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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE PERIOD ENDED OCTOBER 26, 2002

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

For the transition period from __________ to __________

Commission File Number 0-8141

NORSTAN, INC.
(Exact name of registrant as specified in its charter)

5101 Shady Oak Road, Minnetonka, Minnesota 55343-4100

Telephone (952) 352-4000   Fax (952) 352-4949   Internet www.norstan.com

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x. No o.

On November 25, 2002, there were 12,622,187 shares outstanding of the registrant’s common stock, par value $0.10 per share, its only class of equity securities.

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PART I. FINANCIAL INFORMATION
ITEM 1.

NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
UNAUDITED
(In thousands, except per share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

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NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

UNAUDITED
(In thousands, except share amounts)

The accompanying notes are an integral part of these consolidated balance sheets.

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NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

UNAUDITED
(In thousands, except share amounts)

The accompanying notes are an integral part of these consolidated balance sheets.

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NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW

UNAUDITED

(In thousands)

The accompanying notes are an integral part of these consolidated financial statements.

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NORSTAN, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

OCTOBER 26, 2002

UNAUDITED

     The information furnished in this report is unaudited and reflects normal recurring adjustments and such other adjustments which, in the opinion of management, are necessary to present fairly the operating results for the interim periods. The operating results for the interim periods presented are not necessarily indicative of the operating results to be expected for the full fiscal year. This report should be read in conjunction with Norstan’s Annual Report on Form 10-K for the year ended April 30, 2002.

PRINCIPLES OF CONSOLIDATION

     The accompanying consolidated financial statements include the accounts of Norstan and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

DISCONTINUED OPERATIONS

Network Services:

     On February 4, 2002, Norstan announced that it had entered into a definitive agreement to sell its Network Services business to NetWolves Corporation (NASDAQ: WOLV) for $7.5 million. The transaction was completed on July 9, 2002, effective on July 1, 2002. Pursuant to the terms of the purchase agreement, $3.75 million was received at closing and the remaining $3.75 million is due one year from closing, evidenced by a non-interest bearing promissory note in favor of Norstan. The Company recorded a pre-tax gain on this sale of $2.7 million in its first quarter of fiscal 2003 based solely on the $3.75 million cash received. Any additional gains related to receipt of payments on the promissory note will be recorded when collection is assured. Network Services provided multiple source long distance services and related consulting and professional services. Because of the sale of this business unit, Network Services results of operations have been reported as discontinued operations for all periods presented.

Consulting:

     During fiscal 2001, Norstan divested its IT consulting business in order to focus on its core competencies of providing communications technology services and solutions to channel partners and direct enterprise customers. In addition to refocusing Norstan’s strategy, the absence of realized synergies between the Company’s communications and IT consulting businesses and recurring losses within the consulting business contributed to management’s decision to divest of this non-strategic business segment.

     Divestiture of its IT consulting business began on February 7, 2001 with the sale of the Company’s 75% interest in Connaissance Consulting to Connaissance’s founder. Terms of the sale required the payment of $3.0 million in cash at closing and delivery of promissory notes drawn in favor of Norstan with an aggregate face amount of $13.0 million maturing on various dates, commencing on April 30, 2001 and ending December 31, 2005. To date, $1.0 million has been collected on one of the notes and the remaining $12.0 million has been fully reserved for, including a charge of $5.0 million recorded during the fourth quarter of fiscal 2002.

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     The divestiture concluded with the sale of Norstan Consulting on April 30, 2001 to a management group led by Norstan Consulting’s former President and the Company’s former Vice Chairman. Terms of the sale required the payment of $500,000 in cash at closing and delivery of a promissory note drawn in favor of the Company in the face amount of $1.5 million maturing on August 28, 2001. In addition, as part of the transaction, Norstan retained its rights to certain assets and assumed certain liabilities of Norstan Consulting. As of April 30, 2002, the promissory note had been paid in full.

     The results of these two business units have historically been reported as the Company’s “Consulting” business segment. With these sales, Consulting’s results of operations are reported as discontinued operations for all periods presented.

     Financial Information Related to Discontinued Operations:

     Net assets of discontinued operations include the following (in thousands):

Summary operating results of the discontinued operations are as follows (in thousands):

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     In addition to the operating results above, Norstan recorded a net gain on the disposal of discontinued operations of $2.3 million in the first six months of fiscal 2003. The gain on disposal includes the following: (i) a pre-tax gain on the sale of Norstan’s Network Services business of $2.7 million ($2.3 million after tax), (ii) a $259,000 net gain related to payments collected on the promissory note received by the Company as part of the PRIMA Consulting arbitration settlement of February 25, 2002, ($155,000 net gain in the second quarter ended October 26, 2002) and (iii) a $269,000 net loss related to additional costs incurred in the disposition of Connaissance Consulting.

