UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
For the quarter ended | Commission File Number: | |
September 30, 2004 | 0-10211 |
INTER-TEL, INCORPORATED
Incorporated in the State of Arizona | I.R.S. No. 86-0220994 |
1615 S. 52nd Street
Tempe, Arizona 85281
(480) 449-8900
Title of Class |
Outstanding as of September 30, 2004 |
|||
Common Stock, no par value |
25,865,371 |
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 periods 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 Act). Yes [X] No[ ]
INDEX
INTER-TEL, INCORPORATED AND SUBSIDIARIES
Page | ||||||||
PART I. | ||||||||
3 | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
14 | ||||||||
35 | ||||||||
36 | ||||||||
PART II. | ||||||||
36 | ||||||||
36 | ||||||||
36 | ||||||||
36 | ||||||||
36 | ||||||||
37 | ||||||||
37 | ||||||||
MANAGEMENT CERTIFICATIONS |
38 | |||||||
EX-31.1 | ||||||||
EX-31.2 | ||||||||
EX-32.1 | ||||||||
EX-32.2 |
2
PART I. FINANCIAL INFORMATION
September 30, | December 31, | |||||||
2004 | 2003 | |||||||
(in thousands, except share amounts) |
(Unaudited) |
(Note A) |
||||||
ASSETS |
||||||||
CURRENT ASSETS |
||||||||
Cash and equivalents |
$ | 152,634 | $ | 115,197 | ||||
Short-term investments |
61,892 | 59,334 | ||||||
Total cash and short-term investments |
214,526 | 174,531 | ||||||
Accounts receivable, net of allowances of $11,117
in 2004 and $11,010 in 2003 |
43,397 | 43,434 | ||||||
Inventories, net of allowances of $6,863 in 2004
and $6,952 in 2003 |
17,193 | 14,648 | ||||||
Net investment in sales-leases, net of allowances
of $801 in 2004 and $749 in 2003 |
16,888 | 15,502 | ||||||
Income taxes receivable |
2,612 | 8,196 | ||||||
Deferred income taxes |
15,655 | 13,789 | ||||||
Prepaid expenses and other assets |
6,328 | 6,432 | ||||||
TOTAL CURRENT ASSETS |
316,599 | 276,532 | ||||||
PROPERTY, PLANT & EQUIPMENT |
26,411 | 24,657 | ||||||
GOODWILL |
19,277 | 17,967 | ||||||
PURCHASED INTANGIBLE ASSETS |
7,462 | 8,191 | ||||||
NET INVESTMENT IN SALES-LEASES, net of allowances
of $1,741 in 2004 and $1,985 in 2003 |
31,237 | 32,529 | ||||||
TOTAL ASSETS |
$ | 400,986 | $ | 359,876 | ||||
LIABILITIES AND SHAREHOLDERS EQUITY |
||||||||
CURRENT LIABILITIES |
||||||||
Accounts payable |
$ | 29,763 | $ | 28,386 | ||||
Other current liabilities |
46,173 | 47,585 | ||||||
TOTAL CURRENT LIABILITIES |
75,936 | 75,971 | ||||||
DEFERRED TAX LIABILITY |
71,378 | 57,996 | ||||||
LEASE RECOURSE LIABILITY |
12,344 | 12,020 | ||||||
RESTRUCTURING RESERVE |
| 49 | ||||||
OTHER LIABILITIES |
7,317 | 6,535 | ||||||
SHAREHOLDERS EQUITY |
||||||||
Common stock, no par value-authorized 100,000,000
shares; issued27,161,823 shares;
outstanding25,865,371 at September 30, 2004 and
25,429,642 shares at December 31, 2003 |
115,693 | 113,960 | ||||||
Retained earnings |
132,896 | 113,299 | ||||||
Accumulated other comprehensive income |
1,122 | 1,025 | ||||||
249,711 | 228,284 | |||||||
Less: Treasury stock at cost 1,296,452 shares
at September 30, 2004 and 1,732,181 shares at
December 31, 2003 |
(15,700 | ) | (20,979 | ) | ||||
TOTAL SHAREHOLDERS EQUITY |
234,011 | 207,305 | ||||||
TOTAL LIABILITIES AND SHAREHOLDERS EQUITY |
$ | 400,986 | $ | 359,876 | ||||
See accompanying notes.
3
INTER-TEL, INCORPORATED AND SUBSIDIARIES
Three Months | Nine Months | |||||||||||||||
(In thousands, except | Ended September 30, |
Ended September 30, |
||||||||||||||
per share amounts) |
2004 |
2003 |
2004 |
2003 |
||||||||||||
NET SALES |
$ | 105,506 | $ | 94,545 | $ | 306,445 | $ | 273,816 | ||||||||
Cost of sales |
49,572 | 45,301 | 144,114 | 130,248 | ||||||||||||
GROSS PROFIT |
55,934 | 49,244 | 162,331 | 143,568 | ||||||||||||
Research and development |
7,637 | 5,718 | 20,816 | 16,378 | ||||||||||||
Selling, general and administrative |
34,575 | 31,761 | 103,916 | 96,008 | ||||||||||||
Amortization of purchased intangible assets |
414 | 445 | 1,295 | 1,359 | ||||||||||||
42,626 | 37,924 | 126,027 | 113,745 | |||||||||||||
OPERATING INCOME |
13,308 | 11,320 | 36,304 | 29,823 | ||||||||||||
Interest and other income |
732 | 351 | 1,808 | 1,226 | ||||||||||||
Foreign currency transaction gains (losses) |
(7 | ) | 5 | (281 | ) | (9 | ) | |||||||||
Interest expense |
(20 | ) | (34 | ) | (108 | ) | (137 | ) | ||||||||
INCOME BEFORE INCOME TAXES |
14,013 | 11,642 | 37,723 | 30,903 | ||||||||||||
Income tax provision |
4,807 | 4,424 | 13,580 | 11,744 | ||||||||||||
NET INCOME |
$ | 9,206 | $ | 7,218 | $ | 24,143 | $ | 19,159 | ||||||||
NET INCOME PER SHARE |
||||||||||||||||
Basic |
$ | 0.36 | $ | 0.29 | $ | 0.94 | $ | 0.77 | ||||||||
Diluted |
$ | 0.34 | $ | 0.27 | $ | 0.89 | $ | 0.73 | ||||||||
DIVIDENDS PER SHARE |
$ | 0.07 | $ | 0.06 | $ | 0.19 | $ | 0.12 | ||||||||
Weighted average basic common shares |
25,816 | 25,107 | 25,691 | 24,991 | ||||||||||||
Weighted average diluted common shares |
26,944 | 26,865 | 27,185 | 26,291 | ||||||||||||
See accompanying notes.
4
INTER-TEL, INCORPORATED AND SUBSIDIARIES
Nine Months | ||||||||
Ended September 30, |
||||||||
(In thousands) |
2004 |
2003 |
||||||
OPERATING ACTIVITIES |
||||||||
Net income |
$ | 24,143 | $ | 19,159 | ||||
Adjustments to reconcile net income to net cash provided
by operating activities: |
||||||||
Depreciation of fixed assets |
5,849 | 5,290 | ||||||
Amortization of patents included in R&D expenses |
166 | 166 | ||||||
Amortization of purchased intangible assets |
1,295 | 1,359 | ||||||
Provision for losses on receivables |
1,417 | 2,397 | ||||||
Provision for losses on leases |
2,856 | 3,831 | ||||||
Provision for inventory valuation |
1,166 | 479 | ||||||
Decrease in other liabilities |
(1,268 | ) | (2,658 | ) | ||||
Loss on sale of property and equipment |
2 | 91 | ||||||
Deferred income taxes |
11,516 | 14,885 | ||||||
Effect of exchange rate changes |
97 | 102 | ||||||
Changes in operating assets and liabilities |
649 | (25,522 | ) | |||||
NET CASH PROVIDED BY OPERATING ACTIVITIES |
47,888 | 19,579 | ||||||
INVESTING ACTIVITIES |
||||||||
Purchases of short-term investments |
(75,133 | ) | (141,869 | ) | ||||
Maturities and sales of short-term investments |
72,575 | 113,710 | ||||||
Additions to property, plant and equipment |
(7,436 | ) | (5,219 | ) | ||||
Proceeds from disposal of property, plant and equipment |
21 | 75 | ||||||
Proceeds from investment in Inter-Tel.NET/Vianet |
| 1,450 | ||||||
Cash used in acquisitions |
(1,458 | ) | (450 | ) | ||||
NET CASH USED IN INVESTING ACTIVITIES |
(11,431 | ) | (32,303 | ) | ||||
FINANCING ACTIVITIES |
||||||||
Cash dividends paid |
(4,611 | ) | (2,245 | ) | ||||
Treasury stock purchases |
| (206 | ) | |||||
Payments on term debt |
(39 | ) | (89 | ) | ||||
Proceeds from exercise of stock options, including
shareholder loan repayments |
5,130 | 3,260 | ||||||
Proceeds from stock issued under the ESPP |
500 | 468 | ||||||
NET CASH PROVIDED BY FINANCING ACTIVITIES |
980 | 1,188 | ||||||
INCREASE (DECREASE) IN CASH AND EQUIVALENTS |
37,437 | (11,536 | ) | |||||
CASH AND EQUIVALENTS AT BEGINNING OF PERIOD |
115,197 | 84,923 | ||||||
CASH AND EQUIVALENTS AT END OF PERIOD |
$ | 152,634 | $ | 73,387 | ||||
See accompanying notes.
5
INTER-TEL, INCORPORATED AND SUBSIDIARIES
NOTE ABASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with United States generally accepted accounting principles applicable to interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results for the interim periods presented have been included. Operating results for the quarter and nine months ending September 30, 2004 are not necessarily indicative of the results that may be expected for the year ended December 31, 2004. The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the consolidated financial statements and notes thereto included in the Companys annual report on Form 10-K for the year ended December 31, 2003.
Certain prior year amounts have been reclassified to conform with the current period presentation.
Stock-Based Compensation
In 2002, the Financial Accounting Standards Board (FASB) issued Statement No. 148 Accounting for Stock-Based CompensationTransition and Disclosure, an amendment of FASB Statement No. 123 (SFAS No. 148), which provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entitys accounting policy decisions with respect to stock-based employee compensation. Finally, this statement amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. We adopted SFAS No. 148 in the fourth quarter of 2002. Since we have not changed to a fair value method of stock-based compensation, the applicable portion of this statement only affects our footnote disclosures.
We do not recognize compensation expense relating to employee stock options because we only grant options with an exercise price equal to the fair value of the stock on the effective date of grant. At September 30, 2004, the Company has four stock-based employee and director incentive plans and an employee stock purchase plan. The Company accounts for these plans under the recognition and measurement principles of APB No. 25, Accounting for Stock Issued to Employees, and related interpretations. Stock-based employee compensation costs are not reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. If we had elected to recognize compensation expense using a fair value approach, and therefore determined the compensation based on the value as determined by the modified Black-Scholes option pricing model, the pro forma net income and earnings per share would have been as follows:
6
Three Months Ended | Nine Months Ended | |||||||||||||||
(In thousands, except | September 30, |
September 30, |
||||||||||||||
per share amounts) |
2004 |
2003 |
2004 |
2003 |
||||||||||||
Net income, as reported |
$ | 9,206 | $ | 7,218 | $ | 24,143 | $ | 19,159 | ||||||||
Deduct: total
stock-based
compensation expense,
determined under fair
value based method for
all awards, net of tax |
(836 | ) | (896 | ) | (2,457 | ) | (2,281 | ) | ||||||||
Pro forma net income |
$ | 8,370 | $ | 6,322 | $ | 21,686 | $ | 16,878 | ||||||||
Earnings per share of common stock: |
||||||||||||||||
Basic as reported |
$ | 0.36 | $ | 0.29 | $ | 0.94 | $ | 0.77 | ||||||||
Basic pro forma |
$ | 0.32 | $ | 0.25 | $ | 0.84 | $ | 0.68 | ||||||||
Diluted as reported |
$ | 0.34 | $ | 0.27 | $ | 0.89 | $ | 0.73 | ||||||||
Diluted pro forma |
$ | 0.31 | $ | 0.24 | $ | 0.80 | $ | 0.64 |
The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model using the low end of reasonable assumptions for input variables rather than attempting to identify a best-point estimate. The option pricing model utilized the following weighted average assumptions for 2004 and 2003: risk free interest rates of 3.36% for 2004 and 2.98% for 2003; dividend yields of 1.13% for 2004 and 1.2% for 2003; volatility factors of the expected market price of our stock averaged 0.480 for 2004 and 0.579 for 2003. Employee stock options vest over four to five year periods and director options vest at the end of six months from the grant date.
Contingencies
We are a party to various claims and litigation in the normal course of business. Managements current estimated range of liability related to various claims and pending litigation is based on claims for which our management can estimate the amount and range of loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending claims and litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our pending litigation and revise our estimates. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial position.
Divisions of the United States Department of Justice are investigating other companies and Inter-Tels participation in a federally funded E-Rate program to connect schools and libraries to the Internet. The Justice Department has provided Inter-Tel with a description of the evidence on which the investigations are based. Inter-Tel has been engaged in discussions with various divisions of the Justice Department regarding the resolution or settlement of these investigations, which include a civil lawsuit, currently stayed, initiated by the San Francisco Unified School District and in which the Justice Department intervened. Inter-Tel is presently unable to predict or determine the final outcome of, or to estimate the potential range of loss with respect to, the investigations. Based upon the information known at this time, we do not know what, if any, impact the investigations may have on the Companys business or financial condition. There can be no assurance, however, that a resolution or settlement will be reached. If Inter-Tel is convicted of any crime or subjected to sanctions, or debarred from certain government contracts, or if penalties, damages or other monetary remedies are assessed against Inter-Tel in connection with or related to these and other investigations, our business and operating results could be materially and adversely affected. The existence and disclosure of the investigations may have already caused competitive harm to Inter-Tel, and any unfavorable resolution to these matters may further harm Inter-Tels business.
