** **

| **** | **** |
|------|------|

** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

# ** **

# **FORM 10-Q**

 

**(Mark One)**

 
| **ý**                                                                                                                                                                                                                                             |   | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                   |
| **For the quarterly period ended  March 31, 2003**                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                   |
| **o**                                                                                                                                                                                                                                                  |   | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE  ACT**                   |
|                                                                                                                                                                                                                                                   |
| **For the transition period from                     to                   ** |
|                                                                                                                                                                                                                                                   |   |                                                                                   |   |   |
| **Commission file number 001-15789**                                                                                                                                                                                                                   |

 

**STRATUSSERVICES GROUP, INC.**

(Exact name ofRegistrant 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 mark whether theregistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports)and (2) has been subject to such filing requirements for the past 90 days.  Yes ý     No o

 

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

 

As of May 16, 2003, 18,901,478 shares of the Registrant’s common stockwere outstanding.

 

 

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**Part I – Financial Information**

**Item 1. – Financial Statements**

** **

**STRATUS SERVICESGROUP, INC.**

Condensed Balance Sheets

 
|                                                                                                                                                                                                           |   | **March 31,  2003** |       | **September  30,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|--------------------------|--------|
|                                                                                                                                                                                                           |   | **(Unaudited)**     |       |                     |   |
| Assets                                                                                                                                                                                                         |   |                |       |                     |   |
| Current  assets                                                                                                                                                                                                |   |                |       |                     |   |
| Cash and cash equivalents                                                                                                                                                                                      |   | $                   | 234,803    |                     | $      | 162,646 |   |
| Accounts receivable – less allowance for doubtful  accounts of  $1,555,000 and $1,742,000                                                                                                            |   | 12,418,719          |       | 9,179,543                |   |
| Unbilled receivables                                                                                                                                                                                           |   | 2,716,342           |       | 2,065,972                |   |
| Other receivables                                                                                                                                                                                              |   | —              |       | 250,000                  |   |
| Prepaid insurance                                                                                                                                                                                              |   | 2,474,746           |       | 2,709,331                |   |
| Prepaid expenses and other current assets                                                                                                                                                                      |   | 320,068             |       | 333,601                  |   |
|                                                                                                                                                                                                           |   | 18,164,678          |       | 14,701,093               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Property and equipment, net of accumulated  depreciation                                                                                                                                                       |   | 1,272,098           |       | 1,281,817                |   |
| Intangible assets, net of accumulated amortization                                                                                                                                                             |   | 1,568,607           |       | 802,145                  |   |
| Goodwill                                                                                                                                                                                                       |   | 7,085,582           |       | 7,085,582                |   |
| Deferred financing costs, net of accumulated  amortization                                                                                                                                                     |   | 4,964               |       | 5,768                    |   |
| Other assets                                                                                                                                                                                                   |   | 180,899             |       | 154,991                  |   |
|                                                                                                                                                                                                           |   | $                   | 28,276,828 |                     | $      | 24,031,396 |   |
| Liabilities and  Stockholders’ Equity                                                                                                                                                                     |   |                |       |                     |   |
| Current liabilities                                                                                                                                                                                            |   |                |       |                     |   |
| Loans payable (current portion)                                                                                                                                                                                |   | $                   | 750,695    |                     | $      | 464,830 |   |
| Loans payable – related parties                                                                                                                                                                           |   | 341,000             |       | 116,000                  |   |
| Notes payable – acquisitions (current portion)                                                                                                                                                            |   | 624,887             |       | 578,040                  |   |
| Line of credit                                                                                                                                                                                                 |   | 10,359,108          |       | 7,739,117                |   |
| Cash overdraft                                                                                                                                                                                                 |   | 1,044,629           |       | 731,501                  |   |
| Insurance obligation payable                                                                                                                                                                                   |   | —              |       | 128,075                  |   |
| Accounts payable and accrued expenses                                                                                                                                                                          |   | 6,938,700           |       | 5,472,696                |   |
| Accrued payroll and taxes                                                                                                                                                                                      |   | 2,475,733           |       | 1,828,629                |   |
| Payroll taxes payable                                                                                                                                                                                          |   | 1,585,145           |       | 929,328                  |   |
|                                                                                                                                                                                                           |   | 24,119,897          |       | 17,988,216               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Loans payable (net of current portion)                                                                                                                                                                         |   | 105,287             |       | 217,965                  |   |
| Notes payable – acquisitions (net of current  portion)                                                                                                                                                    |   | 2,388,818           |       | 1,919,532                |   |
| Convertible debt                                                                                                                                                                                               |   | 40,000              |       | 40,000                   |   |
|                                                                                                                                                                                                           |   | 26,654,002          |       | 20,165,713               |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Temporary equity – put options                                                                                                                                                                            |   | 823,000             |       | 823,000                  |   |
| Commitments and contingencies                                                                                                                                                                                  |   |                |       |                     |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Stockholders’ equity                                                                                                                                                                                      |   |                |       |                     |   |
| Preferred stock, $.01 par value, 5,000,000 shares  authorized                                                                                                                                                  |   |                |       |                     |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series A voting redeemable convertible preferred  stock, $.01 par value, 1,458,933 shares issued and outstanding, liquidation  preference of $4,376,799 (including unpaid dividends of $498,564 and  $345,376) |   | 3,549,564           |       | 3,293,376                |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series E non-voting convertible preferred stock,  $.01 par value, 18,046 and 16,683 shares issued and outstanding, liquidation  preference of $1,804,600 (including unpaid dividends of $64,059 and $20,000)   |   | 1,868,659           |       | 1,485,947                |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series F voting convertible preferred stock, $.01  par value, 8,000 shares issued and outstanding, liquidation preference of  $800,000                                                                         |   | 800,000             |       | 1,000,000                |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Series H non-voting convertible preferred stock, $.01  par value, 5,000 shares issued and outstanding, liquidation preference of  $500,000                                                                     |   | 500,000             |       | 500,000                  |   |
|                                                                                                                                                                                                           |   |                |       |                     |   |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 18,491,478 and 11,522,567 shares issued and outstanding                                                                                          |   | 184,915             |       | 115,226                  |   |
| Additional paid-in capital                                                                                                                                                                                     |   | 12,394,387          |       | 12,626,733               |   |
| Accumulated deficit                                                                                                                                                                                            |   | (18,497,699         | )          | (15,978,599              | )      |
| Total stockholders’ equity                                                                                                                                                                                |   | 799,826             |       | 3,042,683                |   |
|                                                                                                                                                                                                           |   | $                   | 28,276,828 |                     | $      | 24,031,396 |   |

 

See notes to condensed financial statements.

