(Exact name of Registrant as specified in its charter)

 

 

(Address, including zip code, and telephone number, including

area code, of Registrant’s principal executive offices)

 

 

As of November 1, 2006 there were 18.5 million shares of the registrant’s common stock outstanding.

 

 

 

 

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

 

The accompanying condensed consolidated financial information of SYS and its subsidiaries (SYS or the Company) should be read in conjunction with the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended June 30, 2006 filed with the Securities and Exchange Commission (SEC). The accompanying financial information includes all subsidiaries on a consolidated basis and all normal recurring adjustments which are considered necessary by the Company's management for a fair presentation of the financial position, results of operations and cash flows for the periods presented. However, these results are not necessarily indicative of results for a full fiscal year. All of the Company’s operations are conducted in the United States.

The Company’s fiscal year is from July 1 through June 30.  The Company uses the 5-4-4 weeks per period method for each quarter; periods one (July) and twelve (June) may vary slightly in the actual number of days due to the beginning and end of each fiscal year.

 

The preparation of financial statements in conformity with Generally Accepted Accounting Principles in the United States (US GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the future, the Company may realize actual results that differ from the current reported estimates.  The Company’s significant estimates include those related to revenues and customer billings, recovery of indirect costs, allowance for doubtful accounts, valuation of long-lived assets including identifiable intangibles and goodwill, accounting for income taxes including any related valuation allowance, contingencies, and share-based compensation.

Certain amounts in the prior year financial statements have been reclassified to conform to the current year financial statement presentation. In particular, allocable overhead costs that were previously reported as selling, general and administrative expenses were reclassified to costs of revenues in the amount of $0.3 million and certain other costs also previously included in selling, general and administrative expenses were reclassified to research, engineering and development expenses in the amount of $0.3 million. Additionally, $0.1 million of cash flows related to the Company’s Employee Stock Purchase Plan previously classified as financing activities were reclassified to operating activities. The Company believes these reclassifications were immaterial to the overall presentation of the accompanying financial statements.

In July 2006, the FASB issued FASB Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes”, which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN No. 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN No. 48 will be effective July 1, 2007 and the Company is in the process of determining the effect, if any, the adoption of FIN No. 48 will have on its financial condition or results of operations.

In September 2006, the FASB issued FASB Statement No. 157 (SFAS 157), “Fair Value Measurements”. SFAS 157 proscribes a single definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The accounting provisions of SFAS 157 will be effective for the Company beginning July 1, 2008. The Company does not believe the adoption of SFAS 157 will have a material impact on its financial condition or results of operations.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (SAB 108). SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. When the effect of initial adoption is material, companies will record the effect as a cumulative effect adjustment to beginning of year retained earnings. SAB 108 will be effective for the Company beginning July 1, 2007. The Company is in the process of determining whether the initial adoption will have a material impact on its financial condition.

The Company has two stock plans that provide or have provided for the grant to employees of stock options, permit the grant of non-statutory share-based awards to paid consultants, and provide for the automatic grant of non-statutory share-based awards to outside directors. The plans may have options with terms of no more than ten years. The maximum terms of the options granted under these plans have been seven years with a maximum vesting of five years. The Company also has an employee stock purchase plan (ESPP) for employees to purchase its common stock at a discount. The ESPP provides for enrollment on the first day of a six-month period in which the employees can elect payroll deductions for the purchase of the Company’s common stock. The exercise date of the ESPP is the last day of the six month period and the purchase price is 85% of the fair market value of a share of common stock on the enrollment or exercise date, whichever is lower.

The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), effective July 1, 2005 using a modified prospective application, as permitted under SFAS 123(R). Under the modified-prospective-transition method, share-based compensation expense recognized during the three months ended September 29, 2006 and September 30, 2005 includes stock options granted prior to, but not yet vested as of July 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123 and the following items based on the grant date values estimated in accordance with the provisions of SFAS No. 123R: (a) stock options granted after June 30, 2005, (b) ESPP with offering periods commencing subsequent to June 30, 2005 and (c) stock issued to employees of the Company.

