T NETIX INC - 10-Q Quarterly Report

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.

See accompanying notes to unaudited 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 $0.8 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 is presented under the equity method of accounting and such investment is included in “Intangibles and other assets, net” at September 30, 2003. Equity in the results of operations was a negligible loss and income of $0.1 million for the three and nine months ended September 30, 2003, respectively, which is included in “Interest and other expenses, net.”

In June 2002, the Company purchased substantially all of the assets of ACT Telecom, Inc., a Houston, Texas based prepaid calling platform provider and wholly-owned subsidiary of ClearMediaOne, Inc. Assets included a telecommunication switch, prepaid calling platform and associated software. The purchase price was approximately $0.7 million, including $0.3 million in cash and the issuance of a $0.4 million note due and payable on or before June 2003. The purchase price was allocated to property and equipment ($0.6 million) and intangibles and other assets ($0.1 million). The note was paid in full in November 2002.

Income per common share are presented in accordance with the provisions of Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”). Basic income 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 income 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.

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 income (loss) per common share for the three and nine months ended September 30, 2003 does not include 3,072,000 and 3,139,000, respectively, of potentially dilutive securities, including common stock options and warrants, as their effect would be anti-dilutive. For the three and nine months ended September 30, 2002, common stock equivalents of 1,920,000 and 1,722,000, respectively, 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 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):

The per share weighted-average fair value of stock options issued by the Company during 2003 and 2002 was $2.05 and $2.81, 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.

SFAS No. 130, “Reporting Comprehensive Income,” requires that certain items such as foreign currency translation adjustments and unrealized gains and losses on certain derivative instruments classified as a hedge be presented as separate components of shareholders’ equity. Total comprehensive income for the nine months ended September 30, 2003 and September 30, 2002 was approximately $6.0 million and $2.9 million, respectively. Total comprehensive income for the three months ended September 30, 2003 and September 30, 2002 was approximately $6.5 million and $0.6 million, respectively.

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. The adoption of this statement, effective January 1, 2003, had no material impact upon the Company’s financial position or results of operations.

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 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 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.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS No. 150 is effective for all financial instruments created or

modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company does not expect the adoption of SFAS No. 150 to have a material impact on its financial position or results of operations.

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF 00-21, “Revenue Arrangements with Multiple Deliverables,” related to the timing of revenue recognition for arrangements in which goods or services or both are delivered separately in a bundled sales arrangement. The EITF requires that when the deliverables included in this type of arrangement meet certain criteria they should be accounted for separately as separate units of accounting. This may result in a difference in the timing of revenue recognition but will not result in a change in the total amount of revenue recognized in a bundled sales arrangement. The allocation of revenue to the separate deliverables is based on the relative fair value of each item. If the fair value is not available for the delivered items then the residual method must be used. This method requires that the amount allocated to the undelivered items in the arrangement is their full fair value. This would result in the discount, if any, being allocated to the delivered items. This consensus is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. EITF 00-21 did not have an impact upon initial adoption and is not expected to have a material impact on its ongoing results of operations, financial position or cash flows.

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

Bad debt expense for the three months ended September 30, 2003, was $2.4 million or 19% of direct call provisioning revenue of $12.8 million. For the comparative three month period ended September 30, 2002, bad debt expense totaled $3.5 million, or 28% of the $12.7 million in direct call provisioning revenue. Bad debt expense was $10.0 million or 23% of direct call provisioning revenue of $43.2 million for the nine months ended September 30, 2003. For the comparative nine month period ended September 30, 2002, bad debt expense totaled $9.6 million, or 27% of the $35.0 million in direct call provisioning revenue.

Future debt maturities for each of the next five years are summarized as follows (in thousands):

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 $3.8 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 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

the Company’s 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 September 30, 2003, the New Credit Facility provides for maximum credit availability of $28.4 million, subject to limitations based on certain financial covenants, and consists of a $11.4 million Senior Secured Term Loan, a $9.0 million Senior Subordinated Promissory Note and a Revolving Credit Facility with an availability of up to $8.0 million. At September 30, 2003, the Company had no borrowings outstanding under the Revolving Credit Facility.

The Senior Secured Term Loan bears interest at LIBOR plus 6.0%, with 13 equal quarterly principal installment payments remaining through 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 Company was in compliance with all such requirements at September 30, 2003. 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 (in thousands):

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 134,360 shares of SpeechWorks common stock valued at $0.3 million at the time of the transaction, (both cash and stock being 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. As part of the sales agreement, the Company retained the right to utilize the speech recognition technology in the corrections industry. SpeechWorks stock (net of the escrow) received by the Company was subsequently sold in July 2003 with net proceeds to the Company of approximately $0.5 million resulting in a gain of approximately $0.3 million.

