FORM 10-Q/A
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from January 1, 2004 to March 31, 2004
Commission file number: 0-21479
I-SECTOR CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 76-0515249
(State of incorporation) (I.R.S. Employer Identification No.)
6401 SOUTHWEST FREEWAY
HOUSTON, TEXAS 77074
(Address of principal executive offices) (Zip code)
REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE: (713) 795-2000
(Former name, former address, and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ]
(APPLICABLE ONLY TO CORPORATE REGISTRANTS)
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.
Outstanding
Title As of May 26, 2004
----- ------------------
Common Stock, $.01 par value per share 4,827,754 shares outstanding
PART I INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
I-SECTOR CORPORATION
FORM 10-Q/A
QUARTER ENDED MARCH 31, 2004
Part I. Financial Information
Item 1. Condensed Consolidated Financial Statements - I-Sector Corporation
(Unaudited):
Condensed Consolidated Balance Sheets at December 31, 2003 and March 31,
2004
Condensed Consolidated Statements of Income for the three months ended
March 31, 2003 and 2004
Condensed Consolidated Statement of Stockholders' Equity for the three
months ended March 31, 2004
Condensed Consolidated Statements of Cash Flows for the three months
ended March 31, 2003 and 2004
Notes to Condensed Consolidated Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
Part II. Other Information
Item 1. Legal Proceedings
Item 2. Other Information
Item 6. Exhibits
Signatures
PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and par value amounts)
DECEMBER 31, MARCH 31,
2003 2004
------------ ---------
(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents .................................................... $ 2,172 $ 1,724
Accounts receivable - trade, net of allowance of $612 and $590 .............. 9,757 9,417
Accounts receivable - affiliates ............................................. 16 6
Accounts receivable - other .................................................. 29 27
Notes receivable, net of allowance of $373 and $438 .......................... 676 1,062
Inventory .................................................................... 1,038 1,315
Cost and estimated earnings in excess of billings ............................ 1,452 2,204
Other current assets ......................................................... 943 548
-------- --------
Total current assets .................................................... 16,083 16,303
Property and equipment, net of accumulated depreciation of $1,887 and $2,004 ...... 1,271 1,270
Notes receivable, long-term, net of allowance of $250 and $250 ................... 252 125
Patent license rights, net of accumulated amortization of $265 and $293 ........... 849 822
Deferred offering costs ........................................................... 317 803
Other intangible assets, net of accumulated amortization of $335 and $386 ........ 435 383
-------- --------
Total Assets ....................................................... $ 19,207 $ 19,706
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Notes payable and current portion of long-term debt .......................... $ 1,784 $ 1,299
Accounts payable ............................................................. 6,524 7,142
Billings in excess of cost and estimated earnings ............................ 262 112
Accrued expenses ............................................................. 2,676 3,004
Net liabilities related to discontinued operations ........................... 557 642
Deferred revenue ............................................................. 556 736
-------- --------
Total current liabilities ................................................ 12,359 12,935
-------- --------
Long-term debt .................................................................... 229 204
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, $.01 par value, 5,000,000 shares authorized,
no shares issued ......................................................... -- --
Common stock, $.01 par value, 15,000,000 shares authorized,
4,762,809 and 4,803,794 issued ........................................... 48 48
Additional paid in capital .................................................... 10,853 10,912
Additional paid in capital - other ............................................ 337 187
Treasury stock, at cost 811,800 and 811,800 shares ............................ (1,373) (1,373)
Retained deficit .............................................................. (3,246) (3,207)
-------- --------
Total stockholders' equity ............................................... 6,619 6,567
-------- --------
Total Liabilities and Stockholders' Equity .......................... $ 19,207 $ 19,706
-------- --------
See notes to consolidated financial statements
3
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share amounts)
(Unaudited)
Three months ended March 31,
---------------------------------------
2003 2004
----------- ----------
Revenue:
Products ....................................... $ 6,722 $ 10,194
Services ....................................... 1,289 1,944
Custom projects ................................ 2,069 2,137
----------- ----------
Total revenue .................................. 10,080 14,275
----------- ----------
Cost of goods and services:
Products ....................................... 5,904 8,491
Services ....................................... 1,100 1,286
Custom projects ................................ 801 962
----------- ----------
Total cost of goods and services ............... 7,805 10,739
----------- ----------
Gross profit ............................. 2,275 3,536
Selling, general and administrative expenses ...... 3,376 3,499
----------- ----------
Operating income (loss) ........................... (1,101) 37
Interest and other income, net .................... 10 19
----------- ----------
Income (loss) from continuing
operations before income taxes .................. (1,091) 56
Income taxes ...................................... -- 5
----------- ----------
Net income (loss) from continuing
operations ...................................... (1,091) 51
Discontinued operations:
Loss on disposal of discontinued
operations, net of taxes ........................ -- (12)
----------- ----------
Net income (loss) ................................. $ (1,091) $ 39
----------- ----------
Net income (loss) per share
Basic:
Net income (loss) from continuing
operations ...................................... $ (0.30) $ 0.01
Loss on disposal of discontinued
operations, net of taxes .......................... -- --
----------- ----------
Net income (loss) per share ....................... $ (0.30) $ 0.01
----------- ----------
Diluted:
Net income (loss) from continuing
operations ...................................... $ (0.30) $ 0.01
Loss on disposal of discontinued
operations, net of taxes ........................ -- --
----------- ----------
Net income (loss) per share ....................... $ (0.30) $ 0.01
----------- ----------
Shares used in computing net
income (loss) per share:
Basic ............................................. 3,630,285 3,978,407
----------- ----------
Diluted ........................................... 3,630,285 4,544,406
----------- ----------
See notes to consolidated financial statements
4
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In thousands, except share amounts)
(Unaudited)
$.01 par value Additional
Common Stock Additional Paid-In
------------------- Paid-In Capital- Treasury Retained
Shares Amount Capital Other Stock Deficit Total
--------- ------ ------- ----- ------- ------- -------
Balance at December 31, 2003 4,762,809 $48 $10,853 $ 337 $(1,373) $(3,246) $ 6,619
Revaluation of options to consultants -- -- -- (150) -- -- (150)
Exercise of common stock options 40,985 -- 59 -- -- -- 59
Net income -- -- -- -- -- 39 39
--------- --- ------- ----- ------- ------- -------
Balance at March 31, 2004 4,803,794 $48 $10,912 $ 187 $(1,373) $(3,207) $ 6,567
========= === ======= ===== ======= ======= =======
The accompanying notes are an integral part of this
consolidated financial statement
5
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended March 31,
----------------------------
2003 2004
