrued on overdue accounts receivable. The allowance for doubtful accounts receivable is charged to income inamounts sufficient to maintain the allowance for uncollectible accounts at alevel management believes is adequate to cover any probable losses.  Management determines the adequacy of theallowance based on historical write-off percentages and information collectedfrom individual customers.  Accountsreceivable are charged off against the allowance when collectibilityis determined to be permanently impaired (bankruptcy, lack of contact, accountbalance over one year old, etc.).   

        The third critical accounting policy relates todepreciation of fixed assets. The purchase of equipment is capitalized based onits cost. We provide depreciation of fixed assets using the straight-linemethod over the equipment's estimated useful life. We have also excluded$102,000 and $100,000 for the year ended December 31, 2002 and 2001respectively in depreciation from Cost of Sales. 

Extraordinary Transactions

        In connection with the sale in November 1999 ofMatrix Telecom (a former subsidiary of NetLojix) to Platinum Equity HoldingsLLC, the amount of the final purchase price is subject to adjustment based onfinalization of a balance sheet for Matrix Telecom as of August 31, 1999 andagreement by both parties. NetLojix provided the purchaser a Matrix Telecombalance sheet prepared in accordance with generally accepted accountingprinciples as required.  We weresubsequently notified by Platinum that it materially disagreed with the closingbalance sheet that we prepared and that it believed it was entitled to areduction of the purchase price we had received.  We attempted to resolve the matter, but thepurchaser resisted submitting the matter to an independent firm of accountantschosen by the parties for final resolution, as required by the contract.   Our last contact with Platinum regardingthis matter was in February 2001, and we have had no indication since then thatPlatinum intends to pursue this dispute. At this time, we do not expect any additional expense or recovery andhave chosen not to pursue legal action against Platinum.  We believe that the ultimate resolution ofthe items in dispute will not materially affect the recorded gain.

        On September 30, 2001 we sold a portion of our NewYork technical support services business (consisting of our New York Citycustomer list and related customer contracts) to Laser Printer Care Company,Ltd. We retained all of our help desk customers and contracts. This was anon-cash transaction with the purchaser assuming our responsibility for unusedcustomer retainers and remaining terms on service agreements, which were heldas liabilities.  We recorded a gain (netof costs) of $203,000 in connection with this sale as a result of the removalof these liabilities. In addition, if the purchaser was able to renew retainers,service agreements or provide any additional services to the customers thatwere transferred, then it was to pay us 5% of any such cash received prior toSeptember 30, 2002. We have recorded $3,918 in such additional payments as ofSeptember 30, 2002.

 

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         On December 30, 2002 NetLojixannounced the signing of a definitive agreement for the merger of NetLojixAcquisitions Corporation with and into NetLojix. NetLojix AcquisitionsCorporation is owned and controlled by Anthony E. Papa and James P. Pisani(NetLojix's Chief Executive Officer and President, respectively).  Under the terms of the merger, NetLojixAcquisitions Corporation will pay approximately $260,000 for all theoutstanding shares of NetLojix's common stock (other than those shares beneficiallyowned by Mr. Papa and Mr. Pisani). Stockholders will receive $0.02 in cash, without interest, for eachoutstanding share of NetLojix's common stock (other than any shares owned byMr. Papa or Mr. Pisani or any dissenting stockholders).  Following the merger, NetLojix will no longerbe publicly traded and will continue operations as a privately heldcorporation.  The merger and the mergeragreement have been approved by both an independent special committee and bythe full Board of Directors of NetLojix. However, the closing of the merger is subject to a number of conditions,including approval by a majority of NetLojix stockholders.

**RESULTS OF OPERATIONS**

**Year Ended December31, 2002 compared with Year Ended December 31, 2001**

***Revenues***

        Revenues from operations decreased $4.6 million or 24.4% to$14.5 million for the year ended December 31, 2002 as compared to $19.1 millionfor 2001.  Revenues from related partieswere $3.9 million for 2002, an increase of $104,000, or 3%, over 2001.  For the year ended December 31, 2002, revenuefrom related parties as a percentage of total revenue increased 7 percentagepoints, to 27%, with the increase growing throughout the year.  These related parties include UICI, ExcelAgent Services LLC, HealthAxis.com and Specialized Association Services (allcompanies affiliated with a director and/or certain otherstockholders of NetLojix). The increase in revenue from related parties as apercentage of total revenue was mainly due to the loss or decrease in servicesof non-affiliated customers such as Infosys, SG Cowen Securities Corporation,ABN AMRO Inc. and the New York City technical support services customers thatwe sold to Laser Printer Care Company Ltd. These related party revenues reflect long distance and data networkservices we provide to such parties on effectively the same terms as our othercustomers. For the twelve months ended December 31, 2002, UICI accounted forapproximately $2.1 million of NetLojix's $3.9 million of 2002 related party revenue.  However, UICI terminated NetLojix as its longdistance services provider with service ending in December of 2002. 

 

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*NetworkConnectivity Segment*

        During 2002 we derived 54.5% of our revenues from networkconnectivity services versus 50.9% in 2001. Network connectivity services revenues,decreased $1.9 million to $7.9 million for the year ended December 31, 2002from $9.8 million for the year ended December 31, 2001. Within the networkconnectivity services segment, data and voice services accounted for $1.4million of the decrease with the balance of the decrease attributable toInternet services.  Data and voiceservices revenues decreased 19.5% from the year 2001 primarily due to the lossof a large customer.  Internet servicesrevenues decreased $0.5 million or 17.9% to $2.3 million. The decrease isprimarily due to a decrease in dial up connectivity accounts and reducedpricing on some of our dedicated products due to the competitiveness of theindustry

*Technical Support Services Segment*

        Technical support services revenues were $5.1 million forthe year ended December 31, 2002, a decrease of 35.1% or $2.7 million from theyear ended December 31, 2001. Approximately $1.2 million of the decrease was due to the reduction ofrevenue from the sale of a portion of the New York technical support servicesbusiness (consisting of the New York City customer list and related customercontracts) to Laser Printer Care Company Ltd. The remaining decrease in revenue was associated with a large customer'sdecision to decrease spending in this area.   

*Application Development and Hosting Segment*

        Application development and hosting services revenuesdecreased to $1.5 million for the year ended December 31, 2002 from $1.6million for the year ended December 31, 2001, a 5.1% decrease.  The decrease is primarily due to lowercustomer spending on non-recurring revenue streams such as applicationdevelopment projects and our increased focus on monthly recurring revenue streamssuch as hosting and managed services. For the year ended December 31, 2002 revenues from hosting servicesincreased 1.1% over the year ended December 31, 2001.

***Gross Margin***

        Gross margin from operations as a percentage of revenuesdecreased to 40.3% for the year ended December 31, 2002 from 40.5% for the yearended December 31, 2001. Gross profit from operations decreased $1.9 million to$5.8 million for the year ended December 31, 2002 from $7.7 million for theyear ended December 31, 2001. 

*Network Connectivity Segment*

         Network connectivityservices gross margin as a percent of revenue decreased to 33.2% for the yearended December 31, 2002 from 35.1% for the year ended December 31, 2001.  Within the network connectivity servicessegment, data and voice gross margins averaged 21.2% vs. 19.5% in thecomparable period in 2002. The increase in gross margin was primarily due toincreased rates for one of our larger customers due to their decision not torenew their contract.  Gross margins forInternet services decreased to 61.0% during the year ended December 31, 2002vs. 62.0% for the comparable period in 2001. The decrease from 2001 isprimarily attributable to the added costs associated with the reorganization ofour network to produce future cost savings. 

 

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*Technical Support Services Segment*

        Technical support services gross margin was 39.4%during the year ended December 31, 2002 compared to 40.3% for the comparableperiod in 2001.  Gross margins in thetechnical service segment decreased primarily as a result of increased costsassociated with creating an in house remote help desk along with specialprojects that required us to supplement our own personnel with higher costsubcontractors in order to accommodate our customersneeds.

*Application Development and Hosting Segment*

        Application development and web hosting gross margin was80.0% during the year ended December 31, 2002 compared to 73.4% for the yearended December 31, 2001.  The increase isattributable to staff reductions in the application development area andfocusing our applications development efforts on e-commerce, web centricapplications and managed web hosting which are generally higher marginservices.

***Selling, General, and Administrative Costs***

        Selling, general, andadministrative costs decreased $1.6 million to $5.7 million for the year endedDecember 31, 2002 from $7.3 million for the year ended December 31, 2001. As a percentage of revenues, selling, general and administrative costs increasedto 39.1% for the year ended December 31, 2002 from 38.2% for the year endedDecember 31, 2001.

        Ofthe decrease in selling, general and administrative expenses, $0.7 million isattributable to the sale of a portion of the New York technical supportservices business (consisting of the New York City customer list and relatedcustomer contracts) to Laser Printer Care Company Ltd.  Approximately $0.65 million is due todecreased salary expense. The remainder is due to decreased professionalservice fees, primarily due to the change in auditors and the decline of legalfees after the 2001 court approval of a settlement of a class action securitieslawsuit. 

***Depreciation and Amortization***

        Depreciation and amortization decreased $0.8 million to $0.8million for the year ended December 31, 2002 from $1.6 million for the yearended December 31, 2001. The decrease was primarily due to decreasedamortization related to the write off of approximately $5.1 million of goodwilland other long-lived intangible assets (primarily acquired customer bases) onDecember 31, 2001.  Using FAS-121 weassess the recoverability of our recorded goodwill by determining whether theamortization of the balance over its remaining life could be recovered throughestimated undiscounted future cash flows of the acquired businesses.  Also, we assess the recoverability of ouracquired customer bases by comparing the recorded value to estimatedundiscounted future cash flows from the use of the asset. The amount ofimpairment is measured based on the difference between the recorded net bookvalue and the estimated fair value of the intangible assets.  We recognized the possibility of impairmentto the intangible assets recorded for the acquisitions of Remote Lojix/ PCSI,Inc., Smith Technology Solutions, Inc., and CW Electronic Enterprises, Inc. dueto a significant change in business climate. Increased competition applying downward pressure on prices, economicfactors causing reduced spending by all customers and the loss of key customersled us to this conclusion.  Thecalculation of the estimated undiscounted future cash flows for these threeTechnical Support Service acquisitions did not support that any of the recordedgoodwill in the net amount of $4,248,000 or other long-lived intangible assetsin the net amount of $851,000 would be recovered.  The total was written off as of December 31,2001.

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***SettlementCosts***

        On October 4, 2000, NetLojixfinalized an agreement with counsel for the plaintiff class to settle alloutstanding claims under a federal securities class action lawsuit then pendingagainst NetLojix. During the last quarter of 2000 and the first quarter of2001, NetLojix paid a total of $150,000 for administrative costs and othersettlement implementation expenses. 

        On May 29, 2001, the court enteredits final order of dismissal and approval of the settlement.  During the third quarter of 2002, we issuedfor distribution to the claimant class members, and payment of the plaintiffsattorneys' fees and litigation expenses, a total of 232,000 shares of commonstock and warrants to purchase 200,000 shares of NetLojix's common stock.  During the three month period ended March 31,2000, we recorded a charge against earnings of $998,000 and a liabilityrelating to the expected settlement. The value of the settlement charge wasbased on the shares being valued at the current stock price at the time of$3.06 and the warrant value being calculated by using the Black-Scholes method.On the date that the settlement became effective, this liability was adjustedusing the same method as stated above based on NetLojix current market value of$0.27. This resulted in a credit to earnings in the second quarter of 2001 of$684,000.

***InterestExpense***

        At December 31, 2002, we hadapproximately $1.2 million in borrowings outstanding under our secured line ofcredit.  During the year ended December31, 2002 we averaged approximately $1.1 million in outstanding borrowings.  Interest expense decreased to $118,000 forthe year ended December 31, 2002 from $140,000 for the year ended December 31,2001, as a result of lower rates offsetting the higher level of averageborrowings outstanding.

**LIQUIDITY AND CAPITALRESOURCES**

        Forthe year ended December 31, 2002, NetLojix reported a net loss from continuingoperations of $0.9 million and net cash used from operations of $0.3 million.  As of December 31, 2002, NetLojix had cashused by investing activities of $0.06 million with cash provided from financingactivities of $0.75 million.  The mainchange in the cash flow statement from December 31, 2001, is the increase inborrowings, which paid down accounts payable. As of December 31, 2002, NetLojix had cash and cash equivalents of $0.5million and an outstanding indebtedness on its line of credit of $1.2 million.At that date, we had a working capital deficit of $2.8 million.  As a result of our operating losses and ourworking capital deficiency, our auditors have indicated that they havesubstantial doubt about our ability to continue as a going concern.

 

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        OnJanuary 31, 2002, we repaid our secured credit facility with Coast BusinessCredit and entered into a new secured credit facility with DTL One, LLC("DTL"), a newly formed entity affiliated with director Jeffrey J. Jensen.  Under the DTL line of credit, we may borrowup to 80% of eligible receivables (as defined) up to a total amount of $2.0million.  Borrowings under the line ofcredit bear interest, payable monthly, based upon the prime rate of Bank ofAmerica NT & SA plus 2%, with a minimum interest rate of 10%. Borrowingsunder the credit facility are secured by substantially all of our assets.  The credit facility will mature on January31, 2004.  After January 31, 2003, DTLmay terminate the line of credit without cause, upon six months notice.  As of March 24, 2003, approximately $1.2million is outstanding under the credit facility, and no amounts are availableto be borrowed under the formula described above.  We have been in default under the DTLfacility since January 2003, because our borrowings have exceeded 80% of oureligible receivables.  DTL has notifiedus that it does not intend to renew the line of credit upon expiration, but hasnot yet exercised its right to accelerate the required repayment of the amountsdue under the facility.  

