****

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

# ** **

**FORM 10-Q/A**

 

**(Mark One)**

 

| **ý**                                                                                                                                                                                                                     |   | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                           |
| **For the quarterly period ended March 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**                                                                                                                                                                                     |

 

**STRATUSSERVICES GROUP, INC.**

(Exact name of Registrant as specified inits 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) |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports) and (2)has been subject to such filing requirements for the past 90 days.  Yes ý               No o

 

Indicate by check mark whether the registrant isan accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes o               No ý

 

Asof May 16, 2003, 18,901,478 shares of the Registrant’s common stock wereoutstanding.

 

 

----

 

**Part I – FinancialInformation**

**Item 1. – FinancialStatements**

 

**STRATUSSERVICES GROUP, INC.**

Condensed Balance Sheets

 
|                                                                                                                                                                                                           |   | **March 31,  2003** |       | **September  30,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|--------------------------|--------|
|                                                                                                                                                                                                           |   | **As Restated**     |       |                     |   |
|                                                                                                                                                                                                           |   | **(Unaudited)**     |       |                     |   |
| Assets                                                                                                                                                                                                         |   |                |       |                     |   |
| Current assets                                                                                                                                                                                                 |   |                |       |                     |   |
| Cash and cash equivalents                                                                                                                                                                                      |   | $                   | 234,803    |                     | $      | 162,646 |   |
| Accounts receivable – less allowance for doubtful  accounts of  $1,555,000 and $1,742,000                                                                                                       |   | 12,418,719          |       | 9,179,543                |   |
| Unbilled receivables                                                                                                                                                                                           |   | 2,716,342           |       | 2,065,972                |   |
| Other receivables                                                                                                                                                                                              |   | —              |       | 250,000                  |   |
| Prepaid insurance                                                                                                                                                                                              |   | 2,474,746           |       | 2,709,331                |   |
| Prepaid expenses and other current assets                                                                                                                                                                      |   | 320,068             |       | 333,601                  |   |
|                                                                                                                                                                                                           |   | 18,164,678          |       | 14,701,093               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Property and equipment, net of accumulated  depreciation                                                                                                                                                       |   | 1,272,098           |       | 1,281,817                |   |
| Intangible assets, net of accumulated amortization                                                                                                                                                             |   | 1,812,607           |       | 802,145                  |   |
| Goodwill                                                                                                                                                                                                       |   | 7,085,582           |       | 7,085,582                |   |
| Deferred financing costs, net of accumulated  amortization                                                                                                                                                     |   | 4,964               |       | 5,768                    |   |
| Other assets                                                                                                                                                                                                   |   | 180,899             |       | 154,991                  |   |
|                                                                                                                                                                                                           |   | $                   | 28,520,828 |                     | $      | 24,031,396 |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Liabilities and  Stockholders’ Equity                                                                                                                                                                     |   |                |       |                     |   |
| Current liabilities                                                                                                                                                                                            |   |                |       |                     |   |
| Loans payable (current portion)                                                                                                                                                                                |   | $                   | 750,695    |                     | $      | 464,830 |   |
| Loans payable – related parties                                                                                                                                                                           |   | 341,000             |       | 116,000                  |   |
| Notes payable – acquisitions (current portion)                                                                                                                                                            |   | 624,887             |       | 578,040                  |   |
| Line of credit                                                                                                                                                                                                 |   | 10,359,108          |       | 7,739,117                |   |
| Cash overdraft                                                                                                                                                                                                 |   | 1,044,629           |       | 731,501                  |   |
| Insurance obligation payable                                                                                                                                                                                   |   | —              |       | 128,075                  |   |
| Accounts payable and accrued expenses                                                                                                                                                                          |   | 7,182,700           |       | 5,472,696                |   |
| Accrued payroll and taxes                                                                                                                                                                                      |   | 2,475,733           |       | 1,828,629                |   |
| Payroll taxes payable                                                                                                                                                                                          |   | 1,585,145           |       | 929,328                  |   |
|                                                                                                                                                                                                           |   | 24,363,897          |       | 17,988,216               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Loans payable (net of current portion)                                                                                                                                                                         |   | 105,287             |       | 217,965                  |   |
| Notes payable – acquisitions (net of current  portion)                                                                                                                                                    |   | 2,388,818           |       | 1,919,532                |   |
| Convertible debt                                                                                                                                                                                               |   | 40,000              |       | 40,000                   |   |
|                                                                                                                                                                                                           |   | 26,898,002          |       | 20,165,713               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Temporary equity – put options                                                                                                                                                                            |   | 823,000             |       | 823,000                  |   |
| Commitments and contingencies                                                                                                                                                                                  |   |                |       |                     |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Stockholders’  equity                                                                                                                                                                                     |   |                |       |                     |   |
| Preferred  stock, $.01 par value, 5,000,000 shares authorized                                                                                                                                                  |   |                |       |                     |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| 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 $498,564 and  $345,376) |   | 3,549,564           |       | 3,293,376                |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series E non-voting convertible preferred stock,  $.01 par value, 18,046 and 16,683 shares issued and outstanding, liquidation  preference of $1,804,600 (including unpaid dividends of $64,059 and $20,000)   |   | 1,868,659           |       | 1,485,947                |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series F voting convertible preferred stock, $.01  par value, 8,000 shares issued and outstanding, liquidation preference of  $800,000                                                                         |   | 800,000             |       | 1,000,000                |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series H non-voting convertible preferred stock,  $.01 par value, 5,000 shares issued and outstanding, liquidation preference  of $500,000                                                                     |   | 500,000             |       | 500,000                  |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 18,491,478 and 11,522,567 shares issued and outstanding                                                                                          |   | 184,915             |       | 115,226                  |   |
| Additional  paid-in capital                                                                                                                                                                                    |   | 12,394,387          |       | 12,626,733               |   |
| Accumulated  deficit                                                                                                                                                                                           |   | (18,497,699         | )          | (15,978,599              | )      |
| Total stockholders’ equity                                                                                                                                                                                |   | 799,826             |       | 3,042,683                |   |
|                                                                                                                                                                                                           |   | $                   | 28,520,828 |                     | $      | 24,031,396 |   |

 

See notes to condensed financial statements.

 

2

----

 

**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Operations

(Unaudited)

 
|                                                                          |   | **Three  Months Ended  March 31,** |       | **Six Months  Ended  March 31,** |   |
|-------------------------------------------------------------------------------|--------|------------------------------------|------------|----------------------------------|--------|
|                                                                          |   | **2003**                           |       | **2002**                         |   | **2003** |   | **2002** |   |
|                                                                          |   | **As Restated**                    |       | **As Restated**                  |   | **As Restated** |   | **As Restated** |   |
| Revenues                                                                      |   | $                                  | 23,878,770 |                             | $      | 15,816,142 |   | $ | 43,903,790 |   | $ | 28,947,961 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Cost of revenues                                                              |   | 20,637,167                         |       | 13,147,464                       |   | 37,303,459 |   | 23,605,381 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Gross Profit                                                                  |   | 3,241,603                          |       | 2,668,678                        |   | 6,600,331 |   | 5,342,580 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Selling, general and administrative  expenses                                 |   | 4,023,143                          |       | 3,305,380                        |   | 7,579,652 |   | 6,206,867 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Other charges                                                                 |   | 523,000                            |       | —                           |   | 523,000 |   | — |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Operating (loss) from continuing operations                                   |   | (1,304,540                         | )          | (636,702                         | )      | (1,502,321 | ) | (864,287 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Other income (expenses)                                                       |   |                               |       |                             |   |   |   |   |   |
| Interest and financing costs                                                  |   | (546,808                           | )          | (451,564                         | )      | (1,045,719 | ) | (963,607 | ) |
| Other income                                                                  |   | 22,653                             |       | 35,825                           |   | 28,940 |   | 41,510 |   |
|                                                                          |   | (524,155                           | )          | (415,739                         | )      | (1,016,779 | ) | (922,097 | ) |
| (Loss) from continuing operations                                             |   | (1,828,695                         | )          | (1,052,441                       | )      | (2,519,100 | ) | (1,786,384 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Discontinued operations – (loss) from  discontinued Engineering Division |   | —                             |       | (312,059                         | )      | — |   | (238,793 | ) |
| Gain on sale of Engineering Division                                          |   | —                             |       | 1,759,056                        |   | — |   | 1,759,056 |   |
| Net earnings (loss)                                                           |   | (1,828,695                         | )          | 394,556                          |   | (2,519,100 | ) | (266,121 | ) |
| Dividends and accretion on preferred stock                                    |   | (407,663                           | )          | (166,000                         | )      | (773,757 | ) | (290,000 | ) |
| Net earnings (loss) attributable to common  stockholders                      |   | $                                  | (2,236,358 | )                                | $      | 228,556 |   | $ | (3,292,857 | ) | $ | (556,121 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Net earnings (loss) per share attributable  to common stockholders            |   |                               |       |                             |   |   |   |   |   |
| Basic:                                                                        |   |                               |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                             |   | $                                  | (.13       | )                                | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Earnings from discontinued operations                                         |   | —                             |       | .14                              |   | — |   | .16 |   |
| Net earnings (loss)                                                           |   | $                                  |  (.13 | )                                | $      |  .02 |   | $ |  (.21 | ) | $ |  (.06 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Diluted:                                                                      |   |                               |       |                             |   |   |   |   |   |
| (Loss) from  continuing operations                                            |   | $                                  | (.13       | )                                | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Earnings  from discontinued operations                                        |   | —                             |       | .14                              |   | — |   | .16 |   |
| Net earnings (loss)                                                           |   | $                                  | (.13       | )                                | $      | .02 |   | $ | (.21 | ) | $ | (.06 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Weighted average shares, outstanding per  common share                        |   |                               |       |                             |   |   |   |   |   |
| Basic                                                                         |   | 17,599,034                         |       | 10,382,034                       |   | 15,950,320 |   | 9,583,750 |   |
| Diluted                                                                       |   | 17,599,034                         |       | 10,382,034                       |   | 15,950,320 |   | 9,583,750 |   |

 

See notes to condensed financial statements.

