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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the quarterly period ended September 30, 2004
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.
Commission File Number: 0-15938
Farmstead Telephone Group, Inc.
------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 06-1205743
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
22 Prestige Park Circle
East Hartford, CT 06108
(Address of principal executive offices) (Zip Code)
(860) 610-6000
(Registrant's telephone number, including area code)
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 by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of October 30, 2004, the registrant had 3,322,182 shares of its
$0.001 par value Common Stock outstanding.
TABLE OF CONTENTS TO FORM 10-Q
PART I. FINANCIAL INFORMATION
Page
----
ITEM 1. FINANCIAL STATEMENTS (Unaudited)
Consolidated Balance Sheets - September 30, 2004 and
December 31, 2003 3
Consolidated Statements of Operations - Three and Nine
Months Ended September 30, 2004 and 2003 4
Consolidated Statements of Cash Flows - Nine Months Ended
September 30, 2004 and 2003 5
Notes to Consolidated Financial Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 14
ITEM 4. CONTROLS AND PROCEDURES 14
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 14
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 14
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 14
ITEM 5. OTHER INFORMATION 14
ITEM 6. EXHIBITS 15
SIGNATURES 15
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(In thousands) 2004 2003
- ----------------------------------------------------------------------------------------------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 386 $ 827
Accounts receivable, net 2,007 1,408
Inventories, net 1,840 1,969
Other current assets 343 447
- -------------------------------------------------------------------------------------------------
Total Current Assets 4,576 4,651
- -------------------------------------------------------------------------------------------------
Property and equipment, net 227 313
Other assets 95 327
- -------------------------------------------------------------------------------------------------
Total Assets $ 4,898 $ 5,291
=================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,354 $ 1,248
Debt maturing within one year 211 -
Accrued expenses and other current liabilities 399 274
- -------------------------------------------------------------------------------------------------
Total Current Liabilities 1,964 1,522
- -------------------------------------------------------------------------------------------------
Other liabilities 563 478
- -------------------------------------------------------------------------------------------------
Total Liabilities 2,527 2,000
- -------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 9)
Stockholders' Equity:
Preferred stock, $0.001 par value; 2,000,000 shares authorized;
no shares issued and outstanding - -
Common stock, $0.001 par value; 30,000,000 shares authorized;
3,322,182 and 3,311,601 shares issued and outstanding at
September 30, 2004 and December 31, 2003, respectively 3 3
Additional paid-in capital 12,320 12,316
Accumulated deficit (9,926) (8,996)
Accumulated other comprehensive loss (26) (32)
- -------------------------------------------------------------------------------------------------
Total Stockholders' Equity 2,371 3,291
- -------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 4,898 $ 5,291
=================================================================================================
See accompanying notes to consolidated financial statements.
3
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
For the Three For the Nine
Months Ended Months Ended
September 30, September 30,
----------------- ------------------
(In thousands, except loss per share amounts) 2004 2003 2004 2003
- ------------------------------------------------------------------------------------------
Revenues:
Equipment $2,967 $2,945 $8,473 $10,025
Services and other revenue 371 350 1,160 1,644
- ------------------------------------------------------------------------------------------
Total revenues 3,338 3,295 9,633 11,669
Cost of Revenues:
Equipment 2,164 1,990 6,180 6,876
Services and other revenue 257 172 718 1,102
Other cost of revenues 113 187 450 634
- ------------------------------------------------------------------------------------------
Total cost of revenues 2,534 2,349 7,348 8,612
- ------------------------------------------------------------------------------------------
Gross profit 804 946 2,285 3,057
Selling, general and administrative expenses 980 1,080 3,200 3,449
- ------------------------------------------------------------------------------------------
Operating loss (176) (134) (915) (392)
Interest expense (7) (11) (19) (21)
Other income 2 3 4 6
- ------------------------------------------------------------------------------------------
Loss before income taxes (181) (142) (930) (407)
Provision (benefit) for income taxes (6) 7 - 19
- ------------------------------------------------------------------------------------------
Net loss $ (175) $ (149) $ (930) $ (426)
==========================================================================================
Basic and diluted net loss per common share: $ (.05) $ (.04) $ (.28) $ (.13)
Weighted average common shares outstanding: 3,317 3,306 3,315 3,303
==========================================================================================
See accompanying notes to consolidated financial statements.
4
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Nine Months Ended September 30, 2004 and 2003
(In thousands) 2004 2003
- ---------------------------------------------------------------------------
Cash flows from operating activities:
Net loss $(930) $(426)
Adjustments to reconcile net loss to net cash flows
used in operating activities:
Provision for doubtful accounts receivable 24 25
Provision for losses on inventories 82 25
Depreciation and amortization 111 133
Decrease in accumulated other comprehensive loss 6 -
Changes in operating assets and liabilities:
Increase in accounts receivable (623) (146)
Decrease (increase) in inventories 47 (25)
Decrease (increase) in other assets 61 (352)
Increase (decrease) in accounts payable 106 (6)
Increase (decrease) in accrued expenses and other
current liabilities 125 (25)
Increase in other liabilities 85 77
- --------------------------------------------------------------------------
Net cash used in operating activities (906) (720)
- --------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment (25) (60)
- --------------------------------------------------------------------------
Net cash used in investing activities (25) (60)
- --------------------------------------------------------------------------
Cash flows from financing activities:
Borrowings under revolving credit line 211 135
Borrowing against cash value of insurance policy 275 -
Issuance of common stock 4 2
- --------------------------------------------------------------------------
Net cash provided by financing activities 490 137
- --------------------------------------------------------------------------
Net decrease in cash and cash equivalents (441) (643)
Cash and cash equivalents at beginning of period 827 994
- --------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 386 $ 351
==========================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 20 $ 18
Income taxes 4 5
See accompanying notes to consolidated financial statements.