The following table summarizes certain information regarding stock options during the three months ended September 29, 2006 (in thousands):

The following is a summary of the share-based compensation expense recognized by the Company for the three months ending September 29, 2006 and September 30, 2005 (in thousands):

 

 

Accounts receivables consist of the following (in thousands):

Inventory consisted of the following (in thousands):

Furniture, equipment and leasehold improvements consisted of the following (in thousands):

Depreciation and amortization expense for furniture, equipment and leasehold improvements was $0.2 million and $0.1 million for the three months ended September 29, 2006 and September 30, 2005, respectively.

Intangible assets consist of the following (in thousands):

Amortization expense for intangible assets was $0.3 million and $0.1 million for the three months ended September 29, 2006 and September 30, 2005, respectively.

 

 

The changes in the carrying amount of goodwill during the three months ended September 29, 2006 are as follows (in thousands):

(1) See Note 11 regarding our reportable segments.

The following table shows the detail of our convertible notes payable as of September 29, 2006 and June 30, 2006 (amounts in thousands):

Maturities of principal balances of convertible notes, excluding the effect of the discount, are: Fiscal 2007 - $2.1 million and 2009 - $3.1 million.

Related parties consist of directors, officers and employees of the Company and their affiliates that are holders of the notes payable.

 

The Company has a bank line of credit facility which provides for borrowings of up to $4.0 million. This credit facility, as it relates to any balances outstanding on the line of credit, expires in December 2006, contains financial and other covenants, and is collateralized by substantially all of the assets of the Company. Borrowings pursuant to the line of credit bear interest at the bank’s prime rate plus 0.25% (8.5% as of September 29, 2006). As of September 29, 2006, the Company had approximately $0.3 million of borrowings outstanding under this line of credit. On September 27, 2006, the Company and the lender amended the terms of the credit facility to eliminate the minimum quarterly net income covenant, the current assets to current liabilities covenant, the ratio of Senior debt to EBITDA covenant, and modify the tangible effective net worth covenant and cash flow coverage ratio covenant.

The credit facility allows the Company to use, under a Sub Facility, up to $2.0 million of the credit facility for permitted acquisition purposes and $750,000 for minority investment purposes.  The Company is subject to certain restrictions on the permitted acquisitions and minority investments and in some cases must receive Comerica's consent prior to using the facility for such purposes.

If the Sub Facility is used for permitted acquisitions or minority investments, such borrowings must be repaid over 48 months. During fiscal 2006, in connection with the purchase of RBIS, the Company utilized $1.0 million of the line of credit for payment of a portion of the purchase consideration. In accordance with the terms of the credit facility, the $1.0 million was converted to a term note effective June 10, 2006. The term note is payable in monthly installments of $20,833 plus interest for the fiscal years 2007 through 2010, with payments beginning in October, 2006. As of September 29, 2006, $1.0 million was outstanding under the term note, of which $0.3 million was classified as a current liability. A total of $0.25 million of principal amounts of this note are due annually in fiscal years 2007, 2008, 2009 and 2010. The outstanding balance related to the Sub Facility reduces the maximum borrowings available under the line of credit. As a result, as of September 29, 2006, the maximum borrowing under the line of credit was $3.0 million and the remaining available borrowing capacity on the line of credit was approximately $2.7 million.

 

Basic net income (loss) per common share is calculated by dividing net income applicable to common stock by the weighted average number of common shares outstanding during the period. The calculation of diluted net income (loss) per common share is similar to that of basic net income (loss) per common share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares, principally those issuable upon the conversion of notes payable and the exercise of stock options and warrants, were issued during the period.

