U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the quarterly period ended September 30, 2003
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number: 0-15938
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 past 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 October 31, 2003, the registrant had 3,311,601 shares of its
$0.001 par value Common Stock outstanding.
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(In thousands) 2003 2002
----------------------------------------------------------------------------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 351 $ 994
Accounts receivable, net (Note 2) 1,990 1,869
Inventories, net (Note 3) 2,309 2,309
Other current assets 353 69
----------------------------------------------------------------------------------
Total Current Assets 5,003 5,241
----------------------------------------------------------------------------------
Property and equipment, net 321 394
Other assets 306 238
----------------------------------------------------------------------------------
Total Assets $ 5,630 $ 5,873
==================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,105 $ 1,111
Debt maturing within one year (Note 4) 135 -
Accrued expenses and other current liabilities
(Note 5) 360 385
----------------------------------------------------------------------------------
Total Current Liabilities 1,600 1,496
----------------------------------------------------------------------------------
Other liabilities 425 348
----------------------------------------------------------------------------------
Total Liabilities 2,025 1,844
----------------------------------------------------------------------------------
Commitments and contingencies (Note 9)
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; 3,311,601 and 3,298,958
shares issued and outstanding at September 30,
2003 and December 31, 2002, respectively 3 3
Additional paid-in capital 12,315 12,313
Accumulated deficit (8,713) (8,287)
----------------------------------------------------------------------------------
Total Stockholders' Equity 3,605 4,029
----------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 5,630 $ 5,873
==================================================================================
See accompanying notes to consolidated financial statements.
2
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
For the Three For the Nine
Months Ended Months Ended
September 30, September 30,
----------------- -------------------
(In thousands, except loss per share amounts) 2003 2002 2003 2002
------------------------------------------------------------------------------------------
Revenues:
Equipment $2,945 $4,378 $10,025 $14,255
Services and other revenue 292 388 1,462 1,302
------------------------------------------------------------------------------------------
Total revenues 3,237 4,766 11,487 15,557
Cost of Revenues:
Equipment 1,973 3,195 6,842 10,495
Services and other revenue 131 217 955 795
Other cost of revenues 187 289 633 1,141
------------------------------------------------------------------------------------------
Total cost of revenues 2,291 3,701 8,430 12,431
------------------------------------------------------------------------------------------
Gross profit 946 1,065 3,057 3,126
Selling, general and administrative expenses 1,080 1,352 3,449 4,429
------------------------------------------------------------------------------------------
Operating loss (134) (287) (392) (1,303)
Interest expense (11) (2) (21) (24)
Other income 3 4 6 94
------------------------------------------------------------------------------------------
Loss before income taxes (142) (285) (407) (1,233)
Provision (benefit) for income taxes 7 (1) 19 12
------------------------------------------------------------------------------------------
Net loss $ (149) $ (284) $ (426) $(1,245)
==========================================================================================
Basic and diluted net loss per common share: $ (.05) $ (.09) $ (.13) $ (.38)
Weighted average common shares outstanding:
Basic and diluted 3,306 3,290 3,303 3,285
==========================================================================================
See accompanying notes to consolidated financial statements.
3
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Nine Months Ended September 30, 2003 and 2002
(In thousands) 2003 2002
---------------------------------------------------------------------------------
Cash flows from operating activities:
Net loss $(426) $(1,245)
Adjustments to reconcile net loss to net cash flows
used in operating activities:
Provision for (reversal of) doubtful accounts receivable 25 (48)
Provision for losses on inventories 25 45
Depreciation and amortization 133 161
Value of compensatory stock options issued - 11
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable (146) 554
(Increase) decrease in inventories (25) 1,338
Increase in other assets (352) (7)
Decrease in accounts payable (6) (1,027)
Decrease in accrued expenses and other current
liabilities (25) (292)
Increase in other liabilities 77 66
---------------------------------------------------------------------------------
Net cash used in operating activities (720) (444)
---------------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment (60) (60)
Acquisition of InfiNet - (153)
---------------------------------------------------------------------------------
Net cash used in investing activities (60) (213)
---------------------------------------------------------------------------------
Cash flows from financing activities:
Borrowings under revolving credit line 135 238
Repayments of capital lease obligation - (37)
Issuance of common stock 2 13
Capital distribution to minority interest partner - (100)
---------------------------------------------------------------------------------
Net cash provided by financing activities 137 114
---------------------------------------------------------------------------------
Net decrease in cash and cash equivalents (643) (543)
Cash and cash equivalents at beginning of period 994 1,479
---------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 351 $ 936
=================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 18 $ 23
Income taxes 5 17
See accompanying notes to consolidated financial statements.
