Back to GetFilings.com

Table of Contents

UNITED STATES

FORM 10-K

x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

FOR THE FISCAL YEAR ENDED APRIL 30, 2004

OR

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

Commission file number 0-8141

Securities registered pursuant to Section 12(b) of the Act: None

Common Stock ($.10 par value per share)

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

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

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes o     No þ

      As of November 1, 2003 (the most recently completed fiscal second quarter), the aggregate market value of the voting stock held by non-affiliates of the registrant, computed by reference to the average high and low prices on such date as reported by the Nasdaq National Market System was approximately $35,802,000.

      As of July 19, 2004 there were outstanding 13,466,346 shares of the registrant’s common stock, par value $.10 per share, its only class of equity securities.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the registrant’s definitive proxy statement to be filed within 120 days after the end of the fiscal year covered by this report are incorporated by reference into Part III hereof.

TABLE OF CONTENTS

Table of Contents

PART I

      Norstan, Inc. (Norstan, the Company, we, us, or our) is a full-service communications solutions and services company delivering voice and data technologies and services, and remanufactured equipment to corporate end-users and public sector companies. Norstan offers a full range of technologies for customer contact solutions and converged solutions, including applications such as messaging, conferencing and enterprise mobility. Additionally, we provide a host of communications services including ProtectNet® Life Cycle services, project management, implementation, field delivery, voice and data network monitoring, and managed and professional services.

      Norstan operates principally through its subsidiaries: Norstan Communications, Inc., Norstan Canada, Ltd., Vibes Technologies, Inc. and Norstan Financial Services, Inc. Headquartered in Minnetonka, Minnesota, we have sales and services locations in the United States and Canada. Norstan’s common stock is listed on the NASDAQ stock market under the symbol NRRD.

      Our mission is to improve the way our customers communicate. We offer a broad array of technology platforms, software solutions and on-going system maintenance services. Currently, we work with approximately 2,400 key customers, and have serviced approximately 12,000 sites over the past two years. We draw customers from a variety of industry groups, including the following:

      We have established strategic relationships with market leading communications manufacturers that enable our ability to offer best-in-class, custom-tailored solutions to our customers. Norstan maintains 25 sales and service locations and 5 distribution centers in the United States and Canada. We serve numerous customer sites across a broad range of industries and focus our marketing efforts on middle-market and Fortune 2000 companies with complex technology and communications requirements. We believe our service capabilities will enable Norstan to capture a greater portion of each customer’s communication budgets in the future, as well as, provide other growth opportunities through multi-channel marketing.

      To address the complex communications requirements of our customers, Norstan provides a broad range of products and services through two interrelated business segments: Communications Solutions and Services and Resale Services, which respectively accounted for 86.6% and 13.4% of Norstan’s fiscal 2004 revenues. Communications Solutions and Services provide solutions and services focused on enterprise and public sector customers in the U.S. and Canada, including hardware and software applications that support voice and data communications and customer contact solutions. Resale Services provides refurbished voice and data products to the secondary market.

      In February 2004, we announced a reorganization of our Communications Solutions and Services business segment, which is comprised primarily of our Solutions and Services and Corporate Customer Services business units. Also included in this business segment are Norstan Convergence Development Group (Norstan CDG) and our Financial Services business units.

	•	Solutions and Services. Solutions and Services, the largest business within this segment, concentrates customer acquisition and retention efforts in two geographically focused business units. Each business unit is managed by a senior vice president with sales, operational, project management,

1

Table of Contents

		financial performance and services delivery responsibilities that are aligned with specific solutions for customers in defined geographic markets.
	•	Corporate Customer Services. We have realigned several of our sales support and services functions to form our Corporate Customer Services organization. This organization focuses on providing support to the Solutions and Services team and meeting customer needs for products, service programs, engineering and professional services, product marketing, remote support, procurement and logistics.

      Norstan CDG develops packaged and customized applications that help accelerate and enhance the migration strategies for the increasing number of customers embracing Internet Protocol (IP) telephony. Norstan CDG develop and deploys applications compatible with Cisco Systems’ IP solutions. This business delivers its solutions and services exclusively through reseller partners via the Norstan CDG IPT Alliance Partner Program.

      Effective April 30, 2004, Financial Services was incorporated into the Communications Solutions and Services business segment. As a result of our strategic decision in fiscal 2002 to no longer offer financing directly to our customers, revenues for this business continue to decline as we completely wind down its operations. This fact, coupled with our restructuring efforts in fiscal 2004, make it no longer necessary to provide these results as a separate business segment.

      Norstan’s Channels Development business unit, specializing in technology implementation and support services for network providers, manufacturers, integrators and resellers, has been integrated into the Solutions and Services business, expanding the sales and services support offered to current channel partners. At this time, Norstan is not actively pursuing new channel partner relationships.

      Norstan’s Resale Services segment is comprised of two businesses:

	•	Norstan Resale Services Group. Norstan Resale Services Group, a business unit of Norstan Communications, Inc., offers customers refurbished telephony equipment, as well as, new video conferencing systems, components, desktop products, accessories and services. Such products and services were previously offered through Siemens Resale Services group prior to Siemens’ election in July 2004 to end its alliance with Norstan in the used equipment business.
	•	Vibes Technologies, Inc. Vibes Technologies, Inc., a wholly owned subsidiary of Norstan Communications, Inc., is a leader in telecom and data equipment remanufacture and repair, specializing in top-line key systems, phones, data and other components.

      In March 2003, Norstan purchased from NetCom Systems, Inc. certain assets, including intellectual property, relating to NetCom’s voice over IP telephony applications software operations. This unit, renamed the Norstan Convergence Development Group, is involved in the development of applications that increase the effectiveness and productivity of IP communications systems. The acquisition consideration totaled $3.0 million, consisting of a cash payment of $1.1 million at closing and $1.1 million 120 days after the closing, and guaranteed payments aggregating $800,000 deliverable over the next two years. The purchase agreement provides that Norstan may pay NetCom Systems contingent consideration of up to $3.0 million based on the amount of new software license fees received by Norstan during the two-year period following the closing of the purchase transaction. At our discretion, up to 50% of any contingent consideration may be paid in shares of Norstan’s common stock. We hired certain key NetCom personnel associated with NetCom’s development of IP telephony applications software. In fiscal 2003, we recorded $2.6 million for intangible assets relating to proprietary technology and $400,000 in goodwill relating to the $3.0 million acquisition consideration. Results of Norstan CDG are included in our Communications Solutions and Services business segment.

2

Table of Contents

      In July 2002, we completed the sale of our Network Services business to NetWolves Corporation for $7.5 million, including $3.75 million in cash and a promissory note for $3.75 million. During the fourth quarter of fiscal 2003, we received $2.9 million in cash and other non-monetary assets in early settlement of this note. Management concluded that Network Services lacked synergies with our strategic focus.

      There is a transformation happening within the enterprise market — a slow but steady migration from traditional private-branch exchange (PBX) networks to IP telephony. Voice over IP (VoIP) technology has improved in quality causing enterprises to evaluate the strategic benefits of IP solutions and the return on investments (ROI) associated with a migration as they purchase or upgrade their communications infrastructure. Network convergence has become widely accepted. The Internet is now a strategic method to deliver applications and services. IP communications is no longer a tactical decision for the enterprise — it is a strategic investment with a real ROI.

      Demand for communications products and services are showing signs of modest improvement. Gartner Dataquest, a market research firm specializing in telecommunications market information, estimated in 2003, IP lines on both pure IP-PBX and IP-enabled systems composed approximately 14% of all premises switching equipment (PSE) line shipments, up from 9% the previous year. Within the IP market sector, 55% of lines ship on pure IP-PBX systems, while the remaining 45% ship on IP-enabled platforms. IP uptake remains highest in North America, while 20% of all PSE line shipments were IP in 2003. Within four years, Gartner expects IP line shipments to have overtaken traditional lines on premises switching systems. In 2007, Gartner Dataquest predicts 51% of all PSE lines will be IP, most of the rest will be traditional lines on IP-enabled systems, and a very small percentage will be traditional lines on PBX/key telephone systems.

      According to industry research firm InfoTech, the forecast for revenue from converged IP telephony infrastructure applications and services for the U.S. enterprise segment is expected to exceed $10.0 billion in 2007, up from $1.9 billion in 2003. Additionally, revenue from converged applications on enterprise IP telephony systems is expected to reach $3.0 billion in 2007, up from $0.4 billion in 2003.

