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UNITED STATES
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 March 31, 2005
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the transition period from ____________ to ____________
Commission File Number: 0-15938
Farmstead Telephone Group, Inc.
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(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, including area code)
___________________________________________________________________________
(Former name, former address and former fiscal year,
if changed since last report)
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 preceeding 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 April 30, 2005, the registrant had 3,342,730 shares of its $0.001 par
value Common Stock outstanding.
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TABLE OF CONTENTS TO FORM 10-Q
PART I. FINANCIAL INFORMATION
Page
----
ITEM 1. FINANCIAL STATEMENTS (Unaudited)
Consolidated Balance Sheets - March 31, 2005 and
December 31, 2004 3
Consolidated Statements of Operations - Three Months
Ended March 31, 2005 and 2004 4
Consolidated Statement of Changes in Stockholders'
Equity - Three Months Ended March 31, 2005 4
Consolidated Statements of Cash Flows - Three Months
Ended March 31, 2005 and 2004 5
Notes to Consolidated Financial Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 11
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 15
ITEM 4. CONTROLS AND PROCEDURES 15
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 15
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 15
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 15
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 15
ITEM 5. OTHER INFORMATION 15
ITEM 6. EXHIBITS 16
SIGNATURES 16
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
(In thousands) 2005 2004
---------------------------------------------------------------------------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 247 $ 217
Accounts receivable, net 1,544 1,453
Inventories, net 1,588 1,627
Other current assets 359 378
-------------------------------------------------------------------------------
Total Current Assets 3,738 3,675
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Property and equipment, net 281 268
Deferred financing costs (Note 7) 415 -
Other assets 104 107
-------------------------------------------------------------------------------
Total Assets $ 4,538 $ 4,050
===============================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,656 $ 1,110
Debt maturing within one year 153 187
Accrued expenses and other current liabilities 609 242
-------------------------------------------------------------------------------
Total Current Liabilities 2,418 1,539
-------------------------------------------------------------------------------
Postretirement benefit obligation 624 593
Notes payable 60 39
-------------------------------------------------------------------------------
Total Liabilities 3,102 2,171
-------------------------------------------------------------------------------
Commitments and contingencies (Note 11)
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; 3,342,730 and 3,322,182
shares issued and outstanding at March 31, 2005
and December 31, 2004, respectively 3 3
Additional paid-in capital 12,513 12,320
Accumulated deficit (11,059) (10,420)
Accumulated other comprehensive loss (21) (24)
-------------------------------------------------------------------------------
Total Stockholders' Equity 1,436 1,879
-------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 4,538 $ 4,050
===============================================================================
See accompanying notes to consolidated financial statements.
3
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
March 31,
------------------
(In thousands, except per share amounts) 2005 2004
------------------------------------------------------------------------
Revenues:
Equipment $1,965 $2,922
Services and other revenue 444 484
------------------------------------------------------------------------
Net revenues 2,409 3,406
Cost of revenues:
Equipment 1,319 2,046
Services and other revenue 234 272
Other cost of revenues 102 211
------------------------------------------------------------------------
Total cost of revenues 1,655 2,529
------------------------------------------------------------------------
Gross profit 754 877
Selling, general and administrative expenses 1,384 1,210
------------------------------------------------------------------------
Operating loss (630) (333)
Interest expense (8) (6)
Other income 3 1
------------------------------------------------------------------------
Loss before income taxes (635) (338)
Provision for income taxes 4 3
------------------------------------------------------------------------
Net loss $ (639) $ (341)
========================================================================
Basic and diluted net loss per common share $ (.19) $ (.10)
Weighted average common shares outstanding:
Basic and diluted 3,328 3,313
========================================================================
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES
IN STOCKHOLDERS' EQUITY (UNAUDITED)
Three Months ended March 31, 2005
Accumulated
Common Stock Additional Accum- Other
----------------- 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 - - - (639) - (639)
Amortization of pension liability adjustment 3 3
------
Comprehensive loss (636)
Issuance of warrants - - 186 - - 186
Issuance of common stock 21 - 7 - - 7
----------------------------------------------------------------------------------------------------------------------------
Balance at March 31, 2005 3,343 $3 $12,513 $(11,059) $(21) $1,436
============================================================================================================================
See accompanying notes to consolidated financial statements.
