** **

****

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

 

**(Mark One)**

 

| **ý**                                                 |   | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------|
|                                                       |
| **For the quarterly period ended December 31,  2003** |
|                                                       |
| **o**                                                      |   | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE  EXCHANGE ACT**                   |

 

**For the transition period from                   to                   **

 

**Commission file number****      ****001-15789**

 

**STRATUS SERVICES GROUP, INC.**

(Exact name of Registrant as specified in its charter)

 

| **Delaware**                                                                        |   | **22-3499261**                       |
|-------------------------------------------------------------------------------------|--------|--------------------------------------|
| (State of other jurisdiction of incorporation or organization)                      |   | (I.R.S. Employer Identification No.) |
|                                                                                |   |                                 |
| **500 Craig Road, Suite 201, Manalapan, New  Jersey  07726**                   |
| (Address of principal executive offices)                                            |
|                                                                                |   |                                 |
| **(732) 866-0300**                                                                  |
| (Issuer’s telephone number)                                                    |
|                                                                                |   |                                 |
|                                                                                |   |                                 |
| (Former name, former address and former fiscal  year, if changed since last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý                 Noo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12-b of the Exchange Act). Yes o                 Noý

 

Asof February 13, 2004, 23,648,576 shares of the Registrant’s common stockwere outstanding.

 

 

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**STRATUSSERVICES GROUP, INC.**

Condensed Balance Sheets

 
|                                                                                                                                                                                                           |   | **December 31,  2003** |       | **September 30,  2003** |    |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|------------------------------|---------|
|                                                                                                                                                                                                           |   | **(Unaudited)**             |       |                         |    |
| Assets                                                                                                                                                                                                         |   |                        |       |                         |    |
| Current assets                                                                                                                                                                                                 |   |                        |       |                         |    |
| Cash                                                                                                                                                                                                           |   | $                           | 185,129    |                         | $       | 53,753 |   |
| Accounts receivable–less allowance for doubtful  accounts of $1,737,000 and $1,733,000                                                                                                                    |   | 12,336,854                  |       | 12,833,749                   |    |
| Unbilled receivables                                                                                                                                                                                           |   | 1,218,469                   |       | 671,271                      |    |
| Notes receivable (current portion)                                                                                                                                                                             |   | 25,541                      |       | 25,240                       |    |
| Prepaid insurance                                                                                                                                                                                              |   | 1,826,650                   |       | 2,271,715                    |    |
| Prepaid expenses and other current assets                                                                                                                                                                      |   | 213,764                     |       | 277,262                      |    |
|                                                                                                                                                                                                           |   | 15,806,407                  |       | 16,132,990                   |    |
|                                                                                                                                                                                                           |   |                        |       |                         |    |
| Notes receivable (net of current portion)                                                                                                                                                                      |   | 89,258                      |       | 95,166                       |    |
| Note receivable – related party                                                                                                                                                                           |   | 128,071                     |       | 128,000                      |    |
| Property and equipment, net of accumulated  depreciation                                                                                                                                                       |   | 844,977                     |       | 937,718                      |    |
| Intangible assets, net of accumulated amortization                                                                                                                                                             |   | 1,391,268                   |       | 1,501,509                    |    |
| Goodwill                                                                                                                                                                                                       |   | 5,816,353                   |       | 5,816,353                    |    |
| Deferred registration costs                                                                                                                                                                                    |   | 441,746                     |       | 374,365                      |    |
| Other assets                                                                                                                                                                                                   |   | 157,319                     |       | 164,380                      |    |
|                                                                                                                                                                                                           |   | $                           | 24,675,399 |                         | $       | 25,150,551 |   |
|                                                                                                                                                                                                           |   |                        |       |                         |    |
| Liabilities and Stockholders’ Equity                                                                                                                                                                      |   |                        |       |                         |    |
| Current liabilities                                                                                                                                                                                            |   |                        |       |                         |    |
| Loans payable (current portion)                                                                                                                                                                                |   | $                           | 564,156    |                         | $       | 737,514 |   |
| Loans payable – related parties                                                                                                                                                                           |   | 458,004                     |       | 503,377                      |    |
| Notes payable – acquisitions (current portion)                                                                                                                                                            |   | 691,382                     |       | 657,224                      |    |
| Line of credit                                                                                                                                                                                                 |   | 8,933,746                   |       | 8,312,275                    |    |
| Cash overdraft                                                                                                                                                                                                 |   | 349,179                     |       | 699,057                      |    |
| Insurance obligation payable                                                                                                                                                                                   |   | 25,034                      |       | 97,506                       |    |
| Accounts payable and accrued expenses                                                                                                                                                                          |   | 4,690,240                   |       | 4,787,404                    |    |
| Accrued payroll and taxes                                                                                                                                                                                      |   | 2,093,408                   |       | 2,473,596                    |    |
| Payroll taxes payable                                                                                                                                                                                          |   | 4,973,247                   |       | 5,021,411                    |    |
| Put options liability                                                                                                                                                                                          |   | 823,000                     |       | 823,000                      |    |
|                                                                                                                                                                                                           |   | 23,601,396                  |       | 24,112,324                   |    |
|                                                                                                                                                                                                           |   |                        |       |                         |    |
| Loans payable (net of current portion)                                                                                                                                                                         |   | 26,652                      |       | 37,890                       |    |
| Notes payable – acquisitions (net of current  portion)                                                                                                                                                    |   | 1,899,157                   |       | 2,065,280                    |    |
| Convertible debt                                                                                                                                                                                               |   | 40,000                      |       | 40,000                       |    |
| Series A voting redeemable convertible preferred  stock, $.01 par value, 1,458,933 shares issued and outstanding, liquidation  preference of $4,376,799 (including unpaid dividends of $728,346 and  $671,752) |   | 3,941,346                   |       | 3,809,752                    |    |
|                                                                                                                                                                                                           |   | 29,508,551                  |       | 30,065,216                   |    |
| Commitments and contingencies                                                                                                                                                                                  |   |                        |       |                         |    |
| Stockholders’ equity                                                                                                                                                                                      |   |                        |       |                         |    |
| Preferred stock, $.01 par value, 5,000,000 shares  authorized                                                                                                                                                  |   |                        |       |                         |    |
|                                                                                                                                                                                                           |   |                        |       |                         |    |
| Series E non-voting convertible preferred stock,  $.01 par value, 38,107 and 40,257 shares issued and outstanding, liquidation  preference of $3,810,835 (including unpaid dividends of $120,436 and $60,295)  |   | 3,931,271                   |       | 4,0180,130                   |    |
|                                                                                                                                                                                                           |   |                        |       |                         |    |
| Series F voting convertible preferred stock, $.01  par value, 6,000 and 8,000 shares issued and outstanding, liquidation  preference of $600,000 (including unpaid dividends of $40,500 and $28,000)           |   | 640,500                     |       | 828,000                      |    |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 23,648,486 and 19,795,038 shares issued and outstanding                                                                                          |   | 236,485                     |       | 197,950                      |    |
| Additional paid-in capital                                                                                                                                                                                     |   | 12,032,767                  |       | 11,728,943                   |    |
| Accumulated deficit                                                                                                                                                                                            |   | (21,674,175                 | )          | (21,755,718                  | )  |
| Total stockholders’ equity (deficiency)                                                                                                                                                                   |   | (4,833,152                  | )          | (4,914,695                   | )  |
|                                                                                                                                                                                                           |   | $                           | 24,675,399 |                         | $       | 25,150,551 |   |

 

See notes to condensed financial statements

 

2

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**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Operations

(Unaudited)

 
|                                                                  |   | **Three  Months Ended  December 31,** |       |
|-----------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                  |   | **2003**                                   |       | **2002** |   |
|                                                                  |   |                                       |       | **(Restated)** |   |
|                                                                  |   |                                       |       |   |   |
| Revenues                                                              |   | $                                          | 23,886,064 |   | $ | 14,611,085 |   |
|                                                                  |   |                                       |       |   |   |
| Cost of revenues                                                      |   | 20,353,942                                 |       | 12,124,271 |   |
|                                                                  |   |                                       |       |   |   |
| Gross Profit                                                          |   | 3,532,122                                  |       | 2,486,814 |   |
|                                                                  |   |                                       |       |   |   |
| Selling, general and administrative  expenses                         |   | 3,006,949                                  |       | 2,787,252 |   |
|                                                                  |   |                                       |       |   |   |
| Operating income (loss) from continuing  operations                   |   | 525,173                                    |       | (300,438 | ) |
|                                                                  |   |                                       |       |   |   |
| Other income (expenses)                                               |   |                                       |       |   |   |
| Interest and financing costs                                          |   | (453,194                                   | )          | (437,063 | ) |
| Other income                                                          |   | 9,564                                      |       | 6,287 |   |
|                                                                  |   | (443,630                                   | )          | (430,776 | ) |
| Earnings (loss) from continuing operations                            |   | 81,543                                     |       | (731,214 | ) |
|                                                                  |   |                                       |       |   |   |
| Discontinued operations – earnings from  discontinued operations |   | 3⁄4                                     |       | 40,809 |   |
|                                                                  |   |                                       |       |   |   |
| Net earnings (loss)                                                   |   | 81,543                                     |       | (690,405 | ) |
| Dividends and accretion on preferred stock                            |   | (72,641                                    | )          | (366,094 | ) |
|                                                                  |   |                                       |       |   |   |
| Net earnings (loss) attributable to common  stockholders              |   | $                                          | 8,902      |   | $ | (1,056,499 | ) |
|                                                                  |   |                                       |       |   |   |
| Net earnings (loss) per share attributable  to common stockholders    |   |                                       |       |   |   |
| Basic:                                                                |   |                                       |       |   |   |
| Earnings (loss) from continuing operations                            |   | $                                          | —     |   | $ | (.07 | ) |
| Earnings from discontinued operations                                 |   | —                                     |       | — |   |
| Net (loss)                                                            |   | $                                          | —     |   | $ | (.07 | ) |
|                                                                  |   |                                       |       |   |   |
| Diluted:                                                              |   |                                       |       |   |   |
| (Loss) from continuing operations                                     |   | $                                          | —     |   | $ | (.07 | ) |
| Earnings from discontinued operations                                 |   | —                                     |       | — |   |
| Net (loss)                                                            |   | $                                          | —     |   | $ | (.07 | ) |
|                                                                  |   |                                       |       |   |   |
| Weighted average shares outstanding per  common share                 |   |                                       |       |   |   |
| Basic                                                                 |   | 21,089,266                                 |       | 14,337,271 |   |
| Diluted                                                               |   | 21,144,193                                 |       | 14,337,271 |   |

