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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

For the quarter ended March 31, 2003

Commission file number 0-25016

T-NETIX, Inc.

Registrant’s telephone number, including area code:

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

      Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

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FORM 10-Q CROSS REFERENCE INDEX

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PART I

INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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T-NETIX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to unaudited condensed consolidated financial statements.

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T-NETIX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to unaudited condensed consolidated financial statements.

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T-NETIX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to unaudited condensed consolidated financial statements.

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T-NETIX, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

      The accompanying unaudited consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary to reflect a fair presentation of the financial position and results of operations of T-NETIX, Inc. and subsidiaries (the “Company”) for the interim periods presented. All adjustments, in the opinion of management, are of a normal and recurring nature. Some adjustments involve estimates, which may require revision in subsequent interim periods or at year-end. The financial statements have been presented in accordance with generally accepted accounting principles. Refer to notes to consolidated financial statements, which appear in the 2002 Annual Report on Form 10-K for the Company’s accounting polices, which are pertinent to these statements.

      In March 2003 the Company acquired a 50% preferred stock interest in a newly formed company, Accudata Technologies, Inc. (“Accudata”). Of the $0.7 million invested in Accudata, $0.5 million went to the purchase out of a Chapter XI bankruptcy proceeding of substantially all of the assets (in essence the ongoing business) of Revenue Communications, Inc. With such purchase, Accudata became one of only twelve active telephone line information databases (“LIDB”) in the United States where important customer information is stored and maintained, including telephone number, service provider and collect call preferences. The investment in Accudata will allow the Company cost effective, flexible, high-speed access to a centralized LIDB through sophisticated SS7 transport technology and considerably enhances our capacity to utilize new technology for controlling bad debt and unbillables. The investment in Accudata is presented under the equity method of accounting and such investment is included in “Intangibles and other assets, net” at March 31, 2003. Equity in the results of operations for the three months ended March 31, 2003 was not significant.

      Earnings (loss) per common share are presented in accordance with the provisions of Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”). Basic earnings per share excludes dilution for common stock equivalents and is computed by dividing income or loss available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations (in thousands):

      The calculation of diluted net loss per common share for the three months ended March 31, 2003 does not include 3,540,000 of potentially dilutive securities, including common stock options and warrants, as their effect would be anti-dilutive. For the three months ended March 31, 2002, common stock equivalents of 1,548,000 were not included in the diluted earnings per share calculation, as their effect would be anti-dilutive.

      The Company uses the intrinsic-value method as provided by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” in accounting for its stock option plans and provides pro forma disclosure of the compensation expense determined under the fair value provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” Accordingly, the Company did not recognize compensation expense upon the issuance of its stock options because the option terms were fixed and the exercise price equaled the market price of the Company’s common stock on the date of grant.

      The following table displays the effect on net earnings and earnings per share had the fair value method been applied during each period presented (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The per share weighted-average fair value of stock options issued by the Company during 2003 and 2002 was $1.30 and $3.00 respectively, on the dates of grant using the Black-Scholes option-pricing model. The following weighted-average assumptions were used to determine the fair value of stock options granted:

      The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

      In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations”. This statement addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and reported as a liability. This statement is effective for fiscal years beginning after June 15, 2002. The adoption of this statement, effective January 1, 2003, had no material impact upon the Company’s financial position or results of operations.

      In May 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” Under the provisions of SFAS No. 145, gains and losses from the early extinguishment of debt are no longer classified as an extraordinary item, net of income taxes, but are included in the determination of pretax earnings. The effective date for SFAS No. 145 is for fiscal years beginning after May 15, 2002, with early application encouraged.

      In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses accounting and reporting for costs associated with exit or disposal activities by requiring that a liability for a cost associated with an exit or disposal activity be recognized and measured at fair value only when the liability is incurred. SFAS No. 146 also nullifies EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002.

      In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123.” This Statement amends No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and interim financial statements. Certain of the disclosure modifications are included in the notes to these consolidated financial statements.

      In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 also requires that a liability be recorded in the guarantor’s balance sheet upon issuance of certain guarantees. FIN 45 also requires disclosure about certain guarantees that an entity has issued. The Company has implemented the disclosure requirements required by FIN 45, which were effective for fiscal years ending after December 15, 2002. The Company will apply the recognition provisions of FIN 45 prospectively to guarantees issued after December 31, 2002. The adoption of this statement had no material effect upon the Company’s financial position or results of operations.

      In January 2003, FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not expect FIN 46 to have a material effect on its financial position or results of operations.

      Certain amounts in the 2003 financial statements have been reclassified to conform to the 2002 presentation.

