UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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

FOR THE PERIOD ENDED OCTOBER 30, 2004

OR

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

For the transition period from                     to

Commission File Number 0-8141

NORSTAN, INC.

5101 Shady Oak Road, Minnetonka, Minnesota 55343-4100

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

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

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

On December 7, 2004, there were 13,821,679 shares outstanding of the registrant’s common stock, par value $0.10 per share, its only class of equity securities.

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1.

NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
UNAUDITED

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

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NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
UNAUDITED

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

2

NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
UNAUDITED
(In thousands, except share amounts)

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

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NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED

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

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NORSTAN, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED

     The information furnished in this report is unaudited and reflects normal recurring adjustments and such other adjustments which, in the opinion of management, are necessary to present fairly the operating results for the interim periods identified herein pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. This report should be read in conjunction with our Annual Report on Form 10-K for the year ended April 30, 2004. The operating results for the interim periods presented are not necessarily indicative of the operating results to be expected for the full fiscal year. When we refer to the Company, Norstan, we, us or our, we mean Norstan, Inc. and its subsidiaries.

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Principles of Consolidation:

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

Use of Estimates:

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

Revenue Recognition:

     Within our Communications Solutions and Services business segment, revenues from the sale and installation of products and systems are recognized under the percentage-of-completion method of accounting for long-term contracts. Revenues from maintenance service contracts, moves, adds, and changes, and network integration services, are recognized as the services are provided and financial services’ revenues are recognized over the life of the related lease receivables using the effective interest method. Resale Services’ revenues are generated from the secondary equipment market and are recognized upon performance of contractual obligations, which is upon shipment.

Inventories:

     Inventories include purchased parts and equipment and are stated at the lower of cost, determined on a weighted-average cost basis, or estimated realizable value.

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Property and Equipment:

     Property and equipment are stated at cost and include expenditures that increase the useful lives of existing property and equipment. Maintenance, repairs and minor renewals are charged to operations as incurred. When property and equipment are disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss is reflected in operations. Property and equipment is depreciated over the estimated useful lives of two to ten years under the straight-line method for financial reporting purposes. Accelerated methods of depreciation are used for income tax reporting.

     Pursuant to the requirements of Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment of Long-Lived Assets,” in determining whether an impairment has occurred, our policy is to evaluate, at each balance sheet date, whether events and circumstances have taken place to indicate that the book value of our assets may not be recoverable. If such indicators were present, impairment would be assessed using estimates of undiscounted cash flows attributable to the assets. In the event such cash flows are not expected to be sufficient to recover the book values of the assets, the assets would be written down to their estimated fair values. There were no writedowns recorded under SFAS No. 144 in the first and second quarters of fiscal 2005 or fiscal 2004, except for those included in restructuring and other charges (see Note 7).

Goodwill and Other Intangible Assets:

     Pursuant to the requirements of SFAS No. 142, we test goodwill for impairment on an annual basis or more frequently if circumstances warrant using a fair value approach. No circumstances occurred during the second quarter of fiscal 2005 that warranted testing goodwill for impairment. In addition, we recorded amortization expense of $134,000 in the second quarter of fiscal 2004, related to the intangible assets acquired as part of our fiscal 2003 internet protocol (IP) telephony applications software acquisition from NetCom Systems, Inc. (see Note 2). No such amortization expense was recorded in the second quarter of fiscal 2005 as all of these intangible assets were sold at the end of the first quarter of fiscal 2005.

     In the second quarter of fiscal 2005, we acquired certain intangible assets for $500,000 in cash to facilitate Norstan Resale Services Group’s business. These intangible assets are being amortized over 24 months and $63,000 in amortization expense was recorded in the second quarter of fiscal 2005. The amortization expense is included in selling, general and administrative expenses in the consolidated statements of operations.

     The components of goodwill and other intangible assets were as follows (in thousands):

     The change in the gross carrying amounts of goodwill and other intangible assets for the six months ended October 30, 2004 were as follows (in thousands):

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Warranty:

     We are subject to warranty claims for products and overall solutions that may fail to perform as expected due to design, installation or manufacturing deficiencies. Customers continue to require their outside suppliers to guarantee or warrant their products/solutions and bear the cost of repair or replacement of such products/solutions. Depending on the terms under which we supply products/solutions to our customers, a customer may hold us responsible for some or all of the repair, replacement or redesign/reinstallation costs of defective products/solutions, when the product/solution supplied did not perform as represented. We generally provide customers a warranty on products consistent with the warranty we receive from the original equipment manufacturer. In most instances, the original equipment manufacturer bears the cost to replace defective products. We provide the necessary labor to redesign, reinstall or replace products/solutions that did not perform as represented. Our policy is to reserve for estimated future costs based upon historical trends of actual costs incurred. The warranty reserve is included in other accrued liabilities within our consolidated balance sheets.