      As the economy shows signs of recovery, and as the enterprise segment continues its dependence on technology-based solutions, information technology (IT) spending is expected to increase. Gartner believes that the market for IP telephony products and information technology services has reached an inflection point as investments are being made to upgrade or replace voice and data equipment purchased prior to the significant spending made in preparation of the Y2K changeover that occurred over four years ago. In previous years, these purchasing decisions had been delayed due to slow development and acceptance of new IP technology, and economic conditions, among other factors. In sum, we believe that the current mix of technological advances, economic conditions and enterprise dependence on technology-based solutions will create demand for new complex, business applications and upgrades in 2004 and beyond.

      While customers continue to rely heavily on technology to reduce transaction costs by increasing operational efficiencies, the bias toward software-centric solutions in lieu of hardware continues. Notwithstanding macroeconomic conditions, growth continues to occur in areas such as customer contact solutions, computer telephony integration, unified media and convergence solutions (IP telephony).

      Current financial pressures are also making it increasingly difficult for communications equipment manufacturers to support a direct distribution model. Moreover, most independent distribution channels lack an adequate geographic footprint, infrastructure, processes, and resources to effectively fulfill manufacturers’ need to deploy complex high-end technology solutions. These factors have resulted in the need to perform systems integration and support services through third-party providers. In addition, a key competency being driven by the market is the ability to effectively integrate disparate technology platforms into enterprise-wide applications solutions. As a third-party provider, Norstan believes we are well positioned to take advantage of this market opportunity.

3

Table of Contents

      While the recent economic outlook has been positive and overall levels of business capital spending in certain market segments, specifically information technology and telecommunications services industries, are showing signs of improvement, a lag in near-term spending continues to negatively affect our business performance. However, we believe that as the economy further strengthens and capital spending improves, customers will invest in communications systems and infrastructure.

      In fiscal 2003 and the first half of fiscal 2004, Norstan’s strategy was one of gaining market share through geographic expansion into tier one markets. We broadened our presence into cities such as New York, Los Angeles, Dallas, Chicago and San Francisco. Our recent financial performance and financial constraints have resulted in our need to re-evaluate our investments in certain of these and other cities, such as Atlanta, Detroit and Philadelphia. Our strategic focus has now changed from one of broader geographic coverage, to one of increasing share by creating deeper coverage in specific markets with specific technologies. We will be more selective in our pursuit of new customers, markets, products and services. This change in strategic focus may result in lower revenues but higher profitability in fiscal 2005 than in fiscal 2004.

      In fiscal 2001, our relationships with Nortel Networks and Cisco Systems expanded our geographic reach and are providing new revenue opportunities. With the addition of these new technology partners, we have been experiencing pricing pressure and a change in our product mix, which in part, has contributed to decreased product gross margins that negatively affected our financial performance. We believe that the restructuring undertaken in fiscal 2004 of our Communications Solutions and Services business segment and increased emphasis on project management capabilities will help reduce the negative affect on gross margins in the future.

      Our Solutions and Services business focuses sales and operations in specific geographic markets. Within these geographies, communications solutions are offered where Norstan has an established customer base and expertise in services delivery in the areas of converged solutions, customer contact solutions, infrastructure and ProtectNet® Life Cycle services. Within this organization is a dedicated sales team focused on serving our installed customer base. Approximately 50% of our revenue is annuity in nature derived from the on-going services we provide these customers.

      Our Resale Services segment expects increased volume from the re-sale of refurbished telecommunications and data equipment and industry consolidation. Vibes Technologies, Inc. is uniquely positioned to take advantage of these trends with its e-commerce web site. The combination of this web-based approach and Norstan’s knowledge of the secondary market is expected to provide the basis for growth in this business segment. Our Norstan Resale Services Group offers refurbished communications products and services from a variety of manufacturers to the secondary market.

      We are focusing on several initiatives to better position our business to be successful in fiscal 2005:

	•	Improving company profitability — There are opportunities in many areas of our business to improve Norstan’s profitability, such as improving gross margins for our installation and services, decreasing the cost of customer acquisition, and reducing general and administrative overhead.
	•	Retaining our existing customers — We have built a substantial installed customer base consisting of Fortune 2000 and middle-market companies. We will continue to increase our resources committed to maintaining these relationships, offering our customers additional solutions and services that further improve their communications systems and their ability to run their businesses more efficiently.

4

Table of Contents

	•	Delivering advanced business applications — A significant differentiator for Norstan is our capability to provide customers with advanced business applications and services to support them. We are delivering advanced business applications and strategic solutions, complementing these applications with knowledge, professional services and support upon which Norstan has built its reputation for over 30 years.
	•	Developing Resale Services — We will continue to develop our Resale Services businesses by adding additional voice and data products and accessories that will augment our existing offerings.
	•	Developing new business selectively — Competition within the areas of convergence and applications is fierce and the technology is complex. We will concentrate our new business development in geographic areas where opportunities, skills and resources exist, and on sales and services yielding the highest returns.

      Norstan provides customers with a broad range of communication solutions and services. Our capabilities include the design, development and implementation and ongoing support of communications solutions in a variety of customer environments. These products and services are delivered through two business segments: Communications Solutions and Services and Resale Services.

      Within its core Communications Solutions and Services segment are two interrelated business units:

	Solutions and Services — Provides best-in-class communications technologies and services focused on Fortune 2000 and middle-market enterprise customers in the U.S. and Canada. Product and service offerings are focused within four primary areas:

	Norstan Convergence Development Group — Specializes in the development of IP telephony applications to enhance and accelerate the enterprise customer’s convergence migration strategy.

5

Table of Contents

      Norstan’s Resale Services segment provides refurbished voice and data products to end users. This segment is comprised of two business units:

	Norstan Resale Services Group — Offers customers refurbished telephony equipment, as well as, new video conferencing systems, components, desktop products, accessories and services from ClearOne, Kentrox, Plantronics, Polycom, Siemens and SpectraLink. Prior to the expiration of Siemens’ alliance with Norstan in the resale business in July 2004, we managed the acquisition, marketing, refurbishment and resale of Siemens certified used telephony equipment. Effective August 1, 2004, we will buy and sell used Siemens equipment to refurbish and offer to the secondary market, primarily in the U.S. and Canada.
	Vibes Technologies, Inc. — A leader in telecom and data equipment remanufacture and repair, specializing in top-line key systems, phones, data and other components, providing customers legendary customer service and expertise in systems manufactured by Aspect Communications, Avaya, Cisco Systems, Executone, Nortel Networks, Plantronics, Polycom and SpectraLink.

      Norstan focuses its marketing efforts on middle-market and Fortune 2000 companies with complex communication requirements. No single customer accounted for more than five percent of Norstan’s total revenue during any of the last three fiscal years. A sample of our current customers includes:

      Our relationships and/or experience with a wide range of leading communications technology manufacturers enable us to deliver the appropriate solution to each of our customers. These include:

      In addition, we distribute communication products that fit specific segments of the marketplace. These include hybrid switching systems, personal computer-based voice processing and video conferencing systems, as well as data communication products.

6

Table of Contents

      Norstan has been a distributor of Siemens equipment since 1976 and is currently Siemens’ largest distributor in North America. The term of the distribution agreement signed in January 1999, was for five years and has been extended one year, currently through January 2005. Our relationship with Siemens is integral to our business. Any significant disruption of this distribution relationship could have a material adverse impact on our financial condition and results of operations.

      Norstan and Siemens have been parties in a used equipment alliance in which we managed the acquisition, marketing, refurbishment and resale of Siemens certified used telephony equipment, becoming the largest supplier of Siemens and ROLM refurbished equipment. On July 22, 2004, Siemens Information and Communication Networks, Inc., elected to end their alliance with us in the used equipment business effective at the expiration of the current agreement, July 31, 2004. Effective August 1, 2004, we will continue offering customers refurbished Siemens telephony equipment, in addition to new and used audio and video conferencing systems, wireless solutions, call center accessories, components, desktop products, and services through our Norstan Resale Services Group.

      The termination of this resale alliance does not affect our ongoing distribution agreement with Siemens with respect to new equipment.

