SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended June 30, 2004

Commission File No. 0-26912

Vodavi Technology, Inc.

(480) 443-6000

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 o.

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

The number of shares outstanding of registrant’s Common Stock, $.001 par value per share, as of July 26, 2004 was 3,634,437.

VODAVI TECHNOLOGY, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2004

TABLE OF CONTENTS

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

VODAVI TECHNOLOGY, INC.

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

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VODAVI TECHNOLOGY, INC.

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

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VODAVI TECHNOLOGY, INC.

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

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VODAVI TECHNOLOGY, INC.

(a) INTERIM FINANCIAL REPORTING

The accompanying unaudited Consolidated Financial Statements have been prepared by Vodavi Technology, Inc. and subsidiaries (“Vodavi” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and, in the opinion of management, include all adjustments (consisting of normal recurring accruals and adjustments) necessary for a fair presentation of results of operations, financial position, and cash flows as of and for the periods presented.

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the period reported. Actual results could differ from those estimates. Estimates are used in accounting for, among other things, customer incentive programs, allowances for bad debts and sales returns, inventory obsolescence, product warranty, depreciation, taxes and other contingencies. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the Consolidated Financial Statements in the period they are determined to be necessary.

The results for the three and six-month periods ended June 30, 2004 are not necessarily indicative of financial results for the full year. These financial statements should be read in conjunction with the audited Consolidated Financial Statements and notes thereto included in Vodavi’s Annual Report on Form 10-K for the year ended December 31, 2003.

[SPACE INTENTIONALLY LEFT BLANK]

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(b) CALCULATION OF EARNINGS PER SHARE

The Company displays basic and diluted earnings per share (EPS). Basic EPS is determined by dividing net income (loss) by the weighted average number of common shares outstanding. The basic weighted average number of common shares outstanding excludes all dilutive securities. Diluted EPS is determined by dividing net income by the weighted average number of common shares and dilutive securities outstanding.

A reconciliation of the numerator and denominator (weighted average number of shares outstanding) of the basic and diluted EPS computation is as follows:

(1)		Dilutive securities are calculated using the treasury stock method and the average market price during the period.
(2)		Options having an exercise price greater than the average market price during the reporting period are anti-dilutive, and therefore do not enter into the earnings per share calculation.

(c) STOCK OPTION PLANS

Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”, encourages entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and provide pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method as defined in SFAS No. 123 had been applied. The Company applies the intrinsic value method under APB No. 25 and provides the pro forma disclosure provisions of SFAS No. 123.

No stock-based employee compensation cost is reflected in net income as all options granted under the Plan had an exercise price equal to or greater than the market price of the underlying common stock on the date of grant. If the Company had accounted for its stock-based compensation plan using a fair-value-based method of accounting as prescribed in SFAS No. 123, the Company’s net income and earnings per share would have been reported as follows:

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During the six-month period ended June 30, 2004, 53,750 options were granted at a weighted average exercise price of $6.37. Also during the six-month period ended June 30, 2004, 54,375 options were exercised with total proceeds of approximately $132,000 that resulted in a tax benefit of $65,000.

(d) STOCK REPURCHASES

In June 2003, the Company repurchased 829,199 shares of its common stock for $2.40 per share pursuant to a tender offer. The purchase was funded through advances on a revolving line of credit and borrowings on a term loan. As of June 30, 2004, there were no outstanding balances on the revolving line of credit or term loan. The repurchased shares were retired.

In May 2004, the Company commenced a stock repurchase program to purchase up to $1.0 million of the Company’s common stock through October 2004. As of June 30, 2004, the Company repurchased 30,402 shares at a total cost of $152,000. The repurchased shares are held in treasury.

(e) RECLASSIFICATIONS

Certain reclassifications have been made to the consolidated balance sheet as of December 31, 2003 to conform to the current period’s presentation.

(f) SEGMENT REPORTING

The Company operates in one reportable segment, the distribution of business telecommunications equipment. Accordingly, the Company has only presented financial information for its one reportable segment.

