UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q/A
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the quarterly period ended September 30, 2005
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number: 001-12155
Farmstead Telephone Group, Inc.
-------------------------------
(Exact name of registrant as specified in its charter)
Delaware 06-1205743
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
22 Prestige Park Circle
East Hartford, CT 06108
(Address of principal executive offices) (Zip Code)
(860) 610-6000
(Registrant's telephone number)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of October 27, 2005, the registrant had 3,747,132 shares of its $0.001
par value Common Stock outstanding.
EXPLANATORY NOTE:
-----------------
This Form 10-Q/A to the Company's Quarterly Report on Form 10-Q for
the quarterly period ended September 30, 2005, initially filed with the
Securities and Exchange Commission on November 14, 2005, amends Part I,
Items 1 and 2 for the three and nine months ended September 30, 2005. This
Form 10-Q/A continues to reflect circumstances as of the date of the
original filing of the Quarterly Report on Form 10-Q for the quarterly
period ended September 30, 2005 and we have not updated the disclosures
contained herein to reflect events that occurred at a later date, except
for items related to the restatement or where otherwise indicated.
The accompanying consolidated financial statements as of September
30, 2005, and for the three and nine months ended September 30, 2005, have
been restated to correct an error pertaining to the accounting for warrants
and outstanding borrowings under convertible notes issued to the Laurus
Master Fund Ltd. ("Laurus") in connection with a three-year Secured
Revolving Note agreement dated March 31, 2005. See a more detailed
discussion of the restatement in Item 1, Note 1- "Restatement" to the Notes
to Consolidated Financial Statements.
We have filed amended reports on Form 10-Q/A for the quarterly
periods ended March 31, 2005 and June 30, 2005 which reflect the
corrections in the accounting for convertible notes and warrants issued to
Laurus during 2005. The consolidated financial statements for the years
ended December 31, 2005, 2004 and 2003 included in our Annual Report on
Form 10-K for the year ended December 31, 2005 should be relied upon.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Page
----
ITEM 1. FINANCIAL STATEMENTS (Unaudited)
Consolidated Balance Sheets - September 30, 2005 and December 31, 2004 3
Consolidated Statements of Operations - For the Three and Nine Months
Ended September 30, 2005 and 2004 4
Consolidated Statement of Changes in Stockholders' Equity (Deficiency) -
For the Nine Months Ended September 30, 2005 5
Consolidated Statements of Cash Flows - For the Nine Months Ended
September 30, 2005 and 2004 6
Notes to Consolidated Financial Statements 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 17
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 26
ITEM 4. CONTROLS AND PROCEDURES 26
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 26
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 26
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 26
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 26
ITEM 5. OTHER INFORMATION 27
ITEM 6. EXHIBITS 27
SIGNATURES 27
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(In thousands) 2005 2004
--------------------------------------------------------------------------------------------------
(Unaudited)
(As Restated)
ASSETS
Current assets:
Cash and cash equivalents $ 186 $ 217
Accounts receivable, net 3,598 1,453
Inventories, net 1,345 1,627
Other current assets 108 378
------------------------------------------------------------------------------------------------
Total Current Assets 5,237 3,675
------------------------------------------------------------------------------------------------
Property and equipment, net 563 268
Deferred financing costs (Note 6) 560 -
Other assets 107 107
------------------------------------------------------------------------------------------------
Total Assets $ 6,467 $ 4,050
================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
Current liabilities:
Accounts payable $ 3,123 $ 1,110
Accrued expenses and other current liabilities 410 242
Current portion of convertible debt, net of unamortized
discount of $592 (Note 6) 26 -
Revolving credit facility note (Note 6) - 179
Derivative financial instruments (Note 7) 762 -
Current portion of long-term debt (Note 8) 30 8
------------------------------------------------------------------------------------------------
Total Current Liabilities 4,351 1,539
------------------------------------------------------------------------------------------------
Postretirement benefit obligation 688 593
Convertible debt, net of unamortized discount of $494 (Note 6) 6
Derivative financial instruments (Note 7) 2,130 -
Long-term debt (Note 8) 56 39
------------------------------------------------------------------------------------------------
Total Liabilities 7,231 2,171
------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 12)
Stockholders' Equity (Deficiency):
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;
3,747,132 and 3,322,182 shares issued and outstanding at
September 30, 2005 and December 31, 2004, respectively 4 3
Additional paid-in capital 13,148 12,320
Accumulated deficit (13,898) (10,420)
Accumulated other comprehensive loss (18) (24)
------------------------------------------------------------------------------------------------
Total Stockholders' Equity (Deficiency) (764) 1,879
------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity (Deficiency) $ 6,467 $ 4,050
================================================================================================
See accompanying notes to consolidated financial statements.
3
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) 2005 2004 2005 2004
------------------------------------------------------------------------------------------
(As Restated) (As Restated)
Revenues:
Equipment $ 3,890 $2,967 $ 9,578 $8,473
Services and other revenue 917 371 2,121 1,160
------------------------------------------------------------------------------------------
Total revenues 4,807 3,338 11,699 9,633
Cost of Revenues:
Equipment 2,887 2,164 6,901 6,180
Services and other revenue 573 257 1,128 718
Other cost of revenues 108 113 341 450
------------------------------------------------------------------------------------------
Total cost of revenues 3,568 2,534 8,370 7,348
------------------------------------------------------------------------------------------
Gross profit 1,239 804 3,329 2,285
Selling, general and administrative expenses 1,885 980 5,033 3,200
------------------------------------------------------------------------------------------
Operating loss (646) (176) (1,704) (915)
------------------------------------------------------------------------------------------
Other income (expense):
Interest expense (Note 17) (55) (7) (111) (19)
Derivative instrument expense (1,949) - (1,662) -
Other Income 3 2 7 4
------------------------------------------------------------------------------------------
Total other income (expense) (2,001) (5) (1,766) (15)
------------------------------------------------------------------------------------------
Loss before income taxes (2,647) (181) (3,470) (930)
Provision (benefit) for income taxes 1 (6) 8 -
------------------------------------------------------------------------------------------
Net loss (2,648) $ (175) (3,478) $ (930)
==========================================================================================
Basic and diluted net loss per common share: $ (.75) $ (.05) $ (1.02) $ (.28)
Weighted average common shares outstanding:
Basic and diluted 3,511 3,317 3,398 3,315
==========================================================================================
See accompanying notes to consolidated financial statements.
4
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIENCY)
(UNAUDITED)
For the Nine Months ended September 30, 2005 (As Restated)
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 - - - (3,478) - (3,478)
Amortization of pension liability
adjustment - - - - 6 6
-------
Comprehensive loss (3,472)
Common stock issued upon conversion
of Laurus debt 325 1 731 - - 732
Common stock issued upon exercise of
stock options 55 - 67 - - 67
Common stock issued under employee
stock purchase plan 45 - 30 - - 30
--------------------------------------------------------------------------------------------------------------
Balance at September 30, 2005 3,747 $4 $13,148 $(13,898) $(18) $ (764)
==============================================================================================================
See accompanying notes to consolidated financial statements.
5
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Nine Months Ended September 30, 2005 and 2004
(In thousands) 2005 2004
-----------------------------------------------------------------------------------------
(As Restated)
Cash flows from operating activities:
Net loss $(3,478) $(930)
Adjustments to reconcile net loss to net cash flows
used in operating activities:
Provision for doubtful accounts receivable 27 24
Provision for losses on inventories 30 82
Depreciation and amortization of property and equipment 81 111
Amortization of deferred financing costs 47 -
Amortization of discount on convertible debt 43 -
Derivative instrument expense 1,662
Decrease in accumulated other comprehensive loss 6 6
Changes in operating assets and liabilities:
Increase in accounts receivable (2,172) (623)
Decrease in inventories 252 47
Decrease in other assets 270 61
Increase in accounts payable 2,013 106
Increase in accrued postretirement benefit obligation 95 85
Increase in accrued expenses and other current liabilities 166 125
----------------------------------------------------------------------------------------
Net cash used in operating activities (958) (906)
----------------------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment (320) (25)
----------------------------------------------------------------------------------------
Net cash used in investing activities (320) (25)
----------------------------------------------------------------------------------------
Cash flows from financing activities:
(Repayments) borrowings under BACC credit facility (179) 211
Borrowings under convertible debt facility 1,618 -
Deferred financing costs (272) -
Borrowing against cash value of insurance policy - 275
Proceeds from exercise of stock options and employee
stock purchases 97 4
Repayments of long-term debt and capital lease obligations (17) -
----------------------------------------------------------------------------------------
Net cash provided by financing activities 1,247 490
----------------------------------------------------------------------------------------
Net decrease in cash and cash equivalents (31) (441)
Cash and cash equivalents at beginning of period 217 827
----------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 186 $ 386
========================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 46 $ 20
Income taxes 2 4
Non-cash financing and investing activities:
Purchase of equipment under capital lease 56 -
Common stock issued on conversion of debt 732 -
Discounts on warrants issued to Laurus 335
Discounts on issuance of convertible debt 1,094 -
See accompanying notes to consolidated financial statements.
6
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION, BUSINESS OPERATIONS, AND SIGNIFICANT ACCOUNTING
POLICIES
The consolidated financial statements presented herein consist of the
accounts of Farmstead Telephone Group, Inc. and its wholly-owned
subsidiaries. The accompanying consolidated financial statements as of
September 30, 2005 and for the three and nine months ended September 30,
2005 and 2004 have been prepared in accordance with accounting principles
generally accepted in the United States of America and the rules and
regulations of the Securities and Exchange Commission for interim financial
statements. In the Company's opinion, the unaudited interim consolidated
financial statements and accompanying notes reflect all adjustments,
consisting of normal and recurring adjustments that are necessary for a
fair statement of 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. This Form 10-Q/A
should be read in conjunction with the consolidated financial statements
and notes thereto included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2004.