     The following table presents a summary of the warranty reserve (in thousands):

Foreign Currency:

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

Earnings (Loss) Per Share Data:

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

     A reconciliation of EPS calculations under SFAS No. 128 was as follows (in thousands, except per share amounts):

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     For the quarters ended October 30, 2004 and November 1, 2003, weighted average shares of 1.7 million and 3.4 million, respectively, have been excluded from the computation of diluted earnings per share, as required under SFAS No. 128, as the effect of their inclusion would be anti-dilutive. For the comparable six month periods then ended, 1.8 million and 3.3 million weighted average shares have been excluded as the effect of their inclusion would be anti-dilutive.

Comprehensive Income (Loss):

     We report comprehensive income (loss) and its components pursuant to the requirements of SFAS No. 130, “Reporting Comprehensive Income”. For Norstan, comprehensive income (loss) consists of net income (loss) adjusted for foreign currency translation adjustments. Comprehensive income, as defined by SFAS No. 130, was approximately $1.6 million for the quarter ended October 30, 2004 and was a loss of approximately $3.3 million for the similar period ended November 1, 2003. For the six month period ended October 30, 2004, our comprehensive income was $2.9 million as compared to a loss of $5.2 million for the six months ended November 1, 2003.

Supplemental Cash Flow Information:

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

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NOTE 2 – NORSTAN CONVERGENCE DEVELOPMENT GROUP:

     In March 2003, we purchased certain assets and intellectual property from NetCom Systems, Inc. (NetCom) related to NetCom’s voice over IP telephony applications software operations. 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 of $800,000 payable over the next two years ($400,000 paid April 2004 with the remaining $400,000 due April 2005). The purchase agreement provided that we may pay NetCom contingent consideration 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. We funded the purchase of these assets from borrowings under our credit facility. We also hired certain key NetCom personnel who were involved in NetCom’s development of IP telephony applications software. This group comprised our Norstan Convergence Development Group (Norstan CDG) and its results of operations are included in our Communications Solutions and Services segment.

     The following table summarizes the fair value of the assets acquired as determined by an independent appraisal (in thousands):

     The amortizable intangible assets relating to proprietary technology were being amortized over five years on a straight-line basis. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the goodwill acquired in the acquisition has not been amortized. The intangible assets and goodwill acquired have been allocated to our Communications Solutions and Services business segment. Pro forma results related to the acquisition were not material to our financial condition or results of operations.

     On July 30, 2004, we sold the assets and the intellectual property related to Norstan CDG to IPcelerate, Inc. (IPcelerate), a privately held developer of voice over IP applications, for $2.5 million in cash and promissory notes, and the assumption by the purchaser of approximately $400,000 in liabilities. Pursuant to the terms of the purchase agreement, we received $1.25 million at closing and $1.25 million evidenced by non-interest bearing promissory notes in favor of Norstan ($1.05 million due January 30, 2005 and $200,000 due February 28, 2005). We recorded a pre-tax gain of $88,000 from the sale in the first quarter of fiscal 2005. This gain is comprised of total consideration received and liabilities assumed by IPcelerate (including the payable to NetCom for approximately $400,000 due April 2005) less assets sold (consisting primarily of the remaining unamortized portion of the technology intangible assets) as well as the write-off of the goodwill recorded as part of the original CDG purchase.

NOTE 3 - DISCONTINUED OPERATIONS:

     In July 2002, we sold our Network Services business to NetWolves Corporation 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, had been reflected at a zero value until such time as the unregistered common stock was monetized or monetizable. On June 2, 2004, these shares were registered with the Securities and Exchange Commission and, accordingly, we recorded an additional gain on the sale of discontinued operations of $87,000, net of tax, in the first quarter of fiscal 2005. These shares are recorded in other current assets in the accompanying consolidated balance sheets and will be marked-to-market based on changes in NetWolves stock price going forward until such time as they are

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sold. Network Services provided multiple source long distance services and related consulting and professional services.

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

NOTE 4 - INCOME TAXES:

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

     Realization of our net deferred tax assets is dependent on our ability to generate sufficient future taxable income. Should our operating strategies fail to produce sufficient taxable income in the future, we would need to record a valuation allowance in the appropriate future reporting period as required by generally accepted accounting principles. Norstan’s U.S. net operating loss carryforwards expire from 2020 to 2021, and the Canadian net operating loss carryforwards expire through fiscal 2011.