Inventories
We value our inventories at the lower of cost (principally on a standard cost basis, which approximates the first-in, first-out (FIFO) method) or market.
7
NOTE BEARNINGS PER SHARE
Diluted earnings per share assume that outstanding common shares were increased by shares issuable upon the exercise of all outstanding stock options for which the market price exceeds exercise price, less shares which could have been purchased with related proceeds, if the effect would not be antidilutive.
The following table sets forth the computation of basic and diluted earnings per share:
Three Months Ended | Nine Months Ended | |||||||||||||||
(In thousands, except | September 30, |
September 30, |
||||||||||||||
per share amounts) |
2004 |
2003 |
2004 |
2003 |
||||||||||||
Numerator: Net income |
$ | 9,206 | $ | 7,218 | $ | 24,143 | $ | 19,159 | ||||||||
Denominator: |
||||||||||||||||
Denominator for basic earnings per
share weighted average shares |
25,816 | 25,107 | 25,691 | 24,991 | ||||||||||||
Effect of dilutive securities: |
||||||||||||||||
Employee and director stock options |
1,128 | 1,758 | 1,494 | 1,300 | ||||||||||||
Denominator for diluted earnings per
share adjusted weighted average
shares and assumed conversions |
26,944 | 26,865 | 27,185 | 26,291 | ||||||||||||
Basic earnings per share |
$ | 0.36 | $ | 0.29 | $ | 0.94 | $ | 0.77 | ||||||||
Diluted earnings per share |
$ | 0.34 | $ | 0.27 | $ | 0.89 | $ | 0.73 | ||||||||
Options excluded from diluted net
earnings per share calculations (1) |
311 | 227 | 209 | 301 | ||||||||||||
(1) At September 30, 2004 and September 30, 2003, options to purchase shares of Inter-Tel stock were excluded from the calculation of diluted net earnings per share for the periods presented because the exercise price of these options was greater than the average market price of the common shares for the respective fiscal periods, and therefore the effect would have been antidilutive.
NOTE C ACQUISITIONS, TECHNOLOGY INVESTMENTS AND RESTRUCTURING CHARGES
New Sales Offices. In January and July 2004, we acquired certain assets and assumed certain liabilities relating to the customer bases of two former dealers, one in Tennessee and one in South Carolina. The total assets acquired and liabilities assumed from these acquisitions were approximately $1 million and $0.5 million, respectively. Purchased intangibles and goodwill recorded as a result of the transactions totaled $0.7 million and $1.6 million, respectively. The goodwill is non-amortizable. The balances included in other purchased intangible assets will be amortized over a period of five years.
In connection with opening a new sales office in Pennsylvania during December 2003, we acquired certain assets and assumed certain liabilities relating to a customer base of a former dealer. The total assets acquired and liabilities assumed were approximately $0.6 million and $0.9 million, respectively. Total goodwill and purchased intangibles recorded as a result of the transaction were $0.2 million and $0.1 million, respectively. The goodwill balance is non-amortizable. The balance included in the $0.1 million in other purchased intangible assets is being amortized over a period of five years. Refer to Note F, Subsequent Events for additional information regarding acquisitions.
Technology Investment. In connection with the acquisition of the rights to certain developed technology for a capitalized purchase price of $2.25 million (included in purchased intangible assets) during the year ended December 31, 2003, the Company entered into an arrangement with the selling entity under which the selling entity would perform additional development activities on a cost reimbursement basis
8
through August 15, 2004. Under the terms of the arrangement, the selling entity could also earn bonus payments totaling up to $1,000,000 for meeting certain development milestones. Milestone bonuses totaling $750,000 for the nine months ended September 30, 2004, including $250,000 for the third quarter, were achieved and expensed as research and development costs. Technological feasibility of the underlying technology has not yet been achieved to provide for viable product sales. As of September 30, 2004, the remaining milestone bonus of $250,000 is dependent on future events and is not considered to be probable or reasonably estimable. The following table summarizes details of the expenses in connection with this technology investment recorded during the three and nine month periods ended September 30:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, |
September 30, |
|||||||||||||||
(In thousands) |
2004 |
2003 |
2004 |
2003 |
||||||||||||
Milestone bonus payments |
$ | 250 | $ | | $ | 750 | $ | | ||||||||
Development activities on a cost
reimbursement basis |
98 | 164 | 649 | 164 | ||||||||||||
Totals |
$ | 348 | $ | 164 | $ | 1,399 | $ | 164 | ||||||||
Swan. On December 3, 2002, Inter-Tel Integrated Systems, Inc., our wholly owned subsidiary, acquired 100% of the capital stock of Swan Solutions Limited (Swan) in England and Wales, for $4.0 million in cash. $3.0 million was paid at closing, $250,000 was paid in June 2003 and $250,000 was paid in December 2003. The remaining $500,000 was subject to the achievement of five performance milestones at $100,000 each. As of June 30, 2004, portions of all five $100,000 milestones had been achieved for which $450,436 was paid to the Swan shareholders. Of this amount, the final $100,000 milestone achievement was paid during the second quarter of 2004. Payments relating to the achievement of performance milestones were capitalized and are being amortized as purchased intangible assets. In total, the Company recorded amortizable intangible technology assets totaling $3.9 million in connection with this acquisition. These technology assets are being amortized over five years. During the quarters ended September 30, 2004 and September 30, 2003, the amortization of purchased intangible assets from Swan was approximately $197,000 in each period, respectively.
Each of the acquisitions discussed above were not material business acquisitions either individually or collectively and each has been accounted for using the purchase method of accounting. The results of operations of each of these acquisitions have been included in our accompanying consolidated statements of operations from the date of the acquisitions.
The values for acquired developed technology were determined based on the negotiated prices paid to acquire the technology. Each of our technology acquisitions, including Swan and Technology Investment noted above and other prior technology acquisitions, was made primarily to acquire a specific technology, rather than for the purpose of acquiring an operating company. The technologies acquired have been used to add additional features/applications to our current products, sold separately as new products or obtained primarily for use with our next generation of products.
The weighted-average amortization period for total purchased intangibles as of December 31, 2003 and September 30, 2004 was 7 years for each period, respectively. The weighted-average amortization period as of December 31, 2003 and September 30, 2004 for developed technology was 7.5 years for each period, and 4.8 and 5.0 years, respectively, for customer lists and non-compete agreements.
Executone Restructuring Charge. During the second quarter of 2000, we recognized a restructuring charge related to acquired Executone operations. We accounted for the restructuring of the Executone operations, including severance and related costs, the shut down and consolidation of the Milford facility and the impairment of assets associated with the restructuring as identified in the table below. Accrued costs associated with this plan were estimates, although the original estimates made for
9
the second quarter of 2000 for reserve balances have not changed significantly through September 30, 2004.
Exit costs associated with the closure of the Milford facility also included liabilities for building, furniture and equipment lease, and other contractual obligations. We are liable for the lease on the Milford buildings through January 2005. To date, we have entered into sublease agreements with third parties to sublease portions of the facility and equipment. The reserve for lease and other contractual obligations is identified in the table below.
The following table summarizes details of the restructuring charge taken in the second quarter of 2000 in connection with the Executone acquisition, including the description of the type and amount of liabilities assumed, and activity in the reserve balances from the date of the charge through September 30, 2004:
Activity | Reserve | |||||||||||||||||||
Cash/ | Restructuring | Through | 2004 | Balance | ||||||||||||||||
Description |
Non-Cash |
Charge |
2003 |
Activity |
At 9/30/04 |
|||||||||||||||
Personnel Costs: |
||||||||||||||||||||
Severance and termination costs |
Cash | $ | (1,583 | ) | $ | 1,583 | $ | | $ | | ||||||||||
Other plant closure costs |
Cash | (230 | ) | 230 | | | ||||||||||||||
Lease termination and other
contractual obligations (net of
anticipated recovery): |
||||||||||||||||||||
Building and equipment leases |
Cash | (7,444 | ) | 6,198 | 976 | (270 | ) | |||||||||||||
Other contractual obligations |
Cash | (1,700 | ) | 1,700 | | | ||||||||||||||
Impairment of Assets: |
||||||||||||||||||||
Inventories |
Non-Cash | (3,454 | ) | 3,454 | | | ||||||||||||||
Prepaid inventory and other
expenses |
Non-Cash | (2,485 | ) | 2,485 | | | ||||||||||||||
Accounts receivable |
Non-Cash | (1,685 | ) | 1,685 | | | ||||||||||||||
Fixed assets |
Non-Cash | (3,151 | ) | 3,009 | 41 | (101 | ) | |||||||||||||
Net intangible assets |
Non-Cash | (29,184 | ) | 29,184 | | | ||||||||||||||
Total |
$ | (50,916 | ) | $ | 49,528 | $ | 1,017 | $ | (371 | ) | ||||||||||
NOTE D SEGMENT INFORMATION
Inter-Tel follows Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). SFAS 131 established standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS 131 also established standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions as to how to allocate resources and assess performance. The Companys chief decision maker, as defined under SFAS 131, is the Chief Executive Officer.
We view our operations as primarily composed of two segments: (1) our principal segment, which includes sales of telephone systems, telecommunications software, hardware and related services, and (2) network services, including resale of local and long distance calling services, voice circuits and data circuits through NetSolutions®, as well as commissions earned by Network Services Agency, our wholly-owned subsidiary serving as an agent selling local and network services such as T-1 access, frame relay and other voice and data circuit services on behalf of Regional Bell Operating Companies (RBOCs) and local exchange carriers (collectively, Network Services). Sales of these systems, software, related services
10
and Network Services are provided through the Companys direct sales offices and dealer network to business customers throughout the United States, and in parts of Europe, Asia, Mexico and Canada. As a result, financial information disclosed represents substantially all of the financial information related to the Companys two principal operating segments. Results of operations for the Network Services segment, if the operations were not included as part of the consolidated group, could differ materially, as the operations are integral to the total telephony solution offered by us to our customers.
For the quarters and nine months ended September 30, 2004 and 2003, we generated income from business segments as follows:
Three Months Ended September 30, 2004 |
||||||||||||
Principal | Network | |||||||||||
(In thousands, except per share amounts) |
Segment |
Services |
Total |
|||||||||
Net sales |
$ | 93,015 | $ | 12,491 | $ | 105,506 | ||||||
Gross profit |
51,118 | 4,816 | 55,934 | |||||||||
Operating income |
11,150 | 2,158 | 13,308 | |||||||||
Interest and other income |
675 | 57 | 732 | |||||||||
Foreign currency transaction losses |
(7 | ) | | (7 | ) | |||||||
Interest expense |
(12 | ) | (8 | ) | (20 | ) | ||||||
Net income |
$ | 7,710 | $ | 1,496 | $ | 9,206 | ||||||
Net income per diluted share (1) |
$ | 0.28 | $ | 0.06 | $ | 0.34 | ||||||
Weighted average diluted shares (1) |
26,944 | 26,944 | 26,944 | |||||||||
Total assets |
$ | 377,596 | $ | 23,390 | $ | 400,986 | ||||||
Depreciation and amortization |
2,324 | 19 | 2,343 |
Three Months Ended September 30, 2003 |
||||||||||||
Principal | Network | |||||||||||
(In thousands, except per share amounts) |
Segment |
Services |
Total |
|||||||||
Net sales |
$ | 83,527 | $ | 11,018 | $ | 94,545 | ||||||
Gross profit |
44,816 | 4,428 | 49,244 | |||||||||
Operating income |
9,503 | 1,817 | 11,320 | |||||||||
Interest and other income |
308 | 43 | 351 | |||||||||
Foreign currency transaction gains |
5 | | 5 | |||||||||
Interest expense |
(34 | ) | | (34 | ) | |||||||
Net income |
$ | 6,065 | $ | 1,153 | $ | 7,218 | ||||||
Net income per diluted share (1) |
$ | 0.23 | $ | 0.04 | $ | 0.27 | ||||||
Weighted average diluted shares (1) |
26,865 | 26,865 | 26,865 | |||||||||
Total assets |
$ | 294,402 | $ | 20,275 | $ | 314,677 | ||||||
Depreciation and amortization |
2,219 | 38 | 2,257 |
Nine Months Ended September 30, 2004 |
||||||||||||
Principal | Network | |||||||||||
(In thousands, except per share amounts) |
Segment |
Services |
Total |
|||||||||
Net sales |
$ | 269,731 | $ | 36,714 | $ | 306,445 | ||||||
Gross profit |
147,821 | 14,510 | 162,331 | |||||||||
Operating income |
29,900 | 6,404 | 36,304 | |||||||||
Interest and other income |
1,651 | 157 | 1,808 | |||||||||
Foreign currency transaction losses |
(281 | ) | | (281 | ) | |||||||
Interest expense |
(99 | ) | (9 | ) | (108 | ) | ||||||
Net income |
$ | 19,910 | $ | 4,233 | $ | 24,143 | ||||||
Net income per diluted share (1) |
$ | 0.73 | $ | 0.16 | $ | 0.89 | ||||||
Weighted average diluted shares (1) |
27,185 | 27,185 | 27,185 | |||||||||
Total assets |
$ | 377,596 | $ | 23,390 | $ | 400,986 | ||||||
Depreciation and amortization |
7,219 | 91 | 7,310 |
11
Nine Months Ended September 30, 2003 |
||||||||||||
Principal | Network | |||||||||||
(In thousands, except per share amounts) |
Segment |
Services |
Total |
|||||||||
Net sales |
$ | 241,750 | $ | 32,066 | $ | 273,816 | ||||||
Gross profit |
130,824 | 12,744 | 143,568 | |||||||||
Operating income |
24,680 | 5,143 | 29,823 | |||||||||
Interest and other income |
1,115 | 111 | 1,226 | |||||||||
Foreign currency transaction losses |
(9 | ) | | (9 | ) | |||||||
Interest expense |
(137 | ) | | (137 | ) | |||||||
Net income |
$ | 15,901 | $ | 3,258 | $ | 19,159 | ||||||
Net income per diluted share (1) |
$ | 0.61 | $ | 0.12 | $ | 0.73 | ||||||
Weighted average diluted shares (1) |
26,291 | 26,291 | 26,291 | |||||||||
Total assets |
$ | 294,402 | $ | 20,275 | $ | 314,677 | ||||||
Depreciation and amortization |
6,696 | 119 | 6,815 |
(1) Options that are antidilutive because the exercise price was greater than the average market price of the common shares are not included in the computation of diluted earnings per share.
