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GVP > SEC Filings for GVP > Form 10-Q on 14-Nov-2012All Recent SEC Filings

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Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") is a world leader in real-time high fidelity simulation. The Company provides simulation and educational solutions and services to the nuclear and fossil electric utility industry, and the chemical and petrochemical industries.

GSE is the parent company of:
¨ GSE Power Systems, Inc., a Delaware corporation;

¨ GSE Power Systems, AB, a Swedish corporation;

¨ GSE Engineering Systems (Beijing) Co. Ltd., a Chinese limited liability company;

¨ GSE Systems, Ltd., a Scottish limited liability company;

¨ TAS Engineering Consultants Ltd., an English limited liability company;

¨ GSE EnVision, LLC, a New Jersey limited-liability company; and

¨ EnVision Systems (India) Pvt. Ltd., an Indian limited liability company.

The Company has a 49% minority interest in GSE-UNIS Simulation Technology Co., Ltd., a Chinese limited liability company, and has a 10% minority interest in Emirates Simulation Academy, LLC, a United Arab Emirates limited liability company. The Company has only one reportable segment.

Cautionary Statement Regarding Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward looking statements. Forward-looking statements are not statements of historical facts, but rather reflect our current expectations concerning future events and results. We use words such as "expects", "intends", "believes", "may", "will" and "anticipates" to indicate forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including, but not limited to, those factors set forth under Item 1A - Risk Factors of the Company's 2011 Annual Report on Form 10-K and those other risks and uncertainties detailed in the Company's periodic reports and registration statements filed with the Securities and Exchange Commission. We caution that these risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict these new risk factors, nor can we assess the effect, if any, of the new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ from those expressed or implied by these forward-looking statements.

If any one or more of these expectations and assumptions proves incorrect, actual results will likely differ materially from those contemplated by the forward-looking statements. Even if all of the foregoing assumptions and expectations prove correct, actual results may still differ materially from those expressed in the forward-looking statements as a result of factors we may not anticipate or that may be beyond our control. While we cannot assess the future impact that any of these differences could have on our business, financial condition, results of operations and cash flows or the market price of shares of our common stock, the differences could be significant. We do not undertake to update any forward-looking statements made by us, whether as a result of new information, future events or otherwise. You are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in this report.

General Business Environment

It has been over 18 months since a 9.0 magnitude earthquake and subsequent tsunami occurred along the northeast coast of Japan which damaged the Fukushima Daiichi I Nuclear Power Plant, which is maintained by the Tokyo Electric Power Company (TEPCO).

Most countries with nuclear programs reacted to the Fukushima disaster by announcing the delay of new nuclear plants while they conducted reviews of their programs. On March 9, 2012, the U.S. Nuclear Regulatory Commission (NRC) approved the first three new regulatory requirements to deal with safety issues based on eight changes identified by the NRC's Fukushima task force, with implementation required by the end of 2016. The three orders require safety enhancements of operating reactors, construction permit holders, and combined license holders. These orders require nuclear power plants to implement safety enhancements related to (1) mitigation strategies to respond to extreme natural events resulting in the loss of power at plants, (2) ensuring reliable hardened containment vents, and (3) enhancing spent fuel pool instrumentation. In addition, the NRC requested each reactor reevaluate the seismic and flooding hazards at their site using present-day methods and information.

On May 31, 2012, the State Council, China's Cabinet, approved a nuclear safety plan for 2011-2015 following a nine month safety inspection of China's 41 nuclear power plants, which are either operating or under construction. The inspection reportedly showed that most of China's nuclear power stations meet both Chinese and International Atomic Energy Agency standards. According to the Council's statements, the main issues have been for some nuclear power plants to meet new standards on flood protection and for some research reactors to meet new earthquake requirements. Some power plants must also develop better procedures for severe accident prevention and mitigation. Although the Chinese government has not made a decision on when to start approving new nuclear plant projects, there are signs that the decision may come soon. China National Nuclear Power, the biggest nuclear power developer in the country, announced plans to raise money for projects worth more than $27 billion through what could be one of the biggest initial public offerings (IPO) in China and the first for a nuclear power company. The Ministry of Environmental Protection has approved the IPO plan, which must still be submitted to the China Securities Regulatory Commission for approval.