Restatement
The accompanying consolidated financial statements as of September
30, 2005 and for the three and nine months ended September 30, 2005 (the
"2005 Financial Statements") have been restated to correct an error
pertaining to the accounting for warrants and outstanding borrowings under
convertible notes issued to the Laurus Master Fund Ltd. ("Laurus") in
connection with a three-year Secured Revolving Note agreement dated March
31, 2005. Specifically, the Company has adjusted its 2005 Financial
Statements in order to apply the accounting methodology required under EITF
Issue 00-19, "Accounting for Derivative Financial Instruments Indexed to,
and Potentially Settled in, a Company's Own Stock". Applying this
methodology resulted in the recording of derivative financial instrument
liabilities attributable to borrowings under the credit agreement and to
the freestanding warrants issued to Laurus, and non-cash derivative
instrument expense of $1,949,000 and $1,662,000 for the three and nine
months ended September 30, 2005, respectively. The effect of the foregoing
on the 2005 Financial Statements is as follows (in thousands, except per
share amounts):
Consolidated Balance Sheet: September 30, 2005
----------------------
As
Previously As
Reported Restated
---------- --------
Total assets $6,291 $6,467
Total liabilities 4,939 7,231
Stockholders' equity (deficiency) 1,352 (764)
----------------------------------------------------------
Consolidated Results of Operations: Three Months Ended Nine Months Ended
September 30, 2005 September 30, 2005
---------------------- ----------------------
As As
Previously As Previously As
Reported Restated Reported Restated
------------------------------------------------
Operating loss $(646) $ (646) $(1,704) $(1,704)
Net loss (704) (2,648) (1,816) (3,478)
Net loss per common share:
Basic and diluted $(.20) $ (.75) $ (.53) $ (1.02)
=====================================================================================
Business Operations
As presented in the consolidated financial statements contained in
this report, the Company incurred net losses of $2,648,000 and $3,478,000
for the three and nine months ended September 30, 2005, respectively. These
results include non-cash derivative instrument expense of $1,949,000 for
the three-month period, and $1,662,000 for the nine-month period, arising
from borrowings under a three-year convertible revolving credit facility
entered into with Laurus effective March 31, 2006, and the issuance of
freestanding warrants in connection therewith, as more fully described in
Note 6 - Convertible Debt. The derivative instrument expense was primarily
attributable to increases in the calculated market value of the
7
conversion options embedded in the convertible borrowings and the free-
standing warrants since their initial valuations, resulting from increases
in the market value of the Company's common stock during the reported
periods. Excluding the non-cash derivative instrument expense, the
Company's net losses would have been $699,000 and $816,000 for the
respective three and nine months ended September 30, 2005.
In addition, the Company has incurred substantial losses in each of
the past four fiscal years. 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. By the end of September 2005, the
Company's direct sales and sales support group was significantly larger
than September 2004, and revenues for the three and nine months ended
September 30, 2005 were 44% and 21% higher than the comparable prior year
periods.
In May 2005, the Company took steps to further diversify its product
offerings, forming a wholly-owned subsidiary named "One IP Voice" which,
when operational, will offer carrier-based hosted IP telephony services
along with network services. Its primary target will be the SMB ("small-to-
medium sized business") market.
In order to finance its business expansion plans, effective March 31,
2005 the Company entered into a $3 million credit arrangement with Laurus,
replacing a $1.7 million credit facility with Business Alliance Capital
Corporation. For additional information, refer to Note 6 - Convertible Debt
contained herein. Additionally, in October 2005, the Company engaged the
services of an investment banking firm, and intends to raise additional
capital through one or a series of private offerings of securities, as more
fully described in Note 16 - Subsequent Events, contained herein.
Significant Accounting Policies
Derivative financial instruments
We do not use derivative instruments to hedge exposures to cash flow,
market, or foreign currency risks.
We review the terms of convertible debt and equity instruments we
issue to determine whether there are embedded derivative instruments,
including the embedded conversion option, that are required to be
bifurcated and accounted for separately as a derivative financial
instrument. In circumstances where the convertible instrument contains more
than one embedded derivative instrument, including the conversion option,
that is required to be bifurcated, the bifurcated derivative instruments
are accounted for as a single, compound derivative instrument. Also, in
connection with the sale of convertible debt and equity instruments, we may
issue freestanding warrants that may, depending on their terms, be
accounted for as derivative instrument liabilities, rather than as equity.
We may also issue options or warrants to non-employees in connection with
consulting or other services they provide.
Certain instruments, including convertible debt and equity
instruments and the freestanding options and warrants issued in connection
with those convertible instruments, may be subject to registration rights
agreements, which impose penalties for failure to register the underlying
common stock by a defined date. The existence of the potential cash
penalties under the related registration rights agreement requires that the
embedded conversion option be accounted for as a derivative instrument
liability. Similarly, the potential cash penalties under the related
registration rights agreement may require us to account for the
freestanding options and warrants as derivative financial instrument
liabilities, rather than as equity. In addition, when the ability to
physical or net-share settle the conversion option or the exercise of the
freestanding options or warrants is deemed to not be within the control of
the Company, the embedded conversion option or freestanding options or
warrants may be required to be accounted for as a derivative financial
instrument liability.
Derivative financial instruments are measured at their fair value.
For derivative financial instruments that are accounted for as liabilities,
the derivative instrument is initially recorded at its fair value and is
then revalued at each reporting date, with changes in the fair value
reported as charges or credits to income. For option-based derivative
financial instruments, we use the Black-Scholes option pricing model to
value the derivative instruments. When the convertible debt or equity
instruments contain embedded derivative instruments that are to be
bifurcated and accounted for as liabilities, the total proceeds allocated
to the convertible host instruments are first allocated to the fair value
of all the bifurcated derivative instruments. The remaining proceeds, if
any, are then allocated to the convertible instruments themselves, usually
resulting in those instruments being recorded at a discount from their face
amount.
To the extent that the fair values of any freestanding and/or
bifurcated derivative instrument liabilities exceed the total proceeds
received, an immediate charge to income is recognized, in order to
initially record the derivative instrument liabilities at their fair value.
The discount from the face value of the convertible debt, together with the
stated interest on the
8
instrument, is amortized over the life of the instrument through periodic
charges to income, usually using the effective interest method.
The classification of derivative instruments, including whether such
instruments should be recorded as liabilities or as equity, is reassessed
periodically, including at the end of each reporting period. If
reclassification is required, the fair value of the derivative instrument,
as of the determination date, is reclassified. Any previous charges or
credits to income for changes in the fair value of the derivative
instrument are not reversed. Derivative instrument liabilities are
classified in the balance sheet as current or non-current based on whether
or not net-cash settlement of the derivative instrument could be required
within 12 months of the balance sheet date.
2. RECLASSIFICATIONS
Certain amounts in the prior year's financial statements have been
reclassified to conform to the 2005 presentation.
3. ACCOUNTS RECEIVABLE, NET
September 30, December 31,
(In thousands) 2005 2004
-----------------------------------------------------------------------
Trade accounts receivable $3,246 $1,379
Less: allowance for doubtful accounts (87) (60)
-----------------------------------------------------------------------
Trade accounts receivable, net 3,159 1,319
Other receivables 439 134
-----------------------------------------------------------------------
Accounts receivable, net $3,598 $1,453
=======================================================================
Other receivables primarily consist of commissions, rebates and other
dealer incentives due from Avaya and are recorded in the consolidated
financial statements when earned.
4. INVENTORIES, NET
September 30, December 31,
(In thousands) 2005 2004
------------------------------------------------------------------------------------
Finished goods and spare parts $1,167 $1,341
Work in process * 244 352
Rental equipment 12 52
------------------------------------------------------------------------------------
1,423 1,745
Less: reserves for excess and obsolete inventories (78) (118)
------------------------------------------------------------------------------------
Inventories, net $1,345 $1,627
====================================================================================
* Consists of used equipment requiring repair or refurbishing.
5. PROPERTY AND EQUIPMENT, NET
Estimated
Useful Lives September 30, December 31,
(In thousands) (Yrs.) 2005 2004
------------------------------------------------------------------------------------------------
Computer and office equipment 3 - 5 $ 1,062 $ 1,071
IP network equipment and licenses 5 301 -
Furniture and fixtures 5 - 10 288 288
Leasehold improvements 10 171 171
Capitalized software development costs 5 98 98
Automobile 5 50 50
Leased equipment under capital lease * 3 56 -
------------------------------------------------------------------------------------------------
2,026 1,678
Less: accumulated depreciation and amortization (1,463) (1,410)
------------------------------------------------------------------------------------------------
Property and equipment, net $ 563 $ 268
================================================================================================
* Consists of computer equipment.
9
6. CONVERTIBLE DEBT
September 30, December 31,
(In thousands) 2005 2004
---------------------------------------------------------------------------------------
Borrowing under secured revolving credit facility note $ 618 $ -
Secured convertible Minimum Borrowing Note 500 -
Less: unamortized discount attributable to the
revolving credit facility note (592) -
Less: unamortized discount attributable to the
Minimum Borrowing Note (494) -
---------------------------------------------------------------------------------------
Convertible Debt, net of unamortized discounts 32
Less: current portion (26)
---------------------------------------------------------------------------------------
Convertible Debt, net of unamortized discounts $ 6 $ -
=======================================================================================
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. 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 to time. The Company also issued Laurus a five-year warrant (the
"Warrant") to purchase an aggregate of 500,000 shares of common stock of
the Company at an exercise price of $1.82 per share. The warrant exercise
price was set at 130% of the average closing price of the Company's common
stock over the ten trading days preceding the execution of the agreement,
and is subject to anti-dilution protection adjustments. This transaction
was completed in a private offering pursuant to an exemption from
registration under Section 4(2) of the Securities Act of 1933, as amended.