        In July 2002, UICI (a public company affiliated with  certain stockholders of NetLojix) terminatedNetLojix as its long distance services provider.  The termination became effective in December2002. For the year ended December 31, 2002, UICI accounted for approximately$2.1 million of NetLojix's revenues. Also in July 2002, ABN AMRO Inc. terminated NetLojix as its technicalservices provider.  For the year endedDecember 31, 2002, ABN AMRO accounted for approximately $563,000 of NetLojix'srevenues.  Finally, SG Cowen SecuritiesCorporation, our single largest customer, dramatically reduced its usage of ourservices in 2002, and has indicated that it will further reduce or eliminateits usage of our services in 2003. These terminations or reductions willnegatively affect our cash flow from operations. 

        We believe that current market conditions are not conduciveto raising additional equity capital at this time.  Our current low stock price and delistingfrom The Nasdaq SmallCap Market present substantialobstacles to raising any equity capital. 

        Historically, our cash flow from operations, our securedborrowings, and occasional private placements of both common and preferredstock have been sufficient to meet working capital and capital expenditurerequirements. However, as noted above, our cash flow from operations has beennegatively affected, and no additional amounts are available to us under ourcredit facility or through the capital markets. During the last two years, we have taken steps to conserve cash andreduce operating expenses.  If our cashflow from operations continues to be negative, we will have to engage inadditional cost control measures in order to meet our minimum working capitalrequirements.

 

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        Asof December 31, 2002, NetLojix's current assetsconsisted primarily of cash of $473,000 and accounts receivable of $1,259,000,net of an allowance for doubtful accounts of $239,000.  For the year endedDecember 31, 2002 accounts receivable from related parties was $0.4 million or33%.  This reserve is established based on factorssurrounding the credit risk of customers, historical trends and otherinformation.  At that date, $108,000 ofour accounts receivable were over ninety days past due, including one customerwith a $124,000 balance on a payment plan.  NetLojix's current liabilities included $1.2million on our line of credit and $2.3 million in accounts payable,payroll related expenses and accrued network services.  At December 31, 2002, NetLojix had $664,000of unearned revenue, which consisted primarily of amounts billed and/or paid inadvance for telecom and Internet related services with smaller amounts relatingto prepaid retainers and service contracts. In connection with our 1998 acquisition of Remote Lojix/PCSI, Inc. wehave accrued $461,000 in possible liabilities, which makes up most of our othercurrent liabilities. However our ultimate liability may exceed that amount.  On March 10, 2003 we received an assessmentfrom the New York State Department of Taxation and Finance related to a portionof this liability in the amount of $115,000. 

        Welease office space and various equipment under operatingleases which expire in various years through 2006.  In the normal course of business, operatingleases are generally renewed or replaced by other leases. Total rental expensewas $658,000 in 2002 and $742,000 in 2001. Future minimum lease payments undernon-cancelable operating leases (with initial or remaining lease terms inexcess of one year) as of December 31, 2002 are: $301,000; 2003 - $206,000;2004 - $163,000; 2005 - $124,000; 2006 - and $0; 2007.  NetLojix currently has multiple contracts forswitching and transmission facilities, equipment, network lines andsoftware.  The total commitment isapproximately $475,000 with termination dates ranging from present throughsecond quarter 2005.  The commitmentconsists of a number of small contracts with venders for services with varyingminimum amounts and termination dates, none of which is material byitself.  The larger telecom contractswith minimum commitments that we have had in the past have been renegotiated toexclude minimums.

        NetLojixhas service contracts with the majority of its business customers.  Some of these contracts have minimumcommitments by the customers that range in amount from $25 to $35,000 permonth. The majority of such contracts have fixed terms of one year.  Many of our service contracts have no minimumcommitments or fixed terms and are based on actual usage.

**INFLATION**

        The relatively moderate rates ofinflation over the past two years have had an insignificant effect on our netsales and our profitability.

**RECENTLY-ISSUEDACCOUNTING PRONOUNCEMENTS**

        In June 2001, the FinancialAccounting Standards Board issued SFAS 141 "Business Combinations",and SFAS 142, "Goodwill and Other Intangible Assets", effective forfiscal years beginning after December 15, 2001. Under the new rules, goodwill and certain intangible assets will nolonger be amortized but will be subject to annual impairment tests.  Other intangible assets with finite usefullives will continue to be amortized over their useful lives.  We do not expect any material effect on ourfinancial position or results of operations from the adoption of thesestatements.  The Company adopted thispronouncement on January 1, 2002.

 

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         In August 2001, the FASB issued SFAS143, "Accounting for Asset Retirement Obligations", effective forfiscal years starting after June 15, 2002. SFAS 143 establishes accounting standards for recognition andmeasurement of a liability for the costs of asset retirement obligations.  Under SFAS 143, the costs of retiring anasset will be recorded as a liability when the retirement obligation arises,and will be amortized to expense over the life of the asset.  We do not expect any material effect on ourfinancial position or results of operations from the adoption of thisstatement. The Company adopted this pronouncement on January 1, 2003. 

         In October 2001, the FASB issuedSFAS 144, "Accounting for the Impairment or Disposal of  Long-Lived Assets,"  effective for fiscal years starting afterDecember 15, 2001 and interim periods within those years.  SFAS 144 addresses financial accounting andreporting for the impairment or disposal of long-lived assets and discontinuedoperations.  We do not expect anymaterial effect on our financial position or results of operations from theadoption of this statement. The Company adopted this pronouncement on January1, 2002. 

         In June 2002, the FASB issued SFAS146, "Accounting for Costs Associated with Exit or DisposalActivities", which nullifies EITF Issue 94-3.  SFAS 146 is effective for exit and disposalactivities that are initiated after December 31, 2002 and requires that aliability for a cost associated with an exit or disposal activity be recognizedwhen the liability is incurred, in contrast to the date of an entity'scommitment to an exit plan, as required by EITF Issue 94-3.  The Company adopted this pronouncement onJanuary 1, 2003.

**ITEM 7. FINANCIAL STATEMENTS**

         The financial statements of NetLojixare included beginning immediately following the signature page to thisreport.  

**ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE**

        By unanimous written consent,effective November 12, 2001, the Board of Directors of NetLojix, uponrecommendation of the Audit Committee of the Board of Directors, approved thedismissal of Ernst & Young LLP as independent auditors for NetLojix. 

        The audit report of Ernst &Young LLP on NetLojix's consolidated financial statements as of and for theyear ended December 31, 2000 did not contain an adverse opinion or a disclaimerof opinion and was not qualified or modified as to uncertainty, audit scope, oraccounting principles; however, the report was qualified as to our ability tocontinue as a going concern. 

 

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        In connection with the audits of NetLojix's consolidated financial statements for the fiscal year ended December31, 2000, and the subsequent interim period preceding the dismissal, there wereno disagreements with Ernst & Young LLP on any matter of accountingprinciples or practices, financial statement disclosure, or auditing scope orprocedure, which disagreements, if not resolved to the satisfaction of Ernst& Young LLP would have caused Ernst & Young LLP to make reference tothe subject matter of the disagreements in connection with their report. 

        Ernst & Young LLP furnishedNetLojix with a letter addressed to the Securities and Exchange Commissionstating that it agrees with the above statements. A copy of that letter, datedNovember 13, 2001, has been filed with the Commission by NetLojix. 

        On November 12, 2001, NetLojixengaged Farber & Hass LLP, certified public accountants, as independent auditorsfor NetLojix for 2001. The engagement of Farber & Hass LLP was approved byunanimous written consent of the Board of Directors of NetLojix, uponrecommendation of the Audit Committee of the Board of Directors. 

        During the two fiscal years ended December31, 2000, and the subsequent interim period preceding this engagement, neither NetLojix nor anyone acting on its behalf consulted Farber & Hass LLPregarding the application of accounting principles to a specified transaction,either completed or proposed; the type of audit opinion that might be renderedon NetLojix's financial statements; or any disagreement with, or reportableevent relating to, Ernst & Young LLP.

**PART III**

**ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERSAND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT**

Directors

        There are five members of our Board of Directors.  Information with respect to the directors isset forth below.

***        Anthony E. Papa***, age 40, has been the Chairmanof the Board and Chief Executive Officer of NetLojix since October 1996.  Mr. Papa was also President of NetLojix fromOctober 1996 until February 1998. Prior to October 1996, Mr. Papa had served asPresident of ICS Communications, Inc., Richardson, Texas, a national providerof cable television, wireless paging, local and long distance telephoneservices from December 1992.  Beforejoining ICS Communications, Mr. Papa served as general manager for Spectradyne,Inc., the largest provider of pay-per-view entertainment and interactive servicesto the hospitality industry.   Mr. Papais a director of ABC-Clio, Inc., an international publisher of historicalreference materials for institutions of higher education.   Mr. Papa received a B.S. in Management fromIona College, in New Rochelle, New York. 

 

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***        JamesP. Pisani***,age 38, has been the President of NetLojix since February 1998, and has servedas Chief Operating Officer and Secretary of NetLojix since October 1996.  From October 1996 to May 1999, Mr. Pisani wasthe Chief Financial Officer of NetLojix. Mr. Pisani also served as Chief Accounting Officer of NetLojix fromOctober 1998 until May 3, 1999 From October 1996 to February 1998,Mr. Pisani was the Executive Vice President of NetLojix. Prior to October 1996,he served as Vice President of Sales and National Accounts for ICSCommunications.  While at ICS, Mr. Pisaniwas responsible for that firm's business-to-business and consumer salesactivities. Mr. Pisani graduated from Princeton University in 1986, with adegree in Economics.

***        JeffreyJ. Jensen***,age 44, has been a director of NetLojix since January 1998.  He has been the President of SpecializedAssociation Services, Ltd., which provides marketing and administrativeservices to regional and national trade associations, for more than five years.Between 1996 and July 1998, Specialized Association Services was known as COREMarketing, Inc. and provided direct mail and telemarketing facilities inaddition to its other activities. Mr. Jensen has also been the President ofUnited Group Service Centers, Inc., an employee leasing company, since January2000, and prior to that was its Vice President for more than five years.  Mr. Jensen is a director of RMH Teleservices, Inc. (Nasdaq: RMHT),a provider of outsourced customer relationship management, and became Chairmanof the Board of that company in August 2002. Mr. Jensen received B.A. degrees in Economics and Philosophy fromCornell College, in Mount Vernon, Iowa and holds an M.S. in Information Systemsfrom the University of Texas at Arlington.

***        AnthonyD. Martin***,age 53, has been a director of NetLojix since April 1999. Mr. Martin was thePresident and Chief Operating Officer of PF.Net Communications, Inc., afacilities-based provider of high capacity fiber optic network andinfrastructure and communications services, from March 2000 to December2000.  Mr. Martin was Managing Directorof CrossHill Financial Group Inc., from March 1998 to April 2000.  From January 1997 through July 1997, heserved as President and CEO of Nexus Communications, Inc., a start-up companyproviding information services.  FromJanuary 1994 to December 1996, he served as Vice President, BusinessDevelopment of MCI Metro, MCI Telecommunications, Inc.'s local serviceinitiative.  Prior to that, he heldseveral senior management positions at MCI, including Vice President, AccessServices Project Management; Vice President, Systems Engineering and SupportOperations; Vice President, Carrier Marketing and Alliances; Vice President,Finance Administration; and Vice President, Technical Planning.  He received a B.S. from the United StatesNaval Academy and an M.B.A. from the University of Detroit. 

***       Peter Wenner***, age 44, has been a director ofNetLojix since October 2002.  Mr. Wenner is a principal of Wenner& Associates, LLC, which provides financial, strategic and real estateconsulting services for clients located in Europe, China and the UnitedStates.  From April 1997 through April2001, Mr. Wenner was a principal of and developmentmanager for Atlas Homes, LLC, which developed a 500-acre masterplanned residential development. He received a Bachelor of Science degree fromthe University of Wisconsin and a Master of Business Administration degree fromthe University of Southern California.

 

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----

 

Executive Officers 

        Setforth below is information with respect to the only executive officer ofNetLojix other than Messrs. Papa and Pisani. Information with respect to Messrs. Papa and Pisani is set forth aboveunder "Directors."

***        Gregory J. Wilson,*** age 36, has been Treasurerof NetLojix since March 2001. He has served as Controller and Chief AccountingOfficer of NetLojix since January 2001, and prior to that he had served asAssistant Controller of NetLojix since January 2000.  From January 1994 to January 2000, Mr. Wilsonwas the Accounting Manager for Imperial Credit Industries, Inc., a financialservices holding company.  Mr. Wilsonreceived a B.S. and an M.B.A. from the California Polytechnic University, SanLuis Obispo.

        There are no family relationships between any directors orexecutive officers of NetLojix.

Section 16(a) Beneficial Ownership Reporting Compliance

        Section 16(a) of the Securities Exchange Act of 1934requires NetLojix's officers and directors, and persons who own more than tenpercent of a registered class of NetLojix's equity securities to file reportsof ownership and changes in ownership with the SEC.  Officers, directors and greater than ten-percentshareholders are required by SEC regulation to furnish NetLojix with copies ofall Section 16(a) forms they file.