Our revenues are generated predominantly in the United States. Total revenues generated from U.S. customers totaled $296.7 million, or 96.8% of total revenues, and $265.6 million, or 97.0% of total revenues for the nine months ended September 30, 2004 and 2003, respectively. Total revenues generated from U.S. customers totaled $102.3 million, or 96.9% of total revenues, and $91.8 million, or 97.1% of total revenues for the quarters ended September 30, 2004 and 2003, respectively. The Companys revenues from international sources were primarily generated from customers located in the United Kingdom, Europe and Asia. In the third quarters of 2004 and 2003, revenues from customers located internationally accounted for 3.1% and 2.9% of total revenues, respectively. In the nine months ended September 30, 2004 and 2003, revenues from customers located internationally accounted for 3.2% and 3.0% of total revenues, respectively. Our applicable long-lived assets at September 30, 2004, included Property, Plant & Equipment; Goodwill; and Purchased Intangible Assets. The net amount located in the United States was $50.4 million and the amount in foreign countries was $2.8 million at September 30, 2004. At December 31, 2003, the net amount located in the United States was $47.3 million and the amount in foreign countries was $3.5 million.
NOTE E NET INVESTMENT IN SALES-LEASES
Net investment in sales-leases represents the value of sales-leases presently held under our Total Solution program. We currently sell the rental payments due to us from most of the sales-leases. We maintain reserves against our estimate of potential credit losses for the balance of sales-leases held and for the balance of sold rental payments remaining unbilled. The following table provides detail on the total net balances in sales-leases:
September 30, | December 31, | |||||||
(in thousands) |
2004 |
2003 |
||||||
Lease balances included in consolidated accounts receivable, net of
allowances of $1,520 in 2004 and $1,774 in 2003 |
$ | 6,724 | $ | 7,240 | ||||
Net investment in Sales-Leases: |
||||||||
Current portion, net of allowances of $801 in 2004 and $749 in 2003 |
16,888 | 15,502 | ||||||
Long-term portion, includes residual amounts of $472 in 2004 and
$652 in 2003, net of allowances of $1,741 in 2004 and $1,985 in
2003 |
31,237 | 32,529 | ||||||
Total investment in Sales-Leases, net of allowances of $4,062 in 2004
and $4,508 in 2003 |
54,849 | 55,271 | ||||||
Sold rental payments remaining unbilled (subject to limited recourse
provisions), net of allowances of $12,344 in 2004 and $12,020 in 2003 |
221,433 | 198,091 | ||||||
12
September 30, | December 31, | |||||||
(in thousands) |
2004 |
2003 |
||||||
Total balance of sales-leases and sold rental payments remaining
unbilled, net of allowances |
$ | 276,282 | $ | 253,362 | ||||
Total allowances for entire lease portfolio (including limited
recourse liabilities) |
$ | 16,406 | $ | 16,528 | ||||
Reserve levels are established based on portfolio size, loss experience, levels of past due accounts and periodic, detailed reviews of the portfolio. Recourse on the sold rental payments is contractually limited to a percentage of the net credit losses in a given annual period as compared to the beginning portfolio balance for a specific portfolio of sold leases. While our recourse is limited, we maintain reserves at a level that we believe is sufficient to cover all anticipated credit losses. The aggregate reserve for uncollectible lease payments and recourse liability represents the reserve for the entire lease portfolio.
These reserves are either netted from consolidated accounts receivable, netted against current or long-term investment in sales-leases or included in long-term liabilities for sold rental payments remaining unbilled. Sales of rental payments per period are as follows:
Nine Months Ended | Year Ended | |||||||
(In thousands) |
September 30, 2004 |
December 31, 2003 |
||||||
Sales of rental payments |
$ | 84,172 | $ | 88,352 | ||||
Sold payments remaining unbilled at end of period |
$ | 233,777 | $ | 210,111 |
Sales of rental payments represent the gross selling price or total present value of the payment stream on the sale of the rental payments to third parties. Sold payments remaining unbilled at the end of the period represent the total balance of leases that is not included in our balance sheet. We do not expect to incur any significant losses in excess of reserves from the recourse provisions related to the sale of rental payments.
NOTE F SUBSEQUENT EVENTS
In October 2004, after the close of the third fiscal quarter of 2004, we acquired selected assets and assumed certain liabilities of former Inter-Tel dealers in Pittsburgh, Pennsylvania and Las Vegas, Nevada. In October 2004, we also acquired selected assets and assumed certain liabilities of Linktivity, which develops Web-based conferencing solutions, notably Linktivity® software. These solutions are designed to provide real-time communications and remote control software to enable instantaneous, browser-to-browser Web conferencing and help desk support solutions. In October 2004, Inter-Tel also entered into a source license arrangement for select audio conferencing and web presentation technology from eDial, a subsidiary of Alcatel Marketing USA.
Each of the acquisitions discussed above were not material business acquisitions either individually or collectively and each will be accounted for using the purchase method of accounting. The results of operations of each of these acquisitions will be included in our accompanying consolidated statements of operations from the date of the acquisitions, beginning in our fourth fiscal quarter of 2004.
13
ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
This Quarterly Report to Shareholders on Form 10-Q (10-Q) contains forward-looking statements that involve risks and uncertainties. The statements contained in this 10-Q that are not purely historical are 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, including without limitation statements regarding our expectations, beliefs, intentions or strategies for the future. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. The cautionary statements made in this 10-Q should be read as being applicable to all related forward-looking statements wherever they appear in this document. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under Factors That May Affect Future Operating Results below and elsewhere in this document.
Overview
Inter-Tel (Nasdaq: INTL), incorporated in 1969, is a single point of contact, full service provider of converged voice and data business communications systems, voice mail systems and networking applications. Our customers include business enterprises, federal, state and local government agencies and non-profit organizations. We market and sell the following products and services:
| Inter-Tel Axxess® and Inter-Tel EncoreCX® converged voice and data business communication systems, |
| integrated voice mail, voice processing and unified messaging systems, |
| IP telephony voice and data routers, and e-commerce software, |
| managed services, including voice and data network design and traffic provisioning, custom application development, and financial solutions packages (leasing), |
| networking applications, including the design and implementation of voice and data networks, |
| local and long distance calling services, voice circuits, data circuits and other communications services and peripheral products, |
| call accounting software, computer-telephone integration (CTI) applications, and |
| maintenance and support services for our products. |
We have developed a distribution network of direct sales offices, dealers and value added resellers (VARs), which sell our products to organizations throughout the United States and internationally, primarily targeting small-to-medium enterprises, service organizations and governmental agencies. As of September 30, 2004, we had 57 direct sales offices in the United States, one in Japan, and a network of hundreds of dealers and VARs, primarily in the United States, which purchase directly from us. Included in our sales office in Phoenix is the primary location for our national and government accounts division, as well as our local, long distance, voice and data circuits, and network services (Network Services) divisions. Network Services includes resale of local and long distance calling services, through NetSolutions®, as well as commissions earned by Network Services Agency, our wholly-owned subsidiary serving as an agent selling local and network services such as T-1 access, frame relay and other voice and data circuit services on behalf of Regional Bell Operating Companies (RBOCs) and local exchange carriers. Our wholesale distribution center is located in Tempe, Arizona, which is the primary location from which we distribute products to our network of direct sales offices, dealers and VARs. Our primary research and development facility is located in Chandler, Arizona. In addition, we maintain a wholesale distribution office in the United Kingdom that supplies Inter-Tels dealers and distributors throughout the UK and other parts of Europe, and we have dealers in Japan and Mexico. We also maintain a research and development and software sales office in the United Kingdom.
Key performance indicators that we use in order to manage our business and evaluate our financial and operating performance include: revenues, costs and gross margins, and cash flows.
Inter-Tel recognizes revenue from the following significant sources of revenue:
14
| End-user sales through our direct sales offices and government and national accounts division. We recognize revenue from sales of systems, software and services to end-user customers upon installation of the systems and performance of the services, respectively, allowing for use by our customers of these systems. We defer pre-payments for communications services and recognize these pre-payments as revenue as the communications services are provided. Our direct sales force is also responsible for sales of other services to end users, including managed services; resale of local and long distance services; resale of voice and data circuits; lease financing using sales-type lease accounting; and maintenance agreements; as identified in greater detail below. |
| Dealer and VAR sales. For shipments to dealers and other distributors, our revenue is recognized as products are shipped and services are rendered, because the sales process is complete. Title to these products passes when goods are shipped (free-on-board shipping point). We provide a number of incentives, promotions and awards to certain dealers and other distributors. These incentives primarily represent discounts (which are recognized as a reduction of sales), advertising allowances and awards (which are recognized as marketing expense) and management assistance (which is expensed as incurred). |
| Resale of long distance. We recognize revenue from long distance resale services as services are provided. |
| Sales-leases. For our sales-type lease accounting, we record the discounted present values of minimum rental payments under sales-type leases as sales, net of provisions for continuing administration and other expenses over the lease period. We record the lease sales at the time of system sale and installation as discussed above for sales to end user customers. The net rental streams are sold to funding sources on a regular basis with the income streams discounted by prevailing like-term rates at the time of sale. Gains or losses resulting from the sale of net rental payments from such leases are also recorded as net sales. |
| Maintenance. Maintenance revenue is recognized ratably over the term of the maintenance agreement. |
Our consolidated net sales for the quarters ended September 30, 2004 and 2003 were $105.5 million and $94.5 million, respectively. The 11.6% increase in revenue in the third quarter of 2004 compared to the third quarter of 2003 was primarily attributable to improved general economic conditions, as our customers were more willing to spend on business communications systems. The increase in net sales can also be attributed in part to new product releases and improved sales in our long distance resale division. We cannot provide assurance, however, that the recent increase in revenue will continue in the future as we believe businesses may be reluctant to significantly increase spending on enterprise communications systems in the near future. In addition, we believe uncertainty exists in the marketplace caused by the transition of communication systems from circuit-switch to packet-switch architectures, and some buyers may delay making investments in new systems.
We believe that enterprises continue to be concerned about their ability to increase revenues and profitability, in part due to the continued uncertain economic environment and slowdown in the past few years. To maintain or improve profitability, we believe that businesses have attempted to reduce costs and capital spending. We expect continued pressure on our ability to generate or expand sales and it is not clear whether business communications spending will improve significantly in the near term. We cannot predict the nature, timing and extent of future business investments in communications systems and as a result, if and when our net sales will increase.
The markets in which we compete have been characterized by rapid technological changes and increasing customer requirements. We have sought to address these requirements through the development of software enhancements and improvements to existing systems and the introduction of new systems, products, and applications. Inter-Tels research and development efforts over the last several years have been focused primarily on the development of, and enhancements to, our Axxess system, including adding new applications, enhancing our IP convergence applications and IP endpoints, developing Unified Communications applications, developing presence management applications, and developing speech-recognition and text-to-speech applications. More recently, Inter-Tels research and development efforts have been focused on the development of converged systems and software, Session Initiation Protocol (SIP) interfaces and applications, as well as the development of a new line of multi- protocol SIP IP endpoints. In addition, in October 2004, we also acquired selected assets and assumed
15
certain liabilities of Linktivity, which develops Web-based conferencing solutions, notably Linktivity® software, and announced an agreement to license certain intellectual property from eDial. These solutions are designed to provide real-time communications and remote control software to enable instantaneous, browser-to-browser Web conferencing and help desk support solutions. We intend to further develop this technology and integrate the applications and solutions into our product offerings. Refer to Note F of Notes to Condensed Consolidated Financial Statements for additional information.
Costs and gross margins. Our costs of products sold primarily consist of materials, labor and overhead. Our costs of services performed consist primarily of labor, parts and service overhead. Total costs of goods and services sold increased 9.4%, or $4.3 million, to $49.6 million for the quarter ended September 30, 2004, compared to $45.3 million for the corresponding period in 2003. Our consolidated gross margin percentage was 53.0% in the third quarter of 2004 compared to 52.1% in the third quarter of 2003. The increase in the dollar amount of the cost of goods sold was primarily attributable to the higher volume of net sales. However, the gross margin improvement was principally attributable to product design improvements, higher relative software content in our products and cost containment efforts. Other factors affecting both the increases in costs of goods sold and the gross margin percentage are described in greater detail in Results of Operations below.
