EXHIBIT 13
ANNUAL REPORT TO SHAREHOLDERS
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
EXECUTONE Information Systems, Inc. (the Company) develops, markets and supports
voice and data communications systems. Products and services include telephone
systems, voice mail systems, inbound and outbound call center systems and
specialized healthcare communications systems. The Company's UniStar
Entertainment indirect subsidiary has the exclusive right to design, develop and
manage the National Indian Lottery (NIL). The Company's products are sold under
the EXECUTONE'r', INFOSTAR'r', IDS'tm', LIFESAVER'tm' and INFOSTAR/ILS'tm' brand
names through a national network of independent distributors and company direct
sales and service employees.
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.
1997 COMPARED TO 1996
Results of Operations
On May 31, 1996, the Company sold substantially all of its direct sales and
services organization, including its long-distance reseller business
(hereinafter referred to as the "sale of the direct offices"), for consideration
valued at $69.6 million to Clarity Telecom Holdings, Inc. d/b/a Executone
Business Solutions (Clarity, subsequently known as Claricom). As a result of the
business sales and dispositions consummated during the first half of 1996,
including the sale of the direct offices, the financial results for 1997 are not
comparable to 1996, other than on certain measures of overall profitability.
During 1997, the Company generated approximately $0.1 million in operating
income compared to an operating loss of $3.4 million in 1996. The Company had a
net loss of $0.2 million, or $0.00 per share in 1997, compared to a net loss of
$2.6 million, or ($0.05) per share in 1996, excluding the gain on the sale of
the direct offices.
The 1997 results, while improved over 1996, were not in line with the Company's
expectations. Increased revenues achieved by the Healthcare Communications
business in 1997 along with the non-recurring expenses incurred in the first
half of 1996 relating to the sale of the direct sales offices were the primary
reasons for the year over year improvement. However, these favorable variances
were largely offset by the much lower than anticipated sales levels to the
Company's largest distributor.
Computer Telephony
The mission of the Computer Telephony (CT) business is to develop and distribute
telephony products that are easy to install, easy to maintain, easy to use and
create value for its customers. CT offers a complete portfolio of applications
built upon the IDS'tm' family of digital telephone systems. 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), callback predictive
dialing and wireless communications. 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.
1
CT markets its products through independent distribution and direct sales. The
direct sales effort focuses on product and service sales to National and
Government Accounts. The Company utilizes its independent distribution channel
to service and install direct company sales through a National Account Service
Arrangement with the independent channel. CT had 1997 revenues of $117.2
million, compared to $129.4 million in 1996. The decrease in revenue is due to a
$16.0 million decrease in sales to Claricom, the purchaser of the direct offices
and the Company's largest distributor during 1997. For comparability, the 1996
revenue includes sales revenue to the former direct sales and service
organization prior to the sale. Excluding Claricom, the remainder of the
independent distribution channel increased revenue by $6.4 million, or 22%,
compared to 1996. Revenues from the retail portion of CT were largely stable
year over year. Repair revenue decreased approximately $2 million, primarily due
to lower Claricom activity, and LCR revenues increased almost 50% to $1.8
million.
The reduced level of sales to Claricom, the Company's largest distributor, had a
significant impact on the financial results for 1997. Effective April 1, 1998,
Claricom became a non-exclusive distributor of the Company's products in all
parts of its territory. It is the Company's intention to supplement sales in the
Claricom territories with additional distribution. The Company has identified
other distributors to sell the Company's products in certain parts of Claricom's
territory, which will give the Company the ability over time to increase
revenues by adding alternative distribution in Claricom territories.
Since Claricom accounted for more than 10% of the Company's revenues in 1997 and
is expected to continue to represent a large portion of the Company's revenues,
the reduction of sales to Claricom could have a material adverse effect on the
Company if the Company could not supplement the shipments to the Claricom
territories with other alternative distribution. The Company believes that
within a reasonable period of time it can establish alternative distribution
channels in Claricom's major markets to supplement the reduced volume from
Claricom. However, the Company cannot state with certainty when, or the extent
to which, such alternative distribution arrangements will be completed or their
effect on revenues.
Healthcare Communications
The mission of the Healthcare Communications business is to provide a full array
of solutions that enable healthcare facilities to realize a substantial savings
in operating costs without compromising the quality of patient care. Integrated
on the scaleable Healthcare Communications Platform (HCP), healthcare products
are designed to improve patient care quality, prevent technological obsolescence
and increase staff productivity. 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 seamlessly integrated to enhance a facility's
communications and information networking. Healthcare customers include
hospitals, surgical centers, nursing homes and assisted living centers.
Revenues for 1997 were $39.0 million compared to $30.2 million in 1996 due to an
increase in new installations, system upgrades and expansions.
Other Matters
Interest expense decreased to $2.0 million in 1997 from $2.7 million in 1996 due
to a decrease in the debt outstanding during 1996 after the sale of the direct
offices. The proceeds of the sale in 1996 were used to repay the then entire
outstanding balance on the Company's revolving credit facility. Other income,
net, decreased by $0.3 million compared to 1996 primarily due to lower interest
income on invested cash.
The Company accounts for income taxes in accordance with FAS No. 109,
"Accounting for Income Taxes". For the year ended December 31, 1997, the Company
recorded a tax benefit of $0.1 million. The tax benefit for the year increased
the deferred tax asset reflecting an increase in tax benefits to be utilized in
the future. As of December 31, 1997, the deferred tax asset of $18.6 million
represents the expected benefits to be received from the utilization of tax
benefit carryforwards. The Company believes that the deferred tax asset will
more likely than not be recognized in the carryforward periods.
For the years ended December 31, 1997 and 1996, more than 10% of the Company's
revenues were derived from a single
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independent distributor, Claricom. Revenues, net of discounts, were $29.3
million and $31.7 million for 1997 and the seven-month period after the sale of
the direct sales and service organization in 1996, respectively. Had the sale to
Claricom taken place at the beginning of 1996, it is estimated that Claricom
revenues for 1996 would have been $45.3 million. This includes $13.6 million in
sales to the former direct sales and service organization prior to the sale to
Claricom. See "Computer Telephony" above. In 1997, the Company adopted FAS No.
128, "Earnings per Share," effective for periods ending after December 15, 1997.
As a result, the Company's reported earnings per share for prior years were
restated. The effect of this accounting change on previously reported earnings
per share data was to increase 1996 basic earnings per share by $0.01 compared
to the original calculation of primary earnings per share pursuant to APB No.
15. Earnings per share did not change for 1997 or 1995.
During 1996, the Company adopted FAS No. 123, "Accounting for Stock-Based
Compensation". In compliance with the provisions of the new statement, the
Company has elected to continue to apply APB Opinion 25 in accounting for its
stock compensation plans and, accordingly, has not recognized compensation
expense for its plans. If compensation cost had been determined in accordance
with FAS No. 123, net income would have been reduced by $0.2 million, $0.1
million and $0.3 million for 1997, 1996 and 1995, respectively. The change in
earnings per share would have been immaterial for each of the three years.
The Company has conducted a review of its computer systems to identify systems
that could be affected by the "Year 2000" issue. Systems that do not properly
recognize such information could generate erroneous data or fail. Although the
Company estimates the cost to resolve the Year 2000 issue through its current
software system is less than $0.5 million, it has decided as part of its
long-term information systems plan to convert to a new and more comprehensive
software system which will cost approximately $2 million, including installation
and data conversion costs. These costs will be capitalized and depreciated over
the expected service life of the system beginning in 1999. The Company believes
that the conversion to new software will resolve the Year 2000 issue. However,
if the conversion is not completed timely, the Year 2000 problem may have a
material impact on the operations of the Company.
Unistar
On December 19, 1995, the Company acquired 100% of the common stock of Unistar
Gaming Corporation (Unistar Gaming) for 3.7 million shares of the Company's
common stock valued at $5.4 million and 350,000 shares of newly issued preferred
stock valued at $7.3 million. Unistar Gaming was privately-held prior to the
acquisition. Its subsidiary, UniStar Entertainment, Inc. (UniStar), has an
exclusive five-year contract ending January 2003 to design, develop, finance and
manage the NIL for the Coeur d'Alene Tribe of Idaho ("CDA" or "the Tribe"). See
Note L of the Notes to Consolidated Financial Statements for the terms of the
agreement with the Tribe.
The initial goal of the investment in UniStar was to establish and manage a
telephone lottery that could be played by any individual of majority age,
residing in one of the 36 states or the District of Columbia that currently
operates a state-run lottery. In the original telephone-based lottery, it was
contemplated that calls via an 800 number would be processed with interactive
voice response equipment or live agents located on the Tribe's Reservation in
Idaho using ACD software to process nationwide lottery sales. The NIL business
plan has evolved in response to legal challenges to encompass Internet-based
instant lottery games, and as of January 1998, a local, non-toll-free telephone
and Internet-accessible weekly draw lottery. The Company has made a significant
investment in UniStar, which upon acquisition created 8% dilution to the
Company's stockholders and, subsequent to the acquisition, has totaled an
additional $11.3 million in cash. In 1997, the Company invested $6.7 million as
part of the cost to develop the software systems, building and other costs
related to the project, $5.9 million of which have been recorded as assets on
the balance sheet. The total UniStar investment as of December 31, 1997 is $25.4
million, including $15.8 million in goodwill and $8.0 million in other assets
with the remainder consisting of funded UniStar expenses. In the opinion of the
Company's management, this investment is justified based upon the potential
returns.
In an attempt to block the NIL, certain states filed letters under 18 U.S.C.
Section 1084 to prevent the long-distance carriers from providing telephone
service to the NIL. In 1995, the CDA initiated legal action against AT&T
Corporation (AT&T) to compel the long-distance carriers to provide telephone
service to the NIL. The CDA's position is that the lottery is authorized by the
Indian Gaming Regulatory Act (IGRA) passed by Congress in 1988, that IGRA
preempts state law, and that 18 U.S.C. Section 1084 is inapplicable and,
therefore, the states lack authority to issue the Section
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1084 notification letters to any carrier. On February 28, 1996, the CDA Tribal
Court ruled that CDA had satisfied all requirements of IGRA and the Section 1084
letters issued by certain state attorneys general in an effort to interfere with
the lawful operation of the NIL are invalid. In addition, the Tribal Court ruled
that the long-distance carriers cannot refuse to provide telephone service based
upon 18 U.S.C. Section 1084. On July 2, 1997, the Tribal Appellate Court
affirmed the lower Tribal Court's rulings and analysis, upholding the CDA's
right to conduct the telephone lottery. On August 22, 1997, AT&T filed a
complaint for declaratory judgment in the U.S. District Court in Idaho against
the CDA, seeking a federal court ruling as to the enforceability of the Tribal
Court's May 1, 1996 order affirming the CDA's right to conduct the telephone
lottery. The CDA has answered that complaint.
