UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.
For the quarterly period ended September 30, 2005
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.
Commission File Number: 0-15938
Farmstead Telephone Group, Inc.
-------------------------------
(Exact name of registrant as specified in its charter)
Delaware 06-1205743
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
22 Prestige Park Circle
East Hartford, CT 06108
(Address of principal executive offices) (Zip Code)
(860) 610-6000
(Registrant's telephone number)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the 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.
TABLE OF CONTENTS TO FORM 10-Q
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 - 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 14
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 22
ITEM 4. CONTROLS AND PROCEDURES 22
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 22
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 23
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 23
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 23
ITEM 5. OTHER INFORMATION 23
ITEM 6. EXHIBITS 23
SIGNATURES 24
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)
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) 384 -
Other assets 107 107
-------------------------------------------------------------------------------------------------
Total Assets $ 6,291 $ 4,050
=================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,123 $ 1,110
Debt maturing within one year (Note 6) 648 187
Accrued expenses and other current liabilities 408 242
-------------------------------------------------------------------------------------------------
Total Current Liabilities 4,179 1,539
-------------------------------------------------------------------------------------------------
Postretirement benefit obligation 688 593
Long-term debt (Note 6) 72 39
-------------------------------------------------------------------------------------------------
Total Liabilities 4,939 2,171
-------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 10)
Stockholders' Equity:
Preferred stock, $0.001 par value; 2,000,000 shares authorized;
no shares issued and outstanding - -
Common stock, $0.001 par value; 30,000,000 shares authorized;
3,747,132 and 3,322,182 shares issued and outstanding at
September 30, 2005 and December 31, 2004, respectively 4 3
Additional paid-in capital 13,602 12,320
Accumulated deficit (12,236) (10,420)
Accumulated other comprehensive loss (18) (24)
-------------------------------------------------------------------------------------------------
Total Stockholders' Equity 1,352 1,879
-------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 6,291 $ 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
------------------------------------------------------------------------------------------
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)
Interest expense (60) (7) (111) (19)
Other income 3 2 7 4
------------------------------------------------------------------------------------------
Loss before income taxes (703) (181) (1,808) (930)
Provision for income taxes 1 (6) 8 -
------------------------------------------------------------------------------------------
Net loss (704) $ (175) (1,816) $ (930)
==========================================================================================
Basic and diluted net loss per common share: $ (.20) $ (.05) $ (.53) $ (.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
(UNAUDITED)
For the Nine Months ended September 30, 2005
Accumulated
Common Stock Additional Accum- Other
----------------- Paid-in ulated Comprehensive
(In thousands) Shares Amount Capital Deficit Loss Total
------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2004 3,322 $3 $12,320 $(10,420) $(24) $ 1,879
Net loss - - - (1,816) - (1,816)
Amortization of pension liability
adjustment - - - - 6 6
-------
Comprehensive loss (1,810)
Warrants issued in connection with
convertible debt financing - - 186 - - 186
Beneficial conversion discount on
convertible note payable - - 500 - - 500
Common stock issued upon conversion
of note payable 325 1 499 - - 500
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 $13,602 $(12,236) $(18) $ 1,352
==================================================================================================================
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
-----------------------------------------------------------------------------------
Cash flows from operating activities:
Net loss $(1,816) $(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 74 -
Amortization of debt discount 16 -
Decrease in accumulated other comprehensive loss 6 6
Increase in accrued postretirement benefit obligation 95 85
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 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:
Net borrowings under revolving credit lines 939 211
Proceeds from convertible note payable 500 -
Deferred financing costs (272) -
Borrowing against cash value of insurance policy - 275
Proceeds from the issuance of common stock 97 4
Repayments of long-term debt (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 -
Debt discount recorded on issuance of note payable 500 -
6
Fair value of warrant recorded as deferred financing cost
in connection with revolving credit facility 186 -
See accompanying notes to consolidated financial statements.
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The consolidated financial statements presented herein consist of the
accounts of Farmstead Telephone Group, Inc. and its wholly-owned
subsidiaries. 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 should
be read in conjunction with the consolidated financial statements and notes
thereto included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2004.
2. OPERATIONS
As presented in the consolidated financial statements contained in
this report, the Company incurred net losses of $704,000 and $1,816,000 for
the three and nine months ended September 30, 2005, respectively. 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 in the first quarter of 2006, 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 a new
lender, replacing a $1.7 million credit facility with Business Alliance
Capital Corporation. For additional information, refer to Note 6, Debt
Obligations 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 14, Subsequent Events,
contained herein.
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
====================================================================
7
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.
