**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

**(Mark One)**

 

| **ý**                                                                                                                                            |   | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------|
|                                                                                                                                                  |   |                                                                                   |
| **For the quarterly period ended March 31, 2004**                                                                                                     |
|                                                                                                                                                  |   |                                                                                   |
| **o**                                                                                                                                                 |   | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                   |
|                                                                                                                                                  |   |                                                                                   |
| **For the transition period from            to           ** |
|                                                                                                                                                  |   |                                                                                   |
| **Commission file number  001-15789**                                                                                                       |

 

**STRATUS SERVICES GROUP, INC.**

(Exactname of Registrant as specified in its charter)

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.  Yes ý              No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 120-b of theExchange Act).  Yes o              No ý

 

As of May 7, 2004, 24,648,576 shares of theRegistrant’s common stock were outstanding.

 

 

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**STRATUS SERVICESGROUP, INC.**

Condensed Consolidated Balance Sheets

 
|                                                                                                                                                                                                           |   | **March 31,  2004** |       | **September  30,  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|--------------------------|--------|
|                                                                                                                                                                                                           |   | **(Unaudited)**     |       |                     |   |
| Assets                                                                                                                                                                                                         |   |                |       |                     |   |
| Current assets                                                                                                                                                                                                 |   |                |       |                     |   |
| Cash                                                                                                                                                                                                           |   | $                   | 594,714    |                     | $      | 53,753 |   |
| Accounts receivable–less  allowance for doubtful accounts of $1,812,000 and $1,733,000                                                                                                                    |   | 11,572,741          |       | 12,833,749               |   |
| Unbilled receivables                                                                                                                                                                                           |   | 1,348,064           |       | 671,271                  |   |
| Notes receivable (current portion)                                                                                                                                                                             |   | 32,221              |       | 25,240                   |   |
| Prepaid insurance                                                                                                                                                                                              |   | 1,603,789           |       | 2,271,715                |   |
| Prepaid expenses and other current assets                                                                                                                                                                      |   | 195,616             |       | 277,262                  |   |
|                                                                                                                                                                                                           |   | 15,347,145          |       | 16,132,990               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Notes receivable (net of current portion)                                                                                                                                                                      |   | 82,649              |       | 95,166                   |   |
| Note receivable – related party                                                                                                                                                                           |   | 128,000             |       | 128,000                  |   |
| Property and equipment, net of accumulated  depreciation                                                                                                                                                       |   | 747,902             |       | 937,718                  |   |
| Intangible assets, net of accumulated  amortization                                                                                                                                                            |   | 1,277,921           |       | 1,501,509                |   |
| Goodwill                                                                                                                                                                                                       |   | 5,816,353           |       | 5,816,353                |   |
| Deferred registration costs                                                                                                                                                                                    |   | 571,001             |       | 374,365                  |   |
| Other assets                                                                                                                                                                                                   |   | 204,144             |       | 164,380                  |   |
|                                                                                                                                                                                                           |   | $                   | 24,175,115 |                     | $      | 25,150,551 |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Liabilities  and Stockholders’ Equity (Deficiency)                                                                                                                                                        |   |                |       |                     |   |
| Current liabilities                                                                                                                                                                                            |   |                |       |                     |   |
| Loans payable (current portion)                                                                                                                                                                                |   | $                   | 453,128    |                     | $      | 737,514 |   |
| Loans payable – related parties                                                                                                                                                                           |   | 457,337             |       | 503,377                  |   |
| Notes payable – acquisitions (current  portion)                                                                                                                                                           |   | 726,099             |       | 657,224                  |   |
| Line of credit                                                                                                                                                                                                 |   | 8,107,908           |       | 8,312,275                |   |
| Cash overdraft                                                                                                                                                                                                 |   | 16,181              |       | 699,057                  |   |
| Insurance obligation payable                                                                                                                                                                                   |   | 352                 |       | 97,506                   |   |
| Accounts payable and accrued expenses                                                                                                                                                                          |   | 5,250,049           |       | 4,787,404                |   |
| Accrued payroll and taxes                                                                                                                                                                                      |   | 3,082,554           |       | 2,473,596                |   |
| Payroll taxes payable                                                                                                                                                                                          |   | 5,160,509           |       | 5,021,411                |   |
| Put options liability                                                                                                                                                                                          |   | 823,000             |       | 823,000                  |   |
|                                                                                                                                                                                                           |   | 24,077,117          |       | 24,112,324               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Loans payable (net of current portion)                                                                                                                                                                         |   | 17,205              |       | 37,890                   |   |
| Notes payable – acquisitions (net of  current portion)                                                                                                                                                    |   | 1,729,979           |       | 2,065,280                |   |
| Convertible debt                                                                                                                                                                                               |   | 40,000              |       | 40,000                   |   |
| Series A voting redeemable convertible  preferred stock, $.01 par value, 1,458,933 shares issued and outstanding,  liquidation preference of $4,376,799 (including unpaid dividends of $804,940  and $671,752) |   | 4,073,600           |       | 3,809,752                |   |
|                                                                                                                                                                                                           |   | 29,937,901          |       | 30,065,216               |   |
| Commitments and contingencies                                                                                                                                                                                  |   |                |       |                     |   |
| Stockholders’ equity (deficiency)                                                                                                                                                                         |   |                |       |                     |   |
| Preferred stock, $.01 par value, 5,000,000  shares authorized                                                                                                                                                  |   |                |       |                     |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series E non-voting convertible preferred  stock, $.01 par value, 47,728 and 40,257 shares issued and outstanding,  liquidation preference of $4,722,920 (including unpaid dividends of $166,467  and $60,295) |   | 4,939,387           |       | 4,0180,130               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series F voting convertible preferred  stock, $.01 par value, 6,000 and 8,000 shares issued and outstanding,  liquidation preference of $600,000 (including unpaid dividends of $51,000 and  $28,000)          |   | 651,000             |       | 828,000                  |   |
| Common stock, $.01 par value, 100,000,000  shares authorized; 24,948,576 and 19,795,038 shares issued and outstanding                                                                                          |   | 249,486             |       | 197,950                  |   |
| Additional paid-in capital                                                                                                                                                                                     |   | 11,058,150          |       | 11,728,943               |   |
| Accumulated deficit                                                                                                                                                                                            |   | (22,660,809         | )          | (21,755,718              | )      |
| Total stockholders’ equity (deficiency)                                                                                                                                                                   |   | (5,762,786          | )          | (4,914,695               | )      |
|                                                                                                                                                                                                           |   | $                   | 24,175,115 |                     | $      | 25,150,551 |   |

 

See notes to condensedconsolidated financial statements

 

2

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**STRATUS SERVICESGROUP, INC.**

Condensed Consolidated Statements of Operations

(Unaudited)

 
|                                                                |   | **Three  Months Ended  March 31,** |       | **Six Months  Ended  March 31,** |   |
|---------------------------------------------------------------------|--------|------------------------------------|------------|----------------------------------|--------|
|                                                                |   | **2004**                           |       | **2003**                         |   | **2004** |   | **2003** |   |
|                                                                |   |                               |       | **(Restated)**                   |   |   |   | **(Restated)** |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Revenues                                                            |   | $                                  | 23,513,725 |                             | $      | 19,056,373 |   | $ | 47,399,789 |   | $ | 33,667,458 |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Cost of revenues                                                    |   | 20,740,440                         |       | 16,350,223                       |   | 41,094,382 |   | 28,474,494 |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Gross Profit                                                        |   | 2,773,285                          |       | 2,706,150                        |   | 6,305,407 |   | 5,192,964 |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Selling, general and administrative  expenses                       |   | 3,175,291                          |       | 3,267,045                        |   | 6,182,240 |   | 6,054,297 |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Other charges                                                       |   | —                             |       | 340,000                          |   | — |   | 340,000 |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Operating income (loss) from continuing  operations                 |   | (402,006                           | )          | (900,895                         | )      | 123,167 |   | (1,201,333 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Other income (expenses)                                             |   |                               |       |                             |   |   |   |   |   |
| Interest and financing costs                                        |   | (563,480                           | )          | (491,427                         | )      | (1,016,674 | ) | (928,490 | ) |
| Other income (expense)                                              |   | (21,148                            | )          | 22,653                           |   | (11,584 | ) | 28,940 |   |
|                                                                |   | (584,628                           | )          | (468,774                         | )      | (1,028,258 | ) | (899,550 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Loss from continuing operations                                     |   | (986,634                           | )          | (1,369,669                       | )      | (905,091 | ) | (2,100,883 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Discontinued operations – (loss) from  discontinued operations |   | —                             |       | (459,026                         | )      | — |   | (418,217 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Net (loss)                                                          |   | (986,634                           | )          | (1,828,695                       | )      | (905,091 | ) | (2,519,100 | ) |
| Dividends and accretion on preferred stock                          |   | (1,176,116                         | )          | (407,663                         | )      | (1,248,757 | ) | (773,757 | ) |
| Net (loss) attributable to common  stockholders                     |   | $                                  | (2,162,750 | )                                | $      | (2,236,358 | ) | $ | (2,153,848 | ) | $ | (3,292,857 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Net earnings (loss) per share attributable  to common stockholders  |   |                               |       |                             |   |   |   |   |   |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Basic:                                                              |   |                               |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                   |   | $                                  | (.09       | )                                | $      | (.10 | ) | $ | (.10 | ) | $ | (.18 | ) |
| (Loss) from discontinued operations                                 |   | —                             |       | (.03                             | )      | — |   | (.03 | ) |
| Net earnings (loss)                                                 |   | $                                  | (.09       | )                                | $      | (.13 | ) | $ | (.10 | ) | $ | (.21 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Diluted:                                                            |   |                               |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                   |   | $                                  | (.09       | )                                | $      | (.10 | ) | $ | (.10 | ) | $ | (.18 | ) |
| (Loss) from discontinued operations                                 |   | —                             |       | (.03                             | )      | — |   | (.03 | ) |
| Net earnings (loss)                                                 |   | $                                  | (.09       | )                                | $      | (.13 | ) | $ | (.10 | ) | $ | (.21 | ) |
|                                                                |   |                               |       |                             |   |   |   |   |   |
| Weighted average shares outstanding per  common share               |   |                               |       |                             |   |   |   |   |   |
| Basic                                                               |   | 24,127,607                         |       | 17,599,034                       |   | 22,600,135 |   | 15,950,320 |   |
| Diluted                                                             |   | 24,127,607                         |       | 17,599,034                       |   | 22,600,135 |   | 15,950,320 |   |