On May 28, 1997, the State of Missouri brought an action in the Missouri Circuit
Court in Kansas City against UniStar and the CDA to enjoin the NIL's US Lottery
Internet instant games offered by the CDA and managed by UniStar. The complaint
sought civil penalties, attorneys fees and court costs. The complaint alleged
that the US Lottery violates Missouri anti-gaming laws and that the marketing
and promotion of the US Lottery violate the Missouri Merchandising Practices
Act. The CDA and UniStar removed the case to the U.S. District Court for the
Western District of Missouri, which denied the State's subsequent motion to
remand the case back to the state court. The Court subsequently granted a motion
to dismiss CDA from the case based on sovereign immunity. The Court denied the
motion to dismiss UniStar based on sovereign immunity, although the Court
indicated it might reconsider that decision. UniStar filed a motion for
reconsideration of its motion for dismissal.
On January 28, 1998, the State of Missouri sought to dismiss voluntarily the
existing case against UniStar and filed the next day, a new action against the
Company, UniStar and two tribal officials, with essentially the same
allegations, in state court. The State obtained a temporary restraining order
from a state judge enjoining the marketing of the Internet and telephone lottery
in the State of Missouri. On February 5, 1998, the U. S. District Court for the
Eastern District of Missouri ruled that this second case also should be heard in
federal court, transferred the second case to the Western District of Missouri
where the original case had been filed, and dissolved the state court's
temporary restraining order, effective February 9, 1998. A motion to dismiss the
second case based on the sovereign immunity of all the defendants and a motion
to abstain in favor of the jurisdiction of the CDA Tribal Court are pending. The
state has noticed its appeal of the federal district court's rulings to the
Eighth Circuit Court of Appeals.
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 the Company,
UniStar and the CDA, to permanently enjoin the US Lottery offered by the Tribe
on the Internet and managed by UniStar. The complaint alleges that the offering
of the US Lottery violates Wisconsin anti-gambling laws and that legality of the
US Lottery has been misrepresented to Wisconsin residents in violation of state
law. In addition to an injunction, the suit seeks restitution, civil penalties,
attorneys' fees and court costs. The Company, UniStar and the CDA have removed
the case to the U.S. District Court in Wisconsin. On February 18, 1998, the
District Court dismissed the Tribe from the case based on sovereign immunity and
dismissed the Company based on the State's failure to state a claim against the
Company. Motions to dismiss the case against UniStar were denied. UniStar has
filed its notice of appeal of this decision to the Seventh Circuit Court of
Appeals.
The NIL conducts business under the US Lottery trade name. The US Lottery began
test marketing its Instant ticket games on the Internet in July 1997. Through
December 31, 1997, the US Lottery generated revenues of $1.5 million. On January
20, 1998, the US Lottery launched its first Draw game, the Super6. Tickets for
the Super6 can be purchased either over the Internet or by telephone. As of
March 31, 1998, the registered base of the US Lottery was approximately 21,000
people with about 3,000 active players. Due to advertising, professional fees
and other startup costs, the NIL has yet to generate a profit. As a result,
UniStar has not recognized any revenue as of December 31, 1997.
There are market and legal risks associated with the development of the NIL. The
Company believes there is a national market for the NIL based upon research into
the experience of other national lotteries and the growth of the overall lottery
market. However, there is no assurance that there will be acceptance of a
telephone or Internet lottery. Based upon the ruling of the Tribal Appellate
Court affirming the CDA's right to conduct the telephone lottery and opinions
from outside legal counsel, the Company also believes that the legal decision
rendered by the CDA Tribal Court and affirmed by the Tribal Appellate Court will
ultimately be affirmed by the Idaho federal court. The Company believes that
UniStar also will prevail in the Missouri and Wisconsin lawsuits. However, there
is no assurance of such a legal outcome. In the event that the telephone and
Internet lotteries do not attain the level of market acceptance anticipated by
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the Company or if the outcome of the pending lawsuits is adverse, the Company
would have to reevaluate its investment in UniStar.
SUBSEQUENT EVENTS
Corporate Reorganization
On January 8, 1998, the Company announced the beginning of the restructuring of
its businesses and the retirement of its Chief Executive Officer (CEO). These
announcements have resulted in several related charges which will be reflected
in the consolidated financial statements for the first quarter of 1998.
Alan Kessman, Chairman and CEO of the Company announced his intention to retire
from the management of the day-to-day operations of the Company. In accordance
with the diminishment of responsibility section of his employment continuity
agreement, Mr. Kessman will receive a severance payment of $1.3 million. The
Company will establish a reserve for this cost during the first quarter of 1998.
The Company has retained an executive search firm to find a successor for
Mr. Kessman, who has agreed to remain in his current position until his
successor is selected. The Company has incurred approximately $0.2 million
in expenses to recruit a new CEO which will be expensed as part of the
restructuring charge in the first quarter of 1998.
In addition, the Company has restructured current operations which resulted in a
workforce reduction during January and February 1998. The Company will incur
approximately $0.6 million for severance, benefits and other restructuring
charges in the first quarter of 1998.
As previously announced, Furman Selz LLC has been hired to advise the Company as
to certain financing and corporate restructuring options. Based upon advice of
Furman Selz and the recommendation of a special committee of the Board of
Directors, the Board has determined that it is in the best interests of the
shareholders of the Company to separate the business of the Company's UniStar
subsidiary from the operations of its computer telephony and healthcare
communications businesses. The Company expects, subject to completion of further
analysis and receipt of necessary approvals, that the separation would be
effected through a taxable distribution to shareholders later this year.
During the first quarter of 1998, the Company incurred approximately $0.2
million in advisory expenses related to preparation and review of corporate
restructuring options. Future expenses will be dependent upon the form and
nature of the corporate restructuring. The Company is also pursuing a plan to
retain and motivate key employees, the details of which are expected to be
concluded by the second quarter of 1998.
In total, the Company expects to record a restructuring charge of approximately
$2.3 million during the first quarter of 1998.
Amended Distributor Agreement with Claricom
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-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.
1996 COMPARED TO 1995
5
Results of Operations
With the sale of the direct offices and the sale of the Videoconferencing
division in 1996, the year as a whole was not comparable to 1995 other than on
overall measures of profitability such as operating or net income. In addition,
with the timing of the sale, the first half of 1996 is not comparable to the
second half of 1996 either on a financial or operational basis. For the first
six months of 1996, the primary mission of the Company, and the primary focus of
management resources, was to complete the sale of the direct offices while
transitioning the Company, adversely affecting operating results. For the second
six months of 1996, the Company operated on a post-sale standalone basis.
Excluding the gain on the sale of businesses, operating income for the
six-month period ended December 31, 1996 was $7.3 million compared to an
operating loss of $10.7 million for the first six months of 1996. Net income
for the six-month period ended December 31, 1996 was $4.4 million, or
$0.09 per share, compared to a net loss of $7.0 million, or ($0.14) per share,
for the first six months of 1996.
The Company recorded a pretax gain of $48.9 million net of transaction,
severance and other related costs of which $47.5 million was recorded during the
three-month period ended June 30, 1996. An additional $1.4 million pretax gain
was recorded during the three-month period ended December 31, 1996 reflecting
purchase price adjustments. The proceeds were used to repay the Company's bank
borrowings and the excess was invested in short-term cash investments.
In June 1996, the Company sold its Videoconferencing division to BT Visual
Images LLC for a $0.2 million note, royalties on videoconferencing revenue
through June 1998 and contingent consideration related to the sale of inventory
transferred to the buyer as part of the sale. The Company recorded a reserve for
loss of $3.9 million on the transaction during the three-month period ended
March 31, 1996. The Company has filed a legal action against GPT Video Systems,
with whom the Company terminated its distribution agreement for failure to
deliver properly functioning videoconferencing products on a timely basis, which
case is in the discovery stages.
In April 1996, the Company also sold its Inmate Calling business for $0.5
million in cash and notes and recorded a pretax loss of $1.0 million.
CT includes independent distribution, National Accounts and Government Systems.
Revenues for 1996, excluding revenues derived from the business sold, were
$129.4 million, of which $76.1 million was generated during the last six months
of 1996. Sales to Claricom totaled $31.7 million during the seven-month,
post-sale period. Healthcare revenues for 1996 were $30.2 million, of which
$17.3 million was generated during the last six months of 1996. Selling, general
and administrative costs were higher than anticipated as the transition of
post-sale administrative functions such as billing and inventory control was
more costly than planned.
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 $28 million, $50 million and $23 million as of December 31, 1997,
1996 and 1995, respectively.
At December 31, 1997 and 1996, cash and cash equivalents amounted to $7.7
million and $27.7 million, respectively, or 11% and 32% of current assets,
respectively. The $20.0 million decrease in cash and cash equivalents was used
to repurchase $4.9 million of the Company's common stock, fund $5.8 million in
operating activities, purchase $1.5 million in capital equipment and fund $5.6
million relating to the Company's investment in UniStar. Cash used by operating
activities was $5.8 million compared to $11.0 million in 1996. The decrease in
cash used by operating activities is primarily due to the decrease in average
trade receivables due to lower revenues over the periods.
Total debt at December 31, 1997 was $15.6 million, an increase of $0.9 million
from $14.7 million at December 31, 1996. The increase in debt is due to $1.8
million in capital lease obligations incurred in connection with equipment
acquisitions and an increase to the carrying value of the convertible
subordinated debentures of $0.3 million due to accretion, offset by $1.2 million
in debt repayments on other borrowings.
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Proceeds from the sale of the direct offices included $5.0 million of cash which
was held in escrow and reported on the consolidated balance sheet as of December
31, 1997 and 1996 as restricted cash. These funds were released to the Company
by Claricom on March 31, 1998.
The Company obtained a new revolving credit facility (the Credit Facility) in
October 1997. The $35 million Credit Facility is unsecured and expires in
January 2000. It consists of a revolving line of credit providing for direct
borrowings and letter of credit advances, subject to availability. Direct
borrowings and letter of credit advances are made available pursuant to a
formula that measures total outstanding debt in relation to cash, accounts
receivable and earnings before interest, taxes, depreciation and amortization.