      Accounts receivable consist of the following:

      Bad debt expense was $4.1 million or 27% of direct call provisioning revenue of $15.1 million for the three months ended March 31, 2003. For the comparative three month period ended March 31, 2002, bad debt expense totaled $2.5 million, or 29% of the $8.2 million in direct call provisioning revenue and 1% of the $15.3 million in telecommunication services revenue.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Property and equipment consist of the following:

      Intangible and other assets consist of the following:

      Accrued liabilities consist of the following:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Debt consists of the following:

      Future debt maturities for each of the next five years are summarized as follows:

      In September 1999, the Company entered into a Senior Secured Revolving Credit Facility (the “Credit Facility”) with its commercial bank. The Credit Facility provided for maximum credit of $40 million subject to limitations based on certain financial covenants. In April 2001, the Company’s lenders extended the maturity date on its credit agreement to March 31, 2002. The maximum available borrowings on the facility was reduced to $30 million and interest was set at prime rate plus 1.25% effective March 31, 2001 increasing by 0.25% each quarter thereafter on June 30, September 30 and December 31, 2001. In addition, monthly payments of $0.2 million on the term loan commenced in April 2001. In March 2002, the maturity date of the Credit Facility was extended to June 30, 2002. In April 2002, the Company obtained a further commitment from the bank to extend this facility to January 2003. Within the terms of the March and April 2002 extensions, maximum available borrowing from the facility was reduced to $21.8 million, consisting of a $7.8 million term portion and a $14.0 million line of credit. Interest was set at prime plus 2.25%, effective March 31, 2002. In addition, monthly payments of $0.2 million on the term loan were set to continue through November 2002, when the Company obtained new financing (see below).

      The Company issued a subordinated note payable of $3.75 million, due April 30, 2001, to a director and significant shareholder of the Company (the “Subordinated Note Payable”). The note, repaid when the Company obtained new financing (see below), bore interest at prime rate plus one percent every six months. The lender received warrants, immediately exercisable, to purchase 25,000 shares of common stock at an exercise price of $6.05 per share for a period of five years. This note was extended in April 2001 to April 2002 at which time the lender received additional warrants, immediately exercisable, to purchase 25,000 shares of

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

common stock at an exercise price of $2.75 per share for a period of five years. In March 2002, this note was extended to July 2002. In April 2002 this note was extended to February 2003 to facilitate the refinancing of our overall financing structure. Additional warrants to purchase 18,223 shares of common stock at an exercise price of $2.75, on the previous terms, were issued related to this extension. The estimated fair value of the stock purchase warrants, calculated using the Black-Scholes model, was recorded as deferred financing fees and amortized over the term of the debt.

      In November 2002, the Company obtained new financing (the “New Credit Facility). Net proceeds of this New Credit Facility were utilized to repay in full the existing Credit Facility and the Subordinated Note Payable. As of March 31, 2003, the New Credit Facility provides for maximum credit availability of $30.2 million, subject to limitations based on certain financial covenants, and consists of a $13.1 million Senior Secured Term Loan, a $9.1 million Senior Subordinated Promissory Note and a Revolving Credit Facility with an availability of up to $8.0 million.

      The Senior Secured Term Loan bears interest at LIBOR plus 6.0%, with 15 equal quarterly principal installment payments thorough December 2006. Effective March 31,2003, the Company entered into an interest rate swap agreement which effectively converts this variable rate debt to a fixed rate. (See Note 6 “Interest Rate Swap” of “Notes to Condensed Consolidated Financial Statements.”) Due in 2008, the Senior Subordinated Promissory Note bears interest at a fixed rate of 13%, payable on a quarterly basis, with an additional 4.75% of interest payable in kind. In addition, the lender received detachable stock purchase warrants, which are immediately exercisable, to purchase 186,792 shares of common stock at an exercise price of $0.01 per share. The expiration date of these warrants is November 2010. The estimated fair value of the stock purchase warrants, calculated using the Black-Scholes model, was recorded as a debt discount and is being amortized over the term of the Senior Subordinated Promissory Note. Availability under the Revolving Credit Facility is based on the lesser of eligible accounts receivable or a calculated maximum leverage ratio. Interest on the Revolving Credit Facility is set at prime plus 3.5% with a 0.75% annual commitment fee assessed on the unused portion of this Facility.

