SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 0-22196 INNODATA ISOGEN, INC. (Exact name of registrant as specified in its charter) Delaware 13-3475943 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) Three University Plaza Hackensack, New Jersey 07601 (Address of principal executive offices) (Zip Code) (201) 488-1200 (Registrant's telephone number) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes |_| No |X| Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes |_| No |X| State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. 23,184,018 shares of common stock, $.01 par value, as of October 31, 2005.
Page No. -------- PART I. FINANCIAL INFORMATION Condensed Consolidated Balance Sheets 2 Condensed Consolidated Statements of Operations for the Three Months Ended September 30, 2005 and 2004 3 Condensed Consolidated Statements of Operations for the Nine Months Ended September 30, 2005 and 2004 4 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004 5 Notes to Consolidated Financial Statements for the Nine Months Ended September 30, 2005 and 2004 6 Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Quantitative and Qualitative Disclosures about Market Risk 26 Controls and Procedures 26 PART II. OTHER INFORMATION 27 1
INNODATA ISOGEN, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) <TABLE> <CAPTION> September 30, December 31, 2005 2004 ----------- ----------- Unaudited Derived from audited financial statements <S> <C> <C> ASSETS CURRENT ASSETS: Cash and equivalents $ 21,380 $ 20,663 Accounts receivable-net 5,208 8,019 Prepaid expenses and other current assets 2,997 1,757 Deferred income taxes 307 645 ----------- ----------- Total current assets 29,892 31,084 PROPERTY AND EQUIPMENT - NET 4,555 4,559 OTHER ASSETS 1,752 893 GOODWILL 675 675 ----------- ----------- TOTAL $ 36,874 $ 37,211 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and accrued expenses $ 2,900 $ 3,412 Accrued salaries, wages and related benefits 3,421 3,979 Income and other taxes 1,089 1,304 Current portion of long-term obligations 702 180 ----------- ----------- Total current liabilities 8,112 8,875 ----------- ----------- DEFERRED INCOME TAXES 1,480 1,449 ----------- ----------- LONG-TERM OBLIGATIONS 686 150 ----------- ----------- STOCKHOLDERS' EQUITY: Serial preferred stock; 5,000,000 shares authorized, none outstanding Common stock, $.01 par value; 75,000,000 shares authorized; 23,184,000 and 22,679,000 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively 232 227 Additional paid-in capital 15,861 14,914 Retained earnings 10,503 11,596 ----------- ----------- Total stockholders' equity 26,596 26,737 ----------- ----------- TOTAL $ 36,874 $ 37,211 =========== =========== </TABLE> See notes to unaudited condensed consolidated financial statements 2
INNODATA ISOGEN, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 (In thousands, except per share amounts) (Unaudited) - -------------------------------------------------------------------------------- 2005 2004 ---------- ---------- REVENUES $ 9,647 $ 15,927 ---------- ---------- OPERATING COSTS AND EXPENSES: Direct operating expenses 7,272 8,847 Selling and administrative expenses 3,677 2,847 Interest (income) - net (114) (14) ---------- ---------- Total 10,835 11,680 ---------- ---------- (LOSS) INCOME BEFORE (BENEFIT FROM) PROVISION FOR INCOME TAXES (1,188) 4,247 (BENEFIT FROM) PROVISION FOR INCOME TAXES (313) 1,144 ---------- ---------- NET (LOSS) INCOME $ (875) $ 3,103 ========== ========== BASIC (LOSS) INCOME PER SHARE $ (.04) $ .14 ========== ========== WEIGHTED AVERAGE SHARES OUTSTANDING 23,165 22,429 ========== ========== DILUTED (LOSS) INCOME PER SHARE $ (.04) $ .13 ========== ========== DILUTIVE SHARES OUTSTANDING 23,165 24,659 ========== ========== See notes to unaudited condensed consolidated financial statements 3
INNODATA ISOGEN, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 (In thousands, except per share amounts) (Unaudited) - -------------------------------------------------------------------------------- 2005 2004 ---------- ---------- REVENUES $ 30,947 $ 40,438 ---------- ---------- OPERATING COSTS AND EXPENSES: Direct operating expenses 22,972 24,481 Selling and administrative expenses 9,767 7,514 Bad debt recovery - net -- (963) Interest income - net (309) (13) ---------- ---------- Total 32,430 31,019 ---------- ---------- (LOSS) INCOME BEFORE (BENEFIT FROM) PROVISION FOR INCOME TAXES (1,483) 9,419 (BENEFIT FROM) PROVISION FOR INCOME TAXES (390) 2,659 ---------- ---------- NET (LOSS) INCOME $ (1,093) $ 6,760 ========== ========== BASIC (LOSS) INCOME PER SHARE $ (.05) $ .30 ========== ========== WEIGHTED AVERAGE SHARES OUTSTANDING 22,922 22,176 ========== ========== DILUTED (LOSS) INCOME PER SHARE $ (.05) $ .28 ========== ========== DILUTIVE SHARES OUTSTANDING 22,922 24,541 ========== ========== See notes to unaudited condensed consolidated financial statements 4
INNODATA ISOGEN, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2005 and 2004 (In thousands) (Unaudited) - -------------------------------------------------------------------------------- 2005 2004 ---------- ---------- OPERATING ACTIVITIES: Net (loss) income $ (1,093) $ 6,760 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation and amortization 2,349 3,042 Non-cash compensation 15 44 Deferred income taxes 369 1,127 Changes in operating assets and liabilities: Accounts receivable 2,811 (2,114) Refundable income taxes -- 1,075 Prepaid expenses and other current assets (1,152) (937) Other assets (301) (182) Accounts payable and accrued expenses (512) 206 Accrued salaries and wages (558) 1,239 Income and other taxes (77) 909 ---------- ---------- Net cash provided by operating activities 1,851 11,169 ---------- ---------- INVESTING ACTIVITIES: Capital expenditures (1,408) (1,671) Restricted cash -- 1,000 ---------- ---------- Net cash used in investing activities (1,408) (671) ---------- ---------- FINANCING ACTIVITIES: Payment of long term obligations (525) (110) Proceeds from exercise of stock options 799 670 ---------- ---------- Net cash provided by financing activities 274 560 ---------- ---------- INCREASE IN CASH 717 11,058 CASH AND EQUIVALENTS, BEGINNING OF PERIOD 20,663 5,051 ---------- ---------- CASH AND EQUIVALENTS, END OF PERIOD $ 21,380 $ 16,109 ========== ========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 15 $ 11 ========== ========== Income taxes $ 499 $ 616 ========== ========== See notes to unaudited condensed consolidated financial statements 5
INNODATA ISOGEN, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED OCTOBER 31, 2005 AND 2004 (Unaudited) - -------------------------------------------------------------------------------- 1. Innodata Isogen, Inc. and subsidiaries (the "Company"), is a leading provider of content supply chain services and solutions. The Company manufactures content by providing digitization, imaging, data conversion, XML and markup, metadata creation, advanced classification, editorial, knowledge and related services. It also designs, implements, integrates and deploys systems used to manage content. The consolidated financial statements include the accounts of Innodata Isogen, Inc. and its subsidiaries, all of which are wholly owned. All intercompany transactions and balances have been eliminated in consolidation. In the opinion of the Company, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of September 30, 2005, the results of operations for the three and nine months ended September 30, 2005 and 2004, and the cash flows for the nine months ended September 30, 2005 and 2004. The results of operations for the three and nine months ended September 30, 2005 and 2004 are not necessarily indicative of results that may be expected for any other interim period or for the full year. These financial statements should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2004 included in the Company's Annual Report on Form 10-K. The accounting policies used in preparing these financial statements are the same as those described in the December 31, 2004 financial statements. 6