 

3

----

 

**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Cash Flows

(Unaudited)

 
|                                                                                                                   |   | **Six Months  Ended** |       |
|------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|
|                                                                                                                   |   | **March 31,  2003**   |       | **March 31,  2002** |   |
|                                                                                                                   |   | **As Restated**       |       |   |   |
| Cash flows from operating activities                                                                                   |   |                  |       |   |   |
| Net (loss) from continuing operations                                                                                  |   | $                     | (2,519,100 | ) | $ | (1,547,591 | ) |
| Net (loss) from discontinued operations                                                                                |   | 3⁄4                |       | (238,793 | ) |
| Adjustments to reconcile net earnings  (loss) to net cash used by operating activities                                 |   |                  |       |   |   |
| Depreciation                                                                                                           |   | 273,069               |       | 265,971 |   |
| Amortization                                                                                                           |   | 181,057               |       | 272,024 |   |
| Provision for doubtful accounts                                                                                        |   | 50,000                |       | 208,000 |   |
| Deferred financing costs amortization                                                                                  |   | 804                   |       | 388,978 |   |
| Loss on sales of shares of investment                                                                                  |   | 3⁄4                |       | 9,550 |   |
| Gain on extinguishment of convertible debt                                                                             |   | 3⁄4                |       | (3,277 | ) |
| Gain on sale of Engineering Division                                                                                   |   | 3⁄4                |       | (1,759,056 | ) |
| Interest expense amortization for the  intrinsic value of the beneficial conversion feature of convertible  debentures |   |                  |       | 104,535 |   |
| Accrued interest                                                                                                       |   | (7,388                | )          | 92,021 |   |
| Imputed interest                                                                                                       |   | 22,747                |       | 3⁄4 |   |
| Changes in operating assets and liabilities                                                                            |   |                  |       |   |   |
| Accounts receivable                                                                                                    |   | (3,939,546            | )          | (1,745,285 | ) |
| Prepaid insurance                                                                                                      |   | 234,585               |       | 207,304 |   |
| Prepaid expenses and other current assets                                                                              |   | 13,533                |       | (58,480 | ) |
| Other assets                                                                                                           |   | (25,908               | )          | 12,836 |   |
| Insurance obligation payable                                                                                           |   | (128,075              | )          | (475,356 | ) |
| Accrued payroll and taxes                                                                                              |   | 647,104               |       | 75,916 |   |
| Payroll taxes payable                                                                                                  |   | 655,817               |       | 238,819 |   |
| Accounts payable and accrued expenses                                                                                  |   | 1,645,892             |       | 943,141 |   |
| Total adjustments                                                                                                      |   | (376,309              | )          | (1,222,359 | ) |
|                                                                                                                   |   | (2,895,409            | )          | (1,488,480 | ) |
| Cash flows (used in) investing activities                                                                              |   |                  |       |   |   |
| Purchase of property and equipment                                                                                     |   | (188,350              | )          | (246,399 | ) |
| Proceeds from sales of shares of investment                                                                            |   | 3⁄4                |       | 5,466 |   |
| Payments for business acquisitions                                                                                     |   | (61,644               | )          | (181,920 | ) |
| Net proceeds from sale of Engineering  Division                                                                        |   | 3⁄4                |       | 1,459,079 |   |
|                                                                                                                   |   | (249,994              | )          | 1,036,226 |   |
| Cash flows from financing activities                                                                                   |   |                  |       |   |   |
| Proceeds from issuance of Common Stock                                                                                 |   | —                |       | 222,083 |   |
| Proceeds from issuance of Preferred Stock                                                                              |   | 186,400               |       | 282,500 |   |
| Proceeds from loans payable                                                                                            |   | 380,000               |       | 271,195 |   |
| Payments of loans payable                                                                                              |   | (106,813              | )          | (11,566 | ) |
| Proceeds from loans payable—related parties                                                                       |   | 300,000               |       | 50,000 |   |
| Payments of loans payable—related parties                                                                         |   | (75,000               | )          | (50,000 | ) |
| Payments of notes payable – acquisitions                                                                          |   | (352,489              | )          | (142,769 | ) |
| Net proceeds from line of credit                                                                                       |   | 2,619,991             |       | 723,529 |   |
| Cash overdraft                                                                                                         |   | 313,128               |       | 3⁄4 |   |
| Cost in connection with common stock issued  for acquisition                                                           |   | 3⁄4                |       | (2,000 | ) |
| Net proceeds from convertible debt                                                                                     |   | 3⁄4                |       | 326,871 |   |
| Redemption of convertible debt                                                                                         |   | 3⁄4                |       | (301,992 | ) |
| Dividends paid                                                                                                         |   | (47,657               | )          | 3⁄4 |   |
|                                                                                                                   |   | 3,217,560             |       | 1,367,851 |   |
| Net change in cash and cash equivalents                                                                                |   | 72,157                |       | 915,597 |   |
| Cash and cash equivalents - beginning                                                                                  |   | 162,646               |       | 171,822 |   |
| Cash and cash equivalents - ending                                                                                     |   | $                     | 234,803    |   | $ | 1,087,419 |   |

 

See notes to condensed financial statements.

 

4

----

 

**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Cash Flows

(Unaudited)

 
|                                                                                                                                 |   | **Six Months  Ended** |      |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|-----------|
|                                                                                                                                 |   | **March 31,  2003**   |      | **March 31,  2002** |   |
|                                                                                                                                 |   | **As Restated**       |      |   |   |
| Supplemental disclosure of cash paid                                                                                                 |   |                  |      |   |   |
| Interest                                                                                                                             |   | $                     | 1,047,762 |   | $ | 437,693 |   |
| Schedule of noncash investing and financing  activities                                                                              |   |                  |      |   |   |
| Fair value of assets acquired                                                                                                        |   | $                     | 1,266,519 |   | $ | 1,814,355 |   |
| Less: cash paid                                                                                                                      |   | (176,644              | )         | (334,355 | ) |
| Less:   common stock and put options issued                                                                                     |   | 3⁄4                |      | (380,000 | ) |
| Liabilities assumed                                                                                                                  |   | $                     | 1,089,875 |   | $ | 1,100,000 |   |
|                                                                                                                                 |   |                  |      |   |   |   |   |
| Issuance of Series B Preferred Stock in  exchange for convertible and other debt (including $160,000 loans payable-related  parties) |   | $                     | —    |   | $ | 1,106,499 |   |
| Issuance of common stock upon conversion of  convertible preferred stock                                                             |   | $                     | 754,200   |   | 3⁄4 |   |
| Issuance of common stock in exchange for  accounts payable and accrued expenses                                                      |   | $                     | 37,500    |   | $ | 59,000 |   |
| Issuance of common stock upon conversion of  convertible debt                                                                        |   | 3⁄4                |      | $ | 736,003 |   |
| Issuance of warrants for fees                                                                                                        |   | 3⁄4                |      | $ | 55,000 |   |
| Cumulative dividends and accretion on  preferred stock                                                                               |   | $                     | 493,100   |   | $ | 290,000 |   |

 

See notes to condensed financial statements.

 

5

----

 

**STRATUS SERVICES GROUP, INC.**

Notes to Condensed Financial Statements

(Unaudited)

 

### **NOTE 1 – BASIS OF PRESENTATION**

 

The accompanying condensed financial statementshave been prepared by the Company, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission.  Certain information and disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States have been condensed or omittedpursuant to such rules and regulations. These condensed financial statements reflect all adjustments (consistingonly of normal recurring adjustments) that, in the opinion of management, arenecessary to present fairly the financial position, the results of operationsand cash flows of the Company for the periods presented.  It is suggested that these condensedfinancial statements be read in conjunction with the consolidated financialstatements and the notes thereto included in the Company’s Annual Report onForm 10-K.