 

See notes to condensedconsolidated financial statements

 

3

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**STRATUS SERVICESGROUP, INC.**

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 
|                                                                                        |   | **Six Months  Ended  March 31,** |     |
|---------------------------------------------------------------------------------------------|--------|----------------------------------|----------|
|                                                                                        |   | **2004**                         |     | **2003** |   |
|                                                                                        |   |                             |     | **(Restated)** |   |
| Cash flows from operating activities                                                        |   |                             |     |   |   |
| Net (loss) from continuing operations                                                       |   | $                                | (905,091 | ) | $ | (2,100,883 | ) |
| Net (loss) from discontinued operations                                                     |   | —                           |     | (418,217 | ) |
| Adjustments to reconcile net (loss) to net  cash provided by (used in) operating activities |   |                             |     |   |   |
| Depreciation                                                                                |   | 207,334                          |     | 273,069 |   |
| Amortization                                                                                |   | 223,658                          |     | 181,057 |   |
| Provision for doubtful accounts                                                             |   | 75,000                           |     | 50,000 |   |
| Deferred financing costs amortization                                                       |   | 804                              |     | 804 |   |
| Accrued interest                                                                            |   | 135,091                          |     | (7,388 | ) |
| Imputed interest                                                                            |   | 42,122                           |     | 22,747 |   |
| Dividends and accretion on preferred stock                                                  |   | 263,848                          |     | — |   |
| Changes in operating assets and liabilities                                                 |   |                             |     |   |   |
| Accounts receivable                                                                         |   | 509,215                          |     | (3,939,546 | ) |
| Prepaid insurance                                                                           |   | 667,926                          |     | 234,585 |   |
| Prepaid expenses and other current assets                                                   |   | 81,646                           |     | 13,533 |   |
| Other assets                                                                                |   | (40,568                          | )        | (25,908 | ) |
| Insurance obligation payable                                                                |   | (97,154                          | )        | (128,075 | ) |
| Accrued payroll and taxes                                                                   |   | 608,958                          |     | 647,104 |   |
| Payroll taxes payable                                                                       |   | 139,098                          |     | 655,817 |   |
| Accounts payable and accrued expenses                                                       |   | 384,554                          |     | 1,645,892 |   |
| Total adjustments                                                                           |   | 3,201,532                        |     | (376,309 | ) |
|                                                                                        |   | 2,296,441                        |     | (2,895,409 | ) |
| Cash flows (used in) investing activities                                                   |   |                             |     |   |   |
| Purchase of property and equipment                                                          |   | (17,518                          | )        | (188,350 | ) |
| Collection of notes receivable                                                              |   | 5,536                            |     | — |   |
| Payments for business acquisitions                                                          |   | —                           |     | (61,644 | ) |
|                                                                                        |   | (11,982                          | )        | (249,994 | ) |
| Cash flows from (used in) financing  activities                                             |   |                             |     |   |   |
| Payment of registration costs                                                               |   | (196,636                         | )        | — |   |
| Proceeds from issuance of Preferred Stock                                                   |   | —                           |     | 186,400 |   |
| Proceeds from loans payable                                                                 |   | 12,337                           |     | 380,000 |   |
| Payments of loans payable                                                                   |   | (312,408                         | )        | (106,813 | ) |
| Proceeds from loans payable – related  parties                                         |   | —                           |     | 300,000 |   |
| Payments of loans payable – related parties                                            |   | (51,000                          | )        | (75,000 | ) |
| Payments of notes payable – acquisitions                                               |   | (308,548                         | )        | (352,489 | ) |
| Net (payments)/proceeds from line of credit                                                 |   | (204,367                         | )        | 2,619,991 |   |
| Cash overdraft                                                                              |   | (682,876                         | )        | 313,128 |   |
| Dividends paid                                                                              |   | —                           |     | (47,657 | ) |
|                                                                                        |   | (1,743,498                       | )        | 3,217,560 |   |
| Net change in cash and cash equivalents                                                     |   | 540,961                          |     | 72,157 |   |
| Cash and cash equivalents – beginning                                                  |   | 53,753                           |     | 162,646 |   |
| Cash and cash equivalents – ending                                                     |   | $                                | 594,714  |   | $ | 234,803 |   |

 

See notes to condensed consolidatedfinancial statements

 

4

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**STRATUS SERVICES GROUP, INC.**

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 
|                                                                            |   | **Six Months  Ended  March 31,** |      |
|---------------------------------------------------------------------------------|--------|----------------------------------|-----------|
|                                                                            |   | **2004**                         |      | **2003** |   |
|                                                                            |   |                             |      | **(Restated)** |   |
| Supplemental disclosure of cash paid                                            |   |                             |      |   |   |
| Interest                                                                        |   | $                                | 617,735   |   | $ | 1,047,762 |   |
| Schedule of noncash investing and financing  activities                         |   |                             |      |   |   |
| Fair value of assets acquired                                                   |   | $                                | —    |   | $ | 1,266,519 |   |
| Less: cash paid                                                                 |   | —                           |      | (176,644 | ) |
| Liabilities assumed                                                             |   | $                                | —    |   | $ | 1,089,875 |   |
|                                                                            |   |                             |      |   |   |
| Issuance of common stock upon conversion of  convertible preferred stock        |   | $                                | 572,500   |   | $ | 754,200 |   |
| Issuance of common stock in exchange for  accounts payable and accrued expenses |   | $                                | 57,000    |   | $ | 37,500 |   |
| Cumulative dividends and accretion on  preferred stock                          |   | $                                | 1,248,757 |   | $ | 493,100 |   |

 

See notes to condensedconsolidated financial statements

 

5

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**STRATUS SERVICES GROUP, INC.**

Notes to Condensed ConsolidatedFinancial Statements

(Unaudited)

 

### **NOTE1 – BASIS OF PRESENTATION**

### ** **

The accompanying condensed consolidated financialstatements have been prepared by the Company, without audit, pursuant to therules and regulations of the Securities and Exchange Commission.  Certain information and disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States have been condensed oromitted pursuant to such rules and regulations.  These condensed consolidated financial statements reflect all adjustments(consisting only of normal recurring adjustments) that, in the opinion ofmanagement, are necessary to present fairly the financial position, the resultsof operations and cash flows of the Company for the periods presented.  It is suggested that these condensedconsolidated financial statements be read in conjunction with the consolidatedfinancial statements and the notes thereto included in the Company’s AnnualReport on Form 10-K.

 

The results of operations for the interim periodspresented are not necessarily indicative of the results to be expected for thefull year.

 

The following summarizes revenues:

 
|       |   | **Three  Months Ended  March 31,** |       | **Six Months  Ended  March 31,** |   |
|------------|--------|------------------------------------|------------|----------------------------------|--------|
|       |   | **2004**                           |       | **2003**                         |   | **2004** |   | **2003** |   |
|       |   |                               |       | **(Restated)**                   |   |   |   | **(Restated)** |   |
|       |   |                               |       |                             |   |   |   |   |   |
| Staffing   |   | $                                  | 23,513,725 |                             | $      | 18,886,667 |   | $ | 47,361,255 |   | $ | 33,254,675 |   |
|       |   |                               |       |                             |   |   |   |   |   |
| Payrolling |   | —                             |       | 169,706                          |   | 38,534 |   | 412,783 |   |
|       |   | $                                  | 23,513,725 |                             | $      | 19,056,373 |   | $ | 47,399,789 |   | $ | 33,667,458 |   |

 

Unlike traditional staffingservices, under a payrolling arrangement, the Company’s customer recruits andidentifies individuals for the Company to hire to provide services to thecustomer.  The Company becomes thestatutory employer although the customer maintains substantially all controlover those employees.  Accordingly,Emerging Issues Task Force (“EITF”) 99-19, “Reporting Revenue Gross as aPrincipal versus Net as an Agent” requires that the Company does not reflectthe direct payroll costs paid to such employees in revenues and cost ofrevenue.

 

**NOTE 2 – NEW ACCOUNTINGPRONOUNCEMENTS**

** **

FASB Interpretation No. 46(“FIN 46”) – Consolidation of Variable Interest Entities was effective for allenterprises with variable interests in variable interest entities created afterJanuary 31, 2003.  FIN 46R, which wasrevised in December 2003, was effective for all entities to which theprovisions of FIN 46 were not applied as of December 24, 2003.  The Company adopted the provision of FIN 46Ras of March 31, 2004.  Under FIN 46R, ifan entity is determined to be a variable interest entity, it must beconsolidated by the enterprise that absorbs the majority of the entity’sexpected losses, receives a majority of the entity’s expected residual returns,or both.

 

As a result of adopting FIN46R, the Company has consolidated Stratus Technology Services, LLC (“STS”), ajoint venture in which the Company has a 50% interest (See Note 11).  The Company was deemed to be the primarybeneficiary of STS since a son of the Chief Executive Officer of the Companyhas a majority interest in the other 50% venturer.  STS provides information technology staffing services.  After elimination of inter-company balances,the only asset remaining of STS included in the Company’s consolidated balancesheet is employee advances of $7,447, which is included in “Other Assets”.

 

Prior to the adoption of FIN46R, the Company accounted for its investment in STS under the equity methodand accordingly, included its share of the earnings (loss) of STS in “Otherincome (expense)”.  Beginning with thethird quarter of fiscal 2004, STS will no longer be accounted for under theequity method, and its revenues and expenses will be included in the Company’sconsolidated statement of operations and will reflect the other venturer’sshare of earnings (loss) as a minority interest.

 

Creditors of STS have norecourse to the general credit of the Company.