 

2

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**STRATUS SERVICESGROUP, INC.**

Condensed Statements of Operations

(Unaudited)

 
|                                                                          |   | **Three  Months Ended  March 31,** |       | **Six Months  Ended  March 31,** |   |
|-------------------------------------------------------------------------------|--------|------------------------------------|------------|----------------------------------|--------|
|                                                                          |   | **2003**                           |       | **2002**                         |   | **2003** |   | **2002** |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Revenues                                                                      |   | $                                  | 25,607,094 |                             | $      | 17,505,428 |   | $ | 47,754,822 |   | $ | 32,298,652 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Cost of revenues                                                              |   | 22,365,491                         |       | 14,836,750                       |   | 41,154,491 |   | 26,956,072 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Gross Profit                                                                  |   | 3,241,603                          |       | 2,668,678                        |   | 6,600,331 |   | 5,342,580 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Selling, general and administrative  expenses                                 |   | 4,023,143                          |       | 3,305,380                        |   | 7,579,652 |   | 6,206,867 |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Other charges                                                                 |   | 523,000                            |       | —                           |   | 523,000 |   | — |   |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Operating (loss) from continuing operations                                   |   | (1,304,540                         | )          | (636,702                         | )      | (1,502,321 | ) | (864,287 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Other income (expenses)                                                       |   |                               |       |                             |   |   |   |   |   |
| Interest and financing costs                                                  |   | (546,808                           | )          | (451,564                         | )      | (1,045,719 | ) | (963,607 | ) |
| Other income                                                                  |   | 22,653                             |       | 35,825                           |   | 28,940 |   | 41,510 |   |
|                                                                          |   | (524,155                           | )          | (415,739                         | )      | (1,016,779 | ) | (922,097 | ) |
| (Loss) from continuing operations                                             |   | (1,828,695                         | )          | (1,052,441                       | )      | (2,519,100 | ) | (1,786,384 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Discontinued operations – (loss) from  discontinued Engineering Division |   | —                             |       | (312,059                         | )      | — |   | (238,793 | ) |
| Gain on sale of Engineering Division                                          |   | —                             |       | 1,759,056                        |   | — |   | 1,759,056 |   |
| Net earnings (loss)                                                           |   | (1,828,695                         | )          | 394,556                          |   | (2,519,100 | ) | (266,121 | ) |
| Dividends and accretion on preferred stock                                    |   | (407,663                           | )          | (166,000                         | )      | (773,757 | ) | (290,000 | ) |
| Net earnings (loss) attributable to common  stockholders                      |   | $                                  | (2,236,358 | )                                | $      | 228,556 |   | $ | (3,292,857 | ) | $ | (556,121 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Net earnings (loss) per share attributable  to common stockholders            |   |                               |       |                             |   |   |   |   |   |
| Basic:                                                                        |   |                               |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                             |   | $                                  | (.13       | )                                | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Earnings from discontinued operations                                         |   | —                             |       | .14                              |   | — |   | .16 |   |
| Net earnings (loss)                                                           |   | $                                  | (.13       | )                                | $      | .02 |   | $ | (.21 | ) | $ | (.06 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Diluted:                                                                      |   |                               |       |                             |   |   |   |   |   |
| (Loss) from continuing operations                                             |   | $                                  | (.13       | )                                | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Earnings from discontinued operations                                         |   | —                             |       | .14                              |   | — |   | .16 |   |
| Net earnings (loss)                                                           |   | $                                  | (.13       | )                                | $      | .02 |   | $ | (.21 | ) | $ | (.06 | ) |
|                                                                          |   |                               |       |                             |   |   |   |   |   |
| Weighted average shares, outstanding per  common share                        |   |                               |       |                             |   |   |   |   |   |
| Basic                                                                         |   | 17,599,034                         |       | 10,382,034                       |   | 15,950,320 |   | 9,583,750 |   |
| Diluted                                                                       |   | 17,599,034                         |       | 10,382,034                       |   | 15,950,320 |   | 9,583,750 |   |

 

See notes to condensed financial statements.

 

3

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**STRATUS SERVICESGROUP, INC.**

Condensed Statements of Cash Flows

(Unaudited)