The following table summarizes the calculation of basic and diluted net income (loss) per common share for each period (in thousands except per share data):

For the three months ended September 29, 2006, a total of 1.9 million shares related to stock options, convertible notes and the ESPP were excluded from the calculation of diluted EPS because they were anti-dilutive.

Periodically, the Company is involved in legal actions in the normal course of business, including audits and investigations by various governmental agencies that result from our work as a governmental contractor. There are currently no such legal matters outstanding.

Effective July 1, 2006 certain business activities that were managed and reported under the DSG were moved into the PSSIG and are now managed and reported within that business group. The activities consisted principally of training related services and certain software services-based contracts that are inter-related with other activities in the PSSIG. Prior year amounts have been reclassified to reflect the inclusion of these activities in the PSSIG.

For the three months ended September 29, 2006, the Company’s revenues were derived primarily from engineering and technical services, but also included product sales that represented less than 10% of consolidated revenues. For the three months ended September 30, 2005, the Company’s revenues were derived solely from engineering and technical services. Revenues for all periods presented were from customers located in the U. S. The Company has no operations located outside of the U. S.

Sales to the U.S. government, including both defense and non-defense agencies, and sales as a subcontractor as well as direct sales, aggregated approximately $15.0 million, or 92.1% of consolidated revenues in the three months ended September 29, 2006. The Company did not have any significant non-government sales during the three months ended September 30, 2005. No single contract or individual customer accounted for more than 10% of total revenue for the three months ended September 29, 2006 and September 30, 2005, respectively.

 

Selected financial data by segment is as follows (in thousands):

 

On October 17, 2006, the Company acquired all the outstanding common stock of Ai Metrix in a stock transaction for approximately $7.7 million, inclusive of approximately $0.4 million of transaction costs. The Company will include the financial results of Ai Metrix in its consolidated financial statements beginning October 17, 2006. Ai Metrix is a Reston, Virginia-based provider of innovative network management solutions. The merger furthers one of SYS’s goals of broadening its customer base for both commercial and governmental entities as well as broadening its existing product base.

In connection with the merger, the Company issued approximately 3.1 million shares of common stock, valued at approximately $7.3 million based on the average closing price of the Company’s common stock for the period beginning two days before and the day of the execution of the merger agreement. Additional consideration of up to 1.9 million shares of SYS common stock may be issued if certain EBITDA targets are met through December 31, 2007.

The merger was accounted for under the purchase method of accounting in accordance with Statement of Financial Standards No. 141 “Business Combinations” (SFAS 141). The total purchase price of $7.7 million has been preliminarily allocated to the net tangible and intangible assets of Ai Metrix acquired in connection with the merger based on the estimated fair values on the effective date of the merger which consisted of cash $0.1 million, accounts receivable $1.8 million, property and equipment and prepaid expenses $0.2 million and accounts payable and accrued expenses ($0.8). The remaining purchase price of $6.4 million will be allocated to deferred revenue, deferred taxes, goodwill and identified intangible assets. The allocation of the purchase price has not been finalized and is subject to change. The primary areas of the purchase price allocation that are not yet finalized relate primarily to deferred taxes, deferred revenue and intangible assets. The Company plans to complete the purchase price allocation during fiscal year 2007.

The excess of the Company’s total acquisition costs over the estimated fair value of the net assets acquired will be allocated to goodwill. The Company expects that the goodwill will be included as part of the PSSIG segment. The goodwill is not subject to amortization and none of the amount assigned to goodwill is deductible for tax purposes.

 

SYS and its subsidiaries provide information connectivity solutions that capture, analyze and present real-time information to customers in the Department of Defense (DoD), Department of Homeland Security (DHS), other government agencies and to large industrial companies.  Using interoperable communications software, sensors, digital video broadcast and surveillance technologies, wireless networks, decision-support tools and Net-centric technologies, our technical experts enhance complex decision-making. Founded in 1966, SYS is headquartered in San Diego and has principal offices in California, Virginia and Maryland.

