****

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

# ** **

# **FORM 10-Q**

 

| **(Mark One)**                                                                                                                                                                                                                                                     |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                               |
| **ý**                                                                                                                                                                                                                                                         | **QUARTERLY REPORT UNDER SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the quarterly period ended June 30, 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 asspecified in its charter)

 

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

 

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days. Yes ý              No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes o              No ý

 

As of August 6, 2003, 19,128,462 shares of the Registrant’s commonstock were outstanding.

 

 

----

 

**Part I – Financial Information**

**Item 1. – Financial Statements**

 

**STRATUS SERVICESGROUP, INC.**

Condensed Balance Sheets

 
|                                                                                                                                                                                                           |   | **June 30,  2003** |       | **September  30,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|--------------------------|--------|
|                                                                                                                                                                                                           |   | **(Unaudited)**    |       |                     |   |
| Assets                                                                                                                                                                                                         |   |               |       |                     |   |
| Current assets                                                                                                                                                                                                 |   |               |       |                     |   |
| Cash and cash equivalents                                                                                                                                                                                      |   | $                  | 374,973    |                     | $      | 162,646 |   |
| Accounts receivable – less allowance for doubtful  accounts of $1,980,000 and $1,742,000                                                                                                                  |   | 12,053,408         |       | 9,179,543                |   |
| Unbilled receivables                                                                                                                                                                                           |   | 2,610,814          |       | 2,065,972                |   |
| Other receivables                                                                                                                                                                                              |   | —             |       | 250,000                  |   |
| Prepaid insurance                                                                                                                                                                                              |   | 3,173,585          |       | 2,709,331                |   |
| Prepaid expenses and other current assets                                                                                                                                                                      |   | 299,461            |       | 333,601                  |   |
|                                                                                                                                                                                                           |   | 18,512,241         |       | 14,701,093               |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Property and equipment, net of accumulated  depreciation                                                                                                                                                       |   | 1,169,008          |       | 1,281,817                |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Intangible assets, net of accumulated amortization                                                                                                                                                             |   | 1,707,920          |       | 802,145                  |   |
| Goodwill                                                                                                                                                                                                       |   | 7,085,582          |       | 7,085,582                |   |
| Deferred financing costs, net of accumulated  amortization                                                                                                                                                     |   | 4,562              |       | 5,768                    |   |
| Other assets                                                                                                                                                                                                   |   | 245,729            |       | 154,991                  |   |
|                                                                                                                                                                                                           |   | $                  | 28,725,042 |                     | $      | 24,031,396 |   |
| Liabilities and  Stockholders’ Equity                                                                                                                                                                     |   |               |       |                     |   |
| Current liabilities                                                                                                                                                                                            |   |               |       |                     |   |
| Loans payable (current portion)                                                                                                                                                                                |   | $                  | 1,043,917  |                     | $      | 464,830 |   |
| Loans payable – related parties                                                                                                                                                                           |   | 457,337            |       | 116,000                  |   |
| Notes payable – acquisitions (current portion)                                                                                                                                                            |   | 645,453            |       | 578,040                  |   |
| Line of credit                                                                                                                                                                                                 |   | 9,508,071          |       | 7,739,117                |   |
| Cash overdraft                                                                                                                                                                                                 |   | 1,652,252          |       | 731,501                  |   |
| Insurance obligation payable                                                                                                                                                                                   |   | 168,604            |       | 128,075                  |   |
| Accounts payable and accrued expenses                                                                                                                                                                          |   | 8,108,535          |       | 5,472,696                |   |
| Accrued payroll and taxes                                                                                                                                                                                      |   | 2,462,760          |       | 1,828,629                |   |
| Payroll taxes payable                                                                                                                                                                                          |   | 1,922,572          |       | 929,328                  |   |
|                                                                                                                                                                                                           |   | 25,969,501         |       | 17,988,216               |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Loans payable (net of current portion)                                                                                                                                                                         |   | 105,460            |       | 217,965                  |   |
| Notes payable – acquisitions (net of current  portion)                                                                                                                                                    |   | 2,228,636          |       | 1,919,532                |   |
| Convertible debt                                                                                                                                                                                               |   | 40,000             |       | 40,000                   |   |
|                                                                                                                                                                                                           |   | 28,343,597         |       | 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 $575,158 and  $345,376) |   | 3,679,158          |       | 3,293,376                |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Series E non-voting convertible preferred stock,  $.01 par value, 17,031 and 16,683 shares issued and outstanding, liquidation  preference of $1,703,100 (including unpaid dividends of $94,040 and $20,000)   |   | 1,797,140          |       | 1,485,947                |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Series F voting convertible preferred stock, $.01  par value, 8,000 and 10,000 shares issued and outstanding, liquidation  preference of $800,000 (including unpaid dividends of $14,000 and $-0-)             |   | 814,000            |       | 1,000,000                |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Series H non-voting convertible preferred stock,  $.01 par value, 5,000 shares issued and outstanding, liquidation preference  of $500,000 (including unpaid dividends of $7,500 and $-0-)                     |   | 507,500            |       | 500,000                  |   |
|                                                                                                                                                                                                           |   |               |       |                     |   |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 19,001,478 and 11,522,567 shares issued and outstanding                                                                                          |   | 190,015            |       | 115,226                  |   |
| Additional paid-in capital                                                                                                                                                                                     |   | 12,356,712         |       | 12,626,733               |   |
| Accumulated deficit                                                                                                                                                                                            |   | (19,786,080        | )          | (15,978,599              | )      |
| Total stockholders’ equity (deficiency)                                                                                                                                                                   |   | (441,555           | )          | 3,042,683                |   |
|                                                                                                                                                                                                           |   | $                  | 28,725,042 |                     | $      | 24,031,396 |   |

 

See notes to condensed financial statements.

 

2

----

 

**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Operations

(Unaudited)

 
|                                                                          |   | **Three  Months Ended  June 30,** |       | **Nine  Months Ended  June 30,** |   |
|-------------------------------------------------------------------------------|--------|-----------------------------------|------------|----------------------------------|--------|
|                                                                          |   | **2003**                          |       | **2002**                         |   | **2003** |   | **2002** |   |
| Revenues                                                                      |   | $                                 | 26,951,354 |                             | $      | 19,269,395 |   | $ | 74,706,176 |   | $ | 51,568,047 |   |
| Cost of revenues                                                              |   | 23,335,202                        |       | 16,387,222                       |   | 64,489,693 |   | 43,343,294 |   |
| Gross Profit                                                                  |   | 3,616,152                         |       | 2,882,173                        |   | 10,216,483 |   | 8,224,753 |   |
| Selling, general and administrative  expenses                                 |   | 4,551,259                         |       | 4,337,929                        |   | 12,130,911 |   | 10,535,246 |   |
| Loss on impairment of goodwill                                                |   | 3⁄4                            |       | 100,000                          |   | 3⁄4 |   | 100,000 |   |
| Other charges                                                                 |   | 3⁄4                            |       | 103,226                          |   | 523,000 |   | 103,226 |   |
|                                                                          |   |                              |       |                             |   |   |   |   |   |
| Operating (loss) from continuing operations                                   |   | (935,107                          | )          | (1,658,982                       | )      | (2,437,428 | ) | (2,513,719 | ) |
|                                                                          |   |                              |       |                             |   |   |   |   |   |
| Other income (expenses)                                                       |   |                              |       |                             |   |   |   |   |   |
| Interest and financing costs                                                  |   | (395,739                          | )          | (573,799                         | )      | (1,441,458 | ) | (1,537,406 | ) |
| (Loss) on sale of investment                                                  |   | 3⁄4                            |       | (2,149,865                       | )      | 3⁄4 |   | (2,159,415 | ) |
| Other income                                                                  |   | 42,465                            |       | 25,260                           |   | 71,405 |   | 66,770 |   |
|                                                                          |   | (353,274                          | )          | (2,698,404                       | )      | (1,370,053 | ) | (3,630,051 | ) |
|                                                                          |   |                              |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                             |   | (1,288,381                        | )          | (4,357,386                       | )      | (3,807,481 | ) | (6,143,770 | ) |
|                                                                          |   |                              |       |                             |   |   |   |   |   |
| Discontinued operations – (loss) from  discontinued Engineering Division |   | 3⁄4                            |       | (7,366                           | )      | 3⁄4 |   | (246,159 | ) |
| Gain on sale of Engineering Division                                          |   | 3⁄4                            |       | 3⁄4                           |   | 3⁄4 |   | 1,759,056 |   |
| Net earnings (loss)                                                           |   | (1,288,381                        | )          | (4,364,752                       | )      | (3,807,481 | ) | (4,630,873 | ) |
| Dividends and accretion on preferred stock                                    |   | (181,075                          | )          | (288,110                         | )      | (954,832 | ) | (578,110 | ) |
| Net earnings (loss) attributable to common  stockholders                      |   | $                                 | (1,469,456 | )                                | $      | (4,652,862 | ) | $ | (4,762,313 | ) | $ | (5,208,983 | ) |
|                                                                          |   |                              |       |                             |   |   |   |   |   |
| Net earnings (loss) per share attributable  to common stockholders            |   |                              |       |                             |   |   |   |   |   |
| Basic:                                                                        |   |                              |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                             |   | $                                 | (.08       | )                                | $      | (.40 | ) | $ | (.28 | ) | $ | (.66 | ) |
| Earnings from discontinued operations                                         |   | 3⁄4                            |       | 3⁄4                           |   | 3⁄4 |   | .15 |   |
| Net earnings (loss)                                                           |   | $                                 | (.08       | )                                | $      | (.40 | ) | $ | (.28 | ) | $ | (.51 | ) |
| Diluted:                                                                      |   |                              |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                             |   | $                                 | (.08       | )                                | $      | (.40 | ) | $ | (.28 | ) | $ | (.66 | ) |
| Earnings from discontinued operations                                         |   | 3⁄4                            |       | 3⁄4                           |   | 3⁄4 |   | .15 |   |
| Net earnings (loss)                                                           |   | $                                 | (.08       | )                                | $      | (.40 | ) | $ | (.28 | ) | $ | (.51 | ) |
|                                                                          |   |                              |       |                             |   |   |   |   |   |
| Weighted average shares, outstanding per common  share                        |   |                              |       |                             |   |   |   |   |   |
| Basic                                                                         |   | 18,867,632                        |       | 11,522,567                       |   | 16,922,697 |   | 10,230,023 |   |
| Diluted                                                                       |   | 18,867,632                        |       | 11,522,567                       |   | 16,922,697 |   | 10,230,023 |   |

 

See notes to condensed financial statements.