 
|                                                                                                                                        |   | **Six Months  Ended** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|
|                                                                                                                                        |   | **March 31,  2003**   |       | **March 31,  2002** |   |
| Cash flows from operating activities                                                                                                        |   |                  |       |   |   |
| Net (loss) from continuing operations                                                                                                       |   | $                     | (2,519,100 | ) | $ | (1,547,591 | ) |
| Net (loss) from discontinued operations                                                                                                     |   | 3⁄4                |       | (238,793 | ) |
| Adjustments to reconcile net earnings  (loss) to net cash used by operating activities                                                      |   |                  |       |   |   |
| Depreciation                                                                                                                                |   | 273,069               |       | 265,971 |   |
| Amortization                                                                                                                                |   | 181,057               |       | 272,024 |   |
| Provision for doubtful accounts                                                                                                             |   | 50,000                |       | 208,000 |   |
| Deferred financing costs amortization                                                                                                       |   | 804                   |       | 388,978 |   |
| Loss on sales of shares of investment                                                                                                       |   | 3⁄4                |       | 9,550 |   |
| Gain on extinguishment of convertible debt                                                                                                  |   | 3⁄4                |       | (3,277 | ) |
| Gain on sale of Engineering Division                                                                                                        |   | 3⁄4                |       | (1,759,056 | ) |
| Interest expense amortization for the  intrinsic value of the beneficial conversion feature of convertible  debentures                      |   |                  |       | 104,535 |   |
| Accrued interest                                                                                                                            |   | (7,388                | )          | 92,021 |   |
| Imputed interest                                                                                                                            |   | 22,747                |       | 3⁄4 |   |
| Changes in operating assets and liabilities                                                                                                 |   |                  |       |   |   |
| Accounts receivable                                                                                                                         |   | (3,939,546            | )          | (1,745,285 | ) |
| Prepaid insurance                                                                                                                           |   | 234,585               |       | 207,304 |   |
| Prepaid expenses and other current assets                                                                                                   |   | 13,533                |       | (58,480 | ) |
| Other assets                                                                                                                                |   | (25,908               | )          | 12,836 |   |
| Insurance obligation payable                                                                                                                |   | (128,075              | )          | (475,356 | ) |
| Accrued payroll and taxes                                                                                                                   |   | 647,104               |       | 75,916 |   |
| Payroll taxes payable                                                                                                                       |   | 655,817               |       | 238,819 |   |
| Accounts payable and accrued expenses                                                                                                       |   | 1,645,892             |       | 943,141 |   |
| Total adjustments                                                                                                                           |   | (376,309              | )          | (1,222,359 | ) |
|                                                                                                                                        |   | (2,895,409            | )          | (1,488,480 | ) |
| Cash flows (used in) investing activities                                                                                                   |   |                  |       |   |   |
| Purchase of property and equipment                                                                                                          |   | (188,350              | )          | (246,399 | ) |
| Proceeds from sales of shares of investment                                                                                                 |   | 3⁄4                |       | 5,466 |   |
| Payments for business acquisitions                                                                                                          |   | (61,644               | )          | (181,920 | ) |
| Net proceeds from sale of Engineering  Division                                                                                             |   | 3⁄4                |       | 1,459,079 |   |
|                                                                                                                                        |   | (249,994              | )          | 1,036,226 |   |
| Cash flows from financing activities                                                                                                        |   |                  |       |   |   |
| Proceeds from issuance of Common Stock                                                                                                      |   | 3⁄4                |       | 222,083 |   |
| Proceeds from issuance of Preferred Stock                                                                                                   |   | 186,400               |       | 282,500 |   |
| Proceeds from loans payable                                                                                                                 |   | 380,000               |       | 271,195 |   |
| Payments of loans payable                                                                                                                   |   | (106,813              | )          | (11,566 | ) |
| Proceeds from loans payable – related  parties                                                                                         |   | 300,000               |       | 50,000 |   |
| Payments of loans payable – related parties                                                                                            |   | (75,000               | )          | (50,000 | ) |
| Payments of notes payable – acquisitions                                                                                               |   | (352,489              | )          | (142,769 | ) |
| Net proceeds from line of credit                                                                                                            |   | 2,619,991             |       | 723,529 |   |
| Cash overdraft                                                                                                                              |   | 313,128               |       | 3⁄4 |   |
| Cost in connection with common stock issued  for acquisition                                                                                |   | 3⁄4                |       | (2,000 | ) |
| Net proceeds from convertible debt                                                                                                          |   | 3⁄4                |       | 326,871 |   |
| Redemption of convertible debt                                                                                                              |   | 3⁄4                |       | (301,992 | ) |
| Dividends paid                                                                                                                              |   | (47,657               | )          | 3⁄4 |   |
|                                                                                                                                        |   | 3,217,560             |       | 1,367,851 |   |
| Net change in cash and cash equivalents                                                                                                     |   | 72,157                |       | 915,597 |   |
| Cash and cash equivalents – beginning                                                                                                  |   | 162,646               |       | 171,822 |   |
| Cash and cash equivalents – ending                                                                                                     |   | $                     | 234,803    |   | $ | 1,087,419 |   |
|                                                                                                                                        |   |                  |       |   |   |
| Supplemental disclosure of cash paid                                                                                                        |   |                  |       |   |   |
| Interest                                                                                                                                    |   | $                     | 1,047,762  |   | $ | 437,693 |   |
| Schedule of noncash investing and financing  activities                                                                                     |   |                  |       |   |   |
| Fair value of assets acquired                                                                                                               |   | $                     | 1,022,519  |   | $ | 1,814,355 |   |
| Less: cash paid                                                                                                                             |   | (176,644              | )          | (334,355 | ) |
| Less:   common stock and put options issued                                                                                            |   | 3⁄4                |       | (380,000 | ) |
| Liabilities assumed                                                                                                                         |   | $                     | 845,875    |   | $ | 1,100,000 |   |
|                                                                                                                                        |   |                  |       |   |   |
| Issuance of Series B Preferred Stock in  exchange for convertible and other debt (including $160,000 loans payable –  related parties) |   | $                     | —     |   | $ | 1,106,499 |   |
| Issuance of common stock upon conversion of  convertible preferred stock                                                                    |   | $                     | 754,200    |   | 3⁄4 |   |
| Issuance of common stock in exchange for  accounts payable and accrued expenses                                                             |   | $                     | 37,500     |   | $ | 59,000 |   |
| Issuance of common stock upon conversion of  convertible debt                                                                               |   | 3⁄4                |       | $ | 736,003 |   |
| Issuance of warrants for fees                                                                                                               |   | 3⁄4                |       | $ | 55,000 |   |
| Cumulative dividends and accretion on  preferred stock                                                                                      |   | $                     | 493,100    |   | $ | 290,000 |   |

 

4

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**STRATUS SERVICES GROUP, INC.**

Notes to Condensed Financial Statements

(Unaudited)

 

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

 

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

 

The results of operations for the interimperiods presented are not necessarily indicative of the results to be expectedfor the full year.

 

**NOTE 2 – LIQUIDITY**

 

At March 31, 2003, the Company had limitedliquid resources.  Current liabilitieswere $24,119,897 and current assets were $18,164,678.  The difference of $5,955,219 is a working capital deficit, whichis primarily the result of losses continuously incurred beginning the yearended September 30, 2001.  Currentliabilities include a cash overdraft of $1,044,629, which is represented byoutstanding checks.  These conditionsraise substantial doubts about the Company’s ability to continue as a goingconcern.  The financial statements donot include any adjustments to reflect the possible future effect on therecoverability and classification of assets or the amounts and classificationof liabilities that may result from the outcome of this uncertainty.

 

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

 

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

 

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

 

**NOTE 3 – EARNINGS/LOSS PER SHARE**

 

Basic “Earnings Per Share” (“EPS”) excludesdilution and is computed by dividing earnings available to common stockholdersby the weighted-average number of common shares outstanding during theperiod.  Diluted EPS assumes conversionof dilutive options and warrants, and the issuance of common stock for allother potentially dilutive equivalent shares outstanding.  There were no dilutive shares for the threeand six months ended March 31, 2003 and 2002.

 

**NOTE4 – INTANGIBLE ASSETS**

 

At the beginning of fiscal year ended September30, 2003, the Company adopted the provisions of Statement of Financial AccountingStandards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”.  The provisions of SFAS No. 142 prohibit theamortization of goodwill and certain intangible assets that are deemed to haveindefinite lives and require that such assets be tested for impairmentannually, or more frequently if events or

 

5

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changes in circumstances indicate that the assetmight be impaired and written down to fair value.  In order to assess the fair value of its goodwill andindefinite-lived intangible assets as of the adoption date, the Company engagedan independent valuation firm to assist in determining the fair value.  The valuation process appraised theCompany’s assets and liabilities using a combination of present value andmultiple of earnings valuation techniques. Based upon the results of the valuation it was determined that there wasno impairment of goodwill.