The following describes certain of the material terms of the
financing transaction with Laurus. The description below is not a complete
description of the material terms of the financing transaction and is
qualified in its entirety by reference to the agreements entered into in
connection with the financing which were included as exhibits to the
Company's Annual Report on Form 10-K for the year ended December 31, 2004:
Principal Borrowing Terms and Prepayment: Borrowings are advanced
pursuant to a formula consisting of (i) 90% of eligible accounts
receivable, as defined (primarily receivables that are less than 90 days
old), and (ii) 30% of eligible inventory, as defined (primarily inventory
classified as "finished goods"), up to a maximum inventory advance of
$600,000, less any reserves required by Laurus. Interest on the outstanding
borrowings is charged at the per annum rate of two percentage points (2%)
above the prime rate, but not less than 6%. The interest rate charged,
however, will be decreased by 2% (or 200 basis points) for every 25%
increase in the market price of the Company's common stock above the fixed
conversion price, down to a minimum interest charge of 0.0%. The Company
will additionally be charged a fee equal to 0.25% of the unused portion of
the facility. Should the Company terminate the financing agreement with
Laurus prior to the maturity date, the Company will incur an early payment
fee equal to 4%, 3% and 2% of the Capital Availability Amount if terminated
in the first, second or third year, respectively, of the term.
Security and Events of Default. Borrowings under the Laurus Notes are
secured by a lien on substantially all of the Company's assets. The
Security Agreement contains no specific financial covenants; however, it
defines certain circumstances under which the agreement can be declared in
default and subject to termination, including among others if (i) there is
a material adverse change in the Company's business or financial condition;
(ii) an insolvency proceeding is commenced; (iii) the Company defaults on
any of its material agreements with third parties or there are material
liens or attachments levied against the Company's assets; (iv) the
Company's common stock ceases to be publicly traded; and (v) the Company
fails to comply with the terms, representations and conditions of the
agreement. Upon the occurrence of an Event of Default, the interest rate
charged will be increased by 1-1/2 % per month until the default is cured;
should the default continue beyond any applicable grace period, Laurus
could require the Company to repay 120% of any principal and interest
outstanding under the agreement.
Conversion Rights and Limitation. All or a portion of the outstanding
principal and interest due under the Laurus Notes may be converted, at the
option of the Holder, into shares of the Company's common stock, at the
Fixed Conversion Price ("FCP") of $1.54. The FCP was originally set at 110%
of the average closing price of the Company's common stock over the ten
trading days preceding the execution of the agreement, and is subject to
anti-dilution protection adjustments. The
10
FCP will be reset once $1.5 million of debt has been converted. The Laurus
Notes contain a mandatory conversion feature such that, if the average
closing price of the common stock as reported by Bloomberg, L.P. on the
Principal Market for five (5) consecutive trading days in any calendar
month shall be greater than 115% of the FCP, the Holder shall convert into
shares of common stock such portion of the principal amount outstanding
under any Minimum Borrowing Note (together with accrued interest and fees
in respect thereof) on such date equal to ten percent (10%) of the
aggregate dollar trading volume of the common stock for the period of
twenty-two (22) trading days preceding the date of the mandatory
conversion. The Holder shall not be required under any circumstances to
make more than one (1) mandatory conversion in any calendar month. By
agreement between the parties, Laurus will not own greater than 4.99% of
the outstanding shares of the Company's common stock except that (i) upon
the occurrence and during the continuance of an Event of Default, or (ii)
upon 75 days prior notice to the Company, their ownership could increase to
19.99%. Upon receipt of a conversion notice from the Holder, the Company
can elect to pay cash to the Holder in lieu of issuing shares of common
stock, at a price per share equal to the intraday high price of the stock.
Registration Rights. Pursuant to the terms of a Registration Rights
Agreement, the Company is obligated to file and obtain effectiveness for a
registration statement registering the resale of shares of the Company's
common stock issuable upon conversion of the Laurus Notes and the exercise
of the Warrant. If the registration statement is not timely filed, or
declared effective the Company will be subject to certain penalties. On
June 24, 2005, the Company completed the registration of the common stock
issuable upon conversion of the initial Minimum Borrowing Note and the
Warrant. On October 11, 2005, the Company completed the registration of the
common stock issuable upon conversion of the second Minimum Borrowing Note.
During the three months ended September 30, 2005, the initial
$500,000 Minimum Borrowing Note was fully converted to 324,675 shares of
common stock, resulting in a $732,000 credit to Additional Paid-in Capital
consisting of a $210,000 net carrying value converted and $522,000 of
extinguished derivative liability.
As of September 30, 2005, the amount of available borrowings under
the Laurus credit facility, pursuant to borrowing formulas, was as follows
(in thousands):
Available borrowings supported by collateral base $2,690
Less: amount borrowed under revolving credit facility (618)
Less: amount borrowed under Minimum Borrowing Note (500)
------
Available to borrow $1,572
======
The average and highest amounts borrowed under the Laurus credit
facility during the three months ended September 30, 2005 were
approximately $1,124,000 and $1,606,000, respectively. The average and
highest amounts borrowed under all credit facilities during the nine months
ended September 30, 2005 were approximately $721,000 and $1,640,000,
respectively. The Company was in compliance with the provisions of its loan
agreement as of September 30, 2005.
Since the secured convertible notes are not considered to be
conventional convertible debt, the embedded conversion option in the
secured convertible notes is subject to the requirements of EITF Issue 00-
19. The Company is also required to bifurcate the embedded conversion
option and account for it as a derivative instrument liability because of
the potential penalties that we may have to pay Laurus under the
Registration Rights Agreement, together with the fact that the conversion
price of the debt can be adjusted if we issue common stock at a lower
price. In addition, other embedded derivative instruments in the secured
convertible notes, including the interest rate reset feature and Laurus'
right to put the debt back to us with a 20% premium upon certain Events of
Default, were considered in determining the derivative instrument to
bifurcate and account for. This derivative instrument liability was
initially recorded at its fair value and is then adjusted to fair value at
the end of each subsequent period, with any changes in the fair value
charged or credited to income in the period of change. The most significant
component of this compound derivative instrument is the embedded conversion
option, which is revalued using the Black-Scholes option pricing model.
The proceeds received from Laurus under the two Minimum Borrowing
Notes ("MBNs") issued during 2005 were first allocated to the fair value of
the bifurcated embedded derivative instruments included in the convertible
notes, with the remaining proceeds allocated to the MBN, resulting in these
notes being recorded at a significant discount from their face amounts.
This discount, together with the stated interest on the MBN, is being
amortized using an effective interest method over the term of the MBN.
Since there are frequent borrowings and repayments under the revolving
note, the value of the embedded derivative instruments is calculated upon
advances, and the discount is recognized as the advances are repaid, with
the stated interest recognized currently.
11
The 500,000 warrants issued to Laurus were initially valued at
$335,000, using the Black-Scholes option pricing model and the following
assumptions: market price - $1.31; exercise price - $1.82; expected term -
5 years; volatility - 65%; interest rate - 4.18%; and dividends - 0. Since
there are potential penalties that we may have to pay Laurus under the
Registration Rights Agreement, the warrants have been recorded as a
derivative instrument liability, rather than as equity. This derivative
instrument liability is adjusted to fair value (using the Black-Scholes
option pricing model) at the end of each subsequent reporting period, and
any changes in the fair value are charged or credited to income in the
period of change. Since the nature of the Laurus credit facility is
revolving, with continuous advances and repayments expected over its term,
and with an indeterminate amount of Minimum Borrowing Notes which can be
created and converted, it is not practical to allocate the warrant value to
the initial proceeds of the borrowings under the facility to any one
Minimum Borrowing Note. As such, the initial valuation of $335,000 has been
recorded as a deferred financing cost, and is being amortized to expense
over the term of the facility using an effective interest method. As of
September 30, 2005, the unamortized balance was $331,000.
In connection with the Laurus credit facility, the Company also paid
Laurus a $117,000 prepaid facility fee, and incurred other placement fees
and expenses totaling $155,000. These amounts, aggregating $272,000, have
also been recorded as deferred financing costs on the balance sheet, and as
of September 30, 2005 the unamortized balance was $229,000. The facility
fee is being amortized to interest expense on a straight-line basis over
the term of the facility, while the other fees and expenses are being
amortized to SG&A expense on a straight-line basis over the term of the
facility.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The following derivative liabilities related to warrants and embedded
derivative instruments were outstanding as of September 30, 2005 (in
thousands). There were no such instruments or derivative liabilities
outstanding as of December 31, 2004.
Issue Expiration Value- Value-
Instrument: Date Date Issue date 9/30/05
----------------------------------------------------------------------------------------------------
Laurus Minimum Borrowing Note (Note 6) 4/4/2005 3/31/2008 $323 $ -
Laurus Minimum Borrowing Note (Note 6) 9/2/2005 3/31/2008 773 911
9/21/2005-
Laurus Revolving Note (Note 6) 9/30/2005 3/31/2008 594 762
----------------------------------------------------------------------------------------------------
Fair value of bifurcated embedded derivative
instrument liabilities 1,673
500,000 common stock warrants issued to
Laurus (Note 6) 3/31/2005 3/31/2010 335 1,219
----------------------------------------------------------------------------------------------------
Total derivative financial instruments 2,892
Less: amount attributable to the Laurus Revolving
Note, reported in current liabilities (762)
----------------------------------------------------------------------------------------------------
Derivative financial instruments recorded in
non-current liabilities $2,130
====================================================================================================
The Company uses the Black-Scholes option pricing model to value
warrants, and the embedded conversion option components of any bifurcated
embedded derivative instruments that are recorded as derivative
liabilities. See Note 6 - Convertible Debt. In valuing the warrants and the
embedded conversion option components of the bifurcated embedded derivative
instruments, at the time they were issued and at September 30, 2005, we
used the following assumptions: market price of our common stock on the
date of valuation; an expected dividend yield of 0%; an expected life equal
to either the remaining period to the expiration date of the warrants or
maturity date of the convertible debt instruments; expected volatility of
65%; and a risk-free rate of return ranging from 3.79-4.18%, based on
constant maturity rates published by the U.S. Federal Reserve, applicable
to the remaining life of the instruments.