4
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. 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 and InfiNet Systems, LLC (both
companies are inactive). The accompanying consolidated financial statements
as of and for the three and nine months ended September 30, 2003 and 2002
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, that are necessary for a fair statement
of financial position and results for the interim periods presented. The
results of operations for the interim periods are not necessarily
indicative of the results to be experienced for the entire fiscal year.
Certain prior year amounts on the Consolidated Statements of Cash Flows
have been reclassified to conform to the current interim period
presentation. This Form 10-Q 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, 2002.
2. ACCOUNTS RECEIVABLE, NET
Accounts receivable, net consist of the following (in thousands):
September 30, December 31,
2003 2002
----------------------------------------------------------------------
Trade accounts receivable $1,812 $1,892
Other receivables 208 24
----------------------------------------------------------------------
2,020 1,916
Less: allowance for doubtful accounts (30) (47)
----------------------------------------------------------------------
Accounts receivable, net $1,990 $1,869
======================================================================
Other receivables consist of commissions, rebates and other dealer
incentives due from Avaya, Inc., and are recorded in the consolidated
financial statements when earned.
3. INVENTORIES, NET
Inventories are stated at the lower of cost or market, and are valued
on an average cost basis. Inventories, net consist of the following (in
thousands):
September 30, December 31,
2003 2002
-----------------------------------------------------------------------------------
Finished goods and spare parts $2,195 $2,362
Work in process (a) 461 456
Rental equipment 17 53
-----------------------------------------------------------------------------------
2,673 2,871
Less: reserves for excess and obsolete inventories (364) (562)
-----------------------------------------------------------------------------------
Inventories, net $2,309 $2,309
===================================================================================
(a) Work in process inventories consists of used equipment requiring
repair or refurbishing.
4. DEBT MATURING WITHIN ONE YEAR
On February 19, 2003 the Company entered into a one-year, $1.5
million revolving loan agreement (the "BACC Agreement") with Business
Alliance Capital Corporation ("BACC"), replacing the Wachovia Loan
Agreement. Under the terms of the BACC Agreement, borrowings are advanced
at 75% of eligible accounts receivable, as defined (primarily receivables
that are less than 90 days old and, in the case of system sales, the
receivable does not become "eligible" until the system has been installed),
and at 25% of the value of eligible inventory, as defined (primarily
inventory that was purchased pursuant to a firm customer order), provided
that the amount advanced against eligible inventory shall not exceed
$200,000 or 30% of all outstanding advances under the BACC Agreement.
Interest is charged at the per annum rate of one and one-
5
half percentage points (1.5%) above the prime rate, but not less than
5.75%, and is subject to a minimum interest charge based on a minimum daily
loan balance of $250,000 regardless of the actual loan balance. Under the
BACC Agreement, the Company is charged an annual facility fee of 1% of the
facility ($15,000) and a monthly service fee equal to .25% of the average
loan balance, subject to a minimum daily loan balance of $250,000. As
additional security to BACC, the Company issued a $300,000 standby letter
of credit in favor of BACC, secured by cash, which can be drawn upon, up to
the amount of the Company's outstanding obligation to BACC, ninety days
after an event of default (see Note 9). The BACC Agreement restricts the
Company from the payment of dividends and limits capital expenditures
during the term of the agreement to $150,000, without the consent of BACC.