2. An analysis of the changes in each caption of stockholders' equity for the nine months ended September 30, 2005 and 2004 (in thousands) is as follows. <TABLE> <CAPTION> Additional Common Stock Paid-in Retained Shares Amount Capital Earnings Total ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> January 1, 2005 22,679 $ 227 $ 14,914 $ 11,596 $ 26,737 Net loss -- -- -- (1,093) (1,093) Issuance of common stock upon exercise of stock options 505 5 794 -- 799 Tax benefit from exercise of options -- -- 138 -- 138 Non-cash compensation -- -- 15 -- 15 ---------- ---------- ---------- ---------- ---------- September 30, 2005 23,184 $ 232 $ 15,861 $ 10,503 $ 26,596 ========== ========== ========== ========== ========== </TABLE> <TABLE> <CAPTION> Additional Common Stock Paid-in Retained Treasury Shares Amount Capital Earnings Stock Total ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> January 1, 2004 22,535 $ 226 $ 15,413 $ 3,739 $ (1,974) $ 17,404 Net income -- -- -- 6,760 -- 6,760 Issuance of common stock upon exercise of stock options 607 5 665 -- -- 670 Tax benefit from exercise of options -- -- 221 -- -- 221 Non-cash compensation -- -- 44 -- -- 44 ---------- ---------- ---------- ---------- ---------- ---------- September 30, 2004 23,142 $ 231 $ 16,343 $ 10,499 $ (1,974) $ 25,099 ========== ========== ========== ========== ========== ========== </TABLE> 3. Basic (loss) income per share is based on the weighted average number of common shares outstanding without consideration of potential common stock. Diluted income per share is based on the weighted average number of common and potential common shares outstanding. The difference between weighted average common shares outstanding and adjusted dilutive shares outstanding represents the dilutive effect of outstanding options. Options to purchase 2.5 million shares of common stock in 2005 and 1.4 million shares of common stock in 2004 were outstanding but not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares and therefore, the effect would have been antidilutive. In addition, for 2005, diluted net loss per share does not include 1,394,000 and 1,867,000 potential common shares derived from stock options for the three and nine months ended September 30, 2005, because as a result of the Company incurring losses for the respective periods, their effect would have been antidilutive. 7
The basis of the (loss) earnings per share computation for the three and nine months ended September 30, 2005 and 2004 (in thousands, except per share amounts) is as follows: <TABLE> <CAPTION> Three Months Nine Months ------------------------ ------------------------ 2005 2004 2005 2004 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Net (loss) income $ (875) $ 3,103 $ (1,093) $ 6,760 ========== ========== ========== ========== Weighted average common shares outstanding 23,165 22,429 22,922 22,176 Dilutive effect of outstanding options -- 2,230 -- 2,365 ---------- ---------- ---------- ---------- Adjusted for dilutive computation 23,165 24,659 22,922 24,541 ========== ========== ========== ========== Basic (loss) income per share $ (.04) $ .14 $ (.05) $ .30 ========== ========== ========== ========== Diluted (loss) income per share $ (.04) $ .13 $ (.05) $ .28 ========== ========== ========== ========== </TABLE> 4. The Company accounts for its stock options issued to employees and outside directors pursuant to Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" and has adopted the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123." Accordingly, no compensation expense has been recognized in connection with the issuance of stock options for the three and nine months ended September 30, 2005 and 2004. The following table illustrates the effect on net (loss) income and (loss) earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands except per share amounts). <TABLE> <CAPTION> Three months ended Nine months ended September 30, September 30, ------------------------ ------------------------ 2005 2004 2005 2004 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Net (loss) income as reported $ (875) $ 3,103 $ (1,093) $ 6,760 Deduct: Total stock-based employee compensation determined under fair value based method, net of related tax effects (297) (615) (3,082) (2,033) ---------- ---------- ---------- ---------- Pro forma net (loss) income $ (1,172) $ 2,488 $ (4,175) $ 4,727 ========== ========== ========== ========== (Loss) income per share: Basic - as reported $ (.04) $ .14 $ (.05) $ .30 ========== ========== ========== ========== Basic - pro forma $ (.05) $ .11 $ (.18) $ .21 ========== ========== ========== ========== Diluted - as reported $ (.04) $ .13 $ (.05) $ .28 ========== ========== ========== ========== Diluted - pro forma $ (.05) $ .10 $ (.18) $ .19 ========== ========== ========== ========== </TABLE> 8
5. On May 16, 2005, the Company and certain of its officers and directors agreed to change the initial exercise price and initial expiration date of vested options to purchase 1,390,346 shares of the Company's common stock held by such officers to a new price of $2.59, and to new expiration dates as follows: Initial Initial Expiration New New Expiration Quantity Price Date Price Date -------- ------- ------------------ ----- -------------- 540,346 $1.56 May 31, 2005 $2.59 108,000 per year commencing May 31, 2009, remainder on May 31, 2013 810,000 $2.25 770,000 on $2.59 162,000 per year October 8, 2005 commencing and 40,000 on September 30, 2009 October 18, 2005 until September 30, 2012, 8,000 on September 30, 2013 and 154,000 on March 31, 2014 40,000 $2.50 October 3, 2005 $2.59 October 3, 2010 In connection with the extension, the option holders agreed not to sell, pledge or otherwise dispose of any of the shares of common stock received upon exercise of their respective option(s) referred to above until the earliest to occur of (i) May 16, 2007; (ii) the first day on which the closing market price for the Company's stock is at least $5.00 per share for ten consecutive trading days; or (iii) the termination of employment or directorship (as applicable) with the Company either (A) by the Company, for reasons other than "for cause"; or (B) by the option holder, upon mutual agreement between the option holder and the Company. In addition, the Chief Executive Officer further agreed to pay to the Company any pre-tax net profit earned from the sale of the shares of common stock received upon exercise of his options set forth above if he directly or indirectly competes with the Company or solicits Company customers or clients during the period from May 16, 2005 until the first anniversary of the termination of his employment for any reason. No equity compensation expense has been recorded because the exercise price of the modified options was equal to the price of the underlying common stock on the date the grants were modified. In addition, pursuant to EITF 00-23, the Company has determined that the modified grants continue to qualify for fixed accounting treatment. 9