------------ ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .............................................................. $(1,091) $ 39
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Net loss from discontinued operations .................................... -- 12
Tax benefit from discontinued operations ................................. -- 5
Depreciation and amortization ............................................ 165 201
Loss on retirement of assets ............................................. 4 18
Bad debt expense (recoveries) ............................................ 482 (182)
Changes in assets and liabilities that provided (used) cash:
Accounts receivable, net ................................................. 16 431
Accounts receivable, affiliates and other ................................ 47 12
Inventory ................................................................ (87) (277)
Notes receivable ......................................................... 290 (168)
Other current assets ..................................................... (145) 245
Accounts payable ......................................................... (780) 618
Cost and estimated earnings in excess of billings ........................ (199) (752)
Billings in excess of cost and estimated earnings ........................ 194 (150)
Accrued expenses ......................................................... 126 (90)
Deferred revenue ......................................................... (26) 180
------- -------
Net cash provided by (used in) continuing operations ............... (1,004) 142
Net operating activities from discontinued operations .......................... (258) --
------- -------
Net cash provided by (used in) operating activities ................ (1,262) 142
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures ........................................................... (173) (139)
------- -------
Net cash used in investing activities .............................. (173) (139)
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Exercise of stock options ...................................................... 1 59
Payments on notes payable ...................................................... (68) (1,714)
Notes payable - interest bearing borrowings on credit line ..................... -- 1,204
------- -------
Net cash used in financing activities ............................. (67) (451)
------- -------
NET DECREASE IN CASH AND CASH EQUIVALENTS ............................................ (1,502) (448)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD ..................................... 3,491 2,172
------- -------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ........................................... $ 1,989 1,724
------- -------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest ......................................................... $ -- $ 24
SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES:
Revaluation of options granted to consultants .................................. $ -- $ 150
Offering costs accrued ......................................................... -- 486
See notes to consolidated financial statements
6
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
I-Sector Corporation and subsidiaries ("I-Sector" or the "Company") is
engaged in selling and supporting IP telephony solutions as well as related
network infrastructure, their proprietary computer-telephony software, and
performing remote-enabled managed services for the information and communication
technology used by their customers:
o Internetwork Experts, Inc. ("INX") is a network professional
services and integration organization focused on delivering
comprehensive Cisco-centric IP communications solutions to clients
ranging from mid-size to large enterprises. IP communications
solutions include design and implementation, ongoing support and
applications enablement. Supporting practice areas include network
architecture, security, and wireless. To provide these services INX
employs highly trained IP communications consultants and network
engineering staff, who are trained and experienced in both large,
complex network infrastructure technology and IP communications
technology.
o Stratasoft, Inc. ("Stratasoft") creates and markets software related
to the integration of computer and telephone technologies. This
software is used by professional contact centers and other complex,
high-volume telephony environments and is marketed under the trade
name "Stratasoft". Stratasoft intends to use its computer telephony
software development expertise to create and market new software
products that enhance Cisco-centric IP telephony solutions.
o Valerent, Inc. ("Valerent") provides information technology
solutions that lower its client's expense by utilizing centralized,
remote enabled computing management tools which predict, announce
and manage service interruptions. Additionally Valerent provides
customers with traditional computer services such as on-site and
carry-in computer repair, application support, operating system and
network migration services, turn-key outsourced IT helpdesk
solutions, technical staff augmentation for IT helpdesk operations,
and helpdesk solutions consulting services.
The condensed consolidated financial statements presented herein as of and
for the three-month periods ended March 31, 2003 and 2004 are unaudited;
however, all adjustments which are, in the opinion of management, necessary for
a fair presentation of the financial position, results of operations, and cash
flows for the periods covered have been made and are of a normal, recurring
nature. The results of the interim periods are not necessarily indicative of
results for the full year. The consolidated balance sheet as of December 31,
2003 is derived from audited consolidated financial statements but does not
include all disclosures required by accounting principles generally accepted in
the United States of America. Although management believes the disclosures are
adequate, certain information and disclosures normally included in the notes to
the financial statements have been condensed or omitted as permitted by the
rules and regulations of the Securities and Exchange Commission. These interim
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in I-Sector's 2003 Annual Report on Form
10-K.
I-Sector's significant accounting policies are as follows:
RECLASSIFICATIONS - Certain prior period amounts in the statements of cash
flows presented herein have been reclassified to conform to current period
presentation.
USE OF ESTIMATES - The preparation of the financial statements in
conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amount
of revenue and expense during the reporting period. Actual results could differ
from these estimates.
REVENUE RECOGNITION - I-Sector has a number of different revenue
components, which vary between its reportable operating segments. Each
reportable operating segment has more than one revenue component, and revenue is
recognized differently for each component (or "stream") of revenue earned by
operating segment. The material revenue streams earned by I-Sector, some of
which are earned by more than one operating segment, and some by only one
operating segment, are:
Products Revenue. Three of I-Sector's operating segments earn revenue from
product shipments. Product shipment revenue occurs when products
manufactured by other parties are purchased and resold to a customer and
such products are contracted for independently of material services.
I-Sector recognizes revenue from product shipments when the product is
shipped or delivered to the customer. In all three segments, the four
criteria for
7
revenue recognition have been met because: (1) there are written, executed
contracts, or in the case of INX and Valerent, in some situations there
are binding purchase orders; (2) delivery has occurred or services have
been rendered. Stratasoft, however, recognizes revenue on the percentage
of completion method, as described below; (3) the price is fixed or
determinable, and (4) collectibility is reasonably assured. Each of
I-Sector's business segments perform credit research prior to extending
credit. In Stratasoft's business segment, a substantial portion of the
total contract price is received in cash or letter of credit when the unit
is installed.
