UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the quarterly period ended March 31, 2006
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 a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the
Exchange Act. (Check one):
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [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 April 28, 2006, the registrant had 3,975,282 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 - March 31, 2006 and
December 31, 2005 3
Consolidated Statements of Operations - For the
Three Months Ended March 31, 2006 and 2005 4
Consolidated Statement of Changes in Stockholders' Equity
(Deficiency) - For the Three Months Ended March 31, 2006 5
Consolidated Statements of Cash Flows - For the Three
Months Ended March 31, 2006 and 2005 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 22
ITEM 4. CONTROLS AND PROCEDURES 22
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 22
ITEM 1A. RISK FACTORS 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 23
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
(In thousands) 2006 2005
---------------------------------------------------------------------------------------------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 361 $ 222
Accounts receivable, net 3,428 3,125
Inventories, net 780 723
Other current assets 229 281
---------------------------------------------------------------------------------------------------
Total Current Assets 4,798 4,351
---------------------------------------------------------------------------------------------------
Property and equipment, net 696 615
Deferred financing costs 509 535
Other assets 106 103
---------------------------------------------------------------------------------------------------
Total Assets $ 6,109 $ 5,604
===================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
Current liabilities:
Accounts payable $ 3,320 $ 3,105
Accrued expenses and other current liabilities 583 539
Current portion of convertible debt, net of unamortized discount
of $549 at December 31, 2005 (Note 6) - 860
Derivative financial instruments (Note 7) - 385
Current portion of long-term debt (Note 5) 36 30
---------------------------------------------------------------------------------------------------
Total Current Liabilities 3,939 4,919
---------------------------------------------------------------------------------------------------
Postretirement benefit obligation 751 719
Convertible debt, net of unamortized discount (Note 6) 8 8
Derivative financial instruments (Note 7) 5,628 406
Long-term debt (Note 5) 54 49
---------------------------------------------------------------------------------------------------
Total Liabilities 10,380 6,101
---------------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' Equity (Deficiency):
Preferred stock, $0.001 par value; 2,000,000
shares authorized; 194,520 and 0 shares of
Series A issued and outstanding at March 31,
2006 and December 31, 2005 (Note 14) 151 -
Common stock, $0.001 par value; 30,000,000
shares authorized; 3,946,032 and 3,817,132
shares issued and outstanding at March 31, 2006
and December 31, 2005, respectively 4 4
Additional paid-in capital 13,414 13,249
Accumulated deficit (17,826) (13,734)
Accumulated other comprehensive loss (14) (16)
---------------------------------------------------------------------------------------------------
Total Stockholders' Equity (Deficiency) (4,271) (497)
---------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 6,109 $ 5,604
===================================================================================================
See accompanying notes to consolidated financial statements.
3
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
March 31,
------------------
(In thousands, except per share amounts) 2006 2005
--------------------------------------------------------------------
Revenues:
Equipment $ 3,464 $ 1,965
Services and other revenue 950 444
--------------------------------------------------------------------
Net revenues 4,414 2,409
Cost of revenues:
Equipment 2,417 1,319
Services and other revenue 598 234
Other cost of revenues 154 102
--------------------------------------------------------------------
Total cost of revenues 3,169 1,655
--------------------------------------------------------------------
Gross profit 1,245 754
Selling, general and administrative expenses 2,614 1,384
--------------------------------------------------------------------
Operating loss (1,369) (630)
Other income (expense):
Interest expense (Note 12) (84) (8)
Derivative instrument expense (2,634) (393)
Other income 2 3
--------------------------------------------------------------------
Total other income (expense) (2,716) (398)
--------------------------------------------------------------------
Loss before income taxes (4,085) (1,028)
Provision for income taxes 7 4
--------------------------------------------------------------------
Net loss (4,092) (1,032)
Accreted preferred stock dividend 1 -
--------------------------------------------------------------------
Net loss attributable to common shareholders (4,093) (1,032)
====================================================================
Basic and diluted net loss per common share $ (1.06) $ (.31)
Weighted average common shares outstanding:
Basic and diluted 3,859 3,328
====================================================================
See accompanying notes to consolidated financial statements.
4
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIENCY)
(UNAUDITED)
For the Three Months Ended March 31, 2006
Accumulated
Preferred Stock Common Stock Additional Accum- Other
--------------- --------------- Paid-in ulated Comprehensive
(In thousands) Shares Amount Shares Amount Capital Deficit Loss Total
---------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2005
- - 3,817 $4 $13,249 $(13,734) $(16) $ (497)
Net loss - - - - - (4,092) - (4,092)
Amortization of pension liability
adjustment - - - - - - 2 2
Comprehensive loss (4,090)
Stock-based compensation - - - - 84 - - 84
Common stock issued under stock option
and stock purchase plans - - 20 - 34 - - 34
Shares issued upon conversion of Laurus
debt - - 110 - 124 - - 124
Warrants issued for notes payable - - - - 857 - - 857
Issuance of preferred stock 195 150 - - - - - 150
Issue costs and expenses in connection
with placement of convertible note and
Series A preferred stock - - - - (384) - - (384)
Warrants for preferred and common stock
issued in connection with placement
of convertible note and Series A
preferred stock - - - - (549) - - (549)
Accretion of dividends on Series A
preferred stock - 1 - - (1) - - -
---------------------------------------------------------------------------------------------------------------------------------
Balance at March 31, 2006 195 151 3,947 $4 $13,414 $(17,826) $(14) $(4,271)
=================================================================================================================================
See accompanying notes to consolidated financial statements.
5
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Three Months Ended March 31, 2006 and 2005
(In thousands) 2006 2005
----------------------------------------------------------------------------------------
Cash flows from operating activities:
Net loss $(4,092) $(1,032)
Adjustments to reconcile net loss to net cash flows
provided by (used in) operating activities:
Provision for doubtful accounts receivable 9 9
Provision for losses on inventories 13 8
Depreciation and amortization of property and equipment 49 25
Amortization of deferred financing costs 26 -
Amortization of discounts on convertible notes 27 -
Unrealized loss on derivative instruments 2,634 393
Stock-based compensation expense 84
Decrease in accumulated other comprehensive loss 2 3
Changes in operating assets and liabilities:
Increase in accounts receivable (312) (100)
(Increase) decrease in inventories (70) 31
Decrease in other assets 49 22
Increase in accounts payable 215 546
Increase in accrued expenses and other current liabilities 46 367
Increase in accrued postretirement benefit obligation 32 31
----------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities (1,288) 303
----------------------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment (112) (3)
----------------------------------------------------------------------------------------
Net cash used in investing activities (112) (3)
----------------------------------------------------------------------------------------
Cash flows from financing activities:
Repayments of BACC revolving loan advances - (46)
Repayments of Laurus revolving loan advances (1,409) -
Proceeds from issuance of convertible note, net 913 -
Proceeds from issuance of Series A preferred stock, net 2,008 -
Deferred financing costs - (229)
Repayment of long-term debt and capital lease obligations (7) (2)
Proceeds from exercise of stock options and employee
stock purchases 34 7
----------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 1,539 (270)
----------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 139 30
Cash and cash equivalents at beginning of period 222 217
----------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 361 $ 247
========================================================================================
6
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 30 $ 8
Income taxes 1 2
Non-cash financing and investing activities:
Purchase of equipment under capital lease 18 36
Common stock issued upon Laurus minimum borrowing
note conversions 124 -
Discounts on warrants issued to Laurus - 335
Warrants issued in connection with convertible notes 857 -
Preferred shares issued on conversion of convertible note 628 -
Warrants issued to placement agent in connection with
convertible note and Series A preferred stock offering 550 -
Preferred shares and warrants issued to investors 2,154
See accompanying notes to consolidated financial statements.