6. The Company's operations are classified into two reporting segments: (1) outsourced content services and (2) IT professional services. The outsourced content services segment focuses on fabrication services and knowledge services. Fabrication services include digitization and data conversion services, content creation and XML services. Knowledge services include content enhancement, hyperlinking, indexing and general editorial services. The IT professional services segment focuses on the design, implementation, integration and deployment of systems used to author, manage and distribute content. The Company's outsourced content services revenues are generated principally from its production facilities located in the Philippines, India and Sri Lanka. The Company does not depend on revenues from sources internal to the countries in which the Company operates; nevertheless, the Company is subject to certain adverse economic and political risks relating to overseas economies in general, such as inflation, currency fluctuations and regulatory burdens. <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------ ------------------------ 2005 2004 2005 2004 ---------- ---------- ---------- ---------- (in thousands) (in thousands) <S> <C> <C> <C> <C> Revenues Outsourced content services $ 8,505 $ 13,071 $ 26,805 $ 31,575 IT professional services 1,142 2,856 4,142 8,863 ---------- ---------- ---------- ---------- Total consolidated $ 9,647 $ 15,927 $ 30,947 $ 40,438 ========== ========== ========== ========== Depreciation and amortization: Outsourced client services $ 661 $ 877 $ 2,050 $ 2,765 IT professional services 29 24 76 64 Selling and corporate administration 78 73 223 213 ---------- ---------- ---------- ---------- Total consolidated $ 768 $ 974 $ 2,349 $ 3,042 ========== ========== ========== ========== (Loss) income before income taxes Outsourced client services $ 2,100 $ 5,391 $ 6,625 $ 11,645 IT professional services 155 1,467 762 4,484 Selling and corporate administration (3,443) (2,611) (8,870) (6,710) ---------- ---------- ---------- ---------- Total consolidated $ (1,188) $ 4,247 ($ 1,483) $ 9,419 ========== ========== ========== ========== </TABLE> September 30, December 31, 2005 2004 ---------- ---------- (in thousands) Total assets Outsourced content services $ 13,331 $ 15,937 IT professional services 1,559 2,033 Corporate (includes corporate cash) 21,984 19,241 ---------- ---------- Total consolidated $ 36,874 $ 37,211 ========== ========== 10
Included in selling and administrative expenses are research and development costs approximating $300,000 and $500,000 for the three and nine months ended September 30, 2005, respectively. One client accounted for 28% and 22% of the Company's revenues for the three months ended September 30, 2005 and 2004, respectively. A second client accounted for 37% of the Company's revenues for the three months ended September 30, 2004. No other client accounted for 10% or more of revenues during these periods. Further, in the three months ended September 30, 2005 and 2004, revenues to non-US clients accounted for 38% and 28%, respectively, of the Company's revenues. One client accounted for 25% and 23% of the Company's revenues for the nine months ended September 30, 2005 and 2004, respectively. A second client accounted for 15% and 29% of the Company's revenues for the nine months ended September 30, 2005 and 2004, respectively. No other client accounted for 10% or more of the Company's revenues during these periods. Further, in the nine months ended September 30, 2005 and 2004, revenues to non-US clients accounted for 33% and 30%, respectively, of the Company's revenues. A significant amount of the Company's revenues are derived from clients in the publishing industry. Accordingly, the Company's accounts receivable generally include significant amounts due from such clients. In addition, as of September 30, 2005, approximately 33% of the Company's accounts receivable was from foreign (principally European) clients, of which 23% was due from one client. 7. In 2005, the Company entered into an agreement with a vendor to acquire certain additional software licenses and to receive support and subsequent software upgrades on this and other currently owned software licenses through February 2008. Pursuant to the agreement, the Company paid $396,000 as of September 30, 2005, and will make nine payments of approximately $132,000 per quarter thereafter, commencing in December 2005. The total cost was allocated to the following asset accounts: Other current assets $ 487,000 Other assets (long-term) 608,000 Property and equipment 488,000 ----------- Total $ 1,583,000 =========== The current portion of the obligation totaling approximately $528,000 is included on the balance sheet under current portion of long term obligations. The remaining long-term portion is reflected as a long-term obligation. Also included in long-term obligations are long-term capital lease obligations totaling $26,000. The total obligation and associated cost totaling $1,394,000 is considered a non-cash investing and financing activity. 11
8. In the three and nine months ended September 30, 2005, the benefit from income taxes as a percentage of loss before income taxes was 26%, which is lower than the U.S. Federal statutory tax rate, principally due to losses attributable to certain overseas subsidiaries for which no income tax benefit is available. In the three and nine months ended September 30, 2004, the provision for income taxes as a percentage of income before income taxes was 27% and 28%, respectively, which is lower than the U.S. Federal statutory tax rate, principally due to certain overseas income which is neither subject to foreign income taxes because of tax holidays granted to the Company, nor subject to tax in the U.S. unless repatriated. 9. The Company has a $5 million line of credit pursuant to which it may borrow up to 80% of eligible accounts receivable at the bank's alternate base rate plus 1/2% or LIBOR plus 3%. The line, which expires in May, 2006, is secured by the company's accounts receivable. The Company has not borrowed against its credit line in 2005. 10. In January 2004, the Company reached a settlement agreement and received $1,000,000 cash from a former client as full satisfaction of a $2.6 million dollar remaining outstanding balance that the Company had fully written off as a bad debt in 2001. The $1,000,000 receipt, net of $37,000 in recovery costs, is reflected as bad debt recovery income in the statement of operations for the nine months ended September 30, 2004. 11. In connection with the cessation of all operations at certain foreign subsidiaries, certain former employees have filed various actions against one of the Company's Philippine subsidiaries, and have purported to also sue the Company and certain of its officers and directors, seeking to require reinstatement of employment and to recover back wages for an allegedly illegal facility closing on June 7, 2002 based on the terms of a collective bargaining agreement with this subsidiary. If the complainants' claims had merit, they could be entitled to back wages of up to $5.0 million for the period from June 7, 2002 to June 6, 2005, consistent with prevailing jurisprudence. Based upon consultation with legal counsel, management believes the claims are without merit and is defending against them vigorously. 12. In August 2004, the Internal Revenue Service ("IRS") promulgated regulations, effective August 12, 2004, that treated certain of the Company's subsidiaries that are incorporated in foreign jurisdictions and also domesticated as Delaware limited liability companies as U.S. corporations for U.S. federal income tax purposes. In the preamble to such regulations, the IRS expressed its view that dual registered companies described in the preceding sentence are also treated as U.S. corporations for U.S. federal income tax purposes for periods prior to August 12, 2004. Notwithstanding this view, the Company believes that its historic treatment of these subsidiaries as not having been required to pay taxes in the United States for the period prior to August 12, 2004 is correct, and intends to vigorously defend its treatment if challenged. As such, the Company has made no provision for U.S. taxes in its financial statements for these entities for the periods prior to August 12, 2004. However, if challenges by the IRS were ultimately successful, the Company's potential U.S. federal income tax liability could approximate $2.5 million, excluding interest and potential penalties. Furthermore, the Company cannot assure that the IRS will not assert other positions with respect to the foregoing matters that, if successful, could increase materially the Company's liability for U.S. federal income taxes. In December 2004, the Company effected certain filings in Delaware to ensure that these subsidiaries will not be treated as U.S. corporations for U.S. federal income tax purposes as of the date of filing and as such, will not be subject to U.S. federal income taxes commencing January 1, 2005. 12