The Credit Facility agreement contains certain restrictive covenants that
include, among other things, limitations on total outstanding debt, minimum
levels of consolidated net worth and maximum levels of capital expenditures and
capitalized leases. During 1997, the Company was in compliance with all such
financial covenants. Interest rates are also subject to adjustment based upon
certain financial ratios. Refer to Note C of the Notes to Consolidated Financial
Statements.
Required principal payments for debt in 1998 are approximately $1.0 million. The
Company believes that borrowings under the Credit Facility and cash flow from
operations will be sufficient to meet working capital and other requirements for
1998.
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SELECTED FINANCIAL DATA
The following is selected financial data for EXECUTONE for the five years ended
December 31, 1997. (In thousands, except for per share amounts)
Years Ended December 31,
---------------------------------------------------------------------------------
1997 1996 1995 1994 1993
---------------------------------------------------------------------------------
Revenues (1) $156,396 $212,022 $296,393 $291,969 $271,765
======== ======== ======== ======== ========
Income (Loss) Before
Income Taxes From
Continuing Operations(2) $ (358) $ 39,782 $(39,221) $ 10,041 $ 7,580
======== ======== ======== ======== ========
Income (Loss) From
Continuing Operations $ (221) $ 24,162 $(36,934) $ 6,734 $ 4,903
Income From
Discontinued Operations,
Net of Taxes(3) --- --- --- 757 298
Extraordinary Item - Loss on
Extinguishment of Debt,
Net of Taxes(4) --- (355) --- --- ---
-------- -------- -------- -------- -------
Net Income (Loss) $ (221) $ 23,807 $(36,934) $ 7,491 $ 5,201
======== ======== ======== ======== =======
EARNINGS (LOSS) PER SHARE:
Continuing Operations $ --- $ 0.47 $ (0.79) $ 0.15 $ 0.15
Discontinued Operations --- --- --- 0.02 0.01
Extraordinary Item --- (0.01) --- --- ---
-------- -------- -------- -------- -------
Net Income (Loss) $ --- $ 0.46 $ (0.79) $ 0.17 $ 0.16
======== ======== ======== ======== =======
DILUTED EARNINGS (LOSS) PER SHARE:
Continuing Operations $ --- $ 0.46 $ (0.79) $ 0.14 $ 0.10
Discontinued Operations --- --- --- 0.02 0.01
Extraordinary Item --- (0.01) --- --- ---
-------- -------- -------- -------- -------
Net Income (Loss) $ --- $ 0.45 $ (0.79) $ 0.16 $ 0.11
======== ======== ======== ======== =======
Total Assets $138,864 $152,009 $167,844 $189,481 $175,555
======== ======== ======== ======== ========
Long-Term Debt $ 14,643 $ 13,837 $ 29,829 $ 24,698 $ 32,279
======== ======== ======== ======== ========
Cash Dividends Declared
Per Share (5) $ --- $ --- $ --- $ --- $ ---
======== ======== ======== ======== ========
(1) The decline in revenues in 1997 and 1996 from prior years is attributable
to the sale of the Company's direct sales and service organization (DSOs)
in May 1996 (See Note M).
(2) The 1996 financial results included a pretax gain on the sale of the
Company's DSO's of $48.9 million (See Note M). The 1995 financial results
included a restructuring charge of $44.0 million (See Note N).
(3) Discontinued operations are presented for the Vodavi Communications Systems
Division (VCS) which was sold in March 1994.
(4) The 1996 extraordinary item relates to the write-off of deferred debt issue
costs associated with the Company's revolving credit facility repaid in
June 1996.
(5) The Company has not declared or paid any cash dividends on its Common
Stock. Refer to "Stock Data".
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EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share amounts)
Years Ended December 31,
1997 1996 1995
---- ---- ----
REVENUES $156,396 $212,022 $296,393
COST OF REVENUES 103,387 132,510 173,536
--------- -------- ---------
Gross Profit 53,009 79,512 122,857
--------- -------- ---------
OPERATING EXPENSES:
Product development and engineering 12,794 13,773 14,703
Selling, general and administrative 40,125 69,180 100,520
Provision for restructuring and unusual items
(Note N) --- --- 44,042
--------- -------- ---------
52,919 82,953 159,265
--------- -------- ---------
OPERATING INCOME (LOSS) 90 (3,441) (36,408)
INTEREST EXPENSE (1,985) (2,707) (3,920)
NET GAIN ON SALE OF BUSINESSES (Note M) --- 44,060 ---
OTHER INCOME, NET 1,537 1,870 2,129
ACQUISITION COSTS (Note M) --- --- (1,022)
--------- -------- ---------
INCOME (LOSS) BEFORE INCOME TAXES (358) 39,782 (39,221)
PROVISION (BENEFIT) FOR INCOME TAXES:
Cash 6 4,200 350
Noncash (Note D) (143) 11,420 (2,637)
---------- -------- ---------
(137) 15,620 (2,287)
---------- -------- ---------
INCOME (LOSS) BEFORE EXTRAORDINARY ITEM (221) 24,162 (36,934)
Extraordinary item - loss on extinguishment
of debt (net of income tax benefit of $238) --- (355) ---
---------- -------- ---------
NET INCOME (LOSS) $ (221) $ 23,807 $ (36,934)
========== ======== =========
EARNINGS (LOSS) PER SHARE:
INCOME (LOSS) BEFORE EXTRAORDINARY
ITEM $ --- $ 0.47 $ (0.79)
EXTRAORDINARY ITEM --- (0.01) ---
---------- -------- ---------
NET INCOME (LOSS) $ --- $ 0.46 $ (0.79)
========== ======== =========
DILUTED EARNINGS (LOSS) PER SHARE:
INCOME (LOSS) BEFORE EXTRAORDINARY
ITEM $ --- $ 0.46 $ (0.79)
EXTRAORDINARY ITEM --- (0.01) ---
---------- -------- ---------
NET INCOME (LOSS) $ --- $ 0.45 $ (0.79)
========== ======== =========
AVERAGE COMMON SHARES OUTSTANDING:
BASIC 49,655 51,712 46,919
========== ======== =========
DILUTED 49,655 52,251 46,919
========== ======== =========
The accompanying notes are an integral part of these consolidated statements.
9
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Years Ended December 31,
1997 1996 1995
---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Income (loss) before extraordinary item $ (221) $ 24,162 $(36,934)
Adjustments to reconcile net income (loss) to net
cash used by operating activities:
Depreciation and amortization 2,969 4,242 6,093
Deferred income tax provision (benefit) (137) 11,420 (2,637)
Net gain on sale of businesses (Note M) --- (44,060) (1,087)
Provision for restructuring and unusual items
(Note N) --- --- 44,042
Provision for losses on accounts receivable 277 1,921 1,440
Other, net 201 (465) (250)
Changes in working capital items:
Accounts receivable 5,439 (8,754) (4,205)
Inventories (3,893) 1,048 (3,121)
Accounts payable and accruals (8,779) (2,857) (9,402)
Other working capital items, net (1,668) 2,375 2,177
--------- -------- --------
NET CASH USED BY OPERATING ACTIVITIES (5,812) (10,968) (3,884)
--------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (1,469) (2,534) (3,457)
Dispositions of businesses --- 56,948 125
Investment in UniStar (5,556) (4,182) ---
Proceeds from sale of VCS --- --- 1,200
Other, net (1,325) 298 822
--------- -------- --------
NET CASH (USED) PROVIDED BY
INVESTING ACTIVITIES (8,350) 50,530 (1,310)
--------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings (repayments) under revolving credit
facility --- (15,445) 4,478
Repayments of other long-term debt (1,182) (1,134) (622)
Repurchase of stock (4,893) (4,554) (810)
Proceeds from issuance of stock 268 819 1,641
Other borrowings --- 356 750
--------- -------- --------
NET CASH (USED) PROVIDED BY FINANCING
ACTIVITIES (5,807) (19,958) 5,437
--------- -------- --------
INCREASE (DECREASE) IN CASH
AND CASH EQUIVALENTS (19,969) 19,604 243
CASH AND CASH EQUIVALENTS - BEGINNING
OF YEAR 27,696 8,092 7,849
--------- -------- --------
CASH AND CASH EQUIVALENTS - END
OF YEAR $ 7,727 $ 27,696 $ 8,092
========= ======== ========
The accompanying notes are an integral part of these consolidated statements.
10
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share amounts) December 31, December 31,
1997 1996
------------ -----------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 7,727 $ 27,696
Restricted cash 5,084 ---
Accounts receivable, net of allowance
of $1,814 and $2,106 33,403 38,992
Inventories 20,436 16,814
Prepaid expenses and other current assets 4,091 3,099
-------- --------
Total Current Assets 70,741 86,601
RESTRICTED CASH --- 5,031
PROPERTY AND EQUIPMENT, net 7,767 7,578
INTANGIBLE ASSETS, net (Note L) 19,765 19,893
DEFERRED TAXES 18,577 18,434
OTHER ASSETS 22,014 14,472
-------- --------
$138,864 $152,009
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt $ 951 $ 882
Accounts payable 23,009 26,666
Accrued payroll and related costs 3,007 3,398
Accrued liabilities 13,123 17,956
Deferred revenue and customer deposits 2,541 3,164
-------- --------
Total Current Liabilities 42,631 52,066
LONG-TERM DEBT 14,643 13,837
OTHER LONG-TERM LIABILITIES 1,092 759
-------- --------
Total Liabilities 58,366 66,662
-------- --------
STOCKHOLDERS' EQUITY:
Common stock: $.01 par value; 80,000,000 shares
authorized; 49,660,359 and 51,173,755 issued and
outstanding 497 512
Preferred stock: $.01 par value; Cumulative Convertible
Preferred Stock (Series A), 250,000 shares authorized,
issued and outstanding; Cumulative Contingently
Convertible Preferred Stock (Series B), 100,000 shares
authorized, issued and outstanding 7,300 7,300
Additional paid-in capital 71,500 76,113
Retained earnings (since July 1, 1988) 1,201 1,422
-------- --------
Total Stockholders' Equity 80,498 85,347
-------- --------
$138,864 $152,009
======== ========
The accompanying notes are an integral part of these consolidated balance
sheets.
