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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB (X) QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 For the quarterly period ended October 31, 2004 OR (  ) TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 000-19608 ARI Network Services, Inc. 
 (Exact name of small business issuer as specified in its charter.) WISCONSIN
    
    39-1388360(State or other jurisdiction of
    
    (IRS Employer Identification No.)incorporation or organization)
 11425 W. Lake Park Drive, Milwaukee, Wisconsin 53224 
  Issuers telephone number (414) 973-4300 Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES
[ü]
     NO [  ] As of December 10, 2004 there were 5,963,347 shares of the registrants shares
outstanding. Transitional Small Business Disclosure Format (check one). ü
 1




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##### Table of Contents



ARI Network Services, Inc. FORM 10-QSB FOR THE THREE MONTHS ENDED OCTOBER 31, 2004 INDEX PagePART I
- FINANCIAL INFORMATIONItem 1 Financial statementsCondensed balance sheets - October 31, 2004 and July 31, 2004
    
    
    3-4Condensed statements of operations for the three months ended October 31, 2004
and 2003
    
    
    5Condensed statements of cash flows for the three months ended October 31,

2004 and 2003
    
    
    6Notes to unaudited condensed financial statements
    
    
    7-8Item 2 Managements discussion and analysis or plan of operation
    
    
    8-17Item 3 Controls and procedures
    
    
    18PART II - OTHER INFORMATIONItem 2 Unregistered sales of equity securities and use of proceeds
    
    
    18Item 6 Exhibits
    
    
    18Signatures
    
    
    19302 Certification302 Certification906 Certification906 Certification
 2




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ARI Network Services, Inc. 
 Balance Sheets  (In thousands, except share and per share data)  (Unaudited)
 October 31
    
    July 312004
    
    2004ASSETSCurrent assets:Cash
    
    $
    3,170
    
    
    $
    3,357Trade receivables, less allowance for doubtful accounts of $65
at October 31, 2004 and $44 at July 31, 2004
    
    
    752
    
    
    
    1,121Prepaid expenses and other
    
    
    109
    
    
    
    187Total current assets
    
    
    4,031
    
    
    
    4,665Equipment and leasehold improvements:Computer equipment
    
    
    4,670
    
    
    
    4,607Leasehold improvements
    
    
    73
    
    
    
    73Furniture and equipment
    
    
    1,497
    
    
    
    1,4916,240
    
    
    
    6,171Less accumulated depreciation and amortization
    
    
    5,684
    
    
    
    5,630Net equipment and leasehold improvements
    
    
    556
    
    
    
    541Other assets
    
    
    39
    
    
    
    15Capitalized software product costs
    
    
    10,805
    
    
    
    10,203Less accumulated amortization
    
    
    9,374
    
    
    
    9,233Net capitalized software product costs
    
    
    1,431
    
    
    
    970Total Assets
    
    $
    6,057
    
    
    $
    6,191
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##### Table of Contents



ARI Network Services, Inc.
Balance Sheets(In thousands, except share and per share data)(Unaudited) October 31
    
    July 312004
    
    2004LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIT)Current liabilities:Current portion of notes payable
    
    $
    1,000
    
    
    $
    1,000Accounts payable
    
    
    282
    
    
    
    260Deferred revenue
    
    
    4,843
    
    
    
    5,453Accrued payroll and related liabilities
    
    
    1,185
    
    
    
    951Accrued sales, use and income taxes
    
    
    429
    
    
    
    489Other accrued liabilities
    
    
    623
    
    
    
    564Current portion of capital lease obligations
    
    
    7
    
    
    
    10Total current liabilities
    
    
    8,369
    
    
    
    8,727Long term liabilities:Notes payable (net of discount)
    
    
    3,033
    
    
    
    3,306Long term payroll related liabilities
    
    
    495
    
    
    
    495Other long term liabilities
    
    
    211
    
    
    
    211Capital lease obligations
    
    
    3
    
    
    
    3Total long term liabilities
    
    
    3,742
    
    
    
    4,015Shareholders equity (deficit):Cumulative preferred stock, par value $.001 per share,
1,000,000 shares authorized; 0 shares issued and
outstanding at October 31, 2004 and July 31, 2004, respectively
    
    
    
    
    
    
    Common stock, par value $.001 per share, 25,000,000 shares
authorized; 5,963,347 and 5,923,034 shares issued and outstanding
at October 31, 2004 and July 31, 2004, respectively
    
    
    5
    
    
    
    5Common stock warrants and options
    
    
    36
    
    
    
    36Additional paid-in-capital
    
    
    93,628
    
    
    
    93,625Accumulated deficit
    
    
    (99,723
    )
    
    
    (100,217
    )Total shareholders equity (deficit)
    
    
    (6,054
    )
    
    
    (6,551
    )Total Liabilities and Shareholders Equity (Deficit)
    
    $
    6,057
    
    
    $
    6,191
 See notes to unaudited condensed financial statements. Note: The balance sheet at July 31, 2004 has been derived from the audited
balance sheet at that date but does not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. 4




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ARI Network Services, Inc. 
 Statements of Operations  (In thousands, except per share data)
(Unaudited)
 Three months endedOctober 312004
    
    2003Net revenues:Subscriptions, support and other services fees
    
    $
    2,402
    
    
    $
    2,289Software licenses and renewals
    
    
    576
    
    
    
    589Professional services
    
    
    297
    
    
    
    4073,275
    
    
    
    3,285Cost of products and services sold:Subscriptions, support and other services fees
    
    
    193
    
    
    
    155Software licenses and renewals *
    
    
    154
    
    
    
    462Professional services
    
    
    82
    
    
    
    191429
    
    
    
    808Gross margin
    
    
    2,846
    
    
    
    2,477Operating expenses:Depreciation and amortization (exclusive of amortization of
software products included in cost of products and
services sold)
    
