UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q/A
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.
For the quarterly period ended June 30, 2005
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.
Commission File Number: 001-12155
Farmstead Telephone Group, Inc.
-------------------------------
(Exact name of registrant as specified in its charter)
Delaware 06-1205743
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
22 Prestige Park Circle
East Hartford, CT 06108
(Address of principal executive offices) (Zip Code)
(860) 610-6000
(Registrant's telephone number)
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 Exchange Act).
Yes [ ] No [X]
As of July 31, 2005, the registrant had 3,352,730 shares of its $0.001 par
value Common Stock outstanding.
EXPLANATORY NOTE:
-----------------
This Form 10-Q/A to the Company's Quarterly Report on Form 10-Q for
the quarterly period ended June 30, 2005, initially filed with the
Securities and Exchange Commission on August 11, 2005, amends Part I, Items
1 and 2 for the three and six months ended June 30, 2005. This Form 10-Q/A
continues to reflect circumstances as of the date of the original filing of
the Quarterly Report on Form 10-Q for the quarterly period ended June 30,
2005 and we have not updated the disclosures contained herein to reflect
events that occurred at a later date, except for items related to the
restatement or where otherwise indicated.
The accompanying consolidated financial statements as of June 30,
2005 and for the three and six months ended June 30, 2005 have been
restated to correct an error pertaining to the accounting for warrants and
outstanding borrowings under convertible notes issued to the Laurus Master
Fund Ltd. ("Laurus") in connection with a three-year Secured Revolving Note
agreement dated March 31, 2005. See a more detailed discussion of the
restatement in Item 1, Note 1- "Restatement" to the Notes to Consolidated
Financial Statements.
We anticipate filing an amended report on Form 10-Q for the quarterly
period ended September 30, 2005 which will reflect a continuation of
corrections in the accounting for convertible notes and warrants issued to
Laurus during 2005. The consolidated financial statements for the years
ended December 31, 2005, 2004 and 2003 included in our Annual Report on
Form 10-K for the year ended December 31, 2005 should be relied upon.
TABLE OF CONTENTS TO FORM 10-Q
PART I. FINANCIAL INFORMATION
Page
----
ITEM 1. FINANCIAL STATEMENTS (Unaudited)
Consolidated Balance Sheets - June 30, 2005 and December 31, 2004 3
Consolidated Statements of Operations - Three and Six Months
Ended June 30, 2005 and 2004 4
Consolidated Statement of Changes in Stockholders' Equity -
Six Months Ended June 30, 2005 4
Consolidated Statements of Cash Flows - Six Months Ended
June 30, 2005 and 2004 5
Notes to Consolidated Financial Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 15
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 20
ITEM 4. CONTROLS AND PROCEDURES 20
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 20
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 20
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 21
ITEM 5. OTHER INFORMATION 21
ITEM 6. EXHIBITS 21
SIGNATURES 22
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
(In thousands) 2005 2004
------------------------------------------------------------------------------------------------
(Unaudited)
(As Restated)
ASSETS
Current assets:
Cash and cash equivalents $ 390 $ 217
Accounts receivable, net 3,467 1,453
Inventories, net 1,429 1,627
Other current assets 101 378
--------------------------------------------------------------------------------------------
Total Current Assets 5,387 3,675
Property and equipment, net 289 268
Deferred financing costs (Note 6) 569 -
Other assets 107 107
--------------------------------------------------------------------------------------------
Total Assets $ 6,352 $ 4,050
============================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,674 $ 1,110
Accrued expenses and other current liabilities 341 242
Current portion of convertible debt, net of unamortized
discount of $251 (Note 6) 699 -
Revolving credit facility note (Note 8) - 179
Derivative financial instruments (Note 7) 231 -
Debt maturing within one year (Note 8) 31 8
--------------------------------------------------------------------------------------------
Total Current Liabilities 3,976 1,539
Postretirement benefit obligation 656 593
Convertible debt, net of unamortized discount of $307 (Note 6) 193 -
Long-term debt (Note 8) 62 39
Derivative financial instruments (Note 7) 394 -
--------------------------------------------------------------------------------------------
Total Liabilities 5,281 2,171
--------------------------------------------------------------------------------------------
Commitments and contingencies (Note 12)
Stockholders' Equity:
Preferred stock, $0.001 par value; 2,000,000 shares authorized;
no shares issued and outstanding - -
Common stock, $0.001 par value; 30,000,000 shares authorized;
3,352,730 and 3,322,182 shares issued and outstanding at
June 30, 2005 and December 31, 2004, respectively 3 3
Additional paid-in capital 12,337 12,320
Accumulated deficit (11,250) (10,420)
Accumulated other comprehensive loss (19) (24)
--------------------------------------------------------------------------------------------
Total Stockholders' Equity 1,071 1,879
--------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 6,352 $ 4,050
============================================================================================
See accompanying notes to consolidated financial statements.
3
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
For the Three For the Six
Months Ended Months Ended
June 30, June 30,
---------------- ----------------
(In thousands, except loss per share amounts) 2005 2004 2005 2004
------------------------------------------------------------------------------------------
(As Restated) (As Restated)
Revenues:
Equipment $3,723 $2,584 $5,688 $5,506
Services and other revenue 760 305 1,204 789
-------------------------------------------------------------------------------------------
Total revenues 4,483 2,889 6,892 6,295
Cost of Revenues:
Equipment 2,695 1,970 4,014 4,016
Services and other revenue 321 189 555 461
Other cost of revenues 131 126 233 337
-------------------------------------------------------------------------------------------
Total cost of revenues 3,147 2,285 4,802 4,814
-------------------------------------------------------------------------------------------
Gross profit 1,336 604 2,090 1,481
Selling, general and administrative expenses 1,765 1,010 3,148 2,220
-------------------------------------------------------------------------------------------
Operating loss (429) (406) (1,058) (739)
-------------------------------------------------------------------------------------------
Other income (expense):
Interest expense (Note 14) (48) (6) (56) (12)
Derivative instrument income 681 - 287 -
Other income 1 1 4 2
-------------------------------------------------------------------------------------------
Total other income (expense) 634 (5) 235 (10)
-------------------------------------------------------------------------------------------
Income (loss) before income taxes 205 (411) (823) (749)
Provision for income taxes 3 3 7 6
-------------------------------------------------------------------------------------------
Net income ( loss) $ 202 $ (414) $ (830) $ (755)
===========================================================================================
Net income (loss) per common share:
Basic $ .06 $ (.12) $ (.25) $ (.23)
Diluted $ .05 $ (.12) $ (.25) $ (.23)
Weighted average common shares outstanding:
Basic 3,353 3,316 3,340 3,314
Diluted 4,391 3,316 3,340 3,314
===========================================================================================
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(UNAUDITED)
Six Months ended June 30, 2005 (As Restated)
Accumulated
Additional Accum- Other
Common Stock Paid-in ulated Comprehensive
(In thousands) Shares Amount Capital Deficit Loss Total
--------------------------------------------------------------------------------------------------------
Balance at December 31, 2004 3,322 $3 $12,320 $(10,420) $(24) $1,879
Net loss - - - (830) - (830)
Amortization of pension liability - - - - 5 5
------
Comprehensive loss - - - - - (825)
Issuance of common stock 31 - 17 - - 17
--------------------------------------------------------------------------------------------------------
Balance at June 30, 2005 3,353 $3 $12,337 $(11,250) $(19) $1,071
========================================================================================================
See accompanying notes to consolidated financial statements.