11
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(In thousands, except for Common Stock Preferred Stock Additional Retained Total
share amounts) ------------------ ------------------ Paid-In Earnings Stockholders'
Shares Amount Shares Amount Capital (Deficit) Equity
------ ------ ------ ------ ------- --------- ------
Balance at December 31, 1994 45,647,894 $456 --- $ --- $72,303 $14,549 $87,308
Proceeds from issuances of stock
from employee stock plans 1,934,492 19 1,613 1,632
Warrants exercised for common
stock 363,549 4 (4) ---
Common and preferred stock issued
to acquire Unistar (Note L) 3,700,000 37 350,000 7,300 5,374 12,711
Common stock issued for
investment in DCC (Note G) 353,118 4 1,100 1,104
Repurchase of stock (340,561) (3) (807) (810)
Amortization of deferred
compensation 89 89
Net loss (36,934) (36,934)
-------------------------------------------------------------------------------------
Balance at December 31, 1995 51,658,492 $517 350,000 $7,300 $79,668 $(22,385) $65,100
Proceeds from issuances of stock
from employee stock plans 810,036 8 839 847
Warrants exercised for common
stock 199,431 2 7 9
Repurchase of stock (1,494,204) (15) (4,536) (4,551)
Amortization of deferred
compensation 135 135
Net income 23,807 23,807
-------------------------------------------------------------------------------------
Balance at December 31, 1996 51,173,755 $512 350,000 $7,300 $76,113 $1,422 $85,347
Proceeds from issuances of stock
from employee stock plans 323,490 3 201 204
Warrants exercised for common
stock 50,000 1 60 61
Repurchase of stock (1,886,886) (19) (4,874) (4,893)
Net loss (221) (221)
-------------------------------------------------------------------------------------
Balance at December 31, 1997 49,660,359 $497 350,000 $7,300 $71,500 $1,201 $80,498
=====================================================================================
The accompanying notes are an integral part of these consolidated statements.
12
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 systems. Products and services include telephone
systems, voice mail systems, inbound and outbound call center systems and
specialized healthcare communications systems. The Company's UniStar
Entertainment indirect subsidiary (UniStar) has an exclusive five-year contract
with the Coeur d'Alene Tribe of Idaho (CDA) to design, develop, finance and
manage the National Indian Lottery (NIL). Products and services are sold under
the EXECUTONE'r', INFOSTAR'r', IDS'tm', LIFESAVER'tm' and INFOSTAR/ILS'tm' 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 was formed in July 1988 through the merger of ISOETEC
Communications, Inc. (ISOETEC) with Vodavi Technology Corporation (Vodavi). The
merger of ISOETEC into Vodavi was accounted for under the purchase method of
accounting and Vodavi was deemed to have undergone a quasi-reorganization for
accounting purposes. As of July 1988, Vodavi's accumulated deficit of
approximately $49.7 million was eliminated. Executone, Inc. was acquired in 1988
from Contel Corporation (Contel) for promissory notes and cash.
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. 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. Certain prior
year amounts have been reclassified to conform to the current year's
presentation.
Use of Estimates. 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.
Revenue Recognition. The Company recognizes revenue on equipment sales and
software licenses to independent sales and service offices when shipped. Revenue
from equipment, software and installation contracts with end-users is recognized
when the contract or contract phase for major installations is substantially
completed. Revenue derived from the sale of service contracts is amortized
ratably over the service contract period on a straight-line basis.
Earnings Per Share. Earnings per share is calculated in accordance with the
provisions of FAS No. 128, "Earnings per Share", effective for periods ending
after December 15, 1997. Accordingly, prior year amounts have been restated.
Earnings per share is based upon the weighted average number of shares of common
stock outstanding during the period. Diluted earnings per share is based upon
the weighted average number of shares of common stock outstanding plus the
dilutive effect of stock options and warrants outstanding during the period.
Stock options and warrants, the convertible preferred stock and the convertible
debentures, which are antidilutive, have been excluded from the computations.
Cash Equivalents. Cash equivalents include short-term investments with original
maturities of three months or less.
Inventories. Inventories are stated at the lower of first-in, first-out (FIFO)
cost or market and consist of the following at December 31, 1997 and 1996:
(Amounts in thousands) 1997 1996
---------------------- ---- ----
Raw Materials $ 4,672 $ 3,493
Finished Goods 15,764 13,321
-------- --------
$20,436 $16,814
======= =======
13
Intangible Assets. Intangible assets represent the excess of the purchase price
of the predecessor companies acquired over the fair value of the net tangible
assets acquired. The carrying value of intangibles is evaluated periodically in
accordance with the provisions of FAS No. 121, "Accounting for the Impairment of
Long-Lived Assets", by projecting the lowest level of future undiscounted net
cash flows of the underlying businesses. If the sum of such cash flows is less
than the book value of the long-lived assets, including intangibles, projected
future cash flows are discounted and intangibles are adjusted accordingly.
Amortization is provided over a 40-year period, except for the goodwill related
to the UniStar acquisition which will be amortized beginning in 1998 over the
five-year term of the management agreement (See Note L). Intangible assets at
December 31, 1997 and 1996 are net of accumulated amortization of $1.1 million
and $1.0 million, respectively.
Property and Equipment. Property and equipment at December 31, 1997 and 1996
consist of the following:
(Amounts in thousands) 1997 1996
---------------------- ---- ----
Furniture and fixtures $ 887 $ 1,992
Leasehold improvements 1,718 1,813
Machinery and equipment 16,858 20,253
--------- ----------
19,463 24,058
Accumulated depreciation (11,696) (16,480)
--------- ----------
Property and equipment, net $ 7,767 $ 7,578
========= ==========
Depreciation is provided on a straight-line basis over the estimated economic
useful lives of property and equipment which range from three to ten years for
equipment. Amortization, principally of leasehold improvements, is provided over
the life of the respective lease terms which range from five to ten years.
Income Taxes. The Company utilizes the liability method of accounting for income
taxes as set forth in FAS No. 109, "Accounting for Income Taxes". Under the
liability method, deferred taxes are determined based on the difference between
the financial statement and tax bases of assets and liabilities using enacted
tax rates in effect in the years in which the differences are expected to
reverse.
Product Development and Engineering. Product development and engineering costs
are expensed as incurred.
Fair Value of Financial Instruments. The fair value of the Company's Convertible
Subordinated Debentures at December 31, 1997 is approximately $14.6 million,
based upon market quotes. The carrying value of all other financial instruments
included in the accompanying consolidated financial statements approximate fair
value as of December 31, 1997 based upon current interest rates.
Noncash Investing and Financing Activities. The following noncash investing and
financing activities took place during the three years ended December 31, 1997:
(Amounts in thousands) 1997 1996 1995
---------------------- ---- ---- ----
Note Receivable and Warrants from Sale of
DSOs (Note M) $ --- $ 8,100 $ ---
Restricted Cash Received from Sale of
DSOs (Note M) --- 5,031 ---
Common and Preferred Stock issued to
acquire Unistar (Note L) --- --- 12,711
Notes receivable for 1995 disposition of direct sales
offices (Note M) --- --- 1,911
Equity investment in DCC (Note G) --- --- 1,505
Common shares exchanged to exercise options
and warrants 507 549 1,137
Capital leases for equipment acquisitions 1,805 302 437
14
Refer to the consolidated statements of cash flows for information on
cash-related operating, investing and financing activities.
NOTE C - DEBT
The Company's debt is summarized below at December 31, 1997 and 1996:
(Amounts in thousands) 1997 1996
- ---------------------- ---- ----
Borrowings Under Revolving Credit Facility (a) $ --- $ ---
Convertible Subordinated Debentures (b) 12,569 12,317
Capital Lease Obligations (c) 2,326 1,499
Other 699 903
------- --------
Total Debt 15,594 14,719
Less: Current Portion of Long-Term Debt 951 882
------- --------
Total Long-Term Debt $14,643 $ 13,837
======= ========
(a) The Company obtained a new revolving credit facility (the Credit Facility)
in October 1997. The $35 million Credit Facility is unsecured and expires
in January 2000. It consists of a revolving line of credit providing for
direct borrowings and letter of credit advances, subject to availability.
Direct borrowings and letter of credit advances are made available pursuant
to a formula that measures outstanding debt in relation to cash, accounts
receivable and earnings before interest, taxes, depreciation and
amortization. To minimize interest expense on the revolving line of credit,
the Company has the option to borrow money based upon an adjusted prime
borrowing rate (8.5% at December 31, 1997) or at an adjusted eurodollar
rate (8.2% at December 31, 1997). Approximately $19.8 million was available
at December 31, 1997 under the revolving line of credit, after giving
effect to $7.2 million that was committed to cover outstanding letters of
credit. The unused portion of the line of credit has a commitment fee of
0.375%. The Company repaid all amounts outstanding under the previous
revolving credit facility in June 1996. No direct borrowings against the
revolving credit facility were outstanding at December 31, 1997 and 1996.
The Company's average outstanding indebtedness under the revolving line of
credit for the year ended December 31, 1996 was $6.5 million, and the
average interest rate on such indebtedness was 7.9%.
The Credit Facility agreement contains certain restrictive covenants
including, among other things, limitations on total outstanding debt,
minimum levels of consolidated net worth and maximum levels of capital
expenditures and capitalized leases. During 1997, the Company was in
compliance with all such financial covenants. Interest rates are also
subject to adjustment based upon certain financial ratios.
(b) The Company's Convertible Subordinated Debentures (the Debentures), issued
in April 1986, are due March 15, 2011 and bear interest at 7 1/2%, payable
March 15th and September 15th. The face value of the outstanding Debentures
at December 31, 1997 was $16.4 million. The face value of the Debentures
was adjusted to fair value in connection with the Company's 1988
quasi-reorganization. The Debentures are convertible at the option of the
holder into Common Stock of the Company at any time on or before March 15,
2011, unless previously redeemed, at a conversion price of $10.625 per
share, subject to adjustment in certain events. Subject to certain
restrictions, the Debentures are redeemable in whole or in part, at the
option of the Company, at par. The Debentures are also subject to annual
sinking fund payments of $1.5 million. In January 1992, $15 million
principal amount of Debentures with a book value of $10.1 million was
exchanged for 674,865 shares of Convertible Preferred Stock and 2,999,400
Common Stock Purchase Warrants. Debentures reacquired by the Company in the
debt-for-equity exchange and in connection with Warrant exercises were
delivered in lieu of cash in satisfying sinking fund requirements. Thus, no
cash sinking fund payment will be due on the Debentures until March 2008.