 

See notes to condensed financial statements

 

3

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**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Cash Flows

(Unaudited)

 
|                                                                                   |   | **Three Months Ended****December 31,** |    |
|----------------------------------------------------------------------------------------|--------|---------------------------------------------|---------|
|                                                                                   |   | **2003**                                    |    | **2002** |   |
|                                                                                   |   |                                        |    | **(Restated)** |   |
| Cash flows from operating activities                                                   |   |                                        |    |   |   |
| Net earnings (loss) from continuing operations                                         |   | $                                           | 81,543  |   | $ | (731,214 | ) |
| Net earnings from discontinued operations                                              |   | 3⁄4                                      |    | 40,809 |   |
| Adjustments to reconcile net earnings (loss) to  net cash used by operating activities |   |                                        |    |   |   |
| Depreciation                                                                           |   | 103,429                                     |    | 138,879 |   |
| Amortization                                                                           |   | 110,311                                     |    | 74,412 |   |
| Provision for doubtful accounts                                                        |   | 3⁄4                                      |    | 25,000 |   |
| Deferred financing costs amortization                                                  |   | 402                                         |    | 402 |   |
| Accrued interest                                                                       |   | 19,182                                      |    | (20,588 | ) |
| Imputed interest                                                                       |   | 21,313                                      |    | 7,633 |   |
| Dividends and accretion on preferred stock                                             |   | 131,584                                     |    | 3⁄4 |   |
| Changes in operating assets and liabilities                                            |   |                                        |    |   |   |
| Accounts receivable                                                                    |   | (50,303                                     | )       | (916,710 | ) |
| Prepaid insurance                                                                      |   | 445,065                                     |    | (136,050 | ) |
| Prepaid expenses and other current assets                                              |   | 63,498                                      |    | 3,779 |   |
| Other assets                                                                           |   | 6,659                                       |    | (27,010 | ) |
| Insurance obligation payable                                                           |   | (72,472                                     | )       | (115,732 | ) |
| Accrued payroll and taxes                                                              |   | (380,188                                    | )       | 259,995 |   |
| Payroll taxes payable                                                                  |   | (48,164                                     | )       | (453,759 | ) |
| Accounts payable and accrued expenses                                                  |   | (116,346                                    | )       | 507,544 |   |
| Total adjustments                                                                      |   | 233,980                                     |    | (652,205 | ) |
|                                                                                   |   | 315,523                                     |    | (1,342,610 | ) |
| Cash flows (used in) investing activities                                              |   |                                        |    |   |   |
| Purchase of property and equipment                                                     |   | (10,688                                     | )       | (134,346 | ) |
| Collection of notes receivable                                                         |   | 5,536                                       |    | 3⁄4 |   |
| Payments for business acquisitions                                                     |   | 3⁄4                                      |    | (38,000 | ) |
|                                                                                   |   | (5,152                                      | )       | (172,346 | ) |
| Cash flows from financing activities                                                   |   |                                        |    |   |   |
| Payments of registration costs                                                         |   | (67,381                                     | )       | 3⁄4 |   |
| Proceeds from loans payable                                                            |   | 5,000                                       |    | 680,000 |   |
| Payments of loans payable                                                              |   | (234,929                                    | )       | (62,641 | ) |
| Payments of notes payable – acquisitions                                          |   | (153,278                                    | )       | (182,823 | ) |
| Net proceeds from line of credit                                                       |   | 621,471                                     |    | 1,015,747 |   |
| Cash overdraft                                                                         |   | (349,878                                    | )       | (66,853 | ) |
| Dividends paid                                                                         |   | 3⁄4                                      |    | (17,500 | ) |
|                                                                                   |   | (178,995                                    | )       | 1,365,930 |   |
| Net change in cash                                                                     |   | 131,376                                     |    | (149,026 | ) |
| Cash – beginning                                                                  |   | 53,753                                      |    | 162,646 |   |
| Cash – ending                                                                     |   | $                                           | 185,129 |   | $ | 13,620 |   |
| Supplemental disclosure of cash paid                                                   |   |                                        |    |   |   |
| Interest                                                                               |   | $                                           | 320,418 |   | $ | 519,499 |   |
| Schedule of Noncash Investing and Financing  Activities                           |   |                                        |    |   |   |
| Fair value of assets acquired                                                          |   | $                                           | —  |   | $ | 1,242,875 |   |
| Less: cash paid                                                                        |   | —                                      |    | (153,000 | ) |
| Liabilities assumed                                                                    |   | $                                           | —  |   | $ | 1,089,875 |   |
|                                                                                   |   |                                        |    |   |   |
| Issuance of common stock upon conversion of  convertible preferred stock               |   | $                                           | 415,000 |   | $ | 511,000 |   |
| Issuance of common stock in exchange for accounts  payable and accrued expenses        |   | $                                           | —  |   | $ | 37,500 |   |
| Cumulative dividends and accretion on preferred  stock                                 |   | $                                           | 72,641  |   | $ | 384,594 |   |

 

See notes to condensed financial statements

 

4

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**STRATUS SERVICES GROUP, INC.**

Notes to Condensed Financial Statements

(Unaudited)

 

**NOTE 1 – BASIS OF PRESENTATION**

 

Theaccompanying condensed financial statements have been prepared by the Company,without audit, pursuant to the rules and regulations of the Securities andExchange Commission.  Certaininformation and disclosures normally included in financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates have been condensed or omitted pursuant to such rules andregulations.  These condensed financialstatements reflect all adjustments (consisting only of normal recurringadjustments) that, in the opinion of management, are necessary to presentfairly the financial position, the results of operations and cash flows of theCompany for the periods presented.  Itis suggested that these condensed financial statements be read in conjunctionwith the consolidated financial statements and the notes thereto included inthe Company’s Annual Report on Form 10-K.

 

Theresults of operations for the interim periods presented are not necessarilyindicative of the results to be expected for the full year.

 

Thefollowing summarizes revenues:

 
|       |   | **Three Months Ended****December 31,** |       |
|------------|--------|---------------------------------------------|------------|
|       |   | **2003**                                    |       | **2002** |   |
|       |   |                                        |       | **(Restated)** |   |
|       |   |                                        |       |   |   |
| Staffing   |   | $                                           | 23,847,530 |   | $ | 14,368,008 |   |
|       |   |                                        |       |   |   |
| Payrolling |   | 38,534                                      |       | 243,077 |   |
|       |   | $                                           | 23,886,064 |   | $ | 14,611,085 |   |

 

Unlike traditional staffing services, under apayrolling arrangement, the Company’s customer recruits and identifiesindividuals for the Company to hire to provide services to the customer.  The Company becomes the statutory employeralthough the customer maintains substantially all control over thoseemployees.  Accordingly, Emerging IssuesTask Force (“EITF”) 99-19, “Reporting Revenue Gross as a Principal versus Netas an Agent” requires that the Company does not reflect the direct payrollcosts paid to such employees in revenues and cost of revenue.

 

**NOTE 2 – LIQUIDITY**

 

AtDecember 31, 2003, the Company had limited liquid resources.  Current liabilities were $23,601,396 andcurrent assets were $15,806,407.  Thedifference of $7,794,989 is a working capital deficit, which is primarily theresult of losses incurred during the years ended September 30, 2003, 2002and 2001.  Current liabilities include acash overdraft of $349,179, which is represented by outstanding checks.  These conditions raise substantial doubtsabout the Company’s ability to continue as a going concern.  The financial statements do not include anyadjustments to reflect the possible future effect on the recoverability andclassification of assets or the amounts and classification of liabilities thatmay result from the outcome of this uncertainty.

 

TheCompany’s continuation of existence is dependent upon the continued cooperationof its creditors, its ability to generate sufficient cash flow to meet itscontinuing obligations on a timely basis, to fund the operating and capitalneeds, and to obtain additional financing as may be necessary.

 

Managementof the Company has taken steps to revise and reduce its operating requirement,which it believes will be sufficient to assure continued operations andimplementation of the Company’s plans. The steps include closing branches that are not profitable,consolidating branches and reductions in staffing and other selling, generaland administrative expenses.

 

TheCompany continues to pursue other sources of equity or long-term debtfinancings.  The Company also continuesto negotiate payment plans and other accommodations with its creditors.

 

5

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**NOTE 3 – EARNINGS/LOSS PER SHARE**

 

Basic“Earnings Per Share” (“EPS”) excludes dilution and is computed by dividing earningsavailable to common stockholders by the weighted-average number of commonshares outstanding during the period. Diluted EPS assumes conversion of dilutive options and warrants, and theissuance of common stock for all other potentially dilutive equivalent sharesoutstanding.  Dilutive shares were -0-and -0- for the three months ended December 31, 2003 and 2002respectively.

 

**NOTE 4 – INTANGIBLE ASSETS**

 

Wecompleted our annual impairment review of goodwill during the first quarter offiscal 2004 and determined that no impairment change was required.

 

Asof December 31, 2003 and September 30, 2003, intangible assetsconsisted of the following:

 
|                                  |   | **December 31,  2003** |      | **September 30,  2003** |   |
|---------------------------------------|--------|-----------------------------|-----------|------------------------------|--------|
|                                  |   |                        |      |                         |   |
| Covenant-not-to-compete               |   | $                           | 230,480   |                         | $      | 230,480 |   |
| Customer list                         |   | 1,957,709                   |      | 1,957,709                    |   |
|                                  |   | 2,188,189                   |      | 2,188,189                    |   |
| Less:   accumulated amortization |   | (796,921                    | )         | (686,610                     | )      |
|                                  |   | $                           | 1,391,268 |                         | $      | 1,501,579 |   |

 

Estimatedamortization expense for each of the next five years is as follows:

 
| **For the Year Ending December 31,** |   |    |    |
|-------------------------------------------|--------|---------|---------|
|                                      |   |    |    |
| 2004                                      |   | $       | 412,000 |   |
| 2005                                      |   | 330,000 |    |
| 2006                                      |   | 156,000 |    |
| 2007                                      |   | 155,000 |    |
| 2008                                      |   | 152,000 |    |
|                                           |        |         |         |  |

 

**NOTE 5 – LINE OF CREDIT**

 

TheCompany has a loan and security agreement (the “Loan Agreement”) with a lendinginstitution whereby the Company can borrow up to 85% of eligible accountsreceivable, as defined, not to exceed the lesser of $12 million or six timesthe Company’s tangible net worth (as defined). Until December 2002, borrowings under the Loan Agreement boreinterest at

 

11/2% above the prime rate (see below) and are collateralized by substantiallyall of the Company’s assets.  The LoanAgreement expires on June 12, 2004.

