EXECUTONE INFORMATION SYSTEMS, INC. 10-Q (6/30/99)
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File No. 0-11551
EXECUTONE Information Systems, Inc.
(Exact name of registrant as specified in its charter)
Virginia 86-0449210
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
478 Wheelers Farms Road, Milford, Connecticut 06460
(Address of principal executive offices) (Zip Code)
(203) 876-7600
(Registrant's telephone number, including area code)
N/A
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15 (d) of the
Securities Exchange Act of 1934 during the 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
The number of shares outstanding of registrant's Common Stock,
$.01 par value per share, as of July 30, 1999 was 62,951,733.
INDEX
EXECUTONE Information Systems, Inc.
Page #
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets -
June 30, 1999 and December 31, 1998. 3
Consolidated Statements of Operations -
Three Months and Six Months Ended June 30,
1999 and 1998. 4
Consolidated Statements of Cash Flows -
Six Months Ended June 30, 1999 and 1998. 5
Notes to Consolidated Financial Statements. 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 13
PART II. OTHER INFORMATION 20
SIGNATURES 21
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
(In thousands, except for share amounts) 1999 1998
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 89 $ 1,482
Accounts receivable, net of
allowance of $1,477 and $1,720 26,229 25,531
Inventories 19,801 24,753
Prepaid expenses and other current assets 4,561 4,966
Total Current Assets 50,680 56,732
PROPERTY AND EQUIPMENT, net 9,839 10,604
INTANGIBLE ASSETS, net 3,731 3,795
DEFERRED TAXES 22,811 22,811
OTHER ASSETS 9,169 16,363
$ 96,230 $ 110,305
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt $ 1,056 $ 856
Accounts payable 11,954 18,093
Accrued payroll and related costs 3,607 3,969
Accrued liabilities 12,532 15,046
Deferred revenue and customer deposits 2,250 2,439
Total Current Liabilities 31,399 40,403
LONG-TERM DEBT 26,527 23,693
OTHER LONG-TERM LIABILITIES 2,445 2,445
TOTAL LIABILITIES 60,371 66,541
STOCKHOLDERS' EQUITY:
Common stock: $.01 par value; 80,000,000 shares
authorized; 62,937,508 and 49,834,807 issued
and outstanding 629 498
Preferred stock -- 7,300
Additional paid-in capital 78,184 71,624
Accumulated deficit (42,954) (35,658)
Total Stockholders' Equity 35,859 43,764
$ 96,230 $ 110,305
The accompanying notes are an integral part of these consolidated
balance sheets.
3
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except for Three Months Ended Six Months Ended
per share amounts) June 30, June 30,
1999 1998 1999 1998
REVENUES $ 32,201 $ 34,707 $ 63,950 $ 68,610
COST OF REVENUES 22,002 22,857 43,378 45,922
Gross Profit 10,199 11,850 20,572 22,688
OPERATING EXPENSES:
Product development and engineering 1,996 2,540 4,361 5,053
Selling, general and administrative 11,804 9,591 23,274 19,216
Provision for special charges --- 2,139 --- 4,483
13,800 14,270 27,635 28,752
OPERATING LOSS (3,601) (2,420) (7,063) (6,064)
INTEREST EXPENSE (723) (538) (1,476) (1,046)
OTHER INCOME, net 58 87 1,243 110
LOSS BEFORE INCOME TAXES (4,266) (2,871) (7,296) (7,000)
INCOME TAX BENEFIT --- (1,148) --- (2,799)
NET LOSS $(4,266) $(1,723) $(7,296) $ (4,201)
LOSS PER SHARE $ (0.07) $ (0.03) $ (0.13) $ (0.08)
AVERAGE DILUTED COMMON SHARES 59,512 49,733 54,520 49,715
The accompanying notes are an integral part of these consolidated
statements.
4
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
(In thousands) June 30,
1999 1998
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (7,296) $ (4,201)
Adjustments to reconcile net loss to net cash used by
operating activities:
Depreciation and amortization 1,644 1,777
Income tax benefit not currently receivable --- (2,799)
Noncash items, including noncash interest expense,
noncash provision for losses on accounts receivable
and income from equity investment 78 165
Gain on distributor note and warrant redemption (1,161) ---
Change in working capital items:
Accounts receivable (628) 2,077
Inventories 4,815 (3,094)
Accounts payable and accruals (7,896) (917)
Restricted cash --- 5,084
Other working capital items 454 48
NET CASH USED BY OPERATING ACTIVITIES (9,990) (1,860)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (277) (519)
Investment in eLottery (1,929) (3,770)
Proceeds from distributor note and warrant redemption 9,261 ---
Other, net --- (384)
NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES 7,055 (4,673)
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under revolving credit facility 2,866 1,195
Repayments of other long-term debt (514) (571)
Repurchase of stock (1,340) ---
Proceeds from issuance of stock 530 83
NET CASH PROVIDED BY FINANCING ACTIVITIES 1,542 707
DECREASE IN CASH AND CASH EQUIVALENTS (1,393) (5,826)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD 1,482 7,727
CASH AND CASH EQUIVALENTS - END OF PERIOD $ 89 $ 1,901
The accompanying notes are an integral part of these consolidated statements.
5
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE A - NATURE OF THE BUSINESS AND FORMATION OF THE COMPANY
EXECUTONE Information Systems, Inc. (the Company) develops,
markets and supports voice and data communications and
information systems. Products and services include telephone
systems, voice mail systems, inbound and outbound call center
systems and specialized healthcare communications and workflow
management systems. Products and services are sold under the
EXECUTONE, INFOSTAR, IDS, LIFESAVER and INFOSTAR/ILS brand names
through a national network of independent distributors and direct
sales and service employees. The Company's products are
manufactured primarily in the United States, Malaysia, China and
the Dominican Republic.