 

The results of operations for the interimperiods presented are not necessarily indicative of the results to be expectedfor the full year.  The condensedbalance sheet as at March 31, 2003 are the condensed statements of cashflowsfor the three and six months then ended, have been amended to include thecontingent portion of the purchase price of an acquisition on December 1, 2002(see Note 11).  In addition, the Companyhas changed the method of reporting the revenues for payrolling services(“payrolling”) from gross billing to a net revenue basis.  Accordingly, reported revenues and relatedcost of revenues have been reduced and restated by $1,728,324 and $1,689,286 inthe three months ended March 31, 2003 and 2002, respectively and by $3,851,032and $3,350,691 in the six months ended March 31, 2003 and 2002,respectively.  The change had no effecton the Company’s net operating results.

 
|       |   | **Three  Months Ended  March 31,** |       | **Nine  Months Ended  March 31,** |   |
|------------|--------|------------------------------------|------------|-----------------------------------|--------|
|       |   | **2003**                           |       | **2002**                          |   | **2003** |   | **2002** |   |
| Staffing   |   | $                                  | 23,709,064 |                              | $      | 15,692,062, |   | $ | 43,491,007 |   | $ | 28,700,789 |   |
|       |   |                               |       |                              |   |   |   |   |   |
| Payrolling |   | 69,706                             |       | 124,080                           |   | 412,783 |   | 247,172 |   |
|       |   | $                                  | 23,878,770 |                              | $      | 15,816,142 |   | $ | 43,903,790 |   | $ | 28,947,961 |   |

 

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 we do not reflect the direct payroll costs paid tosuch employees in revenues and cost of revenue.

 

**NOTE 2 – LIQUIDITY**

 

At March 31, 2003, the Company had limitedliquid resources.  Current liabilitieswere $24,363,897 and current assets were $18,164,678.  The difference of $6,199,219 is a working capital deficit, whichis primarily the result of losses continuously incurred beginning the yearended September 30, 2001.  Currentliabilities include a cash overdraft of $1,044,629, which is represented byoutstanding checks.  These conditionsraise substantial doubts about the Company’s ability to continue as a goingconcern.  The financial statements donot include any adjustments to reflect the possible future effect on therecoverability and classification of assets or the amounts and classificationof liabilities that may result from the outcome of this uncertainty.

 

The Company’s continuation of existence isdependent upon the continued cooperation of its creditors, its ability togenerate sufficient cash flow to meet its continuing obligations on a timelybasis, to fund the operating and capital needs, and to obtain additional financingas may be necessary.

 

6

----

 

Management of the Company has taken steps torevise and reduce its operating requirements, which it believes will besufficient to assure continued operations and implementation of the Company’splans.  The steps include closingbranches that are not profitable, consolidating branches and reductions instaffing and other selling, general and administrative expenses.

 

The Company continues to pursue other sources ofequity or long-term debt financings. The Company also continues to negotiate payment plans and otheraccommodations with its creditors.

 

7

----

 

**NOTE 3 – EARNINGS/LOSS PER SHARE**

 

Basic “Earnings Per Share” (“EPS”) excludes dilutionand is computed by dividing earnings available to common stockholders by theweighted-average number of common shares outstanding during the period.  Diluted EPS assumes conversion of dilutiveoptions and warrants, and the issuance of common stock for all otherpotentially dilutive equivalent shares outstanding.  There were no dilutive shares for the three and six months endedMarch 31, 2003 and 2002.

 

**NOTE4 – INTANGIBLE ASSETS**

 

At the beginning of fiscal year ended September30, 2003, the Company adopted the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 142, “Goodwill and Other IntangibleAssets”.  The provisions of SFAS No. 142prohibit the amortization of goodwill and certain intangible assets that aredeemed to have indefinite lives and require that such assets be tested forimpairment annually, or more frequently if events or changes in circumstancesindicate that the asset might be impaired and written down to fair value.  In order to assess the fair value of itsgoodwill and indefinite-lived intangible assets as of the adoption date, theCompany engaged an independent valuation firm to assist in determining the fairvalue.  The valuation process appraisedthe Company’s assets and liabilities using a combination of present value andmultiple of earnings valuation techniques. Based upon the results of the valuation it was determined that there wasno impairment of goodwill.

 

As of March 31, 2003 and September 30, 2002,intangible assets consisted of the following:

 

|                                  |   | **March 31,  2003** |      | **September  30, 2002** |   |
|---------------------------------------|--------|---------------------|-----------|-------------------------|--------|
|                                  |   |                |      |                    |   |
| Covenant-not-to-compete               |   | $                   | 232,680   |                    | $      | 213,180 |   |
| Customer list                         |   | 2,063,735           |      | 891,716                 |   |
|                                  |   | 2,296,415           |      | 1,104,896               |   |
| Less:   accumulated amortization |   | (483,808            | )         | (302,751                | )      |
|                                  |   | $                   | 1,812,607 |                    | $      | 802,145 |   |

 

For the three and six months ended March 31,2002, the Company recorded goodwill amortization of $72,294 and $144,588,respectively.  Excluding thisamortization expense net (loss) attributable to common stockholders fromcontinuing operations for the three and six months ended March 31, 2002, wouldhave been $(1,146,147) and $(1,931,796) or $(.11) and $(.20) per basic anddiluted share, respectively.

### ** **

Estimated amortization expense for each of the next five years is asfollows:

 

| **For the  Year Ending  March 31,** |   |    |    |
|-------------------------------------|--------|---------|---------|
|                                |   |    |    |
| 2004                                |   | $       | 249,000 |   |
| 2005                                |   | 216,000 |    |
| 2006                                |   | 193,000 |    |
| 2007                                |   | 121,000 |    |
| 2008                                |   | 119,000 |    |
|                                     |        |         |         |  |

 

### **NOTE 5 – LINE OF CREDIT**

 

The Company has a loan and security agreement(the “Agreement”) with a lending institution whereby the Company can borrow upto 85% of eligible accounts receivable, as defined, not to exceed the lesser of$12 million or six times the Company’s tangible net worth (as defined).  Borrowings under the Agreement bore interestat 1 1/2% above the prime rate (see below) and are collateralized by substantiallyall of the Company’s assets.  TheAgreement expires on June 12, 2004.

 

8

----

 

At March 31, 2003, the Company was in violationof the following covenants under the Agreement:

 

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

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

 

The Company has received a waiver from thelender on the above violations and, in December 2002, entered into amodification of the Agreement.  Themodification provided that borrowings under the Agreement bore interest at 1 3⁄4%above the prime rate, as long as the Company was in violation of any of thecovenants under the Agreement.

 

Effective April 10, 2003, the Company enteredinto another modification of the Agreement which provides that borrowings underthe Agreement bear interest at 3% above the prime rate.

 

The prime rate at March 31, 2003 was 4.25%.

 

### **NOTE 6 – CONVERTIBLE DEBT**

 

At various times during the six months endedMarch 31, 2002, the Company issued convertible debentures through privateplacements.  The debentures boreinterest at 6% a year, payable quarterly and had a maturity date of five yearsfrom issuance.  Each debenture wasconvertible after 120 days from issuance into the number of shares of theCompany’s common stock determined by dividing the principal amount of thedebenture by the lesser of (a) 120% of the closing bid price of the commonstock on the trading day immediately preceding the issuance date or (b) 75% ofthe average closing bid price of the common stock for the five trading daysimmediately preceding the date of the conversion.  The Company had the right to prepay any of the debentures at anytime at a prepayment rate that varied from 115% to 125% of the amount of thedebenture depending on when the prepayment is made.

 

The discount arising from the 75% beneficial conversion feature wascharged to interest expense during the period from the issuance of thedebenture to the earliest time at which the debenture becomes convertible.

 

During the six months ended March 31, 2002, the Company redeemed$258,394 of debentures resulting in a gain of approximately $3,000, which isincluded in “Other income (expense)” in the condensed statement of operations.

 

In March 2002, the Company entered into an agreement with the holder(the “Debenture Holder”) of all but $40,000 of the outstanding debenturespursuant to which it issued to the Debenture Holder 231,300 shares of Series BConvertible Preferred Stock (see Note 7) in exchange for (i) $456,499 aggregateprincipal amount of Debentures, (ii) the cancellation of a $400,000 promissorynote previously issued by the Company to the Debenture Holder and (iii)$300,000 in cash.  As a result, only $40,000of Debentures remains outstanding.

 

**NOTE 7 – 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 is being accreted through a charge to additionalpaid-in-capital through the June 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 by theBoard 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

 

9

----

 

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.

 

***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.

 

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 sixmonths ended March 31, 2003, holders of Series E Preferred Stock converted5,637 shares into 4,718,911 shares of Common Stock at conversion prices between$.108 and $.186.

 

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

 

In July 2002, theCompany’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 which was the market priceat date of issuance.  The number ofshares issuable upon conversion is determined by multiplying the number ofshares of Series F Preferred Stock to be converted by $100, and dividing theresult 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

 

10

----

 

Series F PreferredStock are entitled to vote at the meeting. Holders of the Series F Preferred Stock are entitled to vote as aseparate class on any proposed amendment to the terms of the Series F PreferredStock which would increase or decrease the number of authorized shares ofSeries F Preferred Stock or have an adverse impact on the Series F PreferredStock and on any proposal to create a new class of shares having rights orpreferences equal to or having priority to the 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 six monthsended March 31, 2003, the Company’s Chief Executive Officer converted 2,000shares of the Series F Preferred Stock into 2,000,000 shares of Common Stock.

 

***d.******                                     ******Series H***

 

The holders of theSeries H Preferred Stock are entitled to cumulative dividends at a rate of 6%per year, payable quarterly, commencing on March 30, 2004, in preference andpriority to any payment of any dividend on the Company’s Common Stock.  Dividends may be paid, at the Company’soption, either in cash or in shares of Common Stock, valued at the Series HConversion Price (as defined below). Holders of Series H Preferred Stock are entitled to a liquidationpreference of $100 per share, plus accrued and unpaid dividends before anyliquidation payment may be made to holders of the Company’s Common Stock.