 

6

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**NOTE 3 - LIQUIDITY**

 

At March 31, 2004, the Company had limited liquidresources.  Current liabilities were$24,077,117 and current assets were $15,347,145.  The difference of $8,729,972 is a working capital deficit, whichis primarily the result of losses incurred during the last four years.  Current liabilities include a cash overdraftof $16,181, 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 dependentupon the continued cooperation of its creditors, its ability to generatesufficient cash flow to meet its continuing obligations on a timely basis, tofund the operating and capital needs, and to obtain additional financing as maybe necessary.

 

Management of the Company has taken steps to reviseand reduce its operating requirements, which it believes will be sufficient toassure continued 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 ofequity or long-term debt financings. The Company also continues to negotiate payment plans and otheraccommodations with its creditors.

 

**NOTE 4 –EARNINGS/LOSS PER SHARE**

** **

Basic “Earnings Per Share” (“EPS”) excludes dilutionand is computed by dividing earnings available to common stockholders by theweighted-average number of common shares outstanding during the period.  Diluted EPS assumes conversion of dilutiveoptions and warrants, and the issuance of common stock for all otherpotentially dilutive equivalent shares outstanding.  There were no dilutive shares for the three and six months endedMarch 31, 2004 and 2003.

 

**NOTE 5 –INTANGIBLE ASSETS**

 

We completed our annual impairment review of goodwillduring the first quarter of fiscal 2004 and determined that no impairmentcharge was required.

 

As of March 31, 2004 and September 30, 2003,intangible assets consisted of the following:

 
|                           |   | **March 31,  2004** |      | **September  30, 2003** |   |
|--------------------------------|--------|---------------------|-----------|-------------------------|--------|
|                           |   |                |      |                    |   |
| Covenant-not-to-compete        |   | $                   | 230,480   |                    | $      | 230,480 |   |
| Customer list                  |   | 1,957,709           |      | 1,957,709               |   |
|                           |   | 2,188,189           |      | 2,188,189               |   |
|                           |   |                |      |                    |   |
| Less: accumulated amortization |   | (910,268            | )         | (686,610                | )      |
|                           |   | $                   | 1,277,921 |                    | $      | 1,501,579 |   |

 

Estimated amortization expense for each of the nextfive years is as follows:

 
| **For the  Twelve Months Ending March 31,** |   |    |    |
|---------------------------------------------|--------|---------|---------|
| 2005                                        |   | $       | 401,000 |   |
| 2006                                        |   | 206,000 |    |
| 2007                                        |   | 156,000 |    |
| 2008                                        |   | 156,000 |    |
| 2009                                        |   | 152,000 |    |
|                                             |        |         |         |  |

 

7

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### **NOTE6 – LINE OF CREDIT**

### ** **

The Company has a loan and security agreement (the“Loan Agreement”) with a lending institution whereby the Company can borrow upto 85% of eligible accounts receivable, as defined, not to exceed the lesser of$12 million or six times the Company’s tangible net worth (as defined).  Until April 10, 2003, borrowings under theLoan Agreement bore interest at

 

1 3/4% above the prime rate (see below) and arecollateralized by substantially all of the Company’s assets.  The Loan Agreement expires on June 12, 2005.

 

At March 31, 2004, the Company was in violation of thefollowing covenants under the Loan Agreement:

 

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

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

 

The Company has received a waiver from the lender onthe above.

 

Effective April 10, 2003, the Company entered into amodification of the Loan Agreement which provides that borrowings under theLoan Agreement bear interest at 3% above the prime rate.  The prime rate at March 31, 2004 was 4%.

 

**NOTE 7 –PREFERRED STOCK**

 

***a.******                                     ******SeriesA***

*** ***

The shares ofSeries A Preferred Stock have a stated value of $3.00 per share.  The difference between the carrying valueand redemption value of the Series A Preferred Stock was being accreted througha charge to additional paid-in-capital through September 30, 2003, since priorto September 30, 2003, the current value of the Series A Preferred Stock,including accrued dividends, had been included in stockholders’ equity.  Pursuant to SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity”, thecurrent value of the Series A Preferred Stock, including accrued dividends wasclassified as a liability at September 30, 2003.  Accordingly, subsequent to September 30, 2003, the differencebetween the carrying value and redemption value of the Series A Preferred Stockis being accreted through a charge to interest expense through the June 30,2008 redemption date.

 

The Series APreferred Stock entitles the holders thereof to cumulative dividends at $.21per share per year, payable semi-annually, commencing on December 31, 2001,when and if declared by the Board of Directors.  The shares of Series A Preferred Stock are convertible at theoption of the holder into shares of the Company’s Common Stock on a one-for-onebasis.  On June 30, 2008, the Companywill be required to redeem any shares of Series A Preferred Stock outstandingat a redemption price of $3.00 per share together with accrued and unpaiddividends, payable at the Company’s option, either in cash or in shares ofcommon stock.  For purposes ofdetermining the number of shares which the Company will be required to issue ifit chooses to pay the redemption price in shares of Common Stock, the CommonStock will have a value equal to the average closing price of the Common Stockduring the five trading days immediately preceding the date of redemption.

 

In July 2003, theCompany entered into an agreement with Artisan (UK) plc (“Artisan”) pursuant to which the Company has agreed to redeemthe aggregate 1,458,933 shares of its Series A Preferred Stock owned byArtisan.com and Cater Barnard (USA) plc, an affiliate of Artisan.  These shares represent all of the shares ofSeries A Preferred Stock currently outstanding.  The agreement, as amended in March 2004, provides that theCompany’s obligation to redeem the Series A Preferred Stock is contingent uponthe Company’s sale of not less than $1,000,000 of units consisting of one shareof common stock and one common stock warrant (“Units”) in a proposed“best-efforts” public offering of securities (the “Offering”).  If the Company sells at least $1,000,000 ofUnits in the Offering, it will be obligated to pay $500,000 to Artisan within 7days after the $1,000,000 of Units are sold. In addition, the Company will be obligated to pay Artisan an additional$250,000 by January 31, 2005 or, at the Company’s option, issue to Artisanshares of the Company’s common stock having an aggregate market value of$250,000, based upon the average closing bid prices of the common stock for the30 trading days preceding January 31, 2005. If the Company fails to make the $250,000 payment in cash or stock, itwill be required to pay Artisan $300,000 in cash, plus interest calculated on adaily basis at a rate of 18% a year from the date of the default to the datethe default is cured.  The Company hasalso agreed to issue to Artisan 1,750,000 shares of the Company’s common stockwithin 7 days of the initial closing of the Offering.

 

8

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

*** ***

The shares of Series E Preferred Stock have a stated value of $100 pershare.  The holders of the Series EPreferred stock are entitled to cumulative dividends at a rate of 6% of thestated value per year, payable every 120 days, in preference and priority toany payment of any dividend on the Company’s Common Stock.  Dividends may be paid, at the Company’soption, either in cash or in shares of Common Stock, valued at the Series EConversion 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 convertible into Common Stock at aconversion price equal to 75% of the average of the closing bid prices, for thefive trading days preceding the conversion date, for the Common Stock.  The number of shares issuable uponconversion is determined by multiplying the number of shares of Series EPreferred Stock to be converted by $100, and dividing the result by the SeriesE Conversion Price then in effect.

 

Holders of Series E Preferred Stock do not have any voting rights, exceptas required by law.

 

The Company may redeem the shares of the Series E Preferred Stock at anytime prior to conversion, at a redemption price of 115% of the purchase pricepaid for the Series E Preferred Shares, plus any accrued but unpaid dividends.

 

The discount arising from the beneficial conversion feature was treatedas a dividend from the date of issuance to the earliest conversion date.

 

During the six months ended March 31, 2004, holders of Series E PreferredStock converted 3,725 shares into 2,853,538 shares of common stock atconversion prices between $.116 and $.1575 . During the six months ended March 31, 2003, holders of Series EPreferred Stock converted 5,637 shares into 4,718,911 shares of Common Stock atconversion prices between $.108 and $.186.

 

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

*** ***

In July 2002, the Company’s Chief Executive Officer (the “CEO”) invested$1,000,000 in the Company in exchange for 10,000 shares of newly created SeriesF Convertible Preferred Stock (the “Series F Preferred Stock”), which has astated value of $100 per share.

 

The holder of the Series F Preferred Stock is entitled to receive, fromassets legally available therefore, cumulative dividends at a rate of 7% peryear, accrued daily, payable monthly, in preference and priority to any paymentof any dividend on the Common Stock and on the Series F Preferred Stock.  Dividends may be paid, at the Company’soption, either in cash or in shares of Common Stock, valued at the Series FConversion Price (as defined below). Holders of Series F Preferred Stock are entitled to a liquidationpreference of $100 per share, plus accrued and unpaid dividends.

 

The Series F Preferred Stock is convertible into Common Stock at aconversion price (the “Series F Conversion Price”) equal to $.10 pershare.  The number of shares issuableupon conversion 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, holders of Series F Preferred Stockand holders of Common Stock shall vote together as a single class on eachmatter submitted to a vote of stockholders. Each outstanding share of Series F Preferred Stock shall be entitled tothe number of votes equal to the number of full shares of Common Stock intowhich each such share of Series F Preferred Stock is then convertible on the datefor determination of stockholders entitled to vote at the meeting.  Holders of the Series F Preferred Stock areentitled to vote at the meeting. Holders of the Series F Preferred Stock are entitled to vote as aseparate class on any proposed amendment to the terms of the Series F PreferredStock which would increase or decrease the number of authorized shares ofSeries F Preferred Stock or have an adverse impact on the Series F PreferredStock and on any proposal to create a new class of shares having rights orpreferences equal to or having priority to the Series F Preferred Stock.

 

9

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The Company may redeem the shares of the Series F Preferred Stock at anytime prior to conversion at a redemption price of 115% of the purchase pricepaid for the Series F Preferred Shares plus any accrued but unpaid dividends.

 

During the six months ended March 31, 2004, the Company’s CEO converted2,000 shares of the Series F Preferred Stock into 2,000,000 shares of commonstock.  During the six months endedMarch 31, 2003, the Company’s CEO converted 2,000 shares of the Series FPreferred Stock into 2,000,000 shares of common stock.