The BACC 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; (iv) the Company fails
to comply with the terms, representations and conditions of the BACC
Agreement, or (v) there are material liens or attachments levied against
the Company's assets. In the event the BACC Agreement is terminated prior
to its expiration date, the Company is obligated to pay a fee equal to 4%
of the $1.5 million advance limit.
As of September 30, 2003, outstanding borrowings under the BACC
Agreement were $135,000. The unused portion of the credit facility as of
September 30, 2003 was $1,365,000, of which $731,000 was available under
the Company's borrowing formulas. The average and highest amounts borrowed
during the three months ended September 30, 2003 were approximately
$507,000 and $967,000, respectively. The average and highest amounts
borrowed under all credit facilities during the nine months ended September
30, 2003 were approximately $271,000 and $967,000, respectively. The
Company was in compliance with the provisions of its loan agreement as of
September 30, 2003.
5. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
Accrued expenses and other current liabilities consist of the
following (in thousands):
September 30, December 31,
2003 2002
-------------------------------------------------------------------------------
Salaries, commissions and benefits $206 $241
License fees 71 24
Other 83 120
-------------------------------------------------------------------------------
Accrued expenses and other current liabilities $360 $385
===============================================================================
6. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
FASB INTERPRETATION NO. 45. In November 2002, the Financial
Accounting Standards Board issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 elaborates on the
existing disclosure requirements for most guarantees, including loan
guarantees such as standby letters of credit. It also requires that at the
time a company issues a guarantee, the company must recognize an initial
liability for the fair market value of the obligations it assumes under
that guarantee and must disclose that information in its interim and annual
financial statements. The initial recognition and measurement provisions of
FIN 45 apply on a prospective basis to guarantees issued or modified after
December 31, 2002. The Company adopted FIN 45 effective January 1, 2003.
The Company has no guarantees of the type contemplated by FIN 45 requiring
recognition of an initial liability on its books, however applicable
disclosures are reflected in Note 9 - Commitments and Contingencies.
7. 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 awards. Had compensation cost for the Company's stock
option plan 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 (dollars in thousands except per share amounts):
6
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2003 2002 2003 2002
---------------------------------------------------------------------------------------
Net loss, as reported $(149) $(284) $(426) $(1,245)
Add: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax
effects (16) (45) (62) (134)
---------------------------------------------------------------------------------------
Pro forma net loss (165) (329) (488) (1,379)
Pro forma net loss per share:
Basic and diluted $(.05) $(.10) $(.15) $ (.42)
=======================================================================================
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 2003 and 2002; expected volatility of
113% for 2003 and 2002; average risk-free interest rate of 2.81% for 2003
and 3.68% for 2002; and an expected option holding period of 5.6 years for
2003 and 2002.
8. MAJOR CUSTOMERS AND CONCENTRATIONS OF CREDIT RISK
During the three and nine months ended September 30, 2003, and the
nine months ended September 30, 2002, no customer accounted for more than
10% of revenues. During the three months ended September 30, 2002, one
customer accounted for 11% of revenues. The Company extends credit to its
customers in the normal course of business. As of September 30, 2003, two
customers accounted for 28% of accounts receivable. As of December 31,
2002, one customer accounted for 11% of accounts receivable. Although the
Company is subject to changes in economic conditions which may impact its
overall credit risk, the Company sells to a wide variety of customers, and
does not focus on any particular industry sector. The Company establishes
its allowance for doubtful accounts based upon factors surrounding the
credit risk of specific customers, historical trends and experience, and
other information available to it. Management considers the Company's
credit risk to be satisfactorily diversified and believes that its
allowance for doubtful accounts is adequate to absorb estimated losses as
of September 30, 2003.
9. COMMITMENTS AND CONTINGENCIES
Letter of Credit. In connection with the Company's revolving credit
agreement with BACC, the Company issued a $300,000 irrevocable standby
letter of credit ("LC") in favor of BACC. The LC can be drawn upon by BACC
to satisfy any outstanding obligations under the Company's loan agreement
ninety days after an event of default. The LC is secured by cash, and since
this cash is restricted from use by the Company during the term of the LC,
it has been classified under other current assets in the consolidated
balance sheet at September 30, 2003.