Services Revenue. All of I-Sector's operating segments earn revenue from
providing stand-alone services revenue. This revenue consist of billings
for engineering and technician time, programming services, which are
provided on either a hourly basis or a flat-fee basis, support contracts
and the service component of maintenance and repair service ticket
transactions. These services are contracted for separately from any
product sale, and generally for contracts of short duration are recognized
when the service is performed and when collection is reasonably assured.
Two of I-Sector's segments sometimes earn agency fee revenue from various
sources, the primary source of which is referring customers to other
organizations for which an agency fee is received. This revenue is
recognized at the earlier of when payment is received or when notification
of amounts being due is received from the entity paying such agency fee
and collectibility is reasonably assured.
One of I-Sector's segments, INX, has certain fixed and flat fee services
contracts that extend over three months or more, and are accounted for on
the percentage of completion method of method of accounting. The
percentage of revenue recognized in any particular period is determined on
the basis of the relationship of the actual hours worked to estimated
total hours to complete the contract. Revisions of the estimated hours to
complete are reflected in the period in which the facts necessitating the
revisions become known. When a contract indicates a loss, a provision is
made for the total anticipated loss.
Custom Project Revenue. One of I-Sector's segments, Stratasoft, earns
revenue from projects that are recognized using the percentage of
completion method of accounting for such revenue. The majority of
Stratasoft's revenue consists of system sales in which it bundles its
proprietary software, along with third-party hardware products and
material related software customization services, installation, training
services, warranty services and incidental post contract support ("PCS")
together under a single contract with the customer. PCS is insignificant
on such contracts for one year or less, and therefore, we have determined
that the value of such PCS should not be unbundled from the project
revenue as set forth in paragraph 59 of SOP 97-2. Accordingly, such PCS
revenue is recognized together with the project revenue, and the estimated
cost to provide the PCS is accrued. The value of the PCS is determinable
within the contract, which defines the period that the PCS is granted and
offers renewals at stated amounts, thereby defining the value of the PCS.
The software customization, together with the hardware customization and
integration, represent a significant modification, customization and/or
production of the product and, therefore, the entire arrangement is
required to be accounted for using the percentage of completion method of
accounting pursuant to SOP 81-1. The percentage of revenue recognized in
any particular period is determined principally on the basis of the
relationship of the cost of work performed on the contract to estimated
total costs. The percentage-of-completion method relies on estimates of
total expected contract revenue and costs. We follow this method since
reasonably dependable estimates of the revenue and costs applicable to
various stages of a contract can be made. Revisions of estimates are
reflected in the period in which the facts necessitating the revisions
become known. When a contract indicates a loss, a provision is made for
the total anticipated loss. The following reflects the amounts relating to
uncompleted contracts at:
December 31, March 31,
2003 2004
------------ ---------
Costs incurred on uncompleted contracts .............. $ 1,019 $ 1,491
Estimated earnings ................................... 3,117 4,036
------- -------
4,136 5,527
Less: Billings to date ............................... 2,946 3,435
------- -------
Total ................................................ $ 1,190 $ 2,092
------- -------
Included in accompanying balance sheets under the
following captions:
Cost and estimated earnings in excess of billings .... $ 1,452 $ 2,204
Billings in excess of cost and estimated earnings .... (262) (112)
------- -------
Total ................................................ $ 1,190 $ 2,092
------- -------
During March 2004, I-Sector's operating segment Stratasoft deferred $180
of revenue for software products sold on a note that was not due within
twelve months of the note origination, and the related revenue was
deferred at
8
March 31, 2004. Revenue from this sale will be recognized in the
accounting periods that payments from the customer are received.
VENDOR INCENTIVES - From time to time, the Company participates in
programs provided by suppliers that enable it to earn incentives. These
incentives are generally earned based upon sales volume, sales growth and
customer satisfaction levels. The amounts earned under these programs are
recorded as a reduction of cost of goods when earned and determinable. The
amount of vendor incentives recognized can vary significantly between quarterly
and annual periods. During the three-month period ended March 31, 2004, the
Company recognized $622 in vendor incentives that relate to the six-month
measurement period ended January 31, 2004.
WARRANTY RESERVE - I-Sector records a warranty reserve related to certain
software products sold by its Stratasoft subsidiary. That reserve is classified
in accrued expenses and is amortized over the life of the warranty, which is
generally twelve months, against actual warranty expenditures. This warranty
reserve relates to the estimate of warranty obligations from sales of
Stratasoft's call center telephony systems, which consist of Stratasoft's
software, configured hardware components as well as telephone support relating
to Stratasoft's software products. This liability amount has been consistently
recorded within each period as a charge to cost of goods based upon five percent
of period revenue. This percentage was based upon a review of the costs of
providing the warranty work, which was initially performed in connection with
the acquisition of the Stratasoft technology. Stratasoft incurs numerous types
of costs related to the warranty work, which includes labor cost of technicians
and programmers, hardware cost, the cost of developing and uploading software
patches related to "bug fixes", telephone support, and hardware parts cost
related to defective hardware sold as a part of a complete Stratasoft system.
The majority of these costs are individually insignificant amounts for which the
cost/benefit relationship does not warrant tracking, but which we periodically
assess and continue to estimate at approximately five percent of Stratasoft
sales. As the actual costs are not tracked, Stratasoft amortizes the recorded
amounts to cost of goods over the average life of the contractual warranty
period as costs are believed to be incurred ratably over the warranty period.
The difference between the actual warranty costs incurred and the amount of
amortization is not considered to be materially different. The following table
depicts the activity in the warranty reserve:
Three Months Ended
March 31,
------------------
2004
------------------
Balance, beginning of the period ........ $ 302
Additions to reserve .................... 90
Expenses offset against reserve ......... (97)
-----
Balance, end of period .................. $ 295
-----
STOCK-BASED COMPENSATION - The Company has elected to account for
stock-based compensation using the intrinsic value method of accounting in
accordance with Accounting Principles Bulletin ("APB") No. 25 "Accounting for
Stock Issued to Employees". Under this method no compensation expense is
recognized when the number of shares granted is known and the exercise price of
the stock option is equal to or greater than the fair value of the common stock
on the grant date. The Company has recorded no stock-based compensation
associated with stock options granted to employees and directors in its
consolidated statement of operations. I-Sector and its subsidiaries apply the
fair value method as prescribed by SFAS No. 123, as interpreted and amended, for
stock and stock options issued to non-employees and during the three month
period ended March 31, 2004, recorded a $63 benefit. If compensation cost for
all option issuances had been determined consistent with the fair value method,
I-Sector's net income (loss) per share would have increased to the pro-forma
amounts indicated below for the three month periods ended March 31, 2003 and
2004.