 

AtDecember 31, 2003, the Company was in violation of the following covenantsunder the Loan Agreement:

 

(i)                                     Failing to meet the tangible net worthrequirement, and;

(ii)                                  The Company’s Common Stock being delistedfrom the Nasdaq SmallCap Market

 

TheCompany has received a waiver from the lender on the above violations and, inDecember 2002, entered into a modification of the Loan Agreement.  The modification provided that borrowingsunder the Loan Agreement would bear interest at 1 3⁄4% above the prime rate, aslong as the Company is in violation of any of the covenants under theAgreement.

 

EffectiveApril 10, 2003, the Company entered into another modification of the LoanAgreement which provides that borrowings under the Loan Agreement bear interestat 3% above the prime rate.  The primerate at December 31, 2003 was 4%.

 

6

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**NOTE 6 – PREFERRED STOCK**

 

***a.******                                     ******Series A***

 

The shares of Series A Preferred Stock have astated value of $3.00 per share.  Thedifference between the carrying value and redemption value of the Series APreferred Stock was being accreted through a charge to additional paid-in-capitalthrough September 30, 2003, since prior to September 30, 2003, thecurrent value of the Series A Preferred Stock, including accrued dividends, hadbeen included in stockholders’ equity. Pursuant to SFAS No. 150, “Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity”, the current value of theSeries A Preferred Stock, including accrued dividends was classified as aliability at September 30, 2003. Accordingly, subsequent to September 30, 2003, the differencebetween the carrying value and redemption value of the Series A Preferred Stockis being accreted through a charge to interest expense through theJune 30, 2008 redemption date.

 

The Series A Preferred Stock entitles theholders thereof to cumulative dividends at $.21 per share per year, payablesemi-annually, commencing on December 31, 2001, when and if declared bythe Board of Directors.  The shares ofSeries A Preferred Stock are convertible at the option of the holder intoshares of the Company’s Common Stock on a one-for-one basis.  On June 30, 2008, the Company will berequired to redeem any shares of Series A Preferred Stock outstanding at aredemption price of $3.00 per share together with accrued and unpaid dividends,payable at the Company’s option, either in cash or in shares of commonstock.  For purposes of determining thenumber of shares which the Company will be required to issue if it chooses topay the redemption price in shares of Common Stock, the Common Stock will havea value equal to the average closing price of the Common Stock during the fivetrading days immediately preceding the date of redemption.

 

In July 2003, the Company entered intoan agreement with Artisan (UK) plc (“Artisan”) pursuant to which the Companyhas agreed to redeem the aggregate 1,458,933 shares of its Series A PreferredStock owned by Artisan.com and Cater Barnard (USA) plc, an affiliate ofArtisan.  These shares represent all ofthe shares of Series A Preferred Stock currently outstanding.  The obligation to redeem the Series APreferred Stock is contingent upon the Company’s sale of not less than$4,000,000 of units consisting of one share of common stock and one commonstock warrant (“Units”) in a proposed “best-efforts” public offering ofsecurities (the “Offering”).  If theCompany sells at least $4,000,000 of Units in the Offering, it will beobligated to pay $500,000 to Artisan within 15 days after the $4,000,000 ofUnits are sold.  In addition, theCompany will be obligated to pay Artisan an additional $250,000 byJanuary 31, 2005 or, at the Company’s option, issue to Artisan shares ofthe Company’s common stock having an aggregate market value of $250,000, basedupon the average closing bid prices of the common stock for the 30 trading dayspreceding January 31, 2005.  If theCompany fails to make the $250,000 payment in cash or stock, it will berequired to pay Artisan $300,000 in cash, plus interest calculated on a dailybasis at a rate of 18% from the date of the default to the date the default iscured.  The Company has also agreed toissue to Artisan a number of shares of the Company’s common stock which willrepresent 5.5% of its outstanding common stock, subject to certain adjustments,upon completion of the sale of $4,000,000 million of units of common stock sothat the total number of shares of common stock issued to Artisan will equal5.5% of the Company’s common stock after giving effect to the assumed exerciseof all warrants and options that then have exercise prices equal to or less thanthe then current price of the Company’s common stock and the conversion of allconvertible securities that then have conversion prices equal to or less thanthe then current market price of the Company’s common stock.

 

***b.******                                     ******Series E***

 

The shares ofSeries E Preferred Stock have a stated value of $100 per share.  The holders of the Series E Preferred stockare entitled to cumulative dividends at a rate of 6% of the stated value peryear, payable every 120 days, in preference and priority to any payment of anydividend on the Company’s Common Stock. Dividends may be paid, at the Company’s option, either in cash or inshares of Common Stock, valued at the Series E Conversion Price (as definedbelow).  Holders of Series E PreferredStock are entitled to a liquidation preference of $100 per share, plus accruedand unpaid dividends.

 

The Series EPreferred Stock is convertible into Common Stock at a conversion price equal to75% of the average of the closing bid prices, for the five trading dayspreceding the conversion date, for the Common Stock.  The number of shares issuable upon conversion is determined bymultiplying the number of shares of Series E Preferred Stock to be converted by$100, and dividing the result by the Series E Conversion Price then in effect.

 

7

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Holders of Series EPreferred Stock do not have any voting rights, except as required by law.

 

The Company mayredeem the shares of the Series E Preferred Stock at any time prior toconversion, at a redemption price of 115% of the purchase price paid for theSeries E Preferred Shares, plus any accrued but unpaid dividends.

 

The discountarising from the beneficial conversion feature was treated as a dividend fromthe date of issuance to the earliest conversion date.

 

During the threemonths ended December 31, 2003, holders of Series E Preferred Stockconverted 2,150 shares into 1,853,448 shares of common stock at a conversionprice of $.116.  During the three monthsended December 31, 2002, holders of Series E Preferred Stock converted5,205 shares into 4,486,911 shares of Common Stock at conversion prices between$.108 and $.1365.

 

***c.******                                      ******Series F***

 

In July 2002,the Company’s Chief Executive Officer invested $1,000,000 in the Company inexchange for 10,000 shares of newly created Series F Convertible PreferredStock (the “Series F Preferred Stock”), which has a stated value of $100 pershare.

 

The holder of theSeries F Preferred Stock is entitled to receive, from assets legally availabletherefore, cumulative dividends at a rate of 7% per year, accrued daily,payable monthly, in preference and priority to any payment of any dividend onthe Common Stock and on the Series F Preferred Stock.  Dividends may be paid, at the Company’s option, either in cash orin shares of Common Stock, valued at the Series F Conversion Price (as definedbelow).  Holders of Series F PreferredStock are entitled to a liquidation preference of $100 per share, plus accruedand unpaid dividends.

 

The Series FPreferred Stock is convertible into Common Stock at a conversion price (the“Series F Conversion Price”) equal to $.10 per share.  The number of shares issuable upon conversion is determined bymultiplying the number of shares of Series F Preferred Stock to be converted by$100, and dividing the result by the Series F Conversion Price.

 

Except as otherwiserequired by law, holders of Series F Preferred Stock and holders of CommonStock shall vote together as a single class on each matter submitted to a voteof stockholders.  Each outstanding shareof Series F Preferred Stock shall be entitled to the number of votes equal tothe number of full shares of Common Stock into which each such share of SeriesF Preferred Stock is then convertible on the date for determination ofstockholders entitled to vote at the meeting. Holders of the Series F Preferred Stock are entitled to vote at themeeting.  Holders of the Series FPreferred Stock are entitled to vote as a separate class on any proposedamendment to the terms of the Series F Preferred Stock which would increase ordecrease the number of authorized shares of Series F Preferred Stock or have anadverse impact on the Series F Preferred Stock and on any proposal to create anew class of shares having rights or preferences equal to or having priority tothe Series F Preferred Stock.

 

The Company mayredeem the shares of the Series F Preferred Stock at any time prior toconversion at a redemption price of 115% of the purchase price paid for theSeries F Preferred Shares plus any accrued but unpaid dividends.

 

During the threemonths ended December 31, 2003, the Company’s Chief Executive Officerconverted 2,000 shares of the Series F Preferred Stock into 2,000,000 of commonstock.