     For the second quarter ended October 30, 2004, we recorded a tax provision of 38.0% on the income generated from continuing operations and a 38.0% benefit on the loss on disposal of discontinued operations. For the second quarter of fiscal 2004, we recorded a tax benefit of 39.0% on both the loss incurred from continuing operations and on the loss on the disposal of discontinued operations. For the six month period ended October 30, 2004, we recorded a tax provision of 38.0% on our income from continuing operations and on the gain on disposal of discontinued operations. In the similar period last year, we recorded a tax benefit of 39.0% on the loss from continuing operations and a 39.0% provision on the gain on disposal of discontinued operations. These effective rates represent our federal statutory rate adjusted for state income taxes and other permanent tax items.

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NOTE 5 - STOCK-BASED COMPENSATION:

     We apply Accounting Principles Board (APB) Opinion No. 25 “Accounting for Stock Issued to Employees” and related interpretations in accounting for our stock-based compensation plans. Accordingly, no compensation cost has been recognized in the accompanying statements of operations. Had compensation cost been recognized based on the fair values of options at the grant dates consistent with the provisions of SFAS No. 123 “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, our net income (loss) (in thousands) and net income (loss) per common share would have changed to the following pro forma amounts:

NOTE 6 – DEBT OBLIGATIONS:

     In December 2003, we entered into a five year $27.5 million secured credit agreement with Wells Fargo Foothill, Inc. consisting of the following components: A) a $5.0 million revolving line of credit, and B) a $22.5 million term loan payable in 30 monthly installments of $333,333 beginning on February 1, 2004, with the remaining $12.5 million principal due and payable upon maturity at December 9, 2008. Availability under the revolving line of credit 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, as amended, requires us to maintain, on a quarterly basis, minimum levels of EBITDA (earnings before interest, taxes, depreciation and amortization), certain levels of Norstan Resale Services Group revenues, and limits our capital expenditures on an annual basis. As of October 30, 2004, borrowings under this agreement were $18.3 million with an average interest rate of 8.25%. We were in compliance with all applicable financial covenants as of October 30, 2004.

     Proceeds from the 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.

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     During the periods presented in this quarterly 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%.

     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 through at least April 30, 2005. However, there is no assurance that the assumptions used by management in formulating this assessment will prove accurate or that additional financing, if needed, will be available in the future on acceptable terms.

     NOTE 7 - RESTRUCTURING AND OTHER CHARGES:

     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 150 people (all of whom have been terminated) 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.

     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 (all of whom have been terminated as of October 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 8).

     As of October 30, 2004, there remained restructuring and other reserves of approximately $6.7 million in the accompanying consolidated balance sheet; $5.0 million included in other accrued current liabilities and $1.7 million in other long-term liabilities. We anticipate the majority of the remaining employee severance costs will be paid by the end of fiscal 2005. Payment of certain facility costs will extend through fiscal 2012.

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     The following table summarizes the remaining reserves reflected in our accompanying consolidated balance sheet (in thousands):

     NOTE 8 – COMMITMENTS AND CONTINGENCIES :

Legal Proceedings:

     In April 2004, we received a Commitment Adjustment Letter from the Universal Services Administrative Company (USAC), which oversees the Federal Communications Commission’s School 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 we had installed specific equipment and services 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. In June 2004, we filed an appeal with USAC and began an investigation of the Navajo Prep project. A reserve of $2.2 million was established in the fourth quarter of fiscal 2004. As a result of the investigation, Norstan has decided not to pursue the appeal. In addition, on its own initiative, Norstan will review all of its other E-rate projects for compliance with E-rate program requirements. Norstan received a total of approximately $5.5 million for such other E-rate projects.

     In February 2002, we were 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 provided 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 planned to 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 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. As of October 30, 2004, we retained title to one remaining property.

     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.

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Vendor Agreements:

     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.

     In addition to Norstan’s distribution of new Siemens equipment pursuant to the distribution agreement, 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 resale alliance with us in the used equipment business effective at the expiration of the current agreement, July 31, 2004. Effective August 1, 2004, we continued to offer customers refurbished Siemens telephony equipment. Norstan Resale Services Group now competes directly with Siemens in procurement as well as the sale of refurbished equipment to end users. In addition, we offer 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.