4
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31,
------------------
(In thousands) 2005 2004
-------------------------------------------------------------------------------------
Cash flows from operating activities:
Net loss $(639) $(341)
Adjustments to reconcile net loss to net cash flows
provided by (used in) operating activities:
Provision for doubtful accounts receivable 9 9
Provision for losses on inventories 8 9
Depreciation and amortization 25 36
Decrease in accumulated other comprehensive loss 3 2
Increase in accrued postretirement benefit obligation 31 29
Changes in operating assets and liabilities:
Increase in accounts receivable (100) (485)
(Increase) decrease in inventories 31 (380)
Increase in other assets (7) (36)
Increase in accounts payable 546 265
Increase in accrued expenses and other current liabilities 167 119
-----------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 74 (773)
-----------------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment (3) (12)
-----------------------------------------------------------------------------------
Net cash used in investing activities (3) (12)
-----------------------------------------------------------------------------------
Cash flows from financing activities:
Borrowings (repayments) under revolving credit line (46) 305
Proceeds from issuance of common stock 7 2
Repayments of capital lease obligations (2) -
-----------------------------------------------------------------------------------
Net cash (used in) provided by financing activities (41) 307
-----------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 30 (478)
Cash and cash equivalents at beginning of period 217 827
-----------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 247 $ 349
===================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 8 $ 6
Income taxes 2 4
Non-cash financing and investing activities:
Purchase of equipment under capital lease 36 -
Value of warrant issued in connection with revolving
credit facility 186 -
See accompanying notes to consolidated financial statements.
5
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 (inactive) and InfiNet Systems, LLC
(inactive). The accompanying consolidated financial statements as of March
31, 2005 and for the three months ended March 31, 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 three months ended March 31, 2005 are not
necessarily indicative of the results that may be expected for the entire
fiscal year. 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, 2004.
2. OPERATIONS:
As presented in the consolidated financial statements contained in
this report, the Company incurred a net loss of $639,000 for the quarter
ended March 31, 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 83% larger than in March 2004, and March 2005 bookings and
revenues were significantly higher than in recent months. The Company
intends to hire additional sales professionals during 2005 as required to
meet its SMB revenue expectations. In May 2005, the Company formed 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 a new
lender, replacing a $1.7 million credit facility with Business Alliance
Capital Corporation. For additional information, refer to Note 7, Debt
Obligations contained herein.
3. RECLASSIFICATIONS
Certain amounts in prior years' financial statements have been
reclassified to conform to the 2005 presentation.
4. ACCOUNTS RECEIVABLE, NET
March 31, December 31,
(Dollars in thousands) 2005 2004
--------------------------------------------------------------------
Trade accounts receivable $1,383 $1,379
Less: allowance for doubtful accounts (69) (60)
-----------------------------------------------------------------
Trade accounts receivable, net 1,314 1,319
Other receivables 230 134
-----------------------------------------------------------------
Accounts receivable, net $1,544 $1,453
=================================================================
6
Other receivables consist of commissions, rebates and other dealer
incentives due from Avaya Inc., and are recorded in the consolidated
financial statements when earned. Refer to Note 1, "Accounting for
Manufacturer Incentives" in the Company's Annual Report on Form 10-K for
the year ended December 31, 2004.
5. INVENTORIES, NET
March 31, December 31,
(Dollars in thousands) 2005 2004
---------------------------------------------------------------------------------
Finished goods and spare parts $1,292 $1,341
Work in process (a) 296 352
Rental equipment 42 52
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1,630 1,745
Less: reserves for excess and obsolete inventories (42) (118)
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Inventories, net $1,588 $1,627
==============================================================================
(a) Work in process inventories consist of used equipment requiring
repair or refurbishing.
6. PROPERTY AND EQUIPMENT, NET
Estimated
Useful Lives March 31, December 31,
(Dollars in Thousands) (Yrs.) 2005 2004
-----------------------------------------------------------------------------------------------
Computer and office equipment 3 - 5 $ 1,073 $ 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 36 -
--------------------------------------------------------------------------------------------
1,716 1,678
Less: accumulated depreciation and amortization (1,435) (1,410)
--------------------------------------------------------------------------------------------
Property and equipment, net $ 281 $ 268
============================================================================================
Leased equipment under capital lease consists of computer equipment.
7. DEBT OBLIGATIONS
March 31, December 31,
(Dollars In thousands) 2005 2004
-------------------------------------------------------------------
BACC revolving credit facility note $ 133 $ 179
Installment purchase note 46 47
Leased equipment under capital lease 34 -
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213 226
Less: debt maturing within one year (153) (187)
---------------------------------------------------------------
Long-term debt obligations $ 60 $ 39
===============================================================
Credit Arrangements:
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. The average and highest amounts borrowed under the BACC
facility during the three months ended March 31, 2005 were approximately
$223,000 and $447,000, respectively.