In Japan, all of the country's 54 commercial nuclear reactors had gone offline since the Fukushima disaster. The Japanese government has asked the plant operators to conduct stress tests: computer simulations designed to show how the reactors would hold up during a large natural disaster. In April, 2012, the Japanese nuclear regulators issued a list of 30 lessons from the Fukushima disaster. Although the Japanese Prime Minister, Yoshihiko Noda, has called for restarting the plants as soon as possible, he has said that the reactors will not restart without the approval of local community leaders. Many such local leaders have stated that the stress tests are not enough and want additional guidelines issued before the nuclear reactors are restarted. However, on July 1, 2012, Japan restarted the reactor No. 3 at Ohi nuclear power plant.

Previous nuclear accidents have resulted in new regulations requiring additional operator training, higher fidelity models and new testing scenarios. Accordingly, as evidenced by the new safety rules that the NRC has recently issued, the Chinese State Council's Safety Plan, and the debate in Japan as to the need for new regulatory guidelines, it is likely that there will be additional governmental regulations requiring plant modifications and new testing scenarios that will result in the need for higher simulator fidelity, such as that designed and supplied by GSE.

GSE has developed PSA-HD™, an engineering-grade nuclear simulation solution that allows operations personnel to train for and develop responses to severe accident scenarios based on the operations of their specific facility. PSA-HD utilizes MAAP 5.0 as the calculation engine, with GSE's real-time executive and graphical interface to provide a dynamic, real-time solution for severe accident analysis. MAAP 5.0 is an Electric Power Research Institute (EPRI) software program that performs severe accident analysis for nuclear power plants including assessments of core damage and radiological transport. A valid license to MAAP 5.0 from EPRI is required to use MAAP 5.0 with PSA-HD. PSA-HD's real-time code can be integrated with a nuclear plant's existing full-scope training simulator and is applicable to all current nuclear plant designs. PSA-HD can be used to validate the utility's severe accident management guidelines (SAMGs), demonstrate the safety of current plant designs to regulators and stakeholders, and identify potential issues with existing plant design that may require modification. PSA-HD includes high-fidelity models of the plant's reactor core, containment structures and spent fuel pool. The models simulate severe accident conditions which mirror those that occurred at the Fukushima facility, such as the release of radioactive materials due to overheating of the core, exposure of the fuel rods in the spent fuel pool, and hydrogen build up in the containment building.

In order to meet the world's growing energy needs, the growth of all forms of energy is critical. Per the ExxonMobil 2012 the Outlook for Energy: A View to 2040, "By 2040 electricity generation will account for more than 40% of global energy consumption. Oil will remain the most widely used fuel, but natural gas will grow fast enough to overtake coal for the number-two position. For both oil and natural gas, an increasing share of global supply will come from unconventional sources, such as those from shale formations. Demand for natural gas will rise by more than 60% through 2040." For more than three decades, GSE has leveraged the simulation capability that we initially developed for nuclear power for non-nuclear projects. Globally we have delivered 121 fossil power plant simulators and 96 process industry simulators. Our EnVision™ products include interactive multi-media tutorials and simulation models primarily for the petrochemical and oil & gas refining industries. These products provide a foundation in process fundamentals, as well as plant operations and interaction. GSE now has a tiered offering when it comes to simulation, as well as a large library of training content in multiple languages.

According to the U.S. Energy Information Administration, world energy consumption is forecasted to increase by 52% from 505 quadrillion BTU in 2008 to 770 quadrillion BTU in 2035. New consumption means new production, which means new plants, new workers, and an enormous amount of training to provide a skilled workforce. GSE recognized this growing need for energy industry training several years ago and began developing various training solutions leveraging the use of our simulation technology. GSE created a 163 module, five-simulator training course that was sold to the Emirates Simulation Academy LLC, in the UAE, a training academy that was created by GSE and two other partners in 2007. The Company worked with the University of Strathclyde in Glasgow, Scotland to incorporate GSE's simulation into the University's degreed and industrial education programs. GSE developed a 20-week "Nuclear Operator Jump Start Training Program" for Southern Nuclear Company in Augusta, GA utilizing the Company's VPanel™ interactive visual training simulator. The advantage of the VPanel simulator is its scalability and ease of configuration for both team and individual training, plant specific or cross training. The VPanel allows customers to utilize their existing simulator load while bringing many full scope simulator capabilities directly into the classroom for a fraction of the cost. The "Operator Jump Start" program helps customers screen and train new operator candidates. This training program is designed to provide essential knowledge and skills to potential nuclear plant operators and to determine if candidates have the ability to successfully complete the customer's own operator licensing programs. The program includes instruction on fundamental sciences (including Generic Fundamentals Examinations "GFES"), plant components, systems, and operations.

