** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 
| **For the  quarterly period ended September 30, 2004** | ** ** | **Commission File Number** | **1-13591** |
|--------------------------------------------------------|------------|----------------------------|-------------|

 

**AXS-ONEINC.**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **13-2966911**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
| ** **                                                       | ** ** | ** **                            |
| **301  Route 17 North  Rutherford, New Jersey**                  | ** ** | **07070**                             |
| (Address of  principal executive offices)                        |       | (Zip Code)                            |

 

**(201)935-3400**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether the registrant:  (1) has filedall reports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 
|   | YES | ý | NO | o |
|--------|-----|--------|----|---|

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 
|   | YES | o | NO | ý |
|--------|-----|---|----|--------|

 

 

Number of sharesoutstanding of the issuer’s common stock as of November 5, 2004

 
| **Class**                                | ** ** | **Number of Shares Outstanding** |
|------------------------------------------|------------|----------------------------------|
| Common Stock,  par value $0.01 per share |       | 28,274,983                       |

 

 

----

 

**AXS-ONEINC.**

 

**INDEX**

 
| **PART I**     | **FINANCIAL INFORMATION** | ** **                                                                                                                   |
|----------------|---------------------------|------------------------------------------------------------------------------------------------------------------------------|
| ** **     | ** **                | ** **                                                                                                                   |
|           | Item 1.                   | Financial Statements                                                                                                         |   |
|           |                      |                                                                                                                         |   |
|           |                      | Consolidated Balance Sheets  September 30, 2004 (unaudited) and December 31, 2003                                            |   |
|           |                      | Consolidated  Statements of Operations (unaudited)  Three and nine months ended September 30, 2004 and 2003                  |   |
|           |                      | Consolidated  Statements of Comprehensive Income (Loss) (unaudited)  Three and nine months ended September 30, 2004 and 2003 |   |
|           |                      | Consolidated  Statements of Cash Flows (unaudited)  Three and nine months ended September 30, 2004 and 2003                  |   |
|           |                      | Notes  to Consolidated Interim Financial Statements                                                                          |   |
|           |                      |                                                                                                                         |   |
|           | Item  2.                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  |   |
|           |                      |                                                                                                                         |   |
|           | Item  3.                  | Quantitative  and Qualitative Disclosures About Market Risk                                                                  |   |
|           |                      |                                                                                                                         |   |
|           | Item 4.                   | Controls and Procedures                                                                                                      |   |
|           |                      |                                                                                                                         |   |
| **PART II**    | **OTHER INFORMATION**     | ** **                                                                                                                   |
|           |                      |                                                                                                                         |   |
|           | Item 1.                   | Legal Proceedings                                                                                                            |   |
|           |                      |                                                                                                                         |   |
|           | Item  6.                  | Exhibits                                                                                                                     |   |
|           |                      |                                                                                                                         |   |
| **SIGNATURES** | ** **                | ** **                                                                                                                   |
|           |                      |                                                                                                                         |   |
|           | Signatures                |                                                                                                                         |

 

2

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**AXS-ONEINC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands, except per share data)**

** **
| ** **                                                                                                                                                          | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                          | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                          |       |                    |       |                   |       |
| Current  assets:                                                                                                                                                    |       |                    |       |                   |       |
| Cash  and cash equivalents                                                                                                                                          |       | $                       | 6,681      |                   | $          | 2,946 |   |
| Restricted  cash                                                                                                                                                    |       | 55                      |       | 56                     |       |
| Accounts  receivable, net of allowance for doubtful accounts of $623 and $200 at  September 30, 2004 and December 31, 2003, respectively                            |       | 5,788                   |       | 5,541                  |       |
| Due  from joint venture                                                                                                                                             |       | 127                     |       | 107                    |       |
| Prepaid  expenses and other current assets                                                                                                                          |       | 821                     |       | 603                    |       |
| Total  current assets                                                                                                                                               |       | 13,472                  |       | 9,253                  |       |
| Equipment  and leasehold improvements, at cost:                                                                                                                     |       |                    |       |                   |       |
| Computer  and office equipment                                                                                                                                      |       | 11,364                  |       | 11,098                 |       |
| Furniture  and fixtures                                                                                                                                             |       | 929                     |       | 924                    |       |
| Leasehold  improvements                                                                                                                                             |       | 879                     |       | 873                    |       |
|                                                                                                                                                                |       | 13,172                  |       | 12,895                 |       |
| Less—accumulated  depreciation and amortization                                                                                                                |       | 12,761                  |       | 12,559                 |       |
|                                                                                                                                                                |       | 411                     |       | 336                    |       |
| Capitalized  software development costs, net of accumulated amortization of $10,328 and  $9,487 at September 30, 2004 and December 31, 2003, respectively           |       | 2,106                   |       | 2,364                  |       |
| Other  assets                                                                                                                                                       |       | 185                     |       | 197                    |       |
|                                                                                                                                                                |       | $                       | 16,174     |                   | $          | 12,150 |   |
|                                                                                                                                                                |       |                    |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                             |       |                    |       |                   |       |
| Current  liabilities:                                                                                                                                               |       |                    |       |                   |       |
| Current  portion of long-term debt                                                                                                                                  |       | $                       | —     |                   | $          | 547 |   |
| Accounts  payable                                                                                                                                                   |       | 1,715                   |       | 1,737                  |       |
| Accrued  expenses                                                                                                                                                   |       | 3,800                   |       | 3,111                  |       |
| Due  to joint venture                                                                                                                                               |       | —                  |       | 4                      |       |
| Deferred  revenue                                                                                                                                                   |       | 9,258                   |       | 8,946                  |       |
| Total  current liabilities                                                                                                                                          |       | 14,773                  |       | 14,345                 |       |
| Long-term  liabilities:                                                                                                                                             |       |                    |       |                   |       |
| Long-term  deferred revenue                                                                                                                                         |       | 505                     |       | 1,504                  |       |
| Commitments  and contingencies                                                                                                                                      |       |                    |       |                   |       |
| Stockholders’  equity (deficit):                                                                                                                               |       |                    |       |                   |       |
| Preferred  stock, $.01 par value, authorized 5,000 shares, no shares issued and  outstanding                                                                        |       | —                  |       | —                 |       |
| Common  stock, $.01 par value, authorized 50,000 shares; 28,254 and 25,026 shares issued  and outstanding at September 30, 2004 and December 31, 2003, respectively |       | 283                     |       | 250                    |       |
| Additional  paid-in capital                                                                                                                                         |       | 80,271                  |       | 72,148                 |       |
| Accumulated  deficit                                                                                                                                                |       | (79,939                 | )          | (76,453                | )          |
| Accumulated  other comprehensive income                                                                                                                             |       | 281                     |       | 356                    |       |
| Total  stockholders’ equity (deficit)                                                                                                                          |       | 896                     |       | (3,699                 | )          |
|                                                                                                                                                                |       | $                       | 16,174     |                   | $          | 12,150 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

3

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**AXS-ONEINC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Inthousands, except per share data)**

**(Unaudited)**

 
| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                          | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                           |       |                                  |       |                                 |       |   |   |   |   |
| License  fees                                       |       | $                                     | 1,306      |                                 | $          | 2,459 |   | $ | 4,770 |   | $ | 5,054 |   |
| Services                                            |       | 7,759                                 |       | 7,681                                |       | 24,621 |   | 23,930 |   |
| Other-related  party                                |       | 80                                    |       | 71                                   |       | 181 |   | 260 |   |
| Total  revenues                                     |       | 9,145                                 |       | 10,211                               |       | 29,572 |   | 29,244 |   |
|                                                |       |                                  |       |                                 |       |   |   |   |   |
| Operating  expenses:                                |       |                                  |       |                                 |       |   |   |   |   |
| Cost  of license fees                               |       | 693                                   |       | 371                                  |       | 1,479 |   | 1,090 |   |
| Cost  of services                                   |       | 4,129                                 |       | 3,815                                |       | 12,926 |   | 11,782 |   |
| Sales  and marketing                                |       | 2,271                                 |       | 1,780                                |       | 6,696 |   | 5,535 |   |
| Research  and development                           |       | 2,081                                 |       | 1,697                                |       | 6,017 |   | 4,949 |   |
| General  and administrative                         |       | 1,714                                 |       | 1,483                                |       | 4,811 |   | 4,146 |   |
| Restructuring  and other costs                      |       | (83                                   | )          | —                               |       | 1,020 |   | — |   |
| Total  operating expenses                           |       | 10,805                                |       | 9,146                                |       | 32,949 |   | 27,502 |   |
| Operating  income (loss)                            |       | (1,660                                | )          | 1,065                                |       | (3,377 | ) | 1,742 |   |
| Other  income (expense):                            |       |                                  |       |                                 |       |   |   |   |   |
| Interest  income                                    |       | 40                                    |       | 17                                   |       | 105 |   | 49 |   |
| Interest  expense                                   |       | —                                |       | (48                                  | )          | (14 | ) | (167 | ) |
| Gain  on sale of subsidiary                         |       | —                                |       | —                               |       | — |   | 71 |   |
| Equity  in income (losses) of joint ventures        |       | (40                                   | )          | (81                                  | )          | (122 | ) | 34 |   |
| Other  expense, net                                 |       | (17                                   | )          | (6                                   | )          | (68 | ) | (172 | ) |
| Other  expense, net                                 |       | (17                                   | )          | (118                                 | )          | (99 | ) | (185 | ) |
| Income  (loss) before income taxes                  |       | $                                     | (1,677     | )                                    | $          | 947 |   | $ | (3,476 | ) | $ | 1,557 |   |
| Income  tax benefit (expense)                       |       | 18                                    |       | (29                                  | )          | (10 | ) | (57 | ) |
| Net  income (loss)                                  |       | $                                     | (1,659     | )                                    | $          | 918 |   | $ | (3,486 | ) | $ | 1,500 |   |
|                                                |       |                                  |       |                                 |       |   |   |   |   |
| Basic  net income (loss) per common share           |       | $                                     | (0.06      | )                                    | $          | 0.04 |   | $ | (0.13 | ) | $ | 0.06 |   |
| Weighted  average basic common shares outstanding   |       | 28,106                                |       | 24,960                               |       | 27,094 |   | 24,929 |   |
|                                                |       |                                  |       |                                 |       |   |   |   |   |
| Diluted  net income (loss) per common share         |       | $                                     | (0.06      | )                                    | $          | 0.04 |   | $ | (0.13 | ) | $ | 0.06 |   |
| Weighted  average diluted common shares outstanding |       | 28,106                                |       | 26,228                               |       | 27,094 |   | 25,932 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

4

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**AXS-ONEINC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)**

**(In thousands)**

**(Unaudited)**

 
| ** **                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                               | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                                  |       |                                 |       |   |   |   |   |
| Net  income (loss)                       |       | $                                     | (1,659     | )                                    | $          | 918 |   | $ | (3,486 | ) | $ | 1,500 |   |
| Foreign  currency translation adjustment |       | (68                                   | )          | (29                                  | )          | (75 | ) | (9 | ) |
| Comprehensive  income (loss)             |       | $                                     | (1,727     | )                                    | $          | 889 |   | $ | (3,561 | ) | $ | 1,491 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