We enhance situational awareness in battlefield, environmental disaster and crisis environments for our national security customers. We optimize utilization of remote assets for our industrial, energy and transportation customers. We also provide solution lifecycle support with program, financial, test and logistical services, including classroom and online training.

Management currently considers the following events, trends and uncertainties to be important to understanding the financial condition and operating performance of SYS.

 

The following table sets forth certain items, including consolidated revenues for the three months ended September 29, 2006 and September 30, 2005:

 

 

Revenues by reportable segment for the three months ended September 29, 2006 and September 30, 2005 were as follows (in thousands):

Effective July 1, 2006 certain business activities that were managed and reported under the DSG were moved into the PSSIG and are now managed and reported within that business group. The activities consisted principally of training related services and certain software services based contracts that are inter-related with other activities in the PSSIG. Prior year amounts have been reclassified to reflect the inclusion of these activities in the PSSIG.

The growth in the PSSIG operating segment is primarily attributable to growth from the recent acquisitions of cVideo and Logic Innovations, which together added revenues of $1.3 million in the first quarter of fiscal 2007 and approximately $1.2 million from increases in training and software engineering services in the PSSIG . The growth in the DSG segment is primarily attributable to the acquisition of RBIS, which added $2.2 million in revenue for the first quarter of fiscal 2007, offset by decreases of $1.6 million related to certain programs within C4ISR and management and engineering services.

As a percentage of revenue, costs of revenue were 77.0% for the first quarter of fiscal 2007 and 80.2% for the same period in fiscal 2006, resulting in gross margins of 23.0% and 19.8%, respectively. The increase in gross margin in the first quarter of fiscal 2007 compared to the same period in fiscal 2006 was primarily due to the introduction of product revenues through the acquisition of cVideo and Logic Innovations during the second quarter of fiscal 2006.

Income from operations for the current fiscal year includes share-based compensation expense incurred during the first quarter of fiscal 2007 and 2006 of approximately $0.1 million and $0.2 million, respectively, which included non-cash expenses associated with stock options granted to employees, the employee stock purchase plan and in the first quarter of fiscal 2006, non-cash expenses related to an employee stock purchase agreement. The recognition of these share-based compensation expenses is in accordance with FASB No. 123R, which was adopted as of the beginning of the fiscal 2006.

Historically, we have financed our operations and met our capital expenditure requirements through cash flows provided from operations, long-term borrowings (including the sale of convertible notes), sales of equity securities and the use of our line of credit. The significant components of our working capital are liquid assets such as cash, trade accounts receivable, inventories and income taxes receivable, reduced by accounts payable, accrued expenses, line of credit, the current portion of our term note, the current portion of our convertible notes payable, the current portion of our deferred tax liabilities and deferred revenue. Working capital was $7.7 million at September 29, 2006 compared to $7.3 million at June 30, 2006.

As of September 29, 2006, we had convertible notes payable totaling $5.2 million consisting of $1.5 million remaining from a $3.2 million private placement completed during 2004 (excluding $28,000 balance of note discount), $0.4 million issued in connection with the acquisition of Polexis, $0.2 million issued in connection with the Antin acquisition, and $3.1 million issued in conjunction with the private placement in February 2006. A total of $2.1 million of the convertible notes mature in fiscal 2007.

 

