XETA TECHNOLOGIES INC - 10-K Annual Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended October 31, 2002

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-16231

XETA Technologies, Inc.
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(Exact name of registrant as specified in its charter)

Oklahoma 73-1130045
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

1814 West Tacoma, Broken Arrow, Oklahoma 74012
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(Address of principal executive offices) (Zip Code)

Registrant's telephone number including area code: (918) 664-8200
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Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value
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(Title of Class)

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 past 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

Yes x No
--- ---

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).

Yes No X
--- ---

The aggregate market value of the voting stock held by non-affiliates of the
registrant, computed by reference to the Nasdaq closing price on April 30, 2002,
the last business day of the registrant's most recently completed second fiscal
quarter, was approximately $39,692,529.

The number of shares outstanding of the registrant's Common Stock as of
December 31, 2002 was 9,702,952 (excluding 1,018,788 treasury shares).

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement to be filed with the Securities and Exchange
Commission in connection with the Annual Meeting of Shareholders to be held
April 3, 2003 are incorporated into Part III, Items 11 through 13 hereof.

PART I

Our disclosure and analysis in this report and in our 2002 Annual Report to
Shareholders contain some forward-looking statements. Forward-looking statements
give our current expectations or forecasts of future events, but are not
guarantees of performance. Actual results may differ materially from those
described in forward-looking statements. Many factors mentioned in this report
will be important in determining future results. Therefore, you are requested to
read the more detailed cautionary statement about forward-looking statements set
forth in Item 7, "Management's Discussion and Analysis of Financial Condition
and Results of Operations" below, and to consider all forward-looking statements
in light of the risks and uncertainties described under the heading "Outlook and
Risk Factors" under Item 7 below.

ITEM 1. BUSINESS

DEVELOPMENT AND DESCRIPTION OF BUSINESS

XETA Technologies, Inc. (the "Company"), an Oklahoma corporation formed in
1981, is a leading provider of integrated communications solutions including:
traditional voice and data products as well as converged systems applications
such as VoIP, wireless, contact centers, unified messaging, and video solutions.
We specialize in providing these solutions to multi-location mid-size and large
companies throughout the United States. In addition to selling these products to
customers, we derive a significant portion of our revenues and gross profits
from the installation and maintenance of these systems, utilizing our
nation-wide network of Company-employed design engineers and service technicians
as well as our 24-hour, 7-days-per-week call center located in our headquarters
building in Broken Arrow, Oklahoma.

For the past two years, we have been battling difficult macro-economic
conditions as capital spending on new technology products, especially
telecommunications products, has been severely restricted by most U.S.
companies. As a result, we've had to adopt several defensive tactics to remain
profitable. These tactics included suspending most growth-oriented activities,
maintaining operating expenses at levels commensurate with revenues, and
generating significant positive cash flows from operations. While doggedly
executing these tactics, we've kept our overall vision intact by maintaining our
core technical competencies and improving operational efficiencies, especially
those directly related to customer satisfaction.

As we enter fiscal 2003, the near-term direction of the market for our
products is mixed. We completed the last half of fiscal 2002 with
quarter-over-quarter growth in revenues and we're guardedly optimistic that the
Company can return to year-over-year growth in revenues and profits in fiscal
2003. However, the market remains fragile. A sudden and severe downturn, similar
to those experienced in each of the last two fiscal years, could still occur
forcing us to quickly resume a defensive posture.

Regardless of near-term prospects, we remain confident in our long-term
vision. Specifically, the rapid development of converged voice and data networks
continues to occur and adoption of these new technologies and their related
applications is also beginning to accelerate. Despite the difficult economic
conditions of the last two years, we believe the Company is well-positioned to
expand rapidly when spending on these systems begins to grow modestly again.

COMMERCIAL PRODUCTS

We are one of the largest authorized dealers of Avaya, Inc.'s ("Avaya")
products in the U.S. We sell a broad line of Avaya communications systems and
software for enterprises including converged voice and data, customer
relationship management and messaging. Our converged voice and data network
products provided by Avaya include traditional voice communications systems and
IP telephony offerings. Traditional voice products are marketed under the
DEFINITY(R) Solutions product family. Definity systems provide reliable voice
communications and offer integration with a customer's data network. These
systems will support a wide variety of voice and data applications such as call
centers, messaging, and VoIP. The Definity systems can be "IP-enabled" to
facilitate the transition to more advanced systems with fully integrated voice
and data networks. We also sell traditional voice products for medium and small
users under the MERLIN MAGIX(TM) Systems and the PARTNER(R) Communications
Systems product families. We market Avaya's messaging systems under the name
AUDIX(R).

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Our advanced communications product offering from Avaya is marketed under
the name ECLIPS, or Enterprise Class of IP Solutions. Avaya significantly
expanded this product line during fiscal 2002. This new generation of IP-based
products is driven by Avaya's MultiVantage(TM) voice application software
coupled with a variety of highly configurable network elements including Avaya's
Media Servers, Media Gateways, and proprietary software applications. The ECLIPS
line is designed to offer customers a high level of choice in configurations for
both centralized and distributed business environments, including global,
multi-site, campus, branch, remote and home office communications environments.
Customers, with the help of our design engineers, can design their systems to
their unique needs and scale from 40 or fewer users to more than 1 million.
These new ECLIPS products are in addition to the IP600 product line introduced
in 2001. The IP600 series can be upgraded to the MultiVantage software.

We also sell data networking products to the commercial market under
non-exclusive dealership agreements with Cisco and Hewlett Packard.

HOSPITALITY PRODUCTS

Communications Systems. We distribute Avaya's DEFINITY(R) Guestworks(TM)
Systems and Hitachi's 5000(R) Series Digital Communications Systems to the
hospitality industry under nationwide, non-exclusive dealer agreements with both
vendors. Both of these systems are equipped with lodging specific software,
which integrates with nearly all aspects of the hotel's operations. We also
offer a variety of related products such as voice mail systems, analog
telephones, uninterruptible power supplies, announcement systems, and others,
most of which also have lodging specific software features. Most of these
products are sold in conjunction with the sale of new communications systems
and, with the exception of voice mail systems, are purchased from regional and
national suppliers. Sales of communications systems to the lodging industry
represented 11%, 12%, and 13% of total revenues in fiscal 2002, 2001, and 2000,
respectively.

Call Accounting Products. We also market a line of proprietary call
accounting systems under the XL(R) and Virtual XL(R) ("VXL") series name.
Introduced in 1998, the VXL is a PC-based system designed to operate on a
hotel's local or wide area network, and if that network is connected to the
Internet, the VXL can also be accessed via an Internet connection. The VXL
systems are our latest technology in a series of call accounting products we
have successfully marketed since our inception. Many of those earlier products
remain in the field and are supported by our service and technical staff.

INSTALLATION AND SERVICES

We have nation-wide Customer Service, Project Management, Professional
Services, Installation and Consulting organizations to support our customers.
This extensive services organization is one of the key differentiators between
our competitors and us. The purchase price of our systems typically includes
charges for professional services, project management activities, and
installation costs, all of which are reflected as installation and service
revenues in our financial statements.

Our service organization includes our National Service Center ("NSC") housed
at our headquarters building in Broken Arrow, OK. We support our customers who
have purchased maintenance contracts on their systems from the NSC as well as
other customers who use the NSC who purchase service on a time and materials
basis. We employ a network of highly trained technicians who are strategically
located in major metropolitan areas and can be dispatched by the NSC to support
our customers in the field or install new systems. We also employ a cadre of
design engineers (the Professional Services Organization "PSO") trained in the
design of the new, converged networks discussed above. The PSO provides high-end
services to assist our customers in navigating their way to a cost-effective and
productivity-boosting network design. Much of the work done by the PSO
represents pre-sales work and is often not recovered in revenues, representing a
significant investment. We believe, however, that by hiring the most qualified
personnel possible and keeping their talents in-house, we have built a
competitive advantage in the marketplace as most of our competitors do not have
the financial strength to make this investment. Finally, we have a boutique
software consulting operation to assist customers in Microsoft Exchange and
Unified Messaging applications. Revenues from our software consulting business
are mostly derived from the Pacific Northwest region and represent less than 2%
of total revenues.

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For our distributed products, we typically pass on the manufacturer's
limited warranty, which is generally one year in length. Labor costs associated
with fulfilling the warranty requirements are generally borne by us. For Avaya
products, we attempt to sell Avaya's post-warranty maintenance contracts, for
which we earn a commission. In some circumstances however, we sell our own
post-warranty maintenance plan. Most of these contracts are with our lodging
industry customers. Hitachi, unlike Avaya, does not have its own field service
force. Therefore, for Hitachi products, which are distributed only to our
lodging customers, we always attempt to sell our own post-warranty maintenance
contract.

For proprietary call accounting products sold to the lodging industry, we
provide our customers with a limited one-year warranty covering parts and labor.
Subsequent to the expiration of the warranty, we offer after-market service
contracts to our lodging customers under one year and multi-year service
contracts. We earn a significant portion of our recurring service revenues from
lodging customers who maintain service contracts on their systems.

SOFTWARE AND PRODUCT DEVELOPMENT

We have traditionally developed proprietary telecommunications products
specifically for the lodging industry. However, as a result of our expansion
into the general commercial market and other various changes in technology which
have decreased the importance of call accounting systems in the lodging
industry, we have redirected our development resources toward internal IT needs.
We do not expect a significant change in this strategy in the near future.

MARKETING

Our marketing efforts to the commercial sector (non-lodging) are targeted at
the "enterprise" space, which is loosely defined as mid-sized to large
commercial customers. We especially prefer complex, multi-site applications in
which we can leverage our in-house PSO capabilities and our standard nation-wide
implementation capabilities. We market our products and services through our
direct sales force and through relationships with Avaya's direct sales force
under Avaya's Business Partner program. This program is part of Avaya's
announced corporate strategy of moving significant portions of its equipment
sales revenues into its dealer channels. As such, we market our implementation
abilities to Avaya's direct sales force as well as directly to end-users. When
partnering with Avaya to provide design, equipment and installation of
communications solutions to customers, we typically work directly with the
customer, take title to the inventory prior to its shipment to the customer and
are responsible for the entire implementation project.

In addition to the broad commercial sector, we also have marketing
initiatives into two specific vertical markets: government and healthcare. These
initiatives generally encompass having sales personnel dedicated to
understanding the unique needs and buying channels of these markets and
tailoring our solutions designs and implementation to these markets. In January
2003, we launched an additional initiative into the mid-market sector. In this
initiative, we will focus our sales efforts on mid-sized businesses in specific
large metropolitan areas.

Our marketing effort to the lodging industry relies more heavily on our
experience and reputation. Over the course of serving this market for 20 years,
we have built strong long-term relationships with a wide range of personnel
(corporate hotel chain personnel, property management officials, industry
consultants, hotel owners, and on-site financial or operating officers) that can
be the key decision makers for the purchase of hotel telecommunications
equipment. We have relationships with nearly all hotel chains and major property
management companies. These relationships are key to our past and future success
and our marketing efforts are targeted at strengthening and deepening those
relationships rather than the more broad promotional efforts sometimes employed
in our marketing efforts to the commercial sector.

In addition, we offer a variety of sales programs to the lodging industry,
the most significant of which is the XETAPLAN program. Under the XETAPLAN
program, customers are provided one of our call accounting products for a period
of three to five years in exchange for a monthly fee paid to us. Service on the
products is also included in the contract. For communications systems we sell to
the lodging industry, we offer a package of value-added services including a
call accounting system and a service package with a specified number of free
labor hours and weekly appointments with our certified technicians to correct
minor malfunctions or to perform routine maintenance.

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MAJOR CUSTOMERS

During fiscal 2002, we did not have any single customer that comprised more
than 10% of our revenues.

BACKLOG

At December 31, 2002 our backlog of orders for systems sales was $5.9
million compared to $2.7 million at the same time last year. We expect all of
this backlog to ship and be recognized as revenue by October 31, 2003.

COMPETITION

Commercial. The market for the communications systems products and services
we sell is highly competitive. As communications systems rapidly evolve from
stand-alone voice systems to highly integrated, software-driven, IP-based
systems, they become subject to more rapid technological change. We have chosen
to sell the Avaya voice product line to our commercial sector because we believe
Avaya is the market leader in enterprise communications systems, call centers,
and messaging systems. Our competitive position in the commercial market is
therefore directly related to Avaya's ability to continue to be the market
leader in these product lines. There are several manufacturers, some of which
have greater financial, sales, marketing, distribution, technical,
manufacturing, and other resources than Avaya, who are competing fiercely in
this rapidly changing market. These competitors include: Cisco Systems, Inc.,
Nortel Networks Corporation, Siemens Aktiengesellschaft, and Alcatel S.A. In
addition to other manufacturers' products and their direct and indirect sales
forces, we face significant competition from the other over 1,100 Avaya dealers
in the U.S. We believe most of these dealers do not have our technical
competence, nation-wide capabilities, and financial strength, but many compete
very effectively in certain product lines or in certain geographic areas.