12
8. LONG-TERM DEBT
September 30, December 31,
(In thousands) 2005 2004
--------------------------------------------------------------------
Installment purchase note $ 42 $47
Obligations under capital lease 44 -
--------------------------------------------------------------------
86 47
Less: debt maturing within one year (30) (8)
--------------------------------------------------------------------
Long-term debt obligations $ 56 $39
====================================================================
Installment Purchase Note:
--------------------------
The Company is financing an automobile through a $50,056, 3.75% note
payable to a finance company. The note is payable in 38 monthly
installments of $799, with a final payment of $24,236 on January 7, 2008.
The note balance at September 30, 2005 was $41,903, of which $8,154 was
classified under debt maturing within one year.
Obligations under Capital Lease:
--------------------------------
During 2005, the Company entered into non-cancelable lease agreements
to finance $56,000 of computer equipment with payment terms ranging from 24
to 36 months. Monthly lease payments aggregate $1,984 and the agreements
contain a $1.00 purchase option at the end of the lease term. The effective
interest rate on the lease obligations is 10.38 to 10.5%. The principal
balance of these obligations at September 30, 2005 was $43,855, of which
$21,681 was classified under debt maturing within one year.
9. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
September 30, December 31,
(In thousands) 2005 2004
-------------------------------------------------------------------------------
Salaries, commissions and benefits $316 $167
Other 94 75
-------------------------------------------------------------------------------
Accrued expenses and other current liabilities $410 $242
===============================================================================
10. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 123 (revised 2004)"), revising FASB
Statement 123, "Accounting for Stock-Based Compensation" and superseding
APB Opinion No. 25, "Accounting for Stock Issued to Employees,". This
Statement establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services,
focusing primarily on transactions in which an entity obtains employee
services in share-based payment transactions. SFAS No. 123 (revised 2004)
requires a public entity to measure the cost of employee services received
in exchange for an award of equity instruments based on the grant-date fair
value of the award (with limited exceptions). That cost will be recognized
over the period during which an employee is required to provide service in
exchange for the award. Accounting for share-based compensation
transactions using the intrinsic method supplemented by pro forma
disclosures will no longer be permissible. This statement is effective as
of the beginning of the first interim or annual reporting period that
begins after December 15, 2005 and the Company will adopt the standard in
the first quarter of fiscal 2006. The adoption of this standard will have
an impact on the Company's results of operations as it will be required to
expense the fair value of all share based payments; 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" ("SFAS No. 151"). This statement
clarifies the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage). It also requires
that these items be recognized as current-period charges regardless of
whether they meet the criterion of "so abnormal". This statement also
clarifies the circumstances under which fixed overhead costs associated
with operating facilities involved in inventory processing should be
capitalized. The provisions of SFAS No. 151 are effective for fiscal years
beginning after June 15, 2005 and the Company will be required to adopt
this standard in its 2006 fiscal year. The Company has not determined the
impact, if any, that this statement will have on its consolidated financial
position or results of operations.
13
11. STOCK OPTIONS
The Company applies the disclosure only provisions of Financial
Accounting Standards Board Statement ("SFAS") No. 123, "Accounting for
Stock-based Compensation" ("SFAS 123") and SFAS No. 148, "Accounting for
Stock-based Compensation - Transition and Disclosure" ("SFAS 148") for
employee stock option and warrant awards. Had compensation cost for the
Company's stock option plan and issued warrants been determined in
accordance with the fair value-based method prescribed under SFAS 123, the
Company's net loss and basic and diluted net loss per share would have
approximated the pro forma amounts indicated below (in thousands except per
share amounts):
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2005 2004 2005 2004
--------------------------------------------------------------------------------------------
Net loss, as reported $(2,648) $(175) $(3,478) $(930)
Add: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (202) (10) (441) (38)
--------------------------------------------------------------------------------------------
Pro forma net loss $(2,850) $(185) $(3,919) $(968)
Pro forma net loss per share:
Basic and diluted $ (.81) $(.06) $ (1.15) $(.29)
============================================================================================
The weighted-average fair value of options granted during the three
and nine months ended September 30, 2005 was $1.04 and $.80, respectively,
compared to $.13 and $.24, respectively, for the three and nine months
ended September 30, 2004. The fair value of stock options used to compute
pro forma net loss and net loss per share disclosures was estimated on the
date of grant using the Black-Scholes option-pricing model with the
following weighted average assumptions: dividend yield of 0% for 2005 and
2004; expected volatility of 55% for 2005 and 50% for 2004; average risk-
free interest rate of 3.8% -4.2% for 2005 and 3.1-3.3 % for 2004; and an
expected option holding period of 3.5 years for 2005 and 2004.
12. COMMITMENTS AND CONTINGENCIES
Employment agreements:
On January 15, 2005 the Company hired Mr. Alfred G. Stein to the
position of Executive Vice President. From September 13, 2004 to his date
of hire, Mr. Stein was a consultant to the Company, assisting management in
the development of a strategic re-direction of the Company's sales
organization and product offerings, for which he earned $40,000 in
consulting fees. Mr. Stein has an employment agreement expiring December
31, 2007 which includes the following key provisions: (i) an annual base
salary of $175,000, (ii) an annual bonus of up to 100% of base salary based
upon the attainment of a Board-approved annual business plan which includes
revenue and operating profit targets and (iii) the grant of a five-year
warrant to purchase up to 250,000 shares of common stock at an exercise
price of $0.67 per share, which was equal to the closing price of the
common stock on his date of hire. The Company registered 150,000 shares
underlying the warrant, and has agreed to register the remaining 100,000
shares by January 15, 2007.
On March 1, 2005, the Company hired Mr. Nevelle R. Johnson to the
position of Executive Vice President. Mr. Johnson's responsibilities
include management of the Company's national sales organization, as well as
the development of new product and service offerings. Mr. Johnson has an
employment agreement expiring December 31, 2008 which includes the
following key provisions: (i) an initial annual base salary of $200,000;
(ii) an annual bonus of up to 50% of base salary based upon attaining
earnings targets approved by the Board of Directors; (iii) the grant of a
five-year warrant to purchase up to 250,000 shares of common stock at an
exercise price of $1.10 per share, which was equal to the closing price of
the common stock on his date of hire; and (iv) payment by the Company of
life insurance premiums not exceeding $5,000 per month, provided that the
Company attains at least 75% of targeted earnings. The Company registered
100,000 of the shares underlying the warrant, and has agreed to register an
additional 100,000 shares by March 1, 2007 and the remaining 50,000 shares
by March 1, 2008.
Both Mr. Stein's and Mr. Johnson's employment agreements provide
severance pay should they terminate their agreements for "good cause", as
defined, or should the Company terminate their agreements without cause, or
in the event of a change in control of the Company, as defined. Severance
pay would amount to three times the amount of the then-current base salary
and the average bonus paid during the three most recent calendar years.
These individuals would not be entitled to any severance or other
compensation if they voluntarily terminate their employment or if they are
terminated by the Company "for cause", as defined. Their agreements also
contain non-compete stipulations.
14
On October 13, 2005, the Company and Mr. Jean-Marc Stiegemeier, the
Company's Chairman, Chief Executive Officer and President executed an
agreement modifying the following terms of Mr. Stiegemeier's employment
agreement with the Company: (i) the vesting date of 300,000 of the 600,000
options granted in October 2004 was changed to October 1, 2005; and (ii)
the use of a Company-leased residential house was extended for an
additional year. In addition, Mr. Stiegemeier's Base Salary, as defined,
was increased to $500,000 per annum. These changes were approved by the
Company's Compensation Committee and the full Board of Directors, and are
effective as of October 1, 2005.
13. EMPLOYEE BENEFIT PLANS
The components of the net periodic benefit cost included in the
results of operations for the three and nine months ended September 30,
2005 and 2004 are as follows:
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
(In thousands) 2005 2004 2005 2004
Service cost $21 $20 $ 64 $60
Interest cost 12 9 32 26
Recognized actuarial losses 1 2 6 6
---------------------------------------------------------------------
Net expense $34 $31 $102 $92
=====================================================================
14. SEGMENT INFORMATION
Historically, the Company has operated in a single business segment,
selling telecommunications equipment to businesses. During 2005, the
Company commenced activities related to the development of a new business
segment which, when operational, will provide hosted carrier-based Voice
over IP products and related network services to the small-to-medium
business marketplace. The hosted VoIP business is currently in the
development stage and, accordingly, has not yet generated reportable
revenues. Summarized financial information for the Company's reportable
business segments for the three and nine months ended September 30, 2005 is
presented below. Geographic information is not presented because the
Company does not operate outside of the United States. Corporate expenses
consist primarily of compensation and benefits, costs associated with
corporate governance and compliance, investor relations, and other shared
general expenses not allocated to the business segments.
Business segment information as of and for the three months ended
September 30, 2005 is as follows:
Telecom- IP
munication Telephony
(In thousands) Equipment Services Corporate Consol.
--------------------------------------------------------------------------------
Revenues $4,807 $ - $ - $4,807
Operating loss (145) (243) (258) (646)
Depreciation and amortization 24 1 3 28
Property and equipment, net 236 301 26 563
Capital expenditures 1 301 - 302
================================================================================
Business segment information as of and for the nine months ended
September 30, 2005 is as follows:
Telecom- IP
munication Telephony
(In thousands) Equipment Services Corporate Consol.
