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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1996
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. 0-11630
INTELECT COMMUNICATIONS SYSTEMS LIMITED
(Exact name of registrant as specified in its charter)
BERMUDA N/A
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
REID HOUSE, 31 CHURCH STREET
HAMILTON, BERMUDA
HM12
(Address of principal executive offices, zip code)
(441) 295-8639
(Registrant's telephone number, including area code)
------------------------
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 __
There were 14,132,617 shares of the registrant's Common Stock, par value
$.01 per share, outstanding on October 31, 1996.
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INTELECT COMMUNICATIONS SYSTEMS LIMITED
INDEX
PAGE
PART I FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
Consolidated Balance Sheets of the Company 2
at September 30, 1996 (unaudited) and December 31, 1995
Consolidated Statements of Operations of the Company 3
(unaudited) for the three and nine months ended September 30, 1996 and 1995
Consolidated Statements of Cash Flows of the Company 4
(unaudited) for the nine months ended September 30, 1996 and 1995
Notes to the Consolidated Financial Statements 5
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 8
CONDITION AND RESULTS OF OPERATIONS
PART II OTHER INFORMATION
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K 12
SIGNATURES 12
PART I - FINANCIALINFORMATION
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Thousands of U.S. Dollars)
(Unaudited)
SEPTEMBER 30 December 31
1996 1995
------------------- ------------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 4,079 $ 15,039
Marketable securities 93 -
Accounts receivable 2,260 1,375
Inventories 3,052 2,537
Prepaid expenses 394 406
Other current assets 429 -
Loan receivable - 600
------------------- ------------------
10,307 19,957
PROPERTY AND EQUIPMENT - NET 5,151 1,839
EXCESS OF COST OVER NET ASSETS OF COMPANIES ACQUIRED 18,720 8,685
SOFTWARE DEVELOPMENT COSTS 3,386 -
DEFERRED FINANCING COSTS 1,854 -
DEFERRED INCOME TAXES 818 -
OTHER INTANGIBLE ASSETS 4,603 758
------------------- ------------------
$ 44,839 $ 31,239
=================== ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 2,482 $ 1,680
Accrued liabilities 1,639 1,989
Net liabilities of discontinued operations 400 476
Current installments of obligations under capital leases 126 145
Current maturities of long-term debt 3,848 1,041
------------------- ------------------
8,495 5,331
LONG-TERM OBLIGATIONS UNDER CAPITAL LEASES,
net of current maturities 195 200
LONG-TERM DEBT, net of current maturities 3,730 168
CONVERTIBLE DEBENTURES 10,128 -
------------------- ------------------
22,548 5,699
------------------- ------------------
SHAREHOLDERS' EQUITY:
Common shares, $0.01 par value,
80,000,000 shares authorized.
13,794,055 issued and outstanding at September 30,
1996; (December 31,1995 - 11,385,117) 138 114
Share premium 23,724 11,673
Unrealized gain on marketable securities 39 -
Retained earnings (deficit) - since November 1, 1992 (1,610) 13,753
------------------- ------------------
22,291 25,540
------------------- ------------------
$ 44,839 $ 31,239
=================== ==================
2
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Thousands of U.S. Dollars, except share data)
(Unaudited)
Three Months Ended Nine Months Ended
September 30 September 30
----------------------------- ----------------------------
1996 1995 1996 1995
---- ---- ---- ----
STATEMENT OF OPERATIONS
REVENUES:
Net sales $ 445 $ 1,176 $ 3,670 $ 1,789
Services 1,470 - 3,533 -
Interest and other income 126 52 417 99
------------- ----------- ------------- -----------
2,041 1,228 7,620 1,888
------------- ----------- ------------- -----------
COSTS AND EXPENSES:
Cost of sales 2,616 846 7,616 1,350
Selling, general and administrative 5,131 1,183 12,662 1,786
Engineering and development 1,114 821 3,107 1,311
Interest 459 39 626 41
Equity in loss of investee - - - 280
------------- ----------- ------------- -----------
9,320 2,889 24,011 4,768
------------- ----------- ------------- -----------
LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES (7,279) (1,661) (16,391) (2,880)
INCOME TAX BENEFIT (VALUATION ALLOWANCE) (1,215) - 1,046 -
------------- ----------- ------------- -----------
LOSS FROM CONTINUING OPERATIONS (8,494) (1,661) (15,345) (2,880)
DISCONTINUED OPERATIONS:
Income (loss) from discontinued operations (9) 1,233 (18) 2,307
------------- ----------- ------------- -----------
LOSS BEFORE EXTRAORDINARY ITEM (8,503) (428) (15,363) (573)
EQUITY IN EXTRAORDINARY GAIN OF INVESTEE - - - 646