      Norstan’s product and service offerings are brought to market through three separate but complementary businesses. These businesses use a variety of distribution channels to market and sell the Company’s products and services. These are reflected in our business units as follows:

      This multi-channel distribution model uses the most cost-effective sales channels to bring Norstan’s products and service offerings to market. Each channel is staffed with sales professionals who are highly focused and have a comprehensive understanding of their markets. In addition, these professionals are aligned with specific manufacturer partners.

      Within the Solutions and Services business, our sales professionals have been trained to evaluate each customer’s technology and service needs. The sales process begins by obtaining an understanding of the customer’s business goals and objectives. The sales professional conducts an analysis of the customer’s current and potential future communication and IT systems requirements, as well as service delivery needs. After assessing the customer’s business and communications needs, the sales professional and a Norstan solutions engineer develop a solution to satisfy the customer’s current and anticipated requirements. Norstan’s services delivery team then works with the customer to plan the delivery and implementation of the solution and to identify required training. By planning the precise requirements of each phase of the solution delivery, Norstan’s team of sales, solutions engineering and services delivery specialists are able to minimize service interruption for the customer.

      Norstan also provides an ongoing customer service program designed to meet our customer’s application requirements. These service programs incorporate remote diagnostics, in-field service and support, additional training, and help desk resources from Norstan’s expert customer support team, located in Norstan’s Customer Solution Center, a virtual center comprised of strategically located solution centers across the U.S. and Canada.

      Norstan’s marketing strategy is designed to capture a high percentage of existing customers’ communication and IT budgets and also identify and develop new customer relationships. Additionally, Norstan’s

7

Table of Contents

      The Norstan Convergence Development Group develops IP telephony applications to enhance customers’ convergence strategy distributed to targeted channel partners through the Norstan CDG IPT Alliance Partner Program. This program enables channel partners of our target manufacturers, such as Cisco Systems, to gain access to convergence applications to offer their client bases. Certification levels are available to accommodate partners who wish to sell, install and provide direct support for Norstan applications, as well as for partners who choose to sell applications but rely on Norstan to install and support their customers.

      Our Resale Services business units offer value-minded customers the highest quality refurbished systems, components, desktop products, new accessories and services available in the U.S. and Canada. Sales are driven through qualified and trained telesales account executives focused on existing customer accounts and strategic prospects. This telesales group works closely with our Solutions and Services business and channel partners. Through the Vibestech.com web site, additional sales and service are available to our customers. Norstan’s Resale Services provides a total life cycle solution for our customers and enables Norstan to maintain these customer relationships for many years.

      Norstan believes providing exceptional customer service is a critical element in our ability to compete effectively in the communication marketplace. We have invested in new technology designed to resolve a substantial portion of our customer’s support and service issues quickly and remotely. Norstan coordinates its customer service response through our Customer Solutions Center, a virtual center comprised of strategically located centers in Minneapolis and Cleveland with smaller centers focused on specific customer sets in Los Angeles and Montreal. In fiscal 2004, these centers handled more than 350,000 customer calls with approximately 65% of the service-related calls addressed remotely. For calls requiring immediate on-site service and support, Norstan maintains a force of highly trained service technicians, design engineers and customer support representatives that can respond to the client’s physical location.

      Norstan has approximately 130 employees in its four remote diagnostics and dispatch centers devoted primarily to providing customer service, and more than 260 service technicians in the field. With Norstan’s remote problem resolution capability and our staff of highly trained technicians, we are able to promptly resolve customer support requests and service needs. Norstan’s commitment to customer service is evidenced by a fiscal 2004 survey of Norstan’s communication customers that found an overall satisfaction rating of 97%. This survey was administered by an independent third party.

8

Table of Contents

      Headquartered in Minnetonka, Minnesota, Norstan currently supports its customers with sales, service and/or distribution centers located in 28 cities within the United States and Canada:

      As of April 30, 2004, Norstan had 1,090 employees, including 990 in the U.S. and 100 in Canada. Norstan’s employee population consists of 192 in sales and marketing, 628 in operations, service and installation, 237 administrative and professional personnel and 33 consultants. Of these employees, 78 are covered by collective bargaining agreements. We believe relations with our employees are good and we have not experienced any work stoppages.

      Our marketing strategy is designed to capture a larger portion of existing customers’ communication and IT budgets and to identify and develop new customer relationships. Norstan also competes with its customers’ internal resources for those who may maintain their own equipment, particularly when these resources represent a fixed cost to the customer. Such competition may impose additional pricing pressures on Norstan. Subject to this competitive environment, Norstan competes on the basis of the depth and breadth of services and products we offer; our ability to integrate IT and communication systems as the underlying technologies continue to converge; our reputation for providing superior customer service; and, the number and strength of our customer relationships.

      Norstan also competes in its markets with Avaya Communications, NextiraOne, a division of Platinum Equities, and Regional Bell Operating Companies, such as SBC Communications, and telcos such as Verizon Communications. In addition, we may compete with regionally located service providers.

      Following the termination of the alliance with Siemens in the resale business, Norstan Resale Services Group will now compete directly with Siemens in this market.

      Norstan relies upon a combination of nondisclosure and other contractual arrangements with certain key employees and business partners, and trade secret, copyright and trademark laws and intellectual property laws to protect our proprietary rights and the proprietary rights of third parties from whom we license intellectual property. We enter into confidentiality agreements with certain employees and business partners and limit the distribution of proprietary information.

      With the sale of Norstan Network Services in July 2002, we are no longer subject to government regulations that have a material effect on our operations.

9

Table of Contents

      As of April 30, 2004, Norstan had signed contracts for telecommunications products and professional services aggregating approximately $19.2 million, substantially all of which are expected to be fulfilled by the end of fiscal 2005. As of April 30, 2003, Norstan had signed contracts aggregating approximately $20.2 million, substantially all of which were fulfilled by the end of fiscal 2004. The usual time period between the execution of a contract and the completion of the installation is three to twelve months, depending on the size and complexity of the system.

      We conduct our operations in leased facilities. Our executive offices are located in Minnetonka, Minnesota, where we occupy approximately 129,000 square feet of office space. We also have locations in Brecksville, Ohio, and Phoenix, Arizona, where we occupy approximately 42,750 and 22,440 square feet of office space, respectively. In addition, Norstan occupies sales and service offices in 16 other cities within the United States. In Canada, Norstan occupies approximately 30,700 square feet of office space in Toronto, Ontario, which serves as our Canadian headquarters. Norstan also occupies sales and service offices in three other cities within the Canadian provinces of Alberta, Quebec and British Columbia. We believe that the above-mentioned facilities are adequate and suitable for our current needs.

      In April 2004, Norstan received a commitment adjustment letter from the Universal Services Administrative Company (USAC), which oversees the Federal Communications Commission’s Schools and Libraries Program of the Universal Service Fund, also called the “E-rate program.” Funding commitments under the E-rate program provide for discounts on eligible services such as telecommunications services, internet access, network equipment and wiring of instructional buildings and classrooms to connect to the Internet. The letter informed Norstan that USAC had undertaken an audit of the Navajo Preparatory School (Navajo Prep) project for funding year 2001, in which Norstan had installed specific equipment and service for which we received approximately $2.2 million. The audit report concluded that Navajo Prep had not complied with key requirements of the E-rate program and, consistent with E-rate policies, USAC is seeking recovery of the full amount disbursed to Norstan on behalf of Navajo Prep. On June 1, 2004, Norstan filed an appeal with USAC and is continuing its investigation of the Navajo Prep project. While we will continue to defend and appeal USAC’s decision, Norstan may be required to repay all or a portion of the $2.2 million. Accordingly, we established a reserve of $2.2 million in the fourth quarter of fiscal 2004.