Sales of systems through our direct sales organization typically generate higher gross margins than sales through our dealers and VARs, primarily because we recognize both the wholesale and retail margins on these sales. Conversely, sales of systems through our dealers and VARs typically generate lower gross margins than sales through our direct sales organization, although direct sales typically require higher levels of selling, general and administrative expenses. In addition, our long distance services and DataNet products typically generate lower gross margins than sales of software and system products. Historically, sales of scrap have not been material and have not affected our profit margins. For revenues recognized under sales-leases, we record the costs of systems installed as costs of sales. Our margins may vary from period to period depending upon distribution channel, product and software mix. In the event that sales through our direct sales offices increase as a percentage of net sales, our overall gross margin could improve. Conversely, in the event net sales to dealers or sales of long distance services increase as a percentage of net sales, our overall gross margin could decline.
Our operating results depend upon a variety of factors, including the volume and timing of orders received during a period, the mix of products sold and the mix of distribution channels, general economic conditions and world events impacting businesses, patterns of capital spending by customers, the timing of new product announcements and releases by us and our competitors, pricing pressures, the cost and effect of acquisitions and the availability and cost of products and components from our suppliers. Historically, a substantial portion of our net sales in a given quarter has been recorded in the third month of the quarter, with a concentration of such net sales in the last two weeks of the quarter. In addition, we are subject to seasonal variations in our operating results, as net sales for the first and third quarters are frequently less than those experienced during the fourth and second quarters, respectively. Net sales from the third quarter of 2004 did not follow this historical pattern, since sales improved compared to the second quarter of 2004; however, we do not anticipate a significant change in the historical trend.
Cash Flows. At September 30, 2004, Inter-Tels cash and short-term investments totaled $214.5 million. We also maintain a $10 million unsecured, revolving line of credit with BankOne, NA, which is available through June 1, 2006 and ordinarily used to support international letters of credit to suppliers, if necessary. As of September 30, 2004, none of the credit line was used. Historically, our primary source of cash has come from net income plus non-cash charges for depreciation and amortization expenses. We have generated cash from continuing operations in every year since 1986. In 1993, 1995 and 1997, the Company received net proceeds from stock offerings, offset in part by cash expended to repurchase the Companys common stock in these and other periods. In addition, Inter-Tel historically has paid cash for capital expenditures relating to property and equipment and for most acquisitions. Inter-Tel has also received cash proceeds from the exercise of stock options and our Employee Stock Purchase Plan. We believe our working capital and credit facilities, together with cash generated from operations, will be sufficient to develop and expand our business operations, to finance acquisitions of additional resellers of telephony products and other strategic acquisitions or corporate alliances, and to provide adequate working capital for the foreseeable future.
16
We offer our customers a package of lease financing and other services under the name Total Solution (formerly, Totalease). Total Solution provides our customers lease financing, maintenance and support services, fixed price upgrades and other benefits. We finance this program through the periodic resale of lease rental streams to financial institutions. Refer to Note E of Notes to Condensed Consolidated Financial Statements for additional information regarding our program.
Results of Operations
The following table sets forth certain statement of operations data expressed as a percentage of net sales for the periods indicated:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, |
September 30, |
|||||||||||||||
2004 |
2003 |
2004 |
2003 |
|||||||||||||
NET SALES |
100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | ||||||||
Cost of sales |
47.0 | 47.9 | 47.0 | 47.6 | ||||||||||||
GROSS PROFIT |
53.0 | 52.1 | 53.0 | 52.4 | ||||||||||||
Research and development |
7.2 | 6.0 | 6.8 | 6.0 | ||||||||||||
Selling, general and administrative |
32.8 | 33.6 | 33.9 | 35.1 | ||||||||||||
Amortization of purchased intangibles |
0.4 | 0.5 | 0.4 | 0.5 | ||||||||||||
OPERATING INCOME |
12.6 | 12.0 | 11.8 | 10.9 | ||||||||||||
Interest and other income |
0.7 | 0.4 | 0.6 | 0.4 | ||||||||||||
Foreign currency transaction gains
(losses) |
(0.0 | ) | 0.0 | (0.1 | ) | (0.0 | ) | |||||||||
Interest expense |
(0.0 | ) | (0.0 | ) | (0.0 | ) | (0.1 | ) | ||||||||
Income before income taxes |
13.3 | 12.3 | 12.3 | 11.3 | ||||||||||||
Income tax provision |
4.6 | 4.7 | 4.4 | 4.3 | ||||||||||||
Net income |
8.7 | % | 7.6 | % | 7.9 | % | 7.0 | % | ||||||||
Net Sales. Net sales increased 11.6%, or $11.0 million, to $105.5 million in the third quarter of 2004 from $94.5 million in the third quarter of 2003. Net sales increased 11.9%, or $32.6 million, to $306.4 million in the first nine months of 2004 from $273.8 million in the first nine months of 2003. Sales from our direct sales offices (including revenues from lease financing), increased 11.7%, or $6.0 million, in the third quarter of 2004 and 11.1%, or $16.5 million, in the first nine months of 2004 compared to the corresponding periods in 2003. Sales from our dealer network increased by 9.4%, or $2.0 million, in the third quarter of 2004, and 11.4%, or $7.0 million, in the first nine months of 2004 compared to the corresponding periods in 2003. Sales from our Network Services divisions increased by 13.4%, or $1.5 million, in the third quarter of 2004 and 14.5%, or $4.6 million, in the first nine months of 2004 compared to the corresponding periods in 2003. Sales from our DataNet division increased 40.2%, or $1.2 million, in the third quarter of 2004 and 46.6%, or $3.3 million, for the first nine months of 2004, compared to the corresponding periods in 2003. International revenues increased by 17.6%, or $0.5 million, in the third quarter of 2004 and 18.9%, or $1.5 million, for the first nine months of 2004 compared to the corresponding periods in 2003. These changes in the third quarter and first nine months of 2004 were offset in small part by decreases of 1.8%, or $0.1 million, in the third quarter and 2.5% or $0.4 million for the first nine months of 2004 from our government and national accounts division compared to the corresponding periods in 2003.
The increase in net sales for the third quarter and first nine months of 2004 compared to the corresponding periods in 2003 from our direct sales offices, dealer channel, international operations and NetSolutions® division were primarily attributable to improved economic conditions affecting our industry, as well as improved revenues in the core business and Network Services operations, despite continued competitive pressures and some delayed buying decisions. The increases in net sales were also primarily a result of higher volumes of systems sold. In some instances, prices of various telecommunications systems decreased, and discounts or other promotions were offered to customers to generate sales in both our direct and indirect channels. Sales to new customers in our direct sales channel increased on a percentage basis relative to recurring revenues from existing customers during the third quarter and first nine months of 2004; however, recurring revenue to existing customers increased in dollar volume compared to the corresponding periods in 2003.
17
Sales from our Network Services (NetSolutions® and Network Services Agency divisions) and DataNet divisions increased significantly on a percentage basis in the third quarter and first nine months of 2004 as compared to the corresponding periods in 2003. Net sales increased in NetSolutions®, our long distance resale division, despite downward pricing pressure and significant competition. Increased sales volume has allowed NetSolutions® to offer more competitive pricing, which improved sales to our existing customer base. Sales increased in DataNet primarily due to additional sales to a few customers. Offsetting the net increase in sales from Network Services was a decrease of $0.2 million and $1.7 million, respectively, in Network Services Agency revenues in the quarter and nine months ended September 30, 2004 compared to the corresponding periods in 2003, related primarily to revisions to our agency commissions agreement with a Regional Bell Operating Company (RBOC), which deferred revenue recognition on sales and commissions on local and network services such as T-1 access frame relay and other voice and data circuit services. See Note D of Notes to Condensed Consolidated Financial Statements for additional segment reporting information.
Gross Profit. Gross profit for the third quarter of 2004 increased 13.6% to $55.9 million, or 53.0% of net sales, from $49.2 million, or 52.1% of net sales, in the third quarter of 2003. Gross profit increased 13.1% to $162.3 million, or 53.0% of net sales, in the first nine months of 2004 compared to $143.6 million, or 52.4% of net sales, in the first nine months of 2003. The increase in gross profit dollars in the third quarter of 2004 resulted primarily from a higher volume of consolidated net sales, and gross profit also improved as a percentage of net sales relative to the corresponding period in 2003. For the nine month period ended September 30, 2004, consolidated gross profit improved 13.1% compared to the corresponding period in 2003, and gross profit also improved as a percentage of net sales relative to the corresponding period in 2003. Factors affecting the increased consolidated gross profit percentage in both corresponding periods include higher relative software content in our products, product design improvements and cost containment efforts. Factors which offset in part the increase in gross profit as a percentage of net sales included lower relative recurring revenues from existing customers; increased sales volume in the resale of local and long distance services; greater competitive pricing pressures throughout our operations; and pricing discounts or special promotions on telephone system sales.
During the third quarter and first nine months of 2004, recurring revenue dollars from existing customers in our direct sales and national and government accounts channels increased from these same channels relative to the third quarter and first nine months of 2003, but recurring revenues as a percentage of net sales declined slightly. Existing customers accounted for a significant portion of our net sales from maintenance and other services, software additions and/or upgrades, and other peripheral products such as video conferencing, call logging solutions, wireless endpoints, power protection, wired and wireless headsets, audio conferencing units and networking products during the third quarter of 2004. Our business communications platforms allow for system migration without the complete replacement of hardware, enabling us to offer enhancements and new solutions through software-only upgrades to our existing customers. Consequently, our gross margins are generally higher with recurring revenues because we incur less materials costs relative to new installations. The slight decline in recurring revenues was more than offset by other factors noted above, including higher relative software content in our products, product design improvements and cost containment efforts.
Sales from NetSolutions® increased by 22.8%, or $6.4 million, in the first nine months of 2004 as compared to the first nine months of 2003, and 16.7% or $1.7 million in the third quarter of 2004 compared to the corresponding period in 2003. Although gross margins are generally lower in this division than our consolidated margins, the margins improved slightly in the third quarter and first nine months of 2004 relative to the corresponding periods in 2003, based in part on our ability to negotiate more favorable pricing with vendors on higher resale volumes. Sales from Network Services Agency, however, decreased 17.4%, or $0.2 million, for the third quarter and 41.1%, or $1.7 million, in the first nine months of 2004 compared to the corresponding periods in 2003. This division generally receives commissions on network services we sell as an agent for Regional Bell Operating Companies. Sales from this division carry little to no equipment costs and generated margins of 85.1% during the first nine months of 2004 and 90.9% during the first nine months of 2003. Accordingly, the decrease in sales from this division offset in part our increase in consolidated gross profit and gross margins.
We cannot accurately predict future consolidated gross margins based on a number of factors, including among others, competitive pricing pressures, sales of systems, software and services through
18
different distribution channels, supplier and agency agreements, and the mix of systems, software and services we sell.
Research and Development. Research and development expenses for the third quarter of 2004 increased 33.6% to $7.6 million, or 7.2% of net sales, from $5.7 million, or 6.0% of net sales, for the third quarter of 2003. Research and development expenses increased 27.1% to $20.8 million, or 6.8% of net sales, in the first nine months of 2004 compared to $16.4 million, or 6.0% of net sales, in the first nine months of 2003. Included in research and development expenses in both the third quarter of 2004 and the third quarter of 2003 was amortization of patents totaling $55,000 in each period. The increases in research and development expenses for both the third quarter and the nine months ended September 30, 2004 were primarily attributable to the increased engineering headcount and third-party outsourcing of selected development costs in connection with our efforts to accelerate development of new products and software. To a lesser extent, the increases were also attributable to increased research and development spending related to our development of convergence applications and new SIP and IP endpoint technology. In the third quarter and nine months ended September 30, 2004, research and development expenses were directed principally toward the continued development of converged systems and software, unified messaging and voice processing software, speech recognition and text-to-speech applications, call center applications, unified communications applications, IP endpoint development, and certain CTI and IVR applications and SIP applications. We expect that research and development expenses will increase in absolute dollars and as a percentage of net sales relative to the prior year as we continue to develop and enhance existing and new technologies and products.
Selling, general and administrative. In the third quarter of 2004, selling, general and administrative expenses, excluding amortization, increased 8.9% to $34.6 million, or 32.8% of net sales, from $31.8 million, or 33.6% of net sales, in the third quarter of 2003. For the nine months ended September 30, 2004 selling general and administrative expenses increased 8.2% to $103.9 million, or 33.9% of net sales, from $96.0 million, or 35.1% of net sales, compared to the corresponding period in 2003. The increases in absolute dollars were primarily due to increased expenses associated with the increases in consolidated net sales in 2004 compared to 2003 and to the opening of new sales offices in Philadelphia, Tennessee and South Carolina. In addition, higher net sales in our long distance resale division led to increased selling expenses and commission costs in the third quarter and first nine months of 2004 relative to such costs for the corresponding periods in 2003. In the third quarter and nine months ended September 30, 2004, selling, general and administrative expenses decreased as a percentage of net sales, primarily due to the greater leverage of fixed expenses on the higher volume of sales, relative to the corresponding periods in 2003. We expect that for the foreseeable future selling, general and administrative expenses may vary in absolute dollars and as a percentage of net sales.
Amortization of purchased intangible assets. We adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) effective in the beginning of fiscal 2002. In accordance with SFAS 142, we ceased amortizing goodwill. We are required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. As of September 30, 2004, no impairment of goodwill has been recognized in 2004. We face the risk that future goodwill impairment tests may result in charges to earnings.