--------------------------------------------------------------------------------
Revenues $11,699 $ - $ - $11,699
Operating loss (469) (486) (749) (1,704)
Depreciation and amortization 69 4 8 81
Property and equipment, net 236 301 26 563
Capital expenditures 19 301 - 320
================================================================================
The following table reconciles the totals reported for the operating
loss of the segments to the Company's reported loss before income taxes:
15
Three months Nine months
ended ended
(In thousands) September 30, 2005 September 30, 2005
---------------------------------------------------------------------------------
Total segment operating losses $ (388) $ (955)
Unallocated amounts:
Corporate expenses (258) (749)
Interest expense (55) (111)
Derivative instrument expense (1,949) (1,662)
Other income 3 7
---------------------------------------------------------------------------------
Consolidated loss before income taxes $(2,647) $(3,470)
=================================================================================
15. LOSS PER SHARE
Basic loss per share was computed by dividing net loss (the
numerator) by the weighted average number of shares of common stock
outstanding (the denominator) during the reporting periods. Weighted
average outstanding options and warrants to purchase 1,705,576 and 19,385
shares of common stock were not included in the computation of diluted loss
per share for the three months ended September 30, 2005 and 2004,
respectively, because their inclusion would be antidilutive. Weighted
average outstanding options and warrants to purchase 1,159,742 and 36,123
shares of common stock were not included in the computation of diluted loss
per share for the nine months ended September 30, 2005 and 2004,
respectively, because their inclusion would be antidilutive.
16. SUBSEQUENT EVENTS
On November 2, 2005 the Company filed a Notice of Special meeting and
Proxy Statement with the SEC, seeking shareholder approval on the proposed
issuance of more than 20% of the Company's outstanding shares of Common
Stock in connection with any one or series or combinations of private
offerings to investors of the Company's securities, and a secondary
offering to the public of Common Stock, in an approximate aggregate amount
in the range of $6,000,000 to $26,000,000 (exclusive of any securities
which may be sold upon exercise of any over-allotment options). In
connection therewith, on October 31, 2005 the Company entered into an
agreement with a leading New York-based investment banking firm, which has
agreed on a "best efforts" basis to immediately place private offerings
with investors, and to act as the principal underwriter on a "firm
commitment" basis for a possible secondary offering to the public of the
Company's common stock sometime in 2006. Funds raised will be primarily
used to finance the continuing buildout of One IP Voice's IP telephony
business.
On November 8, 2005, the Company received notice from the American
Stock Exchange ("AMEX") that the Company no longer complies with the AMEX's
continued listing standards due to its failure to maintain stockholders'
equity of at least $4 million, which minimum level is required due to its
history of losses in three out of its four most recent fiscal years, as set
forth in Section 1003 (a) (ii) of the AMEX Company Guide, and that its
securities are, therefore, subject to being delisted from the AMEX. The
Company was previously granted an eighteen month period to regain
compliance with this standard, and such compliance period ended as of
November 7, 2005.
The foregoing determination by the AMEX staff was made subsequent to
the Company's update and submission of the Company's plan for upcoming
private offerings of its securities to investors for which the Company had
requested a ninety (90) day extension from November 7, 2005 in order to
complete the offerings and regain compliance with the AMEX continued
listing requirements. Such update and submission to AMEX included the
Notice of the Special Meeting of the Stockholders and Proxy Statement to
approve such transactions which have been filed with the SEC as Schedule
14A on November 2, 2005, an engagement agreement dated October 31, 2005
with an investment banking firm, which agreed to be the lead placement
agent for the private offerings on a "best efforts" basis and to be the
managing underwriter for a possible secondary public offering of common
stock on a "firm-commitment" basis planned for sometime in 2006, and a
detailed timetable to consummate the private offerings and regain
compliance.
According to the AMEX notice, the Company must appeal by November 16,
2005, or the AMEX staff determination will become final. AMEX staff will
suspend trading in the Company's securities and submit an application to
the SEC to strike the Company's common stock from listing and registration
on the AMEX in accordance with the Securities Exchange Act of 1934, as
amended, and the rules promulgated thereunder.
16
The Company plans to appeal this determination by the AMEX staff and
to request a hearing before an AMEX panel (the "Panel"). The time and place
of such a hearing will be determined by the Panel. There can be no
assurance that the Panel would grant the relief sought by the Company or,
even if it does, the Company will be able to implement its plan of
compliance consistent with the relief sought. If the Panel does not grant
the relief sought by the Company, its securities would be de-listed from
the AMEX. In that event, the Company would also seek quotation of its
securities on the OTC Bulletin Board.
The Company fully intends to pursue stockholders' approval and
complete the transactions contemplated in the filed Schedule 14A. The
Company believes that the completion of the private offerings described in
the Schedule 14A will put the Company back in compliance with the AMEX
continued listing requirement for stockholders' equity. If the Company is
able to regain compliance anytime between now and the hearing with AMEX
staff, the de-listing process would be withdrawn. The contemplated private
and secondary public offerings are also intended to raise additional
capital for the Company to use in the continuing buildout of its One IP
Voice, Inc. IP telephony business.
The Company disclosed its previous AMEX notice and circumstances
relating to its current listing deficiency in its previous filings with the
SEC starting with Current Report on Form 8-K filed with the SEC on July 23,
2004 and last disclosed on the Proxy Statement on Schedule 14A filed with
the SEC on November 2, 2005.
17. INTEREST EXPENSE
Interest expense for the three and nine months ended September 30,
2005 and 2004 consisted of the following:
Three months ended Nine months ended
(In thousands) September 30 September 30
---------------------------------------------------------------------------------------------
2005 2004 2005 2004
---- ---- ---- ----
Interest expense on outstanding borrowings $19 $7 $ 44 $19
Amortization of deferred financing costs (1) 11 - 23 -
Amortization of discounts on convertible notes (2) 25 - 44 -
-------------------------------------------------------------------------------------------
Total interest expense $55 $7 $111 $19
===========================================================================================
Amortization of deferred financing costs for the three and nine
months ended September 30, 2005 consists of $1,000 and $4,000,
respectively, of amortization of an imputed discount on warrants
issued to Laurus and $10,000 and $19,000, respectively, of
amortization of a prepaid facility fee of $117,000 in connection with
the Laurus revolving credit facility entered into on March 31, 2005.
These costs are included in deferred financing costs on the
Consolidated Balance Sheet, and are being amortized to interest
expense over the three-year term of the facility. See Note 6.
Discounts imputed in accounting for the Company's convertible notes
issued to the Laurus pursuant to this credit facility, are being
amortized to interest expense over their term using the effective
interest method. See Note 6.
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
17
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 September 30, 2005, we reported a net loss
of $2,648,000 or $.75 per share on revenues of $4,807,000. This compares
with a net loss of $175,000 or $.05 per share on revenues of $3,338,000
recorded for the three months ended September 30, 2004. The 2005 results
include a non-cash derivative instrument expense of $1,949,000, arising
from borrowings under a three-year convertible revolving credit facility
entered into with Laurus effective March 31, 2006, and the issuance of
freestanding warrants in connection therewith, as more fully described in
Note 6 - Convertible Debt. The derivative instrument expense was primarily
attributable to increases in the calculated market value of the conversion
options embedded in the convertible borrowings and the free-standing
warrants since their initial valuations, resulting from increases in the
market value of the Company's common stock during the reported periods.
Excluding the derivative instrument expense, the Company's net loss would
have been $699,000 or $.20 per share for the three months ended September
30, 2005.
For the nine months ended September 30, 2005, we reported a net loss
of $3,478,000 or $1.02 per share on revenues of $11,699,000. This compares
with a net loss of $930,000 or $.28 per share on revenues of $9,633,000
recorded for the nine months ended September 30, 2004. The 2005 results
include a non-cash derivative instrument expense of $1,662,000, as
described in the preceding paragraph. Excluding the derivative instrument
expense, the Company's net loss would have been $816,000 or $.24 per share
for the nine months ended September 30, 2005.
The operating results for the three and nine month periods of 2005
also include losses of approximately $243,000 and $486,000, respectively,
attributed to our new business entity One IP Voice, Inc. as further
described below. The net loss for the nine month period of 2005 also
includes one-time expenses aggregating $84,000 incurred in connection with
the termination of our credit facility with Business Alliance Capital
Corporation.
There continues to be intense competition in the market areas that we
serve, particularly with our larger, "Enterprise" customers. This has
particularly been the case in the aftermarket parts business in which, over
the last several years, the Company has experienced significant sales price
erosion, as aftermarket parts have become more of a commodity and subject
to "price shopping" by customers. 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 current business strategy is to
transition to a full communications solutions provider, becoming less
dependent on equipment sales, and developing more sources of recurring
revenues, such as through installation and maintenance services. These
efforts to date have resulted in increased revenues in 2005 as compared to
2004.
In May 2005, the Company took steps to further diversify its product
offerings, forming a wholly-owned subsidiary named "One IP Voice" which,
when operational by the beginning of 2006, will offer carrier-based hosted
IP telephony services along with network services. Its primary target will
be the small-to-medium size business ("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. The
Company has also engaged the services of an investment banking firm to
assist the Company in raising additional capital needed to continue the
build out and national deployment of its IP telephony products and
services. For additional information on our financial resources, refer to
Note 6 - Convertible Debt, Note 16 - Subsequent Events and the "Liquidity
and Capital Resources" section which follows.
Additional information on our results of operations and financial
condition for the three and nine months ended September 30, 2005 follows
below.