During the fourth quarter of 2002, the Company recorded a $1.1 million impairment charge to an asset relating to a prepaid contract for call validation query services that was then in legal dispute between the Company and Illuminet. 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, of the Company’s rights under the contract, which is the likely course of action for the Company with respect to this asset. In September 2003 a preliminary settlement of this legal dispute was reached, pending definitive documents (See Part II Other Information, Item 1. Legal Proceedings). As a result of the terms of this preliminary settlement, the Company further reduced the value of the query transport service agreement to $0.3 million in September 2003. For the nine months ended September 30, 2003 and the year ended December 31, 2002, the prepaid validation asset has been classified as an “Asset Held for Sale.”

In 2002 and 2003, the Company had three reportable segments: the Telecommunications Services, Direct Call Provisioning and Equipment Sales segments (i.e., 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 (i.e., Telecommunications Services segment) and through direct contracts between the Company and correctional facilities (i.e., Direct Call Provisioning segment). In addition, primarily through its subsidiary TELEQUIP Labs, the Company sells inmate call processing systems to certain telecommunication providers (i.e., Equipment Sales segment).

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

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 of each segment based on operating income (loss). Total assets are the assets owned by or allocated to each segment. Assets included in the “Corporate and Other” column include all assets not specifically allocated to a segment. There are no intersegment sales. The Company’s reportable segments are specific business units that offer different products and services and have varying operating costs associated with such products. 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 September 30, 2003 is as follows (in thousands):

Segment information for the three months ended September 30, 2002 is as follows (in thousands):

Segment information for the nine months ended September 30, 2003 is as follows (in thousands):

Segment information for the nine months ended September 30, 2002 is as follows (in thousands):

There was no intersegment revenue for the three and nine months ending September 30, 2003 and the comparable 2002 period. Consolidated total assets included intercompany borrowing eliminations of approximately $1.5 million as of September 30, 2003.

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 converted the $11.4 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 notional 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 90 day 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 Company has designated the interest rate swap as a cash flow hedge in accordance with the requirements of SFAS No. 133, “Accounting for Derivatives and Hedging Activities” and its amendments. Any gain or loss is recorded as interest expense in the same period or periods that the hedged transaction affects earnings. At September 30, 2003, the fair value of the interest rate swap, with quarterly settlements

through September 2006, was a liability of approximately $0.1 million with the offset recorded in other comprehensive income. The Company will assess the valuation of the interest rate swap quarterly on 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.

The Company is involved in various claims and legal actions in the ordinary course of business. In the opinion of management, these matters will not have a material impact on the financial condition, liquidity, or results of operations of the Company.

For a comprehensive understanding of the Company’s 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 the Company’s existing telecommunications service provider customers such as Verizon, AT&T and SBC Communications, to win new contracts for the Company’s 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 the Company’s sales or pricing, the impact of competitive products and pricing in the Corrections Division, the Company’s 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.

The Company makes forward-looking statements in this report and may make such statements in future filings with the Securities and Exchange Commission. The Company 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 the Company’s expectations and possible or assumed future results of operations. When the Company uses any of the words “believe”, “expect”, “anticipate”, “estimate” or similar expressions, we are making a forward-looking statement. While the Company believes that forward-looking statements are reasonable, the reader 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 the Company’s results of operations. Except as required by applicable law, the Company does 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.

In the Corrections Division the Company derives revenue from three operating segments: 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 the Company’s telecommunications service provider customers including Verizon, AT&T, SBC Communications, Qwest and Sprint. Here, the Company provides 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 the Company either shares the revenue with or receives a prescribed fee from the Company’s telecommunications services providers for each call completed. The Company receives additional fees for validating the phone numbers dialed by inmates.

The Company’s Direct Call Provisioning operating segment provides inmate calling services directly as a telecommunications provider to correctional facilities, or “Direct Customers.” In a typical arrangement, the

Company operates under site-specific contracts, generally for a period of two to three years. The Company provides the equipment, security enhanced call processing, call validation, and customer service and support directly to the facility. The Company then uses the services of third parties to bill the calls on the called party’s local exchange carrier bill. Direct call provisioning revenue is substantially higher than the percentage of revenue or transaction based pricing compensation associated with telecommunications services because the Company receives the entire retail value of the collect call. Due to commissions and other operating costs, including the allowance for uncollectible accounts, the gross margin percentage from this model is lower than our telecommunication service arrangements.

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 current or future competitors for these contracts, which would have a material adverse effect on the Company’s business, operating results, and financial condition.

The Company’s Equipment Sales segment generates revenue through the sale of its inmate calling system (primarily the systems of the Company’s 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.

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 the Company 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, the Company 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.

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 the SECUREvoice product. Due to the subsequent sale of the assets, related operating results of the 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”.

Results of Operations for the Three months ended September 30, 2003 Compared to September 30, 2002

The following table sets forth certain statement of operations data as a percentage of total revenue for the three months ended September 30, 2003 and 2002.

Total Revenue. Total revenue for the three months ended September 30, 2003 was $27.9 million, a decrease of 12% from $31.7 million for the corresponding 2002 period. This decrease was attributable to a decrease in telecommunications services of $1.7 million and equipment sales and other of $2.1 million.