9
Three Months Ended
March 31,
-------------------------
2003 2004
--------- ---------
Basic and diluted:
Net income (loss) as reported ......... $ (1,091) $ 39
Deduct: Total stock-based employee
compensation determined
under fair value
based method for all
awards, net of related
tax effects ....................... 10 22
--------- ---------
Pro forma net income (loss) ........... $ (1,101) $ 17
--------- ---------
Earnings per share:
Basic - as reported ................... $ (0.30) $ 0.01
Basic - pro forma ..................... $ (0.30) $ 0.00
Diluted - as reported ................. $ (0.30) $ 0.01
Diluted - pro forma ................... $ (0.30) $ 0.00
EARNINGS PER SHARE - Basic net income per share is computed on the basis
of the weighted-average number of common shares outstanding during the periods.
Diluted net income per share is computed based upon the weighted-average number
of common shares plus the assumed issuance of common shares for all potentially
dilutive securities using the treasury stock method (See Note 4).
FAIR VALUE OF FINANCIAL INSTRUMENTS - I-Sector's financial instruments
consist of cash and cash equivalents, accounts receivable and accounts payable
for which the carrying values approximate fair values given the short-term
maturity of the instruments. The carrying value of the Company's debt
instruments approximate their fair value based on estimates of rates offered to
the Company for instruments with the same maturity dates and security
structures.
ACCOUNTING PRONOUNCEMENTS - In January 2003, the FASB issued FASB
Interpretation 46 ("FIN 46"), "Consolidation of Variable Interest Entities - An
Interpretation of ARB No. 51". FIN 46 addresses consolidation by business
enterprises of variable interest entities. This Interpretation applies
immediately to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise obtains an interest after that
date. It applies in the first fiscal year or interim period beginning after June
15, 2003, to variable interest entities in which an enterprise holds a variable
interest that it acquired before February 1, 2003. On December 17, 2003, the
FASB to issued FIN 46(R), providing a deferral of the application of FIN 46 for
interests held by public entities in a variable interest entity or potential
variable interest entity until fiscal periods ending after March 15, 2004. The
Company has assessed the impact of FIN 46 on its financial statements,
particularly its relationship with Allstar Equities, Inc., and adoption of this
statement did not have an impact on the Company's financial statements.
2. DISCONTINUED OPERATIONS
In 1999, I-Sector decided to sell both its computer products reselling
business and its PBX telephone systems dealer business. During the periods
specified below, I-Sector recognized a gain (loss) on disposal, net of income
tax provision, of these two businesses as follows:
March 31,
---------------
2003 2004
----- ----
Computer Products Division (net of tax benefits
of $3 and $4, respectively) .................... $ (5) $ (9)
Telecom Division (net of taxes and tax benefits
of $2 and $(1), respectively) .................. 5 (3)
----- ----
Net loss on disposal .............................. $ -- $(12)
----- ----
The balance sheet caption "Net liabilities related to discontinued
operations" contains $557 and $642 at December 31, 2003 and March 31, 2004,
respectively, of estimated future expenses related to the winding up of the
Telecom Division and the Computer Products Division, and includes amounts
related to settlement of pending litigation and to Telecom warranties. An
additional $85 relating to the rebate repayment claims from a former vendor was
reclassified from accrued liabilities to net liabilities related to discontinued
operations during the three month period ending March 31, 2004.
10
3. SEGMENT INFORMATION
I-Sector has four reportable segments: INX, Stratasoft, Valerent and
Corporate. Corporate is not a revenue generating operating segment. The
accounting policies of the business segments are the same as those for I-Sector.
I-Sector evaluates performance of each segment based on operating income.
Management views trade accounts receivable and inventory and not total assets in
their decision-making. Inter-segment sales and transfers are not significant and
are shown in the Eliminations column in the following table. The tables below
show the results of the four reportable segments:
For the quarter ended March 31, 2004:
INX Stratasoft Valerent Corporate Eliminations Consolidated
--------------- ------------- ---------- ------------- ------------- -------------
Revenue:
Products................ $ 10,061 $ - $ 334 $ - $ (201) $ 10,194
Services................ 913 - 1,031 - - 1,944
Custom projects......... - 2,137 - - - 2,137
--------------- ------------- ---------- ------------- ------------- -------------
Total revenue.............. 10,974 2,137 1,365 - (201) 14,275
--------------- ------------- ---------- ------------- ------------- -------------
Cost of goods and
Services:
Products................ 8,382 - 310 - (201) 8,491
Services................ 589 - 697 - - 1,286
Custom projects..... - 962 - - - 962
--------------- ------------- ---------- ------------- ------------- -------------
Cost of goods and
Services.............. 8,971 962 1,007 - (201) 10,739
--------------- ------------- ---------- ------------- ------------- -------------
Gross profit............... 2,003 1,175 358 - - 3,536
Selling, general and
administrative expenses.... 1,884 1,020 390 205 - 3,499
--------------- ------------- ---------- ------------- ------------- -------------
Operating income (loss).... $ 119 $ 155 $ (32) $ (205) - 37
--------------- ------------- ---------- ------------- -------------
Interest and other income, net................................................................................. 19
-------------
Income from continuing operations before income taxes.......................................................... 56
Income taxes................................................................................................... 5
-------------
Net income from continuing operations.......................................................................... 51
Net loss on disposal of discontinued operations, net of taxes.................................................. (12)
-------------
Net income .................................................................................................... $ 39
-------------
Trade accounts
receivable, net.......... $ 7,683 $ 1,127 $ 517 $ 90 $ - $ 9,417
--------------- ---------------- ---------- ------------- ------------- -------------
Inventory.................. $ 817 $ 466 $ 32 $ - $ - $ 1,315
--------------- ---------------- ---------- ------------- ------------- -------------
For the quarter ended March 31, 2003:
INX Stratasoft Valerent Corporate Eliminations Consolidated
--------------- -------------- ----------- ----------- ------------- -------------
Revenue:
