Outstanding options and warrants to purchase shares of common stock, representing approximately 3.2 million shares of common stock, were not included in the computations of diluted net income (loss) per share for the three and nine months ended September 30, 2001 because their effect would be anti-dilutive.

6. STOCK OPTIONS

During the first nine months of 2001, the Company granted options to purchase an aggregate of 60,000 shares of the Company's common stock at an exercise price of $1.50 per share, which was equal to or greater than the fair market value on the date of grant. All of these options were granted to six officers and directors of the Company. These options, which were granted under the Company's Long-Term Stock Investment Plan, will vest on the first anniversary date of grant.

7. SETTLEMENT OF LITIGATION

On November 30, 2000, immediately prior to a scheduled jury trial, the Company settled its long-standing litigation with two former executives of the Company, Austin Iodice and Anthony Giglio. In accordance with the terms of the settlement, the Company paid to the plaintiffs $325,000 on January 2, 2001 and $300,000 on May 1, 2001 and issued options to them to purchase 555,628 shares of common stock in the aggregate at an exercise price of $0.6625 per share on January 2, 2001.

8. INDUSTRY SEGMENT INFORMATION

The Company has determined that its reportable segments can be distinguished principally by the types of services offered to the Company's clients.

Prior to filing its Annual Report on Form 10-K for the year ended December 31, 2000, the Company reported its results through two operating segments -- Staff Augmentation and Financial Services. Principally as a result of the development by the Company's PrO Unlimited® subsidiary of a business offering web-enabled solutions for the procurement, tracking and engagement of contingent labor, the Company began reporting its results through three operating segments -- Staff Augmentation, Human Capital Management Services and Financial Services.

Revenues and profits in the Staff Augmentation segment are generated by providing supplemental staffing to client companies, generally on a time-and-materials basis. In the IT field, the Company provides highly skilled programmers, help desk personnel, systems consultants and analysts, software engineers and project managers for a wide range of technical assignments, including client server, mainframe, desktop services, help desk and Internet/Intranet. In the telecom sector, the Company provides skilled telecom personnel to plan, design, engineer, install and maintain wireless and wireline telecommunications systems, including cellular, PCS, microwave, radio, satellite and other networks. In addition, the Company provides a broad range of other staffing services to its customers in the Staff Augmentation segment, including laboratory support (through the Company's Labforce® division), medical office support, professional, scientific, clerical and call center staffing.

Revenues and profits in the Human Capital Management segment are generated through consulting and payrolling services to its clients. Through its PrO Unlimited subsidiary, the Company provides end-to-end web-enabled solutions for the effective procurement, tracking and engagement of contingent or non-employee labor. The contingent labor force consists of independent contractors, temporary workers, consultants, returning retirees and freelancers.

Revenues and profits in the Financial Services segment are generated through contracts for payrolling, funding and outsourcing services to its clients. In this segment, the Company processes payrolls, prepares reports, pays payroll taxes and prepares and files tax returns for the contingent personnel employed by independent staffing firms. The Company also purchases the accounts receivable of independent staffing firms and receives payments directly from these firms' clients.

The accounting policies of the segments are the same as those described in Note 2 to the consolidated financial statements of the Company included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000. The Company evaluates the performance of its segments and allocates resources to them based on operating contribution, which represents segment revenues less direct costs of operations, excluding the allocation of corporate general and administrative expenses. Assets of the operating segments reflect primarily net accounts receivable associated with segment activities; all other assets are included as corporate assets. The Company does not track expenditures for long-lived assets on a segment basis.

The table below presents information on the revenues and operating contribution for each segment for the three and nine months ended September 30, 2001 and September 30, 2000, and items which reconcile segment operating contribution to the Company's reported pre-tax income (loss) (in thousands).

9. ACCOUNTING AND DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

On January 1, 2001, the Company adopted Statement of Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." However, since the Company does not have any derivatives and does not engage in hedging activities, the adoption of SFAS No. 133 had no impact on the Company's consolidated financial statements.