------------- ----------- ------------- -----------
NET INCOME (LOSS) FOR PERIOD $ (8,503) $ (428) $ (15,363) $ 73
============= =========== ============= ===========
EARNINGS PER SHARE
PRIMARY AND FULLY DILUTED EARNINGS
INCOME (LOSS) PER SHARE
Continuing operations $ (0.63) $ (0.14) $ (1.14) $ (0.25)
Discontinued operations $ - $ 0.10 $ - $ 0.20
------------- ----------- ------------- -----------
Loss before extraordinary item $ (0.63) $ (0.04) $ (1.14) $ (0.05)
------------- ----------- ------------- -----------
Extraordinary item $ - $ - $ - $ 0.06
------------- ----------- ------------- -----------
Net income (loss) for period $ (0.63) $ (0.04) $ (1.14) $ 0.01
============= =========== ============= ===========
WEIGHTED AVERAGE NUMBER OF SHARES AND COMMON STOCK
EQUIVALENTS OUTSTANDING (IN THOUSANDS) 13,547 11,939 13,499 11,616
============= =========== ============= ===========
3
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Thousands of U.S. Dollars, except share data)
(Unaudited)
Nine Months Ended September 30
-------------------------------------------------
1996 1995
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) for period $ (15,363) $ 73
Adjustments to reconcile net income to net cash used in operating activities:
Equity in income of investee - net - (366)
Depreciation and amortization 2,525 367
Deferred tax benefit (1,046) -
(Income) loss from discontinued operations 18 (2,722)
Foreign exchange translation 14 -
Noncash compensation 380 -
Noncash financing costs 207 -
Noncash compensation on acquisition of Mosaic Information Technologies Inc. 500 -
Noncash interest 251 (35)
Changes in operating assets and liabilities:
Accounts receivable (251) (208)
Inventories (208) (678)
Other assets (362) (106)
Software development costs (3,392) -
Deferred financing costs (1,201) -
Accounts payable and accrued liabilities (24) 387
Net liabilities of discontinued operations (76) 9
Noncash adjustment to goodwill (41) 294
------------------- -------------------
Net cash used in operating activities (16,869) (2,985)
------------------- -------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in discontinued operation - (678)
Capital expenditures (3,338) (230)
Purchase of marketable securities (55) -
Investment in and advances to Intelect - (499)
Investment in other assets (1,582) (406)
Loan receivable 600 -
Proceeds on sale of fixed assets 57 2
Acquisition of Intelect, Inc. - (632)
Acquisition of Intelect Europe Limited. - (391)
Acquisition of DNA Enterprises, Inc. (3,010) -
Acquisition of Mosaic Information Technologies Inc. (2,004) -
------------------- -------------------
Net cash used in investing activities (9,332) (2,834)
------------------- -------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of convertible debentures, net of deferred financing
costs 13,799 -
Proceeds from issuance of notes payable - 9,880
Payments on notes payable (880) (6,430)
Proceeds from issuance of capital leases 55 10
Payments on capital lease obligations (84) (44)
Payment of long-term debt (122) -
Proceeds from issuance of common shares 2,473 665
Quasi-reorganization - 45
------------------- -------------------
Net cash provided by financing activities 15,241 4,126
------------------- -------------------
NET DECREASE IN CASH AND CASH EQUIVALENTS (10,960) (1,693)
CASH AND CASH EQUIVALENTS, beginning of period 15,039 2,555
------------------- -------------------
CASH AND CASH EQUIVALENTS, end of period $ 4,079 $ 862
=================== ===================
4
INTELECT COMMUNICATIONS SYSTEMS LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, 1996
BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared by
the Company without audit in accordance with generally accepted accounting
principles for interim financial statements and with instructions to Form 10-Q
and Article 10 of Regulation S-X. In the opinion of management, all adjustments
(consisting only of normal recurring accruals) considered necessary for a fair
presentation have been included.
The accompanying consolidated financial statements do not include certain
footnotes and financial presentations normally required under generally accepted
accounting principles and, therefore, should be read in conjunction with the
audited financial statements included in the Company's Transition Report on Form
10-K as at December 31, 1995.
RESTATEMENTS
During 1995, the Company changed its fiscal year end to December 31 from
October 31. Accordingly, the Company has filed a Transition Report on Form 10-K
for the transition period from November 1, 1995 to December 31, 1995 (the
"Transition Period"). Going forward, the Company will report results for the
quarters ending March 31, June 30, September 30 and December 31.