The Company's eLottery subsidiary (formerly named Unistar Gaming
Corp.) develops, provides and maintains Internet, intranet and
telephone communications, accounting, database and other
applications and services for use by the domestic and
international lottery market. eLottery's UniStar Entertainment
subsidiary had the exclusive right to design, develop and manage
the National Indian Lottery (NIL) of the Coeur d'Alene Tribe of
Idaho (CDA). The NIL was operational beginning in January 1998.
However, in response to an adverse legal opinion on December 17,
1998, eLottery and the CDA terminated the operations of the NIL
and the US Lottery telephone and Internet operations managed by
eLottery.
NOTE B - BASIS OF PRESENTATION
The accompanying consolidated financial statements include the
accounts of the Company and its subsidiaries. In consolidating
the accompanying financial statements, all significant
intercompany transactions have been eliminated. Investments in
affiliated companies owned more than 20%, but not in excess of
50%, are recorded under the equity method.
The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
NOTE C - INCOME TAXES
The Company accounts for income taxes in accordance with FAS No.
109, "Accounting for Income Taxes." The deferred tax asset
represents the benefits that are more likely than not to be
realized from the utilization of pre- and post-acquisition tax
benefit carryforwards, which include net operating losses, tax
credits and the excess of tax bases over the fair value of the
net assets of the Company.
For the six-month periods ended June 30, 1999 and 1998, the
Company made cash payments for income taxes of approximately
$55,000 and $59,000, respectively.
6
NOTE D - EARNINGS PER SHARE
Earnings per share is based on the weighted average number of
shares of common stock and dilutive
common stock equivalents (which include stock options and
warrants) outstanding during the periods. Common stock
equivalents, the convertible preferred stock and the convertible
debentures which are antidilutive have been excluded from the
computations.
A reconciliation of the Company's loss per share calculations for
the three-month and six-month periods ended June 30, 1999 and
1998, respectively, is as follows:
Per Share
(in thousands, except for per share amounts) Loss Shares Amount
For the three months ended June 30, 1999:
Basic and Diluted Loss Per Share: $(4,266) 59,512 $(0.07)
For the three months ended June 30, 1998:
Basic and Diluted Loss Per Share: $(1,723) 49,733 $(0.03)
For the six months ended June 30, 1999:
Basic and Diluted Loss Per Share: $(7,296) 54,520 $(0.13)
For the six months ended June 30, 1998:
Basic and Diluted Loss Per Share: $(4,201) 49,715 $(0.08)
The Company's Convertible Subordinated Debentures are convertible
into approximately 1.5 million shares of common stock as of June
30, 1999. The shares issuable upon conversion of the Debentures
were not included in the computation of diluted earnings per
share because they would be antidilutive for each of the periods
presented. Incremental common shares assumed to be issued for
stock options totaling 1,530,000 and 75,000 shares for the three-
month periods ended June 30, 1999 and 1998, respectively, were
not included in the computation of diluted earnings per share due
to the net losses for both periods. Corresponding amounts for
the six-month periods ended June 30, 1999 and 1998 were 1,164,000
and 90,000 shares, respectively.
The convertible preferred stock issued in connection with the
acquisition of eLottery was antidilutive, at issuance, and has
been excluded from the above calculations. On April 13, 1999,
the convertible preferred stock was redeemed (See Note G).
NOTE E - INVENTORIES
Inventories are stated at lower of first-in, first-out (FIFO)
cost or market and consist of the following:
(amounts in thousands) 6/30/99 12/31/98
Raw Materials $ 2,481 $ 2,527
Finished Goods 17,320 22,226
$ 19,801 $ 24,753
7
NOTE F - eLOTTERY
Acquisition
On December 19, 1995, EXECUTONE Information Systems, Inc.
(Executone) acquired 100% of the common stock of Unistar Gaming
Corp. for common and preferred stock with a combined value of
$12.7 million. In January 1999, Unistar Gaming Corp. changed its
name to eLottery, Inc. (eLottery). Any reference herein to
eLottery shall be deemed to include business conducted under the
name Unistar Gaming Corp. eLottery's wholly-owned subsidiary,
UniStar Entertainment, Inc. (UniStar Entertainment) had an
exclusive five-year management agreement with the CDA, which was
the primary asset acquired, to provide design, development,
financial and management services to the NIL. The NIL was
operational beginning in January 1998. However, in response to
an adverse legal opinion on December 17, 1998, eLottery and the
CDA terminated the operations of the NIL and the US Lottery
telephone and Internet operations managed by eLottery.
The preferred stock consisted of 250,000 shares of Cumulative
Convertible Preferred Stock, Series A (Series A Preferred Stock)
and 100,000 shares of Cumulative Contingently Convertible
Preferred Stock, Series B (Series B Preferred Stock). The Series
A Preferred Stock was to earn dividends equal to 18.5% of the
consolidated retained earnings of eLottery as of the end of a
fiscal period, less any dividends paid to the holders of the
Series A Preferred Stock prior to such date. The Series B
Preferred Stock was to earn dividends equal to 31.5% of the
consolidated retained earnings of eLottery as of the end of a
fiscal period, less any dividends paid to the holders of the
Series B Preferred Stock prior to such date. On April 7, 1999,
the Company reached agreement with the preferred shareholders to
accelerate redemption of the Series A and Series B preferred
shares, with such shares actually being redeemed effective
April 13, 1999 (see Note G).