    
    54
    
    
    
    35Customer operations and support
    
    
    262
    
    
    
    283Selling, general and administrative
    
    
    1,709
    
    
    
    1,758Software development and technical support
    
    
    421
    
    
    
    341Operating expenses before amounts capitalized
    
    
    2,446
    
    
    
    2,417Less capitalized portion
    
    
    (162
    )
    
    
    (64
    )Net operating expenses
    
    
    2,284
    
    
    
    2,353Operating income
    
    
    562
    
    
    
    124Other income (expense):Interest expense
    
    
    (44
    )
    
    
    (81
    )Other, net
    
    
    12
    
    
    
    29Total other income (expense)
    
    
    (32
    )
    
    
    (52
    )Income before provision for income taxes
    
    
    530
    
    
    
    72Income tax expense
    
    
    (36
    )
    
    
    Net income
    
    $
    494
    
    
    $
    72Average common shares outstanding:Basic
    
    
    5,951
    
    
    
    5,796Diluted
    
    
    6,248
    
    
    
    5,921Net income per share:Basic
    
    $
    0.08
    
    
    $
    0.01Diluted
    
    $
    0.08
    
    
    $
    0.01
 See notes to unaudited condensed financial statements.  *
    
    Includes amortization of software products of $141 and $443 and excludes
other depreciation and amortization shown separately 5




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ARI Network Services, Inc. 
 Statements of Cash Flows  (In thousands)
(Unaudited)
 Three months endedOctober 312004
    
    2003Operating activitiesNet income
    
    $
    494
    
    
    $
    72Adjustments to reconcile net income to net cash provided
by operating activities:Amortization of software products
    
    
    141
    
    
    
    443Amortization of deferred financing costs, debt discount and
excess carrying value over face amount of notes payable
    
    
    (21
    )
    
    
    (15
    )Depreciation and other amortization
    
    
    54
    
    
    
    35Stock issued as contribution to 401(k) plan
    
    
    37
    
    
    
    37Net change in receivables, prepaid expenses and other
current assets
    
    
    422
    
    
    
    149Net change in accounts payable, deferred revenue,
accrued liabilities and other long term liabilities
    
    
    (392
    )
    
    
    (653
    )Net cash provided by operating activities
    
    
    735
    
    
    
    68Investing activitiesPurchase of equipment and leasehold improvements
    
    
    (69
    )
    
    
    (17
    )Purchase of assets related to acquisitions
    
    
    
    
    
    
    (108
    )Software product costs capitalized
    
    
    (602
    )
    
    
    (64
    )Net cash used in investing activities
    
    
    (671
    )
    
    
    (189
    )Financing activitiesPayments under notes payable
    
    
    (251
    )
    
    
    (200
    )Payments of capital lease obligations
    
    
    (3
    )
    
    
    (7
    )Debt issuance costs incurred
    
    
    
    
    
    
    (20
    )Proceeds from issuance of common stock
    
    
    3
    
    
    
    2Net cash used in financing activities
    
    
    (251
    )
    
    
    (225
    )Net decrease in cash
    
    
    (187
    )
    
    
    (346
    )Cash at beginning of period
    
    
    3,357
    
    
    
    2,120Cash at end of period
    
    $
    3,170
    
    
    $
    1,774Cash paid for interest
    
    $
    64
    
    
    $
    22Cash paid for income taxes
    
    $
    55
    
    
    $
    Noncash investing and financing activitiesIssuance of common stock in connection with acquisitions
    
    $
    
    
    
    $
    37Exchange of equity to debt
    
    
    
    
    
    
    1,000
 See notes to unaudited condensed financial statements. 6




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Notes to Condensed Financial Statements
(Unaudited)
October 31, 2004 1. BASIS OF PRESENTATION The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for fiscal year end financial statements. In the opinion
of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. Operating
results for the three months ended October 31, 2004 are not necessarily
indicative of the results that may be expected for the fiscal year ending July
31, 2005. For further information, refer to the financial statements and
footnotes thereto included in the Companys annual report on Form 10-KSB for
the year ended July 31, 2004. 2. BASIC AND DILUTED NET INCOME PER SHARE Basic net income per common share is computed by dividing net income by the
weighted average number of common shares outstanding during the period.
Diluted net income per common share is computed by dividing net income by the
weighted average number of common shares outstanding during the period and
reflects the potential dilution that could occur if all of the Companys
outstanding stock options and warrants that are in the money were exercised
(calculated using the treasury stock method). The following table is a
reconciliation of the weighted average number of common shares and equivalents
outstanding in the calculation of basic and diluted net income per common share
(in thousands) for the periods indicated. Three months endedOctober 312004
    
    2003Weighted average common shares outstanding
    
    
    5,951
    
    
    
    5,796Dilutive effect of stock options
    
    
    297
    
    
    
    125Diluted weighted average common shares outstanding
    
    
    6,248
    
    
    
    5,921
 3. STOCK-BASED COMPENSATION The Company has stock-based compensation plans. SFAS No. 148 Accounting for
Stock-Based Compensation  Transition and Disclosure requires companies with
stock-based compensation plans to disclose the pro forma effect of stock-based
compensation on earnings and earnings per share. The following table sets
forth the effect on earnings and earnings per share (in thousands, except per
share data) of stock-based compensation had the cost been determined based upon
the fair value at the grant date for awards under the plan using the
Black-Scholes valuation method. Three months endedOctober 312004
    
    2003Net income, as reported
    
    $
    494
    
    
    $
    72Stock-based compensation using the
fair value method
    
    
    (35
    )
    