(c) The Company has entered into capital lease arrangements for office
furniture, computer and test equipment with a net book value of
approximately $2.3 million and $1.5 million at December 31, 1997 and 1996,
respectively. Such leases have been capitalized using implicit interest
rates which range from 2% to 11%.
15
The following is a schedule of future maturities of long-term debt at December
31, 1997:
Years Ending December 31: (Amounts in thousands)
------------------------ ----------------------
1998 $ 951
1999 551
2000 500
2001 566
2002 261
Thereafter 12,765
-------
$15,594
=======
For the years ended December 31, 1997, 1996 and 1995, the Company made cash
payments of approximately $1.8 million, $2.6 million and $3.6 million,
respectively, for interest expense on indebtedness.
NOTE D - INCOME TAXES
The components of the provision (benefit) for income taxes applicable to income
(loss) from continuing operations for the three years ended December 31, 1997
are as follows:
(Amounts in thousands) 1997 1996 1995
---------------------- ---- ---- ----
Current - Federal $ --- $ 1,100 $ 150
- State --- 3,100 200
- Foreign 6 --- ---
------ ------- -------
6 4,200 350
------ ------- -------
Deferred - Federal (111) 11,005 (1,922)
- State (32) 415 (715)
------ ------- -------
(143) 11,420 (2,637)
------ ------- -------
$ (137) $15,620 $(2,287)
====== ======= =======
For the year ended December 31, 1996, the Company recorded a deferred income tax
benefit of $238,000 related to an extraordinary loss on the extinguishment of
debt.
A reconciliation of the statutory federal income tax provision (benefit) to the
reported income tax provision (benefit) on income (loss) from continuing
operations for the three years ended December 31, 1997 is as follows:
(Amounts in thousands) 1997 1996 1995
- ---------------------- ---- ---- ----
Statutory income tax provision (benefit) $ (122) $13,924 $(13,335)
State income taxes, net of
federal income tax benefit (21) 2,364 (338)
Impairment of intangible assets --- --- 11,392
Amortization of intangible assets 45 44 171
Research and development credit (807) (351) (148)
Other 768 (361) (29)
------ ------- --------
Reported income tax provision (benefit) $ (137) $15,620 $ (2,287)
====== ======= ========
16
The components of and changes in the net deferred tax asset are as follows:
Deferred
December 31, (Expense) December 31,
(Amounts in thousands) 1996 Benefit 1997
- ---------------------- -------------- ----------- ---------
Net operating loss and tax credit carryforwards $19,609 $ 5,552 $25,161
Inventory reserves 4,974 (2,778) 2,196
Accrued liabilities and restructuring costs 1,146 (740) 406
Debenture revaluation (1,531) 94 (1,437)
Other (1,020) (1,985) (3,005)
------- -------- -------
23,178 143 23,321
Valuation allowance (4,744) --- (4,744)
------- -------- -------
Deferred tax asset $18,434 $ 143 $18,577
======= ======== =======
The deferred tax asset represents the benefits expected to be realized from the
utilization of pre- and post-acquisition tax benefit carryforwards, which
include net operating loss carryforwards (NOLs), tax credit carryforwards and
the excess of tax bases over fair value of the net assets of the Company. The
utilization of these tax benefits for financial reporting purposes will be
reflected in the provision for income taxes each year, as applicable.
In order to fully realize the remaining deferred tax asset of $18.6 million as
of December 31, 1997, the Company will need to generate future taxable income of
approximately $50 million prior to the expiration of the NOLs and tax credit
carryforwards. Although the Company believes that it is more likely than not
that the deferred tax asset will be fully realized based on current projections
of future pre-tax income, a valuation allowance has been provided for a portion
of the deferred tax asset. The amount of the deferred tax asset considered
realizable, however, could be reduced if estimates of future taxable income
during the carryforward period are reduced.
As of December 31, 1997, the Company has NOLs and tax credit carryforwards
(subject to review by the Internal Revenue Service) available to offset future
income for tax return purposes of approximately $60.5 million and $5.0 million,
respectively. A portion of the NOLs and tax credit carryforwards were generated
prior to the formation of the Company and their utilization is subject to
certain limitations imposed by the Internal Revenue Code. The NOLs expire as
follows: $25.3 million in 2004; $9.7 million in 2005; $12.3 million in 2006;
$0.8 million in 2010; $12.4 million in 2012.
A reconciliation of the Company's income (loss) before taxes for financial
reporting purposes to taxable income for the three years ended December 31, 1997
is as follows:
(Amounts in thousands) 1997 1996 1995
- ---------------------- ---- ---- ----
Income (loss) before taxes $ (358) $ 39,782 $(39,221)
Extraordinary Item --- (592) ---
--------- -------- --------
Income (loss) before taxes for financial
reporting purposes (358) 39,190 (39,221)
Differences between income (loss) before taxes for
financial reporting purposes and taxable income:
Permanent differences (28) 124 28,600
-------- -------- --------
Book taxable income (loss) (386) 39,314 (10,621)
Net changes in temporary differences (12,063) (15,282) 11,433
-------- -------- --------
Taxable income (loss) $(12,449) $ 24,032 $ 812
======== ======== ========
17
The permanent differences relate to the write-off (in 1995) and amortization of
goodwill, which are not deductible, and other items which adjusted book income
but are not included in determining taxable income. Changes in temporary
differences principally relate to the taxable gain on the sale of businesses (in
1996), the impairment in service stock inventory (in 1995), inventory reserves
and other costs accrued for book purposes, but not deducted for tax purposes
until subsequently paid.
For the years ended December 31, 1997, 1996 and 1995, the Company made cash
payments of approximately $0.4 million, $1.5 million and $0.2 million,
respectively, for income taxes.
NOTE E - EARNINGS PER SHARE
A reconciliation of the Company's earnings (loss) per share calculations for the
three years ended December 31, 1997 is as follows:
(in thousands, except for per share amounts) Income/(Loss) Shares Per Share Amount
For the year ended December 31, 1997: ------------- ------ ----------------
Basic and Diluted Loss Per Share:
Net Loss $ (221) 49,655 $ ---
======= ====== =====
For the year ended December 31, 1996:
Basic Earnings Per Share:
Income from Continuing Operations $24,162 51,712 $0.47
=====
Stock Options and Warrants 539
------- ------
Diluted Earnings Per Share:
Income from Continuing Operations $24,162 52,251 $0.46
======= ====== =====
For the year ended December 31, 1995:
Basic and Diluted Loss Per Share:
Net Loss $(36,934) 46,919 $(0.79)
======== ====== ======
The Company's Convertible Subordinated Debentures (see Note C(b)) are
convertible into approximately 1.5 million shares of common stock as of December
31, 1997. 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. Due to net losses for the years
ended December 31, 1997 and 1995, all stock options and warrants were
antidilutive, regardless of the exercise prices. Options to purchase
approximately 1.0 million shares of common stock as of December 31, 1996 were
not included in the computation of diluted earnings per share because the
exercise price was greater than the average market price of the shares of common
stock.
The convertible preferred stock issued in connection with the acquisition of
UniStar (See Note L) is antidilutive and has been excluded from the above
calculations.
In 1997, the Company adopted FAS No. 128, "Earnings per Share," effective for
periods ending after December 15, 1997. As a result, the Company's reported
earnings per share for prior years were restated. The effect of this accounting
change on previously reported earnings per share data was to increase 1996 basic
earnings per share by $0.01 compared to the previously reported calculation of
primary earnings per share. Earnings per share did not change for 1997 or 1995.
18
NOTE F - COMMITMENTS AND CONTINGENCIES
Operating Leases. The Company conducts its business operations in leased
premises under noncancellable operating lease agreements expiring at various
dates through 2005. Rental expense under operating leases amounted to $4.2
million, $6.3 million and $9.6 million for the years ended December 31, 1997,
1996 and 1995, respectively.
The following represents the future minimum rental payments due under
noncancellable operating leases that have initial or remaining lease terms in
excess of one year as of December 31, 1997:
Years Ending December 31, (Amounts in thousands)
------------------------ ----------------------
1998 $ 3,219
1999 3,198
2000 3,198
2001 3,323
2002 3,586
Thereafter 7,400
-------
$23,924
=======
Litigation. The Company has various lawsuits, claims and contingent liabilities
arising from the conduct of business; however, in the opinion of management,
they are not expected to have a material adverse effect on the results of
operations, cash flow or financial position of the Company. See Note L for
discussion of legal issues related to UniStar.
NOTE G - RELATED PARTY TRANSACTIONS
During 1995, the Company acquired 43% of the common stock and certain other
assets of Dialogic Communications Corporation (DCC), a vendor of certain
telephony products, in exchange for 353,118 shares of the Company's common stock
and $100,000 cash. This investment is included in Other Assets and the related
equity income is included in Other Income, Net.
NOTE H - STOCK OPTIONS AND WARRANTS
The Company has established stock option plans under which it is authorized to
grant both incentive stock options and non-qualified stock options to officers
and other key employees. Options are granted at a price not less than the fair
market value on the date of the grant and generally become exercisable over a
four-year period and expire after five years. Shares available for granting of
future options under these plans total 2.3 million as of December 31, 1997.
The Company also had non-plan options outstanding at December 31, 1997, all of
which were exercisable. These options expire at various dates through March
2001. Certain options include registration rights for the shares issuable
thereunder.
19
A summary of the status of the Company's stock option plans, as well as non-plan
options, as of December 31, 1997, 1996 and 1995 is as follows:
1997 1996 1995
---------------------------- ----------------------------- ---------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
---------------------------- ---------------------------- ---------------------------
Outstanding 1/1 1,972,485 $2.54 2,858,577 $2.18 3,977,782 $1.33
Granted 251,400 $2.32 316,875 $2.65 1,027,500 $3.05
Exercised (481,786) $1.23 (761,570) $1.28 (1,970,760) $0.92
Cancelled (231,200) $2.71 (441,397) $2.46 (175,945) $2.27
---------- ---------- -----------
Outstanding 12/31 1,510,899 $2.89 1,972,485 $2.54 2,858,577 $2.18
========= ========== ===========
Options exercisable
12/31 1,017,134 $3.04 1,335,402 $2.44 1,862,286 $1.93
========= ========== ===========
Information relative to options outstanding at December 31, 1997 is as follows:
Options Outstanding Options Exercisable
---------------------------------------------- -------------------------
Weighted Weighted Weighted
Shares Average Average Shares Average
Exercises Outstanding Remaining Exercise Exercisable Exercise
Prices 12/31/97 Life (yrs) Price 12/31/97 Price
- ---------------- ---------------------------------------------- -------------------------
$1.75 - $ 2.00 251,300 1.2 $1.96 206,300 $1.97
$2.03 - $ 2.50 288,900 4.3 $2.35 94,077 $2.38
$2.56 - $ 3.00 330,769 3.1 $2.82 200,102 $2.89
$3.10 - $20.43 639,930 2.8 $3.55 516,655 $3.64
---------- ----------
$1.75 - $20.43 1,510,899 2.9 $2.89 1,017,134 $3.04
The fair value of options granted during 1997, 1996 and 1995 was $1.24, $1.20
and $1.09 per share, respectively. Fair value was estimated using the
Black-Scholes option-pricing model with the following assumptions: expected
volatility ranging from 66% to 85%, risk-free interest rate of 6.2%, an expected
option life of 5.0 years and no dividend yield.