 

The Series HPreferred Stock is convertible into Common Stock at a conversion price (the“Series H Conversion Price”) equal to the lower of $.20 per share, which wasthe market price at date of issuance, or the average market price of the CommonStock for the five trading days immediately preceding the conversion date.  The number of shares issuable uponconversion is determined by multiplying the number of shares of Series HPreferred Stock to be converted by $100 and dividing the result by the Series HConversion Price then in effect.

 

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

 

The Company has theright, but not the obligation, to redeem the shares of Series H Preferred Stockat any time prior to conversion at a redemption price of 115% of the purchaseprice paid for the Series H Preferred Shares plus any accrued but unpaiddividends.

 

**NOTE 8 – OTHER CHARGES**

 

During the period May 1, 2001 through May 20,2002, the Company maintained workers’ compensation insurance with an insurancecompany, with a deductible of $150,000 per incident.  The Company had established reserves based upon its evaluation ofthe status of claims still open in conjunction with claims reserve informationprovided to the Company by the insurance company.  The Company believes that the insurance company has paid andreserved claims in excess of what should have been paid or reserved.  Although the Company believes it can recoversome of the amounts already paid, this can only be pursued through litigationagainst the insurance company.  Sincethere is no assurance the Company will prevail, the Company recorded $523,000of additional payments made and reserves in the three and six months endedMarch 31, 2003.

 

**NOTE 9 – STOCK–BASED COMPENSATION**

 

The Company accounts for its stock-basedcompensation plans using the intrinsic value method in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees”.  Accordingly, no stock-basedemployee compensation cost has been recognized in the financial statements asall options granted under the Company’s stock option plan, had an exerciseprice at least equal to the market value of the underlying common stock on thedate of grant.  The pro formainformation below is based on provisions of

 

11

----

 

SFAS No. 123, “Accounting for Stock-BasedCompensation”, as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure”, issued in December 2002.

 
|                                                                                                                                  |   | **Three Months Ended  March 31,** |       | **Six Months Ended  March 31,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|---------------------------------|--------|
|                                                                                                                                  |   | **2003**                          |       | **2002**                        |   | **2003** |   | **2002** |   |
|                                                                                                                                  |   |                              |       |                            |   |   |   |   |   |
| Net (loss) from continuing operations  attributable to common stockholders, as reported                                               |   | $                                 | (2,236,358 | )                               | $      | (1,218,441 | ) | $ | (3,292,857 | ) | $ | (2,076,384 | ) |
| Deduct:                                                                                                                               |   |                              |       |                            |   |   |   |   |   |
| Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |   | (827,908                          | )          | (618,989                        | )      | (1,419,238 | ) | (1,171,917 | ) |
|                                                                                                                                  |   |                              |       |                            |   |   |   |   |   |
| Pro forma net (loss) from continuing  operations attributable to common stockholders                                                  |   | $                                 | (3,064,266 | )                               | $      | (1,837,430 | ) | $ | (4,712,095 | ) | $ | (3,248,301 | ) |
|                                                                                                                                  |   |                              |       |                            |   |   |   |   |   |
| (Loss) from continuing operations per  common share attributable to common stockholders:                                              |   |                              |       |                            |   |   |   |   |   |
| Basic – as reported                                                                                                              |   | $                                 | (.13       | )                               | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Basic – pro forma                                                                                                                |   | $                                 | (.17       | )                               | $      | (.18 | ) | $ | (.30 | ) | $ | (.34 | ) |
|                                                                                                                                  |   |                              |       |                            |   |   |   |   |   |
| Diluted – as reported                                                                                                            |   | $                                 | (.13       | )                               | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Basic – pro forma                                                                                                                |   | $                                 | (.17       | )                               | $      | (.18 | ) | $ | (.30 | ) | $ | (.34 | ) |

 

 

**NOTE 10 – DISCONTINUED OPERATIONS, SALE OFENGINEERING DIVISION**

 

On March 28, 2002, the Company completed thesale of the assets of its Engineering Services Division (the “Division”) to SEAConsulting Services Corporation (“SEA”) pursuant to the Asset PurchaseAgreement dated as of January 24, 2002, among the Company, SEP, LLC (“SEP”),Charles Sahyoun, Sahyoun Holders LLC and SEA.

 

The assets of the Division had beentransferred to SEP, a limited liability company in which the Company owns a 70%interest, at the time of the execution of the Asset Purchase Agreement.  Sahyoun Holders, LLC, a company wholly-ownedby Charles Sahyoun, the President of the Division, owns the remaining 30%interest in SEP.

 

Under the terms of the Asset PurchaseAgreement, the Company received an initial cash payment of $1,560,000, whichrepresented 80% of the initial $2,200,000 installment of the purchase pricepayable to SEP after the satisfaction of certain liabilities and expenses ofSEP.  Sahyoun Holdings, LLC received theother 20% of the initial net installment of the purchase price, or $440,000.

 

The Asset Purchase Agreementrequires SEA to make the following additional payments to SEP:

 

(i)                                     A payment of $1million, plus or minus the amount by which SEA’s profit for the six monthsended June 30, 2002, as determined pursuant to the Asset Purchase Agreement, isgreater or less than $600,000 (the “Second Payment”);

 

(ii)                                  A payment of $1million, plus or minus the amount by which SEA’s profit for the six monthsended December 31, 2002, as determined pursuant to the Asset PurchaseAgreement, is greater or less than $600,000 (the “Third Payment”);

 

(iii)                               Five subsequentannual payments (the “Subsequent Payments”) which will be based upon a multipleof the annual successive increases, if any, in SEA’s profit during the fiveyear period beginning on January 1, 2003 and ending December 31, 2007.

 

12

----

 

Pursuant to an allocation and indemnityagreement entered into by the Company, Sahyoun Holdings, LLC and CharlesSahyoun (the “Allocation and Indemnity Agreement”), the Company was entitled to$250,000 of the Second Payment and $250,000 of the Third Payment.  On April 15, 2002, by letter agreementbetween the Company, Sahyoun Holdings, LLC and Joseph J. Raymond, Sr., theChairman and Chief Executive Officer of the Company, the parties agreed to amodification of the Allocation and Indemnity Agreement.  Per that letter agreement, Sahyoun Holdings,LLC provided the Company with $200,000 cash in exchange for the Company’sshort-term, 90-day demand note, due and payable by August 1, 2002 in the amountof $250,000.  Such $250,000 was repaidby the Company from its $250,000 share of the Second Payment which was receivedin June 2002.  Sahyoun Holdings, LLC andCharles Sahyoun have guaranteed the $250,000 payment to be made to the Companyfrom the Third Payment, regardless of the operating results of SEA.  Upon its receipt of all of the paymentsrequired under the Allocation and Indemnity Agreement, the Company’s interestin SEP will terminate and the Company will not be entitled to any additionalpayments under the Asset Purchase Agreement, including the SubsequentPayments.  Sahyoun Holdings, LLC isentitled to all amounts paid to SEP under the Asset Purchase Agreement otherthan $500,000 of payments made or payable to the Company pursuant to theAllocation and Indemnity Agreement and guaranteed by Charles Sahyoun andSahyoun Holdings, LLC, as described above.

 

The transaction resulted in a gain, which wascalculated as follows:

 

| Initial cash payment            |   | $         | 2,200,000 |   |
|---------------------------------|--------|-----------|-----------|--------|
| Guaranteed additional  payments |   | 500,000   |      |
| Less costs of sale:             |   |      |      |
| Allocation to Charles  Sahyoun  |   | (440,000  | )         |
| Broker’s fee               |   | (200,000  | )         |
| Other costs                     |   | (100,921  | )         |
| Balance                         |   | 1,959,079 |      |
| Net assets sold                 |   | 200,023   |      |
| Gain                            |   | $         | 1,759,056 |   |

 

In December 2002, the Company and CharlesSahyoun agreed to offset the $250,000 of the Third Payment due to the Companyagainst $250,000 of accrued commissions due Charles Sahyoun.  As a result, the Company is not entitled toany additional payments under the Asset Purchase Agreement.

 

Revenues from the Division were $1,135,000and $2,730,000 for the three and six months ended March 31, 2002, respectively.

 

### **NOTE 11 – ACQUISITION**

 

Effective as of December 1, 2002, (the“Effective Date”), the Company purchased substantially all of the tangible andintangible assets, excluding accounts receivable, of six offices of ElitePersonnel Services (“Elite”), a California corporation.  The Elite branches provide temporary lightindustrial and clerical staffing in six business locations in California andNevada. The Company also took over Elite’s Downey, California office, fromwhich Elite serviced no accounts but which it utilized as a corporateoffice.  The company will continue toutilize the Downey office as a regional corporate facility.  The acquisition of Elite furthers theCompany’s expansion into the California staffing market.  Pursuant to the terms of an Asset PurchaseAgreement between the Registrant and Elite dated November 19, 2002 (the “AssetPurchase Agreement”), the purchase price payable at closing (the “Base PurchasePrice”) for the assets was $1,264,000, all of which was represented by anunsecured promissory note.  In additionto the Base Purchase Price, Elite will also receive as a deferred purchaseprice, an amount equal to 10% of the annual “Gross Profits” as defined in theAsset Purchase Agreement of the acquired business between $2,500,000 and$3,200,000, and 15% of the annual Gross Profits of the acquired business inexcess of $3,200,000 for a minimum period of one year from the Effective Dateand for a period of two years from the Effective Date, if Gross Profits duringthe first year reach specified levels. The note includes a stated imputed interest at 4% per year and ispayable over an eight-year period in equal monthly payments beginning 30 daysafter the Effective Date.  In connectionwith the transaction, Elite, its President and other key management membersentered into Non-Competition and Non-Solicitation Agreements pursuant to whichthey

 

13

----

 

agreed not to compete with the Registrant in theterritories of the acquired business for periods ranging from twelve months tofive years, and to not solicit the employees or customers of the acquiredbusiness for periods ranging from twelve months to five years.  Additionally, Elite’s President has alsoentered into an Employment Agreement, as of the Effective Date, with theCompany for a minimum of a one year term. This term can be extended if certain targeted Gross Profit levels areattained.