 

**NOTE 8 –STOCK – BASED COMPENSATION**

** **

The Company accounts for its stock-basedcompensation plans using the intrinsic value method in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees”.  Accordingly, no stock-basedemployee compensation cost has been recognized in the financial statements as alloptions granted under the Company’s stock option plan, had an exercise price atleast equal to the market value of the underlying common stock on the date ofgrant.  The pro forma information belowis based on provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation”, as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure”, issued in December 2002.

 
|                                                                                                                                  |   | **Three  Months Ended  March 31,** |       | **Six Months  Ended  March 31,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|------------|----------------------------------|--------|
|                                                                                                                                  |   | **2004**                           |       | **2003**                         |   | **2004** |   | **2003** |   |
|                                                                                                                                  |   |                               |       | **(Restated)**                   |   |   |   | **(Restated)** |   |
| Net (loss) from continuing operations  attributable to common stockholders, as reported                                               |   | $                                  | (2,162,750 | )                                | $      | (1,777,332 | ) | $ | (2,153,848 | ) | $ | (2,874,640 | ) |
|                                                                                                                                  |   |                               |       |                             |   |   |   |   |   |
| Deduct:                                                                                                                               |   |                               |       |                             |   |   |   |   |   |
| Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |   | (208,700                           | )          | (827,908                         | )      | (417,400 | ) | (1,419,238 | ) |
|                                                                                                                                  |   |                               |       |                             |   |   |   |   |   |
| Proforma net (loss) from continuing  operations attributable to common stockholders                                                   |   | $                                  | (2,371,450 | )                                | $      | (2,605,240 | ) | $ | (2,571,248 | ) | $ | (4,293,878 | ) |
|                                                                                                                                  |   |                               |       |                             |   |   |   |   |   |
| Earnings(loss) from continuing operations  per common share attributable to common stockholders:                                      |   |                               |       |                             |   |   |   |   |   |
| Basic – as reported                                                                                                              |   | $                                  | (.09       | )                                | $      | (.10 | ) | $ | (.10 | ) | $ | (.18 | ) |
| Basic – pro forma                                                                                                                |   | $                                  | (.10       | )                                | $      | (.15 | ) | $ | (.11 | ) | $ | (.27 | ) |
|                                                                                                                                  |   |                               |       |                             |   |   |   |   |   |
| Diluted – as reported                                                                                                            |   | $                                  | (.09       | )                                | $      | (.10 | ) | $ | (.10 | ) | $ | (.18 | ) |
| Diluted – pro forma                                                                                                              |   | $                                  | (.10       | )                                | $      | (.15 | ) | $ | (.11 | ) | $ | (.27 | ) |

 

### **NOTE9 – ACQUISITION**

### ** **

Effective as of December 1, 2002, (the“Effective Date”), the Company purchased substantially all of the tangible andintangible assets, excluding accounts receivable, of six offices of ElitePersonnel Services (“Elite”), a California corporation.  The Elite branches provide temporary lightindustrial and clerical staffing in six business locations in California andNevada.  The Company also took overElite’s Downey, California office, from which Elite serviced no accounts butwhich it utilized as a corporate office. The Company intends to continue to utilize the Downey office as aregional corporate facility.  Theacquisition of Elite furthers the Company’s expansion into the Californiastaffing market.  Pursuant to the termsof an Asset Purchase Agreement between the Company and Elite dated November 19,2002 (the “Asset Purchase Agreement”), the purchase price payable at closing(the “Base Purchase Price”) for the assets was

 

10

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$1,264,000, all of which was represented byan unsecured promissory note.  Inaddition to the Base Purchase Price, Elite will also receive as a deferredpurchase price, an amount equal to 10% of the annual “Gross Profits” as definedin the Asset 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 period of two years from the Effective Date.  In connection with the transaction, Elite,its President and other key management members entered into non-competition andnon-solicitation agreements pursuant to which they agreed not to compete withthe Company in the territories of the acquired business for periods rangingfrom twelve months to five years, and to not solicit the employees or customersof the acquired business for periods ranging from twelve months to five years.

 

For financial accounting purposes, intereston the note has been imputed at a rate of 11% per year.  Accordingly, the note and Base PurchasePrice has been recorded at $845,875.  Inaccordance with SFAS No. 141, “Business Combinations” the contingent portion ofthe purchase price has been recognized as a liability to the extent that thenet acquired assets exceed the purchase price. Accordingly, $244,000 is included in “Accounts payable and accrued expenses”on the attached balance sheets as of March 31, 2004 and September 30,2003.  There was an additional $176,644of costs paid to third parties in connection with the acquisition.

 

The following summarizes the fair value ofthe assets acquired at the date of acquisition based upon a third-partyvaluation 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 |   |

 

The covenant-not-to-compete and customer listare being amortized over their estimated useful life of five and seven years,respectively.

 

### **Theunaudited pro forma results of operations for the six months ended March 31,2003 presented below assume that the acquisition had occurred at the beginningof fiscal 2003.  This information ispresented for informational purposes only and includes certain adjustments suchas amortization of intangibles resulting from the acquisitions and interestexpense related to acquisition debt.**

### ** **

| Revenues                                                                   |   | $          | 39,245,458 |   |
|----------------------------------------------------------------------------|--------|------------|------------|--------|
| Net (loss) from continuing operations  attributable to common stockholders |   | (2,814,666 | )          |
|                                                                       |   |       |       |
| Net (loss) per share attributable to common  stockholders                  |   |       |       |
| Basic                                                                      |   | $          | (.18       | )      |
| Diluted                                                                    |   | $          | (.18       | )      |

### ** **

### **NOTE 10 – DISCONTINUEDOPERATIONS**

### ** **

### ***Sale of Certain Branches***

### *** ***

On March 9, 2003, theCompany completed the sale of substantially all of the tangible and intangibleassets, excluding accounts receivable, of its Colorado Springs, Coloradooffice.  Pursuant to the terms of anasset purchase agreement between the Company and US Temp Services, Inc. (“USTemps”) dated March 9, 2003, the purchase price for the purchased assets was$20,000 which was paid by a promissory note, which bears interest at the rateof 6% per year and is payable in monthly installments of $608 over a three yearperiod.  The note is secured by asecurity interest on all of the purchased assets.

 

The purchase price for the assets acquired byUS Temps was arrived at through negotiations between the parties and resultedin a gain on sale of $13,958.

 

On August 22, 2003, the Company completed thesale, effective as of August 18, 2003 (the “ALS Effective Date”) ofsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of its Miami Springs, Florida office.  Pursuant to the terms of the Asset Purchase Agreement between theCompany and ALS, LLC, a Florida limited liability company (“ALS”) dated August22, 2003 (the “Purchase Agreement”), the purchase price for the purchasedassets was $128,000, which was paid by a promissory note, which bears interestat the rate of 7% per year with payments over a 60

 

11

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month period.  The amount of the monthly payments due under the note is greaterof $10 per month or 20% of the monthly net profits generated by the staffing businessoriginating from the purchased assets. However, until such time as all outstanding amounts due and owing by theCompany to ALS, as of the date of the Purchase Agreement in the amount of$289,635, ($150,000 at March 31, 2004), have been paid in full, these monthlypayments shall be deducted from any and all amounts due from the Company to ALS(see Note 11).  The note is securedby a security interest in all of the purchased assets.

 

In connection with the transaction, ALSentered into a non-compete and non-solicitation agreement pursuant to which ALSagreed not to compete with the Company with respect to any of the Company’sother remaining offices for a period of 18 months.

 

The purchase price for the assets acquired byALS was arrived at through negotiations with a related party purchaser andresulted in a gain on sale of $10,777. The son of the Company’s President and Chief Executive Officer is a 50%member in ALS, LLC.

 

On September 10, 2003, the Company completedthe sale, effective as of September 15, 2003 (the “Effective Date”), ofsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of five of its New Jersey offices to D/O Staffing LLC (“D/O”).  The offices sold are the following:  Elizabeth, New Brunswick, Paterson, PerthAmboy, and Trenton, New Jersey. Pursuant to the terms of an asset purchase agreement between D/O and theCompany dated September 10, 2003 (the D/O Purchase Agreement”), the basepurchase price for the purchased assets was $1,250,000 payable as follows:

 

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

 

(ii)           $100,000 payable in certified funds into escrow at the closing to beheld in escrow by attorneys for the Buyer pursuant to the terms of an escrowagreement, to account for certain post-closing adjustments.

 

Additionally, the Company may be entitled toreceive as a deferred purchase price (the “Bonus”), an amount equal to$125,000, if, for the one year period measured from the Effective Date, thepurchased assets generate for D/O at least $18,000,000 in actual billings byclient accounts serviced by the Company as of the Closing and transferred bythe Company to D/O pursuant to the D/O Purchase Agreement.  The Bonus, if any, is payable by apromissory note, payable over 24 months and bearing interest at an interestrate of 6% a year.

 

The purchase price for the assets was arrivedat through negotiations between the parties and resulted in a (loss) on sale of$(50,354).

 

On September 29, 2003, the Company completedthe sale of substantially all of the tangible and intangible assets, excludingaccounts receivable, of its Las Vegas, Nevada office.  Pursuant to the terms of an asset purchase agreement between theCompany and US Temps dated September 29, 2003, the purchase price for thepurchased assets was $105,000, all of which was paid by a promissory note,which bears interest at the rate of 6% per year and is payable in monthlyinstallments of $2,030, over a five year period.  The note is secured by a security interest on al of the purchasedassets.

 

The purchase price for the assets acquired byUS Temps was arrived at through negotiations between the parties and resultedin a gain on sale of $4,599.

 

Revenues from the aforementioned certainbranches were $4,822,397 and $10,236,332 for the three and six months endedMarch 31, 2003, respectively.

 

The statement of operations for the three andsix months ended March 31, 2003, has been reclassified to reflect the operatingresults of the sold branches as discontinued operations.

 

### **NOTE 11 - RELATED PARTYTRANSACTIONS**

### ** **

***ConsultingAgreement***

*** ***

The son of the ChiefExecutive Officer of the Company (the (“CEO”) provides consulting services tothe Company.  Consulting expense was$16,200 and $30,100 for the six months ended March 31, 2004 and 2003,respectively.