On October 31, 1995 the Company sold its prior principal operating
subsidiary, Savage Corporation ("Savage"). Accordingly, Savage's results are
accounted for as discontinued operations in the accompanying financial
statements.
INCOME TAXES
The Company provides for income taxes in interim periods based on the
estimated effective income tax rate of the complete fiscal year. An income tax
benefit is computed on the pre-tax loss of consolidated entities according to
applicable taxing jurisdictions based on current tax law. Deferred taxes result
from the future tax consequences associated with temporary differences between
the amount of assets and liabilities recorded for tax and financial accounting
purposes. A valuation allowance for deferred tax assets is recorded to the
extent the Company cannot determine, in accordance with the provision of
Statement of Financial Accounting Standards No. 109 "Accounting for Income
Taxes", that the ultimate realization of net deferred tax assets against income
is more likely than not.
OTHER INTANGIBLE ASSETS
Other Intangible Assets include licensed technology of $3,500,000 which is
carried at its present value with an imputed interest rate of 7% on the deferred
balance and will be amortized over a three year period to cost of goods sold
based on anticipated revenue generation.
ACQUISITIONS
The Company concluded the acquisitions of DNA Enterprises, Inc. ("DNA") on
February 13, 1996 and Mosaic Information Technologies Inc. ("Mosaic") on March
29, 1996. Both acquisitions have been accounted for as purchases and accordingly
the accompanying financial statements include the results of DNA and Mosaic from
their respective acquisition dates. The excess of purchase price over the
estimated fair values of the net assets acquired has been recorded as goodwill,
which is being amortized over ten years.
5
The estimated fair values of assets and liabilities of Mosaic and DNA
acquired are summarized below. Adjustments made during the second quarter to
certain Mosaic assets and Goodwill are included (thousands of U.S. Dollars):
SEPTEMBER 30
-------------------------------------
MOSAIC DNA
------ ---
Cash $ 27 $ 3
Accounts receivable
55 621
Inventory
245 -
Property and equipment
81 502
Goodwill
4,640 7,280
Accounts payable and accruals
(285) (214)
Debt
(16) (180)
---------------- ----------------
$ 4,747 $ 8,012
================ ================
LONG-TERM DEBT (thousands of U.S. Dollars)
SEPTEMBER 30 December 31
---------------- ----------------
1996 1995
---- ----
Subordinated debentures - at 6% due in five equal
annual installments commencing June 1996 $ 215 $ 224
Deferred purchase price payment due in
installments on February 1997 and 1998 (i) 5,000 -
Present value of license technology installment
payments due in quarterly amounts of $325,000 (ii) 2,363 -
Other - 985
---------------- ----------------
7,578 1,209
Less: current installments
(3,848) (1,041)
---------------- ----------------
$ 3,730 $ 168
================ ================
Notes:
(i) Deferred purchase price payments relate to the acquisition
of DNA Enterprises, Inc., as follows: (a) $1,000,000 in
cash on February 13, 1997; (b) $400,000 in cash on
February 13, 1998; (c) Warrants issued to certain
shareholders of DNA to purchase 300,000 Common Shares at
$5.00 per share February 13, 1996; and (d) Warrants to be
issued to certain shareholders of DNA to purchase an
additional 300,000 Common Shares at $7.00 per share on
February 13, 1998. The Company has agreed to repurchase
the Common Shares issued pursuant to the warrants under
(c) and (d) above at prices of $5.00, $5.50 and $6.00 per
share on the first, second and third anniversary of
Closing, respectively, at the option of the selling
shareholders and a liability of $3,600,000 has been
accrued in anticipation of this put option.
(ii) $3,500,000 of which $325,000 and $625,000 was paid in
September and June, 1996, respectively. The balance is
payable quarterly, in arrears, in installments of $325,000
and has been recorded at present value based on an imputed
interest rate of 7%.
CONVERTIBLE DEBENTURES
During the second quarter ended June 30, 1996, the Company issued
Convertible Debentures (the "June Debentures") in the aggregate principal amount
of $5,000,000. The June Debentures were fully converted into 773,515 Common
Shares as at September 30, 1996.
During the third quarter ended September 30, 1996, the Company issued
Convertible Debentures (the "August Debentures") in the aggregate principal
amount of $10,000,000 bearing interest at 7.5%, payable quarterly in arrears.