    
    (20
    )Pro forma net income
    
    $
    459
    
    
    $
    52Net income per shareBasic - as reported
    
    $
    0.08
    
    
    $
    0.01Basic - pro forma
    
    $
    0.08
    
    
    $
    0.01Diluted - as reported
    
    $
    0.08
    
    
    $
    0.01Diluted - pro forma
    
    $
    0.07
    
    
    $
    0.01
 4. NOTES PAYABLE On April 24, 2003, the Company restructured its debt. In exchange for
previously outstanding securities, the Company issued to a group of investors
(collectively, the New Holders), in aggregate, $500,000 in cash, new
unsecured notes in the amount of $3.9 million (the New Notes) and new
warrants for 250,000 common shares, exercisable at $1.00 per share (the New
Warrants). The interest rate on the New Notes is the prime interest rate plus
2%. The New Notes are payable in $200,000 quarterly installments commencing
March 31, 2004 through December 31, 2005 and $300,000 quarterly installments
commencing March 31, 2006 until paid in full. The New Notes do not contain any
financial covenants, but the Company is restricted from permitting certain
liens on its assets. In addition, in the event of payment default that is not
cured within ninety (90) days, Taglich Brothers, Inc., one of the New Holders,
has the right to appoint one designee to the Companys Board of Directors. The
New Warrants were estimated to have a value of $36,000, of which the
unamortized amount reduces the carrying amount of the debt. 7




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In accordance with SFAS No. 15, Accounting by Debtors and Creditors for
Troubled Debt Restructurings, the exchange of the previously outstanding
securities for $500,000 in cash, the New Notes and the New Warrants was
accounted for as a troubled debt restructuring and no gain was recorded.
Instead the liability in excess of the future cash flows to the New Holders,
which was originally approximately $322,000, remains on the balance sheet as a
long term debt and is being amortized as a reduction of interest expense over
the life of the New Notes. On August 7, 2003, the Company purchased from WITECH Corporation 1,025,308
shares of the Companys common stock, 30,000 common stock warrants and 20,350
shares of Series A Preferred Stock for $200,000 at closing and an $800,000
promissory note which is payable quarterly through September 30, 2007, at the
prime interest rate plus 2%. 5. SHAREHOLDER RIGHTS PLAN On August 7, 2003, the Company adopted a Shareholder Rights Plan designed to
protect the interests of common shareholders from an inadequate or unfair
takeover, but not affect a takeover proposal which the Board of Directors
believes is fair to all shareholders. Under the Shareholder Rights Plan
adopted by the Board of Directors, all shareholders of record on August 18,
2003 received one Preferred Share Purchase Right for each share of common stock
they owned. These Rights trade in tandem with the common stock until and
unless they are triggered. Should a person or group acquire more than 10% of
ARIs common stock (or if an existing holder of 10% or more of the common stock
were to increase its position by more than 1%), the Rights would become
exercisable for every shareholder except the acquirer that triggered the
exercise. The Rights, if triggered, would give the other shareholders the
ability to purchase additional stock of ARI at a substantial discount. The
rights will expire on August 18, 2013, and can be redeemed by the Company for
$0.01 per Right at any time prior to a person or group becoming a 10%
shareholder. 
 MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION Results of Operations Total revenue for the quarter ended October 31, 2004 decreased $10,000 or less
than 1% compared to the same period last year, primarily due to a decrease in
revenues from the Companys non-North American catalog products in the
Equipment Industry. Earnings increased from net income of $72,000, or $0.01
per share for the quarter ended October 31, 2003 to net income of $494,000 or
$0.08 per share for the quarter ended October 31, 2004. Management believes
that the Company will have modest revenue growth and continue to be profitable
for the remainder of fiscal 2005, although there can be no assurance that this
will occur. Critical Accounting Policies and Estimates General The Companys discussion and analysis of its financial condition and results of
operations are based upon its financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires the Company to make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, the Company evaluates its estimates,
including those related to customer contracts, bad debts, capitalized software
product costs, financing instruments, revenue recognition and other accrued
expenses. The Company bases its estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent
from other sources. Actual results may differ from these estimates under
different assumptions or conditions. The Company believes the following critical accounting policies affect its more
significant judgments and estimates used in the preparation of its financial
statements. Revenue Recognition Revenue for use of the network and for information services is recognized in
the period such services are utilized. Revenue from annual or periodic
maintenance fees, license and license renewal fees and catalog subscription
fees is recognized ratably over the period the service is provided.
Arrangements that include acceptance terms beyond the Companys standard terms
are not recognized until acceptance has occurred. If collectibility is not
considered probable, revenue is recognized when the fee is collected.
Arrangements that include professional services are evaluated to determine
whether those services are essential to the functionality of other elements of
the arrangement. When professional services are not considered essential, the
revenue allocable to the professional services is recognized as the services
are performed. When professional services are considered 8