6. DEBT OBLIGATIONS
September 30, December 31,
(In thousands) 2005 2004
------------------------------------------------------------------------------------
Laurus revolving credit facility note $ 618 $ -
Laurus convertible minimum borrowing note 500 -
Unamortized debt discount on minimum borrowing note (484) -
BACC revolving credit facility note - 179
Installment purchase note 42 47
Leased equipment under capital lease 44 -
------------------------------------------------------------------------------------
720 226
Less: debt maturing within one year (648) (187)
------------------------------------------------------------------------------------
Long-term debt obligations $ 72 $ 39
===================================================================================
Credit Arrangements:
On March 31, 2005, the Company terminated its $1.7 million revolving
credit facility with Business Alliance Capital Corporation ("BACC"),
repaying the outstanding balance and an early-termination fee of $68,000 on
April 1, 2005. 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
8
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 at an exercise price of $1.82 per share.
The warrant exercise price was set at 130% of the average closing price of
the Company's common stock over the ten trading days preceding the
execution of the agreement, and is subject to anti-dilution protection
adjustments. This transaction was completed in a private offering pursuant
to an exemption from registration under Section 4(2) of the Securities Act
of 1933, as amended.
The fair value of the Warrant was estimated using the Black-Scholes
pricing model with the following assumptions: fair market value of the
underlying common stock of $1.08 per share (which amount represents the
closing price of the common stock on the date that the principal terms and
conditions of the financing were approved by both parties); zero dividends;
expected volatility of 55%; a risk-free interest rate of 3.9% and an
expected holding period of 4.5 years. The resulting value of $186,299,
along with a $117,000 prepaid facility fee, have been recorded in deferred
financing costs, and are being amortized to interest expense over the term
of the facility. Other direct costs incurred by the Company in the
execution of the agreements with Laurus, approximating $155,000, have also
been recorded on the balance sheet under deferred financing costs, and are
being amortized to SG&A expense over the term of the facility.
The following describes certain of the material terms of the
financing transaction with Laurus. The description below is not a complete
description of the material terms of the financing transaction and is
qualified in its entirety by reference to the agreements entered into in
connection with the financing which were included as exhibits to the
Company's Annual Report on Form 10-K for the year ended December 31, 2004:
Principal Borrowing Terms and Prepayment: Borrowings are advanced
pursuant to a formula consisting of (i) 90% of eligible accounts
receivable, as defined (primarily receivables that are less than 90 days
old), and (ii) 30% of eligible inventory, as defined (primarily inventory
classified as "finished goods"), up to a maximum inventory advance of
$600,000, less any reserves required by Laurus. Interest on the
outstanding borrowings is charged at the per annum rate of two percentage
points (2%) above the prime rate, but not less than 6%. The interest rate
charged, however, will be decreased by 2% (or 200 basis points) for every
25% increase in the market price of the Company's common stock above the
fixed conversion price, down to a minimum interest charge of 0.0%. The
Company is additionally 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 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
9
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. 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.
As of September 30, 2005, outstanding borrowings with Laurus
consisted of $618,186 under the revolving loan portion of the credit
facility and a $500,000 convertible Minimum Borrowing Note ("MBN"), issued
September 2, 2005. The Company has recorded a beneficial conversion
premium on the issuance of the MBN in the amount of $500,000, calculated as
the difference between the fixed conversion price of the note ($1.54) and
the market value of the Company's common stock on the date of issuance
($3.08) times the number of convertible shares (324,675). The beneficial
conversion premium has been recorded on the balance sheet as a debt
discount and an increase in additional paid-in capital. The debt discount
will be amortized to interest expense over the life of the MBN or as the
debt is converted to common stock. The unused portion of the credit
facility as of September 30, 2005 was $1,881,814, of which $1,572,061 was
available to borrow. 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.
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.
Note Payable:
The Company is financing an automobile through a $50,056, 3.75% note
payable to a finance company. The note is payable in 38 monthly
installments of $799, with a final payment of $24,236 on January 7, 2008.
The note balance at September 30, 2005 was $41,903, of which $8,154 was
classified under debt maturing within one year.
7. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
September 30, December 31,
(In thousands) 2005 2004
-------------------------------------------------------------------------------
Salaries, commissions and benefits $316 $167
Other 92 75
-------------------------------------------------------------------------------
Accrued expenses and other current liabilities $408 $242
===============================================================================
8. 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
10
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.
9. 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 (dollars in thousands
except per share amounts):
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2005 2004 2005 2004
---------------------------------------------------------------------------------------------
Net loss, as reported $(704) $(175) $(1,816) $(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 (906) (185) (2,257) (968)
Pro forma net loss per share:
Basic and diluted $(.26) $(.06) $ (.66) $(.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.
10. 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
11
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.
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.
11. 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
=====================================================================
12. 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 operating
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
--------------------------------------------------------------------------------
12
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:
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 (60) (111)
Other income 3 7
--------------------------------------------------------------------------------
Consolidated loss before income taxes $(703) $(1,808)
--------------------------------------------------------------------------------
13. 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.
14. 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 overallotment 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.
13
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.