      The New Credit Facility is collateralized by substantially all of the assets of the Company. Under the terms of the New Credit Facility, the Company is required to maintain certain financial ratios and other financial covenants. These ratios include a debt to four-quarter rolling earnings before interest, taxes and depreciation and amortization (EBITDA) ratio, a ratio of EBITDA less capital expenditures to fixed charges (interest, taxes and scheduled debt service payments), and a minimum capitalization ratio. The Agreement also places limits on the amount of additional indebtedness the Company can incur.

      In August 2001, the Company formalized the decision to offer for sale its voice verification business unit, which includes the SpeakEZ voice verification products, and operations were substantially curtailed in November 2001 Accordingly, related operating results have been reported as discontinued operations. The financial information for the discontinued speaker verification operations is as follows:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      In July 2002, the Company completed the sale of the SpeakEZ voice verification assets to SpeechWorks International, Inc. (“SpeechWorks”) for $0.4 million cash and approximately 130,000 shares of SpeechWorks common stock valued at $0.3 million, subject to a 10% escrow provision and recognized a gain on the sale of discontinued operations of $0.3 million. In addition, SpeechWorks will pay the Company an earn-out fee based on the sale over the next two years of future SpeechWorks products incorporating the SpeakEZ technology. Payment of the earn-out fee, if any, will be made through the issuance of additional shares of SpeechWorks common stock. As part of the sales agreement, the Company retained the right to utilize the speech recognition technology in the corrections industry. SpeechWorks stock received by the Company will not be registered.

      During the year ended December 31, 2002, the Company recorded a $1.1 million impairment charge to an asset relating to a prepaid contract for call validation query services that is currently in legal dispute (See Part II Other Information, Item 1. Legal Proceedings). The impairment charge does not change the Company’s belief in its rights under the disputed contract nor does it change the Company’s position to pursue its rights. In March 2003, the Company invested in another provider of similar services that it anticipates will significantly reduce its costs of validation services and uncollectable accounts (See Note 1 of “Notes to Condensed Consolidated Financial Statements”). As such, the Company intends to assign its rights to third parties under the terms of the disputed contract. The $1.1 million impairment charge recorded during the fourth quarter of 2002 reduced the carrying value of the asset to $0.9 million, or the expected value to be realized through sale, net of any selling expenses. For the three months ended March 31, 2003 and the year ended December 31, 2002, the prepaid validation asset has been classified as an “Asset Held for Sale.”

      Statement of Financial Accounting Standards No. 131, “Disclosures About Segments of an Enterprise and Related Information,” (“SFAS 131”), establishes standards for reporting operating segments in annual financial statements. SFAS 131 also establishes standards for disclosures about products and services, geographic areas and major customers.

      In 2003 and 2002, the Company had a single reportable segment: the Corrections Division. Through its Corrections Division, the Company provides inmate telecommunication products and services for correctional facilities, including security enhanced call processing, call validation and billing services for inmate calling. Depending upon the contractual relationship at the site and the type of customer, the Company provides these products and services through service agreements with other telecommunications service providers, including Verizon, AT&T, SBC Communications, Sprint and Qwest and through direct contracts between the Company and correctional facilities. In addition, primarily through its subsidiary TELEQUIP Labs, the Company sells inmate call processing systems to certain telecommunication providers.

      Formerly, the Company reported two additional business segments: the Internet Services and SpeakEZ Voice Verification divisions. Through its Internet Service Division, the Company provided interLATA Internet services to Qwest customers through a master service agreement, the “Qwest Agreement”. Effective November 2001, substantially all services and associated revenue under this agreement ceased due to the expiration of this contract. The SpeakEZ Voice Print technology is proprietary software that compares the speech pattern of a current speaker with a stored digital voiceprint of the authorized person to confirm or reject claimed identity. In August 2001, the Company formalized its decision to offer for sale its voice verification business unit and substantially curtailed operations in November 2001. Accordingly, related operating results of this business unit have been reported as discontinued operations in the condensed consolidated financial statements. Segment reporting has been conformed to correspond to the current presentation. As described in

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 4 of “Notes to the Condensed Consolidated Financial Statements,” the Company completed the sale of SpeakEZ assets in July 2002.

      The Company evaluates performance based on earnings (loss) before income taxes. Additional measures include operating income, depreciation and amortization, and interest expense. There are no intersegment sales. The Company’s reportable segments are specific business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Segment information for the three months ended March 31, 2003 and the comparable 2002 period is as follows:

      There was no intersegment revenue for the three months ending March 31, 2003 and the comparable 2002 period. Consolidated total assets included eliminations of approximately $2.2 million as of March 31, 2003. Eliminations consist of intercompany receivables in the Corrections Division and intercompany payables in the TELEQUIP Labs subsidiary related solely to intercompany borrowings.