10. RELATED PARTY TRANSACTION

On September 21, 2001, the Company completed the exchange of $18.0 million principal amount of PIK Debentures for the Company's Convertible Note in the principal amount of $8.0 million, plus $1.0 million in cash. The Convertible Note was issued to a limited partnership in which John Fanning, the Company's Chairman and Chief Executive Officer, holds the principal economic interest. Rosemary Maniscalco, a director of the Company, is the general partner of this limited partnership and, by virtue of this role, is deemed to be a beneficial owner of the Convertible Note. See Note 3 for a description of the terms of the Convertible Note.

11. NEW ACCOUNTING STANDARDS

In July 2001, the FASB issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.

The Company is required to adopt the provisions of Statement 141 immediately, and to adopt Statement 142 effective January 1, 2002. Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-Statement 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before June 30, 2001 will continue to be amortized prior to the adoption of Statement 142.

Statement 141 will require upon adoption of Statement 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in Statement 141 for recognition apart from goodwill. Upon adoption of Statement 142, the Company will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company will be required to test the intangible asset for impairment in accordance with the provisions of Statement 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period.

In connection with the transitional goodwill impairment evaluation, Statement 142 will require the Company to perform an assessment of whether there is an indication that goodwill is impaired as of the date of adoption. To accomplish this the Company must identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. The Company will then have up to nine months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit's carrying amount. To the extent a reporting unit's carrying amount exceeds its fair value, an indication exists that the reporting unit's goodwill may be impaired and the Company must perform the second step of the transitional impairment test. In the second step, the Company must compare the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with Statement 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in the Company's statement of operations.

As of the date of adoption, the Company expects to have unamortized goodwill and identifiable intangible assets in the amount of $134.9 million, which will be subject to the transition provisions of Statements 141 and 142. Amortization expense related to goodwill was $4.1 million and $3.1 million for the year ended December 31, 2000 and the nine months ended September 30, 2001, respectively. Because of the extensive effort needed to comply with adopting Statements 141 and 142, it is not practicable to reasonably estimate the impact of adopting these Statements on the Company's financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle.

In July 2001, the FASB issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations ("SFAS 143"). SFAS 143 is effective for fiscal years beginning after June 15, 2002, and establishes an accounting standard requiring the recording of the fair value of liabilities associated with the retirement of long-lived assets in the period in which they are incurred. The Company does not expect the adoption of SFAS 143 to have a significant effect on its results of operations or its financial position.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, while retaining the fundamental recognition and measurement provisions of that statement. SFAS No. 144 requires that a long-lived asset to be abandoned, exchanged for a similar productive asset or distributed to owners in a spinoff to be considered held and used until it is disposed of. However, SFAS No. 144 requires that management consider revising the depreciable life of such long-lived asset. With respect to long-lived assets to be disposed of by sale, SFAS No. 144 retains the provisions of SFAS No. 121 and, therefore, requires that discontinued operations no longer be measured on a net realizable value basis and that future operating losses associated with such discontinued operations no longer be recognized before they occur. SFAS No. 144 is effective for all fiscal quarters of fiscal years beginning after December 15, 2001, and will thus be adopted by the Company on January 1, 2002. The Company has not determined the effect, if any, that the adoption of SFAS No. 144 will have on the Company's consolidated financial statements.

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

The discussion set forth below supplements the information found in the unaudited consolidated financial statements and related notes of COMFORCE Corporation ("COMFORCE") and its subsidiaries, including COMFORCE Operating, Inc. ("COI") (collectively, the "Company").

Overview

Staffing personnel placed by the Company are employees of the Company. The Company is responsible for employee related expenses for its employees, including workers' compensation, unemployment compensation insurance, Medicare and Social Security taxes and general payroll expenses. The Company offers health, dental, disability and life insurance to its billable employees. Staffing and consulting companies, including the Company, typically pay their billable employees for their services before receiving payment from their customers, often resulting in significant outstanding receivables. To the extent the Company increases revenues through acquisitions and/or internal growth, these receivables will grow and there will be greater requirements for borrowing availability under its credit facility to fund current operations.

Prior to filing its Annual Report on Form 10-K for the year ended December 31, 2000, the Company reported its results through two operating segments -- Staff Augmentation and Financial Services. Principally as a result of the development by the Company's PrO Unlimited subsidiary of a business offering web-enabled solutions for the procurement, tracking and engagement of contingent labor, the Company began reporting its results through three operating segments -- Staff Augmentation, Human Capital Management Services and Financial Services. The Staff Augmentation segment provides information technology (IT), telecom and other staffing services. The Human Capital Management Services segment provides contingent workforce management services. The Financial Services segment provides payroll, funding and outsourcing services to independent consulting and staffing companies.