18
Revenues
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
(In thousands) 2005 2004 2005 2004
---------------------------------------------------------------------------
Equipment:
End-user equipment sales $3,739 $2,356 $ 9,273 $7,391
Equipment sales to resellers 151 611 305 1,082
---------------------------------------------------------------------------
Total equipment sales 3,890 2,967 9,578 8,473
---------------------------------------------------------------------------
Services:
Installations 652 262 1,311 782
Rentals, repair and other 12 48 60 119
Other revenue 253 61 750 259
---------------------------------------------------------------------------
Total services and other revenue 917 371 2,121 1,160
---------------------------------------------------------------------------
Consolidated revenues $4,807 $3,338 $11,699 $9,633
===========================================================================
Equipment Sales. Total equipment sales for the three months ended
September 30, 2005, were $3,890,000, an increase of $923,000 or 31% from
the comparable 2004 period. The increase consisted of a $1,383,000 increase
in end-user sales, less a $460,000 decrease in equipment sales to resellers
("wholesale sales"). The increase in end-user sales was attributable to a
$2,029,000 or 308% increase in system sales less a $646,000 or 38% decrease
in parts sales. Total equipment sales for the nine months ended September
30, 2005, were $9,578,000, an increase of $1,105,000 or 13% from the
comparable 2004 period. The increase consisted of a $1,882,000 increase in
end-user sales, less a $777,000 decrease in wholesale sales. The increase
in end-user sales was attributable to a $2,875,000 or 125% increase in
system sales, partly offset by a $993,000 or 20% decline in parts sales.
During 2005, we continued a strategy of diversifying our product offerings
by marketing the sale of complete telecommunications systems to our
customer base. In March 2005, we significantly expanded our sales force and
began targeting the SMB marketplace, which is primarily oriented towards
systems sales. Other factors affecting end-user equipment sales for 2005
have previously been described in the "Overview" section above. Wholesale
sales have been impacted by some of the same factors which affected end
user sales and our shift in emphasis to new system sales.
Services revenues for the three months ended September 30, 2005 were
$664,000, an increase of $354,000 or 114% from the comparable 2004 period.
Services revenues for the nine months ended September 30, 2005 were
$1,371,000, an increase of $470,000 or 52% from the comparable 2004 period.
The increases in each period were attributable to installation services
which have increased due to the increases in system sales. An increase or
decrease in installation revenues, however, does not always coincide with
the reported increase or decrease in system sales since installations may
occur in different periods than the related system sale.
Other revenue for the three months ended September 30, 2005 was
$253,000, an increase of $192,000 or 315% from the comparable 2004 period.
Other revenue for the nine months ended September 30, 2005 was $750,000, an
increase of $491,000 or 190% from the comparable 2004 period. The increase
in each period was attributable to higher commissions earned on Avaya
maintenance contract sales. In the sale of Avaya maintenance contracts, the
Company receives a one-time commission, and all of the equipment service
obligations are borne entirely by Avaya.
The Company expects to begin marketing its One IP Voice product
offerings to businesses in the first quarter of 2006.
Cost of Revenues and Gross Profit. Total cost of revenues for the
three months ended September 30, 2005 was $3,568,000, an increase of
$1,034,000 or 41% from the comparable 2004 period. The gross profit for the
three months ended September 30, 2005 was $1,239,000, an increase of
$435,000 or 54% from the comparable 2004 period. As a percentage of
revenue, the overall gross profit margin was 26% for the three months ended
September 30, 2005, compared to 24% for the comparable 2004 period.
Total cost of revenues for the nine months ended September 30, 2005
was $8,370,000, an increase of $1,022,000, or 14% from the comparable 2004
period. The gross profit for the nine months ended September 30, 2005 was
$3,329,000 an increase of $1,044,000 or 46% from the comparable 2004
period. As a percentage of revenue, the overall gross profit margin was 28%
for the nine months ended September 30, 2005, compared to 24% for the
comparable 2004 period.
In general, our gross profit margins are dependent upon a variety of
factors including (1) product mix - gross margins can vary significantly
among parts sales, system sales and our various service offerings. The
parts business, for example, involves hundreds of parts that generate
significantly varying gross profit margins depending upon their
availability,
19
competition, and demand conditions in the marketplace; (2) customer mix -
we sell parts to both end-users and to other equipment resellers. Our
larger "Enterprise" companies often receive significant purchase discounts
from Avaya, which could cause us to accept lower gross margins as we
compete against Avaya directly for this business; (3) the level and amount
of vendor discounts and purchase rebates available to us from Avaya and its
master distributors; (4) capacity - as sales volume rises or falls,
overhead costs, consisting primarily of product handling, purchasing, and
facility costs, can become a lower or higher percentage of sales dollars;
(5) competitive pressures - as a result of the slowdown in capital
equipment spending in our industry, and the large number of Avaya dealers
nationwide, we have been faced with increased price competition; and (6)
obsolescence charges. The combined effect of all of these factors could
result in varying gross profit margins from period to period.
Gross Profit Margins on Equipment Sales. For the three months ended
September 30, 2005, the gross profit margin on equipment sales decreased to
26% from 27% in 2004. For the nine months ended September 30, 2005, the
gross profit margin on equipment sales increased to 28% from 27% in 2004.
The gross profit margin for the 2004 period was negatively impacted by an
increase in obsolescence reserves, and by the payment of license fees to
Avaya, under a program which terminated in June 2004. Excluding the effects
of these items, the gross profit margin on equipment sales for the nine
months ended September 30, 2004 would have been 29%. As compared to the
prior year periods, the Company experienced a decline in the gross profit
margins generated by the sale of aftermarket parts. This is attributable to
the fact that the parts business has become more of a "commodity" business
and less of a "value-added" business. It has therefore become more prone to
price-shopping by customers, who are tending more towards awarding
contracts to the lowest bidder. The impact of a reduced parts business
however, has been offset by significantly higher sales of systems at
improved profit margins from 2004. We expect continued pressure on our
equipment profit margins going forward, particularly in the sale of
aftermarket parts, due to continuing price competition.
Gross Profit Margins on Services and Other Revenue. For the three
months ended September 30, 2005, the Company realized an overall 38% profit
margin on its combined service and other revenues, compared to 31% recorded
in 2004. For the nine months ended September 30, 2005, the Company realized
an overall 47% profit margin on its combined service and other revenues,
compared to 38% recorded in 2004. The profit margin increase in each period
was attributable to significantly higher commission revenues earned from
the sale of Avaya maintenance contracts, which generate 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 September 30, 2005, these expenses were 4% lower than 2004, and
represented approximately 3% of 2005 equipment sales revenues, compared to
4% of 2004 equipment sales revenues. For the nine months ended September
30, 2005, these expenses were 24% lower than 2004, and represented
approximately 4% of 2005 equipment sales revenues, compared to 5% of 2004
equipment sales revenues. The reduction in other cost of revenues primarily
resulted from lower personnel levels and other overhead costs.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses
for the three months ended September 30, 2005 were $1,885,000, an increase
of $905,000 or 92% from the comparable 2004 period. SG&A expenses for the
three months ended September 30, 2005 were 39% of revenues, compared to 29%
of revenues in 2004. SG&A expenses for the nine months ended September 30,
2005 were $5,033,000, an increase of $1,833,000 or 57% from the comparable
2004 period. SG&A expenses for the nine months ended September 30, 2005
were 43% of revenues, compared to 33% of revenues in 2004. Approximately
90% of the increase in SG&A in each period was attributable to increased
personnel levels, including compensation and benefits, recruiting fees, and
incremental office and travel expenses.
As a part of the Company's turnaround plan, it hired a new President
and CEO in October 2004, and two Executive Vice Presidents - one
responsible for operations (hired in January 2005) and one responsible for
sales (hired in March 2005). In addition, during March 2005 the Company
significantly increased its sales and sales support group and launched an
initiative to market its products and services to the SMB marketplace.
Included in SG&A expense for the three and nine months ended
September 30, 2005 were $243,000 and $486,000 of expenses related to the
formation of One IP Voice, Inc. and the development of an IP telephony
services business segment. The expenses consisted primarily of
compensation, consulting, marketing, training and office expenses, as the
Company began the process of hiring its management and support teams and
developing its product offerings and marketing materials.
In connection with the replacement of the BACC credit facility with
the Laurus credit facility, the Company incurred in March 2005 one-time
expenses totaling $84,000, consisting of a $68,000 early termination fee,
and a $16,000 charge to write-off of the remaining balance of its annual
loan commitment fee with BACC. In addition, as of September 30, 2005 the
Company had incurred $155,000 of direct costs associated with the
acquisition of the Laurus credit facility. These costs are
20
included in deferred financing costs on the balance sheet and are being
amortized to SG&A expense over the term of the facility. As of September
30, 2005 approximately $23,000 has been amortized.
We expect our SG&A expenses to increase as we continue the
infrastructure development and deployment of our One IP Voice product
offerings.
Other Income (Expense). Other income (expense) for the three months
ended September 30, 2005 was $(2,001,000), compared with $(5,000) for 2004.
Other income (expense) for the nine months ended September 30, 2005 was
$(1,766,000), compared to $(15,000) for 2004. The principal components of
other income (expense) are as follows.
Interest Expense:
Three months ended Nine months ended
September 30 September 30
------------------ -----------------
(In thousands) 2005 2004 2005 2004
-----------------------------------------------------------------------------------------
Interest expense on outstanding borrowings $19 $7 $ 44 $19
Amortization of deferred financing costs 11 - 23 -
Amortization of discounts on convertible notes 25 - 44 -
-----------------------------------------------------------------------------------------
Total interest expense $55 $7 $111 $19
=========================================================================================
The increase in interest expense on outstanding borrowings was
attributable to higher average borrowing levels under the Company's credit
facilities and to higher interest rates. Amortization of deferred financing
costs for the three and nine months ended September 30, 2005 consists of
$1,000 and $4,000, respectively, of amortization of an imputed discount on
warrants issued to the Laurus Master Fund LTD ("Laurus") and $10,000 and
$19,000, respectively, of amortization of a prepaid facility fee of
$117,000 in connection with a revolving credit facility entered into with
Laurus on March 31, 2005. These costs are included in deferred financing
costs on the Consolidated Balance Sheet, and are being amortized to
interest expense over the three-year term of the facility. Discounts
imputed in accounting for the Company's convertible notes issued to the
Laurus Master Fund pursuant to this credit facility, are being amortized to
interest expense over their term using the effective interest method.
