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Form 10-Q for WINDSWEPT ENVIRONMENTAL GROUP INC


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8-Feb-2006

Quarterly Report



ITEM 2. MANAGEMENT`S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW
We, through our wholly-owned subsidiaries, provide a full array of emergency response, remediation and disaster restoration services to a broad range of clients. We have expertise in the areas of hazardous materials remediation, microbial remediation, testing, toxicology, training, wetlands restoration, wildlife and natural resources rehabilitation, asbestos and lead abatement, technical advisory services, restoration and site renovation services.

Our revenues are derived primarily from providing emergency response, remediation and disaster restoration services to new and repeat customers on time and materials basis or pursuant to fixed-price contracts, including in connection with sudden catastrophes, such as in connection with the services that we are providing in the aftermath of Hurricanes Katrina and Wilma. In the thirteen and twenty-six week periods ended December 27, 2005 and fiscal 2005, substantially all of our revenues were derived from time and materials contracts. Under our fixed-price contracts, we assess the scope of work to be done and contract to perform a specified scope of work for a fixed price, subject to adjustment for work outside such scope of work, upon prior approval by our customers. Because most of our projects consist of emergency or disaster responses, which do not permit a definitive prior assessment of the full scope of work entailed and require immediate attention in order to mitigate loss and maximize recovery, most of our projects are performed on a time and materials basis. Under our time and materials contracts, we charge our customers for labor, equipment usage, allocated overhead and a markup relating thereto. Our cost of revenues consists primarily of labor and labor-related costs, insurance, benefits and insurance, travel and entertainment repairs, maintenance, equipment rental, materials and supplies, disposal costs and depreciation of capital equipment. Our selling, general, and administrative expenses primarily consist of expenses related to provisions for doubtful accounts, legal fees, sales salaries, marketing and consulting.

We have encountered difficulty with cash collections and slow cash flow due primarily to factors including:

o customers refusing to pay prior to receiving insurance reimbursements;
o customers` facility managers needing to wait for insurance adjustors to approve work before the remission of payment; and
o certain customers refusing to pay in connection with disputed change orders.

In an effort to enhance our cash flows from operations, beginning in our 2005 fiscal year, we began implementing improvements in our billing and invoicing procedures as follows:

o we generally do not commence projects until we have a fully executed contract;
o our service contracts provide that our customers are directly obligated for our services;
o we require client approval with respect to the work performed or to be performed; o we generally seek deposits or mobilization fees for our time and materials contracts;
o we engage local legal counsel in the areas in which we operate to file liens against customers` real property in the event of contract disputes; and
o all invoices submitted for payment are reviewed for proper documentation.

Because some of these are relatively new changes, no assurances can be given that they will be successful in improving our collections and cash flows. Further, approximately 4% of our current projects are performed under procedures that predate these improvements.

In light of the foregoing, we expect to generate sufficient cash flow from operations to support our working capital needs and to adequately fund our current operations for at least the next twelve months. However, any further difficulty collecting our accounts receivable or further significant growth could adversely affect our liquidity. In the event that we do not generate sufficient positive cash flow from operations, we may need to seek additional financing in addition to the financing provided by Laurus. Laurus is under no obligation to provide any funding to us. Currently, we have no credit facility for additional borrowing.

On June 30, 2005, we issued to Laurus a three-year secured convertible term note in the principal amount of $5,000,000. Subsequently, Laurus loaned us an additional $2,350,000, and we amended and restated the note accordingly. As of February 2, 2006, the principal amount of the Laurus note outstanding equaled $6,890,625. On November 10, 2005, Laurus agreed to defer the principal monthly payments due in November and December 2005 in the aggregate amount of $495,375 until June 30, 2008, the maturity date of the Laurus note, in order to facilitate financing of our gulf coast and Florida operations.

We currently are engaged on various projects within our customary scope of services for private sector commercial and residential customers in the gulf coast and Florida regions. Under time and materials contracts or other arrangements, we have billed in excess of $9.8 million of work that we have completed in connection with these projects through January 31, 2006. We have also billed in excess of $8.9 million for projects in these areas that are still in progress. As of January 1, 2006 we have billed an aggregate of over $20 million of time and materials projects during our fiscal 2006. Management believes that we will be engaged to perform additional projects in this region in the near term; however, no assurance can be given in this regard until contracts relating to these projects have been executed.