     In addition, we maintain relationships with a wide range of leading technology companies including Aspect Communications, Applied Voice and Speech Technologies (AVST), Cisco Systems, Ericsson, Intervoice, Nortel Networks, ScanSoft, SpectraLink, Verint, and Witness Systems.

     NOTE 9 - BUSINESS SEGMENTS:

     We deliver our products and services through two business segments, Communications Solutions and Services and Resale Services. Interim disclosures under the requirements of SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information,” were as follows (in thousands):

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ITEM 2.

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

Overview

     General. 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. 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 ProtecNet^® 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 84.3% and 15.7% of our revenues, respectively, for the six months ended October 30, 2004. 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.

     The following table summarizes the source of our revenues by product/service offerings for the three and six month periods ended October 30, 2004 and November 1, 2003:

(a)

Converged Solutions includes internet protocol (IP) telephony, voice systems, audio conferencing, data networking/collaboration and wireless voice and data solutions. Customer Contact Solutions includes contact center platforms, interactive voice response and speech recognition as well as computer telephony integration. Infrastructure/Other includes structured cabling, optical networks and multimedia solutions.

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     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. 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 continue to 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 and cash flows in fiscal 2005 as compared to fiscal 2004.

     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 ProtecNet^® Life Cycle services. Within this organization is a dedicated sales team focused on serving our installed customer base. Approximately 50% of our total company revenue is annuity in nature derived from the services we provide these customers.

     Our Resale Services segment expects increased volume from the sale of refurbished telecommunications and data equipment. Vibes Technologies, Inc. and Norstan Resale Services Group’s extensive knowledge of the secondary market and their customer relationships are expected to provide the basis for growth in this business segment. These business units offer a variety of manufacturers’ refurbished and new communications products as well as related services 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 and decreasing the cost of customer acquisition. We believe that the restructuring undertaken in fiscal 2004 of our Communications Solutions and Services business segment and increased emphasis on project management capabilities have helped us market and deliver communication solutions in a more efficient and profitable manner.

•

Retaining our existing customers – We have built a substantial installed customer base consisting of Fortune 2000 and middle-market companies. We have increased 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.

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     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 approximately 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 through the remainder of fiscal 2005.

     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.

Results of Operations

     Summary

     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:

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     Continuing Operations

     Revenues. Total revenues from continuing operations increased less than 1.0% to $56.7 million in the second quarter of fiscal 2005, as compared to $56.4 million in the second quarter of fiscal 2004. For the comparable six month period ended October 30, 2004, revenues decreased 2.0% to $111.1 million compared to $113.3 million in the similar period last year.

     Revenues within the Communications Solutions and Services segment decreased 2.0% to $47.6 million for the second quarter of fiscal 2005, compared to $48.5 million in the similar period last year. For the six month period ended October 30, 2004, revenues in this segment were down 4.7% to $93.6 million compared to $98.2 million for the similar period ended November 1, 2003. For the second quarter of fiscal 2005, Solutions’ revenues were up 1.5% as compared to the second quarter of fiscal 2004. However, in the comparable six month periods of fiscal 2005 and fiscal 2004, Solutions revenues were down 4.0%. For the quarter, increased converged solutions and customer contact solutions revenues more than offset decreased infrastructure revenues. Year-to-date, the decrease in infrastructure revenues outpaced the improved converged solutions revenues. Customer contact solutions were relatively flat year-to-date. Services revenues were down 4.3% and 4.7% for the three and six month periods ended October 30, 2004, respectively. These decreases were primarily a result of decreased conferencing, professional service revenues and moves, adds and changes (MAC). Revenues from service contracts remained relatively flat. We continue to concentrate on retention of our service contract and MAC customers as well as acquisition of new customers in this segment.

     For the quarter ended October 30, 2004, Resale Services’ revenues increased $1.2 million or 15.0% to $9.1 million as compared to $7.9 million in the second quarter of fiscal 2004. For the six month period ended October 30, 2004, revenues increased 15.1% to $17.5 million from $15.2 million in the comparable six month period a year ago. Revenues for Vibes Technologies, Inc. were up 10.4% and 13.8% for the three and six months ended October 30, 2004, respectively, as compared to the similar periods last year. These improvements in Vibes’ revenues were in part due to increased product availability and a more experienced sales team. In addition, Norstan Resale Services Group revenues were up 20.9% and 17.0% for the second quarter and six month periods ended October 30, 2004, respectively, as compared to the same periods ended November 1, 2003. As previously stated, Siemens elected to end our alliance in the refurbished equipment business at the end of July 2004. Commencing August 1, 2004, Norstan Resale Services Group began recording revenues based on shipments to our customers as compared to under the terms of the Siemens resale alliance. These year-over-year increases in revenues were primarily due to this change.