      Since the interest rate on the Senior Secured Term Loan outstanding under the New Credit Facility is variable, the Company is exposed to variability in interest payments due to changes in interest rates. Management believes it is prudent to limit variability of its interest payments. To meet this objective, on March 31, 2003, the Company entered into an interest rate swap agreement which effectively converts the $13.1 million of variable rate debt outstanding under the New Credit Facility to a fixed rate. Under the terms of this interest rate swap agreement, the notation amount of the swap coincides with the maturity schedule of the Senior Secured Term Loan and has an expiration date of September 2006. On a quarterly basis, the Company will receive variable interest rate payments based on three month LIBOR and make fixed interest rate payments of 2.4%, thereby creating the equivalent of fixed rate debt. The net effect of this agreement is to lock the effective interest rate on the Senior Secured Term Loan at 8.4% through its maturity in 2006.

      The interest rate swap agreement does qualify for hedge accounting. As of March 31, 2003, the interest rate swap has no fair value. The Company will assess the valuation of this derivative instrument periodically on

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

a go forward basis. The Company does not enter into derivative instruments for any other purpose than cash flow hedging purposes and does not intend to speculate using derivative instruments.

      From time to time we have been, and expect to continue to be subject to various legal and administrative proceedings or various claims in the normal course of our business. We believe the ultimate disposition of these matters will not have a material affect on our financial condition, liquidity, or results of operations.

      During 2000, a case styled Valdez v. State of New Mexico, et al. against Gateway and several other defendants was dismissed. The complaint, generally alleging violations of state unfair practices, antitrust and constitutional laws, included class action certification of all persons who had been billed for and paid for telephone calls initiated by an inmate confined in a New Mexico correctional facility. On appeal by plaintiffs, in August 2002 the New Mexico State Supreme Court affirmed the District Court’s dismissal of the plaintiffs’ case.

      T-NETIX is a defendant in a state case brought in June 2000 in the Superior Court of Washington for King County, styled Sandy Judd, et al. v. American Telephone and Telegraph Company, et al. In this case, the complaint joined several inmate telecommunications service providers as defendants, including T-NETIX. The complaint includes a request for certification by the court of a plaintiffs’ class action consisting of all persons who have been billed for and paid for telephone calls initiated by an inmate confined in a jail, prison, detention center or other Washington correctional facility. The complaint alleges violations of the Washington Consumer Protection Act (WCPA) and requests an injunction under the Washington Consumer Protection Act and common law to enjoin further violations. The trial court dismissed all claims with prejudice against all defendants except T-NETIX and AT&T. Plaintiffs have appealed the dismissal of the other defendants and T-NETIX has crossed appealed. The T-NETIX and AT&T claims have been referred to the Washington Utilities and Transportation Commission while the trial court proceeding is in abeyance. The Commission has not yet commenced any proceedings.

      Gateway has been litigating an appeal from a favorable ruling in Kentucky federal court in the case Gus “Skip” Daleure, Jr., et al vs. Commonwealth of Kentucky, et al. Plaintiffs, a class of relatives of prisoners incarcerated in Kentucky correctional facilities, sued, in October 1997, the Commonwealth of Kentucky, the Kentucky Department of Corrections, the state of Missouri, several Kentucky, Missouri, Arizona and Indiana municipal entities, and various private telephone providers alleging antitrust violations and excessive rates in connection with the provision of telephone services to inmates. The plaintiffs alleged Sherman Act, Robinson-Patman Act, and Equal Protection violations. The district court held, on motions to dismiss, that Kentucky did not have personal jurisdiction over defendants not located in or doing business in the state of Kentucky; that telephone calls are not goods or commodities and thus are not subject to the antitrust provisions of the Robinson-Patman Act; that Plaintiffs did not state a claim for relief under the Equal Protection Clause of the Fourteenth Amendment; and that Plaintiffs had not shown any harm in support of its antitrust claim under Section 1 of the Sherman Act. The trial judge did not, however, dismiss the plaintiff’s petition for injunctive relief, despite these findings. Recently, the appeal brought by the plaintiffs has been dismissed and no further action has been taken.

      In another case styled Robert E. Lee Jones, Jr. vs. MCI Communications, et al, plaintiffs, 43 inmates of the Bland Correctional Center in Virginia, filed a pro se action in January, 2001 alleging constitutional violations, RICO Act violations and violations of Federal wiretapping laws. This case was dismissed on all counts in November 2001 and plaintiffs appealed. The dismissal was affirmed by the Fourth Circuit in July 2002.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      In October 2001, relatives of prisoners incarcerated in Oklahoma Department of Correctional facilities filed a putative class action against T-NETIX, AT&T, Evercom and the Oklahoma Department of Corrections for claims in anti-trust, under due process, equal protection and the first amendment. This case, styled Kathy Lamon, et al v. Ron Ward, et al, was dismissed by the Plaintiffs in July 2002.