Derivative instrument expense. The Company recorded expense of
$1,949,000 and $1,662,000 during the three and nine months ended September
30, 2005, respectively, from derivative instrument liabilities arising from
its financing transactions with Laurus, as more fully described in Note 6 -
Convertible Debt, due primarily to increases in the calculated market value
of the conversion options embedded in the convertible borrowings from
Laurus and the free-standing warrants issued to Laurus since their initial
valuations, resulting from increases in the market value of the Company's
common stock during the reporting periods. Income or losses generated from
these derivative liabilities principally arise from changes in the fair
market value of the Company's common stock price during each reporting
period, as the Company is required to record "mark-to-market" adjustments
to the calculated value of its derivative liabilities. These "mark-to-
market" adjustments are non-cash, with no impact on liquidity. Refer to
Notes 1, 6 and 7 in the Notes to Consolidated Financial Statements
contained herein for further discussion on the nature of the derivative
financial instruments and the Company's accounting policies.
Other income for both periods presented consisted of interest earned
on invested cash.
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 $886,000 at September 30, 2005, compared to $2,136,000 at December 31,
2004. The working capital ratio was 1.2 to 1 at September 30, 2005,
compared to 2.4 to 1 at December 31, 2004. Operating activities used
$958,000 during the nine months ended September 30, 2005, compared to the
use of $906,000 in the comparable 2004 period. Net cash used by operating
activities in 2005 consisted of a net loss of $3,478,000 less non-cash
items of $1,896,000, and net cash generated by changes in operating assets
and liabilities of $624,000. The principal non-cash item in 2005 was
$1,662,000 of derivative instrument expense. The increase in our accounts
receivable was attributable to a 37% increase in third quarter 2005
revenues over the fourth quarter of 2004, including growth in our systems
sales revenues which often have a longer cash collection period than parts
sales since there is typically an installation requirement to be completed
prior to full payment. The growth in accounts payable is partly
21
attributable to our revenue growth, and partly attributable to incremental
expenses associated with the development of One IP Voice ("OIPV").
Investing activities used $320,000 during the nine months ended
September 30, 2005, compared to $25,000 in 2004. Net cash used by investing
activities in 2005 and 2004 consisted of capital expenditures. Capital
expenditures during 2005 were principally for the purchase of network
equipment and licenses in connection with the build out of an IP telephony
platform for our OIPV subsidiary, and computer and office equipment to
support our expanded personnel levels. Pursuant to our loan agreement with
Laurus, we may obtain external financing on capital expenditures up to
$500,000 in any fiscal year period before requiring Laurus's prior
approval.
Financing activities provided $1,247,000 during the nine months ended
September 30, 2005 principally from borrowings under our revolving credit
lines and a convertible note, net of related costs incurred. On March 31,
2005, we terminated our $1.7 million revolving credit facility with BACC,
repaying the outstanding balance on April 1, 2005, and entered into a
financing transaction with Laurus Master Fund, Ltd., ("Laurus"), providing
for a three-year, $3 million revolving loan credit facility. Refer to Note
6 - Convertible Debt, of the Notes to Consolidated Financial Statements
included herein for further information on the principal terms and
conditions of this financing transaction.
Our ability to provide cash to satisfy working capital requirements
continues to be dependent upon generating positive cash flow from
operations and upon formula borrowings under our revolving credit facility.
Historically, our working capital borrowings have increased during periods
of revenue growth. This is because our cash receipts cycle is longer than
our cash disbursements cycle. As our revenues from systems sales increases,
the cash receipts cycle may lengthen, unless we can consistently negotiate
up-front deposits and progress payments under our systems sales contracts.
In addition, our working capital requirements are expected to significantly
increase as we continue the build out of the infrastructure of capital
equipment, systems and personnel required to deploy our hosted VoIP service
offerings through OIPV.
On October 31, 2005, we engaged the services of an investment banking
firm to assist the Company in raising additional capital. In order to raise
the capital required for the continuing buildout of OIPV and regain
compliance with the AMEX's minimum stockholders' equity requirement so as
to maintain the Company's listing on AMEX, the board of directors of the
Company has approved, subject to stockholders' approval, one or a series or
combination of private offerings to investors of the Company's Securities ,
and a secondary offering to the public of Common Stock, said shares
currently intended to be offered to the public in a firm commitment
underwriting sometime during 2006. The aggregate amount sought out by the
Company is anticipated to be in range of approximately $6,000,000 to
$26,000,000 (exclusive of any securities which may be sold upon exercise of
any over-allotment options).
No assurances can be given that we will be successful in completing
the above-referenced financing transactions, since they are dependent upon,
among other factors, obtaining shareholder approval and the market
conditions prevailing during the offering periods. In order to obtain such
additional financing, we may also need to demonstrate improved operating
performance.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2004 under the subheading "Critical
Accounting Policies and Estimates" is still considered current and
applicable, and is hereby incorporated into this Quarterly Report on Form
10-Q.
Derivative instruments. In connection with the issuance of debt or
equity instruments, we may also issue warrants to purchase our common
stock. In certain circumstances, these warrants may be classified as
derivative liabilities, rather than as equity. Additionally, the debt or
equity instruments that we issue may contain embedded derivative
instruments, such as conversion options, which in certain circumstances may
be required to be bifurcated from the associated host instrument and
accounted for separately as a derivative instrument liability.
The identification of, and accounting for, derivative instruments is
complex. Our derivative instrument liabilities are revalued at the end of
each reporting period, with changes in the fair value of the derivative
liability recorded as charges or credits to income in the period in which
the changes occur. For warrants and bifurcated conversion options that are
accounted for as derivative instrument liabilities, we determine the fair
value of these instruments using the Black-Scholes option pricing model.
That model requires assumptions related to the remaining term of the
instruments and risk-free rates of return, our current common stock price
and expected dividend yield, and the expected volatility of our common
stock price over the life of the conversion option. We estimate the future
volatility of our common stock price based on several factors, including
the history of our stock price and the experience of other entities
considered comparable to us. The identification of, and
22
accounting for, derivative instruments and the assumptions used to value
them can significantly affect our financial position and results of
operations.
RISKS, UNCERTAINTIES AND OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2004 under the subheading "Risks,
Uncertainties and Other Factors That May Affect Future Results" is still
considered current and applicable, and is hereby incorporated into this
Quarterly Report on Form 10-Q, along with the following update:
We could be delisted by the American Stock Exchange.
As previously stated in prior filings, on May 7, 2004 we received
notice from the Amex that we did not meet certain of the Amex's continued
listing standards as a result of having stockholders' equity less than $4
million and net losses in three out of our four most recent fiscal years,
as set forth in Section 1003 (a) (ii) of the Amex Company Guide. We were
afforded the opportunity to submit a plan of compliance to the Amex and, on
June 15, 2004, presented our plan. On July 19, 2004 the Amex notified us
that it accepted our plan of compliance and granted us an extension until
November 7, 2005 to regain compliance with the continued listing standard
related to minimum stockholders' equity.
On November 8, 2005, the Company received notice from the American
Stock Exchange ("AMEX") that the Company no longer complies with the AMEX's
continued listing standards due to its failure to maintain stockholders'
equity of at least $4 million, as set forth in Section 1003 (a) (ii) of the
AMEX Company Guide, and that its securities are, therefore, subject to
being delisted from the AMEX
The Company plans to appeal this determination by the AMEX staff and
to request a hearing before an AMEX panel (the "Panel"). The time and place
of such a hearing will be determined by the Panel. There can be no
assurance that the Panel would grant a relief sought by the Company or,
even if it does, the Company will be able to implement its plan of
compliance consistent with the relief sought. If the Panel does not grant
the relief sought by the Company, its securities would be de-listed from
the AMEX. In that event, the Company would seek quotation of its securities
on the OTC Bulletin Board.
Whether or not the Amex grants us an extension, if we are unable to
close one or more financing transactions prior to the end of any applicable
appeal period or extension period, we will be delisted. Additionally, if we
fail to receive stockholder approval of our financing proposals at our
December 16, 2005 Special Meeting of Stockholders, we would be unable to
list any of the shares of common stock potentially issuable pursuant to
those proposals, which may affect our ability to attract investors. For
further information related to our delisting notification and our financing
plans, please refer to Note 16, Subsequent Events, contained herein.
The following additional risk factors are attributable to the
business activities of the Company's newly-formed subsidiary, One IP Voice
("OIPV"):
We intend to pursue a new business direction - the marketing of
carrier-based, hosted VoIP products and related network services - which
may not be profitable.
During 2005, we began devoting significant management and capital
resources to the development of this business, and we expect to continue to
do so; however we cannot provide assurance that this new business venture
will be profitable. Our business model is still being developed, and it has
not yet been proven out. There is also no guarantee that we will be
successful in generating significant revenues from future sales of our
planned IP products and services. If we are not able to generate
significant revenues selling into the VoIP telephony market, our business
and operating results would be seriously harmed.
We currently have limited cash resources, and we may not be
successful in financing the buildout of our new business venture
Please refer to the discussion above under Liquidity and Capital
Resources. As discussed in this section, our cash needs are expected to
significantly increase as we continue the buildout of OIPV and the
deployment of its products. It has become necessary to seek out external
financing sources in order to raise capital, since our core business does
not generate sufficient cash to meet the projected short-term cash
requirements of OIPV. In the event that we are unable to obtain sufficient
external funding for this project, we may be unable to complete the
buildout of the OIPV business as currently planned.