In addition, the Company is subject to various legal proceedings and claims which arise in the ordinary course of business. While management currently believes that the ultimate outcome of all these proceedings will not have a material adverse effect on the Company's financial position or overall trends in results of operations, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on the operating results of the period in which the ruling occurs. In addition, the estimate of potential impact on the Company's financial position or overall results of operations for the above legal proceedings could change in the future. 13. The Company's production facilities are located in the Philippines, India and Sri Lanka. To the extent that the currencies of these countries fluctuate, the Company is subject to risks of changing costs of production after pricing is established for certain customer projects. However, most significant contracts contain provisions for price renegotiation. 14. The Company is obligated under certain circumstances to indemnify directors and certain officers against costs and liabilities incurred in actions or threatened actions brought against such individual because such individual acted in the capacity of director and/or officer of the Company. In addition, the Company has contracts with certain clients pursuant to which the Company has agreed to indemnify the client for certain specified and limited claims. These indemnification obligations are in the ordinary course of business and, in many cases, do not include a limit on maximum potential future payments. As of September 30, 2005, the Company has not recorded liability for any obligations arising as a result of these indemnifications. 15. In December 2004, the FASB issued SFAS No. 123 (R), "Share-Based Payment", which is a revision of SFAS No. 123 and supersedes Accounting Principles Board ("APB") Opinion No. 25. SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. Pro forma disclosure of the income statement effects of share-based payments is no longer an alternative. SFAS No. 123 (R) is effective for all stock-based awards granted on or after January 1, 2006. In addition, companies must also recognize compensation expense related to any awards that are not fully vested as of the effective date. Compensation expense for the unvested awards will be measured based on the fair value of the awards previously calculated in developing the pro forma disclosures in accordance with the provisions of SFAS No. 123. The Company is currently evaluating SFAS No. 123 (R), including the method of adoption, and expects its adoption will result in increased compensation expense in the future. 13
16. In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 ("FAS 109-1"), "Application of FASB Statement No. 109, `Accounting for Income Taxes,' to the Tax Deduction on Qualified Production Activities provided by the American Jobs Creation Act of 2004." The American Jobs Creation Act, or AJCA, creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividend received deduction for certain qualified dividends from controlled foreign corporations. FAS 109-1 clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with FASB Statement No. 109. Our evaluation of the AJCA with respect to the additional deduction is still in process and we expect to complete the evaluation process in 2005. As such, we cannot reasonably estimate the income tax effect of any such repatriation at the present time. 17. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29." The guidance in APB Opinion No. 29, "Accounting for Nonmonetary Transactions", is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. This Statement amends APB No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153, which was adopted by the Company on July 1, 2005, does not have a material impact on our financial position or on our results of operations. 14
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Disclosures in this Form 10-Q contain certain forward-looking statements, including without limitation, statements concerning our operations, economic performance, and financial condition. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words "estimate," "believe," "expect," and "anticipate" and other similar expressions generally identify forward-looking statements, which speak only as of their dates. These forward-looking statements are based largely on our current expectations, and are subject to a number of risks and uncertainties, including without limitation, continuing revenue concentration in a limited number of clients, continuing reliance on project-based work, worsening of market conditions, changes in external market factors, the ability and willingness of our clients and prospective clients to execute business plans which give rise to requirements for digital content and professional services in knowledge processing, difficulty in integrating and deriving synergies from acquisitions, potential undiscovered liabilities of companies that we acquire, changes in our business or growth strategy, the emergence of new or growing competitors, various other competitive and technological factors, and other risks and uncertainties indicated from time to time in our filings with the Securities and Exchange Commission. Our actual results could differ materially from the results referred to in the forward-looking statements. In light of these risks and uncertainties, there can be no assurance that the results referred to in the forward-looking statements contained in this release will occur. We undertake no obligation to update or review any guidance or other forward-looking information, whether as a result of new information, future developments or otherwise. The Company Innodata Isogen is a leading provider of business services that help organizations create, manage, use and distribute information more effectively and economically. We provide outsourced content services and content-related information technology (IT) professional services. Our outsourced content services focus on fabrication services and knowledge services. Fabrication services include digitization, imaging, data conversion, XML and mark-up services, as well as language translation and content creation services. Knowledge services include content enhancement, taxonomy, controlled vocabulary development, hyperlinking, mark-up indexing, abstracting and general editorial services. Our IT professional services focus on the design, implementation, integration and deployment of systems used to author, manage and distribute content. 15