(g) COMMITMENTS AND CONTINGENCIES

The Company is subject to certain asserted and unasserted claims encountered in the normal course of business. The Company believes that the resolution of these matters will not have a material adverse effect on its financial position or results of operations. However, the Company cannot provide assurance that damages resulting from the resolution of these matters, if any, will not have a material adverse effect on the Company’s financial position or results of operations.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Business Overview

We design, develop, market, and support a broad range of business telecommunications solutions, including traditional and IP telephony products, voice processing products, as well as computer telephony products, that address a wide variety of business applications. Our telecommunications solutions incorporate sophisticated features such as automatic call distribution, scalable networking, Internet protocol, or IP, and wireless solutions. Our voice processing products include Internet messaging, automated attendant, and voice and fax mail. Our computer telephony products enable users to integrate the functionality of their telephone systems with their computer systems. We market our products primarily in the United States as well as in foreign countries through a distribution model consisting primarily of wholesale distributors and direct dealers.

Critical Accounting Policies and Estimates

     Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates and judgments, including those related to customer incentives, bad debts, sales returns, excess and obsolete inventory, and contingencies and litigation. We base our estimates and judgments on historical experience and on various other factors that are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Customer Incentives

     We record reductions to revenue for customer incentive programs, including special pricing agreements, price protection for our distributors, promotions, and other volume-related rebate programs. Such reductions to revenue are estimates, which are based on a number of factors, including our assumptions related to customer redemption rates, sales volumes, and inventory levels at our distributors. If actual results differ from our original assumptions, revisions are made to our estimates that could result in additional reductions to our reported revenue in the period the revisions are made. Additionally, if market conditions were to decline, we may take actions to increase the level of customer incentive offerings that could result in an incremental reduction of revenue in the period in which we offer the incentive.

Bad Debts

     We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Additionally, we have a significant concentration of accounts receivable with our two largest distributors, Graybar Electric Company, Inc. and Target Distributing Company. As of June 30, 2004, Graybar accounted for 31% and Target accounted for 24% of our total accounts receivable. If either Graybar or Target’s financial condition were to deteriorate, resulting in their inability to make payments to us, it could have a material adverse impact on our financial condition and results of operations.

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Sales Returns

     We maintain allowances for estimated sales returns. While we have distribution agreements with our largest distributors that limit the amount of sales returns on active products, we generally allow returns of products that we discontinue. Accordingly, the timing and amount of revisions to our estimates for sales returns is largely influenced by our decisions to discontinue product lines and our ability to predict the inventory levels of such products at our largest distributors. Revisions to these estimates have the effect of increasing or decreasing the reported amount of revenue in the period in which the revisions are made. We generally do not accept product returns from our direct dealers unless the product is damaged.

Excess and Obsolete Inventory

     We record our inventory at the lower of cost or market value. Our assessment of market value is determined by, among other things, historical and forecasted sales activity, the condition of specific inventory items, and competitive pricing considerations. When the assessed market value is less than the historical cost, provision is made in the financial statements to write-down the carrying amount of the respective inventory items to market value. If actual results are less favorable than our original assumptions for determining market value, additional inventory write-downs may be required.

     The above listing is not intended to be a comprehensive list of our accounting policies. See our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003, which contains accounting policies and other disclosures required by generally accepted accounting principles in the United States of America.

Results of Operations

     The following table sets forth, for the periods indicated the percentage of total revenue represented by certain revenue and expense items. The table and the discussion below should be read in conjunction with the consolidated financial statements and notes thereto that appear elsewhere in this report.

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Quarter Ended June 30, 2004 Compared With Quarter Ended June 30, 2003

Revenue

     Revenue for the three-month period ended June 30, 2004 totaled $11.2 million, an increase of 10.0%, from revenue of $10.2 million for the same period of 2003. Sales of our telephone systems increased 11.7% to $9.4 million during the second quarter of 2004 compared to $8.4 million in 2003. The increase in telephone system sales is attributed to an increase in unit sales of our STS product line and the sale of larger systems within the XTS product line. Sales of commercial grade single line telephones declined from $592,000 in the second quarter of 2003 to $485,000 in the most recent quarter. During the second quarter of 2004, we began de-marketing our 2700 Series of single line telephones and in June 2004 we introduced the 2800 Series. We expect sales of single line telephones to accelerate in the second half of 2004. Sales of telephony applications, including voice processing, computer telephony integration, and unified messaging remained unchanged at approximately $1.1 million during the respective quarterly periods.