One of our regular sources of liquidity is our revolving line of credit facility for $4.0 million that expires on December 28, 2006. Our revolving line of credit facility had an outstanding balance of $0.3 million at September 29, 2006. The $4.0 million revolving line of credit facility allows SYS to use (i) the full $4.0 million for working capital purposes or (ii) under a Sub Facility, up to $2.0 million of the credit facility for permitted acquisition purposes and $750,000 for minority investment purposes. The line of credit is subject to certain restrictions on permitted acquisitions and minority investments, and in some cases, we must receive the lender’s consent prior to using the facility for such purposes. If used for permitted acquisitions or minority investments, these advances must be repaid over 48 months. During fiscal 2006, in connection with the purchase of RBIS, we utilized $1.0 million of this line for payment of a portion of the purchase consideration. In accordance with the terms of the credit facility, the $1.0 million was converted to a term note effective June 10, 2006. The term note is payable in monthly installments of $20,833 plus interest for fiscal years 2007 through 2010, with payments beginning October, 2006. The balance of the term note as of September 29, 2006 was $1.0 million, of which $0.3 million was classified as a current liability. A total of $0.25 million of principal amounts of this note are due in fiscal years 2007, 2008, 2009 and 2010. The outstanding balance related to the Sub Facility reduces the maximum borrowings available under the line of credit. As a result, as of September 29, 2006, the maximum borrowing under the line of credit was $3.0 million and the remaining available borrowing capacity on the line of credit was approximately $2.7 million.

On September 27, 2006, SYS and the lender agreed to amend the terms of the line of credit to eliminate the minimum quarterly net income covenant, current assets to current liabilities covenant and ratio of senior debt to EBITDA covenant and modify the tangible effective net worth covenant and cash flow coverage ratio covenant.

We have the option of being charged prime plus 0.25% or LIBOR plus 300 basis points on the credit facility and prime plus 0.50% or LIBOR plus 325 basis points on the sub facility subject to minimum advance amounts and duration under the LIBOR option. The loan is collateralized by all of our assets including accounts receivable. Borrowings are limited to 80% of our billed accounts receivable that are less than 90 days old.

The maturity dates of principal amounts owed under the $1.0 million term note with this lender would not be affected by the termination of the line of credit. However, in the event of termination, the covenants currently applicable to the line of credit would remain applicable to the term note for as long as amounts are outstanding. Long-term liquidity and continued acquisition related growth will depend on our ability to manage cash, raise cash through debt and equity financing transactions and regain profitability. We may seek to raise additional capital from time to time as market conditions permit and subject to Board approval. Our recent losses may impact our ability to raise capital or extend the expiration date of our line of credit.

(1) Includes principal and interest

 

 

Currently, a substantial part of our business is work we do for the U.S. Government. Even though the amount of business we receive from this customer is growing and we have negotiated multiple-year contracts that include option and award years, budget changes in Congress or the U.S. Government could have a significant and adverse effect on us. In addition, we do not know whether the U.S. Government will exercise each option or award year available on a contract. Depending on the contract, we may perform as a prime contractor or as a subcontractor to another prime contractor. In cases where we perform as a subcontractor, we may be subject to price modifications required by the prime contractor. Such price modifications, if not mitigated by a corresponding reduction of costs, could have a negative impact on our profitability.

 

 

A significant number of our customers are government agencies, principally DoD agencies. These agencies often do not set their own budgets and therefore have little control over the amount of money they can spend. In addition, these agencies experience political pressure that may dictate the manner in which they spend money. Due to political and budgetary processes and other scheduling delays that frequently occur in the contract or bidding process, some government agency orders may be canceled or substantially delayed, and the receipt of revenues or payments may be substantially delayed.

 

In addition, future sales to government agencies will depend on our ability to meet government contracting requirements, certain of which may be onerous or impossible to meet, resulting in our inability to obtain particular contracts. Common requirements in government contracts include bonding, provisions permitting the purchasing agency to modify or terminate the contract at-will and without penalty and provisions permitting the agency to perform investigations or audits of our business practices.

 The U.S. Government has a program that encourages and sometimes requires large prime contractors to use small businesses. The U.S. Government restricts the competition on some contracts to qualifying small businesses. Some of our contracts and subcontracts have been awarded based on our eligibility as a small business. The definition of a small business depends on the type of product or service being provided. The U.S. Government uses North American Industry Classification System (NAICS) codes to classify the small business size standards for all industries. One of our primary NAICS codes was for engineering services, and beginning in fiscal year 2005, we no longer qualified as a small business using this code. However, we still qualify as a small business using several other NAICS codes. In addition, the small business contracts currently held by us do not terminate as a result of our no longer qualifying as a small business under any specific NAICS Code, and any option years on these contracts are also not affected by a change in small business status. Nevertheless, it is possible that our future revenues may be adversely impacted by our recent growth and consequent failure to qualify as a small business under certain NAICS codes.