Products................ $ 6,661 $ - $ 193 $ - $ (132) $ 6,722
Services................ 477 - 812 - - 1,289
Custom projects......... - 2,069 - - - 2,069
--------------- -------------- ----------- ----------- ------------- -------------
Total revenue.............. 7,138 2,069 1,005 - (132) 10,080
--------------- -------------- ----------- ----------- ------------- -------------
Cost of goods and
Services:
Products................ 5,844 - 192 - (132) 5,904
Services................ 516 - 584 - - 1,100
Custom projects......... - 801 - - - 801
--------------- -------------- ----------- ----------- ------------- -------------
Cost of goods
and Services....... 6,360 801 776 - (132) 7,805
--------------- -------------- ----------- ----------- ------------- -------------
Gross profit............... 778 1,268 229 - - 2,275
Selling, general and
administrative expenses.... 945 1,596 560 275 - 3,376
--------------- -------------- ----------- ----------- ------------- -------------
Operating loss............. $ (167) $ (328) $ (331) $ (275) $ - $ (1,101)
--------------- -------------- ----------- ----------- -------------
Interest and other income, net............................................................................... 10
-------------
Loss from continuing operations before income taxes.......................................................... (1,091)
Income taxes................................................................................................. -
-------------
Net loss from continuing operations.......................................................................... (1,091)
Net gain on disposal of discontinued operations, net of taxes................................................ -
-------------
Net loss..................................................................................................... $ (1,091)
-------------
11
INX Stratasoft Valerent Corporate Eliminations Consolidated
--------------- -------------- ----------- ----------- ------------- -------------
Trade accounts
receivable, net.......... $ 4,175 $ 1,166 $ 509 $ 77 $ - $ 5,927
--------------- -------------- ----------- ----------- -------------
Accounts receivable retained from discontinued operations, net............................................... 100
-------------
Total accounts receivable, net............................................................................... $ 6,027
-------------
Inventory.................. $ 347 $ 486 $ 35 $ - $ - $ 868
--------------- -------------- ----------- ----------- ------------- -------------
International sales accounted for $356 or 3.7% and $654 or 4.6% of
consolidated revenues and 21.8% and 30.6% of the Stratasoft segment revenues in
the three months ended March 31, 2003 and 2004, respectively. International
sales are derived primarily from Canada, the United Kingdom, Germany, Greece,
India, Egypt, the Philippines and Granada.
4. EARNINGS PER SHARE
Basic EPS is computed by dividing net income (loss) by the
weighted-average number of common shares outstanding for the period. Diluted EPS
is based on the weighted-average number of shares outstanding during each period
and the assumed exercise of dilutive stock options and warrants less the number
of treasury shares assumed to be purchased from the proceeds using the average
market price of the Company's common stock for each of the periods presented.
For the quarter ended March 31, 2003, I-Sector's potentially dilutive
options of 159,794 were not used in the calculation of diluted earnings since
the effect of potentially dilutive securities in computing a loss per share is
antidilutive.
The potentially dilutive options of the Company's wholly-owned subsidiary,
INX, (see Note 9) did not impact the calculation of I-Sector's earnings per
share for the three months ended March 31, 2003 since the effect would have been
antidilutive. In the three months ended March 31, 2004, net income from
continuing operations for purposes of computing the income per share decreased
$4 for the assumed exercise of INX options under the treasury method.
Three Months Ended
March 31,
----------------------------
2003 2004
----------- -----------
Numerator for basic earnings
per share:
Net income (loss) from
continuing operations ............ $ (1,091) $ 51
Gain (loss) on disposal of
discontinued operations,
net of taxes ..................... -- (12)
----------- -----------
Net income (loss) .................. $ (1,091) $ 39
----------- -----------
Numerator for diluted earnings
per share:
Net income (loss) from
continuing operations ............ $ (1,091) $ 51
INX income attributable to
potential minority interest
net income (loss) from
continuing operations used
in computing loss per share ...... -- 4
Loss on disposal of discontinued
operations, net of taxes .......... -- (12)
----------- -----------
Net income (loss) .................. $ (1,091) $ 34
----------- -----------
Denominator for basic earnings
per share - weighted-average
shares outstanding ............... 3,630,285 3,978,407
Effect of dilutive securities:
Shares issuable from assumed
conversion of common stock
options and restricted
stock ............................ -- 565,999
Denominator for diluted
earnings per share -
weighted-average shares
outstanding ...................... 3,630,285 4,544,406
5. DEBT
On September 27, 2001, Stratasoft, a subsidiary of I-Sector, signed a note
payable to a third party for $725, payable in monthly installments through
February 2007. The note does not bear interest and I-Sector has imputed interest
at 5.5% to record the debt and related patent license asset and has recorded
interest expense of $3 and $5 the three month periods ended March 31, 2003 and
2004, respectively. This note is collateralized by Stratasoft's patent license
assets and Stratasoft has granted a security interest in its pending patent
application and the next two patent applications filed by Stratasoft. In
connection with this note payable, I-Sector has short-term debt maturing within
one year of $68 and $71 at
12
December 31, 2003 and March 31, 2004, respectively; and long-term debt of $184
and $165 at December 31, 2003 and March 31, 2004, respectively.
In October 2001, I-Sector signed a non-interest bearing note payable for
$39 payable in monthly installments through October 2004. In connection with
this note payable, I-Sector has short-term debt maturing within one year of $10
and $6 at December 31, 2003 and March 31, 2004, respectively.
In December 2003, I-Sector signed a 36-month non-cancelable capital lease
for the purchase of equipment. I-Sector imputed interest at 10% to record the
debt on which I-Sector has recorded $2 interest expense for the three month
period ending March 31, 2004. In connection with this capital lease, I-Sector
has recorded short-term debt maturing within one year of $18 and $17 at December
31, 2003 and March 31, 2004, respectively; and long-term debt of $45 and $39 at
December 31, 2003 and March 31, 2004, respectively.