Hospitality. We sell both Avaya and Hitachi communications systems to the
lodging market and, as such, face similar competitive pressures to those
discussed above under "Commercial Competition". However, since the lodging
market is a small, niche market, we believe our most effective competitive
strengths are the performance and reliability of our proprietary hospitality
systems and our high level of service commitment to this unique market. While we
believe that our reputation and nation-wide presence contribute significantly to
our success in the lodging market, there can be no assurance given that we will
be able to continue to expand our market share in the future.

MANUFACTURING

All of the assembly of systems relates to our proprietary call accounting
systems sold exclusively to the lodging industry. As a mature product line,
these systems comprise less than 2% of our total revenues. We assemble these
products, which include the XL(R), Virtual XL(R), and XPERT(R) systems, from an
inventory of components, parts and sub-assemblies obtained from various
suppliers. These components are purchased from a variety of regional and
national distributors at prices which fluctuate based on demand and volumes
purchased. Some components, although widely distributed, are manufactured by a
single, usually foreign, source and are therefore subject to shortages and price
fluctuations if manufacturing is interrupted. We maintain adequate inventories
of components to mitigate short-term shortages and believe the ultimate risk of
long-term shortages is minimal. Our proprietary products are based on PC
technology, which is continually and rapidly changing. As a result, some of the
components originally designed for use in our systems have been phased out of
production and replaced by more advanced technology. To date, these
substitutions have not forced us to substantially redesign our systems and there
has been minimal effect on the overall system cost. There can be no assurance
given, however, that future obsolescence of key components would not result in
unanticipated delays in shipments of systems due to redesign and testing of
assemblies.

We use outside contractors to assemble our proprietary printed circuit
boards. The components and blank circuit boards are purchased, inventoried, and
supplied to the outside contractor for assembly and quality control testing. We
perform various quality control procedures, including powering up completed
systems and allowing them to "burn-in" before being assembled into a final unit
for a specific customer location, and performing final testing prior to
shipment.

5

EMPLOYEES

At December 31, 2002, we employed 285 employees, including 1 part-time
employee.

COPYRIGHTS, PATENTS AND TRADEMARKS

We recognize that our reputation for quality products and services gives
value to our product and service offerings names. Therefore, we place high
importance upon protecting such names by obtaining registered trademarks where
practicable and appropriate. We own registered United States trademarks on the
following names for use in the marketing of our services and systems: "XETA,"
"XETAXCEL," "XACT," "XPERT," "XPERT+," "XL," "XPANDER," and "Virtual XL." All of
these marks are registered on the principal register of the United States Patent
and Trademark Office ("PTO"), with the exception of XPANDER(R), which is
registered on the supplemental register. We have also applied for U.S. trademark
registration of the name "XTRAMILE," which application is currently pending.

We attempt to protect our proprietary technology through a combination of
trade secrets, non-disclosure agreements, copyright claims, and technical
measures. We believe that patent protection is less significant to protecting
our proprietary technology and technical expertise than the other measures
listed above. For this reason, we have never applied for patents on our hardware
or software technology with the exception of the technology for "XPANDER."

ITEM 2. PROPERTIES

Our principal executive office and Service Center are located in a 37,000
square foot, Company-owned, single story building located in a suburban business
park near Tulsa, Oklahoma. This facility also houses the Company's warehouse and
assembly areas to support its hospitality sales channel. The building is located
on a 13-acre tract of land. The property is subject to a mortgage held by Bank
One, Oklahoma, NA, to secure the Company's credit facility.

Our commercial channel shipping operations are primarily located in leased
facilities in St. Louis, Missouri. In addition to the warehouse, this facility
houses sales staff, technical design, professional services, and installation
support personnel. We also lease other office space throughout the U.S. for
sales, consulting, and technical staff and have informal office arrangements
with our regional technicians to allow for some storage of spare parts
inventory.

ITEM 3. LEGAL PROCEEDINGS

Since 1994, we have been monitoring numerous patent infringement lawsuits
filed by Phonometrics, Inc., a Florida company, against certain
telecommunications equipment manufacturers and hotels who use such equipment.
While we have not been named as a defendant in any of these cases, several of
our call accounting customers are named defendants. These customers have
notified us that they will seek indemnification under the terms of their
contracts with us. However, because there are other equipment vendors implicated
along with us in the cases filed against our customers, we have never assumed
the outright defense of our customers in any of these actions.

All of the cases filed by Phonometrics against our customers were originally
filed in, or transferred to, the United States District Court for the Southern
District of Florida. In October 1998, the Florida Court dismissed all of the
cases filed against the hotels for failure to state a claim, relying on the
precedent established in Phonometrics' unsuccessful patent infringement lawsuit
against Northern Telecom. Phonometrics appealed the Florida court's order and
the United States Court of Appeals for the Federal Circuit reversed the District
Court's dismissal of the cases, but did so solely upon the basis of a procedural
matter. The Appeals Court made no ruling with respect to the merits of
Phonometrics' case and remanded the cases back to the Florida court for further
proceedings. These cases were reopened in April 2000. In November 2001 several
defendant hotels filed motions for summary judgment. These motions were granted
in favor of

6

the defendant hotels and the cases were closed after final judgment was issued
against Phonometrics in April 2002. Subsequently, Phonometrics filed an appeal
of the judgment, which is currently pending. In August 2002, the defendant
hotels were awarded attorneys' fees and costs. Thereafter, Phonometrics filed an
appeal of this award as well, which is also currently pending. We will continue
to monitor proceedings in these actions.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

7

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS.

Our Common Stock, $.001 par value, is currently traded on the
over-the-counter market and is reported in the National Association of
Securities Dealers Automated Quotation ("NASDAQ") System under the symbol
"XETA."

The high and low bid prices for the Common Stock, as reported by the
National Association of Securities Dealers through its NASDAQ System, for each
of the quarters during our two most recent fiscal years are set forth below.
These prices reflect inter-dealer prices, without adjustment for retail
mark-ups, mark-downs or commissions and may not necessarily represent actual
transactions.

We have never paid cash dividends on our Common Stock. Payment of cash
dividends is dependent upon our earnings, capital requirements, overall
financial condition and other factors deemed relevant by the Board of Directors.
Currently, we are prohibited by our credit facility from paying cash dividends.

As of December 31, 2002, the latest practicable date for which such
information is available, we had 184 shareholders of record. In addition, based
upon information received as of December 11, 2002, we have approximately 5,916
shareholders who hold their stock in brokerage accounts.

EQUITY COMPENSATION PLAN INFORMATION

(1) All of these options were granted as part of an initial compensation package
to several different officers of the Company upon their hiring. These
options generally vested or were earned over periods ranging from one to
three years, and are exercisable for a period of ten years from the date of
grant or date earned.

8

ITEM 6. SELECTED FINANCIAL DATA.

9

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

In the following discussion and elsewhere in this Annual Report on Form
10-K, we make forward-looking statements regarding future events and our future
performance and results. These and other forward-looking statements are not
guarantees of performance, but rather reflect our current expectations,
estimates and forecasts about the industry and markets in which we operate, and
our assumptions and beliefs based upon information currently available to us.
Forward-looking statements can generally be identified by words such as
"expects," "anticipates," "targets", "plans," "believes," "intends," "projects,"
"estimates," and similar words or expressions. These forward-looking statements
are subject to risks and uncertainties, which are difficult to predict. Thus,
actual results may differ materially and adversely from those expressed in such
statements. Factors that might cause or contribute to such different results
include, but are not limited to, those discussed below in this Report under the
heading "Outlook and Risk Factors," and in our Quarterly Reports on Form 10-Q
and other reports filed by us with the Securities & Exchange Commission.
Consequently, investors are cautioned to read and consider all forward-looking
statements in conjunction with such risk factors and uncertainties. Further, all
forward-looking statements are subject to the provisions of the Private
Securities Litigation Reform Act of 1995.

OVERVIEW

For the year ending October 31, 2002, we reported net income of $.878
million or $.09 per share diluted on revenues of $53.7 million. These results
compare to net income of $3.481 million or $.36 per share diluted on revenues of
$86.1 million in fiscal 2001. These results reflect the difficult market
conditions that began in the first quarter of fiscal 2001 and continued into
fiscal 2002 producing declines of nearly 50% in year-over-year systems revenues.
These market conditions were marked by an unusually high degree of customer
pessimism producing extended buying cycles and project deferments. Beginning in
the second quarter of fiscal 2001 when we found ourselves in a very difficult
economic environment, we suspended most of our planned growth initiatives and
primarily executed a set of short-term, defensive tactics designed to achieve
three goals: remain profitable, generate sufficient cash flows to support our
debt service requirements, and maintain and even enhance our core competencies
that are our primary differentiators in the market. We achieved these goals by
carefully managing our headcount, controlling discretionary expenditures, and
aggressively managing our accounts receivable and inventories. In so doing, we
have been able to retain the employees possessing the key skill sets related to
the design and implementation of complex voice, data and integrated
communications systems. Therefore, our ability to re-institute our growth
initiatives has not been compromised during the recent downturn.

RESULTS OF OPERATIONS

Year ending October 31, 2002 compared to October 31, 2001. Net revenues for
fiscal 2002 were $53.7 million compared to $86.1 million in fiscal 2001, a 37%
decline. Net income for fiscal 2002 was $.878 million compared to $3.481 million
in fiscal 2001, a 75% decline. Discussed below are the major revenue, gross
margin, and operating expense items that affected our financial results during
fiscal 2002.

Systems Sales. Sales of systems and equipment were $27.9 million in fiscal
2002, a 46% decrease from fiscal 2001. This decrease consisted of a decrease in
systems sales to commercial customers of $20.2 million or 48% and a decrease in
systems sales to lodging customers of $4 million or 40%. These decreases reflect
the market conditions present during fiscal 2002 in which customers severely
curtailed capital spending on telecommunications related equipment. These
decisions by customers reflected an unusually high degree of pessimism regarding
the overall economy, as customers perceive the need to use their available
capital cautiously until a clear economic recovery is underway. We believe that
customers have, in most cases, deferred their buying decisions temporarily
rather than canceling planned projects.

A significant portion of our commercial equipment sales continue to be
derived from our "Business Partner" relationship with Avaya, Inc. ("Avaya").
Avaya is pursuing a strategy of moving a greater portion of its revenues through
its dealer sales channel. With our unique, in-house design capabilities and
nation-wide sales and implementation

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capabilities, we are well positioned to take advantage of this strategy and we
carefully cultivate relationships with the Avaya sales team. Under these
arrangements, we take title to the equipment and then sell it directly to the
end-user customer, bearing the collection and warranty risks.

Installation and Service Revenues. Revenues earned from installation and
service related activities were $25.4 million, a 23% decrease from fiscal 2001.
Installation and service revenues are comprised of four primary segments:
Installation, Contracts, MAC, and Consulting. Installation revenues, which are
derived primarily from sales of new systems, decreased 55% in fiscal 2002
compared to the prior year. Contract revenues increased 1% in fiscal 2002.
Contract revenues are derived primarily from our base of lodging customers who
have contracts with us to maintain their phone and call accounting systems.
These revenues are relatively stable from year-to-year and provide us with a key
source of profitability and cash flows. These consistent revenues were the key
to our remaining profitable during the market downturn we have experienced over
the past two years. MAC revenues represent revenues we earn from customers for
moves, adds and changes to their systems, or other services contracted for on a
time and materials basis. A portion of these revenues is affected by general
economic trends as customers defer minor upgrades, expansions, and preventative
maintenance projects during down business cycles. Consequently, MAC revenues
decreased 40% in fiscal 2002. Consulting revenues increased 65% in fiscal 2002
reflecting our increased emphasis on providing professional services to
customers as well as the increase in complex implementations completed.

Gross Margins. Gross margins were 21.6% in fiscal 2002 compared to 27.2% in
fiscal 2001. This decrease consisted of a decrease in gross margins earned on
systems sales to 23.2% in fiscal 2002 compared to 30.3% in fiscal 2001 and a
decrease in gross margins earned on services revenues to 25.9% in fiscal 2002
compared to 28.7% in fiscal 2001.

One of the primary factors affecting our gross margins on systems sales
during fiscal 2002 was an adjustment we made to the reserve for inventory
obsolescence. During the third quarter, we increased the reserve for obsolete
inventory by $775,000. This increase was charged to systems cost of goods sold
in our financial statements. Without this non-recurring adjustment, our gross
margins on systems sales would have been 26%. The remainder of the decline in
gross margins is related to a variety of factors including product mix, customer
mix, and increasing competitive pressures. Our gross margins on sales of systems
is dependent upon a variety of factors: 1) we sell a wide variety of products,
some of which generate gross margins in excess of 50% and some of which earn
gross margins of less than 20%; 2) we sell to several different customer sets,
some of which have pre-negotiated contracts with Avaya which result in lower
margins for us; and 3) as a distributor, we receive various forms of financial
incentives from our suppliers and from Avaya which can vary based on special
promotions, product-types purchased, the end-user customer, seasonality, etc.
All of these factors contribute to the unpredictability of our systems gross
margins. In fiscal 2002, in addition to the adjustment discussed above, we
believe the decline in systems gross margins is also due to competitive
pressures reflecting the poor economic conditions present during the year. We
believe that our gross margins on systems sales will continue to be under
pressure and we expect gross margins on systems sales in fiscal 2003 to be
similar to those earned in fiscal 2002 without the effect of the reserve
adjustment.