The August Debentures mature on August 8, 1998, are redeemable for cash at the
Company's option after August 8, 1997 at 125% of par value for six months and
thereafter at 120% of par value or if the Nasdaq trading price of the Company's
Common Shares falls below the fixed conversion price of $11.0825, the Company
can redeem at any time for the sum of the product of the number of common shares
of the Company's U.S.$0.01 par value per share (the "Common Shares") issuable
upon conversion at the current Nasdaq trading price. The August Debentures are
convertible at the holder's option into the Common Shares of the Company at the
lower of (i) 85% of the Nasdaq five day closing bid trailing average price of
the Common Shares prior to the Notice of Conversion date or (ii) the fixed
conversion price of $11.0825. The August Debentures are convertible into Common
Shares at the rate of one-third after October 7, 1996, one-third after November
6, 1996, and one-third after December 6, 1996.
6
SOFTWARE DEVELOPMENT COSTS
Capitalization of software development cost commences upon the
establishment of technological feasibility. Both the establishment of
technological feasibility and the ongoing assessment of recoverability of
capitalized development costs involve judgment by management with respect to
certain external factors, including, but not limited to, anticipated future
revenues, estimated economic life and possible developments in software and
hardware technologies. The Company has not capitalized any costs in prior
periods because eligible amounts were immaterial for those periods. The Company
believes that technological feasibility and future revenue potential has now
been established for the Company's SONETLYNX(TM) and CS4 product lines.
Accordingly, relevant and eligible expenditures for these products have been
capitalized in the accompanying financial statements.
INVENTORIES
The components of inventories are as follows (thousands of U.S. dollars):
SEPTEMBER 30 December 31
---------------- ----------------
1996 1995
---- ----
Raw materials $ 2,187 $ 1,554
Work in progress 232 544
Finished goods 1,298 1,169
---------------- ----------------
3,717 3,267
Less: allowance for obsolescence 665 730
---------------- ----------------
$ 3,052 $ 2,537
================ ================
ACCOUNTING FOR WARRANTS
In October, 1995 the Financial Accounting Standards Board issued Statement
123 ("FAS 123") "Accounting for Stock-Based Compensation", which requires
companies to value all options and warrants issued for compensation at their
"fair value" at the date of issuance. FAS 123 affects all companies whose
financial years begin after December 15, 1995. FAS 123 establishes financial
accounting and reporting standards for stock based employee compensation plans
and encourages, but does not require, all entities to adopt a fair value based
method of accounting for employee stock option plans. The Company has elected to
continue accounting for its stock-based employee compensation plans in
accordance with the intrinsic value based method of accounting.
The effect of this new accounting standard is twofold (i) all employee
stock options must be valued and disclosed on a pro-forma basis in note form in
the year end financial statements and (ii) all warrants and options granted for
services must be valued on a call option basis and expensed accordingly. The
pricing model used in this calculation, the Black-Scholes Model, makes certain
assumptions about the underlying stock-based primarily on its past performance
in order to determine future performance.
During the third quarter of 1996, the Company issued certain warrants to
third parties as partial payment of financial advisory fees in connection with
the issuance of the August Debentures. These warrants were issued as part
payment of a finders fee and entitle the holders to purchase a total of 70,063
and 125,000 of the Common Shares at a price of $8.56375 per share and $9.5625
per share, respectively. Using the prescribed Black-Scholes Model the value
placed on these warrants is $453,000 and $561,000, respectively. These amounts,
together with other debt issue costs of $985,000, are being amortized to
financing expense over the life of the August Debentures or until conversion
takes place at which time these costs will be debited to paid-in capital.
SUBSEQUENT EVENTS
On October 7, 1996, the Company reached an agreement with the previous
owners of Intelect, Inc. (the "Vendors"), under which the Vendors exchanged
their rights to future "earn-out" payments of up to $4,000,000 and Debentures
with a remaining value of $215,000 in exchange for 169,986 Common Shares plus
$140 cash in lieu of fractional shares. This transaction will be accounted for
in the fourth quarter and will result in an increase in Goodwill of
approximately $1,039,000.
On October 15, 1996 (the "Issuance Date") the Company issued an additional
$10,000,000 in Convertible Debentures (the "October Debentures") to the holders
of the June Debentures. The October Debentures are due on October 15, 1998,
bearing interest at 7%, are redeemable for cash at the Company's option at
117.5% of their face value and are convertible at the holder's option into
common shares in equal one-third amounts of principal sixty, ninety and one
hundred twenty days after the Issuance Date at 82.5% of the average five day
closing bid price on Nasdaq prior to the notice of conversion date.