      In February 2002, Norstan was awarded $7.2 million resulting from a claim before the American Arbitration Association against the former owner of PRIMA Consulting (PRIMA) which claims arose out of our September 1997 acquisition of PRIMA. Subsequently, we reached a settlement with the former owner, Mr. Michael Vadini. The settlement provides that Norstan receive $3.0 million in cash, a promissory note issued by Mr. Vadini for $1.0 million to be paid in monthly installments beginning in June 2002, and certain real properties. As a result of the settlement, we recorded a $3.0 million pre-tax gain in the fourth quarter of fiscal 2002, based on the amount of cash received. We recorded a full reserve against the real property and the promissory note and will record any future gains on the sale of the real properties and collection of the promissory note as amounts are assured of realization. In December 2002, after receiving the first six $83,333 monthly installment payments, we agreed to accept a lump sum payment of $470,000 in settlement of the remaining monthly installments which totaled approximately $500,000 at that time. We recorded a gain, net of tax, of approximately $591,000 through discontinued operations relating to payments received on the promissory note during fiscal 2003. In addition, in May 2003, one of the real properties was sold and a pre-tax gain of approximately $253,000 was recorded through discontinued operations in the first quarter of fiscal 2004. In addition, in January 2004, a second real property was sold and a pre-tax gain of approximately $341,000 was recorded through discontinued operations in the third quarter of fiscal 2004.

10

Table of Contents

      We are involved in other legal actions in the ordinary course of our business. Although the outcome of any such legal actions cannot be predicted, in the opinion of management there are no other legal proceedings pending against or involving Norstan for which the outcome is likely to have a material adverse effect upon our business, operating results or financial condition.

      Norstan did not submit any matters to a vote of security holders during the last quarter of the fiscal year covered by this report.

11

Table of Contents

PART II

      Our common stock is traded on the National Over-the-Counter market and is listed on the national market system of the National Association of Securities Dealers’ Automated Quotations system (NASDAQ) under the symbol NRRD. The following table sets forth the high and low sale prices for our common stock as reported by NASDAQ for each quarterly period during the two most recent fiscal years:

      As of July 19, 2004, there were 3,640 holders of record of Norstan’s common stock.

      Norstan has not recently declared or paid any cash dividends on our common stock and does not intend to pay cash dividends on our common stock in the foreseeable future. We currently expect to retain earnings to finance the operations and the expansion of our business. In addition, our current long-term credit agreement prohibits the payment of cash dividends without the prior written consent of our lender thereunder.

12

Table of Contents

      The selected consolidated financial data set forth below as of and for each of the fiscal years in the five-year period ended April 30, 2004, have been derived from our consolidated financial statements, which have been audited by Deloitte & Touche LLP, an independent registered public accounting firm. The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the notes thereto included elsewhere in this report.

13

Table of Contents

      General. We are a full-service communications solutions and services company delivering voice and data technologies and services, and remanufactured equipment to corporate end-users and public sector companies. We offer a full range of technologies for customer contact solutions and converged solutions, including applications such as messaging, conferencing and enterprise mobility. Additionally, we provide a host of communications services including ProtectNet® Life Cycle services, project management, implementation, field delivery, voice and data network monitoring, and managed and professional services.

      We drive our business by delivering communications solutions and services through the installation of a broad array of technology platforms, software solutions and on-going system maintenance needs. Currently, we work with approximately 2,400 key customers, and have serviced approximately 12,000 sites over the past two years. We draw customers from a variety of industry groups. Norstan maintains a direct sales force focused on the delivery of complex applications for current and potential Fortune 2000 and middle-market customers and an inside sales organization focused on other opportunities. Our remanufactured equipment segment supports a diverse customer base, including Norstan’s customer base, resellers, distributors and other end users with efficient and reliable secondary market solutions.

      Operating Segments. To address the complex communications requirements of our customers, Norstan provides a broad range of products and services through two interrelated business segments: Communications Solutions and Services and Resale Services, which accounted for 86.6% and 13.4% of our fiscal 2004 revenues, respectively. Communications Solutions and Services provide solutions and services focused on enterprise and public sector customers throughout the U.S. and Canada, including hardware and software applications that support voice and data communications and customer contact solutions. Resale Services provides refurbished voice and data products to the secondary market.

14

Table of Contents

      The following table summarizes the source of our revenues by product/ service offerings over the past three fiscal years:

      Effective April 30, 2004, our previously reported business segment, Financial Services, was incorporated into our Communications Solutions and Services business segment. As a result of our strategic decision in fiscal 2002 to no longer offer financing directly to our customers, revenues for this business continue to decline as we completely wind down its operations and it is no longer necessary to provide these results as a separate business segment. Financing is currently offered under a private-label leasing program through an arrangement with Citicapital Technology Finance, Inc., formerly Fidelity Leasing.

      In fiscal 2003 and the first half of fiscal 2004, Norstan’s strategy was one of gaining market share through geographic expansion into tier one markets. We broadened our presence into cities such as New York, Los Angeles, Dallas, Chicago and San Francisco. Our recent financial performance and financial constraints have resulted in our need to re-evaluate our investments in certain of these and other cities, such as Atlanta, Detroit and Philadelphia. Our strategic focus has now changed from one of broader geographic coverage, to one of increasing share by creating deeper coverage in specific markets with specific technologies. We will be more selective in our pursuit of new customers, markets, products and services. This change in strategic focus may result in lower revenues but higher profitability in fiscal 2005 as compared to fiscal 2004.

      In fiscal 2001, our relationships with Nortel Networks and Cisco Systems expanded our geographic reach and are providing new revenue opportunities. With the addition of these new technology partners, we have been experiencing pricing pressure and a change in our product mix, which in part, has contributed to decreased product gross margins that negatively affected our financial performance. We believe that the restructuring undertaken in fiscal 2004 of our Communications Solutions and Services business segment and increased emphasis on project management capabilities will help reduce the negative affect of these overruns on future financial performance.

      Our Solutions and Services business focuses sales and operations in specific geographic markets. Within these geographies, communications solutions are offered where Norstan has an established customer base and expertise in services delivery in the areas of converged solutions, customer contact solutions, infrastructure and ProtectNet® Life Cycle services. Within this organization is a dedicated sales team focused on serving our installed customer base. Approximately 50% of our revenue is annuity in nature derived from the on-going services we provide these customers.

15

Table of Contents

      Our Resale Services segment expects increased volume from the re-sale of refurbished telecommunications and data equipment and industry consolidation. Vibes Technologies, Inc. is uniquely positioned to take advantage of these trends with its e-commerce web site. The combination of this web-based approach and Norstan’s knowledge of the secondary market is expected to provide the basis for growth in this business segment. Our Norstan Resale Services Group offers refurbished communications products and services from a variety of manufacturers to the secondary market.

      We are focusing on several initiatives to better position our business to be successful in fiscal 2005:

	•	Improving company profitability — There are opportunities in many areas of our business to improve Norstan’s profitability, such as improving gross margins for our installation and services, decreasing the cost of customer acquisition, and reducing general and administrative overhead.
	•	Retaining our existing customers — We have built a substantial installed customer base consisting of Fortune 2000 and middle-market companies. We will continue to increase our resources committed to maintaining these relationships, offering our customers additional solutions and services that further improve their communications systems and their ability to run their businesses more efficiently.
	•	Delivering advanced business applications — A significant differentiator for Norstan is our capability to provide customers with advanced business applications and services to support them. We are delivering advanced business applications and strategic solutions, complementing these applications with knowledge, professional services and support upon which Norstan has built its reputation for over 30 years.
	•	Developing Resale Services — We will continue to develop our Resale Services businesses by adding additional voice and data products and accessories that will augment our existing offerings.
	•	Developing new business selectively — Competition within the areas of convergence and applications is fierce and the technology is complex. We will concentrate our new business development in geographic areas where opportunities, skills and resources exist, and on sales and services yielding the highest returns.

      Fiscal 2004 Restructuring. During fiscal 2004, we took significant actions to reorganize and refocus the sales and service efforts of our Communications Solutions and Services business segment. We reduced our workforce by more than 20.0% to a headcount of 1,090 at April 30, 2004 from 1,366 at April 30, 2003. We consolidated certain facilities to concentrate our customer acquisition and retention efforts in those geographic markets where we can deliver our solutions and services in a more efficient and profitable manner. In addition, asset impairment charges related to certain capitalized system application costs and hardware costs were recorded.

      As the effect of these restructuring efforts were realized during fiscal 2004, our quarterly operating income (excluding restructuring and other charges) improved quarter-over-quarter throughout the year. We expect the benefits from these cost reduction measures will continue in fiscal 2005 and beyond.

      Discontinued Operations. Over the past few years, we have disposed of certain non-strategic business units. In fiscal 2001, we sold our IT consulting businesses; Connaissance Consulting and Norstan Consulting. In fiscal 2003, we sold our Network Services business. Because of the sale of these business units, their results of operations are reported as discontinued operations for all periods presented.