 

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

 
|                                  |   | **March 31,  2003** |      | **September  30, 2002** |   |
|---------------------------------------|--------|---------------------|-----------|-------------------------|--------|
|                                  |   |                |      |                    |   |
| Covenant-not-to-compete               |   | $                   | 232,680   |                    | $      | 213,180 |   |
| Customer list                         |   | 1,819,735           |      | 891,716                 |   |
|                                  |   | 2,052,415           |      | 1,104,896               |   |
| Less:   accumulated amortization |   | (483,808            | )         | (302,751                | )      |
|                                  |   | $                   | 1,568,607 |                    | $      | 802,145 |   |

 

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

### ** **

Estimated amortization expensefor each of the next five years is as follows:

 

| **For the  Year Ending  March 31,** |   |     |   |
|-------------------------------------|--------|----------|--------|
| 2004                                |   | $225,000 |   |
| 2005                                |   | 192,000  |   |
| 2006                                |   | 169,000  |   |
| 2007                                |   | 97,000   |   |
| 2008                                |   | 95,000   |   |

 

### **NOTE 5 – LINE OF CREDIT**

 

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

 

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

 

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

(ii)       TheCompany’s Common Stock being delisted from the Nasdaq SmallCap Market

 

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

 

Effective April 10, 2003, the Companyentered into another modification of the Agreement which provides thatborrowings under the Agreement bear interest at 3% above the prime rate.

 

The prime rate at March 31, 2003 was4.25%.

 

### **NOTE 6 – CONVERTIBLE DEBT**

 

At various times during thesix months ended March 31, 2002, the Company issued convertible debenturesthrough private placements.  Thedebentures bore interest at 6% a year, payable quarterly and had a maturitydate of five years from issuance.  Eachdebenture was convertible after 120 days from issuance into the number ofshares of the Company’s common stock determined by dividing the principalamount of the debenture by the lesser of (a) 120% of the closing bid price ofthe common stock on the trading day immediately preceding the issuance date or(b) 75% of the average closing bid price of the common stock for the five tradingdays immediately preceding the date of the conversion.  The Company had the right to prepay any ofthe debentures at any time at a prepayment rate that varied from 115% to 125%of the amount of the debenture depending on when the prepayment is made.

 

6

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

 

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

 

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

 

**NOTE 7 – PREFERRED STOCK**

 

***a.             Series A***

 

The shares of Series A Preferred Stock have a stated value of $3.00 pershare.  The difference between thecarrying value and redemption value of the Series A Preferred Stock is beingaccreted through a charge to additional paid-in-capital through the June 30,2008 redemption date.

 

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

 

***b.             Series E***

 

The shares of Series E Preferred Stock have astated value of $100 per share.  Theholders of the Series E Preferred stock are entitled to cumulative dividends ata rate of 6% of the stated value per year, payable every 120 days, in preferenceand priority to any payment of any dividend on the Company’s Common Stock.  Dividends may be paid, at the Company’soption, either in cash or in shares of Common Stock, valued at the Series 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 convertibleinto Common Stock at a conversion price equal to 75% of the average of theclosing bid prices, for the five trading days preceding the conversion date,for the Common Stock.  The number ofshares issuable upon conversion is determined by multiplying the number ofshares of Series E Preferred Stock to be converted by $100, and dividing theresult by the Series E Conversion Price then in effect.

 

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

 

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

 

7

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

 

During the six months ended March 31, 2003,holders of Series E Preferred Stock converted 5,637 shares into 4,718,911shares of Common Stock at conversion prices between $.108 and $.186.

 

***c.             Series F***

 

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

 

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

 

The Series F Preferred Stock is convertibleinto Common Stock at a conversion price (the “Series F Conversion Price”) equalto $.10 per share which was the market price at date of issuance.  The number of shares issuable uponconversion is determined by multiplying the number of shares of Series FPreferred Stock to be converted by $100, and dividing the result by the SeriesF Conversion Price.

 

Except as otherwise required by law, holdersof Series F Preferred Stock and holders of Common Stock shall vote together asa single class on each matter submitted to a vote of stockholders.  Each outstanding share of Series F PreferredStock shall be entitled to the number of votes equal to the number of fullshares of Common Stock into which each such share of Series F Preferred Stockis then convertible on the date for determination of stockholders entitled tovote at the meeting.  Holders of theSeries F Preferred Stock are entitled to vote at the meeting.  Holders of the Series F Preferred Stock areentitled to vote as a separate class on any proposed amendment to the terms ofthe Series F Preferred Stock which would increase or decrease the number of authorizedshares of Series F Preferred Stock or have an adverse impact on the Series FPreferred Stock and on any proposal to create a new class of shares havingrights or preferences equal to or having priority to the Series F PreferredStock.

 

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

 

During the six months ended March 31, 2003,the Company’s Chief Executive Officer converted 2,000 shares of the Series FPreferred Stock into 2,000,000 shares of Common Stock.

 

***d.             Series H***

 

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

 

The Series H Preferred Stock is convertibleinto Common Stock at a conversion price (the “Series H Conversion Price”) equalto the lower of $.20 per share, which was the market price at date of issuance,or the average market price of the Common Stock for the five trading daysimmediately preceding the conversion date. The number of shares

 

8

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issuable upon conversion is determined bymultiplying the number of shares of Series H Preferred Stock to be converted by$100 and dividing the result by the Series H Conversion Price then in effect.

 

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

 

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

 

**NOTE8 – OTHER CHARGES**

 

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

 

**NOTE 9 – STOCK-BASED COMPENSATION**

 

The Company accounts for its stock-basedcompensation plans using the intrinsic value method in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees”.  Accordingly, no stock-basedemployee compensation cost has been recognized in the financial statements asall options granted under the Company’s stock option plan, had an exerciseprice at least equal to the market value of the underlying common stock on thedate of grant.  The pro forma informationbelow is 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,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|------------|---------------------------------------|--------|
|                                                                                                                                  |   | **2003**                                |       | **2002**                              |   | **2003** |   | **2002** |   |
|                                                                                                                                  |   |                                    |       |                                  |   |   |   |   |   |
| Net (loss) from continuing operations  attributable to common stockholders, as reported                                               |   | $                                       | (2,236,358 | )                                     | $      | (1,218,441 | ) | $ | (3,292,857 | ) | $ | (2,076,384 | ) |
| Deduct:                                                                                                                               |   |                                    |       |                                  |   |   |   |   |   |
| Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |   | (827,908                                | )          | (618,989                              | )      | (1,419,238 | ) | (1,171,917 | ) |
|                                                                                                                                  |   |                                    |       |                                  |   |   |   |   |   |
| Pro forma net (loss) from continuing  operations attributable to common stockholders                                                  |   | $                                       | (3,064,266 | )                                     | $      | (1,837,430 | ) | $ | (4,712,095 | ) | $ | (3,248,301 | ) |
|                                                                                                                                  |   |                                    |       |                                  |   |   |   |   |   |
| (Loss) from continuing operations per  common share attributable to common stockholders:                                              |   |                                    |       |                                  |   |   |   |   |   |
| Basic - as reported                                                                                                                   |   | $                                       | (.13       | )                                     | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Basic - pro forma                                                                                                                     |   | $                                       | (.17       | )                                     | $      | (.18 | ) | $ | (.30 | ) | $ | (.34 | ) |
|                                                                                                                                  |   |                                    |       |                                  |   |   |   |   |   |
| Diluted - as reported                                                                                                                 |   | $                                       | (.13       | )                                     | $      | (.12 | ) | $ | (.21 | ) | $ | (.22 | ) |
| Basic - pro forma                                                                                                                     |   | $                                       | (.17       | )                                     | $      | (.18 | ) | $ | (.30 | ) | $ | (.34 | ) |