On March 31, 2005, the Company entered into a financing transaction
with Laurus Master Fund, Ltd., ("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
7
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 fair value of the Warrant was estimated using the Black-Scholes
pricing model with the following assumptions: fair market value of the
underlying common stock of $1.08 per share (which amount represents the
closing price of the common stock on the date that the principal terms and
conditions of the financing were approved by both parties); zero dividends;
expected volatility of 55%; a risk-free interest rate of 3.9% and an
expected holding period of 4.5 years. The resulting value of $186,299 has
been recorded on the books in deferred financing costs, and will be
amortized to expense over the term of the facility. Also included in
deferred financing costs on the balance sheet at March 31, 2005 is $229,000
of fees and expenses incurred by the Company in connection with the Laurus
facility, including a $117,000 prepaid facility fee, a $50,000 broker fee,
and $62,000 of legal and other direct costs incurred. These fees will be
charged to expense on a pro-rata basis over the term of the facility.
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 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, subject to
certain limitations as defined, if the market price of the common stock is
15% above the fixed conversion price of $1.54 per share for five
consecutive trading days in any month. The fixed conversion price 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 fixed
conversion price will be reset once $1.5 million of debt has been
converted. 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. 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%.
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.
8
Obligations under Capital Lease:
In March 2005, the Company entered into non-cancelable lease
agreement to finance $36,112 of computer equipment. Monthly lease
payments are $1,103 with a $1.00 purchase option at the end of 36 months.
The effective interest rate on the capitalized lease obligation is 10.38%.
The note balance at March 31, 2005 was $34,257, of which $12,037 was
classified under debt maturing within one year.
Note Payable:
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 March 31, 2005 was $45,975, of which $8,154 was
classified under debt maturing within one year.
8. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
March 31, December 31,
(Dollars in thousands) 2005 2004
-----------------------------------------------------------------------------
Salaries, commissions and benefits $257 $167
Accrued deferred financing costs 200 -
Other 152 75
-------------------------------------------------------------------------
Accrued expenses and other current liabilities $609 $242
=========================================================================
Refer to Note 7 for information on the nature of the deferred
financing costs. Other accrued expenses include a one-time $68,000 fee for
the early termination of the BACC credit facility.
9. 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.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an
amendment of ARB No. 43, Chapter 4,". 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.
10. 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
9
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):
Three Months Ended
March 31,
------------------
2005 2004
-------------------------------------------------------------------------
Net loss, as reported $(638) $(341)
Add: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects (202) (21)
-----------------------------------------------------------------------
Pro forma net loss $(840) $(362)
Pro forma net loss per share:
Basic and diluted $(.25) $(.05)
=======================================================================
The weighted-average fair value of options and warrants granted
during the three months ended March 31, 2005 and 2004 was $.35 and $.56,
respectively. The fair value of stock options and warrants 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 109% for 2004; average risk-
free interest rate of 3.8% for 2005 and 3.02 % for 2004; and an expected
option holding period of 3.5 years for 2005 and 4.7 years for 2004.
11. COMMITMENTS AND CONTINGENCIES
Employment agreements:
On January 15, 2005 the Company hired Mr. Alfred G. Stein for 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 the date of hire. The Company is currently in the
process of registering 150,000 of the 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 common stock on the 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 is
currently in the process of registering 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.
12. EMPLOYEE BENEFIT PLANS
The components of the net periodic benefit cost included in the
results of operations for the three months ended March 31, 2005 and 2004
are as follows:
10
(Dollars in thousands) 2005 2004
---------------------------------------------
Service cost $22 $20
Interest cost 10 9
Recognized actuarial losses 2 2
--------------------------------------------
Net expense $34 $31
============================================
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 March 31, 2005, we reported a net loss of
$639,000 or $.19 per share on revenues of $2,409,000. This compares with a
net loss of $341,000 or $.10 per share on revenues of $3,406,000 recorded
for the three months ended March 31, 2004. The net loss for 2005 includes
a one-time expenses aggregating $84,000 incurred in connection with the
termination of our credit facility with Business Alliance Capital
Corporation. There are several factors which have contributed to these
results. First, there continues to be intense competition in the market
areas that we serve, particularly with our larger, "Enterprise" customers.