5

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**AXS-ONEINC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In thousands)

(Unaudited)

 
| ** **                                                                                                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Cash  flows from operating activities:                                                                     |       |                                 |       |   |   |
| Net  income (loss)                                                                                         |       | $                                    | (3,486     | ) | $ | 1,500 |   |
| Adjustments  to reconcile net income (loss) to net cash flows provided by (used in)  operating activities: |       |                                 |       |   |   |
| Increase  in cash surrender value of officers’ life insurance                                         |       | (10                                  | )          | (14 | ) |
| Depreciation  and amortization                                                                             |       | 1,038                                |       | 1,214 |   |
| Net  provision for (recovery of) doubtful accounts                                                         |       | 436                                  |       | (132 | ) |
| Gain  on sale of subsidiary                                                                                |       | —                               |       | (71 | ) |
| Equity  in (income) losses of joint venture                                                                |       | 122                                  |       | (34 | ) |
| Consulting  services received in lieu of payment on accounts receivable                                    |       | 213                                  |       | 45 |   |
| Changes  in assets and liabilities:                                                                        |       |                                 |       |   |   |
| Restricted  cash                                                                                           |       | —                               |       | 27 |   |
| Accounts  receivable                                                                                       |       | (890                                 | )          | (293 | ) |
| Due  from/to joint venture                                                                                 |       | (106                                 | )          | 167 |   |
| Prepaid  expenses and other current assets                                                                 |       | (217                                 | )          | 76 |   |
| Accounts  payable and accrued expenses                                                                     |       | 679                                  |       | (862 | ) |
| Deferred  revenue                                                                                          |       | (675                                 | )          | (570 | ) |
| Net  cash flows provided by (used in) operating activities                                                 |       | (2,896                               | )          | 1,053 |   |
|                                                                                                       |       |                                 |       |   |   |
| Cash  flows from investing activities:                                                                     |       |                                 |       |   |   |
| Change  in other assets                                                                                    |       | 27                                   |       | 11 |   |
| Loans  to joint ventures                                                                                   |       | (115                                 | )          | (156 | ) |
| Capitalized  software development costs                                                                    |       | (582                                 | )          | (971 | ) |
| Purchase  of equipment and leasehold improvements                                                          |       | (275                                 | )          | (154 | ) |
| Net  cash flows used in investing activities                                                               |       | (945                                 | )          | (1,270 | ) |
|                                                                                                       |       |                                 |       |   |   |
| Cash  flows from financing activities:                                                                     |       |                                 |       |   |   |
| Proceeds  from exercise of stock options and warrants                                                      |       | 464                                  |       | 71 |   |
| Net  proceeds from the sale of common stock                                                                |       | 7,692                                |       | — |   |
| Payments  of long term debt                                                                                |       | (547                                 | )          | (1,350 | ) |
| Net  cash flows provided by (used in) financing activities                                                 |       | 7,609                                |       | (1,279 | ) |
| Foreign  currency exchange rate effects on cash and cash equivalents                                       |       | (33                                  | )          | 138 |   |
| Net increase  (decrease) in cash and cash equivalents                                                      |       | 3,735                                |       | (1,358 | ) |
| Cash  and cash equivalents, beginning of period                                                            |       | 2,946                                |       | 2,702 |   |
| Cash  and cash equivalents, end of period                                                                  |       | $                                    | 6,681      |   | $ | 1,344 |   |
|                                                                                                       |       |                                 |       |   |   |
| Supplemental  disclosures of cash flow information:                                                        |       |                                 |       |   |   |
| Cash  paid during the period for -                                                                         |       |                                 |       |   |   |
| Interest                                                                                                   |       | $                                    | 21         |   | $ | 180 |   |
| Income  taxes                                                                                              |       | $                                    | 17         |   | $ | 108 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

6

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**AXS-ONE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED INTERIM FINANCIALSTATEMENTS**

**(In thousands, except per share data)**

**(Unaudited)**

 

**(1) OPERATIONS, BUSINESSCONDITIONS AND SIGNIFICANT ACCOUNTING POLICIES**

** **

The Company designs, markets and supports recordscompliance management solutions that include digital archiving, businessprocess management, electronic document delivery and integrated recordsdisposition and discovery for e-mail, instant messaging, images, SAP and othercorporate records, as well as financial management applications for global 2000businesses, and scheduling and time and expense solutions for professionalservices organizations.  The Company alsooffers consulting, implementation, training, technical support and maintenanceservices in support of its customers’ use of its software products.

 

(a) *Basis of Presentation*

 

The accompanyingconsolidated interim financial statements include the accounts of AXS-One Inc.,its wholly owned subsidiaries located in Australia, Singapore, South Africa,and the United Kingdom and its division located in Canada (collectively, the *“Company*”).  Allsignificant intercompany transactions and balances have been eliminated.  In December 2003, the Company dissolved thelegal entity of the subsidiary located in Canada.  The Canadian operation is now a division ofthe U.S. operation and, as such, continues to be included in the consolidatedfinancial statements of the Company.  

 

The Company has a 49% ownership in one joint venturein its South African operation.  Allsignificant intercompany transactions and balances have been eliminated.  The joint venture is considered to be avariable interest entity as defined in FASB Interpretation No. 46R, “Consolidationof Variable Interest Entities” (FIN 46R). However, we have determined that the Company is not the primarybeneficiary.  Accordingly, the Companyuses the equity method of accounting for its joint venture whereby investments,including loans to the joint venture, are stated at cost plus or minus theCompany’s equity in undistributed earnings or losses.  

 

The unaudited consolidated interim financialstatements have been prepared by the Company in accordance with accountingprinciples generally accepted in the United States of America and, in theopinion of management, contain all adjustments, consisting only of those of a normalrecurring nature, necessary for a fair presentation of these consolidatedinterim financial statements.

 

These consolidatedinterim financial statements should be read in conjunction with theconsolidated financial statements and related notes included in the Company’s2003 Annual Report on Form 10-K filed with the Securities and ExchangeCommission.

 

The results of operationsfor the three and nine months ended September 30, 2004 are not necessarilyindicative of results to be expected for the full year 2004 or any futureperiods.

 

(b) *RevenueRecognition*

*** ***

The Company recognizesrevenue in accordance with Statement of Position 97-2, “Software RevenueRecognition” (“SOP 97-2”), and Statement of Position 98-9, “Modification of SOP97-2, Software Revenue Recognition, With Respect to Certain Transactions.”  Revenue from non-cancelable softwarelicenses, through both direct and indirect channels, is recognized when thelicense agreement has been signed, delivery has occurred, the fee is fixed ordeterminable and collectibility is probable. In multiple element arrangements, the Company defers the vendor-specificobjective evidence of fair value

 

7

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(“VSOE”) related to theundelivered elements and recognizes revenue on the delivered elements using theresidual method.  The most commonlydeferred element is initial maintenance, which is recognized on a straight-linebasis over the initial maintenance term. The VSOE of maintenance is determined by using a consistent percentageof maintenance fee to license fee based on renewal rates.  Maintenance fees in subsequent years arerecognized on a straight-line basis over the life of the applicable agreement.  Maintenance contracts entitle the customer tohot-line support and all unspecified product upgrades released during the termof the maintenance contract.  Upgradesinclude any and all unspecified patches or releases related to a licensedsoftware product.  Maintenance does notinclude implementation services to install these upgrades.

 

Revenues from transactionfees associated with a hosting arrangement are recognized based on the actualnumber of transactions processed through the system during the period. 

 

Delivery of softwaregenerally occurs when the product (on CDs) is delivered to a commoncarrier.  Occasionally, delivery occursthrough electronic means where the software is made available through theCompany’s secure FTP (File Transfer Protocol) site.  The Company does not offer any customers orresellers a right of return.

 

For software license andmaintenance revenue, the Company assesses whether the fee is fixed anddeterminable and whether or not collection is probable.  The Company assesses whether the fee is fixedand determinable based on the payment terms associated with thetransaction.  If a significant portion ofa fee is due after the Company’s normal payment terms, which are 30 to 90 daysfrom invoice date, the fee is not considered to be fixed and determinable.  In these cases, the Company recognizesrevenue as the fees become due.

 

The majority of the Company’s training and consultingservices are billed based on hourly rates. The Company generally recognizes revenue as these services are performedwhen there is also evidence of an arrangement, the fee is fixed or determinableand collectibility is reasonably assured. However, when the Company enters into an arrangement that requires it toperform significant work either to alter the underlying software or to buildadditional complex interfaces so that the software performs as the customerrequests, the Company recognizes the entire fee using the percentage ofcompletion method of accounting.  Thiswould apply to the Company’s custom programming services which are generallycontracted on a fixed fee basis. Anticipated losses, if any, are charged to operations in the period suchlosses are determined.

 

Revenues from the jointventure (included in Revenues: Other-Related Parties in the Company’sConsolidated Statements of Operations) includes consulting revenue for thejoint venture’s use of the Company’s South African subsidiary’s consultants andfor management fees arising from the Company’s South African subsidiaryproviding managerial, technical and other related services, including directorservices, to the joint venture in accordance with the joint ventureagreement.  Revenue is recognized uponperformance of the services.

 

The Company assessesassuredness of collection for its revenue transactions based on a number offactors, including past transaction history with the customer and thecredit-worthiness of the customer.  TheCompany does not request collateral from its customers.  If the Company determines that collection ofa fee is uncertain, it defers the fee and recognizes revenue at the time theuncertainty is eliminated, which is generally upon receipt of cash.  

 

8

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In accordance with EITF Issue No. 01-14, “IncomeStatement Characterization of Reimbursement Received for ‘Out of Pocket’Expenses Incurred,” reimbursements received for out-of-pocket expenses incurredare classified as services revenue in the unaudited consolidated statements ofoperations.  

 

(c)*Variable Interest Entity*

 

We adopted FIN 46R as required on March 31, 2004.  The Company’s 49% owned joint venture,African Solutions (Pty) Ltd (“African Solutions”), is considered to be avariable interest entity as defined in FIN 46R. However, the Company has determined that the majority owner, AfricanLegends Technology, absorbs the majority of the expected losses and therefore,African Legends Technology, is the primary beneficiary.  Due to the fact that the Company is not theprimary beneficiary of African Solutions, the adoption of FIN 46R did not havean impact on the Company’s consolidated financial position or results ofoperations.  

 

African Solutions is acting as an non-exclusiveauthorized third party service provider to provide consulting andimplementation services, and as a non-exclusive representative in providingmarketing and promotional services directly to the end users in regard to,among other things, AXS-One’s software products, but is required to remainfocused on the AXS-One product range. African Solutions conducts business throughout the African continentwhere its target markets are the Financial Sector and Government Departments.