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION, BUSINESS OPERATIONS AND SIGNIFICANT ACCOUNTING
POLICIES
Basis of Presentation
The consolidated financial statements presented herein consist of the
accounts of Farmstead Telephone Group, Inc. and its wholly-owned
subsidiaries. The accompanying consolidated financial statements as of
March 31, 2006 and for the three months ended March 31, 2006 and 2005 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, 2005.
Business Operations
As presented in the consolidated financial statements contained in
this report, the Company incurred a net loss of $4,092,000 for the three
months ended March 31, 2006. This net loss includes non-cash derivative
instrument expense of $2,634,000 arising from (i) borrowings under a three-
year convertible revolving credit facility entered into in 2005, together
with freestanding warrants issued to the lender in connection therewith,
and (ii) the issuance of preferred stock and warrants to accredited
investors, and to the Company's placement agent in connection with private
placements of such securities during 2006. Excluding the non-cash
derivative instrument expense, the Company otherwise incurred an operating
loss of $1,369,000 and a net loss of $1,458,000 during the three months
ended March 31, 2006. Approximately $976,000 of the operating loss was
attributable to the startup operations of the Company's wholly-owned
subsidiary, One IP Voice, Inc.
In May, 2005, the Company formed a wholly-owned subsidiary named One
IP Voice, Inc. ("OIPV"). OIPV was formed to provide carrier-based VoIP
telephony solutions along with network services. Its primary target market
is the small-to-medium sized business ("SMB") market, which the Company
believes is the fastest growing segment of the telecommunications systems
business. OIPV's product offerings include Hosted IP Centrex and IP
Trunking services, bundled with private OIPV "last mile" connectivity on a
national basis, long distance calling, On Net calling, local area calling,
911 capabilities and Wide Area Network ("WAN") voice and data connectivity.
In January 2006, the Company launched the national marketing of OIPV's
products and services.
Despite a negative cash flow from operations for the three months
ended March 31, 2006, the Company has been able to secure financing to
support its operations to date. In addition to borrowing availability
under the Company's revolving credit
7
facility, during the first quarter of 2006 the Company raised approximately
$3 million through various offerings of convertible debt and convertible
preferred stock to unaffiliated private investors. In April, 2006 the
Company raised an additional $1.1 million, before expenses, from the
further sale of convertible preferred stock. The continued development of
OIPV will, however, require additional financing, as it has not developed
sufficient revenues to support its operations. Going forward, the Company
plans to raise significant amounts of additional cash through private and
public equity offerings in order to support the expansion of OIPV's
business. No assurance can be given, however, that funding in the amounts
required by the Company will be available, which may impact management's
growth plans for this new business.
2. ACCOUNTS RECEIVABLE, NET
March 31, December 31,
(In thousands) 2006 2005
-------------------------------------------------------------------
Trade accounts receivable $3,000 $2,815
Less: allowance for doubtful accounts (84) (75)
--------------------------------------------------------------------
Trade accounts receivable, net 2,916 2,740
Other receivables 512 385
--------------------------------------------------------------------
Accounts receivable, net $3,428 $3,125
====================================================================
Other receivables primarily consist of commissions, rebates and other
dealer incentives due from Avaya and are recorded in the consolidated
financial statements when earned.
3. INVENTORIES, NET
March 31, December 31,
(In thousands) 2006 2005**
---------------------------------------------------------------------------------
Finished goods and spare parts $1,179 $1,136
Work in process * 227 202
Rental equipment 14 12
---------------------------------------------------------------------------------
1,420 1,350
Less: reserves for excess and obsolete inventories (640) (627)
---------------------------------------------------------------------------------
Inventories, net $ 780 $ 723
=================================================================================
* Consists of used equipment requiring repair or refurbishing.
** The amounts shown in this table for December 31, 2005 for finished
goods and spare parts, and for the reserves for excess and obsolete
inventories reflect a correction of a typographical error. The
amounts originally reported were $947 and ($438), respectively. This
correction had no effect on the net reported value.
4. PROPERTY AND EQUIPMENT, NET
Estimated
Useful Lives March 31, December 31,
(In thousands) (Yrs.) 2006 2005
-----------------------------------------------------------------------------------------------
Computer and office equipment 3 - 5 $ 1,068 $ 1,065
IP network equipment and licenses 5 500 391
Furniture and fixtures 5 - 10 288 288
Leasehold improvements 10 171 171
Capitalized software development costs 5 98 98
Automobile 5 50 50
Leased computer equipment under capital lease 3 74 56
-----------------------------------------------------------------------------------------------
2,249 2,119
Less: accumulated depreciation and amortization (1,553) (1,504)
-----------------------------------------------------------------------------------------------
Property and equipment, net $ 696 $ 615
===============================================================================================
8
5. DEBT OBLIGATIONS
Long-term debt obligations consisted of the following:
March 31, December 31,
(In thousands) 2006 2005
------------------------------------------------------------------
Installment purchase note $ 38 $ 40
Obligations under capital lease 52 39
------------------------------------------------------------------
90 79
Less: debt maturing within one year (36) (30)
------------------------------------------------------------------
Long-term debt obligations $ 54 $ 49
==================================================================
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 March 31, 2006 was $37,826, of which $8,154 was
classified under current portion of long-term debt.
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. In 2006, an additional $18,000 of computer equipment was
leased under similar terms. Monthly lease payments aggregate $2,604 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 10.4% to
13.4%. The principal balance of these obligations at March 31, 2006 was
$51,481, of which $27,942 was classified under current portion of long-term
debt.
6. CONVERTIBLE DEBT
Convertible debt obligations consisted of the following:
March 31, December 31,
(In thousands) 2006 2005
----------------------------------------------------------------------------
Borrowing under secured revolving credit
facility note $ - $1,409
Secured convertible Minimum Borrowing Note 283 423
Less: unamortized discount attributable to the
revolving credit facility note - (549)
Less: unamortized discount attributable to the
Minimum Borrowing Note (275) (415)
----------------------------------------------------------------------------
Convertible Debt, net of unamortized discounts 8 868
Less: current portion - (860)
----------------------------------------------------------------------------
Convertible Debt, net of unamortized discounts $ 8 $ 8
============================================================================
On March 31, 2005, the Company repaid all advances under the secured
revolving credit facility note with Laurus Master Fund, Ltd. ("Laurus")
with proceeds received from its private placement of convertible debt and
Series A preferred stock. During 2006, $140,000 of debt under the existing
Minimum Borrowing Note was converted to 110,000 shares of common stock.