The decline in gross margins earned on services revenues is directly related
to the decline in sales of systems, which as discussed above, is the primary
driver of the installation and professional services components of our services
revenues. A significant portion of our services costs of sales are relatively
fixed headcount related expenses such as wages, benefits, payroll taxes, etc.
Therefore, as our installation revenues have declined, our margins on this
component of our services revenues have suffered in direct proportion. Also, we
maintain a staff of professional design and implementation engineers who are
highly trained and uniquely qualified technicians. This group, known as our
Professional Services Organization ("PSO"), is key to our ability to design and
implement complex, voice, data, and converged communications systems. In
addition, we have a group of Microsoft-certified software engineers who
integrate complex software applications and perform operating systems
administration ("AOS") for customers. Throughout the downturn in our business,
we have made careful reductions in our overall headcount to remain profitable.
We have chosen, however, to maintain the PSO and AOS groups to be able to
preserve our long-range strategy. While the AOS group operates at small
operating profit, this choice has had significant, negative implications on our
services margins as most of the PSO's efforts are expended in pre-sales related
design and quote activities. Without sufficient professional services fees
generated by systems sales, the costs of operating the PSO group must be covered
by other more profitable components of the services organization. However, as
one of the primary differentiators between us and our competitors, we are
committed to maintaining the PSO group as long as possible and still remain
profitable.

11

A final component to our gross margins is the margins earned on other
revenues and our corporate cost of goods sold expenses. Other revenues represent
sales and cost of goods sold on equipment outside the Company's normal
provisioning processes. Corporate cost of goods sold represents the cost of the
Company's material logistics and purchasing functions.

Operating Expenses. Operating expenses were $10.5 million or 19.4% of
revenues in fiscal 2002 compared to $16.1 million or 18.7% of revenues in fiscal
2001. The decrease in operating expenses reflects: 1) cost reductions totaling
approximately $2.3 million produced primarily by reduced headcount, salary
reductions for officers and directors, and reduced marketing expenditures to
adjust to our declining revenue base, 2) reduced commission expense of $1.2
million reflecting the decrease in gross profits, 3) a non-recurring adjustment
to decrease the reserve for bad debts of $700,000, and 4) reduced amortization
expense of $1.4 million due to our adoption of Statement of Financial Accounting
Standard No. 142 ("SFAS 142") regarding the accounting for intangible assets and
goodwill. In the third quarter, we determined that our efforts to collect our
accounts receivables had succeeded sufficiently that our allowance for doubtful
accounts was significantly overstated. As a result, we reduced the allowance by
$700,000 in the third quarter. This amount was recorded as a reduction in
selling, general and administrative expenses. The balance of the reserve for bad
debts at October 31, 2002 was $346,000, which we believe is adequate. Since
April of 2001, we have managed our operating expenses primarily by closely
monitoring and managing our headcount and by implementing tight controls over
discretionary expenditures. We believe that our current sales, IT, and
administrative staffing levels are appropriate for our present activity levels
and could support substantially increased revenue levels, thereby significantly
increasing our profitability as revenue increase.

We adopted SFAS 142 as of November 1, 2001. Upon adoption of this standard,
we were required to conduct an initial test of potential impairment of the
recorded value of goodwill on our balance sheet to be followed by annual tests
for impairment. Impairment, as defined by SFAS 142, is the condition that exists
when the carrying amount of goodwill exceeds its implied fair value. We
completed the initial evaluation as of the date of adoption and the first annual
test of impairment was completed as of October 31, 2002. To assist in the
valuations, we hired independent valuation experts who conducted the testing in
accordance with generally accepted appraisal standards and SFAS 142, and
performed such procedures as they considered necessary in their sole discretion.
The valuation experts performed various macro and micro economic analyses,
reviewed our historical financial statements, interviewed various members of our
management, identified comparable companies, and applied a variety of other
valuation techniques. Fair value was determined by applying a weighted average
to various generally accepted valuation methodologies, including discounted
future cash earnings and market valuation (i.e. quoted prices for sales of
similar companies or securities). In both the evaluations conducted to date,
which were performed by separate appraisal firms, the results indicated that the
fair value of our reporting units in which goodwill is associated was higher
than their respective carrying values on our balance sheet. Therefore no
impairment loss was recognized.

Interest and Other Income. Interest expense consists of interest paid or
accrued on our credit facility. Interest expense declined in fiscal 2002 by $1.2
million reflecting lower average debt levels. Also, during fiscal 2002, we
capitalized interest expense of $277,000 related to our Oracle implementation
project compared to $131,000 in fiscal 2001. During fiscal 2002, we reduced our
overall bank debt by $9.6 million through funds generated from operations. Net
other income earned in fiscal 2002 represents the partial reversal of an
acquisition related accrual set up during fiscal 2000 and interest income earned
from sales-type leases. The amount of the non-recurring accrual reversal
recorded to other income was $826,000. We set up this accrual as part of the
purchase of U.S. Technologies, Inc. in November, 1999 to reflect the fact that
we were inheriting an aggressive tax position taken by UST. At the time of the
acquisition, we chose to accrue for the potential losses to be incurred if the
tax position was overturned. In consultation with our financial and tax
advisors, we have monitored this matter since the time of the acquisition and we
believed it was appropriate to reduce the accrual.

Tax Expense. We have recorded a combined federal and state tax provision of
39% in all years presented. This rate reflects the effective federal tax rate
plus the estimated composite state income tax rate.

Operating Margins. Our net income as a percent of revenues in fiscal 2002
was 1.6% compared to 4% last year. This decline primarily reflects lower gross
margins earned in fiscal 2002 as discussed above. We believe that our current
business model and debt levels would support a target operating margin of 8%.
However, we will have to realize sustained growth in our revenues, primarily
through increased sales of systems to commercial customers, and improved gross
margins to reach this target.

12

Year ending October 31, 2001 compared to October 31, 2000. Net revenues for
fiscal 2001 were $86.1 million compared to $102.4 million for fiscal 2000, a 16%
decline. Net income for fiscal 2001 was $3.5 million compared to $6.5 million
for the previous year, a 46% decline. Discussed below are the major revenue,
gross margin, and operating expense items that affected our financial results
during fiscal 2001.

Systems Sales. Sales of systems in fiscal 2001 were $52.028 million compared
to $70.231 million in fiscal 2000. This decline sales of systems consisted of a
decline in sales of systems to commercial customers of 23% and a decline in
sales of systems to lodging customers of 35%.

The decrease in commercial equipment sales is the result of overall market
conditions that deteriorated throughout the year. Beginning late in our first
quarter, order rates for new equipment became erratic. By the end of the second
quarter, a clear decline in order rates was apparent and visibility into the
near-term was murky. That condition existed throughout fiscal 2001, as customers
perceived the need to use their available capital cautiously until a clear
economic recovery was underway.

Sales of communications systems to the lodging industry also declined
reflecting the recession being experienced in the overall U.S. economy and, more
particularly, in the lodging sector. Also, the decline reflects the fact that
many hotels upgraded their communications systems during the Year 2000 ("Y2K")
upgrade cycle and, therefore, did not perceive a need for new systems in fiscal
2001. Finally, the events of September 11th had an immediate and negative impact
on the lodging industry which lasted throughout fiscal 2001.

Installation and Service Revenues. Revenues derived from installation and
service activities increased $1.9 million or 6% to $33.1 million in fiscal 2001.
This increase consisted of sales of professional services from our acquired
networking and professional services organizations, partially offset by
decreased revenues from installation activities due to lower equipment and
systems sales as discussed above. Revenues earned from maintenance contracts
were relatively constant.

Gross Margins. Gross margins earned in 2001 were 27.3% compared to 30% in
fiscal 2000. This decline in gross margins consisted of declines in margins on
each of our major revenue streams. In general, these declines can be attributed
to the overall decline in higher margin large systems projects in both the
commercial and lodging market sectors as economic conditions have resulted in
lower capital spending by customers. The gross margins earned on commercial
equipment sales were 29% in fiscal 2001 compared to 31% for the prior year. The
gross margins earned on lodging systems sales were 35.9% in fiscal 2001 compared
to 37.1% in fiscal 2000. The gross margins earned on installation and service
revenues for fiscal 2001 were 29% compared to 30.7% in the prior year. In the
second quarter of fiscal 2001, we experienced a sudden and significant downturn
in our business, which resulted in a dramatic decline in the margins earned on
installation and service revenues due to their sensitivity to labor costs. In
response, we implemented a workforce reduction. A significant portion of this
reduction was targeted toward the installation and service workforce to restore
the gross margins in this area.

Operating Expenses. Operating expenses, excluding amortization expense, were
16.9% of total revenues in fiscal 2001 compared to 16.5% in the year earlier.
This relatively consistent expense level was maintained through the workforce
and other cost reductions in sales expenses and through efficiencies gained
through continued integration of general and administrative activities of the
acquired companies. Amortization expense reflects primarily the amortization of
goodwill acquired in the four acquisitions completed in the past two fiscal
years.

Interest and Other Income. Interest expense consists of interest paid or
accrued on our credit facility. Interest expense declined in fiscal 2001 by
$259,000 or 11%, primarily reflecting lower average interest rates experienced
during the year. Other income and expense consists primarily of interest income
earned from our sales-type lease receivable portfolio. Interest income declined
by $122,000 or 21% in fiscal 2001 reflecting the maturing of the lease
portfolio.

Tax Expense. We recorded a combined federal and state tax provision of 39%
in all years presented. This rate reflects the effective federal tax rate plus
the estimated composite state income tax rate.

Operating Margins. Net income as a percent of revenues for fiscal 2001 was
4% compared to 6.3% in the prior year. This decline primarily reflects lower
gross margins earned in fiscal 2001 as discussed above and also relatively
constant amortization expense between the two years. While we were able to
adjust most of our cost structure to reflect the reduced revenues earned, the
amortization charge from goodwill is not dependent upon revenues.

13

LIQUIDITY AND CAPITAL RESOURCES

During fiscal 2002, our operations generated $12.9 million in cash flows
from operations. These cash flows included $2.6 million generated from income
and non-cash expenses, $9.3 million from reductions in trade accounts
receivables and sales-type leases, and $1 million in net changes in other
working capital items. These positive cash flows were used to reduce our bank
debt by $9.6 million and for capital expenditures of $2.1 million.

Generating significant positive cash flows has been a key tactic we have
employed during the market downturn of the past two fiscal years. To achieve
success in this area, we have focused great attention on the management of our
accounts receivables and inventories to ensure that we are minimizing our
investments in working capital and maximizing our debt reduction. At October 31,
2002, our total bank debt was $14.9 million and we had $2 million available to
us for working capital needs under our revolving line of credit. As discussed
above, despite the substantially lower revenues and profits experienced in the
past two years, we've been able to continue to generate substantial cash flows
from operations through careful management of working capital. As a result, all
regularly scheduled principal payments have been made.

In late 1999, concurrent with our expansion into the commercial market via
an acquisition strategy, we put in place a credit facility with a syndicate of
banks. Borrowings under this credit facility were supported by forecasted strong
cash flows from our core lodging operations as well as from the acquired
businesses. Consequently, the various financial ratio requirements that were
incorporated into the credit facility as indicators of our financial condition
were based on cash flows generated by earnings. As discussed throughout this
report, since early 2001, our profitability has steadily declined due to
difficult market conditions; we have therefore failed to generate sufficient
cash earnings (as defined in the credit facility) to meet one of the financial
ratio requirements as of October 31, 2002. Our banks have waived this default
and our availability under our working capital revolver has been extended to
March 31, 2003. We will continue to not be in compliance with one or more of the
financial ratio requirements contained in the credit facility until improvements
in our revenues and earnings materialize. We cannot give any assurances that our
banking partners will continue to provide a working capital line of credit under
these circumstances. See "Credit Facility and Working Capital" under "Outlook
and Risk Factors" below for a further discussion of the risks associated with
our credit facility.

Although we typically have access to a variety of capital sources such as
additional bank debt, private placements of subordinated debt, and public or
private sales of additional equity, the availability of those sources at
acceptable prices or at any price in some cases, is currently limited given our
current level of earnings. We continue to be focused on managing our working
capital to maximize cash flows and managing our cost structure to remain
profitable, while holding together the key technical and sales competencies
which we believe as essential to our long-term success.