CRITICAL ACCOUNTING POLICIES
Management`s discussion and analysis of our financial position and results of operations is based upon our audited consolidated financial statements for our fiscal year ended June 28, 2005, which have been prepared in accordance with accounting principles generally accepted in the United States of America, and our unaudited interim consolidated financial statements for our fiscal quarter ended December 27, 2005. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates. We believe that the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of our consolidated financial statements are accounting for stock based transactions, contracts, allowance for doubtful accounts and the valuation allowance related to deferred tax assets.

Stock Based Transactions - We consummated various transactions where we paid the consideration primarily in options or warrants to purchase our common stock. These transactions include financing transactions and providing incentives to attract, retain and motivate employees, officers and directors.

We have recognized the value of the equity instruments issued in connection with financing transactions in accordance with Accounting Principles Board Opinion No. 14 and Emerging Issues Task Force Consensuses 98-5 and 00-27. The intrinsic value of the options and the fair value of the warrants were calculated and the proportionate values of the resulting debt and equity components have been recognized as debt discounts with equivalent increases in amounts reflected as equity. The beneficial conversion feature of the Note, including the effective values under EITF 00-27, has also been recognized as a debt discount, with an equivalent increase in the amount reflected as equity. All of these discounts are being amortized over the three-year life of the debt in accordance with EITF 00-27. Once the transaction value is determined, we record the transaction value as an expense with a corresponding increase in paid-in capital.

When options or warrants to purchase our common stock are used as incentives for employees, officers or directors, we use the intrinsic value method in accordance with the recognition and measurement principles of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," as permitted by Statement of Financial Accounting Standards "SFAS" No. 123. The intrinsic value method calculates the value of the option or warrant at the difference between the exercise price per share and the market price per share of the common stock on the day the option or warrant is granted, except that such value is zero if the exercise price is higher than the market price of the common stock. Once the transaction value is determined, we record the transaction value as an expense with a corresponding increase in paid-in capital.

When options or warrants to purchase our common stock are used in transactions with third parties, the transaction is valued using the Black-Scholes valuation method. The Black-Scholes valuation method is widely accepted as providing the fair market value of an option or warrant to purchase stock at a fixed price for a specified period of time. Black-Scholes uses five variables to establish market value of stock options or warrants:

o exercise price (the price to be paid for a share in our stock);
o price of our stock on the day the options or warrants are granted;
o number of days that the options or warrants can be exercised before they expire;
o trading volatility of our stock; and
o annual interest rate on the day the option or warrant is granted.

The determination of expected volatility requires management to make an estimate and the actual volatility may vary significantly from that estimate. Accordingly, the determination of the resulting expense is based on a management estimate.

Contract Accounting - Revenue derived from services provided to customers over periods of less than one month is recognized at the completion of the related contracts. Revenue from fixed price contracts that extend over periods of one month or more is recognized using the percentage-of-completion method, measured by the percentage of costs incurred to date compared to estimated total costs for each contract. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes in job performance, job conditions, estimated profitability, the effect of contract penalty provisions and final contract settlements may result in revisions to estimates of costs and income and are recognized in the period in which the revisions are determined. Revenue from claims, such as claims relating to disputed change orders, is recognized when realization is probable and the amount can be reliably estimated. Revenues from time and material contracts that extend over a period of more than one month are recognized as services are performed.

Allowance for Doubtful Accounts - We maintain an allowance for doubtful trade accounts receivable for estimated losses resulting from the inability of our customers to make required payments. In determining collectibility, we review available customer account and financial information, including public filings and credit reports, current trends, credit policy, and accounts receivable aging and may also consult legal counsel when appropriate. A considerable amount of judgment is required when we assess the likelihood of our realization of accounts receivables, including assessing the probability of collection and the current credit worthiness of each customer. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for doubtful accounts could be required. When it is deemed probable that a specific customer account is uncollectible, that balance is included in the reserve calculation. Actual results could differ from these estimates.

Deferred Tax Asset Valuation Allowance - We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Due to our history of losses, we have recorded a full valuation allowance against our net deferred tax assets as of June 28, 2005 and December 27, 2005. We currently provide for income taxes only to the extent that we expect to pay cash taxes on current income. When we are profitable at levels which cause management to conclude that is more likely than not that we will realize all or a portion of our deferred tax assets, we record the estimated net realizable value of our deferred tax assets at that time and provide for income taxes at our combined federal and state effective rates.


