Form 10-K/A for 21ST CENTURY TECHNOLOGIES INC
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3-Dec-2004
Annual Report
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information contained in this section should be read in conjunction with the Selected Financial Data and our Financial Statements and notes thereto appearing elsewhere in this 10K. The 10K, including the Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about our industry, our beliefs, and our assumptions. Words such as "anticipates", "expects", "intends", "plans", "believes", "seeks", and "estimates" and variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements including without limitation (1) any future economic downturn could impair our customers' ability to repay our loans and increase our non-performing assets, (2) a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities, (3) interest rate volatility could adversely affect our results, (4) the risks associated with the possible disruption in the Company's operations due to terrorism and (5) the risks, uncertainties and other factors we identify from time to time in our filings with the Securities and Exchange Commission, including our Form 10-Ks, Form 10-Qs and Form 8-Ks. Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be incorrect. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Annual Report should not be regarded as a representation by us that our plans and objectives will be achieved. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report.
OVERVIEW
21st Century Technologies, Inc is a financial services company providing financing and advisory services to small and medium-sized companies throughout the United States. Effective October 1, 2003, we converted to a Business Development Company under the Investment Company Act of 1940. Upon completion of this conversion, we became an internally managed, diversified, closed-end investment company. Prior to the conversion we were a diversified holding company.
The results of operations for the year ended December 31, 2003 and the three-month period from October 1, 2003 through December 31, 2003 reflect our results as a business development company under the Investment Company Act of 1940. The three-month period from October 1, 2003 through December 31, 2003 includes a one-time conversion adjustment. The nine-month period from January 1, 2003 through September 30, 2003 reflects our results prior to operating as a business development company under the Investment Company Act of 1940. The principal difference between these two reporting periods relate to accounting for investments at fair value rather than cost; the fact that we no longer consolidate our wholly owned subsidiaries (Portfolio Companies). See Note A to our Financial Statements. In addition, certain prior year items have been reclassified to conform to the current year presentation as a business development company.
PORTFOLIO COMPOSITION
Our primary business is lending to and investing in businesses, with subordinated debt and equity-based investments, including warrants and equity appreciation rights. The total portfolio value of investments in publicly traded and non-publicly traded securities was $10.4 million at fair value at December 31, 2003.
OPERATING INCOME
Operating income includes interest income on commercial loans, advisory and management fees, and other income. Interest income is comprised of commercial loan interest at contractual rates and upfront fees that are amortized into income over the life of the loan.
Income from operations before cumulative effect of accounting change for the 3 months ended December 31, 2003 was $1,776,585. Net income after cumulative effect of accounting change was $2,009,581. Operating income before cumulative effect of accounting change was $105,535 and after cumulative effect of accounting change was $337,531. Net Loss for the period ended September 30, 2003 was $1,671,050. Net losses for the years ended December 31, 2002 and 2001 respectively was $1,930,845 and $5,766,572, respectively.
OPERATING EXPENSES
Operating expenses include interest expense on borrowings, employee compensation and general and administrative expenses.
Operating expenses for the 3-months ended December 31, 2003 were $249,583 and $1,530,079 for the nine-months ended September 30, 2003 for a total annual cost of $1,779,662. This compares with operating expenses of $2,457,330 and $5,561,418 for the years ended December 31, 2002 and 2001 respectively. Cost containment, efficiencies of operations and discontinuing unprofitable operations are the primary factors making these decreases possible.
RECONCILIATION OF NET OPERATING INCOME TO NET INCREASE (DECREASE)
IN STOCKHOLDER'S EQUITY FROM EARNINGS (LOSS)
Because we are a business development company, our investments are carried at fair value. (See discussion in "Management's Discussion and Analysis of Financial Condition and Results of Operations--Overview"). Realized gain for the year ended December 31, 2003 was $337,531. The net change in unrealized appreciation for the 3-months ended December 31, 2003 was $868,000 and the net change in unrealized depreciation on investments for the nine-months ended September 30, 2003 was $3,345,891. The appreciation occurred in investments made after conversion to a business development company and the depreciation is reflected by the accounting change to fair value of the formerly consolidated subsidiaries which are now recorded at fair value.
CUMULATIVE EFFECT OF ACCOUNTING CHANGES (CONVERSION TO
BUSINESS DEVELOPMENT COMPANY)
The results of operations for 2003 are divided into two periods. The nine-month period, representing the period January 1, 2003 through September 30, 2003, reflects the Company's results prior to operating as a business development company under the Investment Company Act of 1940, as amended. The three-month period ended December 31, 2003, reflects the Company's results as a business development company under the Investment Company Act of 1940, as amended. Accounting principles used in the preparation of the financial statements beginning October 1, 2003 are different than those of prior periods and, therefore, the financial position and results of operations of these periods are not directly comparable. The primary differences in accounting principles relate to the carrying value of investments--see corresponding sections below for further discussion.
The cumulative effect adjustment for the three-month period ended December 31, 2003 reflects the effects of conversion to a business development company as follows:
CUMULATIVE EFFECT OF BUSINESS
DEVELOPMENT COMPANY CONVERSION
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Effect of recording equity investments at fair value $ (4,213,891)
Adjustments for previously adjusted net assets 4,570,444
Adjustment for previously consolidated net loss (123,557)
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$ 232,996
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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
CASH AND CASH EQUIVALENTS
At December 31, 2003 and December 31, 2002, we had $1.8 million and $-0-, respectively, in cash and cash equivalents. We had investments in equity securities with fair value of $6,430,000 and $-0- at December 31, 2003 and December 31, 2002, respectively. Our objective is to maintain a low cash balance, while keeping sufficient cash on hand to cover current funding requirements and operations.