As of March 31, 2006, the amount of available borrowings under the
revolving portion of the credit facility, pursuant to borrowing formulas,
was as follows (in thousands):
Available borrowings supported by collateral base $2,313
Less: amount borrowed under revolving credit facility -
Less: amount borrowed under the Minimum Borrowing Note (283)
------
Available to borrow $2,030
======
The average and highest amounts borrowed under the Laurus credit
facility during the three months ended March 31, 2006 were approximately
$1,427,000 and $1,884,000, respectively. The Company was in compliance
with the provisions of its loan agreement as of March 31, 2006. Future
required principal repayments under the MBN as of March 31, 2006 are: 2006
- $0; 2007 - $0; and 2008 - $283,000.
9
7. DERIVATIVE FINANCIAL INSTRUMENTS
The following derivative liabilities related to warrants and embedded
derivative instruments were outstanding as of March 31, 2006 and December
31, 2005 (in thousands):
Issue Expiration Exercise Value- Value- Value-
Instrument: Date Date Price Issue date 3/31/06 12/31/05
---------------------------------------------------------------------------------------------------------------------------------
Laurus Minimum Borrowing Note (Note 6) 9/2/2005 3/31/2008 $ 1.27 $ 323 $ 355 $ 135
12/6/05-
Laurus Revolving Note (Note 6) 12/31/05 3/31/2008 1.27 558 - 385
58,970 shares of Series A preferred stock issued
in connection with convertible note (Note 15) 2/17/2006 - - 625 875 -
135,550 shares of Series A preferred stock issued 2/17/2006-
in private placement (Note 14) 3/17/2006 - - 1,459 2,019 -
---------------------------------------------------------------------------------------------------------------------------------
Fair value of bifurcated embedded derivative
instrument liabilities 3,249 520
500,000 common stock warrants issued to Laurus 3/31/2005 3/31/2010 1.82 335 681 271
150,000 common stock warrants issued to placement
agent in connection with convertible note (Note 15) 2/8/2006 2/8/2011 1.27 197 251 -
677,750 common stock warrants issued in private 2/17/2006- 2/17/2016-
placement (Note 14) 3/17/2006 3/17/2016 2.125 695 967 -
20,332 preferred stock warrants issued to 2/17/2006- 2/17/2016-
placement agent in private placement (Note 14) 3/17/2006 3/17/2016 17.00 213 295 -
101,660 common stock warrants issued to placement 2/17/2006- 2/17/2016-
agent in private placement (Note 14) 3/17/2006 3/17/2016 2.125 140 185 -
---------------------------------------------------------------------------------------------------------------------------------
Total derivative financial instruments 5,628 791
Less: amount attributable to the Revolving Note,
reported in current liabilities - (385)
---------------------------------------------------------------------------------------------------------------------------------
Derivative financial instruments recorded in
non-current liabilities $5,628 $ 406
=================================================================================================================================
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. In valuing the (i) Laurus warrants and the embedded
conversion option components of Laurus's bifurcated embedded derivative
instruments; and (ii) the warrants to acquire common stock issued to the
Series A investors and the placement agent, at the time they were issued
and at each quarter ending date, 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% based on historical experience; and
a risk-free rate of return based on constant maturity rates published by
the U.S. Federal Reserve, applicable to the remaining life of the
instruments. In valuing the shares of Series A preferred stock issued to
investors, as well as the warrants to acquire preferred stock issued to the
placement agent, we used the same assumptions as above, except that we used
an expected life of 4.5 years to conversion to common stock because there
is a mandatory conversion option once the market price of the Company's
common stock exceeds $5.00 per share for 20 trading days.
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. 123R"), revising FASB Statement 123,
"Accounting for Stock-Based Compensation" and superseding APB Opinion No.
25, "Accounting for Stock Issued to Employees" and its related
implementation guidance. 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
10
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, accordingly, the Company adopted the standard in the first
quarter of fiscal 2006. For further information, refer to Note 10.
9. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
March 31, December 31,
(In thousands) 2006 2005
-----------------------------------------------------------------------------
Salaries, commissions and benefits $427 $296
Legal fees and expenses 56 104
Income and property taxes 41 36
Customer deposits and unearned revenue 31 30
Employee Stock Purchase Plan deposits 4 28
Other 24 45
-----------------------------------------------------------------------------
Accrued expenses and other current liabilities $583 $539
=============================================================================
10. STOCK-BASED COMPENSATION
Effective January 1, 2006, the Company adopted SFAS 123R using the
modified prospective method as permitted under SFAS 123R. Under this
transition method, compensation cost recognized in the first quarter of
fiscal 2006 includes: (a) compensation cost for all share-based payments
granted prior to, but not yet vested as of December 31, 2005, based on the
grant-date fair value estimated in accordance with the provisions of SFAS
123, and (b) compensation cost for all share-based payments granted
subsequent to December 31, 2005, based on the grant-date fair value
estimated in accordance with the provisions of SFAS 123R. In accordance
with the modified prospective method of adoption, the Company's results of
operations and financial position for prior periods have not been restated.
Stock Option Plans: The Company has outstanding options granted
under the following plans: (i) the Farmstead Telephone Group, Inc. 2002
Stock Option Plan (the "2002 Plan") and (ii) the Farmstead Telephone Group,
Inc. 1992 Stock Option Plan (the "1992 Plan"). The 1992 Stock Option Plan
terminated in May 2002; however options previously granted under the 1992
Plan may continue to be exercised in accordance with the terms of the
individual grants. The Company grants options with varying vesting terms,
including 100% exercisable after 1 year, 50% per year over 2 years, and 25%
or 20% per year over 4 or 5 years. The vesting terms vary depending upon
the circumstances - e.g. options included in an employment offer may be
subject to negotiation- and are reviewed with the Board of Directors.
The 2002 Plan currently permits the granting of options to purchase
up to 2.3 million shares of common stock to employees, directors and
consultants of the Company, which shall be either incentive stock options
("ISOs") as defined under Section 422 of the Internal Revenue Code, or non-
qualified stock options ("NSOs"). ISOs may be granted at no less than
market value at the time of grant, with a maximum term of ten years except,
for a 10% or more stockholder, the exercise price shall not be less than
110% of market value, with a maximum term of five years. NSOs may be
granted at no less than 50% of market value at the time of grant, with a
maximum term of 10 years. Any option granted pursuant to this Plan which
for any reason fails to qualify as an ISO shall be deemed to have been
granted as an option not qualified under Section 422 of the Code. The
maximum number of shares issuable under the 2002 Plan, which expires April
3, 2012, is 2,300,000.
Employee Stock Purchase Plans - The Company also has an employee
stock purchase plan ("ESPP") that allows eligible employees to purchase,
through payroll deductions, shares of the Company's common stock at a
discount from the fair market value of the common stock at specified dates.
Employees may withdraw from an offering before the purchase date and obtain
a refund of the amounts withheld. In the semi-annual offering period that
ended February 2006, the Company amended the terms of the ESPP such that
the discount was reduced from 15% to 5% of the market value of the common
stock as of the last day of the offering period. This change in the plan
resulted in the expense related to the ESPP to be non-compensatory under
SFAS 123R. During the quarter ended March 31, 2006 employees purchased
18,900 shares of common stock for $33,642.
Under SFAS 123R, the Company recognized $84,000 of compensation
expense during the quarter ended March 31, 2006. Of this amount, $16,000
was charged to Other cost of revenues, and $68,000 was charged to SG&A
expense. The following table details the effect on net loss and loss per
share had stock-based compensation expense been recorded for the quarter
ended March 31, 2005 based on the fair-value method under SFAS 123,
"Accounting for Stock-based Compensation" (in thousands, except per share
amount).