 

8

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**NOTE 7 – STOCK – BASED COMPENSATION**

 

TheCompany accounts for its stock-based compensation plans using the intrinsicvalue method in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees”. Accordingly, no stock-based employee compensation cost has beenrecognized in the financial statements as all options granted under theCompany’s stock option plan, had an exercise price at least equal to the marketvalue of the underlying common stock on the date of grant.  The pro forma information below is based onprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, asamended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transitionand Disclosure”, issued in December 2002.

 
|                                                                                                                                  |   | **Three  Months Ended** |       |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                                                                                  |   | **2003**                |       | **2002** |   |
|                                                                                                                                  |   |                    | ** ** |   | ** ** |
| Net earnings (loss) from continuing operations  attributable to common stockholders, as reported                                      |   | $                       | 8,902      |   | $ | (1,097,308 | ) |
|                                                                                                                                  |   |                    |       |   |   |
| Deduct:                                                                                                                               |   |                    |       |   |   |
| Total stock-based employee compensation expense  determined under fair value based method for all awards, net of  related tax effects |   | (208,700                | )          | (591,330 | ) |
|                                                                                                                                  |   |                    |       |   |   |
| Pro forma net (loss) from continuing  operations attributable to common stockholders                                                  |   | $                       | (199,798   | ) | $ | (1,688,638 | ) |
|                                                                                                                                  |   |                    |       |   |   |
| Earnings (loss) from continuing operations  per common share attributable to common stockholders:                                     |   |                    |       |   |   |
| Basic – as reported                                                                                                              |   | $                       | —     |   | $ | (.07 | ) |
| Basic – pro forma                                                                                                                |   | $                       | (.01       | ) | $ | (.12 | ) |
|                                                                                                                                  |   |                    |       |   |   |
| Diluted – as reported                                                                                                            |   | $                       | —     |   | $ | (.07 | ) |
| Diluted – pro forma                                                                                                              |   | $                       | (.01       | ) | $ | (.12 | ) |

 

**NOTE 8 – ACQUISITION**

 

Effectiveas of December 1, 2002, (the “Effective Date”), the Company purchasedsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of six offices of Elite Personnel Services (“Elite”), a Californiacorporation.  The Elite branches providetemporary light industrial and clerical staffing in six business locations inCalifornia and Nevada.  The Company alsotook over Elite’s Downey, California office, from which Elite serviced noaccounts but which it utilized as a corporate office.  The Company intends to continue to utilize the Downey office as aregional corporate facility.  Theacquisition of Elite furthers the Company’s expansion into the Californiastaffing market.  Pursuant to the termsof an Asset Purchase Agreement between the Company and Elite datedNovember 19, 2002 (the “Asset Purchase Agreement”), the purchase pricepayable at closing (the “Base Purchase Price”) for the assets was $1,264,000,all of which was represented by an unsecured promissory note.  In addition to the Base Purchase Price,Elite will also receive as a deferred purchase price, an amount equal to 10% ofthe annual “Gross Profits” as defined in the Asset Purchase Agreement of theacquired business between $2,500,000 and $3,200,000, and 15% of the annualGross Profits of the acquired business in excess of $3,200,000 for a period oftwo years from the Effective Date.  Inconnection with the transaction, Elite, its President and other key managementmembers entered into non-competition and non-solicitation agreements pursuantto which they agreed not to compete with the Company in the territories of theacquired business for periods ranging from twelve months to five years, and tonot solicit the employees or customers of the acquired business for periodsranging from twelve months to five years.

 

Forfinancial accounting purposes, interest on the note has been imputed at a rateof 11% per year.  Accordingly, the noteand Base Purchase Price has been recorded at $845,875.  In accordance with SFAS No. 141, “BusinessCombinations” the contingent portion of the purchase price has been recognizedas a liability to the extent that the net acquired assets exceed the purchaseprice.  Accordingly, $244,000 isincluded in “Accounts payable and accrued expenses” on the attached balancesheets as of December 31, 2003 and September 30, 2003.  There was an additional $176,644 of costspaid to third parties in connection with the acquisition.

 

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Thefollowing summarizes the fair value of the assets acquired at the date ofacquisition based upon a third-party valuation of certain intangible assets:

 
| Property  and equipment |   | $         | 75,000    |   |
|-------------------------|--------|-----------|-----------|--------|
| Covenant-not-to-compete |   | 19,500    |      |
| Customer list           |   | 1,172,019 |      |
| Total assets acquired   |   | $         | 1,266,519 |   |

 

Thecovenant-not-to-compete and customer list are being amortized over theirestimated useful life of five and seven years, respectively.

 

The unaudited pro forma resultsof operations for the three months ended December 31, 2002 presented belowassume that the acquisition had occurred at the beginning of fiscal 2003.  This information is presented forinformational purposes only and includes certain adjustments such asamortization of intangibles resulting from the acquisitions and interestexpense related to acquisition debt.

 
| Revenues                                                                   |   | $          | 19,579,437 |   |
|----------------------------------------------------------------------------|--------|------------|------------|--------|
| Net (loss) from continuing operations attributable  to common stockholders |   | (1,031,340 | )          |
|                                                                       |   |       |       |
| Net (loss) per share attributable to common  stockholders                  |   |       |       |
| Basic                                                                      |   | $          | (.07       | )      |
| Diluted                                                                    |   | $          | (.07       | )      |

 

**NOTE 9 – DISCONTINUED OPERATIONS**

 

***Sale of CertainBranches***

OnMarch 9, 2003, the Company completed the sale of substantially all of thetangible and intangible assets, excluding accounts receivable, of its ColoradoSprings, Colorado office.  Pursuant tothe terms of an asset purchase agreement between the Company and US TempServices, Inc. (“US Temps”) dated March 9, 2003, the purchase price forthe purchased assets was $20,000 which was paid by a promissory note, whichbears interest at the rate of 6% per year and is payable in monthlyinstallments of $608 over a three year period. The note is secured by a security interest on all of the purchasedassets.

 

Thepurchase price for the assets acquired by US Temps was arrived at througharms-length negotiations between the parties and resulted in a gain on sale of$13,958.

 

OnAugust 22, 2003, the Company completed the sale, effective as ofAugust 18, 2003 (the “ALS Effective Date” of substantially all of thetangible and intangible assets, excluding accounts receivable, of its MiamiSprings, Florida office.  Pursuant tothe terms of the Asset Purchase Agreement between the Company and ALS, LLC, aFlorida limited liability company (“ALS”) dated August 22, 2003 (the“Purchase Agreement”), the purchase price for the purchased assets was$128,000, which was paid by a promissory note, which bears interest at the rateof 7% per year with payments over a 60 month period.  The amount of the monthly payments due under the note is greaterof $10 per month or 20% of the monthly net profits generated by the staffingbusiness originating from the purchased assets.  However, until such time as all outstanding amounts due and owingby the Company to ALS, as of the date of the Purchase Agreement in the amountof $289,635, ($261,042 at December 31, 2003), have been paid in full,these monthly payments shall be deducted from any and all amounts due from theCompany to ALS (see Note 10).  The noteis secured by a security interest in all of the purchased assets.

 

Inconnection with the transaction, ALS entered into a non-compete andnon-solicitation agreement pursuant to which ALS agreed not to compete with theCompany with respect to any of the Company’s other remaining offices for aperiod of 18 months.

 

Thepurchase price for the assets acquired by ALS was arrived at throughnegotiations with a related party purchaser and resulted in a gain on sale of$10,777.  The son of the Company’sPresident and Chief Executive Officer is a 50% member in ALS, LLC.

 

OnSeptember 10, 2003, the Company completed the sale, effective as ofSeptember 15,2003 (the “Effective Date”), of substantially all of thetangible and intangible assets, excluding accounts receivable, of five of itsNew Jersey offices to D/O Staffing LLC (“D/O”).  The offices sold are the following:  Elizabeth, New Jersey; New Brunswick, New Jersey; Paterson,

 

10

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NewJersey; Perth Amboy, New Jersey and Trenton, New Jersey.  Pursuant to the terms of an asset purchaseagreement between D/O and us dated September 10, 2003 (the D/O PurchaseAgreement”), the base purchase price for the purchased assets was $1,250,000payable as follows:

 

(i)                                     $1,150,000payable in certified funds at the closing; and

 

(ii)                                  $100,000payable in certified funds into escrow at the closing to be held in escrow byattorneys for the Buyer pursuant to the terms of an escrow agreement, toaccount for certain post-closing adjustments.

 

Additionally,the Company may be entitled to receive as a deferred purchase price (the“Bonus”), an amount equal to $125,000, if, for the one year period measuredfrom the Effective Date, the purchased assets generate for D/O at least$18,000,000 in actual billings by client accounts serviced by the Company as ofthe Closing and transferred by the Company to D/O pursuant to the D/O PurchaseAgreement.  The Bonus, if any, ispayable by a promissory note, payable over 24 months and bearing interest at aninterest rate of 6% a year.

 

Thetransaction resulted in a (loss) on sale of $(50,354).

 

OnSeptember 29, 2003, the Company completed the sale of substantially all ofthe tangible and intangible assets, excluding accounts receivable, of its LasVegas, Nevada office.  Pursuant to theterms of an asset purchase agreement between the Company and US Temps dated September 29,2003, the purchase price for the purchased assets was $105,000, all of whichwas paid by a promissory note, which bears interest at the rate of 6% per yearand is payable in monthly installments of $2,030, over a five year period.  The note is secured by a security intereston al of the purchased assets.

 

Thetransaction resulted in a gain on sale of $4,599.

 

Revenuesfrom the aforementioned certain branches were $5,413,935 for the three monthsended December 31, 2002.

 

Thestatement of operations for the three months ended December 31, 2002, hasbeen reclassified to reflect the operating results of the sold branches asdiscontinued operations.

 

**NOTE 10 - RELATED PARTY TRANSACTIONS**

 

***Consulting Agreement***

Theson of the Chief Executive Officer of the Company (the (“CEO”) providesconsulting services to the Company. Consulting expense was $1,200 and $13,600 for the three months endedDecember 31, 2003 and 2002, respectively.

 

TheCompany has paid consulting fees to an entity whose stockholder is another sonof the CEO of the Company.  Consultingfees amounted to $-0- and $24,000 for the three months ended December 31,2003 and 2002, respectively.

 

***Joint Venture***

TheCompany provides information technology staffing services through a jointventure, Stratus Technology Services, LLC (“STS”), in which the Company has a50% interest.  A son of the CEO of theCompany has a majority interest in the other 50% venturer.  The Company’s (loss) from operations of STSof $(14,593) and $(2,969) for the three months ended December 31, 2003 and2002, respectively, is included in other income (expense) in the statements ofoperations.

 

Summarizedfinancial information of STS is not provided because the investment is notmaterial.

 

***Note Receivable***

The$128,000 “Note Receivable - related party” as of December 31, 2003, is theamount due from ALS in connection with the sale of the Company’s Miami Springs,Florida office (see Note 9).  ALS is theholding company for Advantage Services Group, LLC (“Advantage”).

 

***Cost of Revenues***

In November 2003, theCompany entered into agreements with Advantage, whereby Advantage is to providepayrolling services with respect to four of the Company’s accounts, atAdvantage’s cost plus a fee ranging between 2% to 3%.  The Company has pledged the four accounts as security for itsobligation under these agreements.  Inaddition, if the aggregate payroll of employees provided under these agreementsdoes not equal at least $8 million by November 30, 2004, the

 

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Company will be required to payAdvantage an amount equal to 8% of the shortfall.  Costs incurred under the agreements and a previous agreement was$1,663,879 and $606,534 in the three months ended December 31, 2003 and2002, respectively.