5
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The consolidated financial statements presented herein consist of the
accounts of Farmstead Telephone Group, Inc. and its wholly owned
subsidiaries, FTG Venture Corporation (inactive) and InfiNet Systems, LLC
(inactive). The accompanying consolidated financial statements as of
September 30, 2004 and for the three and nine months ended September 30,
2004 and 2003 have been prepared in accordance with accounting principles
generally accepted in the United States of America and the rules and
regulations of the Securities and Exchange Commission for interim financial
statements. In the Company's opinion, the unaudited interim consolidated
financial statements and accompanying notes reflect all adjustments,
consisting of normal and recurring adjustments that are necessary for a
fair statement of results for the interim periods presented. The results
of operations for the interim periods are not necessarily indicative of the
results to be experienced for the entire fiscal year. This Form 10-Q should
be read in conjunction with the consolidated financial statements and notes
thereto included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2003.
2. OPERATIONS
As presented in the consolidated financial statements contained in
this report, the Company incurred a net loss of $175,000 for the quarter
ended September 30, 2004, a net loss of $930,000 for the nine months ended
September 30, 2004, and has incurred substantial losses in each of the past
three fiscal years. These losses have been primarily the result of
significant declines in revenues over these periods, with the exception of
a 1% increase in revenues in the current year quarter over the comparable
2003 period, and some deterioration in profit margins. There is currently
no clear indication that sales levels will significantly increase in the
near term and, in fact, they could continue to decline. The Company has
been restructuring its operations in order to align its operating expenses
with its revenue levels. During 2004, these actions resulted in a reduction
of 21% of its workforce, primarily operations and administrative positions.
The Company is currently focusing on strategies to increase revenues, which
may include a further diversification of its product offerings, and
increasing the size of its sales force. The Company is also currently
seeking out business partners interested in merging with the Company, as
well as investment banking relationships to assist in obtaining capital to
finance any mergers/acquisitions. In August, 2004, the Company engaged the
services of a business consultant to evaluate the Company's current
business model and operating performance, and assist in developing and
implementing a strategic redirection. Effective October 1, 2004, the
Company hired this individual in the capacity of President and Chief
Executive Officer. For additional information refer to Note 12.
On August 2, 2004, the Company received notification from Avaya, Inc.
that, effective July 30, 2004, it was terminating the Authorized
Remarketing Supplier aftermarket program (the "ARS Program") under which
the Company sold "Classic Avaya(TM)" products. The Company will be allowed
continued use of the Classic Avaya licensed trade mark for a period of 90
days from the termination date. Avaya is currently developing successor
programs to the ARS Program, and the Company expects to be included in
these programs. Since the beginning of 2004, in anticipation of the
possible termination of the ARS Program, the Company has been selling
"Farmstead Certified" refurbished equipment in addition to "Classic Avaya"-
labeled equipment. The Company believes that the termination of the ARS
Program will not have a material adverse impact on the Company.
3. RECLASSIFICATIONS
Certain amounts in the Consolidated Statement of Operations for the
three and nine months ended September 30, 2003 were reclassified to conform
to the current period presentation.
4. ACCOUNTS RECEIVABLE, NET
September 30, December 31,
(Dollars in thousands) 2004 2003
- ------------------------------------------------------------------------
Trade accounts receivable $2,025 $1,410
Less: allowance for doubtful accounts (73) (80)
- ------------------------------------------------------------------------
Trade accounts receivable, net 1,952 1,330
Other receivables 55 78
- ------------------------------------------------------------------------
Accounts receivable, net $2,007 $1,408
========================================================================
6
Other receivables primarily consist of commissions, rebates and other
dealer incentives due from Avaya, Inc., and are recorded in the
consolidated financial statements when earned.
5. INVENTORIES, NET
September 30, December 31,
(Dollars in thousands) 2004 2003
- -------------------------------------------------------------------------------------
Finished goods and spare parts $1,484 $1,817
Work in process (a) 403 450
Rental equipment 46 61
- -------------------------------------------------------------------------------------
1,933 2,328
Less: reserves for excess and obsolete inventories (93) (359)
- -------------------------------------------------------------------------------------
Inventories, net $1,840 $1,969
=====================================================================================
(a) Work in process inventories consist of used equipment requiring
repair or refurbishing.
6. DEBT MATURING WITHIN ONE YEAR
On February 19, 2004, the Company's revolving credit facility with
Business Alliance Capital Corporation ("BACC") was extended for an
additional one-year term with the following modifications: (i) the credit
facility advance limit was increased from $1.5 million to $1.7 million; and
(ii) the amount that could be advanced against eligible inventory was
increased from $200,000 to $400,000. For additional information on the
terms and conditions of the BACC credit facility, refer to the Company's
Form 10-K filed with the Securities and Exchange Commission for the year
ended December 31, 2003.