 

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 is includedin “Accounts payable and accrued expenses” on the attached condensed balancesheet as at March 31, 2003.  There wasan additional $176,644 of costs paid to third parties in connection with theacquisition.

 

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 results of operations presentedbelow assume that the acquisition and another acquisition that occurredeffective January 1, 2002, had occurred at the beginning of fiscal 2002.  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.**

### ** **

|                                                                       |   | **Unaudited  Six Months Ended  March 31,** |       |
|----------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                       |   | **2003**                                   |       | **2002** |   |
| Revenues                                                                   |   | $                                          | 49,933,153 |   | $ | 45,498,961 |   |
| Net (loss) from continuing operations  attributable to common stockholders |   | (3,192,883                                 | )          | (2,160,384 | ) |
|                                                                       |   |                                       |       |   |   |
| Net (loss) per share attributable to common  stockholders                  |   |                                       |       |   |   |
| Basic                                                                      |   | $                                          | (.20       | ) | $ | (.23 | ) |
| Diluted                                                                    |   | $                                          | (.20       | ) | $ | (.23 | ) |

### ** **

### **NOTE 12 – RELATED PARTY TRANSACTIONS**

### ** **

During the six months ended March 31, 2003, ason and the brother of the Chief Executive Officer of the Company (the “CEO”)each loaned $100,000 to the Company.  Inaddition, one of the members of the Board of Directors of the Company loaned$100,000 to the Company.  Each of theaforementioned loans is unsecured and due on demand.  The loans are outstanding at March 31, 2003 and included in loanspayable on the condensed balance sheet.

 

During the six months ended March 31, 2003, theCEO was repaid $75,000 for a previous loan to the Company.  In addition, the CEO loaned the Company$50,000, which was repaid prior to March 31, 2003.

 

 

14

----

 

### **NOTE 13 - SUBSEQUENT EVENT**

 

In April 2003, holders of Series E PreferredStock converted 1,015 shares into 410,000 shares of common stock at aconversion price of $.2475.

 

15

----

 

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

 

This Form 10-Q contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933, asamended and Section 21E of the Securities Exchange Act of 1934, asamended.  These statements relate tofuture economic performance, plans and objectives of management for futureoperations and projections of revenue and other financial items that are basedon the beliefs of our management, as well as assumptions made by, andinformation currently available to, our management.  The words “expect”, “estimate”, “anticipate”, “believe”,“intend”, and similar expressions are intended to identify forward-lookingstatements.  Such statements involveassumptions, uncertainties and risks. If one or more of these risks or uncertainties materialize or underlyingassumptions prove incorrect, actual outcomes may vary materially from thoseanticipated, estimated or expected. Among the key factors that may have a direct bearing on our expectedoperating results, performance or financial condition are economic conditionsfacing the staffing industry generally; uncertainties related to the job marketand our ability to attract qualified candidates; uncertainties associated withour brief operating history; our continued operating losses and their effect onliquidity; our ability to raise additional capital; the continued cooperationof our creditors; 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.

 

Our critical accounting policies and estimates are described in ourAnnual Report on Form 10-K for the fiscal year ended September 30, 2002.

 

### **Introduction**

 

We provide a wide range of staffing, engineering and productivityconsulting services nationally through a network of offices located throughoutthe United States.  We recognizerevenues based on hours worked by assigned personnel.  Generally, we bill our customers a pre-negotiated, fixed rate perhour for the hours worked by our temporary employees.  We are responsible for workers’ compensation, unemploymentcompensation insurance, Medicare and Social Security taxes and other generalpayroll related expenses for all of the temporary employees we place.  These expenses are included in the cost ofrevenue.  Because we pay our temporaryemployees only for the hours they actually work, wages for our temporarypersonnel are a variable cost that increases or decreases in proportion torevenues.  Gross profit margin variesdepending on the type of services offered. In some instances, temporary employees placed by us may decide to acceptan offer of permanent employment from the customer and thereby “convert” thetemporary position to a permanent position. Fees received from such conversions are included in our revenues.  Selling, general and administrative expensesinclude payroll for management and administrative employees, office occupancycosts, sales and marketing expenses and other general and administrative costs.

 

16

----

 

**Results of Operations**

**Discontinued Operations/Acquisition orDisposition of Assets**

 

OnJanuary 24, 2002, we entered into an agreement to sell the assets of ourEngineering Services Division (the “Division”) to SEA Consulting ServicesCorporation (“SEA”).  Closing of thesale was contingent upon shareholder approval and the receipt of a fairnessopinion by us.

 

On March 28, 2002, we completed the sale of theassets of the Division to SEA pursuant to the Asset Purchase Agreement dated asof January 24, 2002 among us, SEP, LLC (“SEP”), Charles Sahyoun, SahyounHoldings LLC and SEA.  The transactionwas approved by a vote of our stockholders at the annual meeting ofstockholders held on March 28, 2002.

 

The assets of the Division had been transferredto SEP, a limited liability company in which we owned a 70% interest, at thetime of the execution of the Asset Purchase Agreement.  Sahyoun Holdings, LLC, a company whollyowned by Charles Sahyoun, the President of the Division, owns the remaining 30%interest in SEP.

 

Under the terms of the Asset Purchase Agreement,we received an initial cash payment of $1,560,000, which represented 80% of theinitial $2,200,000 installment of the purchase price payable to SEP after thesatisfaction of certain liabilities and expenses of SEP.  Sahyoun Holdings, LLC received the other 20%of the initial net installment of the purchase price, or $440,000.

 

The Asset Purchase Agreement requires thepurchaser to make the following additional payments to SEP:

 

(a)                                  A payment of $1 million, plus or minusthe amount by which SEA’s profit for the six months ended June 30, 2002, asdetermined pursuant to the Asset Purchase Agreement, is greater or less than$600,000 (the “Second Payment”);

 

(b)                                 A payment of $1 million, plus or minusthe amount by which the SEA’s profit for the six months ended December 31,2002, as determined pursuant to the Asset Purchase Agreement, is greater orless than $600,000 (the “Third Payment”);

 

(c)                                  Five subsequent annual payments (the“Subsequent Payments”) which will be based upon a multiple of the annualsuccessive increases, if any, in the SEA’s profit during the five year periodbeginning on January 1, 2003 and ending December 31, 2007.

 

Pursuantto an allocation and indemnity agreement entered into by us, Sahyoun Holdings,LLC and Mr. Sahyoun (the “Allocation and Indemnity Agreement”), we wereentitled to $250,000 of the Second Payment and $250,000 of the ThirdPayment.  On April 15, 2002, by letteragreement between us, Sahyoun Holdings, LLC and Joseph J. Raymond, Sr., ourChairman and Chief Executive Officer, the parties agreed to a modification ofthe Allocation and Indemnity Agreement. Per that letter agreement, Sahyoun Holdings, LLC provided us with$200,000 cash in exchange for our short-term, 90-day demand note, due andpayable by August 1, 2002 in the amount of $250,000.  The $250,000 was paid by us from our share of the Second Paymentwhich was received by us in June 2002.

 

Sahyoun Holdings LLC and Mr. Sahyoun have guaranteedthe $250,000 payment to be made to us from the Third Payment, regardless of theoperating results of SEA.  In December2002, Mr. Sahyoun and we agreed to offset the $250,000 against $250,000 ofaccrued commissions due Mr. Sahyoun.  Asa result, we will not be entitled to any additional payments under the AssetPurchase Agreement, including the Subsequent Payments.  Sahyoun Holdings LLC is entitled to allamounts paid to SEP under the Asset Purchase Agreement other than $500,000 ofpayments made or payable to us pursuant to the Allocation and IndemnityAgreement and guaranteed by Charles Sahyoun and Sahyoun Holdings, LLC asdescribed above.  Under the terms of theAsset Purchase Agreement, Sahyoun Holdings LLC will not be entitled to anySubsequent Payments or its allocable share of the Second and Third Payments ifMr. Sahyoun’s employment with SEA ceases for any reason other than death orpermanent disability prior to December 31, 2003.

 

17

----

 

Effective January 1, 2002, we purchasedsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of seven offices of PES. The initial purchase price was $1,480,000, represented by a $1,100,000promissory note and 400,000 shares of our common stock.  There was an additional $334,355 of costsincurred in connection with the acquisitions. In addition, PES is entitled to earnout payments of 15% of pretax profitof the acquired business up to a total of $1.25 million or the expiration often years, whichever occurs first.  Thenote bears interest at 6% a year and is payable over a ten-year period in equalquarterly payments.