23
The success of our new business venture is dependent on the growth
and public acceptance of VoIP telephony products and services.
As we enter this emerging marketplace, we will be dependent upon
future demand for VoIP telephony systems and services. In order for the IP
telephony market to continue to grow, several things need to occur.
Telephony service providers must continue to invest in the deployment of
high speed broadband networks to residential and business customers. VoIP
networks must improve quality of service for real-time communications,
managing effects such as packet jitter, packet loss, and unreliable
bandwidth, so that toll-quality service can be provided. VoIP telephony
equipment and services must achieve a similar level of reliability that
users of the public switched telephone network have come to expect from
their telephone service. VoIP telephony service providers such as ourselves
must offer cost and feature benefits that are sufficient to cause customers
to switch away from traditional telephony service providers. Furthermore,
end users in markets serviced by recently deregulated telecommunications
providers are not familiar with obtaining services from competitors of
these providers and may be reluctant to use new providers, such as
ourselves. We will need to devote substantial resources to educate
customers and end users about the benefits of VoIP telephony solutions in
general and our services in particular. If any or all of these factors fail
to occur, our business may decline.
The VoIP telephony market is subject to rapid technological change
and we will depend on new product and service introductions in order to
establish, maintain and grow our business.
VoIP telephony is an emerging market that is characterized by rapid
changes in customer requirements, frequent introductions of new and
enhanced products, and continuing and rapid technological advancement. To
compete successfully in this emerging market, we will have to offer VoIP
telephony products and services that will incorporate the latest
technological advancements in features, performance and cost-effectiveness,
and respond to changing customer requirements.
Decreasing telecommunications rates may diminish or eliminate our
planned competitive pricing structure.
Decreasing telecommunications rates may diminish or eliminate the
competitive pricing structure of our services. Telecommunications rates
have decreased significantly over the last few years in most of the markets
in which we intend to operate, and we anticipate that rates will continue
to be reduced. Users who select our services to take advantage of the
current pricing differential between traditional telecommunications rates
and our rates may switch to traditional telecommunications carriers as such
pricing differentials diminish or disappear, and we will be unable to use
such pricing differentials to attract new customers in the future.
Continued rate decreases would require us to lower our rates to remain
competitive and adversely impact our profit margins.
Our success will depend on third parties in our planned distribution
channels.
We plan to sell our products primarily through resellers, and we are
focusing our business development efforts on establishing distribution
channels. Our planned revenues and future growth will depend in large part
on sales of our products through reseller and other distribution
relationships. We may not be successful in developing distribution
relationships. Agreements with distribution partners may not require
minimum purchases or restrict development or distribution of competitive
products. In addition, distributors and resellers may not dedicate
sufficient resources or give sufficient priority to selling our products.
Our failure to develop distribution channels, the loss of a distribution
relationship or a decline in the efforts of a material reseller or
distributor could have a material adverse effect on our business, financial
condition or results of operations.
We will need to attract and retain key personnel to support our
products and ongoing operations.
To date, we have been successful in hiring certain key business
development and technical management personnel; however the continuing
build out of our business plan requires the hiring of other key marketing,
engineering, customer service and administrative personnel. Our future
success depends upon the continued services of our executive officers and
other key employees who have critical industry experience and relationships
that we rely on to implement our business plan. The loss of the services of
any of our officers or key employees could delay the development of OIPV
and its products and services, and negatively impact our financial results
and impair our growth.
We will rely on third party network service providers to originate
and terminate substantially all of our public switched telephone network
calls.
We will depend on the availability of third party network service
providers that provide telephone numbers and public switched telephone
network (PSTN) call termination and origination services for our future IP
telephony customers. Many of these network service providers have been
affected by the downturn in the telecommunications industry and may be
forced to terminate the services that we will depend on. The time to
interface our technology to another network service provider, if
24
available, and qualify this new service could have a material adverse
effect on our business, operating results or financial condition.
The failure of IP networks to meet the reliability and quality
standards required for voice and video communications could render our
products obsolete.
Circuit-switched telephony networks feature very high reliability,
with a guaranteed quality of service. In addition, such networks have
imperceptible delay and consistently satisfactory audio quality. Emerging
broadband IP networks, such as LANs, WANs, and the Internet, or emerging
last mile technologies such as cable, digital subscriber lines, and
wireless local loop, may not be suitable for telephony unless such networks
and technologies can provide reliability and quality consistent with these
standards.
Future legislation or regulation of the internet and/or voice and
video over IP services could restrict our business, prevent us from
offering service or increase our cost of doing business.
At present there are few laws, regulations or rulings that
specifically address access to commerce and communications services on the
Internet, including IP telephony. We are unable to predict the impact, if
any, that future legislation, legal decisions or regulations concerning the
Internet may have on our business, financial condition, and results of
operations. Regulation may be targeted towards, among other things,
assessing access or settlement charges, imposing taxes related to internet
communications and imposing tariffs or regulations based on encryption
concerns or the characteristics and quality of products and services, any
of which could restrict our business or increase our cost of doing
business. The increasing growth of the broadband IP telephony market and
popularity of broadband IP telephony products and services heighten the
risk that governments or other legislative bodies will seek to regulate
broadband IP telephony and the Internet. In addition, large, established
telecommunication companies may devote substantial lobbying efforts to
influence the regulation of the broadband IP telephony market, which may be
contrary to our interests.
Potential regulation of Internet service providers could adversely
affect our operations.
To date, the FCC has treated Internet service providers as
information service providers. Information service providers are currently
exempt from federal and state regulations governing common carriers,
including the obligation to pay access charges and contribute to the
universal service fund. The FCC is currently examining the status of
Internet service providers and the services they provide. If the FCC were
to determine that Internet service providers, or the services they provide,
are subject to FCC regulation, including the payment of access charges and
contribution to the universal service funds, it could have a material
adverse effect on our business, financial condition and operating results.
There may be risks associated with 911 emergency dialing.
On June 3, 2005 the Commission released the VoIP 911 Order adopting
rules that require interconnected VoIP providers to provide their new and
existing subscribers with 911 service no later than November 28, 2005.
Specifically, as a condition of providing interconnected VoIP service, each
interconnected VoIP provider must, in addition to satisfying the subscriber
notification, acknowledgment, and labeling requirements set forth in
section 9.5(e) of the Commission's rules:
* Transmit all 911 calls to the public safety answering point (PSAP),
designated statewide default answering point, or appropriate local
emergency authority that serves the caller's "Registered Location (An end-
user's "Registered Location" is the most recent information obtained by an
interconnected VoIP service provider that identifies the physical location
of the end-user)." Such transmissions must include the caller's Automatic
Numbering Information ("ANI", which is a system that identifies the billing
account for a call and, for 911 systems, identifies the calling party and
may be used as a call back number) and Registered Location to the extent
that the PSAP, designated statewide default answering point, or appropriate
local emergency authority is capable of receiving and processing such
information;
* Route all 911 calls through the use of ANI and, if necessary,
pseudo-ANI (a "pseudo-ANI" is a number, consisting of the same number of
digits as ANI, that is not a North American Numbering Plan telephone
directory number and may be used in place of an ANI to convey special
meaning. The special meaning assigned to the pseudo-ANI is determined by
agreements, as necessary, between the system originating the call,
intermediate systems handling and routing the call, and the destination
system) via the Wireline E911 Network (The "Wireline E911 Network" is a
dedicated wireline network that: (1) is interconnected with but largely
separate from the public switched telephone network; (2) includes a
selective router; and (3) is utilized to route designated statewide default
answering point or appropriate local emergency authority from or through
the appropriate Automatic Location Identification database), and make a
caller's Registered Location available to the appropriate PSAP;
25
* Obtain from each of its existing and new customers, prior to the
initiation of service, a Registered Location; and
* Provide all of their end users one or more methods of updating
their Registered Location at will and in a timely manner. At least one
method must allow end users to use only the same equipment (such as the
Internet telephone) that they use to access their interconnected VoIP
service.
We currently have no subscribers, as we are still in the process of
developing and deploying our VoIP platform. However, we intend to comply
with all current rules and regulations provided by the FCC in regards to
911/E911 services prior to the initiation of service to subscribers.
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
Securities 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 Securities 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
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The proposals voted upon at the Company's Annual Meeting of
Stockholders, held July 14, 2005, along with the voting results, were
as follows:
26
(1) Election of Directors: All nominees were elected: The results of
the balloting were as follows:
Votes Votes
Nominees For Withheld
--------------------- --------- ---------
Jean-Marc Stiegemeier 3,208,981 41,071
George J. Taylor, Jr. 3,188,401 61,651
Harold L. Hanson 3,207,714 42,338
Hugh M Taylor 3,205,551 44,501
Joseph J. Kelley 3,208,534 41,518
Ronald P. Pettirossi 3,212,658 37,394
(2) Ratification of the appointment of Carlin, Charron & Rosen LLP as
independent auditors of the Company for the year ending December
31, 2005: The proposal was approved with 3,197,907 votes for,
40,840 votes against and 11,305 abstentions.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS:
The following documents are filed as Exhibits to this Quarterly
Report on Form 10-Q:
31.1 Certification of the Chief Executive Officer, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of the Chief Financial Officer, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of the Chief Executive Officer, pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of the Chief Financial Officer, pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
FARMSTEAD TELEPHONE GROUP, INC.
Dated: May 26, 2006 /s/ Jean-Marc Stiegemeier
-----------------------------------
Jean-Marc Stiegemeier
Chief Executive Officer, President
Dated: May 26, 2006 /s/ Robert G LaVigne
-----------------------------------
Robert G. LaVigne
Executive Vice President, Chief
Financial Officer
27