Legal and Other Risks
On October 16, 1995, the CDA filed an action entitled Coeur
d'Alene Tribe v. AT&T Corp. in the Tribal Court, located in
Plummer, Idaho (Case No. C195-097): (i) requesting a ruling that
the NIL is legal under the federal Indian Gaming Regulatory Act
of 1988 (IGRA), that IGRA preempts state laws on the subject of
Indian gaming, that Section 1084 is inapplicable and that
therefore the states lack authority to issue Section 1084
notification letters to any long-distance carrier; and (ii)
seeking an injunction preventing AT&T from refusing to provide
telephone service to the NIL. The CDA took the position that all
NIL gaming activity was occurring on "Indian lands" as required
by IGRA. On February 28, 1996, the Tribal Court ruled: (i) that
all requirements of IGRA have been satisfied; (ii) that Section
1084 is inapplicable and the states lack jurisdiction to
interfere with the NIL; and (iii) that AT&T cannot refuse service
to the NIL. On July 2, 1997, the Tribal Appellate Court affirmed
the lower Tribal Court's May 1, 1996 ruling and analysis upholding
the CDA's right to conduct the NIL telephone lottery. On
August 22, 1997, AT&T filed a complaint for declaratory judgment
against the CDA in the U. S. District Court for the District of
Idaho, to obtain a federal court ruling on the validity and
enforceability of the Tribal Court ruling. On December 17, 1998,
that Court issued an opinion and order denying the motions and
counter-claims of the CDA and granting declaratory judgment in
favor of AT&T upholding the position of AT&T and overruling the
decisions of the Tribal Courts. In response to that decision,
eLottery and the CDA terminated operations of the NIL and the US
Lottery. The CDA has appealed the District Court decision;
however, eLottery is not participating in or funding any appeal
of this ruling.
8
On September 14, 1998, the CDA, eLottery and representatives of
the U.S. Department of Justice had discussions regarding a
declaratory judgment to be sought jointly from the U.S. District
Court for the District of Idaho as to whether the operation of
the NIL is legal under 18 U.S.C. Sections 1952 and 1955. eLottery
was informed that the Department of Justice views such operation
to be in violation of such statutes. The Department of Justice
proposed that the parties file a joint stipulation of facts and
cross-motions for summary judgment in the declaratory judgment
action. On December 17, 1998, the Idaho Federal District Court
issued an opinion and order granting declaratory judgment in
favor of AT&T in the action styled AT&T v. Coeur d' Alene Tribe.
In response to that decision, eLottery and the CDA terminated
operation of the NIL and the US Lottery. In light of the ruling
of the U.S. District Court of Idaho and the termination of the
NIL and the US Lottery, eLottery has requested confirmation from
the Department of Justice that no further action will be taken.
On May 28, 1997, the Attorney General of the State of Missouri
brought an action in the Circuit Court of Jackson County,
Missouri, against the CDA and UniStar Entertainment seeking to
enjoin the NIL games offered over the Internet. The complaint
also sought civil penalties, attorneys fees and court costs. The
complaint alleged that the NIL violated Missouri anti-gambling
laws and that the marketing of the games violated the Missouri
Merchandising Practices Act. UniStar Entertainment and the CDA
removed the case to the U.S. District Court for the Western
District of Missouri. After the Court denied the State's motion
to remand and dismissed the CDA on the basis of sovereign
immunity, the State dismissed Unistar Entertainment without
prejudice.
On January 29, 1998, the State of Missouri filed in state court a
new lawsuit against Unistar Entertainment, Executone and two
tribal officials. This lawsuit essentially repeated the
allegations from the State's first lawsuit and was likewise
removed to federal court. Following a decision by the Eighth
Circuit Court of Appeals in the State's first lawsuit, which held
that the existence of federal subject matter jurisdiction over
Missouri's lawsuits depends on whether the gaming activities of
the NIL occurred on Indian lands, a hearing on that issue has
been scheduled for September 25, 1999. Unistar Entertainment and
Executone have filed motions to dismiss based on sovereign
immunity and lack of personal jurisdiction. These motions are
pending.
On September 15, 1997, the State of Wisconsin, by its Attorney
General, filed an action in the Wisconsin State Circuit Court for
Dane County against Executone, UniStar Entertainment and the CDA
to permanently enjoin the NIL games offered over the Internet.
The complaint alleged that the NIL violated Wisconsin anti-
gambling laws and that the legality of the NIL was misrepresented
to Wisconsin residents in violation of state law. In addition to
an injunction, the suit sought restitution, civil penalties,
attorneys' fees and court costs. Executone, UniStar
Entertainment and the CDA removed the case to the U.S. District
Court in Wisconsin, and the District Court dismissed the CDA from
the case based on sovereign immunity and dismissed Executone
based on the State's failure to state a claim against Executone.
In June 1999, the State of Wisconsin dismissed the litigation
against eLottery based upon eLottery's refund of customer
balances after termination of the NIL and its agreement not to
offer a similar lottery to Wisconsin residents in the future,
absent a court ruling as to its legality.
Investment in eLottery
The Company periodically evaluates the recoverability of its
investment in eLottery in accordance with the provisions of FAS
No. 121, "Accounting for the Impairment of Long-Lived Assets" by
projecting future undiscounted net cash flows for the underlying
businesses. If the sum of such cash flows is not
sufficient to recover the Company's investment in eLottery,
projected cash flows would then be
9
discounted and the carrying value of Company's investment would
be adjusted accordingly. On December 17, 1998, the United States
District Court for the District of Idaho ruled in the case of
AT&T vs. Coeur d'Alene Tribe that the orders previously issued by
the Tribal Court upholding the legality of the US Lottery were
erroneous (see Legal and Other Risks for a description of the
litigation). In response to this legal decision, eLottery and
the CDA terminated operation of the NIL and the US Lottery in
every state where it had been offered. Management determined
that all of eLottery's assets related to the NIL were impaired
and were written down to zero during the fourth quarter of 1998.