LIQUIDITY AND CAPITAL RESOURCES
We expect our cash on hand and cash generated from operations, to be adequate to meet our cash needs at our current level of operations, including the next twelve months. We generally fund new originations using cash on hand, advances under our credit facilities and equity financings.
BORROWINGS
The Company's borrowings consist of a non-interest bearing purchase note payable incurred in the acquisition of Paramount MultiServices, Inc. and several installment and promissory notes, which bear interest at 6.0% to 10%, are unsecured and contain no restrictions.
The purchase note payable is payable in annual installments of either the Company's restricted common stock or cash through December 2006. Because the terms of the note did not provide for interest, the Company has discounted the carrying value of this note to its fair value using a discounted interest rate of 5%.
On September 27,2002, the Company issued a $200,000 convertible promissory note convertible into 1,200,000 shares of Series A Convertible Preferred Stock, when authorized and issued, with rights and preferences as the Company may determine, to Fredericks Partners, a California partnership. The note provided for interest at 10% and was due March 27, 2003. In addition, the note gave its holders 600,000,000 votes as "debt votes" awarded by the Board of Directors by resolution of September 27, 2002. The note provided that it may be converted at any time prior to payment. On February 20, 2003, Fredericks Partners exercised its conversion priviledge.
CRITICAL ACCOUNTING POLICIES
The financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions.
INCOME RECOGNITION
Interest on commercial loans is computed by methods that generally result in level rates of return on principal amounts outstanding. When a loan becomes 90 days or more past due, or if we otherwise do not expect the customer to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and cease recognizing interest income on that loan until all principal has been paid. However, we may make exceptions to this policy if the investment is well secured and in the process of collection.
In accordance with GAAP, we include in income certain amounts that we have not yet received in cash, such as contractual payment-in-kind (PIK) interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term. However, in certain cases, a customer makes principal payments on its loan prior to making payments to reduce the PIK loan balances and, therefore, the PIK portion of a customer's loan can increase while the total outstanding amount of the loan to that customer may stay the same or decrease. There is no PIK loan balance at December 31, 2003.
Loan origination fees are deferred and amortized as adjustments to the related loan's yield over the contractual life of the loan. In certain loan arrangements, warrants or other equity interests are received from the borrower as additional origination fees. The borrowers granting these interests are typically non-publicly traded companies. We record the financial instruments received at estimated fair value as determined by our board of directors or an independent valuation expert. Fair values are determined using various valuation models which attempt to estimate the underlying value of the associated entity. These models are then applied to our ownership share considering any discounts for transfer restrictions or other terms which impact the value. Changes in these values are recorded through our statement of operations. Any resulting discount on the loan from recordation of warrant and other equity instruments are accreted into income over the term of the loan.
VALUATION OF INVESTMENTS
At December 31, 2003, approximately 97% of our total assets represented investments recorded at fair value. Value, as defined in Section 2(a)(41) of 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the board of directors. Since there is typically no readily ascertainable market value for the investments in our portfolio, we value substantially all of our investments at fair value as determined in good faith by the board of directors pursuant to a valuation policy and a consistent valuation process. Because of the inherent uncertainty of determining the fair value of investments that do not have a readily ascertainable market value, the fair value of our investments determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.
There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses. Instead, we must determine the fair value of each individual investment on a quarterly basis. We will record unrealized depreciation on investments when we believe that an investment has become impaired, including where collection of a loan or realization of an equity security is doubtful. Conversely, we will record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and, therefore, our investment has also appreciated in value, where appropriate.
As a business development company, we invest primarily in illiquid securities including debt and equity securities of private companies. The structure of each debt and equity security is specifically negotiated to enable us to protect our investment and maximize our returns. We generally include many terms governing interest rate, repayment terms, prepayment penalties, financial covenants, operating covenants, ownership parameters, dilution parameters, liquidation preferences, voting rights, and put or call rights. Our investments are generally subject to some restrictions on resale and generally have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation process requires an analysis of various factors. Our fair value methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.
VALUATION OF LOANS AND DEBT SECURITIES
As a general rule, we do not value our loans or debt securities above cost, but loans and debt securities will be subject to fair value write-downs when the asset is considered impaired. In many cases, our loan agreements allow for increases in the spread to the base index rate if the financial or operational performance of the customer deteriorates or shows negative variances from the customer's business plan and, in some cases, allow for decreases in the spread if financial or operational performance improves or exceeds the customer's plan.
VALUATION OF EQUITY SECURITIES
With respect to private equity securities, each investment is valued using industry valuation benchmarks, and then the value is assigned a discount reflecting the illiquid nature of the investment, as well as our minority, non-control position. When an external event such as a purchase transaction, public offering, or subsequent equity sale occurs, the pricing indicated by the external event will be used to corroborate our private equity valuation. Securities that are traded in the over-the-counter market or on a stock exchange generally will be valued at the prevailing bid price on the valuation date. However, restricted and unrestricted publicly traded securities may be valued at discounts from the public market value due to restrictions on sale, the size of our investment or market liquidity concerns.
RECENT DEVELOPMENTS
The Company has entered into a letter of intent to acquire DLC, Inc., a Las Vegas based general contracting firm. DLC has a multi-year history of successful projects, including several federal and local government projects. DLC currently has gross income of approximately $3 million dollars per year. We anticipate closing this transaction in the second quarter of 2004.
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