16

Table of Contents

      The following table sets forth certain items from our consolidated statements of operations expressed as a percentage of total revenues:

      The following table sets forth the gross margin percentages for each of our business segments:

      Revenues. Total revenues from continuing operations decreased approximately $1.1 million or less than 1.0% to $225.8 million in fiscal 2004 from $226.9 million in fiscal 2003.

      Revenues within the Communications Solutions and Services segment decreased $2.2 million or 1.1% to $195.5 million in fiscal 2004 from $197.7 million in fiscal 2003. Revenues from Solutions were down 1.2% year-over-year. Our fiscal 2004 Solutions revenues from customer contact solutions, IP telephony and newer voice solution product offerings were up approximately $18.0 million or 70.0% over fiscal 2003. These increases were offset by lower volume related to our traditional voice solutions product offerings, infrastructure and other products. Service revenues for fiscal 2004 were down less than 1.0% compared to 2003. Our service contract revenues and volume of moves, adds and changes (MAC) were flat year-over-year. In addition, revenues from our professional services and managed communications services were up slightly, generally offset by decreased conferencing and channels activity.

      As previously stated, our Financial Services operations are winding down, and the revenues from it continue to decline. As a result, we are reporting the results of this former business segment as a component of Communications Solutions and Services for all periods presented. Financial Services fiscal 2004 revenues were $2.2 million, down 30.3% from fiscal 2003. This decrease was attributed to our strategic decision not to offer financing directly to our customers.

      Resale Services’ revenues increased $1.1 million or 3.9% to $30.3 million in fiscal 2004, as compared to $29.2 million in fiscal 2003. Revenues for Vibes Technologies, our integrated direct and web-based e-commerce business which remanufactures and resells voice and data equipment, were up 5.9% year-over-year. In addition, our Siemens Resale Services group revenues were up 1.2% in the comparable periods. Opportunities for further growth within this segment include the addition of new product offerings

17

Table of Contents

      Gross Margin. Norstan’s gross margin decreased $2.9 million or 4.2% to $65.4 million from $68.2 million in fiscal 2003. As a percent of total revenues, gross margin was 28.9% in fiscal 2004 compared to 30.1% in fiscal 2003.

      Gross margin percentages for any specific period of time are affected by numerous factors, including but not limited to, competitive market pricing, product and/or service mix, labor utilization, project cost overruns, and operations spending.

      Communications Solutions and Services gross margin decreased $3.4 million to $54.7 million in fiscal 2004 as compared to $58.1 million in fiscal 2003. Gross margin as a percent of revenues for this segment was 28.0% in fiscal 2004 as compared to 29.4% in fiscal 2003.

      Within this segment, Solutions’ margins were 19.0% and 22.0% in fiscal 2004 and 2003, respectively. This decrease was generally the result of our expansion efforts, changing product mix, continued pricing pressure at point of sale and cost overruns on certain projects. Services’ margins were relatively unchanged in fiscal 2004 at 32.3% as compared to 32.5% in fiscal 2003. During fiscal 2004, Services’ margins were favorably impacted by the restructuring actions taken during the year offset by customer price sensitivity, increased training costs and our changing mix of service offerings.

      Resale Services’ gross margin was up slightly to 35.1% of revenues in fiscal 2004, as compared to 34.6% in fiscal 2003. The increase is primarily the result of changes in the mix of products sold during the comparable periods. Norstan’s alliance with Siemens in the refurbished equipment business terminated at the end of July 2004. Commencing on August 1, 2004, Norstan Resale Services Group now competes directly with Siemens in procurement as well as the resale of refurbished equipment to end users. Although NRSG’s margins or other aspects of its financial performance may be impacted by these changes, management cannot currently assess whether these factors will have a material adverse impact on our results of operations or financial condition.

      Selling, General and Administrative Expenses. Norstan’s selling, general and administrative expenses were $65.3 million in fiscal 2004 compared to $66.8 million in fiscal 2003, a decrease of $1.5 million or 2.2%. As a percent of revenues, selling, general and administrative expenses improved slightly to 28.9% in fiscal 2004, compared to 29.5% in fiscal 2003. The decrease in fiscal 2004 selling, general and administrative expenses was primarily the result of the restructuring efforts undertaken during the year. The resulting reduction in personnel and related costs were somewhat offset by investments we made in fiscal 2004 related to marketing and business development including expansion into certain tier one cities, IP telephony applications and service retention efforts. These lower levels of spending should continue as we closely monitor all of our expenses and as we fully realize the benefit from the restructuring actions taken in fiscal 2004.

      Restructuring and Other Charges. As explained below, we recorded approximately $13.5 million in restructuring and other charges in fiscal 2004. No such charges were recorded in fiscal 2003.

      During the second quarter of fiscal 2004, we recorded restructuring and other charges of $4.2 million, consisting of a restructuring charge of $3.7 million and a write-off of certain fixed assets of approximately $500,000. These charges were primarily within our Communications Solutions and Services segment and relate to actions completed by the end of our second fiscal quarter. The restructuring charge of $3.7 million related to a workforce reduction of approximately 150 people as we continued to right-size our organization and bring our expense structure in-line with anticipated revenues and changing market demand for our solutions and services. This charge consisted of $3.3 million in severance costs and other related employment benefits, together with $400,000 in lease termination and other facility costs. In addition, we recorded a charge of approximately $500,000 for the write-off of certain assets. These assets consisted primarily of non-recoverable capitalized system applications costs and other hardware costs.

18

Table of Contents

      During the fourth quarter of fiscal 2004, we recorded additional restructuring and other charges of $9.4 million. Approximately $7.2 million of this amount was for our reorganization efforts announced in February 2004. Included in these efforts was a reorganization of our Communications Solutions and Services segment to better focus our efforts and to streamline sales and services to improve profitability. Solutions and Services now concentrates customer acquisition and retention efforts into two geographically focused business units. In addition, our sales support and service functions have been realigned to better serve our solutions and services team and our customers’ needs. This restructuring charge includes $2.4 million in costs associated with employee and severance costs related to a workforce reduction of 100 people (80 were terminated as of April 30, 2004), $3.9 million related to facilities exit and other contractual costs, and $831,000 in other asset impairment charges. The remaining $2.2 million charge relates to a claim made by the Universal Services Administrative Company (USAC) regarding a specific E-rate project completed by Norstan. The USAC is seeking a recovery of amounts dispursed by the USAC to Norstan on behalf of one of our customers. We are appealing this claim. However, as we may be required to repay a portion or all of the disputed funding, we have established the requisite reserve (see Note 12 to the Consolidated Financial Statements).

      Interest Expense. Interest expense was $2.3 million in fiscal 2004, as compared to $2.2 million in fiscal 2003. Interest expense is incurred primarily under our long-term credit facilities. Average month-end borrowings outstanding under our long-term credit agreements were $20.0 million in fiscal 2004 and $21.2 million in fiscal 2003. Weighted average interest rates under the long-term credit agreements were 6.1% in fiscal 2004 compared to 6.8% in fiscal 2003. Interest costs in fiscal 2004 increased as compared to 2003 due to higher borrowings and costs under our new credit facility entered into during the current year.

      Other Income (Expense). Net other income of $105,000 was recorded in fiscal 2004 compared to net other expense of $4,000 in fiscal 2003.

      Income Taxes. In fiscal 2004, we recorded a tax benefit from continuing operations of $6.0 million, compared to a tax benefit of $323,000 in fiscal 2003. Fiscal 2004 reflects an effective rate of 38%, representing the effect of the Company’s federal statutory rate adjusted for state income taxes and other permanent tax items. The fiscal 2003 benefit reflects the reduction of certain valuation allowances relating to our capital loss and Canadian net operating loss carryforwards.

      We anticipate recording a tax provision on earnings in fiscal 2005 at an effective tax rate of 38.0% to 39.0%.

      Net Income (Loss) from Continuing Operations. A net loss of $9.8 million or $0.75 per diluted share was reported in fiscal 2004, as compared to a net loss of $404,000 or $0.03 per share in fiscal 2003.