RESULTS OF OPERATIONS

THIRTEEN WEEKS ENDED DECEMBER 27, 2005 AND DECEMBER 28, 2004

Revenue
Total revenues for the thirteen weeks ended December 27, 2005 increased by $10,355,063, or 140.7%, to $17,714,342 from $7,359,279 for the thirteen weeks ended December 28, 2004. This increase in revenue was primarily attributable to $14,108,400 of revenues from work relating to Hurricane Katrina and $1,320,769 of revenues from work relating to Hurricane Wilma, and was partially offset by a $573,968 decrease in spill related work.


Cost of Revenues


Cost of revenues increased $3,820,840 or 87.4%, to $8,190,707 for the thirteen weeks ended December 27, 2005 as compared to $4,369,867 for the thirteen weeks ended December 28, 2004. This increase was primarily attributable to labor and other costs relating to our work in connection with Hurricanes Katrina and Wilma. Our cost of revenues consists primarily of labor and labor-related costs, payroll taxes, benefits, training, job-related insurance costs, travel and travel-related costs, repairs, maintenance and rental of job equipment, materials and supplies, testing and sampling, transportation, disposal, and depreciation of capital equipment.


Gross Profit


Gross profit increased by $6,534,223, or 218.6%, to $9,523,635, or 53.7%, of total revenues for the thirteen weeks ended December 27, 2005 as compared to $2,989,412, or 40.6%, of total revenues for the thirteen weeks ended December 28, 2004. This increase in gross profit was due primarily to a higher percentage of higher margin equipment usage in connection with our hurricane-related projects.


Selling, General and Administrative Expenses


Selling, general and administrative expenses increased by $1,000,457, or 66.6%, to $2,503,303 for the thirteen weeks ended December 27, 2005 from $1,502,846 for the thirteen weeks ended December 28, 2004 and constituted approximately 14.1% and 20.4% of revenues in such periods, respectively. This increase was primarily attributable to an increased provision of $700,000 to our allowance for doubtful accounts, increased accounting and legal fees of $71,628, and a $15,090 increase in marketing expenses. These were partially offset by a decrease of $25,314 in management fees. Our selling, general, and administrative expenses primarily consist of expenses related to provisions for doubtful accounts, professional fees, salaries and related benefits, insurance, marketing and all other office- and administrative-related expenses.


Benefit Related to Variable Accounting Treatment for Officer Options


Under the terms of a previous employment agreement we entered into and a separate agreement with Spotless, our president and chief executive officer was able to sell to us, or in certain circumstances to Spotless, all shares of our common stock held by him and all shares of our common stock underlying vested options to purchase shares of our common stock held by him upon the occurrence of certain events. Due to the terms of the options, changes in the market price of our common stock, in either direction, resulted in a corresponding expense or benefit. There was no benefit or expense required to be recorded in the thirteen weeks ended December 27, 2005 due to the elimination of this risk on June 30, 2005. There was no benefit or expense required to be recorded in the thirteen weeks ended December 28, 2004 due to the low market price of our common stock.


Interest Expense


Interest expense increased by $609,223, or 1,100.6%, to $664,575 for the thirteen weeks ended December 27, 2005 from $55,352 for the thirteen weeks ended December 28, 2004. This increase was primarily due to an increase of $168,491 of interest expense incurred to Laurus, $181,958 of amortization of discounts, and an increase of $296,211 attributable to the amortization of deferred financing costs relating to the Laurus transaction, partially offset by a reduction of $40,620 in interest expense incurred to Spotless.


Provision for Income Taxes


The provision for income taxes for the thirteen weeks ended December 27, 2005 was $3,159,138 as compared to $43,659 for the thirteen weeks ended December 28, 2004. This increase was the result of higher taxable income for the thirteen weeks ended December 27, 2005, primarily attributable to our hurricane-related work in that period.


Net Income


We generated net income of $3,196,162 and net income attributable to common stockholders of $3,176,662 for the thirteen weeks ended December 27, 2005, as compared to net income of $1,388,310 and net income attributable to common stockholders of $1,368,810 incurred for the thirteen weeks ended December 28, 2004. These changes were the result of the factors discussed above.