Amortization of purchased intangible assets included in operating expenses was $414,000 in the third quarter of 2004, compared to $445,000 in the third quarter of 2003. In addition, $55,000 of amortization was included in research and development expenses for the third quarter of 2004 and the third quarter of 2003. Amortization of purchased intangible assets included in operating expenses was $1.3 million for the nine months ended September 30, 2004, compared to $1.4 million for the nine months ended September 30, 2003. An additional $166,000 of amortization was included in research and development expenses for each of the nine months ended September 30, 2004 and September 30, 2003. The slight decreases in the amortization of purchased intangible assets for the third quarter and nine months ended September 30, 2004, compared to the corresponding periods in 2003 were primarily related to full amortization of certain previously purchased intangibles, offset by additional amortization from recent acquisitions. For additional information regarding purchased intangible assets, see Note C Acquisitions, Dispositions and Restructuring Charges to the Condensed Consolidated Financial Statements.
Interest and Other Income. Interest and other income in 2004 and 2003 consisted primarily of interest income and foreign currency transaction gains or losses. The net increase in interest and other
19
income of $381,000 in the third quarter of 2004 compared to the corresponding period in 2003, was due primarily to higher levels of invested funds, as well as slightly higher interest rates. The changes in both foreign transaction gains and losses and interest expense in the quarter ended September 30, 2004 were nominal compared to the quarter ended September 30, 2003. Income from interest and short-term investments in the first nine months of 2004 increased $582,000 compared to the first nine months of 2003 due primarily to higher levels of invested funds and higher interest rates. Net foreign currency transaction losses in the first nine months of 2004 were $281,000 compared to losses of $9,000 in the first nine months of 2003. Interest expense in the first nine months of 2004 was $108,000, a slight reduction compared to $137,000 in the first nine months of 2003.
Income Taxes. Inter-Tels income tax rate for the third quarter of 2004 was 34.3% compared to 38.0% for the third quarter of 2003, and 36.0% in the first nine months of 2004 compared to 38.0% for the corresponding period in 2003. The decrease in the rate is primarily attributable to increases in tax-exempt income earned from short-term investments and higher utilization of research and development credits based on higher costs. Inter-Tel currently expects the full-year 2004 tax rate to be comparable to the tax rate effective for the first nine months of 2004, subject to prospective changes in the tax laws or other factors.
Net Income. Net income for the third quarter of 2004 was $9.2 million ($0.34 per diluted share), an increase of 27.5% compared to net income of $7.2 million ($0.27 per diluted share) in the third quarter of 2003. Net income for the nine months ended September 30, 2004 was $24.1 million ($0.89 per diluted share), an increase of 26.0% compared to net income of $19.2 million ($0.73 per diluted share) for the nine months ended September 30, 2003.
The increases in net income for the third quarter and nine months ended September 30, 2004 compared to corresponding periods in 2003 are primarily attributable to higher gross profit and increased operating efficiencies, offset in part by higher research and development expenses. Additional information regarding other items is described in further detail above.
Inflation/Currency Fluctuation
Inflation and currency fluctuations have not previously had a material impact on Inter-Tels operations. International procurement agreements have traditionally been denominated in U.S. currency. The potential expansion of international operations in the United Kingdom and Europe and increased sales, if any, in Japan and other parts of Asia could result in higher international sales as a percentage of total revenues; however, international revenues do not currently represent a significant portion of our total revenues.
Liquidity and Capital Resources
Nine Months Ended | ||||||||
September 30, |
||||||||
(In thousands) |
2004 |
2003 |
||||||
Net cash provided by operating activities |
$ | 47,888 | $ | 19,579 | ||||
Net cash used in investing activities |
(11,431 | ) | (32,303 | ) | ||||
Net cash provided by financing activities |
980 | 1,188 | ||||||
Increase (decrease) in cash and equivalents |
37,437 | (11,536 | ) | |||||
Cash and equivalents at beginning of period |
115,197 | 84,923 | ||||||
Cash and equivalents at end of period |
$ | 152,634 | $ | 73,387 | ||||
At September 30, 2004, cash and equivalents totaled $152.6 million, an increase of approximately $37.4 million from the balance of $115.2 million at December 31, 2003. At September 30, 2004, cash and equivalents and short-term investments totaled $214.5 million, an increase of approximately $40.0 million from the balance of $174.5 million at December 31, 2003. We maintain a $10 million unsecured, revolving line of credit with Bank One, NA that is available through June 1, 2006. Under the credit facility, we have the option to borrow at a prime rate or adjusted LIBOR interest rate. Historically, we have used the credit facility primarily to support international letters of credit to suppliers. However, as of September 30, 2004, none of the credit line was used. The remaining cash balances may be used for acquisitions, strategic alliances, working capital, dividends and general corporate purposes.
20
Net cash provided by operating activities totaled $47.9 million for the nine months ended September 30, 2004, compared to $19.6 million for the corresponding period in 2003. Cash provided by operating activities in the first nine months of 2004 was primarily the result of cash generated from profitable operations, including non-cash depreciation, provisions for losses and amortization charges. In addition, an increase in deferred income taxes of $11.5 million in the first nine months of 2004 contributed to the increase. Cash provided by operating activities in the first nine months of 2003 was primarily the result of cash generated from profitable operations as in 2004; however, the 2003 period included an increase in deferred income taxes of $14.9 million. Additionally, cash provided by the changes in operating assets and liabilities in the first nine months of 2004 was $0.6 million, compared to cash used in the changes in operating assets and liabilities of $25.5 million for the corresponding period in 2003. The cash provided by the change in operating assets and liabilities in the first nine months of 2004 was primarily due to a decrease in income tax receivables, offset in part by an increase in inventories and slight increases in lease receivables. The $25.5 million use of cash in the change in operating assets and liabilities in the first nine months of 2003 was primarily a result of an increase in the accounts receivable, investment in sales-leases and income tax receivables. If we are able to expand sales through our direct sales offices, dealer network and government and national accounts divisions, this would likely require additional working capital for increased accounts receivable and inventories.
Net cash used in investing activities totaled $11.4 million for the nine months ended September 30, 2004 compared to $32.3 million for the nine months ended September 30, 2003. Net cash generated by maturities and sales of short-term investments during the first nine months of 2004 was $72.6 million, offset by net cash used in the purchase of short-term investments of $75.1 million during the nine months ended September 30, 2004. Net cash used in the purchase of short-term investments during the nine months ended September 30, 2003 was $141.9 million, offset in part by maturities and sales of short-term investments of $113.7 million in the first nine months of 2003. Net cash of $7.4 million was used to acquire additional property, plant and equipment during the first nine months of 2004 compared to $5.2 million for the corresponding period in 2003, and net cash of $1.5 million was used in acquisitions in the first nine months of 2004 compared to $450,000 for the corresponding period in 2003. In the first quarter of 2003, Inter-Tel also received payment from the Vianet shareholders of $1.45 million, as payment of a loan in connection with the sale of 83% of our interest in Inter-Tel.NET, and in exchange for the full release of our guarantee of vendor obligations.
Net cash provided by financing activities totaled approximately $980,000 for the nine months ended September 30, 2004, compared to cash provided by financing activities of $1.2 million for the corresponding period in 2003. Net cash provided by proceeds from the exercise of stock options and from stock issued under the Companys employee stock purchase plan totaling $5.6 million in the first nine months of 2004 was offset in part by cash used for dividends, which totaled approximately $4.6 million during the same period. Net cash provided by the exercise of stock options and from stock issued under the Companys employee stock purchase plan totaled $3.7 million during the first nine months of 2003, which was offset in part by cash used for dividends totaling approximately $2.2 million in the same period. During the first nine months of 2004 and 2003, we reissued treasury shares through stock option exercises and issuances. In the nine month period ending September 30, 2004, the proceeds received from these reissued treasury shares were higher than the cost basis of the treasury stock reissued, resulting in an increase to retained earnings of approximately $140,000. In the nine month period ending September 30, 2003, the proceeds received from these reissued treasury shares were higher than the cost basis of the treasury stock reissued, resulting in an increase in retained earnings of $151,000.
We offer to our customers lease financing and other services, including our Total Solution (formerly Totalease) program, through our Inter-Tel Leasing, Inc. subsidiary. We fund our Total Solution program in part through the sale to financial institutions of rental payment streams under the leases. Sold lease rentals totaling $233.8 million and $210.1 million remained unbilled at September 30, 2004 and December 31, 2003, respectively. We are obligated to repurchase such income streams in the event of defaults by lease customers and, accordingly, maintain reserves based on loss experience and past due accounts. Although, to date, we have been able to resell the rental streams from leases under the Total Solution program profitably and on a substantially current basis, the timing and profitability of lease resales could impact our business and operating results, particularly in an environment of fluctuating interest rates and
21
economic uncertainty. If we are required to repurchase rental streams and realize losses thereon in amounts exceeding our reserves, our operating results will be adversely affected.
Divisions of the United States Department of Justice are investigating other companies and Inter-Tels participation in a federally funded E-Rate program to connect schools and libraries to the Internet. The Justice Department has provided Inter-Tel with a description of the evidence on which the investigations are based. Inter-Tel has been engaged in discussions with various divisions of the Justice Department regarding the resolution or settlement of these investigations, which include a civil lawsuit, currently stayed, initiated by the San Francisco Unified School District and in which the Justice Department intervened. Inter-Tel is presently unable to predict or determine the final outcome of, or to estimate the potential range of loss with respect to, the investigations. Based upon the information known at this time, we do not know what, if any, impact the investigations may have on the Companys business or financial condition. There can be no assurance, however, that a resolution or settlement will be reached. If Inter-Tel is convicted of any crime or subjected to sanctions, or debarred from certain government contracts, or if penalties, damages or other monetary remedies are assessed against Inter-Tel in connection with or related to these and other investigations, our business and operating results could be materially and adversely affected. The existence and disclosure of the investigations may have already caused competitive harm to Inter-Tel, and any unfavorable resolution to these matters may further harm Inter-Tels business.
We believe that our working capital and credit facilities, together with cash generated from operations, will be sufficient to develop and expand our business operations, to finance acquisitions of additional resellers of telephony products and other strategic acquisitions or corporate alliances, and to provide adequate working capital for the foreseeable future. However, to the extent that additional funds are required in the future to address working capital needs and to provide funding for capital expenditures, expansion of the business or additional acquisitions, we will seek additional financing. There can be no assurance that additional financing will be available when required or on acceptable terms.
Off-Balance Sheet Arrangements
As part of our ongoing business, we do not participate in transactions that involve unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. However, we offer to our customers lease financing and other services through our Inter-Tel Leasing, Inc. subsidiary. We fund our Total Solution program in part through the sale to financial institutions of rental payment streams under the leases. Such financial institutions have the option to require us to repurchase such income streams, subject to limitations, in the event of defaults by lease customers and, accordingly, we maintain reserves based on loss experience and past due accounts. For more information regarding our lease portfolio and financing, please see Liquidity and Capital Resources and Note E of Notes to Condensed Consolidated Financial Statements.
Critical Accounting Policies and Estimates
The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our condensed consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our financial statements and they require our most difficult, subjective or complex judgments in the preparation of our condensed consolidated financial statements:
Revenue Recognition. In December 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition. The Company applies the provisions of SAB 104 to all revenue transactions. SAB 104 supercedes SAB 101, Revenue Recognition in Financial Statements. The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101
22
related to multiple element revenue arrangements, superceded as a result of the issuance of EITF 00-21. Additionally, SAB 104 rescinded the SECs Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (the FAQ) issued with SAB 101 that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB 104. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The issuance of SAB 104 did not have a material impact on the Companys financial position, results of operations or cash flows.
End-user sales through our direct sales offices and government and national accounts division. Revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is both fixed and determinable and; (iv) collectibility is reasonably probable. Revenue derived from sales of systems and services to end-user customers is recognized upon primary installation of the systems and performance of the services, respectively, allowing for use by our customers of these systems. Pre-payments for communications services are deferred and recognized as revenue as the communications services are provided. We do not generally allow sales returns either by the terms of our contracts or in practice, except for returns related to warranty provisions.
Dealer and VAR sales. For shipments to dealers and other distributors, our revenues are recorded as products are shipped and services are rendered, when the sales process is complete. These shipments are primarily to third-party dealers and distributors, and title passes when goods are shipped (free-on-board shipping point). We do not generally allow sales returns either by the terms of our contracts or in practice, except for returns related to warranty provisions. We provide a number of incentives, promotions and awards to certain dealers and other distributors. These incentives primarily represent discounts (which are recognized as a reduction of sales), advertising allowances and awards (which are recognized as marketing expense) and management assistance (which is expensed as incurred).
Resale of long distance. We recognize revenue from long distance resale services as services are provided.
Maintenance revenues. We recognize maintenance revenue ratably over the term of applicable maintenance agreements.
Sales-Leases. For our sales-type lease accounting, we follow the guidance provided by FASB Statement No. 13, Accounting for Leases and FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities A Replacement of FASB Statement No. 125. We record the discounted present values of minimum rental payments under sales-type leases as sales, net of provisions for continuing administration and other expenses over the lease period. We record the lease sales at the time of system sale and installation pursuant to Staff Accounting Bulletin No. 104, as discussed above for sales to end user customers. The costs of systems installed under these sales-leases are recorded as costs of sales. The net rental streams are sold to funding sources on a regular basis with the income streams discounted by prevailing like-term rates at the time of sale. Gains or losses resulting from the sale of net rental payments from such leases are recorded as net sales. We establish and maintain reserves against potential recourse following the resales based upon historical loss experience, past due accounts and specific account analysis. The allowance for uncollectible minimum lease payments and recourse liability at the end of the year represents reserves against the entire lease portfolio. Management reviews the adequacy of the allowance on a regular basis and adjusts the allowance as required. These reserves are either netted in the accounts receivable, current and long-term components of Net investments in Sales-Leases on the balance sheet, or included in long-term liabilities on our balance sheet for off-balance sheet leases.