As of September 30, 2004, outstanding borrowings with BACC were
$210,600. The unused portion of the credit facility as of September 30,
2004 was $1,489,400, of which $1,010,994 was available to borrow. The
average and highest amounts borrowed during the three months ended
September 30, 2004 were approximately $201,000 and $350,000, respectively.
The average and highest amounts borrowed during the nine months ended
September 30, 2004 were approximately $173,000 and $401,000, respectively.
The Company was in compliance with the provisions of its loan agreement as
of September 30, 2004.
7. STOCK OPTIONS
The Company applies the disclosure only provisions of Financial
Accounting Standards Board Statement ("SFAS") No. 123, "Accounting for
Stock-based Compensation" ("SFAS 123") and SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" for employee stock
option awards. Had compensation cost for the Company's stock option plan
been determined in accordance with the fair value-based method prescribed
under SFAS 123, the Company's net loss and basic and diluted net loss per
share would have approximated the pro forma amounts indicated below
(dollars in thousands except per share amounts):
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------
Net loss, as reported $(175) $(149) $(930) $(426)
Add: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects (10) (16) (38) (62)
- ---------------------------------------------------------------------------------------------
Pro forma net loss $(185) $(165) $(968) (488)
Pro forma net loss per share:
Basic and diluted $(.06) $(.05) $(.29) $(.15)
=============================================================================================
The fair value of stock options used to compute pro forma net loss
and net loss per share disclosures was estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted average
assumptions: dividend yield of 0% for 2004 and 2003; expected volatility of
50% for 2004 and 113% for 2003; average risk-free interest rate of
3.1 % for 2004 and 2.78% for 2003; and an expected option holding period of
3.5 years for 2004 and 5.6 years for 2003.
7
8. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In December 2003, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 132 (revised 2003), "Employers' Disclosures about Pensions
and Other Postretirement Benefits, an Amendment of FASB Statements No. 87,
88 and 106" ("SFAS No. 132"). SFAS No. 132 requires, for defined benefit
pension plans and other defined postretirement benefit plans, additional
disclosures regarding plan assets, investment strategy, measurement date,
plan obligations, cash flows and components of net periodic benefit cost,
effective upon issuance. The Company adopted the annual disclosure
requirements for the year ended December 31, 2003. The Company adopted the
interim disclosure requirements in the first quarter of 2004, with current
quarter disclosures provided in Note 10.
9. COMMITMENTS AND CONTINGENCIES
Lease Agreements. On March 23, 2004, the Company entered into a new
lease agreement on its corporate offices and distribution center located at
22 Prestige Park Circle, East Hartford, CT. This agreement replaced the
Company's existing lease due to expire in December 2004. Under the new
lease agreement, which became effective May 1, 2004, the Company is leasing
25,051 square feet for a 10-year, 8-month period expiring December 31,
2014. The lease contains one five-year renewal option. The lease also
allows the Company the one-time option to terminate the lease without
penalty on December 31, 2009. Minimum monthly rent will amount to $11,377
for 2004, $13,047 for years 2005 - 2009, and $13,569 for years 2010 - 2014.
The Company is additionally obligated to pay the lessor its proportionate
share of the property operating costs at an amount equal to $1.20 per
square foot, subject to a 2% annual increase.
On March 31, 2004, the Company terminated, without penalty, its lease
agreement on 15,137 square feet of warehouse space that was scheduled to
expire December 31, 2004. The lease termination was effective April 1,
2004.
Letter of Credit. In connection with the Company's revolving credit
agreement with BACC, the Company issued a $300,000 irrevocable standby
letter of credit ("LC") in favor of BACC. The LC can be drawn upon by BACC
to satisfy any outstanding obligations under the Company's loan agreement
ninety days after an event of default. The LC is secured by cash, and
since this cash is restricted from use by the Company during the term of
the LC, it has been classified under other current assets in the
consolidated balance sheet at September 30, 2004 and December 31, 2003.
10. EMPLOYEE BENEFIT PLANS
The components of the net periodic benefit cost included in the
results of operations for the three and nine months ended September 30,
2004 and 2003 are as follows:
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
(Dollars in thousands) 2004 2003 2004 2003
- ------------------------------------------------------------------------
Service cost $20 $17 $60 $52
Interest cost 9 7 26 22
Recognized actuarial losses 2 - 6 -
- --------------------------------------------------------------------
Net expense $31 $24 $92 $74
====================================================================
11. STOCKHOLDERS' EQUITY
On May 7, 2004 the Company received notice from the American Stock
Exchange (the "Amex" or the "Exchange") that it did not meet certain of the
Exchange's continued listing standards as a result of having stockholders'
equity less than $4 million and net losses in three out of its four most
recent fiscal years, as set forth in Section 1003 (a) (ii) of the Amex
Company Guide. The Company was afforded the opportunity to submit a plan
of compliance to the Exchange and on June 15, 2004 presented its plan to
the Exchange. On July 19, 2004 the Exchange notified the Company that it
accepted its plan of compliance and granted the Company an extension of
time to regain compliance with the continued listing standards. The
Company will be subject to periodic review by Exchange Staff during the
extension period which expires November 7, 2005. Failure to make progress
consistent with the plan or to regain compliance with the continued listing
standards by the end of the extension period could result in the Company
being delisted from the American Stock Exchange.