     The after-tax gain on the sale of the Network Services business reflects the reversal of a $1.6 million tax valuation allowance which had been previously established for the Company’s capital loss carryforwards. The sale of the Network Services business will allow Norstan to fully utilize these capital loss carryforwards. Accordingly, this valuation allowance was reversed through discontinued operations.

FOREIGN CURRENCY

     For Norstan’s Canadian operations, assets and liabilities are translated at exchange rates as of the balance sheet date, and revenues and expenses are translated at average exchange rates prevailing during the period. Translation adjustments are recorded as a separate component of shareholders’ equity.

SUPPLEMENTAL CASH FLOW INFORMATION

     Supplemental disclosure of cash flow information is as follows (in thousands):

RECENTLY ISSUED ACCOUNTING STANDARDS

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (SFAS No. 146), “Accounting for Costs Associated with Exit or Disposal Activities”. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 modifies the definition and requirement for recognition of exit costs in Emerging Issues Task Force Issue No. 94-3 where a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. Norstan does not believe that the adoption of this statement will have a material effect on its financial position or results of operations.

     In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”). SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes FASB Statement No. 121, “Accounting for the Impairment of Long-Lived Assets To Be Disposed Of” and the accounting and reporting provisions of APB Opinion No. 30. The changes required by SFAS No. 144 resolve significant implementation issues related to SFAS No. 121 and improve financial reporting by requiring that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. The requirements of SFAS No. 144 also broaden the presentation of discontinued operations to include more disposal transactions. Norstan will adopt SFAS No. 144 in fiscal 2003 and does not anticipate a significant effect from the adoption on its financial position or results of operations.

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USE OF ESTIMATES

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the periods presented. Estimates are used for such items as allowances for doubtful accounts, inventory valuation, depreciable lives of property and equipment, warranty reserves and others. Ultimate results may differ from those estimates.

EARNINGS PER SHARE DATA

     Norstan reports net income (loss) per share pursuant to the requirements of the Statement of Financial Accounting Standards No. 128 “Earnings per Share” (“SFAS No. 128”). SFAS No. 128 requires presentation of basic and diluted earnings (loss) per share (EPS). Basic EPS is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted EPS reflects potential dilution from outstanding stock options and other securities using the treasury stock method.

COMPREHENSIVE INCOME

     Norstan reports comprehensive income and its components pursuant to the requirements of SFAS No. 130, “Reporting Comprehensive Income”. For the Company, comprehensive income consists of net income (loss) adjusted for foreign currency translation adjustments. Comprehensive income, as defined by SFAS No. 130, was approximately $585,000 for the quarter ended October 26, 2002 and $197,000 for the similar period ended October 27, 2001. For the six month period ended October 26, 2002, the Company had comprehensive income of $2.8 million, as compared to $394,000 for the six months ended October 27, 2001.

VENDOR AGREEMENTS

     Norstan has been a distributor of Siemens communication equipment since 1976 and is Siemens’ largest independent distributor in North America. The term of the current distributor agreement with Siemens, signed in January 1999, is five years. Norstan and Siemens are also parties to an agreement scheduled to expire on July 27, 2003 pursuant to which Norstan is authorized to refurbish and sell previously owned Siemens equipment.

INCOME TAXES

     Deferred income taxes are provided for differences between the financial statement carrying amounts and the tax basis of Norstan’s assets and liabilities at currently enacted tax rates.

     Realization of the Company’s net deferred tax asset is dependent on Norstan’s ability to generate sufficient future taxable income. With the execution of the Company’s 2002 operating plan and management’s expectations for 2003 and beyond, Norstan believes that it is more likely than not that the recorded asset will be realized. Should the Company’s operating strategies fail to produce sufficient taxable income in the future, Norstan would record an additional valuation allowance in the appropriate future reporting period, as required by generally accepted accounting principles. Norstan’s U.S. net operating loss carryforwards expire from 2020 to 2021.

     For the fiscal period ended October 26, 2002, Norstan recorded a tax provision of 38.0% on net income from continuing operations and net income from operations of discontinued operations. In addition, a provision of 38.0% was recorded on the gains on disposal of discontinued operations, net of a $608,000 tax benefit related to the Company’s deferred capital loss carryforward tax asset.

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BANK FINANCING

     On July 12, 2002, Norstan entered into a new $30.0 million credit agreement with certain banks consisting of the following components: A) a $21.0 million revolving line of credit, with availability based on eligible receivables and inventory, as defined, and B) a $9.0 million term loan with quarterly payments of $1.0 million which began October 25, 2002. The revolving line matures on June 28, 2004 and the term note matures on October 29, 2004. The term note is subject to certain prepayment provisions in the event the Company receives cash from the collection of the promissory note related to the sale of Network Services. The agreement also provides that when the term loan is paid to an amount less than $5.0 million, the Company has an option to increase the revolving commitment amount to $25.0 million provided accounts receivable and inventory levels support such an increase.