4
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Six Months Ended June 30, 2005 and 2004
(In thousands) 2005 2004
--------------------------------------------------------------------------------------
(As Restated)
Cash flows from operating activities:
Net loss $ (830) $(755)
Adjustments to reconcile net loss to net cash flows
used in operating activities:
Provision for doubtful accounts receivable 18 18
Provision for losses on inventories 18 68
Depreciation and amortization of property and equipment 53 73
Amortization of deferred financing costs 23 -
Amortization of discounts on convertible debt 19 -
Unrealized gain on derivative instruments (287) -
Decrease in accumulated other comprehensive loss 5 4
Changes in operating assets and liabilities:
Increase in accounts receivable (2,032) (119)
Decrease (increase) in inventories 180 (245)
Decrease in other assets 277 7
Increase in accounts payable 1,564 5
Increase in accrued expenses and other current liabilities 99 174
Increase in postretirement benefit obligation 63 57
--------------------------------------------------------------------------------------
Net cash used in operating activities (830) (713)
--------------------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment (18) (23)
--------------------------------------------------------------------------------------
Net cash used in investing activities (18) (23)
--------------------------------------------------------------------------------------
Cash flows from financing activities:
(Repayments) borrowings under revolving credit line (179) 218
Borrowings under convertible debt facility 1,450 -
Deferred financing costs (257) -
Proceeds from issuance of common stock 17 2
Repayments of long-term debt and capital lease obligations (10) -
--------------------------------------------------------------------------------------
Net cash provided by financing activities 1,021 220
--------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 173 (516)
Cash and cash equivalents at beginning of period 217 827
--------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 390 $311
======================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 20 $ 14
Income taxes 2 4
Non-cash financing and investing activities:
Purchase of equipment under capital lease 56 -
Discount on warrants issued to Laurus 335 -
Discounts on issuance of convertible debt 557 -
See accompanying notes to consolidated financial statements.
5
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION, BUSINESS OPERATIONS, AND SIGNIFICANT
ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements presented herein consist of the
accounts of Farmstead Telephone Group, Inc. and its wholly owned
subsidiaries, FTG Venture Corporation (inactive) and InfiNet Systems, LLC
(inactive). The accompanying consolidated financial statements as of June
30, 2005 and for the three and six months ended June 30, 2005 and 2004 have
been prepared in accordance with accounting principles generally accepted
in the United States of America and the rules and regulations of the
Securities and Exchange Commission for interim financial statements. In
the Company's opinion, the unaudited interim consolidated financial
statements and accompanying notes reflect all adjustments, consisting of
normal and recurring adjustments, which are necessary for a fair
presentation of its financial position and operating results for the
interim periods presented. The results of operations for the interim
periods are not necessarily indicative of the results that may be expected
for the entire fiscal year. This Form 10-Q/A should be read in conjunction
with the consolidated financial statements and notes thereto included in
the Company's Annual Report on Form 10-K for the year ended December 31,
2004.
Restatement
The accompanying consolidated financial statements as of June 30,
2005 and for the three and six months ended June 30, 2005 (the "2005
Financial Statements") have been restated to correct an error pertaining to
the accounting for warrants and outstanding borrowings under convertible
notes issued to the Laurus Master Fund Ltd. ("Laurus") in connection with a
three-year Secured Revolving Note agreement dated March 31, 2005.
Specifically, the Company has adjusted its 2005 Financial Statements in
order to apply the accounting methodology required under EITF Issue 00-19,
"Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock". Applying this methodology
resulted in the recording of derivative financial instrument liabilities
attributable to borrowings under the credit agreement and to the
freestanding warrants issued to Laurus, and non-cash derivative instrument
income of $681,000 and $287,000 for the three and six months ended June 30,
2005, respectively. The effect of the foregoing on the 2005 Financial
Statements is as follows (in thousands, except per share amounts):
Consolidated Balance Sheet: June 30, 2005
-------------
As
Previously As
Reported Restated
--------------------------------------------------------
Total assets $6,190 $6,352
Total liabilities 5,215 5,281
Stockholders' equity 975 1,071
-------------------------------------------------------
Consolidated Results of Operations: Three Months Ended Six Months Ended
June 30, 2005 June 30, 2005
------------------ ----------------
As As
Previously As Previously As
Reported Restated Reported Restated
---------------------------------------------------------------------------------------
Operating loss $(429) $(429) $(1,058) $(1,058)
Net income (loss) (474) 202 (1,112) (830)
Net income (loss) per common share:
Basic $(.14) $ .06 $ (.33) $ (.25)
Diluted (.14) .05 (.33) (.25)
---------------------------------------------------------------------------------------
6
Business Operations
As presented in the consolidated financial statements contained in
this report, the Company incurred net income of $202,000 for the three
months ended June 30, 2005 and a net loss of $830,000 for the six months
ended June 30, 2005. These results include non-cash derivative instrument
income of $681,000 for the three-month period, and $287,000 for the six-
month period, arising from borrowings under a three-year convertible
revolving credit facility entered into effective March 31, 2006, and the
issuance of freestanding warrants in connection therewith, as more fully
described in Note 6, Convertible Debt. Excluding the non-cash derivative
instrument income, the Company otherwise incurred losses of $479,000 and
$1,117,000 during the three and six months ended June 30, 2005.
In addition, the Company has incurred substantial losses in each of
the past four fiscal years. These losses have been primarily the result of
significant declines in revenues over these periods. As further described
in the Company's Annual Report on Form 10-K for the year ended December 31,
2004, the Company has taken several measures to turnaround its operating
performance. The turnaround strategy is principally based upon building a
larger and more highly qualified sales force, and diversifying the
Company's product offerings and targeted customers. The business strategy
is to transition to a full communications solutions provider, becoming less
dependent on parts sales, and developing more sources of recurring
revenues, such as through installation and maintenance services. As a part
of the turnaround plan, the Company hired a new President and CEO in
October 2004, and two Executive Vice Presidents - one responsible for
operations (hired in January 2005) and one responsible for sales (hired in
March 2005). In March, the Company significantly expanded its sales
infrastructure and opportunities, first by the hiring of twenty three sales
and sales support professionals formerly employed by Avaya Inc., and second
by entering into a trial agreement with Avaya to provide products and
services to the SMB ("small-to-medium sized business") market which
commenced in March with the launch of a nationwide SMB sales program. At
the end of March 2005, the Company's direct sales force was 85% larger than
in June 2004. As a result of these efforts, the Company has been
successful in uplifting revenues, as revenues for the three and six months
ended June 30, 2005 were 55% and 9% higher than the comparable prior year
periods. In fact, the $4,483,000 in revenues for the quarter ended June
30, 2005 was the highest revenue quarter since the second quarter of 2002,
and the Company recorded a profit for the month of June, which was the
Company's first profitable month since May 2003.
In May 2005, the Company took steps to further diversify its product
offerings, forming a wholly-owned subsidiary named "One IP Voice" which,
when operational, will offer carrier-based hosted IP telephony services
along with network services. Its primary target will be the SMB market.
In order to finance its business expansion plans, effective March 31,
2005 the Company entered into a $3 million credit arrangement with Laurus,
replacing a $1.7 million credit facility with Business Alliance Capital
Corporation. For additional information, refer to Note 6 - Convertible
Debt contained herein.
Significant Accounting Policies
Derivative financial instruments
We do not use derivative instruments to hedge exposures to cash flow,
market, or foreign currency risks.
We review the terms of convertible debt and equity instruments we
issue to determine whether there are embedded derivative instruments,
including the embedded conversion option, that are required to be
bifurcated and accounted for separately as a derivative financial
instrument. In circumstances where the convertible instrument contains more
than one embedded derivative instrument, including the conversion option,
that is required to be bifurcated, the bifurcated derivative instruments
are accounted for as a single, compound derivative instrument. Also, in
connection with the sale of convertible debt and equity instruments, we may
issue freestanding warrants that may, depending on their terms, be
accounted for as derivative instrument liabilities, rather than as equity.
We may also issue options or warrants to non-employees in connection with
consulting or other services they provide.
Certain instruments, including convertible debt and equity
instruments and the freestanding options and warrants issued in connection
with those convertible instruments, may be subject to registration rights
agreements, which impose penalties for failure to register the underlying
common stock by a defined date. The existence of the potential cash
penalties under the related registration rights agreement requires that the
embedded conversion option be accounted for as a derivative instrument
liability. Similarly, the potential cash penalties under the related
registration rights agreement may require us to account for the
freestanding options and warrants as derivative financial instrument
liabilities, rather than as equity. In addition, when the ability to
physical or net-share settle the conversion option or the exercise of the
freestanding options or
7
warrants is deemed to not be within the control of the Company, the
embedded conversion option or freestanding options or warrants may be
required to be accounted for as a derivative financial instrument
liability.
Derivative financial instruments are measured at their fair value.
