April
5,
2006
VIA
FACSIMILE (202) 772-9210
Mr.
Brad
Skinner
Accounting
Branch Chief
Division
of Corporation Finance
United
States Securities & Exchange Commission
Mail
Stop
4561
100
F
Street N.E.
Washington,
D.C. 20549
|
Re:
|
SYS
Form 10-KSB for the Fiscal Year Ended June 30,
2005
|
Filed
September 28, 2005
Form
10-Q
for the Quarterly period Ended December 31, 2005
Filed
February 14, 2006
File
No.
1-32397
Dear
Mr.
Skinner:
This
letter has been prepared in response to the comment contained in your letters
of
March 10, 2006 and February 21, 2006 with regard to the
above-referenced report on Form 10-KSB and Form 10-Q. This comment is addressed,
below:
Form
10-Q for the Quarterly Period ended December 31, 2005
Item
1. Financial Statements
Note
10. Acquisitions
1. We
have
read your response to prior comment number 1 and do not believe that you have
adequately addressed our concerns. Please explain to us, as requested in the
previous comment, why you have allocated a relatively immaterial amount to
customer-related intangibles and technology considering your disclosure
indicating that the purpose of the transaction was to expand your products
and
customer base. You response should explain, in detail, why there is little
value
assigned to assets that would reflect your stated objectives for the
transaction. We may have further comment.
Response
Discussion
The
disclosure in our Form 10-Q states that “we are selectively acquiring businesses
and technologies that complement and enhance our existing businesses and that
will allow us to broaden our customer base” (Form 10-Q, p.21). Our intent was to
convey the message that with these enhanced capabilities we are able to pursue
a
broader cross section of the Department of Defense (DoD), Department of Homeland
Security (DHS) and other government markets as our primary objective and that
the addition of new customers from the acquisition is a secondary objective.
In
many cases, we won’t be able to pursue the acquired company’s customers with our
overall SYS solutions and further, both cVideo and Logic operate in industries
where they often sell through distributors and don’t often have customer
specific contracts.
An
additional attribute of this strategy is that “we expect that this operating
strategy will continue and we also expect that with the expanded capabilities
that we’ve acquired, together with our existing capabilities that we will be
able to bid on larger government contracts and programs” (Form 10-Q, p.21). Key
to this strategy is that SYS has already developed or acquired certain other
core capabilities where we can then “plug-in” some of the assets from a cVideo
or Logic. That being said, each of these companies has separate stand alone
value and that is what we’ve endeavored to evaluate in our purchase allocation
process.
In
the
case of both Logic Innovations and cVideo, our strategy is then
threefold:
| (i) |
To
take their respective product offerings “together with other SYS owned
technologies, products and expertise” to deliver into the DoD, DHS and
other governmental agencies. SYS already has an existing customer
base in
these markets whereas the acquired companies did not have any presence
and
they would not have been able to develop access to these customers
without
being aligned with SYS. This allows SYS to provide a more complete
solution to our customers and furthers our ability to pursue a broader
set
of government program opportunities. Further, the phrase “together with
other SYS owned technologies, products and expertise” are critical to this
strategy. Simply having the cVideo or Logic products to sell into
these
customers is not enough by themselves. However, when offered together
with
a larger “solution” approach from SYS which incorporates sensors and
sensor related technologies, decision support tools, systems engineering
expertise and program management it is this total solution capability
that
creates the compelling business opportunities, not one-off product
sales;
|
| (ii) |
Provide
SYS access to a set of customers within the Logic and cVideo markets
where
we might ultimately have the potential to offer other SYS capabilities.
However, in this respect only a limited portion of those customer
segments
would be applicable for such purposes and we’re really referring to a
customer base in general and
finally;
|
| (iii) |
Broaden
the overall base of SYS business as we deploy our strategy of developing
a
revenue mix consisting of our core services business enhanced by
products
based offerings and to expand the base of our business into additional
non-DoD government agencies and municipalities as well as to the
industrial and commercial markets.
|
These
transactions referred to in Note 10 were accounted for using the purchase method
in accordance with SFAS No. 141, Business Combinations, whereby the net tangible
and intangibles assets acquired and liabilities assumed were recognized at
their
fair market values at the date of acquisition, based on estimates made by
management which were based on a consistent approach we’ve used in prior
acquisitions and relying on specific accounting literature used for guidance
as
outlined below.