Outsourced content services for business processes that we anticipate a client will require for an indefinite period generate what we regard as recurring revenues. Outsourced content services for a specific project generate revenues that we regard as non-recurring. A substantial majority of our IT professional services is provided on a project basis that generates non-recurring revenues. We have experienced, and expect to continue to experience, significant fluctuations in our quarterly revenues and results of operations. While we seek, wherever possible, to counterbalance periodic declines in revenues on completion of large projects with new arrangements to provide services to the same client or others, we may not be able to avoid declines in revenues when large projects are completed. Our inability in any period to obtain sufficient new projects to counterbalance any decreases in such work adversely affects our revenues and results of operations for the period. We have historically relied on a very limited number of clients that have accounted for a significant portion of our revenues. We may lose any of these or any of our other major clients as a result of our failure to meet or satisfy our clients' requirements; the completion, termination or reduction of a project or engagement; or the selection of another service provider. Our revenues and results of operations are adversely affected when these events occur. Our services are typically subject to client requirements, and in most cases are terminable upon 30 to 90 days' notice. Other factors, some of which are beyond our control, that may also affect our quarterly results include the size, mix, timing and terms and conditions of client projects; variations in the duration, size and scope of our projects or engagements; market acceptance of our clients' new products and services; our ability to manage costs; local factors and events that affect our production volume, such as local holidays; unforeseen events, such as earthquakes, storms and civil unrest; currency exchange fluctuations; changes in pricing policies by us or our competitors; the introduction of new services by us or our competitors; and acquisition and integration costs related to possible acquisitions of other businesses. The Company's production facilities are located in the Philippines, India and Sri Lanka. To the extent that the currencies of these countries fluctuate, the Company is subject to risks of changing costs of production after pricing is established for certain customer projects. However, most significant contracts contain provisions for price renegotiation. Direct operating costs for both our outsourced content services and IT professional services consist of direct payroll, occupancy costs, depreciation, telecommunications, computer services and supplies. We intend to reduce direct operating costs of our IT professional services as a percentage of revenues from our IT professional services by increasing our offshore IT professional services staff. Selling and administrative expenses for both our outsourced content services and IT professional services consist of management and administrative salaries, selling and marketing costs and administrative overhead. We anticipate selling expenses will continue to increase in absolute terms as we continue to build and enhance our business development infrastructure. 16
Results of Operations Three Months Ended September 30, 2005 and 2004 Revenues Revenues were $9.6 million for the three months ended September 30, 2005 compared to $15.9 million for the similar period in 2004, a decrease of 39%. In addition, our revenues for the three months ended September 30, 2005 decreased 5% from second quarter 2005 revenues of approximately $10.1 million. The sequential decline in quarterly revenues primarily reflects a sequential decrease in IT professional services segment revenues of approximately $700,000 offset by a $200,000 increase in third quarter 2005 outsourced content services segment revenues. Revenues from outsourced content services decreased 35% to $8.5 million for the three months ended September 30, 2005 from $13 million for the similar period in 2004. This decrease primarily reflects a $4.0 million decline in revenues from a major outsourced content services project that was terminated late in the first quarter of 2005. Revenues from IT professional services decreased 60%, to $1.1 million for the three months ended September 30, 2005 from $2.9 million for the similar period in 2004. The results in the 2004 period reflect approximately $1.3 million of revenues from a project that completed in the third quarter of 2004. One client accounted for 28% and 22% of our total revenues for the three months ended September 30, 2005 and 2004, respectively. A second client accounted for 37% of our revenues for the three months ended September 30, 2004. No other client accounted for 10% or more of our total revenues for these periods. Further, for the three months ended September 30, 2005 and 2004, revenues from clients located in foreign countries (principally in Europe) accounted for 38% and 28% of our total revenues, respectively. For the three months ended September 30, 2005, approximately 62% of our revenue was recurring and 38% was non-recurring, compared with 45% and 55%, respectively, for the three months ended September 30, 2004. Direct Operating Costs Direct operating costs were $7.3 million and $8.8 million for the three months ended September 30, 2005 and 2004, respectively, a decrease of 18%. Direct operating costs as a percentage of revenues for the three months ended September 30, 2005 and 2004, were 75% and 56% respectively. 17
Direct operating costs for outsourced content services were $6.3 million and $7.5 million in the three months ended September 30, 2005 and 2004, respectively. Direct operating costs of outsourced content services as a percentage of revenues from outsourced content services were 74% and 57% for the three months ended September 30, 2005 and 2004, respectively. Variable costs of production as a percent of revenues increased slightly. Although fixed costs declined slightly in absolute terms, fixed costs as a percent of revenues increased by approximately 14 percentage points. This increase was attributable to decreased revenues in 2005 without a corresponding decrease in fixed costs. Direct operating costs for IT professional services were $1.0 million and $1.3 million for the three months ended September 30, 2005 and 2004, respectively, a decrease of 29%. Direct operating costs of IT professional services as a percentage of revenues from IT professional services were 86% and 48% for the three months ended September 30, 2005 and 2004, respectively. The dollar decrease in direct operating costs of IT professional services for the 2005 period was due to a reduction in labor costs. The increase in direct operating costs of IT professional services as a percentage of revenues from IT professional services for the 2005 period was primarily attributable to decreased revenues without a corresponding decrease in these costs. Selling and Administrative Expenses Selling and administrative expenses were $3.7 million and $2.8 million for the three months ended September 30, 2005 and 2004, respectively, an increase of 29%. Selling and administrative expenses as a percentage of revenues were 38% and 18% for the three months ended September 30, 2005 and 2004, respectively. Selling and marketing expenses increased by approximately $500,000, partly as a result of increased costs from our continued efforts to enhance our business development infrastructure. In addition, during the three months ended September 30, 2005, we spent approximately $300,000 in new services research and development. The balance of the increase from 2004 reflects general increases in administrative costs. Other In the three months ended September 30, 2005, the benefit from income taxes as a percentage of loss before income taxes was 26%, which is lower than the U.S. Federal statutory tax rate, principally due to losses attributable to certain overseas subsidiaries for which no tax benefit is available. In the three months ended September 30, 2004, the provision for income taxes as a percentage of income before income taxes was 27%, which is lower than the U.S. Federal statutory tax rate, principally due to certain overseas income which is neither subject to foreign income taxes because of tax holidays granted to the Company, nor subject to tax in the U.S. unless repatriated. 18