 

The US Government is currently prosecuting a major war effort in Iraq, a major world wide global war on terrorism including troops in Afghanistan and other countries. The products and services that SYS offers in information connectivity, sensor networking, and command and control provides solutions to the real-time information and communications challenges faced in the efforts to address these crises. However, continued spending for the war effort may cause a shift in funding for these transformational technology solutions. The lack of funding for our programs will cause a material adverse affect on our financial condition, results of operations and cash flows.

 

 

Our future success and ability to compete depends in part upon our employees and their customer relationships, as well as our proprietary technology and trademarks, which we attempt to protect with a combination of patent, copyright, trademark and trade secret claims, as well as with our confidentiality procedures and employee contract provisions. These legal protections afford only limited protection and are time-consuming and expensive to obtain and/or maintain. Further, despite our efforts, we may not prevent third parties from soliciting our employees or customers or infringing upon or misappropriating our intellectual property. Our employees, customer relationships and intellectual property may not provide us with a competitive advantage adequate to prevent competitors from entering the markets for our products and services. Additionally, our competitors could independently develop non-infringing technologies that are competitive with, and equivalent or superior to, our technology. Monitoring infringement and/or misappropriation of intellectual property can be difficult, and it is possible that we would not detect an infringement or misappropriation of our proprietary rights. Even if we were to detect an infringement or misappropriation of our proprietary rights, litigation to enforce these rights would be costly and would cause us to divert financial and other resources from our normal business operations.

 

 

Certain key employees are intimately involved in our business and have day-to-day relationships with critical customers. Competition for highly skilled business, product development, technical and other personnel is intense, and we may not be successful in recruiting new personnel or in retaining our existing personnel. A failure on our part to retain the services of these key personnel could have a material adverse effect on our operating results and financial condition. We do not maintain key man life insurance on any of our employees with the exception of our CEO.

 

 

We have many competitors with comparable characteristics and capabilities that compete for the same group of customers. Our competitors are competent and experienced and are continuously working to take projects away from us. Many of our competitors have greater financial, technical, marketing and other resources than we do. Our ability to compete effectively may be adversely affected by the ability of these competitors to devote greater resources to the sale and marketing of their products and services than are available to us.

 

 

As a government contractor, we must comply with, and we are affected by, various government regulations. Changes in these regulations could affect our operating results, and we could be subject to penalties for failure to comply with them. Among the most significant of these regulations are:

 

 

Our provisional indirect billing rates are approved at least annually by the Defense Contract Management Agency (DCMA) after being reviewed by the Defense Contract Audit Agency (DCAA).  These rates can differ from our actual indirect rates.  We budget to have our actual indirect rates as close as possible to our government approved indirect rates at fiscal year end.  Throughout the year, management assesses how these rates compare to forecasted rates for the year.  If a variance is expected to exceed the amount to be billed, provisions for such variance are recognized at that time.

For interim reporting purposes, SYS applies overhead and selling, general and administrative expenses as a percentage of direct contract costs based on annual budgeted indirect expense rates. To the extent actual expenses for an interim period are greater than the budgeted rates, the variance is deferred if management believes it is probable that the variance will be absorbed by planned contract activity. This probability assessment includes projecting whether future indirect costs will be sufficiently less than the annual budgeted rates or can be absorbed by seeking increased billing rates applied on cost-plus-fee contracts. At the end of each interim reporting period, management assesses the recoverability of any amount deferred to determine if any portion should be charged to expense. In assessing the recoverability of variances deferred, management takes into consideration estimates of the amount of direct labor and other direct costs to be incurred in future interim periods, the feasibility of modifications for provisional billing rates, and the likelihood that an approved increase in provisional billing rates can be passed along to a customer. If assumptions about the probability of recovering deferred variances change, deferred amounts could be expensed and such expenses could have a material adverse effect on the results of operations.