Telecommunications services revenue decreased 12% to $12.5 million for the three months ended September 30, 2003, from $14.2 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, the loss of contracts by telecommunication service provider customers and to a decline in call volumes related to blocking certain call attempts that would otherwise be unbillable.

Direct call provisioning revenue increased to $12.8 million for the three months ended September 30, 2003, from $12.7 million in the corresponding prior period. This increase was primarily due to the awarding in the latter six months of 2002 of several department of corrections contracts for which the Company is provisioning comprehensive or the long distance communication service on a direct basis, offset partially by a decline in call volumes related to blocking certain call attempts that would otherwise be unbillable.

Equipment sales and other revenue declined 45% to $2.6 million for the three month period ended September 30, 2003 from $4.7 million in the corresponding prior period. This decrease was primarily due to the finalization of certain financial aspects of the Qwest Agreement which resulted in a $2.5 million one-time payment in 2002.

Operating costs. Total operating costs decreased 6% to $18.3 million for the three months ended September 30, 2003 from $19.3 million in the corresponding prior period. The decrease was primarily due to a

decrease in telecommunication services expenses of $1.5 million, offset partially by an increase of $0.4 million in the cost of equipment sold and a $0.1 million increase in direct call provisioning costs.

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 September 30, 2003 and 2002.

Operating costs associated with providing telecommunications services as a percentage of corresponding revenue were 41% for the three months ended September 30, 2003, a decrease from 44% for the comparable 2002 period. Total telecommunications services operating costs were $5.1 million for the three months ended September 30, 2003 and $6.3 million for the corresponding prior period. The decrease in costs as a percentage of applicable revenue in 2003 was due primarily to a decrease in labor and repair and maintenance expenses, partially offset by increased call validation costs.

Direct call provisioning costs, as a percentage of applicable revenue, were 96% of revenue for the three months ended September 30, 2003 compared to 95% in the comparable 2002 period. Total direct call provisioning operating costs, including bad debt expense, were $12.2 million for the three months ended September 30, 2003 compared to $12.1 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 commission expense associated with one-time settlements of commission disputes, offset partially by a decrease in bad debt expense. The proportional decrease in bad debt expense reflects the Company’s improved ability to block calls attempting to be processed through Competitive Local Exchange Carriers (“CLEC”) where the Company does not have billing arrangements. The Company, beginning in the first quarter of 2002, began modifying its call handling processes to block certain of these CLEC calls. Combined with the deployment of new technology and techniques to control bad debt and unbillables, the Company has been successful in reducing its unbillable call volume and overall bad debt expense as a percentage of direct call provisioning revenue to 19% for the three months ended September 30, 2003 compared to 28% in the 2002 period.

Cost of equipment sold and other as a percentage of applicable revenue increased to 49% of revenue for the three months ended September 30, 2003 from 20% for the corresponding prior period. Total costs of equipment sold and other were $1.3 million for the three months ended September 30, 2003 compared to $0.9 million for the corresponding 2002 period. The increase in costs as a percentage of applicable revenue was primarily due to the favorable settlement of certain claims and liabilities associated with the Qwest Agreement in 2002 and to a writedown of obsolete inventory in 2003.

Selling, General and Administrative Expenses. Selling, general and administrative expenses were $6.5 million for the three months ended September 30, 2003 and $6.6 million in the comparable 2002 period.

Research and Development Expenses. Research and development expenses were $1.0 million in the three months ended September 30, 2003 compared to $0.8 million for the corresponding prior period. This increase was primarily due to an increase in consulting services costs related to the acceleration of several product development efforts.

Impairment of Assets Held for Sale. During the nine months ended September 30, 2003, the Company recorded a $0.7 million impairment of the prepaid Illuminet validation asset classified as an “Assets Held for Sale.” This impairment was based on the terms of a preliminary settlement reached in September 2003 of a legal dispute between the Company and Illuminet, Inc. regarding this asset (See Part II: Other Information, Item 1. Legal Proceedings).

Depreciation and Amortization Expenses. Depreciation and amortization expense was $2.9 million for the three months ended September 30, 2003, a decrease from $3.3 million for the comparable 2002 period. Depreciation expense decreased to $2.7 million in the three months ended September 30, 2003 compared to $3.0 million in 2002. Amortization expenses were $0.2 million for the three months ended September 30, 2003 compared to $0.3 million in 2002.

Patent Litigation Settlement, Net of Expenses. In September 2003, the Company reached a settlement with Global Tel*Link Corporation regarding its ongoing patent infringement lawsuit. The settlement included a one-time cash payment of $12.0 million and an on-going royalty fee over the remaining life of the Company’s patents based on the number of telephone instruments in service. Partially offsetting this settlement were $0.5 million in legal, professional services and license fees incurred during the three months ended September 30, 2003. This compares to $0.2 million in legal fees and other professional service costs incurred in the comparable 2002 period related to this patent litigation. Legal fees and other professional service costs related to the patent litigation have been reclassified to offset the settlement award in 2003. Such litigation related costs were previously reported as selling, general and administrative expenses.