RECENT ACCOUNTING PRONOUNCEMENTS

In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), which requires that
long-lived assets to be disposed of by sale be measured at the lower of the
carrying amount or fair value less cost to sell, whether reported in continuing
operations or in discontinued operations. SFAS 144 also expands the reporting of
discontinued operations to include components of an entity that have been or
will be disposed of rather than limiting such discontinuance to a segment of a
business. SFAS 144 excludes from the definition of long-lived assets goodwill
and other intangibles that are not amortized in accordance with SFAS 142. SFAS
144 is effective for our 2003 fiscal year. The adoption of SFAS 144 is not
expected to have a material impact on our consolidated results of operations,
financial position or cash flows.

In May 2001, the FASB issued Statement No. 145, which rescinds SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," SFAS No. 44,
"Accounting for Intangible Assets of Motor Carriers," and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements" ("SFAS
145"). SFAS 145 also amends SFAS No. 13, "Accounting for Leases," to eliminate
an inconsistency between the required accounting for sale-leaseback transactions
and the required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. As a result of the
rescission of SFAS 4 and SFAS 64, the criteria in Accounting Principles Board

14

Opinion No. 30 will be used to classify gains and losses from debt
extinguishment. SFAS 145 also amends other existing authoritative pronouncements
to make various technical corrections, clarify meanings, or describe their
applicability under changed conditions. SFAS 145 is effective for our 2003
fiscal year. The adoption of SFAS 145 is not expected to have a material impact
on our consolidated results of operations, financial position or cash flows.

In June 2002, the FASB issued Statement No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146"), which addresses
financial accounting and reporting for costs associated with exit or disposal
activities, and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)" which
previously governed the accounting treatment for restructuring activities. SFAS
146 applies to costs associated with an exit activity that does not involve an
entity newly acquired in a business combination or with a disposal activity
covered by SFAS 144. Those costs include, but are not limited to, the following:
(1) termination benefits provided to current employees that are involuntarily
terminated under the terms of a benefit arrangement that, in substance, is not
an ongoing benefit arrangement or an individual deferred-compensation contract,
(2) costs to terminate a contract that is not a capital lease, and (3) costs to
consolidate facilities or relocate employees. SFAS 146 does not apply to costs
associated with the retirement of long-lived assets covered by SFAS 143. SFAS
146 will be applied prospectively and is effective for exit or disposal
activities initiated after December 31, 2002. Early adoption is permitted.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our financial statements are prepared based on the application of generally
accepted accounting principals in the U.S. These accounting principals require
us to exercise significant judgment about future events that affect the amounts
reported throughout our financial statements. Actual events could unfold quite
differently than our previous judgments had predicted. Therefore the estimates
and assumptions inherent in the financial statements included in this report
could be materially different once those actual events are known. We believe the
following policies may involve a higher degree of judgment and complexity in
their application and represent critical accounting policies used in the
preparation of our financial statements. If different assumptions or estimates
were used, our financial statements could be materially different from those
included in this report.

Revenue Recognition. We recognize revenues from sales of equipment based on
shipment, which is generally easily determined. Revenues from installation and
service activities are recognized based upon completion of the activity and
customer acceptance, which sometimes requires judgment on our part. Revenues
from maintenance contracts are recognized ratably over the term of the
underlying contract.

Collectibility of Accounts Receivable. We must make judgments about the
collectibility of our accounts receivable to be able to present them at their
net realizable value on the balance sheet. To do this, we carefully analyze the
aging of our customer accounts, try to understand why accounts have not been
paid, and review historical bad debt problems. From this analysis, we record an
estimated allowance for receivables which we believe will ultimately become
uncollectible. In the third quarter of fiscal 2002, we reduced our estimated
allowance for bad debts by $700,000 because, in our judgment, our estimate was
significantly overstated. This amount was recorded as a decrease in general and
administrative expenses. We actively manage our accounts receivable to minimize
our credit risks and believe that our current allowance for doubtful accounts is
fairly stated.

Realizability of Inventory Values. We make judgments about the ultimate
realizability of our inventory in order to record our inventory at its lower of
cost or market. These judgments involve reviewing current demand for our
products in comparison to present inventory levels and reviewing inventory costs
compared to current market values. We maintain a significant inventory of used
and refurbished parts for which these assessments require a high degree of
judgment. In the third and fourth quarters of fiscal 2002, we recorded increases
to our provision for obsolete and slow-moving inventories of $775,000 and
$75,000, respectively, reflecting our judgment that our provision was
understated. These amounts were recorded as an increase to systems cost of goods
sold.

Goodwill and Other Long-lived Assets. We have a significant amount of
goodwill on our balance sheet resulting from the acquisitions made in fiscal
2000 and 2001. As required by generally accepted accounting principals, we
conducted the annual goodwill impairment review immediately after the completion
of the fiscal year. We engaged an independent valuation expert to assist us in
this review and they determined that the value of our goodwill was not

15

impaired. The valuation process is very judgmental, principally in the
preparation of financial forecasts, allocations of accounts to reporting
segments, market premiums, control of ownership premiums, and discount rates. We
have recorded property, equipment, and capitalized software costs at historical
cost less accumulated depreciation or amortization. The determination of useful
economic lives and whether or not these assets are impaired involves significant
judgment.

Accruals for Contractual Obligations and Contingent Liabilities. On products
manufactured or installed by us, we have varying degrees of warranty
obligations. We use historical trends and make other judgments to estimate our
liability for such obligations. We also must record estimated liabilities for
many forms of federal, state, and local taxes. Our ultimate liability for these
taxes depends upon a number of factors including the interpretation of statutes
and the mix of our taxable income between higher and lower taxing jurisdictions.

OUTLOOK AND RISK FACTORS

Our business and our prospects are subject to many risks. The following
items are representative of the risks, uncertainties and assumptions that could
affect our business, our future performance and the outcome of the
forward-looking statements we make.

OUR FINANCIAL RESULTS MAY NOT IMPROVE.

We expect our financial results to improve in fiscal 2003 over fiscal 2002
levels. We believe these improvements will be derived from better execution by
our sales staff, continued expansion of Avaya's Business Partner Program, our
improved ability to design and implement complex systems, and modest
improvements in economic conditions. However, our expectations are subject to
risks that these contributing factors may not occur, as well as numerous other
risks which are discussed in more depth below.

OUR BUSINESS IS ADVERSELY AFFECTED BY UNFAVORABLE ECONOMIC CONDITIONS IN THE
UNITED STATES AND, IN PARTICULAR, MARKET CONDITIONS FOR TELECOMMUNICATIONS AND
NETWORKING EQUIPMENT AND SERVICES.

Since April, 2001, capital spending on the equipment we sell has been
increasingly curtailed by the weak U.S. economy. This decline reflects
businesses' concern about their ability to increase their revenues and their
profitability. To counter this concern, these businesses have implemented
significant cost reduction programs and have greatly reduced or even frozen
capital spending projects. If this situation continues, we may not reach the
improved financial results we expect in fiscal 2003. If these conditions worsen,
it is likely that we will have to implement our own cost reduction program to
stay profitable and meet our debt obligations.

OUR BUSINESS IS HEAVILY DEPENDENT UPON AVAYA, OUR PRIMARY SUPPLIER OF
COMMUNICATIONS EQUIPMENT FOR RESALE, AND OUR LONG-TERM STRATEGY AND SUCCESS
DEPENDS UPON AVAYA'S ABILITY TO TRANSITION THEIR PRODUCT LINE TO HIGHER GROWTH
MARKETS IN THE TELECOMMUNICATIONS EQUIPMENT INDUSTRY AND TO COMPETE EFFECTIVELY
IN THESE MARKETS.

Avaya is a market leader in traditional voice communications systems and is
pursuing a strategy to transition their product lines to converged voice and
data network products, customer contact management applications and unified
communications applications, all of which are predicted to be higher growth
markets in the future than traditional voice systems. We believe that this
strategy is sound and have based our long-term strategy and success upon the
future growth of this emerging market. Therefore, we are aggressively educating
our sales and technical staffs as well as our customers regarding these emerging
products and in particular, Avaya products. Our success in this market, however,
depends heavily upon Avaya's ability to develop these new products on a timely
basis and compete effectively with other manufacturers' products in this market.
While our distributor agreement with Avaya is non-exclusive and we can and do
represent other manufacturers' products in the marketplace, we are heavily
invested in Avaya's products and distribution network at the present time.

For the past several quarters, Avaya has suffered declining revenues and has
posted substantial operating losses. To date, Avaya reports that it has
continued to fund the critical research and development efforts that are
essential to competing in the rapidly changing converged voice and data products
market. However, should Avaya's financial condition deteriorate to the point
that it can no longer continue to develop and introduce market-leading
telecommunications products, the impact on our long-term strategy would likely
be very severe.

16

As a result of these factors, we routinely evaluate the product lines and
market position of other major manufacturers. We believe that we could add an
additional manufacturer's product lines if it became prudent to do so in the
future. However, doing so could create a disruption in our business and lower
margins due to reduced purchasing power.

OUR OPERATING RESULTS COULD BE ADVERSELY IMPACTED BY CHANGES IN INCENTIVE
PROGRAMS OFFERED BY AVAYA.

Avaya, like many major manufacturers, provides various financial incentive
programs to support the advertising and sale of its products. We receive
substantial rebates through these common incentive programs to offset both costs
of goods sold and marketing expenses. We also receive commissions from Avaya to
sell their maintenance contracts. These amounts are material to our operating
results. Avaya has changed several of these programs for the coming fiscal year.
As a result of these changes, we believe that we could receive less incentive
compensation in fiscal 2003 than we did in fiscal 2002. The actual magnitude of
these changes on our financial results will be dependent upon the mix of
products sold and our ability to expand our sales and marketing efforts in ways
that are rewarded monetarily by these programs.

IF AVAYA CHOSE TO REDUCE OR ELIMINATE ITS "BUSINESS PARTNER" PROGRAM, OUR
REVENUES WOULD LIKELY BE SIGNIFICANTLY LOWER.

Avaya markets its products to major U.S. companies through its direct sales
force. The remainder of the U.S. market is served primarily through Avaya
dealers, like us. On some of its major accounts, Avaya selects one of its
dealers to assist in the fulfillment of the customer's order through its
"Business Partner" program. We have carefully positioned ourselves as one of a
few favored Business Partners by building our in-house design and implementation
capabilities, providing nationwide implementation services, and through access
to our 24 X 7 service center. We aggressively market these capabilities and
differentiators to the Avaya direct sales force who generally select the
Business Partners for their accounts. Revenues earned from customers in which we
"partner" with Avaya are a significant portion of our overall revenues.
Therefore, our near-term financial results are dependent upon this program
continuing.

THE INTRODUCTION OF NEW PRODUCTS COULD RESULT IN REDUCED REVENUES, REDUCED
GROSS MARGINS, REDUCED CUSTOMER SATISFACTION, AND LONGER COLLECTION PERIODS.

We are selling a variety of new, highly complex, products which incorporate
leading-edge technology, including both hardware and software. The early
versions of these products, which we are selling currently, can contain software
"bugs" and other defects which can cause the products to not function as
intended. We will likely be dependent upon Avaya to fix these problems as they
occur. An inability of Avaya to correct these problems quickly could result in
damage to our reputation, reduced revenues, reduced customer satisfaction, and
delays in payments from customers for products purchased.

WE ARE CONNECTING OUR PRODUCTS TO OUR CUSTOMERS' COMPUTER NETWORKS AND
PROBLEMS WITH THE IMPLEMENTATION OF THESE PRODUCTS COULD CAUSE DISRUPTION TO OUR
CUSTOMERS' ENTIRE OPERATIONS.

Unlike traditional, stand-alone voice systems, our new products typically
are connected to our customers' existing local and wide area networks. While we
believe the risk of our products disrupting other traffic or operations on these
networks is low, these products are new and unforeseen problems may occur which
could cause significant disruption to our customers' operations. These
disruptions, in turn, could result in reduced customer satisfaction, delays in
payments from customers, damage to our reputation, and even reduced revenues.

WE EXPECT OUR GROSS MARGINS TO VARY OVER TIME AND INCREASING COMPETITIVE
PRESSURES MAY ERODE OUR GROSS MARGINS.

Our gross margins are impacted by a variety of factors including: changes in
customer and product mix, increased price competition, and changes in shipment
volume. We expect these factors to cause our gross margins to be inconsistent as
we make quarter-to-quarter and year-to-year comparisons. Also during economic
slumps, price competition usually increases. We believe the market for our
products is going through such a cycle currently and that these pricing
pressures are a factor in the declining margins earned on systems sales. If the
economy stays flat or declines further, it is likely that price will become an
ever-increasing competitive factor and result in lower gross margins on system
sales.

17

IT IS LIKELY THAT WE WILL CONTINUE TO BE IN DEFAULT OF ONE OF OUR FINANCIAL
COVENANTS UNDER OUR CREDIT FACILITY.