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essential, revenue under the arrangement is recognized pursuant to contract
accounting using the percentage-of-completion method with
progress-to-completion measured based upon labor hours incurred. When the
current estimates of total contract revenue and contract cost indicate a loss,
a provision for the entire loss on the contract is made. Revenue on
arrangements with customers who are not the ultimate users (resellers) is
deferred if there is any contingency on the ability and intent of the reseller
to sell such software to a third party. Bad Debts The Company maintains an allowance for doubtful accounts for estimated losses
resulting from the inability of its customers to make required payments. The
Company currently reserves for most amounts due over 90 days, unless there is
reasonable assurance of collectibility. If the financial condition of the
Companys customers were to deteriorate, resulting in an impairment of their
ability to make payments, additional allowances may be required. Use of Estimates The preparation of the Companys financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions about accrued expenses that affect
the amounts reported in the financial statements and accompanying notes. Actual
results could differ from those estimates. Impairment of Long-Lived Assets Equipment and leasehold improvements and capitalized software product costs are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable. If the sum of the expected
undiscounted cash flows is less than the carrying value of the related asset or
group of assets, a loss is recognized for the difference between the fair value
and carrying value of the asset or group of assets. Debt Instruments The Company valued debt discounts for Common Stock Warrants and Options granted
in consideration for Notes Payable using the Black Scholes valuation method.
Non-cash interest expense is recorded for the amortization of the debt discount
over the term of the debt. Deferred Tax Asset The tax effect of the temporary differences between the book and tax bases of
assets and liabilities and the estimated tax benefit from tax net operating
losses are reported as deferred tax assets and liabilities in the balance
sheet. An assessment of the likelihood that net deferred tax assets will be
realized from future taxable income is performed. Because the ultimate
realizability of deferred tax assets is highly subject to the outcome of future
events, the amount established as valuation allowances is considered to be a
significant estimate that is subject to change in the near term. To the extent
a valuation allowance is established or there is a change in the allowance
during a period, the change is reflected with a corresponding increase or
decrease in the tax provision in the statement of operations. Stock-Based Compensation The Company accounts for its employee stock option plans under the recognition
and measurement principles of Accounting Principles Board (APB) Opinion No.
25, Accounting for Stock Issued to Employees, and related Interpretations.
Under APB Opinion No. 25, no stock-based compensation is reflected in net
income, as all options granted under the plans had an exercise price equal to
the market value of the underlying common stock on the date of grant and the
related number of shares granted is fixed at that point in time. 9




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Revenues The Company is a leading provider of electronic parts catalogs and related
technology and services to increase sales and profits for dealers in the
manufactured equipment market. The Company currently provides 78 catalogs of
manufactured equipment from 65 manufacturers to approximately 28,000 dealers in
more than 100 countries in 12 segments of the worldwide manufactured equipment
market including outdoor power, power sports, motorcycles, recreation vehicles,
marine, construction, floor maintenance, agricultural equipment, auto and truck
parts after-market and others primarily in the U.S., Canada, Europe and
Australia. Collectively, dealers and distributors have over 88,000 catalog
subscriptions. The Company supplies three types of software and services: (1)
robust Web and CD-ROM interactive electronic parts catalogs, (2) integrated
marketing services including template-based website services and
technology-enabled direct mail services and (3) communication or transaction
services. The Companys primary product line is electronic cataloging; the
other products are supplementary offerings that leverage its position in the
catalog market. The following table sets forth certain Catalog, Customer and Subscription
information by region derived from the Companys financial and customer
databases. The number of distinct distributors and dealers is estimated
because some subscriptions are distributed by third parties (including
manufacturers), which may or may not inform ARI of the distributors and/or
dealers to which the subscription is distributed. Because the estimating
methodology is still being refined, comparisons to prior quarters may or may
not be indicative of business trends. Catalog, Customer and Subscription Information by Region
(As of October 31, 2004) Distinct
    
    
    
    
    
    Distinct
    
    DistinctCatalogs
    
    Manufacturers
    
    Subscriptions
    
    Distributors
    
    Dealers(Estimated)
    
    (Estimated)North American
    
    
    71
    
    
    
    55
    
    
    
    71,635
    
    
    
    108
    
    
    
    19,367Non-North American
    
    
    68
    
    
    
    10
    
    
    
    16,956
    
    
    
    18
    
    
    
    8,640Included in both Regions
    
    
    (61
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    78
    
    
    
    65
    
    
    
    88,591
    
    
    
    126
    
    
    
    28,007
 Catalog
    
    =
    
    A separately sold and/or distributed parts catalog. A manufacturer may have more
one catalog. More than one brand or distinct product line may be included in a
catalog.Distinct Manufacturer
    
    =
    
    A single independent manufacturer, not owned by another manufacturer, served by
ARI. Distinct manufacturers are included in the region they most serve even if they
have catalogs in both regions.Subscription
    
    =
    
    Catalogs subscribed to by a single dealer or distributor. A dealer or
distributor may subscribe to more than one catalog.Distinct Distributor
    
    =
    
    A single independent distributor, not owned by another distributor, served by ARI. A
distributor generally buys from manufacturers and sells to dealers.Distinct Dealer
    
    =
    
    A single independent servicing dealer, not owned by another dealer, served by ARI.
 As part of its historical business practice, the Company continues to provide
electronic directory and transaction services to U.S. and Canadian agribusiness
industry. As the Company focuses on its core businesses in the Equipment
industry, revenues in the non-equipment industry are expected to continue to
decline during fiscal 2005. Management reviews the Companys recurring vs. non-recurring revenue in the
aggregate and within the North American Equipment, non-North American Equipment
and non-Equipment industries and by product category within the Equipment
Industry. 10




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The following tables set forth, for the periods indicated, certain revenue
information derived from the Companys unaudited financial statements. Revenue by Industry Sector
(In thousands) Three months endedOctober 31
    
    Percent2004
    
    2003
    
    ChangeIndustry Sector:Equipment IndustryNorth AmericanRecurring
    
    $
    2,492
    
    
    $
    2,355
    
    
    
    6
    %Non-recurring
    
    
    395
    
    
    
    366
    
    
    
    8
    %Subtotal
    
    
    2,887
    
    
    
    2,721
    
    
    
    6
    %Non-North AmericanRecurring
    
    
    224
    
    
    
    295
    
    
    
    (24
    %)Non-recurring
    
    
    
    
    
    
    68
    
    
    
    (100
    %)Subtotal
    
    
    224
    
    
    
    363
    
    
    
    (38
    %)Total Equipment IndustryRecurring
    
    
    2,716
    
    
    
    2,650
    
    
    
    3
    %Non-recurring
    
    
    395
    
    
    
    434
    
    
    
    (9
    %)Subtotal
    
    
    3,111
    
    
    
    3,084
    
    
    
    1
    %Non-equipment IndustryRecurring
    
    
    164
    
    
    
    201
    
    
    
    (18
    %)Non-recurring
    
    
    