 

3

----

 

**STRATUSSERVICES GROUP, INC.**

Condensed Statements of Cash Flows

(Unaudited)

 
|                                                                                                                   |   | **Nine  Months Ended** |       |
|------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|
|                                                                                                                   |   | **June 30,  2003**     |       | **June 30,  2002** |   |
| Cash flows (used in) operating activities                                                                              |   |                   |       |   |   |
| Net (loss) from continuing operations                                                                                  |   | $                      | (3,807,481 | ) | $ | (6,143,770 | ) |
| Net (loss) from discontinued operations                                                                                |   | 3⁄4                 |       | 1,512,897 |   |
| Adjustments to reconcile net earnings  (loss) to net cash used by operating activities                                 |   |                   |       |   |   |
| Depreciation                                                                                                           |   | 409,607                |       | 388,274 |   |
| Amortization                                                                                                           |   | 285,744                |       | 418,720 |   |
| Provision for doubtful accounts                                                                                        |   | 475,000                |       | 958,000 |   |
| Loss on impairment of goodwill                                                                                         |   | 3⁄4                 |       | 100,000 |   |
| Deferred financing costs amortization                                                                                  |   | 1,206                  |       | 405,069 |   |
| Loss on sales of shares of investment                                                                                  |   | 3⁄4                 |       | 2,159,415 |   |
| 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 |   | 3⁄4                 |       | 104,535 |   |
| Common stock and warrants issued for fees                                                                              |   | 47,000                 |       | 3⁄4 |   |
| Accrued interest                                                                                                       |   | 51,946                 |       | 206,856 |   |
| Imputed interest                                                                                                       |   | 45,029                 |       | 3⁄4 |   |
| Changes in operating assets and liabilities                                                                            |   |                   |       |   |   |
| Accounts receivable                                                                                                    |   | (3,893,707             | )          | (1,452,347 | ) |
| Prepaid insurance                                                                                                      |   | (464,254               | )          | (1,307,771 | ) |
| Prepaid expenses and other current assets                                                                              |   | 34,140                 |       | (17,593 | ) |
| Other assets                                                                                                           |   | (90,738                | )          | 20,234 |   |
| Insurance obligation payable                                                                                           |   | 40,529                 |       | (328,669 | ) |
| Accrued payroll and taxes                                                                                              |   | 634,131                |       | 80,483 |   |
| Payroll taxes payable                                                                                                  |   | 993,244                |       | 651,956 |   |
| Accounts payable and accrued expenses                                                                                  |   | 2,512,393              |       | 1,595,740 |   |
| Total adjustments                                                                                                      |   | 1,081,270              |       | 2,220,569 |   |
|                                                                                                                   |   | (2,726,211             | )          | (2,410,304 | ) |
| Cash flows from (used in) investing  activities                                                                        |   |                   |       |   |   |
| Purchase of property and equipment                                                                                     |   | (221,798               | )          | (283,816 | ) |
| Proceeds from sales of shares of investment                                                                            |   | 3⁄4                 |       | 206,631 |   |
| Payments for business acquisitions                                                                                     |   | (61,644                | )          | (336,727 | ) |
| Net proceeds from sale of Engineering  Division                                                                        |   | 3⁄4                 |       | 1,709,079 |   |
|                                                                                                                   |   | (283,442               | )          | 1,295,167 |   |
| Cash flows from financing activities                                                                                   |   |                   |       |   |   |
| Proceeds from issuance of common stock                                                                                 |   | 3⁄4                 |       | 222,083 |   |
| Proceeds from issuance of preferred stock                                                                              |   | 186,400                |       | 282,500 |   |
| Proceeds from loans payable                                                                                            |   | 755,000                |       | 828,195 |   |
| Payments of loans payable                                                                                              |   | (188,418               | )          | (235,596 | ) |
| Proceeds from loans payable—related parties                                                                       |   | 416,337                |       | 50,000 |   |
| Payments of loans payable—related parties                                                                         |   | (75,000                | )          | (50,000 | ) |
| Payments of notes payable – acquisitions                                                                          |   | (514,387               | )          | (488,343 | ) |
| Net proceeds from line of credit                                                                                       |   | 1,768,954              |       | (63,452 | ) |
| Cash overdraft                                                                                                         |   | 920,751                |       | 872,334 |   |
| 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 | ) |
| Redemption of preferred stock                                                                                          |   | 3⁄4                 |       | (455,000 | ) |
| Dividends paid                                                                                                         |   | (47,657                | )          | 3⁄4 |   |
|                                                                                                                   |   | 3,221,980              |       | 985,600 |   |
| Net change in cash and cash equivalents                                                                                |   | 212,327                |       | (129,537 | ) |
| Cash and cash equivalents – beginning                                                                             |   | 162,646                |       | 171,822 |   |
| Cash and cash equivalents – ending                                                                                |   | $                      | 374,973    |   | $ | 42,285 |   |

 

See notes to condensed financial statements.

 

4

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**STRATUS SERVICESGROUP, INC.**

Condensed Statements of Cash Flows

(Unaudited)

 
|                                                                                                                                 |   | **Six Months  Ended** |      |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|-----------|
|                                                                                                                                 |   | **June 30,  2003**    |      | **June 30,  2002** |   |
|                                                                                                                                 |   |                  |      |   |   |
| Supplemental disclosure of cash paid                                                                                                 |   |                  |      |   |   |
| Interest                                                                                                                             |   | $                     | 988,428   |   | $ | 881,100 |   |
| Schedule of noncash investing and financing  activities                                                                              |   |                  |      |   |   |
| Fair value of assets acquired                                                                                                        |   | $                     | 1,266,519 |   | $ | 1,816,727 |   |
| Less: cash paid                                                                                                                      |   | (176,644              | )         | (336,727 | ) |
| 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                                                             |   | $                     | 855,700   |   | $ | — |   |
| 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                                                                        |   | $                     | —    |   | $ | 736,003 |   |
| Issuance of warrants for fees                                                                                                        |   | $                     | 19,500    |   | $ | 55,000 |   |
| Issuance of common stock for fees                                                                                                    |   | $                     | 27,500    |   | $ | — |   |
| Cumulative dividends and accretion on  preferred stock                                                                               |   | $                     | 674,175   |   | $ | 578,110 |   |

 

See notes to condensed financial statements.

 

5

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**STRATUS SERVICES GROUP, INC.**

Notes to Condensed Financial Statements

(Unaudited)

 

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

 

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

 

The results of operations for the interim periods presented are notnecessarily indicative of the results to be expected for the full year.

 

**NOTE 2 – LIQUIDITY**

 

At June 30, 2003, the Company had limited liquid resources.  Current liabilities were $25,969,501 andcurrent assets were $18,512,241.  Thedifference of $7,457,260 is a working capital deficit, which is primarily theresult of losses continuously incurred beginning the year ended September 30,2001.  Current liabilities include acash overdraft of $1,652,252, which is represented by outstanding checks.  These conditions raise substantial doubtsabout the Company’s ability to continue as a going concern.  The financial statements do not include anyadjustments to reflect the possible future effect on the recoverability andclassification of assets or the amounts and classification of liabilities thatmay result from the outcome of this uncertainty.

 

The Company’s continuation of existence is dependent upon the continuedcooperation of its creditors, its ability to generate sufficient cash flow tomeet its continuing obligations on a timely basis, to fund the operating andcapital needs, and to obtain additional financing as may be necessary.

 

Management of the Company has taken steps to revise and reduce itsoperating requirements, which it believes will be sufficient to assurecontinued operations and implementation of the Company’s plans.  The steps include closing branches that arenot profitable, consolidating branches and reductions in staffing and otherselling, general and administrative expenses.

 

The Company continues to pursue other sources of equity or long-termdebt financings.  The Company alsocontinues to negotiate payment plans and other accommodations with itscreditors.

 

**NOTE 3 – EARNINGS/LOSS PER SHARE**

 

Basic “Earnings Per Share” (“EPS”) excludes dilution and is computed bydividing earnings available to common stockholders by the weighted-averagenumber 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 nine months endedJune 30, 2003 and 2002.