### ** **

Inaddition to the foregoing, in November 2003, the Company agreed to payAdvantage $5,000 per week until $225,000 owed to Advantage in connection withthe previous agreement for payrolling services has been paid.  As of December 31, 2003, $15,000 hasbeen paid under this agreement.  Theobligation to pay this amount is secured by a warrant to purchase 2,000,000shares of the Company’s common stock. The warrant, which is exercisable only if the Company defaults on itspayment obligations to Advantage, has an exercise price equal to the lower of$.15 per share or 75% of the then current market price of the common stock.

 

**NOTE 11 - SUBSEQUENT EVENTS**

 

a.                           Pursuant to certain registration rightsgranted to the holders of the Series E Preferred Stock, the Company isobligated to file a registration statement under the Securities Act of 1933with respect to the shares of common stock issuable upon conversion of theSeries E Preferred Stock.  The Companyis obligated to pay penalties for each 120 day period that such registrationstatement has not been filed and declared effective.  As per agreement with the holders of the Series E PreferredStock, the next penalty measurement date was extended until January 31,2004.  In addition, the holders of theSeries E Preferred Stock agreed that any penalty amounts due would be paid asadditional shares of Series E Preferred Stock.

 

Since there was no registration statement filed by January 31,2004, an additional 5,716 shares will be issued as payment of the $571,605 dueto holders of the Series E Preferred Stock.

 

b.                          On February 13, 2004, the Company filed, withthe Securities and Exchange Commission, a Form S-4 Registration Statementwhereby the Company has offered to exchange each outstanding share of theSeries E Preferred Stock for, at the election of the holder, common stock andcommon stock purchase warrants or Series I Preferred Stock (the “ExchangeOffer”).

 

Pursuantto the terms of the Exchange Offer, the Company will exchange each share ofSeries E Preferred Stock, at the holder’s election, for either (i) 100 sharesof common stock and 200 common stock purchase warrants for each $100 in liquidation preference and accrued dividends representedby the Series E Preferred Stock; or (ii) one share of Series I Preferred Stockhaving a stated value of $100 per share for each $100 in liquidation preferenceand accrued dividends represented by the Series E Preferred Stock.

 

Eachwarrant entitles its owner to purchase one share of common stock for $.95.  The warrants will be exercisable at any timeduring the period commencing one year after the closing of the Exchange Offerand for a period of three years thereafter, unless the Company has redeemedthem.  The Company may redeem the warrants,at a redemption price of $.10 per warrant, upon thirty days prior writtennotice beginning one year after the closing of the Exchange Offer, once theclosing bid price of the common stock has been at least $1.66 for 20consecutive trading days.

 

TheCompany will be required to redeem each share of the Series I Preferred Stockfor an amount equal to the stated value of $100 per share plus all accrued andunpaid dividends on the six month anniversary date of the issuance of theSeries I Preferred Stock to the extent permitted by applicable law.  If the Company fails to redeem the Series IPreferred Stock, as required, each share of Series I Preferred Stock willthereafter be convertible, at the option of the holder, into 100 shares ofcommon stock and 200 common stock purchase warrants for each $100 of statedvalue and accrued and unpaid dividends represented by the Series I PreferredStock at the time of conversion.

 

TheExchange Offer is subject to several conditions, the most significant being (i)the sale of at least $1 million of units in a public offering of units in theOffering (see Note 6); and (ii) the effectiveness of the registration statementregarding the Exchange Offer.

 

TheExchange Offer will remain open until March 17, 2004, but the Company has aright to extend the offering period.

 

TheCompany has not obtained, nor will it obtain, approval of the Exchange Offerfrom either the holders of the common stock or holders of the Series EPreferred Stock.

 

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**Item 2 - MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

### ** **

ThisForm 10-Q contains “forward-looking statements” within the meaning ofSection 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended.  These statements relate to future economic performance, plans andobjectives of management for future operations and projections of revenue andother financial items that are based on the beliefs of our management, as wellas assumptions made by, and information currently available to, ourmanagement.  The words “expect”,“estimate”, “anticipate”, “believe”, “intend”, and similar expressions areintended to identify forward-looking statements.  Such statements involve assumptions, uncertainties andrisks.  If one or more of these risks oruncertainties materialize or underlying assumptions prove incorrect, actualoutcomes may vary materially from those anticipated, estimated or expected.  Among the key factors that may have a directbearing on our expected operating results, performance or financial conditionare economic conditions facing the staffing industry generally; uncertaintiesrelated to the job market and our ability to attract qualified candidates;uncertainties associated with our brief operating history; our ability to raiseadditional capital; our ability to achieve and manage growth; our ability tosuccessfully identify suitable acquisition candidates, complete acquisitions orintegrate the acquired business into our operations; our ability to attract andretain qualified personnel; our ability to develop new services; our ability tocross-sell our services to existing clients; our ability to enhance and expandexisting offices; our ability to open new offices; general economic conditions;and other factors discussed from time to time in our filings with theSecurities and Exchange Commission. These factors are not intended to represent a complete list of all risksand uncertainties inherent in our business. The following discussion and analysis should be read in conjunction withthe Condensed Financial Statements and notes appearing elsewhere in thisreport.

 

Ourcritical accounting policies and estimates are described in our Annual Reporton Form 10-K for the fiscal year ended September 30, 2003.

 

**Introduction**

 

Weprovide a wide range of staffing and productivity consulting servicesnationally through a network of offices located throughout the UnitedStates.  Regardless of the type oftemporary service offering we provide, we recognize revenues based on hoursworked by assigned personnel. Generally, we bill our customers a pre-negotiated, fixed rate per hourfor the hours worked by our temporary employees.  Therefore we do not separate our various service offerings intoseparate offering segments.  We do notroutinely provide discrete financial information about any particular serviceoffering to assess its performance.  Asset forth below, certain of our service offerings target specific markets, butwe do not necessarily conduct separate marketing campaigns for suchservices.  We are responsible forworkers’ compensation, unemployment compensation insurance, Medicare and SocialSecurity taxes and other general payroll related expenses for all of thetemporary employees we place.  Theseexpenses are included in the cost of revenue. Because we pay our temporary employees only for the hours they actuallywork, wages for our temporary personnel are a variable cost that increases ordecreases in proportion to revenues. Gross profit margin varies depending on the type of servicesoffered.  In some instances, temporaryemployees placed by us may decide to accept an offer of permanent employmentfrom the customer and thereby “convert” the temporary position to a permanentposition.  Fees received from suchconversions are included in our revenues. Selling, general and administrative expenses include payroll formanagement and administrative employees, office occupancy costs, sales andmarketing expenses and other general and administrative costs.

 

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**Results of OperationsDiscontinued Operations/Acquisition or Disposition of Assets**

 

EffectiveDecember 1, 2002, we purchased substantially all of the tangible andintangible assets, excluding accounts receivable, of six offices of ElitePersonnel Services, Inc.  Pursuant to aAsset Purchase Agreement dated November 19, 2002, between us and Elite(the “Elite Purchase Agreement”), the purchase price paid at closing (the “BasePurchase Price”) was $1,264,000, all of which was represented by a promissorynote (the “Note”) payable over eight years, in equal monthly installments.  Imputed interest at the rate of 4% per yearis included in the Note amount. Accordingly, the net Base Purchase Price was $1,083,813.

 

Inaddition to the Base Purchase Price, Elite may also receive as deferredpurchase price an amount equal to 10% of “Gross Profits” as defined in theElite Purchase Agreement, of the acquired business between $2,500,000 and$3,200,000 per year, plus 15% of Gross Profits of the acquired business inexcess of $3,200,000 per year, for a minimum of one year from the effectivedate of the transaction, and for a period of two years from the effective dateif Gross Profits for the first year reach specified levels.

 

OnSeptember 29, 2003, we completed the sale of substantially all of thetangible and intangible assets, excluding accounts receivable, of our LasVegas, Nevada office.  Pursuant to theterms of an Asset Purchase Agreement between us and US Temp Services, Inc. (“USTemps”) dated September 29, 2003, the purchase price for the purchasedassets was $105,000, all of which was paid by means of a promissory note, whichbears interest at the rate of 6% per year and is payable in monthly installmentsof $2,030, over a 5 year period.  Thenote is secured by a security interest on all of the purchased assets.  The purchase price for the assets acquiredby US Temps was arrived at through arms-length negotiations between theparties.

 

OnSeptember 10, 2003, we completed the sale, effective as ofSeptember 15, 2003 (the “Effective Date”), of substantially all of thetangible and intangible assets, excluding accounts receivable, of five of ourNew Jersey offices to D/O Staffing LLC (“D/O”).  The offices sold are the following:  Elizabeth, New Jersey; New Brunswick, New Jersey; Paterson, NewJersey; Perth Amboy, New Jersey and Trenton, New Jersey.  Pursuant to the terms of an asset purchaseagreement between D/O and us dated September 10, 2003 (the “D/O PurchaseAgreement”), the base purchase price for the purchased assets was $1,250,000,payable as follows:

 

(i)                                     $1,150,000payable in certified funds at the closing; and

 

(ii)                                  $100,000 payable in certified funds intoescrow at the closing to be held in escrow by attorneys for the Buyer pursuantto the terms of an escrow agreement, to account for certain post-closingadjustments.

 

Additionally,we may be entitled to receive as a deferred purchase price (the “Bonus”), anamount equal to $125,000 if, for the one year period measured from theEffective Date, the purchased assets generate for D/O at least $18,000,000 inactual billings by client accounts serviced by us as of the closing andtransferred by us to D/O pursuant to the D/O Purchase Agreement.  The Bonus, if any, is payable by way of apromissory note, payable over a 24 month period and bearing interest at aninterest rate of 6% per year.

 

Thepurchase price for the assets was arrived at through arms-length negotiationsbetween the parties.