      In September 2001, T-NETIX filed patent litigation against MCI WorldCom, Inc. and Global Tel*Link Corporation. The lawsuit, filed in the Eastern District of Texas, alleges infringement of six United States patents protecting call processing equipment and services for the inmate calling industry. In July 2002, MCI WorldCom, Inc. filed a Chapter XI bankruptcy proceeding that automatically stayed any further proceeding against them. On August 7, 2002, T-NETIX subsequently filed its motion to sever MCI WorldCom from the patent litigation, which was granted on February 13, 2003. Trial is set for October 2003.

      Since September 1997 and through October 2001, pursuant to a written agreement entered into in connection with a settlement of an arbitration proceeding, the Company was making monthly payments to a vendor of query transport services with the understanding that the payments were for future services to be utilized by the Company. The services to be provided by Illuminet, Inc. under the contract were in the nature of the transport of queried by Illuminet to a certain database maintained by and available to Illuminet. In order to utilize such transport the queries were to be directed from the Company for connection to Illuminet utilizing certain technologies. Attempts were continually made by the Company over the time period to complete connectivity but connectivity was never accomplished. In November 2001, Illuminet notified the Company that no credits for such services would be honored. In January 2002 Illuminet filed a claim before the original arbitration panel in Fairway, Kansas, requesting money damages for T-NETIX’s breach and declaratory relief that no credits are due T-NETIX. The Company has made payments totaling approximately $2.1 million pursuant to this written agreement. The payments (the value of which has been written down for the period ended December 31, 2002) are classified as an “Asset Held for Sale” at March 31, 2003 and December 31, 2002 (See Note 4 of “Notes to the Condensed Consolidated Financial Statements”). It is the contention of the Company, in the arbitration proceeding, that the fault in the lack of connectivity, be it the lack of proper technology, proper responsiveness on the part of Illuminet, or otherwise, was that of Illuminet and that the Company is still entitled to the services for which it paid. The Company intends to vigorously pursue its rights under the agreement. In the event the Company is not supported in the arbitration or any related litigation, the balance of the prepaid expense could be impaired. The arbitration hearing is scheduled for September 2003.

      In August 2001, the U.S. Bankruptcy Court for the Central District of California approved the sale of assets of OAN Services, Inc. (“OAN”), a Chapter 11 debtor and the primary billing agent of the Company. The Company and about 20 other customers received a portion of the proceeds. The sole objecting customer appealed to the Bankruptcy Appellate Panel but it was dismissed as moot. In December 2001, the Bankruptcy Court granted OAN’s Summary Judgment Motion and ruled against the objecting customer. In late August 2002, the United Stated District Court reversed the summary judgment and remanded the case to the Bankruptcy Court. The objecting customer has notified the other customers, including the Company, that if it ultimately prevails, it intends to pursue available claims against the bankruptcy estate and the customers receiving the portion of the proceeds.

      Condes v. Evercom Systems, Inc., et al. is an action filed against SBC Communications, Pacific Bell Tel. Co. and Evercom Systems, Inc. in state court in Alameda County, California in June 2002, alleging unfair trade practices based on asserted billing of collect calls which were not accepted or authorized, and requesting class action certification. T-NETIX was joined as a defendant on March 11, 2003.

      In January 2003 suit was filed against T-NETIX and various state correctional officials in the District Court of Johnson County, Nebraska styled Dukhan Iqraa Jihad Mumin, Vicky Marie Kitt v. T-NETIX

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Telephone Company, et al. The suit, brought pro se by an inmate on behalf of himself and the other plaintiffs, alleges violations of privacy, United States and Nebraska constitutional and civil rights. The complaint includes a demand for compensatory damages of $500,000 and a total of $3,000,000 in treble and compensatory damages. Following a May hearing on a Motion to Dismiss for failure to state a claim on which relief can be granted filed by the Company, the Court granted the Company’s Motion to Dismiss on all claims allowing the Plaintiff to replead with respect to certain claims or be faced with final dismissal on those as well.

      Richardson v. T-NETIX Telecommunications, Inc. and Colman v. Miller , et al., are two civil actions filed pro se on February 6, 2003 by inmates with the state Court of Common Pleas in Somerset County, Pennsylvania. These non-class action complaints allege inaccurate billing for pre-paid services in one Pennsylvania Prison location and request injunctive relief, unspecified compensatory damages and $2,500 in punitive damages.