7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FOR THE PERIOD ENDED SEPTEMBER 30, 1996
RESULTS OF OPERATIONS
The Company is transitioning through a period of consolidating and
integrating newly acquired operations, bringing to market innovative new
products, implementing extensive development and engineering of advanced new
products, and expanding Company wide marketing and sales efforts. The costs and
other effects of these programs and activities are adversely impacting current
results for the intended purpose of improving revenues, operating performance
and financial results in future reporting periods.
During the period ended September 30, 1995, the Company completed its
purchase of Intelect, Inc. and included the results of Intelect, Inc. from the
date of acquisition (April 24, 1995), but had not yet acquired DNA Enterprises,
Inc. ("DNA") or Mosaic Information Technologies Inc., which was renamed Intelect
Visual Communications Corp. ("IVC") in October 1996. Accordingly, management
does not believe that comparisons of the current period to the same period in
1995 would be meaningful in determining a trend.
The following table shows the results of operations for the periods
indicated as a percentage of net sales, services and other revenues:
(Unaudited)
Three Months Ended Nine Months Ended
September 30 September 30
------------------------------------- ------------------------------------
1996 1995 1996 1995
------------------------------------- ------------------------------------
Net sales, services and other revenues 100.0% 100.0% 100.0% 100.0%
Cost of sales 128.2% 68.9% 99.9% 71.2%
------------------ ------------------ ----------------- -----------------
Gross profit (loss) (28.2%) 31.1% .1% 28.8%
Selling, general and administrative 180.6% 77.4% 133.1% 75.3%
Engineering and development 54.6% 66.8% 40.8% 69.0%
Interest expense 22.5% 3.2% 8.2% 2.2%
Amortization and depreciation 70.9% 19.0% 33.0% 19.3%
Equity in loss of investee .0% .0% .0% 14.8%
------------------ ------------------ ----------------- -----------------
Operating loss before income taxes (356.8%) (135.3%) (215.2%) (151.8%)
Income (loss) from discontinued operations (.4%) 100.4% (.2%) 121.6%
------------------ ------------------ ----------------- -----------------
Loss before extraordinary item (357.2%) (34.9%) (215.4%) (30.2%)
Equity in extraordinary gain of investee .0% .0% .0% 34.0%
------------------ ------------------ ----------------- -----------------
Income (loss) before income taxes (357.2%) (34.9%) (215.4%) 3.8%
------------------ ------------------ ----------------- -----------------
NET SALES AND SERVICES
Net sales and services revenue for the three months ended September 30,
1996 increased 62.8% to $1,915,000 from $1,176,000 in the three month period
ended September 30, 1995. For the three months ended September 30, 1996 and 1995
respectively, these sales were comprised of (i) SONETLYNX(TM) fiber optic
multiplexer product 11.8% and 0%, (ii) S4(TM) product of 5.3% and 39.5%, (iii)
videoconferencing sales of 2.2% and 0% through IVC from the date of acquisition
(March 29, 1996); (iv) engineering service fees of 76.8% and 0%, for services
provided by DNA; (v) information security products 2.5% and 7.1%, distributed by
the Company's U.K. based value added reseller, and (vi) other products 1.5% and
53.4%, consisting primarily of analog air traffic control communications
switching systems.
Initial releases of the Company's new SONETLYNX(TM) product line were
introduced during the second quarter of 1996. Customer demonstrations, tests and
initial orders of the OC-1 version are underway into the second half of 1996.
Primary emphasis is being placed upon establishing distribution arrangements and
sales channels. Increased sales are currently expected during the fourth quarter
of 1996 and upon completion of the OC-3 version targeted for release during the
fourth quarter of 1996.
The sales cycle for the Company's new digital switch product line, S4(TM),
effectively commenced with customer acceptance for its first major commercial
installation in Iceland. This installation went "live" during the third week of
July and is functioning on a stand alone basis, controlling North Atlantic air
traffic in a 4.2 million square mile air space.
8
The Company released its LANScape(TM) videoconferencing product on October
17, 1996. Installations are being made at client locations in the fourth
quarter, initially as Beta sites. Reseller agreements have been signed with a
number of large and experienced network systems integrators and value added
re-sellers to distribute and install this product line. The Company expects to
release its second product, named Vubridge(TM), in the fourth quarter of 1996.
Engineering services continued at a level similar to the second quarter.
DNA announced its first hardware products, two board level digital signal
processing (DSP) systems. In October a global OEM agreement was announced with a
leading company in the DSP accelerator board market in order to provide an
immediate sales channel for the products.
Information security products are sold primarily to the military market,
which is influenced by unpredictable events and budgetary constraints that can
cause significant variances in sales from quarter to quarter. Due to the
unpredictability of these product sales, the Company has decided to curtail
selling activity in this area and, accordingly, the Company has refocused its UK
operation to be a support organization for its core products for European
markets.