     Sales through our direct sales office in the Phoenix Metropolitan area totaled $491,000 during the second quarter of 2004 compared with $352,000 during the same period of 2003. The increase in sales through our direct sales office is attributable to the expansion of our sales force and the positive impact of a focused sales and marketing program.

     Our revenue is reported net of reserves for sales returns, discounts, customer incentive programs, and inter-company eliminations, and includes shipping and handling charges. These items resulted in a net reduction to revenue of $229,000 in the 2004 period compared with a reduction of $241,000 in the 2003 period.

Gross Margin

     Our gross margin was approximately $3.9 million and $3.4 million for the quarterly periods ended June 30, 2004 and 2003, respectively. Our gross margin as a percentage of total revenue increased to 35.0% during 2004 from 33.7% during 2003. The increase in our gross margin percentage during 2004 is a direct result of the mix of product sales, a higher volume of sales to cover the fixed component of cost of sales, and increased sales at our direct sales office.

Engineering and Product Development

     Engineering and product development expenditures decreased slightly to $492,000 during the second quarter of 2004 from $517,000 in the same period of 2003. We continue to invest in the development of our next generation IP telephone systems, the convergence of and enhancements to our traditional telephone systems, and enhancements to our voice processing and other telephony applications.

Selling, General, and Administrative Expenses

     Selling, general, and administrative expenses increased to $2.7 million in the second quarter of 2004 from approximately $2.3 million in the second quarter of 2003. As a percentage of revenue, selling, general and administrative increased to 24% in the second quarter of 2004 from 23% in the same period of 2003. Factors that increased our expenses include increased compensation, increased marketing and promotional activity, and an increase in headcount.

Interest Expense

     Interest expense decreased to $4,500 during the second quarter of 2004 from $27,000 for the same period a year ago.

Income Taxes

     We provided for federal and state income taxes using an effective rate of 38.6% during the second quarter of 2004 compared to 39.7% in 2003. Our effective tax rate in 2004 is expected to be consistent with our effective tax rate that we reported for the 2003 fiscal year.

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Six Months Ended June 30, 2004 Compared With Six Months Ended June 30, 2003

Revenue

     Revenue for the six-month period ended June 30, 2004 totaled $21.0 million, an increase of 9.1%, from revenue of $19.3 million for the same period of 2003. Sales of our telephone systems increased 11.7% to $17.4 million during the first half of 2004 compared to $15.6 million in 2003. The increase in telephone system sales is attributed to an increase in unit sales of our STS product line and the sale of larger systems within the XTS product line. Sales of commercial grade single line telephones remained unchanged at $1.0 million for each of the six-month periods of 2004 and 2003. During the second quarter of 2004, we began de-marketing our 2700 Series of single line telephones and in June 2004 we introduced the 2800 Series. We expect sales of single line telephones to accelerate in the second half of 2004. Sales of telephony applications, including voice processing, computer telephony integration, and unified messaging decreased slightly to $2.5 million from $2.7 million during the respective periods of 2004 and 2003. The decline in telephony applications is a direct result selling more embedded voice mail applications, which are reported in telephone system sales.

     Sales through our direct sales office in the Phoenix Metropolitan area totaled $900,000 during the first six months of 2004 compared with $614,000 during the same period of 2003. The increase in sales through our direct sales office is attributable to the expansion of our sales force and the positive impact of a focused sales and marketing program.

     Our revenue is reported net of reserves for sales returns, discounts, customer incentive programs, and inter-company eliminations, and includes shipping and handling charges. These items resulted in a net reduction to revenue of $793,000 in the 2004 period compared with a reduction of $600,000 in the 2003 period.