        Based solely on a review of the copies of Section 16(a)forms furnished to NetLojix, and on written representations that no Forms 5were required, NetLojix believes that during 2002 no officer, director orgreater than ten-percent shareholder failed to file on a timely basis anyreport required under Section 16(a). Four shareholders who are not directors or officers of NetLojix did fileForms 5 reporting transactions that took place in prior years.  These shareholders had previously filed aSchedule 13D indicating that they constituted a "group" for purposes of Section13(d) of the Exchange Act that owned in excess of ten percent of NetLojix'soutstanding common stock.  Theshareholders have represented to NetLojix that they no longer constituted a groupat the time of the transactions reported in the Forms 5, but that they filedthe Forms 5 to explain clearly the lack of group status and out of an abundanceof caution.  Information with respect tosuch Forms 5 is set forth below:

| Name of Person    | Number  of Late Reports | Number  of Transactions | Type  of Report |
|-------------------|-------------------------|-------------------------|-----------------|
| Gladys M.  Jensen | 1                       | 1                       | Form  5         |
| James J. Jensen   | 1                       | 2                       | Form  5         |
| Janet J. Jensen   | 1                       | 1                       | Form  5         |
| Ronald L.  Jensen | 1                       | 3                       | Form  5         |

 

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        Director Jeffrey J. Jensen filed aForm 5 in September 2002 reporting option awards from prior years.  However, all such awards had been previouslyreported on Forms 4 or 5.

**ITEM 10. EXECUTIVE COMPENSATION**

        The following table summarizes allcompensation for the fiscal year ended December 31, 2002 paid to NetLojix'sChief Executive Officer and the other executive officers of NetLojix who wereserving as executive officers on December 31, 2002 and whose compensationexceeded $100,000 for such year (the "Named Executive Officers").  Titles shown are those held by the NamedExecutive Officers at December 31, 2002.

**SUMMARY COMPENSATION TABLE**

|  | Annual Compensation | Long-Term   Compensation   Awards |  
Name and  Principal  Position

Fiscal Year

Salary

Bonus

Restricted  Stock  Awards  ($)

Securities  Underlying  Options  (#)

All Other  Compensation(1)

Anthony E. Papa  Chairman and Chief  Executive Officer 

2002

$253,935 (2)

(3)

--

--

--

2001

212,815 (4)

139,781 (4)

10,000  (5)

400,000

--

2000

 252,513

  25,000 (6)

--

100,000

5,250
   
James P. Pisani   President, Chief  Operating  Officer  and Secretary 

2002

$253,572 (7)

(3)

--

--

--

2001

205,864 (8)

139,781 (8)

10,000 (5)

400,000

--

2000

229,558

 25,000 (6)

--

100,000

1,406
   
Matthew A. Blumenthal (9)  Vice President Sales   &  Field Service

2002

$165,000

 2,097 (10)

--

--

--

2001

165,000

17,614 (10)

--

100,000

--

2000

110,422

75,359 (11)

--

145,000

4,748
   
(1)      Represents company contribution todefined contribution plan. 

(2)      At the request of NetLojix, Mr. Papahas agreed to defer payment of $40,116 of this amount to future years.

(3)      The executive's employment agreementprovides for a bonus based on financial performance objectives to be negotiatedin good faith by the executive and NetLojix consistent with the objectives usedfor 2001.  The executive and NetLojixhave not yet negotiated these amounts. As a result, the amount of the executive's bonus for 2002 is notcalculable as of March 24, 2003.

(4)      Reflects a voluntary reduction in2001 salary made by Mr. Papa in the amount of $25,535.  At the request of NetLojix, Mr. Papa alsoagreed to defer payment of $4,915 of his salary and the full amount of his 2001bonus to future years.

(5)      Represents the grant of 100,000shares of restricted stock, less the amount actually paid for the shares.  The value of the grant on December 31, 2002,was $1,000, based on the closing price of the common stock on the OTC BulletinBoard on that date.  Of these shares, 30%vested on April 30, 2002, 30% will vest on April 30, 2003, and the remainderwill vest on April 30, 2004.

 

 

28

 

(6)      Retentionbonus paid in January 2000.

(7)      Atthe request of NetLojix, Mr. Pisani has agreed to defer payment of $44,841 ofthis amount to future years.

(8)      Reflects a voluntary reduction in2001 salary made by Mr. Pisani in the amount of $27,661. At the request ofNetLojix, Mr. Pisani also agreed to defer payment of $16,964 of his salary andthe full amount of his 2001 bonus to future years.

(9)      Mr. Blumenthal ceased to be employedby NetLojix on January 24, 2003.  

(10)    Consists of sales commissions paid.

(11)    Includes $55,071 of sales commissionspaid.

        There were no option grants to the Named Executive Officersduring the year ended December 31, 2002. No stock appreciation rights were awarded during such year.

        The followingtable provides information with respect to the unexercised stock options heldas of December 31, 2002, by the Named Executive Officers.  None of the Named Executive Officersexercised stock options during the year ended December 31, 2002.

** **

**                                     OPTIONVALUES AT DECEMBER 31, 2001**

 

Number of Securities Underlying   Unexercised Options   atDecember 31, 2002

Value of Unexercised In-the-Money Options   at December 31, 2002 (1)

 
         NameExercisable
Unexercisable

Exercisable

Unexercisable
              
Anthony E. Papa

245,000

355,000

$0

$0
                 
James P. Pisani

245,000

355,000

$0

$0
                 
Matthew  A. Blumenthal(2)

107,500

147,500

$0

$0

(1)           The closing price of the common stock on the OTC BulletinBoard on December 31, 2002 was $0.01 per share.(2)           Unlessexercised, all of Mr. Blumenthal's options will expire on April 24, 2003.

Director Compensation

        Our policy is to pay eachnon-employee director a fee of $1,500 for each Board or committee meeting heattends; employee directors do not receive this fee. We reimburse directors'reasonable expenses in connection with attendance at board and committeemeetings.  Directors (includingnon-employee directors) are also eligible to receive grants of stock optionsand restricted stock under our 1997 Stock Incentive Plan and 1998 StockIncentive Plan.  

Agreementswith Executive Officers

        On September 10, 2001, NetLojixentered into an employment agreement with Anthony E. Papa, which provides thatMr. Papa will act as the Chief Executive Officer of NetLojix.  The current term of the agreement continuesuntil April 1, 2005, but will be automatically extended for additional one-yearperiods unless NetLojix notifies Mr. Papa at least two years in advance of theexpiration of the then-current term.  Mr.Papa's current base salary under the agreement is $255,955 per year, which willincrease by a minimum of three percent during each year of the term.  In addition to this base salary, Mr. Papa maybe entitled to receive bonuses based on the financial performance of NetLojixand the accomplishment by NetLojix of other business objectives, as determinedfrom time to time by Mr. Papa and the Board of Directors.  Due to NetLojix's cash position, Mr. Papatook a voluntary one-time compensation reduction for 2001 in the amount of$25,535 and agreed to defer payment of $144,696 of his 2001 salary and bonus tofuture years; of this amount $66,804 has since been repaid.  Mr. Papa has also agreed to defer payment of$40,116 of his 2002 salary and bonus to future years.

 

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        The agreement with Mr. Papa may beterminated by NetLojix either for cause or without cause.  If NetLojix terminates the agreement withoutcause, it must continue to pay Mr. Papa his base salary for a period of 18months after termination together with any bonuses relating to the year inwhich the termination takes place.  Mr.Papa may terminate the agreement, without cause, upon 120 days notice toNetLojix; no payments by NetLojix are required in that event.  If a Change in Control (as defined in the1998 Stock Incentive Plan) of NetLojix occurs, Mr. Papa will have a limitedright to terminate his employment without cause, and NetLojix will be requiredto pay him his base salary for a period of one year after termination togetherwith any bonuses relating to the year in which the termination takes place.

        On September 10, 2001, NetLojixentered into an employment agreement with James P. Pisani which provides thatMr. Pisani will act as the President, Chief Operating Officer and Secretary ofNetLojix.  Except for his position andduties, and the performance criteria for the payment of bonuses, the agreementwith Mr. Pisani is identical to the agreement with Mr. Papa.  Due to NetLojix's cash position, Mr. Pisanitook a voluntary one-time compensation reduction for 2001 in the amount of$27,661 and agreed to defer payment of $156,745 of his 2001 salary and bonus tofuture years; of this amount $66,804 has since been repaid.  Mr. Pisani has also agreed to defer paymentof $44,841 of his 2002 salary and bonus to future years.

        The employment agreements with Mr.Papa and Mr. Pisani were unanimously approved by the Compensation Committee ofNetLojix's Board of Directors.

CompensationCommittee Interlocks And Insider Participation 

        During 2002, the CompensationCommittee consisted of Mr. Jensen and Mr. Martin.  None of such Compensation Committee memberswas or has been an officer or employee of NetLojix or any of its subsidiaries.Certain entities with which Mr. Jensen was affiliated received payments fromNetLojix during 2002. See "Certain Relationships and Related Transactions."

        No executive officer of NetLojixserved at any time during the year ended December 31, 2002 as a member of theBoard of Directors or Compensation Committee of any entity that has one or moreexecutive officers serving as a member of NetLojix's Board or CompensationCommittee.
 
30

 

**ITEM 11. SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

         The following table sets forth stock ownershipinformation for (i) each person known to NetLojix to own beneficially more thanfive percent of the outstanding shares of NetLojix common stock, (ii) eachdirector of NetLojix, (iii) each of the Named Executive Officers, and (iv) thedirectors and executive officers as a group. The percentages of common stock beneficially owned are based upon 14,695,149shares of the common stock outstanding as of March 24, 2003.

Name of Beneficial Owner   

Amount Beneficially   Owned

PercentOf Class (1)
               
5% Stockholders:
           
Jami J. Jensen (2)  1401 Colt Circle   Castle Rock, Colorado 80104

895,430 (3)

6.1%
           
Julie J. Jensen (4)  6220 Garnett Road   Chevy Chase, Maryland 20815

  907,554  (3)(5)

6.2%
           
Directors and Executive  Officers:

 

 
           
Anthony E. Papa (6)

3,692,656 (7)(8)

23.4%
           
James P. Pisani (6)

3,692,656 (7)(9)

23.4%
           
Jeffrey J. Jensen (10)

           995,430  (3)(11)

6.8%
           
Anthony D. Martin

         100,000 (11)

*
           
Peter Wenner

0

*
           
Gregory J. Wilson 

          10,750 (12)

*
           
All directors and executive officers   as a group (6 persons)

  3,803,406 (13)

23.9%

* Represents less than 1%. 

 

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(1)      Beneficialownership is determined in accordance with the rules of the Securities andExchange Commission (the "SEC").  Incomputing the number of shares beneficially owned by a person and thepercentage ownership of that person, shares of NetLojix's common stock subjectto options held by that person that are exercisable within sixty (60) daysfollowing March 24, 2003 are deemed outstanding.  However, such shares of common stock are notdeemed outstanding for the purpose of computing the percentage ownership of anyother person. Unless otherwise indicated in the footnotes to this table, eachperson named in the table has sole voting and sole investment power withrespect to the shares set forth opposite such person's name. 

(2)      Informationis derived from a Schedule 13D/A filed by thisindividual with the SEC on March 10, 2003.  

(3)      Includes43,692 shares owned by the Jenesis Group, acharitable foundation.  As a trustee ofthis foundation, the individual shares voting and investment power with respectto such shares with the other trustees. The individual disclaims beneficial ownership of these shares.

(4)      Informationis derived from a Schedule 13D/A filed by thisindividual with the SEC on March 7, 2003.

(5)      Includes12,124 shares owned by The Chasdrew Fund, acharitable foundation. As a trustee of this foundation, the individual sharesvoting and investment power with respect to such shares with the othertrustees.  Ms. Jensen disclaimsbeneficial ownership of these shares.

(6)      Informationis derived from a Schedule 13D/A filed by Mr. Papa, Mr. Pisani and NetLojixAcquisitions Corporation with the SEC on March 10, 2003.  The Schedule 13D/A notes that, as a result oftheir joint ownership of NetLojix Acquisitions Corporation and their agreementwith respect to the proposed "going private" transaction, Mr. Papa and Mr.Pisani may be considered to be a "group" within the meaning of Section 13 ofthe Securities Exchange Act of 1934, as amended, and thus may be deemed to ownbeneficially each other's shares. The Schedule 13D/A further notes that, as aresult of other agreements NetLojix Acquisitions Corporation has with DTL One,LLC (which is owned by Mr. Jensen) and with Tommy Lin and Patrick Lin (theowners of NetLojix's outstanding Series A convertible preferred stock),  Mr. Papa and Mr.Pisani may be deemed to own beneficially the shares owned by Mr. Jensen and theshares issuable upon conversion of the Series A convertible preferred stockowned by the Lins. The address of Mr. Papa and Mr. Pisani is c/o NetLojix Communications,Inc., 501 Bath Street, Santa Barbara, CA 93101.

(7)      Includes(i) 862,963 outstanding shares owned directly by Mr. Papa, (ii) 415,000 sharesthat may be acquired under options held by Mr. Papa that were exercisablewithin 60 days of March 24, 2003, (iii) 856,563 outstanding shares owneddirectly by Mr. Pisani, (iv) 415,000 shares that may be acquired under optionsheld by Mr. Pisani that were exercisable within 60 days of March 24, 2003, (v)995,430 shares shown in this table as being beneficially owned by Mr. Jensen,and (vi) 147,700 shares issuable upon conversion of the Series A convertiblepreferred stock owned by the Lins.