 

12

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The Company has paid consulting fees to anentity whose stockholder is another son of the CEO of the Company.  Consulting fees amounted to $14,000 and$50,000 for the six months ended March 31, 2004 and 2003, respectively.

 

***Joint Venture***

*** ***

The Company providesinformation technology staffing services through a joint venture, StratusTechnology Services, LLC (“STS”), in which the Company has a 50% interest.  A son of the CEO of the Company has amajority interest in the other 50% venturer. The Company’s income (loss) from operations of STS of $(19,280) and$28,136 for the six months ended March 31, 2004 and 2003, respectively, and$(24,575) and $22,346 for the three months ended March 31, 2004 and 2003,respectively, is included in other income (expense) in the statements ofoperations.

 

Effective March 31, 2004, the Company adoptedthe provisions of FIN 46R as it relates to STS (See Note 2).

 

***Note Receivable***

 

The $128,000 “Note Receivable – relatedparty” as of March 31, 2004, is the amount due from ALS in connection with thesale of the Company’s Miami Springs, Florida office (see Note 10).  ALS is the holding company for AdvantageServices Group, LLC (“Advantage”).

 

***Cost of Revenues***

 

### **InNovember 2003, the Company entered into agreements with Advantage, wherebyAdvantage is to provide payrolling services with respect to four of theCompany’s accounts, at Advantage’s cost plus a fee ranging between 2% to 3%.  The Company has pledged the four accounts assecurity for its obligation under these agreements.  In addition, if the aggregate payroll of employees provided underthese agreements does not equal at least $8 million by November 30, 2004, theCompany will be required to pay Advantage an amount equal to 8% of theshortfall.  Costs incurred under theagreements and a previous agreement was $3,871,593 and $1,210,232 in the sixmonths ended March 31, 2004 and 2003, respectively.**

### ** **

In addition to theforegoing, in November 2003, the Company agreed to pay Advantage $5,000 perweek until $225,000 owed to Advantage in connection with the previous agreementfor payrolling services has been paid. As of March 31, 2004, $75,000 has been paid under this agreement.  The obligation to pay this amount is securedby a warrant to purchase 2,000,000 shares of the Company’s common stock.  The warrant, which is exercisable only ifthe Company defaults on its payment obligations to Advantage, has an exerciseprice equal to the lower of $.15 per share or 75% of the then current marketprice of the common stock.

 

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**Item 2 -****MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION****ANDRESULTS OF OPERATIONS**

### ** **

This Form 10-Q contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933, asamended and Section 21E of the Securities Exchange Act of 1934, asamended.  These statements relate tofuture economic performance, plans and objectives of management for futureoperations and projections of revenue and other financial items that are basedon the beliefs of our management, as well as assumptions made by, andinformation currently available to, our management.  The words “expect”, “estimate”, “anticipate”, “believe”,“intend”, and similar expressions are intended to identify forward-lookingstatements.  Such statements involveassumptions, uncertainties and risks. If one or more of these risks or uncertainties materialize or underlyingassumptions prove incorrect, actual outcomes may vary materially from thoseanticipated, estimated or expected. Among the key factors that may have a direct bearing on our expectedoperating results, performance or financial condition are economic conditionsfacing the staffing industry generally; uncertainties related to the job marketand our ability to attract qualified candidates; uncertainties associated withour brief operating history; our ability to raise additional capital; 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; the continued cooperation of our creditors; our ability todevelop new services; our ability to cross-sell our services to existingclients; our ability to enhance and expand existing offices; our ability toopen new offices; general economic conditions; and other factors discussed fromtime to time in our filings with the Securities and Exchange Commission.  These factors are not intended to representa complete list of all risks and uncertainties inherent in our business.  The following discussion and analysis shouldbe read in conjunction with the Condensed Financial Statements and notesappearing elsewhere in this report.

 

Our critical accounting policies andestimates are described in our Annual Report on Form 10-K for the fiscal yearended September 30, 2003.

 

### **Introduction**

### ** **

We provide a wide range of staffing andproductivity consulting 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.  Therefore we do not separateour various service offerings into separate offering segments.  We do not routinely provide discretefinancial information about any particular service offering to assess itsperformance.  As set forth below,certain of our service offerings target specific markets, but we do notnecessarily conduct separate marketing campaigns for such services.  We are responsible for workers’ compensation,unemployment compensation insurance, Medicare and Social Security taxes andother general payroll related expenses for all of the temporary employees weplace.  These expenses are included inthe cost of revenue.  Because we pay ourtemporary employees only for the hours they actually work, wages for ourtemporary personnel are a variable cost that increases or decreases inproportion to revenues.  Gross profitmargin varies depending on the type of services offered.  In some instances, temporary employeesplaced by us may decide to accept an offer of permanent employment from thecustomer 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 ofOperations**

**DiscontinuedOperations/Acquisition or Disposition of Assets**

 

Effective December 1, 2002, we purchasedsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of six offices of Elite Personnel Services, Inc.  Pursuant to a Asset Purchase Agreement datedNovember 19, 2002, between us and Elite (the “Elite Purchase Agreement”), thepurchase price paid at closing (the “Base Purchase Price”) was $1,264,000, allof which was represented by a promissory note (the “Note”) payable over eightyears, in equal monthly installments. Imputed interest at the rate of 4% per year is included in the Noteamount.  Accordingly, the net BasePurchase Price was $1,083,813.

 

In addition to the Base Purchase Price, Elitemay also receive as deferred purchase price an amount equal to 10% of “GrossProfits” as defined in the Elite Purchase Agreement, of the acquired businessbetween $2,500,000 and $3,200,000 per year, plus 15% of Gross Profits of theacquired business in excess of $3,200,000 per year, for a minimum of one yearfrom the effective date of the transaction, and for a period of two years fromthe effective date if Gross Profits for the first year reach specified levels.

 

On September 29, 2003, we completed the saleof substantially all of the tangible and intangible assets, excluding accountsreceivable, of our Las Vegas, Nevada office. Pursuant to the terms of an Asset Purchase Agreement between us and USTemp Services, Inc. (“US Temps”) dated September 29, 2003, the purchase pricefor the purchased assets was $105,000, all of which was paid by means of apromissory note, which bears interest at the rate of 6% per year and is payablein monthly installments of $2,030, over a 5 year period.  The note is secured by a security intereston all of the purchased assets.  Thepurchase price for the assets acquired by US Temps was arrived at througharms-length negotiations between the parties.

 

On September 10, 2003, we completed the sale,effective as of September 15, 2003 (the “Effective Date”), of substantially allof the tangible and intangible assets, excluding accounts receivable, of fiveof our New Jersey offices to D/O Staffing LLC (“D/O”).  The offices sold are the following:  Elizabeth, New Brunswick, Paterson, PerthAmboy, and Trenton, New Jersey. Pursuant to the terms of an asset purchase agreement between D/O and usdated September 10, 2003 (the “D/O Purchase Agreement”), the base purchaseprice for the purchased assets was $1,250,000, payable as follows:

 

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

 

(ii)           $100,000 payable in certified funds into escrow at the closing to beheld in escrow by attorneys for the Buyer pursuant to the terms of an escrowagreement, to account for certain post-closing adjustments.

 

Additionally, we may beentitled to receive as a deferred purchase price (the “Bonus”), an amount equalto $125,000 if, for the one year period measured from the Effective Date, thepurchased assets generate for D/O at least $18,000,000 in actual billings byclient accounts serviced by us as of the closing and transferred by us to D/Opursuant to the D/O Purchase Agreement. The Bonus, if any, is payable by way of a promissory note, payable overa 24 month period and bearing interest at an interest rate of 6% per year.

 

The purchase price for the assets was arrivedat through arms-length negotiations between the parties.

 

On August 22, 2003, we completed the sale,effective as of August 18, 2003 (the “ALS Effective Date”) of substantially allof the tangible and intangible assets, excluding accounts receivable, of ourMiami Springs, Florida office.  Pursuantto the terms of the Asset Purchase Agreement between us and ALS, LLC, a Floridalimited liability company (“ALS”) dated August 22, 2003 (the “PurchaseAgreement”), the purchase price for the purchased assets was $128,000, all ofwhich was paid by means of a promissory note, which bears interest at the rateof 7% per annum, with payments over a 60 month period.  The amount of the monthly payments due underthe note will be the greater of $10 per month or 20% of the monthly net profitsgenerated by the staffing business originating from the purchased assets,commencing October 31, 2003.  However,until such time as all outstanding receivables due and owing by us to ALS, asof the date of the Purchase Agreement in the amount of $289,635, have been paidin full, these monthly payments shall be deducted from any and all amounts duefrom us to ALS.  The note is secured bya security interest in all of the purchased assets.

 

The purchase price for the assets acquired byALS was arrived at through negotiations with a related party purchaser.  The son of our President and Chief ExecutiveOfficer is a 50% member in ALS, LLC.  Webelieve that the terms of the transaction are comparable to those which wouldhave been obtained in a transaction with an unrelated party.  Proceeds from the Note will be used to paydown existing debt and for working capital purposes.

 

On March 9, 2003, we completed the sale ofsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of our Colorado Springs, Colorado office.  Pursuant to the terms of an asset purchase agreement between usand US Temps dated March 9, 2003, the purchase price for the purchased assetswas $20,000, all of which was paid by means

 

15

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of a promissory note, which bears interest atthe rate of 6% per year and is payable in monthly installments of $608, over athree year period.  The note is securedby a security interest on all of the purchased assets.

 

**ContinuingOperations**

**ThreeMonths Ended March 31, 2004 Compared to Three Months Ended March 31, 2003**

** **

***Revenues.***  Revenues increased 23.4% to $23,513,795 forthe three months ended March 31, 2004 from $19,056,373 for the three monthsended March 31, 2003.  This increase wasa result of an increase in billable hours.