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 "Risk, 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, press releases, conferences, or otherwise may be forward-
looking statements within the meaning of the Act.
7
RESULTS OF OPERATIONS
OVERVIEW. For the three months ended September 30, 2003, we recorded
a net loss of $149,000 or $.05 per share on revenues of $3,237,000,
compared to a net loss of $284,000 or $.09 per share on revenues of
$4,766,000 for the comparable prior year period. For the nine months ended
September 30, 2003, we recorded a net loss of $426,000 or $.13 per share on
revenues of $11,487,000, compared to a net loss of $1,245,000 or $.38 per
share on revenues of $15,557,000 for the comparable prior year period.
We continue to believe that our operating results for 2003 reflect in
part the continuing soft market conditions for telecommunications products
in the United States. There have, however, been some signs of improvement
in our industry as evidenced by improved operating results from some of the
key manufacturers, and we are encouraged by an increase in sales quotation
activities. Our overall strategy has been to properly size our business in
relation to current revenue run-rates, while preserving our technical
resources which are critical to maintaining and growing a systems and
services business. We have remained in a somewhat defensive posture,
attempting to offset the financial impact of a reduced revenue stream by
reducing, more tightly controlling, and deferring where possible, operating
costs and expenses. As a result, although third quarter 2003 revenues were
32% lower than third quarter 2002 revenues, and 26% lower year-to-date, we
managed to reduce our comparative net losses by 48% and 66%, respectively.
We accomplished this through reducing our selling, general and
administrative expenses by 20% quarter-over-quarter, and by 22% year-over-
year, and by significantly increasing our profit margins from 22% to 29%
quarter-over-quarter, and from 20% to 27% year-over-year, through new
revenue opportunities such as selling Avaya maintenance contracts,
personnel reductions, improved product buying and outsourcing equipment
repair operations.
Having made substantial progress in reducing costs and increasing
profit margins, our primary business focus for the near term will center on
strategies to increase sales revenues. We believe that our return to
profitability will now be driven more so by increasing sales levels than
from further cost reductions. To that end, we have been hiring additional
experienced salespersons to provide more coverage of existing and potential
customers located within the market areas that we serve; broadening our
product offerings; and we plan to increase the marketing of Farmstead's
products and capabilities, including our on-line ordering system. However,
should there be a continuation of operating losses, we will implement
further cost and infrastructure reduction measures as deemed necessary,
which may hinder the execution of our long-term growth plans. As further
described in the Liquidity and Capital Resources section below, our current
year operating activities and losses, plus the issuance of a $300,000
letter of credit required by our lender, has used up, or restricted the use
of, a significant amount of our beginning of year cash. Our current cash
position and borrowing capacity could be a limiting factor to our growth,
particularly if operating losses continue or, if growth is predominantly in
the systems products since under our current loan agreement, we are
prohibited from borrowing against receivables generated by systems sales
until such time as the systems are installed. Under these circumstances, we
could deplete our cash, borrowing availability and/or require a higher
credit line. However, as of September 30, 2003, we had $3.4 million in
working capital, with $2.3 million in inventories. We have begun a program
to reduce our inventory levels, selling off excess quantities through
aftermarket parts resellers, which will generate cash needed for
operations. Additional information on our results of operations and
financial condition for the three and nine months ended September 30, 2003
follows below.