(8)      Mr.Papa disclaims beneficial ownership of any common stock other than the 862,963outstanding shares he owns directly and the 415,000 shares that he may acquireunder options that were exercisable within 60 days of March 24, 2003.

(9)      Mr. Pisani disclaims beneficial ownership of any common stock other than the856,563 outstanding shares he owns directly and the 415,000 shares that he mayacquire under options that were exercisable within 60 days of March 24, 2003.

(10)    Informationis derived from a Schedule 13D/A filed by thisindividual with the SEC on March 7, 2003. Mr. Jensen's address is 6500 Belt Line Road, Suite 170, Irving, TX76063.

(11)    Includes100,000 shares that may be acquired under options that were exercisable within60 days of March 24, 2003.  

(12)    Includes2,000 shares owned by Mr. Wilson's spouse and 8,750 shares that may be acquiredunder options that were exercisable within 60 days of March 24, 2003.

(13)    Includes 1,038,750 shares that may be acquired under optionsthat were exercisable within 60 days of March 24, 2003.  Also includes 147,700 shares issuable uponconversion of the Series A convertible preferred stock owned by the Lins, as to which all directors and executive officersdisclaim beneficial ownership.

 

32

 

"GoingPrivate" Transaction

        On December 30, 2002, NetLojixentered into an agreement for the merger of NetLojix Acquisitions Corporation("NAC") with and into NetLojix. NAC is owned and controlled by Mr. Papa and Mr.Pisani.  Under the terms of this "goingprivate" transaction, NAC will pay approximately $260,000 for all theoutstanding shares of NetLojix's common stock (other than those sharesbeneficially owned by Mr. Papa and Mr. Pisani or by any dissentingstockholders).  Stockholders will receive$0.02 in cash, without interest, for each outstanding share of NetLojix'scommon stock (other than any shares owned by Mr. Papa or Mr. Pisani or anydissenting stockholders).  Following themerger, all of the common stock of NetLojix will be owned by Mr. Papa and Mr.Pisani; NetLojix will no longer be publicly traded and will continue operationsas a privately held corporation.  Themerger and the merger agreement have been approved by both an independent specialcommittee and by the full Board of Directors of NetLojix.  However, the closing of the merger is subjectto a number of significant conditions, including approval by a majority ofNetLojix stockholders.

        DTL One, LLC, which is owned andmanaged by Director Jeffrey J. Jensen, has agreed to lend up to $300,000 to NACin connection with this "going private" transaction.  Tommy Lin and Patrick Lin, the owners of allof NetLojix's outstanding Series A convertible preferred stock, have alsoagreed to consent to the transaction, to the extent that their consent isnecessary.

Securities Authorized for Issuance Under Equity Compensation Plans

        The following table summarizesinformation as December 31, 2002, with respect to compensation plans of NetLojix under which equity securities may be issued.

**EQUITY COMPENSATION PLAN INFORMATION**

Number of shares of  common stock to be issued   upon exercise  of  outstanding options,  warrants and rights

Weighted-average exercise   price of outstanding options,  warrants and rights

Number of shares of common stock remaining available for  future issuance under equity compensation plans (excluding securities reflected in the first column)

Equity compensation plans approved  by security holders (1)

2,339,984

$1.75

577,256

Equity compensation plans not  approved by security holders (2)

100,000

$3.22

0

Total

(1)           Includesthe 1997 Stock Incentive Plan and the 1998 Stock Incentive Plan, as amended.(2)           Reflectswarrants to purchase 100,000 shares of common stock issued to Kaufman Bros.,L.P.

 

33

 

        InJanuary 2000, we retained Kaufman Bros., L.P. to act as our financial advisorand investment banker.  As part of theircompensation for these services, we issued to Kaufman Bros. a warrant topurchase up to 100,000 shares of our common stock.  The exercise price is $3.28 per share.  The warrant is exercisable, in whole or inpart, until January 10, 2005.  

**ITEM 12. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

***        "Going Private"Transaction. ***On December30, 2002, NetLojix entered into an agreement for the merger of NetLojixAcquisitions Corporation ("NAC") with and into NetLojix. NAC is owned andcontrolled by Mr. Papa and Mr. Pisani. Under the terms of this "going private" transaction, NAC will payapproximately $260,000 for all the outstanding shares of NetLojix's commonstock (other than those shares beneficially owned by Mr. Papa and Mr. Pisani orby any dissenting stockholders). Stockholders will receive $0.02 in cash, without interest, for eachoutstanding share of NetLojix's common stock (other than any shares owned byMr. Papa or Mr. Pisani or any dissenting stockholders).  Following the merger, all of the common stockof NetLojix will be owned by Mr. Papa and Mr. Pisani; NetLojix will no longerbe publicly traded and will continue operations as a privately heldcorporation.  The merger and the mergeragreement have been approved by both an independent special committee and bythe full Board of Directors of NetLojix. However, the closing of the merger is subject to a number of significantconditions, including approval by a majority of NetLojix stockholders.

***        Long Distance Services.***Director Jeffrey J. Jensenand/or hisfather, mother, adult siblings and related charitable foundations havesignificant ownership in companies to which NetLojix provides long distance anddata network service. Services are provided pursuant to NetLojix's standardterm agreements.  Balances related tooperating activities are settled monthly. We neither receive nor provide any benefits outside of a standardcustomer-supplier relationship.  Thetotal amount received by NetLojix pursuant to these agreements in 2002 wasapproximately $4,486,000.   

***        Credit Line with DTL One, LLC***.   On January 31, 2002, NetLojix's securedcredit facility with Coast Business Credit expired, and NetLojix entered into anew secured line of credit facility with DTL One, LLC ("DTL").  DTL is owned and controlled by directorJeffrey J. Jensen. Under the DTL line of credit, NetLojix may borrow up to 80%of eligible receivables (as defined) up to a total amount of $2.0 million.  Borrowings under the line of credit bearinterest, payable monthly, based upon the prime rate of Bank of America NT& SA plus 2% with a minimum interest rate of 10%. Borrowings under thecredit facility are secured by substantially all assets of NetLojix. As ofMarch 24, 2003, approximately $1.2 million is outstanding under the creditfacility, and no amounts are available to be borrowed under the formuladescribed above.  As of January 2003, weare in default under the line of credit, because our borrowings exceed the 80%limitation.  DTL has notified us that itdoes not intend to renew the line of credit, but has not called the note.  The credit facility also prohibits thepayment of dividends and limits the size of business acquisitions that we maymake without the prior consent of DTL. NetLojix believes that the terms of theDTL line of credit are more favorable to NetLojix than those of any othercredit facility available to NetLojix to replace the expiring Coast agreement.  

 

34

 

***        Clark Debt.***  Since 1998, NetLojix has from time to timeloaned or advanced Craig R. Clark, its former Vice President of BusinessDevelopment, a total of $86,000, including interest. All of these loans andobligations are unsecured.  Mr. Clarkresigned from all positions with NetLojix, effective March 31, 2002.  NetLojix then notified Mr. Clark that theloan was due and payable in full. NetLojix has not yet received any payment from Mr. Clark.  We chose to reserve for the total amountadvanced as of June 30, 2002.

***        Policy on Related Party Transactions*. **NetLojix'spolicy is to conduct an appropriate review of all related party transactions onan ongoing basis and to utilize the Audit Committee or a special committee ofthe Board of Directors to review potential conflict of interest situationswhere appropriate.

**ITEM 13. EXHIBITS ANDREPORTS ON FORM 8-K**

        (a)        The index to the financial statementsand financial statement schedules filed as part of this report is set forthimmediately following the signature page. 

        (b)        During the quarter ending December 31, 2002, NetLojix filedtwo Current Reports on Form 8-K. On December 3, 2002, NetLojix filed a Form 8-K (Items 5 and 7) reportingthe receipt of the going private proposal from Mr. Papa and Mr. Pisani andNetLojix's press release regarding the same. On December 31, 2002, NetLojix filed a Form 8-K (Items 5 and 7)reporting the execution of the definitive Agreement and Plan of Merger withNetLojix Acquisitions Corporation as part of the going private transaction andNetLojix's press release regarding the same.

        (c)        The index to the exhibits filed as part of this report is setforth immediately following the financial statements.

**ITEM 14. CONTROLS AND PROCEDURES**

        Within 90 days prior to the date offiling this report, an evaluation was performed under the supervision and withthe participation of our management, including the Chief Executive Officer andTreasurer and Controller, of the effectiveness of the design and operation of NetLojix's disclosure controls and procedures (as defined in Rule 13a-14(c) ofthe Exchange Act). Based on and as of the time of such evaluation, ourmanagement, including the Chief Executive Officer and Treasurer and Controller,concluded that NetLojix's disclosure controls and procedures were effective intimely alerting them to material information relating to NetLojix (includingits consolidated subsidiaries) required to be included in our reports filed orsubmitted by NetLojix under the Exchange Act. There have been no significantchanges in our internal controls or in other factors that could significantlyaffect internal controls subsequent to the time of such evaluation.
 
35

 

**SIGNATURES**

Inaccordance with Section 13 or 15(d) of the Exchange Act, the registrant causedthis report to be signed on it behalf by the undersigned, thereunto dulyauthorized.

**NETLOJIX  COMMUNICATIONS, INC.**
Dated:   March 26, 2003          By      /S/ ANTHONY E. PAPA        AnthonyE. Papa, Chairmanof the Board and Chief      ExecutiveOfficer
Inaccordance with the Exchange Act, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities indicatedon this 26th day of March 2003.
By      /S/ ANTHONY E. PAPA             AnthonyE. Papa,Chairmanof the Board and Chief      ExecutiveOfficer(PrincipalExecutive Officer)  By      /S/ JAMES P. PISANI                James P. Pisani,President and Chief Operating Officer   By      /S/ GREGORY J. WILSONGregory J. Wilson,Treasurer and Controller(Principal Financial Officer and       PrincipalAccounting Officer)  By      /S/ JEFFREY J. JENSEN             Jeffrey J. JensenDirector  By       /S/ ANTHONY D. MARTIN        Anthony D. MartinDirector  By       /S/ PETER WENNER        Peter WennerDirector 
 

36

 

**CERTIFICATIONS**

I,Anthony E. Papa, certify that: 

1.I have reviewed this annual report on Form 10-KSB of NetLojix CommunicationsInc.; 

2.Based on my knowledge, this annual report does not contain any untrue statementof a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this annual report; 

3.Based on my knowledge, the financial statements, and other financialinformation included in this annual report, fairly present in all materialrespects the financial condition, results of operations and cash flows of theregistrant as of, and for, the periods presented in this annual report; 

4.The registrant's other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave: 

a)designed such disclosure controls and procedures to ensure that materialinformation relating to the registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this annual report is being prepared; 

b)evaluated the effectiveness of the registrant's disclosure controls andprocedures as of a date within 90 days prior to the filing date of this annualreport (the "Evaluation Date"); and 

c)presented in this annual report our conclusions aboutthe effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date; 

5.The registrant's other certifying officers and I have disclosed, based on ourmost recent evaluation, to the registrant's auditors and the audit committee ofregistrant's board of directors (or persons performing the equivalent functions):

a)all significant deficiencies in the design or operation of internal controlswhich could adversely affect the registrant's ability to record, process,summarize and report financial data and have identified for the registrant'sauditors any material weaknesses in internal controls; and 

b)any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant'sinternal controls; and 

6.The registrant's other certifying officers and I have indicated in this annualreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses. 

DateMarch 26, 2003 

/s/  ANTHONY E. PAPA --------------------------------- AnthonyE. Papa Chairmanof the Board and ChiefExecutive Officer 

 

 

I,Gregory J. Wilson, certify that: 

1.I have reviewed this annual report on Form 10-KSB of NetLojix CommunicationsInc.; 

2.Based on my knowledge, this annual report does not contain any untrue statementof a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this annual report; 

3.Based on my knowledge, the financial statements, and other financialinformation included in this annual report, fairly present in all materialrespects the financial condition, results of operations and cash flows of theregistrant as of, and for, the periods presented in this annual report; 

4.The registrant's other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave: 

a)designed such disclosure controls and procedures to ensure that materialinformation relating to the registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this annual report is being prepared; 

b)evaluated the effectiveness of the registrant's disclosure controls andprocedures as of a date within 90 days prior to the filing date of this annualreport (the "Evaluation Date"); and 

c)presented in this annual report our conclusions aboutthe effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date; 

5.The registrant's other certifying officers and I have disclosed, based on ourmost recent evaluation, to the registrant's auditors and the audit committee ofregistrant's board of directors (or persons performing the equivalentfunctions): 

a)all significant deficiencies in the design or operation of internal controlswhich could adversely affect the registrant's ability to record, process,summarize and report financial data and have identified for the registrant'sauditors any material weaknesses in internal controls; and 

b)any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant'sinternal controls; and 

6.The registrant's other certifying officers and I have indicated in this annualreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses. 

DateMarch 26, 2003

/s/  GREGORY J. WILSON --------------------------------- GregoryJ. Wilson Treasurerand Controller (Principal FinancialOfficer and Principal Accounting Officer)

 

39

 

**INDEX  TO CONSOLIDATED FINANCIAL STATEMENTS**
       
Page
        
Report  of Farber & Hass LLP, Independent Auditors............

F-2
     
Consolidated  Balance Sheet, December 31, 2002 ................ 

F-3
     
Consolidated  Statements of Operations, Years ended 

December  31, 2002 and 2001 .............................................  