 

 

We regularly employ subcontractors to assist us in satisfying our contractual obligations. We could have disputes with subcontractors concerning a number of issues, including the quality and timeliness of their work, a decision on our part not to extend task orders or issue new task orders under a subcontract, or our hiring of former personnel of a subcontractor. A failure by one or more of our subcontractors to satisfactorily deliver agreed-upon services on a timely basis could materially and adversely impact our ability to perform our obligations as a prime contractor. In extreme cases, such subcontractor performance deficiencies could result in the government terminating our contract for default. A default termination could expose us to liability for excess costs of procurement by the government and have a material adverse effect on our ability to compete for future contracts and task orders, which in turn could also have a material impact on our results of operations.

 

 

If we cannot obtain the necessary security clearances, we may not be able to perform classified work for the government and our revenues may be adversely affected. Certain government contracts require our facilities and some of our employees to maintain security clearances. If we lose or are unable to obtain security clearances required for a particular contract, the client can terminate the contract or decide not to renew it upon its expiration. As a result, to the extent we cannot obtain the required security clearances for our employees working on a contract, we may not derive the revenue anticipated from that contract. Any such reduction in revenue, if not replaced with revenue from other contracts, could seriously harm our operating results.

Security breaches in sensitive government systems could result in the loss of clients and negative publicity. Many of the systems we develop involve managing and protecting information involved in national security and other sensitive government functions. A security breach in one of these systems could cause serious harm to our business, could result in negative publicity and could prevent us from having further access to such critically sensitive systems or other similarly sensitive areas for other government clients.

 

 

We plan to grow our revenues and profits by adding to our existing customer base through organic growth and by the acquisition of other government services and government or commercial technology related companies. Over the past five years we have hired senior management personnel capable of establishing new business units within SYS. Rapid expansion through internal growth has required additional capital resources. We plan to continue this approach to building our business. There can be no assurances that such an approach will result in profitability in the future.

 

We believe that we can also grow through the acquisition of other government services companies and government or commercial technology related companies that have product offerings which may be sold to both commercial and government customers. The acquisition of other companies and growing those businesses is uncertain and contains a variety of business risks, including: integration, cultural differences, the retention of key personnel, competition, protection of intellectual property, industry changes and others. We intend to attempt to expand our operations through the acquisition of other companies. Acquisitions and attempted acquisitions may place a strain on our limited personnel, financial and other resources. Our ability to manage this growth, should it occur, will require expansion of our capabilities and personnel. We may not be able to find qualified personnel to fill additional positions or be able to successfully manage a larger organization. Further, we intend to finance these transactions through a combination of cash and/or equity and debt financing transactions. Our ability to use our stock as an acquisition currency may be limited because the trading volume in our stock has been low, our stock price has been volatile, and our stock may not maintain a price sufficient to support transactions without excessive dilution.

 

 

While we are likely to look for new funding to assist in the acquisition of businesses, it is uncertain whether such funding will be available. Our substantial reliance on our revolving line of credit facility with Comerica Bank - California imposes certain limitations on us, such as complying with financial covenants. If we are to grow and expand our operations, we will need to raise significant amounts of additional capital. We may not be successful in raising additional capital, or if we are successful, that we will be able to raise capital on reasonable terms. If we do raise additional capital, our existing shareholders may incur substantial and immediate dilution. The net loss reported for the three months ended September 29, 2006 and for fiscal year ended June 30, 2006 may further impact our ability to raise capital.