     The revolving facility and term loan bear interest at the bank’s reference rate plus 1.0% or Eurodollar rate advance plus 3.0% through December 31, 2002 with provisions for future rate reductions if Norstan meets certain financial targets. Borrowings under this agreement were $19.9 million as of October 26, 2002 and averaged $22.3 million during the first six month period of fiscal 2003 with average interest rates of 6.3%. Annual commitment fees range from .375% to .25%. Under this agreement the Company is required to maintain minimum levels of tangible net worth and EBT and achieve certain other financial ratios. As of October 26, 2002, Norstan was in compliance with all applicable financial covenants.

     Norstan’s management believes that a combination of cash expected to be generated from operations, borrowing capacity available under the financing arrangements discussed above, and cash received or expected to be received from collection of promissory notes and other transactions will be adequate to meet the anticipated liquidity and capital resource requirements of its business through at least April 30, 2003.

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BUSINESS SEGMENTS

     Norstan delivers its products and services through three business segments, Communications Technology Solutions and Services, Resale Services and Financial Services. The Company’s interim disclosures pursuant to the requirements of SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information,” are as follows (in thousands):

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

     Norstan, Inc. (“Norstan” or the “Company”) is a full-service communications solutions and services company that delivers voice and data technologies and services, and remanufactured equipment to select corporate end-users and channel partners. Norstan offers a full range of technologies for call center design, IP telephony/PBX, messaging, infrastructure, conferencing, and mobility. Norstan manages the operations of its subsidiaries, Norstan Communications, Inc., Norstan Canada, Ltd., Norstan Financial Services, Inc., Vibes Technologies, Inc., Norstan International, Inc., and Norstan-UK Limited. The Company is headquartered in Minnetonka, Minnesota with sales and services throughout North America. Norstan’s common stock is listed on the Nasdaq stock market under the symbol NRRD.

     Norstan drives its business by delivering legendary service through the installation of a broad array of technology platforms, software solutions and on-going system maintenance needs. The Company currently works with approximately 18,000 customers, drawing its customers from the banking/finance, healthcare, manufacturing, retail, government, education, utilities, finance/insurance and non-profit sectors. The Company derives revenues from technology service support sales to a broad channel of manufacturers, resellers and distributors and through partnerships with manufacturers offering best-in-class technology. Norstan also maintains a direct sales effort focused on Fortune 2000 companies and an inside sales force focused on smaller opportunities. The Company’s remanufactured equipment segment supports Norstan’s customer base, channel partners, resellers and distributors with efficient and reliable resale services.

     To address the complex communication requirements of its customers, Norstan provides a broad range of products and services through three interrelated business segments: Communications Technology Solutions and Services, Resale Services, and Financial Services which accounted for 84.8%, 13.6%, and 1.6% of Norstan’s revenues for the six months ended October 26, 2002, respectively. Communications Technology Solutions and Services provides best-in-class technologies and services focused on selected enterprise customers throughout North America and technology implementation and support services for network providers, manufacturers, integrators, and resellers. Resale Services provides refurbished and re-certified voice and data products to end users. Financial Services supports the sales process by providing customers with customized financing alternatives.

     In July 2002, Norstan completed the sale of its Network Services business to NetWolves Corporation for $7.5 million, consisting of $3.75 million in cash and a non-interest bearing promissory note for $3.75 million. Network Services provided multiple source long distance services and related consulting and professional services to its customers. Management concluded that the Network Services unit was not strategic to the Company’s overall future direction.

     During fiscal 2001, Norstan divested its IT consulting business in order to focus on its core competencies of providing communications technology services and solutions to channel partners and direct enterprise customers. The two units that made up the Company’s IT consulting business, Connaissance Consulting and Norstan Consulting, were sold on February 7 and April 30, 2001, respectively. The absence of synergies between Norstan’s communications and consulting businesses and recurring losses within the consulting businesses also contributed to the decision to divest of this non-strategic business segment.

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SUMMARY

     During the quarter ended October 26, 2002, the Company reported net income of $584,000 or $0.04 per diluted share, as compared to net income of $335,000 or $0.03 per diluted share for the quarter ended October 27, 2001. For the six month period ended October 26, 2002, the Company reported net income of $2.8 million or $0.21 per diluted share, as compared to net income of $488,000 or $0.04 per diluted share, for the similar period last year.

SELECTED CONSOLIDATED FINANCIAL DATA