 

As of September 30, 2004,AXS-One’s total exposure to loss as a result of its involvement in AfricanSolutions is $127, representing the Company’s net investment in AfricanSolutions as of September 30, 2004.  

 

Presented below isselected financial data for African Solutions as of September 30, 2004 andDecember 31, 2003 and for the three and nine months ended September 30, 2004and 2003.

 
| ** **      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Total  revenues |       | $                                     | 298        |                                 | $          | 230 |   | $ | 1,012 |   | $ | 1,083 |   |
| Operating  loss |       | $                                     | (33        | )                                    | $          | (144 | ) | $ | (111 | ) | $ | (354 | ) |

 

Total assets were $408 and $119 as of September 30,2004 and December 31, 2003, respectively. Total stockholders’ deficit was $(1,463) and $(251) as of September 30,2004 and December 31, 2003, respectively.

 

(d) *Stock-Based Compensation*

 

FASB Statement No. 148, “Accounting for Stock BasedCompensation-Transition and Disclosure, an Amendment of FASB Statement No. 123”(“SFAS 148”) provides alternative methods of transition for a voluntary changeto the fair value method of accounting for stock-based compensation.  However, it allows an entity to continue tomeasure compensation cost for stock instruments granted to employees using theintrinsic-value method of accounting prescribed by Accounting Principles BoardOpinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” providedit discloses the effect of SFAS

 

9

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123, as amended by SFAS 148, in the footnotes to thefinancial statements.  On November 14,2003, the FASB decided to require stock-based employee compensation to berecorded as a charge to earnings beginning in 2005.  On October 14, 2004, the FASB decided thatthe effective date would be postponed until any interim or annual periodbeginning after June 15, 2004.  Untilthat time, the Company has chosen to continue to account for stock-basedcompensation using the intrinsic-value method.  Accordingly, no stock option relatedcompensation expense has been recognized in the consolidated statements ofoperations, as all options granted had an exercise price equal to the marketvalue of the underlying stock on the date of grant.  

 

Had the Company, however, elected to recognizecompensation cost based on fair value of the stock options at the date of grantunder SFAS 123, as amended by SFAS 148, such costs would have been recognizedratably over the vesting period of the underlying instruments and the Company’snet income (loss) and net income (loss) per common share would have changed tothe pro forma amounts indicated in the table below. 

 
| ** **                                                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Net  income (loss) as reported                                                                            |       | $                                     | (1,659     | )                                    | $          | 918 |   | $ | (3,486 | ) | $ | 1,500 |   |
| Deduct:  Total stock based employee compensation determined under fair value based  method for all awards |       | 483                                   |       | 326                                  |       | 1,043 |   | 1,047 |   |
| Pro  forma net income (loss)                                                                              |       | $                                     | (2,142     | )                                    | $          | 592 |   | $ | (4,529 | ) | $ | 453 |   |
|                                                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Net  income (loss) per common share:                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Basic  - as reported                                                                                      |       | $                                     | (0.06      | )                                    | $          | 0.04 |   | $ | (0.13 | ) | $ | 0.06 |   |
| Basic  - pro forma                                                                                        |       | (0.09                                 | )          | 0.02                                 |       | (0.18 | ) | 0.02 |   |
|                                                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Diluted-  as reported                                                                                     |       | $                                     | (0.06      | )                                    | $          | 0.04 |   | $ | (0.13 | ) | $ | 0.06 |   |
| Diluted  - pro forma                                                                                      |       | (0.09                                 | )          | 0.02                                 |       | (0.18 | ) | 0.02 |   |

 

The Company has used theBlack-Scholes option-pricing model in calculating the fair value of optionsgranted.  The assumptions used and theweighted average information for the three and nine months ended September 30,2004 and 2003 are as follows:

 

10

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| ** **                                                                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Risk-free  interest rate                                                                                              |       | 4.89                                  | %          | 4.88                                 | %          | 5.07 | % | 4.64 | % |
| Expected  dividend yield                                                                                              |       | —                                |       | —                               |       | — |   | — |   |
| Expected  lives                                                                                                       |       | 7 years                               |       | 7 years                              |       | 7 years |   | 7 years |   |
| Expected  volatility                                                                                                  |       | 84                                    | %          | 45                                   | %          | 86 | % | 56 | % |
| Weighted-average  grant date fair value of options granted during the period                                          |       | $                                     | 2.14       |                                 | $          | 0.95 |   | $ | 2.99 |   | $ | 0.81 |   |
| Weighted-average  remaining contractual life of options outstanding                                                   |       | 6.9 years                             |       | 6.5 years                            |       | 6.9 years |   | 6.5 years |   |
| Weighted-average  exercise price of 3,988 and 3,913 options exercisable at September 30, 2004  and 2003, respectively |       | $                                     | 1.74       |                                 | $          | 1.72 |   | $ | 1.74 |   | $ | 1.72 |   |

 

**2) REVOLVING LINE OF CREDIT ANDLONG-TERM DEBT**

 

On March 31, 1998, the Company entered into a Loan andSecurity Agreement that contained a revolving line of credit and a termloan.  The unpaid principal on the termloan at December 31, 2003 of $547 was fully paid as of March 31, 2004.  The Loan and Security Agreement terminated onMay 28, 2004 in accordance with Amendment No. 15.  As of September 30, 2004, no amounts remainoutstanding or available under this agreement. (For further information see Note 3 to the Company’s 2003 Annual Reporton Form 10-K.)

 

On August 11, 2004, theCompany entered into a two-year Loan and Security Agreement (“Agreement”) whichcontains a revolving line of credit under which the Company has available thelesser of $4 million or 80% of eligible accounts, as defined.  The available amount under the revolving lineof credit at September 30, 2004 was approximately $2.9 million of which noamounts were outstanding.

 

Borrowings under the revolvingline of credit bear interest at prime rate plus one half of one percent(0.5%).  The Agreement provides for anon-refundable commitment fee of $30 per year and an unused revolving linefacility fee of .25% per annum.  Theunused revolving line facility fee can be reduced if the Company maintains cashin a non-interest bearing checking account with the lender during the term ofthe agreement.  The Agreement is securedby substantially all domestic assets of the Company and contains certainfinancial restrictive covenants based on adjusted quick ratio, as defined, andearnings before interest, taxes and depreciation and amortization(EBITDA).  

 

As of September 30, 2004,the Company was in default of the covenant based on EBITDA.  The Company requested and received a waiverfrom the lender allowing for the default without penalty for the September 30,2004 covenant and is currently in the process of amending this covenant for theperiod ended December 31, 2004.   TheCompany was in compliance with all other covenants.

 

11

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**(3) BASIC AND DILUTED NET INCOME(LOSS) PER COMMON SHARE**

** **

Basic and diluted netincome (loss) per common share is presented in accordance with SFAS No. 128, “Earningsper Share” (“SFAS No. 128”). 

 

Basic net income (loss)per common share is based on the weighted average number of shares of commonstock outstanding during the period. Diluted net loss per common share for the three and nine months endedSeptember 30, 2004 does not include the effects of outstanding options topurchase 7,168 shares of common stock and outstanding warrants to purchase 516shares of common stock for each period as the effect of their inclusion isanti-dilutive for the periods.  Dilutednet income per common share for the three and nine months ended September 30,2003 does not include the effects of outstanding options to purchase 3,064 and3,267 shares of common stock, respectively, and outstanding warrants topurchase, for both periods, 100 shares of common stock as the effect of theirinclusion is anti-dilutive for the periods. 

 

The following represents the calculations of the basicand diluted net income (loss) per common share for the three and nine monthsended September 30, 2004 and 2003.

 
| ** **                                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                             | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Net  income (loss)                                                     |       | $                                     | (1,659     | )                                    | $          | 918 |   | $ | (3,486 | ) | $ | 1,500 |   |
|                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Weighted  average basic common shares outstanding during the periods   |       | 28,106                                |       | 24,960                               |       | 27,094 |   | 24,929 |   |
|                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Dilutive  effect of stock options and warrants                         |       | —                                |       | 1,268                                |       | — |   | 1,003 |   |
| Weighted  average diluted common shares outstanding during the periods |       | 28,106                                |       | 26,228                               |       | 27,094 |   | 25,932 |   |
|                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Basic  net income (loss) per common share                              |       | $                                     | (0.06      | )                                    | $          | 0.04 |   | $ | (0.13 | ) | $ | 0.06 |   |
|                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Diluted  net income (loss) per common share                            |       | $                                     | (0.06      | )                                    | $          | 0.04 |   | $ | (0.13 | ) | $ | 0.06 |   |

 

**(4) OPERATING SEGMENTS**

 

In the fourth quarter of 2003, the Companyconsolidated the sales and marketing efforts of its three business units inorder to streamline the sales process and control expenses.  The Company now has only two product linesthat it offers to specific markets as part of its strategy to focus on marketopportunities.  The two product lines areas follows:

 

a)              AXS-One EnterpriseSolutions provide Enterprise Financial Solutions to global 2000 companies thatenable organizations to achieve process transparency throughout their valuechain.  These include AXS-One’sFoundation products for which the Company has an extensive installed base ofcustomers.  It also includes TivitySolutions, a verticalized version of AXS-One Enterprise solutions that providea full suite of business solutions and services to organizations that primarilysell professionals’ time.

 

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b)             AXS-One CompliancePlatform Solutions enable organizations to utilize documents and data generatedby their corporate applications as an asset while reducing operationaloverheads and addressing requirements for corporate governance, legal discoveryand industry regulations associated with how corporate records are managed andretained.  Utilizing the AXS-OneCompliance Platform Solutions, organizations can capture, archive, manage,search, supervise, integrate, share and audit their electronic records,regardless of originating platform.  Morethan 250 disparate document and data types can be managed including e-mail,instant messages, images, voice and video, office documents, ERP-generated datasuch as SAP, and electronic print reports generated by host systems.  AXS-One Compliance Platform solutions targetlarge information-centric organizations that can utilize self-serviceinformation systems to improve communications with their customers and improveaccess to business intelligence.