For derivative financial instruments that are accounted for as liabilities,
the derivative instrument is initially recorded at its fair value and is
then revalued at each reporting date, with changes in the fair value
reported as charges or credits to income. For option-based derivative
financial instruments, we use the Black-Scholes option pricing model to
value the derivative instruments. When the convertible debt or equity
instruments contain embedded derivative instruments that are to be
bifurcated and accounted for as liabilities, the total proceeds allocated
to the convertible host instruments are first allocated to the fair value
of all the bifurcated derivative instruments. The remaining proceeds, if
any, are then allocated to the convertible instruments themselves, usually
resulting in those instruments being recorded at a discount from their face
amount.
To the extent that the fair values of any freestanding and/or
bifurcated derivative instrument liabilities exceed the total proceeds
received, an immediate charge to income is recognized, in order to
initially record the derivative instrument liabilities at their fair value.
The discount from the face value of the convertible debt, together with the
stated interest on the instrument, is amortized over the life of the
instrument through periodic charges to income, usually using the effective
interest method.
The classification of derivative instruments, including whether such
instruments should be recorded as liabilities or as equity, is reassessed
periodically, including at the end of each reporting period. If
reclassification is required, the fair value of the derivative instrument,
as of the determination date, is reclassified. Any previous charges or
credits to income for changes in the fair value of the derivative
instrument are not reversed. Derivative instrument liabilities are
classified in the balance sheet as current or non-current based on whether
or not net-cash settlement of the derivative instrument could be required
within 12 months of the balance sheet date.
2. RECLASSIFICATIONS
Certain amounts in the prior year's financial statements have been
reclassified to conform to the 2005 presentation.
3. ACCOUNTS RECEIVABLE, NET
June 30, December 31,
(In thousands) 2005 2004
-------------------------------------------------------------------
Trade accounts receivable $3,051 $1,379
Less: allowance for doubtful accounts (78) (60)
-------------------------------------------------------------------
Trade accounts receivable, net 2,973 1,319
Other receivables 494 134
-------------------------------------------------------------------
Accounts receivable, net $3,467 $1,453
===================================================================
Other receivables primarily consist of commissions, rebates and other
dealer incentives due from Avaya and are recorded in the consolidated
financial statements when earned.
4. INVENTORIES, NET
June 30, December 31,
(In thousands) 2005 2004
-------------------------------------------------------------------
Finished goods and spare parts $1,260 $1,341
Work in process (a) 208 352
Rental equipment 13 52
-------------------------------------------------------------------
1,481 1,745
Less: reserves for excess and
obsolete inventories (52) (118)
-------------------------------------------------------------------
Inventories, net $1,429 $1,627
===================================================================
(a) Work in process inventories consist of used equipment requiring
repair or refurbishing.
8
5. PROPERTY AND EQUIPMENT, NET
Estimated
Useful Lives June 30, December 31,
(In thousands) (Yrs.) 2005 2004
----------------------------------------------------------------------------------------
Computer and office equipment 3 - 5 $ 1,062 $ 1,071
Furniture and fixtures 5 - 10 288 288
Leasehold improvements 10 171 171
Capitalized software development costs 5 98 98
Automobile 5 50 50
Leased equipment under capital lease 3 56 -
-------------------------------------------------------------------------------------
1,725 1,678
Less: accumulated depreciation and amortization (1,436) (1,410)
-------------------------------------------------------------------------------------
Property and equipment, net $ 289 $ 268
=====================================================================================
Leased equipment under capital lease consists of computer equipment.
6. CONVERTIBLE DEBT
June 30, December 31,
(In thousands) 2005 2004
-----------------------------------------------------------------------------------
Borrowing under secured revolving credit facility note $ 950 $ -
Secured convertible Minimum Borrowing Note 500 -
Less: unamortized discount attributable to the
revolving credit facility note (251) -
Less: unamortized discount attributable to the
Minimum Borrowing Note (307) -
------------------------------------------------------------------------------
Convertible Debt, net of unamortized discounts 892 -
Less: current portion (699) -
------------------------------------------------------------------------------
Convertible Debt, net of unamortized discounts $ 193 $ -
==============================================================================
On March 31, 2005, the Company entered into a financing transaction
with Laurus, providing for a three-year, $3 million ("Capital Availability
Amount") revolving loan credit facility which includes a Secured Revolving
Note (the "Revolving Note") and a Secured Convertible Minimum Borrowing
Note (together with the Revolving Note, the "Laurus Notes"). The initial
Minimum Borrowing Note was set at $500,000, the proceeds of which were
advanced to the Company on April 4, 2005. Amounts outstanding under the
Laurus Notes will either be paid in cash at their March 31, 2008 maturity
date or, at Laurus' option, by converting such amounts into shares of the
Company's common stock from time to time. The Company also issued Laurus a
five-year warrant (the "Warrant") to purchase an aggregate of 500,000
shares of common stock of the Company at an exercise price of $1.82 per
share. The warrant exercise price was set at 130% of the average closing
price of the Company's common stock over the ten trading days preceding the
execution of the agreement, and is subject to anti-dilution protection
adjustments. This transaction was completed in a private offering pursuant
to an exemption from registration under Section 4(2) of the Securities Act
of 1933, as amended.
The following describes certain of the material terms of the
financing transaction with Laurus. The description below is not a complete
description of the material terms of the financing transaction and is
qualified in its entirety by reference to the agreements entered into in
connection with the financing which were included as exhibits to the
Company's Annual Report on Form 10-K for the year ended December 31, 2004:
Principal Borrowing Terms and Prepayment: Borrowings are advanced
pursuant to a formula consisting of (i) 90% of eligible accounts
receivable, as defined (primarily receivables that are less than 90 days
old), and (ii) 30% of eligible inventory, as defined (primarily inventory
classified as "finished goods"), up to a maximum inventory advance of
$600,000, less any reserves required by Laurus. Interest on the
outstanding borrowings is charged at the per annum rate of two percentage
points (2%) above the prime rate, but not less than 6%. The interest rate
charged, however, will be decreased by 2% (or 200 basis points) for every
25% increase in the market price of the Company's common stock above the
fixed conversion price, down to a minimum interest charge of 0.0%. The
Company will additionally be charged a fee equal to 0.25% of the unused
portion of the facility. Should the Company terminate the financing
agreement with Laurus prior to the
9
maturity date, the Company will incur an early payment fee equal to 4%, 3%
and 2% of the Capital Availability Amount if terminated in the first,
second or third year, respectively, of the term.
Security and Events of Default. Borrowings under the Laurus Notes are
secured by a lien on substantially all of the Company's assets. The
Security Agreement contains no specific financial covenants; however, it
defines certain circumstances under which the agreement can be declared in
default and subject to termination, including among others if (i) there is
a material adverse change in the Company's business or financial condition;
(ii) an insolvency proceeding is commenced; (iii) the Company defaults on
any of its material agreements with third parties or there are material
liens or attachments levied against the Company's assets; (iv) the
Company's common stock ceases to be publicly traded; and (v) the Company
fails to comply with the terms, representations and conditions of the
agreement. Upon the occurrence of an Event of Default, the interest rate
charged will be increased by 1-1/2 % per month until the default is cured;
should the default continue beyond any applicable grace period, Laurus
could require the Company to repay 120% of any principal and interest
outstanding under the agreement.
Conversion Rights and Limitation. All or a portion of the outstanding
principal and interest due under the Laurus Notes may be converted, at the
option of the Holder, into shares of the Company's common stock, at the
Fixed Conversion Price ("FCP") of $1.54. The FCP was originally set at
110% of the average closing price of the Company's common stock over the
ten trading days preceding the execution of the agreement, and is subject
to anti-dilution protection adjustments. The FCP will be reset once $1.5
million of debt has been converted. The Laurus Notes contain a mandatory
conversion feature such that, if the average closing price of the common
stock as reported by Bloomberg, L.P. on the Principal Market for five (5)
consecutive trading days in any calendar month shall be greater than 115%
of the FCP, the Holder shall convert into shares of common stock such
portion of the principal amount outstanding under any Minimum Borrowing
Note (together with accrued interest and fees in respect thereof) on such
date equal to ten percent (10%) of the aggregate dollar trading volume of
the common stock for the period of twenty-two (22) trading days preceding
the date of the mandatory conversion. The Holder shall not be required
under any circumstances to make more than one (1) mandatory conversion in
any calendar month. By agreement between the parties, Laurus will not own
greater than 4.99% of the outstanding shares of the Company's common stock
except that (i) upon the occurrence and during the continuance of an Event
of Default, or (ii) upon 75 days prior notice to the Company, their
ownership could increase to 19.99%. Upon receipt of a conversion notice
from the Holder, the Company can elect to pay cash to the Holder in lieu of
issuing shares of common stock, at a price per share equal to the intraday
high price of the stock.