As discussed under "Liquidity and Capital Resources" above, our net income
in the fourth quarter of fiscal 2002 was insufficient to meet one of the
financial covenants, the "coverage ratio," contained in our credit facility. We
have made all scheduled principal payments on our debt and are in compliance
with all other covenants as of the end of the year. Our lenders have waived this
default. It is likely that we will not be in compliance with the coverage ratio
until improvements in our revenues and earnings materialize. There can be no
assurance given that our banking partners will waive future defaults and
continue to provide a working capital line of credit under these circumstances.
Furthermore, they could elect to demand immediate payment of our debt. The
occurrence of either of these events would create an immediate, critical
situation for the Company requiring us to forgo long-range strategies and
planning, and demanding that all of our focus and efforts be directed toward
reacting to a challenge of immeasurable proportions.

IF OUR REVENUES AND NET INCOME DO NOT IMPROVE, WE MAY NOT HAVE ADEQUATE OR
COST-EFFECTIVE LIQUIDITY OR CAPITAL RESOURCES TO FINANCE OUR BUSINESS.

Our revolving line of credit expires on March 31, 2003. It is likely that we
will have to show continued improvements in operating results to extend the
maturity of the line of credit. In addition, in fiscal 2002, we were able to
reduce various working capital accounts to produce significant cash flows from
operations, which was used mostly to reduce our debt. Most significantly, we
reduced trade receivables, inventories, and sales-type lease receivables through
aggressive management of these accounts. We will continue our close monitoring
of these balances, but we will not be able to generate as much cash from working
capital in fiscal 2003 as we did in fiscal 2002. Should our financial results
not improve and if we are not able to extend our revolving line of credit, our
options for financing our business would be very limited in the current economic
conditions. In such circumstances, we would likely pursue more drastic tactics
than previously employed. Such actions might include selling equity at a
substantial discount to current market prices, delaying payments to vendors, and
laying off key technical and managerial personnel.

IF OUR DEALER AGREEMENTS WITH THE ORIGINAL EQUIPMENT MANUFACTURERS ARE
TERMINATED PREMATURELY OR UNEXPECTEDLY, OUR BUSINESS COULD BE ADVERSELY
AFFECTED.

We sell communications systems under dealer agreements with Avaya, Inc.
(formerly Lucent Technologies) and Hitachi Telecom, (USA), Inc. We are a major
dealer for both manufacturers and consider our relationship with both to be
good. Nevertheless, if our strategic relationship with Avaya, and to a lesser
degree with Hitachi, were to be terminated prematurely or unexpectedly, our
operating results would be adversely impacted. Furthermore, in both the separate
agreements that we have with Avaya for distribution of products to the
commercial and lodging markets and the agreement with Hitachi, we must meet
certain volume commitments to earn the pricing structure provided in the dealer
agreements. In addition, our relationship with Avaya is administered through a
joint agreement between us, Avaya, and one of Avaya's "super distributors". We
receive specified pricing through our agreement with this "super distributor"
which is based on certain volume requirements. If we fail to meet any of these
requirements, future profit margins could suffer.

WE ARE DEPENDENT UPON A FEW SUPPLIERS.

Our growth and ability to meet customer demand also depends in part on our
capability to obtain timely deliveries of parts from suppliers. Our agreement
with Avaya specifies the use of the "super distributor" from whom we purchase
most Avaya products. While this supplier has performed effectively and has been
relatively flexible to date, there is no assurance that the present general
economic conditions or other specific conditions unique to the supplier will not
cause an interruption in the supply of products in the future.

THE SUCCESS OF OUR BUSINESS DEPENDS SIGNIFICANTLY UPON OUR ABILITY TO RETAIN
AND RECRUIT HIGHLY SKILLED PERSONNEL.

Our ability to attract, train, motivate and retain highly skilled and
qualified technical and sales personnel is critical to our success. Competition
for such employees in the rapidly changing telecommunications industry is
typically intense, although the current economic conditions have temporarily
eased some of this pressure. As we have transformed our company into an
integrated communications solutions provider, we have invested heavily the in
the hiring and training of personnel to sell and service our new products and
service offerings. If we're unable to retain our skilled employees or to

18

hire additional qualified personnel as needed, it could adversely impact our
ability to implement our strategies efficiently and effectively.

WE ARE FACED WITH INTENSE COMPETITION AND RAPIDLY CHANGING TECHNOLOGIES IN
THE INDUSTRY AND MARKET IN WHICH WE OPERATE.

The market for our products and services is highly competitive and subject
to rapidly changing technologies. As the industry itself evolves and new
technologies and products are introduced into the marketplace, new participants
enter the market and existing competitors seek to strengthen their positions and
expand their product/service offerings. There has been a trend toward industry
consolidation, which can lead to the creation of stronger competitors who may be
better able to compete as a sole-source vendor for customers. While we believe
that through the expansion and transformation of the last few years, we are
well-positioned to compete effectively in the marketplace, our failure to
maintain or enhance this position could adversely affect our business and
results of operations.

IF ONE OR MORE OF OUR SIGNIFICANT LODGING CUSTOMERS ARE UNABLE TO SURVIVE
THE RECESSION WITHIN THE LODGING INDUSTRY, OUR FINANCIAL RESULTS MAY BE
NEGATIVELY IMPACTED. ALSO, WE ARE EXPOSED TO THE CREDIT RISK OF SOME OF OUR
CUSTOMERS AND TO CREDIT EXPOSURES IN THE WEAKENED LODGING MARKET IN PARTICULAR.

As a result of the overall downturn in the economy in general and the
recession in the lodging industry in particular as a result of the September
11th attacks, there continues to be uncertainty to the long-term health of many
of our customers. Through expansion into the general commercial market, we have
divested the company from our previous dependence on this sector. However, the
lodging market remains an important part of our business and the financial
failure of one or more of our significant lodging customers could have a
material, negative impact on our financial results. Most of our sales are on an
"open credit" basis, with payment terms which can range to 30 days. Because of
the current economic slowdown, our exposure to credit risks, especially among
our lodging customers, has necessarily increased.

WE MIGHT HAVE TO RECORD A SIGNIFICANT GOODWILL IMPAIRMENT LOSS IN THE EVENT
OUR BUSINESS CONTINUES TO DECLINE.

Under SFAS 142, the new goodwill accounting rule, we are required to
evaluate the fair value of each of our reporting units annually and determine if
the fair value is less than the carrying value of those reporting units, and if
so, an impairment loss is recorded in the income statement. The determination of
fair value is a highly subjective exercise and can produce very different
results based on the assumptions used and methodologies employed. It is likely
that if our financial results continue to decline and if macroeconomic
conditions continue to erode, we would have to record a non-cash impairment loss
in our operating statement. The amount of such impairment is impossible to
predict, but would likely be very material to our operating results and could
represent and significant portion of our shareholders' equity.

THE SUCCESSFUL COMPLETION OF THE UPGRADE TO OUR TECHNOLOGY INFRASTRUCTURE
AND INFORMATION SYSTEMS IS CRITICAL TO OUR ABILITY TO EFFECTIVELY AND
EFFICIENTLY OPERATE OUR BUSINESS IN THE FUTURE. ALSO, IMPLEMENTATION OF THE
SYSTEM WILL SIGNIFICANTLY INCREASE OUR DEPRECIATION EXPENSE.

Our success in navigating the current market will depend heavily upon our
ability to assemble the necessary information to make informed decisions and
implement those decisions quickly and effectively. For the past 18 months, we
have been working on a major upgrade to our technology infrastructure and
information systems. This upgrade will result in a consolidation from four
critical legacy systems to one. Due to constraints that we have imposed on
capital spending, we have purposely slowed down the development of this system.
Furthermore, at our current revenue and activity levels, conversion to this new
system is not critical to our near-term success. However, we believe it is
prudent to proceed with the conversion while our revenues are at these lower
levels in anticipation of future growth. While we are taking great care to
properly plan this implementation and to test the solution fully prior to the
conversion, there can be no guarantees given that the conversion will not
disrupt our operations. In addition, at the time we place the new information
system into service, we will begin depreciating our investment in the system.
This depreciation will result in a pre-tax, non-cash charge to our earnings of
approximately $210,000 per quarter based on the $5.9 million currently invested
in this project.

19

OUR TARGETED OPERATING MARGINS OF 8% MAY NOT BE ACHIEVABLE.

We believe that our current business model and debt levels would support an
operating margin of 8%. This target assumes that we can 1) generate
significantly higher revenues; 2) earn higher gross margins; and 3) operate our
material logistics and general and administrative functions at about the same
levels as we currently do. These assumptions are not tested through past
experience operating in the commercial sector of our market and may not be
achievable.

OUR STOCK PRICE MAY CONTINUE TO BE VOLATILE.

Historically, our stock has not been widely followed by investment analysts
and has been subject to price and volume trading volatility. This volatility is
sometimes tied to overall market conditions and may or may not reflect our
financial performance. Due to the current negative perception of technology
related stocks, our declining revenues, and the relatively small size of our
market capitalization, we have seen interest from the financial community
decline further during fiscal 2002. As a result, there is increased risk that
our stock could experience even greater volatility from momentum trading by only
a few stock market participants.

OUR BUSINESS IS SUBJECT TO THE RISKS OF TORNADOES AND OTHER NATURAL
CATASTROPHIC EVENTS AND TO INTERRUPTIONS CAUSED BY MANMADE PROBLEMS SUCH AS
COMPUTER VIRUSES OR TERRORISM.

Our corporate headquarters and NSC is located in northwestern Oklahoma, a
region known to be part of "tornado alley". A significant natural disaster, such
as a tornado, could have a material adverse impact on our business, operating
results, and financial condition. In addition, despite our implementation of
network security measures, our servers are vulnerable to computer viruses,
break-ins, and similar disruptions from unauthorized tampering with our computer
systems. Any such event could also cause a material adverse impact on our
business, operating results, and financial condition. In addition, acts of war
or acts of terrorism could have a material adverse impact on our business,
operating results, and financial condition. The continued threat of terrorism
and heightened security and military response to this threat, or any future acts
of terrorism, may cause further disruption to our economy and create further
uncertainties. To the extent that such disruptions or uncertainties result in
delays or cancellations of customer orders, or the manufacture or shipment of
our products, our business, operating results, and financial condition could be
materially and adversely affected.

WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS AND LITIGATION, WHICH COULD CAUSE
US TO INCUR SIGNIFICANT EXPENSES OR PREVENT US FROM SELLING CERTAIN PRODUCTS AND
SERVICES.

Third parties, including customers, may assert claims or initiate legal
action against our manufacturers, suppliers, customers or us, alleging that the
products we sell infringe on another's proprietary rights. Regardless of the
merit of a claim, these types of claims can be time-consuming, result in costly
litigation, or require us to enter into costly license agreements. In some
instances, a successful claim could prevent us from selling a particular product
or service. We have not conducted patent searches on the third party products we
distribute, to independently determine whether they infringe upon another's
proprietary rights; nor would it be practical or cost effective for us to do so.
Rather, we rely on infringement indemnities given to us by the manufacturers of
the equipment we distribute. However, because these indemnities are not absolute
and in some instances have limits of coverage, no assurance can be given that in
the event of an infringement claim, our indemnification by the equipment
manufacturer will be adequate to hold us harmless or that we will even be
entitled to indemnification by the equipment manufacturer.

If any infringement or other intellectual property claim is brought against
us and is successful, whether it is based upon a third party manufacturer's
equipment that we distribute, or upon our own proprietary products, our
business, operating results and financial condition could be materially and
adversely affected.

WE ARE SUBJECT TO A VARIETY OF OTHER GENERAL RISKS AND UNCERTAINTIES
INHERENT IN DOING BUSINESS.

In addition to the specific factors discussed above, we are subject to
certain risks that are inherent in doing business, such as general industry and
market conditions and growth rates, general economic and political conditions,
costs of obtaining insurance, unexpected death of key employees, changes in
employment laws and regulations, and other events that can impact revenues and
the cost of doing business.

20

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Market risks relating to our operations result primarily from changes in
interest rates. We did not use derivative financial instruments for speculative
or trading purposes during the 2002 fiscal year.

Interest Rate Risk. We are subject to the risk of fluctuation in interest
rates in the normal course of business due to our utilization of variable debt.
Our credit facility bears interest at a floating rate at either the London
Interbank Offered Rate (1.79% at October 31, 2002) plus 3.75% or the bank's
prime rate (4.75% at October 31, 2002). In an effort to manage the risk
associated with variable interest rates, in November 2001, we entered, into
interest rate swaps to hedge the variability of cash flows associated with
variable rate interest payments, on amortizing notional amounts of $10.0
million. At October 31, 2002, the notional amount included under the interest
rate swap was $8.24 million. The "pay fixed rates" under the swap agreements are
3.32%. The "receive floating rates" for the swap agreements are "1-month" LIBOR,
resetting monthly. The interest rate swaps expire in November 2004. Variable
rate debt outstanding at October 31, 2002, net of the swap agreements was $6.6
million. A hypothetical 10% increase in interest rates would not have a material
impact on our financial position or cash flows.