These
estimates were based on a combination of factors including, but not limited
to,
our familiarity with the acquired businesses, their respective industries and
customers and how these product offerings will be utilized by SYS in the future.
In addition to SFAS No. 141 management considered the FASB Interpretation No.
4,
Applicability of FASB Statement No.2 to Business Combinations Accounted for
by
the Purchase Method and the AICPA Practice Aid, “Assets Acquired in a Business
Combination to Be Used in Research and Development Activities.”
SYS
management has developed purchase price methodologies for determining asset
values utilizing generally accepted valuation practices including income
approaches, market approaches and cost approaches depending on the facts and
circumstances and we use the approach that we deem most appropriate given the
nature of the asset. These methodologies have been consistently applied for
all
of the transactions completed to date all of which have been reviewed by our
auditor’s valuation professionals.
Analysis
The
following is our analysis by acquisition regarding our allocation of a
“relatively immaterial” amount to customer-related intangibles and
technology:
Logic
Innovations, Inc. (“Logic”)
Logic
is
a privately held, San Diego-based provider of solutions that ensure the fast
and
efficient delivery of digital audio, video and data to the broadcasting,
communications and consumer electronics industries.
The
allocations for technology and customers are as follows:
|
Intangible
|
Preliminary
Value (10Q)
|
Valuation
(1)
|
Life
|
|
Technology
|
$200,000
|
$109,944
|
5
|
|
Customer
relationships
|
$100,000
|
$56,352
|
5
|
|
Trade
name
|
$100,000
|
$38,134
|
5
|
(1) These
numbers will be in the third quarter 10-Q, which will be updated.
Note
that
for the second quarter ended December 31, 2005, the amount of amortization
expense charged was $9,374 based on the preliminary values and the amount based
on the valuation would have been $5,963.
Technology-Based:
Logic
Innovations primarily uses off the shelf components with the exception of the
printed circuit boards and firmware coding. Logic has developed a core set
of
products that are often modified or customized via software features and
functionalities depending on the end-user requirements. Logic does not currently
have any filed or issued patents in regards to this technology.
The
Company has estimated identifiable revenue streams associated with three
different types of technologies as well as an estimated cash flow that will
be
generated for the execution of these future revenues. The three types of
technologies are as follows: existing technology, in process research and
development (“IPR&D”) and future technology. Existing technology is defined
as completed technology which is already in the market generating revenue.
IPR&D is defined as R&D that is still in process at the time of the
acquisition for new non-sustaining technology, which will be completed at a
future date. Future technology is defined as technology, which has not begun
research.
For
this
analysis, the existing technology and IPR&D estimated revenue streams are
discounted in order to estimate the present value of the acquired technology
or
IPR&D at the time of acquisition. A discounted cash flow calculation has
several key assumptions; the more significant assumptions that affect the
estimated value of the technology and IPR&D are discussed
below:
| · |
Technology
Valuation -
Based on input from Logic’s management, the existing technology revenue
stream accounts for approx.
70% of total FY 2006E revenue and decays to 10% in FY 2010. Existing
technology cash flows are derived from these revenue streams and
we
discount the cash flow streams to estimate the present value of the
technology.
|
| · |
Discount
Rate - The
discount rate to apply to the estimation of the tax amortization
benefit
should be specific to the intangible assets that are being valued.
Accordingly, the rate should be reflective of the related risks for
the
intangible assets. To estimate an appropriate discount rate, we applied
a
build-up method.
|
Based
on
this analysis, SYS believes that the technology has value and as such recorded
a
preliminary value of approximately $200,000 and a valuation of
$109,944.