A compounding problem is facing the energy industry. While experiencing rapid growth requiring new plants and new workers, the incumbent industry workforce is aging and facing dramatic turnover. Per the Nuclear Energy Institute, as of 2008 nearly 38% of the U.S. nuclear power industry would be eligible to retire by 2013. According to the Center for Energy Workforce Development, an estimated 46% of the current energy industry workforce may need to be replaced by 2015 due to attrition and retirement. While the data is readily available in the nuclear industry because it is so heavily regulated, similar demographics exist in the fossil, oil & gas, chemical and petrochemical industries. The impact of this pending workforce turnover has been somewhat delayed due to the recent global economic downturn which has forced many employees to postpone their retirements. Accordingly, the Company anticipates that in the near future, a larger number of employees are likely to retire within a shorter time span and the need to find qualified employees to replace them will become an acute issue.

Except for some insightful early adopters, many companies tend to put off spending on training until their training needs become acute. Often it is viewed as a cost rather than an investment, and is often one of the first expenditures to be reduced during economic downturns. However, the statistics associated with new plant builds and the aging workforce are undeniable, and training will be required to supply the skilled employees that will be needed to staff the new plants and replace the retirees. Therefore, when the energy industry recognizes the need to train, they will want training that is faster and better than what is traditionally available. Additionally, they will have to consider the nature of the next generation workforce who has grown up with a computer and vast amounts of interactive multimedia. Standard classroom training will not provide the efficacy that will be needed nor satisfy the interest level of the new workforce.

In fact, according to the NTL Institute's statistics on adult learner retention only 5% of information is retained from lecture, and only 10% from reading. However, 75% retention is accomplished when learners practice by doing. These statistics support GSE's success with the Nuclear Operator Jump Start Training Program at Southern Nuclear Company, as our design combines traditional instructor-led classroom training with structured simulator exercises supporting the concepts learned. This model is transportable globally to anywhere a new energy workforce is needed.

Case studies demonstrate that the inclusion of "serious gaming" technology such as immersive 3D environments can reduce training time and improve learning significantly. In fact, the Royal Canadian Army was able to reduce the cost of training and increase the pass rate of students by incorporating gaming into the curriculum. Due to the advancement of computer processing power and graphics technology, immersive commercially viable off-the-shelf 3D game engines are readily available. Additionally, this style of learning also lends itself to the next generation workforce, and as such GSE is investing significantly in 3D visualization training products. This investment comes in the form of strategic hires, investment in technology, and software product development. Through development efforts already undertaken, GSE's engineers have discovered how to link our industry-leading, high fidelity models to commercially off-the-shelf game engines. This enables us to make the invisible visible, for example seeing the inside of an operating reactor, steam generator, or turbine generator. Blending the learning strategy by incorporating 3D visualization interfacing high fidelity real time simulation models will allow GSE to provide the energy industry with better, faster, less costly training ideally suited for the next generation workforce, which we have branded as ACTIV-3Di. In September 2012, the Company introduced the Virtual Flow Loop TrainerTM. It can cost approximately $1.0 million to construct a brick and mortar flow loop facility for training plant operating and maintenance staff. The Virtual Flow Loop Trainer is a practical and cost-effective alternative that operates on personal computers across a company's existing IT infrastructure. The Virtual Flow Loop Trainer provides the same level of training in a convenient, flexible environment. The Virtual Flow Loop Trainer is applicable across all industries and learning organizations that need to train their staff and students on both the fundamental and practical operations of a wide variety of pumps, valves, controllers, and instrumentation. We received our first 3D visualization orders in 2011 and will recognize modest revenue from 3D visualization training products in 2012.