 

**NOTE 4 – INTANGIBLEASSETS**

 

At the beginning of fiscal year ended September 30, 2003, the Companyadopted the provisions of Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets”.  The provisions of SFAS No. 142 prohibit the amortization ofgoodwill and certain intangible assets that are deemed to have indefinite livesand require that such assets be tested for impairment

 

6

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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 June 30, 2003 and September 30, 2002, intangible assets consistedof the following:

 
|                                  |   | **June 30,  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 |   | (588,495           | )         | (302,751                | )      |
|                                  |   | $                  | 1,707,920 |                    | $      | 802,145 |   |

 

Forthe three and nine months ended June 30, 2002, the Company recorded goodwillamortization of $72,294 and $216,882, respectively.  Excluding this amortization expense net (loss) attributable tocommon stockholders from continuing operations for the three and nine monthsended June 30, 2002, would have been $(4,580,568) and $(4,992,101) or $(.40)and $(.49) per basic and diluted share, respectively.

### ** **

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

 

| **For the Year Ending  June 30,** |   |    |    |
|-----------------------------------|--------|---------|---------|
|                              |   |    |    |
| 2004                              |   | $       | 398,000 |   |
| 2005                              |   | 376,000 |    |
| 2006                              |   | 169,000 |    |
| 2007                              |   | 121,000 |    |
| 2008                              |   | 118,000 |    |
|                                   |        |         |         |  |

 

### **NOTE 5 – LINE OF CREDIT**

 

The Company has a loan and security agreement (the “Loan Agreement”)with a lending institution whereby the Company can borrow up to 85% of eligibleaccounts receivable, as defined, not to exceed the lesser of $12 million or sixtimes the Company’s tangible net worth (as defined).  Until December 2002, 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.  The LoanAgreement expires on June 12, 2004.

 

At June 30, 2003, the Company was in violation of the followingcovenants under the Loan Agreement:

 

(i)                         Failingto meet the tangible net worth requirement, and;

(ii)                      TheCompany’s Common Stock being delisted from 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 Loan Agreement.  Themodification provided that borrowings under the Loan Agreement bore interest at1 3⁄4% above the prime rate, as long as the Company was in violation of any ofthe covenants under the Loan Agreement.

 

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

 

7

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The prime rate at June 30, 2003 was 4.00%.

 

### **NOTE 6 – CONVERTIBLE DEBT**

 

At various times during the nine months endedJune 30, 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 nine months ended June 30, 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 a stated value of $3.00 pershare.  The difference between thecarrying value and redemption value of the Series A Preferred Stock is beingaccreted through a charge to additional paid-in-capital through the June 30,2008 redemption date.

 

The Series A Preferred Stock entitles the holders thereof to cumulativedividends at $.21 per share per year, payable semi-annually, commencing onDecember 31, 2001, when and if declared by the Board of Directors.  The shares of Series A Preferred Stock areconvertible at the option of the holder into shares of the Company’s CommonStock on a one-for-one basis.  On June30, 2008, the Company will be required to redeem any shares of Series APreferred Stock outstanding at a redemption price of $3.00 per share togetherwith accrued and unpaid dividends, payable at the Company’s option, either incash or in shares of common stock.  Forpurposes of determining the number of shares which the Company will be requiredto issue if it chooses to pay the redemption price in shares of Common Stock,the Common Stock will have a value equal to the average closing price of theCommon Stock during the five trading days immediately preceding the date ofredemption.

 

8

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

 

The shares of Series E Preferred Stock have astated value of $100 per share.  Theholders of the Series E Preferred stock are entitled to cumulative dividends ata rate of 6% of the stated value per year, payable every 120 days, inpreference and priority to any payment of any dividend on the Company’s CommonStock.  Dividends may be paid, at theCompany’s option, either in cash or in shares of Common Stock, valued at theSeries E Conversion Price (as defined below). Holders of Series E Preferred Stock are entitled to a liquidationpreference of $100 per share, plus accrued and unpaid dividends.

 

The Series E Preferred Stock is convertibleinto Common Stock at a conversion price equal to 75% of the average of theclosing bid prices, for the five trading days preceding the conversion date,for the Common Stock.  The number ofshares issuable upon conversion is determined by multiplying the number ofshares of Series E Preferred Stock to be converted by $100, and dividing theresult by the Series E Conversion Price then in effect.

 

Holders of Series E Preferred Stock do nothave any voting rights, except as required by law.

 

The Company may redeem the shares of theSeries E Preferred Stock at any time prior to conversion, at a redemption priceof 115% of the purchase price paid for the Series E Preferred Shares, plus anyaccrued but unpaid dividends.

 

The discount arising from the beneficialconversion feature was treated as a dividend from the date of issuance to theearliest conversion date.

 

During the nine months ended June 30, 2003,holders of Series E Preferred Stock converted 6,652 shares into 5,128,911shares of Common Stock at conversion prices between $.108 and $.2475.

 

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

 

In July 2002, the Company’s Chief ExecutiveOfficer invested $1,000,000 in the Company in exchange for 10,000 shares ofnewly created Series F Convertible Preferred Stock (the “Series F PreferredStock”), which has a stated value of $100 per share.

 

The holder of the Series F Preferred Stock isentitled to receive, from assets legally available therefore, cumulativedividends at a rate of 7% per year, accrued daily, payable monthly, inpreference and priority to any payment of any dividend on the Common Stock andon the Series F Preferred Stock. Dividends may be paid, at the Company’s option, either in cash or inshares 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 F Preferred Stock is convertibleinto Common Stock at a conversion price (the “Series F Conversion Price”) equalto $.10 per share which was the market price at date of issuance.  The number of shares issuable uponconversion is determined by multiplying the number of shares of Series FPreferred Stock to be converted by $100, and dividing the result by the SeriesF Conversion Price.

 

Except as otherwise required by law, holdersof Series F Preferred Stock and holders of Common Stock shall vote together asa single class on each matter submitted to a vote of stockholders.  Each outstanding share of Series F PreferredStock shall be entitled to the number of votes equal to the number of fullshares of Common Stock into which each such share of Series F Preferred Stockis then convertible on the date for determination of stockholders entitled tovote at the meeting.  Holders of the SeriesF Preferred Stock are entitled to vote as a separate class on any proposedamendment to the terms of the Series F Preferred Stock which would increase ordecrease the number of authorized shares of Series F Preferred Stock or have anadverse impact

 

9

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on the Series F Preferred Stock and on anyproposal to create a new class of shares having rights or preferences equal toor having priority to the Series F Preferred Stock.

 

The Company may redeem the shares of theSeries F Preferred Stock at any time prior to conversion at a redemption priceof 115% of the purchase price paid for the Series F Preferred Shares plus anyaccrued but unpaid dividends.

 

During the nine months ended June 30, 2003,the Company’s Chief Executive Officer converted 2,000 shares of the Series FPreferred Stock into 2,000,000 shares of Common Stock.

 

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

 

The holders of the Series H Preferred Stockare entitled to cumulative dividends at a rate of 6% per year, payablequarterly, commencing on March 30, 2004, in preference and priority to anypayment 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 H Preferred Stock is convertibleinto Common Stock at a conversion price (the “Series H Conversion Price”) equalto the lower of $.20 per share, which was the market price at date of issuance,or the average market price of the Common Stock for the five trading daysimmediately preceding the conversion date. The number of shares issuable upon conversion is determined bymultiplying the number of shares of Series H Preferred Stock to be converted by$100 and dividing the result by the Series H Conversion Price then in effect.

 

Holders of Series H Preferred Stock do nothave any voting rights, except as required by law.

 

The Company has the right, but not theobligation, to redeem the shares of Series H Preferred Stock at any time priorto conversion at a redemption price of 115% of the purchase price paid for theSeries H Preferred Shares plus any accrued but unpaid dividends.

 

**NOTE 8 – OTHER CHARGES**

 

During the period May 1, 2001 through May 20, 2002, the Companymaintained workers’ compensation insurance with an insurance company, with adeductible of $150,000 per incident. The Company had established reserves based upon its evaluation of thestatus 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 litigation againstthe insurance company.  Since there isno assurance the Company will prevail, the Company recorded $523,000 ofadditional payments made and reserves in the nine months ended June 30, 2003.

 

**NOTE 9 – STOCK-BASED COMPENSATION**

 

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

 

10

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|                                                                                                                                  |   | **Three Months Ended****June 30,** |       | **Nine Months Ended****June 30,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|------------|-----------------------------------|--------|
|                                                                                                                                  |   | **2003**                           |       | **2002**                          |   | **2003** |   | **2002** |   |
| Net (loss) from continuing operations attributable  to common stockholders, as reported                                               |   | $                                  | (1,469,456 | )                                 | $      | (4,645,496 | ) | $ | (4,762,313 | ) | $ | (6,721,880 | ) |
|                                                                                                                                  |   |                               |       |                              |   |   |   |   |   |
| Deduct:                                                                                                                               |   |                               |       |                              |   |   |   |   |   |
| Total stock-based employee compensation expense  determined under fair value based method for all awards, net of related tax  effects |   | (281,518                           | )          | (610,088                          | )      | (1,700,756 | ) | (1,782,005 | ) |
|                                                                                                                                  |   |                               |       |                              |   |   |   |   |   |
| Pro forma net (loss) from continuing operations  attributable to common stockholders                                                  |   | $                                  | (1,750,974 | )                                 | $      | (5,255,584 | ) | $ | (6,463,069 | ) | $ | (8,503,885 | ) |
|                                                                                                                                  |   |                               |       |                              |   |   |   |   |   |
| (Loss) from continuing operations per common share  attributable to common stockholders:                                              |   |                               |       |                              |   |   |   |   |   |
| Basic – as reported                                                                                                              |   | $                                  | (.08       | )                                 | $      | (.40 | ) | $ | (.28 | ) | $ | (.51 | ) |
| Basic – pro forma                                                                                                                |   | $                                  | (.09       | )                                 | $      | (.46 | ) | $ | (.38 | ) | $ | (.83 | ) |
|                                                                                                                                  |   |                               |       |                              |   |   |   |   |   |
| Diluted – as reported                                                                                                            |   | $                                  | (.08       | )                                 | $      | (.40 | ) | $ | (.28 | ) | $ | (.51 | ) |
| Basic – pro forma                                                                                                                |   | $                                  | (.09       | )                                 | $      | (.46 | ) | $ | (.38 | ) | $ | (.83 | ) |

 

**NOTE 10 – INVESTMENT**

 

In the six months ended June 2002, theCompany sold its entire 26.3% investment in enterpriseAsia.com, apublicly-traded foreign company.  TheCompany received net proceeds of $206,631 and recorded a loss on the sales of$2,159,415.