 

EffectiveDecember 1, 2002, we purchased substantially all of the tangible and intangibleassets, excluding accounts receivable, of six offices of Elite PersonnelServices, Inc.  We also took overElite’s Downey, California office, from which Elite serviced no accounts, butwhich it utilized as a corporate office. We will continue to utilize the Downey office as a regional corporatefacility.  Pursuant to a Asset PurchaseAgreement dated November 19, 2002 between us and Elite (the “Asset PurchaseAgreement”), the purchase price paid at closing (the “Base Purchase Price”) was$1,264,000, all of which was represented by a promissory note (the “Note”)payable over eight years, in equal monthly installments.  Imputed interest at the rate of 4% per yearis included in the Note amount.  Forfinancial accounting purposes, interest on the note has been imputed at a rateof 11% per year.  Accordingly, the netBase Purchase Price was recorded as $845,875.

 

Inaddition to the Base Purchase Price, Elite may also receive as deferredpurchase price an amount equal to 10% of “Gross Profits” as defined in theAsset 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, and for a period of two years from the Effective Date if Gross Profitsfor the first year reach specified levels.

 

Inconnection with this acquisition, we also entered into an employment andnon-compete agreement for a five-year period with the President and solestockholder of Elite.

 

**Continuing Operations**

**Three Months Ended March 31, 2003 Compared toThree Months Ended March 31, 2002**

 

***Revenues.***  Revenues increased 51.0% to $23,878,770 forthe three months ended March 31, 2003 from $15,816,142 for the three monthsended March 31, 2002.  Approximately$7.4 million of the increase was attributable to the acquisition in December2002.  Excluding acquisitions, revenuesincreased 4.2%.  This increase was aresult of an increase in billable hours.

 

***Gross Profit.***  Gross profit increased 21.5% to $3,241,603for the three months ended March 31, 2003 from $2,668,678 for the three monthsended March 31, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenuesdecreased to 13.6% for the three months ended March 31, 2003 from 16.9% for thethree months ended March 31, 2002.  Thisdecrease was a result of increased pricing competition of staffing services andincreases in the cost of workers’ compensation insurance and state unemploymenttaxes.  In addition, we have beenassessed the penalty rate by the New Jersey Department of Labor for stateunemployment taxes because of payment delinquencies (see Part II—Item 5 of thisreport).  The estimated additionalexpense in the three months ended March 31, 2003 is $250,000.

 

***Selling, General andAdministrative Expenses.**** *Selling, generaland administrative expenses, not including depreciation and amortization,increased 22.1% to $3,782,308 for the three months ended March 31, 2003 from$3,084,964 for the three months ended March 31, 2002.  Selling, general and administrative expenses, not includingdepreciation and amortization, as a percentage of revenues decreased to 15.8%for the three months ended March 31, 2003 from 19.5% for the three months endedMarch 31, 2002.  The increase in thedollar amount is primarily a result of the acquisitions in January and December2002, whereas the percentage of revenue decrease is attributable to significantcost reductions implemented by us and the increase in revenues with noproportionate increase in selling, general and administrative expenses.

 

***Depreciation andAmortization.*** Depreciation and amortization expenses, not including amortization ofgoodwill of $72,294 in the three months ended March 31, 2002, increased to$240,835 for the three months

 

18

----

 

ended March 31, 2003 from $148,122 for the three months ended March 31,2002.  Depreciation and amortization,not including the amortization of goodwill, as a percentage of revenuesincreased to 1.0% for the three months ended March 31, 2003 from 0.9% for thethree months ended March 31, 2002.  Theincrease was due to capital expenditures and amortization of intangibles inconnection with the acquisition in December 2002.

 

***Other Charges.***  During the period May 1, 2001 through May20, 2002, we maintained workers’ compensation insurance with an insurancecompany, with a deductible of $150,000 per incident.  We had established reserves based upon our evaluation of thestatus of claims still open in conjunction with claims reserve informationprovided to us by the insurance company. We believe that the insurance company has paid and reserved claims inexcess of what should have been paid or reserved.  Although we believe we can recover some of the amounts alreadypaid, this can only be pursued through litigation against the insurancecompany.  Since there is no assurance wewill prevail, we recorded $523,000 of additional payments made and reserves inthe three months ended March 31, 2003.

 

***Interest andFinancing Costs.*** Interest and financing costs increased 21.1% to $546,808 for the threemonths ended March 31, 2003 from**$451,564for the three months ended March 31, 2002. Included in the amounts for the three months ended March 31, 2002 was$68,000, which is the portion of the discount on the beneficial conversionfeature of convertible debt.  Theincrease is attributable to the increase in borrowings under our line of creditbecause of increased revenues and additional loans required to provide fundingfor our operations.

 

***Net LossAttributable to Common Stockholders.**** *Asa result of the foregoing, we had a net loss and net loss attributable tocommon stockholders of ($1,828,695) and ($2,236,358), respectively for thethree months ended March 31, 2003 compared to a net loss and net lossattributable to common stockholders of ($1,052,441) and ($1,218,441) for thethree months ended March 31, 2002, respectively.

 

**Continuing Operations**

**Six Months Ended March 31, 2003 Compared toSix Months Ended March 31, 2002**

 

***Revenues.***  Revenues increased 51.7% to $43,903,790 forthe six months ended March 31, 2003 from $28,947,961 for the six months endedMarch 31, 2002.  Approximately $13.8million of the increase was attributable to the acquisitions in January andDecember 2002.  Excluding acquisitions,revenues increased 5.1%.  This increasewas the result of an increase in billable hours.

 

***Gross Profit.***  Gross profit increased 23.5% to $6,600,311for the six months ended March 31, 2003 from $5,342,580 for the six monthsended March 31, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenuesdecreased to 15.0% for the six months ended March 31, 2003 from 18.5% for thesix months ended March 31, 2002.  Thisdecrease was a result of increased pricing competition of staffing services andincreases in the cost of workers’ compensation insurance and state unemploymenttaxes.  In addition, we have beenassessed the penalty rate by the New Jersey Department of Labor for stateunemployment taxes because of payment delinquencies (see Part II—Item 5 of thisreport).  The estimated additionalexpense in the six months ended March 31, 2003 is $476,000.

 

***Selling, General andAdministrative Expenses.***  Selling, general and administrative expenses, not includingdepreciation and amortization, increased 23.7% to $7,125,526 for the six monthsended March 31, 2003 from $5,761,360 for the six months ended March 31,2002.  Selling, general andadministrative expenses, not including depreciation and amortization, as apercentage or revenues decreased to 16.2% for the six months ended March 31,2003 from 19.9% for the six months ended March 31, 2002.  The increase in the dollar amount isprimarily a result of the acquisitions in January and December 2002, whereasthe percentage of revenue decrease is attributable to significant costreductions implemented by us and the increase in revenues with no proportionateincrease in selling, general and administrative expenses.

 

***Depreciation andAmortization.*** Depreciation and amortization expenses, not including amortization ofgoodwill of $144,588 in the six months ended March 31, 2002, increased to$454,127 for the six months ended March 31, 2003 from $300,919 for the sixmonths ended March 31, 2002. Depreciation and amortization, not including the amortization ofgoodwill, as a percentage of revenues was 1.0% for the six months ended March

 

19

----

 

31, 2003 and 2002.  The increasein the dollar amount was due to capital expenditures and amortization ofintangibles in connection with the acquisition in December 2002.

 

***Other Charges.***  During the period May 1, 2001 through May20, 2002, we maintained workers’ compensation insurance with an insurancecompany, with a deductible of $150,000 per incident.  We had established reserves based upon our evaluation of thestatus of claims still open in conjunction with claims reserve informationprovided to us by the insurance company. We believe that the insurance company has paid and reserved claims in excessof what should have been paid or reserved. Although we believe we can recover some of the amounts already paid,this can only be pursued through litigation against the insurance company.  Since there is no assurance we will prevail,we recorded $523,000 of additional payments made and reserves in the six monthsended March 31, 2003.

 

***Interest andFinancing Costs.*** Interest and financing costs increased 8.5% to $1,045,719 for the sixmonths ended March 31, 2003 from $963,607 for the six months ended March 31,2002.  Included in the amounts for thesix months ended March 31, 2002 was $68,000, which is the portion of thediscount on the beneficial conversion feature of convertible debt.  Also included in the amounts for the sixmonths ended March 31, 2002 was approximately $224,000 of amortization ofdeferred financing costs related to the convertible debt.  The increase is attributable to the increasein borrowings under our line of credit because of increased revenues andadditional loans required to provide funding for our operations.

 

***Net LossAttributable to Common Stockholders.***  As a result of the foregoing, we had a netloss and net loss attributable to common stockholders of ($2,519,100) and($3,292,857), respectively for the six months ended March 31, 2003 compared toa net loss and net loss attributable to common stockholders of ($1,786,384) and($2,076,384) for the six months ended March 31, 2002, respectively.

 

**Liquidity and Capital Resources**

 

At March 31, 2003, we had limited liquidresources.  Current liabilities were$24,363,897 and current assets were $18,164,678.  The difference of $6,199,219 is a working capital deficit, whichis primarily the result of losses incurred during the last two 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.