Besides new employees, the dramatic increase in energy demand world-wide over the next 30 years will require new plants of all sources, too. Obviously, these new plants will need to be engineered and designed prior to construction, and GSE's modeling tools are being used more and more to verify and validate control system design and overall plant designs. Finding design errors during engineering rather than construction allows plant startup to occur sooner saving countless dollars and allowing revenue generation sooner. GSE is developing new design solutions leveraging our high fidelity simulation models to improve and streamline the plant engineering process.

Results of Operations

The following table sets forth the results of operations for the periods
presented expressed in thousands of dollars and as a percentage of revenue:

(in thousands)              Three Months ended September 30,                    Nine Months ended September 30,
                       2012          %           2011          %           2012          %          2011          %
Contract revenue    $ 13,009       100.0 %    $ 12,549       100.0 %    $ 39,581       100.0 %   $ 36,128       100.0 %
Cost of revenue        7,960        61.2 %       7,931        63.2 %      26,143        66.0 %     24,278        67.2 %

Gross profit           5,049        38.8 %       4,618        36.8 %      13,438        34.0 %     11,850        32.8 %
Selling, general
administrative         3,483        26.8 %       3,302        26.3 %      10,663        27.0 %      9,920        27.5 %
Depreciation             131         1.0 %         137         1.1 %         406         1.0 %        365         1.0 %
Amortization of
intangible assets         79         0.6 %         204         1.6 %         235         0.6 %        629         1.7 %
Total operating
expenses               3,693        28.4 %       3,643        29.0 %      11,304        28.6 %     10,914        30.2 %

Operating income       1,356        10.4 %         975         7.8 %       2,134         5.4 %        936         2.6 %

Interest income,
net                       36         0.3 %          29         0.2 %         121         0.3 %         91         0.3 %
Gain (loss) on
instruments, net          20         0.2 %        (129 )      (1.0 )%         36         0.1 %         49         0.1 %
Other income
(expense), net           (97 )      (0.8 )%         31         0.2 %          82         0.2 %         70         0.2 %

Income before
income taxes           1,315        10.1 %         906         7.2 %       2,373         6.0 %      1,146         3.2 %

(benefit) for
income taxes             499         3.8 %          48         0.4 %         869         2.2 %       (481 )      (1.3 )%

Net income          $    816         6.3 %    $    858         6.8 %    $  1,504         3.8 %   $  1,627         4.5 %

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates.

A summary of the Company's significant accounting policies as of December 31, 2011 is included in Note 2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Certain of our accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term contracts, capitalization of computer software development costs, valuation of intangible assets acquired, contingent consideration issued in business acquisitions, and the recoverability of deferred tax assets. These critical accounting policies and estimates are discussed in the Management's Discussion and Analysis of Financial Condition and Results of Operations section in the 2011 Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

Results of Operations - Three and Nine months ended September 30, 2012 versus Three and Nine months ended September 30, 2011

Contract Revenue. Total contract revenue for the three months ended September 30, 2012 totaled $13.0 million, which was 3.7% greater than the $12.5 million total revenue for the three months ended September 30, 2011. For the nine months ended September 30, 2012, contract revenue totaled $39.6 million, a $3.5 million increase from the $36.1 million for the nine months ended September 30 2011. The Company recorded total orders of $34.9 million in the nine months ended September 30, 2012 compared to $28.4 million for the nine months ended September 30, 2011. During the second quarter of 2012, GSE's wholly-owned subsidiary, GSE EnVision LLC ("EnVision"), received a multi-year contract to provide simulation and computer-based learning modules to the subsidiary of a global energy services company. Revenue from such contract for the three and nine months ended September 30, 2012 was $2.0 million and $2.4 million, respectively. Revenue related to the $26.9 million full scope simulator and digital control system order from Slovenské elektrárne, a.s. ("SE") was $293,000 (2.3% of revenue) and $1.6 million (12.5% of revenue) for the three months ended September 30, 2012 and 2011, respectively. For the nine months ended September 30, 2012 and 2011, revenue from SE was $1.9 million (4.8% of revenue) and $4.5 million (12.3% of revenue), respectively. At September 30, 2012, the Company's backlog was $47.2 million, of which $4.1 million is related to the SE contract. At December 31, 2011 the Company's backlog totaled $51.5 million.