GROSS PROFIT
The Company's gross loss of $575,000 or (28.2%) for the three months ended
September 30, 1996 was a decrease of $957,000 compared to a gross margin of
$382,000 or 31.1% for the three months ended September 30, 1995. The third
quarter 1996 result was below normal operating margins due to under-absorption
of operating costs and the initial placement or sale of new products as test
modules with low or negative margins. In addition, the anticipation of
increasing sales in the short-term and the development of scheduled product
releases has necessitated the hiring and maintenance of core personnel in both
operations (manufacturing) and sustaining engineering. Management currently
expects that higher sales volumes in future quarters should result in higher
margins.
The Company's hardware and software design and development subsidiary DNA
has currently committed over one-half of its personnel resources to the
Company's CS4 project in order to expedite the completion of a demonstration
prototype of the CS4, scheduled for November, 1996. DNA's profit on the CS4
project is eliminated on consolidation.
SELLING, GENERAL AND ADMINISTRATIVE (SG&A)
For the three months ended September 30, 1996 SG&A expenses, not including
Amortization and Depreciation (below) were up $2,735,000 at $3,685,000 or 180.6%
from $950,000 or 77.4% compared with the three months ended September 30, 1995.
This increase is due in part to the acquisitions of new business, financing
costs and ramp up in staffing for the selling, marketing and manufacturing of
the Company's products. Selling and marketing expenses for the three months
ended September 30, 1996 increased 284.4% to $1,795,000 compared with $467,000
for the same period in 1995. G&A expenses were up 163.96% at $1,890,000 compared
with $716,000 for the same period 1995.
Marketing and selling expenses relating to the rollout of the SONETLYNX(TM)
product line and initial marketing for the CS4 in advance of sales amounted to
$957,000. Marketing and selling expenses relating to the Company's
videoconferencing product line in advance of sales amounted to $673,000.
Marketing and selling expenses relating to the market development of the
Company's products into the European market amounted to $165,000. Included in
the marketing and selling expenses above, are $86,000 and $262,000 for
advertising and trade shows, respectively.
Prior year administrative expenses reflect traditional costs primarily
associated with the Company's status as a publicly traded company and related
reporting requirements. However, legal and audit expenses have increased
substantially from prior years and are expected to continue at a similar level.
Deferred financing costs associated with the Company's issuance of the June
Debentures and August Debentures amounted to $328,000 and $985,000, respectively
in cash expenditures, and $1,058,000 and $1,014,000 in non-cash costs related to
the issuance of warrants pursuant to FAS 123, which are being amortized over the
life of the June Debentures and August Debentures. The June Debentures were
fully converted by September 30, 1996 and all un-amortized finance and warrant
costs totaling $1,211,000 have been debited to paid-in capital.
INTEREST EXPENSE
Interest expense increased to $459,000 or 22.5% from $39,000 or 3.2% for
the three months ended September 30, 1996 and 1995 respectively. The amount of
interest expense in the current quarter represents interest on (i) a line of
credit of $300,000 to finance receivables which bears interest at 12% generating
$4,000; (ii) Debentures owed to the previous owners of Intelect, Inc., which
bear interest at 6% generating $9,000, (iii) Convertible Debentures issued by
the Company in June and August, 1996, which bear interest at 7.5% generating
$183,000; (iv) licensed technology at a net present value of 7% generating
$46,000; (v) non-cash interest of $83,000 being the 17.5% redemption premium on
the balance of the June Debentures, which were converted in full by September
30, 1996 with the redemption amount credited to paid-in capital; (vi) non-cash
interest of $128,000 (the redemption premium of the
9
August Debentures), which is the sum of the product of the number of common
shares issuable upon conversion at the quarter end Nasdaq trading price, which
is being amortized over the life of the August Debentures pursuant to APB 21;
and (vii) capital leases of $6,000.
AMORTIZATION AND DEPRECIATION
Amortization and depreciation is included in SG&A and is comprised of the
following (thousands of U.S. Dollars):
Three Months Ended Nine Months Ended
September 30 September 30
------------------------------ ------------------------------
1996 1995 1996 1995
---- ---- ---- ----
Depreciation of Property & Equipment $ 199 $ 79 $ 539 $ 106
Amortization of Goodwill 1,212 154 1,901 261
Technology Amortization
35 - 85 -
-------------- --------------- -------------- --------------
$ 1,446 $ 223 $ 2,525 $ 367
============== =============== ============== ==============
Depreciation of property and equipment has increased in part due to the
recent acquisitions. Goodwill is amortized over periods from 10 - 15 years and
has also increased due to the acquisitions of DNA and IVC. Technology
amortization relates to intellectual properties purchased in 1995 and 1996.