 

**NOTE 11 - DISCONTINUED OPERATIONS, SALE OFENGINEERING DIVISION**

 

On March 28, 2002, the Company completed the sale of the assets of itsEngineering Services Division (the “Division”) to SEA Consulting ServicesCorporation (“SEA”) pursuant to the Asset Purchase Agreement dated as ofJanuary 24, 2002, among the Company, SEP, LLC (“SEP”), Charles Sahyoun, SahyounHolders LLC and SEA.

 

The assets of the Division had been transferred to SEP, a limitedliability company in which the Company owned a 70% interest, at the time of theexecution of the Asset Purchase Agreement. Sahyoun Holders, LLC, a company wholly-owned by Charles Sahyoun, thePresident of the Division, owned the remaining 30% interest in SEP.

 

Under the terms of the Asset Purchase Agreement, the Company receivedan initial cash payment of $1,560,000, which represented 80% of the initial$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 SEA tomake the following additional payments to SEP:

 

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

 

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

 

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

 

11

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Pursuant to an allocation and indemnity agreement entered into by theCompany, Sahyoun Holdings, LLC and Charles Sahyoun (the “Allocation andIndemnity Agreement”), the Company was entitled to $250,000 of the SecondPayment and $250,000 of the Third Payment. On April 15, 2002, by letter agreement between the Company, SahyounHoldings, LLC and Joseph J. Raymond, Sr., the Chairman and Chief ExecutiveOfficer of the Company, the parties agreed to a modification of the Allocationand Indemnity Agreement.  Per thatletter agreement, Sahyoun Holdings, LLC provided the Company with $200,000 cashin exchange for the Company’s short-term, 90-day demand note, due and payableby August 1, 2002 in the amount of $250,000. Such $250,000 was repaid by the Company from its $250,000 share of theSecond Payment which was received in June 2002.  Sahyoun Holdings, LLC and Charles Sahyoun have guaranteed the$250,000 payment to be made to the Company from the Third Payment, regardlessof the operating results of SEA.  Uponits receipt of all of the payments required under the Allocation and IndemnityAgreement, the Company’s interest in SEP will terminate and the Company willnot be entitled to any additional payments under the Asset Purchase Agreement,including the Subsequent Payments. Sahyoun Holdings, LLC is entitled to all amounts paid to SEP under theAsset Purchase Agreement other than $500,000 of payments made or payable to theCompany pursuant to the Allocation and Indemnity Agreement and guaranteed byCharles Sahyoun and Sahyoun Holdings, LLC, as described above.

 

The transaction resulted in a gain, which was calculated 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 Charles Sahyoun agreed to offset the$250,000 of the Third Payment due to the Company against $250,000 of accruedcommissions due Charles Sahyoun.  As aresult, the Company is not entitled to any additional payments under the AssetPurchase Agreement.

 

Revenues from the Division were $2,730,000 for the nine months endedJune 30, 2002.

 

### **NOTE 12 – ACQUISITION**

 

Effectiveas of December 1, 2002, (the “Effective Date”), the Company purchasedsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of six offices of Elite Personnel Services (“Elite”), a Californiacorporation.  The Elite branches providetemporary light industrial and clerical staffing in six business locations inCalifornia and Nevada. The Company also took over Elite’s Downey, Californiaoffice, from which Elite serviced no accounts but which it utilized as acorporate office.  The Company intendsto continue to utilize 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 

 

12

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otherkey management members entered into Non-Competition and Non-SolicitationAgreements pursuant to which they agreed not to compete with the Registrant inthe territories of the acquired business for periods ranging from twelve monthsto five 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 of March 31, 2003. There was an additional $176,644 of costs paid tothird parties in connection with the acquisition.

 

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  Nine Months Ended  June 30,** |       |
|----------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                       |   | **2003**                                   |       | **2002** |   |
|                                                                       |   |                                       |       |   |   |
| Revenues                                                                   |   | $                                          | 80,284,176 |   | $ | 74,511,047 |   |
| Net (loss) from continuing operations attributable  to common stockholders |   | (4,702,339                                 | )          | (6,971,880 | ) |
|                                                                       |   |                                       |       |   |   |
| Net (loss) per share attributable to common  stockholders                  |   |                                       |       |   |   |
| Basic                                                                      |   | $                                          | (.28       | ) | $ | (.68 | ) |
| Diluted                                                                    |   | $                                          | (.28       | ) | $ | (.68 | ) |

### ** **

13

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**NOTE13 – RELATED PARTY TRANSACTIONS**

### ** **

Duringthe nine months ended June 30, 2003, a son and the brother of the ChiefExecutive Officer of the Company (the “CEO”) each loaned $100,000 to the Company.  In addition, two of the members of the Boardof Directors of the Company loaned $100,000 and $116,337, respectively, to theCompany.  Each of the aforementionedloans is unsecured and due on demand. The loans are outstanding at June 30, 2003 and included in loans payableon the condensed balance sheet.

 

Duringthe nine months ended June 30, 2003, the CEO was repaid $75,000 for a previousloan to the Company.  In addition, theCEO loaned the Company $50,000, which was repaid prior to June 30, 2003.

 

### **NOTE 14 - SUBSEQUENT EVENTS**

 

In July 2003, the Company sold 14,362 shares of Series E PreferredStock in private placements for $1,436,250 in cash.

 

In July 2003, holders of Series E Preferred Stock converted 200 sharesinto 126,984 shares of common stock at a conversion price of $.1575.

 

In July 2003, the Company entered into an agreement with the holder ofthe Series H Preferred Stock pursuant to which the 5,000 shares of Series HPreferred Stock plus accrued dividends of $8,750 were exchanged for 5,087 sharesof Series E Preferred Stock.

 

On July 30, 2003, the Company and the Series E holders entered into aletter agreement (the “Compromise Agreement”) to compromise certain disputedpenalties arising out of the Company’s alleged failure to timely cause the suspensionof the effectiveness of the Company’s Form S-1 Registration Statement, filedwith the SEC on behalf of the Series E holders to terminate at the earliestpossible date.  Pursuant to the terms ofthe Compromise Agreement, while the Company does not admit that it failed tofulfill its contractual obligations to the Series E shareholders, in theinterest of amicably resolving this matter, the Company issued an additional4,477 shares of Series E Preferred Stock to the Series E shareholders.

 

On July 29, 2003, the Company received written notification from theholder of a put option that it was exercising its option which requires theCompany to buy back 400,000 shares of its Common Stock at $2 per share.  The Company has thirty days from the receiptof the notification, unless otherwise agreed to in writing, to pay the$800,000.  The Company is attempting tonegotiate an arrangement which would permit the Company to pay this amount overan extended period of time or upon receipt of financing.  No assurance can be given that the holder ofthe put option will agree to such an arrangement.

 

OnJuly 31, 2003, the Company and Artisan (UK) plc (“Artisan”), the solebeneficial shareholder of Stratus’ issued and outstanding Series A PreferredStock (the “Series A Stock”) entered into a letter agreement (the “RedemptionAgreement”), which requires the Company to redeem, subject to the terms andconditions of the Redemption Agreement, the Series A Stock in the event thatthe Company raises at least $4.0 million in a proposed “best-efforts” publicoffering of securities (the “Offering”). A copy of the Redemption Agreement is being filed as an Exhibit to thisForm 10-Q.

 

Perthe terms of the Redemption Agreement, within fifteen days after the Companycompletes the sale of at least $4,000,000 of securities in the Offering (the“Initial Closing”) the Company will be required to pay to Artisan the lump sumof $500,000.  In addition, the Companywill be obligated to pay Artisan the sum of $250,000 by January 31, 2005, or,at its option, deliver to Artisan shares of common stock with an aggregatevalue of $250,000, based on the average of the closing bid prices of theCompany’s common stock for the thirty consecutive trading days prior to January31, 2005.

 

Nointerest will accrue on this obligation over such eighteen month period;however, in the event that the Company shall default on its obligations to paysuch $250,000 in cash or in stock, then Artisan shall be 

 

14

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entitledto receive a cash payment of $300,000, plus default interest, at a rate of 18%calculated on a daily basis, from the date of the default until the default iscured.

 

Artisan,or its designee, will be entitled to receive within fifteen days of the InitialClosing a number of shares of common stock equal to 5.5% of the issued andoutstanding shares of common stock, as of the date of the Initial Closing.  Additionally, upon final completion of theOffering (the “Final Closing”), Artisan shall be entitled to receive suchnumber of shares of common stock, as will result in Artisan holding, as of thedate of the Final Closing, an amount of common shares equal to 5.5% of theCompany’s common stock after giving effect to the assumed exercise of allwarrants and options that have exercise prices equal to or below the thencurrent market price of our common stock and the conversion of all convertiblesecurities that then have conversion prices equal to or below the then currentmarket price of our common stock.