11
Three Months
Ended
March 31, 2005
-------------------------------------------------------------------------------
Net loss, as reported $(1,032)
Add: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects (202)
-------------------------------------------------------------------------------
Pro forma net loss $(1,234)
Pro forma net loss per share:
Basic and diluted $ (.37)
===============================================================================
Grant-Date Fair Value
---------------------
The Company uses the Black-Scholes option pricing model to calculate
the grant-date fair value of an award. The fair value of options granted
during the first quarter of fiscal 2006 and the first quarter of fiscal
2005 were calculated using the following estimated weighted average
assumptions:
Three Months Ended March 31,
----------------------------
2006 2005
---- ----
Risk-free rate of return 4.63% 3.88%
Expected life of award (years) 3.6 3.6
Expected dividend yield of stock 0% 0%
Expected volatility of stock 65% 55%
Weighted-average fair value $.98 $.49
Risk-free interest rate - the Company uses the constant maturity rates on
U.S. Treasury securities published by the U. S. Federal Reserve for a
period that is commensurate with the expected term assumption.
Expected term - the Company estimates the expected term of its option
grants through a review of its historical employee exercise behavior and
through consultation with an independent third-party advisor with the
requisite expertise in stock option valuations who also considered the
Company's history of stock price appreciation/decline and studies on
employee exercise behavior.
Expected dividend yield - the Company assumes a 0% yield since it has never
declared a dividend on its common stock and is currently prohibited from
doing so without the consent of its lender.
Expected volatility - the Company estimates volatility by considering both
historical volatility and implied (future) volatility in consultation with
an independent third-party advisor with expertise in this area. In
determining implied volatility, the Company and advisor consider such
factors as the thinly-traded nature of the Company's stock over significant
time-spans, and a review of volatility in the Company's industry sector.
The Company currently believes that the use of implied volatility results
in a more accurate estimate of the grant-date fair value of employee stock
options because it more appropriately reflects the market's expectations of
future volatility. Historical volatility during the period commensurate
with the expected term of the Company's stock options over the past several
years included a period of time that the Company's stock price experienced
unprecedented increases and subsequent declines. The Company believes that
this past stock price volatility is unlikely to be indicative of future
stock price behavior.
Option Plan Activity
--------------------
A summary of the activity under the Company's stock option plans
during the three months ended March 31, 2006 is as follows (aggregate
intrinsic value in thousands):
Weighted
Weighted average
average remaining Aggregate
Number exercise contractual intrinsic
of shares price term (years) value
---------------------------------------------------------------------------------------------------
Outstanding at December 31, 2005 2,684,619 $1.45 5.3 $ 706
Granted 168,000 1.92
Exercised (500) .41
Canceled (1,500) 1.76
Forfeited (7,750) 1.19
---------------------------------------------------------------------------------------------------
Outstanding at March 31, 2006 2,842,869 1.48 5.2 $2,415
===================================================================================================
12
Exercisable at March 31, 2006 2,298,869 $1.38 4.3 $2,104
Vested or expected to vest at March 31, 2006 2,785,855 1.48 4.8 2,284
The weighted-average grant-date fair value of options granted during
the three months ended March 31, 2006 was $.98. The total intrinsic value
of options exercised during the three months ended March 31, 2006 was $835.
Cash received from stock option exercises during the three months ended
march 31, 2006 was $205.
Warrants
--------
As of March 31, 2006, there were 900,000 warrants outstanding that
were issued to certain executive officers of the Company, all of which were
fully vested at December 31, 2005. The weighted-average exercise price of
the warrants is $.67. As of March 31, 2006, the warrants had a weighted-
average exercise price of $.67, a weighted-average remaining contractual
term of 3.9 years, and an aggregate intrinsic value of $1,471,500.
Expense
-------
The Company recognizes expense using the straight-line prorated
allocation method. The amount of stock-based compensation recognized
during a period is based on the value of the portion of the awards that are
ultimately expected to vest. SFAS 123R requires forfeitures to be estimated
at the time of grant and revised, if necessary, in subsequent periods if
actual forfeitures differ from those estimates. The term "forfeitures" is
distinct from "cancellations" or "expirations" and represents only the
unvested portion of the surrendered option. The Company has applied an
annual forfeiture rate of 4% to all unvested options as of January 1, 2006.
Ultimately, the actual expense recognized over the vesting period will only
be for those shares that vest. As of March 31, 2006, there was $359,000 of
total unrecognized compensation cost related to unvested share-based
awards. That cost is expected to be recognized into expense over a
weighted-average period of 1.3 years.
11. EMPLOYEE BENEFIT PLANS
The components of the net periodic benefit cost included in the
results of operations for the three months ended March 31, 2006 and 2005
are as follows:
Three months ended
March 31,
------------------
(In thousands) 2006 2005
--------------------------------------------------
Service cost $22 $22
Interest cost 12 10
Recognized actuarial losses 2 2
-----------------------------------------------
Net expense $36 $34
===============================================
12. INTEREST EXPENSE
Interest expense for the three months ended March 31, 2006 and 2005
consisted of the following:
Three months ended
March 31,
------------------
(In thousands) 2006 2005
-------------------------------------------------------------------------
Interest expense on outstanding borrowings $44 $8
Amortization of deferred financing costs (1) 13 -
Amortization of discounts on convertible notes (2) 27 -
-------------------------------------------------------------------------
Total interest expense $84 $8
=========================================================================
(1) Consists of $3,048 amortization of an imputed discount on
warrants issued to the Laurus Master Fund Ltd. ("Laurus") and $9,750 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.
(2) Consists of (i) the write-off of a $23,220 discount recorded in
valuing free-standing warrants issued in connection with a convertible note
which was subsequently repaid (see Note 15); and (ii) $4,358 amortization
of a discount imputed in accounting for the Company's convertible minimum
borrowing note with Laurus (see Note 6).
13
13. SEGMENT INFORMATION
Historically, the Company has operated in a single business segment,
selling telecommunications equipment to businesses. During 2005, the
Company formed OIPV and commenced activities related to the development of a
new business segment which provides hosted carrier-based Voice over IP
products and related network services to the small-to-medium business
marketplace. The hosted VoIP business, presented below as the "IP Telephony"
business segment, commenced sales operations in January 2006. Summarized
financial information for the Company's reportable business segments for the
three months ended March 31, 2006 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
March 31, 2006 is as follows:
Telecom- IP
munication Telephony
(In thousands) Equipment Services Corporate Consol.
------------------------------------------------------------------------------------
Revenues $4,407 $ 7 $ - $ 4,414
Operating loss (135) (976) (258) (1,369)
Depreciation and amortization 27 22 - 49
Identifiable assets 5,013 561 535 6,109
Capital expenditures 21 109 - 130
====================================================================================
At March 31, 2005, the Company was operating in only one segment and,
accordingly, segment information is not presented for that period.