Interest and Other Expenses. Interest and other expense was $0.8 million for the three months ended September 30, 2003 compared to $0.9 million for the corresponding prior period.

Income Tax Expense. Income tax expense was $2.7 million in the three months ended September 30, 2003 due primarily to the increase in pre-tax income in 2003.

Results of Operations for the Nine months ended September 30, 2003 Compared to September 30, 2002

The following table sets forth certain statement of operations data as a percentage of total revenue for the nine months ended September 30, 2003 and 2002.

Total Revenue. Total revenue for the nine months ended September 30, 2003 was $89.0 million, an increase of 1% from $87.8 million for the corresponding 2002 period. This increase was attributable to increases in direct call provisioning of $8.3 million offset partially by a decrease in telecommunications services of $5.9 million and equipment sales and other of $1.2 million.

Telecommunications services revenue decreased 13% to $38.8 million for the nine months ended September 30, 2003, from $44.7 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, the loss of contracts by telecommunication service provider customers and to a decline in call volumes related to blocking certain call attempts that would otherwise be unbillable.

Direct call provisioning revenue increased 20% to $43.2 million for the nine months ended September 30, 2003, from $35.0 million in the corresponding prior period. This increase was primarily due to the award in the latter half of 2002 of several department of corrections contracts for which the Company is provisioning comprehensive or long distance communication service on a direct basis. The addition of these sites is a result of being successful in providing competitive bidding arrangements for contracts directly with correctional facilities. Partially offsetting the increased call volume from new contracts was a decline in call volumes related to blocking certain call attempts that would otherwise be unbillable.

Equipment sales and other revenue decreased 15% to $6.9 million for the nine month period ended September 30, 2003 from $8.1 million in the corresponding prior period. This decrease was primarily due to the favorable settlement of certain financial aspects of the Qwest Agreement which resulted in a one-time $2.5 million payment in 2002, offset partially by increased ancillary equipment sales and equipment upgrades to several telecommunication service provider customers in 2003. Such equipment sales and the sale of

equipment through the Company’s wholly-owned subsidiary, TELEQUIP Labs, Inc. are dependent upon the timing of sales and installations of a limited number of telecommunications services provider customers.

Operating costs. Total operating costs increased 9% to $57.6 million for the nine months ended September 30, 2003 from $52.7 million in the corresponding prior period. The increase was primarily due to an increase in direct call provisioning expenses of $6.8 million and equipment sales and other of $0.3 million, partially offset by a decrease in telecommunication services expenses of $2.2 million.

The following table sets forth the operating costs and expenses for each type of revenue as a percentage of corresponding revenue for the nine months ended September 30, 2003 and 2002.

Operating costs associated with providing telecommunications services as a percentage of corresponding revenue was 39% for the nine months ended September 30, 2003 and 38% for the comparable 2002 period. Total telecommunications services operating costs were $15.1 million for the nine months ended September 30, 2003 compared to $17.1 million for the corresponding prior period.

Direct call provisioning costs, as a percentage of applicable revenue, were 92% of revenue for the nine months ended September 30, 2003 compared to 95% in the comparable 2002 period. Due to the awarding of several department of corrections contracts in the latter half of 2002, total direct call provisioning operating costs, including bad debt expenses, increased to $40.0 million for the nine months ended September 30, 2003 from $33.2 million for the corresponding 2002 period. The decrease in costs as a percentage of applicable revenue in 2003 was due primarily to a proportional decrease in bad debt expense and communication costs. The decrease in bad debt expense reflects the Company’s improved ability to block calls attempting to be processed through Competitive Local Exchange Carriers (“CLEC”) where the Company does not have billing arrangements. The Company, beginning in the first quarter of 2002, began modifying its call handling processes to block certain of these CLEC calls. Combined with the deployment of new technology and techniques to control bad debt and unbillables, the Company has been successful in reducing its unbillable call volume and overall bad debt expense as a percentage of applicable revenue to 23% for the nine months ended September 30, 2003 compared to 27% in the 2002 period.

Cost of equipment sold and other as a percentage of applicable revenue increased to 42% of revenue for the nine months ended September 30, 2003 from 31% for the corresponding prior period. Total costs of equipment sold and other were $2.9 million for the nine months ended September 30, 2003 and $2.5 million for the corresponding prior period. The increase in costs as a percentage of applicable revenue was primarily due to the favorable settlement of certain claims and liabilities associated with the Qwest Agreement in 2002 and to a writedown of obsolete inventory in 2003, offset partially by a change in the revenue mix for equipment and other sales in 2003.

Selling, General and Administrative Expenses. Selling, general and administrative expenses were $17.4 million for the nine months ended September 30, 2003 and $17.3 million in the comparable 2002 period.

Research and Development Expenses. Research and development expenses were $2.6 million in the nine months ended September 30, 2003 compared to $2.3 million for the corresponding prior period. This increase was primarily due to an increase in consulting costs related to the acceleration of several product development efforts.