 

Inconjunction with the proposed issuance of common stock, Artisan has agreed toexecute a lock-up agreement with the Company (the “Lock-Up Agreement”) with thefollowing terms:

 

(a)                                  Any common stock issued in connection withthe Redemption Agreement shall be subject to a lock-up for a period of fourteenmonths following issuance; however, Artisan will retain the voting rights tosame; and

 

(b)                                 Any common stock held by Artisan as of thedate of the signing of the Redemption Agreement, shall be subject to lock-upfor a period of 135 days from the completion of the Initial Closing.  Thereafter, assuming the completion of aproposed 1-for-4 reverse split of the Company’s common stock in connection withthe Offering, Artisan shall be entitled to sell up to 25,000 shares of commonstock per month until July 31, 2004, when there will be no further restrictionson sales of the Company’s common stock by Artisan.

 

TheBoard of Directors of Stratus and the Board of Directors of Artisan havealready approved of the entering into of the Redemption Agreement.

 

Thecompletion of the above transactions is contingent upon completion of theInitial Closing of the Offering.

 

Ifthe Company does not deliver the $500,000 and 5.5% of its outstanding commonstock to Artisan within fifteen days of the Initial Closing, or if the InitialClosing does not take place within nine months of the date of the RedemptionAgreement, then Artisan will have the right to immediately terminate theRedemption Agreement.

 

Atthe signing of the Redemption Agreement, the Company delivered into escrow allvoting rights to the Series A Stock and the common stock held by Artisan as ofthat date.  After the Company paysArtisan the amounts owed to it in connection with the redemption of the SeriesA Preferred Stock, the proxy previously given by Artisan and its affiliates toJoseph J. Raymond, the Company’s Chairman and Chief Executive Officer, willterminate.

 

15

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

 

This Form 10-Q contains “forward-looking statements” within the meaningof Section 27A of the Securities Act of 1933, as amended and Section 21E of theSecurities Exchange Act of 1934, as amended. These statements relate to future economic performance, plans andobjectives of management for future operations and projections of revenue andother financial items that are based on the beliefs of our management, as wellas assumptions made by, and information currently available to, ourmanagement.  The words “expect”,“estimate”, “anticipate”, “believe”, “intend”, and similar expressions areintended to identify forward-looking statements.  Such statements involve assumptions, uncertainties andrisks.  If one or more of these risks oruncertainties materialize or underlying assumptions prove incorrect, actualoutcomes may vary materially from those anticipated, estimated orexpected.  Among the key factors thatmay have a direct bearing on our expected operating results, performance orfinancial condition are economic conditions facing the staffing industrygenerally; uncertainties related to the job market and our ability to attractqualified candidates; uncertainties associated with our brief operating history;our continued operating losses and their effect on liquidity; our ability toraise additional capital; the continued cooperation of our creditors; ourability to achieve and manage growth; our ability to successfully identifysuitable acquisition candidates, complete acquisitions or integrate theacquired business into our operations; our ability to attract and retainqualified 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 and productivity consultingservices associated with such services nationally through a network of officeslocated throughout the United States. Regardless of the type of temporary service offering we provide, werecognize revenues based on hours worked by assigned personnel.  Generally, we bill our customers apre-negotiated, fixed rate per hour for the hours worked by our temporaryemployees.  We are responsible forworkers’ compensation, unemployment compensation insurance, Medicare and SocialSecurity taxes and other general payroll related expenses for all of thetemporary employees we place.  These expensesare included in the cost of revenue. Because we pay our temporary employees only for the hours they actuallywork, wages for our temporary personnel are a variable cost that increases ordecreases in proportion to revenues. Gross profit margin varies depending on the type of servicesoffered.  In some instances, temporaryemployees placed by us may decide to accept an offer of permanent employmentfrom the customer and thereby “convert” the temporary position to a permanentposition.  Fees received from suchconversions are included in our revenues. Selling, general and administrative expenses include payroll formanagement and administrative employees, office occupancy costs, sales andmarketing expenses and other general and administrative costs.

 

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**Results of 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.

 

OnMarch 28, 2002, we completed the sale of the assets of the Division to SEApursuant to the Asset Purchase Agreement dated as of January 24, 2002 among us,SEP, LLC (“SEP”), Charles Sahyoun, Sahyoun Holdings LLC and SEA.  The transaction was approved by a vote ofour stockholders at the annual meeting of stockholders held on March 28, 2002.

 

Theassets of the Division had been transferred to SEP, a limited liability companyin which we owned a 70% interest, at the time of the execution of the AssetPurchase Agreement.  Sahyoun Holdings,LLC, a company wholly owned by Charles Sahyoun, the President of the Division,owned the remaining 30% interest in SEP.

 

Underthe terms of the Asset Purchase Agreement, we received an initial cash paymentof $1,560,000, which represented 80% of the initial $2,200,000 installment ofthe purchase price payable to SEP after the satisfaction of certain liabilitiesand expenses of SEP.  Sahyoun Holdings,LLC received the other 20% of the initial net installment of the purchaseprice, or $440,000.

 

TheAsset Purchase Agreement requires the purchaser to make the following additionalpayments to SEP:

 

(a)                                  A payment of $1 million, plus or minus theamount 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 minus theamount by which the SEA’s profit for the six months ended December 31, 2002, asdetermined pursuant to the Asset Purchase Agreement, is greater or less 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 $200,000cash in exchange for our short-term, 90-day demand note, due and payable byAugust 1, 2002 in the amount of $250,000. The $250,000 was paid by us from our share of the Second Payment whichwas received by us in June 2002.

 

SahyounHoldings LLC and Mr. Sahyoun have guaranteed the $250,000 payment to be made tous from the Third Payment, regardless of the operating results of SEA.  In December 2002, Mr. Sahyoun and we agreedto offset the $250,000 against $250,000 of accrued commissions due Mr. Sahyoun.  As a result, we will not be entitled to anyadditional payments under the Asset Purchase Agreement, including theSubsequent Payments.  Sahyoun HoldingsLLC is entitled to all amounts paid to SEP under the Asset Purchase Agreementother than $500,000 of payments made or payable to us pursuant to theAllocation and Indemnity Agreement and guaranteed by Charles Sahyoun andSahyoun Holdings, LLC as described above. Under the terms of the Asset Purchase Agreement, Sahyoun Holdings LLCwill not be entitled to any Subsequent Payments or its allocable share of theSecond and Third Payments if Mr. Sahyoun’s employment with SEA ceases for anyreason other than death or permanent disability prior to December 31, 2003.

 

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EffectiveJanuary 1, 2002, we purchased substantially all of the tangible and intangibleassets, excluding accounts receivable, of seven offices of PES.  The initial purchase price was $1,480,000,represented by a $1,100,000 promissory note and 400,000 shares of our commonstock.  There was an additional $334,355of costs incurred in connection with the acquisitions.  In addition, PES is entitled to earnoutpayments of 15% of pretax profit of the acquired business up to a total of$1.25 million or the expiration of ten years, whichever occurs first.  The note bears interest at 6% a year and ispayable over a ten-year period in equal quarterly 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 June 30, 2003 Compared toThree Months Ended June 30, 2002**

 

***Revenues.***  Revenues increased 39.9% to $26,951,354 forthe three months ended June 30, 2003 from $19,269,395 for the three monthsended June 30, 2002.  Approximately $6.9million of the increase was attributable to the acquisition in December2002.  Excluding acquisitions, revenuesincreased 4.0%.  This increase was aresult of an increase in billable hours.

 

***Gross Profit.***  Gross profit increased 25.5% to $3,616,152for the three months ended June 30, 2003 from $2,882,173 for the three monthsended June 30, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenuesdecreased to 13.4% for the three months ended June 30, 2003 from 15.0% for thethree months ended June 30, 2002.  Thisdecrease was a result of increased pricing competition for staffing servicesand increases in the cost of workers’ compensation insurance and stateunemployment taxes.  In addition, wehave been assessed the penalty rate by the New Jersey Department of Labor forstate unemployment taxes because of payment delinquencies (see “Liquidity andCapital Resources”).  The estimatedadditional expense in the three months ended June 30, 2003 is $224,000.

 

***Selling, General andAdministrative Expenses.**** *Selling, generaland administrative expenses, not including depreciation and amortization andprovision for doubtful accounts, increased 17.0% to $3,883,035 for the threemonths ended June 30, 2003 from $3,318,929 for the three months ended June 30,2002.  Selling, general andadministrative expenses, not including depreciation and amortization andprovision for doubtful accounts, as a percentage of revenues decreased to 14.4%for the three months ended June 30, 2003 from 17.2% for the three months endedJune 30, 2002.  The increase in thedollar amount is primarily a result of the acquisition in December 2002,whereas the 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.

 

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***Depreciation andAmortization.*** Depreciation and amortization expenses, not including amortization ofgoodwill of $72,294 in the three months ended June 30, 2002, increased to$241,225 for the three months ended June 30, 2003 from $196,706 for the threemonths ended June 30, 2002. Depreciation and amortization, not including the amortization of goodwill,as a percentage of revenues decreased to 0.9% for the three months ended June30, 2003 from 1.0% for the three months ended June 30, 2002.  The increase in dollar amount was due tocapital expenditures and amortization of intangibles in connection with theacquisition in December 2002.