    
    
    
    
    
    
    
    Subtotal
    
    
    164
    
    
    
    201
    
    
    
    (18
    %)Total RevenueRecurring
    
    
    2,880
    
    
    
    2,851
    
    
    
    1
    %Non-recurring
    
    
    395
    
    
    
    434
    
    
    
    (9
    %)Grand Total
    
    $
    3,275
    
    
    $
    3,285
    
    
    
    0
    %
 Revenue by Product in the Equipment Industry
(In thousands) Three months endedOctober 31
    
    Percent2004
    
    2003
    
    ChangeProduct:Equipment IndustryCatalog and relatedRecurring
    
    $
    2,599
    
    
    $
    2,517
    
    
    
    3
    %Non-recurring
    
    
    395
    
    
    
    428
    
    
    
    (8
    %)Subtotal
    
    
    2,994
    
    
    
    2,945
    
    
    
    2
    %CommunicationsRecurring
    
    
    117
    
    
    
    133
    
    
    
    (12
    %)Non-recurring
    
    
    
    
    
    
    6
    
    
    
    (100
    %)Subtotal
    
    
    117
    
    
    
    139
    
    
    
    (16
    %)Total Equipment Industry
    
    $
    3,111
    
    
    $
    3,084
    
    
    
    1
    %
 11




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##### Table of Contents



Recurring revenues are derived from catalog subscription fees, catalog data
update fees, software maintenance and support fees, software license renewals,
network traffic and support fees and other miscellaneous subscription fees.
Non-recurring revenues are derived from initial software licenses and
professional services fees. Recurring revenue, as a percentage of total
revenue, was 88% for the three months ended October 31, 2004 compared to 87%
for the same period last year. Management believes that the relationship of
approximately three quarters recurring revenue to one quarter non-recurring
revenue establishes an appropriate level of base revenue while the Company
continues to add new sales to drive future increases in recurring revenue. If
the manufacturing sector of the economy improves in the future, the percentage
of recurring revenue may be slightly lower, indicating a higher amount of new
business. This ratio is expected to fluctuate from quarter to quarter and year
to year, depending on the nature, size and timing of new business. Equipment Industry The Equipment Industry has been a growing percentage of the Companys revenue
over the past six years and is composed of several vertical markets including
outdoor power, power sports, motorcycles, recreation vehicles, marine,
construction, floor maintenance, agricultural equipment, auto and truck parts
after-market and others primarily in the U.S., Canada, Europe and Australia.
Managements strategy is to expand the Companys electronic parts catalog
software and services business with dealers in the existing vertical markets
and the manufacturers and distributors whose products they sell and service,
add supplemental products for existing customers, and then expand to other
similar markets in the future. Revenues in the Equipment Industry increased,
as a percentage of total revenues, from 94% for the three months ended October
31, 2003 to 95% for the three months ended October 31, 2004.  North AmericanRecurring revenues in the North American Equipment Industry increased for the
three month period ended October 31, 2004, compared to the same period last
year, primarily due to an increase in the base revenue of subscription
renewals from the Companys catalog products. Non-recurring revenues in the
North American Equipment Industry increased for the three month period ended
October 31, 2004, compared to the same period last year, primarily due to new
customer contracts.Non-North AmericanRecurring revenues in the non-North American Equipment Industry decreased for
the three month period ended October 31, 2004, compared to the same period
last year, primarily due to the loss of a customer in the power generation
market and the discontinuation of a legacy microfiche publishing application.
Non-recurring revenues in the non-North American Equipment Industry
decreased for the three month period ended October 31, 2004, compared to the
same period last year, primarily due to lack of new sales as the company is
in the process of reorganizing its European operations to a dealer-centric
model similar to its North American operations.Catalog and Related ProductsRecurring revenues from the Companys catalog and related products in the
Equipment Industry increased for the three month period ended October 31,
2004, compared to the same period last year, primarily due to an increase in
the Companys base revenue from catalog customers and an increase in the
volume of catalogs purchased by dealers. Management expects recurring
catalog and related revenues to continue to increase in the North American
Industry and to remain relatively the same as the first quarter of fiscal
2005 in the non-North American Equipment Industry through the fourth quarter
of fiscal 2005.Communications ProductsRevenues from the Companys communications products decreased for the three
months ended October 31, 2004, compared to the same period last year,
primarily due to a decline in the base of customers as the Company focused
the business primarily on its catalog products. Management expects revenues
from communications products will be a declining percentage of total revenue
for the remainder of fiscal 2005. Non-Equipment Industry Business The Companys business outside of the Equipment Industry includes sales of
database management and electronic communication services to the agricultural
inputs industry. Revenues in this business have decreased for the three months
ended October 31, 2004, compared to the same period last year because an
industry association introduced a competitive offering to our database
management services. As a result, many of the agricultural inputs industry
participants did not renew their contracts for database management services,
which were approximately $500,000 on an annual basis and expire each December.
The Company continues to provide electronic communication services to the
agricultural inputs industry, but management expects these revenues to continue
to decline for the remainder of fiscal 2005. 12




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##### Table of Contents



Cost of Products and Services Sold The following table sets forth, for the periods indicated, certain information
regarding revenue and cost of products and services sold which is derived from
the Companys unaudited financial statements. Cost of Products and Services Sold as a Percent of Revenue by Revenue Type(In thousands) Three months endedOctober 31
    
    Percent2004
    
    2003
    
    ChangeSubscriptions, support and other services feesRevenue
    
    $
    2,402
    
    
    $
    2,289
    
    
    
    5
    %Cost of revenue
    
    
    193
    
    
    
    155
    
    
    
    25
    %Cost of revenue as a percent of revenue
    
    
    8
    %
    
    
    7
    %Software licenses and renewalsRevenue
    
    
    576
    
    
    
    589
    
    
    