8
12. SUBSEQUENT EVENTS
On October 1, 2004, Jean-Marc Stiegemeier was hired as the Company's
new President and Chief Executive Officer, succeeding George J. Taylor,
Jr., the Company's founder. Mr. Stiegemeier (the "Executive") was also
appointed to the Company's Board of Directors. The Executive's employment
agreement (the "Agreement") expires December 31, 2009. The Agreement
includes the following key provisions: (i) an annual base salary of
$300,000, which may be increased by the Board in its discretion or
decreased by the Board under certain defined circumstances; (ii) a one-time
special bonus of $37,500, $25,000 of which was payable October 1, 2004,
with the balance payable in January 2005; (iii) an annual bonus of up to
100% of Executive's base salary based upon the attainment of a Board-
approved earnings target for that year; and (iv) as an incentive to reduce
the Company's "acquisition" costs, Executive would receive an "acquisition
incentive bonus" equal to one percent (1%) of the Purchase Price, as
defined in the Agreement, for each acquisition that is concluded during
the term of this Agreement without any obligation by the Company to pay any
fees, commissions or any other cash or equity-based compensation to any
third party(ies) for or in connection with (a) the identification of the
entity that is the subject of the acquisition; (b) the valuation of the
acquisition or (c) the negotiation of the purchase price and other key
business terms of the acquisition with the selling party or its
representatives. Concurrent with the effective date of the Agreement,
Executive was issued a Warrant to purchase up to Four Hundred Thousand
(400,000) shares of common stock at fair market value. The Warrant is
exercisable immediately and expires five years from the date of grant. The
underlying common stock is unregistered as of the date of issuance of the
warrant. The Executive was also granted an option to purchase up to Six
Hundred Thousand (600,000) shares of common stock under the 2002 Stock
Option Plan at an exercise price equal to the fair market value of the
common stock. Three Hundred Thousand (300,000) shares are exercisable one
year after the grant date, with the remainder exercisable two years after
the grant date. The options expire ten years after the grant date.
The Agreement also provides severance pay for the Executive during
the term of the Agreement under certain circumstances. Should the Company
terminate the agreement without "cause", or if the Executive terminates the
Agreement "for good reason", or in the event the Executive resigns after a
"change in control", as all are defined in the Agreement, then severance
pay will equal three times the "Executive Compensation Amount" as defined.
From August 16, 2004 to October 1, 2004, the Executive provided business
consulting services to the Company for which the Executive received $53,714
in fees and expenses.
On October 1, 2004, Mr. Taylor's employment agreement with the
Company was modified ("Modified Agreement"), extending his "Active"
employment period through December 31, 2007 and eliminating his "Limited"
employment period. The Modified Agreement includes the following major
provisions: (i) a base salary of $200,000 for 2005, increasing to $250,000
in 2006 and $300,000 in 2007; (ii) an annual bonus of up to 100% of
Executive's base salary based upon the attainment of a Board-approved
earnings target for that year; and (iii) an "acquisition incentive bonus"
as described above for Executive. Mr. Taylor will continue to serve as
Chairman of the Board.
13. LOSS PER SHARE
Basic loss per share was computed by dividing net loss by the
weighted average number of shares of common stock outstanding during the
reporting periods. Options to purchase 1,899,782 shares of common stock at
an average exercise price of $1.71, and 1,865,706 shares of common stock at
an average exercise price of $1.73 were not included in the computation of
diluted loss per share for the three months ended September 30, 2004 and
2003, respectively, because inclusion of these options would be
antidilutive. Options to purchase 1,882,920 shares of common stock at an
average exercise price of $1.71, and 1,849,565 shares of common stock at an
average exercise price of $1.73 were not included in the computation of
diluted loss per share for the nine months ended September 30, 2004 and
2003, respectively, because inclusion of these options would be
antidilutive.
On October 1, 2004, a Warrant to purchase up to Four Hundred Thousand
(400,000) shares of common stock at fair market value was issued to the
Company's new President and CEO. In addition, said individual was also
granted an option to purchase up to Six Hundred Thousand (600,000) shares
of common stock under the 2002 Stock Option Plan at an exercise price equal
to the fair market value of the common stock. See Note 12.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The discussions set forth below and elsewhere in this Quarterly
Report on Form 10-Q contain certain statements, based on current
expectations, estimates, forecasts and projections about the industry in
which we operate and management's beliefs
9
and assumptions, which are not historical facts and are considered forward-
looking statements within the meaning of the Private Securities Litigation
Reform Act of 1995 ("the Act"). Forward-looking statements include, without
limitation, any statement that may predict, forecast, indicate, or imply
future results, performance, or achievements, and may contain the words
"believe," "will be," "will continue," "will likely result," "anticipates,"
"seeks to," "estimates," "expects," "intends," "plans," "predicts,"
"projects," and similar words, expressions or phrases of similar meaning.
Our actual results could differ materially from those projected in the
forward-looking statements as a result of certain risks, uncertainties and
assumptions, which are difficult to predict. Many of these risks and
uncertainties are described under the heading "Risks, Uncertainties and
Other Factors That May Affect Future Results" below. All forward-looking
statements included in this document are based upon information available
to us on the date hereof. We undertake no obligation to update publicly
any forward-looking statements, whether as a result of new information,
future events or otherwise. In addition, other written or oral statements
made or incorporated by reference from time to time by us or our
representatives in this report, other reports, filings with the Securities
and Exchange Commission ("SEC"), press releases, conferences, or otherwise
may be forward-looking statements within the meaning of the Act.