All of the Company's remaining investment in eLottery relates to
its business as an Internet retailer of lottery products for
legally authorized entities.
In February 1997, the Company signed agreements with Virtual
Gaming Technologies (formerly Internet Gaming Technologies (IGT))
and CasinoWorld Holdings, Ltd. (CWH). The agreements required
the Company to invest $700,000 in IGT common stock in September
1996 under a previous agreement. In addition, the Company was
granted a 200,000-share, five-year option set at 15% more than
the price per share on the initial investment, or $3.45 per
share. CWH provided project management services overseeing the
development of the software for the NIL, with the Company
contracting independently for system software development. The
Company acquired all hardware for the system without financial
obligation by either IGT or CWH. Approximately $800,000 in
hardware costs were incurred as of June 30, 1999.
The investment in IGT is being accounted for under the cost
method. All hardware costs incurred are being capitalized and
depreciated over the useful life of the assets. As of June 30,
1999, approximately $3.4 million has been spent on software
development. Such payments are being capitalized and depreciated
over a five-year period.
NOTE G - DIVESTITURE OF CORE BUSINESSES
On March 29, 1999, the Company announced that it planned to
divest its core telephone and healthcare businesses and change
the name of the Company to eLottery, Inc. At the same time, the
Executone Board of Directors announced it had received an offer
for those businesses from a group to be led by Stanley J. Kabala,
Chairman and Chief Executive Officer of Executone, and that it
has formed a special committee of the Board to accomplish that
divestiture.
The offer from management was approximately $70 million and is
subject to a number of conditions including negotiation of a
definitive agreement, financing, the waiver or expiration of a
pre-existing right of first offer, and approval of the Executone
shareholders. A final decision as to the method of divesting
this business has not been made by the Board. The Company
expects to recognize a gain on the transaction, which may be
deferred over some undetermined future period, dependent upon the
final terms.
The proceeds of any sale will remain in the Company to help it
accelerate the achievement of eLottery's business plans. At the
conclusion of the transaction and subject to shareholder
approval, Executone would be renamed eLottery, Inc. eLottery's
activities to date have been primarily related to the
organization of the company, developing the business and gaming
systems necessary to operate a national telephone lottery and the
USlottery.com Internet site and preparing a marketing plan for
selling its technology to entities licensed to sell lottery
tickets. With the termination of operations of the NIL
and the divestiture of the core telephony and healthcare
businesses, eLottery expects to derive its future revenues from
acting as an Internet retailer of lottery products for legally
authorized entities, the sale or licensing of the technology it
has developed and advertising on its Internet web site,
eLotteryWorld.com and Internet web sites offering game-based
entertainment. eLottery has yet to record any revenue.
10
On April 13, 1999, as part of its plan to separate its telephony
and healthcare businesses from eLottery, the Company accelerated
the redemption of its Series A and Series B preferred stock.
Upon redemption, the preferred shares were redeemed for 13.3
million shares of common stock, or approximately 21% of
eLottery's common stock, and are no longer entitled to receive a
total of 50% of eLottery's retained earnings as preferred
dividends.
NOTE H - SEGMENTS
The Company's reportable business segments provide products and
services, which are marketed through both retail and independent
distribution channels. These businesses are managed and reported
separately because they serve distinct markets.
Computer
(amounts in thousands) Telephony Healthcare eLottery Corporate Totals
Three months ended June 30, 1999
Revenue $ 23,673 $ 8,528 $ -- $ -- $ 32,201
Segment Income (Loss) 226 (1,398) (896) (1,533) (3,601)
Three months ended June 30, 1998
Revenue $ 24,554 $ 10,153 $ -- $ -- $ 34,707
Segment Income (Loss) 209 (92) (219) (179) (281)
Six months ended June 30, 1999
Revenue $ 46,928 $ 17,022 $ -- $ -- $ 63,950
Segment Income (Loss) 786 (3,231) (1,551) (3,067) (7,063)
Six months ended June 30, 1998
Revenue $ 49,262 $ 19,348 $ -- $ -- $ 68,610
Segment Loss (153) (836) (413) (179) (1,581)
The following reconciles the Company's segment loss to the
reported net loss for the three-month and six-month periods ended
June 30, 1999 and 1998:
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
(amounts in thousands) 1999 1998 1999 1998
Total segment loss $ (3,601) $ (281) $ (7,063) $ (1,581)
Special charges -- (2,139) -- (4,483)
Interest expense (723) (538) (1,476) (1,046)
Other income, net 58 87 1,243 110
Income tax benefit -- 1,148 -- 2,799
Net loss $ (4,266) $ (1,723) $ (7,296) $ (4,201)
Corporate assets were reduced by approximately $8.0 million
during the first quarter of 1999 due to the repayment of the note
receivable from Claricom and the redemption of Claricom warrants
issued to the Company (See Note I).
11
NOTE I - OTHER MATTERS
For the six-month periods ended June 30, 1999 and 1998,
respectively, the Company made cash payments of approximately
$1.2 million and $0.9 million for interest expense on
indebtedness.
During the six-month periods ended June 30, 1999 and 1998,
respectively, noncash financing activities included capital lease
obligations incurred in connection with computer software and
equipment acquisitions of $0.6 million and $0.5 million.