F-4
     
Consolidated  Statements of Stockholders' Equity, Years 

ended December 31, 2002 and 2001  .................................. 

F-5
     
Consolidated  Statements of Cash Flows, Years ended 

December  31, 2002 and 2001 .............................................

F-6
     
Notes  to Consolidated Financial Statements...........................

F-7
     
Schedule  II - Valuation and Qualifying Accounts, Years 

ended December 31, 2002 and 2001  .................................. 

S-1

 
 
 

 

F-1

 

 

**INDEPENDENTAUDITORS' REPORT**

To the Board of Directors andStockholdersofNetLojix Communications, Inc.:

We have audited the accompanyingconsolidated balance sheet of NetLojix Communications, Inc. (the"Company") as of December 31, 2002 and the related consolidatedstatements of operations, stockholders' deficit and cash flows for the twoyears then ended.  These consolidatedfinancial statements are the responsibility of the Company's management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits. 

We conducted our audits inaccordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audits to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall presentation of the financialstatements.  We believe that our auditsprovide a reasonable basis for our opinion.

In our opinion, the accompanyingconsolidated financial statements present fairly, in all material respects, thefinancial position of the Company at December 31, 2002 and the results of itsoperations and its cash flows for the two years then ended in conformity withaccounting principles generally accepted in the United States.

As more fullydescribed in Note 1, the Company has incurred recurring operating losses,has a working capital deficiency and is unable to borrow any additional amountsunder its secured line of credit.  Theseconditions raise substantial doubt about the Company's ability to continue as agoing concern.  Management's plans inregard to these matters are described in Note 15.  The financial statements do not include anyadjustments to reflect the possible future effects on the recoverability andclassification of assets or the amounts and classification of liabilities thatmay result from the outcome of this uncertainty.

Oxnard, California                                                                                                   /s/Farber & Hass LLPMarch 24, 2003

 

F-2

 

 
        NETLOJIX COMMUNICATIONS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS        DECEMBER 31, 2002
2002
AssetsCURRENT ASSETSCash$     473,000 Accounts receivable, net     842,000         Accounts receivable from related parties     417,000         Prepaid expenses and other current assets     183,000 Total current assets   1,915,000 Property and equipment, net     706,000 Other assets      56,000 Total assets$   2,677,000 
Liabilities and Stockholders' Deficit CURRENT LIABILITIESRevolving line of credit$   1,200,000         Accounts payable and other accrued expenses   1,210,000         Accrued payroll related liabilities     577,000         Accrued network services costs     496,000         Litigation settlement liability       6,000 Sales and excise tax payable      53,000 Unearned revenue     664,000 Other current liabilities     474,000 Total current liabilities   4,680,000 Long-term obligations      11,000 Total liabilities   4,691,000         Commitments and contingencies  (Notes 2, 9 and 12)STOCKHOLDERS' DEFICIT        Preferred stock, authorized 1,000,000 shares, $0.01 par value          Series A convertible preferred stock, designated 250,000 shares,            cumulative as to 8% dividends, 147,700 shares issued and            outstanding (Liquidation preference of $822,000 at December 31,            2002 including dividends in arrears totaling $231,392.)        1,000         Common stock, authorized 40,000,000 shares          $0.01 par value, issued 14,858,054 shares at December 31, 2002     149,000         Deferred Compensation - restricted stock      (9,000)Additional paid-in capital  28,631,000 Preferred dividends    (102,000)Accumulated deficit (30,682,000)        Treasury stock, $0.01 par value, 162,905 common shares at  December 31, 2002      (2,000)Total stockholders' deficit  (2,014,000)                 Total liabilities and stockholders' deficit$   2,677,000 See accompanying notes.
F-3

 

 
NETLOJIX COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS        YEARS ENDED DECEMBER 31, 2002, 2001
2002
2001SERVICE REVENUESUnrelated parties$  10,548,000 $  15,315,000 Related parties - (note 7)   3,929,000    3,826,000   14,477,000   19,141,000 COST OF SERVICE REVENUES        (exclusive of depreciation - note 1D)   8,638,000   11,396,000 GROSS MARGIN   5,839,000    7,745,000 OPERATING EXPENSES        Selling, general and administrative   5,660,000    7,310,000         Litigation settlement (recovery)           -     (684,000)        Gain on sale of contracts and customer List           -     (203,000)        Provision for intangible asset impairment           -    5,099,000 Depreciation and amortization     835,000    1,561,000       Total operating expenses   6,495,000   13,083,000   OPERATING LOSS    (656,000)  (5,338,000)Interest expense    (118,000)    (140,000)Other income (expense), net    (146,000)     163,000         Loss from continuing operationsbefore income taxes    (920,000)  (5,315,000)Income tax           -            - NET  LOSS$    (920,000)$  (5,315,000)        Net loss per common share - basic and diluted$        (.06)$        (.36)Weighted average number of        common shares - basic and diluted  14,719,051   14,581,944 See accompanying notes.
 

F-4

 

 

NETLOJIX COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2002 and 2001       
Preferred Stock
Common StockDeffered       Compensation
Additional      Paid-In(Accumulated      Treasury StockSharesAmountDividendsShares
AmountStockCapitalDeficit)Shares
Amount
TotalBALANCES,December 31, 2000    148,000       1,000     102,000  14,482,000      145,000           -  28,554,000  (24,447,000)   (163,000)     (2,000)   4,149,000       Issuance of restricted stock          -           -     200,000        2,000     (20,000)     20,000            -           -           -        2,000       Stock Compensation earned          -           -           -            -       4,000           -            -           -           -        4,000       Purchase of stock from 401k plan          -           -           -            -           -      (4,000)           -     (25,000)          -       (4,000)Net loss          -           -           -            -           -           -   (5,315,000)          -           -   (5,315,000)                     - December 31, 2001    148,000       1,000     102,000  14,682,000      147,000     (16,000) 28,570,000  (29,762,000)   (188,000)     (2,000)  (1,164,000)      Deferred Compensation - restricted stock          -           -           -            -       7,000           -            -           -           -        7,000       Retirement of 401k stock          -           -     (25,000)           -           -           -            -           -           -            - Retirement of CWE escrow shares          -           -     (31,000)           -           -           -            -      25,000           -            -       issued Litigation Shares          -           -     232,000        2,000           -      61,000            -           -           -       63,000 Net loss          -           -           -            -           -           -     (920,000)          -           -     (920,000)December 31, 2002    148,000  $       1,000  $     102,000  14,858,000  $      149,000  $      (9,000) $  28,631,000  $  (30,682,000)   (163,000) $      (2,000) $   (2,014,000)      See accompanying notes.
F-5

 

 
NETLOJIX COMMUNICATIONS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS        YEARS ENDED DECEMBER 31, 2002 AND 2001
2002
2001        CASH FLOWS FROM OPERATING ACTIVITIES:Net loss from operations$    (920,000)$  (5,315,000)        Adjustments to reconcile net loss from operations          to cash provided by (used by) operating activities:Depreciation and amortization     835,000    1,561,000         Provision for intangible asset impairments           -    5,099,000 Provision for bad debts     218,000      119,000         Gain on sale of Contracts and Customer List           -     (203,000)Litigation settlement (recovery)           -     (684,000)Stock compensation earned       7,000        4,000         Changes in operating assets and liabilities:Accounts receivable     818,000      292,000 Due from affiliates     144,000      271,000 Other current assets     109,000       85,000 Litigation settlement liability      (4,000)    (183,000)Accounts payable and accrued liabilities  (1,498,000)    (230,000)        Cash provided by (used by) operating activities    (291,000)     816,000         CASH FLOWS FROM INVESTING ACTIVITIES:Additions to property and equipment     (61,000)    (149,000)  Cash used by investing activities     (61,000)    (149,000)        CASH FLOWS FROM FINANCING ACTIVITIES:Principal payments on capital leases     (15,000)     (18,000)        Amount borrowed (paid) on line of credit, net     773,000     (751,000)Amounts paid on long term borrowings      (5,000)      (6,000)Purchase of treasury stock           -       (4,000)          Cash provided by (used by) financing activities     753,000     (779,000)        Net increase (decrease) in cash and cash equivalents     401,000     (112,000)        Cash and cash equivalents at beginning of period   72,000  184,000        Cash and cash equivalents at end of period$     473,000 $      72,000         Cash paid (received) during the period:Interest - operations$     118,000 $     140,000 Income taxes - operations           -            - Noncash investing and financing activities:$           - $           - See accompanying notes.
F-6
 
 

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

(1)     Summary of Significant Accounting Policies

        (A)     Business and Background

        NetLojix Communications, Inc. ("NetLojix" or the "Company") provides technologyand network management services that enable businesses to operate effectively inthe increasingly complex world of electronic commerce and communications. The services we provide include advanced Internet, data, and voice connectivity,technical support and application development and hosting services.  We are a single-source provider of enterprise network solutions integrating ourcomplete portfolio of broadband connectivity; applications development andhosting; and technical help desk, system integration and maintenance. Oursupport teams provide design, implementation and management of LAN, WAN andeBusiness solutions, including frame relay, DSL, iVPN, VOIP and Internet access. We offer these services on a stand-alone basis or bundled as part of a totalsolution.  

        (B)      Going Concern

        The Company is in default under its secured credit facility and cannot borrowadditional funds.  In addition, at December 31, 2002, the Company had aworking capital deficit of $2,765,000 and a stockholders' deficit of$2,014,000.  These factors raise substantial doubt about the Company'sability to continue as a going concern.  See Note 15 for management's plansin this regard.

        The consolidatedfinancial statements have been prepared assuming that the Company will continueto operate as a going concern, which contemplates the realization of assets andthe settlement of liabilities in the normal course of business.  Noadjustment has been made to the recorded amount of assets or the recorded amountor classification of liabilities which would be required if the Company wereunable to continue its operations.

        (C)     Principles of Consolidation

        The consolidated financial statements include the accounts of the Company andits wholly owned subsidiaries. All significant intercompany balances andtransactions have been eliminated in consolidation.

        (D)      Depreciation Excluded from Cost of Sales

        We have excluded $102,000 and $100,000 in depreciation from Cost of Sales forthe years ended December 31, 2002 and 2001, respectively.  Such amounts areincluded in depreciation in the operating expense section of the Statement ofOperations and represents depreciation of equipment used in our data center.

        (E)     Accounts Receivable

        Accounts receivable are net of allowances fordoubtful accounts and other provisions of $239,000 as of December 31, 2002. Interest is not accrued on overdue accounts receivable.  The allowance fordoubtful accounts receivable is charged to income in amounts sufficient tomaintain the allowance for uncollectible accounts at a level management believesis adequate to cover any probable losses.  Management determines theadequacy of the allowance based on historical write-off percentages andinformation collected from individual customers.  Accounts receivable arecharged off against the allowance when collectibility is determined to bepermanently impaired (bankruptcy, lack of contact, account balance over one yearold, etc.). 

 

F-7

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

        (F)     Revenue Recognition

       Revenues for long distance, frame relay, Internet, applications development andweb hosting services are recognized as service is provided. Amounts paid inadvance are recorded as unearned revenue and recognized as services areprovided.  Within the Technical Support Services segment, we sell servicesunder hourly service contracts (whether prepaid or billed in arrears), flat feeservice contracts or prepaid maintenance contracts.  For prepaidmaintenance contracts, we recognize revenue ratably over the service period. A small number of our applications development contracts contain customeracceptance provisions.  In accordance with SAB 101, we recognize revenue onsuch contracts only after a customer has indicated acceptance or the customeracceptance period has lapsed.  For all other services, revenues arerecognized when the services are rendered. 

        (G)     Property and Equipment

        Property andequipment are recorded at cost. Maintenance and repairs are charged againstincome as incurred, while renewals and major replacements are capitalized. Thecost and related accumulated depreciation of assets sold or retired are removedfrom the accounts, and any resulting gain or loss is reflected in operations. Weprovide depreciation of fixed assets using the straight-line method over thefollowing estimated useful lives of the respective assets.
Computer equipment & software2-5 yearsOffice furniture and equipment1-7 yearsLeasehold improvementsLease termVehicles3 years
        (H)     Goodwill

       Goodwill represents the excess of purchase price over the fair value of netassets acquired in various acquisitions.  Using FAS-121 we assess therecoverability of our recorded goodwill by determining whether the amortizationof the goodwill balance over its remaining life could be recovered throughundiscounted future cash flows of the acquired businesses.  We recognizedthe possibility of impairment to the goodwill recorded for the acquisitions ofRemote Lojix/PCSI, Inc., Smith Technology Solutions, Inc., and CW ElectronicEnterprises, Inc. due to a significant change in business climate. Increased competition applying downward pressure on prices, economic factorscausing reduced spending by all customers and the loss of a few key customersled us to this conclusion.  The calculation of the estimated undiscountedfuture cash flows for these three Technical Support Service acquisitions did notsupport that any of the recorded goodwill in the net amount of $4,248,000 wouldbe recovered.  This amount was written off as of December 31,2001.

        (I)     Customer Bases Acquired and Other Intangible Assets

       Customer Bases Acquired of $0 and $290,000 as of December 31, 2002 and 2001,respectively, is recorded net of accumulated amortization of $1,583,000 and$1,293,000, respectively. The customer bases acquired were recorded in otherassets and were amortized on a straight-line basis over five years. We also have included in intangible assets the covenants-not-to-compete obtainedin connection with two acquisitions in 2000, the balance of which was $0 and$75,000 as of December 31, 2002 and 2001, respectively, net of accumulatedamortization of $200,000 and $125,000. These covenants-not-to-compete wereamortized on a straight-line basis over the contract period of two years. 