Historically, our reserves have been adequate to cover write-offs. Our total reserve for losses related to the entire lease portfolio, including amounts classified as accounts receivable in our balance sheet, declined from 6.1% at December 31, 2003 to 5.6% at September 30, 2004, primarily as a result of improved write-off experience and accounts receivable agings. Should the financial condition of our customers deteriorate in the future, additional reserves in amounts that could be material to the financial statements could be required.
23
Goodwill and Other Intangible Assets. On January 1, 2002, Inter-Tel adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. Purchase prices of acquired businesses that are accounted for as purchases have been allocated to the assets and liabilities acquired based on the estimated fair values on the respective acquisition dates. Based on these values, the excess purchase prices over the fair value of the net assets acquired were allocated to goodwill.
Prior to January 1, 2002, Inter-Tel amortized goodwill over the useful life of the underlying asset, not to exceed 40 years. On January 1, 2002, Inter-Tel began accounting for goodwill under the provisions of SFAS Nos. 141 and 142 and discontinued the amortization of goodwill after January 1, 2002. As of September 30, 2004, Inter-Tel had gross goodwill of $24.3 million and accumulated amortization of $5.0 million. Inter-Tel completed two acquisitions through September 30, 2004 and one in 2003 and has not recorded any amortization for these acquisitions on amounts allocated to goodwill in accordance with SFAS No. 141.
The Company performs an annual impairment test on Goodwill using the two-step process prescribed in SFAS No. 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. In addition, the Company will perform impairment tests during any reporting period in which events or changes in circumstances indicate that an impairment may have incurred. Inter-Tel performed the first step of the required impairment tests for goodwill as of December 31, 2003 and determined that goodwill is not impaired and it is not necessary to record any impairment losses related to goodwill. At September 30, 2004 and December 31, 2003, $17.1 million of the Companys goodwill, net of amortization, relates to the Companys principal segment and $2.1 million relates to the Network Services segment. There is only one reporting unit (i.e., one component) as defined in paragraph 30 of SFAS 142 within each of the Companys two operating segments as defined in paragraph 10 of SFAS 131. Therefore the reporting units are identical to the segments. Fair value has been determined for each segment in order to determine the recoverability of the recorded goodwill. At December 31, 2003, the Company primarily considered an allocated portion of the market capitalization for the entire Company using average common stock prices in determining that no impairment has occurred. This allocated market capitalization value far exceeded the net carrying value of the goodwill included in the financial statements. Therefore, the second step for potential impairment was unnecessary.
The Company evaluates the remaining useful lives of its purchased intangible assets, all of which are subject to amortization, each reporting period. Any changes to estimated remaining lives prospectively effect the remaining period of amortization. In addition, the purchased intangible assets are reviewed for possible impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. A loss would be recognized for any excess of the carrying amount over the estimated fair value. As of September 30, 2004, Inter-Tel had gross purchased intangible assets of $14.9 million and accumulated amortization of $7.4 million.
At September 30, 2004 and December 31, 2003, goodwill, net of accumulated amortization, totaled $19.3 million and $18.0 million, respectively. Other acquisition-related intangibles, net of accumulated amortization, totaled $7.5 million at September 30, 2004 and $8.2 at December 31, 2003. Accumulated amortization through September 30, 2004 was $12.4 million, including $5.0 million of accumulated amortization attributable to goodwill and $7.4 million of accumulated amortization of other acquisition-related intangibles. Accumulated amortization through December 31, 2003 was $11.0 million, including $5.0 million of accumulated amortization attributable to goodwill and $6.0 million of accumulated amortization of other acquisition-related intangibles. Other acquisition-related intangibles, comprised primarily of developed technology (5-10 year lives), customer lists (5 year lives) and non-competition agreements (2-5 year lives), are amortized on a straight-line basis. The useful lives for developed technology are based on the remaining lives of patents acquired or the estimated useful life of the technology, whichever is shorter. The useful lives of the customer lists are based on the expected period of value for such lists. The useful lives for non-competition agreements are based on the contractual terms of the agreements.
Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Additional reserves or allowances for doubtful accounts are recorded for our sales-type leases, discussed above in Sales-Leases. We establish and maintain reserves against estimated losses based upon historical loss experience, past due
24
accounts and specific account analysis. Management reviews the level of the allowances for doubtful accounts on a regular basis and adjusts the level of the allowances as needed. In evaluating our allowance we consider accounts in excess of 60 days old as well as other risks in the more current portions of the accounts included. At September 30, 2004, our allowance for doubtful accounts for accounts receivable were $11.1 million of our $54.5 million in gross accounts receivable. If the financial condition of our customers or channel partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Inventories. We value our inventories at the lower of cost (principally on a standard cost basis, which approximates the first-in, first-out (FIFO) method) or market. Significant management judgment is required to determine the reserve for obsolete or excess inventory and we make our assessment primarily on a significant product-by-product basis for the immediately preceding twelve-month period, adjusted for expected changes in projected sales or marketing demand. Inventory on hand may exceed future demand either because the product is outdated or obsolete, or because the amount on hand is more than can be used to meet estimated future needs. We consider criteria such as customer demand, product life cycles, changing technologies, slow moving inventory and market conditions. We write down our excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value. Historically, sales of scrap have not been material and have not affected our profit margins. At September 30, 2004, our inventory reserves were $6.9 million of our $24.1 million gross inventories. If actual customer demand, product life cycles, changing technologies and market conditions are less favorable than those projected by management, additional inventory write-downs may be required in the future.
Contingencies. We are a party to various claims and litigation in the normal course of business. Managements current estimated range of liability related to various claims and pending litigation is based on claims for which management can estimate the amount and range of loss, or can estimate a minimum amount of a loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending claims and litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our claims and pending litigation, revise our estimates and accrue for any losses to the extent that they are probable and the amount is estimable. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial position.
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
This Report on Form 10-Q 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. Actual results could differ materially from those projected in the forward-looking statements as a result of many risk factors including, without limitation, those set forth under Factors That May Affect Future Results Of Operations below. In evaluating Inter-Tels business, shareholders and prospective investors should consider carefully the following factors in addition to the other information set forth in this document.
Risks Related to Our Business
Our operating results have historically depended on a number of factors, and these factors may cause our operating results to fluctuate in the future.
Our quarterly operating results have historically depended on, and may fluctuate in the future as a result of, many factors including:
| volume and timing of orders received during the quarter; |
| gross margin fluctuations associated with the mix of products sold; |
| the mix of distribution channels; |
| general economic conditions and the condition of the markets our business addresses; |
| patterns of capital spending by customers; |
| the timing of new product announcements and releases by us and our competitors and other competitive factors; |
| pricing pressures; |
| the cost and effect of acquisitions; |
25
| the availability and cost of products and components from our suppliers, including shipping and manufacturing problems associated with subcontracted vendors; |
| national and regional weather patterns; and |
| threats of or outbreaks of war, hostilities, terrorist acts or other civil disturbances. |
In addition, we have historically operated with a relatively small backlog, with sales and operating results in any quarter depending principally on orders booked and shipped in that quarter. In the past, we have recorded a substantial portion of our net sales for a given quarter in the third month of that quarter, with a concentration of such net sales in the last two weeks of the quarter. Market demand for investment in capital equipment such as business communications systems and associated call processing and voice processing software applications depends largely on general economic conditions and can vary significantly as a result of changing conditions in the economy as a whole. We cannot assure you that we can continue to be successful operating with a small backlog or whether historical backlog trends will continue in the future.
Our expense levels are based in part on expectations of future sales and, if sales levels do not meet expectations, our operating results could be harmed. In addition, because sales of business communications systems through our dealers typically produce lower gross margins than sales through our direct sales organization, operating results have varied, and will continue to vary based upon the mix of sales through direct and indirect channels. In addition, in the past we have derived a significant part of our revenue from recurring revenue streams, which typically produce higher gross margins. If we do not maintain recurring revenue streams at current or historic levels, our operating results will suffer if we do not significantly increase sales to new customers. Moreover, particularly in an environment of fluctuating interest rates, the timing and profitability of lease resales from quarter to quarter could impact operating results. Long distance and DataNet sales, which typically have lower gross margins than our core business, have grown in recent periods at a faster rate than our overall net sales, although gross margins may fluctuate in these divisions from period to period. Consolidated gross margins could be harmed if long distance calling services continue to increase as a percentage of net sales or if gross margins from this division decline. We also experience seasonal fluctuations in our operating results, as net sales for the first quarter is frequently less than the fourth quarter, and net sales for the third quarter is frequently less than the second quarter. As a result of these and other factors, we have historically experienced, and could continue to experience in the future, fluctuations in net sales and operating results on a quarterly basis.
Our market is subject to rapid technological change and to compete successfully, we must continually introduce new and enhanced products and services that achieve broad market acceptance.
The market for our products and services is characterized by rapid technological change, evolving industry standards and vigorous customer demand for new products, applications and services. To compete successfully, we must continually enhance our existing telecommunications products, related software and customer services, and develop new technologies and applications in a timely and cost- effective manner. If we fail to introduce new products and services that achieve broad market acceptance, or if we do not adapt our existing products and services to customer demands or evolving industry standards, our business could be significantly harmed. Problems and delays associated with new product development have in the past contributed to lost sales. In addition, current competitors or new market entrants may offer products, applications or services that are better adapted to changing technology or customer demands and that could render our products and services unmarketable or obsolete.
In addition, if the markets for computer-telephony applications, Internet Protocol network products, or related products fail to develop or continue to develop more slowly than we anticipate, or if we are unable for any reason to capitalize on any of these emerging market opportunities, our business, financial condition and operating results could be significantly harmed.
Our future success largely depends on increased commercial acceptance of our Axxess® system, EncoreCX®, speech recognition, Interactive Voice Response, presence management, collaboration, messaging products, Session Initiation Protocol (SIP) applications, and related computer-telephony products.
Over the past 18 to 24 months, we have introduced Unified Communicator® software, a web-based, speech-recognition, wireless PDA, and Wireless Application Protocol (WAP) software application for
26
controlling and managing calls, contacts and presence status; Enterprise® Conferencing and Enterprise® Instant Messaging software, a SIP-based web and audio conferencing application; Model 8500 series digital endpoints; Model 8600 series Multi-protocol SIP endpoints; Inter-Tel Application Platform, a highly flexible speech-recognition, text-to-speech and CTI application generation platform; enhanced convergence features on the Axxess system, including support of standard Session Initiation Protocol (SIP) endpoints and trunk gateways; and several other telephony-related products. During the past 12 to 18 months, sales of our Axxess business communications systems and related software have comprised a substantial portion of our net sales. Our future success depends, in large part, upon increased commercial acceptance and adoption of the products identified above, as well as the Axxess system, the Application Platform, the Unified Communicator and related computer-telephony products, EncoreCX products, converged systems and software, SIP standards-based applications and devices, new speech recognition and Interactive Voice Response products, and future upgrades and enhancements to these products and networking platforms. We cannot assure you that these products or platforms will achieve commercial acceptance in the future.
Our products are complex and may contain errors or defects that are detected only after their release, which may cause us to incur significant unexpected expenses and lost sales.
Our telecommunications products and software are highly complex. Although our new products and upgrades are examined and tested prior to release, they can only be fully tested when used by a large customer base. Consequently, our customers have in the past and may in the future discover program errors, or bugs, or other defects after new products and upgrades have been released. Some of these bugs may result from defects contained in component parts or software from our suppliers or other third parties that are intended to be compatible with our products and over which we have little or no control. Although we have test procedures and quality control standards in place designed to minimize the number of errors and defects in our products, we cannot assure you that our new products and upgrades will be free of bugs when released. If we are unable to quickly or successfully correct bugs identified after release, we could experience the following, any of which would harm our business:
| costs associated with the remediation of any problems; |
| costs associated with design modifications; |
| loss of or delay in revenues; |
| loss of customers; |
| failure to achieve market acceptance or loss of market share; |
| increased service and warranty costs; |
| liabilities to our customers; and |
| increased insurance costs. |
The complexity of our products could cause delays in the development and release of new products and services. As a result, customer demand for our products could decline, which could harm our business.
Due to the complexity of our products and software, we have in the past experienced and expect in the future to experience delays in the development and release of new products or product enhancements. If we fail to introduce new software, products or services in a timely manner, or fail to release upgrades to our existing systems or products and software on a regular and timely basis, customer demand for our products and software could decline, which would harm our business.
Business acquisitions, new business ventures, dispositions or joint ventures entail numerous risks and may disrupt our business, dilute shareholder value and distract management attention.
As part of our business strategy, we consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Such acquisitions could materially adversely affect our operating results and/or the price of our common stock. Acquisitions also entail numerous risks, some of which we have experienced and may continue to experience, including:
| unanticipated costs and liabilities; |
| difficulty of assimilating the operations, products and personnel of the acquired business; |
| difficulties in managing the financial and strategic position of acquired or developed products, services and technologies; |
27
| difficulties in maintaining customer relationships; |
| difficulties in servicing and maintaining acquired products, in particular where a substantial portion of the targets sales were derived from our competitors products and services; |
| difficulty of assimilating the vendors and independent contractors of the acquired business; |
| the diversion of managements attention from the core business; |
| inability to maintain uniform standards, controls, policies and procedures; and |
| impairment of relationships with acquired employees and customers occurring as a result of integration of the acquired business. |
In particular, in recent years our operating results were materially adversely affected by several of the factors described above, including substantial acquisition-related charges and operating losses from the Executone acquisition. Refer to Note C to the Condensed Consolidated Financial Statements for additional information.