Gross Margin

     Our gross margin was approximately $7.3 million in 2004 compared with $6.6 million in 2003. Our gross margin as a percentage of total revenue increased to 34.8% during 2004 from 34.3% during 2003. The increase in our gross margin percentage during 2004 is a direct result of the mix of product sales, a higher volume of sales to cover the fixed component of cost of sales, and increased sales at our direct sales office.

Engineering and Product Development

     Engineering and product development expenditures were relatively unchanged at approximately $1.0 million in 2004 compared to $1.1 million in the first six months of 2003.

Selling, General, and Administrative Expenses

     Selling, general, and administrative expenses increased to $5.2 million in 2004 compared to $4.7 million in the first six months of 2003. Factors that increased our expenses include increased compensation, increased marketing and promotional activity, and an increase in headcount.

Interest Expense

     Interest expense decreased to $14,000 for the first six months of 2004 from $52,000 for the same period a year ago.

Income Taxes

We provided for federal and state income taxes using an effective rate of 38.4% during the first half of 2004 compared with 39.8% for the same period of 2003. Our effective tax rate in 2004 is expected to be consistent with our effective tax rate that we reported for the 2003 fiscal year.

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Liquidity and Capital Resources

     Our net working capital position was approximately $8.6 million at June 30, 2004 and December 31, 2003. We had a cash balance of $2.6 million at June 30, 2004 compared with a cash balance of $2.9 million at December 31, 2003. Factors that decreased our cash position during the first six months of 2004 included an increase in accounts receivable of $715,000 and the pay down of accounts payable and accrued liabilities of $160,000 and $369,000, respectively. We also used approximately $233,000 during the first six months of 2004 for the purchase of property and equipment, $152,000 to repurchase 30,402 shares of our common stock, and $900,000 to pay off our term loan. Sources of cash included positive income from operations, a reduction in inventory of $996,000 and other current assets of $103,000, and $132,000 from the exercise of stock options.

     Our accounts receivable days sales outstanding, calculated on a quarterly basis, were approximately 62 days as of June 30, 2004 compared to 59 days as of December 31, 2003.

     Our inventory turnover, measured in terms of days outstanding on a quarterly basis, was 51 days as of June 30, 2004 compared to 67 days as of December 31, 2003. The decrease in inventory days outstanding is a direct result of our efforts to rationalize our product lines and an increase in sales.

     Trade payables and accrued liabilities, including payables to third-party and related-party manufacturers, were approximately $6.9 million as of June 30, 2004 compared with $7.4 million as of December 31, 2003. The level of our trade payables and accrued liabilities between periods is largely influenced by the timing of payments we make to our largest suppliers for inventory items and payments to cover payroll, income taxes, and customer rebates. We generally pay trade payables within 45 days from the invoice date, except for payments to our largest supplier, which are 60 days from the invoice date.

     We had a $15.0 million credit facility with General Electric Capital Corporation that expired in April 2003. The line of credit bore interest at 2.5% over the 30-day commercial paper rate. Advances under the line of credit were based upon eligible accounts receivable and inventory of our wholly owned subsidiary, Vodavi Communications Systems, Inc., and were secured by substantially all of our assets. The revolving line of credit contained covenants that are customary for similar credit facilities and also prohibited our operating subsidiaries from paying dividends to us without the consent of GE Capital.

     In April 2003, we entered into a credit agreement with Comerica Bank-California (Comerica) of a size that is more reflective of the current capital requirements of our business. The credit agreement established a $5.0 million revolving line of credit and a $1.0 million term loan. Advances under the credit facility are based upon eligible accounts receivable and inventory of our wholly owned subsidiary, Vodavi Communications Systems, Inc., and are secured by substantially all of our assets. The credit facility contains covenants that are customary for similar credit facilities and also prohibits our operating subsidiaries from paying dividends to us without the consent of Comerica. As of June 30, 2004, we had no outstanding borrowings on our line of credit and $5.0 million available for future advances.

     The $5.0 million revolving line of credit bears interest at Comerica’s prime rate, or 4.0% at June 30, 2004, and requires monthly payments of interest only with all unpaid principal and accrued interest due at its expiration in April 2005. If we are unable to reduce the principal balance on the line of credit to zero for at least 30 consecutive days during any fiscal year, then any remaining balance will be converted into a term loan, or term balance, as defined in the agreement. In addition to interest on the term balance, we will be required to make monthly payments of principal in an amount sufficient to fully amortize the term balance over a thirty-six month period.