     Gross Margin. Norstan’s gross margin in the second quarter of fiscal 2005 increased $1.0 million or 6.2% to $17.7 million, as compared to $16.6 million for the similar period last year. As a percent of total revenues, gross margin improved to 31.2% for the second quarter of fiscal 2005, as compared to 29.4% for the second quarter of fiscal 2004.

     During the six months ended October 30, 2004, gross margin increased 3.6% to $33.8 million as compared to $32.6 million for the six months ended November 1, 2003. As a percent of total revenues, gross margins increased to 30.4% for the six months ended October 30, 2004 as compared to 28.8% for the six month period ended November 1, 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, vendor rebates, and operations spending.

     Communications Solutions and Services gross margin increased $579,000 to $14.3 million in the second quarter of fiscal 2005 as compared to $13.7 million in the second quarter of fiscal 2004. Gross margin as a percent of revenues for this segment improved to 30.0% for the second quarter of fiscal 2005

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as compared to 28.2% in the similar period last year. For the six month period ended October 30, 2004, the gross margin in this segment was relatively flat at $27.5 million as compared to $27.3 million in the comparable period ended November 1, 2003. However, as a percent of total revenues, the gross margins in this segment improved to 29.4% as compared to 27.8% in the comparable period a year ago. Within this segment, Solutions’ margins were 22.3% in the second quarter of fiscal 2005 as compared to 19.8% in the second quarter of fiscal 2004. For the six month period ended October 30, 2004, Solutions’ margins were 21.3% as compared to 20.5% for the similar period ended November 1, 2003. These year-over-year improvements in Solutions margins were primarily the result of higher selling margins, improved operational efficiencies resulting from the restructuring efforts of fiscal 2004 and increased vendor rebates. Services’ margins were 34.3% and 33.7% for the three and six month periods of fiscal 2005 as compared to 32.4% and 31.2% for the similar periods of fiscal 2004. These improved margins are primarily the result of lower operations spending resulting from the restructuring efforts undertaken in fiscal 2004. We continue to assess and improve our installation and service delivery methods in our Communications Solutions and Services segment. In addition, our focus on our project management capabilities, including additional training and incentives, has thus far benefited our margins during fiscal 2005.

     Resale Services’ gross margin was 37.3% of revenues in the second quarter of fiscal 2005, as compared to 37.1% in the second quarter of fiscal 2004. For the comparable six month periods of fiscal 2005 and 2004, Resale’s gross margins were 35.9% and 35.2%, respectively. Within this segment, the differences in the comparable periods’ margins were primarily the result of changes in the mix of products sold during the periods. While Norstan Resale Services Group operating margins and other aspects of this businesses financial performance have been impacted in the short term by the termination of our resale alliance with Siemens on July 30, 2004, we cannot currently assess whether these factors will have a long-term material adverse impact on these results of operations or financial condition.

     Selling, General and Administrative Expenses. Norstan’s selling, general and administrative expenses were $14.7 million in the second quarter of fiscal 2005, down significantly as compared to $17.5 million reported in the similar period last year. As a percent of revenues, selling, general and administrative expenses improved to 26.0% in the second quarter of fiscal 2005, compared to 31.0% in the second quarter of fiscal 2004. For the comparable six month periods ended October 30, 2004 and November 1, 2003, selling, general and administrative expenses decreased $7.8 million to $28.5 million from $36.3 million. For the comparable six month periods, selling, general and administrative expenses as a percent of revenues improved to 25.6% for the period ended October 30, 2004 as compared to 32.0% for the similar period ended November 1, 2003. These decreases in selling, general and administrative expenses were primarily due to our lower headcounts and spending levels resulting from the restructuring efforts undertaken during the second and fourth quarters of fiscal 2004 and the elimination of the costs associated with the Norstan Convergence Development Group which was sold on July 30, 2004. In addition, the second quarter of fiscal 2005 included expenses related to Norstan Resale Services Group. These expenses were previously accounted for as cost of sales under the terms of the Siemens resale alliance.

     Interest Expense. Interest expense increased 11.5% to $616,000 in the second quarter of fiscal 2005 from $553,000 in the similar period last year. For the six month periods ended October 30, 2004 and November 1, 2003, interest expense was $1.2 million and $1.0 million, respectively. The year-over-year increases were primarily due to higher weighted average interest rates in the current period, as compared to last year. Borrowings under the Company’s long-term credit facilities were $18.3 million as of October 30, 2004 as compared to $20.7 million as of November 1, 2003.