 

***Gross Profit.***  Gross profit increased 2.5% to$2,773,285 for the three months ended March 31, 2004 from $2,706,150 for thethree months ended March 31, 2003, primarily as a result of increasedrevenues.  Gross profit as a percentageof revenues decreased to 11.8% for the three months ended March 31, 2004 from14.2% for the three months ended March 31, 2003.  This decrease was a result of increases in the cost of workers’compensation insurance and state unemployment taxes.

 

***Selling, General and Administrative Expenses.**** *Selling,general and administrative expenses decreased 2.8% to $3,175,291 for the threemonths ended March 31, 2004 from $3,267,045 for the three months ended March31, 2003.  Selling, general andadministrative expenses as a percentage of revenues decreased to 13.5% for thethree months ended March 31, 2004 from 17.1% for the three months ended March31, 2003.  The decrease is attributableto significant cost reductions implemented by us and the increase in revenueswith no proportionate increase in selling, general and administrative expenses.

 

***Interest and Financing Costs.*** Interest and financing costs increased 14.7% to $563,480 for the threemonths ended March 31, 2004 from**$491,427for the three months ended March 31, 2003. Interest and financing costs as a percentage of revenues decreased to2.4% for the three months ended March 31, 2004 from 2.6% for the three monthsended March 31, 2003.  Prior toSeptember 30, 2003, the current value of our Series A Preferred Stock had beenincluded in stockholders’ equity.  Inaccordance with Statement of Financial Accounting Standards No. 150,“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity”, the current value of our Series A Preferred Stock wasreclassified as a liability. Accordingly, $132,254 of dividends and accretion relating to the SeriesA Preferred Stock is included in interest and financing costs in the threemonths ended March 31, 2004.  Excludingthis amount, interest and financing costs decreased 12.3% from the three monthsended March 31, 2003.

 

***Net Earnings (Loss) Attributable to Common Stockholders.**** *As a result ofthe foregoing, we had net (loss) and net (loss) attributable to commonstockholders of $(986,634) and $(2,162,750), respectively, for the three monthsended March 31, 2004 compared to a net (loss) and net (loss) attributable tocommon stockholders of $(1,828,695) and $(2,236,538) for the three months endedMarch 31, 2003, respectively.

 

##### **Continuing Operations**

##### **Six Months Ended March 31, 2004 Compared to SixMonths Ended March 31, 2003**

##### ** **

***Revenues.*** Revenues increased 40.8% to $47,399,789 for the six months ended March 31,2004 from $33,667,458 for the six months ended March 31, 2003.  Approximately $5.0 million of the increasewas attributable to the acquisition in December 2002.  Excluding acquisitions, revenues increased 26.0%.  This increase was the result of an increasein billable hours.

 

***Gross Profit.*** Gross profit increased 21.4% to $6,305,407 for the six months endedMarch 31, 2004 from $5,192,964 for the six months ended March 31, 2003,primarily as a result of increased revenues. Gross profit as a percentage of revenues decreased to 13.3% for the sixmonths ended March 31, 2004 from 15.4% for the six months ended March 31,2003.  This decrease was a result ofincreases in the cost of workers’ compensation insurance and state unemploymenttaxes.

 

***Selling, Generaland Administrative Expenses.***  Selling, general andadministrative expenses increased 2.1% to $6,182,240 for the six months endedMarch 31, 2004 from $6,054,297 for the six months ended March 31, 2003.  Selling, general and administrative expensesas a percentage of revenues decreased to 13.0% for the six months ended March31, 2004 from 18.0% for the six months ended March 31, 2003.  The decrease is attributable to significantcost reductions implemented by us and the increase in revenues with no proportionateincrease in selling, general and administrative expenses.

 

***Other Charges.*** During the period May 1, 2001 through May 20, 2002, we maintainedworkers’ compensation insurance with an insurance company, with a deductible of$150,000 per incident.  We hadestablished reserves based upon our evaluation of the status of claims stillopen in conjunction with claims reserve information provided to us by theinsurance company.  We believe that theinsurance company has paid and reserved claims in excess of what should havebeen paid or reserved.  Although webelieve we can recover some of the amounts already paid, this can only bepursued through

 

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litigation against the insurancecompany.  Since there is no assurance wewill prevail, we recorded $340,000 of additional payments made and reserves inthe six months ended March 31, 2003.

 

***Interest andFinancing Costs.***  Interest and financing costs increased 9.5%to $1,016,674 for the six months ended March 31, 2004 from $928,490 for the sixmonths ended March 31, 2003.  Prior toSeptember 30, 2003, the current value of our Series A Preferred Stock had beenincluded in stockholders’ equity.  Inaccordance with Statement of Financial Accounting Standards No. 150, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”, the current value of our Series A Preferred Stock was reclassified asa liability.  Accordingly, $263,848 ofdividends and accretion relating to the Series A Preferred stock is included ininterest and financing costs in the six months ended March 31, 2004.  Excluding this amount, interest andfinancing costs decreased 18.9% from the six months ended March 31, 2003.

 

***Net LossAttributable to Common Stockholders.***  As aresult of the foregoing, we had a net (loss) and net (loss) attributable tocommon stockholders of $(905,091) and $(2,153,848), respectively for the sixmonths ended March 31, 2004, compared to a net (loss) and net (loss)attributable to common stockholders of $(2,519,000) and $(3,292,857) for thesix months ended March 31, 2003, respectively. 

 

**Liquidityand Capital Resources**

** **

At March 31, 2004, we had limited liquidresources.  Current liabilities were$24,077,117 and current assets were $15,347,145.  The difference of $8,729,972 is a working capital deficit, whichis primarily the result of losses incurred during the last four years.  These conditions raise substantial doubtsabout our ability to continue as a going concern.  The financial statements do not include any adjustments toreflect the possible future effect on the recoverability and classification ofassets or the amounts and classification of liabilities that may result fromthe outcome of this uncertainty.

 

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

 

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

 

In order to raise capital to sustain our operations,we have filed a Registration Statement on Form S-1 with respect to a proposedoffering of securities (the “Offering”). We are seeking to raise a minimum of $1,000,000 and a maximum of$10,000,000 through the sale of units consisting of common stock and warrantsto purchase common stock.  The Offeringis being underwritten on a best efforts basis and we can give no assurance thatwe will be successful in raising any funds in the Offering.

 

Net cash provided by (used in) operating activitieswas $2,296,441 and $(2,895,409) in the six months ended March 31, 2004 and2003, respectively.

 

Net cash used in investing activities was $11,982 and$249,994 in the six months ended March 31, 2004 and 2003, respectively.  Cash used for acquisitions for the six monthsended March 31, 2003, was $61,644.  Thebalance in both periods was primarily for capital expenditures.

 

Net cash provided by (used in) financing activitieswas $(1,743,498) and $3,217,560 in the six months ended March 31, 2004 and2003, respectively.  During the threemonths ended March 31, 2003, we received $186,400 in proceeds from the issuanceof our Preferred Stock.  We had netborrowings (repayments) of $(204,367) and $2,619,991 under our line of credit inthe six months ended March 31, 2004 and 2003, respectively.  Net short-term borrowings (repayments) were$(351,071) and $498,187 in the six months ended March 31, 2004 and 2003,respectively.  Payments of notes payable- acquisitions was $308,548 and $352,489 in the six months ended March 31, 2004and 2003, respectively.

 

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

 

We have a loan and security agreement (the “LoanAgreement”) with Capital Temp Funds, Inc., which provides for a line of creditup to 85% of eligible accounts receivable, as defined, not to exceed$12,000,000.  Until April 10, 2003,

 

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borrowings under the Loan Agreement bore interest at arate of prime plus 1 3⁄4%.  (Seebelow)  The Loan Agreement restricts ourability to incur other indebtedness, pay dividends and repurchase stock.  Borrowings under the Loan Agreement arecollateralized by substantially all of our assets.  As of March 31, 2004, $8,107,908 was outstanding under the creditagreement.

 

At March 31, 2004, we were in violation of thefollowing covenants under the Loan Agreement:

 

(i)            Failing to meet the tangible net worth requirements;

 

(ii)           Our common stock being delisted from the NasdaqSmallCap Market

 

We have received a waiver from the lender on all ofthe above violations.  Effective April10, 2003, we entered into a modification of the Loan Agreement which providesthat borrowings under the Loan Agreement bear interest at 3% above the primerate.

 

Holders of the 1,458,933 outstanding shares of ourSeries A Preferred Stock are entitled to dividends at a rate of $.21 per share,per annum, when and if declared by our Board of Directors in preference andpriority to any payment of dividends on our common stock or any other series ofour capital stock.  Dividends on theSeries A Preferred Stock may be paid in additional shares of Preferred Stock ifthe shares of common stock issuable upon the conversion of the Series APreferred Stock have been registered for resale under the Securities Act of1933.  We are obligated to pay quarterlydividends to holders of our Series E Preferred Stock at a rate of 6% per annumof the stated value of the stock in preference and priority to any payment ofdividends on our common stock.  We areobligated to pay monthly dividends on our Series F Preferred Stock at a rate of7% per annum of the stated value of the stock in preference and priority to anypayment of dividends on our common stock. The aggregate stated values of the Series E and Series F Preferred Stockwas $4,722,920 and $600,000, respectively, as of March 31, 2004.  Dividends on the Series E and Series FPreferred Stock may be paid at the Company’s option in shares of common stock(valued at the conversion price of the applicable class of preferred stock) ifsuch shares have been registered for resale under the Securities Act of 1933.

 

We are obligated to redeem any shares of Series APreferred Stock outstanding on June 30, 2008 at a redemption price of $3.00 pershare together with accrued and unpaid dividends.  We have the option to pay the redemption price through theissuance of shares of common stock.  Forpurposes of determining the number of shares we will be required to issue if wepay the redemption price in shares of common stock, the common stock will havea value equal to the average closing price of the common stock during the fivetrading days preceding the date of redemption.