      In July 2002, we sold our Network Services business to NetWolves Corporation (NASDAQ: WOLV) for $7.5 million. Pursuant to the terms of the purchase agreement, $3.75 million was received at closing and the remaining $3.75 million was due one year from closing, evidenced by a non-interest bearing promissory note in favor of Norstan. We recorded a pre-tax gain on this sale of $2.7 million in the first quarter of fiscal 2003 based on the $3.75 million cash received. During the fourth quarter of fiscal 2003, we received payment of $2.9 million in cash as well as other non-monetary assets in early settlement of the promissory note. We recorded a pre-tax gain of $2.8 million in the fourth quarter of fiscal 2003 based on the amount of cash received in settlement of the promissory note. The non-monetary asset, consisting of 300,000 shares of unregistered NetWolves Corporation common stock, has been reflected at a zero value until such time as the unregistered common stock is monetized or monetizable. Network Services provided multiple source long distance services and related consulting and professional services. Because of the sale of this business unit, Network Services results of operations have been reported as discontinued operations for all periods presented.

19

Table of Contents

      During fiscal 2001, we divested our IT consulting business starting in February 2001 with the sale of our 75% interest in Connaissance Consulting to Connaissance’s founder. Terms of the sale required the payment of $3.0 million in cash at closing and delivery of promissory notes drawn in favor of Norstan with an aggregate face amount of $13.0 million maturing on various dates, commencing on April 30, 2001 and ending December 31, 2005. To date, $1.0 million has been collected on one of the notes and the remaining $12.0 million has been fully reserved for, including a charge of $5.0 million recorded during the fourth quarter of fiscal 2002 (see below). The divestiture concluded with the sale of Norstan Consulting on April 30, 2001 to a management group led by Norstan Consulting’s former President and the Company’s former Vice Chairman. Terms of the sale required the payment of $500,000 in cash at closing and delivery of a promissory note drawn in favor of the Company in the face amount of $1.5 million maturing on August 28, 2001. In addition, as part of the transaction, we retained our rights to certain assets and assumed certain liabilities of Norstan Consulting. As of April 30, 2002, the promissory note had been paid in full. The results of these two business units are reported as discontinued operations for all periods presented.

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

      In addition to the operating results above, we recorded a gain on the disposal of discontinued operations of $366,000, net of tax, in fiscal 2004. This gain on disposal resulted primarily from the sale of certain properties we received as part of the Vadini settlement related to the February 2002 arbitration award (see Note 12 to the Consolidated Financial Statements).

      In fiscal 2003, we recorded a net gain on the disposal of discontinued operations of $5.3 million. The gain on disposal included the following: (i) a pre-tax gain on the sale of Norstan’s Network Services business of $5.5 million ($5.0 million after tax), (ii) a $591,000 gain, net of tax, related to payments on the promissory note we received as part of the PRIMA Consulting arbitration settlement of February 2002, and (iii) a $269,000 net loss related to additional costs incurred in the disposition of Connaissance Consulting. The after-tax gain on the sale of our Network Services business reflects the reversal of a $1.9 million tax valuation allowance which had been previously established for our capital loss carryforwards. The sale of the Network Services business allowed us to fully utilize these capital loss carryforwards.

      We also recorded a $1.2 million loss on disposal of discontinued operations in fiscal 2002. The loss on disposal includes the following: (i) a pre-tax charge of $5.0 million ($3.1 million after tax) for an additional reserve on the remaining promissory note receivable from the sale of Connaissance Consulting, and (ii) a pre-tax gain of $3.0 million ($1.9 million after tax) from the arbitration settlement related to PRIMA Consulting (see Note 12 to the Consolidated Financial Statements). During the fourth quarter of fiscal 2002, the purchaser of Connaissance Consulting defaulted on payments then due. We held discussions with the

20

Table of Contents

      Net Income (Loss). For fiscal 2004, we reported a net loss of $9.4 million, or $0.72 per diluted share, as compared to net income of $4.9 million, or $0.39 per diluted share in fiscal 2003.

      Revenues. Total revenues from continuing operations decreased $20.6 million or 8.3% to $226.9 million in fiscal 2003 from $247.5 million in fiscal 2002.

      Revenues within the Communications Solutions and Services segment decreased 8.9% to $197.7 million in fiscal 2003, from $217.1 million in fiscal 2002. Revenues from Solutions’ product offerings were down 7.6% year-over-year as a result of lower revenues in our legacy product offerings, somewhat offset by increased revenues from more recent additions to our portfolio. Services revenues were down 8.3% due to a decrease in revenues from our service contracts, MAC (moves, adds and changes) and convergence/professional services partially offset by increased channels activity and managed communications services.

      Resale Services revenues decreased $1.2 million or 3.9% to $29.2 million in fiscal 2003, as compared to $30.4 million in fiscal 2002. Revenues from Vibes Technologies were up 4.2% year-over-year. This was offset by a 13.1% decrease in revenues in our Siemens Resale Services group.

      Gross Margin. Our gross margin decreased $7.6 million or 10.0% to $68.2 million from $75.9 million in fiscal 2002. As a percent of total revenues, gross margin was 30.1% in fiscal 2003 compared to 30.6% in fiscal 2002. Overall, fiscal 2003 gross margin percentages were positively affected, as compared to fiscal 2002, by a reduction in incentive compensation for our operations departments resulting from our lower than expected performance.

      Gross margin for Communications Solutions and Services decreased $6.6 million to $58.1 million in fiscal 2003 as compared to $64.7 million for fiscal 2002. Gross margin as a percent of revenues for this segment were 29.4% in fiscal 2003 as compared to 29.8% in fiscal 2002.

      Solutions’ margins were 21.3% and 25.7% in fiscal 2003 and 2002, respectively. This decline was the result of increased pricing pressure at the point of sale, changing product mix, current economic conditions, as well as cost overruns on certain projects. Services’ margins were 32.5% in fiscal 2003 and 29.9% in fiscal 2002. Fiscal 2003 margins were favorably affected by reduced incentive compensation and lower headcounts as compared to the previous year.

      Resale Services’ gross margin was down slightly to 34.6% of revenues in fiscal 2003, as compared to 36.7% in fiscal 2002 primarily as a result of a change in the mix of products sold during the comparable periods.

      Selling, General and Administrative Expenses. Norstan’s selling, general and administrative expenses were $66.8 million in fiscal 2003 and $73.9 million in fiscal 2002, a decrease of $7.1 million or 9.7%. As a percent of revenues, selling, general and administrative expenses improved slightly to 29.5% in fiscal 2003, compared to 29.9% in fiscal 2002. The decrease in selling, general and administrative expenses was the result of significantly lower incentive compensation expense in fiscal 2003 as compared to fiscal 2002, as well as continued efforts to right size our operations in light of the current economic environment. At the same time during fiscal 2003, we made investments in expansion into tier one cities, acquisition of assets in IP application development, and additional service sales initiatives and customer retention specialists.

      Interest Expense. Interest expense decreased significantly in fiscal 2003 to $2.2 million, as compared to $4.9 million in fiscal 2002. Interest expense is incurred primarily under our long-term credit facility. Average month-end borrowings outstanding under our long-term credit agreements were $21.2 million in fiscal 2003 and $45.0 million in fiscal 2002. Weighted average interest rates under our long-term credit agreements were 6.8% in fiscal 2003 compared to 9.3% in fiscal 2002.

21

Table of Contents

      Other Income (Expense). Net other expense of $4,000 was recorded in fiscal 2003 as compared to net other income of $651,000 in fiscal 2002. Fiscal 2002 net other income reflects interest income earned on certain promissory notes.

      Income Taxes. In fiscal 2003, we recorded a tax benefit from continuing operations of $323,000, compared to a tax benefit of $8.9 million in fiscal 2002. Fiscal 2003 reflects an effective rate of 39%, representing the effect of our federal statutory rate adjusted for state income taxes and other permanent tax items. In addition, the tax benefit recorded in fiscal 2003 reflects the reduction of certain valuation allowances relating to our capital loss and Canadian net operating loss carryforwards. The fiscal 2002 benefit reflects the reduction of the valuation allowance principally associated with our U.S. net operating loss carryforward.

      Net Income (Loss) from Continuing Operations. A net loss of $404,000 or $0.03 per diluted share was reported in fiscal 2003, as compared to net income of $6.6 million or $0.52 per share in fiscal 2002.

      Discontinued Operations. As discussed above, Norstan’s consolidated financial statements have been restated to report separately the net assets and operating results of the discontinued Network Services and Consulting businesses for all periods presented.