While
we
determined in the case of Logic that there was, in fact, specific IPR&D
projects in process at the acquisition date we also determined that the present
value of the “estimated costs to complete” those projects largely offset the
amount that would otherwise have been separately identified and capitalized
as
of the acquisition date leaving a value of IPR&D of approximately $5,000
which we considered immaterial for purposes of any write-off of
IPR&D.
Customer-Related:
In
approaching the customer-related intangible assets, we needed to assess whether
there were identifiable contractual/legal arrangements or separable customer
lists and non-contractual customer relationships that could be valued. A
customer base, on the other hand, does not meet the criteria for recognition
apart from goodwill because the FASB believes that a customer base represents
a
group of customers that are not known or identifiable to the enterprise
(Statement 141, pars.A17, B165).
Logic
generates revenue primarily through customers in the following sectors: cable,
satellite, broadcast, communications and consumer electronics markets. Logic
also sells to resellers in these channels. Many of the customers of Logic
Innovations are distributors or systems integrators that resell the company’s
products based on their end customer specifications that in many cases are
dictated independently by the end user.
Customer
relationships have an impact on Logic’s revenues and these customers may upgrade
to new products and technologies. In assessing the preliminary value of these
customer relationships, we took several factors into consideration:
| · |
Most
sales are to distributors and systems integrators rather than end
users
|
| · |
Lack
of exclusive arrangements with
distributors
|
| · |
The
customer relationships are mostly non-contractual with no fixed
term
|
| · |
Many
transactions are “one-off’ direct sales where the customer buys product
one time with no follow-on business
|
Based
on these factors, together with the evolving nature of Logic’s products and
markets we determined that the composition of Logic’s customers had begun to
change and would likely continue to change as the company begins to pursue
newer
distance learning markets and the government/DoD markets. Further, we reached
the conclusion that there was not likely to be much opportunity for SYS to
sell
its broader set of capabilities into the current Logic customer
base.
Based
on
input from Logic’s management we determined that approximately 25% of future
Logic revenues would come from their existing customer relationships.
Accordingly, we prepared an preliminary estimate of revenue streams and cash
flows from these customers utilizing certain assumptions regarding decay rates
and discount rates which yielded a preliminary valuation of $100,000 and a
valuation of $56,352.
cVideo,
Inc. (“cVideo”)
cVideo,
is a San Diego based provider of interactive video and information analysis
products for business surveillance and security applications. Over the past,
year and a half, cVideo has been in the market trying to raise capital and
or
attempting to be acquired. During this period their business suffered which
had
a direct impact on our assessment of their purchase price and of the value
of
their customers as well as their products and technology.
SYS
essentially paid for the business by assuming its existing liabilities and
with
some future earnout potential and SYS anticipates their future business to
be
inextricably tied to the overall solutions being provided by SYS rather than
as
a standalone business.
The
allocations for technology and customers are as follows:
|
Intangible
|
Preliminary
value (10Q)
|
Valuation(1)
|
Life
|
|
Technology
|
$200,000
|
$52,699
|
5
|
|
Customers
|
0
|
$8,424
|
5
|
|
Other
assets
|
$22,000
|
$0
|
N/A
|
(1) These
numbers will be in the third quarter 10-Q, which will be updated.
Note
that
for the second quarter ended December 31, 2005, the amount of amortization
expense charged was $3,333 based on the preliminary values and the amount based
on the valuation would have been $1,018.
Technology-Based:
cVideo
uses predominantly off the shelf digital video components and also sources
its
video analytic software from a third party. In prior years, the company had
expended some money in integrating the products together but has not recently
upgraded or expanded its integration of the products and much of the company’s
products will need to be enhanced and adapted to specific customer
environments.
cVideo
does have an issued patent for codec video compression technology which allows
for some market discrimination due to the higher quality and lower bandwidth
required however, newer technologies are rapidly mitigating the marketability
of
this capability and accordingly we didn’t deem the value of the patent to be
significant.
cVideo
has estimated identifiable revenue streams associated with three different
types
of technologies as well as an estimated cash flow that will be generated for
the
execution of these future revenues. The three types of technologies are as
follows existing technology, in process research and development (“IPR&D”)
and future technology. Existing technology is defined as completed technology
which is already in the market generating revenue. IPR&D is defined as
R&D that is still in process at the time of the acquisition for new
non-sustaining technology, which will be completed at a future date. Future
technology is defined as technology, which has not begun research.