REVENUES
Three months ended Nine months ended
September 30, September 30,
------------------ ------------------
(in thousands) 2003 2002 2003 2002
----------------------------------------------------------------------------
End-user equipment sales $2,616 $3,800 $ 8,898 $11,639
Equipment sales to resellers 329 578 1,127 2,616
----------------------------------------------------------------------------
Total equipment sales 2,945 4,378 10,025 14,255
----------------------------------------------------------------------------
Services 201 378 1,274 1,274
Other revenue 91 10 188 28
----------------------------------------------------------------------------
Total services and other revenue 292 388 1,462 1,302
----------------------------------------------------------------------------
Consolidated revenues $3,237 $4,766 $11,487 $15,557
============================================================================
Equipment Sales
---------------
Total equipment sales for the three months ended September 30, 2003,
were $2,945,000, a decrease of $1,433,000 or 33% from the comparable 2002
period. The decrease consisted of a $1,184,000 or 31% decline in end-user
sales, and a $249,000 or 43% decline in equipment sales to resellers
("wholesale sales"). Total equipment sales for the nine months
8
ended September 30, 2003, were $10,025,000, a decrease of $4,230,000 or 30%
from the comparable 2002 period. The decrease consisted of a $2,741,000 or
24% decline in end-user sales, and a $1,489,000 or 57% decline in wholesale
sales. End-user sales consist of both parts sales (new and refurbished),
and systems sales (complete systems and system upgrades).
We attribute these sales declines in part to a continuing soft market
for telecommunications equipment and to the following: (1) the turnover of
sales personnel during the past year and the concurrent hiring and training
of new salespersons and; (2) due to the continued softness in capital
spending for telecommunications products, we have experienced increased
competition for sales, which has resulted in increased sales price
discounting in order to capture business. During 2003, we have continued a
strategy of diversifying our product offerings by marketing the sale of
complete telecommunications systems to our customer base. This is a growth
strategy, designed to augment our long-established aftermarket parts
business that continues as our primary source of revenues. As a result, we
have balanced our sales effort to sell systems, parts and services in order
to diversify our product offerings. The systems business has not yet
developed to the point where order generation is consistent; therefore
revenues from sales of systems have fluctuated greatly from quarter to
quarter. For the three months ended September 30, 2003, systems sales
represented $250,000 of all end-user equipment sales, down 62% from the
comparable prior year quarter; however for the nine months ended September
30, 2003 system sales were $1,432,000, up 33% from the prior year period.
We currently remain committed to further developing our systems sales
business. Revenue generation from all product lines and sales channels is
the primary focus of management, and strategies being implemented include
increasing the size and experience level of both our outside and inside
sales forces, increased marketing of our on-line ordering process, and
other direct-marketing approaches. During the nine months ended September
30, 2003, orders received electronically from customers through our on-line
catalogs represented 3% of revenues. We are, however, still in the early
stages of marketing this process to our customer base.
Services and Other Revenue
--------------------------
For the three months ended September 30, 2003, service revenues were
$201,000, down $177,000 or 47% from the comparable prior year period. Lower
installation revenues accounted for $169,000 of the decrease and is
attributable to lower systems and parts sales. For the nine months ended
September 30, 2003, service revenues were $1,274,000, even with the
comparable prior year period. For the three months ended September 30,
2003, other revenues were $91,000, up $81,000 or 810% from the comparable
prior year period. For the nine months ended September 30, 2003, other
revenues were $188,000, up $160,000 or 571% from the comparable prior year
period. Other revenue consisted primarily of commissions earned from
selling Avaya maintenance contracts. In these transactions we act as a
sales agent of Avaya, and the service obligations are borne entirely by
Avaya. During 2003 we have increased our focus on selling these contracts
as part of our strategy to develop new sources of revenue for the Company.
Significant portions of our sales revenues are derived from "Business
Partner" relationships with Avaya. For the past several years, Avaya has
been pursuing a strategy of more fully utilizing its dealer channel as a
revenue source. Through our relationships with various Avaya sales
personnel, we are often referred business by Avaya. Such referrals however,
have been subject to fluctuation as Avaya's direct sales business
fluctuates. We believe we are well positioned to benefit from our Avaya
relationships (see section entitled, "Risks, Uncertainties and Other
Factors That May Affect Future Results") as capital spending for
telecommunications products improves.