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
ended
(In thousands) March 31, 2006
--------------------------------------------------------
Total segment operating losses $(1,111)
Unallocated amounts:
Corporate expenses (258)
Interest expense (84)
Derivative instrument expense (2,634)
Other income 2
--------------------------------------------------------
Consolidated loss before income taxes $(4,085)
========================================================
14. PREFERRED STOCK
March 31,
(in thousands) 2006
-------------------------------------------------------------------------------
Series A preferred stock, par value $.001, 194,520 shares
issued and outstanding (see also Note 15) $ 3,307
Less: unamortized discount related to warrants issued to
investors and bifurcated embedded derivative instrument (Note 7) (3,156)
-------------------------------------------------------------------------------
Carrying amount at March 31, 2006 $ 151
===============================================================================
On February 17, 2006 and March 17, 2006 the Company sold an aggregate
of 135,550 Unit shares of Series A Preferred Stock to several accredited
investors (the "Investors") at a price of $17.00 per Unit. Each Unit
consists of (i) one share of the Company's Series A Preferred Stock, $.001
par value per share, and (ii) a Warrant to purchase five shares of the
Company's Common Stock, par value $.001 per share, at an exercise price of
$2.125 per share (the Series A Preferred Stock and the Warrant together
"Securities"). The Securities were not registered under the Securities Act
of 1933, as amended, or
14
applicable state securities laws. The Securities are subject to
restrictions on transferability and resale and may not be transferred or
resold except as permitted under the Securities Act of 1933, as amended,
and applicable state securities laws, pursuant to registration or exemption
from those laws. The proceeds received by the Company, net of $184,354
placement agent fees and $112,569 expenses incurred by the Company, were
$2,007,514.
The following describes certain of the material terms of these
transactions. The description below is not a complete description of the
terms of the financing transaction and is qualified in its entirety by
reference to the agreements entered into in connection therewith which are
included as exhibits to previously filed Current Reports on Form 8-K.
Series A Preferred Stock. Each share of Series A Preferred Stock is
convertible into ten shares of common stock, based upon an initial
conversion price of $1.70 per common share. The conversion price of the
Series A Preferred Stock will be subject to a weighted average adjustment
(based on all deemed outstanding shares of Common Stock and shares of
Preferred Stock) and to reduce dilution in the event that the Company
issues additional equity securities (other than the shares reserved for
issuance under or to Laurus Master Fund Ltd., the Company's Stock Option
Plan, the Company's Employee Stock Purchase Plan, employees, officers,
consultants and directors of the Company, and under other currently
existing options, warrants and obligations to issue shares) at a purchase
price less than the Series A Preferred Stock conversion price. The Series
A Preferred Stock conversion price will also be subject to proportional
adjustment for stock splits, stock dividends, recapitalizations and the
like.
Dividends accrue at an 8% annual rate; however the Company is under
no obligation to pay such accruing dividends except under the following
conditions: (i) the Investors have the right to receive in preference to
any dividend on the Common Stock a cumulative non-compounding dividend at
the rate of 8% per annum of the original Preferred A Per Share Price; (ii)
in the event of any liquidation or winding up of the Company, the Investors
shall be entitled to receive in preference to the holders of the Common
Stock an amount equal to two times the original Preferred A Per Share Price
plus any declared but unpaid dividends; and (iii) in the event of a
redemption, as further described below.
The Series A Preferred Stock is subject to mandatory conversion into
shares of common stock upon the earliest to occur of (a) the closing of the
sale of shares of common stock to the public at a price of at least $5.00
per share, subject to anti-dilution adjustments, which results in at least
$10 million of gross proceeds to the Company; (b) the consent of the
majority of the holders of the then outstanding Series A Preferred Stock;
or (c) the date upon which the closing sale price of the common stock
exceeds $5.00 per share for twenty consecutive trading days. All of the
outstanding shares of Series A Preferred Stock shall be redeemed by the
Company at its original issue price plus accrued dividends in three annual
installments commencing 270 days after receipt by the Company at any time
on or after February 17, 2011 and prior to February 17, 2013, of written
notice from the holders of a majority of the then outstanding shares of
Series A Preferred Stock.
The Series A Preferred Stock will vote together with the Common Stock
and not as a separate class except as required by law, however, the holders
of the Series A Preferred Stock, exclusively and as a separate class, will
be entitled to elect one (1) director of the Corporation. Each share of
Series A Preferred Stock shall have a number of votes equal to the number
of shares of Common Stock then issuable upon conversion of such share of
Series A Preferred Stock.
Warrant to Purchase Shares of Stock. The Investors received warrants
to purchase up to an aggregate of 677,750 shares of the Company's common
stock at an exercise price of $2.125 per share. The warrants expire five
years from issuance. In lieu of exercising the warrant with cash, the
Holder may elect to receive that number of shares of common stock equal to
the value of the warrant (or that portion being exercised) at the time of
exercise.
Registration rights. The Company agreed to use its best efforts to
register the common stock underlying the Securities for resale via a Form
S-3 or other appropriate registration statement ("Registration Statement")
within 90 days after the completion of the Series A Offering. The Company
agreed to respond to Securities and Exchange Commission Registration
Statement comments within 10 days and request effectiveness of the
Registration Statement within 3 days of "no review" or "no further
comments". In the event that the registration statement is not declared
effective within this time period, the Company will be subject to an
aggregate penalty of $500 for each business day until such registration
statement becomes effective.
Because the Series A Preferred Stock is not considered to be
"conventional convertible preferred stock", the embedded conversion option
is subject to the accounting requirements of EITF Issue 00-19. Because of
the penalties we may have to pay under the Investor Rights Agreement, and
the fact that the conversion price can be adjusted in certain
circumstances, we are required by EITF 00-19 to bifurcate the embedded
conversion option and account for it as a derivative instrument liability.
This derivative instrument liability was initially valued, using the Black-
Scholes options pricing model, at $10.64 - $10.82 per preferred share,
attributable to two separate closing dates. It is then adjusted to fair
value at the end of each
15
subsequent period, with any changes in fair value charged or credited to
income in the period of change. Refer to Note 7 for further information on
the assumptions used in determining fair market value of the derivative
instruments. The Company allocated the $1,459,000 fair value of the
embedded conversion option and the $695,000 fair value of the 677,750
common stock purchase warrants issued to the investors, to the $2,304,000
gross proceeds received, resulting in an initial net carrying value of
$150,000. This carrying value will be accreted to its original value of
$2,304,000 using an effective interest method over an expected life to
conversion of 4.5 years.
In connection with the above transactions, the Company issued to its
placement agent warrants (the "Placement Agent Warrants") (i) to purchase
up to an aggregate of 101,660 shares of the Company's common stock at an
exercise price of $2.125 per share and (ii) to purchase up to an aggregate
of 20,332 shares of the Company's Series A Preferred Stock at an exercise
price of $17.00 per share. The Placement Agent Warrants expire ten years
from issuance. In lieu of exercising the warrants with cash, the placement
agent may elect to receive that number of shares of common stock or Series
A Preferred Stock, as applicable, equal to the value of the warrant (or
that portion being exercised) at the time of exercise. The Company also
paid the placement agent a fee of $184,354 representing 8% of the gross
proceeds. These placement fees, the $352,941 calculated fair value of the
placement agent warrants, and $112,569 of other transaction costs,
aggregating $650,170, were charged to Additional Paid-in Capital.
15. CONVERTIBLE NOTES
On February 8, 2006, the Company issued a $1,000,000 Principal
Amount Convertible Promissory Note (the "Sotomar Note") to Sotomar -
Empreendimentos Industriais e Imobiliarios, SA (the "Holder") pursuant to a
Convertible Note and Warrant Purchase Agreement (the "Purchase Agreement").