Impairment of Assets Held for Sale. During the nine months ended September 30, 2003, the Company recorded a $0.7 million impairment of the prepaid Illuminet validation asset classified as an “Assets Held for Sale.” This impairment was based on the terms of a preliminary settlement reached in September 2003 of a legal dispute regarding this asset (See Part II: Other Information, Item 1. Legal Proceedings).

Depreciation and Amortization Expenses. Depreciation and amortization expense was $8.9 million for the nine months ended September 30, 2003, an increase from $8.7 million for the comparable 2002 period. Depreciation expense increased to $8.3 million in the nine months ended September 30, 2003 compared to $7.9 million in 2002. Amortization expenses were $0.6 million for the nine months ended September 30, 2003 compared to $0.8 million in the corresponding prior period.

Patent Litigation Settlement, Net of Expenses. In September 2003, the Company reached a settlement with Global Tel*Link Corporation regarding its ongoing patent infringement lawsuit. The settlement included a one-time cash payment of $12.0 million and an on-going royalty fee over the remaining life of the Company’s patents based on the number of telephone instruments in service. Partially offsetting this settlement were $2.1 million in legal, professional services and license fees incurred during the nine months ended September 30, 2003. This compares to $1.5 million in legal fees and other professional service costs incurred in the comparable 2002 period related to this patent litigation. Legal fees and other professional service costs related to the patent litigation have been reclassified to offset the settlement award in 2003. Such litigation related costs were previously reported as selling, general and administrative expenses.

Interest and Other Expenses. Interest and other expense was $2.6 million for the nine months ended September 30, 2003 compared to $1.8 million for the corresponding prior period. The increase in 2003 was attributable to an increase in the average amount of indebtedness outstanding, amortization of debt financing costs and to higher applicable interest rates related to the New Credit Facility obtained in November 2002.

Income Tax Expense. Income tax expense was $2.9 million in the nine months ended September 30, 2003 compared to $0.2 million for the corresponding prior period due primarily to the increase in pre-tax income in 2003.

The Company has historically relied upon operating cash flow, debt financing and the sale of equity securities to fund operations and capital needs. The Company’s 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 $23.0 million for the nine months ended September 30, 2003 compared to $6.6 million in the corresponding 2002 period. This increase was primarily due to a $9.4 million reduction in net working capital, a $2.9 million increase in net income from continuing operations and $12.0 million in cash received related to the patent litigation settlement.

Net cash used in investing activity of continuing operations was $5.9 million for the nine months ended September 30, 2003 compared to $4.7 million in the corresponding 2002 period. Cash used in investing activities consisted primarily of purchases of property, plant, and equipment of $5.6 million for the nine months ended September 30, 2003 compared to $5.0 million in the corresponding 2002 period. Cash used in investing activities in the 2003 period also reflects the Company’s investment in Accudata in March 2003 of $0.8 million.

The Company believes that cash flows from operations and availability under the New Credit Facility will be sufficient in order to meet anticipated cash needs for new installations of inmate call processing systems, upgrades of existing systems, and to finance 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 $2.6 million during the nine months ended September 30, 2003 compared to net debt payments of $1.8 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 financial performance. In April 2001, 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 the 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 $3.8 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 purchase 25,000 shares of 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 the Company’s 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.

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 September 30, 2003, the New Credit Facility provides for maximum credit availability of $28.4 million, subject to limitations based on certain financial covenants, and consists of a $11.4 million Senior Secured Term Loan, a $9.0 million Senior Subordinated Promissory Note and a Revolving Credit Facility with an availability of up to $8.0 million. At September 30, 2003, the Company had no borrowings outstanding under the Revolving Credit Facility.

The Senior Secured Term Loan bears interest at LIBOR plus 6.0%, with 13 equal quarterly principal installment payments remaining through December 2006. The Senior Subordinated Promissory Note is due in 2008 and bears interest at a fixed rate of 13%, payable on a quarterly basis, with an additional 4.75% 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. Availability under the Revolving Credit Facility is based on the lesser of up to 85% 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.

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.

Set forth below is a summary of the Company’s material contractual obligations and commitments as of September 30, 2003:

Under the Company’s New Credit Facility, acceleration of principal payments would occur upon payment default, violation of debt covenants or breach of certain other conditions set forth in the New Credit Facility not cured within 15 days. At September 30, 2003, the Company was in compliance with all of its debt covenants. There are no provisions within the Company’s leasing arrangements that would trigger acceleration of future lease payments. (See Notes 3 and 6 to the Condensed Consolidated Financial Statements for additional information regarding the obligations and commitments listed above.)

The Company does not use securitization of trade receivables, affiliation with special purpose entities or synthetic leases to finance its operations. Additionally, the Company has not entered into any arrangement requiring the Company to guarantee payment of third party debt or to fund losses of an unconsolidated special purpose entity.