 

OnAugust 22, 2003, we completed the sale, effective as of August 18,2003 (the “ALS Effective Date”) of substantially all of the tangible andintangible assets, excluding accounts receivable, of our Miami Springs, Floridaoffice.  Pursuant to the terms of theAsset Purchase Agreement between us and ALS, LLC, a Florida limited liabilitycompany (“ALS”) dated August 22, 2003 (the “Purchase Agreement”), thepurchase price for the purchased assets was $128,000, all of which was paid bymeans of a promissory note, which bears interest at the rate of 7% per annum,with payments over a 60 month period. The amount of the monthly payments due under the note will be thegreater of $10 per month or 20% of the monthly net profits generated by the staffingbusiness originating from the purchased assets, commencing October 31,2003.  However, until such time as alloutstanding receivables due and owing by us to ALS, as of the date of thePurchase Agreement in the amount of $289,635, have been paid in full, thesemonthly payments shall be deducted from any and all amounts due from us toALS.  The note is secured by a securityinterest in all of the purchased assets.

 

Thepurchase price for the assets acquired by ALS was arrived at throughnegotiations with a related party purchaser. The son of our President and Chief Executive Officer is a 50% member inALS, LLC.  We believe that the terms ofthe transaction are comparable to those which would have been obtained in atransaction with an unrelated party. Proceeds from the Note will be used to pay down existing debt and forworking capital purposes.

 

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OnMarch 9, 2003, we completed the sale of substantially all of the tangibleand intangible assets, excluding accounts receivable, of our Colorado Springs,Colorado office.  Pursuant to the termsof an asset purchase agreement between us and US Temps dated March 9,2003, the purchase price for the purchased assets was $20,000, all of which waspaid by means of a promissory note, which bears interest at the rate of 6% peryear and is payable in monthly installments of $608, over a three yearperiod.  The note is secured by asecurity interest on all of the purchased assets.

 

**Continuing Operations**

**Three Months Ended December 31, 2003 Compared to Three MonthsEnded December 31, 2002**

 

***Revenues.*** Revenues increased 63.5% to $23,886,064 for the three months endedDecember 31, 2003 from $14,611,085 for the three months endedDecember 31, 2002.  Approximately $5.0million of the increase was attributable to the acquisition inDecember 2002.  Excludingacquisitions revenues increased 29.5%. This increase was a result of an increase in billable hours.

 

***Gross Profit.*** Gross profit increased 42.0% to $3,532,122 for the three months endedDecember 31, 2003 from $2,486,814 for the three months endedDecember 31, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenuesdecreased to 14.8% for the three months ended December 31, 2003 from 17.0%for the three months ended December 31, 2002.  This decrease was a result of increased pricing competition ofstaffing services and increases in the cost of workers’ compensation insuranceand state unemployment taxes.  Inaddition, we have been assessed the penalty rate by the New Jersey Departmentof Labor for state unemployment taxes because of payment delinquencies (see“Liquidity and Capital Resources”).

 

***Selling, General and AdministrativeExpenses.**** *Selling, general and administrative expensesincreased 7.9% to $3,006,949 for the three months ended December 31, 2003from $2,787,252 for the three months ended December 31, 2002.  Selling, general and administrative expensesas a percentage of revenues decreased to 12.6% for the three months endedDecember 31, 2003 from 19.1% for the three months ended December 31,2002.  The increase in the dollar amountis primarily a result of the acquisition in December 2002, whereas thepercentage of revenue decrease is attributable to significant cost reductionsimplemented by us and the increase in revenues with no proportionate increasein selling, general and administrative expenses.

 

***Interest and Financing Costs.*** Interest and financing costs increased 3.7% to $453,184 for the threemonths ended December 31, 2003 from**$437,063for the three months ended December 31, 2002.  Interest and financing costs as a percentage of revenuesdecreased to 1.9% for the three months ended December 31, 2003 from 3.0%for the three months ended December 31, 2002.  Prior to September 30, 2003, the current value of our SeriesA Preferred Stock had been included in stockholders’ equity.  In accordance with Statement of FinancialAccounting Standards No. 150, “Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity”, the current value of ourSeries A Preferred Stock was reclassified as a liability.  Accordingly, $131,594 of dividends andaccretion relating to the Series A Preferred Stock is included in interest andfinancing costs in the three months ended December 31, 2003.  Excluding this amount, interest andfinancing costs decreased 26.4% from the three months ended December 31,2002.

 

***Net Earnings (Loss) Attributable to CommonStockholders.**** *As a result of the foregoing, we had netearnings and net earnings attributable to common stockholders of $81,543 and$8,902, respectively, for the three months ended December 31, 2003compared to a net (loss) and net (loss) attributable to common stockholders of($731,214) and ($1,097,308) for the three months ended December 31, 2002,respectively.

 

**Liquidity and Capital Resources**

 

AtDecember 31, 2003, we had limited liquid resources.  Current liabilities were $23,601,396 andcurrent assets were $15,806,407.  Thedifference of $7,794,989 is a working capital deficit, which is primarily theresult of losses incurred during the last three years.  These conditions raise substantial doubtsabout our ability to continue as a going concern.  The financial statements do not include any adjustments toreflect the possible future effect on the recoverability and classification ofassets or the amounts and classification of liabilities that may result fromthe outcome of this uncertainty.

 

Ourcontinuation of existence is dependent upon the continued cooperation of ourcreditors, our ability to generate sufficient cash flow to meet our continuingobligations on a timely basis, to fund the operating and capital needs, and toobtain additional financing as may be necessary.

 

Wehave taken steps to revise and reduce our operating requirements, which webelieve will be sufficient to assure continued operations and implementation ofour plans.  The steps include closingbranches that are not profitable,

 

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consolidating branches andreductions in staffing and other selling, general and administrativeexpenses.  We continue to pursue othersources of equity or long-term debt financings.  We also continue to negotiate payments plans and otheraccommodations with our creditors.

 

Inorder to raise capital to sustain our operations, we have filed a RegistrationStatement on Form S-1 with respect to a proposed offering of securities (the“Offering”).  We are seeking to raise aminimum of $1,000,000 and a maximum of $10,000,000 through the sale of unitsconsisting of common stock and warrants to purchase common stock.  The Offering is being underwritten on a bestefforts basis and we can give no assurance that we will be successful inraising any funds in the Offering.  TheRegistration Statement filed in connection with the proposed Offering has notyet become effective.  The securitiesmay not be sold nor may offers to buy the securities be accepted prior to thetime the Registration Statement becomes effective.

 

Netcash provided by (used in) operating activities was $315,523 and ($1,342,610)in the three months ended December 30, 2003 and 2002, respectively.

 

Netcash used in investing activities was $5,152 and $172,346 in the three monthsended December 31, 2003 and 2002, respectively.  Cash used for acquisitions for the three months endedDecember 31, 2002, was $38,000. The balance in both periods was primarily for capital expenditures.

 

Netcash provided by (used in) financing activities was ($178,995) and $1,365,930in the three months ended December 31, 2003 and 2002, respectively.  We had net borrowings of $621,471 and$1,015,747 under our line of credit in the three months ended December 31,2003 and 2002, respectively.  Net short-termborrowings (repayments) were ($229,929) and $617,359 in the three months endedDecember 31, 2003 and 2002, respectively. Payments of notes payable - acquisitions was $153,278 and $182,823 inthe three months ended December 31, 2003 and 2002, respectively.

 

Ourprincipal uses of cash are to fund temporary employee payroll expense and employerrelated payroll taxes, investment in capital equipment, start-up expenses ofnew offices, expansion of services offered, workers’ compensation, generalliability and other insurance coverages, debt service and costs relating toother transactions such as acquisitions. Temporary employees are paid weekly.

 

Wehave a loan and security agreement (the “Loan Agreement”) with Capital TempFunds, Inc., which provides for a line of credit up to 85% of eligible accountsreceivable, as defined, not to exceed $12,000,000.  Until December 2000, advances under the Loan Agreement boreinterest at a rate of prime plus 1 1⁄2%. (See below)  The Loan Agreementrestricts our ability to incur other indebtedness, pay dividends and repurchasestock.  Borrowings under the LoanAgreement are collateralized by substantially all of our assets.  As of December 31, 2003, $8,933,746 wasoutstanding under the credit agreement.

 

AtDecember 31, 2003, we were in violation of the following covenants underthe Loan Agreement:

 

(i)                                     Failing to meet the tangible net worthrequirements;

 

(ii)                                  Our common stock being delisted from theNasdaq SmallCap Market

 

Wehave received a waiver from the lender on all of the above violations.  In December 2002 we entered into amodification of the Loan Agreement.  Themodification provided that borrowings under the Loan Agreement would bearinterest at a rate of prime plus 1 3⁄4% as long as we are in violation of any ofthe covenants under the Loan Agreement. Effective April 10, 2003, we entered into another modification ofthe Loan Agreement which provides that borrowings under the Loan Agreement bearinterest at 3% above the prime rate.

 

Holdersof the 1,458,933 outstanding shares of our Series A Preferred Stock areentitled to dividends at a rate of $.21 per share, per annum, when and ifdeclared by our Board of Directors in preference and priority to any payment ofdividends on our common stock or any other series of our capital stock.  Dividends on the Series A Preferred Stockmay be paid in additional shares of Preferred Stock if the shares of commonstock issuable upon the conversion of the Series A Preferred Stock have beenregistered for resale under the Securities Act of 1933.  We are obligated to pay quarterly dividendsto holders of our Series E Preferred Stock at a rate of 6% per annum of thestated value of the stock in preference and priority to any payment ofdividends on our common stock.  We areobligated to pay monthly dividends on our Series F Preferred Stock at a rate of7% per annum of the stated value of the stock in preference and priority to anypayment of dividends on our common stock. The aggregate stated values of the Series E and Series F Preferred Stockwas $3,810,855 and $600,000, respectively, as of December 31, 2003.  Dividends on the Series E and Series FPreferred Stock may be paid at the

 

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Company’s option in shares ofcommon stock (valued at the conversion price of the applicable class ofpreferred stock) if such shares have been registered for resale under theSecurities Act of 1933.