Registration Rights. Pursuant to the terms of a Registration Rights
Agreement, the Company is obligated to file and obtain effectiveness for a
registration statement registering the resale of shares of the Company's
common stock issuable upon conversion of the Laurus Notes and the exercise
of the Warrant. If the registration statement is not timely filed, or
declared effective the Company will be subject to certain penalties. On
June 24, 2005, the Company completed the registration of the common stock
issuable upon conversion of the initial Minimum Borrowing Note and the
Warrant.
The unused portion of the Laurus credit facility as of June 30, 2005
was $1,549,617, all of which was available to borrow. The average and
highest amounts borrowed under the Laurus credit facility during the three
months ended June 30, 2005 were approximately $815,000 and $1,640,000,
respectively. The average and highest amounts borrowed under all credit
facilities during the six months ended June 30, 2005 were approximately
$521,000 and $1,640,000, respectively. The Company was in compliance with
the provisions of its loan agreement as of June 30, 2005.
Since the secured convertible notes are not considered to be
conventional convertible debt, the embedded conversion option in the
secured convertible notes is subject to the requirements of EITF Issue 00-
19. The Company is also required to bifurcate the embedded conversion
option and account for it as a derivative instrument liability because of
the potential penalties that we may have to pay Laurus under the
Registration Rights Agreement, together with the fact that the conversion
price of the debt can be adjusted if we issue common stock at a lower
price. In addition, other embedded derivative instruments in the secured
convertible notes, including the interest rate reset feature and Laurus'
right to put the debt back to us with a 20% premium upon certain Events of
Default, were considered in determining the derivative instrument to
bifurcate and account for. This derivative instrument liability was
initially recorded at its fair value and is then adjusted to fair value at
the end of each subsequent period, with any changes in the fair value
charged or credited to income in the period of change. The most significant
component of this compound derivative instrument is the embedded conversion
option, which is revalued using the Black-Scholes option pricing model.
The proceeds received from Laurus under the initial Minimum Borrowing
Note ("MBN") were first allocated to the fair value of the bifurcated
embedded derivative instruments included in the MBN, with the remaining
proceeds allocated to the MBN, resulting in the recognition of a $323,000
discount to the principal amount of the MBN. This discount, together with
10
the stated interest on the MBN, is being amortized using an effective
interest method over the term of the MBN. Since there are frequent
borrowings and repayments under the revolving note, the value of the
embedded derivative instruments is calculated upon advances, and the
discount is recognized as the advances are repaid, with the stated interest
recognized currently.
The 500,000 warrants issued to Laurus were initially valued at
$335,000, using the Black-Scholes option pricing model and the following
assumptions: market price - $1.31; exercise price - $1.82; expected term -
5 years; volatility - 65%; interest rate - 4.18%; and dividends - 0. Since
there are potential penalties that we may have to pay Laurus under the
Registration Rights Agreement, the warrants have been recorded as a
derivative instrument liability, rather than as equity. This derivative
instrument liability is adjusted to fair value (using the Black-Scholes
option pricing model) at the end of each subsequent reporting period, and
any changes in the fair value are charged or credited to income in the
period of change. Since the nature of the Laurus credit facility is
revolving, with continuous advances and repayments expected over its term,
and with an indeterminate amount of Minimum Borrowing Notes which can be
created and converted, it is not practical to allocate the warrant value to
the initial proceeds of the borrowings under the facility or to any one
Minimum Borrowing Note. As such, the initial valuation of $335,000 has
been recorded as a deferred financing cost, and is being amortized to
expense over the term of the facility using an effective interest method.
As of June 30, 2005, the unamortized balance was $333,000.
In connection with the Laurus credit facility, the Company also paid
Laurus a $117,000 prepaid facility fee, and incurred other placement fees
and expenses totaling $155,000. These amounts, aggregating $272,000, have
also been recorded as deferred financing costs on the balance sheet, and as
of June 30, 2005 the unamortized balance was $236,000. The facility fee
is being amortized to interest expense on a straight-line basis over the
term of the facility, while the other fees and expenses are being amortized
to SG&A expense on a straight-line basis over the term of the facility.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The following derivative liabilities related to warrants and embedded
derivative instruments were outstanding as of June 30, 2005 (in thousands).
There were no such instruments or derivative liabilities outstanding as of
December 31, 2004.
Issue Expiration Value- Value-
Instrument: Date Date Issue date 6/30/05
-----------------------------------------------------------------------------------------------------
Laurus Minimum Borrowing Note (Note 6) 4/4/2005 3/31/2008 $323 $ 150
6/13/2005-
Laurus Revolving Note (Note 6) 6/30/2005 3/31/2008 254 231
----------------------------------------------------------------------------------------------------
Fair value of bifurcated embedded derivative
instrument liabilities 381
500,000 common stock warrants issued to
Laurus (Note 6) 3/31/2005 3/31/2010 335 244
----------------------------------------------------------------------------------------------------
Total derivative financial instruments 625
Less: amount attributable to the Laurus Revolving
Note, reported in current liabilities (231)
----------------------------------------------------------------------------------------------------
Derivative financial instruments recorded in
non-current liabilities $ 394
====================================================================================================
The Company uses the Black-Scholes option pricing model to value
warrants, and the embedded conversion option components of any bifurcated
embedded derivative instruments that are recorded as derivative
liabilities. See Note 6 - Convertible Debt. In valuing the warrants and
the embedded conversion option components of the bifurcated embedded
derivative instruments, at the time they were issued and at June 30, 2005,
we used the following assumptions: market price of our common stock on the
date of valuation; an expected dividend yield of 0%; an expected life
equal to either the remaining period to the expiration date of the warrants
or maturity date of the convertible debt instruments; expected volatility
of 65%; and a risk-free rate of return ranging from 3.67-4.18%, based on
constant maturity rates published by the U.S. Federal Reserve, applicable
to the remaining life of the instruments.
11
8. DEBT OBLIGATIONS
June 30, December, 31
(In thousands) 2005 2004
----------------------------------------------------------------
BACC revolving credit facility note $ - $179
Installment purchase note 44 47
Obligations under capital lease 49 -
----------------------------------------------------------------
93 226
Less: debt maturing within one year (31) (187)
----------------------------------------------------------------
Long-term debt obligations $62 $ 39
================================================================
BACC revolving credit facility note:
------------------------------------
On March 31, 2005, the Company terminated its $1.7 million revolving
credit facility with Business Alliance Capital Corporation ("BACC"),
repaying the outstanding balance and an early-termination fee of $68,000 on
April 1, 2005. This facility was replaced by the Laurus credit facility as
more fully described in Note 6 - Convertible Debt.
Installment Purchase Note:
--------------------------
The Company is financing an automobile through a $50,056, 3.75% note
payable to a finance company. The note is payable in 38 monthly
installments of $799, with a final payment of $24,236 on January 7, 2008.
The note balance at June 30, 2005 was $43,941, of which $8,154 was
classified under debt maturing within one year.
Obligations under Capital Lease:
--------------------------------
During 2005, the Company entered into non-cancelable lease agreements
to finance $56,000 of computer equipment with payment terms ranging from 24
to 36 months. Monthly lease payments aggregate $1,984 and the agreements
contain a $1.00 purchase option at the end of the lease term. The
effective interest rate on the lease obligations is 10.38 to 10.5%. The
principal balance of these obligations at June 30, 2005 was $48,809, of
which $22,531 was classified under debt maturing within one year.
9. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
June 30, December 31,
(In thousands) 2005 2004
--------------------------------------------------------------------------
Salaries, commissions and benefits $229 $167
Other 112 75
--------------------------------------------------------------------------
Accrued expenses and other current liabilities $341 $242
==========================================================================
10. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 123 (revised 2004)"), revising FASB
Statement 123, "Accounting for Stock-Based Compensation" and superseding
APB Opinion No. 25, "Accounting for Stock Issued to Employees,". This
Statement establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services,
focusing primarily on transactions in which an entity obtains employee
services in share-based payment transactions. SFAS No. 123 (revised 2004)
requires a public entity to measure the cost of employee services received
in exchange for an award of equity instruments based on the grant-date fair
value of the award (with limited exceptions). That cost will be recognized
over the period during which an employee is required to provide service in
exchange for the award. Accounting for share-based compensation
transactions using the intrinsic method supplemented by pro forma
disclosures will no longer be permissible. This statement is effective as
of the beginning of the first interim or annual reporting period that
begins after December 15, 2005 and the Company will adopt the standard in
the first quarter of fiscal 2006. The adoption of this standard will have
an impact on the Company's results of operations as it will be required to
expense the fair value of all share based payment; however the Company has
not yet determined whether or not this impact will be significant.
12
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an
amendment of ARB No. 43, Chapter 4" ("SFAS No. 151"). This statement
clarifies the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage). It also requires
that these items be recognized as current-period charges regardless of
whether they meet the criterion of "so abnormal". This statement also
clarifies the circumstances under which fixed overhead costs associated
with operating facilities involved in inventory processing should be
capitalized. The provisions of SFAS No. 151 are effective for fiscal years
beginning after June 15, 2005 and the Company will adopt this standard in
its third quarter of fiscal 2005. The Company has not determined the
impact, if any, that this statement will have on its consolidated financial
position or results of operations.
11. STOCK OPTIONS
The Company applies the disclosure only provisions of Financial
Accounting Standards Board Statement ("SFAS") No. 123, "Accounting for
Stock-based Compensation" ("SFAS 123") and SFAS No. 148, "Accounting for
Stock-based Compensation - Transition and Disclosure" ("SFAS 148") for
employee stock option and warrant awards. Had compensation cost for the
Company's stock option plan and issued warrants been determined in
accordance with the fair value-based method prescribed under SFAS 123, the
Company's net loss and basic and diluted net loss per share would have
approximated the pro forma amounts indicated below (in thousands except per
share amounts):
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2005 2004 2005 2004
-------------------------------------------------------------------------------------------------
Net income (loss), as reported $202 $(414) $ (830) $(755)
Add: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (37) (17) (239) (38)
------------------------------------------------------------------------------------------------
Pro forma net income (loss) 165 (431) (1,069) (793)
Pro forma net income (loss) per share:
Basic $.05 $(.13) $ (.32) $(.24)
Diluted $.04 $(.13) $ (.32) $(.24)
================================================================================================
The weighted-average fair value of options granted during the three
and six months ended June 30, 2005 was $.49 and $.40, respectively,
compared to $.37 for the three and six months ended June 30, 2004. The fair
value of stock options used to compute pro forma net loss and net loss per
share disclosures was estimated on the date of grant using the Black-
Scholes option-pricing model with the following weighted average
assumptions: dividend yield of 0% for 2005 and 2004; expected volatility of
55% for 2005 and 108% for 2004; average risk-free interest rate of 3.8%
for 2005 and 3.30 % for 2004; and an expected option holding period of 3.5
years for 2005 and 4.3 years for 2004.
12. COMMITMENTS AND CONTINGENCIES
Employment agreements:
On January 15, 2005 the Company hired Mr. Alfred G. Stein to the
position of Executive Vice President. From September 13, 2004 to his date
of hire, Mr. Stein was a consultant to the Company, assisting management in
the development of a strategic re-direction of the Company's sales
organization and product offerings, for which he earned $40,000 in
consulting fees. Mr. Stein has an employment agreement expiring December
31, 2007 which includes the following key provisions: (i) an annual base
salary of $175,000, (ii) an annual bonus of up to 100% of base salary
based upon the attainment of a Board-approved annual business plan which
includes revenue and operating profit targets and (iii) the grant of a
five-year warrant to purchase up to 250,000 shares of common stock at an
exercise price of $0.67 per share, which was equal to the closing price of
the common stock on his date of hire. The Company registered 150,000
shares underlying the warrant, and has agreed to register the remaining
100,000 shares by January 15, 2007.
On March 1, 2005, the Company hired Mr. Nevelle R. Johnson to the
position of Executive Vice President. Mr. Johnson's responsibilities
include management of the Company's national sales organization, as well as
the development of new product and service offerings. Mr. Johnson has an
employment agreement expiring December 31, 2008 which includes the
following key provisions: (i) an initial annual base salary of $200,000;
(ii) an annual bonus of up to 50% of base salary based upon attaining
earnings targets approved by the Board of Directors; (iii) the grant of a
five-year warrant to purchase up to 250,000 shares of common stock at an
exercise price of $1.10 per share, which was equal to the closing price of
the
13
common stock on his date of hire; and (iv) payment by the Company of life
insurance premiums not exceeding $5,000 per month, provided that the
Company attains at least 75% of targeted earnings. The Company registered
100,000 of the shares underlying the warrant, and has agreed to register an
additional 100,000 shares by March 1, 2007 and the remaining 50,000 shares
by March 1, 2008;
Both Mr. Stein's and Mr. Johnson's employment agreements provide
severance pay should they terminate their agreements for "good cause", as
defined, or should the Company terminate their agreements without cause, or
in the event of a change in control of the Company, as defined. Severance
pay would amount to three times the amount of the then-current base salary
and the average bonus paid during the three most recent calendar years.
These individuals would not be entitled to any severance or other
compensation if they voluntarily terminate their employment or if they are
terminated by the Company "for cause", as defined. Their agreements also
contain non-compete stipulations.
13. EMPLOYEE BENEFIT PLANS
The components of the net periodic benefit cost included in the
results of operations for the three and six months ended June 30, 2005 and
2004 are as follows:
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
(In thousands) 2005 2004 2005 2004
------------------------------------------------------------------
Service cost $21 $20 $43 $40
Interest cost 10 9 20 18
Recognized actuarial losses 3 2 5 4
-----------------------------------------------------------------
Net expense $34 $31 $68 $62
=================================================================
14. INTEREST EXPENSE
Three months ended Six months ended
June 30 June 30
------------------ ----------------
(In thousands) 2005 2004 2005 2004
----------------------------------------------------------------------------------------
Interest expense on outstanding borrowings $17 $6 $25 $12
Amortization of deferred financing costs (1) 12 - 12 -
Amortization of discounts on convertible notes (2) 19 - 19 -
---------------------------------------------------------------------------------------
Total interest expense $48 $6 $56 $12
=======================================================================================
Amortization of deferred financing costs consists of $2,000
amortization of an imputed discount on warrants issued to the Laurus
Master Fund Ltd. ("Laurus") and $10,000 of amortization of a prepaid
facility fee of $117,000 in connection with a revolving credit
facility entered into with Laurus on March 31, 2005. These costs are
included in deferred financing costs on the Consolidated Balance
Sheet, and are being amortized to interest expense over the three-
year term of the facility. See Note 6.
Discounts imputed in accounting for the Company's convertible notes
issued to the Laurus pursuant to this credit facility, are being
amortized to interest expense over their term using the effective
interest method. See Note 6.