Debt Restructuring

As part of its strategy to reduce its higher interest rate debt and improve its balance sheet, on February 28, 2001, the Company completed the repurchase of $11.0 million principal amount of its Senior Notes due 2007 (the "Senior Notes") for $7.5 million and on March 5, 2001, the Company completed the repurchase of an additional $2.0 million of Senior Notes for $1.4 million, the repurchase prices of which were paid from lower interest rate borrowings under the Company's revolving credit facility agented by IBJ Whitehall Business Credit Corporation (the "IBJ Credit Facility"). Prior thereto, during the third quarter of 2000, the Company repurchased $10.0 million principal amount of the Senior Notes for a purchase price of $5.1 million, the repurchase price of which was paid from lower interest rate borrowings under the now retired Heller Credit Facility.

In addition, on March 5, 2001, the Company entered into an amendment of the IBJ Credit Facility to permit borrowings thereunder to repurchase the Company's 15% Senior Secured PIK Debentures due 2009 (the "PIK Debentures") under certain circumstances. As amended, the IBJ Credit Facility permits the use of up to $16.5 million in loan proceeds to pay the aggregate repurchase prices of Senior Notes and PIK Debentures and costs associated therewith (including related tax expenses), not more than $9.0 million of which may be used to pay the repurchase price of PIK Debentures and such associated costs.

On March 6, 2001, the Company completed the repurchase of $5.2 million principal amount of PIK Debentures for $2.5 million using lower interest rate borrowings under the IBJ Credit Facility.

On September 21, 2001, the Company completed the exchange of $18.0 million principal amount of PIK Debentures (including accrued and unpaid interest of $860,000) for the Company's 8% Subordinated Convertible Note due December 2, 2009 in the principal amount of $8.0 million (the "Convertible Note"), plus $1.0 million in cash. Interest on the PIK Debentures accrues at the rate of 15% per annum and, through December 1, 2002, may, at the election of the Company, be paid-in-kind through its issuance of additional PIK Debentures. The Convertible Note bears interest at the rate of 8% per annum, payable semi-annually on June 1 and December 1 in each year. Through December 1, 2003, interest on the Convertible Note may, at the election of the Company, be paid-in-kind through its issuance of additional Convertible Notes. The Convertible Note is convertible into the Company's common stock based on a price of $1.70 per share of common stock, provided that if such conversion would result in a change of control occurring under the terms of the indentures governing the PIK Debentures or the Senior Notes, the Convertible Note will be convertible into shares of non-voting preferred stock having a nominal liquidation preference (but no other preferences), which in turn will be convertible into common stock at the holder's option at any time so long as the conversion would not result in a change of control.

The holder of the $18.0 million PIK Debentures that were exchanged for the $8.0 million Convertible Note is a limited partnership in which John Fanning, the Company's Chairman and Chief Executive Officer, holds the principal economic interest. Rosemary Maniscalco, a director of the Company, is the general partner of this limited partnership and, by virtue of this role, is deemed to be a beneficial owner of the Convertible Note. The Company obtained the opinion of an independent investment banking firm of nationally recognized standing that this exchange transaction was fair to the Company from a financial point of view. Prior to the exchange, the Company received the consent to eliminate certain of the covenants in the indenture governing the PIK Debenture.

 

Results of Operations

Three Months Ended September 30, 2001 Compared to Three Months Ended September 30, 2000

Net sales of services for the three months ended September 30, 2001 were $107.5 million, a decrease of 10.7% from net sales of services for the three months ended September 30, 2000 of $120.4 million. The decrease in net sales of services is attributable principally to a sharp decline in the telecom industry resulting in lower sales to telecom customers in the Staff Augmentation division. Sales to staffing services customers also contributed to lower sales in the Staff Augmentation division, partially offset by an increase in net sales of services to information technology customers. Due to the continuing effects of the soft economy, revenues were down in the Human Capital Management Services segment and service revenues declined in the Financial Services segment as well.