Nine Months Ended September 30, 2005 and 2004 Revenues Revenues were $30.9 million for the nine months ended September 30, 2005 compared to $40.4 million for the similar period in 2004, a decrease of 23%. Revenues from outsourced content services decreased 15%, to $26.8 million for the nine months ended September 30, 2005 from $31.5 million for the similar period in 2004. The revenue decrease primarily reflects the termination of a major outsourced content services project that was completed late in the first quarter of 2005 and the scheduled completion of a large outsourced content services project for a second client. Revenues from IT professional services decreased 53% to $4.1 million for the nine months ended September 30, 2005 from $8.9 million for the similar period in 2004. Revenues for the nine months ended September 30, 2004 include approximately $4.3 million in revenues from two large projects that completed during the third quarter of 2004. One client accounted for 25% and 23% of our total revenues for the nine months ended September 30, 2005 and 2004, respectively. A second client accounted for 15% and 29% of our revenues for the nine months ended September 30, 2005 and 2004 respectively. No other client accounted for 10% or more of our total revenues for these periods. Further, for the nine months ended September 30, 2005 and 2004, revenues from clients located in foreign countries (principally in Europe) accounted for 33% and 30% of our total revenues, respectively. For the nine months ended September 30, 2005, approximately 59% of our revenue was recurring and 41% was non-recurring, compared with 49% and 51%, respectively, for the nine months ended September 30, 2004. Direct Operating Costs Direct operating costs were $23.0 million and $24.5 million for the nine months ended September 30, 2005 and 2004, respectively. Direct operating costs as a percentage of revenues for the nine months ended September 30, 2005 and 2004, were 74% and 61% respectively. Direct operating costs for outsourced content services were $19.6 million and $20.1 million for the nine months ended September 30, 2005 and 2004, respectively, a decrease of 3%. Direct operating costs of outsourced content services as a percentage of revenues from outsourced content services were 73% and 64% for the nine months ended September 30, 2005 and 2004, respectively. Although variable costs of production as a percent of revenues remained constant, fixed overhead costs increased both in absolute terms and as a percentage of revenues. The increase in fixed overhead costs resulted principally from increases in facility rent and power costs, as well as increases in labor costs attributable to growth in our engineering technology department and to salary increases generally. The overall increase was in part offset by a $715,000 reduction in depreciation and amortization. 19
Direct operating costs for IT professional services were $3.4 million and $4.4 million for the nine months ended September 30, 2005 and 2004, respectively, a decrease of 22%. Direct operating costs of IT professional services as a percentage of revenues from IT professional services were 82% and 49% for the nine months ended September 30, 2005 and 2004, respectively. The dollar decrease in direct operating costs of IT professional services for the 2005 period was due to a reduction in both labor and non-labor costs. The increase in direct operating costs of IT professional services as a percentage of revenues from IT professional services for the 2005 period was primarily attributable to decreased revenues without a corresponding decrease in these costs. Selling and Administrative Expenses Selling and administrative expenses were $9.8 million and $7.5 million for the nine months ended September 30, 2005 and 2004, respectively, an increase of 30%. Selling and administrative expenses as a percentage of revenues were 32% and 19% for the nine months ended September 30, 2005 and 2004, respectively. Selling and marketing expenses increased by approximately $1.3 million, partly as a result of increased costs from our continued efforts to enhance our business development infrastructure. In addition, during the nine months ended September 30, 2005, we spent approximately $500,000 in new services research and development. The balance of the increase from 2004 reflects general increases in administrative costs. Other In January 2004, we reached a settlement agreement and received $1.0 million in cash from a former client in full satisfaction of a $2.6 million outstanding balance that we had fully written off as a bad debt in 2001. The $1.0 million receipt, net of $37,000 in recovery costs, is reflected as bad debt recovery for the nine months ended September 30, 2004. In the nine months ended September 30, 2005, the benefit from income taxes as a percentage of loss before income taxes was 26%, which is lower than the U.S. Federal statutory tax rate, principally due to losses attributable to certain overseas subsidiaries for which no tax benefit is available. In the nine months ended September 30, 2004, the provision for income taxes as a percentage of income before income taxes was 28%, which is lower than the U.S. Federal statutory tax rate, principally due to certain overseas income which is neither subject to foreign income taxes because of tax holidays granted to the Company, nor subject to tax in the U.S. unless repatriated. 20
Liquidity and Capital Resources Selected measures of liquidity and capital resources, expressed in thousands are as follows: September 30, 2005 December 31, 2004 ------------------ ----------------- Cash and Cash Equivalents $ 21,380 $ 20,663 Working Capital 21,780 22,209 Net Cash Provided By Operating Activities Net cash provided by operating activities was $1.9 million for the nine months ended September 30, 2005 compared to $11.2 million provided by operating activities for the nine months ended December 30, 2004, a decrease of approximately $9.3 million. The $9.3 million decrease in net cash provided by operating activities is principally due to a $7.9 million reduction in net income, a $1.5 million reduction in non-cash charges (of which approximately $750,000 represents a reduction in deferred tax assets and the remainder a reduction in depreciation and amortization). Accounts receivable totaled approximately $5.2 million at September 30, 2005, representing approximately 50 days of sales outstanding compared to $8.0 million, or 57 days, at December 31, 2004. The decrease in days outstanding resulted from increased accounts receivable collections during 2005. A significant amount of the Company's revenues are derived from clients in the publishing industry. Accordingly, the Company's accounts receivable generally include significant amounts due from such clients. In addition, as of September 30, 2005, approximately 