      Net Income. For fiscal 2003, we reported net income of $4.9 million or $0.39 per diluted share, as compared to net income of $7.5 million or $0.59 per diluted share for fiscal 2002.

      The Securities and Exchange Commission requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Note 4 of the Notes to the Consolidated Financial Statements includes a summary of the significant accounting policies and methods used in the preparation of our Consolidated Financial Statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, management evaluates its estimates and assumptions, including those related to revenue recognition, valuation of deferred tax assets, valuation of accounts receivable and estimation of restructuring costs associated with facility closures and workforce reductions. Management bases its estimates and assumptions on historical experience and on various other factors that are believed to be reasonable under the circumstances. The following is a brief discussion of the more significant accounting policies and methods used by Norstan which require the most subjective and complex judgments. We consider these to be critical and changes in applications of these policies could result in materially different amounts being reported under different conditions or using different assumptions.

      Revenue Recognition. Norstan’s principal sources of revenues are derived from the sale, installation and service of our full range of voice and data technologies and services. Within our Communications Solutions and Services segment, revenues from the sale and installation of products and systems are generally recognized under the percentage-of-completion method of accounting for long-term contracts and revenues from maintenance service contracts, moves, adds, and changes, and professional services, are recognized as the services are provided and revenues from the sale of IP application software are generally recognized upon delivery. At April 30, 2004, we had backlog of approximately $19.2 million relating to contracts in process of completion. Service contracts are generally pre-billed either on a quarterly or annual basis and are reflected on the balance sheet as deferred revenue and recognized as revenue over the service period on a straight-line basis. Resale Services’ revenues generated from the secondary equipment market are recognized upon performance of contractual obligations, which is generally upon shipment.

      If we do not accurately estimate the resources required and the scope of work to be performed, or we do not manage our projects properly within the planned periods of time or satisfy our obligations under our

22

Table of Contents

      Valuation of Deferred Tax Assets. Norstan recognizes deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. At April 30, 2004, we had $19.0 million in net deferred tax assets, including $7.5 million relating to net operating loss carryforwards. We regularly review our deferred tax assets for recoverability and establish valuation allowances based on historical taxable income, projected future taxable income by tax jurisdiction, and the expected timing of the reversals of existing temporary differences. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against the net deferred tax assets. In the event that actual results differ from our estimates or that these estimates are adjusted in future periods or if uncertainties arise related to our ability to utilize some or all of the deferred tax assets, we may need to establish additional valuation allowances which could materially impact our financial condition and results of operations. To the extent a valuation allowance is established in a given period, an expense within the tax provision in the statement of operations is recorded. Conversely, when a valuation allowance is reduced, a tax benefit is recorded in the statement of operations.

      In the event that actual results differ significantly from our estimates of future operating results or that these estimates are adjusted in future periods or if uncertainties arise related to the Company’s ability to utilize some or all of the deferred tax assets, we may need to establish additional valuation allowances for some or all of our net deferred tax assets which could materially impact our financial condition and results of operations.

      Valuation of Accounts Receivable. Norstan typically performs credit checks on new install contract customers with orders greater than $100,000. Credit limits are assessed according to current creditworthiness including, but not limited to, the customer’s current financial condition, working capital and payment histories. Collection activity for service contract customers is performed on an ongoing basis with payments generally due in advance of service commencement. In addition, we have a “service hold” policy if a customer is in default of its payment obligation and has provided no immediate commitment to pay. Bad debt reserves are established and continuously evaluated based on customer collections and payments, historical experience and any specific customer collection issues that may have been identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to have similar experience. In addition, a material change in the liquidity or financial position of any of our major customers or any adverse change in general economic conditions could have a material impact on the collectibility of accounts receivable and future operating results.

      Restructuring and Other Charges. In fiscal 2004, Norstan initiated certain restructuring actions, including workforce reductions, lease terminations, other facility exit and contractual costs and asset impairment charges. These restructuring actions require our management to utilize significant estimates related to the expenses for severance and other employee separation costs, facility exit and other exit costs, the amount and timing of estimated sublease rentals that could be reasonably obtained and realizable values of assets made redundant or obsolete. Total accrued restructuring and other charges at April 30, 2004 totaled $8.6 million, of which $4.0 million relates to facility exit and other contractual costs. Included in our accrued restructuring accrual is an estimate of remaining future contractual lease payments. As required by generally accepted accounting principles, we have estimated sublease rentals that could be reasonably received upon sublease of the applicable facilities. We estimated such sublease rentals through the remaining terms of the underlying lease agreements to be approximately $4.8 million at April 30, 2004. Should any of the assumptions (such as the sublease rate or timing) utilized by us to determine estimated sublease rentals be significantly different than ultimate results, our results of operations and cash flows could be significantly impacted.

23

Table of Contents

      General. We have historically funded our working capital needs, capital expenditures and other investment activities through cash flows generated from operations, net proceeds from lease contracts, borrowings from long-term credit facilities and more recently, proceeds from dispositions of discontinued operations. As we move forward, we anticipate that funds generated from operations and borrowing capabilities under our current credit agreement should be sufficient to fund anticipated operating activities, planned capital expenditures and scheduled debt repayments. In connection with the termination of the alliance with Siemens for refurbished equipment effective at the end of July 2004, we anticipate incremental working capital requirements of approximately $2.0 to $3.0 million related to accounts receivable and inventory. As of April 30, 2004, we had cash totaling $2.7 million and access to $5.0 million to draw upon under our revolving credit facility.

      Sources and Uses of Cash. Continuing operations utilized net cash of $3.0 million in fiscal 2004 and provided net cash of $2.1 million and $14.7 million during fiscal 2003 and 2002, respectively. These decreases are primarily the result of the decline in our operating results as we reported a net loss from continuing operations of $9.8 million in fiscal 2004 and $404,000 in fiscal 2003 as compared to net income of $6.6 million in fiscal 2002.

      Investing activities provided net cash of $2.4 million, $6.7 million and $17.5 million in fiscal 2004, 2003 and 2002, respectively. This continued decrease in cash provided by investing activities is due primarily to the reduction in proceeds from lease contracts; $6.9 million in fiscal 2004 as compared to $13.4 million and $25.6 million in fiscal 2003 and 2002, respectively. Historically, our lease portfolio has been a significant source of cash for our business. However, it will continue to decrease over the next few fiscal years as our leasing activity winds down with projected cash provided from lease collections of approximately $4.6 million in fiscal 2005.

      Financing activities provided net cash of $2.3 million in fiscal 2004 as compared to utilizing net cash of $18.0 million and $35.8 million in fiscal 2003 and 2002, respectively. These changes in year-over-year cash provided by/used for financing activities are the result of changes in the nature of our bank financing and leasing debt positions. During fiscal 2003 and 2002, we were able to significantly reduce our long-term debt using both cash provided by continuing operations and investing activities as well as cash provided by dispositions of certain discontinued operations. However, in fiscal 2004, the net cash we utilized in continuing operations, including payments relating to the restructuring and other charges recorded, as well as investments in both our presence in certain tier one cities and our Convergence Development Group, were financed primarily by cash provided by our lease portfolio and additional borrowings under our long-term credit facility. In addition, as our leasing activity winds down, we are no longer borrowing additional funds based on lease receivables. New borrowings related to our lease receivables were $3.6 million in fiscal 2003 while there were no new discounted lease rental borrowings during fiscal 2004 and 2002.

      On December 10, 2003, we entered into a new five year $27.5 million secured credit agreement with Wells Fargo Foothill, Inc. consisting of the following components: A) a $5.0 million revolving credit facility, and B) a $22.5 million term loan payable in 30 monthly installments of $333,333 beginning on February 1, 2004, with the remaining unpaid principal due and payable upon maturity at December 9, 2008. Availability under the revolving credit facility is generally based on a percentage of eligible recurring service and maintenance revenues, as defined. This credit agreement is secured by substantially all of our assets.