 

***Provision forDoubtful Accounts. ***Provisionfor doubtful accounts decreased to $425,000 for the three months ended June 30,2003 from $750,000 for the three months ended June 30, 2002.  Provision for doubtful accounts as apercentage of revenue decreased to 1.6% for the three months ended June 30,2003 from 3.9% for the three months ended June 30, 2002.  The greater amount in 2002 was due to achange in estimate in light of the downturn in the economy at that time and ourevaluation of the recoverability of certain of our accounts.

 

***Interest andFinancing Costs.*** Interest and financing costs decreased 31.0% to $395,739 for the threemonths ended June 30, 2003 from**$573,799for the three months ended June 30, 2002. There was approximately $-0- and $211,000 in the three months ended June30, 2003 and 2002, respectively, for bank overdraft charges.

 

***Net LossAttributable to Common Stockholders.**** *Asa result of the foregoing, we had a net loss and net loss attributable to commonstockholders of ($1,288,381) and ($1,469,456), respectively, for the threemonths ended June 30, 2003 compared to a net loss and net loss attributable tocommon stockholders of ($4,364,752) and ($4,652,862) for the three months endedJune 30, 2002, respectively.

 

**Continuing Operations**

**Nine Months Ended June 30, 2003 Compared toNine Months Ended June 30, 2002**

 

***Revenues.***  Revenues increased 44.9% to $74,706,176 forthe nine months ended June 30, 2003 from $51,568,047 for the nine months endedJune 30, 2002.  Approximately $20.4million of the increase was attributable to the acquisitions in January andDecember 2002.  Excluding acquisitions,revenues increased 5.3%.  This increasewas the result of an increase in billable hours.

 

***Gross Profit.***  Gross profit increased 24.2% to $10,216,483for the nine months ended June 30, 2003 from $8,224,753 for the nine monthsended June 30, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenuesdecreased to 13.7% for the nine months ended June 30, 2003 from 15.9% for thenine months ended June 30, 2002.  Thisdecrease was a result of increased pricing competition for staffing servicesand increases in the cost of workers’ compensation insurance and stateunemployment taxes.  In addition, wehave been assessed the penalty rate by the New Jersey Department of Labor forstate unemployment taxes because of payment delinquencies (see “Liquidity andCapital Resources”).  The estimatedadditional expense in the nine months ended June 30, 2003 is $700,000.

 

***Selling, General andAdministrative Expenses.***  Selling, general and administrative expenses, not includingdepreciation and amortization and provision for doubtful accounts, increased22.9% to $10,960,560 for the nine months ended June 30, 2003 from $8,920,739for the nine months ended June 30, 2002. Selling, general and administrative expenses, not including depreciationand amortization and provision for doubtful accounts, as a percentage of revenuesdecreased to 14.7% for the nine months ended June 30, 2003 from 17.3% for thenine months ended June 30, 2002.  Theincrease in the dollar amount is primarily a result of the acquisitions inJanuary and December 2002, whereas the percentage of revenue decrease isattributable to significant cost reductions implemented by us and the increasein revenues with no proportionate increase in selling, general andadministrative expenses.

 

***Depreciation andAmortization.*** Depreciation and amortization expenses, not including amortization ofgoodwill of $216,882 in the nine months ended June 30, 2002, increased to$695,351 for the nine months ended June 30, 2003 from $497,625 for the ninemonths ended June 30, 2002. Depreciation and amortization, not including the amortization ofgoodwill, as a percentage of revenues decreased to 0.9%

 

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for the nine months ended June 30, 2003 from 1.0% for the nine monthsended June 30, 2002.  The increase inthe dollar amount was due to capital expenditures and amortization ofintangibles in connection with the acquisition in December 2002.

 

***Provision forDoubtful Accounts.***  Provision for doubtful accounts decreased to $475,000 for thenine months ended June 30, 2003 from $900,000 for the nine months ended June30, 2002.  Provision for doubtfulaccounts as a percentage of revenues decreased to 0.6% for the nine monthsended June 30, 2003 from 1.7% for the nine months ended June 30, 2002.  The greater amount in 2002 was due to achange in estimate in light of the downturn in the economy at that time and ourevaluation of the recoverability of certain of our accounts.

 

***Loss on Sale ofInvestment. ***In the nine monthsended June 30, 2002, we sold 63,025,000 shares, representing our entire 26.3%investment in a publicly-traded foreign company for net proceeds of $206,631and realized a loss of $2,159,415.

 

***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 nine months ended June 30, 2003.

 

***Interest andFinancing Costs.*** Interest and financing costs decreased 6.2% to $1,441,458 for the ninemonths ended June 30, 2003 from $1,537,406 for the nine months ended June 30,2002.  Included in the amounts for thenine months ended June 30, 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 ninemonths ended June 30, 2002 was approximately $224,000 of amortization ofdeferred financing costs related to the convertible debt.  After giving effect to these convertibledebt costs, there was a net increase which is attributable to the increase inborrowings 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 ($3,807,481) and($4,762,313), respectively, for the nine months ended June 30, 2003 compared toa net loss and net loss attributable to common stockholders of ($4,630,873) and($5,208,983) for the nine months ended June 30, 2002, respectively.

 

**Liquidity and Capital Resources**

 

AtJune 30, 2003, we had limited liquid resources.  Current liabilities were $25,969,501 and current assets were$18,512,241.  The difference of$7,457,260 is a working capital deficit, which is primarily the result oflosses incurred during the last two years. These conditions raise substantial doubts about our ability to continueas a going concern.  The financialstatements do not include any adjustments to reflect the possible future effecton the recoverability and classification of assets or the amounts andclassification of liabilities that may result from the outcome of thisuncertainty.

###### ** **

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

 

Wehave taken steps to revise and reduce our operating requirements, which webelieve will be sufficient to assure continued operations and implementation ofour plans.  The steps include closingbranches that are not profitable, consolidating branches and reductions instaffing and other selling, general and administrative expenses.  We continue to pursue other sources ofequity or long-term debt financings and

 

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inJuly 2003, we sold 14,362 shares of Series E Preferred Stock for aggregategross proceeds of $1,807,000.  We alsocontinue to negotiate payments plans and other accommodations with ourcreditors.

 

Netcash used in operating activities was $2,726,211 and $2,410,304 in the ninemonths ended June 30, 2003 and 2002, respectively.

 

Netcash provided by (used in) investing activities was ($283,442) and $1,295,167in the nine months ended June 30, 2003 and 2002, respectively.  The sale of our Engineering Division andsale of an investment in the nine months ended June 30, 2002 generated net cashproceeds of $1,709,079 and $206,631, respectively, which was used to fundoperating activities.  Cash used foracquisitions for the nine months ended June 30, 2003 and 2002 was $61,644 and$336,727, respectively.  The balance inboth periods was primarily for capital expenditures.

 

Netcash provided by financing activities was $3,221,980 and $985,600 in the ninemonths ended June 30, 2003 and 2002, respectively.  We had net borrowings (reductions in borrowings) of $1,768,954and ($63,452) under our line of credit in the nine months ended June 30, 2003and 2002, respectively.  We alsoreceived net proceeds less redemptions of $24,879 from the issuance ofconvertible debt in the nine months ended June 30, 2002.  During the nine months ended June 30, 2003and 2002, we received $186,400 and $504,583, respectively, in proceeds from theissuance of our Common Stock and Preferred Stock.  Net short-term borrowings were $907,919 and $592,599 in the ninemonths ended June 30, 2003 and 2002, respectively.  Payments of notes payable-acquisitions were $514,387 and $488,343in the nine months ended June 30, 2003 and 2002, respectively.

 

Ourprincipal uses of cash are to fund temporary employee payroll expense andemployer related payroll taxes, investment in capital equipment, start-upexpenses of new offices, expansion of services offered, workers’ compensation,general liability and other insurance coverage, debt service and costs relatingto other transactions such as acquisitions. Temporary employees are paid weekly.

 

Atvarious times during the years ended September 30, 2002 and 2001, we issuedconvertible debentures through private placements.  The debentures bore interest at 6% a year, payable quarterly andhad a maturity date of five years from issuance.  Each debenture was convertible after 120 days from issuance intothe number of shares of our common stock determined by dividing the principalamount of the debenture by the lesser of (a) 120% of the closing bid price ofthe common stock on the trading day immediately preceding the issuance date or(b) 75% of the average closing bid price of the common stock for the fivetrading days immediately preceding the date of the conversion.  We had the right to prepay any of thedebentures at any time at a prepayment rate that varied from 115% to 125% ofthe amount of the debenture depending on when the prepayment was made.

 

Thediscount arising from the 75% beneficial conversion feature was charged tointerest expense during the period from the issuance of the debenture to theearliest time at which the debenture became convertible.

 

Asa result of conversions of the debentures and certain transactions with thedebenture holders, only $40,000 of debentures remained outstanding at September30, 2002 and June 30, 2003.

 

Wehave a loan and security agreement (the “Loan Agreement”) with a lendinginstitution which provides for a line of credit up to 85% of eligible accountsreceivable, as defined, not to exceed $12,000,000.  Until December 2002, advances under the Loan Agreement boreinterest at a rate of prime plus 1 1/2% (see below).  The Loan Agreement restricts our ability to incur otherindebtedness, pay dividends and repurchase stock.  Borrowings under the Loan Agreement are collateralized bysubstantially all of our assets.  As ofJune 30, 2003, $9,508,071 was outstanding under the Loan Agreement.