     The $1.0 million term loan was available to us only for the purpose of acquiring our common stock. Borrowings on the term loan bore interest at Comerica’s prime rate plus 0.5%.

     In May 2003, we commenced a self-tender offer to purchase up to 1,000,000 shares of our common stock for $2.40 per share. On June 13, 2003, we repurchased 829,199 shares of our common stock at $2.40 per share pursuant to the tender offer. The repurchase was funded through advances on our revolving line of credit and term loan. As of June 30, 2004, there were no amounts outstanding on our revolving line of credit. In April 2004, we repaid the amount outstanding on our term loan with currently available funds.

     We have certain long-term operating lease agreements for our office and warehouse facilities and short-term purchase commitments to our third-party suppliers. We have no special purpose entities or off balance sheet

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financing arrangements, commitments, or guarantees. The following table sets forth all known commitments as of June 30, 2004 and the year in which those commitments become due or are expected to be settled (in thousands):

     From time to time we are subject to certain asserted and unasserted claims encountered in the normal course of business. We believe that the resolution of these matters will not have a material adverse effect on our financial position or results of operations. However, we cannot provide assurance that damages resulting from the resolution of these matters, if any, will not have a material adverse effect on our financial position or results of operations.

     We believe that our working capital and credit facilities are sufficient to fund our capital needs during the next 12 months. Although we currently have no acquisition targets, we intend to continue to explore acquisition opportunities as they arise and may be required to seek additional financing in the future to meet such opportunities.

International Manufacturing Sources

     We currently obtain a substantial majority of our products under various manufacturing arrangements with third-party manufacturers in South Korea and Thailand, including LGE, which owns approximately 24% of our outstanding common stock. We face risks associated with international manufacturing sources. For a more detailed discussion of these risks, please see Item 1, “Business — Risk Factors — We face risks associated with international manufacturing sources” included in our annual report on Form 10-K for the year ended December 31, 2003.

CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS

     This report contains forward-looking statements, including statements regarding our business strategies, our business, and the industry in which we operate. These forward-looking statements are based primarily on our expectations and are subject to a number of risks and uncertainties, some of which are beyond our control. Actual results could differ materially from the forward-looking statements as a result of numerous factors, including those set forth in our Form 10-K for the year ended December 31, 2003, as filed with the Securities and Exchange Commission.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We do not participate in any activities involving derivative financial instruments or other financial and commodity instruments. We do not hold investment securities that would require disclosure of market risk. Our market risk exposure is limited to interest rate risk associated with our credit facility. We incur interest at a variable rate of prime on advances made under our revolving line of credit and prime plus 0.5% on our term loan. At June 30, 2004, we had no outstanding borrowings on the line of credit or term loan.

ITEM 4. CONTROLS AND PROCEDURES

     We have evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of June 30, 2004. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have each concluded that our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed by us in our quarterly reports filed under the Securities Exchange Act within the time periods specified by the Securities and

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Exchange Commission’s rules and forms. During the quarterly period covered by this report, there have not been any changes in our internal controls over financial reporting that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

     Subsequent to the date of their evaluation, there have not been any significant changes in our internal controls or in other factors that could significantly affect these controls, including any corrective action with regard to significant deficiencies and material weaknesses.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

Not applicable.

Item 2. Changes In Securities and Use of Proceeds

Not applicable.

Item 3. Defaults Upon Senior Securities

Not applicable.

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

We held our Annual Meeting of Stockholders on May 17, 2004. The following nominees were elected to our Board of Directors to serve until the next annual meeting of stockholders, until their successors are elected or have been qualified, or until their earlier resignation or removal:

Item 5. Other Information

Not applicable.

Item 6. Exhibits and Reports on Form 8-K

(a)		Exhibits:
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b)		Reports on Form 8-K:

Not applicable

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SIGNATURES

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.

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