 

Weare obligated to redeem any shares of Series A Preferred Stock outstanding onJune 30, 2008 at a redemption price of $3.00 per share together withaccrued and unpaid dividends.  We have theoption to pay the redemption price through the issuance of shares of commonstock.  For purposes of determining thenumber of shares we will be required to issue if we pay the redemption price inshares of common stock, the common stock will have a value equal to the averageclosing price of the common stock during the five trading days preceding thedate of redemption.

 

InJuly 2003, we entered into an agreement with Artisan (UK) plc, the parentcompany of Artisan.com Limited, pursuant to which we have agreed to redeem theaggregate 1,458,933 shares of our Series A Preferred Stock owned by Artisan.comLimited and Cater Barnard (USA) plc, an affiliate of Artisan.  These shares represent all of the shares ofSeries A Preferred Stock currently outstanding.  Our obligation to redeem the Series A Preferred Stock iscontingent upon our sale of not less than $4,000,000 of units in our proposedbest efforts offering of units (“Units”). If we sell at least $4,000,000 of Units in the Offering, we will beobligated to pay $500,000 to Artisan within 15 days after the $4,000,000 ofUnits are sold.  In addition, we will beobligated to pay Artisan an additional $250,000 by January 31, 2005, or,at our option, issue to Artisan shares of our common stock having an aggregatemarket value of $250,000, based upon the average closing bid prices of thecommon stock for the 30 trading days preceding January 31, 2005.  If we fail to make the $250,000 payment incash or stock, we will be required to pay Artisan $300,000 in cash, plusinterest calculated on a daily basis at a rate of 18% from the date of thedefault to the date the default is cured. We have also agreed to issue to Artisan a number of shares of our commonstock which will represent 5.5% of our outstanding common stock, subject tocertain adjustments, upon completion of our sale of $4 million of Units in theOffering.  Further, upon finalcompletion of the Offering, we will be required to issue additional shares ofcommon stock so that the total number of shares of common stock issued toArtisan will equal 5.5% of our common stock after giving effect to the assumedexercise of all warrants and options that then have exercise prices equal to orless than the then current market price of our common stock and the conversionof all convertible securities that then have conversion prices equal to or lessthan the then current market price of our common stock.

 

Otherfixed obligations that we had as of December 31, 2003 include:

 

•                  $854,191 under a promissory note bearing interestat 7% per year which was issued in connection with our acquisition of SourceOne and which is payable in equal quarterly installments of $130,717 until itsmaturity date in August 2005.

 

•                  $973,498 under a promissory note bearinginterest at 6% per year, which was issued in connection with our acquisition ofcertain assets of PES and which is payable in equal quarterly installments of$36,770 until its maturity date in December 2011.

 

•                  $1,092,829, including $329,979 of imputedinterest, under a promissory note which was issued in connection with ouracquisition of Elite and which is payable in equal monthly installments of$13,167 until its maturity in November 2010.

 

•                  $80,000 under a promissory note that was duein April 2002 which bears interest at 18% per year.

 

•                  $54,934 under a promissory note which bearsinterest at 15% per year and which requires us to make payments of principaland interest of $8,000 per month until its maturity date in October 2004.

 

•                  $13,359 under a non-interest bearing promissorynote which requires us to make monthly payments of principal and interest of$13,347 and which is due in full upon the demand of the holder.

 

•                  $39,460 under a promissory note which bearsinterest at 8% per year and which requires us to make monthly payments ofprincipal and interest of $7,500 until it is paid in full.

 

•                  $41,000 under a demand note bearing interestat 10% per annum issued to a corporation wholly owned by the son of Joseph J.Raymond, our President and Chief Executive Officer.

 

•                  $756,504 under demand loans which bearinterest at various rates, including $667 owed to Joseph J. Raymond, $141,000owed to a son of Joseph J. Raymond, $100,000 owed to the brother of Joseph J.Raymond and $100,000 and $116,337 owed to a member of the Board of Directorsand a trust formed for the benefit of the family of a former member of theBoard of Directors, respectively.

 

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•                  $63,555 under promissory notes used toacquire and secured by motor vehicles which require aggregate monthly paymentsof principal and interest of $3,453 and which become due in full at variousdates between July and August, 2005.

 

Allof our offices are leased through operating leases that are not included on thebalance sheet.  As of December 31,2003, future minimum lease payments under lease agreements having initial termsin excess of one year were:  2004 -$532,000, 2005 - $260,000, 2006 - $184,000 and 2007 - $122,000.

 

Wemay be required to make certain “earnout” payments to sellers of businessesthat we have acquired in recent years, including Source One, PES andElite.  The amount of these payments, ifany, will depend upon the results of the acquired businesses.  There were no earnout payments made infiscal 2003.  There is $244,000 includedin “Accounts payable and accrued expenses” on the balance sheet as ofDecember 31, 2003 for estimated earnout payments that we recorded as partof the acquisition of Elite.

 

SourceOne has the right to require us to repurchase 400,000 shares of our commonstock at a price of $2.00 per share at any time after July 27, 2003 andbefore the later of July 27, 2005 and the full payment of the outstandingnote that we issued to it in connection with the acquisition transaction completedwith Source One in July 2001. Source One notified us that it was exercising this right onJuly 29, 2003.  We are attemptingto negotiate an arrangement which would permit us to pay this amount over anextended period of time or upon receipt of financing.  No assurance can be given that Source One will agree to such anarrangement.  In addition, the holder ofthe $80,000 note which was due in April 2002 has the right to require usto repurchase 20,000 shares of common stock at a price of $1.00 per share plusinterest at a rate of 15% per year until the note is paid in full.

 

InJanuary 2003, a $367,216 judgment was awarded against us to an insurancecarrier.  As of December 31, 2003,the judgment has not yet been paid in full; however, we have entered into anagreement with the plaintiff which permits us to satisfy the judgment by makingpayments of $25,000 per month through April 15, 2004 with a final paymentof $30,000 due on May 15, 2004. The unpaid balance of $117,216 at December 31, 2003 is included in“Accounts payable and accrued expenses” on the balance sheet.

 

Duringfiscal 2003, we were notified by both the New Jersey Department of Labor andthe California Department of Industrial Relations that, if certain payrolldelinquencies were not cured, judgment would be entered against us.  As of December 31, 2003, there wasstill an aggregate of $4.4 million in delinquent payroll taxes outstandingwhich are included in “Payroll taxes payable” on the balance sheet as ofDecember 31, 2003.  Judgment hasnot been entered against us in California. While judgment has been entered against us in New Jersey, no actionshave been taken to enforce same.  Wecontinue to work with these state agencies to pay down outstandingdelinquencies.

 

InApril 2003, we were served with a Complaint and named as one of severalDefendants in the matter of *Lopez v. RSI Home Products, Inc., et al.,*(“RSI”),in the Superior Court of California, Orange County.  RSI is one of our former customers.  The case is a class action proceeding alleging failure to payhourly wages and overtime wages, failure to provide rest periods and mealperiods or compensation in lieu thereof, failure to pay wages of terminated orresigned employees, knowing and intentional failure to comply with itemizedemployee wage statement provisions, violation of the unfair competition law,and breach of fiduciary duty.  Thematter has been settled among the parties and the parties await Court approvalof the settlement.  However, thesettlement will not have any adverse effect on our financial condition orresults of operations.

 

Asof December 31, 2003, there were no off-balance sheet arrangements,unconsolidated subsidiaries, commitments or guarantees of other parties, exceptas disclosed in the notes to financial statements.  Stock holders’ equity (deficiency) at that date was ($4,833,152).

 

Weengaged in various transactions with related parties during the three monthsended December 31, 2003 including the following:

 

•                     We paid $1,200 to an entity owned by Jeffrey J. Raymond and who is theson of Joseph J. Raymond, our Chairman, President and Chief Executive Officer,for consulting services.  These amountswere included in selling, general and administrative expense.  The services provided included theidentification of acquisition candidates, acquisition advisory services, duediligence, post-acquisition transition services, customer relations, accountsreceivable collection and strategic planning advice.

 

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### **•**                     Another son of Joseph J.Raymond is a 50% member in ALS, LLC which is the holding company for AdvantageServices Group, Inc. (“Advantage”).  InNovember 2003, we entered into agreements with Advantage, wherebyAdvantage is to provide payrolling services with respect to four of ouraccounts, at Advantage’s cost plus a fee ranging between 2% to 3%.  We have pledged the four accounts assecurity for our obligation under these agreements.  In addition, if the aggregate payroll of employees provided underthese agreements does not equal at least $8 million by November 30, 2004,we will be required to pay Advantage an amount equal to 8% of theshortfall.  Costs incurred under theagreement and a previous agreement was $1,663,879 and $606,534 in the threemonths ended December 31, 2003 and 2002, respectively.

 

### **In addition to the foregoing, in November 2003, weagreed to pay Advantage $5,000 per week until $225,000 owed to Advantage inconnection with the previous agreement for payrolling services has beenpaid.  As of December 31, 2003,$15,000 has been paid under this agreement. The obligation to pay this amount is secured by a warrant to purchase2,000,000 shares of our common stock. The warrant, which is exercisable only if we default on our paymentobligations to Advantage, has an exercise price equal to the lower of $.15 pershare or 75% of the then current market price of the common stock.**

### ** **

Webelieve that all transactions with related parties have been on terms no lessfavorable to us than those that could have been obtained from unaffiliatedthird parties.

 

**Seasonality**

 

Ourbusiness follows the seasonal trends of our customer’s business.  Historically, we have experienced lowerrevenues in the first calendar quarter with revenues accelerating during thesecond and third calendar quarters and then starting to slow again during thefourth calendar quarter.

 

**Impact of Inflation**

 

Webelieve that since our inception, inflation has not had a significant impact onour results of operations.

 

**Impact of Recent Accounting Pronouncements**

 

In January 2003, the FinancialAccounting Standards Board (the “FASB”) issued FASB Interpretation No. 46 (“FIN46”) – Consolidation of Variable Interest Entities, and a revisedinterpretation of FIN 46 (FIN 46-R) was issued in December 2003.  FIN 46 requires that if an entity has acontrolling financial interest in a variable interest entity, the assets,liabilities and results of activities of the variable interest entity should beincluded in the consolidated financial statements of the entity.  The provisions of FIN 46 are effectiveimmediately for all arrangements entered into after January 31, 2003.  We do not have any variable interestentities created after January 31, 2003. For those arrangements entered into prior to January 31, 2003, theFIN 46-R provisions are required to be adopted at the beginning of the firstinterim or annual period ending after March 15, 2004.  We are evaluating the impact of adoptingthis pronouncement as it relates to our investment in Stratus TechnologyServices, LLC (“STS”), since such investment may be required to be consolidatedcommencing in our fiscal period ending March 31, 2004.  The effect of consolidating STS is notexpected to have a material impact on our financial position, results ofoperations or cash flows.