We continue to remain cautious about the near term levels of capital
spending for telecommunications products in the US. We still expect that
our future sales revenues will improve in all of our current sales channels
when capital spending improves, although no assurances can be given as to
the timing of when this will occur.
COST OF REVENUES AND GROSS PROFIT. Total cost of revenues for the
three months ended September 30, 2003 was $2,291,000, down $1,410,000 or
38% from the comparable 2002 period. The gross profit for the three months
ended September 30, 2003 was $946,000, down $119,000 or 11% from the
comparable 2002 period. As a percentage of revenue, the gross profit margin
was 29% for 2003, compared to 22% for the comparable 2002 period. Total
cost of revenues for the nine months ended September 30, 2003 was
$8,430,000, down $4,001,000 or 32% from the comparable 2002 period. The
gross profit for the nine months ended September 30, 2003 was $3,057,000,
down $69,000 or 2% from the comparable 2002 period. As a percentage of
revenue, the gross profit margin was 27% for the nine months ended
September 30,2003, as compared to 20% for the comparable 2002 period.
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.
9
In our partnering relationship with Avaya, certain customers receive pre-
negotiated discounts from Avaya which could lower our gross margins as we
do business with these customers; (3) the level and amount of discounts and
purchase rebates available to us from Avaya and its master distributors and
(4) the level of overhead costs in relation to sales volume. Overhead costs
consist primarily of product handling, purchasing, and facility costs. The
combined effect of all of these factors will result in varying gross profit
margins from period to period.
Gross Profit Margins on Equipment Sales. For the three months ended
September 30, 2003, the gross profit margin on equipment sales increased to
33% from 27% in 2002. This was primarily attributable to increased margins
on both end-user and wholesale parts sales, due to product sales mix and
lower inventory purchase costs. For the nine months ended September 30,
2003, the gross profit margin on equipment sales increased to 32% from 26%
in 2002. This was primarily attributable to (i) increased margins on both
end-user and wholesale parts sales, due to product sales mix and lower
inventory purchase costs; (ii) increased purchase discounts and system
rebates from Avaya; and (iii) lower license fees paid to Avaya.
Gross Profit Margins on Services and Other Revenue. For the three
months ended September 30, 2003, the gross profit margin on services and
other revenue increased to 55%, from 44% in 2002. The increase was
attributable to the increased commissions earned from selling Avaya
maintenance contracts, which generate a 100% profit margin. The gross
profit margin on the services component was otherwise 35%, compared with
43% recorded in 2002. The decrease was attributable to installation
services, which generated an 18% profit margin, compared with a 35% profit
margin in the prior year period. For the nine months ended September 30,
2003, the gross profit margin on services and other revenues declined to
35%, from 39% recorded in 2002. The decrease was attributable to the
services component which generated a profit margin of 25% compared with 38%
in 2002. This decrease was attributable to installation services, which
generated a 16% profit margin, compared with a 31% profit margin in the
prior year period, due to a loss incurred on a large system installation.
Other Cost of Revenues: Other cost of revenues consists of product
handling, purchasing and facility costs and expenses. For the three months
ended September 30, 2003, these expenses were $187,000, or 6% of equipment
revenues, compared to $289,000 or 7% of equipment revenues in the
comparable prior year period. For the nine months ended September 30, 2003,
these expenses were $633,000, or 6% of equipment revenues, compared to
$1,141,000 or 8% of equipment revenues in the comparable prior year period.
As a result of cost reduction initiatives, which included personnel
reductions of over 50%, and increased outsourcing of equipment repair
operations, other cost of revenues were $102,000 or 35% lower in the
current year quarter as compared with the prior year quarter, and were
$508,000 or 45% lower in the current nine-month period as compared with the
prior year nine-month period.
SELLING, GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES. SG&A expenses
for the three months ended September 30, 2003 were $1,080,000, a decrease
of $272,00 or 20% from the comparable 2002 period. SG&A expenses for the
nine months ended September 30, 2003 were $3,449,000, a decrease of
$980,000 or 22% from the comparable 2002 period. SG&A expenses for the
three months ended September 30, 2003 were 33% of revenues, compared to 28%
of revenues in 2002, and for the nine months ended September 30, 2003 and
2002 they were 30% and 28%, respectively, of revenues.