 

The Company evaluates theperformance of its two product lines based on revenues and operatingincome.  Summarized financial informationconcerning the Company’s reportable segments is shown in the followingtable.  The Chief Executive Officer usesthe information below in this format while making decisions about allocatingresources to each product line and assessing its performance.

 
| ** **                                       | ** ** | **AXS-One  Enterprise  Solutions** | ** ** | **Compliance  Platform  Solutions** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|-----------|------------|
| **Three Months Ended September 30, 2004**        |       |                               |       |                                |       |      |       |
| Revenues:                                        |       |                               |       |                                |       |      |       |
| License  fees                                    |       | $                                  | 363        |                                | $          | 943       |       | $ | 1,306 |   |
| Services                                         |       | 6,219                              |       | 1,540                               |       | 7,759     |       |
| Total  Revenues, excluding related party revenue |       | 6,582                              |       | 2,483                               |       | 9,065     |       |
| Operating  income                                |       | 56                                 |       | 451                                 |       | 507       |       |
| Total  assets                                    |       | 13,502                             |       | 2,672                               |       | 16,174    |       |
| Capital  expenditures                            |       | 56                                 |       | 7                                   |       | 63        |       |
| Depreciation  and amortization                   |       | 345                                |       | 8                                   |       | 353       |       |
|                                             |       |                               |       |                                |       |      |       |
| **Three Months Ended September 30, 2003**        |       |                               |       |                                |       |      |       |
| Revenues:                                        |       |                               |       |                                |       |      |       |
| License  fees                                    |       | $                                  | 2,079      |                                | $          | 380       |       | $ | 2,459 |   |
| Services                                         |       | 6,544                              |       | 1,137                               |       | 7,681     |       |
| Total  Revenues, excluding related party revenue |       | 8,623                              |       | 1,517                               |       | 10,140    |       |
| Operating  income                                |       | 2,169                              |       | 561                                 |       | 2,730     |       |
| Total  assets                                    |       | 9,150                              |       | 465                                 |       | 9,615     |       |
| Capital  expenditures                            |       | 47                                 |       | 4                                   |       | 51        |       |
| Depreciation  and amortization                   |       | 389                                |       | 5                                   |       | 394       |       |
|                                             |       |                               |       |                                |       |      |       |

 

13

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| ** **                                       | ** ** | **AXS-One  Enterprise  Solutions** | ** ** | **Compliance  Platform  Solutions** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|-----------|------------|
| **Nine Months Ended September 30, 2004**         |       |                               |       |                                |       |      |       |
| Revenues:                                        |       |                               |       |                                |       |      |       |
| License  fees                                    |       | $                                  | 1,231      |                                | $          | 3,539     |       | $ | 4,770 |   |
| Services                                         |       | 20,355                             |       | 4,266                               |       | 24,621    |       |
| Total  Revenues, excluding related party revenue |       | 21,586                             |       | 7,805                               |       | 29,391    |       |
| Operating  income                                |       | 492                                |       | 2,394                               |       | 2,886     |       |
| Total  assets                                    |       | 13,502                             |       | 2,672                               |       | 16,174    |       |
| Capital  expenditures                            |       | 246                                |       | 29                                  |       | 275       |       |
| Depreciation  and amortization                   |       | 1,017                              |       | 21                                  |       | 1,038     |       |
|                                             |       |                               |       |                                |       |      |       |
| **Nine Months Ended September 30, 2003**         |       |                               |       |                                |       |      |       |
| Revenues:                                        |       |                               |       |                                |       |      |       |
| License  fees                                    |       | $                                  | 4,053      |                                | $          | 1,001     |       | $ | 5,054 |   |
| Services                                         |       | 20,500                             |       | 3,430                               |       | 23,930    |       |
| Total  Revenues, excluding related party revenue |       | 24,553                             |       | 4,431                               |       | 28,984    |       |
| Operating  income                                |       | 4,413                              |       | 1,948                               |       | 6,361     |       |
| Total  assets                                    |       | 9,150                              |       | 465                                 |       | 9,615     |       |
| Capital  expenditures                            |       | 142                                |       | 12                                  |       | 154       |       |
| Depreciation  and amortization                   |       | 1,197                              |       | 17                                  |       | 1,214     |       |

 

Reconciliation of totalsegment operating income to consolidated operating income:

 
| ** **                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                              |       |                                  |       |                                 |       |   |   |   |   |
| Operating  income from reportable segments        |       | $                                     | 507        |                                 | $          | 2,730 |   | $ | 2,886 |   | $ | 6,361 |   |
| Unallocated  revenue, other –related parties |       | 80                                    |       | 71                                   |       | 181 |   | 260 |   |
| Unallocated  general and administrative expense   |       | (1,699                                | )          | (1,471                               | )          | (4,765 | ) | (4,113 | ) |
| Other  corporate unallocated expenses             |       | (548                                  | )          | (265                                 | )          | (1,679 | ) | (766 | ) |
| Total  consolidated operating income (loss)       |       | $                                     | (1,660     | )                                    | $          | 1,065 |   | $ | (3,377 | ) | $ | 1,742 |   |

 

**(5) DIVESTITURE**

 

On September 20, 2001, theCompany sold its wholly-owned subsidiary located in Central and Eastern Europe(C.E.E.), including offices in Poland, Estonia and Bulgaria, to PorterfieldInternational Ltd. (“Buyer”), a company wholly-owned by the former managingdirector of C.E.E. and his wife.  TheCompany received consideration in the form of a promissory note of Buyer in theface amount of $430 which was paid as of December 31, 2002.  A net asset deficiency of the C.E.E. operationsof $(3), at the time of the sale, offset by accrued expenses of $180, directlyrelated to the sale, resulted in a deferred gain of approximately $253, whichthe Company recorded in accordance with the Securities and Exchange Commission’sStaff Accounting Bulletin No. 81 (SAB 81), “Gain Recognition on the Sale of aBusiness or Operating Assets to a Highly Leveraged Entity.”  Additional direct costs of the sale of $8recorded during 2002 reduced the total deferred gain to $245.

 

The Company recognized such gainas the note receivable was paid or equivalent value for services was received,but only after $180 was received. Through December 31, 2002, $430 had been received in either payment tothe Company or equivalent services provided by the Buyer to the Company or tothe

 

14

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Company’s joint venture.  The Company recognized $219 of such gainthrough December 31, 2002, which included a reversal of $45 related to theoriginal $180 in accrued expenses recorded at the time of the sale.  The $45 was recognized during 2002 as aresult of the release of a past customer claim. The remaining gain of $71, reflected as Deferred revenue on the December31, 2002 consolidated balance sheet, was recognized in February 2003 when theCompany received payment from the Company’s joint venture for services providedby the Buyer to the joint venture.  The following table shows the activityrelated to the promissory note and related deferred gain and gain recognized:

 
| ** **                                                     | ** ** | **Note  Receivable** | ** ** | **Deferred  Gain** | ** ** | **Gain  Recognized** | ** ** |
|----------------------------------------------------------------|------------|----------------------|------------|--------------------|------------|----------------------|------------|
| Balance  at December 31, 2001                                  |       | $                    | 336        |               | $          | 253                  |       | $ | — |   |
| Direct  expense incurred in June 2002                          |       | —               |       | (3                 | )          | —               |       |
| Cash  payments and services received through December 31, 2002 |       | (336                 | )          | (174               | )          | 174                  |       |
| Reversal  of accrued expense in September 2002                 |       | —               |       | —             |       | 45                   |       |
| Direct  expense incurred in October 2002                       |       | —               |       | (5                 | )          | —               |       |
| Balance  at December 31, 2002                                  |       | —               |       | 71                 |       | 219                  |       |
| Cash  payments received from joint venture in February 2003    |       | —               |       | (71                | )          | 71                   |       |
| Balance  at September 30, 2003                                 |       | $                    | —     |               | $          | —               |       | $ | 290 |   |

 

**(6) CONTINGENCIES**

** **

Historically, the Companyhas been involved in disputes and/or litigation encountered in its normalcourse of business.  The Company believesthat the ultimate outcome of these proceedings will not have a material adverseeffect on the Company’s business, consolidated financial condition, results ofoperations or cash flows.

 

**(7) PRIVATE PLACEMENT**

 

On April 5, 2004, theCompany completed an offer and sale of 2,581 shares of common stock for $3.10per share in a private placement for total consideration of $8,000.  Upon closing, the Company received netproceeds of approximately $7,700.  TheCompany also issued, at the same time, warrants to purchase an aggregate of 258shares of common stock at $3.98 per share and warrants to purchase 258 sharesof common stock at $4.50 per share. These warrants are exercisable for a period of three years beginningApril 5, 2004.  This private placementand issuance of warrants were made pursuant to the terms of a Unit SubscriptionAgreement, dated as of April 1, 2004, among the Company and several investors.

 

Issuance of the common stockand warrants in the private placement was not registered under the SecuritiesAct of 1933 (“the Act”) in reliance upon Section 4(2) of the Act based on the factthat the shares of common stock and the warrants were issued to a small numberof sophisticated investors who had extensive knowledge of the Company at thetime of the issuance.

 

On April 8, 2004, the Company filed a Form 8-K withthe SEC disclosing details of the private placement and issuance ofwarrants.  On May 4, 2004, the Companyfiled a Form S-3 registration statement with the SEC covering the resale of thesecurities issued and securities issuable upon exercise

 

15

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of the warrants. The Form S-3 registration statement, as amended, was declared effectiveby the SEC on September 28, 2004.

 

**(8) RESTRUCTURING AND OTHER COSTS**

** **

On June 30, 2004, in order to streamline andreorganize the Company to better meet its long-term goals, the Companyeliminated 25 positions in the United States and 11 positions in its foreignoperations.  The Company recorded acharge to operations in the second quarter totaling approximately $0.8 millionrelated to involuntary termination benefits to be paid to the terminatedemployees.  The severance accrual wasadjusted down by approximately $0.1 million in the third quarter mainly due tothe re-assignment of two people previously scheduled for termination.  The activity related to the restructuring isas follows:

 
| Involuntary  termination costs recorded in June 2004        |   | $      | 786    |   |
|-------------------------------------------------------------|--------|--------|--------|--------|
| Cash  payments through June 2004                            |   | — |   |
| Restructuring  liability at June 30, 2004                   |   | $      | 786    |   |
| Cash  payments through September 30, 2004                   |   | (657   | )      |
| Adjustment  to severance accrual through September 30, 2004 |   | (83    | )      |
| Restructuring  liability at September 30, 2004              |   | $      | 46     |   |

 

Inaddition, in June 2004, the Company recognized an expense of approximately $0.3million related to a retirement agreement with the Company’s former CEO.  The Company expects to pay the retirementbenefits in the fourth quarter of 2004.

 

Therestructuring liability and liability for the retirement agreement are includedin accrued expenses on the accompanying September 30, 2004 Consolidated BalanceSheet.

 

16

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**Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion should be read in conjunctionwith the Consolidated Interim Financial Statements and Notes thereto and isqualified in its entirety by reference thereto.

 

This Report containsstatements of a forward-looking nature within the meaning of the safe harborprovisions of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended, relating tofuture events or the future financial performance of AXS-One.  Investors are cautioned that such statementsare only predictions and that actual events or results may differ materially.  In evaluating such statements, investorsshould specifically consider the various factors identified in this Reportwhich could cause actual results to differ materially from those indicated bysuch forward-looking statements, including the matters set forth in “Business—RiskFactors” in our 2003 Annual Report on Form 10K.

 

**Executive Overview**

 

We are a leading providerof Records Compliance Management (including email and instant messagingarchival management), financial management, and workflow software designed toefficiently manage complex business processes. We have implemented high-volume, interoperable, scalable and securebusiness solutions for global 2000 companies. Our Web Services-based technology has been critically acclaimed as bestof class.  Our Records ComplianceManagement solutions provide fast deployment of content management solutions,such as e-mail and instant messaging archival and records management, forregulatory compliance and operational efficiency.  See “Item 1. Business” in our 2003 Annual Report on Form 10K.