     Operating Income. Our operating income for the second quarter of fiscal 2005 was $2.9 million, significantly improved from the operating loss of $5.0 million reported in the similar period last year. For the six month period ended October 30, 2004, operating income was $5.3 million compared to an operating loss of $7.9 million in the comparable period ended November 1, 2003.

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     Income Taxes. For the second quarter ended October 30, 2004, we recorded a tax provision of 38.0% on the income generated from continuing operations and a 38.0% benefit on the loss on disposal of discontinued operations. For the second quarter of fiscal 2004, we recorded a tax benefit of 39.0% on both the loss incurred from continuing operations and on the loss on the disposal of discontinued operations. For the six month period ended October 30, 2004, we recorded a tax provision of 38.0% on our income from continuing operations and on the gain on disposal of discontinued operations. In the similar period last year, we recorded a tax benefit of 39.0% on the loss from continuing operations and a 39.0% provision on the gain on disposal of discontinued operations. These effective rates represent our federal statutory rate adjusted for state income taxes and other permanent tax items.

     Net Income (Loss) from Continuing Operations. We reported net income from continuing operations of $1.4 million or $0.10 per diluted share in the second quarter of fiscal 2005, as compared to a net loss of $3.4 million or $0.26 per diluted share in the similar period last year. For the six month period ended October 30, 2004, net income from continuing operations was $2.6 million or $0.19 per diluted share compared to a net loss from continuing operations of $5.4 million or $0.42 per diluted share in the similar period ended November 1, 2003.

     Discontinued Operations

     In July 2002, we sold our Network Services business to NetWolves Corporation 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, had been reflected at a zero value until such time as the unregistered common stock is monetized or monetizable. On June 2, 2004, these shares were registered with the Securities and Exchange Commission and, accordingly, we recorded an additional gain on the sale of discontinued operations of $87,000, net of tax, in the first quarter of fiscal 2005. These shares are recorded in other current assets in the accompanying consolidated balance sheets and will be marked-to-market based on changes in NetWolves stock price going forward until such time as they are sold. Network Services provided multiple source long distance services and related consulting and professional services.

     Net Income (Loss). We reported net income of $1.4 million or $0.10 per diluted share in the second quarter of fiscal 2005, as compared to a net loss of $3.4 million or $0.26 per diluted share in the similar period last year. For the six months ended October 30, 2004, we recorded net income of $2.7 million or $0.19 per diluted share as compared to a net loss of $5.3 million or $0.41 per diluted share for the similar period ended November 1, 2003.

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Application of Critical Accounting Policies

     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 1 of the Notes to the Consolidated Financial Statements (Unaudited) includes a summary of the significant accounting policies and methods used in the preparation of our Consolidated Financial Statements (Unaudited). 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. 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 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 customer contracts, then future margins may be significantly and negatively affected or losses on existing contracts may need to be recognized. Any such resulting reductions in margins or contract losses could be material to our financial condition and results of operations and would be reflected in the period in which they were identified.

     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. 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.

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     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 reserves relative to accrued restructuring and other charges at October 30, 2004 totaled $6.7 million, of which $3.7 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 $4.9 million at October 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.

Liquidity and Capital Resources

     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 resale 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 during the remainder of fiscal 2005. During the second quarter of fiscal 2005, we used approximately $1.5 million in cash for increases in our inventories, receivables and other assets related to Norstan Resale Services Group. As of October 30, 2004, we had cash totaling $5.9 million and access to $5.0 million to draw upon under our revolving credit facility (limited by the applicable covenant in our credit agreement requiring us to maintain $2.0 million in excess availability).

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     Sources and Uses of Cash. Continuing operations provided net cash of $3.8 million during the six months ended October 30, 2004 as compared to utilizing cash of $3.0 million in the similar period last year. This increase is primarily the result of our improved operating results as we reported net income from continuing operations of $2.6 million in the current six month period as compared to a net loss of $5.4 million in the similar period last year.

     Investing activities provided net cash of $2.5 million during the six months ended October 30, 2004 as compared to $56,000 during the six months ended November 1, 2003. This increase in cash provided by investing activities is primarily due to the receipt of $1.25 million in cash from the disposition of Norstan CDG assets during the current period as compared to our cash outlay of $1.1 million related to the original acquisition in the prior year’s second quarter. In addition, our capital expenditures were down significantly as were our collections on lease contracts. Historically, our lease portfolio has been a significant source of cash for our business. However, cash from this source will continue to decrease over the next few fiscal years as our leasing activity winds down. Currently, management projects that cash provided from lease collections in the remainder of fiscal 2005 will be approximately $2.5 million.