The Company applies APB Opinion 25 in accounting for its plans. Accordingly, no
compensation cost has been recognized for its stock option plans. If
compensation cost had been determined in accordance with FAS No. 123,
"Accounting for Stock-Based Compensation," net income would have been reduced by
$0.2 million, $0.1 million and $0.3 million for 1997, 1996 and 1995,
respectively. The change in earnings per share would have been immaterial each
year.
As of December 31, 1997, the Company has warrants outstanding that permit the
holders to purchase a total of 50,000 shares of Common Stock at prices ranging
from $2.00 to $2.63 per share, expiring through July 2001. Warrants were
exercised for 50,000, 199,431 and 488,890 shares of Common Stock for the three
years ended December 31 1997, 1996 and 1995, respectively. Such exercises were
at average prices of $1.21, $0.04 and $1.00 per share for the years ended
December 31, 1997, 1996 and 1995, respectively. At December 31, 1997, 16,667
warrants were exercisable.
20
NOTE I - STOCK PURCHASE PLAN
A total of 2,750,000 shares of Common Stock are authorized for issuance under
the Company's employee stock purchase plan (the "Employee Plan"). The Employee
Plan permits eligible employees to purchase up to 1,000 shares of Common Stock
at the lower of 85% of the fair market value of the Common Stock at the
beginning or at the end of each six-month offering period. Pursuant to the
Employee Plan, 63,904, 216,504 and 229,636 shares of common stock were sold to
employees during the three years ended December 31, 1997, 1996 and 1995,
respectively. The weighted average fair value of these purchase rights for 1997,
1996 and 1995 was $0.67, $0.81 and $0.97 per share, respectively. Fair value was
estimated using the Black-Scholes option pricing model with the following
assumptions used for all three years: expected volatility ranging from 66% to
85%, risk-free interest rate of 6.0%, an expected term of six months and no
dividend yield.
The Company applies APB Opinion 25 in accounting for the Employee Plan and,
accordingly, no compensation cost has been recognized. If compensation cost had
been determined in accordance with FAS No. 123, the impact on net income and
earnings per share would have been immaterial for 1997, 1996 and 1995.
In 1994, the Company's shareholders adopted the 1994 Executive Stock Incentive
Plan (the "Executive Plan"), which enabled officers and other key employees to
purchase a total of up to 3,000,000 shares of the Company's Common Stock. During
1995 and 1994, the Participants purchased 140,000 and 2,745,000 shares of Common
Stock, respectively, at fair market value, which were financed through
individual bank borrowings at market interest rates by each Participant from
Bank of America Illinois (the "Bank"), payable over five years. In December
1997, the Company agreed, subject to obtaining the agreement of the Bank, that
it would allow the loans to remain outstanding until December 2001. The Company
lends each Participant 85% of the interest due to the Bank, with $1,569,000 and
$980,000 of such loans outstanding as of December 31, 1997 and 1996,
respectively. In December 1997, the Company also loaned each participant the 15%
of the interest that would otherwise have been currently payable. The Company
guarantees the Participant borrowings under a $6.4 million letter of credit.
Participant loans guaranteed by the Company with letters of credit as of
December 31, 1997 and 1996 were $6.1 million and $6.5 million, respectively.
Shares acquired under the Executive Plan are held by the Company as security for
the guarantees under a loan and pledge agreement. Sales of such shares by
Participants are subject to certain restrictions, and, generally, they may not
be sold for five years.
During 1996, the Company repurchased 820,000 shares of Common Stock from
Participants in the Executive Plan who were no longer employees of the Company,
primarily due to the sale of the direct offices (see Note M). The shares were
repurchased because, as nonemployees, the Company could no longer guarantee the
bank loans for these individuals or make advances of interest to the Bank on
their behalf. The Company accepted the stock being held as collateral as payment
in full for the purchase price plus all of the unpaid interest and satisfied the
indebtedness to the Bank on behalf of these individuals. In those instances
where the value of the common stock held as collateral was not sufficient to
cover the purchase price plus all of the unpaid interest, the Company recorded
an aggregate amount of $110,000 in compensation expense for these individuals
during the year.
NOTE J - SAVINGS AND POST-RETIREMENT BENEFIT PLANS
The Company has a 401(k) Savings Plan under which it matches employee
contributions at the discretion of the Company's Board of Directors. The
Company's matching contribution, consisting of shares of its Common Stock
purchased in the open market, is equal to 25% of each employee's contribution,
up to a maximum of $660 per employee. The expense for the matching contribution
for the years ended December 31, 1997, 1996 and 1995 was approximately $261,000,
$540,000 and $687,000, respectively.
The Company has an obligation remaining from the acquisition of Executone, Inc.
to provide post-retirement health and life insurance benefits for a group of
fewer than 75 former Executone, Inc. employees, including two current employees
of the Company. The Company does not provide post-retirement health or life
insurance benefits to any other employees. Effective January 1, 1993, the
Company adopted FAS No. 106, "Employers' Accounting For Postretirement Benefits
Other Than Pensions". This standard requires that the expected cost of these
benefits must be charged to expense during the years that employees render
services. The Company adopted the new standard prospectively and is amortizing
the transition obligation over a 20-year period.
21
Post-retirement benefit expense for the three years ended December 31, 1997
consists of the following:
(Amounts in thousands) 1997 1996 1995
- ---------------------- ---- ---- ----
Interest on accumulated benefit obligation $220 $214 $219
Amortization of transition obligation 116 116 116
Net amortization and other 4 20 20
---- ---- ----
$340 $350 $355
==== ==== ====
The status of the plan at December 31, 1997 and 1996 is as follows:
(Amounts in thousands) 1997 1996
- ---------------------- ---- ----
Accumulated post-retirement benefit obligation (APBO):
Retirees $2,765 $2,875
Active Employees 364 339
------ ------
3,129 3,214
Unamortized transition obligation (1,744) (1,861)
Unrecognized net loss (312) (466)
------ ------
Accrued liability $1,073 $ 887
====== ======
In determining the APBO as of December 31, 1997 and 1996, the weighted average
discount rate used was 7%. The Company used a healthcare cost trend rate of
approximately 11%, decreasing through 2007 and leveling off at 6% thereafter. A
1% increase in the healthcare trend rate would increase the APBO at December 31,
1997 by approximately 3% and increase the interest cost component of the
post-retirement benefit expense for 1997 by less than $10,000.
NOTE K - OTHER INCOME, NET
Other Income, Net consists of the following for the three years ended December
31, 1997:
(Amounts in thousands) 1997 1996 1995
- ---------------------- ---- ---- ----
Interest income $ 741 $1,117 $ 285
Equity in earnings of DCC (Note G) 377 288 401
Gain on sale of two direct sales offices --- --- 1,213
Other, net 419 465 230
------ ------ ------
$1,537 $1,870 $2,129
====== ====== ======
NOTE L - UNISTAR
On December 19, 1995, the Company acquired 100% of the common stock of Unistar
Gaming Corporation (Unistar Gaming) for 3.7 million shares of the Company's
common stock valued at $5.4 million and 350,000 shares of newly issued preferred
stock valued at $7.3 million. Unistar Gaming's subsidiary, UniStar
Entertainment, Inc. (UniStar), has an exclusive five-year contract to design,
develop, finance and manage the National Indian Lottery (NIL) for the Coeur
d'Alene Tribe of Idaho (CDA). The NIL comprises a national telephone lottery
authorized by federal law and a compact between the State of Idaho and CDA, as
well as Internet-based lottery games. In return for providing these management
services to the NIL, UniStar will be paid a fee equal to 30% of the profits of
the NIL. UniStar did not have any assets or operations other than the NIL
contract prior to its acquisition by the Company.
The purchase price was approximately $12.7 million and was based upon the
determination by an investment banking firm of the value assigned to the common
and the preferred stock issued in the transaction. The common stock valuation
was based upon the value of the common stock issued at the closing date,
discounted for restrictions on the sale of the
22
shares, which range from six to twenty-six months. The preferred stock was
valued based upon the number of shares of common stock into which it was
estimated that the preferred shares may be converted at some future date. The
excess of the purchase price over the value of the net liabilities assumed has
been included in intangible assets and will be amortized over the five-year term
of the contract commencing in the first quarter of 1998.
The preferred stock consists 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 has voting rights equal to one
share of common stock and will earn dividends equal to 18.5% of the consolidated
retained earnings of UniStar 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 has voting rights equal to one share of
common stock and will earn dividends equal to 31.5% of the consolidated retained
earnings of UniStar 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. All dividends on
Preferred Stock are payable (i) when and as declared by the Board of Directors,
(ii) upon conversion or redemption of the Series A and Series B Preferred Stock
or (iii) upon liquidation. The Series A and Series B Preferred Stock is
redeemable for a total of 13.3 million shares of common stock (Series A
Preferred Stock for 4.925 million shares and Series B Preferred Stock for 8.375
million shares) at the Company's option. In the event that UniStar meets certain
revenue and profit parameters, the Series A Preferred Stock is convertible for
up to 4.925 million shares of common stock and the Series B Preferred Stock is
convertible for up to 8.375 million shares of common stock (a total of an
additional 13.3 million shares of common stock). Liquidation preferences for all
shares of Series A and Series B preferred stock total $7.3 million as of
December 31, 1997. Liquidation preference is based upon fair market value of the
Series A and Series B preferred stock as determined by the investment banking
firm engaged by the Company, plus any dividends in arrears. As of December 31,
1997, no dividends have accrued to the preferred stockholders.
In an attempt to block the NIL, certain states filed letters under 18 U.S.C.