33% of the Company's accounts receivable was from foreign (principally European) clients, of which 23% was due from one client. Net Cash Used in Investing Activities For the nine months ended September 30, 2005, we spent cash approximating $1,408,000 for capital expenditures, compared to approximately $1,671,000 for the nine months ended September 30, 2004. Furthermore, during the nine months ended September 30, 2005, we financed the purchase of software licenses totaling approximately $488,000. Capital spending in 2005 and 2004 related principally to normal ongoing equipment upgrades, project requirement specific equipment, and improvements in infrastructure. During the next twelve months, we anticipate that capital expenditures for ongoing technology, hardware, equipment and infrastructure upgrades will approximate $3 million. Furthermore, in the next twelve months, we anticipate spending approximately $1.6 million on construction and infrastructure related costs in connection with the relocation of two of our Asian facilities, and for the renovation of our U.S. headquarters. Such anticipated expenditures are in addition to potential capital expenditures for new service offerings. 21
Net Cash Provided by Financing Activities Proceeds from the exercise of stock options provided cash approximating $799,000 and $670,000 for the nine months ended September 30, 2005 and 2004, respectively. In addition, payments of long-term obligations approximated $525,000 and $110,000 for the nine months ended September 30, 2005 and 2004, respectively. During the nine months ended September 30, 2005, we entered into an agreement with a vendor to acquire certain additional software licenses and to receive support and subsequent software upgrades on this and other currently owned software licenses through February 2008 for a total cost of approximately $1.6 million. This total obligation and associated cost totaling approximately $1.6 million is a non-cash investing and financing activity. Of the $1.6 million, approximately $396,000 was paid during the nine months ended September 30, 2005 and $527,000 will be paid as a financing activity in the next 12 months. Availability of Funds We have a $5.0 million line of credit pursuant to which we may borrow up to 80% of eligible accounts receivable at the bank's alternate base rate plus 1/2% or LIBOR plus 3%. The line is secured by our accounts receivable. There are no amounts outstanding under this facility. We believe that existing cash and internally generated funds will be sufficient for our reasonably anticipated working capital and capital expenditure requirements during the next 12 months. We fund our foreign expenditures from our U.S. corporate headquarters on an as-needed basis. Inflation, Seasonality and Prevailing Economic Conditions To date, inflation has not had a significant impact on our operations. We generally perform work for our clients under project-specific contracts, requirements-based contracts or long-term contracts. Contracts are typically subject to numerous termination provisions. Our quarterly operating results are also subject to seasonal fluctuations. Our fourth and first quarters include the months of December and January, when billable services activity by professional staff, as well as engagement decisions by clients, may be reduced due to client budget planning cycles. In addition, demand for our services may be lower in the fourth quarter due to reduced activity during the holiday season and fewer working days for our Philippines based staff during this period. 22
Critical Accounting Policies and Estimates Basis of Presentation and Use of Estimates Management's discussion and analysis of its results of operations and financial condition is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these 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. On an on-going basis, we evaluate our estimates, including those related to accounts receivable. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Allowance for Doubtful Accounts We establish credit terms for new clients based upon management's review of their credit information and project terms, and perform ongoing credit evaluations of our customers, adjusting credit terms when management believes appropriate based upon payment history and an assessment of their current credit worthiness. We record an allowance for doubtful accounts for estimated losses resulting from the inability of our clients to make required payments. We determine this allowance by considering a number of factors, including the length of time trade accounts receivable are past due, our previous loss history, our estimate of the client's current ability to pay its obligation to us, and the condition of the general economy and the industry as a whole. While credit losses have generally been within expectations and the provisions established, we cannot guarantee that credit loss rates in the future will be consistent with those experienced in the past. In addition, we have credit exposure if the financial condition of one of our major clients were to deteriorate. In the event that the financial condition of our clients were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be necessary. Revenue Recognition We recognize revenue for content manufacturing and outsourcing services in the period in which we perform services and deliver in accordance with Staff Accounting Bulletin 104. We recognize IT professional services revenue from custom application and systems integration development which requires significant production, modification or customization of software in accordance with Statement of Position ("SOP") No. 97-2 "Software Revenue Recognition" and in a manner similar to SOP No. 81-1 "Accounting for Performance of Construction-Type and Certain Production-Type Contracts". We recognize revenue for such services billed under fixed fee arrangements in a manner similar to the percentage-of-completion method under contract accounting as we perform services or reach output milestones. We measure the percentage completed either by the percentage of labor hours incurred to date in relation to estimated total labor hours or in consideration of achievement of certain output milestones, depending on the specific nature of each contract. For arrangements in which percentage-of completion accounting is used, we record cash receipts from customers and billed amounts due from customers in excess of recognized revenue as billings in excess of revenues earned on contracts in progress (which is included in accounts receivable). Revenues from fixed-fee projects accounted for less than 10% of our total revenue for the three and nine months ended September 30, 2005 and 2004, respectively. We recognize revenue billed on a time and materials basis as we perform the services. 23