 

AtJune 30, 2003, we were in violation of the following covenants under the LoanAgreement:

 

i)                             Failing to meet the tangible net worthrequirement;

 

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

 

Wehave received a waiver from the lender on all of the above violations and inDecember 2002, entered into a modification of the Loan Agreement.  The modification provided that borrowingsunder the Loan Agreement bore interest at a rate of prime plus 1 3/4% as longas we are in violation of any of the covenants under the Agreement.

 

EffectiveApril 10, 2003, the Company entered into another modification of the LoanAgreement which provides that borrowings under the Loan Agreement bear interestat 3% above the prime rate.

 

Holdersof the 1,458,933 outstanding shares of our Series A Preferred Stock areentitled to dividends at a rate of $.21 per share per annum when and ifdeclared by our Board of Directors in preference and priority to any payment ofdividends on our common stock or any other series of our capital stock.  Dividends on the Series A Preferred Stockmay be paid in additional shares of Preferred Stock if the shares of commonstock issuable upon the conversion of the Series A Preferred Stock have beenregistered for resale under the Securities Act of 1933.  We are obligated to pay quarterly dividendsto holders of our Series E Preferred Stock and, commencing March 2004, holdersof our Series H Preferred Stock, at a rate of 6% per annum of the stated valueof the stock in preference and priority to any payment of dividends on ourcommon stock.  We are obligated to paymonthly 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 $1,703,100, $800,000 and $500,000, respectively, as of June 30, 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.

 

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

 

Otherfixed obligations that we had as of June 30, 2003 include:

 

•                              $1,079,789 under a promissory note bearing interest at 7% per annumwhich was issued in connection with our acquisition of Source One and which ispayable in equal quarterly installments of $130,717 until its maturity date inAugust 2005.

 

•                              $995,565 under a promissory note bearing interest at 6% per annum whichwas issued in connection with our acquisition of certain assets of PES andwhich is payable in equal quarterly installments of $36,770 until its maturitydate in December 2011.

 

•                              $1,171831, including $373,097 of imputed interest, under a promissorynote which was issued in connection with our acquisition of Elite and which ispayable in equal monthly installments of $13,167 until its maturity in November2010.

 

•                              $80,000 under a promissory note that was due in April 2002 which bearsinterest at 18% per annum.

 

•                              $96,759 under a promissory note which bears interest at 15% per annumand which requires us to make payments of principal and interest of $8,000 permonth until its maturity date in October 2004.

 

•                              $91,905 under a non-interest bearing promissory note which requires usto make monthly payments of principal and interest of $13,437 and which is duein full upon the demand of the holder.

 

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•                              $41,000 under a demand note bearing interest at 10% per annum issued toa corporation wholly owned by the son of Joseph J. Raymond, our Chief ExecutiveOfficer.

 

•                              $1,216,337 under demand loans which bear interest at various rates,including $100,000 owed to a son of Joseph J. Raymond, our Chief ExecutiveOfficer.

 

•                              $80,714 under promissory notes used to acquire, and secured by, motorvehicles which require aggregate monthly payments of principal and interest of$3,453 and which become due in full at various dates between July and August,2005.

 

Allof our offices are leased through operating leases that are not included on thebalance sheet.  As of June 30, 2003,future minimum lease payments under lease agreements having initial terms inexcess of one year were:  2004-$621,000, 2005-$373,000, 2006-$137,000 and 2007-$34,000.

 

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 nine months ended June 30, 2002.  There is $244,000 included in accounts payable and accruedexpenses on the balance sheet as of June 30, 2003 for estimated earnoutpayments that we recorded as part of the acquisition of Elite.

 

SourceOne has the right to require us to repurchase 400,000 shares of our commonstock at a price of $2.00 per share at any time after July 27, 2003 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.  Source Onenotified us that it was exercising this right on July 29, 2003.  Payment is due by August 28, 2004.  The Company is attempting to negotiate anarrangement which would permit the Company to pay this amount over an extendedperiod of time or upon receipt of financing. No assurance can be given that Source One will agree to such anarrangement.  In addition, the holder ofthe $80,000 note which was due in April 2002 has the right to require us torepurchase 20,000 shares of common stock at a price of $1.00 per share plusinterest 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 $267,216at June 30, 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 June 30, 2003, asubstantial portion of such payroll tax liabilities had been accrued.

 

In April 2003, we were served with aComplaint and were named as one of several Defendants in the matter of *Lopez v. RSI Home Products, Inc. et al.*(“RSI”), in the Superior Court of California, Orange County.  RSI was one of our customers.  They have since terminated ourcontract.  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 intentional failureto comply with itemized employee wage statement provisions, violation of theunfair competition law, and breach of fiduciary duty.  Defendant RSI has filed a request for arbitration primarilyaddressing our alleged indemnification obligations to it and we havecounterclaimed stating that RSI is obligated to indemnify it.  We have engaged California counsel torepresent it in such proceedings; the time to file an Answer has been extendeduntil such time as the arbitration case has been decided.  The amount of Plaintiff’s claim against allDefendants is not yet reasonably determinable or quantifiable.

 

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InJuly 2003, we entered into an agreement to redeem all of the outstanding sharesof our Series A Preferred Stock.  Ourobligation to redeem the Series A shares is contingent upon us raising at least$4.0 million in a proposed “best efforts” public offering of securities.  The terms of the proposed redemptiontransaction are described in Part II – Item 5 of this report.

 

Asof June 30, 2003, there were no off-balance sheet arrangements, unconsolidatedsubsidiaries, commitments or guarantees of other parties, except as disclosedin the notes to financial statements. As of June 30, 2003, we have a stockholders’ equity (deficiency) of($141,455).

###### ** **

###### **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 Accounting Standards Board (“FASB”) issuedSFAS No. 142, “Goodwill and Other Intangible Assets”.  SFAS No. 142, which must be applied to fiscal years beginningafter December 15, 2001, modifies the accounting and reporting of goodwill andintangible assets.  The pronouncementrequires entities to discontinue the amortization of goodwill; reallocate allexisting goodwill among its reporting segments based on criteria set by SFASNo. 142, and perform initial impairment tests by applying a fair-value-basedanalysis on the goodwill in each reporting segment.  Any impairment at the initial adoption date shall be recognizedas the effect of a change 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 to determine the useful lifeof other intangible assets and amortize the value over the useful life.  If the useful life is determined to beindefinite, no amortization will be recorded. For intangible assets recognized prior to the adoption of SFAS No. 142,the useful life should be reassessed. Other intangible assets are required to be tested for impairment in amanner similar to goodwill.  We adoptedSFAS No. 142 and completed a transitional impairment test, as required by SFASNo. 142, and determined that there was no impairment of goodwill as of October1, 2002.

 

InAugust 2001, the FASB issued SFAS No. 144, “Impairment of Long-LivedAssets”.  SFAS No. 144 supercedes SFASNo. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed of”.  SFAS No. 144retains the requirements of SFAS No. 121 to (a) recognize an impairment loss only if the carrying amount of along-lived asset is not recoverable from its undiscounted cash flows and (b)measure an impairment loss as the difference between the carrying amount andthe fair value of the asset.  SFAS No.144 removes goodwill from its scope. SFAS No. 144 is applicable to financial statements issued for fiscalyears 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.

 

InJune 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated withExit or Disposal Activities” which nullifies EITF No. 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in a Restructuring)”.  SFAS 146 requires that a liability for acost associated with an exit or disposal activity be recognized when theliability is incurred.  Under EITF 94-3,a liability for an exit cost as defined in EITF 94-3 was recognized at the dateof an entity’s commitment to an exit plan. The provisions of SFAS 146 are effective for exit or disposal activitiesthat are initiated after December 31, 2002. The adoption of SFAS 146 may affect the timing of the recognition offuture exit and disposal costs.

 

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InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation of VariableInterest Entities.”  Interpretation 46changes the criteria by which one company includes another entity in itsconsolidated financial statements. Previously, the criteria were based on control through votinginterest.  Interpretation 46 requires avariable interest entity to be consolidated by a company if that company issubject to a majority of the risk of loss from the variable interest entity’sactivities or entitled to receive a majority of the entity’s residual returnsor both.  A company that consolidates avariable interest entity is called the primary beneficiary of that entity.  The consolidation requirements ofInterpretation 46 apply immediately to variable interest entities created afterJanuary 31, 2003.  The consolidationrequirements apply to older entities in the first fiscal year or interim periodbeginning after June 15, 2003.  Certainof the disclosure requirements apply in all financial statements issued afterJanuary 31, 2003, regardless of when the variable interest entity wasestablished.  The Company does notexpect the adoption to have a material impact to the Company’s financialposition or results of operations.

 

**Sensitive Accounting Estimates**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the financial statements and notes.  Significant estimates include management’sestimate of the carrying value of accounts receivable, the impairment of goodwilland the establishment of valuation reserves offsetting deferred taxassets.  Actual results could differfrom those estimates.  The Company’scritical accounting policies relating to these items are described in theCompany’s Annual Report on Form 10-K for the year ended September 30,2002.  As of June 30, 2003, there havebeen no material changes to any of the critical accounting policies containedtherein.

 

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

 

We are subject to the risk of fluctuating interest rates in the ordinarycourse of business for borrowings under our Loan and Security Agreement withCapital Tempfunds, Inc.  This creditagreement provides for a line of credit up to 85% of eligible accountsreceivable, not to exceed $12,000,000. Advances under this credit agreement bear interest at a rate of primeplus 3%.

 

We believe that our business operations are not exposed to market riskrelating to foreign currency exchange risk or commodity price risk.