RESULTS OF OPERATIONS
OVERVIEW. For the three months ended September 30, 2004, we recorded
a net loss of $175,000 or $.05 per share on revenues of $3,338,000. This
compares with a net loss of $149,000 or $.04 per share on revenues of
$3,295,000 recorded for the three months ended September 30, 2003. For the
nine months ended September 30, 2004, we recorded a net loss of $930,000 or
$.28 per share on revenues of $9,633,000. This compares with a net loss of
$426,000 or $.13 per share on revenues of $11,669,000 recorded for the nine
months ended September 30, 2003.
Although third quarter 2004 revenues were 1% higher than the prior
year period, we experienced a decline in our gross profit margin from 29%
in 2003 to 24% in the current year quarter. For the nine months ended
September 30, 2004, we experienced a 17% decline in revenues, and our gross
profit margin declined to 24%, from 26% in the prior year period. There
are several factors which have contributed to these results. First, there
is increased competition in the market areas that we serve, and this has
led to continued sales price erosion and some loss of market share,
particularly in the sale of parts, which we believe has become more of a
commodity and subject to "price shopping" by customers. Our strategy to
diversify our product offerings by selling complete systems and system
upgrades has generated incremental revenues, but sales to date have not
developed enough to compensate for the decline in parts sales. Second, our
sales force has undergone significant turnover in the last two years, and
the productivity ramp-up of new salespersons has taken longer than
expected. Revenue growth is dependent upon a stable, and highly trained
sales force. Third, we continue to believe that corporations are still
cautious about capital equipment spending. We believe that equipment sales
have been affected by the downsizing of many of our customers over the last
few years, which resulted in excess equipment available for re-deployment
in their operations. Although there have been some signs of improvement in
our industry as evidenced by improved operating results from some of the
key manufacturers, and increased sales quotation activities, our overall
order flow has been below our expectations.
During these tough times, we have been reorganizing our operations to
properly size our business in relation to current revenue run-rates, while
trying to preserve our key technical personnel that are critical to
maintaining and growing a systems and services business. Our primary focus
during 2004 has been on strategies to increase revenues while continuing
close controls over operating expenses. However, there is currently no
clear indication that sales levels will significantly increase in the near
term and, in fact, they could continue to decline. In reaction to lower
than expected revenue levels, during the first six months of 2004 we
reduced our workforce by 21%, primarily operations and administrative
positions, but keeping key technical resources intact. We are currently
seeking out business partners interested in merging with the Company, as
well as investment banking relationships to assist in obtaining capital to
finance any mergers/acquisitions.
In August, 2004, the Company engaged the services of a business
consultant to evaluate the Company's current business model and operating
performance, and assist in developing and implementing a strategic
redirection. Effective October 1, 2004, the Company hired this individual,
Mr. Jean-Marc Stiegemeier, in the capacity of President and Chief Executive
Officer. Mr. Stiegemeier has extensive executive management experience in
the telecommunications industry. From 2002 to 2004 he was a business
consultant, advising companies on strategic redirections and turnarounds.
He also served on the board of directors for certain of these companies.
From 1997-2001, he was associated with Exp@nets Inc., a voice and data
solutions provider, serving in various capacities including President and
Director. Prior thereto, Mr. Stiegemeier served as Chairman and CEO of
Franklin Industries Inc., Lucht, Inc., Ships Entertainment, Inc,
California-Telamerica Inc., Morrow Optical, Inc., and Telamerica, Inc. He
was also the President of Honeywell-Telamerica.
Additional information on major components of our operating
performance for the three and nine months ended September 30, 2004 follows
below.
10
REVENUES
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
(in thousands) 2004 2003 2004 2003
- -----------------------------------------------------------------------------
Equipment:
End-user equipment sales $2,356 $2,615 $7,391 $ 8,898
Equipment sales to resellers 611 330 1,082 1,127
- ------------------------------------------------------------------------------
Total equipment sales 2,967 2,945 8,473 10,025
- ------------------------------------------------------------------------------
Services:
Installations 262 155 782 1,089
Rentals and repair 48 46 119 185
Other revenue 61 149 259 370
- ------------------------------------------------------------------------------
Total services and other revenue 371 350 1,160 1,644
- ------------------------------------------------------------------------------
Total revenues $3,338 $3,295 $9,633 $11,669
==============================================================================
Equipment Sales
---------------
Total equipment sales for the three months ended September 30, 2004,
were approximately 1% higher than the comparable 2003 period. The increase
consisted of a $281,000 or 85% increase in sales to equipment resellers
("wholesale sales"), partly offset by a $259,000 or 10% decrease in end-
user equipment sales. Total equipment sales for the nine months ended
September 30, 2004, were 15% below the comparable 2003 period. The
decrease consisted of a $1,507,000 or 17% decline in end-user sales, and a
$45,000 or 4% decline in wholesale sales. End user sales consist of both
parts sales (new and refurbished), and systems sales (complete systems and
system upgrades).