Property and Equipment Property and equipment is stated at cost and is depreciated on the straight-line method over the estimated useful lives of the related assets, which is generally two to five years. Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the lives of the leases. Long-lived Assets We account for long lived assets under Statement of Financial Accounting Standards ("SFAS") 144, Accounting for the Impairment or Disposal of Long Lived Assets. We assess the recoverability of our long-lived assets, which consists primarily of fixed assets and intangible assets with finite useful lives, whenever events or changes in circumstance indicate that the carrying value may not be recoverable. The following factors, if present, may trigger an impairment review: (i) significant underperformance relative to expected historical or projected future operating results; (ii) significant negative industry or economic trends; (iii) significant decline in our stock price for a sustained period; and (iv) a change in our market capitalization relative to net book value. If the recoverability of these assets is unlikely because of the existence of one or more of the above-mentioned factors, we perform an impairment analysis using a projected discounted cash flow method. We must make assumptions regarding estimated future cash flows and other factors to determine the fair value of these respective assets. If these estimates or related assumptions change in the future, we may be required to record an impairment charge. Impairment charges would be included in general and administrative expenses in our statements of operations, and would result in reduced carrying amounts of the related assets on our balance sheets. Income Taxes We determine our deferred taxes based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates, as well as any net operating loss or tax credit carryforwards expected to reduce taxes payable in future years. We provide a valuation allowance when it is more likely than not that some or all of a deferred tax asset will not be realized. Unremitted earnings of foreign subsidiaries have been included in the consolidated financial statements without giving effect to the United States taxes that may be payable on distribution to the United States to the extent such earnings are not anticipated to be remitted to the United States. 24
Goodwill and Other Intangible Assets SFAS 142 requires that we test goodwill for impairment using a two-step fair value based test. The first step of the goodwill impairment test annually, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, the second step of the goodwill impairment test must be performed to measure the amount of the impairment loss, if any. If impairment is determined, we will recognize additional charges to operating expenses in the period in which they are identified, which would result in a reduction of operating results and a reduction in the amount of goodwill. Accounting for Stock-Based Compensation We account for our stock options issued to employees and outside directors pursuant to Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" and have adopted the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation", and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123". Accordingly, in 2005, we have not recognized compensation expense in connection with the issuance of stock options to employees and outside directors. Significant New Accounting Pronouncements Not Yet Adopted In December 2004, the FASB issued SFAS No. 123 (R), "Share-Based Payment", which is a revision of SFAS No. 123 and supersedes Accounting Principles Board ("APB") Opinion No. 25. SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. Pro forma disclosure of the income statement effects of share-based payments is no longer an alternative. SFAS No. 123 (R) is effective for all stock-based awards granted on or after January 1, 2006. In addition, companies must also recognize compensation expense related to any awards that are not fully vested as of the effective date. Compensation expense for the unvested awards will be measured based on the fair value of the awards previously calculated in developing the pro forma disclosures in accordance with the provisions of SFAS No. 123. We are currently evaluating SFAS No. 123 (R), including the method of adoption, and expect its adoption will result in increased compensation expense in the future. In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 ("FAS 109-1"), "Application of FASB Statement No. 109, `Accounting for Income Taxes,' to the Tax Deduction on Qualified Production Activities provided by the American Jobs Creation Act of 2004." The American Jobs Creation Act, or AJCA, creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividend received deduction for certain qualified dividends from controlled foreign corporations. FAS 109-1 clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with FASB Statement No. 109. Our evaluation of the AJCA with respect to the additional deduction is still in process and we expect to complete the evaluation process in 2005. As such, we cannot reasonably estimate the income tax effect of any such repatriation at the present time. 25
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29." The guidance in APB Opinion No. 29, "Accounting for Nonmonetary Transactions", is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. This Statement amends APB No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153, which was adopted by the Company on July 1, 2005, does not have a material impact on our financial position or on our results of operations. Item 3. Quantitative and Qualitative Disclosures About Market Risk We are exposed to interest rate change market risk with respect to our credit line with a financial institution which is priced based on the bank's alternate base rate (6.75% at September 30, 2005) plus 1/2% or LIBOR (3.875% at September 30, 2005) plus 3%. We have not borrowed under this line in 2005. To the extent we utilize all or a portion of this line of credit, changes in the interest rate will have a positive or negative effect on our interest expense. We have operations in foreign countries. While we are exposed to foreign currency fluctuations, we presently have no financial instruments in foreign currency and do not maintain significant funds in foreign currency beyond those necessary for operations. Item 4. Controls and Procedures An evaluation has been carried out under the supervision and with the participation of our management, including our Chief Executive Officer and Principal Financial Officer, of the effectiveness of the design and the operation of our "disclosure controls and procedures" (as such term is defined in Rules 13a-15(e) under the Securities Exchange Act of 1934) as of September 30, 2005 ("Evaluation Date"). Based on such evaluation, our Chief Executive Officer and Principal Financial Officer have concluded that, as of the Evaluation Date, the disclosure controls and procedures are reasonably designed and effective to ensure that (i) information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and (ii) such information is accumulated and communicated to our management, including our Chief Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There were no changes in our internal controls over financial reporting in connection with the evaluation required by paragraph (d) of Rules 13a-15 or 15d-15 under the Exchange Act that occurred during our last fiscal quarter that materially affected or are reasonably likely to materially affect the internal controls over financial reporting. 26
PART II. OTHER INFORMATION Item 1. Legal Proceedings. Not Applicable Item 2. Changes in Securities. Not Applicable Item 3. Defaults upon Senior Securities. Not Applicable Item 4. Submission of Matters to a Vote of Security Holders. Not Applicable. Item 5. Other Information. Not Applicable Item 6. (a) Exhibits. 31.1 Certificate of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002. 31.2 Certificate of Principal Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002. 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002. 27
SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INNODATA ISOGEN, INC. Date: November 14, 2005 /s/ Jack Abuhoff --------------------------------------- Jack Abuhoff Chairman of the Board of Directors, Chief Executive Officer and President Date: November 14, 2005 /s/ Stephen Agress --------------------------------------- Stephen Agress Vice President - Finance Chief Accounting Officer