 

In July 2003, we entered into an agreement withArtisan (UK) plc, the parent company of Artisan.com Limited, pursuant to whichwe have agreed to redeem the aggregate 1,458,933 shares of our Series APreferred Stock owned by Artisan.com Limited and Cater Barnard (USA) plc, anaffiliate of Artisan.  These sharesrepresent all of the shares of Series A Preferred Stock currentlyoutstanding.  The agreement, as amendedin March 2004, provides that our obligation to redeem the Series A PreferredStock is contingent upon our sale of not less than $1,000,000 of units in ourproposed best efforts offering of units (“Units”).  If we sell at least $1,000,000 of Units in the Offering, we willbe obligated to pay $500,000 to Artisan within 7 days after the $1,000,000 ofUnits are sold.  In addition, we will beobligated to pay Artisan an additional $250,000 by January 31, 2005, or, at ouroption, issue to Artisan shares of our common stock having an aggregate marketvalue of $250,000, based upon the average closing bid prices of the commonstock for the 30 trading days preceding January 31, 2005.  If we fail to make the $250,000 payment incash or stock, we will be required to pay Artisan $300,000 in cash, plusinterest calculated on a daily basis at a rate of 18% per year from the date ofthe default to the date the default is cured. We have also agreed to issue to Artisan 1,750,000 of shares of ourcommon stock within 7 days of the initial closing of the Offering. 

 

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Other fixed obligations that we had as of March 31,2004 include:

 

•                  $738,422 under a promissory note bearing interest at7% per year which was issued in connection with our acquisition of Source Oneand which is payable in equal quarterly installments of $130,717 until itsmaturity date in August 2005.

 

•                  $973,498 under a promissory note bearing interest at6% per year, which was issued in connection with our acquisition of certainassets of PES and which is payable in equal quarterly installments of $36,770until its maturity date in December 2011.

 

•                  $1,053,328, including $309,170 of imputed interest,under a promissory note which was issued in connection with our acquisition ofElite and which is payable in equal monthly installments of $13,167 until itsmaturity in November 2010.

 

•                  $80,000 under a promissory note that was due in April2002 which bears interest at 18% per year.

 

•                  $21,963 under a promissory note which bears interestat 15% per year and which requires us to make payments of principal andinterest of $8,000 per month until its maturity date in October 2004.

 

•                  $16,960 under a promissory note which bears interestat 8% per year and which requires us to make monthly payments of principal andinterest of $7,500 until it is paid in full.

 

•                  $7,337 under a promissory note which bears interest at8% per year and is due on July 1, 2004.

 

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

 

•                  $705,753 under demand loans which bear interest atvarious rates, including $100,000 owed to a son of Joseph J. Raymond, $100,000owed to the brother of Joseph J. Raymond and $100,000 and $116,337 owed to amember of the Board of Directors and a trust formed for the benefit of thefamily of a former member of the Board of Directors, respectively.

 

•                  $54,657 under promissory notes used to acquire andsecured by motor vehicles which require aggregate monthly payments of principaland interest of $3,453 and which become due in full at various dates betweenJuly and August, 2005.

 

All of our offices are leased through operating leasesthat are not included on the balance sheet. As of March 31, 2004, future minimum lease payments under leaseagreements having initial terms in excess of one year were:  2005 - $501,000, 2006 - $243,000, 2007 -$193,000, and 2008 - $84,000.

 

We may be required to make certain “earnout” paymentsto sellers of businesses that we have acquired in recent years, includingSource One, PES and Elite.  The amountof these payments, if any, will depend upon the results of the acquiredbusinesses.  There were no earnoutpayments made in fiscal 2003.  There is$244,000 included in “Accounts payable and accrued expenses” on the balancesheet as of March 31, 2004 for estimated earnout payments that we recorded aspart of the acquisition of Elite.

 

Source One has the right to require us to repurchase400,000 shares of our common stock at a price of $2.00 per share at any timeafter July 27, 2003 and before the later of July 27, 2005 and the full paymentof the outstanding note that we issued to it in connection with the acquisitiontransaction completed with Source One in July 2001.  Source One notified us that it was exercising this right on July29, 2003.  We are attempting tonegotiate an arrangement which would permit us to pay this amount over anextended period of time or upon receipt of financing.  No assurance can be given that Source One will agree to such anarrangement.  In addition, the holder ofthe $80,000 note which was due in April 2002 has the right to require us torepurchase 20,000 shares of common stock at a price of $1.00 per share plusinterest at a rate of 15% per year until the note is paid in full.

 

In January 2003, a $367,216 judgment was awardedagainst us to an insurance carrier.  Asof March 31, 2004, the judgment has not yet been paid in full; however, we haveentered into an agreement with the plaintiff which permits us to satisfy thejudgment by making payments of $25,000 per month through April 15, 2004 with afinal payment of $30,000 due on May 15, 2004. The unpaid balance of $42,216 at March 31, 2004 is included in “Accountspayable and accrued expenses” on the balance sheet.

 

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During fiscal 2003, we were notified by both the NewJersey Department of Labor and the California Department of IndustrialRelations that, if certain payroll delinquencies were not cured, judgment wouldbe entered against us.  As of March 31,2004, there was still an aggregate of $4.9 million in delinquent payroll taxesoutstanding which are included in “Payroll taxes payable” on the balance sheetas of March 31, 2004.  Judgment has notbeen entered against us in California. While judgment has been entered against us in New Jersey, no actionshave been taken to enforce same.  Wecontinue to work with these state agencies to pay down outstandingdelinquencies.

 

As of March 31, 2004, there were no off-balance sheetarrangements, unconsolidated subsidiaries, commitments or guarantees of otherparties, except as disclosed in the notes to financial statements.  Stockholders’ equity (deficiency) at thatdate was ($5,762,786).

 

We engaged in various transactions with relatedparties during the six months ended March 31, 2004 including the following:

 

•                     We paid $16,200 to an entity owned byJeffrey J. Raymond and who is the son of Joseph J. Raymond, our Chairman,President and Chief Executive Officer, for consulting services.  We also paid $14,000 to an entity owned byJoseph J. Raymond, Jr., who also is the son of Joseph J. Raymond, forconsulting services.  These amounts wereincluded in selling, general and administrative expense.  The services provided included theidentification of acquisition candidates, acquisition advisory services, duediligence, post-acquisition transition services, customer relations, accountsreceivable collection and strategic planning advice.

 

### **•**                     Joseph J. Raymond, Jr. is a 50%member in ALS, LLC which is the holding company for Advantage Services Group,Inc. (“Advantage”).  In November 2003,we entered into agreements with Advantage, whereby Advantage is to providepayrolling services with respect to four of our accounts, at Advantage’s costplus a fee ranging between 2% to 3%.  Wehave pledged the four accounts as security for our obligation under theseagreements.  In addition, if theaggregate payroll of employees provided under these agreements does not equalat least $8 million by November 30, 2004, we will be required to pay Advantagean amount equal to 8% of the shortfall. Costs incurred under the agreement and a previous agreement was$3,871,593 in the six months ended March 31, 2004.

### ** **

### **In addition to the foregoing, inNovember 2003, we agreed to pay Advantage $5,000 per week until $225,000 owedto Advantage in connection with the previous agreement for payrolling serviceshas been paid.  As of March 31, 2004,$75,000 has been paid under this agreement. The obligation to pay this amount is secured by a warrant to purchase2,000,000 shares of our common stock. The warrant, which is exercisable only if we default on our paymentobligations to Advantage, has an exercise price equal to the lower of $.15 pershare or 75% of the then current market price of the common stock.**

### ** **

We believe that all transactions with related partieshave been on terms no less favorable to us than those that could have beenobtained from unaffiliated third parties.

 

**Seasonality**

** **

Our business follows the seasonal trends of ourcustomer’s business.  Historically, wehave experienced lower revenues in the first calendar quarter with revenuesaccelerating during the second and third calendar quarters and then starting toslow again during the fourth calendar quarter.

 

**Impactof Inflation**

** **

We believe that since our inception, inflation has nothad a significant impact on our results of operations.

 

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**Impact ofRecent Accounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (the “FASB”) issued FASB InterpretationNo. 46 (“FIN 46”) – Consolidation of Variable Interest Entities, and a revisedinterpretation of FIN 46 (FIN 46R) was issued in December 2003.  FIN 46 requires that if an entity has acontrolling financial interest in a variable interest entity, the assets,liabilities and results of activities of the variable interest entity should beincluded in the consolidated financial statements of the entity.  The provisions of FIN 46 are effectiveimmediately for all arrangements entered into after January 31, 2003.  We do not have any variable interestentities created after January 31, 2003. For those arrangements entered into prior to January 31, 2003, the FIN46R provisions are required to be adopted at the beginning of the first interimor annual period ending after March 15, 2004. We adopted the provision of FIN 46R as of March 31, 2004, resulting inthe consolidation of a joint venture previously accounted for under the equitymethod (See Note 2 to the Condensed Consolidated Financial Statements).

 

In May 2003, the FASBissued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity”.  SFAS No. 150 changes the accounting for certain financialinstruments that, under previous guidance, issuers could account for as equityand requires that those instruments be classified as liabilities (or assets incertain circumstances) in statements of financial position.  This statement affects the issuer’saccounting for three types of freestanding financial instruments including (1)mandatorily redeemable shares that are required to be redeemed at a specifiedor determinable date or upon an event certain to occur, (2) put options andforward purchase contracts, which involves financial instruments embodying anobligation that the issuer must or could choose to settle by issuing a variablenumber of its shares or other equity instruments based solely on somethingother than the issuer’s own equity shares and (3) certain obligations that canbe settled with share, the monetary value of which is (i) fixed, tied solely orpredominantly to a variable such as a market index, or (ii) varies inverselywith the value of the issuers’ shares. For public companies, SFAS No. 150 became effective at the beginning ofthe first interim period beginning after June 15, 2003.  As a result of SFAS No. 150, we haveclassified put options that were previously classified as “Temporary equity”and our Series A redeemable convertible preferred stock as liabilities atSeptember 30, 2003.

 

**Sensitive Accounting Estimates**

** **

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and notes.  Significant estimates include management’sestimate of the carrying value of accounts receivable, the impairment ofgoodwill and 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, 2003.  As of March 31, 2004, there have been nomaterial changes to any of the critical accounting policies contained therein.