15. INCOME (LOSS) PER SHARE
Basic income (loss) per share was computed by dividing net income
(loss) (the numerator) by the weighted average number of shares of common
stock outstanding (the denominator) during the reporting periods. Diluted
income per share for the three months ended June 30, 2005 included in the
denominator weighted average outstanding options and warrants to purchase
1,038,087 shares of common stock. Weighted average outstanding options and
warrants to purchase 962,322 shares of common stock were not included in
the computation of diluted loss per share for the six months ended June 30,
2005 because their inclusion would be antidilutive. Weighted average
outstanding options to purchase 34,895 and 43,101 shares of common stock
were not included in the computation of diluted loss per share for the
three and six months ended June 30, 2004, respectively, because their
inclusion would be antidilutive.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The discussions set forth below and elsewhere in this Quarterly
Report on Form 10-Q contain certain statements, based on current
expectations, estimates, forecasts and projections about the industry in
which we operate and management's beliefs and assumptions, which are not
historical facts and are considered forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 ("the
Act"). Forward-looking statements include, without limitation, any
statement that may predict, forecast, indicate, or imply future results,
performance, or achievements, and may contain the words "believe," "will
be," "will continue," "will likely result," "anticipates," "seeks to,"
"estimates," "expects," "intends," "plans," "predicts," "projects," and
similar words, expressions or phrases of similar meaning. Our actual
results could differ materially from those projected in the forward-looking
statements as a result of certain risks, uncertainties and assumptions,
which are difficult to predict. Many of these risks and uncertainties are
described under the heading "Risks, Uncertainties and Other Factors That
May Affect Future Results" below. All forward-looking statements included
in this document are based upon information available to us on the date
hereof. We undertake no obligation to update publicly any forward-looking
statements, whether as a result of new information, future events or
otherwise. In addition, other written or oral statements made or
incorporated by reference from time to time by us or our representatives in
this report, other reports, filings with the Securities and Exchange
Commission ("SEC"), press releases, conferences, or otherwise may be
forward-looking statements within the meaning of the Act.
RESULTS OF OPERATIONS
Overview
For the three months ended June 30, 2005, we reported net income of
$202,000 or $.06 per share on revenues of $4,483,000. Net income includes
non-cash derivative instrument income of $681,000 arising from borrowings
under a three-year convertible revolving credit facility entered into
effective March 31, 2006, and the issuance of freestanding warrants in
connection therewith, as more fully described in Note 6 - Convertible Debt.
Excluding the non-cash derivative instrument income, we otherwise incurred
a $479,000 loss for the three months ended June 30, 2005. This compares
with a net loss of $414,000 or $.12 per share on revenues of $2,889,000
recorded for the three months ended June 30, 2004.
For the six months ended June 30, 2005, we reported a net loss of
$830,000 or $.25 per share on revenues of $6,892,000. The net loss
includes non-cash derivative instrument income of $287,000 as described
above and in Note 6 - Convertible Debt. Excluding the non-cash derivative
instrument income, we otherwise incurred a $1,117,000 loss for the six
months ended June 30, 2005. This compares with a net loss of $755,000 or
$.23 per share on revenues of $6,295,000 recorded for the six months ended
June 30, 2004. The net loss for the six month period of 2005 also
includes one-time expenses aggregating $84,000 incurred in connection with
the termination of our credit facility with Business Alliance Capital
Corporation.
There continues to be intense competition in the market areas that we
serve, particularly with our larger, "Enterprise" customers. This has
particularly been the case in the aftermarket parts business in which, over
the last several years, the Company has experienced significant sales price
erosion, as aftermarket parts have become more of a commodity and subject
to "price shopping" by customers. The Company has worked to lessen the
effects of this trend by increasing its sales force and focusing on
developing its systems sales business and, during the second quarter of
2005 has increased its market share of both parts and systems sales.
As further described in the Company's Annual Report on Form 10-K for
the year ended December 31, 2004, the Company has taken several measures to
turnaround its operating performance. The turnaround strategy is
principally based upon building a larger and more highly qualified sales
force, and diversifying the Company's product offerings and targeted
customers. The business strategy is to transition to a full communications
solutions provider, becoming less dependent on parts sales, and developing
more sources of recurring revenues, such as through installation and
maintenance services. As a first step in the turnaround plan, the Company
hired a new President and CEO in October 2004, and two Executive Vice
Presidents - one responsible for operations (hired in January 2005) and one
responsible for sales (hired in March 2005). In March, the Company
significantly expanded its sales infrastructure and opportunities, first by
the hiring of twenty three sales and sales support professionals formerly
employed by Avaya Inc., and second by entering into a trial agreement with
Avaya to provide products and services to the SMB ("small-to-medium sized
business") market which commenced in March with the launch of a nationwide
SMB sales program. By the end of June 2005, the Company's direct sales and
sales support group
15
was 85% larger than June 2004. As a result of these efforts, The Company
has been successful in uplifting revenues, as revenues for the three and
six months ended June 30, 2005 were 55% and 9% higher than the comparable
prior year periods. In fact, the $4,483,000 in revenues for the quarter
ended June 30, 2005 was the highest revenue quarter since the second
quarter of 2002, and the Company recorded a profit for the month of June,
which was the Company's first profitable month since May 2003.
In May 2005, the Company took steps to further diversify its product
offerings, forming a wholly-owned subsidiary named "One IP Voice" which,
when operational by the end of 2005, will offer carrier-based hosted IP
telephony services along with network services. Its primary target will be
the SMB market. In order to finance its business expansion plans,
effective March 31, 2005 the Company entered into a $3 million credit
arrangement with a new lender, replacing a $1.7 million credit facility
with Business Alliance Capital Corporation. For additional information on
our financial resources, refer to Note 6 - Convertible Debt, and the
"Liquidity and Capital Resources" section which follows.
Additional information on our results of operations and financial
condition for the three and six months ended June 30, 2005 follows below.
Revenues
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
(In thousands) 2005 2004 2005 2004
-------------------------------------------------------------------------------
Equipment:
End-user equipment sales $3,660 $2,272 $5,534 $5,035
Equipment sales to resellers 63 312 154 471
--------------------------------------------------------------------------------
Total equipment sales 3,723 2,584 5,688 5,506
--------------------------------------------------------------------------------
Services:
Installations 401 189 659 520
Rentals, repair and other 18 35 48 71
Other revenue 341 81 497 198
--------------------------------------------------------------------------------
Total services and other revenue 760 305 1,204 789
--------------------------------------------------------------------------------
Consolidated revenues $4,483 $2,889 $6,892 $6,295
================================================================================
Equipment Sales. Total equipment sales for the three months ended
June 30, 2005, were $3,723,000, an increase of $1,139,000 or 44% from the
comparable 2004 period. The increase consisted of a $1,388,000 increase in
end-user sales, less a $249,000 decrease in equipment sales to resellers
("wholesale sales"). The increase in end-user sales was attributable to a
$1,068,000 or 201% increase in system sales and a $320,000 or 18% increase
in parts sales. Total equipment sales for the six months ended June 30,
2005, were $5,688,000, an increase of 182,000 or 3% from the comparable
2004 period. The increase consisted of a $499,000 increase in end-user
sales, less a $317,000 decrease in wholesale sales. The increase in end-
user sales was attributable to an $845,000 or 52% increase in system sales,
partly offset by a $346,000 or 10% decline in parts sales. During 2005, we
continued a strategy of diversifying our product offerings by marketing the
sale of complete telecommunications systems to our customer base. In March
2005, we significantly expanded our sales force and began targeting the SMB
marketplace, which is primarily oriented towards systems sales. Other
factors affecting end-user equipment sales for 2005 have previously been
described in the "Overview" section above. Wholesale sales have been
impacted by some of the same factors which affected end user sales and our
shift in emphasis to new system sales.
Service revenues for the three months ended June 30, 2005 were
$419,000, an increase of $195,000 or 87% from the comparable 2004 period.
Service revenues for the six months ended June 30, 2005 were $707,000, an
increase of $116,000 or 20% from the comparable 2004 period. The
increases in each period were attributable to installation services which
have increased due to the significant increase in second quarter system
sales. An increase or decrease in installation revenues, however, does
not always coincide with the reported increase or decrease in system sales
since installations may occur in different periods than the related system
sale.
Other revenue for the three months ended June 30, 2005 was $341,000,
an increase of $260,000 or 321% from the comparable 2004 period. Other
revenue for the six months ended June 30, 2005 was $497,000, an increase of
$299,000 or 151% from the comparable 2004 period. The increase in each
period was attributable to higher commissions earned on Avaya maintenance
contract sales. In the sale of Avaya maintenance contracts, the Company
receives a one-time commission, and all of the equipment service
obligations are borne entirely by Avaya.
16
Cost of Revenues and Gross Profit. Total cost of revenues for the
three months ended June 30, 2005 was $3,147,000, an increase of $862,000 or
38% from the comparable 2004 period. The gross profit for the three months
ended June 30, 2005 was $1,336,000, an increase of $732,000 or 121% from
the comparable 2004 period. As a percentage of revenue, the overall gross
profit margin was 30% for the three months ended June 30, 2005, compared to
21% for the comparable 2004 period.