 

Our revenues are derivedmainly from license fees from software license agreements entered into betweenAXS-One and our customers with respect to both our products and, to a lesserdegree, third party products resold by AXS-One and services revenues fromsoftware maintenance agreements, training, consulting services includinginstallation and custom programming.

 

We are based inRutherford, New Jersey with approximately 240 full-time employees, as ofSeptember 30, 2004, in offices worldwide, including Australia, Canada,Singapore, South Africa, the United Kingdom and the United States.  Our foreign offices generated approximately36.6% and 35.9% of our total revenues for the three and nine months endedSeptember 30, 2004, respectively, as compared to 30.1% and 47.1%, respectively,for the corresponding prior year periods. We expect that such revenues will continue to represent a significantpercentage of our total revenues in the future. Most of our international license fees and services revenues aredenominated in foreign currencies. Fluctuations in the value of foreign currencies relative to the USdollar in the future could result in fluctuations in our revenue.

 

We have a 49% ownershipin one joint venture in our South African operation, AXS-One African Solutions(Pty) Ltd (“African Solutions”).  AfricanSolutions sells and services our suite of products.  We use the equity method of accounting forour investment whereby the investment, including loans to the joint venture, isstated at cost plus or minus our equity in undistributed earnings or losses.

 

We encounter competitionfor all of our products in all markets and compete primarily based on thequality of our products, our price, our customer service and our time toimplement.  The timing of the release ofnew products is also important to our ability to generate sales.  During the second half of 2003, we launchedour Records Compliance Management solution for e-mail and Instant MessagingArchival, Supervision & Legal Discovery in response to new regulatoryrequirements for financial institutions in

 

17

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the United States as wellas to address the need to reduce costs in the email management area.  Our Records Compliance Management software,including this new product, accounted for approximately 74% of our totallicense fee revenues for the nine months ended September 30, 2004.  During the past nine months, we haveincreased our research and development, sales and services teams in this areain order to meet the needs of this growing market and capitalize on thisopportunity.  However, there is noassurance that these efforts will achieve the desired results.

 

Our future ability togrow revenue will be directly affected by continued price competition and ourability to sustain an increasingly higher maintenance revenue base from whichto grow.  Our growth rate and totalrevenues depend significantly on future services for existing customers as wellas our ability to expand our customer base and to respond successfully to thepace of technological change.  In orderto expand our customer base, we have been actively seeking partnerships withresellers to supplement our direct sales force. These efforts recently resulted in alliances with Sun Microsystems,Sector, Inc., RedFile and NuTech.  SunMicrosystems will resell our Records Compliance Management software to itsexisting enterprise customers and new customers in targeted markets.  Sector, Inc., a leading managed services,communications and data distribution provider for the financial servicesindustry, offers the AXS-One Compliance Platform for Email and InstantMessaging Archival, Supervision and Discovery in a hosted application serviceprovider (ASP) or hybrid environment. Redfile, a digital risk and information management solution provider,will work with us to collaboratively develop and offer a comprehensive hostedarchival solution designed to help corporations meet evolving regulations,expedite legal discovery and streamline records management.  NuTech, a leading systems integrator ofenterprise level messaging solutions, will resell our AXS-One CompliancePlatform to its existing enterprise customers and new customers.  If our maintenance renewal rate or pace ofnew customer acquisitions slows, our revenues and operating results would beadversely affected.

 

We have experienced, andmay in the future experience, significant fluctuations in our quarterly andannual revenues, results of operations and cash flows.  We believe that domestic and internationaloperating results and cash flows will continue to fluctuate significantly inthe future as a result of a variety of factors. For a description of these factors that may affect our operatingresults, see “Business—Risk Factors” in our 2003 Annual Report on Form 10K.

 

In September 2004, our UKsubsidiary entered into three-year agreements with the UK’s four largestvacation tour operators, First Choice, My Travel, Thomas Cook and TUI, toprovide to UK travel agents a hosted service for electronic delivery ofconfirmation invoices and related booking documents that meets the requirementsof the UK regulatory agencies and UK travel agents.  The Electronic Records Delivery solution,hosted by AXS-One, allows tour operators and travel agencies to replace theirpaper based invoicing processes with electronic invoicing systems, therebyreducing operational costs.  With theseagreements, AXS-One will generate recurring transaction fees from five out ofthe top ten European tour operators that account for nearly 50% of all passengerbookings made by the Civil Aviation Authority (CAA)-regulated travel agents andone of the largest ferry operators.  Nosignificant revenue has been recognized through September 30, 2004 related tothese agreements.

 

In October 2004, MattSuffoletto joined AXS-One in the position of Senior Vice President NorthAmerican Sales and Professional Services. Mr. Suffoletto comes to us from Open Text where, for the past threeyears, he was the CEO and President of IXOS Software Inc.  Prior to joining IXOS, he held severalpositions, including the CEO of a startup company, TechTrader, and senior salespositions at such companies as Primavera, DataEase, Lotus and IBM.  Mr. Suffoletto replaced Mr. AlexanderKarakozoff who left AXS-One in early October to pursue other activities.

 

18

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**Results of Operations**

 

The following table setsforth for the periods indicated, certain operating data, and data as apercentage of total revenues:

 
| ** **                             | ** ** | **Three Months Ended  September 30, 2004** | ** ** | **Three Months Ended  September 30, 2003** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | ** **                                 | ** ** | **Data as a**                              | ** ** | ** ** | ** ** | **Data as a** | ** ** |
| ** **                             | ** ** | **As**                                     | ** ** | **percent of**                             | ** ** | **As** | ** ** | **percent of** | ** ** |
| **(in  thousands)**                    | ** ** | **Reported**                               | ** ** | **revenue**                                | ** ** | **Reported** | ** ** | **revenue** | ** ** |
|                                   | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)**                            | ** ** |
| Revenues:                              |       |                                       |       |                                       |       |   |   |   |   |
| License  fees                          |       | $                                          | 1,306      |                                       | 14.3       | % | $ | 2,459 |   | 24.1 | % |
| Services                               |       | 7,759                                      |       | 84.8                                       |       | 7,681 |   | 75.2 |   |
| Other-related  parties                 |       | 80                                         |       | 0.9                                        |       | 71 |   | 0.7 |   |
| Total  revenues                        |       | 9,145                                      |       | 100.0                                      |       | 10,211 |   | 100.0 |   |
|                                   |       |                                       |       |                                       |       |   |   |   |   |
| Operating  expenses:                   |       |                                       |       |                                       |       |   |   |   |   |
| Cost  of license fees                  |       | 693                                        |       | 7.6                                        |       | 371 |   | 3.7 |   |
| Cost  of services                      |       | 4,129                                      |       | 45.1                                       |       | 3,815 |   | 37.4 |   |
| Sales  and marketing                   |       | 2,271                                      |       | 24.8                                       |       | 1,780 |   | 17.4 |   |
| Research  and development              |       | 2,081                                      |       | 22.8                                       |       | 1,697 |   | 16.6 |   |
| General  and administrative            |       | 1,714                                      |       | 18.7                                       |       | 1,483 |   | 14.5 |   |
| Restructuring  and other costs         |       | (83                                        | )          | (0.9                                       | )          | — |   | — |   |
| Total  operating expenses              |       | 10,805                                     |       | 118.1                                      |       | 9,146 |   | 89.6 |   |
| Operating  income (loss)               |       | (1,660                                     | )          | (18.1                                      | )          | 1,065 |   | 10.4 |   |
| Other  income (expense):               |       |                                       |       |                                       |       |   |   |   |   |
| Equity  in losses of joint venture     |       | (40                                        | )          | (0.4                                       | )          | (81 | ) | (0.8 | ) |
| Other  income (expense), net           |       | 23                                         |       | 0.2                                        |       | (37 | ) | (0.3 | ) |
| Other  expense, net                    |       | (17                                        | )          | (0.2                                       | )          | (118 | ) | (1.1 | ) |
| Net  income (loss) before income taxes |       | (1,677                                     | )          | (18.3                                      | )          | 947 |   | 9.3 |   |
| Income  tax benefit (expense)          |       | 18                                         |       | 0.2                                        |       | (29 | ) | (0.3 | ) |
| Net  income (loss)                     |       | $                                          | (1,659     | )                                          | (18.1      | )% | $ | 918 |   | 9.0 | % |

 

19

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| ** **                                  | ** ** | **Nine Months Ended  September 30, 2004** | ** ** | **Nine Months Ended  September 30, 2003** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | ** **                                | ** ** | **Data as a**                             | ** ** | ** ** | ** ** | **Data as a** | ** ** |
| ** **                                  | ** ** | **As**                                    | ** ** | **percent of**                            | ** ** | **As** | ** ** | **percent of** | ** ** |
| **(in  thousands)**                         | ** ** | **Reported**                              | ** ** | **revenue**                               | ** ** | **Reported** | ** ** | **revenue** | ** ** |
| ** **                                  | ** ** | **(Unaudited)**                           | ** ** | **(Unaudited)**                           | ** ** |
| Revenues:                                   |       |                                      |       |                                      |       |   |   |   |   |
| License  fees                               |       | $                                         | 4,770      |                                      | 16.1       | % | $ | 5,054 |   | 17.3 | % |
| Services                                    |       | 24,621                                    |       | 83.3                                      |       | 23,930 |   | 81.8 |   |
| Other-related  parties                      |       | 181                                       |       | 0.6                                       |       | 260 |   | 0.9 |   |
| Total  revenues                             |       | 29,572                                    |       | 100.0                                     |       | 29,244 |   | 100.0 |   |
|                                        |       |                                      |       |                                      |       |   |   |   |   |
| Operating  expenses:                        |       |                                      |       |                                      |       |   |   |   |   |
| Cost  of license fees                       |       | 1,479                                     |       | 5.0                                       |       | 1,090 |   | 3.7 |   |
| Cost  of services                           |       | 12,926                                    |       | 43.7                                      |       | 11,782 |   | 40.3 |   |
| Sales  and marketing                        |       | 6,696                                     |       | 22.6                                      |       | 5,535 |   | 18.9 |   |
| Research  and development                   |       | 6,017                                     |       | 20.4                                      |       | 4,949 |   | 16.9 |   |
| General  and administrative                 |       | 4,811                                     |       | 16.3                                      |       | 4,146 |   | 14.2 |   |
| Restructuring  and other costs              |       | 1,020                                     |       | 3.5                                       |       | — |   | — |   |
| Total  operating expenses                   |       | 32,949                                    |       | 111.5                                     |       | 27,502 |   | 94.0 |   |
| Operating  income (loss)                    |       | (3,377                                    | )          | (11.5                                     | )          | 1,742 |   | 6.0 |   |
| Other  income (expense):                    |       |                                      |       |                                      |       |   |   |   |   |
| Equity  in income (losses) of joint venture |       | (122                                      | )          | (0.4                                      | )          | 34 |   | 0.1 |   |
| Other  income (expense), net                |       | 23                                        |       | 0.1                                       |       | (219 | ) | (0.8 | ) |
| Other  expense, net                         |       | (99                                       | )          | (0.3                                      | )          | (185 | ) | (0.7 | ) |
| Net  income (loss) before taxes             |       | (3,476                                    | )          | (11.8                                     | )          | 1,557 |   | 5.3 |   |
| Income  tax expense                         |       | (10                                       | )          | —                                    |       | (57 | ) | (0.2 | ) |
| Net  income (loss)                          |       | $                                         | (3,486     | )                                         | (11.8      | )% | $ | 1,500 |   | 5.1 | % |

 

**Comparison of Three Months EndedSeptember 30, 2004 to 2003**

 

*Revenues*

 

Total revenues decreased$1.1 million or 10.4% for the three months ended September 30, 2004 as comparedto the corresponding prior year period due to a $1.2 million or 46.9% decreasein license fees partially offset by a $0.1 million or 1.0% increase in servicesrevenues.  The decrease in license feesis mainly the result of a decrease of $1.3 million and $0.1 million in our USand Australian operations, respectively, partially offset by an increase of$0.2 million in our UK operations.  Forthe three months ended September 30, 2003, there was a $1.1 million license feefrom one customer in our U.S. operation. There was no similar license contract for the same period in 2004.