        Using FAS-121 we assess the recoverability of these intangible assets bycomparing the recorded value to estimated undiscounted future cash flows fromthe use of the asset. The amount of impairment, if any, is measured based on thedifference between the recorded net book value and the estimated fair value ofthe intangible assets.  We recognized the possibility of impairment to theCustomer Bases recorded

 

F-8

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

for the acquisitions of Smith TechnologySolutions, Inc., and CW Electronic Enterprises, Inc. due to a significant changein business climate.  Increased competition applying downward pressure onprices, economic factors causing reduced spending by all customers and the lossof a few key customers led us to this conclusion.  The calculation of theestimated undiscounted future cash flows for these two Technical Support Serviceacquisitions did not support that any of the recorded Customer Bases in the netamount of $851,000 would be recovered.  This amount was considered fullyimpaired as ofDecember 31,2001, and was expensed.

       The Company adopted SFAS 142 on January 1, 2002. Under the new rules, theCompany is no longer permitted to amortize intangible assets with indefinitelives; instead they will be subject to periodic tests for impairment.  SFAS142 supercedes APB Opinion #17, Intangible Assets. In accordance with SFAS 142,the Company also performed an impairment test of its remaining customer base asof January 1, 2002 and determined that no write-down was necessary.  As ofDecember 31, 2002 we have fully amortized all intangible assets.

        With all intangible assets with indefinite lives having been written off due toimpairment, previously reported net income and earnings per share will not needadjustment for the exclusion of amortization expense for goodwill, net of incometax. There is no estimated amortization expense for each of the next five yearsended December 31.

        (J)     Use of Estimates

        Management has made a number of estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses during the reporting period to preparethese consolidated financial statements in conformity with generally acceptedaccounting principles.  Actual results could differ from those estimates.

        (K)       Concentrations of Credit Risk 

        Our customers are primarily small to mid-size (50-500 employees) business ownersand are not concentrated in any specific geographic region of the United States.There are slight concentrations around NetLojix's offices in New York, Chicago,Fort Worth, Texas and California.  We generally extend credit to ourcustomers and accounts receivable are generally not collateralized. As ofDecember 31, 2002, three customers comprise $620,000, or 49%, of the accountsreceivable balance as listed below.
SG Cowen Securities      Corporation
$323,000Excel Agent Services, LLC173,000American Administrative Group,      Inc.124,000
$620,000
        In addition, SG Cowen Securities Corporation represents approximately 16.2% ofthe Company's revenues for the year ended December 31, 2002.  This customerreduced its usage of our services in 2002, and has indicated that it willfurther reduce or eliminate its usage of our services in 2003.  Wecurrently do not know if that customer will continue to utilize our services inthe remainder of 2003.

F-9

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

        (L)     Financial Instruments

       Our financial instruments include cash, receivables, payables, and accruedexpenses. The carrying amount of such financial instruments approximates fairvalue because of the short maturity of these instruments.

        (M)     Loss Per Share

        Basic and diluted loss per share has been computed using the weighted averagenumber of shares of common stock outstanding during the period. We have excludedall outstanding convertible preferred stock and outstanding options and warrantsto purchase common stock from the calculation of diluted net loss per share assuch securities are antidilutive for all periods presented. Comprehensive lossfor the years ended December 31, 2002 and 2001 is equal to net loss reported forsuch periods.

        (N)     Reclassifications

        Certain reclassifications have been made to prior period amounts in order toconform to current year presentation.

        (O)     Advertising Costs

        Costs incurred forproducing and communicating advertising are expensed as incurred and areincluded in selling, general and administrative expenses. Consolidatedadvertising expense amounted to $63,000 and $62,000 in 2002 and 2001,respectively.

        (P)    Recently-issuedaccounting pronouncements

        In June 2001, the Financial AccountingStandards Board issued SFAS 141 "Business Combinations", and SFAS 142, "Goodwilland Other Intangible Assets", effective for fiscal years beginning afterDecember 15, 2001.  Under the new rules, goodwill and certain intangibleassets will no longer be amortized but will be subject to annual impairmenttests.  Other intangible assets with finite useful lives will continue tobe amortized over their useful lives.  We do not expect any material effecton our financial position or results of operations from the adoption of thesestatements.  The Company adopted this pronouncement on January 1, 2002.

        In August 2001, the FASB issued SFAS143, "Accounting for Asset Retirement Obligations", effective for fiscal yearsstarting after June 15, 2002.  SFAS 143 establishes accounting standardsfor recognition and measurement of a liability for the costs of asset retirementobligations.  Under SFAS 143, the costs of retiring an asset will berecorded as a liability when the retirement obligation arises, and will beamortized to expense over the life of the asset.  We do not expect anymaterial effect on our financial position or results of operations from theadoption of this statement. The Company adopted this pronouncement on January 1,2003.

         In October 2001, the FASB issued SFAS 144, "Accounting for the Impairment orDisposal of  Long-Lived Assets" , effective for fiscal years starting afterDecember 15, 2001 and interim periods within those years.  SFAS 144addresses financial accounting and reporting for the impairment or disposal oflong-lived assets and discontinued operations.  We do not expect anymaterial effect on our financial position or results of operations from theadoption of this statement. The Company adopted this pronouncement on January 1,2002. 

F-10

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

        In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated withExit or Disposal Activities", which nullifies EITF Issue 94-3.  SFAS 146 iseffective for exit and disposal activities that are initiated after December 31,2002 and requires that a liability for a cost associated with an exit ordisposal activity be recognized when the liability is incurred, in contrast tothe date of an entity's commitment to an exit plan, as required by EITF Issue94-3.  We do not expect any material effect on our financial position orresults of operations from the adoption of this statement. The Company adoptedthis pronouncement on January 1, 2003. 

(2)     Acquisitions and Dispositions

        On September 30, 2001 we sold a portion of our New York technical supportservices business (consisting of our New York City customer list and relatedcustomer contracts) to Laser Printer Care Company, Ltd. We retained all of ourhelp desk customers and contracts. This was a non-cash transaction. Theconsideration consisted of the purchaser assuming our responsibility for unusedcustomer retainers and remaining terms on service agreements, which we held asliabilities.  We recorded a gain (net of costs) of $203,000 in connectionwith this sale as a result of the removal of these liabilities. In addition, ifthe purchaser was able to renew retainers, service agreements or provide anyadditional services to the customers that were transferred, then it was to payus 5% of any such cash received prior to September 30, 2002. We have recorded$3,918 in such additional payments as of September 30, 2002.  No pro formatable is included due to the immaterial difference in results of operations.

(3)     Property and Equipment

        Property and equipment consisted of the following:
        
December 31, 2002 Computer equipment & software
$
1,558,000 Office furniture and equipment
 
279,000 Leasehold improvements 
    308,000 Vehicles 
                    32,000 Total property and equipment 
2,177,000 Accumulated depreciation and      amortization 
             (1,471,000)Property and equipment, net
$
   706,000 
           We recognized total depreciation and amortization expense of $467,000 for 2002. 

(4)     Stockholders' Equity

*        Issuance and Conversion of Preferred Stock*

       The Series A Convertible Preferred Stock ("Series A Stock") is convertible, on aone-to-one basis, into shares of our common stock.

*        Common Stock Transactions*

        On April 30, 2001, we sold a total of 200,000 shares of our restricted stock totwo of our officers and directors under our 1998 Stock Incentive Plan at a priceof $.01 per share. These shares vest 30% at the end of each of the first twoanniversary dates of their issuance and

F-11

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

40% on the third anniversary of their issuance.The difference between the purchase price and the fair market value of the stockat the time of grant is being amortized over the restriction period.  Eachof the two individuals was also granted an option to purchase 400,000 shares ofour common stock under the same plan with the same vesting schedule at anexercise price of $.11 per share. Also in April 2001, we granted to otheremployees, options to purchase 18,000 shares under the same plan at exerciseprices of $.14 and $.17 per share. The options vest at the rate of 25% on eachanniversary of issue.  In the third quarter of 2001 we issued options totwo directors and one employee to purchase 100,000 shares of common stock eachat $.14. The employee's options vest equally over 4 years and the directors'options vest equally over two years.  The above options were all issued atthe fair market value of the stock at the date of grant.

        During December 2001, we repurchased 25,000 shares of our common stock from the NetLojix Communications, Inc. Employees' savings plan and Trust (the "401(k)Plan") at a price of $0.16 per share.  These were unallocated shares thathad been part of the employer contribution to the 401(k) Plan and wererepurchased as a result of our decision to remove stock ownership as an optionunder the 401(k) Plan.  At December 31, 2001 these shares are reflected intreasury stock on the Consolidated Balance Sheet.  These 25,000 shares wereretired in the first quarter of 2002.

       During April 2002, we retired 30,274 shares of our common stock out of the100,000 shares held in escrow from the purchase of CW Electronic Enterprises,Inc. ("CWE2") in 2000.  These shares were returned to NetLojix due todiscrepancies in CWE2's balance sheet at the time of purchase.  Theremaining 69,726 shares were released from escrow to the former owner of CWE2. 

        On August 20, 2002, we issued 232,000 shares of our common stock as part of thesettlement of all outstanding claims under the class action lawsuit initiated inDecember 1998.

*        Common Stock Warrants*

        In January 2000, we retained Kaufman Bros., L.P ("Kaufman Bros.") to act as ourfinancial advisor and investment banker.  As compensation for investmentbanking services, we agreed to pay $25,000 and issue 100,000 warrants expiringin January 2005 to purchase our common stock at an exercise price of $3.28.Using the Black-Scholes pricing model, the fair value of the warrants wasestimated to be $216,000, which was recorded as an expense during the firstquarter of 2000. In addition, we agreed to compensate Kaufman Bros. for anyfinancing or merger transactions facilitated by them in accordance with aspecified fee schedule. Kaufman Bros. ceased providing services to us in August2001.  

        On August 20, 2002, we issued warrants to purchase 200,000 shares of commonstock at an exercise price of $8.00 per share as part of the settlement of alloutstanding claims under the class action lawsuit initiated in December 1998. On October 14, 2002, we exercised our right to redeem all of the warrants for aredemption price of $.05 per share of common stock issuable upon exercise of thewarrants.  As a result, the warrants are no longer outstanding.

        On March 2, 2000, we issued warrants to purchase 75,000 shares of common stockat an exercise price of $5.25 per share to AMRO International, S.A. inconnection with a private placement of our common stock. These warrants expiredon March 1, 2003.

* *

F-12

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

*       Stock Option Grants*

        In 1997, we adopted the 1997 Incentive Stock Option Plan (the "1997 Plan") forstock option grants to officers and key employees.  The 1997 Planauthorizes grants of options to purchase up to 250,000 shares of authorized but unissued common stock and 125,000 shares of restricted common stock.

        Stock options are to be granted with an exercise price greater than or equal tothe stock's fair market value at the date of grant.  Options generally vest25% after one year and 25% each year thereafter until fully vested.  Suchoptions typically expire after ten years. As of December 31, 2002, options topurchase 58,000 shares had been exercised and options to purchase 49,000 shareswere outstanding under the 1997 Plan.  Exercise prices range from $3.00 to$12.00 per share.  In addition, 120,000 shares of restricted stock had beenawarded under the 1997 Plan, all of which have vested in full.

        During 1998, we adopted the 1998 Stock Incentive Plan (the "1998 Plan"), whichinitially provided for the issuance of up to 1,500,000 shares of NetLojix commonstock pursuant to stock options and issuances of restricted stock, as well asfor the grant of stock appreciation rights. At our annual meeting on May 25,2000, the stockholders approved an amendment to the 1998 Stock Incentive Planincreasing the number of shares authorized for issuance under the plan by1,500,000 shares. All stock options granted have an exercise price greater thanor equal to the stock's fair market value at the date of grant.  Optionsgenerally vest 25% after one year and 25% each year thereafter until fullyvested.  Such options typically expire after ten years. As of December 31,2002, options to purchase 75,000 shares had been exercised and options topurchase 2,291,000 shares were outstanding under the 1998 Plan.  Exerciseprices range from $0.11 to $5.375 per share. In addition, 200,000 shares ofrestricted stock had been awarded under the 1998 Plan, 60,000 of which hadvested. 

        During 2001, we granted incentive stock options to two executive officers topurchase a total of 800,000 shares of our common stock at an exercise price of$.11, which was equivalent to the fair market value of the stock at the date ofgrant. The options vest at a rate of 30% per year for the first two years and40% at the end of the third year and were granted pursuant to the 1998 Plan. We also granted incentive stock options under the 1998 Plan to other employeesand officers to purchase a total of 130,000 shares of our common stock atexercise prices ranging from $.13 to $.41 (average exercise price of $.14 pershare), which was equivalent to the fair market value of the stock at the dateof grant. The options vest at a rate of 25% per year over four years.

        During 2001, we granted non-statutory stock options to two Directors to purchasea total of 200,000 shares of our common stock at an exercise price of $.14,which was equivalent to the fair market value of the stock at the date of grant.The options vest at a rate of 50% per year for two years and were grantedpursuant to the 1998 Plan.