21

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

INDEX TO FINANCIAL STATEMENTS OF THE COMPANY PAGE
----

Reports of Independent Public Accountants F-1

Consolidated Financial Statements

Consolidated Balance Sheets - October 31, 2002 and 2001 F-3

Consolidated Statements of Operations - For
the Years Ended October 31, 2002, 2001 and 2000 F-4

Consolidated Statements of Shareholders' Equity -
For the Years Ended October 31, 2002, 2001 and 2000 F-5

Consolidated Statements of Cash Flows - For the
Years Ended October 31, 2002, 2001 and 2000 F-6

Notes to Consolidated Financial Statements F-7

22

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Board of Directors
Xeta Technologies, Inc.:

We have audited the accompanying consolidated balance sheet of Xeta
Technologies, Inc. (an Oklahoma corporation) and subsidiaries as of October 31,
2002 and the related consolidated statement of operations, comprehensive income,
shareholders' equity and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.

We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Xeta Technologies,
Inc. and subsidiaries as of October 31, 2002, and the results of their
operations and their cash flows for the year then ended in conformity with
accounting principles generally accepted in the United States of America.

As explained in Note 1 to the consolidated financial statements, effective
November 1, 2001, the Company changed its method of accounting for goodwill and
other intangible assets to adopt the requirements of Statement of Financial
Accounting Standards No. 142, Goodwill and Other Intangible Assets.

GRANT THORNTON LLP

Tulsa, Oklahoma
December 6, 2002

F-1

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

TO XETA TECHNOLOGIES, INC.:

We have audited the accompanying consolidated balance sheets of Xeta
Technolgies, Inc. (formerly Xeta Corporation, an Oklahoma corporation) and
subsidiaries as of October 31, 2001 and 2000, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
three years in the period ended October 31, 2001. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Xeta
Technologies, Inc. and subsidiaries as of October 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in
the period ended October 31, 2001, in conformity with accounting principles
generally accepted in the United States.

ARTHUR ANDERSEN LLP

Tulsa, Oklahoma
December 11, 2001

THE REPORT OF ARTHUR ANDERSEN, LLP SHOWN ABOVE IS A COPY OF A PREVIOUSLY ISSUED
REPORT; ARTHUR ANDERSEN, LLP HAS NOT REISSUED THIS REPORT.

F-2

XETA TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS

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

F-3

XETA TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

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

F-4

XETA TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

F-5

XETA TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

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

F-6

XETA TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE YEARS ENDED OCTOBER 31, 2002

1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Business

XETA Technologies, Inc. (XETA or the Company) is a leading provider of
integrated communications solutions including: traditional voice and data
products as well as VoIP, wireless, messaging, and contact center applications.
The Company specializes in providing these solutions to multi-location mid-size
and large companies as well as the lodging industry throughout the United
States. In addition to selling these products to customers, the Company also
installs and maintains these systems, using their nation-wide network of
Company-employed design engineers and service technicians as well as its contact
center located at its corporate headquarters in Broken Arrow, OK. These products
are manufactured by a variety of manufacturers including Avaya, Cisco, Hitachi,
and Hewlett Packard. In addition, the Company provides XETA-manufactured call
accounting systems to the hospitality industry. XETA is an Oklahoma corporation.

U.S. Technologies Systems, Inc. (USTI) is a wholly-owned subsidiary of XETA and
was purchased on November 30, 1999 as part of the Company's expansion into the
commercial market. Xetacom, Inc. (Xetacom), is a wholly-owned, but dormant,
subsidiary of the Company.

Cash and Cash Equivalents

Cash and cash equivalents at October 31, 2002, consist of money market accounts
and commercial bank accounts.

Revenue Recognition

Equipment revenues from systems sales are recognized upon shipment of the
system. Installation and service revenues are recognized upon the completion of
the installation or service assignment. Service revenues earned from contractual
arrangements are recognized monthly over the life of the related service
agreement on a straight-line basis. The Company recognizes revenue from
sales-type leases as discussed below under the caption "Lease Accounting."

Accounting for Manufacturer Incentives

The Company receives various forms of incentive payments and rebates from the
manufacturers of the products it sells. Rebates directly related to specific
customer sales are recorded as a reduction in the cost of goods sold on those
systems sales. Incentive payments which are based on purchasing certain product
lines exclusively from one manufacturer ('loyalty rebates") are also recorded as
a reduction in systems cost of goods sold. Rebates designed to offset marketing
expenses and other growth initiatives supported by the manufacturer are recorded
as contra expense to the related expenditure. All incentive payments are
recorded when earned under the specific rules of the incentive plan.

Lease Accounting

A small portion (less than 5%) of the Company's revenues has been generated
using sales-type leases. The Company sells some of its call accounting systems
to the lodging industry under sales-type leases to be paid over three, four and
five-year periods. Because the present value (computed at the rate implicit in
the lease) of the minimum payments under these sales-type leases equals or
exceeds 90 percent of the fair market value of the systems and/or the length of
the lease exceeds 75

F-7

percent of the estimated economic life of the equipment, the Company recognizes
the net effect of these transactions as a sale, as required by accounting
principles generally accepted in the United States of America.

Interest and other income is primarily the recognition of interest income on the
Company's sales-type lease receivables and income earned on short-term cash
investments. Interest income from a sales-type lease represents that portion of
the aggregate payments to be received over the life of the lease, which exceeds
the present value of such payments using a discount factor equal to the rate
implicit in the underlying leases.

Property, Plant and Equipment

The Company capitalizes the cost of all significant property, plant and
equipment additions including equipment manufactured by the Company and
installed at customer locations under certain systems service agreements.
Depreciation is computed over the estimated useful life of the asset or the
terms of the lease for leasehold improvements, whichever is shorter, on a
straight-line basis. When assets are retired or sold, the cost of the assets and
the related accumulated depreciation is removed from the accounts and any
resulting gain or loss is included in income. Maintenance and repair costs are
expensed as incurred. Interest costs related to an investment in long-lived
assets are capitalized as part of the cost of the asset. The Company capitalized
$277,000 and $131,000 in interest costs in fiscal years 2002 and 2001,
respectively.

Research and Development and Capitalization of Software Production Costs

In the past, the Company developed proprietary telecommunications products
related to the lodging industry. The Company capitalized software production
costs related to a product upon the establishment of technological feasibility
as defined by accounting principles generally accepted in the United States of
America. Amortization is provided on a product-by-product basis based upon the
estimated useful life of the software (generally seven years). All other
research and development costs (including those related to software for which
technological feasibility has not been established) are expensed as incurred.
Since the Company's expansion into the general commercial market in fiscal 1999,
the Company has ceased research and development of new products for the lodging
market.

Stock Based Compensation Plans

The Company accounts for its stock-based awards granted to officers, directors
and key employees using APB Opinion No. 25, Accounting for Stock Issued to
Employees. Options under these plans are granted at fair market value on the
date of grant and thus no compensation cost has been recorded in the financial
statements. Accordingly, the Company follows fixed plan accounting. Xeta applies
the disclosure only provisions of Statement of Financial Accounting Standards
No. 123, Accounting for Stock-based Compensation (SFAS 123).

Income Taxes

Several items of income and expense, including certain sales revenues under
sales-type leases, are included in the financial statements in different years
than they are included in the income tax returns. Deferred income taxes are
recorded for the tax effect of these differences.

Warranty and Unearned Revenue

The Company typically provides a one-year warranty from the date of installation
of its systems. The Company defers a portion of each system sale to be
recognized as service revenue during the warranty period. The amount deferred is
generally equal to the sales price of a maintenance contract for the type of
system under warranty and the length of the warranty period.

F-8

The Company also records deposits received on sales orders and prepayments for
maintenance contracts as unearned revenues.

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 disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

Segment Information

The Company has three reportable segments: commercial system sales, lodging
system sales and installation and service. The Company defines commercial system
sales as sales to the non-lodging industry. Installation and service revenues
represent revenues earned from installing and maintaining systems for customers
in both the commercial and lodging segments.

The reporting segments follow the same accounting policies used for the
Company's consolidated financial statements and described in the summary of
significant accounting policies. Company management evaluates a segment's
performance based upon gross margins. Assets are not allocated to the segments.
Sales to customers located outside of the United States are immaterial.

The following is tabulation of business segment information for 2002, 2001 and
2000. Segment information for 2001 and 2000 has been restated to conform to the
current presentation.

Recently Issued Accounting Pronouncements

The Company elected to early adopt Financial Accounting Statement No. 142,
"Goodwill and Other Intangible Assets" on November 1, 2001. Under SFAS 142,
goodwill recorded as a part of a business combination is no longer amortized,
but instead will be subject to at least an annual assessment for impairment by
applying a fair-value-based test. Also, SFAS 142 requires that in future
business combinations, all acquired intangible assets should be separately
stated on the balance sheet if the benefit of the intangible asset is obtained
through contractual or other legal rights, or if the intangible asset can be
sold, transferred, licensed, rented, or exchanged, regardless of the acquirer's
intent to do so. These intangible assets will then be amortized over their
useful lives, resulting in amortization expense. The new rule does not require
that companies evaluate existing goodwill on their books for

F-9

allocation into separately recognized intangible assets. However, companies, at
the time of adoption of the new standard, are required to conduct an initial
fair-value-based goodwill impairment test to determine if the carrying value of
the goodwill on their balance sheet is impaired. To conduct this initial
fair-value assessment, the Company engaged an independent valuation expert. The
results of that assessment indicated that no impairment existed in the value of
recorded goodwill on the Company's books as of November 1, 2001.

In accordance with the standard, the Company conducted its annual appraisal of
goodwill shortly after the close of its fiscal year on October 31, 2002. An
independent valuation expert was engaged to assist in this valuation as well.
The valuation expert conducted their testing using generally accepted appraisal
standards and SFAS 142 and performed such procedures as they considered, in
their sole discretion, as necessary. The valuation expert performed various
macro and micro economic analysis, reviewed the Company's historical financial
statements, interviewed various members of management, identified comparable
companies, and applied a variety of other valuation methodologies including
discounted future cash earnings and market valuation (i.e. quoted prices for
sales of similar companies or securities). The results indicated that the fair
value of the Company's reporting units in which goodwill is associated was
higher than their respective carrying values on the balance sheet. Therefore no
impairment loss was recognized.

Based on the recorded amounts of goodwill on the Company's balance sheet,
approximately $1.4 million in goodwill amortization would have been recorded for
the year ending October 31, 2002 had the Company not early adopted the new
standard.

The goodwill for tax purposes associated with the acquisition of UST exceeded
the goodwill recorded on the financial statements by $1,462,000. The Company is
reducing the goodwill recorded on the financial statements for the tax effect
and the "tax-on-tax" effect of the $1,462,000 basis difference over a 15-year
period. Accrued income taxes and deferred tax liabilities are being reduced as
well. As of October 31, 2002, the Company reduced goodwill by $162,095 for the
impact of the basis difference.

Reclassifications

Certain reclassifications have been made to the 2001 and 2000 income statements
to conform with the 2002 presentation. These reclassifications had no effect on
net income or retained earnings.

Change in Par Value and Stock Split

On June 26, 2000, the Company reduced the par value of its common stock to $.001
and increased the authorized shares to 50 million.

The Company declared a two-for-one stock split which was effective on July 17,
2000. All share and per share amounts contained in these financial statements
and footnotes have been restated to reflect the stock split.

2. ACQUISITIONS:

The accompanying balance sheet and statements of operations represent the
financial condition and results of operations of the Company after consolidating
the operating results of each of the transactions discussed below since the date
of acquisition.

On November 1, 2000, the Company acquired substantially all of the assets of Pro
Networks Corporation (Pro Net) and Key Metrology, Inc. (KMI) in separate
transactions. Both of these acquisitions were made to fulfill part of the
Company's growth strategy to provide complex applications and professional
services in addition to its traditional voice products and services. Both of
these transactions were accounted for using the purchase method of accounting.
The combined purchase price was $5.6 million resulting in approximately $5.3
million in goodwill. Prior to November 1, 2001, the Company amortized goodwill
over 20 years unless circumstances indicated a shorter life was

F-10

appropriate. Both transactions contained earn-out provisions, which could have
resulted in additional purchase price being paid to the sellers; however,
management anticipates that the provisions will expire unearned.

On February 29, 2000, the Company acquired substantially all of the properties
and assets (the Assets) of Advanced Communications Technologies, Inc. (ACT)
pursuant to the terms of an Asset Purchase Agreement (the Purchase Agreement)
dated February 22, 2000, entered into among the Company and ACT, its parent
corporation, Noram Telecommunications, Inc., an Oregon corporation, and its
parent corporation, Quanta Services, Inc., a Delaware corporation. The Company
also assumed all of ACT's existing liabilities as disclosed on ACT's balance
sheet with the exception of inter-company liabilities and income taxes payable
by ACT. The purchase price of the Assets was $3 million which included the book
value (as defined in the Purchase Agreement) of ACT plus $250,000. In
conjunction with the purchase, the Company recorded $874,000 of goodwill.