 

In May 2003, the FASB issued SFAS No.150, “Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity”.  SFAS No. 150changes the accounting for certain financial instruments that, under previousguidance, issuers could account for as equity and requires that thoseinstruments be classified as liabilities (or assets in certain circumstances)in statements of financial position. This statement affects the issuer’s accounting for three types offreestanding financial instruments including (1) mandatorily redeemable sharesthat are required to be redeemed at a specified or determinable date or upon anevent certain to occur, (2) put options and forward purchase contracts, whichinvolves financial instruments embodying an obligation that the issuer must orcould choose to settle by issuing a variable number of its shares or otherequity instruments based solely on something other than the issuer’s own equityshares and (3) certain obligations that can be settled with share, the monetaryvalue of which is (i) fixed, tied solely or predominantly to a variable such asa market index, or (ii) varies inversely with the value of the issuers’shares.  For public companies, SFAS No.150 became effective at the beginning of the first interim period beginningafter June 15, 2003.  As a resultof SFAS No. 150, we have classified put options that were previously classifiedas “Temporary equity” and our Series A redeemable convertible preferred stockas liabilities at September 30, 2003.

 

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**Sensitive Accounting Estimates**

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the amounts reported in thefinancial statements and notes. Significant estimates include management’s estimate of the carryingvalue of accounts receivable, the impairment of goodwill and the establishmentof valuation reserves offsetting deferred tax assets.  Actual results could differ from those estimates.  The Company’s critical accounting policiesrelating to these items are described in the Company’s Annual Report on Form10-K for the year ended September 30, 2003.  As of December 31, 2003, there have been no material changesto any of the critical accounting policies contained therein.

 

**Item 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUTMARKET RISKS**

 

We are subject to the risk of fluctuatinginterest rates in the ordinary course of business for borrowings under our Loanand Security Agreement with Capital Tempfunds, Inc.  This credit agreement provides for a line of credit up to 85% ofeligible accounts receivable, not to exceed $12,000,000.  Advances under this credit agreement bearinterest at a rate of prime plus 3%.

 

We believe that our business operations arenot exposed to market risk relating to foreign currency exchange risk orcommodity price risk.

 

**Item 4. – CONTROLS AND PROCEDURES**

 

At the end of theperiod covered by this report, we carried out an evaluation of theeffectiveness of the design and operations of our disclosure controls andprocedures.  This evaluation was carriedout under the supervision and with the participation of our management,including our Chairman and Chief Executive Officer along with our ChiefFinancial Officer, who concluded that our disclosure controls and procedureswere effective as of the date of the evaluation.  There were no significant changes in our internal controls duringthe quarter ended December 31, 2003 that have materially affected, or arereasonably likely to have materially affected, our internal controls subsequentto the date we carried out our evaluation.

 

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**Part II – Other Information**

**Item 1 – Legal Proceedings**

 

We are involved,from time to time, in routine litigation arising in the ordinary course ofbusiness.  We do not believe that anycurrently pending litigation will have a material adverse effect on ourfinancial position or results of operations.

 

**Item 2 – Changes inSecurities and Use of Proceeds**

 

***Conversion of SeriesE Preferred Stock and Series F Preferred Stock***

 

### **In December 2003, holders ofSeries E Preferred Stock converted 2,150 shares into 1,853,448 shares of ourCommon Stock at a conversion price of $.116. The issuances of the Common Stock upon such conversions were made inreliance upon the exemptions from registration provided under Rule 506 andSection 4(2) of the Securities Act of 1933.**

 

InNovember 2003, Joseph J. Raymond, our President and Chief ExecutiveOfficer, the holder of the Series F Preferred Stock, converted 2,000 sharesinto 2,000,000 shares of our Common Stock at a conversion price of $.10 pershare.  The issuance of the Common Stockupon such conversion was made in reliance upon the exemptions from registrationby Rule 506 and Section 4(2) of the Securities Act of 1933.

 

Wedid not receive any proceeds as a result of such conversions.

 

**Item 3 – Defaults Upon SeniorSecurities**

 

Dividendson our Series A Preferred Stock accrue at a rate of 7% per annum and arepayable semi-annually when and if declared by our Board of Directors.  No such dividends have been declared and, asof the date of the filing of this report, $765,279 of dividends is in arrearson the Series A Preferred Stock.

 

Dividendson our Series E Preferred Stock accrue at a rate of 6% of the stated value peryear, payable every 120 days.  As of thedate of the filing of this report, $147,999 is in arrears on the Series EPreferred Stock.

 

Pursuantto certain registration rights granted to the holders of the Series E PreferredStock, we are obligated to file a registration statement under the SecuritiesAct of 1933 with respect to the shares of common stock issuable upon conversionof the Series E Preferred Stock.  We areobligated to pay penalties for each 120 day period that such registrationstatement has not been filed and declared effective.  As per agreement with the holders of the Series E PreferredStock, the next penalty measurement date was extended until January 31,2004.  In addition, the holders of theSeries E Preferred Stock agreed that any penalty amounts due would be paid asadditional shares of Series E Preferred Stock.

 

Sincethere was no registration statement filed by January 31, 2004, anadditional 5,716 shares will be issued as payment of the $571,605 due toholders of the Series E Preferred Stock.

 

Dividendson our Series F Preferred Stock accrue at a rate of 7% per annum, payablemonthly.  As of the date of the filingof this report, $45,563 is in arrears on the Series F Preferred Stock.

 

**Item 4 – Submission of Matters to a Vote ofSecurity Holders**

### ** **

Therewere no matters submitted to a vote of our security holders during the threemonths ended December 31, 2003.

 

**Item 5 – Other Information**

### ** **

Mr.H. Robert Kingston, a member of the Company’s Board of Directors passed away onJanuary 2, 2004.

 

OnFebruary 13, 2004, we filed, with the Securities and Exchange Commission, aForm S-4 Registration Statement whereby we have offered to exchange eachoutstanding share of our Series E Preferred Stock for, at the election of theholder, common stock and common stock purchase warrants or Series I PreferredStock (the “Exchange Offer”).

 

Pursuantto the terms of the Exchange Offer, we will exchange each share of Series EPreferred Stock, at the holder’s election, for either (i) 100 shares of commonstock and 200 common stock purchase warrants for each $100 in liquidationpreference and accrued dividends represented by the Series E Preferred Stock;or (ii) one share of Series I Preferred Stock

 

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having a stated value of $100per share for each $100 in liquidation preference and accrued dividendsrepresented by the Series E Preferred Stock.

 

Eachwarrant entitles its owner to purchase one share of our common stock for$.95.  The warrants will be exercisableat any time during the period commencing one year after the closing of theExchange Offer and for a period of three years thereafter, unless we have redeemedthem.  We may redeem the warrants, at aredemption price of $.10 per warrant, upon thirty days prior written noticebeginning one year after the closing of the Exchange Offer, once the closingbid price of our common stock has been at least $1.66 for 20 consecutivetrading days.

 

Wewill be required to redeem each share of the Series I Preferred Stock for anamount equal to the stated value of $100 per share plus all accrued and unpaiddividends on the six month anniversary date of the issuance of the Series IPreferred Stock to the extent permitted by applicable law.  If we fail to redeem the Series I PreferredStock, as required, each share of Series I Preferred Stock will thereafter beconvertible, at the option of the holder, into 100 shares of common stock and200 common stock purchase warrants for each $100 of stated value and accruedand unpaid dividends represented by the Series I Preferred Stock at the time ofconversion.

 

TheExchange Offer is subject to several conditions, the most significant being (i)the sale of at least $1 million of units in a public offering of units that weare conducting at or about the same time as we are conducting the ExchangeOffer; and (ii) the effectiveness of the registration statement regarding theExchange Offer.

 

TheExchange Offer will remain open until March 17, 2004, but we have a right toextend the offering period.

 

Wehave not obtained, nor will we obtain, approval of the Exchange Offer fromeither the holders of our common stock or holders of the Series E PreferredStock.

 

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**Item 6 - Exhibits and Reports on Form 8-K**

 

(a)                                                                                  Exhibits

 

10.21                                                                     Compromise Agreement between the Company andSeries E shareholders dated January 6, 2004.  (filed herewith)

 
| **Number** |   | **Description**                                                                                      |
|------------|--------|------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                 |
| 31.1       |   | Certification of Chief Executive Officer pursuant to  Section 302 of Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                                 |
| 31.2       |   | Certification of Chief Financial Officer pursuant to  Section 302 of Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                                 |
| 32.1       |   | Certification of Chief Executive Officer pursuant to  Section 906 of Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                                 |
| 32.2       |   | Certification of Chief Financial Officer pursuant to  Section 906 of Sarbanes-Oxley Act of 2002 |

 

(b)                                                                                 Reports on Form 8-K

 

On January 6, 2004, we filed a Report on Form 8-K toreport (i) the death of H. Robert Kingston, a member of the Company’s Board ofDirectors, on January 2, 2004, and (ii) the issuance of ourDecember 29, 2003 News Release reporting our financial results for thefiscal year ended September 30, 2003.

 

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SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                               | STRATUS SERVICES GROUP, INC. |
|------------------------------------|------------------------------|
|                               |                         |   |
| Date:  February 17, 2004 | By:                          | /s/  Joseph J. Raymond |   |
|                               |                         | Joseph  J. Raymond |
|                               |                         | Chairman  of the Board of Directors, |
|                               |                         | President  and Chief Executive Officer |
|                               |                         |   |
| Date:  February 17, 2004 | By:                          | /s/  Michael A. Maltzman |   |
|                               |                         | Michael  A. Maltzman |
|                               |                         | Chief  Financial Officer |
|                               |                         | (Principal  Financial and Accounting Officer) |

 

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