TWENTY-SIX WEEKS ENDED DECEMBER 27, 2005 AND DECEMBER 28, 2004



Revenue


Total revenues for the twenty-six weeks ended December 27, 2005 increased by $10,040,896, or 78.2%, to $22,878,681 from $12,837,785 for the twenty-six weeks ended December 28, 2004. This increase in revenue was primarily attributable to $15,070,747 of revenues from work relating to Hurricane Katrina and $1,320,769 of revenues from work relating to Hurricane Wilma. This increase was partially offset by a $1,063,799 decrease in spill related work.


Cost of Revenues


Cost of revenues increased $3,843,989 or 44.0%, to $12,575,980 for the twenty-six weeks ended December 27, 2005 as compared to $8,731,991 for the twenty-six weeks ended December 28, 2004. This increase was primarily attributable to labor and other costs relating to our work in connection with Hurricanes Katrina and Wilma. Our cost of revenues consists primarily of labor and labor-related costs, payroll taxes, benefits, training, job-related insurance costs, travel and travel-related costs, repairs, maintenance and rental of job equipment, materials and supplies, testing and sampling, transportation, disposal, and depreciation of capital equipment.


Gross Profit


Gross profit increased by $6,196,907, or 150.9%, to $10,302,701, or 45.0%, of total revenues for the twenty-six weeks ended December 27, 2005 as compared to $4,105,794, or 32.0%, of total revenues for the twenty-six weeks ended December 28, 2004. This increase in gross profit was due primarily to a higher percentage of higher margin equipment usage in connection with our hurricane-related projects.


Selling, General and Administrative Expenses


Selling, general and administrative expenses increased by $1,274,255, or 46.6%, to $4,009,705 for the twenty-six weeks ended December 27, 2005 from $2,735,450 for the twenty-six weeks ended December 28, 2004 and constituted approximately 17.5% and 21.3% of revenues in such periods, respectively. This increase was primarily attributable to an increased provision of $1,250,000 to our allowance for doubtful accounts, increased accounting and legal fees of $303,726, and a $40,256 increase in marketing expenses. These were partially offset by a decrease of $114,316 in consulting fees. Our selling, general, and administrative expenses primarily consist of expenses related to provisions for doubtful accounts, professional fees, salaries and related benefits, insurance, marketing and all other office- and administrative-related expenses.


Benefit Related to Variable Accounting Treatment for Officer Options


Under the terms of a previous employment agreement we entered into and a separate agreement with Spotless, our president and chief executive officer was able to sell to us, or in certain circumstances to Spotless, all shares of our common stock held by him and all shares of our common stock underlying vested options to purchase shares of our common stock held by him upon the occurrence of certain events. Due to the terms of the options, changes in the market price of our common stock, in either direction, resulted in a corresponding expense or benefit. There was no benefit or expense required to be recorded in the twenty-six weeks ended December 27, 2005 due to the elimination of this risk on June 30, 2005. There was no benefit or expense required to be recorded in the twenty-six weeks ended December 28, 2004 due to the low market price of our common stock.


Interest Expense


Interest expense increased by $961,954, or 361.0%, to $1,228,410 for the twenty-six weeks ended December 27, 2005 from $266,456 for the thirteen weeks ended December 28, 2004. This increase was primarily due to an increase of $289,656 of interest expense incurred to Laurus, $317,216 of amortization of discounts, and an increase of $587,690 attributable to the amortization of deferred financing costs relating to the Laurus transaction, partially offset by a reduction of $226,021 in interest expense incurred to Spotless, including a decrease of $145,846 in interest expense recognized in connection with sales of accounts receivable to Spotless because there were no such sales in the twenty-six week period ended December 27, 2005.


Provision for Income Taxes


The provision for income taxes for the twenty-six weeks ended December 27, 2005 was $3,167,356 as compared to $46,248 for the twenty-six weeks ended December 28, 2004. This increase was the result of higher taxable income for the twenty-six weeks ended December 27, 2005, primarily attributable to hurricane-related work in that period.


Net Income


We generated net income of $1,874,720 and net income attributable to common stockholders of $1,835,720, for the twenty-six weeks ended December 27, 2005, as compared to net income of $1,058,962 and net income attributable to common stockholders of $1,019,962 incurred for the twenty-six weeks ended December 28, 2004. These changes were the result of the factors discussed above.