 

For both periods, we had a concentration of totalrevenues within a few select customers. Total revenues for the three months ended September 30, 2004 includedapproximately $1.1 million or 12.5% and $1.1 million or 11.7% of total revenuesfrom two customers, respectively.  Totalrevenues for the three months ended September 30, 2003 included $2.5 million or24.1% of total revenues from one customer.

 

The following table sets forth, for the periodsindicated, each major category of our services revenues as a percent of totalservices revenues:

 

20

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| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                  | ** ** | ** **                           | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(dollars  in thousands)** | ** ** | **Amount**                           | ** ** | **Total** | ** ** | **Amount** | ** ** | **Total** | ** ** |
| Maintenance                 |       | $                                    | 4,371      |   | 56.3 | % | $ | 4,087 |   | 53.2 | % |
| Consulting                  |       | 3,208                                |       | 41.4 | % | 3,488 |   | 45.4 | % |
| Training                    |       | 8                                    |       | 0.1 | % | 32 |   | 0.4 | % |
| Custom  programming         |       | 172                                  |       | 2.2 | % | 74 |   | 1.0 | % |
| Total  services revenue     |       | $                                    | 7,759      |   | 100.0 | % | $ | 7,681 |   | 100.0 | % |

 

The increase in services revenues is mainly a resultof increases of $284 thousand in maintenance revenue resulting from new licenseagreements and customary annual increases for existing agreements and $100thousand in custom programming primarily from a large agreement with onecustomer.  These increases were mostlyoffset by a decrease of $280 thousand in consulting revenue due to lower demandfor services mainly in our US operation.

 

Other-Related Party revenues, as shown in the tablebelow, include management/directors’ fees and consulting revenue from AfricanSolutions.

 
| ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| **(dollars  in thousands)**      | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Management/Directors’  fees |       | $                                     | 10         |   | $ | 8 |   |
| Consulting  revenue              |       | 70                                    |       | 63 |   |
| Total  revenues                  |       | $                                     | 80         |   | $ | 71 |   |

 

Revenues from the joint venture for the three-monthperiod remained consistent with the prior year.

 

*Operating Expenses*

 

Cost of license feesconsist primarily of amortization of capitalized software development costs andamounts paid to third parties with respect to products we resell in conjunctionwith the licensing of our products.  Theelements can vary substantially from period to period as a percentage oflicense fees.  Cost of license feesincreased $0.3 million or 86.8% for the three months ended September 30, 2004,as compared to the corresponding prior year period mainly as a result ofincreased sales of third party software used in conjunction with our software.

 

Cost of services consistsprimarily of personnel and third party costs for product quality assurance,training, installation, consulting and customer support.  Cost of services increased $0.3 million or8.2% for the three months ended September 30, 2004 as compared to thecorresponding prior year period.  Theincrease for the three-month period is mainly due to increases of $0.1 millionin travel and living expenses in various locations and $0.2 million in tempsand consultant expenses mostly in our South African subsidiary.

 

Sales and marketingexpenses consist primarily of salaries, commissions and bonuses related tosales and marketing personnel, as well as travel and promotional expenses.  Sales and marketing expenses increased $0.5million or 27.6% for the three months ended September 30, 2004, as compared tothe

 

21

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corresponding prior yearperiod.  The increase is primarily theresult of increases of $0.4 million in people related expenses due to increasedheadcount for our Compliance Solutions product line, annual salary increasesand related benefits, employee recruitment fees and travel and living expensesand $0.1 million in variable compensation for accrued annual bonuses.

 

Research and developmentexpenses consist primarily of personnel costs, costs of equipment, facilitiesand third party software development costs. Research and development expenses are generally charged to operations asincurred.  However, certain softwaredevelopment costs are capitalized in accordance with Statement of FinancialAccounting Standards No. 86 (“SFAS 86”). Such capitalized software development costs are generally amortized tocost of license fees on a straight-line basis over periods not exceeding threeyears.

 

Research and developmentexpenses (net of capitalized software development costs) increased $0.4 millionor 22.6% for the three months ended September 30, 2004 as compared to thecomparable prior year period.  Theincrease is primarily the result of increases of $0.1 million in temps andconsultants for work on the Records Compliance Management software and adecrease of $0.3 million in capitalized software development costs.  We capitalized $40 thousand in softwaredevelopment costs in the third quarter of 2004 as compared to $317 thousand inthe third quarter of 2003.  The rate ofcapitalization of software development costs may fluctuate depending on the mixand stage of development of our product development and engineeringprojects.  During the third quarter of2004, projects for which we had been capitalizing costs from prior periods weresubstantially completed.  In addition,the amount of time spent on new projects between technological feasibility andgeneral release has been reduced such that we do not expect there to besignificant software development costs capitalized in the future.

 

General and administrative expenses consist primarilyof salaries for administrative, executive and financial personnel, and outsideprofessional fees.  General andadministrative expenses increased $0.2 million or 15.6% for the three monthsended September 30, 2004 as compared to the corresponding prior yearperiod.  The increase for the threemonths is primarily as a result of an increase of $0.3 million in the provisionfor bad debt in our foreign locations of which $0.2 million is in the SouthAfrican operations for one customer. This increase was partially offset by small decreases in variablecompensation expense and other miscellaneous expenses.

 

Restructuring and other costs: On June 30, 2004, inorder to streamline and reorganize our operations to better meet our long-termgoals, we eliminated 25 positions in the United States and 11 positions in ourforeign operations.  We recorded a chargeto operations in the second quarter totaling approximately $0.8 million relatedto involuntary termination benefits to be paid to the terminatedemployees.  In the third quarter, wereduced the restructuring charge by approximately $0.1 million mainly resultingfrom our decision to retain two people in our foreign operations.  The elimination of the net 34 positions is expectedto result in annual savings of approximately $3.2 million that we have begun touse to invest in new business opportunities. At this time, no further reductions of headcount are expected or plannedthroughout the remainder of the year. (See Note 8 to the Consolidated Interim Financial Statements.)

 

*Operating Income (Loss)*

 

Operatingincome (loss) decreased $(2.7) million for the three months ended September 30,2004 as compared to the corresponding prior year period due mainly to adecrease of $1.1 million in total revenues and an increase of $1.7 million inoperating expenses.  The overall increasein operating expenses is as a result of management’s focus to build theinfrastructure in key aspects of the organization, including sales, marketingand research and development.

 

22

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*Other Expense, Net*

 

Other expense, netdecreased $101 thousand to a net expense of $17 thousand for the three monthsended September 30, 2004, as compared to $118 thousand expense in the sameperiod in 2003.  The decreased expense isprimarily due to a decrease of $48 thousand in interest expense and $41thousand of equity in losses of joint venture. There was no borrowing under the revolving line of credit in 2004 andthe term loan was fully paid as of March 31, 2004.  (See Note 2 to the Consolidated InterimFinancial Statements.)

 

*IncomeTax Benefit (Expense)*

 

Theincome tax benefit of $18 thousand for the three months ended September 30,2004 represents an adjustment to the estimated taxes due on expected earningsin our South African subsidiary.

 

**Comparison of Nine Months EndedSeptember 30, 2004 to 2003**

 

*Revenues*

 

Total revenues increased$0.3 million or 1.1% for the nine months ended September 30, 2004, as comparedto the corresponding prior year period. The increase for the nine-month period is mainly attributable to anincrease of $0.7 million in services revenues partially offset by decreases of$0.3 million and $0.1 million in license and other-related party revenue, respectively.  The increase in services revenue is mainlyattributable to an increase of $0.8 million in our U.S. operations partiallyoffset by a decrease of $0.1 million in our foreign operations.  The decrease in license revenues is largelydue to a decrease of $0.5 million in our foreign locations partially offset byan increase of $0.2 million in our US operations due mainly to sales of ourRecords Compliance Management software. The decrease in our foreign locations is mainly in our South Africansubsidiary which had a large contract in the second quarter of 2003 and nosimilar contract in 2004.

 

For both periods, we had a concentration of totalrevenues within a few select customers. Total revenues for the nine months ended September 30, 2004 included$3.0 million or 10.1% and $4.9 million or 16.6% of total revenues from twocustomers, respectively.  Total revenuesfor the nine months ended September 30, 2003 included $3.9 million or 13.2% and$5.9 million or 20.2% of total revenues from two customers, respectively.

 

The following table sets forth, for the periodsindicated, each major category of our services revenues as a percent of totalservices revenues:

 
| ** **                  | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                  | ** ** | ** **                          | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(dollars  in thousands)** | ** ** | **Amount**                          | ** ** | **Total** | ** ** | **Amount** | ** ** | **Total** | ** ** |
| Maintenance                 |       | $                                   | 12,961     |   | 52.6 | % | $ | 12,281 |   | 51.3 | % |
| Consulting                  |       | 11,074                              |       | 45.0 | % | 11,295 |   | 47.2 | % |
| Training                    |       | 45                                  |       | 0.2 | % | 85 |   | 0.4 | % |
| Custom  programming         |       | 541                                 |       | 2.2 | % | 269 |   | 1.1 | % |
| Total  services revenue     |       | $                                   | 24,621     |   | 100.0 | % | $ | 23,930 |   | 100.0 | % |

 

23

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The increase in services revenues in the U.S.operations is due to increases of $0.7 million in maintenance revenues due tonew license agreements and customary annual increases for existing agreementsand $0.3 million in custom programming due to a large agreement with onecustomer.  The decrease in consultingrevenue is mainly the result of a decrease in one foreign location.