        We apply APB Opinion No. 25 in accounting for the 1997 Plan and 1998 Plan;accordingly, no compensation cost has been recognized in the financialstatements for stock options issued to employees.  For stock optionsgranted to non-employees, we account for such options in accordance with therequirements of SFAS No. 123.  Had we determined compensation cost based onthe fair value at the grant date for stock options issued to employees underSFAS No. 123, our financial statements would have reflected the followingamounts: 

                                                                                                                    
  Year    ended December 31,
 
2002
 
2001Additional compensation expense
$
548,000 
$
750,000 Pro forma net loss from    operations
$
(1,468,000)$
(6,065,000)Pro forma net loss from    operations per common share
    $
       (.10) $
       (.42)
 

F-13

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

Pro forma compensation cost for 2001 was estimated using theBlack-Scholes option-pricing model with the following weighted-averageassumptions for 2001: expected volatility of 150%, risk-free interest rate of5.0%; expected life of 8.5 years; and no expected dividend yield for any year. There were no new option grants in 2002.

**OPTIONS SUMMARY**-Stock  option activity is as follows:
      
  Weighted      Average 
Options
   Exercise      Price
Grant-date      Fair Value    Outstanding as of December 31,      2000
  1,924,000 
   3.07
       Granted
    1,127,000 
   0.12
   0.12    Expired
0 
   0
       Canceled
(320,000)
   2.36
       Exercised
                  0 
   0
   Outstanding as of December 31,      2001
2,731,000 
   1.94
        Granted
0 
    0
   0.00     Expired
(85,000)
    3.10
      Canceled
  (306,000)
    3.06
      Exercised
                    0 
   0
 Outstanding as of December      31,2002
   2,340,000 
 1.75
 
                Total expense recorded for stock based awards during 2002 and 2001 was $7,000and $4,000, respectively. 

               The following table summarizes certain information about our stock options atDecember 31, 2002.

                                 Options    Outstanding                                              
  Options Exercisable  
 
 
Weighted 
 
  
 
 
 
Average 
Weighted
  
Weighted
 
 
Remaining 
Average
  
Average
Range of
Number of
Contractual 
Exercise
Number of  
Exercise
Exercise Prices
Options
Life 
Price
Options  
Price      
$ .11 -.25
1,272,000
7.57 years$0.13
445,000$  0.14
   1.78 - 2.13
155,000
7.50 years 1.90
88,000 1.90
   2.78 - 3.28
514,000
7.12 years3.16
301,000 3.17
   4.00 - 5.38
386,000
5.77 years 4.82
309,000  4.78
  8.00 - 12.00
     13,000
3.89 years10.66
      13,000 10.66
 
2,340,000
7.15 years 1.75
 1,156,000  2.42
       At December 31, 2002, we had reserved a total of 3,245,000 shares for issuanceupon conversion of outstanding preferred stock, and exercise of options andwarrants.

 

 

F-14

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

(5)     Federal and State Income Taxes

          Income tax benefit differs from the amounts computed by applying the U.S.federal income tax rate of 34 percent to loss from continuing operations beforeincome taxes as a result of the following:
        Year ended December 31,
 
2002
 
2001Computed "expected" tax      benefit
$
(313,000)
$
(4,595,000)State and local taxes, net      of federal  income tax effect
 
-
 
(30,000)Other permanent items
 
-
 
(17,000)Losses not providing tax      benefit
 
 -
 
 4,642,000 Other 
                   0  
                   0 
$
                    - 
$
                    - 
        Deferred income taxes as of December 31, 2002 and2001, reflect the impact of temporary differences between financial statementcarrying amounts and tax bases of assets and liabilities.  The tax effectsof temporary differences and net operating loss carryforwards that give rise tosignificant portions of the net deferred tax assets at December 31, 2002 and2001 are presented below:

                                                 December 31, 
2002
2001
Deferred tax assets:
      Net      operating loss carryforwards
  $              5,899,000 $          5,586,000 
      Compensation      related items 
196,000   552,000 
      Contingent      liabilities and other  
         171,000               255,000 
      Gross      deferred tax asset 
6,266,000 6,393,000 
      Less      valuation allowance 
         (6,266,000)     (6,393,000)
                     Deferred tax asset 
                          0                          0 
       The valuation allowance for deferred tax assets decreased by $127,000 andincreased by $957,000 during 2002 and 2001, respectively.  

         At December 31, 2002, we have net operating loss carryforwards for federal taxpurposes of approximately $14,667,000, which are available on a limited basis tooffset future federal taxable income, if any, through 2022.  A portion ofthese net-operating losses may be subject to annual limitations as imposed byInternal Revenue Code Section 382. The valuation allowance recorded inconnection with the reverse acquisition of AvTel by Matrix Telecom and theacquisition of Remote Lojix, STS and CWE2 was approximately $3,450,000. 

(6)     Related Party Transactions

          We have had transactions in the normal course of business with various companieswho are related to our shareholders.  We provide long distance and datanetwork service to a number of such related companies. Balances related tooperating activities are settled monthly.  The natures of the relationshipsthat generate the revenues are effectively the same as all other customerrelationships held by the Company. The agreements are standard term agreements. We neither receive nor provide any benefit outside of a standardcustomer-supplier relationship.

 

 

F-15

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

       For the year ended December 31, 2002, revenue from related parties as apercentage of total revenue increased 7 percentage points to 27%, with theincrease growing throughout the year.  The increase was mainly due to theloss of, or reduced services to, non-affiliated customers such as Infosys, SGCowen Securities Corporation, ABN AMRO Inc. and the New York City technicalsupport services customers sold to Laser Printer Care Company Ltd. However, UICI (a public company affiliated with certainstockholders of NetLojix) terminated NetLojix as its long distance servicesprovider as of December 2002.  For the twelve months ended December 31,2002, UICI accounted for approximately $2,084,000 of NetLojix's $3,929,000affiliated revenue.

        On January 31, 2002, NetLojix's secured credit facility with Coast BusinessCredit expired, and NetLojix entered into a new secured credit facility with DTLOne, LLC ("DTL").  DTL is owned and controlled by director Jeffrey J.Jensen. Under the DTL line of credit, NetLojix may borrow up to 80% of eligiblereceivables (as defined) up to a total amount of $2.0 million.  Borrowingsunder the line of credit bear interest, payable monthly, based upon the primerate of Bank of America NT & SA plus 2% with a minimum interest rate of 10%.Borrowings under the credit facility are secured by substantially all assets ofNetLojix. The credit facility also prohibits the payment of dividends and limitsthe size of business acquisitions that we may make without the prior consent ofDTL.  The Company is in violation of the maximum borrowing provisions ofthis credit facility and may not borrow additional amounts.  DTL has notified the Company that it does not intend to renew the line ofcredit when it expires on January 31, 2004.

        Between 1998 and 2000, NetLojix loaned or advanced Craig R. Clark, its formerVice President of Business Development, a total of $86,000, including interest. All of these loans and obligations are unsecured.  On January 15, 2002,NetLojix entered into a separation agreement with Craig R. Clark.  As aresult of the agreement, Mr. Clark resigned from all positions with NetLojix,effective March 31, 2002.  NetLojix then notified Mr. Clark that the loanwas due and payable in full.  NetLojix has not yet received any paymentfrom Mr. Clark.  We chose to reserve for the total amount advanced as ofJune 30, 2002.

(7)     Loss Per Common Share

          Loss per common share is computed as follows: 

 
2002
 
2001
Numerator:

    Net loss

$
(920,000)
$
(5,315,000)
    Preferred dividends

 
                 - 
 
                     - 
    Loss applicable to        common shareholders

$
 (920,000)
$
(5,315,000)
Denominator:

 
 
 
 
Weighted average     number of common     shares used in basic and    diluted loss per common share

 14,719,051 
  14,581,944 Basic and diluted net loss per common      share

$
     (.06)
$
     (.36)
          There are 2,515,000 and 3,065,000 potential common shares excluded from thediluted loss per common share calculation for 2002 and 2001, respectively,because the effect is determined to be antidilutive.

 

F-16

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002**

(8)     Commitments

          We lease office space and various equipment under operating leases which expirein various years through 2006.  In the normal course of business, operatingleases are generally renewed or replaced by other leases. Total rental expensewas $658,000 in 2002 and $742,000 in 2001. Future minimum lease payments undernon-cancelable operating leases (with initial or remaining lease terms in excessof one year) as of December 31, 2002 are: $301,000; 2003 - $206,000; 2004 -$163,000; 2005 - $124,000; 2006 - and $0; 2007.

          NetLojix currently has multiple contracts for switching and transmissionfacilities, equipment, network lines and software.  The total commitment isapproximately $475,000 with termination dates ranging from present throughsecond quarter 2005.  The commitment consists of a number of smallcontracts with venders for services with varying minimum amounts and terminationdates, none of which is material.  The larger telecom contracts withminimum commitments that we have had in the past have been renegotiated toexclude minimums. 

(9)      Lines of Credit

           On January 31, 2002, we repaid our secured credit facility with Coast BusinessCredit ("CBC") and entered into a new secured credit facility with DTL One, LLC("DTL").  DTL is owned and controlled by director Jeffrey J. Jensen. Under the DTL line of credit, we may borrow up to 80% of eligible receivables(as defined) up to a total amount of $2.0 million.  Borrowings under theline of credit bear interest, payable monthly, based upon the prime rate of Bankof America NT & SA plus 2% with a minimum interest rate of 10%. Borrowings underthe credit facility are secured by substantially all of our assets. As of March25, 2003, approximately $1.2 million is outstanding under the credit facility,and no additional amounts may be borrowed under the formula described above. NetLojix has been in default under the credit facility since January 2003,because our borrowings exceed the 80% of eligible receivables limitation. DTL has notified us that it does not intend to renew the line of credit, but hasnot yet exercised its right to accelerate the required repayment of the amountsdue under the facility.  The credit facility also prohibits the payment ofdividends and limits the size of business acquisitions that we can make withoutthe prior consent of DTL.  

           During 2000, we acquired STS subject to STSs line of credit with an outstandingbalance of $91,000 at the date of acquisition. This line, which was secured byall the assets of STS, was repaid in full in early January 2001. Also, in 2000,we acquired CWE2 subject to CWE2's line of credit with a balance of $250,000 atthe date of acquisition. This line is secured by all the assets of CWE2. InDecember 2000 this amount was converted to a term note with payments over twoyears with interest at the lenders base rate plus .5%, or 6.5% at October 31,2002.  The balance of the note was repaid in full in October 2002.

(10)     Segment Reporting

            The primary business segments are Network Connectivity, Technical SupportServices and Application Development and Hosting. All of our services aretargeted toward corporate companies within the United States.  Parentcompany costs are allocated to each segment based on revenue.  However,extraordinary items are not allocated.

 

 

F-17

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002**

 

        The Network Connectivity segment includes services that are point-to-pointconnections of voice or data traffic.  We provide traditional long distanceservices, calling card, dedicated voice and data access and numerous Internetservice options.  Telecommunications product offerings include dedicated orleased lines, switched long distance, frame relay, calling cards, and "1-800"services.  Internet product offerings within the network connectivitysegment include dial-up access, DSL, ISDN and dedicated access.  Thissegment includes the Internet connectivity portion of our Southern Californiabased ISP. 

        The Technical Support Services segment encompasses a broad array of technicalsupport services and solutions including system integration, desktop and networksupport, asset management and help desk solutions. Services include flat-feemaintenance contracts, prepaid time block retainers, help desk managementcontracts, LAN installations, warranty repairs and a small amount of hardwaresales. 

*        *The Applications Development and Hosting servicessegment includes producing, designing, and programming creative multimediaapplications that can be produced as a web application or a stand aloneapplication and hosting including shared, dedicated, co-location and managedservices. 

        We measure our performance based on revenues, gross margin and net income orloss.  

         The results by segment for the years ended December 31, 2002 and 2001 are asfollows:
  
2002
 
 

Network    ConnectivityServices
 

Technical    Support    Services
 

Applications    Development and Web Hosting
 

Total      Revenues                          
 $
7,889,000 
5,043,000 1,545,000 14,477,000 Gross margin
 
2,618,000 
1,986,000 1,235,000 5,839,000 Selling, general &    administration
 
2,622,000 
2,215,000 823,000 5,660,000 Depreciation & amortization
 
531,000 
203,000 101,000 835,000 Interest expense
 
60,000 
47,000 
11,000 118,000 Other (income) expense
 
              57,000 
         74,000 
        15,000          146,000 Net income (loss)
$
(652,000)(553,000)285,000 (920,000)Total assets
 

$
1,481,000 
826,000 370,000 
2,677,000 
 

 

F-18

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 
  
2001
 
 

Network    ConnectivityServices
 

Technical    Support    Services
 

Applications    Development and     Web Hosting
 

Total      Revenues                          
 $
9,741,000 
7,773,000     1,627,000
19,141,000 Gross margin
 
3,417,000 
3,134,000     1,194,000    7,745,000 Selling, general    & administration
 
2,937,000 
3,553,000     820,000
7,310,000 Depreciation &    amortization
 
554,000 
924,000     83,000
1,561,000 Interest expense
 
 78,000 
  62,000  
-
140,000 Other (income)    expense
 
 (246,000)
80,000  
3,000    (163,000)Sale of New York    Technical Support Services Assets
 
 -  203,000  -    203,000 Provision for    asset impairment
 
      -     (5,099,000)
      -    (5,099,000)Corporate    litigation settlement
 
                     -                         -                     -              684,000 Net income (loss)    
 

$
94,000  
 (6,381,000) 
288,000(5,315,000)Total assets
 

$
2,366,000 
1,488,000  485,000
4,339,000 
 

                   Within the three business segments there are multiple types of revenue which arestated separately below:

                                          For the year ended December 31,
 
2002
2001Network Connectivity Services Data & Voice Services$5,522,000 
$         6,859,000       Internet Services 
 2,367,000 
          2,882,000      Technical Support Services
 Technical Support1,668,000 
          3,072,000      Help Desk Services
 3,264,000
          4,567,000Hardware
 111,000 
                  134,000 Applications Development and Web HostingApplications Development400,000                  495,000 Web Hosting     1,145,000             1,132,000 $
14,477,000
$
19,141,000
(11)     Contingencies

            We were defendants in a class action lawsuit under the federal securities lawsfiled in the United States District Court of the Central District of California. This litigation alleged securities fraud as it relates to an unusual upsurge inthe Company's stock price and trading volume on November 12, 1998, when tradingin our stock was halted by Nasdaq. On October 4, 2000, we finalized an agreementwith counsel for

 

F-19

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

the plaintiff class to settle all outstanding claims under theclass action lawsuit. This agreement received the preliminary approval of thecourt on November 8, 2000, and we thereafter paid $150,000 (including $30,000 in2000 and $120,000 in 2001) for administrative costs and other settlementimplementation expenses. On May 29, 2001 the court entered its final order ofdismissal and approval of the settlement.  During the third quarter of2002, we issued for distribution to the claimant class members, and payment ofthe plaintiffs attorneys' fees and litigation expenses, a total of 232,000shares of common stock and warrants to purchase 200,000 shares of NetLojix'scommon stock at an exercise price of $8.00 per share with a term of 2 years.  On October 14, 2002, we exercised our right to redeem all of the warrants for aredemption price of $.05 per share of common stock issuable upon exercise of thewarrants, or $10,000 in the aggregate.  As a result, the warrants are nolonger outstanding.