Gross Profit. Gross profit totaled $5.0 million for the three months ended September 30, 2012 compared to $4.6 million for the same period in 2011. As a percentage of revenue, gross profit increased from 36.8% for the three months ended September 30, 2011 to 38.8% for the three months ended September 30, 2012. For the nine months ended September 30, 2012, gross profit increased from $11.9 million during the same period in 2011 to $13.4 million and as a percentage of revenue, gross profit increased from 32.8% to 34.0%, respectively. The increase in revenue from EnVision which has an overall gross profit significantly higher than the Company's normal gross profits, and the decrease in revenue on the Slovakia contract, which has an overall gross profit lower than the Company's normal gross profits, have contributed to the increase in gross profit for the three and nine months ended September 30, 2012. In addition, during the three months ended September 30, 2011, the Company received a $3.0 million change order related to the SE project which increased the overall gross margin on the project and generated an additional $679,000 in gross profit on the project for both the three and nine months ended September 30, 2011.

Selling, General and Administrative Expenses. Selling, general and administrative ("SG&A") expenses totaled $3.5 million in the three months ended September 30, 2012, a 5.5% increase from the $3.3 million for the same period in 2011. For the nine months ended September 30, 2012 and 2011, SG&A expenses totaled $10.7 million and $9.9 million, respectively. The increase reflects the following spending variances:

¨ Business development and marketing costs increased from $1.3 million to $1.7 million for the three months ended September 30, 2011 and 2012, respectively, and increased from $4.1 million to $5.0 million for the nine months ended September 30, 2011 and 2012, respectively. The Company hired three business development resources in the United States and hired two additional business development resources in Europe as compared to the prior year. Included in business development and marketing costs are bidding and proposal costs, which are the costs of operations personnel assisting with the preparation of contract proposals. Bidding and proposal costs increased by $128,000 and $301,000 during the three and nine months ended September 30, 2012 to $463,000 and $1.4 million, respectively, as compared to the three and nine months ended September 30, 2011.

¨ The Company's general and administrative expenses ("G&A") decreased from $1.7 million to $1.5 million for the three months ended September 30, 2011 and 2012, respectively and decreased from $5.2 million to $4.7 million for the nine months ended September 30, 2011 and 2012, respectively. The fluctuations were primarily attributable to the following:

o The Company incurred $0 and $206,000 of acquisition related expenses, primarily composed of legal, audit, and due diligence expenses for the three and nine months ended September 30, 2011, respectively. The Company did not incur any acquisition related expenses during the three and nine months ended September 30, 2012.

o The change in the fair value of contingent consideration (accretion expense) related to the TAS and EnVision acquisitions totaled $102,000 and $245,000 for the three and nine months ended September 30, 2012, respectively, versus $47,000 and $331,000 for the three and nine months ended September 30, 2011, respectively.

¨ Gross spending on software product development ("development") expenses for the three and nine months ended September 30, 2012 totaled $587,000 and $1.9 million, respectively, as compared to $454,000 and $1.2 million for the three and nine months ended September 30, 2011, respectively. The Company capitalized $306,000 and $914,000 of product development expenses for the three and nine months ended September 30, 2012, respectively, and $186,000 and $572,000 for the same periods in 2011, respectively. Net development spending increased from $268,000 for the three months ended September 30, 2011 to $281,000 for the three months ended September 30, 2012 and from $628,000 for the nine months ended September 30, 2011 to $950,000 for the nine months ended September 30, 2012.

o The Company created a 3D visualization team in January 2011 to develop 3D technology to add to our training programs. The Company incurred $70,000 and $306,000 of costs related to this effort in the three and nine months ended September 30, 2012, respectively, as compared to $104,000 and $231,000 for the same periods in 2011.

o Spending on other software product development totaled $517,000 and $1.6 million for the three and nine months ended September 30, 2012, respectively. For the three and nine months ended September 30, 2011, . . .

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