 

The following table setsforth, for the periods indicated, each category of other related partiesrevenue:

 
| ** **                              | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| **(dollars  in thousands)**             | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Management/Directors’  fee revenue |       | $                                    | 28         |   | $ | 59 |   |
| Consulting  revenue                     |       | 153                                  |       | 201 |   |
| Total  revenues                         |       | $                                    | 181        |   | $ | 260 |   |

 

Other-related party revenue for the nine months endedSeptember 30, 2004 included decreases of $31 thousand and $48 thousand,respectively, in management/directors’ fee revenues and consulting revenue. Thedecrease in management/directors’ fee revenue for the nine months ended September30, 2004 as compared to the same period in 2003 resulted from our decision inthe second quarter of 2003 to temporarily stop charging management fees untilAfrican Solutions becomes profitable. However, directors’ fees were charged for both periods.  The decrease in consulting revenue resultedfrom decreased use of consultants from African Solutions, choosing instead toutilize our own internal staff.

 

*OperatingExpenses*

 

Cost of license fees increased $0.4 million for thenine months ended September 30, 2004, as compared to the corresponding prioryear period.  An increase of $0.6 millionin third party software royalty fees due to increased sales of third partysoftware used in conjunction with our software was partially offset by adecrease of $0.2 million in amortization of capitalized software developmentcosts as a result of certain costs becoming fully amortized in 2003.

 

Cost of servicesincreased $1.1 million or 9.7% for the nine months ended September 30, 2004 ascompared to the corresponding prior year period.  The increase is partially due to an increaseof $0.4 million in temps and consultants expense due to the use of temporaryconsultants to supplement our internal employees on specific assignmentsrelated mostly to the deployment of our newer software products.  The increase is also the result of increasesof $0.2 million in salaries and wages due to annual merit increases and relatedbenefits, $0.3 million in travel and living expenses and $0.1 million in costof third party services for use of independent consultants to supplement ourinternal professional services staff.

 

Sales and marketingexpenses increased $1.2 million or 21.0% for the nine months ended September30, 2004 as compared to the corresponding prior year period.  The increase is primarily a result ofincreases of $0.8 million in salaries and related benefits due to annual meritincreases and new hires, $0.2 million in travel and living expenses, $0.2million in employee recruitment fees, $0.5 million due to increased commissionsand bonuses expense as a direct result of the increase in license fee revenuein the U.S. operation and $0.1 million in other miscellaneous expenses.  These increases were partially offset by adecrease of $0.6 million in commission expense in our South African subsidiarywhich had a large contract in the second quarter of 2003 and no similarcontract in 2004.

 

24

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Research and developmentexpenses (net of capitalized software development costs) increased $1.1 millionor 21.6% for the nine months ended September 30, 2004, as compared to thecorresponding prior year period.  Theincrease is primarily the result of an increase of $0.9 million in personnelrelated expenses due to annual salary increases and related benefits, increaseduse of temporaries and consultants for continued work on development of theRecords Compliance Management software and a decrease in capitalized softwaredevelopment costs.  There was also a $0.1million increase in variable compensation expense due to accrued annual bonuscompensation and a $0.1 million increase in computer supplies expense.  We capitalized $0.6 million in softwaredevelopment costs for the nine months ended September 30, 2004 as compared to$1.0 million for the same period in 2003. The rate of capitalization of software development costs may fluctuatedepending on the mix and stage of development of our product development andengineering projects.

 

General and administrative expenses increased $0.7million or 16.0% for the nine months ended September 30, 2004 as compared tothe corresponding prior year period.  Theincrease is primarily the result of approximately $0.1 million in recruitingexpenses incurred in connection with the selection of our new CEO, an increaseof $0.1 million in temps and consultants expense, $0.1 million in bad debtrecovery that reduced general and administration expenses in the first quarterof 2003 and no similar recovery occurred in 2004 and an additional $0.3 millionincrease in the bad debt provision for the nine month period ended September30, 2004 in our foreign locations.  Thereis also an increase of $0.1 million in professional fees due partly toincreased use of outside attorneys and also due to a credit of approximately$60 thousand in the 2003 period for a settlement of professional fees due fromone vendor and there was no similar credit in the 2004 period.

 

For a discussion of the restructuring charges inRestructuring and other costs, see the quarter-to-quarter comparison above andNote 8 to the Consolidated Interim Financial Statements.  In addition to the restructuring charges, werecognized approximately $0.3 million in expenses related to a retirementagreement with our former CEO.  We expectto pay the retirement benefits in the fourth quarter of 2004.

 

*Operating Income (Loss)*

 

Operating income (loss) decreased $(5.1) million forthe nine months ended September 30, 2004 as compared to the same period in 2003due mainly to $1.0 million inrestructuring charges and other charges and $4.4 million in otherincreased operating expenses.  Theincrease in operating expenses was partially offset by an increase of $0.3million in total revenues.

 

*Other Income (Expense), Net*

 

Other expense, netdecreased $0.1 million for the nine months ended September 30, 2004 as comparedto the same period in 2003.  Decreases of$0.1 million in both interest expense and foreign exchange gain/loss and anincrease of $0.1 million in interest income were mostly offset by an increaseof $0.2 million of equity in losses of joint venture.  Equity in income of joint venture for thenine months ended September 30, 2003 included the sales commission recognizedby the South African joint venture related to a large license contractrecognized during the second quarter of 2003. There was no similar contract during the nine months ended September 30,2004.  Interest expense related to theinterest on the revolving line of credit and term loan that was fully paid asof March 31, 2004. (See Note 2 to the Consolidated Interim FinancialStatements.)

 

25

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*IncomeTax Benefit (Expense)*

 

Incometax expense of $10 thousand for the nine months ended September 30, 2004represents taxes due on expected earnings in our South African subsidiary forthe period.

 

**Liquidity and Capital Resources**

 

On April 5, 2004, wecompleted a private placement of shares of common stock that resulted in thereceipt of net proceeds of approximately $7.7 million.  Prior to that we had a Loan and SecurityAgreement (“Agreement”) that contained a revolving line of credit and a termloan (See Note 2 to the Consolidated Interim Financial Statements).  The term loan was paid in full as of March31, 2004, and no amounts remain outstanding. The Agreement terminated on May 28, 2004 as per the agreement.  On August 11, 2004, the Company entered intoa two-year Loan and Security Agreement which contains a revolving line ofcredit under which the Company has available the lesser of $4 million or 80% ofeligible accounts, as defined (See Note 2 to the Consolidated Interim FinancialStatements).  The available amount underthe revolving line of credit at September 30, 2004 was approximately $2.9million of which no amounts were outstanding.

 

As of September 30, 2004,we were in default of the covenant based on EBITDA.  We requested and received a waiver from thelender allowing for the default without penalty for the September 30, 2004covenant and are currently in the process of amending this covenant for theperiod ended December 31, 2004.  We werein compliance with all other covenants.

 

Our operating activitiesused cash of $2.9 million for the nine months ended September 30, 2004 andprovided cash of $1.1 million for the nine months ended September 30, 2003.  Net cash used by operating activities duringthe nine months ended September 30, 2004 is primarily the result of the netloss, an increase in accounts receivable and a decrease in deferred revenuepartially offset by non-cash depreciation and amortization and increases inprovision for doubtful accounts and accounts payable and accrued expenses.  The decrease in deferred revenue is mainlythe result of a decrease in long-term deferred revenue as nine months of atwo-year agreement with one customer have now been recognized as revenue.  The increase in accounts receivable, mainlyin the US operation, is due to certain customers delaying their payment onconsulting services and annual maintenance renewals.  The increase in accounts payable and accruedexpenses is mainly due to an accrual for commissions and bonuses and costs ofthird party licenses and services.

 

Net cash provided byoperating activities during the nine months ended September 30, 2003 wascomprised primarily of the net income and depreciation and amortization expensepartially offset by decreases in accounts payable and accrued expenses and indeferred revenue.

 

Our investing activitiesused cash of $0.9 million and $1.3 million for the nine months ended September30, 2004 and 2003, respectively.  Theuses of cash for both periods was primarily for capitalized softwaredevelopment costs related to development of new products as well as significantenhancements to certain existing products and for the purchase of computerequipment.

 

Cash provided by (usedin) financing activities was $7.6 million and ($1.3) million for the ninemonths ended September 30, 2004 and 2003, respectively.  For the nine months ended September 30, 2004,cash was primarily provided by the net proceeds received from the privateplacement and the exercise of stock options and warrants during theperiod.  This was partially offset by thepayment of the remaining balance of the outstanding term loan.  Cash used by financing activities for thenine months ended September 30, 2003 was related to the repayment of the termloan.

 

26

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We have no significantcapital commitments.  Planned capitalexpenditures for the year 2004 total approximately $1.2 million, including anysoftware development costs that may qualify for capitalization under SFAS86.  Our aggregate minimum operatinglease payments for 2004 will be approximately $2.0 million.  We generated net income of $2.3 million and$1.9 million for the years ended December 31, 2003 and 2002, respectively,after experiencing a net loss of $4.7 million during the year ended December31, 2001.  For the year ended December31, 2003, we experienced an increase in license fee revenues that, along withservices revenues, had declined in each of the prior two years primarily as aresult of intense competition and rapid technological change together with aslowing of the economy.  Though licensefee revenues declined during the third quarter after increasing during thefirst half of 2004 we expect to increase license fee revenues with sales of ournew products and continue to show improvement in our recurring revenues.  Management’s initiatives over the last twoyears, including the recent restructuring, have been designed to improveoperating results and liquidity and better position AXS-One to compete undercurrent market conditions.  Due to theseefforts, in addition to the private placement, we expect that our current cashbalance and operating cash flow will be sufficient to fund our working capitalrequirements through 2004 and beyond.  Wealso have a new revolving line of credit under which we have available thelesser of $4 million or 80% of eligible accounts, as defined.  Our ability to achieve the anticipatedresults is affected by the extent of cash generated from operations.  There is also the risk that cash held by ourforeign subsidiaries will not be readily available for use in our U.S.operations to pay our obligations as thetransfer of funds is sometimes delayed due to various foreign governmentrestrictions.  Accordingly, we may in thefuture be required to seek new sources of financing or future accommodationsfrom financial institutions.  No assurancecan be given that management’s initiatives will be successful or that any suchadditional sources of financing or lender accommodations will be available.