The proceeds received by the Company, net of an $80,000 placement agent fee
and other expenses, were $913,000. Under the terms of the Sotomar Note,
the outstanding Principal Amount under the Sotomar Note, plus any accrued
but unpaid interest thereon, shall automatically convert into shares of
Series A Preferred Stock upon the sale of Series A Preferred Stock and
warrants to purchase Common Stock to accredited investors in a private
placement transaction pursuant to Regulation D (collectively, "Offered
Securities") which produces at least $500,000 of aggregate gross proceeds
to the Company (a "Preferred Offering"). As a result of the February 17,
2006 sale of Series A Preferred Stock to an accredited investor for
$750,000, the Sotomar Note, together with $2,490 interest accrued thereon,
converted into 58,970 shares of Series A Preferred Stock.
In connection with the issuance of the Sotomar Note, the Holder
received a warrant to purchase up to an aggregate 529,134 shares of the
Company's common stock at an exercise price of $1.27 per share. The warrant
expires ten years from issuance. In lieu of exercising the warrant with
cash, the Holder may elect to receive that number of shares of common stock
equal to the value of the warrant (or that portion being exercised) at the
time of exercise. The warrants were valued using the Black-Scholes options
pricing model, resulting in an $834,000 discount against the proceeds of
the Sotomar Note. Because the exercise price and the number of shares are
fixed, subject to normal anti-dilution adjustments, and the Company can
deliver unregistered shares, the Company recorded this amount directly to
Additional Paid-in Capital. Because the Series A Preferred Stock into
which the Sotomar Note converted has the same characteristics as the other
Series A Preferred Stock, the Company has bifurcated the embedded
conversion option and is accounting for it as a derivative instrument
liability, in the same manner as the other issued Series A Preferred Stock.
Since the value of the embedded conversion option of $627,500 exceeded the
net carrying value of the Sotomar Note of $168,469 at the date of
conversion, the Company reduced the initial carrying value of the
associated Series A Preferred Stock to zero and recorded an immediate
charge to income of $459,031. The series A Preferred Stock will be
accreted to its redemption value of $1,002,490 using the effective interest
method and an estimated life to conversion of 4.5 years.
In connection with the Sotomar Note transaction, and pending receipt
of proceeds from the issuance of the Sotomar Note, on January 30, 2006 an
affiliate of the placement agent advanced the Company $400,000 pursuant to
a convertible note with terms similar to the Sotomar Note. The advance was
repaid with $1,111 of interest on February 8, 2006. A warrant for the
purchase of 22,047 shares of common stock was issued to the affiliate for
providing the advance. The warrant has a 10 year life and is exercisable
at $1.27 per share. Using Black-Scholes the Company calculated a $23,219
value to the warrant. Because the exercise price and the number of shares
are fixed, subject to normal anti-dilution adjustments, and the Company can
deliver unregistered shares without penalty, the Company recorded this
amount directly to Additional Paid-in Capital. Upon repayment of the
advance, the $23,219 unamortized discount was charged to interest expense.
In connection with the Sotomar Note, the placement agent received an
$80,000 fee and a warrant (the "Placement Agent Warrant") to purchase up to
an aggregate 150,000 shares of the Company's common stock at an exercise
price of $1.27 per share. The Placement Agent Warrant expires five years
from issuance. In lieu of exercising this warrant with cash, the placement
agent may elect to receive that number of shares of common stock equal to
the value of the warrant (or that portion being exercised) at the time of
exercise. Because these warrants are subject to the same registration
rights and associated
16
penalties as described in Note 14, the Company has accounted for the
warrant as a derivative instrument liability. See Note 7 for further
accounting information.
16. 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. Not included
in the computation of diluted loss per share for the three months ended
March 31, 2006 were the following weighted average outstanding items: (i)
options and warrants to purchase 1,818,000 shares of common stock; (ii)
223,000 common shares issuable assuming conversion of convertible notes;
and (iii) 636,000 common shares issuable assuming conversion of Series A
preferred stock and warrants to purchase Series A preferred stock. Not
included in the computation of diluted loss per share for the three months
ended March 31, 2005 were weighted average outstanding options and warrants
to purchase 798,000 shares of common stock. These items were excluded from
the computation of diluted loss per share because their inclusion would be
antidilutive in each period presented.
17. SUBSEQUENT EVENTS
On April 17, 2006 the Company sold 64,906 Unit shares of Series A
Preferred Stock to several accredited investors (the "Investors") at a
price of $17.00 per Unit. Each Unit consists of (i) one share of the
Company's Series A Preferred Stock, $.001 par value per share, convertible
into ten shares of Common Stock and (ii) a five-year Warrant to purchase
five shares of the Company's Common Stock, par value $.001 per share, at an
exercise price of $2.125 per share (the Series A Preferred Stock and the
Warrant together "Securities"). The Securities were not registered under
the Securities Act of 1933, as amended, or applicable state securities
laws. The Securities are subject to restrictions on transferability and
resale and may not be transferred or resold except as permitted under the
Securities Act of 1933, as amended, and applicable state securities laws,
pursuant to registration or exemption from those laws.
The proceeds received by the Company, net of fees and expenses
incurred by the Company's placement agent, were $1,011,968.
In connection with the above transaction, the Company issued to its
placement agent warrants (the "Placement Agent Warrants") (i) to purchase
up to an aggregate 48,675 shares of the Company's common stock at an
exercise price of $2.125 per share and (ii) to purchase up to an aggregate
9,735 shares of the Company's Series A Preferred Stock at an exercise price
of $17.00 per share. The Placement Agent Warrants expire ten years from
issuance.
The above transactions represented the "third tranche" of a private
offering of Series A preferred stock which commenced February 17, 2006. See
Note 14 for a description of the material terms of the aforementioned
transactions.
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.
17
RESULTS OF OPERATIONS
Overview
For the three months ended March 31, 2006, we reported a net loss of
$4,092,000 or $1.06 per share on revenues of $4,414,000. The net loss
includes non-cash derivative instrument expense of $2,634,000 primarily
arising from increases in the fair market value of the Company's derivative
financial instruments during this period, as more fully described in Notes
6,7, 14 and 15 of the Notes to Consolidated Financial Statements contained
herein. Excluding the non-cash derivative instrument expense, we otherwise
incurred a $1,458,000 loss for the three months ended March 31, 2006. This
compares with a net loss of $1,032,000 or $.31 per share on revenues of
$2,409,000 recorded for the three months ended March 31, 2005. The
operating results for the three months ended March 31, 2006 includes an
operating loss of approximately $976,000 attributable to our new business
entity One IP Voice, Inc. as further described below. The net loss for the
three 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.
As further described in the Company's Annual Report on Form 10-K for
the year ended December 31, 2005, the Company has taken several measures to
turnaround its operating performance. The turnaround strategy is
principally based upon stabilizing the Company's legacy telecommunications
business through building a larger and more highly qualified sales force
and diversifying the Company's product offerings and targeted customers,
while developing an IP telephony services business in order to transition
the Company's business model to a broader communications solutions
provider. In March 2005, the Company implemented measures to increase
revenues from its legacy telecommunication equipment business by increasing
its sales force and targeting the small-to-medium size business ("SMB")
market while continuing to serve its base of large, "Enterprise" customers.