 

 

As of September 29, 2006, we had issued 15,471,344 shares of common stock. Up to 1,467,881 shares of common stock were issuable upon the exercise of employee stock options at a weighted average exercise price of $2.25 per share, 687,522 shares were issuable upon the conversion of convertible notes from the February 2004 Offering at $2.20 per share, 168,563 shares were issuable upon the conversion of convertible notes from the acquisition of Polexis at $2.32 per share, 78,400 shares were issuable upon the conversion of the convertible note payable from the Antin acquisition at $2.50 per share, 868,056 shares were issuable upon the conversion of convertible notes from the February 2006 Offering at $3.60 per share, 313,401 shares were issuable upon the exercise of warrants issued in connection with the May 27, 2005 Offering at $2.50 per share, 50,000 shares were issuable upon the exercise of warrants issued in connection with the acquisition of the Lomasoft technology at $3.87 per share, 110,000 shares were issuable upon the exercise of warrants issued in connection with various transactions at $4.00 per share, 20,000 shares were issuable upon the exercise of warrants issued for services rendered to SmallCap Corporate Advisors, LLC at $2.44 per share and up to 818,750 shares contingently issuable under earn-out provisions in various acquisition transactions. Shares issued upon any conversion of our outstanding convertible notes or upon the exercise of outstanding options and warrants could adversely affect the market price of our common stock.

 

 

Our common stock is traded on the American Stock Exchange. Trading in our common stock has been sporadic, and at present, there is a limited market for the stock. We cannot predict whether a stronger market will develop. Even if such a market does develop, it may not be sustained. There are no analysts currently covering the Company.

 

 

As of September 29, 2006, a total of 7,370,888 shares of our outstanding common stock were “restricted securities” and could be sold in the public markets only in compliance with Rule 144 adopted under the Securities Act of 1933 or other applicable exemptions from registration. Rule 144 provides that a person holding restricted securities for a period of one year may thereafter sell, in brokerage transactions, an amount not exceeding in any three-month period the greater of either (i) 1% of the issuer’s outstanding common stock or (ii) the average weekly trading volume in the securities during a period of four calendar weeks immediately preceding the sale. Persons who are not affiliated with the issuer and who have held their restricted securities for at least two years are not subject to the volume limitation. Possible or actual sales of our common stock by present shareholders under Rule 144 could have a depressive effect on the price of our common stock.

 

 

 

As a result of their ownership and positions, our directors, executive officers, and affiliated persons, collectively, are able to significantly influence all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. In addition, sales of significant amounts of shares held by our directors and executive officers and affiliated persons, or the prospect of these sales, could adversely affect the market price of our common stock. Management’s stock ownership may discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us, which in turn could reduce our stock price or prevent our shareholders from realizing a premium over our stock price.

Our exposure to market risk for changes in interest rates relates primarily to our investment income and interest expense. As of September 29, 2006 our cash was primarily invested in a money market interest bearing account. A hypothetical 10% adverse change in the average interest rate on our money market cash investments would have had no material effect on net income for the three months ended September 29, 2006. We currently do not utilize any derivative financial instruments to hedge interest rate risks.

We have interest rate risk in that borrowings under our line of credit and term note are based on variable market interest rates. As of September 29, 2006, we had $0.3 million of variable rate debt outstanding under our credit facility and $1.0 million outstanding under a term note.  Presently, the revolving credit line bears interest at a rate of prime plus 0.25% and the term note bears interest at a rate of prime plus 0.50%. A hypothetical 10% increase in the weighted average interest rate on our combined line of credit and term note would not have had a material impact to our results of operations for the three months ended September 29, 2006.

Our privately issued convertible notes have fixed interest rates of 10%, but have exposure to changes in the debt’s fair value. We believe that the fair value of our total outstanding convertible notes is approximately $3.9 million at September 29, 2006 based on the conversion rate of the notes and the closing price of our common stock on September 29, 2006.

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 29, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of September 29, 2006, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective.

Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

*Filed herewith