This has led to continued sales price erosion and some loss of market
share, particularly in the sale of parts, which we believe has become more
of a commodity and subject to "price shopping" by customers. Our strategy
to diversify our product offerings by selling complete systems and system
upgrades has not yet generated enough incremental revenues to compensate
for the decline in parts sales. Second, we recognize the need for a larger
and more effective sales force, particularly during these times. Revenue
growth is dependent upon a highly trained sales force. Third, we continue
to believe that corporations are still cautious about capital equipment
spending. Although there have been some signs of improvement in our
industry, and we are experiencing increased sales quotation activities, our
overall order flow has been below our expectations.
As further described in our Annual Report on Form 10-K for the year
ended December 31, 2004, we have taken several measures to turnaround our
operating performance. The turnaround strategy is principally based upon
building a larger and more highly qualified sales force, and diversifying
our 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, we 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, we significantly expanded our 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, our
direct sales force was 83% larger than in March 2004, and March 2005 revenues
were significantly higher than in recent months. We intend to hire
additional sales professionals during 2005 as required to
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meet our SMB revenue expectations. In May 2005, the Company formed 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 our business expansion plans, effective March 31,
2005 we 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 7, "Debt Obligations", and the "Liquidity and Capital Resources"
section which follows.
Additional information on our results of operations and financial
condition for the three months ended March 31, 2005 follows below.
Revenues
Three Months Ended March 31,
(Dollars in thousands) 2005 % 2004 %
------------------------------------------------------------------
End-user equipment sales $1,875 78 $2,763 81
Equipment sales to resellers 90 4 159 5
------------------------------------------------------------------
Total equipment sales 1,965 82 2,922 86
------------------------------------------------------------------
Services 287 12 367 11
Other revenue 157 6 117 3
------------------------------------------------------------------
Total services and other revenue 444 18 484 14
------------------------------------------------------------------
Consolidated revenues $2,409 100 $3,406 100
==================================================================
Equipment Sales
---------------
Equipment Sales. Total equipment sales for the three months ended
March 31, 2005 were $1,965,000, down $957,000 or 33% from the comparable
2004 period. The decrease consisted of declines in both end-user sales and
sales to resellers. End-user sales consist of both parts sales (new and
refurbished), and systems sales (complete systems and system upgrades).
Factors affecting end-user equipment sales for 2005 have previously been
described in the "Overview" section above. During 2005, we continued a
strategy of diversifying our product offerings by marketing the sale of
complete telecommunications systems to our customer base. In addition, in
March 2005, through the significant expansion of our sales force, we began
targeting the SMB marketplace, which is primarily oriented towards systems
sales.
Equipment sales to resellers ("wholesale sales") decreased by $69,000
or 43% from the comparable 2004 period. Wholesale sales have been impacted
by the same factors noted above that have impacted end-user sales.
Services and Other Revenues
---------------------------
Three Months Ended March 31,
(Dollars in thousands) 2005 2004
-------------------------------------------
Services:
Installations $258 $331
Rentals and repair 29 36
Other revenues 157 117
-------------------------------------------
Services and other revenues $444 $484
===========================================
Service revenues for the three months ended March 31, 2005 were
$287,000, down $80,000 or 22% from the comparable 2004 period. The
decrease was primarily attributable to lower installation revenues, due to
the decline in our parts sales resulting in lower move, add and change
billings, and a decline in systems sales requiring our installation
services. 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 March 31, 2005 was $157,000,
up $40,000 or 34% from the comparable 2004 period. The increase was
attributable to higher commissions earned on Avaya maintenance contract
sales, partly offset by lower freight billed to customers on product
shipments due to lower sales volume. In the sale of Avaya maintenance
contracts, all of the equipment service obligations are borne entirely by
Avaya.
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Cost of Revenues and Gross Profit. Total cost of revenues for the
three months ended March 31, 2005 was $1,655,000, down $874,000 or 35% from
the comparable 2004 period. The gross profit for the three months ended
March 31, 2005 was $754,000, down $123,000 or 14% from the comparable 2004
period. As a percentage of revenue, the overall gross profit margin was
31% for 2005, compared to 26% 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) excess capacity - as sales
volume falls, overhead costs, consisting primarily of product handling,
purchasing, and facility costs, become a 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
March 31, 2005, the gross profit margin on equipment sales increased to 33%
from 30% in 2004. The increase was attributable to higher profit margins
on system sales, as the Company increased its sales of smaller, "non-PBX"
systems. This increase was partly offset by a 2 percentage point decrease
in end-user parts margins. The reduced parts profit margins are
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. In addition, the
Company was not subject to any license fees payable to Avaya during 2005
due to that program's termination in June 2004. License fees expensed in
the comparable 2004 period accounted for a 2 percentage point reduction of
the 2004 gross profit margin. We expect continued pressure on our
equipment profit margins going forward, particularly in the sale of parts
and systems to our larger, "Enterprise" customers, due to continuing price
competition in our marketplace.