We completed one acquisition and one technology purchase during 2003 and one acquisition during January 2004 and one in July 2004. At the beginning of the third quarter of 2003, we acquired rights to certain developed technology and in December 2003, we acquired selected assets and assumed certain liabilities of a former Inter-Tel dealer in the Philadelphia metropolitan area. In January 2004, we acquired selected assets and assumed certain liabilities of a former Inter-Tel dealer in Tennessee and in July 2004, we acquired selected assets and assumed certain liabilities of a former Inter-Tel dealer in South Carolina. These acquisitions are subject to risks and uncertainties including, but not limited to, those indicated above. In October 2004, after the close of the fiscal third quarter of 2004, we acquired selected assets and assumed certain liabilities of former Inter-Tel dealers in Pittsburgh, Pennsylvania and Las Vegas, Nevada. In October 2004, we also acquired selected assets and assumed certain liabilities of Linktivity, which develops Web-based conferencing solutions, notably Linktivity® software. These solutions are designed to provide real-time communications and remote control software to enable instantaneous, browser-to-browser Web conferencing and help desk support solutions. In October 2004, Inter-Tel also entered into a source license arrangement for select audio conferencing and web presentation technology from eDial, a subsidiary of Alcatel Marketing USA.
Finally, to the extent that shares of our stock or the rights to purchase stock are issued in connection with any future acquisitions, dilution to our existing shareholders will result and our earnings per share may suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business, and we may not achieve a satisfactory return on our investment in any acquired businesses.
We may not be able to adequately protect our proprietary technology and may be infringing upon third-party intellectual property rights.
Our success depends upon our proprietary technology. We currently hold twenty-five (25) U.S. patents for telecommunication and messaging products, systems and processes and have applied to the U.S. Patent and Trademark Office for eleven (11) additional patents. We also rely on copyright and trade secret law and contractual provisions to protect our intellectual property. Despite these precautions, third parties could copy or otherwise obtain and use our technology without authorization, or develop similar technology independently.
Any patent, trademark or copyright that we own or have applied to own is subject to being invalidated, circumvented or challenged by a third party. Effective protection of intellectual property rights may be unavailable or limited in foreign countries. We cannot assure that the protection of our proprietary rights will be adequate or that competitors will not independently develop similar technology, duplicate our services or design around any patents or other intellectual property rights we hold. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation could be costly, absorb significant management time and harm our business.
We are also subject to or could become subject to third party claims that our current or future products or services infringe upon the rights of others. For example, we are subject to claims initiated by Avaya, one of our primary competitors, alleging that certain of our key products infringe upon their intellectual property rights, including patents, trademarks, copyrights or other intellectual property rights. We have viewed presentations from Avaya alleging that our Axxess business communications system and
28
associated applications utilize inventions covered by certain of their patents. We are continuing the process of investigating this matter and we have made claims against Avaya for infringement of our patents. The ultimate outcomes by their nature are uncertain and we cannot assure you that these matters, individually or collectively, would not have a material adverse impact on our financial position and future results of operations.
When any such claims are asserted against us, among other means to resolve the dispute, we may seek to license the third partys intellectual property rights. Purchasing such licenses can be expensive, and we cannot assure you that a license will be available on prices or other terms acceptable to us, if at all. Alternatively, we could resort to litigation to challenge such a claim. Litigation could require us to expend significant sums of cash and divert our managements attention. In the event a court renders an enforceable decision with respect to our intellectual property, we may be required to pay significant damages, develop non-infringing technology or acquire licenses to the technology subject to the alleged infringement. Any of these actions or outcomes could harm our business. If we are unable or choose not to license technology, or decide not to challenge a third partys rights, we could encounter substantial and costly delays in product introductions. These delays could result from efforts to design around asserted third party rights or our discovery that the development, manufacture or sale of products requiring these licenses could be foreclosed.
We have many competitors and expect new competitors to enter our market, which could increase price competition and spending on research and development and which may impair our ability to compete successfully.
The markets for our products and services are extremely competitive and we expect competition to increase in the future. Our current and potential competitors in our primary business segments include:
| PABX and converged systems providers, distributors, or resellers such as Alcatel, Altigen, Avaya, Cisco Systems, Comdial, 3Com, Iwatsu, Lucky Goldstar, Mitel, NEC, Nortel, Panasonic, Samsung, ShoreTel, Siemens, Toshiba, Vertical Networks and Vodavi; |
| large data routing and convergence companies such as 3Com and Cisco Systems; |
| voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a subsidiary of NEC America), Avaya, and Captaris (formerly AVT); |
| long distance services providers such as AT&T, MCI, Qwest and Sprint; |
| large computer and software corporations such as IBM, HP, Intel and Microsoft; |
| regional Bell operating companies, or RBOCs, cable television companies, IP Centrex service providers, and satellite and other wireless broadband service providers; and |
| independent leasing companies that provide telecom equipment financing. |
These and other companies may form strategic relationships with each other to compete with us. These relationships may take the form of strategic investments, joint-marketing agreements, licenses or other contractual arrangements. Strategic relationships and business combinations could increase our competitors ability to address customer needs with their product and service offerings.
Many of our competitors and potential competitors have substantially greater financial, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. We cannot be sure that we will have the resources or expertise to compete successfully. Compared to us, our competitors may be able to:
| develop and expand their product and service offerings more quickly; |
| offer greater price discounts or make substantial product promotions; |
| adapt to new or emerging technologies and changing customer needs faster; |
| take advantage of acquisitions and other opportunities more readily; |
| negotiate more favorable licensing agreements with vendors; |
| devote greater resources to the marketing and sale of their products; and |
| address customers service-related issues more adequately. |
Some of our competitors may also be able to provide customers with additional benefits at lower overall costs or to reduce their gross margins aggressively in an effort to increase market share. We cannot be sure we will be able to match cost reductions by our competitors. In recent periods, due to
29
competitive pressures, we have discounted pricing on our telephone systems and offered promotions. In addition, we believe there is likely to be further consolidation in our markets, which could lead to having even larger and more formidable competition and other forms of competition that could cause our business to suffer.
Our reliance on a limited number of suppliers for key components and our dependence on contract manufacturers could impair our ability to manufacture and deliver our products and services in a timely and cost-effective manner.
We currently obtain certain key components for our digital communication platforms, including certain microprocessors, integrated circuits, power supplies, voice processing interface cards and IP telephony cards, from a limited number of suppliers and manufacturers. Our reliance on these limited suppliers and contract manufacturers involves risks and uncertainties, including the possibility of a shortage or delivery delay for some key components. We currently manufacture our products through third-party subcontractors located in the United States, Mexico, the Peoples Republic of China and the United Kingdom. Varian, Inc. currently manufactures a significant portion of our products at Varians Tempe, Arizona facility, including substantially all of the printed circuit boards used in the Axxess systems. Foreign manufacturing facilities are subject to changes in governmental policies, imposition of tariffs and import restrictions and other factors beyond our control. We have experienced occasional delays in the supply of components and finished goods that have harmed our business. If inventory levels are not adequately maintained and managed we are at risk of not having the appropriate inventory quantities on hand to meet sales demand. We may experience similar delays in the future.
Our reliance on third party manufacturers and OEM partners involves a number of additional risks, including reduced control over delivery schedules, quality assurance and costs. Our business may be harmed by any delay in delivery or any shortage of supply of components or finished goods from a supplier. Our business may also be harmed if we are unable to develop alternative or additional supply sources as necessary. To date, we have been able to obtain supplies of components and products in a timely manner even though we do not have long-term supply contracts with any of our contract manufacturers. However, we cannot assure you we will be able to continue to obtain components or finished goods in sufficient quantities or quality or on favorable pricing or delivery terms in the future.
We derive a substantial portion of our net sales from our dealer network and if these dealers do not effectively promote and sell our products, our business and operating results could be harmed.
We derive a substantial portion of our net sales through our network of independent dealers. We face intense competition from other telephone, voice processing, and voice and data router system manufacturers for these dealers business, as most of our dealers carry other products that compete with our products. Our dealers may choose to promote the products of our competitors to our detriment. We have developed programs and expended capital as incentives to our dealers to promote our products, and we cannot assure you that these techniques will continue to be successful. The loss of any significant dealer or group of dealers, or any event or condition harming our dealer network, could harm our business, financial condition and operating results.
We are currently the target of government investigations and in the future we may be subject to litigation, which, if they result in any convictions, sanctions or penalties against us, could harm our business.
Divisions of the United States Department of Justice are investigating other companies and Inter-Tels participation in a federally funded E-Rate program to connect schools and libraries to the Internet. The Justice Department has provided Inter-Tel with a description of the evidence on which the investigations are based. Inter-Tel has been engaged in discussions with various divisions of the Justice Department regarding the resolution or settlement of these investigations, which include a civil lawsuit, currently stayed, initiated by the San Francisco Unified School District and in which the Justice Department intervened. Inter-Tel is presently unable to predict or determine the final outcome of, or to estimate the potential range of loss with respect to, the investigations. Based upon the information known at this time, we do not know what, if any, impact the investigations may have on the Companys business or financial condition. There can be no assurance, however, that a resolution or settlement will be reached. If Inter-Tel is convicted of any crime or subjected to sanctions, or debarred from certain government contracts, or if penalties, damages or other monetary remedies are assessed against Inter-Tel in connection with or related to these and other investigations, our business and operating results could be materially and
30
adversely affected. The existence and disclosure of the investigations may have already caused competitive harm to Inter-Tel, and any unfavorable resolution to these matters may further harm Inter-Tels business.
Inter-Tel is also subject to litigation in the ordinary course of business. We cannot assure you that any adverse outcome in connection with such litigation would not impair our business or financial condition.
Managing our international sales efforts may expose us to additional business risks, which may result in reduced sales or profitability in our international markets.
We are currently expending resources to maintain and expand our international dealer network in the countries in which we already have a presence and in new countries and regions. International sales are subject to a number of risks, including changes in foreign government regulations and telecommunication standards, export license requirements, tariffs and taxes, other trade barriers, difficulties in protecting our intellectual property, fluctuations in currency exchange rates, difficulty in collecting receivables, difficulty in staffing and managing foreign operations, and political and economic instability. In particular, the terrorist acts of September 11, 2001, continued hostilities in Iraq and turmoil in the Middle East and North Korea have created an uncertain international economic environment and we cannot predict the impact of these acts, any future terrorist acts or any related military action on our efforts to expand our international sales. Fluctuations in currency exchange rates could cause our products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. In addition, the costs associated with developing international sales or an international dealer network may not be offset by increased sales in the short term, or at all. Any of these risks could cause our products to become relatively more expensive to customers in a particular country, leading to reduced sales or profitability in that country.
If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our objectives.
We depend on the continued service of, and our ability to attract and retain, qualified technical, marketing, sales and managerial personnel, many of whom would be difficult to replace. Competition for qualified personnel is intense, and we have historically had difficulty in hiring employees in the timeframe we desire, particularly skilled engineers or sales personnel. The loss of any of our key personnel or our failure to effectively recruit additional key personnel could make it difficult for us to manage our business, complete timely product introductions or meet other critical business objectives. Moreover, our operating results could be impaired if we lose a substantial number of key employees from recent acquisitions, including personnel from acquisitions identified in Note C to the Condensed Consolidated Financial Statements. We cannot assure you we will be able to continue to attract and retain the qualified personnel necessary for the development of our business.
Our IP network products may be vulnerable to viruses, other system failure risks and security concerns, which may result in lost customers or slow commercial acceptance of our IP network products.
Inter-Tels IP telephony and network products may be vulnerable to computer viruses or similar disruptive problems. Computer viruses or problems caused by third parties could lead to interruptions, delays or cessation of service that could harm our operations and revenues. In addition, we may lose customers if inappropriate use of the Internet or other IP networks by third parties jeopardizes the security of confidential information, such as credit card or bank account information or the content of conversations over the IP network. In addition, user concerns about privacy and security may cause IP networks in general to grow more slowly, and impair market acceptance of our IP network products in particular, until more comprehensive security technologies are developed.
We may be unable to achieve or manage our growth effectively, which may harm our business.
The ability to operate our business in an evolving market requires an effective planning and management process. Our efforts to achieve growth in our business have placed, and are expected to continue to place, a significant strain on our personnel, management systems, infrastructure and other resources. In addition, our ability to manage any potential future growth effectively will require us to
31
successfully attract, train, motivate and manage new employees, to integrate new employees into our overall operations and to continue to improve our operational, financial and management controls and procedures. Furthermore, we expect we will be required to manage an increasing number of relationships with suppliers, manufacturers, customers and other third parties. If we are unable to implement adequate controls or integrate new employees into our business in an efficient and timely manner, our operations could be adversely affected and our growth could be impaired.
The introduction of new products and services has lengthened our sales cycles, which may result in significant sales and marketing expenses.