      We believe the ultimate disposition of the forgoing matters will not have a material affect on our financial condition, liquidity, or results of operations.

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      For a comprehensive understanding of our financial condition and performance, this discussion should be considered in the context of the condensed consolidated financial statements and accompanying notes and other information contained herein.

      The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Certain information contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Form 10-Q includes forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to, those listed under the caption “Forward Looking Statements and Risk Factors” in the Company’s Form 10-K for the year ended December 31, 2002 which may affect the potential technological obsolescence of existing systems, the renewal of existing site specific Corrections Division customer contracts, the ability to retain the base of current site specific customer contracts, the ability to perform under contractual performance requirements, the continued relationship with existing customers, the ability of our existing telecommunications service provider customers such as Verizon, AT&T and SBC Communications, to win new contracts for our products and services to maintain their market share of the inmate calling market, the effect of economic conditions, the effect of regulation, including the Telecommunications Act of 1996, that could affect our sales or pricing, the impact of competitive products and pricing in the our Corrections Division, our continuing ability to develop hardware and software products, commercialization and technological difficulties, manufacturing capacity and product supply constraints or difficulties, and the actual purchases by current and prospective customers under existing and expected agreements, along with the other risks detailed therein.

      We make forward-looking statements in this report and may make such statements in future filings with the Securities and Exchange Commission. We also may make forward-looking statements in press releases or other public communications. These forward-looking statements are subject to risks and uncertainties and include information about our expectations and possible or assumed future results of operations. When we use any of the words “believe”, “expect”, “anticipate”, “estimate” or similar expressions, we are making a forward-looking statement. While we believe that forward-looking statements are reasonable, you should not place undue reliance in such forward-looking statements, which speak only as of the date made.

      Other factors not currently anticipated by management may also materially and adversely affect our results of operations. Except as required by applicable law, we do not undertake any obligation to publicly release any revisions which may be made to any forward-looking statements to reflect events or circumstances occurring after the date of this report.

Corrections Division

      In the Corrections Division we derive revenue from three main sources: telecommunications services, direct call provisioning and equipment sales. Each form of revenue has specific and varying operating costs associated with such revenue. Selling, general and administrative expenses, along with research and development and depreciation and amortization are common expenses regardless of the revenue generated.

      Telecommunications services revenue is generated under long-term contracts (generally, three to five years) with our telecommunications service provider customers including Verizon, AT&T, SBC Communications, Qwest and Sprint. Here, we provide the equipment, security enhanced call processing, call validation, and service and support through the provider, rather than directly to the facility. The provider does the billing and we either share the revenue with or receive a prescribed fee from our telecommunications services providers for each call completed. We receive additional fees for validating the phone numbers dialed by inmates.

      Our Corrections Division also provides our inmate calling services directly as a telecommunications provider to correctional facilities, or “Direct Customers.” In a typical arrangement, we operate under site-specific contracts, generally for a period of two to three years. We provide the equipment, security enhanced call processing, call validation, and customer service and support directly to the facility. We then use the

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      After the initial term of the direct call provisioning contract, the correctional facility may choose to renew the contract with the existing provider or initiate a formal competitive bid process. The telecommunications industry, particularly the inmate calling market, is and can be expected to remain highly competitive. While the Company has historically maintained a high rate of retention of existing inmate calling service contracts, the Company may not be able to compete effectively with our current or future competitors for these contracts, which would have a material adverse effect on our business, operating results, and financial condition.

      Equipment sales and other revenue include the sales of our inmate calling system (primarily the systems of our wholly owned subsidiary, TELEQUIP Labs, Inc.), and digital recording systems. Currently, sales of inmate calling systems are generally made by TELEQUIP to a limited number of telecommunication service provider customers.

Internet Services Division

      In December 1999, the Company entered into a master service agreement with US WEST ENTERPRISE (now named Qwest America, Inc.) (The “Qwest Agreement”) to provide interLATA Internet services to Qwest customers. The Qwest Agreement, which commenced December 1, 1999, called for us to buy, resell and process billing of Internet bandwidth to these customers. The initial term of the Qwest Agreement was for a minimum of sixteen months until March 2001. Although the Qwest Agreement expired on March 2001, we continued providing services under the Qwest Agreement through October 2001. Effective November 2001, substantially all services and associated revenue under this agreement had ceased due to the expiration of this contract.