###### ** **

Our continuation of existence is dependent uponthe continued cooperation of our creditors, our ability to generate sufficientcash flow to meet our continuing obligations on a timely basis, to fund theoperating and capital needs, and to obtain additional financing as may benecessary.

 

We have taken steps to revise and reduce ouroperating requirements, which we believe will be sufficient to assure continuedoperations and implementation of our plans. The steps include closing branches that are not profitable,consolidating branches and reductions in staffing and other selling, generaland administrative expenses.  Wecontinue to pursue other sources of equity or long-term debt financings.  We also continue to negotiate payments plansand other accommodations with our creditors.

 

Net cash used in operating activities was$2,895,409 and $1,488,480 in the six months ended March 31, 2003 and 2002,respectively.

 

Net cash provided by (used in) investingactivities was ($249,994) and $1,036,226 in the six months ended March 31, 2003and 2002, respectively.  The sale of ourEngineering Division in the six months ended March 31, 2002 generated net cashproceeds of $1,459,079 which was used to fund operating activities.  Cash used for acquisitions for the sixmonths ended March 31, 2003 and 2002 was $61,644 and $181,920,respectively.  The balance in bothperiods was primarily for capital expenditures.

 

Net cash provided by financing activities was$3,217,500 and $1,367,851 in the six months ended March 31, 2003 and 2002,respectively.  We had net borrowings of$2,619,991 and $723,529 under our line of credit in the

 

20

----

 

six months ended March 31, 2003 and 2002,respectively.  We also received netproceeds less redemptions of $24,879 from the issuance of convertible debt inthe six months ended March 31, 2002. During the six months ended March 31, 2003 and 2002, we received$186,400 and $504,583, respectively, in proceeds from the issuance of ourCommon Stock and Preferred Stock.  Netshort-term borrowings were $498,187 and $259,629 in the six months ended March31, 2003 and 2002, respectively.  Paymentsof notes payable-acquisitions was $352,489 and $142,769 in the six months endedMarch 31, 2003 and 2002, respectively.

 

Our principal uses of cash are to fund temporaryemployee payroll expense and employer related payroll taxes, investment incapital equipment, start-up expenses of new offices, expansion of servicesoffered, workers’ compensation, general liability and other insurance coverage,debt service and costs relating to other transactions such asacquisitions.  Temporary employees arepaid weekly.

 

At various times during the years endedSeptember 30, 2002 and 2001, we issued convertible debentures through privateplacements.  The debentures boreinterest at 6% a year, payable quarterly and had a maturity date of five yearsfrom issuance.  Each debenture wasconvertible after 120 days from issuance into the number of shares of ourcommon stock determined by dividing the principal amount of the debenture bythe lesser of (a) 120% of the closing bid price of the common stock on thetrading day immediately preceding the issuance date or (b) 75% of the averageclosing bid price of the common stock for the five trading days immediatelypreceding the date of the conversion. We had the right to prepay any of the debentures at any time at aprepayment rate that varied from 115% to 125% of the amount of the debenturedepending on when the prepayment was made.

 

The discount arising from the 75% beneficialconversion feature was charged to interest expense during the period from theissuance of the debenture to the earliest time at which the debenture becameconvertible.

 

As a result of conversions of the debenturesand certain transactions with the debenture holders, only $40,000 of debenturesremained outstanding at September 30, 2002 and March 31, 2003.

 

We have a loan and security agreement (the“Agreement”) with a lending institution which provides for a line of credit upto 85% of eligible accounts receivable, as defined, not to exceed$12,000,000.  Advances under theAgreement bore interest at a rate of prime plus 1 1/2% (see below).  The credit agreement restricts our abilityto incur other indebtedness, pay dividends and repurchase stock.  Borrowings under the agreement arecollateralized by substantially all of our assets.  As of March 31, 2003, $10,359,108 was outstanding under thecredit agreement.

 

At March 31, 2003, we were in violation of thefollowing covenants under the loan and security agreement:

 

i)                                         Failing to meet the tangible net worthrequirement;

 

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

 

We have received a waiver from the lender on allof the above violations and in December 2002, entered into a modification ofthe Agreement.  The modificationprovided that borrowings under the Agreement bore interest at a rate of primeplus 1 3/4% as long as we are in violation of any of the covenants under theAgreement.

 

Effective April 10, 2003, the Company enteredinto another modification of the Agreement which provides that borrowings underthe Agreement bear interest at 3% above the prime rate.

 

Holders of the 1,458,933 outstanding shares ofour Series A Preferred Stock are entitled to dividends at a rate of $.21 pershare per annum when and if declared by our Board of Directors in preferenceand priority to any payment of dividends on our common stock or any otherseries of our capital stock.  Dividendson the Series A Preferred Stock may be paid in additional shares of PreferredStock if the shares of common stock issuable upon the conversion of the SeriesA Preferred Stock have been registered for resale under the Securities Act of1933.  We are obligated to pay quarterlydividends to holders of our Series E Preferred Stock and, commencing March2004, holders of our Series H Preferred Stock, at a rate of 6% per annum of thestated value of the stock in preference and priority to any payment of dividendson our common stock.  We are obligatedto pay monthly

 

21

----

 

dividends on our Series F Preferred Stock at a rate of 7% per annum ofthe stated value of the stock in preference and priority to any payment ofdividends on our common stock.  Theaggregate stated value of the Series E, Series F and Series H Preferred Stockwas $1,804,600, $800,000 and $500,000, respectively, as of March 31, 2003.  Dividends on the Series E, Series F andSeries H Preferred Stock may be paid at the 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.

 

We are obligated to redeem any shares of SeriesA Preferred Stock outstanding on June 30, 2008 at a redemption price of $3.00per share together with accrued and unpaid dividends.  We have the option to pay the redemption price through theissuance of shares of common stock.  Forpurposes of determining the number of shares we will be required to issue if wepay 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 preceding the date of redemption.

 

Other fixed obligations that we had as of March31, 2003 include:

 

•                              $1,189,686 under a promissory notebearing interest at 7% per annum which was issued in connection with ouracquisition of Source One and which is payable in equal quarterly installmentsof $130,717 until its maturity date in August 2005.

•                              $995,565 under a promissory note bearinginterest at 6% per annum 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.

•                              $1,211,332, including $395,378 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 wasdue in April 2002 which bears interest at 18% per annum.

•                              $12,500 due under promissory notesbearing interest at 6% per annum which were issued in connection with anacquisition transaction completed in January 2001 and which is payable inmonthly installments of $5,000 through June 2003.

•                              $131,837 under a promissory note whichbears interest at 15% per annum and which requires us to make payments ofprincipal and interest of $8,000 per month until its maturity date in October2004.

•                              $130,162 under a non-interest bearingpromissory note which requires us to make monthly payments of principal andinterest of $13,437 and which is due in full upon the demand of the holder.

•                              $41,000 under a demand note bearinginterest at 10% per annum issued to a corporation wholly owned by the son ofJoseph J. Raymond, our Chief Executive Officer.

•                              $725,000 under demand loans which bearinterest at various rates, including $100,000 owed to a son of Joseph J.Raymond, our Chief Executive Officer.

•                              $88,983 under promissory notes used toacquire, and secured by, motor vehicles which require aggregate monthlypayments of principal and interest of $3,453 and which become due in full atvarious dates between July and August, 2005.

 

Allof our offices are leased through operating leases that are not included on thebalance sheet.  As of March 31, 2003,future minimum lease payments under lease agreements having initial terms inexcess of one year were:  2004-$543,000, 2005-$328,000, 2006-$167,000, 2007-$137,000 and 2008 - $11,000.

 

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 2002 or the six months ended March 31, 2002.

 

22

----

 

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 and beforethe later of July 27, 2005 and the full payment of the outstanding note that weissued to it in connection with the acquisition transaction completed withSource One in July 2001.  In addition,the holder of the $80,000 note which was due in April 2002 has the right torequire us to repurchase 20,000 shares of common stock at a price of $1.00 pershare plus interest at a rate of 15% per annum until the note is paid in full.

 

InJanuary 2003, a $367,216 judgment was awarded against us to an insurancecarrier.  As of February 13, 2003, thejudgment was unpaid; however, we have entered into an agreement with theplaintiff which permits us to satisfy the judgment over a three yearperiod.  The unpaid balance of $342,216at March 31, 2003 is included in “Accounts payable and accrued expenses” on thebalance sheet.

 

InFebruary 2003, the New Jersey Department of Labor notified us thatapproximately $2,100,000 of payroll taxes are delinquent.  We dispute that the entire amount is owedand have recently begun discussion with the New Jersey Department of Labor todetermine the actual amount owed and arrange for payment of that amount over aperiod of time.  As of December 31,2002, a substantial portion of such payroll tax liabilities had been accrued.

 

Asof March 31, 2003, there were no off-balance sheet arrangements, unconsolidatedsubsidiaries, commitments or guarantees of other parties, except as disclosedin the notes to financial statements. Stockholders’ equity at that date was $799,826 which represented 7% oftotal assets.

###### ** **

###### **Seasonality**

 

Our business follows the seasonal trends of our customer’sbusiness.  Historically, we haveexperienced lower revenues in the first calendar quarter with revenuesaccelerating during the second and third calendar quarters and then staring toslow again during the fourth calendar quarter.

 

###### **Impact of Inflation**

 

We believe that since our inception, inflation has not had asignificant impact on our results of operations.