Factors affecting end-user equipment sales for the three and nine
months ended September 30, 2004 are also described in the "Overview"
section above. Wholesale sales have been impacted by some of these same
factors. Although our principal supplier of used equipment for resale into
the wholesale market has significantly curtailed operations, thereby
limiting our ability to acquire equipment at a low enough cost for
profitable resale into the wholesale market, we have been pursuing
partnering arrangements with other equipment dealers as a means to bolster
equipment revenues. As a marketing tool to help generate future equipment
revenues, we have also developed an electronic commerce framework called
"ECONNECT". For the nine months ended September 30, 2004, approximately 4%
of our equipment sales were processed through this on-line catalog.
Services and Other Revenue
--------------------------
Service revenues for the three months ended September 30, 2004, were
approximately 54% higher than the comparable 2003 period. The increase was
primarily attributable to higher installation revenues, which in turn is
attributable to increased systems sales from the comparable prior year
period. Services revenues for the nine months ended September 30, 2004
were 29% below the comparable 2003 period. The decrease was attributable
to (i) a 28% decline in installation revenues, although systems sales were
approximately 1% higher than the prior year period and (ii) a 36% decline
in equipment rental and repair revenues. An increase or decrease in
installation revenues does not always coincide with the reported increase
or decrease in system sales since installations may occur in different
periods than the related system sale, and the Company may sell new systems
or system upgrades without being contracted to perform the installation.
Equipment rental revenues are irregular and difficult to predict, since
they tend to be project-oriented.
Other revenue for the three and nine months ended September 30, 2004
and 2003 consisted primarily of freight billed to customers on product
shipments, and commissions earned from selling Avaya maintenance contracts.
In the sale of Avaya maintenance contracts, we act as a sales agent of
Avaya, and the service obligations are borne entirely by Avaya. Other
revenue for the three months ended September 30, 2004 was 59% below the
comparable 2003 period, attributable to lower commissions earned on Avaya
maintenance contracts. Other revenue for the nine months ended September
30, 2004 was 30% below the comparable prior year period due to lower
commissions earned on Avaya maintenance contracts and to lower freight
revenues.
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COST OF REVENUES AND GROSS PROFIT. Total cost of revenues for the
three months ended September 30, 2004 was $2,534,000, an increase of 8% from
the comparable 2003 period. The gross profit for the three months ended
September 30, 2004 was $804,000, a decrease of 15% from the comparable 2003
period. As a percentage of revenue, the gross profit margin was 24% for
2004, compared to 29% for the comparable 2003 period.
Total cost of revenues for the nine months ended September 30, 2004
was $7,348,000, a decrease of 15% from the comparable 2003 period. The
gross profit for the nine months ended September 30, 2004 was $2,285,000, a
decrease of 25% from the comparable 2003 period. As a percentage of
revenue, the gross profit margin was 24% for 2004, compared to 26% for the
comparable 2003 period.
Our gross profit margins are dependent upon a variety of factors
including (1) product mix - gross margins can vary significantly among
parts sales, system sales and our various service offerings. The parts
business, for example, involves hundreds of parts that generate
significantly varying gross profit margins depending upon their
availability, competition, and demand conditions in the marketplace; (2)
customer mix - we sell parts to both end-users and to other equipment
resellers. In our partnering relationship with Avaya, certain customers
receive pre-negotiated discounts from Avaya which could lower our gross
margins as we do business with these customers; (3) the level and amount of
discounts and purchase rebates available to us from Avaya and its master
distributors and (4) the level of overhead costs in relation to sales
volume. Overhead costs consist primarily of materials handling,
purchasing, and facility costs. The combined effect of all of these
factors will result in varying gross profit margins from period to period.
Gross Profit on Equipment Sales. For the three months ended
September 30, 2004, the gross profit margin on equipment sales revenues was
27%, compared to 32% recorded during the comparable prior year period. For
the nine months ended September 30, 2004, the gross profit margin on
equipment sales revenues was 27%, compared to 31% recorded during the
comparable prior year period. The decrease in each period was attributable
to lower profit margins on sales of parts to both end-users and to
wholesalers, partly offset by increased profit margins on systems sales.
As previously discussed, product demand conditions and increased
competition has led to downward pressure on our sales pricing. We expect
continued pressure on our profit margins going forward.
Gross Profit on Services and Other Revenues. For the three months
ended September 30, 2004, the gross profit margin on services and other
revenues was 31%, compared to 51% in the comparable prior year period. The
decreased gross profit margin was attributable to lower maintenance
contract commissions. For the nine months ended September 30, 2004, the
gross profit margin on services and other revenues was 38%, compared to 33%
in the comparable prior year period. The increased gross profit margin was
primarily attributable to higher profit margins on installation services.
Other Cost of Revenues. Other cost of revenues consists of product
handling, purchasing and facility costs and expenses. For the three months
ended September 30, 2004, these expenses were 40% lower than the comparable
prior year period, and represented approximately 4% of equipment sales
revenues during the current period, compared to 6% of equipment sales
revenues in 2003. For the nine months ended September 30, 2004, these
expenses were 29% lower than the comparable prior year period, representing
5% of equipment sales revenues compared to 6% of equipment sales revenues
in 2003. The reduction in other cost of revenues primarily resulted from
personnel reductions implemented during 2004 as well as planned reductions
in facility costs and expenses. During the nine months ended September 30,
2004, we incurred $25,000 in termination pay expense related to the
personnel reductions.