These efforts to date have resulted in increased revenues in 2006 as
compared to 2005. In May 2005, the Company took steps to further diversify
its product offerings, forming a wholly-owned subsidiary named "One IP
Voice" ("OIPV"), which became operational in January 2006, offering
carrier-based hosted IP telephony services along with network services.
Its primary target is also the SMB market.
In order to finance its business turnaround and expansion plans, the
Company increased its credit lines in March 2005, obtaining a $3 million
credit facility from Laurus Master Fund Ltd. which replaced a $1.7 million
credit facility. During 2006, the Company raised approximately $4 million
of additional capital through offerings of convertible debt and Preferred
Stock to unaffiliated private investors. This new capital will be used to
continue the build out and national deployment of its IP telephony products
and services.
Additional information on our results of operations and financial
condition for the three months ended March 31, 2006 follows below.
Revenues
Three months ended
March 31,
------------------
(In thousands) 2006 2005
-------------------------------------------------------
Equipment:
End-user equipment sales $3,327 $1,875
Equipment sales to resellers 137 90
-------------------------------------------------------
Total equipment sales 3,464 1,965
-------------------------------------------------------
Services:
Installations 667 259
Other services 24 28
IP telephony services 7 -
-------------------------------------------------------
Total services 698 287
Other revenue 252 157
-------------------------------------------------------
Total services and other revenue 950 444
-------------------------------------------------------
Consolidated revenues $4,414 $2,409
=======================================================
Equipment Sales. End user equipment sales for the three months ended
March 31, 2006 increased by $1,452,000 or 77% over the comparable 2005
period, of which $1,143,000 was attributable to an increase in systems
sales, and $309,000 was attributable to an increase in aftermarket parts
sales. Equipment sales to resellers also increased by $47,000 or 52% over
the comparable 2005 period. These results are primarily attributable to
the Company's strategy to increase revenues by
18
expanding its sales force, diversify its product offerings, and expand its
customer base by targeting SMBs in addition to its existing base of larger
"Enterprise" customers. The Company's direct sales force has more than
doubled from the prior year quarter. In addition, sales to the SMB
marketplace have significantly increased from a year ago, as have sales of
complete systems to both Enterprise customers and SMB customers.
Services revenue for the three months ended March 31, 2006 increased
by $411,000 or 143% over the comparable 2005 period, attributable to a
$408,000 increase in the legacy telecommunications business installation
revenues. The increase was attributable to the growth 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.
OIPV, which began marketing its IP telephony products and services in
January 2006, recorded its first revenues of $7,000 during the first
quarter of 2006.
Other revenue for the three months ended March 31, 2006 increased by
$95,000 or 61% over the comparable 2005 period, primarily attributable to a
$62,000 increase in 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.
Cost of Revenues and Gross Profit. Total cost of revenues for the
three months ended March 31, 2006 was $3,169,000, an increase of $1,514,000
or 91% from the comparable 2005 period. The gross profit for the three
months ended March 31, 2006 was $1,245,000, an increase of $491,000 or 65%
from the comparable 2005 period. As a percentage of revenue, the overall
gross profit margin was 28% for 2006, compared to 31% for the comparable
2005 period. The overall gross margin was adversely impacted by an $89,000
negative gross profit recorded by OIPV, which generated less revenue during
this period than its production costs. Excluding OIPV, the Company
generated an overall gross profit margin of 30% during the current year
period.
Gross Profit Margins on Equipment Sales. For the three months ended
March 31, 2006, the gross profit margin on equipment sales decreased to 30%
from 33% in 2005. The decline is partly attributable to product mix, as
system sales comprised a significantly larger share of our 2006 equipment
sales revenues than the comparable 2005 period - 59% vs. 45%, and they have
historically generated lower profit margins than the parts sales business.
We are also trending towards more sales of complete systems which typically
have lower profit margins than system upgrades. In addition, profit margins
from our aftermarket parts business were lower than the prior year period.
This continues to be 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.
Gross Profit Margins on Services and Other Revenue. For the three
months ended March 31, 2006, the Company recorded an overall 37% profit
margin on its combined services and other revenue, compared with a 47%
profit margin recorded in the comparable 2005 period. Excluding the
negative profit margin generated by OIPV, as further described below, the
profit margin for 2006 was 42%.
The gross profit margin on services revenue was 21% for the three
months ended March 31, 2006 compared with 29% in the comparable 2005
period. The 2006 profit margin consisted of a 27% profit margin generated
by the Company's legacy telecommunications equipment business segment,
offset by a negative profit margin from its IP telephony business segment
(OIPV). OIPV generated $41,000 of service costs in excess of its realized
revenues during this period, which represented its first quarter of sales
operations. The 2 percentage point decline in the legacy
telecommunications equipment business segment was attributable to the
significant increase in installation revenues, which has historically
generated lower profit margins than other service offerings.
The gross profit margin on other revenues was 81% during the three
months ended March 31, 2006, compared with 80% during the comparable prior
year period. Other revenue primarily consists of one-time commissions
earned on the sale of Avaya maintenance contracts which generate a 100%
profit margin.
Other Costs of Revenue. Other costs of revenue consists of product
handling, purchasing and facility costs and expenses. It additionally
includes the costs incurred by OIPV to operate and maintain its IP network
and the depreciation and amortization of the associated equipment and
licenses. For the three months ended March 31, 2006, these expenses were
$52,000 higher than 2005, primarily attributable to the aforementioned IP
network, equipment and license costs incurred by OIPV.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses
for the three months ended March 31, 2006 were $2,614,000, an increase of
$1,230,000 or 89% from the comparable 2005 period. G&A expenses for the
three
19
months ended March 31, 2006 were 59% of revenues, compared to 57% of
revenues in 2005. Approximately $887,000 or 72% of the increase in SG&A
was attributable to expenses incurred by, or allocated to, OIPV, which was
formed in May 2005 and commenced sales operations in January 2006.
Sales and marketing expenses accounted for $780,000 of the increase
in SG&A, of which $506,000 was attributable to increased sales and sales
support salaries, $156,000 was attributable to increased commissions as a
result of the higher sales level, and $40,000 represented stock option
expense as the Company implemented the requirements of SFAS 123R, as
further described in Note 10. As described above, the Company more than
doubled its direct sales force from a year ago as part of its strategy to
increase revenues in its legacy telecommunications business. In addition,
the buildout to date of OIPV's sales and marketing team accounted for
$304,000 of the salary and commission increase.
General and administrative expenses accounted for $450,000 of the
increase in SG&A, which included increased compensation expenses of
$269,000, and increased employee-related expenses such as insurance,
recruitment fees, office expenses and travel expenses which increased by an
aggregate $241,000. The operations of OIPV accounted for $132,000 of the
increased compensation expenses related to the hiring of management and
administrative personnel. In addition, the Company recognized $28,000 of
stock option expense in the first quarter of 2006. Included in general and
administrative expense in 2005 was $84,000 of expense related to the early
termination of the Company's credit facility with BACC.
We expect our SG&A expenses to increase as we continue the
infrastructure development and deployment of our OIPV product offerings.
Other Income (Expense). Other income (expense) for the three months
ended March 31, 2006 was $(2,716,000), compared with $(398,000) for 2005.
The principal components of other income (expense) are as follows.