 

**Impact of Recent Accounting Pronouncements**

 

In June 2001, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 142, “Goodwill and Other IntangibleAssets”.  SFAS No. 142, which must beapplied to fiscal years beginning after December 15, 2001, modifies theaccounting and reporting of goodwill and intangible assets.  The pronouncement requires entities todiscontinue the amortization of goodwill; reallocate all existing goodwillamong its reporting segments based on criteria set by SFAS No. 142, and performinitial impairment tests by applying a fair-value-based analysis on thegoodwill in each reporting segment.  Anyimpairment at the initial adoption date shall be recognized as the effect of achange in accounting principle. Subsequent to the initial adoption, goodwill shall be tested forimpairment annually or more frequently if circumstances indicate a possibleimpairment.

 

Under SFAS No. 142, entities are required todetermine the useful life of other intangible assets and amortize the valueover the useful life.  If the usefullife is determined to be indefinite, no amortization will be recorded.  For intangible assets recognized prior tothe adoption of SFAS No. 142, the useful life should be reassessed.  Other intangible assets are required to betested for impairment in a manner similar to goodwill.  We adopted SFAS No. 142 and completed atransitional impairment test, as required by SFAS No. 142, and determined thatthere was no impairment of goodwill as of October 1, 2002.

 

In August 2001, the FASB issued SFAS No. 144,“Impairment of Long-Lived Assets”.  SFASNo. 144 supercedes SFAS No. 121, “Accounting for the Impairment of Long-LivedAssets and for Long-Lived Assets to be Disposed of”.  SFAS No. 144 retains the requirements of SFAS No.  121 to (a) recognize an impairment loss onlyif the carrying amount of a long-lived asset is not recoverable from itsundiscounted cash flows and (b) measure an impairment loss as the differencebetween the carrying amount and the fair value of the asset.  SFAS

 

23

----

 

No.144 removes goodwill from its scope. SFAS No. 144 is applicable to financial statements issued forfiscal years beginning after December 15, 2001, or for our fiscal year endingSeptember 30, 2003.  The adoption ofSFAS No. 144 did not have any material adverse impact on our financial positionor results of our operations.

 

In June 2002, the FASB issued SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities” whichnullifies EITF No. 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)”. SFAS 146 requires that a liability for a cost associated with an exit ordisposal activity be recognized when the liability is incurred.  Under EITF 94-3, a liability for an exitcost as defined in EITF 94-3 was recognized at the date of an entity’s commitmentto an exit plan.  The provisions of SFAS146 are effective for exit or disposal activities that are initiated afterDecember 31, 2002.  The adoption of SFAS146 may affect the timing of the recognition of future exit and disposal costs.

 

In January 2003, the FASB issuedInterpretation No. 46, “Consolidation of Variable Interest Entities.”  Interpretation 46 changes the criteria bywhich one company includes another entity in its consolidated financial statements.  Previously, the criteria were based oncontrol through voting interest. Interpretation 46 requires a variable interest entity to be consolidatedby a company if that company is subject to a majority of the risk of loss fromthe variable interest entity’s activities or entitled to receive a majority ofthe entity’s residual returns or both. A company that consolidates a variable interest entity is called theprimary beneficiary of that entity.  Theconsolidation requirements of Interpretation 46 apply immediately to variableinterest entities created after January 31, 2003.  The consolidation requirements apply to older entities in thefirst fiscal year or interim period beginning after June 15, 2003.  Certain of the disclosure requirements applyin all financial statements issued after January 31, 2003, regardless of whenthe variable interest entity was established. The Company does not expect the adoption to have a material impact tothe Company’s financial position or results of operations.

 

**Sensitive AccountingEstimates**

 

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.  Significantestimates include management’s estimate of the carrying value of accountsreceivable, the impairment of goodwill and the establishment of valuationreserves 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, 2002. As of March 31, 2003, there have been no material changes to any of thecritical accounting policies contained therein.

 

**Item 3. – QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET 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**

 

As required by Rule 13a-15 under theSecurities Exchange Act of 1934, within the 90 days prior to the filing date ofthis report, we carried out an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures.  This evaluation was carried out under thesupervision and with the participation of our management, including ourChairman and Chief Executive Officer along with our Chief Financial Officer,who concluded that our disclosure controls and procedures are effective.  Their have been no significant changes inour internal controls or in other factors, which could significantly affectinternal controls subsequent to the date we carried out its evaluation.

 

24

----

 

Disclosure controls and procedures arecontrols and other procedures that are designed to ensure that informationrequired to be disclosed in our reports filed or submitted under the ExchangeAct is recorded, processed, summarized and reported with the time periodsspecified in the Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed in our reports filed under the Exchange Act isaccumulated and communicated to management, including our Chief ExecutiveOfficer and Chief Financial Officer as appropriate, to allow timely decisionsregarding required disclosure.

 

25

----

 

**Part II – Other Information**

**Item 1 –****Legal Proceedings**

 

In January 2003, a$367,216 judgment was awarded against us to the plaintiff in *Ace American Insurance Company v. Stratus ServicesGroup, Inc.*, a contract/tort action in which the plaintiffalleged that we had failed to pay certain insurance premiums.  As of the date of the filing of this Reportthe judgment was unpaid; however, we have entered into an agreement with theplaintiff which permits us to satisfy the judgment over a three yearperiod.  The unpaid balance of $342,216at March 31, 2003 is included in “Accounts payable and accrued expenses” on thebalance sheet.

 

In April 2003, wewere served with a Complaint and were named as one of several Defendants in thematter of *Lopez v. RSI Home Products,Inc. et al.* (“RSI”), in the Superior Court of California, OrangeCounty.  RSI is one of ourcustomers.  The case is a class actionproceeding alleging failure to pay hourly wages and overtime wages, failure toprovide rest periods and meal periods or compensation in lieu thereof, failureto pay wages of terminated or resigned employees, knowing and intentionalfailure to comply with itemized employee wage statement provisions, violationof the unfair competition law, and breach of fiduciary duty.  Stratus has engaged California counsel torepresent it in such proceedings; the time to file an Answer has been extendedto June 6, 2003 for all Defendants.  Theamount of Plaintiff’s claim against all Defendants is not yet reasonablydeterminable or quantifiable.

 

**Item 2 –****Changes in Securities and Use of Proceeds**

 

### ***Conversionof Series E Preferred Stock and Series F Preferred Stock***

### ** **

### **InMarch and April 2003, holders of Series E Preferred Stock converted anadditional 1,445 shares into 642,000 shares of our Common Stock at conversionprices between $.185 and $.248.  Theissuances of the Common Stock upon such conversions were made in reliance uponthe exemptions from registration provided under Rule 506 and Section 4(2) ofthe Securities Act of 1933.**

 

InFebruary 2003, Joseph J. Raymond, our President and Chief Executive Officer,the holder of the Series F Preferred Stock, converted 1,000 shares into1,000,000 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 UponSenior Securities**

 

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, $535,497 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, $77,112 is in arrears on the Series EPreferred Stock.

 

Dividendson our Series H Preferred Stock accrue at a rate of 6% per year, payablequarterly, commencing on March 30, 2004. As of the date of the filing of this report, $3,616 of such dividendshave accrued, but are not yet in arrears.

### ** **

### **Item 4**– Submissionof Matters to a Vote of Security Holders

 

There were no matters submitted to a vote of oursecurity holders during the three months ended March 31, 2003.

 

26

----

 

### **Item 5**–Other Information

 

In February 2003, the New Jersey Department of Labor notified us thatapproximately $2,100,000 of payroll taxes are delinquent.  We dispute that the entire amount is owedand have recently begun discussions with the New Jersey Department of Labor todetermine the actual amount owed and to arrange for payment of that amount overa period of time.  As of March 31, 2003,such payroll tax liabilities had been accrued.

 

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

 
| (a)        |   | Exhibits                                                                                                                                                                                                                                                                                  |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                      |
| **Number** |   | **Description**                                                                                                                                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                      |
| 99.1       |   | Certification of Chief Executive Officer pursuant to Section 906 of  Sarbanes-Oxley Act of 2002                                                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                      |
| 99.2       |   | Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley  Act of 2002                                                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                      |
| (b)        |   | Reports on  Form 8-K                                                                                                                                                                                                                                                                      |
|       |   |                                                                                                                                                                                                                                                                                      |
|       |   | On January 30, 2003, we filed a Form 8-K/A to amend our Form 8-K  filed on November 26, 2003 to include pro forma financial information related  to our acquisition of certain assets of Elite Personnel Services and certain  historical financial information of the acquired business. |

 

27

----

 

SIGNATURES

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                         |   | STRATUS  SERVICES GROUP, INC. |
|------------------------------|--------|-------------------------------|
|                         |   |                          |   |
|                         |   |                          |   |
| Date:  October 14, 2003 |   | By:                           | /s/  Joseph J. Raymond |   |
|                         |   |                          |   |
|                         |   |                          | Joseph J. Raymond |
|                         |   |                          | Chairman of the Board of Directors,  President and Chief Executive Officer |
|                         |   |                          |   |
| Date:  October 14, 2003 |   | By:                           | /s/ Michael A. Maltzman |   |
|                         |   |                          |   |
|                         |   |                          | Michael A. Maltzman |
|                         |   |                          | Chief Financial Officer  (Principal Financial and Accounting Officer) |

 

28

----