For the six-month periods ended June 30, 1999 and 1998, the
Company had two individual customers, each of which generated in
excess of 10% of the Company's revenues. Both customers are
included in the Computer Telephony segment. One customer
accounted for $7.8 million in sales in both the 1999 and 1998
periods. The second customer accounted for $7.2 million and $6.7
million for the same periods, respectively.
On February 26, 1999, the Company received $9.3 million from
Claricom as payment for Claricom's outstanding $5.9 million
junior subordinated note plus interest, along with the redemption
of the warrants issued to the Company as part of the sale of the
direct offices in 1996. As a result, the Company recorded a gain
of $1.2 million during the first quarter of 1999. The gain is
included in other income, net.
The Company recorded a total of $9.0 million in reorganization
and other special charges during the year ended December 31,
1998, of which $4.5 million was recorded during the first six
months of 1998. At June 30, 1999, the remaining reserve balance
associated with these charges was $2.6 million. These amounts
will be paid during 1999, with the exception of $1.5 million
related to the patent litigation settlement, which will be paid
subsequent to December 31, 1999.
On March 30, 1998, the Company entered into an Amended and
Restated Distributor Agreement (the "Amended Agreement") with
Claricom, purchaser of the direct sales offices and the Company's
largest distributor. The Amended Agreement, effective April
1,1998 and continuing through December 31, 2001, provides, among
other things, that Claricom will be a non-exclusive distributor
of the Company's telephony products and that Claricom can market
products competing with those sold by the Company. Upon
execution of the Amended Agreement, Claricom released to the
Company the $5 million plus interest being held in escrow to
satisfy potential indemnity claims under the 1996 Asset Purchase
Agreement and waived all potential contract claims under the
prior distributor agreement.
12
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis explains trends in the
Company's financial condition and results of operations for the
three-month and six-month periods ended June 30, 1999 compared
with the same periods last year. It is intended to help
shareholders and other readers understand the dynamics of the
Company's business and the key factors underlying its financial
results. This discussion should be read in conjunction with the
consolidated financial statements and notes included elsewhere in
this Form 10-Q, and with the Company's audited consolidated
financial statements and notes thereto for the year ended
December 31, 1998. Management believes that certain statements
in this management's discussion and analysis constitute forward-
looking statements within the meaning of the U.S. Private
Securities Litigation Reform Act of 1995 that are based on
current expectations, estimates and projections about the
industries in which the Company operates, management's beliefs
and assumptions made by management. Such forward-looking
statements involve known and unknown risks, uncertainties, and
other factors which may cause the actual results, performance or
achievements of the Company, or industry results, to be
materially different from any future results, performance, or
achievements expressed or implied by such forward-looking
statements. Such risks, uncertainties and assumptions include,
among others, the following: general economic and business
conditions; demographic changes; import protection and
regulation; rapid technology development and changes; timing of
product introductions; the mix of products/services; industry
capacity and other industry trends; and the ability of the
Company to attract and retain key employees.
OVERVIEW
The Company develops, markets and supports voice and data
communications and information systems. Products and services
include telephone systems, voice mail systems, inbound and
outbound call center systems and specialized healthcare
communications and workflow management systems. The Company's
products are sold under the EXECUTONE, INFOSTAR, IDS, LIFESAVER
and INFOSTAR/ILS brand names through a national network of
independent distributors and company direct sales and service
employees. The Company's eLottery subsidiary (formerly named
Unistar Gaming Corp.) develops, provides and maintains Internet,
intranet and telephone communications, accounting, database and
other applications and services for use by the domestic and
international lottery market. eLottery's UniStar Entertainment
subsidiary had the exclusive right to design, develop and manage
the National Indian Lottery (NIL) of the Coeur d'Alene Tribe of
Idaho (CDA). The NIL was operational beginning in January 1998.
However, in response to an adverse legal opinion on
December 17, 1998, eLottery and the CDA terminated the operations
of the NIL and US Lottery telephone and Internet operations
managed by eLottery.
Revenues are derived from product sales to distributors, direct
sales of healthcare products, and direct sales to national
accounts and government customers, as well as installations,
additions, changes, upgrades or relocation of previously
installed systems, maintenance contracts, and service charges to
the existing base of healthcare, national account and government
customers.
DIVESTITURE OF CORE TELEPHONY AND HEALTHCARE BUSINESSES
On March 29, 1999, the Company announced that it planned to
divest its core telephony and healthcare businesses and change
the name of the Company to eLottery, Inc. Since that time, the
Special Committee of the Board of Directors has received multiple
expressions of interest including the
13
previously announced offer from management and is in the process
of evaluating these offers and negotiating final terms. The Board
has not made a final decision as to the method of divesting this
business. The proceeds of any sale will remain in the public
company to help it accelerate the achievement of eLottery's
business plans. When the terms of the sale are finalized, it will
be submitted for shareholder approval.
On April 13, 1999, as part of its plan to separate its telephony
and healthcare businesses from eLottery, the Company accelerated
the redemption of its Series A and Series B preferred stock. All
of the Company's preferred shares were redeemed for approximately
13.3 million common shares. The Company believes this
transaction has simplified its capital structure and aligned the
interests of the former preferred and current common
shareholders.
RESULTS OF OPERATIONS
During the three-month and six-month periods ended June 30, 1999,
revenue, operating income and net income all declined from the
comparable periods in 1998 as the Company continued the re-
engineering program that commended in December 1998 and completed
the installation of new integrated enterprise business software.
Revenue was below expectations, but the Company was able to
reduce expenses more rapidly than expected as a result of the re-
engineering program.