 

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

 

On March 28, 2002, the Company completed thesale of the assets of its Engineering Services Division (the “Division”) to SEAConsulting Services Corporation (“SEA”) pursuant to the Asset PurchaseAgreement dated

 

9

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as of January 24, 2002, among the Company,SEP, LLC (“SEP”), Charles Sahyoun, Sahyoun Holders LLC and SEA.

 

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

 

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

 

TheAsset Purchase Agreement requires SEA to make the following additional paymentsto SEP:

 

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

 

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

 

(iii)            Five subsequent annual payments (the “SubsequentPayments”) which will be based upon a multiple of the annual successiveincreases, if any, in SEA’s profit during the five year period beginning onJanuary 1, 2003 and ending December 31, 2007.

 

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

 

The transaction resulted in a gain, which was calculated as follows:

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

 

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

 

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

 

### **NOTE 11 – ACQUISITION**

 

Effective as of December 1, 2002, (the“Effective Date”), the Company purchased substantially all of the tangible andintangible assets, excluding accounts receivable, of six offices of ElitePersonnel Services (“Elite”), a California corporation.  The Elite branches provide temporary lightindustrial and clerical staffing in six business locations in California andNevada. The Company also took over Elite’s Downey, California office, fromwhich Elite serviced no accounts but which it utilized as a corporateoffice.  The company will continue toutilize the Downey office as a regional corporate facility.  The acquisition of Elite furthers theCompany’s expansion into the California staffing market.  Pursuant to the terms of an Asset PurchaseAgreement between the Registrant and Elite dated November 19, 2002 (the “Asset PurchaseAgreement”), the purchase price payable at closing (the “Base Purchase Price”)for the assets was $1,264,000, all of which was represented by an unsecuredpromissory note.  In addition to theBase Purchase Price, Elite will also receive as a deferred purchase price, anamount equal to 10% of the annual “Gross Profits” as defined in the AssetPurchase Agreement of the acquired business between $2,500,000 and $3,200,000,and 15% of the annual Gross Profits of the acquired business in excess of $3,200,000for a minimum period of one year from the Effective Date and for a period oftwo years from the Effective Date, if Gross Profits during the first year reachspecified levels.  Any additionalpayments due will increase the value initially assigned to the customer listand be amortized over the remaining useful life of the customer list.  The note includes imputed interest at 4% peryear and is payable over an eight-year period in equal monthly paymentsbeginning 30 days after the Effective Date. In connection with the transaction, Elite, its President and other keymanagement members entered into Non-Competition and Non-Solicitation Agreementspursuant to which they agreed not to compete with the Registrant in theterritories of the acquired business for periods ranging from twelve months tofive years, and to not solicit the employees or customers of the acquiredbusiness for periods ranging from twelve months to five years.  Additionally, Elite’s President has alsoentered into an Employment Agreement, as of the Effective Date, with theCompany for a minimum of a one year term. This term can be extended if certain targeted Gross Profit levels areattained.

 

Forfinancial accounting purposes, interest on the note has been imputed at a rateof 11% per year.  Accordingly, the noteand Base Purchase Price has been recorded at $845,875.  There was an additional $176,644 of costspaid to third parties in connection with the acquisition.

 

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

 
| Property and equipment  |   | $       | 75,000    |   |
|-------------------------|--------|---------|-----------|--------|
| Covenant-not-to-compete |   | 19,500  |      |
| Customer list           |   | 928,019 |      |
| Total assets acquired   |   | $       | 1,022,519 |   |

 

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

 

### **The unaudited pro forma results of operations presentedbelow assume that the acquisition and another acquisition that occurredeffective January 1, 2002, had occurred at the beginning of fiscal 2002.  This information is presented forinformational purposes only and includes certain adjustments such asamortization of intangibles resulting from the acquisitions and interestexpense related to acquisition debt.**

 

11

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|                                                                       |   | **Unaudited  Six Months Ended  March 31,** |       |
|----------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                       |   | **2003**                                   |       | **2002** |   |
| Revenues                                                                   |   | $                                          | 53,332,822 |   | $ | 48,849,652 |   |
| Net (loss) from continuing operations  attributable to common stockholders |   | (3,192,883                                 | )          | (2,160,384 | ) |
|                                                                       |   |                                       |       |   |   |
| Net (loss) per share attributable to common  stockholders                  |   |                                       |       |   |   |
| Basic                                                                      |   | $                                          | (.20       | ) | $ | (.23 | ) |
| Diluted                                                                    |   | $                                          | (.20       | ) | $ | (.23 | ) |

### ** **

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

### ** **

During the six months ended March 31, 2003, ason and the brother of the Chief Executive Officer of the Company (the “CEO”)each loaned $100,000 to the Company.  Inaddition, one of the members of the Board of Directors of the Company loaned$100,000 to the Company.  Each of theaforementioned loans is unsecured and is due on demand. The loans bear interestat various rates.  The loans areoutstanding at March 31, 2003 and included in loans payable on the condensedbalance sheet.

 

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

 

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

 

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

 

12

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

 

This Form 10-Q contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933, asamended and Section 21E of the Securities Exchange Act of 1934, asamended.  These statements relate tofuture economic performance, plans and objectives of management for futureoperations and projections of revenue and other financial items that are basedon the beliefs of our management, as well as assumptions made by, andinformation currently available to, our management.  The words “expect”, “estimate”, “anticipate”, “believe”,“intend”, and similar expressions are intended to identify forward-lookingstatements.  Such statements involveassumptions, uncertainties and risks. If one or more of these risks or uncertainties materialize or underlyingassumptions prove incorrect, actual outcomes may vary materially from thoseanticipated, estimated or expected. Among the key factors that may have a direct bearing on our expectedoperating results, performance or financial condition are economic conditionsfacing the staffing industry generally; uncertainties related to the job marketand our ability to attract qualified candidates; uncertainties associated withour brief operating history; our continued operating losses and their effect onliquidity; our ability to raise additional capital; the continued cooperationof our creditors; our ability to achieve and manage growth; our ability tosuccessfully identify suitable acquisition candidates, complete acquisitions orintegrate the acquired business into our operations; our ability to attract andretain qualified personnel; our ability to develop new services; our ability tocross-sell our services to existing clients; our ability to enhance and expandexisting offices; our ability to open new offices; general economic conditions;and other factors discussed from time to time in our filings with theSecurities and Exchange Commission. These factors are not intended to represent a complete list of all risksand uncertainties inherent in our business. The following discussion and analysis should be read in conjunction withthe Condensed Financial Statements and notes appearing elsewhere in thisreport.