 

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**Item 3. – QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISKS**

** **

We are subject to therisk of fluctuating interest rates in the ordinary course of business forborrowings under our Loan and Security Agreement with Capital Tempfunds,Inc.  This credit agreement provides fora line of credit up to 85% of eligible accounts receivable, not to exceed$12,000,000.  Advances under this creditagreement bear interest at a rate of prime plus 3%.

 

We believe that ourbusiness operations are not exposed to market risk relating to foreign currencyexchange risk or commodity price risk.

 

**Item 4. – CONTROLS AND PROCEDURES**

 

Atthe end of the period covered by this report, we carried out an evaluation ofthe effectiveness of the design and operations of our disclosure controls andprocedures.  This evaluation was carriedout under the supervision and with the participation of our management,including our Chairman and Chief Executive Officer along with our ChiefFinancial Officer, who concluded that our disclosure controls and procedureswere effective as of the date of the evaluation.  There were no significant changes in our internal controls duringthe quarter ended March 31, 2004 that have materially affected, or arereasonably likely to have materially affected, our internal controls subsequentto the date we carried out our evaluation.

 

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**PartII – Other Information**

**Item1 – Legal Proceedings**

** **

Weare involved, from time to time, in routine litigation arising in the ordinarycourse of business.  We do not believethat any currently pending litigation will have a material adverse effect onour financial position or results of operations.

 

**Item2 – Changes in Securities and Use of Proceeds**

** **

### ***Conversion of Series E PreferredStock and Series F Preferred Stock***

### *** ***

### **In January and March 2004, weissued an aggregate of 11,196 shares of Series E Preferred Stock to holders ofour Series E Preferred Stock in respect of penalties which had accrued as aresult of our failure to timely register the shares issuable upon conversion ofthe Series E Preferred Stock for public resale.  The issuance was made under Section 4(2) of the Securities Act of1933.  In February 2004, holders ofSeries E Preferred Stock converted 1,575 shares into 1,000,000 shares of ourCommon Stock at a conversion price of $.1575. The issuances of the Common Stock upon such conversions were made inreliance upon the exemptions from registration provided under Rule 506 andSection 4(2) of the Securities Act of 1933.**

### ** **

We did not receive any proceeds as a resultof such conversion.

 

**Item 3 – Defaults Upon Senior Securities**

** **

Dividends on our Series A Preferred Stockaccrue at a rate of 7% per annum and are payable semi-annually when and ifdeclared by our Board of Directors.  Nosuch dividends have been declared and, as of the date of the filing of thisreport, $39,451 of dividends is in arrears on the Series A Preferred Stock.

 

Dividends on our Series E Preferred Stockaccrue at a rate of 6% of the stated value per year, payable every 120days.  As of the date of the filing ofthis report, $203,343 is in arrears on the Series E Preferred Stock.

 

Pursuant to certain registration rightsgranted to the holders of the Series E Preferred Stock, we are obligated tofile a registration statement under the Securities Act of 1933 with respect tothe shares of common stock issuable upon conversion of the Series E PreferredStock.  We are obligated to paypenalties for each 120 day period that such registration statement has not beenfiled and declared effective.  

 

Since there was no registration statementfiled by January 31, 2004, an additional 5,716 shares was issued as payment ofthe $571,605 due to holders of the Series E Preferred Stock.  Thereafter, on March 12, 2004, an additional5,480 shares was issued as payment of $547,980 due to holders of the Series EPreferred Stock.

 

Dividends on our Series F Preferred Stock accrueat a rate of 7% per annum, payable monthly. As of the date of the filing of this report, $56,408 is in arrears onthe Series F Preferred Stock.

 

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

### ** **

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

 

### **Item5 – Other Information**

### ** **

In February 2004, we commenced an exchange offerpursuant to which we have offered to exchange each outstanding share of ourSeries E Preferred Stock for, at the election of the holder, common stock andcommon stock purchase warrants or Series I Preferred Stock and common stockpurchase warrants (the “Exchange Offer”).

 

Pursuant to the terms of theExchange Offer, as amended, we will exchange each share of Series E PreferredStock, at the holder’s election, for either (i) 100 shares of common stock and200 common stock purchase warrants for each $100 in liquidation preference andaccrued dividends represented by the Series E Preferred Stock; or (ii) one shareof Series I Preferred Stock having a stated value of $100 per share and 100common stock purchase warrants for each $100 in liquidation preference andaccrued dividends represented by the Series E Preferred Stock.

 

Each warrant entitles its owner to purchaseone share of our common stock for $.95. The warrants will be exercisable at any time during the periodcommencing one year after the closing of the Exchange Offer and ending thirty(30) months after the closing of the Exchange Offer, unless we have redeemedthem.  We may redeem the warrants, at aredemption

 

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price of $.10 per warrant, upon thirty daysprior written notice beginning one year after the closing of the ExchangeOffer, once the closing bid price of our common stock has been at least $1.66for 20 consecutive trading days.

 

We will be required to redeem each share ofthe Series I Preferred Stock for an amount equal to the stated value of $100per share plus all accrued and unpaid dividends on the one year anniversarydate of the issuance of the Series I Preferred Stock to the extent permitted byapplicable law;  provided, however, thatwe will have the right to extend the required redemption date for an additionalone year, in which case we will be required to pay all dividends accruedthrough the first year of issuance in cash and issue to each holder of Series IPreferred Stock, a number of shares of our common stock which then have a valueequal to 10% of the stated value of the Series I Preferred Stock held.  In addition, if we extend the redemptiondate, we will be required to pay dividends quarterly and pay an advisory fee toan advisor designated by the holders of the Series I Preferred Stock in anamount equal to ten percent (10%) of the aggregate stated value of theoutstanding shares of Series I Preferred Stock, eight percent (8%) of whichwill be payable in cash and two percent (2%) of which will be paid in shares ofour common stock, valued at the then current market value.  If we do not redeem the Series I PreferredStock by the original one year redemption date and fail to extend the originalredemption date, or if we fail to redeem the Series I Preferred Stock by theextended redemption date, the dividend rate of the Series I Preferred Stockwill increase to twenty-four (24%) per annum and the Series I Preferred Stockwill be convertible, at the option of the holder, into either common stock at aconversion price equal to 80% of the average closing bid price of the commonstock during the five trading days preceding the conversion or common stock andwarrants at a rate of 100 shares of common stock and 200 warrants for each $100of stated value and accrued and unpaid dividends represented by the Series IPreferred Stock.  We can give noassurance that we will be able to redeem the Series I Preferred Stock asrequired.  We will have the right, atany time during the 12 month period following the closing of the ExchangeOffer, to cause all of the outstanding shares of the Series I Preferred Stockto be converted into, at the election of the holder, either common stock at aconversion price equal to 80% of the average closing bid price of the commonstock during the five trading days preceding the conversion, or common stockand warrants at a rate of 100 shares of common stock and 200 warrants for each$100 of stated value and accrued and unpaid dividends represented by the SeriesI Preferred Stock.  The discountassociated with the conversion feature of the Series I Preferred Stock couldresult in changes to our earnings in future periods.  Holders of Series I Preferred Stock will have no voting rights,except as provided by law and with respect to certain limited matters.

 

The Exchange Offer is subject to severalconditions, the most significant being the sale of at least $1 million of unitsin a public offering of units that we are conducting at or about the same timeas we are conducting the Exchange Offer.

 

The Exchange Offer, as extended, will remainopen until May 25, 2004, but we have a right to extend the offering period.

 

On May 14, 2004, the Registration Statementon Form S-1 that we filed with the Securities and Exchange Commission, inconnection with our offering of units consisting of one share of our commonstock and two warrants to purchase common stock, became effective.  We are seeking to raise up to $10,000,000 inthe offering (the “Offering”), which is being conducted through ourunderwriter, Essex & York, on a minimum $1,000,000 – maximum $10,000,000“best-efforts” basis.  If we don’t sellat least 1,000,000 units in the offering, the offering will be cancelled.

 

The descriptions of the Exchange Offer andthe Offering set forth above give effect to a proposed one-for-four reversesplit of our common stock which we expect to implement before the closing ofthe Exchange Offer and the Offering. 

 

In April 2004, we entered into a non-bindingletter of intent with Michael O’Donnell which contemplates that we will hireMr. O’Donnell as our Chief Executive Officer. Our hiring of Mr. O’Donnell is subject to the execution of a mutuallysatisfactory employment agreement with Mr. O’Donnell, the completion of a duediligence investigation satisfactory to Mr. O’Donnell and the approval of ourBoard of Directors.  The letter ofintent provides that we will grant options, or other equity in a form to beagreed upon, with respect to approximately six percent (6%) of our outstandingequity on a fully diluted basis to Mr. O’Donnell if we hire him as our ChiefExecutive Officer.

 

Mr. O’Donnell is the founder and ChiefExecutive Officer of ALS, LLC, which provides light industrial performancebased staffing services.  A son of ourChief Executive Officer, Joseph J. Raymond, Jr., holds a 50% interest in ALS,LLC, which acquired substantially all of the assets of our Miami Springs,Florida office in August 2003.  ALS, LLCis the holding company for Advantage Services Group, LLC, which providespayrolling services to certain of our clients. In 2001, Mr. O’Donnell formed MOD Ventures, LLC, which providesspecialized underwriting and capitalization services for new or high growthventures, and which provided consulting services to us in February and March2003.  In addition, Mr. O’Donnellrecently formed Summerlin Capital Partners, which engages in leasing/asset-basedfinancial services consulting. Formerly, Mr. O’Donnell was managing Director of the Global TechnologyServices division of GATX Capital.  Wecan give no assurance that we will be able to finalize the proposed employmentrelationship with Mr. O’Donnell.

 

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### **Item6 - Exhibits and Reports on Form 8-K**

### ** **

(a)                       Exhibits

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

 

(b)                                                                     Reports on Form 8-K

 

On January 6, 2004, theCompany filed a Form 8-K to report on the death, on January 2, 2004, of Mr. H.Robert Kingston, Director, and also to report that, on December 29, 2003, theCompany issued a news release to report its financial results for the fiscalyear ended September 30, 2003.

 

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SIGNATURES

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

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

 

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