     Financing activities utilized net cash of $3.4 million in the first six months of fiscal 2005 as compared to providing net cash of $3.9 million in the similar period of fiscal 2004. During the current quarter, we continued to pay down the balance on the term loan associated with our long-term credit agreement and our remaining discontinued lease rental debt. As our leasing activity winds down, we are no longer borrowing additional funds based on lease receivables. We had no new borrowings related to our lease receivables in the first six months of fiscal 2005 or 2004.

     In December 2003, we entered into a 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 improvement of certain Norstan financial measures. 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, as amended, requires us to maintain, on a quarterly basis, minimum levels of EBITDA (earnings before interest, taxes, depreciation and amortization), certain levels of Norstan Resale Services Group revenues, and limits our capital expenditures on an annual basis. As of October 30, 2004, borrowings under this agreement were $18.3 million with an average interest rate of 8.25%. We were in compliance with all applicable financial covenants as of October 30, 2004.

     Proceeds from the term loan from Wells Fargo Foothill 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 quarterly 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%.

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     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. 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. However, there is no assurance that the assumptions used by management in formulating this assessment will prove accurate or that additional financing, if needed, will be available in the future on acceptable terms.

     Capital Expenditures. We used $822,000 for capital expenditures during the six months ended October 30, 2004 as compared to $2.7 million in the similar period last year. We currently expect capital expenditures of approximately $3.0 to $4.0 million in the aggregate 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, we have made minimal investments in lease contracts in fiscal 2005 and 2004. Net lease receivables decreased to $3.6 million at October 30, 2004 from $5.6 million at April 30, 2004. 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 $1.9 million at October 30, 2004 (of which $1.1 million is due during the remainder of fiscal 2005) as compared to $3.6 million at April 30, 2004. Interest rates on these credit agreements at October 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.

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Norstan Convergence Development Group

     In March 2003, we purchased certain assets and intellectual property from NetCom Systems, Inc. (NetCom) related to NetCom’s voice over IP telephony applications software operations. 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 of $800,000 payable over the next two years ($400,000 paid April 2004 with the remaining $400,000 due April 2005). The purchase agreement provided that we may pay NetCom contingent consideration 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. We funded the purchase of these assets from borrowings under our credit facility. We also hired certain key NetCom personnel who were involved in NetCom’s development of IP telephony applications software. This group comprised our Norstan Convergence Development Group (Norstan CDG) and its results of operations are included in our Communications Solutions and Services segment.

     On July 30, 2004, we sold the assets and the intellectual property related to Norstan CDG to IPcelerate, Inc. (IPcelerate), a privately held developer of voice over IP applications, for $2.5 million in cash and promissory notes, and the assumption by the purchaser of approximately $400,000 in liabilities. Pursuant to the terms of the purchase agreement, we received $1.25 million at closing and $1.25 million evidenced by non-interest bearing promissory notes in favor of Norstan ($1.05 million due January 30, 2005 and $200,000 due February 28, 2005). We recorded a pre-tax gain of $88,000 from the sale in the first quarter of fiscal 2005 in the accompanying consolidated statement of operations. This gain is comprised of total consideration received and liabilities assumed by IPcelerate (including the payable to NetCom for approximately $400,000 due April 2005) less assets sold (consisting primarily of the remaining unamortized portion of the technology intangible assets) as well as the write-off of the goodwill recorded as part of the original CDG purchase.

Forward-Looking Statements

     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 the expectations and beliefs embodied in 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 and regulation affecting the telecommunications industries; any impact of the review of our compliance with the requirements of the federal E-rate funding program, in connection with our involvement in past E-rate projects; Norstan’s business in Canada and applicable exchange rates; the stability of foreign governments; maintaining favorable vendor relationships; 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 the uncertain impact of the termination of the resale alliance with Siemens on the revenues and operating margins in the Norstan Resale Services Group business; labor costs; funding and sourcing of adequate inventory; access to adequate financing; 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.

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ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

General

     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.

Interest Rate Risk

     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 do affect future results of operations and cash flows. We had variable rate debt of $18.3 million outstanding at October 30, 2004 with a weighted average interest rate of 8.25%. Assuming our balance of variable rate debt remains constant at $18.3 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, of $183,000. Conversely, each one-percent decrease in interest rates would result in an annual decrease in interest expense, and a corresponding increase in pre-tax cash flows of $183,000.