 

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

 

### **Introduction**

 

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

 

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**Results of Operations**

**Discontinued Operations/Acquisition orDisposition of Assets**

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Pursuantto an allocation and indemnity agreement entered into by us, Sahyoun Holdings,LLC and Mr. Sahyoun (the “Allocation and Indemnity Agreement”), we wereentitled to $250,000 of the Second Payment and $250,000 of the Third Payment.  On April 15, 2002, by letter agreementbetween us, Sahyoun Holdings, LLC and Joseph J. Raymond, Sr., our Chairman andChief Executive Officer, the parties agreed to a modification of the Allocationand Indemnity Agreement.  Per that letteragreement, Sahyoun Holdings, LLC provided us with $200,000 cash in exchange forour short-term, 90-day demand note, due and payable by August 1, 2002 in theamount of $250,000.  The $250,000 waspaid by us from our share of the Second Payment which was received by us inJune 2002.

 

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

 

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Effective January 1, 2002, we purchased substantially all of thetangible and intangible assets, excluding accounts receivable, of seven officesof PES.  The initial purchase price was$1,480,000, represented by a $1,100,000 promissory note and 400,000 shares ofour common stock.  There was anadditional $334,355 of costs incurred in connection with the acquisitions.  In addition, PES is entitled to earnoutpayments of 15% of pretax profit of the acquired business up to a total of $1.25million or the expiration of ten years, whichever occurs first.  The note bears interest at 6% a year and ispayable over a ten-year period in equal quarterly payments.

 

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

 

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

 

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

 

**Continuing Operations**

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

 

***Revenues.***  Revenues increased 46.3% to $25,607,094 forthe three months ended March 31, 2003 from $17,505,428 for the three monthsended March 31, 2002.  Approximately$7.4 million of the increase was attributable to the acquisition in December2002.  Excluding acquisitions, revenuesincreased 4.1%.  This increase was aresult of an increase in billable hours.

 

***Gross Profit.***  Gross profit increased 21.5% to $3,241,603for the three months ended March 31, 2003 from $2,668,678 for the three monthsended March 31, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenues decreasedto 12.7% for the three months ended March 31, 2003 from 15.2% for the threemonths ended March 31, 2002.  Thisdecrease was a result of increased pricing competition of staffing services andincreases in the cost of workers’ compensation insurance and state unemploymenttaxes.  In addition, we have beenassessed the penalty rate by the New Jersey Department of Labor for stateunemployment taxes because of payment delinquencies (see Part II – Item 5 ofthis report).  The estimated additionalexpense in the three months ended March 31, 2003 is $250,000.

 

***Selling, General andAdministrative Expenses.**** *Selling, generaland administrative expenses, not including depreciation and amortization,increased 22.1% to $3,782,308 for the three months ended March 31, 2003 from$3,084,964 for the three months ended March 31, 2002.  Selling, general and administrative expenses, not includingdepreciation and amortization, as a percentage of revenues decreased to 14.8%for the three months ended March 31, 2003 from 17.6% for the three months endedMarch 31, 2002.  The increase in thedollar amount is primarily a result of the acquisitions in January and December2002, whereas the percentage of revenue decrease is attributable to significantcost reductions implemented by us and the increase in revenues with noproportionate increase in selling, general and administrative expenses.

 

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

 

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ended March 31, 2003 from $148,122 for the three months ended March 31,2002.  Depreciation and amortization,not including the amortization of goodwill, as a percentage of revenuesincreased to 0.9% for the three months ended March 31, 2003 from 0.8% for thethree months ended March 31, 2002.  Theincrease was due to capital expenditures and amortization of intangibles inconnection with the acquisition in December 2002.

 

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

 

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

 

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

 

**Continuing Operations**

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

 

***Revenues.***  Revenues increased 47.9% to $47,754,822 for the six months ended March 31, 2003from $32,298,652 for the six months ended March 31, 2002.  Approximately $13.8 million of the increasewas attributable to the acquisitions in January and December 2002.  Excluding acquisitions, revenues increased5.1%.  This increase was the result ofan increase in billable hours.

 

***Gross Profit.***  Gross profit increased 23.5% to $6,600,311for the six months ended March 31, 2003 from $5,342,580 for the six monthsended March 31, 2002, primarily as a result of increased revenues.  Gross profit as a percentage of revenuesdecreased to 13.8% for the six months ended March 31, 2003 from 16.5% for thesix months ended March 31, 2002.  Thisdecrease was a result of increased pricing competition of staffing services andincreases in the cost of workers’ compensation insurance and state unemploymenttaxes.  In addition, we have beenassessed the penalty rate by the New Jersey Department of Labor for stateunemployment taxes because of payment delinquencies (see Part II – Item 5 ofthis report).  The estimated additionalexpense in the six months ended March 31, 2003 is $476,000.

 

***Selling, General andAdministrative Expenses.***  Selling, general and administrative expenses, not includingdepreciation and amortization, increased 23.7% to $7,125,526 for the six monthsended March 31, 2003 from $5,761,360 for the six months ended March 31,2002.  Selling, general and administrativeexpenses, not including depreciation and amortization, as a percentage orrevenues decreased to 14.9% for the six months ended March 31, 2003 from 17.8%for the six months ended March 31, 2002. The increase in the dollar amount is primarily a result of theacquisitions in January and December 2002, whereas the percentage of revenuedecrease is attributable to significant cost reductions implemented by us andthe increase in revenues with no proportionate increase in selling, general andadministrative expenses.

 

***Depreciation and Amortization.***  Depreciation and amortization expenses, notincluding amortization of goodwill of $144,588 in the six months ended March31, 2002, increased to $454,127 for the six months ended March 31, 2003 from$300,919 for the six months ended March 31, 2002.  Depreciation and amortization, not including the amortization ofgoodwill, as a percentage of revenues increased to 1.0% for the six monthsended

 

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March 31, 2003 from 0.9% for the six months ended March 31, 2002.  The increase was due to capital expendituresand amortization of intangibles in connection with the acquisition in December2002.