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 on 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. The adoption of this statement, effective January 1, 2003, had no material impact on the Company’s financial position or results of operations.

“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 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.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS No. 150 is effective for all financial instruments created or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company does not expect the adoption of SFAS No. 150 to have a material impact on its financial position or results of operations.

As of September 30, 2003, the Company has debt outstanding under the New Credit Facility of $20.4 million. As of September 30, 2003, the New Credit Facility provides for maximum credit availability of $28.4 million, subject to limitations based on certain financial covenants, and consists of a $11.4 million Senior Secured Term Loan, a $9.0 million Senior Subordinated Promissory Note and a Revolving Credit Facility with an availability of up to $8.0 million. The Senior Secured Term Loan and the Revolving Credit Facility bear interest at LIBOR plus 6% and prime plus 3.5%, respectively. Since the interest rate on the Senior Secured Term Loan outstanding and the Revolving Credit Facility is variable and is reset periodically, we are exposed to interest risk. Before implementation of the interest rate swap described below, an increase in interest rates of 1% would have increased estimated annual interest expense by approximately $0.1 million based on the amount of borrowings outstanding under the New Credit Facility at September 30, 2003.

Since the interest rate on the Senior Secured Term Loan outstanding is variable, the Company is exposed to variability in interest payments due to changes in interest rates. Effective March 31, 2003, the Company entered into an interest rate swap agreement which effectively converted the $11.4 million of variable rate debt currently outstanding under the New Credit Facility to a fixed rate. Under the terms of the interest rate swap agreement, the Company will receive variable interest rate payments and make fixed interest rate payments, 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.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15e under the Securities Exchange Act of 1934).

Based on that evaluation, management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective. There have been no significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

From time to time the Company has been, and expects to continue to be subject to various legal and administrative proceedings or various claims in the normal course of business. The Company believes the ultimate disposition of these matters will not have a material adverse effect on the Company’s financial condition, liquidity, or results of operations.

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.

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. The claims against Global Tel*Link were settled in September 2003 with a cash payment to T-NETIX by Global Tel*Link of $12.0 million and on-going royalty payments of $12 per month for each telephone instrument in excess of 25,200 connected to a device using any of the patented technologies.

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 queries 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 were written down during the period ended December 31, 2002) are classified as an “Asset Held for Sale” at December 31, 2002. A preliminary settlement was reached in September 2003, pending definitive documents. In the settlement, T-NETIX will have the right to purchase 200 million query transports for $0.0025 each at any time during the next 10 years. These rights are assignable to any party that is not a customer of Illuminet. As a result of this recent settlement, the Company further reduced the value of this query transport agreement to $0.3 million in September 2003. (See Note 4 of “Notes to the Condensed Consolidated Financial Statements.”)

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. The case is in early stages of discovery.

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 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. On June 30, 2003, the Court dismissed the action. Plaintiff has appealed the ruling.

In May 2003, Global Tel*Link Corporation filed patent litigation against the Company. The lawsuit, filed in the Northern District of Texas, Dallas division, alleges infringement of one United States patent protecting a telephone apparatus. This litigation is in its very early stage.

On August 20, 1996, Value Added Communications, Inc. (“VAC”) and Gateway Technologies, Inc. entered into a Patent License Agreement regarding fourteen United States Patents owned or controlled by Gateway and involving the use of such patents for correctional facilities and for hospitals. One of these patents pertains to on-site automated operator systems that allow persons to make collect telephone calls without the intervention of a human operator, which was one of the patents that was the subject of the recently settled T-NETIX v. Global Tel*Link litigation described above. By letter of October 14, 2003 T-NETIX notified VAC that the license agreement was terminated for breach. On October 24, 2003 VAC filed a lawsuit in State District Court in Dallas County, Texas seeking to have the court declare that VAC was not in breach of the agreement and that the agreement is in force and effect.

The Company believes the ultimate disposition of the forgoing matters will not have a material adverse effect on the Company’s financial condition, liquidity, or results of operations.

Press Release, “T-NETIX Obtains $12 Million Cash Settlement from Global Tel*Link Corporation,” filed as Form 8-K with the SEC on September 8, 2003.

Press Release, “T-NETIX Reports $6.5 Million Net Income for Third Quarter and $6.2 Million for Nine Months Ended September 30, 2003,” filed as Form 8-K with the SEC on November 12, 2003.

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	By:	/s/ HENRY G. SCHOPFER III



	Henry G. Schopfer III,
	Chief Financial Officer


Delaware		84-1037352
(State or Other Jurisdiction of Incorporation)		(I.R.S. Employer Identification No.)