Revenues for the second quarter of 1999 were $32.2 million, with
an operating loss of $3.6 million and a net loss of $4.3 million
or ($.07) per common share. Revenues for the second quarter of
1998 were $34.7 million, with an operating loss of $2.4 million
and a net loss of $1.7 million or ($.03) per common share. For
the six-month period ended June 30, 1999, revenues were $64.0
million, with an operating loss of $7.1 million and a net loss of
$7.3 million or ($.13) per common share. For the same period in
1998, revenues were $68.6 million, with an operating loss of $6.1
million and a net loss of $4.2 million or ($.08) per common share.
The 1998 results include $2.1 million and $4.5 million in special
charges for the three-month and six-month periods ended June 30,
1998, respectively, covering severance and benefits continuation
costs.
The 1999 revenue declines compared to the 1998 periods are
largely the result of the discontinuation of quarter-ending,
distributor-focused sales incentives in the third quarter of
1998, along with certain start-up problems in production planning
and shipping encountered in June during the Company's first month
using its new integrated business software system. Operating
expenses include one-time charges for professional fees
associated with the Company's re-engineering program ($1.5
million in the second quarter of 1999 and $3.1 million for the
year-to-date) and related travel, training and contract labor to
backfill for Company employees engaged in re-engineering and
software implementation ($1.0 million in the second quarter and
$1.4 million for the year to date) as well as a significant ramp up in
eLottery development spending. Excluding these one-time
expenses, operating expenses for the Company declined about $1.2
million for the second quarter of 1999 and $1.8 million for the
1999 year-to-date.
REVENUE
Computer Telephony
Computer telephony products range from PBXs for small to medium-
sized businesses to standards-compliant computer telephony
applications, LAN and Internet-based applications, including
voice mail, unified messaging, automatic call distribution (ACD),
predictive dialing and wireless communications.
14
This business targets the under-400-extension market segment.
Customers range from small companies with fewer than ten
employees to large national accounts and government agencies with
fewer than 400 extensions at any individual location. These
products are marketed through independent distribution and direct
sales, with the direct sales effort focused on product and
service sales to National and Government Accounts.
In the second quarter of 1999, Computer Telephony revenues
decreased $0.9 million, or 4%, compared to the same quarter last
year. For the six-month period ended June 30, 1999, Computer
Telephony revenues declined $2.3 million or almost 5% compared to
the same period in 1998. For both the 1999 periods, the
decreases were primarily a result of lower sales to the wholesale
channel. Beginning with the third quarter of 1998, the Company
changed its business practice of offering distributor-focused
sales incentives at the end of each quarter. Sales incentives
are now designed to stimulate end-user demand with the intent of
creating value for both the end user and the distributor. In
addition, the conversion to the new software in June 1999
resulted in significant equipment backorders at the end of the
quarter. The Company estimates that nearly $2 million in
Computer Telephony revenue was missed during the quarter, most of
which is expected to be recovered in the second half of the year.
Healthcare
Healthcare products range from traditional nurse call systems,
intercoms and room status indicators to more sophisticated
patient reporting systems, infrared locating systems and wireless
technologies. All of these products can be integrated to enhance
a facility's communications and information networking.
Healthcare customers include hospitals, surgical centers, nursing
homes and assisted living centers.
Healthcare reported $1.6 million lower sales for the second
quarter of 1999 compared to the same period in 1998, and $2.3
million lower sales for the 1999 year-to-date compared to the
same period in 1998. Compared to the prior year periods, the
lower revenue reflects lower new order booking as a result of the
increased sales force turnover that resulted from the Company's
efforts to offer the business for sale during 1998 and the change
in business practice away from supply push distributor incentive
programs. Second quarter and year-to-date revenue were also
affected by approximately $0.5 million in backorders and shipping
delays associated with the software conversion. It is expected
that this missed revenue will be recovered in the next quarter.
GROSS PROFIT
Gross profit for the second quarter of 1999 was $10.2 million or
31.7 % of revenue, compared to $11.9 million or 34.1% of revenue
for the same quarter last year. On a year-to-date basis, gross
profit for 1999 was $20.6 million or 32.2% of revenue compared to
$22.7 million or 33.1% of revenue for 1998. Pricing margins
(revenue less direct cost of sales) remained fairly constant.
However, the Company incurred higher period costs for the training
and data conversion associated with the implementation of the new
software package, along with temporary labor to assist on
installations while individuals were being trained on the new
system. In addition, the Company's program to reduce its
inventories to more reasonable levels resulted in a lower
absorption of fixed overhead in its manufacturing facility.
15
OPERATING EXPENSES
Product development expenses were $2.0 million for the second
quarter of 1999, a decrease of approximately $0.5 million from the
same quarter last year. For the year to date, product development
expenses for 1999 were $4.4 million, a decrease of approximately
$0.7 million from the 1998 period. The Company continues to focus
its product development priorities resulting in lower headcount
and lower overall costs.
Selling, general and administrative expenses were $11.8 million,
or 36.7% of revenue for the second quarter of 1999, compared to
$9.6 million or 27.6% of revenue for the same period in 1998.
Year-to-date, selling general and administrative expenses for 1999
were $23.3 million or 36.4% compared to $19.2 million or 28.0% in
1998. The increases over the 1998 periods are primarily due to
professional fees incurred to help the Company re-engineer its
business processes of $1.5 million for the second quarter and $3.0
million for the year to date. eLottery expenses increased
approximately $0.6 million during the second quarter of 1999
compared to the same period last year (an increase of $1.1 million
on a year-to-date basis) due to the Company's efforts to develop
and market eLottery's products, along with the Company's practice
in the first and second quarters of 1998 of charging the NIL for
personnel expenses which, with the termination of the NIL, are now
included in the Company's expenses.