Total cost of revenues for the six months ended June 30, 2005 was
$4,802,000, a decrease of $12,000, or less than one-half percent, from the
comparable 2004 period. The gross profit for the six months ended June 30,
2005 was $2,090,000, an increase of $609,000 or 41% from the comparable
2004 period. As a percentage of revenue, the overall gross profit margin
was 30% for the six months ended June 30, 2005, compared to 24% for the
comparable 2004 period.
In general, our gross profit margins are dependent upon a variety of
factors including (1) product mix - gross margins can vary significantly
among parts sales, system sales and our various service offerings. The
parts business, for example, involves hundreds of parts that generate
significantly varying gross profit margins depending upon their
availability, competition, and demand conditions in the marketplace; (2)
customer mix - we sell parts to both end-users and to other equipment
resellers. Our larger "Enterprise" companies often receive significant
purchase discounts from Avaya, which could cause us to accept lower gross
margins as we compete against Avaya directly for this business; (3) the
level and amount of vendor discounts and purchase rebates available to us
from Avaya and its master distributors; (4) capacity - as sales volume
rises or falls, overhead costs, consisting primarily of product handling,
purchasing, and facility costs, can become a lower or higher percentage of
sales dollars; (5) competitive pressures - as a result of the slowdown in
capital equipment spending in our industry, and the large number of Avaya
dealers nationwide, we have been faced with increased price competition;
and (6) obsolescence charges. The combined effect of all of these factors
could result in varying gross profit margins from period to period.
Gross Profit Margins on Equipment Sales. For the three months ended
June 30, 2005, the gross profit margin on equipment sales increased to 28%
from 24% in 2004. The gross profit margin for the 2004 period was
negatively impacted by an increase in obsolescence reserves and by the
payment of license fees to Avaya from a program that terminated in June
2004. Excluding the effects of these items, the gross profit margin on
2004 equipment sales would have also been 27%. For the six months ended
June 30, 2005, the gross profit margin on equipment sales increased to 29%
from 27% in 2004. The gross profit margin for the 2004 period was also
negatively impacted by an increase in obsolescence reserves and by the
payment of license fees to Avaya. Excluding the effects of these items,
the gross profit margin on 2004 equipment sales would have been 30%. As
compared to the prior year periods, the Company experienced a decline in
the gross profit margins generated by the sale of aftermarket parts. This
is attributable to the fact that the parts business has become more of a
"commodity" business and less of a "value-added" business. It has
therefore become more prone to price-shopping by customers, who are tending
more towards awarding contracts to the lowest bidder. The impact of a
reduced parts business however, has been offset by significantly higher
sales of systems at improved profit margins from 2004. These results can
be primarily attributed to increased sales of systems to the SMB
marketplace as well as to our larger "Enterprise" customers. We expect
continued pressure on our equipment profit margins going forward,
particularly in the sale of parts and systems to our larger customers, due
to continuing price competition.
Gross Profit Margins on Services and Other Revenue. For the three
months ended June 30, 2005, the Company realized an overall 58% profit
margin on its combined service and other revenues, compared to 38% recorded
in 2004. The profit margin increase was attributable to significantly
higher commission revenues earned from the sale of Avaya maintenance
contracts, which generate a 100% profit margin, and to improved margins on
installations. For the six months ended June 30, 2005, the Company realized
an overall 54% profit margin on its combined service and other revenues,
compared to 42% recorded in 2004. The profit margin increase for the six
month period was attributable to significantly higher commission revenues
earned from the sale of Avaya maintenance contracts.
Other Cost of Revenues. Other cost of revenues consists of product
handling, purchasing and facility costs and expenses. For the three months
ended June 30, 2005, these expenses were 4% higher than 2004, and
represented approximately 4% of 2005 equipment sales revenues, compared to
5% of 2004 equipment sales revenues. For the six months ended June 30,
2005, these expenses were 31% lower than 2004, and represented
approximately 4% of 2005 equipment sales revenues, compared to 6% of 2004
equipment sales revenues. The reduction in other cost of revenues primarily
resulted from lower personnel levels and other overhead costs.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses
for the three months ended June 30, 2005 were $1,765,000, an increase of
$755,000 or 75% from the comparable 2004 period. SG&A expenses for the
three months
17
ended June 30, 2005 were 39% of revenues, compared to 35% of revenues in
2004. Approximately 90% of the increase in SG&A was attributable to
increased personnel levels, including compensation and benefits, recruiting
fees, and incremental office and travel expenses. SG&A expenses for the
six months ended June 30, 2005 were $3,148,000, an increase of $928,000 or
42% from the comparable 2004 period. SG&A expenses for the six months ended
June 30, 2005 were 46% of revenues, compared to 35% of revenues in 2004.
Approximately 85% of the increase in SG&A was attributable to increased
personnel levels, including compensation and benefits, recruiting fees, and
incremental office and travel expenses.
As a part of the Company's turnaround plan, it hired a new President
and CEO in October 2004, and two Executive Vice Presidents - one
responsible for operations (hired in January 2005) and one responsible for
sales (hired in March 2005). In addition, by June 30, 2005, the Company's
sales and support group was 85% larger than June 2004. The increase in the
sales and support group was attributable to the launch of a Company
initiative to market its products and services to small to medium-sized
business ("SMB") marketplace.
In connection with the replacement of the BACC credit facility with
the Laurus credit facility, the Company incurred in March 2005 one-time
expenses totaling $84,000, consisting of a $68,000 early termination fee,
and a $16,000 charge to write-off of the remaining balance of its annual
loan commitment fee with BACC. In addition, as of June 30, 2005 the
Company had incurred $140,000 of direct expenses associated with the
acquisition of the Laurus credit facility. These costs are included in
deferred financing costs on the balance sheet and are being amortized to
SG&A expense over the term of the facility. As of June 30, 2005
approximately $11,000 has been expensed.
We expect our SG&A expenses to increase as we continue the execution
of our turnaround strategy, which has begun to focus on the development and
deployment of the hosted VOIP services and products to be marketed through
our newly-formed subsidiary, One IP Voice, Inc.
Other Income (Expense). Other income (expense) for the three months
ended June 30, 2005 was $634,000, compared with $(5,000) for 2004. Other
income (expense) for the six months ended June 30, 2005 was $236,000,
compared to $(10,000) for 2004. The principal components of other income
(expense) are as follows.
Interest Expense:
Three months ended Six months ended
June 30 June 30
------------------ ----------------
(In thousands) 2005 2004 2005 2004
------------------------------------------------------------------------------------
Interest expense on outstanding borrowings $17 $6 $25 $12
Amortization of deferred financing costs 12 - 12 -
Amortization of discounts on convertible notes 19 - 19 -
-----------------------------------------------------------------------------------
Total interest expense $48 $6 $56 $12
===================================================================================
The increase in interest expense on outstanding borrowings was
attributable to higher average borrowing levels under the Company's credit
facilities and to higher interest rates. Amortization of deferred
financing costs consists of $2,000 amortization of an imputed discount on
warrants issued to the Laurus Master Fund LTD ("Laurus") and $10,000 of
amortization of a prepaid facility fee of $117,000 in connection with a
revolving credit facility entered into with Laurus on March 31, 2005.
These costs are included in deferred financing costs on the Consolidated
Balance Sheet, and are being amortized to interest expense over the three-
year term of the facility. Discounts imputed in accounting for the
Company's convertible notes issued to the Laurus Master Fund pursuant to
this credit facility, are being amortized to interest expense over their
term using the effective interest method.
Derivative instrument income. The Company recorded income of
$681,000 and $287,000 during the three and six months ended June 30, 2005,
respectively, from its derivative instrument liabilities arising from its
financing transactions with Laurus, due primarily to the decline in the
fair market value of such derivative instruments from their inception to
June 30, 2005. Income or losses generated from these derivative
liabilities principally arise from changes in the fair market value of the
Company's common stock price during each reporting period, as the Company
is required to record "mark-to-market" adjustments to the value of its
derivative liabilities. These "mark-to-market" adjustments are non-cash,
with no impact on liquidity. Refer to Notes 1, 6 and 7 in the Notes to
Consolidated Financial Statements contained herein for further discussion
on the nature of the derivative financial instruments and the Company's
accounting policies.