During the third quarter 1996, the Company wrote off its goodwill in
Intelect Europe Limited ("IEL") totaling $779,000. A significant contraction in
the market for military electronic equipment in the UK dramatically reduced the
viability of the Company's information security product lines. Accordingly, the
Company has downsized its operations (based in Chesterfield, Derbyshire,
England) and is exploring several disposition strategies including the sale of
the product lines to third parties. The net assets of IEL at September 30, 1996
amounted to $1,420,000 and the final disposition of either the product lines
and/or the net assets may result in an adjustment to this carrying value.
ENGINEERING AND DEVELOPMENT (E&D)
E&D expenses for the three months ended September 30, 1996 were $1,114,000
or 54.6% up from $821,000 or 66.9% for the three months ended September 30,
1995. The current quarter expense is comprised primarily of labor costs for
hardware development and software design not capitalizable under FAS 86 for the
CS4 ($475,000) and SONETLYNX(TM) ($388,000) products in accordance with the
Company's policies. The balance of $251,000 relates to further development of
the Company's videoconferencing ($207,000) and S4(TM), ($44,000) products. This
compares with E&D expenses for the same period in 1995 of $553,000 and $268,000
on the S4(TM) and SONETLYNX(TM) products, respectively.
INCOME (LOSS) FROM DISCONTINUED OPERATIONS
The Company sold Savage Corporation ("Savage") on October 31, 1995. The
results of Savage are accounted for as discontinued operations and, accordingly,
comparative presentations reflect the Company's equity in the earnings of Savage
for the relevant periods. This disposition accounts for the decrease in income
in the three months ended September 30, 1996 to $9,000 from $1,233,000 for the
same period in 1995.
INCOME TAX BENEFIT
The Company recorded a valuation allowance during the quarter ended
September 30, 1996 of $1,215,000 on the U.S. based operations due to sales
activity falling below prior anticipated levels. In light of recent sales
results, the Company has determined that a valuation allowance is appropriate.
The remaining tax benefit reflects a tax rate of 34% and the Company's
current belief that future taxable income will be realizable from reversals of
existing taxable temporary differences and sales of new and existing products.
The timing and amount of such future taxable income may be impacted by a number
of factors, including those discussed below under "Additional Factors That May
Affect Future Results". To the extent that estimates of future taxable income
are reduced or not realized, the amount of such deferred tax assets and the
Company's effective tax rate may be adversely affected.
10
LIQUIDITY AND CAPITAL RESOURCES
The Company's working capital decreased $12,814,000 at September 30, 1996
to $1,812,000 compared with $14,626,000 at December 31, 1995 due primarily to
the Company's acquisitions of DNA and Mosaic and to the funding of E&D programs
and operating losses. The Company regularly reviews its cash funding
requirements on a consolidated basis and attempts to meet those requirements
through a combination of cash on hand, cash provided by operations and possible
future public or private debt and/or equity offerings. The Company utilizes a
centralized corporate strategy for its cash management activities and invests
its excess cash in investment grade, short-term, money market instruments.
The Company believes that the cash proceeds from the issuance of the August
Debentures and October Debentures will be sufficient to meet its operating
capital requirements for the next six months. However, the Company is dependent
on the sales of its products at normal profit margins (projected to commence in
the first quarter of fiscal 1997) to produce positive cash flow from operations
and to fund its future cash requirements. Until such sales are achieved, the
Company is dependent on the continued sale of its Common Shares (or convertible
debentures which can be converted into Common Shares) to fund its short-term
cash needs. Sales of substantial amounts of Common Shares, or the perception
that these sales could occur, could adversely affect prevailing market prices
for the Common Shares and could impair the ability of the Company to raise
additional capital through the sale of its equity securities or through debt
financing and may lead to additional dilution of current shareholder interests,
particularly in the area of earnings per share.
CONTINGENT LIABILITIES
The Company is contingently liable for certain potential liabilities
relating to its discontinued operations. Specifically, the Company has
indemnified the purchaser of Savage against certain product liability,
environmental clean up costs and other contractual liabilities, including
certain asserted successor liability claims, customarily assumed on the sale of
a business. In particular, the Company has been notified that the purchaser of
Savage seeks indemnification in connection with certain product liability
claims. Although the Company believes that it has several defenses available to
it in such a claim, the outcome of such claim cannot be predicted with certainty
at this time. The Company has reserved for all known liabilities and has insured
itself against certain of the product liability claims. However, should
indemnified claims exceed the related insurance coverage and/or the existing
reserves, the Company's results of operations and/or its financial position
could be adversely affected.
ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS
This Form 10-Q contains certain forward looking-statements within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E
of the Securities Exchange Act of 1934 as amended. Actual events and results
could differ materially from those set forth in the forward-looking statements.
Certain factors that may cause such differences include worldwide economic and
political conditions, industry specific factors, the Company's ability to
maintain access to external financing sources and its financial liquidity, the
Company's ability to timely develop and produce commercially viable products at
competitive prices, the availability and cost of components, the Company's
ability to manage expense levels, the Company's ability to manage growth, the
continued financial strength of the Company's dealers and distributors, and the
Company's ability to accurately anticipate customer demand.
The Company's future success is highly dependent upon its ability to
develop, produce and market products that incorporate new technology, are priced
competitively and achieve significant market acceptance. There can be no
assurance that the Company's products will be commercially successful or
technically advanced due to the rapid improvements in information technology and
resulting product obsolescence. There is also no assurance that the Company will
be able to deliver commercial quantities of new products in a timely manner. The
success of new product introductions is dependent on a number of factors,
including market acceptance, the Company's ability to manage risks associated
with product transitions, the effective management of inventory levels in line
with anticipated product demand and the timely manufacturing of products in
appropriate quantities to meet anticipated demand. Specifically, the Company has
committed approximately $10 million to the development of an advanced generation
of its S4(TM) product for application in public telecommunications networks (the
"CS4"). The Company currently estimates that the CS4 will be available for
shipment in the third quarter of 1997. The Company believes that the expected
potential customers for the CS4 include InterExchange Carriers, Local Exchange
Carriers, Wireless, Personal Communications Service, Competitive Access
Providers and, in general, operators of Advanced Intelligent Networks. The
Company will be competing with established equipment manufacturers with greater
financial resources and more developed channels of distribution. No assurances
can be given that the Company will be successful in completing the CS4 on
schedule, that the Company will be successful in competing in this environment
or that it will be able to sell sufficient quantities of the CS4 to recover its
investment or to realize profits. In addition, no prediction can be made as to
the affect, if any, that future sales of common shares issued pursuant to the
June and August Debentures will have on the market price of the common shares
prevailing from time to time.
11
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS.
4(i) Form of 7.5% Convertible Debenture due August 8, 1998 of Intelect
Communications Systems Limited
4(ii) Form of 7%, Series A, Convertible Debenture due October 15, 1998
of Intelect Communications Systems Limited
4(iii) Form of 7%, Series B, Convertible Debenture due October 15, 1998
of Intelect Communications Systems Limited
10(i) Convertible Securities Agreement dated August 8, 1996 among
Intelect Communications Systems Limited and certain
Investors
10(ii) Registration Rights Agreement among Intelect Communications
Systems Limited and certain Investors
10(iii) Convertible Securities Agreement dated October 15, 1996 among
Intelect Communications Systems Limited and Infinity Investors,
Ltd. and Seacrest Capital Limited
10(iv) Registration Rights Agreement dated October 15, 1996 among
Intelect Communications Systems Limited and Infinity Investors,
Ltd. and Seacrest Capital Limited
10(v) Book Entry Transfer Agent Agreement by and among the Company,
Infinity Investors, Ltd., Seacrest Capital Limited and American
Stock Transfer & Trust Company
10(vi) Offer to Purchase the Five Year Six Percent (6%) Subordinated
Debentures of Intelect, Inc. for an Aggregate of 170,000 Shares of
Common Stock, $0.01 Par Value, of Intelect Communications Systems
Limited and the payment of Certain Amounts in Lieu of Issuing
Fractional Shares, Dated September 6, 1996
10(vii) Letter of Transmittal to Accompany Five Year Six Percent (6%)
Subordinated Debentures of Intelect, Inc.
10(viii) Form of Release in Consideration of Exchange of Property
11 Calculation of Earnings Per Share
27 Financial Data Schedule
(B) REPORTS ON FORM 8-K:
None
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.
INTELECT COMMUNICATIONS SYSTEMS LIMITED
(Registrant)
Date: November 13, 1996 /s/ RHIANON M. PEDRO
----------------- -------------------------
Rhianon M. Pedro
Chief Financial Officer
(principal financial officer)
Date: November 13, 1996 /s/ PETER G. LEIGHTON
----------------- --------------------------
Peter G. Leighton
President
12