       During 2000, we recorded a charge against earnings of $998,000 and a liabilityrelating to the expected settlement.  The value of the settlement chargewas based on the shares being valued at the current stock price at the time of$3.06 and the warrant value being calculated by using the Black-Scholes method.On the date that the settlement became effective, this liability was adjustedusing the same method as stated above based on NetLojix current market value of$0.27. This resulted in credit to earnings in the second quarter of 2001 of$684,000.

        In connection with the sale in November 1999 of Matrix Telecom (a formersubsidiary of NetLojix), the final amount of the purchase price was to besubject to adjustment based on finalization of a balance sheet for MatrixTelecom as of August 31, 1999 and agreement by both parties. The purchasernotified us on December 16, 1999 that the purchaser materially disagreed withthe balance sheet of Matrix Telecom that we prepared.  We attempted toresolve the matter, but the purchaser resisted submitting the matter to anindependent firm of accountants chosen by the parties for final resolution, asrequired by the contract. We have had no contact with the purchaser regardingthis matter since February 2001, and have no indication that the purchaserintends to pursue this dispute.  If the purchaser were to pursue thedispute, and if it were to be resolved in the purchaser's favor, we could berequired to repay some of the purchase price to the purchaser in cash.  Anyadjustments in the purchase price would affect the purchase price and therecorded gain.  At this time, we do not believe that any change in thissituation will occur which would materially affect the recorded gain.

        In connection with our 1998 acquisition of Remote Lojix/PCSI, Inc. ("RemoteLojix"), we may be liable for certain obligations to third parties incurred byRemote Lojix and its prior affiliates outstanding at the time of our purchase ofRemote Lojix. We have accrued $461,000 in connection with these possibleliabilities. However our ultimate liability may exceed that amount.  OnMarch 10, 2003 we received an assessment from the New York State Department ofTaxation and Finance related to a portion of this liability in the amount of$115,000.

        We presently have other contingent liabilities relating to various other mattersrelated to the conduct of its business.  On the basis of informationfurnished by counsel and others, management believes that the resolution ofthese contingencies will not materially affect the financial condition orresults of operations.

(12)     Going private transaction

            On December 28, 2002, NetLojix Communications, Inc. ("NetLojix") entered into anAgreement and Plan of Merger (the "merger agreement") with NetLojix AcquisitionsCorporation ("NAC") providing for the merger of NAC with and into NetLojix, withNetLojix as the surviving corporation in the merger. NAC is owned and controlledby Anthony E. Papa and James P. Pisani, NetLojix's Chief Executive Officer andPresident, respectively (the "Executives"). Upon completion of the merger,NetLojix would become a privately held corporation all of the common stock ofwhich would be owned by the Executives. 

 

F-20

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

          The merger agreement provides that, at the effective time of the merger, allissued and outstanding shares of NetLojix common stock (other than shares ofNetLojix common stock held by NAC, the Executives or NetLojix, or shares subjectto properly exercised appraisal rights) will be converted into the right toreceive $0.02 in cash, without interest and less any applicable withholdingtaxes. The closing of the transaction is subject to certain conditions,including the approval of NetLojix stockholders.

(13)     Employee benefit plan

            We maintain a 401(k) plan for the benefit of all full time employees over theage of 21 with at least three months of service. Employees may make voluntarycontributions to the Plan subject to the contribution restrictions of ERISA.Vesting for employer contributions is on a proportionate schedule after 2 to 5years of service. We may make elective matching contributions. During the Planyear ended December 31, 2002, we made no elective matching contribution. Planexpenses incurred by the Company totaled $11,000, and $15,000 during 2002 and2001, respectively.

(14)     Quarterly Financial Data (unaudited)

            The following is a summary of the quarterly results of operations for the yearsended December 31, 2002 and 2001.
  Quarter Ended 2002
March 31,
June 30,  
September, 30
December 31,Net revenues$ 3,921,000 $   3,763,000 $  3,687,000 $   3,106,000 Gross margin 1,631,000    1,512,000   1,425,000    1,271,000 Net loss   (153,000)    (137,000)   (149,000)    (481,000)Basic and diluted loss per      share$            (0.01)$              (0.01)$              (0.01)$               (0.03)
 
   Quarter Ended2001
March 31,
June 30,  
September, 30
December 31,Net revenues$ 5,197,000$  4,951,000$   4,768,000$          4,225,000Gross margin 2,171,000  1,972,000   1,940,000          1,662,000Net Income (loss)   (413,000)          262,000          (138,000)    (5,026,000)Basic and diluted Income            (loss) per share$             (0.03)$               0.02$          (0.01)$               (0.34)
(15)     Management Plans

            As noted in Note 1 above, there is substantial doubt about the Company's ability tocontinue as a going concern.

            Based upon estimates of projected cash flows for the calendar year 2003,management believes that the Company's ability to continue in existence isdependent upon receiving new debt financing, cost reduction and general revenuesfrom the operations of the Company's subsidiaries, as to any of which there canbe no assurance.  Management is currently seeking potential lenders and iscontinuing to reduce costs.

 

 F-21

**NETLOJIX COMMUNICATIONS, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2002 **

 

(16)     Fourth Quarter Adjustment (unaudited)

            In the three months ended December 31, 2002 the Company recorded an adjustmentof $290,000 to amortize the cost of its Internet customer base.

 

 

 

F-22

 

**NETLOJIX COMMUNICATIONS, INC., AND SUBSIDIARIESSCHEDULE II - VALUATION AND QUALIFYING ACCOUNTSYEARS ENDED DECEMBER 31, 2002, 2001 AND 2000**

**  **
Balance at      beginning       of period AdditionsDeductionsAcquisition       
Balance       at end       of periodAllowance for doubtful     accounts and other     provisions - years ended:   
  
                December 31, 2002
$    128,000 
$   217,000(a)
 $    106,000(b)
                     -- 
$            239,000               December 31, 2001
  565,000 
  393,000(a)
  830,000(b)
 -------------- 
  128,000               December 31, 2000
  290,000 
  551,000(a)
  317,000(b)
 $  41,000 (d)  
  565,000
  
 
 
  
 Valuation allowance for      deferred tax asset:
  
 
 
  
                December 31, 2002
$  6,393,000 
$  (127,000)(c)
$                  -- 
$                     -- 
$  6,266,000               December 31, 2001
5,436,000 
   957,000(c)
                 --
                --  
6,393,000               December 31, 2000
4,428,000 
1,008,000(c)
                 -- 
                -- 
5,436,000
(a) Charged to selling, general and administration expense.   (b) Amounts written off.  (c) Recognized as a component of deferred tax assets.  (d) Allowance for receivables of acquired companies.

 

S-1

**INDEX TO EXHIBITS**

**Number**

**Exhibit**

2.1 

Stock Purchase Agreement dated August 31, 1999,  among the Registrant, Matrix Telecom, Inc. and Energy TRACS Acquisition Corp.  (Incorporated by reference to Exhibit 2.1 to Registrant's Current Report on  Form 8-K dated September 8, 1999). 

2.2 

First Amendment to Stock Purchase Agreement dated as of  September 16, 1999, among the Registrant, Matrix Telecom, Inc. and Matrix  Acquisition Holdings Corp. (Incorporated by reference to Exhibit 2.2 to  Registrant's Current Report on Form 8-K dated December 8, 1999) 

2.3

Agreement and Plan of Merger dated as of December 28,  2002, between the Registrant and NetLojix Acquisitions Corporation  (incorporated herein by reference to Appendix A to the preliminary proxy  statement on Schedule 14A filed by the Registrant on December 30, 2002).

3.1 

Certificate of Incorporation of the Registrant, as  amended. (Incorporated by reference to Exhibit 3.1 to Registrant's Quarterly  Report on Form 10-Q for the quarter ended June 30, 2000, File No. 0-27580). 

3.2 

By laws of the Registrant. (Incorporated by reference to  Exhibit 3.2 to Registrant's Annual Report on Form 10-KSB for the year ended  September 30, 1997, File No. 0-27580). 

10.1 

Rights Agreements dated October 23, 1996, between the  Registrant and holders of the Registrant's Series A Convertible Preferred  Stock. (Incorporated by reference to Exhibit 4.2 to Registrant's Current  Report on Form 8-K dated October 23, 1996, File No. 0-27580). 

10.2 

1997 Stock Incentive Plan. (Incorporated by reference to  Exhibit A to the Registrant's definitive Proxy Statement on Schedule 14A  dated January 8, 1997, File No. 0-27580). 

10.3 

1998 Stock Incentive Plan, as amended. (Incorporated by  reference to Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the  year ended December 31, 1999, File No. 0-27580). 

10.4 

Registration Rights and Lockup Agreement dated December  1, 1997, between the Registrant and Matrix Telecom, Inc., on behalf of the  stockholders of Matrix, (Incorporated by reference to Exhibit 4 to  Registrant's Current Report on Form 8-K dated December 1, 1997, File No.  0-27580). 

10.5 

Triple Net Real Property Lease (Multi-Tenant Building)  dated as of February 16, 1998, by and between Bath Street Partners, a  California limited partnership and the Registrant. (Incorporated by reference  to Exhibit 10.8 to Registrant's Annual Report on Form 10-K for the year ended  December 31, 1997, File No. 0-27580). 

10.6 

Stock Purchase Warrants granted by Registrant to Kaufman  Bros., L.P. as of January 10, 2000. (Incorporated by reference to Exhibit  10.15 to Registrant's Annual Report on Form 10-K for the year ended December  31, 1999, File No. 0-27580). 

 

 

10.7 

Stipulation of Settlement dated as of October 4, 2000,  among the Registrant and the representative plaintiffs in the securities  class action pending in the United States District Court for the Central  District of California (IN RE AVTEL SECURITIES LITIGATION, Case No. 98-9236).  (Incorporated by reference to Exhibit 10.1 to Registrant's Quarterly Report  on Form 10-Q for the quarter ended September 30, 2000, File No. 0-27580). 

10.8 

Promissory Note dated December 2, 1998, of Craig R.  Clark to the Registrant, and Promissory Note dated November 17, 2000, of  Craig R. Clark to the Registrant. (Incorporated by reference to Exhibit 10.20  to Registrant's Annual Report on Form 10-K for the year ended December 31,  2000, File No. 0-27580). 

10.9 

Assignment and Assumption Agreement dated as of  September 28, 2001, among the Registrant, Remote Lojix/PCSI, Inc. and Laser  Printer Care Company, Ltd.  (Incorporated by reference to Exhibit 2.1 to  Registrant's Quarterly Report on Form 10-Q for the quarter ended September  30, 2001, File No. 0-27580). 

10.10 

Employment Agreement dated as of September 10, 2001,  between the Registrant and Anthony E. Papa. (Incorporated by reference to  Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q for the quarter  ended September 30, 2001, File No. 0-27580). 

10.11 

Employment Agreement dated as of September 10, 2001,  between the Registrant and James P. Pisani.  (Incorporated by reference  to Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q for the quarter  ended September 30, 2001, File No. 0-27580). 

10.12 

Loan and Security Agreement dated as of January 31,  2002, among the Registrant, Remote Lojix/PCSI, Inc., NetLojix Telecom, Inc.,  Westnet Communications, Inc., CW Electronic Enterprises, Inc., Smith  Technology Solutions, Inc. and DTL One, LLC. (Incorporated by reference to  Exhibit 10.18 to Registrant's Annual Report on Form 10-K for the year ended  December 31, 2001, File No. 0-27580).

21 

List of Subsidiaries 

23 

Consent of Farber & Hass LLP, Independent Auditors 

99.1

Certification of Chief Executive Officer Pursuant to 18  U.S.C. 1350

99.2

Certification of Chief Financial Officer Pursuant to 18  U.S.C. 1350 |
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