Other income for both periods presented consisted of interest earned
on invested cash.
18
Provision for Income Taxes. The provision for income taxes
represents estimated minimum state taxes in all reported periods. We
maintain a full valuation allowance against our net deferred tax assets,
which consist primarily of net operating loss and capital loss
carryforwards, and timing differences between the book and tax treatment of
inventory and other asset valuations. Realization of these net deferred
tax assets is dependent upon our ability to generate future taxable income.
LIQUIDITY AND CAPITAL RESOURCES
Working capital, defined as current assets less current liabilities,
was $1,411,000 at June 30, 2005, a decrease of $725,000 or 34% from
$2,136,000 at December 31, 2004. The working capital ratio was 1.4 to 1 at
June 30, 2005, compared to 2.4 to 1 at December 31, 2004. Operating
activities used $830,000 during the six months ended June 30, 2005,
compared to the use of $713,000 in the comparable 2004 period. Net cash
used by operating activities in 2005 consisted of a net loss of $830,000
less non-cash items of $151,000, and net cash generated by changes in
operating assets and liabilities of $151,000. Net cash generated by
changes in operating assets and liabilities was primarily attributable to
an increase in accounts payable and accrued expenses, a decrease in
inventories and other assets, partly offset by an increase in accounts
receivable resulting from higher sales levels.
Investing activities used $18,000 during the six months ended June
30, 2005, compared to $23,000 in 2004. Net cash used by investing
activities in 2005 and 2004 consisted of capital expenditures. Capital
expenditures during 2005 were principally for computer and office equipment
to support our expanded personnel levels, most of which were financed
through lease agreements. Pursuant to our loan agreement with Laurus, we
may obtain external financing on capital expenditures up to $500,000 in any
fiscal year period before requiring Laurus's prior approval.
Financing activities provided $1,021,000 during the six months ended
June 30, 2005 principally from borrowings under our revolving credit lines,
net of related costs incurred. On March 31, 2005, we terminated our $1.7
million revolving credit facility with BACC, repaying the outstanding
balance on April 1, 2005, and entered into a financing transaction with
Laurus, providing for a three-year, $3 million revolving loan credit
facility. Our borrowing formulas with Laurus are less restrictive than the
formulas provided under the BACC agreement, thereby increasing our
borrowing capacity. Refer to Note 6 - Convertible Debt, of the Notes to
Consolidated Financial Statements included herein for further information
on the principal terms and conditions of this financing transaction.
Our ability to provide cash to satisfy working capital requirements
continues to be dependent upon generating positive cash flow from
operations and upon formula borrowings under our revolving credit facility.
Historically, our working capital borrowings have increased during periods
of revenue growth. This is because our cash receipts cycle is longer than
our cash disbursements cycle. As our revenues from systems sales
increases, as management expects, the cash receipts cycle may lengthen,
unless we can consistently negotiate up-front deposits and progress
payments under our systems sales contracts. In addition, our working
capital requirements are expected to significantly increase by year end as
we continue to buildout the infrastructure of capital equipment, systems
and personnel required to deploy our hosted VoIP service offerings through
our newly-formed subsidiary One IP Voice, Inc. No assurances can be given
that we will have sufficient cash resources to finance all of our future
growth plans, and it may become necessary to seek additional financing
sources for such purposes. In order to obtain additional financing, we may
first need to demonstrate improved operating performance.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2004 under the subheading "Critical
Accounting Policies and Estimates" is still considered current and
applicable, and is hereby incorporated into this Quarterly Report on Form
10-Q.
Derivative instruments. In connection with the issuance of debt or
equity instruments, we may also issue warrants to purchase our common
stock. In certain circumstances, these warrants may be classified as
derivative liabilities, rather than as equity. Additionally, the debt or
equity instruments may contain embedded derivative instruments, such as
conversion options, which in certain circumstances may be required to be
bifurcated from the associated host instrument and accounted for separately
as a derivative instrument liability.
The identification of, and accounting for, derivative instruments is
complex. Our derivative instrument liabilities are revalued at the end of
each reporting period, with changes in the fair value of the derivative
liability recorded as charges or credits to income in the period in which
the changes occur. For warrants and bifurcated conversion options that are
accounted for as derivative instrument liabilities, we determine the fair
value of these instruments using the Black-Scholes option
19
pricing model. That model requires assumptions related to the remaining
term of the instruments and risk-free rates of return, our current common
stock price and expected dividend yield, and the expected volatility of our
common stock price over the life of the conversion option. We estimate the
future volatility of our common stock price based on several factors,
including the history of our stock price and the experience of other
entities considered comparable to us. The identification of, and accounting
for, derivative instruments and the assumptions used to value them can
significantly affect our financial position and results of operations.
RISKS, UNCERTAINTIES AND OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2004 under the subheading "Risks,
Uncertainties and Other Factors That May Affect Future Results" is still
considered current and applicable, and is hereby incorporated into this
Quarterly Report on Form 10-Q.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The discussion included in Item 7A of our Annual Report on Form 10-K
for the year ended December 31, 2004, "Quantitative and Qualitative
Disclosures About Market Risk", is still considered current and applicable,
and is hereby incorporated into this Quarterly Report on Form 10-Q.
ITEM 4. CONTROLS AND PROCEDURES.
(a) Evaluation of Disclosure Controls and Procedures. We maintain
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-
15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange
Act")) that are designed to ensure that information required to be
disclosed in our reports filed under the Exchange Act, is recorded,
processed, summarized and reported within the time periods specified in the
Security and Exchange Commission's rules and forms, and that such
information is accumulated and communicated to our management, including
our Chief (principal) Executive Officer and Chief (principal) Financial
Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and
procedures, management recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives, and management
necessarily was required to apply its judgment in evaluating the cost-
benefit relationship of possible controls and procedures.
An evaluation was conducted by our Chief Executive Officer and Chief
Financial Officer of the effectiveness of the Company's disclosure controls
and procedures as of the end of the period covered by this report. Based on
that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that our disclosure controls and procedures were effective to
ensure that information required to be disclosed in our reports filed under
the Exchange Act, is recorded, processed, summarized and reported within
the time periods specified in the Security and Exchange Commission's rules
and forms.
(b) Changes in Internal Controls. There have been no changes in our
internal control over financial reporting (as defined in Rules 13a-15(f)
and 15d-15(f) under the Exchange Act) during the most recently completed
fiscal quarter that materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION.
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Refer to the Company's Current Report on Form 8-K filed April 5,
2005.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The proposals voted upon at the Company's Annual Meeting of
Stockholders, held July 14, 2005, along with the voting results, were
as follows:
(1) Election of Directors: All nominees were elected: The results
of the balloting were as follows:
Votes Votes
Nominees For Withheld
--------------------------------------------------
Jean-Marc Stiegemeier 3,208,981 41,071
George J. Taylor, Jr. 3,188,401 61,651
Harold L. Hanson 3,207,714 42,338
Hugh M Taylor 3,205,551 44,501
Joseph J. Kelley 3,208,534 41,518
Ronald P. Pettirossi 3,212,658 37,394
(2) Ratification of the appointment of Carlin, Charron & Rosen LLP
as independent auditors of the Company for the year ending
December 31, 2005: The proposal was approved with 3,197,907
votes for, 40,840 votes against and 11,305 abstentions.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS:
The following documents are filed as Exhibits to this Quarterly
Report on Form 10-Q:
31.1 Certification of the Chief Executive Officer, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of the Chief Financial Officer, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of the Chief Executive Officer, pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of the Chief Financial Officer, pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
21
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.
FARMSTEAD TELEPHONE GROUP, INC.
Dated: May 26, 2006 /s/ Jean-Marc Stiegemeier
-------------------------
Jean-Marc Stiegemeier
Chief Executive Officer,
President
Dated: May 26, 2006 /s/ Robert G. LaVigne
---------------------
Robert G. LaVigne
Executive Vice President,
Chief Financial Officer
22