Speaker Verification Division

      The Company formerly reported a third business segment, the SpeakEZ Speaker Verification division. The SpeakEZ Voice Print technology is proprietary software that compares the speech pattern of a current speaker with a stored digital voiceprint of the authorized person to confirm or reject claimed identity. In August 2001, the Company formalized its decision to offer for sale its voice verification business unit and substantially curtailed operations in November 2001. SpeakEZ assets were sold in July 2002 and the Company retained a license to use the technology in its corrections business. This technology is currently utilized in our SECUREvoice product. Due to the subsequent sale of the assets, related operating results of our SpeakEZ voice verification division have been recorded as discontinued operations in the consolidated financial statements. See Note 4 of “Notes to Condensed Consolidated Financial Statements”.

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      The following table sets forth certain statement of operations data as a percentage of total revenue for the three months ended March 31, 2003 and 2002.

      Total Revenue. Total revenue for the three months ended March 31, 2003 was $30.0 million, an increase of 22% from $24.5 million for the corresponding 2002 period. This increase was attributable to increases in direct call provisioning of $6.9 million and equipment sales and other of $0.7 million, offset partially by a decrease in telecommunications services of $2.1 million.

      Telecommunications services revenue decreased 14% to $13.2 million for the three months ended March 31, 2003, from $15.3 million for the corresponding prior period. This decrease was primarily due to the transition of certain department of corrections contracts to a direct call provisioning basis and to a decline in call volumes.

      Direct call provisioning revenue increased 84% to $15.1 million for the three months ended March 31, 2003, from $8.2 million in the corresponding prior period. This increase was primarily due to the awarding in 2002 of several department of corrections contracts for which we are provisioning comprehensive or the long distance communication service on a direct basis. The addition of these sites is a result of our being successful in providing competitive bidding arrangements for contracts directly with correctional facilities.

      Equipment sales and other revenue increased 70% to $1.7 million for the three month period ended March 31, 2003 from $1.0 million in the corresponding prior period. This increase was primarily due to increased equipment sales through our wholly-owned subsidiary, TELEQUIP Labs, Inc. Equipment sales of TELEQUIP are primarily associated with a single telecommunication service provider and revenue associated with such sales are dependent upon the timing of sales and installations for this customer.

      Operating costs. Total operating costs increased 47% to $19.9 million for the three months ended March 31, 2003 from $13.5 million in the corresponding prior period. The increase was primarily due to an increase in direct call provisioning expenses of $6.6 million and the cost of equipment sold of $0.2 million, partially offset by a decrease in telecommunication services expenses of $0.4 million.

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      Operating costs of telecommunications services primarily consist of service administration costs for correctional facilities, including salaries and related personnel expenses, communication costs and inmate calling systems repair and maintenance expenses. Operating costs of telecommunications services also includes costs associated with call validation procedures, primarily network expenses and database access charges. Operating costs associated with direct call provisioning include the costs associated with telephone line access, long distance charges, commissions paid to correctional facilities, costs associated with uncollectible accounts and billing charges.

      The following table sets forth the operating costs and expenses for each type of revenue as a percentage of corresponding revenue for the three months ended March 31, 2003 and 2002.

      Operating costs associated with providing telecommunications services as a percentage of corresponding revenue was 38% for the three months ended March 31, 2003, an increase from 36% for the comparable 2002 period. Total telecommunications services operating costs were $5.1 million for the three months ended March 31, 2003 and $5.5 million for the corresponding prior period. The increase in costs as a percentage of applicable revenue in 2003 was due primarily to an increase in labor and communications expenses, partially offset by lower call validation costs and repairs and maintenance expenses.

      Direct call provisioning costs, as a percentage of applicable revenue, were 93% of revenue for the three months ended March 31, 2003 compared to 91% in the comparable 2002 period. Due to the awarding of several department of corrections contracts in 2002, total direct call provisioning operating costs increased to $14.1 million for the three months ended March 31, 2003 from $7.5 million for the corresponding 2002 period. The increase in costs as a percentage of applicable revenue in 2003 was due primarily to a proportional increase in bad debt expense and commission expenses associated with the increase in direct call provisioning revenue. Bad debt expense increased primarily due to a greater volume of calls being processed to Competitive Local Exchange Carriers (“CLEC”) where the Company does not have billing arrangements. The Company, beginning in the first quarter of 2002, modified its call handling processes to block certain of these CLEC calls, thereby reducing its unbillable call volume.