 

**Segment Information**

 

For the three and nine months ended September 30,2004, AXS-One Enterprise Solutions had license fee revenues of $0.4 million and$1.2 million, respectively, compared to $2.1 million and $4.1 million,respectively, for the comparable prior year period; service revenues of $6.2million and $20.4 million, respectively, compared to $6.5 million and $20.5million, respectively, for the comparable prior year period; and operatingincome of $0.1 million and $0.5 million, respectively, compared to $2.2 millionand $4.4 million, respectively, for the comparable prior year period.  License fees were higher for the three monthsended September 30, 2003 due to a $1.1 million license to one customer.  The nine months ended September 30, 2003 alsoincluded a $0.7 million sale to one customer in our South Africanoperations.  There were no similarlicense contracts in the 2004 periods. Also, there is less demand for our higher priced Foundation productswhile customers continue to license lower priced Web-based add-ons for theirexisting products.  Services revenues in2004, though down 5% in the third quarter as compared to the third quarter of2003, have remained fairly consistent with 2003 revenues for the nine-monthperiod.  An increase in maintenancerevenue was mostly offset by lower consulting revenues during the period.  Operating income decreased primarily as aresult of increases in sales and marketing expense, cost of services andresearch and development costs.

 

Compliance Platform Solutions had license fee revenuesof $0.9 million and $3.5 million, respectively, for the three and nine monthsended September 30, 2004, compared to $0.4 million and $1.0 million, respectivelyfor the comparable prior year periods; services revenue of $1.5 million and$4.3 million, respectively, compared to $1.1 million and $3.4 million,respectively, for the comparable prior year periods and operating income of$0.5 million and $2.4 million, respectively, as compared to $0.6 million and$1.9 million, respectively, for the comparable prior year periods.  The increase in license and services revenuesis mainly due to the sales and implementation of the email/instant messagingarchival

 

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solutions of our Records Compliance Managementsoftware released late in the third quarter of 2003.  The increase in operating income was mainlythe result of the increase in license revenues which more than offset anincrease in operating expenses.

 

**Critical Accounting Policies**

 

Our critical accountingpolicies are as follows:

 

•                  Revenuerecognition and

 

•                  Capitalizedsoftware development costs.

 

***RevenueRecognition***

 

Wederive our revenue primarily from two sources: (i) software licenses, throughboth direct and indirect channels, and (ii) services and support revenue, whichincludes software maintenance, training, consulting and custom programmingrevenue.  We also derive a limited amountof management and directors’ fee revenue from the joint venture (less than 1%of total revenue in 2003) entered into during 2001 by our South Africansubsidiary.  As described below, certainmanagement judgments and estimates must be made and used in connection with therevenue recognized in any accounting period. Material differences may result in the amount and timing of our revenuefor any period if our management made different judgments or utilized differentestimates.  Our policies and proceduresare the same regardless of whether the license is through our direct salesforce or through our resellers.

 

We normally license oursoftware products on a perpetual basis. Each license agreement generally includes a provision for initialpost-contract support (maintenance).  Forthe majority of license sales we use a signed license agreement as evidence ofan arrangement.  Occasionally, where amaster license agreement with a customer already exists, we accept the customer’spurchase order as evidence of an arrangement. For maintenance fees, we use a maintenance agreement as evidence of thearrangement.  We generally use aprofessional services agreement as evidence of an arrangement for our training,custom programming and consulting revenues. Management and directors’ fee revenues from our joint venture areevidenced by a master agreement governing the relationship.

 

We recognize revenue inaccordance with Statement of Position 97-2, “Software Revenue Recognition” (“SOP97-2”), and Statement of Position 98-9, “Modification of SOP 97-2, SoftwareRevenue Recognition, With Respect to Certain Transactions.”  Revenue from non-cancelable softwarelicenses, through both direct and indirect channels, is recognized when thelicense agreement has been signed, delivery has occurred, the fee is fixed ordeterminable and collectibility is probable. In multiple element arrangements, we defer the vendor-specific objectiveevidence of fair value (“VSOE”) related to the undelivered elements andrecognize revenue on the delivered elements using the residual method.  The most commonly deferred element is initialmaintenance, which is recognized on a straight-line basis over the initialmaintenance term.  The VSOE ofmaintenance is determined by using a consistent percentage of maintenance feeto license fee based on renewal rates. Maintenance fees in subsequent years are recognized on a straight-linebasis over the life of the applicable agreement.  Maintenance contracts entitle the customer tohot-line support and all unspecified product upgrades released during the termof the maintenance contract.  Upgradesinclude any and all unspecified patches or releases related to a licensedsoftware product.  Maintenance does notinclude implementation services to install these upgrades.

 

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Revenues from transactionfees associated with a hosting arrangement are recognized based on the actualnumber of transactions processed through the system during the period.

 

Delivery of softwaregenerally occurs when the product (on CDs) is delivered to a commoncarrier.  Occasionally, delivery occursthrough electronic means where the software is made available through oursecure FTP (File Transfer Protocol) site. We do not offer any customers or resellers a right of return.

 

Forsoftware license and maintenance revenue, we assess whether the fee is fixedand determinable and whether or not collection is probable.  We assess whether the fee is fixed anddeterminable based on the payment terms associated with the transaction.  If a significant portion of a fee is dueafter our normal payment terms, which are 30 to 90 days from invoice date, weaccount for the fee as not being fixed and determinable.  In these cases, we recognize revenue as thefees become due.

 

The majorityof our training and consulting services are billed based on hourly rates.  We generally recognize revenue as theseservices are performed when there is also evidence of an arrangement, the feeis fixed or determinable and collectibility is reasonably assured.  However, when we enter into an arrangementthat requires us to perform significant work either to alter the underlyingsoftware or to build additional complex interfaces so that the softwareperforms as the customer requests, we recognize the entire fee using thepercentage of completion method of accounting. This would apply to our custom programming services, which are generallycontracted on a fixed fee basis.  Anticipatedlosses, if any, are charged to operations in the period such losses aredetermined.

 

Revenuesfrom the joint venture (included in Revenues: Other-Related Party in ourConsolidated Interim Statements of Operations) include consulting revenue forthe joint ventures’ use of our South African subsidiary’s consultants and for managementand directors’ fees for our subsidiary providing managerial, technical andother related services, including director services, to the joint venture inaccordance with the joint venture agreement. Revenue is recognized upon performance of the services.

 

Weassess assuredness of collection for revenue transactions based on a number offactors, including past transaction history with the customer and thecredit-worthiness of the customer.  We donot request collateral from our customers. If we determine that collection of a fee is uncertain, we defer the feeand recognize revenue at the time the uncertainly is eliminated, which isgenerally upon receipt of cash.

 

Ourarrangements do not generally include acceptance clauses.  However, if an arrangement includes anacceptance provision, acceptance occurs upon the earliest of receipt of awritten customer acceptance, expiration of the acceptance period or productiveuse of the software by the customer.

 

***CapitalizedSoftware Development Costs***

 

Our policy is to capitalize certain softwaredevelopment costs in accordance with SFAS 86. Under SFAS 86, costs incurred to develop a computer software product arecharged to research and development expense as incurred until technologicalfeasibility has been established.  Weestablish technological feasibility upon completion of a detailed programdesign or working model from which point all research and development costs forthat project are capitalized until the product is available for general releaseto customers.  The establishment oftechnological feasibility and the ongoing assessment of recoverability ofcapitalized software development costs require considerable judgment bymanagement with respect to certain external factors, including, but not limitedto, anticipated future revenues, estimated economic life and changes intechnology.  It is reasonably possiblethat estimates of anticipated future revenues, the remaining estimated economiclife of the products, or both will be reduced in the future due to competitivepressures.  As a result, the carryingamount of the capitalized software costs may be reduced

 

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in the near term. Upon the general release of the software product to customers,capitalization ceases and such costs are amortized (using the straight-linemethod) on a product-by-product basis over the estimated life, which isgenerally three years.

 

**Recently Issued AccountingStandards**

 

In December 2003, the FASB issued Interpretation No.46R, “Consolidation of Variable Interest Entities” (FIN 46R) that addresses theconsolidation of variable interest entities. FIN 46R provides guidance for determining when a primary beneficiaryshould consolidate a variable interest entity, or equivalent structure, thatfunctions to support the activities of the primary beneficiary.  We adopted FIN 46R on March 31, 2004.  Based on our evaluation of thisInterpretation we believe that our 49% owned joint venture, African Solutions,is a variable interest entity (VIE) as defined in FIN 46R.  However, we have determined that the majorityowner, African Legends Technology, absorbs the majority of expected losses andtherefore, African Legends Technology is the primary beneficiary.  Due to the fact that we are not the primarybeneficiary of African Solutions, the adoption of FIN 46R did not have animpact on our consolidated financial position or results of operations.

 

**Item 3.    Quantitativeand Qualitative Disclosures About Market Risk**

 

In the normal course ofbusiness, we are exposed to fluctuations in interest rates and equity marketrisks as we seek debt and equity capital to sustain our operations.  We are also exposed to fluctuations inforeign currency exchange rates as the financial results and financialconditions of our foreign subsidiaries are translated into U.S. dollars inconsolidation.  We do not use derivativeinstruments or hedging to manage our exposures and do not currently hold anymarket risk sensitive instruments for trading purposes.

 

**Certain Factors That May AffectFuture Results and Financial Condition and the Market Price of Securities**

 

See our 2003 AnnualReport on Form 10K for a discussion of risk factors.

 

**Item 4.    Controlsand Procedures**

 

***Evaluationof disclosure controls and procedures***

 

Our chief executive officer and our chief financialofficer, after evaluating the effectiveness of our “disclosure controls andprocedures” (as defined in the Securities Exchange Act of 1934 Rule 13a-15(e))as of September 30, 2004 (the “Evaluation Date”), have concluded that as of theEvaluation Date, our disclosure controls and procedures were effective anddesigned to ensure that material information relating to us and ourconsolidated subsidiaries would be collected and made known to them by otherswithin those entities as appropriate to allow timely decisions regardingrequired disclosure of such information.

 

***Internalcontrols over financial reporting***

 

During the most recent fiscal quarter, there has notbeen any change in our internal control over financial reporting that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**AXS-ONEINC.**

Part II

Other Information

 

**Item 1.    LegalProceedings**

 

Historically, we have been involved in disputes and/orlitigation encountered in our normal course of business.  We believe that the ultimate outcome of theseproceedings will not have a material adverse effect on our business,consolidated financial condition, results of operations or cash flows.

 

**Item 6.    Exhibits**

 
| Exhibit  31.1 | Rule  13a-14(a)/15d-14(a) Certifications – William P. Lyons    |
|---------------|---------------------------------------------------------------------|
| Exhibit  31.2 | Rule  13a-14(a)/15d-14(a) Certifications – William G. Levering |
| Exhibit  32   | Officer  Certifications under 18 USC 1350                           |

 

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**AXS-ONEINC.**

 

 

SIGNATURES

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|                        | AXS-ONE INC. |
|-----------------------------|--------------|
|                        |         |
|                        |         |
| **Date:**November  12, 2004 | By:          | /s/ William P. Lyons |   |
|                        |         | William P. Lyons  Chairman of the Board and  Chief Executive Officer |
|                        |         |   |
|                        |         |   |
|                        | By:          | /s/ William G. Levering  III |   |
|                        |         |  William G.  Levering III   Vice President, Chief Financial Officer,   and Treasurer   (Duly Authorized Officer and    Principal Financial Officer) |
|                             |              |  |  |  |

 

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