Cost of services for the three months ended September 30, 2001 was 80.3% of net sales of services as compared to cost of services of 78.7% for the three months ended September 30, 2000. The cost of services increased as a percentage of net sales for the third quarter of 2001 as compared to the third quarter of 2000 primarily as a result of lower total company sales, in particular, lower sales and gross margin percentage to telecom customers discussed above, as well as decreases in permanent placement fees.

Selling, general and administrative expenses as a percentage of net sales of services were 14.1% for the three months ended September 30, 2001, compared to 14.0% for the three months ended September 30, 2000. Due to the lower sales discussed above, management undertook initiatives to reduce selling, general and administrative costs for the quarter. These costs were further reduced by lower commissions as a result of the decrease in sales discussed above.

Operating income for the three months ended September 30, 2001 was $4.0 million as compared to operating income of $6.9 million for the three months ended September 30, 2000. This 41.7% decrease in operating income for the third quarter of 2001 resulted principally from the decrease in sales and gross margin discussed above, and an increase in depreciation and amortization, partially offset by lower selling, general administrative expenses.

The Company's interest expense for the three months ended September 30, 2001 and September 30, 2000 is attributable to the interest on the Company's credit facility with Heller Financial, Inc. (the "Heller Credit Facility"), which was terminated in December 2000, the IBJ Credit Facility, which was entered into in December 2000, the Senior Notes and the PIK Debentures. The IBJ Credit Facility was entered into to repay the Heller Credit Facility and provide the Company additional borrowing availability. The Heller Credit Facility as well as the financings evidenced by the Senior Notes and PIK Debentures were incurred in 1997, principally in connection with the funding of business acquisitions.

During the first quarter of 2001, the Company repurchased $13.0 million principal amount of Senior Notes for $8.9 million and $5.2 million principal amount of PIK Debentures for $2.5 million (including accrued and unpaid interest of $340,000), the repurchase prices of which were paid from lower interest rate borrowings under the IBJ Credit Facility. On September 21, 2001, the Company completed the exchange of $18.0 million principal amount of PIK Debentures (including accrued and unpaid interest of $860,000) for its Convertible Note (bearing interest at the per annum rate of 8%), plus $1.0 million in cash. The extraordinary gain realized by the Company as a result of these transactions was $9.3 million, which includes the reduction of $1.1 million of deferred financing costs associated with the repurchases, net of tax expense of $6.6 million. See "Financial Condition, Liquidity and Capital Resources" in this Item 2.

The interest expense was lower for the three months ended September 30, 2001 as compared to the three months ended September 30, 2000 due to lower market interest rates and borrowings under the IBJ Credit Facility as well as the reduction of Senior Notes and PIK Debentures through the repurchases described above.

The income tax provision for the three months ended September 30, 2001 was $136,000 on a loss of $842,000 before taxes and extraordinary gain associated with the retirement of the PIK Debentures through the exchange described above. The income tax provision for the three months ended September 30, 2000 was $1.7 million on income before taxes of $2.2 million. The Company provides for income taxes, based upon the estimated effective tax rate (on a year to date basis). The difference between the federal statutory income tax rate and the Company's effective tax rate relates primarily to the nondeductibility of amortization expense associated with certain intangible assets, the nondeductibility of a portion of the interest expense associated with the PIK Debentures and state income taxes.

Nine months Ended September 30, 2001 Compared to Nine months Ended September 30, 2000

Net sales of services for the nine months ended September 30, 2001 were $343.1 million, a decrease of 0.6% from net sales of services for the nine months ended September 30, 2000 of $345.0 million. The decrease in net sales of services is attributable principally to a sharp decline in the telecom industry resulting in lower sales to telecom customers in the Staff Augmentation division. Sales to staffing services customers also contributed to lower sales in the Staff Augmentation division, partially offset by an increase in net sales of services to information technology customers and to the Financial Services segment. Also due to the continuing effects of the soft economy, revenues were lower to the Human Capital Management Services segment.

Cost of services for the nine months ended September 30, 2001 was 79.1% of net sales of services as compared to cost of services of 79.4% for the nine months ended September 30, 2000. The cost of services decreased as a percentage of net sales for the first nine months of 2001 as compared to the first nine months of 2000 as a result of the continued focus on higher margin niche products, partially offset by lower sales (and gross margin percentages on sales) to telecom customers and a decrease in permanent placement fees.