2155 Chenault Drive, Suite 410 Carrollton, Texas 75006 (Address of principal executive offices)		75006 (Zip Code)


Class		Outstanding at October 27, 2003

Common stock, $0.01 stated value		15,052,210


PART I
	Item 1. Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure About Market Risk
	Item 4. Controls and Procedures
PART II OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
INDEX TO EXHIBITS
EX-31.1 Certification of CEO - Section 302
EX-31.2 Certification of CFO - Section 302
EX-32.1 Certification of CEO - Section 906
EX-32.2 Certification of CFO - Section 906


		Page

PART I FINANCIAL INFORMATION
Item 1	Condensed Financial Statements (Unaudited)		3
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3	Quantitative and Qualitative Disclosure About Market Risk		29
Item 4	Controls and Procedures		29
PART II OTHER INFORMATION
Item 1	Legal Proceedings		30
Item 2	Changes in Securities and Use of Proceeds		31
Item 3	Defaults Upon Senior Securities		31
Item 4	Submission of Matters to a Vote of Security Holders		31
Item 5	Other Information		32
Item 6	Exhibits and Reports on Form 8-K		32
Signatures			33
Index to Exhibits			34


Condensed Consolidated Balance Sheets as of September 30, 2003 (Unaudited) and December 31, 2002			3
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2002 (Unaudited)			4
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002 (Unaudited)			5
Notes to Condensed Consolidated Financial Statements (Unaudited)			6

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

		or

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


			September 30,
			2003			December 31,
			(Unaudited)			2002

ASSETS
Cash and cash equivalents			$	20,837		$	6,554
Accounts receivable, net (note 2)				17,134			20,038
Prepaid expenses				1,729			1,608
Inventories				1,187			1,424

		Total current assets		40,887			29,624
Property and equipment, net (note 2)				22,731			25,342
Goodwill, net				2,245			2,245
Deferred tax asset, net				1,395			2,297
Assets held for sale				285			937
Intangible and other assets, net (note 2)				5,609			6,212

		Total assets	$	73,152		$	66,657


LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
	Accounts payable		$	10,855		$	11,070
	Accrued liabilities (note 2)			7,466			5,742
	Current portion of long-term debt (note 3)			3,565			3,694

		Total current liabilities		21,886			20,506
	Long-term debt (note 3)			16,507			19,091

		Total liabilities		38,393			39,597
Commitments and contingencies Stockholders’ equity:
	Preferred stock, $.01 stated value, 10,000,000 shares authorized; no shares issued or outstanding at September 30, 2003 and December 31, 2002, respectively			—			—
	Common stock, $.01 stated value, 70,000,000 shares authorized; 15,052,210 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively			150			150
	Additional paid-in capital			43,986			42,334
	Accumulated other comprehensive income (loss)			(105	)		—
	Accumulated deficit			(9,272	)		(15,424	)

		Total stockholders’ equity		34,759			27,060

Total liabilities and stockholders’ equity			$	73,152		$	66,657



				Three Months						Nine Months
				Ended						Ended
				September 30,						September 30,

				2003			2002			2003			2002

Revenue:
	Telecommunication services			$	12,542		$	14,222		$	38,847		$	44,719
	Direct call provisioning				12,781			12,736			43,235			34,954
	Equipment sales and other				2,579			4,710			6,913			8,127

			Total revenue		27,902			31,668			88,995			87,800
Operating costs and expenses:
	Operating costs (exclusive of depreciation and amortization shown separately below)
		Telecommunications services			5,078			6,270			15,056			17,142
		Direct call provisioning, exclusive of bad debt expense			9,804			8,623			29,958			23,638
		Direct call provisioning — bad debt expense			2,409			3,503			10,017			9,570
		Cost of equipment sold and other			1,266			939			2,888			2,532

			Total operating costs		18,557			19,335			57,919			52,882

			Gross margin		9,345			12,333			31,076			34,918
	Selling, general and administrative				6,522			6,649			17,449			17,288
	Research and development				995			799			2,648			2,320
	Impairment of assets held for sale				653			—			653			—
	Depreciation and amortization				2,918			3,267			8,884			8,678

			Total operating costs and expenses		29,645			30,050			87,553			81,168

			Operating income (loss)		(1,743	)		1,618			1,442			6,632
Patent litigation settlement, net of expenses					11,549			(205	)		9,935			(1,501	)
Interest and other expenses, net					(802	)		(897	)		(2,627	)		(1,823	)
Gain on sale of assets					254			—			286			36

Income from continuing operations before income taxes					9,258			516			9,036			3,344
Income tax expense					(2,726	)		—			(2,884	)		(180	)

	Net income from continuing operations				6,532			516			6,152			3,164
Net loss from discontinued operations					—			(182	)		—			(615	)
Gain on sale of discontinued operations					—			308			—			308

Income (loss) from discontinued operations					—			126			—			(307	)

Net income applicable to common shareholders				$	6,532		$	642		$	6,152		$	2,857

	Income per common share from continuing operations
		Basic		$	0.43		$	0.03		$	0.41		$	0.21

		Diluted		$	0.43		$	0.03		$	0.40		$	0.21

	Income (loss) per common share from discontinued operations
		Basic		$	—		$	0.01		$	—		$	(0.02	)

		Diluted		$	—		$	0.01		$	—		$	(0.02	)