Excluding the effect of the special charges, eLottery expenditures
and the consulting fees incurred in re-engineering the Company's
business processes, 1999 operating expenses for the second quarter
and year-to-date decreased $1.2 million and $1.8 million,
respectively, compared to the same periods in 1998. This reflects
the impact of the Company's cost reduction efforts and is expected
to continue through the end of 1999.
SPECIAL CHARGES
As a result of actions taken by the Company to improve its
business processes, including significant changes in its senior
management structure, along with a provision for a patent
litigation settlement, the Company recorded a total of $9.0
million in reorganization and other special charges during year
ended December 31, 1998, of which $4.5 million was recorded
during the first six months of 1998. At June 30, 1999, the
remaining reserve balance associated with these charges was $2.6
million. These amounts will be paid during 1999, with the
exception of $1.5 million related to the patent litigation
settlement, which will be paid subsequent to December 31, 1999.
INTEREST AND OTHER EXPENSE
Interest expense for the second quarter of 1999 increased $0.2
million compared to the same period in 1998. Year-to-date,
interest expense in 1999 was $0.4 million higher than in 1998.
The increases are due to higher levels of bank borrowings in 1999
compared to the previous year. Other income, net, for the second
quarter was comparable to the prior year. Year-to-date, other
income, net increased $1.2 million compared to the same period in
1998 due to a nonrecurring $1.2 million gain on the receipt of
payment from Claricom on the $5.9 million junior subordinated
note plus interest, along with the redemption of the warrants
held by the Company.
16
eLOTTERY
On December 19, 1995, EXECUTONE Information Systems, Inc.
(Executone) acquired 100% of the common stock of Unistar Gaming
Corp. for common and preferred stock with a combined value of
$12.7 million. In January 1999, Unistar Gaming Corp. changed its
name to eLottery, Inc. (eLottery). Any reference herein to
eLottery shall be deemed to include business conducted under the
name Unistar Gaming Corp. eLottery's wholly-owned subsidiary,
UniStar Entertainment, Inc. (UniStar Entertainment) had an
exclusive five-year management agreement with the CDA, which was
the primary asset acquired, to provide design, development,
financial and management services to the National Indian Lottery.
The NIL was operational beginning in January 1998. However, in
response to an adverse legal opinion on December 17, 1998,
eLottery and the CDA terminated the operations of the NIL and the
US Lottery telephone and Internet operations managed by eLottery.
eLottery's original mission was to develop, install and manage a
National Indian Lottery accessible by telephone. eLottery
developed a state-of-the-art Internet and telephone-based system
providing both instant and draw lottery games, full player
accounting and tracking and automatic credit or debit card
clearance. In early 1998, as a hedge against potential adverse
legal and political decisions, eLottery began investigating
alternative applications and markets for its technology.
eLottery is now pursuing opportunities to become a web-based
retailer of lottery services and to license its systems and
services to state and international lotteries. The Company has
developed and operated systems software that enables the
electronic distribution of lottery tickets over the Internet,
Intranet and via telephone. The Company believes that the
electronic distribution of lottery tickets through these systems
will increase lottery sales because they make the purchase of
tickets more easily accessible and because they make use of
technology to enhance and enliven the lottery gaming experience.
With its unique and proven ability to offer lottery operators its
new Internet and Intranet-based lottery products worldwide, the
Company believes it is well positioned to capitalize on the
growth in non-traditional lottery sales.
During the first six months of 1999, the Company incurred
approximately $2.9 million in cash expenditures related to
eLottery. Of that amount, approximately $1.4 million related to
the termination of NIL operations, including payment of
outstanding invoices, shutdown costs and severance and other
charges. The Company estimates an additional $0.2 million
remaining in NIL-related charges, all of which is expected to be
paid during the third quarter of 1999. eLottery's net loss for
1999 year-to-date is $1.5 million, consisting primarily of
expenses for the development and marketing of its products and
other operating expenses.
With the termination of the NIL and US Lottery, the Company
continues to face certain legal and other risks. See the Notes
to Consolidated Financial Statements for a discussion of the
legal issues, which could impact the Company and its eLottery
business.
YEAR 2000
Status
The Company has completed a review of its computer systems to
identify systems that could be affected by the "Year 2000" issue.
Systems that do not properly recognize information after December
31, 1999 could generate erroneous data or fail. Effective June
30, 1999, as part of its long-term information systems plan, the
Company converted to a new and more comprehensive software system
for its
17
information technology (IT) infrastructure. Including
installation and data conversion costs, the Company spent
approximately $2.7 million on the new system, which is now
operational. The costs for the new system will be capitalized
and depreciated over the expected service life of the system
beginning in July 1999.
Management believes that the conversion to new software will
resolve the Year 2000 issue as it relates to its IT
infrastructure. There are several peripheral systems that will
not be replaced by the new software. These systems are being
made compliant using the Company's internal resources, which have
been redeployed from other projects. The remedial effort for
such systems is complete, with the exception of one subsystem
which was originally scheduled to be upgraded to a newer release.
The Company has decided to not purchase an upgraded version of
the software and will update the current system using internal
resources to make it Year 2000 compliant. The conversion is
expected to be complete early in the fourth quarter and is
expected to cost no more than $25,000, most of which is expected
to be incurred during the third quarter of 1999. Such amounts
will be expensed as incurred.
For non-IT systems (non-information technology that typically
includes imbedded technology such as micro-controllers), the
Company has reviewed its production and other equipment and
determined that there are no significant Year 2000 issues. The
Company continues to seek representations and assurances from its
key vendors regarding timely Year 2000 compliance. Other than
such surveys of its vendors, the Company has not made an
assessment as to whether any of its suppliers or service
providers will be affected by the date change.