Selling, general and administrative expenses as a percentage of net sales of services were 14.5% for the nine months ended September 30, 2001, compared to 14.0% for the nine months ended September 30, 2000. This increase resulted principally from higher payroll and recruiting costs with respect to non-billable staff and investments to expand the infrastructure for the Company's Human Capital Management Services segment during the first half of 2001, offset partially by initiatives made by management during the third quarter to reduce costs.

Operating income for the nine months ended September 30, 2001 was $16.1 million as compared to operating income of $17.5 million for the nine months ended September 30, 2000. This 7.6% decrease in operating income for the nine months ended September 30, 2001 resulted principally from a decrease in sales, particularly in the telecom sector, higher selling, general and administrative expenses and an increase in depreciation and amortization.

The Company's interest expense for the nine months ended September 30, 2001 and September 30, 2000 is attributable to the interest on the Heller Credit Facility, which was terminated in December 2000, the IBJ Credit Facility, which was entered into in December 2000, the Senior Notes and the PIK Debentures. The IBJ Credit Facility was entered into to repay the Heller Credit Facility and provide the Company additional borrowing availability. The Heller Credit Facility as well as the financings evidenced by the Senior Notes and PIK Debentures were incurred in 1997, principally in connection with the funding of business acquisitions.

During the first quarter of 2001, the Company repurchased $13.0 million principal amount of Senior Notes for $8.9 million and $5.2 million principal amount of PIK Debentures for $2.5 million (including accrued and unpaid interest of $340,000), the repurchase prices of which were paid from lower interest rate borrowings under the IBJ Credit Facility. On September 21, 2001, the Company completed the exchange of $18.0 million principal amount of PIK Debentures (including accrued and unpaid interest of $860,000) for its Convertible Note (bearing interest at the per annum rate of 8%), plus $1.0 million in cash. The extraordinary gain realized by Company during the nine months ended September 30, 2001 as a result of the repurchases and the exchange was $9.3 million, which includes the reduction of $1.1 million of deferred financing costs associated with these transactions, net of tax expense of $6.6 million. See "Financial Condition, Liquidity and Capital Resources" in this Item 2.

The interest expense was lower for the nine months ended September 30, 2001 as compared to the nine months ended September 30, 2000 due to lower market interest rates and borrowings under the IBJ Credit Facility as well as the reduction of Senior Notes and PIK Debentures through the repurchases and the exchange described above.

The income tax provision for the nine months ended September 30, 2001 was $1.7 million on income of $439,000 before taxes and extraordinary gain associated with the retirement of the Senior Notes and PIK Debentures through the repurchases and exchange described above. The income tax provision for the nine months ended September 30, 2000 was $2.3 million on income before taxes of $1.3 million. The Company provides for income taxes, based upon the estimated effective tax rate (on a year to date basis). The difference between the federal statutory income tax rate and the Company's effective tax rate relates primarily to the nondeductibility of amortization expense associated with certain intangible assets, the nondeductibility of a portion of the interest expense associated with the PIK Debentures and state income taxes.

Financial Condition, Liquidity and Capital Resources

The Company pays its billable employees weekly for their services, and remits certain statutory payroll and related taxes as well as other fringe benefits. Invoices are generated to reflect these costs plus the Company's markup. These bills are typically paid within 45 days. Increases in the Company's net sales of services, resulting from expansion of existing offices or establishment of new offices, will require additional cash resources.

Management of the Company believes that cash flow from operations and funds anticipated to be available under the IBJ Credit Facility will be sufficient to service the Company's indebtedness and to meet anticipated working capital requirements for the foreseeable future.

During the nine months ended September 30, 2001, the Company's primary sources of funds to meet working capital needs were from borrowings under the IBJ Credit Facility. Cash and cash equivalents increased $554,000 during the nine months ended September 30, 2001. Cash flows provided by operating activities of $26.9 million exceeded cash flows used in financing activities of $22.5 million and cash flows used in investing activities of $3.9 million.

