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Business Context and Reporting Period

This Form 10-Q covers Data Systems & Software Inc. (DSSI) for the quarterly period ended September 30, 2002. The company operates in three segments: Software Consulting and Development, Energy Intelligence Solutions (Comverge), and Computer Hardware. The filing highlights significant liquidity constraints, a major goodwill impairment charge, and operational challenges in its Israeli subsidiary (dsIT) and energy subsidiary (Comverge).

Key Financial Metrics

Note: Financial figures are in thousands unless otherwise noted. The Net Loss includes a non-cash goodwill impairment charge of $2.76 million.

Material Changes vs. Prior Period

• Revenue: Sales increased 9% year-over-year for the quarter and 2% for the nine-month period, driven by growth in the Computer Hardware and Software Consulting segments, partially offset by a 24% decline in Energy Intelligence Solutions sales due to production delays and contract suspensions.
• Profitability: Operating loss widened significantly due to a $2.76 million impairment charge on goodwill and acquired software in the Software Consulting segment, reflecting a decline in the hi-tech market and the Israeli economy.
• Inventory: Inventory levels surged to $3.2 million (from $0.7 million a year prior), primarily due to Comverge's investment in raw materials ($2.9 million) to secure future shipments.
• Liquidity: Cash and cash equivalents dropped from $4.0 million (Dec 31, 2001) to $1.6 million (Sep 30, 2002). Net cash used in operating activities was $5.0 million for the nine-month period.
• Debt Structure: The company issued a $2.0 million 10% convertible note to Laurus Master Fund in June 2002. Interest expense increased due to the amortization of this note's beneficial conversion feature.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• Computer Hardware: Management expects sales to increase to over $7.0 million in Q4 2002 and average over $6.0 million per quarter in 2003, aiming to generate positive cash flow ($700k in Q4, $320k/quarter in 2003).
• Corporate Expenses: The company aims to reduce corporate overhead by an additional 10% to under $600,000 per quarter to preserve liquidity.
• Comverge (Energy): Expected to be cash flow positive in Q4 2002 due to delayed shipments moving to the fourth quarter. However, 2003 projections suggest negative cash flow unless cost structures are adjusted.
• Debt Servicing: Unless cash flow improves, remaining principal payments on the Laurus convertible note will be made in stock, causing significant dilution.

Risks and Contingencies

• Contract Suspension: A major Comverge customer temporarily suspended work in October 2002 due to vendor concerns. While an amendment is agreed in principle, failure to finalize it could materially adversely impact Q4 results.
• Liquidity Risk: The company states its ability to continue as a going concern is contingent on achieving positive cash flow in the hardware segment and further expense reductions. $462,000 of working capital is trapped in the Israeli subsidiary and unavailable for US operations.
• Financing: The company has been unsuccessful in attracting outside equity for Comverge, and capital markets remain unfavorable.

Investor Verification Checklist

• Contract Amendment Status: Verify if the Comverge customer contract amendment was signed and if Q4 shipments proceeded as planned.
• Cash Burn Rate: Monitor monthly cash balances given the $1.6 million cash position and $10 million debt load.
• Hardware Sales Execution: Confirm if the projected 50% sales increase in the Computer Hardware segment materializes in Q4.
• Dilution Impact: Assess the potential share dilution if the Laurus convertible note is settled in stock rather than cash.
• Goodwill Impairment Finalization: Check if the Q4 annual impairment test results in further charges to the Software Consulting segment.