In response to lower sales levels, we have been more tightly
controlling expenses, and deferring them where possible. As a result of
these efforts, for the three months ended September 30, 2003, compensation
expenses were $158,000 or 19% lower than the prior year period, while all
other SG&A expenses were $114,000 or 23% lower than the prior year period.
This included reductions in travel, office, insurance and other employment
related expenses. For the nine months ended September 30, 2003,
compensation expenses were $661,000 or 24% lower than the prior year
period, of which $92,000 of the reduction was attributable to lower sales
commissions from lower sales volume, while all other SG&A expenses were
$319,000 or 20% lower than the prior year period. This included reductions
in travel, consulting, office, depreciation, insurance and other employment
related expenses, offset by higher bad debt and property tax expenses.
Given our current sales levels, we will continue to tightly control our
SG&A expenses.
INTEREST EXPENSE AND OTHER INCOME. Interest expense for the three
months ended September 30, 2003 was $11,000, compared to $2,000 for the
comparable 2002 period. Interest expense for the nine months ended
September 30, 2003 was $21,000, compared to $24,000 for the comparable 2002
period. The increase in interest expense for the three-month period was
attributable to higher average borrowings, while the decrease in interest
expense for the nine-month period was attributable to lower average
borrowings. Other income for the three and nine months ended September 30,
2003 was $3,000 and $4,000, respectively, compared with $6,000 and $94,000
recorded for the respective three and nine months ended September 30, 2002.
Other income for the nine months ended September 30, 2002 included $82,000,
from the sale of common stock of Anthem, Inc., which we received at no
cost, as part of the conversion of Anthem Insurance Companies, Inc. from a
mutual insurance company to a stock insurance company. The balance of other
income for all periods presented consisted primarily of interest earned on
invested cash.
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PROVISION (BENEFIT) FOR INCOME TAXES. The provision (benefit) for
income taxes for the three and nine months ended September 30, 2003 was
$7,000 and $19,000, respectively, compared to ($1,000) and $12,000 for the
respective prior year periods. The provision (benefit) for income taxes
consisted of estimated minimum state taxes in each period. 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 $3,403,000 at September 30, 2003, compared to $3,745,000 at December
31, 2002. The working capital ratio was 3.1 to 1 at September 30, 2003,
compared to 3.5 to 1 at December 31, 2002.
Operating activities used $720,000 during the nine months ended
September 30, 2003. Net cash used by operating activities consisted of a
net loss of $426,000 adjusted for non-cash items of $183,000, and net cash
used by changes in operating assets and liabilities of $477,000. Net cash
used by changes in operating assets and liabilities was primarily
attributable to a $146,000 increase in accounts receivable, and the
$300,000 reclassification of restricted cash (Note 9) to other current
assets.
Investing activities used $60,000 during the nine months ended
September 30, 2003 to fund capital expenditures.
Financing activities generated $137,000 during the nine months ended
September 30, 2003, primarily attributable to working capital borrowings
under our revolving credit facility with BACC. As of September 30, 2003,
outstanding borrowings under the BACC Agreement were $135,000. The unused
portion of the credit facility as of September 30, 2003 was $1,365,000, of
which $731,000 was available under the Company's borrowing formulas. The
average and highest amounts borrowed under all credit facilities during the
nine months ended September 30, 2003 were approximately $271,000 and
$967,000. We were in compliance with the provisions of our loan agreement
as of September 30, 2003.
We are dependent upon generating positive cash flow from operations
and upon our revolving credit facility to provide cash to satisfy working
capital requirements. No assurances can be given that we will have
sufficient cash resources to finance future growth. 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 progress payments under our systems sales contracts.