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.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The discussions set forth below and elsewhere in this Quarterly
Report on Form 10-Q contain certain statements, based on current
expectations, estimates, forecasts and projections about the industry in
which we operate and management's beliefs and assumptions, which are not
historical facts and are considered forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 ("the
Act"). Forward-looking statements include, without limitation, any
statement that may predict, forecast, indicate, or imply future results,
performance, or achievements, and may contain the words "believe," "will
be," "will continue," "will likely result," "anticipates," "seeks to,"
"estimates," "expects," "intends," "plans," "predicts," "projects," and
similar words, expressions or phrases of similar meaning. Our actual
results could differ materially from those projected in the forward-looking
statements as a result of certain risks, uncertainties and assumptions,
which are difficult to predict. Many of these risks and uncertainties are
described under the heading "Risks, Uncertainties and Other Factors That
May Affect Future Results" below. All forward-looking statements included
in this document are based upon information available to us on the date
hereof. We undertake no obligation to update publicly any forward-looking
statements, whether as a result of new information, future events or
otherwise. In addition, other written or oral statements made or
incorporated by reference from time to time by us or our representatives in
this report, other reports, filings with the Securities and Exchange
Commission ("SEC"), press releases, conferences, or otherwise may be
forward-looking statements within the meaning of the Act.
14
RESULTS OF OPERATIONS
Overview
For the three months ended September 30, 2005, we reported a net loss
of $704,000 or $.20 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. For the nine
months ended September 30, 2005, we reported a net loss of $1,816,000 or
$.53 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 operating results for the three
and nine month periods of 2005 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, "Debt Obligations", Note 14, "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.
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
15
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.
Service revenues for the three months ended September 30, 2005 were
$664,000, an increase of $354,000 or 114% from the comparable 2004 period.
Service 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
29% 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, 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
16
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 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.
Interest Expense. Interest expense for the three months ended
September 30, 2005 was $60,000, compared with $7,000 for 2004. Interest
expense for the nine months ended September 30, 2005 was $111,000, compared
with $19,000 for 2004. Included in interest expense for the three and nine
months of 2005 is $25,000 and $51,000 respectively, representing the
amortization of a portion of deferred financing costs incurred in
connection with the acquisition of the Laurus credit facility, as further
described in Note 6. These costs, consisting of a $117,000 facility fee
and a $186,299 value ascribed to the warrants issued to Laurus, are being
amortized to interest expense over the three-year term of the facility.
Interest expense for the three and nine months of 2005 also includes
$16,000 from the amortization of the $500,000 beneficial conversion
feature, recorded as debt discount on the balance sheet, in connection with
the September issuance of a $500,000 convertible note payable to Laurus.
The debt discount will be amortized to interest expense over the life of
the note or on a more accelerated basis as the debt is converted to common
stock. The increase in interest expense was also attributable to higher
average borrowing levels and higher borrowing rates.
17
Other Income. Other income for all periods presented consisted of
interest earned on invested cash.
Provision for Income Taxes. The provision for income taxes
represents estimated minimum state taxes in all reported periods. We
maintain a full valuation allowance against our net deferred tax assets,
which consist primarily of net operating loss and capital loss
carryforwards, and timing differences between the book and tax treatment of
inventory and other asset valuations. Realization of these net deferred
tax assets is dependent upon our ability to generate future taxable income.
LIQUIDITY AND CAPITAL RESOURCES
Working capital, defined as current assets less current liabilities,
was $1,058,000 at September 30, 2005, compared to $2,136,000 at December
31, 2004. The working capital ratio was 1.3 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 $1,816,000 less non-cash
items of $329,000, and net cash generated by changes in operating assets
and liabilities of $529,000. The increase in our accounts receivable was
primarily attributable to significant growth in our systems sales revenues
over the prior year period, for which the cash receipts cycle is longer
than for parts sales since there is typically an installation requirement
to be completed prior to full payment.
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 One IP Voice ("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, "Debt Obligations", of the Notes to Consolidated Financial Statements
included herein for further information on the principal terms and
conditions of this financing transaction.
Our ability to provide cash to satisfy working capital requirements
continues to be dependent upon generating positive cash flow from
operations and upon formula borrowings under our revolving credit facility.
Historically, our working capital borrowings have increased during periods
of revenue growth. This is because our cash receipts cycle is longer than
our cash disbursements cycle. As our revenues from systems sales
increases, 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 overallotment 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.
18
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.
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 14, 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.
Since the beginning of 2005, we have been 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
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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.
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.
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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 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;
21
* 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;
* 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.
22
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:
(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.
23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
FARMSTEAD TELEPHONE GROUP, INC.
Dated: November 14, 2005 /s/ Jean-Marc Stiegemier
----------------------------------
Jean-Marc Stiegemeier
Chief Executive Officer, President
Dated: November 14, 2005 /s/ Robert G. LaVigne
----------------------------------
Robert G. LaVigne
Executive Vice President,
Chief Financial Officer
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