Section 1084 to prevent the long-distance carriers from providing telephone
service to the NIL. In 1995, the CDA initiated legal action against AT&T
Corporation (AT&T) to compel the long-distance carriers to provide telephone
service to the NIL. The CDA's position is that the lottery is authorized by the
Indian Gaming Regulatory Act (IGRA) passed by Congress in 1988, that IGRA
preempts state law, that 18 U.S.C. Section 1084 is inapplicable and, therefore,
that the states lack authority to issue the Section 1084 notification letters to
any carrier. On February 28, 1996, the NIL was ruled lawful by the CDA Tribal
Court. The CDA Tribal Court found that all requirements of IGRA have been
satisfied and the Section 1084 letters issued by certain state attorneys general
in an effort to interfere with the lawful operation of the NIL are invalid. In
addition, the Tribal Court found that the long-distance carriers cannot refuse
to provide the service requested in the action based upon 18 U.S.C. Section
1084. This ruling and a related order dated May 1, 1996 were subsequently
appealed to the Tribal Appellate Court, which on July 2, 1997 affirmed the lower
Tribal Court's May 1, 1996 ruling and analysis upholding the CDA's right to
conduct the 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. The CDA has answered that complaint. In March 1998, the attorneys
general of nineteen states filed a motion for permission to submit a brief as
amicus curiae in the case with respect to the Tribal Court's interpretation of
IGRA and in support of the position taken by AT&T.
On May 28, 1997, the State of Missouri brought an action in the Missouri Circuit
Court in Kansas City against UniStar and the CDA to enjoin the NIL's US Lottery
Internet instant games offered by the CDA and managed by UniStar. The complaint
also seeks civil penalties, attorney's fees and court costs. The complaint
alleged that the US Lottery violates Missouri anti-gaming laws and that the
marketing and promotion of the US Lottery violate the Missouri Merchandising
Practices Act. The CDA and UniStar removed the case to the U.S. District Court
for the Western District of Missouri, which denied the State's subsequent motion
to remand the case back to the state court. The Court also subsequently granted
a motion to dismiss by CDA based on sovereign immunity. The Court denied the
motion to dismiss UniStar based on sovereign immunity, although the Court
indicated it might reconsider that decision. UniStar filed a motion for
reconsideration of its motion for dismissal. The State of Missouri has filed a
notice of appeal evidencing its intent to appeal to the Eighth Circuit Court of
Appeals, the dismissal of the CDA.
On January 28, 1998, the State of Missouri sought to dismiss voluntarily the
existing case against UniStar and filed the next day, a new action against the
Company, UniStar and two tribal officials, with essentially the same
allegations, in a state court in a different district. The State obtained a
temporary restraining order from a state judge enjoining the marketing of the
Internet and telephone lottery in the State of Missouri. On February 5, 1998,
the U.S. District Court for the Eastern District of Missouri ruled that this
second case also should be heard in federal court, transferred the second
23
case to the Western District of Missouri, where the original case had been
filed, and dissolved the state court's temporary restraining order, effective
February 9, 1998. A motion to dismiss the second case based on the sovereign
immunity of all the defendants and a motion to abstain in favor of the
jurisdiction of the CDA Tribal Court are pending. The State of Missouri has
filed a notice of appeal evidencing its intent to appeal the denial of its
motion to remand the case to State Court or in the alternative to grant a
preliminary injunction.
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 the Company,
UniStar and the CDA, to permanently enjoin the US Lottery offered by the Tribe
on the Internet and managed by UniStar. The complaint alleges that the offering
of the US Lottery violates Wisconsin anti-gambling laws and that legality of the
US Lottery has been misrepresented to Wisconsin residents in violation of state
law. In addition to an injunction, the suit seeks restitution, civil penalties,
attorneys' fees and court costs. The Company, UniStar and the CDA have removed
the case to the U.S. District Court in Wisconsin. On February 18, 1998, the
District Court dismissed the Tribe from the case based on sovereign immunity and
dismissed the Company based on the State's failure to state a claim against the
Company. Motions to dismiss the case against UniStar were denied. UniStar has
filed a notice of appeal evidencing its intent to appeal to the Seventh Circuit
Court of Appeals the denial of its motion to dismiss.
The Company believes, based on consultation with and opinions rendered by
outside legal counsel, that the favorable rulings of the tribal courts will be
affirmed by the Idaho federal court. The Company believes that UniStar also will
prevail in the Missouri and Wisconsin lawsuits. However, there is no assurance
of such a legal outcome. The Company accrued $1 million in 1995 to cover
estimated legal costs through the possible appeal to the U.S. District Court. If
the matter is appealed beyond the U.S. District Court or if additional court
challenges are brought by states opposed to the NIL, the Company estimates that
additional legal costs could be in the range of $1 million to $2 million.
Funding for UniStar capital expenditures, including the computers and software
to build the telecommunications system, will be capitalized and depreciated over
the life of the management agreement. The guaranteed monthly advance of $25,000
to the CDA, which began in January 1996, will be reimbursed when the NIL is
operational and making profit distributions to UniStar. In addition, the Company
has capitalized other fundings, consisting primarily of direct UniStar expenses,
professional fees and other expenses, which the Company believes are
reimbursable in accordance with the terms of the management agreement.
Cumulative funding as described above totals $8.0 million ($5.9 million for the
year ended December 31, 1997) and is reflected in non-current other assets.
The Company has also funded legal and other accrued liabilities assumed as part
of the acquisition of UniStar totaling, on a cumulative basis, $2.4 million
($0.3 million for the year ended December 31, 1997). Such cash flows, which were
previously reflected as part of the change in working capital items, are now
reflected as part of the investment in UniStar in the statement of cash flows.
Prior year amounts have been reclassified to conform to the current year's
presentation. The investment in UniStar reflected on the statement of cash flows
includes the deferred charges and assumed liabilities noted above (net of $0.6
million in capital lease obligations) for a cumulative total of $9.7 million
($5.6 million for the year ended December 31, 1997). Since inception, the
Company has also funded various UniStar expenses totaling $1.6 million, which
are reflected in the Company's consolidated net income. Cumulative cash
expenditures on UniStar, including UniStar expenses, total $11.3 million as of
December 31, 1997.
Other than legal costs related to an appeal of the CDA Tribal Court ruling or
other actions by the states, if any, the Company estimates that it will invest
an additional $2 million to $4 million by June 1998. The costs include capital
expenditures for computers and software to build the telecommunications system,
funds to complete the building on the CDA reservation which will be the
operations center for the lottery, and various start-up and operating expenses
including personnel-related costs and advertising expenses. The Company is also
required to make a guaranteed payment of $300,000 per year to the CDA, which is
included in the above estimates. The Company expects it will be able to obtain
additional financing for these costs, if necessary.
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 is to provide project
management services overseeing the development of the software for the NIL, with
the
24
Company contracting independently for system software development. Such charges
are not to exceed $2 million. The Company will acquire all hardware for the
system without financial obligation by either IGT or CWH. Approximately $600,000
in hardware costs were incurred as of December 31, 1997. All of these system
development costs are included in the above estimate for expenditures through
June 1998.
The investment in IGT is being accounted for under the cost method. All hardware
costs incurred will be capitalized and depreciated over the useful life of the
assets, beginning when the assets are placed in service. As of December 31,
1997, $1.5 million in progress payments have been made toward the software
system. Such payments are being deferred until completion of the system and will
be capitalized and depreciated over the life of the asset or term of the
management agreement, whichever is shorter.
There are market and legal risks associated with the development of the NIL. The
Company believes there is a national market for the NIL based upon research into
the experience of other national lotteries and the growth of the overall lottery
market. In the event that the telephone and Internet lotteries do not attain the
level of market acceptance anticipated by the Company or if the outcome of the
pending lawsuits is adverse, the Company would have to reevaluate its investment
in UniStar.
The Company periodically evaluates the recoverability of this investment in
UniStar 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 telephone and Internet lotteries. If the sum of such cash flows is
not sufficient to recover the Company's investment in UniStar, projected cash
flows would then be discounted and the Company's investment would be adjusted
accordingly.
NOTE M - SALE OF BUSINESSES AND OTHER ACQUISITIONS/DISPOSITIONS
On May 31, 1996, the Company sold its direct sales and service organization,
including its Network Services division to Clarity Telecom Holdings, Inc. d/b/a
Executone Business Solutions (Clarity, subsequently renamed Claricom), a new
acquisition company formed for the acquisition by Bain Capital, Inc. The Company
received $61.5 million in cash, a $5.9 million junior subordinated note due July
1, 2004, with interest at 7.5% per year, and warrants to purchase 8% of the
equity issued as of the closing in the new company for $1.1 million, exercisable
for three years. After recording the notes and the warrants at their fair market
value, the total value of the consideration received was $69.6 million. The
Company and Claricom also entered into a five-year exclusive distributor
agreement pursuant to which Claricom will sell and service EXECUTONE'r' and
INFOSTAR'r' telephone products to business and commercial locations that require
up to 400 telephones.
The sale did not include the Pittsburgh direct sales and service office, which
the Company sold to one of its existing independent distributors for
approximately $1.3 million in cash and notes in May 1996, resulting in no gain
or loss. The sale of the direct offices (including the separate sale of the
Pittsburgh office) related primarily to the retail distribution channel of the
Computer Telephony division and included the Network Services division.
The Company recorded a pretax gain of $48.9 million on the sale to Claricom net
of transaction, severance and other costs related to the sale. The proceeds were
used to repay the Company's bank borrowings, and the excess was invested in
short-term cash investments.
The cash proceeds of $61.5 million included $5.0 million which was held in
escrow and reported on the consolidated balance sheet as of December 31, 1997
and 1996 as restricted cash. These funds were released to the Company, by
Claricom on March 31, 1998.
For the years ended December 31, 1997 and 1996, more than 10% of the Company's
revenues were derived from a single independent distributor, Claricom. Revenues,
net of discounts, were $29.3 million and $31.7 for 1997 and for the seven-month
post-sale period in 1996, respectively.
25
In June 1996, the Company sold its Videoconferencing division to BT Visual
Images LLC for a $0.2 million note, royalties on videoconferencing revenue
through June 1998 and contingent consideration related to the sale of equipment
inventory. The Company recorded a loss of $3.9 million on the transaction.
In April 1996, the Company also sold its Inmate Calling business for $0.5
million in cash and notes and recorded a pretax loss of $1.0 million. Neither
the Pittsburgh direct sales office, the Videoconferencing division, nor the
Inmate Calling business constituted a material portion of the Company's assets,
revenues or net income prior to sale.