Under the current lending agreement, we are prohibited from borrowing
against receivables generated by systems sales until the systems are
installed. Under these circumstances, we could run out of availability
and/or require a higher credit line. In order to obtain additional
financing, we may first need to demonstrate improved operating performance.
Since 2002, we have been engaged in a project to develop an e-
business platform, designed to enable our customers to transact business
with us electronically. As of September 30, 2003, we have incurred
cumulative expenditures of $88,000, and currently estimate that we could
spend an additional $25,000 on this project during the balance of 2003 in
order to complete the implementation of our on-line product catalogs, and
integration of the related on-line ordering processes with our computer
systems. There are currently no other material capital expenditures
planned.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion contained in the "Critical Accounting Policies and
Estimates" section of our Annual Report on Form 10-K for the year ended
December 31, 2002 is still considered current and is hereby incorporated
into this Quarterly Report on Form 10-Q.
RISKS, UNCERTAINTIES AND OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS
The discussion included in the "Risks, Uncertainties and Other
Factors That May Affect Future Results" section included in our Annual
Report on Form 10-K for the year ended December 31, 2002 is still
considered current, except for the following discussion of our business
relationship with Avaya, and is hereby incorporated into this Quarterly
Report on Form 10-Q.
Our Authorized Remarketing Supplier ("ARS") Dealer and ARS License
agreements currently expire December 31, 2003; however, we are in the
process of negotiating a similar one-year renewal agreement which could
become effective
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January 1, 2004. Avaya has notified us that they are also considering
replacing the ARS program with a successor program which would allow the
ARS companies to purchase refurbished "Classic Avaya" equipment directly
from Avaya. At this time, it is too early to determine whether the ARS
program will continue into 2004 or what the terms and conditions of any
successor program might be or how it might impact us. We believe that
should the ARS program not be renewed, it will not have a material adverse
impact on our ability to sell refurbished equipment.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risks that have the potential to affect our earnings and cash
flows result primarily from changes in interest rates. Our cash
equivalents, which consist of an investment in a money market fund
consisting of high quality short term instruments, principally US
government and agency issues and commercial paper, are subject to
fluctuating interest rates. A 10 percent change in such current interest
rates would not have a material effect on our results of operations or cash
flow.
We are also exposed to market risk from changes in the interest rate
related to our revolving credit facility, which is based upon the prime
rate charged by a designated bank. Assuming an average borrowing level of
$250,000 (which amount represents the assumed minimum loan balance for
purposes of interest charges under the BACC credit facility) each 1
percentage point increase in the bank's prime rate would result in $2,500
of additional annual interest charges. Under current policies, we do not
use interest rate derivative instruments to manage exposure to interest
rate changes.
ITEM 4. CONTROLS AND PROCEDURES.
(a) Evaluation of Disclosure Controls and Procedures. Our Chief
Executive Officer and Chief Financial Officer have evaluated the
effectiveness of our disclosure controls and procedures (as such term is
defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act
of 1934, as amended (the "Exchange Act")) as of a date within 90 days prior
to the filing date of this Quarterly Report on Form 10-Q. Based on such
evaluation, such officers have concluded that our disclosure controls and
procedures are effective in alerting them on a timely basis to material
information relating to our Company required to be included in our reports
filed or submitted under the Exchange Act.
(b) Changes in Internal Controls. There were no significant changes
in our internal controls or in other factors that could significantly
affect such controls subsequent to the date of their most recent
evaluation.
PART II. OTHER INFORMATION.
ITEMS 1-5 have been omitted because there is nothing to report or they are
inapplicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:
(a) 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.
(b) Reports on Form 8-K: No reports on Form 8-K were filed during
the quarter for which this report is filed.
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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.
FARMSTEAD TELEPHONE GROUP, INC.
Dated: November 12, 2003 /s/ George J. Taylor, Jr.
-----------------------------------
George J. Taylor, Jr.
Chief Executive Officer, President
Dated: November 12, 2003 /s/ Robert G. LaVigne
-----------------------------------
Robert G. LaVigne
Executive Vice President, Chief
Financial Officer
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