    (2
    %)Cost of revenue
    
    
    154
    
    
    
    462
    
    
    
    (67
    %)Cost of revenue as a percent of revenue
    
    
    27
    %
    
    
    78
    %Professional servicesRevenue
    
    
    297
    
    
    
    407
    
    
    
    (27
    %)Cost of revenue
    
    
    82
    
    
    
    191
    
    
    
    (57
    %)Cost of revenue as a percent of revenue
    
    
    28
    %
    
    
    47
    %TotalRevenue
    
    $
    3,275
    
    
    $
    3,285
    
    
    
    0
    %Cost of revenue
    
    
    429
    
    
    
    808
    
    
    
    (47
    %)Cost of revenue as a percent of revenue
    
    
    13
    %
    
    
    25
    %
 Cost of subscriptions, support and other services fees consists primarily of
reseller fees, telecommunications costs, catalog replication and distribution
costs. Cost of subscriptions, support and other services fees as a percentage
of revenue increased for the three month period ended October 31, 2004,
compared to the same period last year primarily due to an increase in catalog
replication costs absorbed by the Company. Management expects gross margins,
as a percent of revenue from subscriptions, support and other services fees, to
be relatively consistent from quarter to quarter. Cost of software licenses and renewals consists primarily of amortization of
software products, royalties and software distribution costs. Cost of software
license and renewals as a percentage of revenue decreased significantly for the
three month period ended October 31, 2004, compared to the same period last
year, primarily due to lower software amortization costs, as the software
product costs of PartSmart acquired in fiscal 1999, became fully amortized in
May, 2004. Gross margins from software licenses and renewals will fluctuate
from quarter to quarter based on the level of revenue, while costs remain
relatively the same as amortization of software is not directly correlated to
the level of revenue generated from software license and renewals. Management
expects software amortization costs to increase slightly from the current level
for the remainder of the year as the Company releases new products, but still
be well below last year. Cost of professional services consists of customization and catalog production
labor. Cost of professional services as a percentage of revenue decreased for
the three month period ended October 31, 2004, compared to the same period last
year, primarily due to the reclassification of catalog production labor that is
not directly billed to the manufacturer to cost of subscriptions where the
Company realizes revenue for this service. These costs had previously not been
segregated from catalog production labor which was billed to the manufacturer.
Management expects cost of professional services to fluctuate from quarter to
quarter depending on the mix of services sold and on the Companys performance
towards the contracted amount for customization projects. 13




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##### Table of Contents



Operating Expenses The following table sets forth, for the periods indicated, certain operating
expense information derived from the Companys unaudited financial statements. Operating Expenses(In thousands) Three months endedOctober 31
    
    Percent2004
    
    2003
    
    ChangeCustomer operations and support
    
    
    262
    
    
    
    283
    
    
    
    (7
    %)Selling, general and administrative
    
    
    1,709
    
    
    
    1,758
    
    
    
    (3
    %)Software development and technical support
    
    
    421
    
    
    
    341
    
    
    
    23
    %Less capitalized portion
    
    
    (162
    )
    
    
    (64
    )
    
    
    153
    %Depreciation and amortization
    
    
    54
    
    
    
    35
    
    
    
    54
    %Net operating expenses
    
    $
    2,284
    
    
    $
    2,353
    
    
    
    (3
    %)
 Customer operations and support consists primarily of server room operations,
software maintenance agreements for the Companys core network and customer
support costs. Customer operations and support costs decreased for the three
month period ended October 31, 2004, compared to the same period last year
primarily due to reduced customer operations and support costs for the
agricultural inputs industry and continued server room cost reductions.
Management expects customer operations and support costs to continue at
relatively the same level for the remainder of fiscal 2005. Selling, general and administrative expenses (SG&A) decreased for the three
month period ended October 31, 2004, compared to the same period last year,
primarily due to decreased legal fees related to the institution of a
Shareholder Rights Plan, the Companys option exchange program and the WITECH
equity buy-back agreement in the first quarter of fiscal 2004, offset in part
by increased sales and marketing expense in the first quarter of fiscal 2005.
SG&A, as a percentage of revenue, decreased slightly from 54% for the three
month period ended October 31, 2003 to 52% for the three month period ended
October 31, 2004. Management expects SG&A costs to increase compared to the
previous year for the remainder of fiscal 2005 due to investments in new
product marketing and the reorganizing of the non-North American business. The Companys technical staff (in-house and contracted) performs both software
development and technical support and software customization and data
conversion services for customer applications. Therefore, management expects
fluctuations between software customization and data conversion services and
development and technical support expenses quarter to quarter, as the mix of
development and customization activities will change based on customer
requirements. Software development and technical support costs increased for
the three month period ended October 31, 2004, compared to the same period last
year, primarily due to temporarily open positions in the first quarter of
fiscal 2004 and a shift in resources from cost of sales to software development
in the first quarter of fiscal 2005. Management expects software development
and technical support costs to continue to be higher than the previous year for
the remainder of fiscal 2005. Capitalized software product costs represented 38% of software development and
technical support for the three month period ended October 31, 2004, compared
to 19% for the same period last year. Capitalized software product costs
fluctuate from quarter to quarter depending on the deployment of the Companys
resources between early stage research, software development available for
capitalization, data conversion, customer customizations and maintenance and
technical support. Management expects that capitalized software product costs
will continue to be higher than the previous year for the remainder of fiscal
2005, because of planned product development investments. Depreciation and amortization expense increased for the three month period
ended October 31, 2004, compared to the same period last year. Management
expects depreciation and amortization to increase slightly for the remainder of
fiscal 2005, as the Company invests in the business. 14