During the fourth quarter of 1995, the Company sold its customer bases in
Wisconsin and Iowa and the net assets of the related direct sales offices for a
total of $2.1 million, consisting of $125,000 cash, a $1.8 million note, the
proceeds of which were received in February 1996, and a $150,000 note due in
installments by November 2001. These sales generated a gain of approximately
$1.2 million, which is included in Other Income, Net for the year ended December
31, 1995.
During the first quarter of 1995, the Company was involved in extensive
negotiations to acquire the Dictaphone division of Pitney Bowes. In April 1995,
the acquisition was awarded to another bidder. The Company incurred
approximately $1 million in fees and expenses related to the attempted
acquisition which were recognized during 1995.
NOTE N - PROVISION FOR RESTRUCTURING
In July 1995, the Company reorganized its then-existing business into five
divisions: Computer Telephony, Healthcare Communications Systems, Call Center
Management, Videoconferencing Products, and Network Services, and changed its
business strategy in the Computer Telephony division to focus on software
applications in the communications market. The business that was acquired in
1988 was a telephone equipment hardware company focused on customers with small
systems, with an emphasis on selling additional hardware and service to generate
add-on revenue. As a result of the change in strategy, the business acquired in
1988 was de-emphasized. The Company adopted FAS No. 121, requiring impairment to
be measured by projecting the lowest level of identifiable future cash flows.
The Company concluded there was an impairment. As a result, the Company recorded
a $44.0 million provision for restructuring consisting of a $33.5 million
goodwill impairment, an $8.8 million write-down of inventory, primarily service
stock relating to the impaired assets and other non-recurring inventory
adjustments, $0.9 million related to the shutdown of the Company's Scottsdale,
Arizona facility and $0.8 million of other unusual items.
In accordance with the provisions of FAS No. 121, the Company prepared
projections of future operating cash flows relating to the telephony business
acquired in 1988 based upon the Company's change in strategic direction. These
projections indicated that this business would not generate sufficient operating
cash flows to realize goodwill and the related service stock. The amount of
impairment of the telephony goodwill was $33.5 million as of June 30, 1995.
The write-off of inventory, primarily service stock, consisted of $1.3 million
of raw materials inventory and $7.5 million of finished goods inventory. These
amounts were determined based upon a review of specific inventory parts along
with projected usage, incorporating the strategic direction of the Company.
NOTE O - SUBSEQUENT EVENTS (UNAUDITED)
Corporate Reorganization. On January 8, 1998, the Company announced the
beginning of the restructuring of its businesses and the retirement of its Chief
Executive Officer (CEO). These announcements have resulted in several related
charges which will be reflected in the consolidated financial statements for the
first quarter of 1998.
Alan Kessman, Chairman and CEO of the Company announced his intention to retire
from the management of the day-to-day operations of the Company. In accordance
with the diminishment of responsibility section of his employment continuity
agreement, Mr. Kessman will receive a severance payment of $1.3 million. The
Company will establish a reserve for this cost during the first quarter of 1998.
The Company has retained an executive search firm to find a successor for Mr.
Kessman, who has agreed to remain in his current position until his successor
is selected. The Company has incurred
26
approximately $0.2 million in expenses to recruit a new CEO which will be
expensed as part of the restructuring charge in the first quarter of 1998.
In addition, the Company has restructured current operations which resulted in a
workforce reduction during January and February 1998. The Company will incur
approximately $0.6 million for severance, benefits and other restructuring
charges in the first quarter of 1998.
As previously announced, Furman Selz LLC has been hired to advise the Company as
to certain financing and corporate restructuring options. Based upon advice of
Furman Selz and the recommendation of a special committee of the Board of
Directors, the Board has determined that it is in the best interests of the
shareholders of the Company to separate the business of the Company's UniStar
subsidiary from the operations of its computer telephony and healthcare
communications businesses. The Company expects, subject to completion of further
analysis and receipt of necessary approvals, that the separation would be
effected through a taxable distribution to shareholders later this year.
During the first quarter of 1998, the Company incurred approximately $0.2
million in advisory expenses related to preparation and review of corporate
restructuring options. Future expenses will be dependent upon the form and
nature of the corporate restructuring. The Company is also pursuing a plan to
retain and motivate key employees, the details of which are expected to be
concluded by the second quarter of 1998.
In total, the Company expects to record a restructuring charge of approximately
$2.3 million during the first quarter of 1998.
Amended Distributor Agreement with Claricom. 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-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.
27
NOTE P - SELECTED QUARTERLY FINANCIAL DATA
The following is a summary of unaudited selected quarterly financial data for
the years ended December 31, 1997 and 1996:
Three Months Ended
-----------------------------------------------------------------
March 31, June 30, September 30, December 31,
(In thousands, except for per share amounts) 1997 1997 1997 1997
---------- -------- ------------- ------------
Revenues $39,019 $34,777 $42,936 $39,664
Gross Profit 14,120 9,899 14,892 14,098
Income (Loss) Before Income Taxes 854 (3,942) 1,321 1,409
Net Income (Loss) 512 (2,371) 793 845
Basic and Diluted Earnings (Loss) Per Share 0.01 (0.05) 0.02 0.02
Three Months Ended
-----------------------------------------------------------------
March 31, June 30, September 30, December 31,
(In thousands, except for per share amounts) 1996 1996 1996 1996
------------ --------- ------------- ------------
Revenues $66,966 $51,982 $44,791 $48,283
Gross Profit 26,520 18,969 16,458 17,565
Income (Loss) Before Income Taxes
and Extraordinary Item (8,969) 39,820 3,535 5,396
Income (Loss) Before Extraordinary Item (5,358) 23,860 2,124 3,536
Net Income (Loss) (5,358) 23,860 2,124 3,181
Earnings (Loss) Per Share:
Income (Loss) Before Extraordinary Item (0.10) 0.46 0.04 0.07
Extraordinary Item --- --- --- (0.01)
Diluted Earnings (Loss) Per Share:
Income (Loss) Before Extraordinary Item (0.10) 0.44 0.04 0.07
Extraordinary Item --- --- --- (0.01)
The three months ended March 31, 1996 includes a loss of $4.9 million relating
to the sale of the Videoconferencing and Inmate Calling businesses (see Note M).
The three months ended June 30 and December 31, 1996 include a pretax gain on
the sale of businesses (See Note M) of $47.5 million and $1.4 million,
respectively.
STOCK DATA
The number of holders of record of the Company's Common Stock as of the close of
business on February 28, 1998 was approximately 2,000. The Common Stock is
traded on the NASDAQ National Market System under the symbol "XTON". As reported
by NASDAQ on February 23, 1998, the closing sale price of the Common Stock on
the NASDAQ National Market System was $2 3/8. The following table reflects in
dollars the high and low closing sale prices for EXECUTONE's Common Stock as
reported by the NASDAQ National Market System for the periods indicated:
Fiscal Period High Low
------------- ---- ---
1997
First Quarter $2 13/16 $2 7/16
Second Quarter 2 3/4 1 11/16
Third Quarter 2 1/8 1 11/16
Fourth Quarter 2 3/4 1 7/8
28
1996
First Quarter $3 7/16 $2 3/16
Second Quarter 3 3/4 2 5/8
Third Quarter 3 1/4 2 5/16
Fourth Quarter 3 1/16 2 3/8
It is the present policy of the Board of Directors to retain earnings for use in
the business and the Company does not anticipate paying any cash dividends on
the Common Stock in the foreseeable future.
29
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders of
EXECUTONE Information Systems, Inc.:
We have audited the accompanying consolidated balance sheets of EXECUTONE
Information Systems, Inc. (a Virginia corporation) and subsidiaries as of
December 31, 1997 and 1996, and the related consolidated statements of
operations, changes in stockholders' equity and cash flows for each of the three
years in the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of EXECUTONE Information Systems,
Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Stamford, Connecticut
February 7, 1998
30
STOCKHOLDER INFORMATION
CORPORATE HEADQUARTERS INDEPENDENT PUBLIC ACCOUNTANTS
EXECUTONE Information Systems, Inc. Arthur Andersen LLP
478 Wheelers Farms Road Champion Plaza
Milford, Connecticut 06460 400 Atlantic Street
(203) 876-7600 Stamford, Connecticut 06912-0021
http://www.executone.com
OUTSIDE COUNSEL
STOCK AND WARRANT TRANSFER AGENT Hunton & Williams
American Stock Transfer and Trust Company Riverfront Plaza
40 Wall Street 951 East Byrd Street
New York, New York 10005 Richmond, Virginia 23219
BOND TRANSFER AGENT ADDITIONAL INFORMATION
U.S. Trust Company of New York A copy of EXECUTONE's Annual Report on Form 10-K,
114 West 47th Street which is filed with the Securities and Exchange Commission,
New York, New York 10036-1532 is available without charge by writing to:
DAVID KRIETZBERG
Treasurer/Investor Relations
Corporate Headquarters
DIRECTORS AND OFFICERS
BOARD OF DIRECTORS
- ---------------------------------------------------------------------------------------------------------------------------------
ALAN KESSMAN JERRY M. SESLOWE 2
Chairman of the Board Managing Director
Resource Holdings, Ltd.
STANLEY M. BLAU 1
Vice Chairman LOUIS K. ADLER 2
Private Investor
THURSTON R. MOORE 1
Partner
Hunton & Williams
RICHARD S. ROSENBLOOM 2
David Sarnoff Professor of Business Administration
Harvard Business School
1 AUDIT COMMITTEE MEMBER
2 COMPENSATION COMMITTEE MEMBER
OFFICERS
- ---------------------------------------------------------------------------------------------------------------------------------
ALAN KESSMAN ANTHONY R. GUARASCIO VIC NORTHRUP
President and Chief Executive Officer Vice President, Finance & Administration Vice President
Chief Financial Officer President, Computer Telephony
MICHAEL W. YACENDA
Executive Vice President ISRAEL J. HERSH FRANK J. ROTATORI
President, UniStar Vice President, Software Engineering Vice President
President, Healthcare Communications
BARBARA C. ANDERSON ROBERT W. HOPWOOD
Vice President, General Counsel and Vice President SHLOMO SHUR
Secretary Vice President - Operations, UniStar Senior Vice President,
Advanced Technology
JAMES E. COOKE III ANDREW KONTOMERKOS
Vice President, National Accounts Senior Vice President, Hardware
Engineering and Production
31