      The $5.0 million revolving credit facility currently bears interest at the bank’s reference rate plus 2.0% or LIBOR plus 4.0% with provisions for future rate reductions based on certain of our financial ratios. The term loan bears interest at the bank’s reference rate plus 3.5%. Annual unused line fees on the revolver are 0.5% and other monthly and annual fees are due to the lender throughout the duration of the agreement. In addition, we are required to meet certain financial and other covenants, including maintaining $2.0 million in excess availability. The agreement requires us to maintain, on a quarterly basis, minimum levels of EBITDA (earnings before interest, taxes, depreciation and amortization) and limits our capital expenditures on an annual basis. As of April 30, 2004, borrowings under this agreement were $20.8 million with an average interest rate of 7.5%. We were in compliance with all applicable financial covenants as of April 30, 2004.

24

Table of Contents

      Proceeds from the new term note were used to repay and terminate our previous credit agreement. As a result of the termination of our previous credit agreement, we wrote-off the remaining $162,000 in unamortized debt financing costs during the third quarter of fiscal 2004. In connection with our new secured credit agreement, we capitalized approximately $575,000 in debt financing costs which are being amortized over the term of the new agreement.

      During the periods presented in this annual report, prior to December 10, 2003, Norstan operated under a previous credit agreement with certain banks, as amended from time to time, consisting of a revolving line of credit and term loan, each secured by substantially all the assets of Norstan. The previous credit agreement provided for interest at various rates ranging from the banks’ reference rate plus 0.5% to the reference rate plus 2.0%, or the Eurodollar rate advance plus 2.5% to the Eurodollar rate advance plus 4.0%, plus annual commitment fees ranging from 0.375% to 0.25%.

      In addition to our cash flows from continuing operations, we have had a significant amount of cash provided by the disposition of discontinued operations during the past few fiscal years. For fiscal 2004, cash provided by discontinued operations was $382,000 as compared to $8.7 million and $3.4 million in fiscal 2003 and 2002, respectively. While we have divested ourselves of our non-strategic business units, we have retained certain assets from these transactions that will be a source of cash in the future when they are monetized and payments are received.

      We believe that a combination of cash expected to be generated from operations and borrowing capacity available under our current financing arrangements will be adequate to fund anticipated operating activities, capital expenditures and debt repayments until at least April 30, 2005. There is no assurance that additional financing, if needed, will be available in the future on acceptable terms.

      Capital Expenditures. We used $2.9 million for capital expenditures during fiscal 2004 as compared to $5.2 million and $5.1 million in fiscal 2003 and 2002, respectively. These expenditures were primarily for computer hardware and software systems. We currently expect capital expenditures of approximately $4.0 to $5.0 million in fiscal 2005, which will be financed by cash from operations or from borrowings under our long-term credit facility.

      Investment in Lease Contracts. Norstan has historically made a significant investment in lease contracts with its customers. As previously discussed, the Company continues to wind down its leasing activities and provide its customers with financing through Citicapital Technology Finance, Inc. As a result, there was only $97,000 invested in lease contracts in fiscal 2004 as compared to $235,000 and $3.0 million in fiscal 2003 and 2002, respectively. Net lease receivables decreased to $5.6 million at April 30, 2004 from $12.3 million at April 30, 2003. We have historically utilized our lease receivables and corresponding underlying equipment to borrow funds from financial institutions on a nonrecourse basis by discounting the stream of future lease payments. Proceeds from discounting are presented on the consolidated balance sheet as discounted lease rentals. Discounted lease rentals totaled $3.6 million at April 30, 2004 (of which $2.8 million is current and will be due in fiscal 2005) as compared to $8.5 million at April 30, 2003. Interest rates on these credit agreements at April 30, 2004 ranged from 6.0% to 8.0%, while payments are due in varying monthly installments through March 2007. Payments due to financial institutions are made from monthly collections of lease receivables from customers. We also sold certain leases to a third party on a nonrecourse basis during July and August 2001. Total proceeds from these sales were $6.4 million which is reflected on the Consolidated Statements of Cash Flow in “Financing Activities”.

      In March 2003, we purchased certain assets and intellectual property from NetCom Systems, Inc. (NetCom) related to NetCom’s voice over Internet Protocol (IP) telephony applications software operations. This group is involved in the development of applications that increase the effectiveness and productivity of IP communications systems. The software assets purchased as part of this transaction include the NetCom Internet Protocol Application (NIPA) Framework — an IP application framework/ architecture which provides a base for the development of efficient and effective IP solutions. Currently, the NIPA Framework is used specifically with Cisco’s AVVID enterprise architecture; however, it can be interfaced with multiple

25

Table of Contents

      We have various contractual obligations and commitments to make future payments including debt agreements, lease obligations and discounted lease rental commitments. The following table summarizes future obligations under these contracts due by period as of April 30, 2004 (in thousands):

      We do not currently have any other material definitive commitments that require cash resources.

      We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources other than operating leases disclosed above, that are material to investors.

      In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 requires a variable interest entity (VIE) to be consolidated when a company is subject to the majority of the risk of loss from the VIE’s activities or is entitled to receive the majority of the entity’s residual returns, or both. In December 2003, the FASB issued a revision to FIN 46 (FIN 46R) which partially delayed the effective date of the interpretation to March 31, 2004 and added additional scope exceptions. The adoption of FIN 46R did not have a material impact on our consolidated results of operations, financial position or cash flows as we do not have a VIE.

26

Table of Contents

      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 how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise became effective September 30, 2003. The adoption of SFAS No. 150 did not have a material impact on our consolidated results of operations, financial position or cash flows.

      From time to time, we may publish forward-looking statements. These forward-looking statements are based on management’s expectations and beliefs concerning future events. Forward-looking statements are necessarily subject to risks, uncertainties and other factors, many of which are outside of our control, that could cause actual results to differ materially from such statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements including those made in this document. In order to comply with the terms of the Private Securities Litigation Reform Act, Norstan notes that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. Some of the risks and uncertainties that may affect the operations, performance, developments and results of our business include the following: national and regional economic conditions; pending and future legislation affecting the telecommunications industries; Norstan’s business in Canada; the stability of foreign governments; market acceptance of our products and services; factors related to the development of new technologies; our continued ability to provide integrated communication solutions for customers in a dynamic industry; product pricing and margins, including uncertain impact of the termination of the alliance with Siemens on the margins in the Norstan Resale Services Group business; labor costs; funding and sourcing of adequate inventory; access to adequate additional financing, if needed; management of growth; integration of acquisitions; and other competitive factors. The foregoing list is not exhaustive, and we disclaim any obligation to subsequently revise any forward-looking statements to reflect events or circumstances after the date of such statements. Because these and other factors could affect our operating results, past financial performance should not necessarily be considered as a reliable indicator of future performance, and investors should not use historical trends to anticipate future period results.

      Market risk represents the risk of changes in value of a financial instrument, derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates and equity prices. Changes in these factors could cause fluctuations in the results of our operations and cash flows. In the ordinary course of business, we are exposed to foreign currency and interest rate risks. These risks primarily relate to the sale of products and services to foreign customers and changes in interest rates on our long-term debt obligations, discounted lease rentals, capital leases and other long-term debt obligations.

      For fixed rate debt, changes in interest rates generally affect the fair market value of the debt instrument, but not results of operations or cash flows. We do not have an obligation to prepay any fixed rate debt prior to maturity, and therefore, interest rate risk and changes in the fair market value of fixed rate debt will not have an effect on results of operations or cash flows until we decide, or are required, to refinance such debt.

      For variable rate debt, changes in interest rates generally do not affect the fair market value of the debt instrument, but does affect future results of operations and cash flows. We had variable rate debt of $20.8 million outstanding at April 30, 2004 with a weighted average interest rate of 7.5%. Assuming our balance of variable rate debt remains constant at $20.8 million, each one-percent increase in interest rates would result in an annual increase in interest expense, and a corresponding decrease in pre-tax cash flows,

27

Table of Contents

      We have periodically financed customer equipment purchases with fixed rate, sales-type leases. The resulting stream of future lease payments was, in turn, used to borrow funds from financial institutions at fixed rates. We are not exposed to interest rate risk in connection with these arrangements because: (i) both the leases and the debt are at fixed interest rates; and (ii) we typically entered into lending arrangements shortly after execution of the related leases.

      The table appearing below presents principal amounts by year of anticipated maturity for our debt obligations and related average interest rates based on the weighted average interest rates at the end of the period. Variable interest rates disclosed do not attempt to project future interest rates. This information should be read in conjunction with Notes 6 and 7 of the Notes to Consolidated Financial Statements (in thousands).