LIQUIDITY AND CAPITAL RESOURCES
As of December 27, 2005, we had a cash balance of $2,494,266, working capital of $6,079,337 and stockholders` equity of $10,002,965. As of September 27, 2005, we had a cash balance of $147,493, working capital of $1,845,015 and stockholders` equity of $5,583,738. As of June 28, 2005, we had a cash balance of $512,711, a working capital deficit of ($1,704,091) and a stockholders` deficit of ($712,889). As of June 29, 2004, we had cash balances of $63,562, a working capital deficit of ($2,103,971) and stockholders` deficit of ($787,955). We generated a net profit of $1,874,720, a net profit of $53,066 and a net loss of ($3,535,334) for our fiscal quarter ended December 27, 2005 and our fiscal years ended June 28, 2005 and June 29, 2004, respectively.

Net cash provided by operating activities was $587,948 for the twenty-six weeks ended December 27, 2005, as compared to the net cash provided by operations of $473,288 for the twenty-six weeks ended December 28, 2004. Accounts receivable increased by $4,233,848, or 36.8%, as of December 27, 2005 to $15,751,255, from $11,517,407 as of December 28, 2004, primarily as a result of work performed in connection with Hurricanes Katrina and Wilma. Accounts payable and accrued expenses decreased by $1,156,854, or 24.0%, as of December 27, 2005 to $3,672,669, from $4,829,523 as of December 28, 2004, primarily as a result of accelerated payments to our venders as a result of our favorable cash position. Net cash provided by financing activities for the twenty-six weeks ended December 27, 2005 was $2,332,363, as compared to cash used by financing activities of $134,508 for the twenty-six weeks ended December 28, 2004, primarily as a direct result of $7,350,000 received in connection with our borrowings from Laurus, the proceeds of which borrowings were used to pay related transaction and other expenses in the amount of $2,314,172 and repay indebtedness to Spotless in the amount of $2,650,000. These transactions resulted in a net increase of $2,350,000 in borrowings

and the cancellation of $1,230,228 of our previous secured note payable to Spotless. The balance of the proceeds, in the amount of $2,053,011, was used to fund working capital and our initial Hurricane Katrina mobilization costs. Financing activities for the twenty-six weeks ended December 28, 2004 used net cash of $134,508 for long-term debt repayment.

Cash used for capital expenditures increased to $938,756, during the twenty-six weeks ended December 27, 2005, as compared to $56,011 for the twenty-six weeks ended December 28, 2004, due to the cost of equipment purchased to perform the work in the Gulf Coast region. At this time, we do not have any other material commitments or plans for capital expenditures. We intend, however, to make additional capital expenditures, to the extent our financial condition permits, as may be required in connection with rendering our services in the future.

Historically, we have financed our operations primarily through issuance of debt and equity securities, through short-term borrowings from our former majority shareholder, and through cash generated from operations. We expect to generate sufficient cash flow from operations to support our working capital needs and to adequately fund our current operations for at least the next twelve months. However, any further difficulty collecting our accounts receivable or further significant growth could adversely affect our liquidity. In the event that we do not generate sufficient positive cash flow from operations, or if we experience changes in our plans or other events that adversely affect our operations or cash flow, we may need to seek additional financing in addition to the financing provided by Laurus. Laurus is under no obligation to provide any funding to us. Currently, we have no credit facility for additional borrowing.

Our future cash requirements are expected to depend on numerous factors, including, but not limited to our ability to:

o Obtain profitable environmental or related construction contracts. So long as we have sufficient working capital, we anticipate continued revenue growth in new and existing service areas and to continue to bid on large projects, though there can be no assurance that any of our bids will be accepted or that we will have sufficient working capital. We currently are engaged on various projects within our customary scope of services for private sector commercial and residential customers in the gulf coast and Florida regions in connection with the aftermath of Hurricanes Katrina and Wilma. Under time and materials contracts or other arrangements, we have billed in excess of $9.8 million of work that we have completed in connection with these projects through January 31, 2006. We have also billed in excess of $8.9 million for projects in these areas that are still in progress. As of January 1, 2006 we have billed an aggregate of over $20 million of time and materials projects during our fiscal 2006. In this connection, we also intend to focus on procuring time and materials contracts, which have historically generated higher gross margins. We also intend to continue our marketing campaign, including radio and newspaper advertising and a public relations program, to inform residents of New Orleans and the surrounding gulf areas about our services. Our management believes that we will be engaged to perform additional projects in this region for the foreseeable future; however, no assurance can be given in . . .

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