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##### Table of Contents



Other Items Earnings increased from net income of $72,000 for the three month period ended
October 31, 2003, to net income of $494,000 for the three month period ended
October 31, 2004. The increase in earnings is primarily due to the decrease in
software amortization expense. Management expects to continue to generate
positive earnings and cash flows for the remainder of fiscal 2005, although
there can be no assurance that this will occur. Interest expense includes both cash and non-cash interest. Interest paid or
accrued for payment was approximately $64,000 and $96,000 for the three month
periods ended October 31, 2004 and 2003, respectively. In addition,
approximately $21,000 and $15,000 of excess debt principal was amortized to
offset interest expense for the three month period ended October 31, 2004 and
2003, respectively. Acquisitions Since December 1995, the Company has had a formal business development program
aimed at identifying, evaluating and closing acquisitions that augment and
strengthen the Companys market position, product offerings, and personnel
resources. Since the programs inception, five acquisitions have been
completed, four of which were fully integrated into the Companys operations
prior to fiscal year 2000. On October 27, 2003, the Company acquired the technology and customer base of
VertX Commerce Corporation (VertX). ARI has been reselling the VertX
software under the brand name WebsiteSmart. The acquisition did not have a
material impact on the Companys financial statements. The business development program is still an important component of the
Companys long-term growth strategy and the Company expects to continue to
pursue it aggressively. Liquidity and Capital Resources The following table sets forth, for the periods indicated, certain cash flow
information derived from the Companys unaudited financial statements. Cash Flow Information(In thousands) Three months endedOctober 31
    
    Percent2004
    
    2003
    
    ChangeNet income
    
    $
    494
    
    
    $
    72Amortization of software products
    
    
    141
    
    
    
    443Amortization of deferred finance costs and
debt discount
    
    
    (21
    )
    
    
    (15
    )Depreciation and other amortization
    
    
    54
    
    
    
    35Stock issued as contribution to 401(k) plan
    
    
    37
    
    
    
    37Net cash provided by operating activities
before changes in working capital
    
    
    705
    
    
    
    572
    
    
    
    23
    %Effect of net changes in working capital
    
    
    30
    
    
    
    (504
    )
    
    
    106
    %Net cash provided by operating activities
    
    
    735
    
    
    
    68
    
    
    
    981
    %Net cash used in investing activities
    
    
    (671
    )
    
    
    (189
    )
    
    
    (255
    %)Net cash provided by operating and
investing activities
    
    $
    64
    
    
    $
    (121
    )
    
    
    153
    %
 Net cash provided by operating activities increased for the three month period
ended October 31, 2004, compared to the same period last year, primarily due to
the increase in net income and the components of working capital. The effect
of net changes in working capital is dependent on the timing of payroll and
other cash disbursements, accruals and the timing of invoices and may vary
significantly from quarter to quarter. Net cash used in investing activities
increased for the three month period ended October 31, 2004, compared to the
same periods last year, primarily due to the acquisition of software from a
third party that will be incorporated into a new ARI product and increased
in-house capitalized software product costs. Management expects the total of
cash provided by operating activities and used in investing activities to be
positive for the remainder of fiscal 2005, although there can be no assurance
that this result will be ultimately achieved. 15




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##### Table of Contents



At October 31, 2004, the Company had cash of approximately $3,170,000 compared
to approximately $3,357,000 at July 31, 2004. The following table sets forth, for the periods indicated, certain information
related to the Companys debt derived from the Companys unaudited financial
statements. Debt Schedule(In thousands) October 31
    
    July 312004
    
    2004
    
    Net(Unaudited)
    
    (Audited)
    
    ChangeNote payable to WITECH:Current portion of note payable
    
    
    200
    
    
    
    200
    
    
    
    Long term portion of note payable
    
    
    400
    
    
    
    450
    
    
    
    (50
    )Total note payable to WITECH
    
    
    600
    
    
    
    650
    
    
    
    (50
    )Notes payable to New Holders:Current portion of notes payable
    
    
    800
    
    
    
    800
    
    
    
    Long term portion of notes payable
    
    
    2,500
    
    
    
    2,700
    
    
    
    (200
    )Total face value of notes payable to New Holders
    
    
    3,300
    
    
    
    3,500
    
    
    
    (200
    )Carrying value in excess of face amount of notes payable
    
    
    157
    
    
    
    182
    
    
    
    (25
    )Debt discount (common stock warrants and options)
    
    
    (24
    )
    
    
    (26
    )
    
    
    2Total carrying value of notes payable to New Holders
    
    
    3,433
    
    
    
    3,656
    
    
    
    (223
    )Total debt and receivables financing
    
    $
    4,033
    
    
    $
    4,306
    
    
    $
    (273
    )
 On April 24, 2003, the Company restructured its debt. In exchange for
previously outstanding debt and securities, the Company issued to a group of
investors (the New Holders), in aggregate, $500,000 in cash, new unsecured
notes in the amount of $3.9 million (the New Notes) and new warrants for
250,000 common shares, exercisable at $1.00 per share (the New Warrants).
The interest rate on the New Notes is prime plus 2%. The New Notes are payable
in $200,000 quarterly installments commencing March 31, 2004 through December
31, 2005 and $300,000 quarterly installments commencing March 31, 2006 until
paid in full. The New Notes do not contain any financial covenants, but the
Company is restricted from permitting certain liens on its assets. In
addition, in the event of payment default that is not cured within ninety (90)
days, Taglich Brothers, Inc., one of the New Holders, has the right to appoint
one designee to the Companys Board of Directors. The New Warrants were
estimated to have a value of $36,000, of which the unamortized amount reduces
the carrying amount of the debt. On August 8, 2003, the Company repurchased from WITECH Corporation 1,025,308
shares of Common Stock, a warrant to purchase 30,000 shares of Common Stock at
$.24 per share, and 20,350 shares of Series A Preferred Stock with an
approximate face value plus accrued and undeclared dividends of $3.5 million.
The Company paid $200,000 in cash and issued a four-year note for $800,000,
payable quarterly and bearing interest at prime plus 2%. The note does not
contain any financial covenants. On July 9, 2004, the Company entered into a line of credit with Bank One, N.A.
which permits the Company to borrow an amount equal to 80% of the book value of
all eligible accounts minus $75,000, up to $500,000, and bears interest at
prime rate. Eligible accounts include certain non-foreign accounts receivable
which are less than 90 days from the invoice date. The line of credit
terminates July 9, 2005, and is secured by substantially all of the Companys
assets. The line of credit limits repurchases of common stock, the payment of
dividends, liens on assets and new indebtedness, and requires the Company to
meet minimum net worth and debt service coverage financial covenants. Management believes that funds generated from operations will be adequate to
fund the Companys operations, investments and debt payments for the
foreseeable future, although additional financing may be necessary if the
Company were to complete a material acquisition or to make a large investment
in its business. 16