The borrowing base amount under the Textron facility is generally the sum
of 80% of eligible accounts receivable (the "Accounts Advance Amount") plus the
lesser of: (a) 90% of eligible inventory purchased by I-Sector from manufactures
with whom Textron has acceptable repurchase agreements, plus 40% of other
eligible inventory; (b) $4,000,000; or 30% of the Accounts Advance Amount. An
account receivable will not qualify as an eligible accounts receivable if, among
other things, it is not paid within 90 days after I-Sector's invoice date, the
customer has failed to pay more than 25% of all accounts receivable owed by the
customer to I-Sector within 90 days after the invoice date, or to the extent
that the customer's total accounts receivable exceed 15% of all I-Sector's
eligible accounts receivable. In February 2004, the syndication loan documents
were executed and the credit line increased from $10,000 to $15,000. Inventory
floor plan borrowings are reflected in accounts payable in the accompanying
consolidated balance sheets, except for $1,688 and $1,204 that is interest
bearing and is reflected in short term debt in the accompanying consolidated
balance sheets at December 31, 2004 and March 31, 2004, respectively. Borrowings
accrue interest at the prime rate (4% at March 31, 2004) plus 2.5% on
outstanding balances that extend beyond the vendor approved free interest
period. This agreement is collateralized by substantially all of I-Sector's
assets except its patent license assets. The loan agreement contains restrictive
covenants measured at each quarter end and requires I-Sector to maintain minimum
tangible capital funds, maintain minimum debt to tangible capital funds ratio,
and achieve a fixed charge coverage ratio. At March 31, 2004, I-Sector was in
compliance with those loan covenants effective at that date and anticipates that
it will be able to comply with its loan covenants for the next twelve months. In
the event I-Sector does not maintain compliance, it would be required to seek
waivers from Textron and Silicon Valley Bank for those events, which, if not
obtained, could accelerate repayment and require I-Sector to seek other sources
of finance. At March 31, 2004, I-Sector had $6,930 outstanding on inventory
floor plan finance borrowings, and the remaining credit availability was $8,070,
subject to borrowing limitations as described above.
6. COMMITMENTS AND CONTINGENCIES
LITIGATION - In August 2002, Inacom Corp. ("Inacom") filed a lawsuit in
the District Court of Douglas County, Nebraska styled Inacom Corp v. I-Sector
Corporation, f/k/a Allstar Systems, Inc., claiming that I-Sector owed the sum of
approximately $570 to Inacom as a result of Inacom's termination of a Vendor
Purchase Agreement between Inacom and I-Sector. I-Sector believes that the claim
is without merit and intends to vigorously contest the demand.
In March 2003, I-Sector and other parties were notified of a demand for
return of payments relating to the business activities of a call center
customer. In March 2004, I-Sector was informed by the claimant that claims will
not be pursued at this time. I-Sector believes that the claims against it, if
re-initiated, are without merit and intends to vigorously contest any demands
related to this matter.
I-Sector is also party to other litigation and claims which management
believes are normal in the course of its operations. While the results of such
litigation and claims cannot be predicted with certainty, I-Sector believes the
final outcome of such matters will not have a materially adverse effect on its
results of operations or financial position.
7. RELATED PARTY TRANSACTIONS
The Company leases office space from Allstar Equities, Inc., a Texas
corporation ("Equities"), a company wholly owned by I-Sector's Chief Executive
Officer. On December 1, 1999 Equities purchased the Company's corporate office
building and executed a direct lease with us with an expiration date of December
31, 2004. In conjunction with Equities obtaining new financing on the building,
a new lease was executed with the Company on February 1, 2002 with an expiration
date of January 31, 2007. The lease has rental rates of $37 per month.
From time to time, I-Sector makes short-term loans and travel advances to
its non-executive employees. The balance of approximately $16 and $6 relating to
these loans and advances is included in the Company's consolidated balance
sheets and reported as part of Accounts receivable - other at December 31, 2003
and March 31, 2004.
13
8. INTANGIBLE ASSETS
On April 7, 2003, I-Sector's subsidiary, INX, acquired certain assets and
liabilities of one of its competitors, Digital Precision, Inc. ("Digital").
Under the terms of the purchase, INX acquired fixed assets valued at $63,
inventory valued at $101 and intellectual property, customer lists, trademarks,
trade names and service marks, contract rights and other intangibles of Digital
valued at $376, as well as assumed certain operating leases of equipment and
office space in Austin, Texas and Dallas, Texas with a net future obligation of
$548. The office space in Dallas, TX was subleased with future rentals of $234.
The intangibles are subject to amortization and have a three year expected life.
The purchase price was $540 in cash and, contingent upon the retention of
certain key employees, the obligation to issue 1,800,000 shares of INX common
stock in April 2004. The contingency was resolved in April 2004, and I-Sector
recognized a minority interest related to the issuance of INX's common stock
(see Note 9) resulting in additional intangible assets of approximately $300.
The results of operations subsequent to April 7, 2003 are included in I-Sector's
consolidated statements of operations.
9. STOCK OPTION PLANS
The company has three stock-based option plans, the 1996 Incentive Stock
Plan, the 1996 Non-Employee Director Stock Option Plan and the Incentive Plan.
Under the Incentive Plan, all I-Sector employees, including officers,
consultants and non-employees directors are eligible to participate.