SELLING, GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES. SG&A expenses
for the three months ended September 30, 2004 were $980,000, a decrease of
9% from the comparable 2003 period. SG&A expenses were 29% of revenues for
the current three-month period as compared to 33% of revenues in 2003. SG&A
expenses for the nine months ended September 30, 2004 were $3,200,000 a
decrease of 7% from the comparable 2003 period. SG&A expenses were 33% of
revenues for the current nine-month period as compared to 30% of revenues
in 2003. The decrease in SG&A expenses in each period was primarily
attributable to (i) lower compensation expense from lower personnel levels
and lower sales commissions; (ii) lower facility rental and operating costs
as a result of a reduction in the number of square feet leased, and (iii)
reductions in various other administrative expenses as a result of cost
reduction initiatives. The decreases were partly offset by higher
marketing expenses, including costs associated with maintaining our
ECONNECT on-line catalog, and lower earned Avaya dealer marketing rebates.
In addition, we incurred $64,000 in outside business consulting fees and
expenses. During the nine months ended September 30, 2004, we also
incurred $17,000 in termination pay expense related to personnel reduction
initiatives.
INTEREST EXPENSE AND OTHER INCOME. Interest expense for the three
months ended September 30, 2004 was $7,000, compared with $11,000 for the
comparable 2003 period. Interest expense for the nine months ended
September 30, 2004 was $19,000, compared with $21,000 for the comparable
2003 period. The fluctuations in interest expense period-over-
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period were attributable to changes in average borrowing levels. Other
income consisted of interest earned on invested cash in all reported
periods.
PROVISION (BENEFIT) FOR INCOME TAXES. The provision for income taxes
represents estimated minimum state taxes in all reported periods. For the
three and nine months ended September 30, 2004, these minimum taxes were
reduced by an $8,000 overaccrual of prior year state taxes. We maintain a
full valuation allowance against our net deferred tax assets, which consist
primarily of net operating loss and capital loss carryforwards, and timing
differences between the book and tax treatment of inventory and other asset
valuations. Realization of these net deferred tax assets is dependent upon
our ability to generate future taxable income.
LIQUIDITY AND CAPITAL RESOURCES
Working capital, defined as current assets less current liabilities,
was $2,612,000 at September 30, 2004, a decrease of $517,000 or 17% from
$3,129,000 at December 31, 2003. The working capital ratio was 2.3 to 1 at
September 30, 2004, compared with 3.1 to 1 at December 31, 2003.
Operating activities used $906,000 during the nine months ended
September 30, 2004. Net cash used by operating activities consisted of a
net loss of $930,000 adjusted for non-cash expense items of $223,000, and
net cash used by changes in operating assets and liabilities of $199,000.
Net cash used by changes in operating assets and liabilities was primarily
attributable to an increase in accounts receivable, partly offset by an
increase in accounts payable and accrued expenses.
Investing activities used $25,000, net of disposals, during the nine
months ended September 30, 2004 to fund capital expenditures.
Financing activities provided $490,000 during the nine months ended
September 30, 2004, primarily attributable to working capital borrowings
under our revolving credit facility with BACC, and borrowings against the
cash value of an insurance policy. On February 19, 2004, the BACC credit
facility was extended for an additional one-year term with the following
modifications: (i) the credit facility advance limit was increased from
$1.5 million to $1.7 million; and (ii) the amount that could be advanced
against eligible inventory was increased from $200,000 to $400,000. For
additional information on the terms and conditions of the BACC credit
facility, refer to our Form 10-K filed with the Securities and Exchange
Commission for the year ended December 31, 2003. As of September 30, 2004,
outstanding borrowings with BACC were $210,600. The unused portion of the
credit facility as of September 30, 2004 was $1,489,400, of which
$1,010,994 was available to borrow. The average and highest amounts
borrowed during the three months ended September 30, 2004 were
approximately $201,000 and $350,000, respectively. The average and highest
amounts borrowed during the nine months ended September 30, 2004 were
approximately $173,000 and $401,000, respectively. We were in compliance
with the provisions of our loan agreement as of September 30, 2004.
As a result of our reduced revenues and employment levels, we early-
terminated one building lease agreement covering 15,137 square feet of
warehouse space (otherwise scheduled to expire December 31, 2004), and
renegotiated the building lease on our main offices and distribution
center, reducing our square footage under rent from approximately 35,000
square feet to approximately 25,000 square feet. These actions are
estimated to reduce our 2004 building rental and operating costs by
approximately $16,000 per month. Refer to Note 9 for further information
on the new lease agreement.
We are dependent upon generating positive cash flow from operations
and upon our revolving credit facility to provide cash to satisfy working
capital requirements. If the trend in operating losses continues, we would
most likely not have the financial resources to sustain or fund our current
level of operations. Historically, our working capital borrowings have
increased during periods of revenue growth. This is because we pay our
vendors over a shorter time period than the period in which we collect our
accounts receivable. Under the current lending agreement, we are
prohibited from borrowing against receivables generated by systems sales
until the systems are installed. Under these circumstances, we could run
out of availability and/or require a higher credit line. In order to
obtain additional financing, we may first need to demonstrate improved
operating performance. No assurances can be given that we will have
sufficient cash resources to finance possible future growth, and it may
become necessary to seek additional financing sources for such purpose.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2003 under the subheading "Critical
Accounting Policies and Estimates" is still considered current and is
hereby incorporated into this Quarterly Report on Form 10-Q.