 

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

 

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

 

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

 

**Liquidity and Capital Resources**

 

At March 31, 2003, we had limited liquidresources.  Current liabilities were$24,119,897 and current assets were $18,164,678.  The difference of $5,955,219 is a working capital deficit, whichis primarily the result of losses incurred during the last two years.  These conditions raise substantial doubtsabout our ability to continue as a going concern.  The financial statements do not include any adjustments toreflect the possible future effect on the recoverability and classification ofassets or the amounts and classification of liabilities that may result fromthe outcome of this uncertainty.

###### ** **

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

As a result of conversions of the debentures and certain transactionswith the debenture holders, only $40,000 of debentures remained outstanding atSeptember 30, 2002 and December 31, 2002.

 

We have a loan and security agreement (the “Agreement”) with a lendinginstitution which provides for a line of credit up to 85% of eligible accountsreceivable, as defined, not to exceed $12,000,000.  Advances under the Agreement bore interest at a rate of primeplus 1 1/2% (see below).  The creditagreement restricts our ability to incur other indebtedness, pay dividends andrepurchase stock.  Borrowings under theagreement are collateralized by substantially all of our assets.  As of March 31, 2003, $10,359,108 wasoutstanding under the credit agreement.

 

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

 

i)                      Failing to meet the tangible net worthrequirement;

 

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

 

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

 

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

 

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

 

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dividends on our Series F Preferred Stock at arate of 7% per annum of the stated value of the stock in preference andpriority to any payment of dividends on our common stock.  The aggregate stated value of the Series E,Series F and Series H Preferred Stock was $1,804,600, $800,000 and $500,000,respectively, as of March 31, 2003. Dividends on the Series E, Series F and Series H Preferred Stock may bepaid at the Company’s option in shares of common stock (valued at theconversion price of the applicable class of preferred stock) if such shareshave been registered for resale under the Securities Act of 1933.

 

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

 

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

 

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

 

•                       $995,565 under a promissory note bearinginterest at 6% per annum which was issued in connection with our acquisition ofcertain assets of PES and which is payable in equal quarterly installments of$36,770 until its maturity date in December 2011.

 

•                       $1,211,332, including $395,378 of imputedinterest, under a promissory note which was issued in connection with ouracquisition of Elite and which is payable in equal monthly installments of$13,167 until its maturity in November 2010.

 

•                       $80,000 under a promissory note that wasdue in April 2002 which bears interest at 18% per annum.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Wemay be required to make certain “earnout” payments to sellers of businessesthat we have acquired in recent years, including Source One, PES andElite.  The amount of these payments, ifany, will depend upon the results of the acquired businesses.  There were no earnout payments made infiscal 2002 or the six months ended March 31, 2003.

 

SourceOne has the right to require us to repurchase 400,000 shares of our commonstock at a price of $2.00 per share at any time after July 27, 2003 and beforethe later of July 27, 2005 and the full payment of the

 

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outstandingnote that we issued to it in connection with the acquisition transactioncompleted with Source One in July 2001. In addition, the holder of the $80,000 note which was due in April 2002has the right to require us to repurchase 20,000 shares of common stock at aprice of $1.00 per share plus interest at a rate of 15% per annum until thenote is paid in full.

 

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

 

In April 2003, we wereserved with a Complaint and named as one of several Defendants in the matter of*Lopez v. RSI Home Products, Inc. et al,*(“RSI”), in the Superior Court of California, Orange County. RSI is one of ourcustomers. The case is a class action proceeding alleging failure to pay hourlywages and overtime wages, failure to provide rest periods and meal periods orcompensation in lieu thereof, failure to pay wages of terminated or resignedemployees, knowing and intentional failure to comply with itemized employeewage statement provisions, violation of the unfair competition law, and breachof fiduciary duty. Stratus has engaged California counsel to represent it insuch proceedings; the time to file an Answer has been extended to June 6, 2003for all Defendants. The amount of Plaintiff’s claim against all Defendants isnot yet reasonably determinable or quantifiable.

 

In February 2003, the NewJersey Department of Labor notified us that approximately $2,100,000 of payrolltaxes are delinquent. We dispute that the entire amount is owed and haverecently begun discussion with the New Jersey Department of Labor to determinethe actual amount owed and arrange for payment of that amount over a period oftime. As of December 31, 2002, a substantial portion of such payroll taxliabilities had been accrued.

 

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

###### ** **

###### **Seasonality**

 

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

 

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

 

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

 

**Impact of Recent Accounting Pronouncements**

 

In June 2001, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 142, “Goodwill and Other Intangible Assets”.  SFAS No. 142, which must be applied to fiscal years beginningafter December 15, 2001, modifies the accounting and reporting of goodwill andintangible assets.  The pronouncementrequires entities to discontinue the amortization of goodwill; reallocate allexisting goodwill among its reporting segments based on criteria set by SFASNo. 142, and perform initial impairment tests by applying a fair-value-basedanalysis on the goodwill in each reporting segment.  Any impairment at the initial adoption date shall be recognizedas the effect of a change in accounting principle.  Subsequent to the initial adoption, goodwill shall be tested forimpairment annually or more frequently if circumstances indicate a possibleimpairment.

 

Under SFAS No. 142, entities are required to determine the useful lifeof other intangible assets and amortize the value over the useful life.  If the useful life is determined to beindefinite, no amortization will be recorded. For intangible assets recognized prior to the adoption of SFAS No. 142,the useful life should be reassessed. Other intangible assets are required to be tested for impairment in amanner similar to goodwill.  We adoptedSFAS No. 142 and completed a transitional impairment test, as required by SFASNo. 142, and determined that there was no impairment of goodwill as of October1, 2002.

 

In August 2001, the FASB issued SFAS No. 144, “Impairment of Long-LivedAssets”.  SFAS No. 144 supercedes SFASNo. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed of”.  SFAS No. 144retains the requirements of SFAS No. 121 to (a) recognize an impairment loss only if the carrying amount of along-lived asset is not recoverable from its undiscounted cash flows and (b)measure an impairment loss as the difference between the carrying amount andthe fair value of the asset.  SFAS No.144 removes goodwill from its scope. SFAS No. 144 is applicable to financial statements issued for fiscalyears beginning after December 15, 2001, or for our fiscal year endingSeptember 30, 2003.  The adoption ofSFAS No. 144 did not have any material adverse impact on our financial positionor results of our operations.

 

In June 2002, the FASB issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities” which nullifies EITF No. 94-3,“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity (including Certain Costs Incurred in aRestructuring)”.  SFAS 146 requires thata liability for a cost associated with an exit or disposal activity be recognizedwhen the liability is incurred.