INX is the only I-Sector subsidiary with an incentive stock option plan in
place. All other subsidiary plans except for INX were terminated in December
2003. The INX plan has not been presented to the shareholders of I-Sector for
approval. INX has granted incentive awards under its incentive plan, and such
awards have been granted to certain employees and to management of INX. Under
INX's plan such options vest typically ratably over three to five years. In
December 2003, the Company amended option agreements with INX's two most senior
executives to convert to a fixed 5-year vesting schedule from one that was
determined based on the percentage of attainment of predefined financial goals
by INX. No stock-based compensation was recorded as the exercise price equaled
or exceeded management's estimated fair value of the INX common stock. Any
unvested INX stock options may vest immediately upon the occurrence of a
liquidity event for that subsidiary. 5,440,000 of the options contain an
exercise restriction which only allows vested options to be exercised upon the
occurrence of a liquidity event or one month prior to the option's expiration
date. The INX options expire ten years after the grant date if they are not
exercised. The INX stock option grants are subject to dilution when I-Sector
purchases additional shares of the subsidiary stock in order to keep the
subsidiary sufficiently capitalized. INX has 8,274,288 options granted and
outstanding, of which 3,395,166 are vested and 805,000 are exercisable at March
31, 2004. The outstanding options have exercise prices ranging from $0.01 to
$0.25 per share with a weighted average of $0.17 per share. There are no shares
in INX's plan available to be issued at March 31, 2004, and INX's plan has been
amended, effective December 31, 2003 so that no further options may be granted
under the plan. The tables below reflect the ownership of INX at March 31, 2004
and summarize the potential dilutive effect on I-Sector's ownership in INX if
all options granted at March 31, 2004 were fully vested and option grants were
exercised, and include the effects of the issuance of stock in 2004 relating to
INX's acquisition of certain assets and liabilities of Digital Precision, Inc.
The table does not assume any repurchase of shares with proceeds from option
exercises.
INX Common Percent
Stock of Total
---------- --------
Ownership of INX shares at March 31, 2004:
Common Stock owned by I-Sector ................. 21,834,333 100.0%
---------- -----
Total Common Stock Outstanding ................. 21,834,333 100.0%
---------- -----
Potential Future I-Sector Dilution of
Ownership:
Common Stock owned by I-Sector at
March 31, 2004 ................................ 21,834,333 68.4%
Options granted and outstanding at
March 31, 2004(1)(2)(3)(4) .................... 8,274,288 25.9%
Contingent obligation to issue Common Stock
related to acquisition(5) ..................... 1,800,000 5.7%
---------- -----
Total at March 31, 2004 ......................... 31,908,621 100.0%
---------- -----
(1) Options granted and outstanding at March 31, 2004 include option grants
for 4,100,000 shares of INX granted to the two senior executives of INX
and vesting of these option grants was performance-based relating to the
percentage of predefined financial goals attained by INX while these two
senior executives remain employed. In December 2003, these option
agreements were amended to convert to a fixed 5-year vesting schedule.
(2) Included in the option grants outstanding at March 31, 2004 are grants
for 1,881,692 shares granted to key employees related to the acquisition
Digital Precision, Inc. Grants for 500,000 of these shares vested April
2003.
14
The balance of the grants for 1,381,692 shares, which were granted in
November 2003, vest over three years, starting in April 2004
(3) During the quarter ended December 31, 2003, INX granted fully vested
options to purchase 1,200,000 shares of INX to the CEO and Chairman of
the Board of I-Sector Corporation. Such option grant was voluntarily
canceled by the CEO and Chairman of the Board of I-Sector Corporation in
February, 2004 in connection with the issuance of a warrant for 1.2
million shares to I-Sector on similar terms. During the year ended
December 31, 2003, INX granted fully vested options to purchase 300,000
shares to the President and CEO of INX. In addition, INX granted options
vesting over three years to various other employees during the year
ended December 31, 2003.
(4) The remainder of the shares included in INX option grants outstanding at
March 31, 2004 vests over either three or five years based upon
continued employment by INX of the individuals to whom such grants have
been made. All options granted by INX expire in ten years if
unexercised.
(5) The 1,800,000 shares were issued in April 2004 (See Note 8).
10. SUBSEQUENT EVENT
On May 12, 2004 the Company closed a public offering of 500,000 Units. The
Units began trading on May 7, 2004, on the American Stock Exchange under the
symbol ISR.U. Each Unit consists of two shares of common stock and one warrant
to purchase one share of common stock at a price of $12.45. The Units were
offered at a public offering price of $16.60 per Unit resulting in $6,500 in
estimated net proceeds. The underwriters have an option to purchase up to 75,000
additional Units to cover over-allotments. The Company intends to use the net
proceeds of this offering primarily for working capital and to repay
interest-bearing debt
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion is qualified in its entirety by, and should be
read in conjunction with, our consolidated financial statements, including the
notes thereto included elsewhere in this Form 10-Q/A and our Form 10-K
previously filed with the Securities and Exchange Commission.
SPECIAL NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This quarterly report on Form 10-Q/A contains forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995
relating to future events or our future financial performance including, but not
limited to, statements contained in Item 2. - "Management's Discussion and
Analysis of Financial Condition and Results of Operations." Readers are
cautioned that any statement that is not a statement of historical fact,
including but not limited to, statements which may be identified by words
including, but not limited to, "anticipate," "appear," "believe," "could,"
"estimate," "expect," "hope," "indicate," "intend," "likely," "may," "might,"
"plan," "potential," "seek," "should," "will," "would," and other variations or
negative expressions thereof, are predictions or estimations and are subject to
known and unknown risks and uncertainties. Numerous factors, including factors
that we have little or no control over, may affect the I-Sector's actual results
and may cause actual results to differ materially from those expressed in the
forward-looking statements contained herein. In evaluating such statements,
readers should consider the various factors identified in I-Sector's annual
report for 2003 on Form 10-K, as filed with the Securities and Exchange
Commission including the matters set forth in Item 1.- "Factors Which May Affect
The Future Results Of Operations," which could cause actual events, performance
or results to differ materially from those indicated by such statements.
GENERAL
We are a leading regional provider of IP telephony and other network
infrastructure and related implementation and support services. The IP telephony
industry is characterized by rapidly evolving and competing technologies. We
compete with larger and better financed entitles. Our three principal offices
are located in Texas, and we primarily market to potential customers
headquartered in, or making purchasing decisions from, Texas. Our long-term
goal, however, is to become one of the leading national providers of
Cisco-centric network and IP telephony solutions to enterprises.
15
We begin Management's Discussion and Analysis of Financial Condition and
Results of Operations with an overview of our strategies for achieving this goal
and becoming profitable. From a financial perspective, these operating
strategies have a number of important implications for our results of operations
and financial condition.