Interest Expense:
Three months ended
(in thousands) March 31,
---------------------------------------------------------------------
2006 2005
---- ----
Interest expense on outstanding borrowings $44 $8
Amortization of deferred financing costs 13 -
Amortization of discounts on convertible notes 27 -
---- ----
Total interest expense $84 $8
==== ====
The increase in interest expense on outstanding borrowings was
attributable to higher average borrowing levels and interest rates under
the Company's credit facilities. Amortization of deferred financing costs
consists of $3,048 amortization of an imputed discount on warrants issued
to the Laurus and $9,750 of amortization of a prepaid facility fee of
$117,000 in connection with the Laurus revolving credit facility entered
into 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. Amortization of
discounts on convertible notes includes $4,358 amortization of the imputed
discount on the Laurus Minimum Borrowing Note (see Note 6), and a $23,220
write-off of the unamortized balance of a discount recorded in valuing
warrants issued in connection with the issuance of a $400,000 convertible
note which was repaid in full (see Note 15). 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 derivative
instrument expense of $2,634,000 and $393,000 during the three months ended
March 31, 2006 and 2005, respectively, from its derivative instrument
liabilities, of which during 2006 (i) $913,000 was attributable to the
Company's convertible debt facility with Laurus, as further described in
Note 6 and 7, and (ii) $1,721,000 was attributable to the Company's private
placement transactions, as more fully described in Notes 7, 14 and 15.
Income or losses generated from these derivative liabilities are non-cash,
with no effect on liquidity, and the amount of income or loss recognized is
affected by changes in the fair market value of the Company's common stock
price during each reporting period, as the Company is required to record
"mark-to-market" adjustments to the value of its derivative liabilities.
The increase in the market value of the Company's common stock during each
quarterly period had a significant impact on the determination of the
amount of derivative instrument expense.
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
20
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 (deficit), defined as current assets less current
liabilities, was $859,000 at March 31, 2006, compared to a deficiency of
($568,000) at December 31, 2005. The working capital ratio was 1.22 to 1
at March 31, 2006, compared to .88 to 1 at December 31, 2005. The working
capital deficiency at December 31, 2005 included a $385,000 derivative
instrument liability related to the Company's convertible revolving credit
facility. The $1,427,000 increase in working capital was primarily
attributable to proceeds received from the issuance of a $1,000,000
convertible note, and from the sale of Series A preferred stock as further
described below.
Operating activities used $1,288,000 during the three months ended
March 31, 2006, compared to providing $303,000 in the comparable 2005
period. Net cash used by operating activities in 2006 consisted of a net
loss of $4,092,000 less non-cash items aggregating $2,844,000, and net cash
used by changes in operating assets and liabilities of $40,000. The non-
cash items consisted primarily of $2,634,000 of expense arising from the
increase in value of the Company's derivative instrument liabilities, as
more fully presented in Note 7.
Investing activities used $112,000 during the three months ended
March 31, 2006, compared to $3,000 in 2005. Net cash used by investing
activities in 2006 and 2005 consisted of capital expenditures. Capital
expenditures during 2006 were principally for the purchase of network
equipment and software in connection with OIPV's continuing build out of
its IP telephony platform, and for 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 of up to $500,000
in any fiscal year period before requiring Laurus's prior approval.
Financing activities provided $1,539,000 during the three months
ended March 31, 2006, principally from net proceeds of $913,000 from the
issuance of a $1 million convertible note and net proceeds of $2,008,000
from the sale of Series A preferred stock. The Company used $1,409,000 of
the proceeds to temporarily pay down the balance of its revolving loan
balance with Laurus. As of March 31, 2006, outstanding borrowings under
the Company's $3 million Laurus credit facility were $283,000, and the
Company had $2,030,000 of borrowing availability.
The Company is not currently generating sufficient cash flow from
operations to cover the operating costs of both our legacy
telecommunications business and One IP Voice, and we are highly dependent
upon our current credit facility and generating cash through offerings of
Company securities to outside investors. During 2006 however, the Company
completed several private placements of convertible debt and equity
securities, raising approximately $4 million, in order to raise capital for
use in its current business and the working capital requirements of OIPV.
Refer to Notes 14, 15 and 17 of the Notes to Consolidated Financial
Statements contained herein, for a description of the material terms of
these financing transactions. To summarize:
* On January 30, 2006, the Company issued a $400,000 Convertible
Promissory Note and a Warrant to purchase 22,047 shares of common stock to
an affiliate of the placement agent, pursuant to a Convertible Promissory
Note and Purchase Agreement. This note was subsequently repaid in full,
with interest, on February 8, 2006.
* On February 8, 2006, the Company issued a $1,000,000 Principal
Amount Convertible Promissory Note (the "Sotomar Note") to Sotomar -
Empreendimentos Industriais e Imobiliarios, SA (the "Holder") pursuant to a
Convertible Note and Warrant Purchase Agreement (the "Purchase Agreement")
of even date. The proceeds received by the Company, net of placement agent
fees and expenses, amounted to approximately $913,000. Pursuant to the
terms of the Sotomar Note, as a result of the sale of Units described
below, on February 17, 2006 the Sotomar Note, together with interest
accrued thereon, converted into 58,970 shares of Series A Preferred Stock.
* On February 17, 2006 and March 17, 2005 the Company sold an
aggregate of 135,550 Unit shares of Series A Preferred Stock to several
accredited investors (the "Investors") at a price of $17.00 per Unit. Each
Unit consists of (i) one share of the Company's Series A Preferred Stock,
$.001 par value per share, and (ii) a Warrant to purchase five shares of
the Company's Common Stock, par value $.001 per share, at an exercise price
of $2.125 per share (the Series A Preferred Stock and the Warrant together
"Securities"). The proceeds received by the Company, net of $184,354
placement agent fees and $112,569 expenses incurred by the Company's
placement agent, were $2,007,514.
* On April 17, 2006 the Company sold an additional 64,906 Unit
shares of Series A Preferred Stock to several accredited investors at a
price of $17.00 per Unit, receiving net proceeds of approximately
$1,000,000.
21
The development of the OIPV business to perform at the operating
levels anticipated by management will require additional financing during
2006. At a Special Meeting of the Stockholders of the Company, held
December 16, 2005, the Company received shareholder approval to conclude
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, in the 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, however, that we will continue to be
successful in raising cash through securities offerings, since they are
dependent upon, among other factors, the market conditions prevailing
during the offering periods. In order to conclude 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, 2005 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.
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, 2005, "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 1A. RISK FACTORS
The discussion included in Item 7 of our Annual Report on Form 10-K
for the year ended December 31, 2005 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.
22
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The Company hereby incorporates by reference the information
contained in Current Reports on Form 8-K filed with the Securities and
Exchange Commission on the following dates: February 14, 2006, February 24,
2006 and March 21, 2006. In connection with the reported transactions, the
Company's placement agent received aggregate cash fees of $264,354, and
warrants to purchase shares of common stock and Series A preferred stock as
described in the aforementioned Current Reports.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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 17, 2006 /s/ Jean-Marc Stiegemeier
------------------------------------
Jean-Marc Stiegemeier
Chief Executive Officer, President
Dated: May 17, 2006 /s/ Robert G. LaVigne
------------------------------------
Robert G. LaVigne
Executive Vice President, Chief
Financial Officer
23