In the past few years, we introduced IP telephony enhancements to the Axxess® system as well as presence management and collaboration applications, which are typically sold to larger customers at a higher average selling price and often represent a significant expenditure in communications infrastructure by the prospective enterprise customer. Accordingly, the purchase of our products typically involves numerous internal approvals relating to the evaluation, testing, implementation and acceptance of new technologies. This evaluation process frequently results in a lengthy sales process, which can range from a few months to more than 12 months, thereby subjecting our sales cycle to a number of significant uncertainties concerning budgetary constraints and internal acceptance reviews. The length of our sales cycle also may vary substantially from customer to customer and along product lines. While our customers are evaluating our products before placing an order with us, we may incur substantial sales and marketing expenses and expend significant management effort. In addition, installation of multiple systems for large, multi-site customers may occur over an extended period of time, and depending on the contract terms with these customers, revenues may be recognized over more than one quarter, as systems are completed in separate phases and accepted by the customers. Consequently, if sales forecasted from a specific customer for a particular quarter are not realized in that quarter, our operating results could be materially adversely affected.
We rely heavily upon third-party packaged software systems to manage and run our business processes and to produce our financial statements. From time to time we upgrade these systems to ensure continuation of support and to expand the functionality of the systems to meet our business needs. The risks associated with the upgrade process include disruption of our business processes, which could harm our business.
We currently run third-party applications for data processing in our distribution center operations, shipping, materials movement, customer service, invoicing, financial record keeping and reporting, and for other operations and administrative functions. The nature of the software industry is to upgrade software systems to make architectural changes, increase functionality and address software bugs. Over time, older versions of the software become less supported or unsupported by our vendors for financial and other reasons and eventually become obsolete. Oracle, the primary supplier of our third-party applications, provides notice of the dates that Oracle will de-support the software and companies are expected to either make plans to upgrade to newer versions or operate without Oracle support. While Oracle and other third-party vendors may provide advanced notice of product upgrade schedules and take other steps to make the upgrade process as straightforward as possible, we are subject to risks associated with the process, and in some cases we may choose to continue to utilize and maintain the unsupported third-party software using our own information systems personnel. Our software systems could become unstable following an upgrade process and impact our ability to process data properly in these systems, including timely and accurate shipment of products, invoicing our customers properly and the production of accurate and timely financial statements. We expect to affect software upgrades in the future and cannot assure you these software upgrades or enhancements will operate as intended or be free from bugs or that we will be able to operate effectively using unsupported third-party software using our existing personnel and resources. If we are unable to successfully integrate new software into our information systems, our operations, customer service and financial reporting could be adversely affected and could harm our business.
Our stock price has been and may continue to be volatile, impairing your ability to sell your shares at or above purchase price.
The market price for our common stock has been highly volatile. The volatility of our stock could be subject to continued wide fluctuations in response to many risk factors listed in this section, and others beyond our control, including:
32
| announcements of developments relating to our business; |
| fluctuations in our operating results; |
| shortfalls in revenue or earnings relative to securities analysts expectations; |
| announcements of technological innovations or new products or enhancements by us or our competitors; |
| announcements of acquisitions or planned acquisitions of other companies or businesses; |
| investors reactions to acquisition announcements or any forecasts of our future results; |
| general economic conditions in the telecommunications industry; |
| the market for Internet-related voice and data products and services; |
| changes in the national or worldwide economy; |
| changes in legislation or regulation affecting the telecommunications industry; |
| threats of or outbreaks of war, hostilities, terrorist acts or other civil disturbances; |
| developments relating to our intellectual property rights and the intellectual property rights of third parties; |
| litigation or governmental investigations of our business practices; |
| changes in our relationships with our customers and suppliers, including shipping and manufacturing problems associated with subcontracted vendors; and |
| national and regional weather patterns. |
In addition, stock prices of technology companies in general, and for voice and data communications companies in particular, have experienced extreme price fluctuations in recent years which have often been unrelated to the operating performance of affected companies. We cannot assure you the market price of our common stock will not experience significant fluctuations in the future, including fluctuations unrelated to our performance.
Our Chairman of the Board of Directors, CEO and President controls 20.0% of our Common Stock and is able to significantly influence matters requiring shareholder approval.
As of September 30, 2004, Steven G. Mihaylo, Inter-Tels Chairman of the Board of Directors, Chief Executive Officer and President, beneficially owned approximately 20.0% of the existing outstanding shares of the common stock of Inter-Tel. As a result, he has the ability to exercise significant influence over all matters requiring shareholder approval. In addition, the concentration of ownership could have the effect of delaying or preventing a change in control of Inter-Tel.
Risks Related to Our Industry
Reductions in spending on enterprise communications equipment may materially and adversely affect our business.
The overall economic slowdown has had and continues to have a harmful effect on the market for enterprise communications equipment. Our customers have reduced significantly their capital spending on communications equipment in an effort to reduce their own costs and bolster their revenues. The market for enterprise communications equipment may only grow at a modest rate or possibly not grow at all, and our financial performance has been and may continue to be materially and adversely affected by the reductions in spending on enterprise communications equipment.
The emerging market for IP network telephony is subject to market risks and uncertainties that could cause significant delays and expenses.
The market for IP network voice communications products has begun to develop only recently, is evolving rapidly and is characterized by an increasing number of market entrants who have introduced or developed products and services for Internet or other IP network voice communications. As is typical of a new and rapidly evolving industry, the demand for and market acceptance of, recently introduced IP network products and services are highly uncertain. We cannot assure you that IP voice networks will become widespread. Even if IP voice networks become more widespread in the future, we cannot assure that our products, including the IP telephony features of the Axxess systems our IP endpoints and IP applications will successfully compete against other market players and attain broad market acceptance.
Moreover, the adoption of IP voice networks and importance of development of products using industry standards such as MGCP and SIP, generally require the acceptance of a new way of exchanging
33
information. In particular, enterprises that have already invested substantial resources in other means of communicating information may be reluctant or slow to adopt a new approach to communications. If the market for IP network voice communications fails to develop or develops more slowly than we anticipate, our IP network telephony products could fail to achieve market acceptance, which in turn could significantly harm our business, financial condition and operating results. This growth may be inhibited by a number of factors, such as quality of infrastructure; security concerns; equipment, software or other technology failures; regulatory encroachments; inconsistent quality of service; poor voice quality over IP networks as compared to circuit-switched networks; and lack of availability of cost-effective, high-speed network capacity. Moreover, as IP-based data communications and telephony usage grow, the infrastructure used to support these IP networks, whether public or private, may not be able to support the demands placed on them and their performance or reliability may decline. The technology that allows voice and facsimile communications over the Internet and other data networks, and the delivery of other value-added services, is still in the early stages of development.
Government regulation of third party long distance and network service entities on which we rely may harm our business.
Our supply of telecommunications services and information depends on several long distance carriers, RBOCs, local exchange carriers, or LECs, and competitive local exchange carriers, or CLECs. We rely on these carriers to provide local and long distance services, including voice and data circuits, to our customers and to provide us with billing information. Long distance services are subject to extensive and uncertain governmental regulation on both the federal and state level. We cannot assure you that the increase in regulations will not harm our business. Our current contracts for the resale of services through long distance carriers include multi-year periods during which we have minimum use requirements and/or costs. The market for long distance services is experiencing, and is expected to continue to experience significant price competition, and this may cause a decrease in end-user rates. We cannot assure you that we will meet minimum use commitments, that we will be able to negotiate lower rates with carriers if end-user rates decrease or that we will be able to extend our contracts with carriers at favorable prices. If we are unable to secure reliable Network Services from certain long distance carriers, RBOCs, LECs and CLECs, or if these entities are unwilling or unable to provide telecommunications services and billing information to us on favorable terms, our ability to expand our own Network Services will be harmed. Carriers that provide telecommunications services to us may also experience financial difficulties, up to and including bankruptcies, which could harm our ability to offer telecommunications services.
Consolidation within the telecommunications industry could increase competition and reduce our customer base.
There has been a trend in the telecommunications industry towards consolidation and we expect this trend to continue as the industry evolves. As a result of this consolidation trend, new stronger companies may emerge that have improved financial resources, enhanced research and development capabilities and a larger and more diverse customer base. The changes within the telecommunications industry may adversely affect our business, operating results and financial condition.
Terrorist activities and resulting military and other actions could harm our business.
Terrorist attacks in New York and Washington, D.C. in September of 2001 disrupted commerce throughout the world. The continued threat of terrorism, the conflict in Iraq and the potential for additional military action and heightened security measures in response to these threats may continue to cause significant disruption to commerce throughout the world. To the extent that disruptions result in a general decrease in corporate spending on information technology or advertising, our business and results of operations could be harmed. We are unable to predict whether the conflict in Iraq and its aftermath, the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have a long-term adverse effect on our business, results of operations or financial condition. Additionally, if any future terrorist attacks were to affect the operation of the Internet or key data centers, our business could be harmed. These and other developments arising out of the potential attacks may make the occurrence of one or more of the factors discussed herein more likely to occur.
34
We Are Exposed To Increased Costs And Risks Associated With Complying With Increasing And New Regulation Of Corporate Governance And Disclosure Standards.
We are spending an increased amount of management time and external resources to comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules. In particular, Section 404 of the Sarbanes-Oxley Act of 2002 requires managements annual review and evaluation of our internal control systems, and attestations of the effectiveness of these systems by our management and by our independent auditors. We are currently documenting and testing our internal control systems and procedures and considering improvements that may be necessary in order for us to comply with the requirements of Section 404 by the end of 2004. This process has required us to hire additional personnel and outside advisory services and has resulted in additional accounting and legal expenses. In addition, the evaluation and attestation processes required by Section 404 are new and neither companies nor auditing firms have significant experience in testing or complying with these requirements. Accordingly, we may encounter problems or delays in completing the review and evaluation, the implementation of improvements and the receipt of a positive attestation by our independent auditors. While we believe that we currently have adequate internal controls over financial reporting, in the event that our chief executive officer, chief financial officer or independent auditors determine that our controls over financial reporting are not effective as defined under Section 404, investor perceptions of Inter-Tel may be adversely affected and could cause a decline in the market price or our stock.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments.
INVESTMENT PORTFOLIO. We do not use derivative financial instruments in our non-trading investment portfolio. Inter-Tel maintains a portfolio of highly liquid cash equivalents typically maturing in three months or less as of the date of purchase. Inter-Tel places its investments in instruments that meet high credit quality standards, as specified in our investment policy guidelines.
The Company also maintains short-term investments, which are all classified as available for sale, and have been recorded at fair value, which approximates cost. Short-term investments include certificates of deposit, auction rate certificates, auction rate preferred securities, municipal preferred securities and mutual funds. The auction rate securities are adjustable-rate securities with dividend rates that are reset periodically by bidders through periodic Dutch auctions generally conducted every 7 to 49 days by a trust company or broker/dealer on behalf of the issuer. The Company believes these securities are highly liquid investments through the related auctions; however, the collateralizing securities have stated terms of up to thirty (30) years. These instruments are rated A or higher by Standard & Poors Ratings Group, or equivalent. The Companys short-term investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to the Companys investment guidelines and market conditions. Given the short-term nature of these investments, and that we have no borrowings outstanding other than short-term letters of credit, we are not subject to significant interest rate risk.
LEASE PORTFOLIO. We offer to our customers lease financing and other services, including our Total Solutions program, through our Inter-Tel Leasing subsidiary. We fund these programs in part through the sale to financial institutions of rental payment streams under the leases. Upon the sale of the rental payment streams, we continue to service the leases and maintain limited recourse on the leases. We maintain reserves for loan losses on all leases based on historical loss experience, past due accounts and specific account analysis. Although to date we have been able to resell the rental streams from leases under our lease programs profitably and on a substantially current basis, the timing and profitability of lease resales could impact our business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If we were required to repurchase rental streams and realize losses thereon in amounts exceeding our reserves, our operating results could be materially adversely
35
affected. See Liquidity and Capital Resources and Critical Accounting Policies and Estimates in Managements Discussion and Analysis for more information regarding our lease portfolio and financing.
IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our international subsidiaries primarily in the local currencies of our subsidiaries for product and service revenues. Inter-Tel is exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. The impact of foreign currency rate changes have historically been insignificant.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
Changes in internal controls over financial reporting. There were no changes in our internal controls over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Sarbanes-Oxley 404 Compliance. We continue the detailed assessment of our internal controls as called for by the Sarbanes-Oxley Act of 2002. We are simultaneously working to complete our evaluation of design phase where we have identified what may be control deficiencies in our system of internal controls, and have been performing the testing phase of our project. We expect to validate any potential control deficiencies and to assess whether or not they rise to the level of significant deficiencies or material weaknesses. We believe we are prepared to investigate any potential control deficiencies, and, where appropriate, to remediate them. Although we have made this project a top priority for the Company, there can be no assurances that all control deficiencies identified and validated will be remediated before the end of the Companys fiscal year or that the remaining unresolved control deficiencies will not rise to the level of significant deficiencies or material weaknesses.
INTER-TEL, INCORPORATED AND SUBSIDIARIES
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are involved from time to time in litigation incidental to our business. We believe that the outcome of current litigation will not have a material adverse effect upon our business, financial condition or results of operations and will not disrupt our normal operations.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not Applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNot Applicable
ITEM 5. OTHER INFORMATION Not Applicable
36
ITEM 6. EXHIBITS:
Exhibit 31.1:
|
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
Exhibit 31.2:
|
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
Exhibit 32.1:
|
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
Exhibit 32.2:
|
Certification of 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.
INTER-TEL, INCORPORATED | ||
November 5, 2004
|
/s/ Steven G. Mihaylo | |
Steven G. Mihaylo | ||
Chairman of the Board, Chief Executive | ||
Officer and President | ||
November 5, 2004
|
/s/ Kurt R. Kneip | |
Kurt R. Kneip | ||
Senior Vice President and | ||
Chief Financial Officer |
37