Risk Assessment
Although the Company believes that internal Year 2000 compliance
will be achieved by December 31, 1999, there can be no assurance
that the Year 2000 problem will not have a material adverse
affect on the Company's business, financial condition and results
of operations. The failure by the Company to correct a material
Year 2000 problem could result in an interruption in, or a
failure of, certain normal business activities or operations.
Presently, the Company perceives that the most reasonably likely
worst case scenario related to the Year 2000 issue is associated
with potential concerns with the ability of third party vendors
to provide products used in the manufacturing process. A
significant disruption in the product manufacturing process could
prevent or delay the Company from completing new installations or
system upgrades and enhancements for its customers. This would
adversely affect the Company's results of operations, liquidity
and financial condition. The Company is not presently aware of
any vendor-related Year 2000 issue that is likely to result in
such a disruption.
Contingency Plan
The Company has formed a project team to develop a contingency
plan to deal with unforeseen conversion failures. The plan will
include the identification of a team of employees to be on call
during the millennium change to monitor key systems, providing
for backup power sources, data retention and recovery procedures
for critical business data and operational plans to address
potential delays in product supply from vendors. The contingency
plan is expected to be in place by the end of the third quarter
of 1999.
OTHER
On March 30, 1998, the Company entered into an Amended and
Restated Distributor Agreement with Claricom (the "Amended
Agreement"). The Amended Agreement, effective April 1, 1998 and
continuing through December 31, 2001, provides, among other
things, that Claricom will be a non-
18
exclusive distributor of the Company's telephony products and
that Claricom can market products competing with those sold by the
Company. Upon execution of the Amended Agreement, Claricom
released to the Company the $5 million plus interest being held
in escrow to satisfy potential indemnity claims under the 1996
Asset Purchase Agreement and waived all potential contract claims
under the prior distributor agreement.
LIQUIDITY AND CAPITAL RESOURCES
The Company's liquidity is represented by cash, cash equivalents
and cash availability under its existing credit facilities. The
Company's liquidity was approximately $5 million as of June 30,
1999 and $10 million as of December 31, 1998.
At June 30, 1999 and December 31, 1998, cash and cash equivalents
amounted to $0.1 million and $1.5 million, respectively, a
decrease of $1.4 million. The decrease was mainly due to the
funding of the Company's operating losses, along with additional
expenditures to fund eLottery development expenses and the
termination of NIL operations and the repurchase of stock,
partially offset by a nonrecurring cash receipt from Claricom
(see below) and additional borrowings from the Company's credit
facility.
The Company used $10.0 million in its operating activities during
the first six months of 1999 compared to $6.9 million in cash
used by operations for the same period in 1998, excluding the
March 1998 release of $5.1 million held in escrow since the sale
of the direct offices in 1996. The increase in funds used by
operating activities is primarily due to the funding of the 1999
operating loss and the reduction in the Company's accounts
payable and accrued liabilities. This was partially offset by
the positive cash impact of the inventory reductions during the
first six months of 1999.
Cash provided by investing activities totaled $7.1 million for
the first six months of 1999, compared to $4.7 million of cash
used during the same period last year. The increase in cash
provided by investing activities is primarily due to a
nonrecurring cash receipt from Claricom. On February 26, 1999,
the Company received $9.3 million from Claricom as payment
for Claricom's outstanding $5.9 million junior subordinated
note plus interest, along with the redemption of the warrants
issued to the Company as part of the sale of the direct offices
in 1996. The Company used the proceeds to reduce outstanding
bank borrowings and accounts payable.
The Company generated $1.5 million in cash from financing
activities during the first six months of 1999. Borrowings for
the first six months of 1999 increased by $2.9 million. An
additional $0.5 million was generated by the issuance of common
shares. Cash was used to repurchase 420,000 shares of the Company's
common stock for $1.3 million and to repay other long-term debt
totaling $0.5 million. During the same period in 1998, the
Company borrowed $1.2 million from its credit facility and used
$0.6 million in cash in its other financing activities, primarily
for debt repayment.
Total debt as of June 30, 1999 was $27.6 million, an increase of
$3.1 million from $24.5 million at December 31, 1998. The
increase is a result of an additional $2.9 million in bank
borrowings, $0.6 million in connection with the acquisition of a
new computer software system, along with an increase in the
carrying value of the convertible subordinated debentures of $0.1
million due to accretion. Debt payments totaled $0.5 million
during the first six months of 1999.
The Company believes that borrowings available under the credit
facility and cash flow from operations will be sufficient to meet
working capital and other requirements for the next twelve
months.
19
PART II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
See Note F of the Notes to Consolidated Financial
Statements in Part I, Item 1 for details on legal
proceedings.
Item 2. CHANGES IN SECURITIES
Not applicable.
Item 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
Item 5. OTHER INFORMATION
Not applicable.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
11 - Statement Regarding Computation of Per
Share Earnings (see Note D of Notes to
Consolidated Financial Statements in Part I,
Item 1).
b) Reports on Form 8-K
On April 29, 1999, with the withdrawal of the
eLottery Registration Statement on Form S-1
on April 14, 1999 and the impending sale of
the Company's core businesses (see Note G of
Notes to Consolidated Financial Statements in
Part I, Item 1), the Company filed a Current
Report on Form 8-K to disclose the risk
factors that could materially adversely
affect the performance of eLottery.
20
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.
EXECUTONE Information Systems, Inc.
Dated: August 13, 1999 /s/ Stanley J. Kabala
Stanley J. Kabala
Chairman, President and
Chief Executive Officer
Dated: August 13, 1999 /s/ Edward W. Stone
Edward W. Stone
Senior Vice President and
Chief Financial Officer
21