For
this
analysis, the existing technology and IPR&D estimated revenue streams are
discounted in order to estimate the present value of the acquired technology
at
the time of acquisition.
Key
Assumptions:
A
discounted cash flow calculation has several key assumptions; the more
significant assumptions that affect the estimated value of the technology are
discussed below:
| · |
Technology
Valuation -
Based on input from cVideo’s management, the existing technology revenue
stream accounts for 100%
of total FY 2006E revenue and decays to approx. 30% in FY 2010. At
the
time of the acquisition, there was no IPR&D. Existing technology cash
flows are derived from these revenue streams and we discount the
cash flow
streams to estimate the present value of the
technology.
|
| · |
Discount
Rate - The
discount rate to apply to the estimation of the tax amortization
benefit
should be specific to the intangible assets that are being valued.
Accordingly, the rate should be reflective of the related risks for
the
intangible assets. To estimate an appropriate discount rate, we applied
a
build-up method.
|
Based
on
this analysis, SYS believes that the technology has value and as such recorded
a
preliminary value of $200,000 and a valuation of $52,699.
Customer-Related:
In
approaching the customer-related intangible assets, we needed to assess whether
there were identifiable contractual/legal arrangements or separable customer
lists and non-contractual customer relationships that could be valued. A
customer base, on the other hand, does not meet the criteria for recognition
apart from goodwill because the FASB believes that a customer base represents
a
group of customers that are not known or identifiable to the enterprise
(Statement 141, pars.A17, B165).
The
DVR
industry is very fragmented with individual systems suppliers having
insignificant market share or penetration into the customer base. At the time
of
acquisition and previous to the acquisition cVideo had been in a state of
financial distress for approximately 12 to 24 months. This financial distress
has strained relationships with distributors and customers alike.
Customers
were not attributed any value for several reasons. These are:
| · |
Sales
to distributors rather than end
users
|
| · |
Lack
of exclusive arrangements with
distributors
|
| · |
Many
transactions are “one-off’ direct sales where the customer buys product
one time with no follow-on business
|
| · |
Acrimonious
customer relationship brought on by cVideo financial
distress
|
Many
of
the customers of cVideo are distributors that resell the company’s products
based on their end customer specifications that in many cases are dictated
independently by the end user.
Many
of
these distributors carry a broad line of different manufacturer’s digital video
recording products and do not have exclusive relationships with any one
manufacturer.
In
the
case of cVideo in particular, it is the SYS customer base that offers the
greatest opportunities for sales and growth of the cVideo based business as
we
incorporate these video surveillance capabilities into our total systems
solutions. Accordingly, no value was assigned to the value of the cVideo
customer base.
Conclusion
We
could
have chosen better words to describe the purpose of the transactions and to
more
clearly explain how these acquisitions fit into the overall SYS strategy (i.e.
how these acquisitions fit into both our customer and technology base as opposed
to the value of the standalone acquired company’s customer base). However, we
believe that we have accounted for the intangibles consistently with our
objectives for the transaction. We would like to request that we include more
clarifying disclosure in future filings. An example of the disclosure we will
contain in future filings, in order to clarify our primary and secondary
objectives, is the following:
With
these enhanced capabilities we are able to pursue a broader cross section of
the
Department of Defense (DoD), Department of Homeland Security (DHS) and other
government markets as our primary objective and that the addition of new
customers from the acquisition is a secondary objective. In many cases, we
won’t
be able to pursue the acquired company’s customers with our overall SYS
solutions and further, both cVideo and Logic operate in industries where they
often sell through distributors and don’t often have customer specific
contracts.
Thank
you
for your time and consideration. If you have any questions, please let me
know.
Very
truly yours,
SYS
By: /s/
Edward
M. Lake