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RISKS, UNCERTAINTIES AND OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2003 under the subheading "Risks,
Uncertainties and Other Factors That May Affect Future Results" is still
considered current and applicable, and is hereby incorporated into this
Quarterly Report on Form 10-Q.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The discussion included in Item 7A of our Annual Report on Form 10-K
for the year ended December 31, 2003, "Quantitative and Qualitative
Disclosures About Market Risk", is still considered current and applicable,
and is hereby incorporated into this Quarterly Report on Form 10-Q.
ITEM 4. CONTROLS AND PROCEDURES.
(a) Evaluation of Disclosure Controls and Procedures. We maintain
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-
15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange
Act")) that are designed to ensure that information required to be
disclosed in our reports filed under the Exchange Act, is recorded,
processed, summarized and reported within the time periods specified in the
Security and Exchange Commission's rules and forms, and that such
information is accumulated and communicated to our management, including
our Chief (principal) Executive Officer and Chief (principal) Financial
Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and
procedures, management recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives, and management
necessarily was required to apply its judgment in evaluating the cost-
benefit relationship of possible controls and procedures.
An evaluation was conducted by our Chief Executive Officer and Chief
Financial Officer of the effectiveness of the Company's disclosure controls
and procedures as of the end of the period covered by this report. Based on
that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that our disclosure controls and procedures were effective to
ensure that information required to be disclosed in our reports filed under
the Exchange Act, is recorded, processed, summarized and reported within
the time periods specified in the Security and Exchange Commission's rules
and forms.
(b) Changes in Internal Controls. There have been no changes in our
internal control over financial reporting (as defined in Rules 13a-15(f)
and 15d-15(f) under the Exchange Act) during the most recently completed
fiscal quarter that materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION.
ITEMS 1, 2, 3, and 4 have been omitted because there is nothing to report
or they are inapplicable.
ITEM 5. OTHER INFORMATION.
On July 23, 2004 the Company filed a report on Form 8-K to report
that on July 19, 2004 the Company received approval from the American Stock
Exchange (the "Amex") on its plan to get back into compliance with the
Amex's continued listing requirements, and to report that it was given an
extension to November 7, 2005, subject to certain requirements, to achieve
compliance with said listing requirements or be subject to delisting from
the Amex.
On August 5, 2004 the Company filed a report on Form 8-K to report
that effective July 30, 2004 Avaya terminated the Authorized Remarketing
Supplier aftermarket program (the "ARS Program") under which the Company
sold "Classic Avaya(TM)" products. The Company will be allowed continued
use of the Classic Avaya licensed trade mark for a period of 90 days from
the termination date.
On October 6, 2004 the Company filed a report on Form 8-K to report
the appointment of Jean-Marc Stiegemeier as the Company's new President and
Chief Executive Officer, succeeding George J. Taylor, Jr., the Company's
founder. The Company also reported that it had entered into an employment
agreement with Mr. Stiegemeier through December 31, 2009, and amended the
employment agreement currently in effect with George J. Taylor, Jr. See
Note 12, "Subsequent Events", to the consolidated financial statements
contained herein for additional information.
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ITEM 6. EXHIBITS.
The following documents are filed as Exhibits to this Quarterly
Report on Form 10-Q:
4(a) Warrant to Purchase common stock of Farmstead Telephone Group,
Inc. issued to Jean-Marc Stiegemeier October 1, 2004 [Exhibit
4(a) to the Form 8-K Current Report filed October 6, 2004]
10(a) Employment Agreement dated October 1, 2004 between Farmstead
Telephone Group, Inc. and Jean-Marc Stiegemeier. [Exhibit
10(a) to the Form 8-K Current Report filed October 6, 2004]
10(b) Fourth Addendum to that Certain Employment Agreement Between
Farmstead Telephone Group, Inc. and George J. Taylor, Jr.
Dated as of January 1, 1998 as Amended by that Certain
Restated First Addendum Dated as of August 1, 2001; as Further
Amended by that Certain Second Addendum Dated as of January 1,
2003; and as Further Amended by that Certain Third Addendum
Dated as of January 1, 2004. [Exhibit 10(b) to the Form 8-K
Current Report filed October 6, 2004]
10(c) Agreement between Farmstead Telephone Group, Inc. and Jean-
Marc Stiegemeier dated August 16, 2004.
31.1 Rule 13a-14(a) or 15d-14(a) Certification of the Chief
Executive Officer.
31.2 Rule 13a-14(a) or 15d-14(a) Certification of the Chief
Financial Officer.
32.1 Certification of the Chief Executive Officer, pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of the Chief Financial Officer, pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
FARMSTEAD TELEPHONE GROUP, INC.
Dated: November 12, 2004 /s/ George J. Taylor, Jr.
------------------------------------
George J. Taylor, Jr.
Chief Executive Officer, President
(through September 30, 2004)
Dated: November 12, 2004 /s/ Robert G. LaVigne
------------------------------------
Robert G. LaVigne
Executive Vice President, Chief
Financial Officer
15