     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.

Foreign Currency Risk

     We are exposed to foreign currency rate risk. Substantially all foreign exchange exposure is related to the value of the Canadian dollar. In general, with a net asset exposure, a weakening of the Canadian dollar relative to the U.S. dollar has a negative translation effect. Conversely, with a net asset exposure, a strengthening of the Canadian dollar would have the opposite effect. The average exchange rates for the Canadian dollar against the U.S. dollar have strengthened over the first six months of fiscal 2005 as compared to the average rates during fiscal 2004.

     Assets and liabilities outside the United States are located primarily in Canada. Our investments in foreign subsidiaries with a functional currency other than the U.S. dollar are not hedged. The potential loss in fair value resulting from a hypothetical 10% adverse change in the Canadian dollar exchange rate would not materially affect our consolidated financial position, results of operations or cash flows. Any gain or loss in fair value associated with the Canadian dollar would be recorded as a separate component of shareholders’ equity.

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Derivative Financial Instruments

     We do not purchase or hold any derivative financial instruments for trading or speculative purposes. We also currently do not have any derivative financial instruments in place to manage interest costs, but may consider utilizing such instruments in the future as a means to manage interest rate risk.

ITEM 4.

CONTROLS AND PROCEDURES

     Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, Norstan conducted an evaluation under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, regarding the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rules 13a-15(b) of the Securities Exchange Act of 1934 (the Exchange Act). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that Norstan’s disclosure controls and procedures are effective to ensure that information that is required to be disclosed by us in reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time period specified in the rules of the Securities Exchange Commission.

     Changes in Internal Controls. There were no changes in Norstan’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     In April 2004, we received a Commitment Adjustment Letter from the Universal Services Administrative Company (USAC), which oversees the Federal Communications Commission’s School 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 we had installed specific equipment and services 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. In June 2004, we filed an appeal with USAC and began an investigation of the Navajo Prep project. A reserve of $2.2 million was established in the fourth quarter of fiscal 2004. As a result of the investigation, Norstan has decided not to pursue the appeal. In addition, on its own initiative, Norstan will review all of its other E-rate projects for compliance with E-rate program requirements. Norstan received a total of approximately $5.5 million for such other E-rate projects.

     In February 2002, we were 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 provided 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 planned to 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 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. As of October 30, 2004, we retained title to one remaining property.

     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.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None.

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

(a)		On September 15, 2004, the annual meeting of shareholders of the Company (the “Annual Meeting”) was held.
(b)		At the Annual Meeting, the following directors were elected:

(c)

The following items were voted upon at the Annual Meeting:

(1)

Election of Directors:

(2)		The shareholders approved an amendment to the Company’s 2000 Employee Stock Purchase Plan increasing the number of shares of common stock issuable thereunder from 1,800,000 to 2,300,000 shares. A total of 4,139,515 shares were voted for the amendment to this plan, 1,548,141 shares were voted against, and 23,036 abstained.
(3)		The shareholders approved the appointment of Deloitte & Touche LLP as the Company’s independent registered public accounting firm for fiscal 2005. A total of 11,034,488 shares were voted for the appointment of Deloitte & Touche LLP, 107,656 shares were voted against and 40,001 abstained.

ITEM 5. OTHER INFORMATION

           None.

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits.

10(a)		Third Amendment to Loan and Security Agreement, dated October 29, 2004, by and among the Company and Wells Fargo Foothill, Inc. [filed herewith]
10(b)		Fourth Amendment to Loan and Security Agreement, dated November 18, 2004, by and among the Company and Wells Fargo Foothill, Inc. [filed herewith]
31.1		Certification of Scott G. Christian, President and Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Robert J. Vold, Senior Vice President and Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32		Certification of Scott G. Christian, President and Chief Executive Officer, and Robert J. Vold, Senior Vice President and Chief Financial Officer, Pursuant to 18 U.S.C. Section 1350, pursuant to Section 906 of the Sarbanes Oxley Act of 2002.

(b)		Reports on Form 8-K.
		The Company filed three reports on Form 8-K during our fiscal second quarter ended October 30, 2004, as follows:

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S I G N A T U R E S

     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.

	NORSTAN, INC. Registrant
Date: December 14, 2004	By	/s/ Scott G. Christian
		Scott G. Christian
		Chief Executive Officer and President (Principal Executive Officer)

Date: December 14, 2004	By	/s/ Robert J. Vold
		Robert J. Vold
		Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

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