On November 30, 1999, the Company acquired USTI, a Missouri Subchapter S
corporation. The Company purchased all of the outstanding common stock of USTI
for $26 million in cash, inclusive of $3 million in hold-backs, plus 300,000
shares of XETA common stock held in treasury with a market value of $3.3 million
on the date of issuance. The transaction was accounted for using the purchase
method of accounting and goodwill of $22,000,000 was added to the Company's
balance sheet.

The unaudited proforma information presented below consists of statement of
operations data as presented if USTI's results had been consolidated from the
first day of the period reported.

3. ACCOUNTS RECEIVABLE:

Trade accounts receivable consist of the following at October 31:

Adjustments to the reserve for doubtful accounts consist of the following at
October 31:

F-11

4. INVENTORIES:

Inventories are stated at the lower of cost (first-in, first-out or average) or
market and consist of the following components at October 31:

Adjustments to the reserve for excess and obsolete inventories consist of the
following:

5. PROPERTY, PLANT AND EQUIPMENT:

Property, plant and equipment consist of the following at October 31:

6. ACCRUED LIABILITIES:

Accrued liabilities consist of the following at October 31:

F-12

7. UNEARNED REVENUE:

Unearned revenue consists of the following at October 31:

8. INCOME TAXES:

Income tax expense is based on pretax financial accounting income. Deferred
income taxes are computed using the asset-liability method in accordance with
SFAS No. 109, "Accounting for Income Taxes" and are provided on all temporary
differences between the financial basis and the tax basis of the Company's
assets and liabilities.

The income tax provision for the years ending October 31, 2002, 2001 and 2000,
consists of the following:

The reconciliation of the statutory income tax rate to the effective income tax
rate is as follows:

The tax effect of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities as of October 31 are
presented below:

F-13

9. CREDIT AGREEMENTS:

Financing for the acquisitions described in Note 2 was provided through an
amended and restated credit facility with a bank. The credit facility consists
of term loans that were used to finance most of the cash purchase price for each
of the acquisitions and a revolving line of credit. On October 31, 2001, the
credit facility was restructured to reflect the Company's current earnings
levels, expand the revolving line of credit, and to more fully collateralize the
outstanding debt. The credit facility was amended three times during fiscal 2002
to reflect changes in the Company's financial condition and to reduce the
availability under the revolving line of credit to $2 million. At October 31,
2002, long-term debt consisted of the following:

Maturities of long-term debt for each of the years ended October 31, are as
follows:

2003 $ 3,288,337
2004 11,565,012

Interest on all outstanding debt under the credit facility accrues at either a)
the London Interbank Offered Rate (which was 1.79% at October 31, 2002) plus
3.75% or b) the bank's prime rate (which was 4.75% at October 31, 2002) plus 1%.
The credit facility requires, among other things, that the Company maintain a
minimum net worth, working capital and debt service coverage ratio and limits
capital expenditures. At October 31, 2002, the Company was either in compliance
with the covenants of the credit facility or had received the appropriate
waivers from its bank.

Based on the borrowing rates currently available to the Company for bank loans
with similar terms and average maturities, the fair value of the long-term debt
approximates the carrying value.

10. STOCK OPTIONS:

During fiscal 2000, the Company adopted a new stock option plan (2000 Plan) for
officers, directors and key employees. The 2000 Plan replaces the previous 1988
Plan, which had expired. Under the 2000 Plan, the Board of Directors or a
committee thereof determine the option price, not to be less than fair market
value at the date of grant, the date of the grant, number of options granted,
and the vesting period. Although there are exceptions, generally options that
have been granted under the 2000 Plan expire 10 years from the date of grant,
have 3-year cliff-vesting and are incentive stock

F-14

options as defined under the applicable IRS tax rules. Options granted under the
previous 1988 Plan generally vested 33 1/3% per year after a 1-year waiting
period.

At October 31, 2002 and 2001, options to purchase 181,007 and 170,840 shares,
respectively, are exercisable.

The Company has also granted options outside the Plan to certain officers and
directors. These options generally expire ten years from the date of grant and
are exercisable over the period stated in each option. The table below presents
information regarding options granted outside the Plan.

The following is a summary of stock options outstanding as of October 31, 2002:

F-15

Accounting for stock options issued to employees is governed by SFAS 123,
"Accounting for Stock Based Compensation." Generally, SFAS 123 requires
companies to record in their financial statements the compensation expense, if
any, related to stock options issued to employees. Under an alternative
accounting method adopted by the Company, SFAS 123 allows the Company to only
disclose the impact of issued stock options as if the expense had been recorded
in the financial statements. Had the Company recorded compensation expense
related to its stock option plans in accordance with SFAS 123, the Company's net
income and earnings per share would have been reduced to the pro forma amounts
indicated below:

The fair value of the options granted was estimated at the date of grant using
the Modified Black-Scholes European pricing model with the following
assumptions: risk free interest rate (4.46% to 5.78%), dividend yield (0.00%),
expected volatility (80.50% to 86.31%), and expected life (6 years).

11. EARNINGS PER SHARE:

All basic earnings per common share were computed by dividing net income by the
weighted average number of shares of common stock outstanding during the
reporting period. A reconciliation of net income and weighted average shares
used in computing basic and diluted earnings per share is as follows:

F-16

12. COMMITMENTS

Minimum future annual payments to be received under various leases are as
follows:

13. MAJOR CUSTOMERS AND CONCENTRATIONS OF CREDIT RISK:

During fiscal 2002, 2001 and 2000, no single customer represented 10 percent or
more of revenues.

The Company extends credit to its customers in the normal course of business,
including under its sales-type lease program. As a result, the Company is
subject to changes in the economic and regulatory environments or other
conditions, which, in turn, may impact the Company's overall credit risk.
However, the Company sells to a wide variety of customers, and except for its
hospitality customers, does not focus its sales and marketing efforts on any
particular industry. Management considers the Company's credit risk to be
satisfactorily diversified and believes that the allowance for doubtful accounts
is adequate to absorb estimated losses at October 31, 2002.

14. EMPLOYMENT AGREEMENTS:

The Company has two incentive compensation plans: one for sales professionals
and one for all other employees. The Employee Bonus Plan ("EBP") provides an
annual incentive compensation opportunity for senior executives and other
employees designated by senior management and the Board of Directors as key
employees. The purpose of the EBP is to provide an incentive for senior
executives to reach Company-wide targeted financial objectives and to reward key
employees for leadership and excellent performance. Those targeted results were
not fully achieved in fiscal 2002, 2001 or 2000; however, the Company elected to
pay partial bonuses of approximately $180,000, $157,500 and 120,000,
respectively.

F-17

15. CONTINGENCIES:

Litigation

Since 1994, we have been monitoring numerous patent infringement lawsuits filed
by PHONOMETRICS, INC., a Florida company, against certain telecommunications
equipment manufacturers and hotels who use such equipment. While we have not
been named as a defendant in any of these cases, several of our call accounting
customers are named defendants. These customers have notified us that they will
seek indemnification under the terms of their contracts with us. However,
because there are other equipment vendors implicated along with us in the cases
filed against our customers, we have never assumed the outright defense of our
customers in any of these actions.

All of the cases filed by Phonometrics against our customers were originally
filed in, or transferred to, the United States District Court for the Southern
District of Florida. In October 1998, the Florida Court dismissed all of the
cases filed against the hotels for failure to state a claim, relying on the
precedent established in Phonometrics' unsuccessful patent infringement lawsuit
against Northern Telecom. Phonometrics appealed the Florida court's order and
the United States Court of Appeals for the Federal Circuit reversed the District
Court's dismissal of the cases, but did so solely upon the basis of a procedural
matter. The Appeals Court made no ruling with respect to the merits of
Phonometrics' case and remanded the cases back to the Florida court for further
proceedings. These cases were reopened in April 2000. In November 2001 several
defendant hotels filed motions for summary judgment. These motions were granted
in favor of the defendant hotels and the cases were closed after final judgment
was issued against Phonometrics in April 2002. Subsequently, Phonometrics filed
an appeal of the judgment, which is currently pending. In August 2002, the
defendant hotels were awarded attorneys' fees and costs. Thereafter,
Phonometrics filed an appeal of this award as well, which is also currently
pending. We will continue to monitor proceedings in these actions.

16. RETIREMENT PLAN:

The Company has a 401(k) retirement plan (Plan). In addition to employee
contributions, the Company makes discretionary matching and profit sharing
contributions to the Plan based on percentages set by the Board of Directors.
Contributions made by the Company to the Plan were approximately $482,000,
$534,000 and $355,000 for the years ending October 31, 2002, 2001 and 2000,
respectively.

F-18

17. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED):

The following quarterly financial data has been prepared from the financial
records of the Company without an audit, and reflects all adjustments which, in
the opinion of management, were of a normal, recurring nature and necessary for
a fair presentation of the results of operations for the interim periods
presented.

F-19

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

We dismissed Arthur Andersen LLP ("Andersen") as our independent auditors on
August 9, 2002 upon the recommendation of our Audit Committee and with the
approval of our Board of Directors. Also on August 9, 2002, we engaged Grant
Thornton LLP ("GT") as our new independent auditors upon the recommendation of
our Audit Committee and with the approval of our Board of Directors.

The reports of Andersen on our consolidated financial statements for each of
our fiscal years ended October 31, 2000 and October 31, 2001 did not contain an
adverse opinion or disclaimer of opinion, nor were they qualified or modified as
to uncertainty, audit scope or accounting principles.

During the fiscal years ended October 31, 2000 and 2001 and through the
interim period from November 1, 2001 through August 9, 2002, (i) there were no
disagreements with Andersen on any matter of accounting principle or practice,
financial statement disclosure or auditing scope or procedure that, if not
resolved to the satisfaction of Andersen, would have caused Andersen to make
reference to the subject matter in connection with its report on our
consolidated financial statements for such years and (ii) there were no
reportable events as defined in Item 304 (a)(1)(v) of Regulation S-K.

Andersen no longer provides the letter required by Item 304(a)(3) confirming
whether it agrees or disagrees with the statements made in the foregoing
disclosure. At the time we filed our report on Form 8-K reporting the change in
our certifying accountant from Andersen to GT, we were advised that Andersen was
no longer issuing such letters, so we relied on the provisions of Item
304T(b)(2) to excuse our inability to comply with the requirements of Item
304(a)(3).

During the fiscal years ended October 31, 2000 and 2001 and the portion of
fiscal 2002 prior to GT's engagement as our accountants, we did not consult with
GT with respect to the application of accounting principles to a specified
transaction, either completed or proposed, or the type of audit opinion that
might be rendered on our consolidated financial statements, or any other matters
or reportable events as set forth in Items 304 (a)(2)(i) and (ii) of Regulation
S-K.

23

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS; COMPLIANCE WITH SECTION 16(a) OF THE
EXCHANGE ACT.

Our directors and executive officers are set forth below. All officers and
members of the Board of Directors serve for a term of one year or until their
successors are duly elected and qualified. Directors may be removed by holders
of 66 2/3% of the Company's outstanding voting shares.

A brief account of the business experience for the past five years of the
individuals listed above follows.

MR. INGRAM has been the Company's Chief Executive Officer since July 1990.
He also served as the Company's President from July 1990 until August 1999 and
re-assumed that position in June 2001. He has been a director of the Company
since March 1989. Mr. Ingram's business experience prior to joining the Company
was concentrated in the oil and gas industry. Mr. Ingram holds a Bachelor of
Science Degree in Petroleum Engineering from the University of Tulsa.

MR. WAGNER has been the Company's Vice President of Finance and Chief
Financial Officer since March 1989. He has been with the Company since July 1988
and became a member of the Board of Directors in March 1996. Mr. Wagner is a
Certified Public Accountant licensed in Oklahoma and received his Bachelor of
Science Degree in Accounting from Oklahoma State University.

MR. PATTERSON joined the Company in March 2000 and serves as Senior Vice
President, Sales and Service. Prior to his employment with the Company, Mr.
Patterson worked for Exxon Corporation and held various executive positions in
Europe, Asia and Latin America with Exxon Company, International. He is a member
of the American Management Association and is active in Organizational
Development, Leadership Development and Investment Management activities. Mr.
Patterson received his Bachelor of Science Degree in Engineering from Oklahoma
State University.

24

MR. REIGEL joined the Company in June 1993 as PBX Product Sales Manager. He
was promoted to Vice President of Marketing and Sales in June 1995; became Vice
President of Hospitality Sales in December, 1999; and is currently Regional Vice
President, Sales - Central. Prior to his employment with the Company, Mr. Reigel
served as a national accounts sales manager for WilTel Communications Systems.
Mr. Reigel received his Bachelor of Science Degree in Business from the
University of Colorado.