	Income per common share applicable to common shareholders
		Basic		$	0.43		$	0.04		$	0.41		$	0.19

		Diluted		$	0.43		$	0.04		$	0.40		$	0.19

	Shares used in computing net income (loss) per common share
		Basic			15,052			15,049			15,052			15,038

		Diluted			15,347			15,359			15,293			15,434



					Nine Months Ended
					September 30,

					2003			2002

Cash flows from operating activities:
	Net income from continuing operations				$	6,152		$	3,164
	Adjustments to reconcile net income (loss) to net cash provided by operating activities from continuing operations:
		Depreciation and amortization				8,884			8,678
		Impairment of assets held for sale				653			—
		Bad debt expense				10,047			9,663
		Deferred taxes				2,554			—
		Gain on the sale of assets				(286	)		(344	)
		Equity income from unconsolidated subsidiary				(22	)		—
		Accretion of discount on subordinated promissory note				62			—
		Changes in operating assets and liabilities:
			Accounts receivable			(7,143	)		(14,671	)
			Prepaid expenses			(121	)		(1,102	)
			Inventories			237			(190	)
			Intangibles and other assets			530			(668	)
			Loss on write-down of investments			—			158
			Accounts payable			(215	)		(1,631	)
			Accrued liabilities			1,620			3,515

				Cash provided by operating activities of continuing operations		22,952			6,572

Cash used in investing activities:
	Purchase of property and equipment					(5,613	)		(5,029	)
	Proceeds from sale of assets					532			638
	Investment in unconsolidated subsidiaries					(812	)		—
	Other investing activities					—			(325	)

				Cash used in investing activities of continuing operations		(5,893	)		(4,716	)

Cash flows from financing activities:
	Net payments on line of credit					—			(1,849	)
	Payments on senior secured term note					(2,625	)		—
	Payments on other debt					(151	)		(237	)
	Common stock issued for cash under Employee Stock Option Plan					—			15

				Cash used in financing activities of continuing operations		(2,776	)		(2,071	)

Cash used by discontinued operations						—			(307	)

Net increase (decrease) in cash and cash equivalents						14,283			(522	)
Cash and cash equivalents at beginning of period						6,554			995

Cash and cash equivalents at end of period					$	20,837		$	473

Supplemental Disclosures:
	Cash paid during the period for:
		Interest			$	1,640		$	1,861

		Income taxes			$	204		$	144

Note received in exchange of assets					$	—		$	91

Assets received in exchange for note					$	—		$	300

Common stock received in exchange for assets					$	—		$	278

Deferred taxes used for stock options charged to additional paid-in capital					$	1,652		$	—



			Three Months Ended				Nine Months Ended
			September 30,				September 30,

			2003		2002		2003		2002

Numerator:
	Net income applicable to common shareholders		$	6,532	$	642	$	6,152	$	2,857

Denominator:
	Denominator for basic income per common share			15,052		15,049		15,052		15,038
	Effect of dilutive securities:
		Stock options		109		277		55		366
		Warrants		186		33		186		30

	Denominator for diluted income per common share			15,347		15,359		15,293		15,434


	2003		2002

Dividend yield		—		—
Expected volatility		81.9%		80.9%
Average expected option life		5.0 years		4.9 years
Risk free interest rate		2.8%		2.9%


Year ending December 31:
	2003		$	875
	2004			3,500
	2005			3,500
	2006			3,500
	2007			—

		Total debt maturities	$	11,375


	Telecommunication		Direct Call			Equipment		Corporate
	Services		Provisioning			Sales & Other		and Other			Total

Revenue from external customers	$	12,542	$	12,781		$	2,579	$	—		$	27,902
Gross margin		7,464		568			1,313		—			9,345
Depreciation and amortization		746		574			33		1,565			2,918
Other operating costs and expenses		—		—			360		7,810			8,170

Operating income (loss)		6,718		(6	)		920		(9,375	)		(1,743	)
Patent litigation, net of expenses												11,549
Interest and other expenses, net												(548	)

Segment earnings from continuing operations before income tax											$	9,258

Total assets	$	13,044	$	14,375		$	5,702	$	40,031		$	73,152


Item 2.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*


	Due In One		Due In		Due In		Due After
	Year Or Less		2-3 Years		4-5 Years		5 Years		Total


	($ In thousands)
Senior secured term note	$	3,500	$	7,000	$	875	$	—	$	11,375
Senior subordinated promissory note		—		—		—		9,000		9,000
Operating leases		807		635		3		—		1,445
Capital lease and other		65		34		—		—		99

Total contractual obligations and commitments	$	4,372	$	7,669	$	878	$	9,000	$	21,919


Item 1.	*Financial Statements*


	*Unaudited Financial Statements*


	*Acquisitions*


	*Income Per Common Share*


Item 3.	*Quantitative and Qualitative Disclosure About Market Risk*


Item 4.	*Submission of Matters to a Vote of Security Holders*


Exhibit
Number		Description

	31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


Exhibit
No.		Description

	31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.