 

**Item 4. – CONTROLSAND PROCEDURES**

 

As of the end of the period covered by this report, we carried out anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures.  Thisevaluation was carried out under the supervision and with the participation ofour management, including our Chairman and Chief Executive Officer along withour Chief Financial Officer, who concluded that our disclosure controls andprocedures were effective as of the date of the evaluation.  Their were no significant changes in ourinternal controls during the quarter ended June 30, 2003 that have materiallyaffected, or are reasonably likely to have materially affected, our internalcontrols subsequent to the date we carried out our  evaluation.

 

Disclosure controls and procedures are controls and other proceduresthat are designed to provide reasonable assurance that information required tobe disclosed in our reports filed or submitted under the Exchange Act isrecorded, processed, summarized and reported with the time periods specified inthe Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to provide reasonableassurance that information required to be disclosed in our reports filed underthe Exchange Act is accumulated and communicated to management, including ourChief Executive Officer and Chief Financial Officer as appropriate, to allowtimely decisions regarding required disclosure.

 

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**Part II – Other Information**

**Item 1 – Legal Proceedings**

 

In April 2003, we were served with aComplaint and were named as one of several Defendants in the matter of *Lopez v. RSI Home Products, Inc. et al.*(“RSI”), in the Superior Court of California, Orange County.  RSI was one of our customers.  They have since terminated ourcontract.  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, failure topay wages of terminated or resigned employees, knowing and intentional failureto comply with itemized employee wage statement provisions, violation of theunfair competition law, and breach of fiduciary duty.  Defendant RSI has filed a request for arbitration primarilyaddressing our alleged indemnification obligations to it and we havecounterclaimed stating that RSI is obligated to indemnify it.  We have engaged California counsel torepresent us in such proceedings; the time to file an Answer has been extendeduntil such time as the arbitration case has been decided.  The amount of Plaintiff’s claim against allDefendants is not yet reasonably determinable or quantifiable.

 

**Item 2 – Changes in Securities and Use ofProceeds**

 

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

### ** **

In July 2003, we sold an aggregate of $1,395,000 (14,362 shares) ofSeries E Preferred Stock in a private placement to 31 investors.  The issuances of the Series E PreferredStock were made in reliance upon the exemptions from registration provided byRule 506 and Section 4(2) of the Securities Act of 1933.  The proceeds from the offering will be usedby us for working capital purposes.

 

In July 2003, holders of Series E Preferred Stock converted 200 sharesinto 126,894 shares of common stock at a conversion price of $.1576.  Additionally, in July 2003, we entered intoan agreement with the holder of the Series H Preferred Stock pursuant to whichthe holder exchanged its remaining 5000 shares of Series H Preferred Stock, onwhich $8,750 of dividends had accrued, for 5,087 shares of Series E PreferredStock.  This exchange transaction wasconducted under Section 3(a)(9) of the Securities Act of 1933.

 

We did not receive any proceeds from such conversions or exchanges.

 

On July 30, 2003, we entered into an agreement (the “CompromiseAgreement”) with a holder of the Series E Preferred Stock, to compromisecertain disputed penalties arising out of our alleged failure to timely causethe suspension of the effectiveness of the Form S-1 Registration Statementthat we filed on behalf of the Series E holders to terminate at the earliestpossible date.  Pursuant to the terms ofthe Compromise Agreement, while we do not admit that we failed to fulfill ourcontractual obligations to the Series E holders, in the interest of amicablyresolving this matter, we agreed to issue an additional 4,477 shares of SeriesE Preferred Stock to the Series E holders.

 

**Item 3 – Defaults Upon SeniorSecurities**

 

Dividendson our Series A Preferred Stock accrue at a rate of 7% per annum and arepayable semi-annually when and if declared by our Board of Directors.  No such dividends have been declared and, asof the date of the filing of this report, $611,252 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, $32,420 is in arrears on the Series EPreferred Stock.

 

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

 

Therewere no matters submitted to a vote of our security holders during the threemonths ended June 30, 2003.

 

### **Item 5 – Other Information**

 

OnJuly 31, 2003, we entered into an agreement (the “Redemption Agreement”) withArtisan (UK) plc (“Artisan”), the sole beneficial shareholder of our issued andoutstanding Series A Preferred Stock (the “Series A Stock”) which requires usto redeem, subject to the terms and conditions of the Redemption Agreement, theSeries A Stock in the event that we raise at least $4.0 million in a proposed“best-efforts” public offering of securities (the “Offering”).  A copy of the Redemption Agreement is beingfiled as an Exhibit to this Form 10-Q.

 

Perthe terms of the Redemption Agreement, within fifteen days after we completethe sale of at least $4,000,000 of securities in the Offering (the “InitialClosing”) we will be required to pay to Artisan the lump sum of $500,000.  In addition, we will be obligated to payArtisan the sum of $250,000 by January 31, 2005, or, at our option, deliver toArtisan shares of our common stock with an aggregate value of $250,000, basedon the average of the closing bid prices for our common stock for the thirtyconsecutive trading days prior to January 31, 2005.

 

Nointerest will accrue on this obligation over such eighteen month period;however, in the event that we default on our obligations to pay such $250,000in cash or in stock, then Artisan shall be entitled to receive a cash paymentof $300,000, plus default interest, at a rate of 18% calculated on a dailybasis, from the date of the default until the default is cured.

 

Artisan,or its designee, will be entitled to receive within fifteen days of the InitialClosing a number of shares of common stock equal to 5.5% of the issued andoutstanding shares of our common stock, as of the date of the InitialClosing.  Additionally, upon finalcompletion of the Offering (the “Final Closing”), Artisan shall be entitled toreceive such number of shares of common stock, as will result in Artisanholding, as of the date of the Final Closing, a number of common shares equalto 5.5% of our common stock after giving effect to the assumed exercise of allwarrants and options that have exercise prices equal to or below the thencurrent market price of our common stock and the conversion of all convertiblesecurities that then have conversion prices equal to or below the then currentmarket price of our common stock.

 

Inconjunction with the proposed issuance of common stock, Artisan has agreed toexecute a lock-up agreement with us (the “Lock-Up Agreement”) with thefollowing terms:

 

(a)                                  Any common stock issued in connection withthe Redemption Agreement shall be subject to a lock-up for a period of fourteenmonths following issuance; however, Artisan will retain the voting rights tosame; and

 

(b)                                 Any common stock held by Artisan as of thedate of the signing of the Redemption Agreement, shall be subject to lock-upfor a period of 135 days from the completion of the Initial Closing.  Thereafter, assuming the completion of aproposed 1-for-4 reverse split of our common stock in connection with theOffering, Artisan shall be entitled to sell up to 25,000 shares of common stockper month until July 31, 2004, when there will be no further restriction onsales of our common stock by Artisan.

 

Thecompletion of the above transactions is contingent upon completion of theInitial Closing of the Offering.  Noassurance can be given that we will be able to sell any securities in theproposed Offering.  The informationprovided above with respect to the proposed Offering does not constitute anoffer to sell securities.  Any offer tosell securities will be made only by prospectus after we file a registrationstatement with the Securities and Exchange Commission.

 

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Ifwe do not deliver the $500,000 and 5.5% of our outstanding common stock toArtisan within fifteen days of the Initial Closing, or if the Initial Closingdoes not take place within nine months of the date of the Redemption Agreement,then Artisan will have the right to immediately terminate the RedemptionAgreement.

 

Atthe signing of the Redemption Agreement, we delivered into escrow all votingrights to the Series A Stock and the common stock held by Artisan as of thatdate.  After we pay Artisan the amountsowed to it in connection with our redemption of the Series A Preferred Stock,the proxy previously given by Artisan and its affiliates to Joseph J. Raymond,our Chairman and Chief Executive Officer, will terminate.

 

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

 

(a)                                                 Exhibits

 
| **Number** |   | **Description**                                                                                 |
|------------|--------|-------------------------------------------------------------------------------------------------|
|       |   |                                                                                            |
| 10.15      |   | Form of Securities Purchase Agreement between the Company and Series  E Shareholders            |
|       |   |                                                                                            |
| 10.16      |   | Compromise Agreement between the Company and Series E Shareholders  dated July 22, 2003         |
|       |   |                                                                                            |
| 10.17      |   | Redemption Agreement dated July 31, 2003 between Artisan (UK) plc and  the Company              |
|       |   |                                                                                            |
| 10.18      |   | Share Exchange Agreement                                                                        |
|       |   |                                                                                            |
| 31.1       |   | Certification of Chief Executive Officer pursuant to Section 302 of  Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                            |
| 31.2       |   | Certification of Chief Financial Officer pursuant to Section 302 of  Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                            |
| 32.1       |   | Certification of Chief Executive Officer pursuant to Section 906 of  Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                            |
| 32.2       |   | Certification of Chief Financial Officer pursuant to Section 906 of  Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                            |
| (b)        |   | Reports on Form 8-K                                                                             |
|       |   |                                                                                            |
|       |   | None                                                                                            |

 

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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:  August 13, 2003 |   | By:                          | /s/ Joseph J. Raymond |   |
|                        |   |                         | Joseph J. Raymond |
|                        |   |                         | Chairman of the Board of Directors, |
|                        |   |                         | President and Chief Executive Officer |
|                        |   |                         |   |
| Date:  August 13, 2003 |   | By:                          | /s/ Michael A. Maltzman |   |
|                        |   |                         | Michael A. Maltzman |
|                        |   |                         | Chief Financial Officer |
|                        |   |                         | (Principal Financial and Accounting Officer) |
|                             |        |                              |  |  |  |

 

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