As of September 30, 2001, the Company had outstanding $56.7 million principal amount under the IBJ Credit Facility bearing interest at a weighted average rate of 6.2% per annum. In addition, as of September 30, 2001, the Company had outstanding $9.7 million principal amount of PIK Debentures bearing interest at a rate of 15% per annum, $87.0 million principal amount of Senior Notes bearing interest at a rate of 12% per annum and $8.0 million principal amount of Convertible Notes bearing interest at the rate of 8% per annum. As more fully described below, the debt service costs associated with the PIK Debentures and the Convertible Notes may be satisfied through the issuance of new PIK Debentures or Convertible Notes, respectively. To date, the Company has chosen to issue new PIK Debentures to pay these costs.

In December 2000, the Company entered into the IBJ Credit Facility to provide greater borrowing availability. The maximum availability of $100.0 million was increased to $110.0 million in January 2001 when additional lending institutions requested to join the loan syndicate. The IBJ Credit Facility was further amended in March 2001 to permit the Company to use certain borrowed funds to repurchase PIK Debentures (in addition to Senior Notes, the repurchase of which was previously permitted).

The Company has adopted a strategy to reduce its higher interest rate debt and improve its balance sheet by retiring Senior Notes and PIK Debentures through public market and privately negotiated transactions and exchanging PIK Debentures for the new Convertible Note with a substantially lower interest rate. In the first quarter of 2001, the Company repurchased $13.0 million principal amount of Senior Notes for $8.9 million and $5.2 million principal amount of PIK Debentures for $2.5 million, the repurchase prices of which were paid from lower interest rate borrowings under the IBJ Credit Facility. In the third quarter of 2001, the Company completed the exchange of $18.0 million principal amount of PIK Debentures (bearing interest at the rate of 15% per annum) for its new $8 million Convertible Note (bearing interest at the rate of 8% per annum), plus $1.0 million in cash.

The IBJ Credit Facility permits the use of up to $16.5 million in loan proceeds to pay the aggregate repurchase prices of Senior Notes and PIK Debentures and costs associated therewith (including related tax expenses), not more than $9.0 million of which may be used to pay the repurchase price of PIK Debentures and such associated costs. In the case of each repurchase and the exchange, the Company has incurred tax liabilities for the forgiveness of indebtedness as a result of its retirement of Senior Notes and PIK Debentures for consideration that is less than par. Management believes that the remaining availability under the IBJ Credit Facility is sufficient to service the Company's indebtedness and to meet anticipated working capital requirements in the foreseeable future.

Substantially all of the consolidated net assets of the Company are assets of COI and all of the net income that has been generated by Company through September 30, 2001 is net income attributable to the operations of COI. Accordingly, except for permitted distributions, these assets and net income are restricted as to their use by COMFORCE. The indenture governing the Senior Notes imposes restrictions on COI making specified payments, which are referred to as "restricted payments," including making distributions or paying dividends (referred to as upstreaming funds) to COMFORCE. Under the indenture, COI is not permitted to make cash distributions to COMFORCE other than (1) to upstream $2.0 million annually ($1.25 million annually prior to 2000) to pay public company expenses, (2) to upstream up to $10.0 million to pay income tax related to deemed forgiveness of PIK Debentures to facilitate the purchase or exchange by COMFORCE of PIK Debentures at less than par, (3) under certain circumstances in connection with a disposition of assets, to upstream proceeds therefrom to repay the PIK Debentures, and (4) to upstream funds to the extent COI meets the restricted payments test under the indenture.

Through December 1, 2002, interest under the PIK Debentures is payable, at the option of COMFORCE, in cash or in kind through the issuance of additional PIK Debentures. In addition, through December 1, 2003, interest under the Convertible Notes is payable, at the option of COMFORCE, in cash or in kind through the issuance of additional Convertible Notes. To date, COMFORCE has paid all interest under the PIK Debentures in kind. Beginning with the interest payment due June 1, 2003, COMFORCE will be required to pay interest on the PIK Debentures in cash. Beginning with the interest payment due June 1, 2004, COMFORCE will be required to pay interest on the Convertible Notes in cash. Its ability to pay cash interest in each case will be dependent on the ability of COI to upstream funds for this purpose under the restricted payments test. In addition, COMFORCE's ability to repay the PIK Debentures at their maturity on December 1, 2009 or the Convertible Note at its maturity on December 2, 2009, or on any earlier required repayment or repurchase date, will also be dependent on the ability of COI to upstream funds for such purposes under the restricted payments test, unless COMFORCE separately obtains a loan or sells its capital stock or other securities to provide funds for such purposes.