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##### Table of Contents



The following table sets forth, for the periods indicated, certain information
reconciling earnings before interest, taxes, depreciation and amortization to
the Companys unaudited financial statements. Earnings before Interest, Taxes, Depreciation and Amortization
(in thousands) Three months endedOctober 31
    
    Percent2004
    
    2003
    
    ChangeNet income
    
    $
    494
    
    
    $
    72Plus: Interest
    
    
    44
    
    
    
    81Amortization of software products
    
    
    141
    
    
    
    443Other depreciation and amortization
    
    
    54
    
    
    
    35Income tax expense
    
    
    36
    
    
    
    Earnings before interest, taxes, depreciation and
amortization
    
    $
    769
    
    
    $
    631
    
    
    
    22
    %
 Earnings before interest, taxes, depreciation and amortization (EBITDA)
increased for the three month period ended October 31, 2004, compared to the
same period last year, primarily due to the reduction in operating expenses net
of capitalized software product costs. Management believes that EBITDA will
continue at the same level for the remainder of fiscal 2005, as the Company
invests in the future, although there can be no assurance that this will occur. This Managements Discussion and Analysis or Plan of Operation discloses EBITDA
(earnings before interest and other taxes, depreciation and amortization) and
cash from operations and investment before changes in working capital
(earn/burn rate), each of which may be considered a non-GAAP financial
measure. Generally, a non-GAAP financial measure is a numerical measure of a
companys performance, financial position or cash flows that either excludes or
includes amounts that are not normally excluded or included in the most
directly comparable measure calculated and presented in accordance with
accounting principles generally accepted in the United States. In order to
fully assess the Companys financial results, management believes that EBITDA
and earn/burn rate are appropriate measures of evaluating operating performance
and liquidity, respectively. EBITDA is a commonly used measurement of
financial performance. In addition, management believes EBITDA is helpful in
understanding period-over-period operating results separate and apart from
items that may, or could, have a disproportionate impact on the Companys
results of operations in any particular period. The Company believes that cash
from operations and investment before changes in working capital items
(earn/burn rate) is helpful in determining and measuring the amount of cash
generated from the Companys business, separate and apart from changes caused
by changes in working capital items, which, over several periods, tend to
offset each other. However, these measures should be considered in addition
to, and not as a substitute for operating income, cash flows or other measures
of financial performance prepared in accordance with generally accepted
accounting principles and may not necessarily be comparable to similarly titled
measures of other companies. Forward Looking Statements Certain statements contained in this Form 10-QSB are forward looking statements
including revenue growth, future cash flows and cash generation and sources of
liquidity. Expressions such as believes, anticipates, expects, and
similar expressions are intended to identify such forward looking statements.
Several important factors can cause actual results to materially differ from
those stated or implied in the forward looking statements. Such factors
include, but are not limited to the factors listed on exhibit 99.1 of the
Companys annual report on Form 10-KSB for the year ended July 31, 2004, which
is incorporated herein by reference. The forward-looking statements are made
only as of the date hereof, and the Company undertakes no obligation to
publicly release the result of any revisions to these forward-looking
statements. 17




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##### Table of Contents



ITEM 3. CONTROLS AND PROCEDURES ARI maintains a set of disclosure controls and procedures that are designed to
ensure that information required to be disclosed by it in the reports filed by
it under the Securities Exchange Act of 1934, as amended (Exchange Act) is
recorded, processed, summarized and reported within the time periods specified
in the SECs rules and forms. ARI carried out an evaluation, under the
supervision and with the participation of its management, including its Chief
Executive Officer and its Chief Financial Officer, of the effectiveness of the
design and operation of its disclosure controls and procedures pursuant to Rule
13a-15 of the Exchange Act. Based on that evaluation, ARIs Chief Executive
Officer and its Chief Financial Officer concluded that ARIs disclosure
controls and procedures are effective as of October 31, 2004. There have been no changes in ARIs internal control over financial reporting
identified in connection with the evaluation discussed above that occurred
during the quarter ended October 31, 2004 that have materially affected, or are
reasonably likely to materially affect, ARIs internal control over financial
reporting. 
 PART II - OTHER INFORMATION 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS During the quarter ended October 31, 2004, the Company did not sell any
equity securities which were not registered under the Securities Act or
repurchase any of its equity securities. 
 ITEM 6. EXHIBITS  31.1
    
    Section 302 Certification of Chief Executive Officer.31.2
    
    Section 302 Certification of Chief Financial Officer.32.1
    
    Section 906 Certification of Chief Executive Officer.32.2
    
    Section 906 Certification of Chief Financial Officer. 18




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##### Table of Contents



SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.  ARI Network Services, Inc.
(Registrant) Date: December 15, 2004
    
    
    
    /s/ Brian E. DearingBrian E. Dearing, Chairman of the Board and Chief Executive Officer/s/ Timothy SherlockTimothy Sherlock, Chief Financial Officer
 19