Gross Profit Margins on Services and Other Revenue. For the three
months ended March 31, 2005, the Company realized an overall 47% profit
margin on its combined service and other revenues, compared to 44% recorded
in 2004. The profit margin on the services component was 30% in 2005
compared to 35% in 2004; the decline being attributable to installation
services. This result, however, was more than offset by an increase in
profit margins generated by other sources of revenue. For the three months
ended March 31, 2005, the Company realized an 80% profit margin on other
revenues, compared to 70% recorded in 2004. This increase was attributable
to higher commission revenues from the sale of Avaya maintenance contracts,
which generated a 100% profit margin.
Other Cost of Revenues. Other cost of revenues consists of product
handling, purchasing and facility costs and expenses. For the three months
ended March 31, 2005, these expenses were 48% lower than 2004, and
represented approximately 5% of 2004 equipment sales revenues, compared to
7% of 2004 equipment sales revenues. The reduction in other cost of
revenues primarily resulted from lower personnel levels as well as lower
facility costs and expenses.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses
for the three months ended March 31, 2005 were $1,384,000, up $174,000 or
14% from the comparable 2004 period. SG&A expenses for the three months
ended March 31, 2005 were 57% of revenues, compared to 36% of revenues in
2004. Virtually all of the increase was attributable to increased
personnel levels and to expenses associated with the termination of the
BACC credit facility. 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 March 2005,
the Company's direct sales force was increased by 83% from March 2004. 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, which included a $68,000 early termination fee, and the
write-off of the remaining balance of its annual loan commitment fee with
BACC.
13
We expect our SG&A expenses to increase as we complete the build out
of our executive management and sales team; however we will continue the
close monitoring of our expense levels going forward into 2005 and expect
that our SG&A expenses will decline as a percent of revenues by the end of
2005.
Interest Expense and Other Income. Interest expense for the three
months ended March 31, 2005 was $8,000, compared with $6,000 for 2004. The
increase was attributable to higher average borrowing levels and higher
borrowing rates. Other income for both periods presented consisted of
interest earned on invested cash.
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 $1,320,000 at March 31, 2005, a decrease of $816,000 or 38% from
$2,136,000 at December 31, 2004. The working capital ratio was 1.6 to 1 at
March 31, 2005, compared to 2.4 to 1 at December 31, 2004. Operating
activities provided $74,000 during 2005, compared to the use of $773,000 in
the comparable 2004 period. Net cash provided by operating activities in
2005 consisted of a net loss of $639,000 less non-cash items of $76,000,
and net cash generated by changes in operating assets and liabilities of
$637,000. Net cash generated by changes in operating assets and
liabilities was primarily attributable to an increase in accounts payable
as we lengthened our vendor payment cycles in response to reduced
availability under our credit facility with Business Alliance Capital
Corporation ("BACC") and lower sales than anticipated during January and
February 2005.
Investing activities used $3,000 during 2005, compared to $12,000 in
2004. Net cash used by investing activities in 2005 and 2004 consisted of
capital expenditures. Capital expenditure requirements during the quarter
ended March 31, 2005 were principally for computer equipment to support our
expanded personnel levels, which were largely financed through capital
leases. There are currently no material commitments for capital
expenditures, although we will continue to purchase computer equipment as
we continue the expansion of our sales force. 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 used $41,000 during 2005 principally from net
repayments under our revolving credit line. On March 31, 2005, we
terminated our $1.7 million revolving credit facility with BACC, repaying
the outstanding balance on April 1, 2005. The average and highest amounts
borrowed under the BACC facility during the three months year ended March
31, 2005 were approximately $223,000 and $447,000, respectively. On March
31, 2005, we entered into a financing transaction with Laurus Master Fund,
Ltd., ("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, and they provided us
with a calculated initial availability of approximately $950,000 after the
funding of the initial $500,000 minimum borrowing note. Refer to Note 7,
"Debt Obligations", 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. 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.
14
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
15
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.
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 11, 2005 /s/ Jean-Marc Stiegemeier
------------------------------------
Jean-Marc Stiegemeier
Chief Executive Officer & President
Dated: May 11, 2005 /s/ Robert G. LaVigne
------------------------------------
Robert G. LaVigne
Executive Vice President, Chief
Financial Officer
16