MR. BURKE joined the Company in November 1999 in conjunction with the
acquisition of USTI and is currently Regional Vice President, Sales - Western.
Prior to his employment with the Company, he had been employed by USTI since
August 1990 and served as the Western Region Sales Director and National Sales
Director. Mr. Burke received his Bachelor of Science Degree in Business from
Niagara University.

MR. BARBER has been a director of the Company since March 1987. He has been
engaged in the private practice of law since October 1980 and is a shareholder
in the law firm of Barber & Bartz, a Professional Corporation, in Tulsa,
Oklahoma, which serves as counsel to the Company. Mr. Barber is also a Certified
Public Accountant licensed in Oklahoma. He received his Bachelor of Science
Degree in Business Administration (Accounting) from the University of Arkansas
and his Juris Doctorate Degree from the University of Tulsa.

MR. DUKE has been a director of the Company since March 1991. From 1980
until August, 2002, he was in senior management in the oil and gas industry,
including time as President and Chief Operating Officer of Hadson Petroleum
(USA), Inc., a domestic oil and gas subsidiary of Hadson Corporation, where he
was responsible for all phases of exploration and production, land, accounting,
operations, product marketing and budgeting and planning. Mr. Duke has a
Bachelor of Science Degree in Petroleum Engineering from the University of
Oklahoma.

DR. HISRICH has been a director of the Company since March 1987. He occupies
the A. Malachi Mixon III Chair in Entrepreneurial Studies and is Professor of
Marketing and Policy Studies at the Weatherhead School of Management at Case
Western Reserve University in Cleveland, Ohio. Prior to assuming such positions,
he occupied the Bovaird Chair of Entrepreneurial Studies and Private Enterprise
and was Professor of Marketing at the College of Business Administration for the
University of Tulsa. He is also a marketing and management consultant. He is a
member of the Board of Directors of Jameson Inn, Inc., and Noteworthy Medical
Systems, Inc., a member of the Editorial Boards of the Journal of Venturing and
the Journal of Small Business Management, and a member of the Board of Directors
of Enterprise Development, Inc. Dr. Hisrich received his Bachelor of Arts Degree
in English and Science from DePauw University and his Master of Business
Administration Degree (Marketing) and Ph.D. in Business Administration
(Marketing, Finance, and Quantitative Methods) from the University of
Cincinnati.

MR. SIEGENTHALER has been a director of the Company since its incorporation.
He also served as its Executive Vice President from July 1990 until March, 1999.
Since 1974, through SEDCO Investments, a partnership in which Mr. Siegenthaler
is a partner, and as an individual, Mr. Siegenthaler has been involved as
partner, shareholder, officer, director, or sole proprietor of a number of
business entities with significant involvement in fabrication and marketing of
steel, steel products and other raw material, real estate, oil and gas, and
telecommunications. Mr. Siegenthaler received his Bachelor's Degree in Liberal
Arts from Oklahoma State University.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Based solely upon a review of Forms 3 and 4 furnished to us during our most
recent fiscal year, Forms 5 furnished to us with respect to our most recent
fiscal year, and written representations made to us by our directors and
officers, we know of no director, officer, or beneficial owner of more than ten
percent of the Company's Common Stock who has failed to file on a timely basis
reports of beneficial ownership of the Company's Common Stock as required by
Section 16(a) of the Securities Exchange Act of 1934 and the rules adopted
thereunder, except as follows: Mr. Don Reigel, our Regional Vice President of
Sales--Central, was late in filing 5 reports on Form 4 reporting 9 transactions.
Mr. Jack Ingram, our President and CEO, was late in filing 2 reports on Form 4
reporting 2 transactions.

25

ITEM 11. EXECUTIVE COMPENSATION.

That portion of the Company's definitive Proxy Statement appearing under the
caption "Executive Compensation," to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A on or before February 28, 2003 and to be
used in connection with the Company's Annual Meeting of Shareholders to be held
April 3, 2003 is hereby incorporated by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

That portion of the Company's definitive Proxy Statement appearing under the
caption "Security Ownership of Certain Beneficial Owners and Management," to be
filed with the Securities and Exchange Commission pursuant to Regulation 14A on
or before February 28, 2003 and to be used in connection with the Company's
Annual Meeting of Shareholders to be held April 3, 2003 is hereby incorporated
by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

That portion of the Company's definitive Proxy Statement appearing under the
caption "Related Transactions," to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A on or before February 28, 2003 and to be
used in connection with the Company's Annual Meeting of Shareholders to be held
April 3, 2003 is hereby incorporated by reference.

ITEM 14. CONTROLS AND PROCEDURES.

(a) Evaluation of Disclosure Controls and Procedures. Based on their
evaluation as of a date within 90 days of the filing date of this Annual Report
on Form 10-K, the Company's principal executive officer and principal financial
officer have concluded that the Company's disclosure controls and procedures (as
defined in Rules 13a-14 (c) and 15d-14 (c) under the Securities Exchange Act of
1934, as amended (the "Exchange Act")) are effective to ensure that information
required to be disclosed by the Company in reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in Securities and Exchange Commission rules and
forms.

(b) Changes in Internal Controls. There were no significant changes in the
Company's internal controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation. There were no
significant deficiencies or material weaknesses, and therefore there were no
corrective actions taken.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

(a) The following documents are filed as a part of this report:

(1) Financial Statements - See Index to Financial Statements at Page 22 of
this Form 10-K.

(2) Financial Statement Schedule - None.

(3) Exhibits - The following exhibits are included with this report or
incorporated herein by reference:

SEC NO. DESCRIPTION

3(i)1 Amended and Restated Certificate of Incorporation of the
Registrant. (Incorporated by reference to Exhibits 3.1 and
3.2 to the Registrant's Registration Statement on Form S-1,
filed on June 17, 1987, File No. 33-7841).

3(i)2 Amendment No. 1 to Amended and Restated Certificate of
Incorporation. (Incorporated by reference to Exhibit 4.2 to
the Registrant's Post-Effective Amendment No. 1 to
Registration Statement on Form S-8, filed on July 28, 1999,
File No. 33-62173).

26

3(i)3 Amendment No. 2 to Amended and Restated Certificate of
Incorporation. (Incorporated by reference to Exhibit
3(i)(c) to the Form 10-Q for the quarter ended April 30,
2000).

3(i)4 Amendment No. 3 to Amended and Restated Certificate of
Incorporation. (Incorporated by reference to Exhibit 4.4 to
the Company's Post-Effective Amendment No. 2 to the
Registration Statement Form S-8, filed on June 28, 2000).

3(ii) Amended and Restated Bylaws of the Registrant.
(Incorporated by reference to Exhibit 3(ii)(a) to the
Registrant's Form 10-Q for the quarter ended April 30,
2001, filed on July 14, 2001).

10.1 Dealer Agreement Among Lucent Technologies, Inc.;
Distributor, Inacom Communications, Inc.; and XETA
Corporation for Business Communications Systems.
(Incorporated by reference to Exhibit 10.1 to Form 10-Q for
the quarter ended April 30, 1999).

10.2 Real Estate Mortgage on the Registrant's Broken Arrow,
Oklahoma property. (Incorporated by reference to Exhibit
2.5 to Report on Form 8-K filed December 15, 1999).

10.3 Pledge and Security Agreement relating to November 30, 1999
Credit. (Incorporated by reference to Exhibit 2.4 to Report
on Form 8-K filed December 15, 1999).

10.4 Subsidiary Guaranty by U.S. Technologies Systems, Inc. of
November 30, 1999 Credit facility. (Incorporated by
reference to Exhibit 2.6 to Report on Form 8-K filed
December 15, 1999).

10.5* Stock Purchase Option dated February 1, 2000 granted to
Larry N. Patterson. (Incorporated by reference to Exhibit
10.9 to Form 10-Q for the quarter ended April 30, 2000).

10.6 Amendment to Dealer Agreement Among Lucent Technologies,
Inc. Distributor, Inacom Communications, Inc.; and XETA
Corporation, for Business Communications Systems, dated
effective March 19, 2000. (Incorporated by reference to
Exhibit 10.10 to Form 10-Q for the quarter ended April 30,
2000).

10.7* XETA Technologies 2000 Stock Option Plan. (Incorporated by
reference to Exhibit 10.11 to Form 10-Q for the quarter
ended April 30, 2000).

10.8* Stock Purchase Option dated August 11, 2000 granted to
Larry N. Patterson. (Incorporated by reference to Exhibit
10.14 to Annual Report on Form 10-K for year ended October
31, 2000).

10.9 Notice of Assignment by Lucent Technologies Inc. dated
September 14, 2000 of all contracts with XETA Technologies,
Inc. to Avaya Inc. (Incorporated by reference to Exhibit
10.16 to Annual Report on Form 10-K for the year ended
October 31, 2000).

10.10 Amended and Restated Credit Agreement dated October 31,
2001 among XETA Technologies, Inc., the Lenders and the
Agent. (Incorporated by reference to Exhibit 10.15 to the
Annual Report on Form 10-K for the year ended October 31,
2001).

10.11 HCX 5000/HCX 5000i(R) Authorized Distributor Agreement for
2002 dated January 1, 2002 between Hitachi Telecom (USA),
Inc. and XETA Corporation. (Incorporated by reference to
Exhibit 10.15 to Form 10-Q for the quarter ended January
31, 2002).

27

10.12 First Amendment to the Amended and Restated Credit
Agreement dated effective as of June 1, 2002 among XETA
Technologies, Inc., the Lenders and the Agent.

10.13 Second Amendment to Amended and Restated Credit Agreement
dated effective as of September 10, 2002 among XETA
Technologies, Inc., the Lenders and the Agent.

21 Subsidiaries of XETA Technologies.

23 Consent of Grant Thornton LLP.

99.1 Certification of the Company's Chief Executive Officer,
Jack R. Ingram, pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.

99.2 Certification of the Company's Chief Financial Officer,
Robert B. Wagner, pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.

* Indicates management contract or compensatory plan or arrangement.

We will provide copies of any exhibit to shareholders who request copies of this
Report and any specific exhibits pursuant to Rule 14a-3 of the Securities and
Exchange Act. Copies of exhibits will be provided upon the payment of our
reasonable costs in furnishing same.

28

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

XETA TECHNOLOGIES, INC.

JANUARY 24, 2003 BY: /s/ Jack R. Ingram
--------------------------------
JACK R. INGRAM, CHIEF EXECUTIVE
OFFICER AND PRESIDENT

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

JANUARY 24, 2003 /s/ Jack R. Ingram
--------------------------------
JACK R. INGRAM, CHIEF EXECUTIVE
OFFICER, PRESIDENT AND
DIRECTOR

JANUARY 24, 2003 /s/ Robert B. Wagner
--------------------------------
ROBERT B. WAGNER, VICE PRESIDENT
OF FINANCE, CHIEF FINANCIAL
OFFICER, AND DIRECTOR

JANUARY 27, 2003 /s/ Donald T. Duke
--------------------------------
DONALD T. DUKE, DIRECTOR

JANUARY 29, 2003 /s/ Ronald L. Siegenthaler
--------------------------------
RONALD L. SIEGENTHALER, DIRECTOR

29

CERTIFICATIONS

I, JACK R. INGRAM, CERTIFY THAT:

1. I have reviewed this annual report on Form 10-K of XETA Technologies, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officer and I have indicated in this
annual report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.

/s/ Jack R. Ingram
- -----------------------------------------------------
Jack R. Ingram, President and Chief Executive Officer

Date: 1/24/03
------------------------------------------------

I, ROBERT B. WAGNER, CERTIFY THAT:

1. I have reviewed this annual report on Form 10-K of XETA Technologies, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officer and I have indicated in this
annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.

/s/ Robert B. Wagner
- -----------------------------------------
Robert B. Wagner, Chief Financial Officer

Date: 1/24/03
------------------------------------

INDEX TO EXHIBITS

10.12 First Amendment to the Amended and Restated Credit Agreement
dated effective as of June 1, 2002 among XETA Technologies,
Inc., the Lenders and the Agent.

10.13 Second Amendment to Amended and Restated Credit Agreement
dated effective as of September 10, 2002 among XETA
Technologies, Inc., the Lenders and the Agent.

21 Subsidiaries of XETA Technologies.

23 Consent of Grant Thornton LLP.

99.1 Certification of the Company's Chief Executive Officer, Jack
R. Ingram, pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.

99.2 Certification of the Company's Chief Financial Officer, Robert
B. Wagner, pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.

* Indicates management contract or compensatory plan or arrangement.

We will provide copies of any exhibit to shareholders who request copies of this
Report and any specific exhibits pursuant to Rule 14a-3 of the Securities and
Exchange Act. Copies of exhibits will be provided upon the payment of our
reasonable costs in furnishing same.