As of September 30, 2001, approximately $135.4 million, or 52.3%, of the Company's total assets were intangible assets. These intangible assets substantially represent amounts attributable to goodwill recorded in connection with the Company's acquisitions. Intangible assets are amortized over a 5 to 40 year period, resulting in an annual non-cash charge of approximately $4.5 million. Effective January 1, 2002, the Company will cease recording goodwill amortization amounting to approximately $4.2 million, as described below under "-New Accounting Standards."

The Company is obligated under various agreements to make earn-out payments to the sellers of companies acquired by the Company and to sellers of franchised businesses repurchased by the Company, subject to the sellers meeting specified contractual requirements. The maximum amount of the remaining potential earn-out payments is approximately $525,000 in cash payable through December 31, 2002. The Company cannot currently estimate whether it will be obligated to pay the maximum amount; however, the Company anticipates that the cash generated by the operations of the acquired companies or franchised businesses will provide all or a substantial part of the capital required to fund the cash portion of the earn-out payments.

New Accounting Standards

In July 2001, the FASB issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.

The Company is required to adopt the provisions of Statement 141 immediately, and to adopt Statement 142 effective January 1, 2002. Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-Statement 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before June 30, 2001 will continue to be amortized prior to the adoption of Statement 142.

Statement 141 will require upon adoption of Statement 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in Statement 141 for recognition apart from goodwill. Upon adoption of Statement 142, the Company will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company will be required to test the intangible asset for impairment in accordance with the provisions of Statement 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period.

In connection with the transitional goodwill impairment evaluation, Statement 142 will require the Company to perform an assessment of whether there is an indication that goodwill is impaired as of the date of adoption. To accomplish this the Company must identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. The Company will then have up to nine months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit's carrying amount. To the extent a reporting unit's carrying amount exceeds its fair value, an indication exists that the reporting unit's goodwill may be impaired and the Company must perform the second step of the transitional impairment test. In the second step, the Company must compare the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with Statement 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in the Company's statement of operations.

As of the date of adoption, the Company expects to have unamortized goodwill and identifiable intangible assets in the amount of $134.9 million, which will be subject to the transition provisions of Statements 141 and 142. Amortization expense related to goodwill was $4.1 million for the year ended December 31, 2000 and $3.1 million for the nine months ended September 30, 2001. Because of the extensive effort needed to comply with adopting Statements 141 and 142, it is not practicable to reasonably estimate the impact of adopting these Statements on the Company's financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle.

In July 2001, the FASB issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations ("SFAS 143"). SFAS 143 is effective for fiscal years beginning after June 15, 2002, and establishes an accounting standard requiring the recording of the fair value of liabilities associated with the retirement of long-lived assets in the period in which they are incurred. The Company is in the process of determining the future impact that the adoption of SFAS 143 may have on its earnings and financial position.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, while retaining the fundamental recognition and measurement provisions of that statement. SFAS No. 144 requires that a long-lived asset to be abandoned, exchanged for a similar productive asset or distributed to owners in a spinoff to be considered held and used until it is disposed of. However, SFAS No. 144 requires that management consider revising the depreciable life of such long-lived asset. With respect to long-lived assets to be disposed of by sale, SFAS No. 144 retains the provisions of SFAS No. 121 and, therefore, requires that discontinued operations no longer be measured on a net realizable value basis and that future operating losses associated with such discontinued operations no longer be recognized before they occur. SFAS No. 144 is effective for all fiscal quarters of fiscal years beginning after December 15, 2001, and will thus be adopted by the Company on January 1, 2002. The Company has not determined the effect, if any, that the adoption of SFAS No. 144 will have on the Company's consolidated financial statements.

Seasonality

The Company's quarterly operating results are affected primarily by the number of billing days in the quarter and the seasonality of its customers' businesses. Demand for engineer-related, IT and telecom staffing services has historically been lower during the second half of the fourth quarter through the following first quarter, and, generally, shows gradual improvement until the second half of the fourth quarter. The Company believes that the effects of seasonality will be less severe in the future if sales of its niche, human capital management and financial service products continue to increase as a percentage of the Company's consolidated net sales of services.