 

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Under EITF 94-3, a liability for an exit cost as defined in EITF 94-3was recognized at the date of an entity’s commitment to an exit plan.  The provisions of SFAS 146 are effective forexit or disposal activities that are initiated after December 31, 2002.  The adoption of SFAS 146 may affect thetiming of the recognition of future exit and disposal costs.

 

In January 2003, the FASB issued Interpretation No. 46, “Consolidationof Variable Interest Entities.” Interpretation 46 changes the criteria by which one company includesanother entity in its consolidated financial statements.  Previously, the criteria were based oncontrol through voting interest.  Interpretation46 requires a variable interest entity to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the variable interestentity’s activities or entitled to receive a majority of the entity’s residualreturns or both.  A company thatconsolidates a variable interest entity is called the primary beneficiary ofthat entity.  The consolidationrequirements of Interpretation 46 apply immediately to variable interestentities created after January 31, 2003. The consolidation requirements apply to older entities in the firstfiscal year or interim period beginning after June 15, 2003.  Certain of the disclosure requirements applyin all financial statements issued after January 31, 2003, regardless of whenthe variable interest entity was established. The Company does not expect the adoption to have a material impact tothe Company’s financial position or results of operations.

 

**SENSITIVE ACCOUNTING ESTIMATES**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the financial statements andnotes. Significant estimates include management’s estimate of the carryingvalue of accounts receivable, the impairment of goodwill and the establishmentof valuation reserves offsetting deferred tax assets. Actual results coulddiffer from those estimates. The Company’s critical accounting policiesrelating to these items are described in the Company’s Annual Report on Form10-K for the year ended September 30, 2002. As of March 31, 2003, there havebeen no material changes to any of the critical accounting policies containedtherein.

 

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

 

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

 

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

 

**Item 4. – CONTROLS AND PROCEDURES**

 

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

 

Disclosure controls and procedures arecontrols and other procedures that are designed to ensure that informationrequired to be disclosed in our reports filed or submitted under the ExchangeAct is recorded, processed, summarized and reported with the time periods specifiedin the Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed in our reports filed under the Exchange Act isaccumulated and communicated to management, including our Chief ExecutiveOfficer and Chief Financial Officer as appropriate, to allow timely decisionsregarding required disclosure.

 

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**Part II – Other Information**

**Item 1 – Legal Proceedings**

 

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

 

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

 

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

 

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

### ** **

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

 

InFebruary 2003, Joseph J. Raymond, our President and Chief Executive Officer,the holder of the Series F Preferred Stock, converted 1,000 shares into1,000,000 shares of our Common Stock at a conversion price of $.10 pershare.  The issuance of the Common Stockupon such conversion was made in reliance upon the exemptions from registrationby Rule 506 and Section 4(2) of the Securities Act of 1933.

 

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

 

**Item 3 – Defaults Upon SeniorSecurities**

 

Dividendson our Series A Preferred Stock accrue at a rate of 7% per annum and arepayable semi-annually when and if declared by our Board of Directors.  No such dividends have been declared and, asof the date of the filing of this report, $535,497 of dividends is in arrearson the Series A Preferred Stock.

 

Dividendson our Series E Preferred Stock accrue at a rate of 6% of the stated value peryear, payable every 120 days.  As of thedate of the filing of this report, $77,112 is in arrears on the Series EPreferred Stock.

 

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

### ** **

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

 

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

 

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### **Item 5 – Other Information**

 

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

 

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

 

(a)             Exhibits

 
| **Number** |   | **Description**                                                                                 |   |
|------------|--------|-------------------------------------------------------------------------------------------------|--------|
|       |   |                                                                                            |   |
| 99.1       |   | Certification of Chief Executive Officer pursuant to Section 906 of  Sarbanes-Oxley Act of 2002 |   |
|       |   |                                                                                            |   |
| 99.2       |   | Certification of Chief Financial Officer pursuant to Section 906 of  Sarbanes-Oxley Act of 2002 |   |

 

(b)             Reports on Form8-K

 

On January 30, 2003, we filed a Form 8-K/A to amend our Form 8-k filed on November 26, 2002 to includepro forma financial information related to our acquisition of certain assets ofElite Personnel Services and certain historical financial information of theacquired business.

 

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SIGNATURES

 

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

 

 
|                     | STRATUS SERVICES GROUP, INC. |                                         |
|--------------------------|------------------------------|----------------------------------------------|
|                     |                         |                                         |   |
|                     |                         |                                         |   |
| Date:  May 15, 2003 | By:                          | /s/ Joseph J. Raymond                        |   |
|                     |                         | Joseph J. Raymond                            |   |
|                     |                         | Chairman of the Board of Directors,          |   |
|                     |                         | President and Chief Executive Officer        |   |
|                     |                         |                                         |   |
|                     |                         |                                         |   |
| Date:  May 15, 2003 | By:                          | /s/ Michael A. Maltzman                      |   |
|                     |                         | Michael A. Maltzman                          |   |
|                     |                         | Chief Financial Officer                      |   |
|                     |                         | (Principal Financial and Accounting Officer) |   |

 

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**CERTIFICATION**

I, Joseph J. Raymond, certify that:

 

1.                                       I have reviewedthis quarterly report on Form 10-Q for the quarterly period ended March 31,2003 of Stratus Services Group, Inc.;

 

2.                                       Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                                       Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a.               designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b.              evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c.               presented in this quarterlyreport our conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date.

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalent function):

 

a.               all significant deficienciesin the design or operation of internal controls which could adversely affectthe registrant’s ability to record, process, summarize and report financialdata and have identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b.              any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls.

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  May 15, 2003 | By:    | /s/ Joseph J. Raymond                |   |
|--------------------------|--------|--------------------------------------|--------|
|                     |   | Joseph J. Raymond                    |   |
|                     |   | Chairman and Chief Executive Officer |   |

 

25

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**CERTIFICATION**

 

I, Michael A. Maltzman,certify that:

 

1.                                       I have reviewedthis quarterly report on Form 10-Q for the quarterly period ended March 31,2003 of Stratus Services Group, Inc.;

 

2.                                       Based on myknowledge, this quarterly report does not contain any untrue statement of a materialfact or omit to state a material fact necessary to make the statements made, inlight of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                                       Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a.               designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b.              evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c.               presented in this quarterlyreport our conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date.

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a.               all significant deficienciesin the design or operation of internal controls which could adversely affectthe registrant’s ability to record, process, summarize and report financialdata and have identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b.              any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls.

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  May 15, 2003 | By:    | /s/ Michael A. Maltzman                     |   |
|--------------------------|--------|---------------------------------------------|--------|
|                     |   | Michael A. Maltzman                         |   |
|                     |   | Vice  President and Chief Financial Officer |   |

 

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