      Cost of equipment sold and other as a percentage of applicable revenue decreased to 44% of revenue for the three months ended March 31, 2003 from 54% for the corresponding prior period. Due to increased equipment sales of TELEQUIP Labs, Inc., total costs of equipment sold and other were $0.7 million for the three months ended March 31, 2003 compared to $0.5 million for the corresponding 2002 period. The decrease in costs as a percentage of applicable revenue was primarily due to the change in the revenue mix for equipment and other sales.

      Selling, General and Administrative Expenses. Selling, general and administrative expenses were $6.3 million for the three months ended March 31, 2003 and $5.7 million in the comparable 2002 period. The increase was primarily due to an increase in professional services and legal fees associated with our ongoing patent litigation.

      Research and Development Expenses. Research and development expenses were $0.8 million in the three months ended March 31, 2003 compared to $0.7 million for the corresponding prior period.

      Depreciation and Amortization Expenses. Depreciation and amortization expense was $3.0 million for the three months ended March 31, 2003, an increase from $2.7 million for the comparable 2002 period. Depreciation expense increased to $2.8 million in the three months ended March 31, 2003 compared to $2.5 million in 2002. Amortization expenses were $0.2 million for the three months ended March 31, 2003 and 2002, respectively.

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      Interest and Other Expenses. Interest and other expense was $0.7 million for the three months ended March 31, 2003 compared to $0.3 million for the corresponding prior period. The increase in 2003 was attributable to an increase in the average amount of indebtedness outstanding and to higher applicable interest rates related to the New Credit Facility obtained in November 2002.

Liquidity and Capital Resources

      The Company has historically relied upon operating cash flow, debt financing and the sale of equity securities to fund operations and capital needs. Our capital needs consist primarily of additions to property and equipment for site telecommunication equipment, upgrades to existing systems and to fund acquisitions.

      Cash provided by continuing operations was $4.0 million for the three months ended March 31, 2003 compared to $3.8 million in the corresponding 2002 period. This increase was primarily due to a $2.1 million reduction in net working capital and a $0.3 million increase in depreciation and amortization expense, partially offset by a $2.2 million decline in net income from continuing operations.

      Net cash used in investing activity of continuing operations was $2.8 million for the three months ended March 31, 2003 compared to $2.2 million in the corresponding 2002 period. Cash used in investing activities consisted primarily of purchases of property, plant, and equipment of $2.0 million for the three months ended March 31, 2003 compared to $2.1 million in the corresponding 2002 period. Cash used in investing activities in the 2003 period also reflect the Company’s investment in Accudata in March 2003 of $0.7 million.

      We anticipate that our capital expenditures in 2003 will increase over 2002 levels based on our anticipated growth in installed systems at correctional facilities. We believe our cash flows from operations and our availability under our New Credit Facility will be sufficient in order for us to meet our anticipated cash needs for new installations of inmate call processing systems, upgrades of existing systems, and to finance our operations for at least the next twelve months.

      Cash used in financing activities of continuing operations consisted primarily of net payments on the Company’s New Credit Facility of $0.9 million during the three months ended March 31, 2003 compared to net debt payments of $0.5 million in the corresponding 2002 period.

      In September 1999, the Company entered into a Senior Secured Revolving Credit Facility (“Credit Facility”) with a commercial bank for working capital and general corporate purposes. The Credit Facility provided maximum credit of $40 million subject to certain financial covenants and our financial performance. In April 2001 our lenders extended the Credit Facility maturity date to March 31, 2002. The maximum available borrowing on the facility was reduced to $30 million consisting of a $10 million term portion and a $20 million line of credit. Interest was set at prime rate plus 1.25% effective March 31, 2001, increasing by 0.25% each quarter thereafter on June 30, September 30, and December 31, 2001. In addition, monthly payments of $0.2 million on the term loan commenced on April 30, 2001. In March 2002 the maturity date of our Credit Facility was extended to July 2002. In April 2002, the Company obtained a further commitment from the bank to extend this facility to January 2003. Maximum available borrowing from the facility was reduced to $21.8 million, consisting of a $7.8 million term portion and a $14.0 million line of credit. Interest was set at prime plus 2.25%, effective March 31, 2002. In addition, monthly payments of $0.2 million on the term loan were set to continue through November 2002, when the Company obtained new financing (see below).

      The Company also issued a subordinated note payable of $3.75 million, due April 30, 2001, to a director and significant shareholder of the Company (the “Subordinated Note Payable”). The note, repaid when the Company obtained new financing (see below), bore interest at prime rate plus one percent per annum payable every six months. The lender received warrants, immediately exercisable, to purchase 25,000 shares of common stock at an exercise price of $6.05 per share for a period of five years. This note was extended in April 2001 to April 2002, at which time the lender received additional warrants, immediately exercisable, to

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