Forward Looking Statements

Various statements made in this Report concerning the manner in which the Company intends to conduct its future operations, and potential trends that may impact future results of operations, are forward looking statements. The Company may be unable to realize its plans and objectives due to various important factors, including, but not limited to, adverse general economic conditions (particularly since the events of September 11, 2001); recent upheavals in the telecommunications industry; heightened competition for customers as well as for contingent personnel which could potentially require the Company to reduce its current fee scales without being able to reduce the personnel costs of its billable employees; due to the Company's significant leverage, its greater vulnerability to economic downturns and its potentially diminished ability to obtain additional financing for capital expenditures or for other purposes; if the Company is unable to sustain the cash flow necessary to support the retention of goodwill on its balance sheet (an analysis of which is required to be conducted annually), it could be required to writedown the impaired assets, which could have a material adverse impact on its financial condition and results of operations; or, if COI does not generate sufficient consolidated net income or have other funds available to upstream to COMFORCE under the restricted payments test of the Senior Notes indenture in order for it to pay cash interest on the PIK Debentures (which is required beginning June 1, 2003) or the Convertible Note (which is required beginning June 1, 2004) or to repay the PIK Debentures or the Convertible Note at their maturity in December 2009, or on any earlier required repayment or repurchase date, then, unless COMFORCE obtains a loan or sells its capital stock or other securities to provide funds for this purpose, the Company will default under the indentures governing the PIK Debentures and the Senior Notes and under the IBJ Credit Facility. Additional important factors that could cause the Company to be unable to realize its plans and objectives are described under "Risk Factors" in the Registration Statement on Form S-3 of the Company filed with the Securities and Exchange Commission on December 21, 2000 (Registration No. 333-52356). The disclosure under "Risk Factors" in the Registration Statement may be accessed through the Web site maintained by the Securities and Exchange Commission at "www.sec.gov." In addition, the Company will provide, without charge, a copy of such "Risk Factors" disclosure to each stockholder of the Company who requests such information. Requests for copies should be directed to the attention of Linda Annicelli, Vice President of Administration at COMFORCE Corporation, 415 Crossways Park Drive, P.O. Box 9006, Woodbury, New York 11797, telephone 516-437-3300.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by Item 3 has been disclosed in Item 7A of the Company's Annual Report on Form 10-K for the year ended December 31, 2000. There has been no material change in the disclosure regarding market risk.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

Since the date of the filing of the Company's Annual Report on Form 10-K for the year ended December 31, 2000, there have been no material new legal proceedings involving the Company or any material developments to the proceedings described in such 10-K.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.

On September 21, 2001, the Company completed the exchange of $18.0 million principal amount of PIK Debentures for the Company's Convertible Note in the principal amount of $8.0 million, plus $1.0 million in cash. The Convertible Note is convertible into the Company's common stock based on a price of $1.70 per share of common stock, provided that if such conversion would result in a change of control occurring under the terms of the indentures governing the PIK Debentures or the Senior Notes, the Convertible Note will be convertible into shares of non-voting preferred stock having a nominal liquidation preference (but no other preferences), which in turn will be convertible into common stock at the holder's option at any time so long as the conversion would not result in a change of control.

The Convertible Note was issued to a limited partnership in which John Fanning, the Company's Chairman and Chief Executive Officer, holds the principal economic interest. Rosemary Maniscalco, a director of the Company, is the general partner of this limited partnership and, by virtue of this role, is deemed to be a beneficial owner of the Convertible Note. RBC Dominion Securities Corporation served as the placement agent in connection with the exchange. The Convertible Note was issued in reliance on the exemption afforded by Section 4(2) of the Securities Act of 1933 and the regulations thereunder.

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. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits.

10.1 Form of the Company's 8% Subordinated Convertible Note due December 2, 2009.

(b) Reports on Form 8-K.

None.

 

 

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, each Registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.

COMFORCE Corporation

By: /s/ Harry Maccarrone

Harry Maccarrone, Executive Vice President
and Chief Financial Officer

Date: November 9, 2001

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 12 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.