STRATEGY
We plan to become profitable in 2004 by implementing the strategies
discussed below. We believe that our strategies will allow us to continue to
increase total revenues in 2004. Most importantly, we also believe our
strategies will enable us to improve our gross profit in 2004 by improving our
gross margins on INX revenue. At the same time, we will seek to contain the
relatively fixed components of our selling, general and administrative expenses
so that those components become a relatively smaller percentage of total
revenues. Although selling expenses can generally be expected to increase as our
revenues increase, we believe that if we are successful in implementing
strategies, many general and administrative expenses (such as management
salaries, administrative wages and professional expenses) will decrease as a
percentage of our total revenues.
Our key operating strategies are as follows:
o seeking larger, full scale IP telephony implementation
projects, as opposed to smaller pilot projects;
o increasing the gross revenues from our higher gross margin
operations, such as INX services and Stratasoft custom
projects, as opposed to product sales, which typically produce
narrower gross margins;
o aligning ourselves with Cisco as our exclusive supplier for
the network and IP telephony equipment and technology that we
offer;
o expanding geographically by acquiring complementary businesses
and by opening our own offices; and
o developing and marketing our own computer telephony software
that operates with and augments Cisco-centric IP telephony
products.
If we are successful in obtaining larger, full scale IP telephony
implementation projects, we expect that our gross revenues from both products
and services will increase because these projects, by their nature, typically
require a substantially higher level of our services and more products than do
smaller projects. Larger projects, however, can strain our financial resources.
For example, a potential customer for a major IP telephony project may require
that we post a bid bond or performance bond in order for us to be awarded the
project. This often occurs on competitive bids. Because of our financial
condition, bonding companies typically require that we provide security to
collateralize the issuance of its bond. We have been financially unable to
provide sufficient collateral in some instances, and as a result have not been
able to obtain the bond. We believe we have occasionally lost business that we
might have otherwise been awarded because we were unable to obtain the bond
required by the potential customer.
Increases in the size and volume of IP telephony projects we undertake can
also challenge our cash management. For example, larger projects can reduce our
available cash by causing us to carry higher levels of inventory. Larger
projects can also require us to invest our available cash in labor costs. This
is because, in some cases, we do not receive payments from our customers for
extended periods of time. Until they pay us, all the cash we previously invested
in labor and products on the project remains tied up. We expect that greater
amounts of our cash will become invested in accounts receivable in the future if
we are successful in growing our business as we intend.
To meet our cash requirements to support this growth, we expect to rely on
capital provided from our operations and our credit facility, which is
collateralized by our accounts receivable and substantially all of our assets.
During May 2004 we raised equity capital through a public offering of our equity
securities with net proceeds of $6.5 million. We intend to use the net proceeds
of this offering primarily for working capital and to repay interest-bearing
debt.
Although over 75% of our revenue in 2003 was attributable to product
sales, the gross profit margins on sales of our services have been substantially
higher than those for sales of products, with the exception of sales of our
proprietary Stratasoft software products. In 2003, for example, the gross profit
margin on sales of products by INX was 12.4%, while the gross profit margin on
sales of services by INX for that year was 29.6%. We therefore plan to increase
revenue from services, particularly our post-implementation services for IP
Telephony. The success of this aspect of our strategy largely depends on our
ability to attract and retain highly skilled and experienced employees.
For the last three years, the largest component of our total cost of sales
and service has been purchases of Cisco-centric IP telephony products by INX.
The majority of those purchases were directly from Cisco. We typically purchase
from various wholesale distributors only when we cannot timely purchase products
directly from Cisco. Our reliance on Cisco as the primary supplier for the
network and IP telephony equipment and technology we offer means that our
results
16
of operations from period to period depend substantially on the terms that we
are able to purchase these product from Cisco and, to a much lesser extent, from
wholesale distributors of Cisco's products. Therefore, our ability to manage the
largest component of our cost of sales and service is very limited and depends
to a large degree on maintaining and growing our relationship with Cisco. Our
cost of products purchased from Cisco can be substantially influenced by whether
Cisco sponsors sales incentive programs and whether we qualify for the
incentives that Cisco offers.
We plan to also grow our business in other geographic areas through
strategic acquisition of similar businesses or by opening our own offices. This
aspect of our strategy can affect our financial condition and results of
operations in many ways. The purchase price for business acquisitions and the
costs of opening offices may require substantial cash and may require us to
incur long term debt. The expenses of a geographic expansion in an area may well
exceed the revenues attributable to a new business or office for some time, even
if it performs as we expect. Additionally, it is possible that our acquisition
activities may require that we record substantial amounts of goodwill if the
purchase consideration paid for an acquisition exceeds the estimated fair value
of the net identified tangible and intangible assets acquired. To the extent an
acquisition results in goodwill, we will reevaluate the realization of that
goodwill at least annually and adjust it as appropriate. The resulting
adjustment could result in significant charges to earnings in future periods.
Developing new or substantially improved computer telephony software
products will likely require us to expend cash and record software development
expenses. Software development costs will likely be expensed because we expect
to incur substantially all costs prior to achieving technological feasibility in
developing a new or substantially improved software product.
MINORITY INTEREST IN INX
Since its formation in 2000, INX has been our wholly-owned subsidiary. In
April 2004, INX ceased to be a wholly-owned subsidiary as the result of the
issuance of INX common stock to the former owners of Digital Precision, which
INX acquired in April 2003. In connection with that acquisition, we agreed to
issue to the seller 1.8 million shares of INX common stock as additional
purchase consideration for their business if certain employees remain employed
through April 4, 2004, the first anniversary of the acquisition. These
conditions were met and the INX stock was issued in April 2004. When that
occurred, our ownership percentage of INX's common stock declined to
approximately 92.4%.
INX has also granted stock options to employees of INX to acquire INX
common stock pursuant to a stock option plan for INX employees. Additionally,
the I-Sector Warrant entitles us to acquire an additional 1.2 million shares of
INX common stock. The exercise prices for the INX options and the I-Sector
Warrant range from $0.01 to $0.25 with a weighted average of $0.17. We estimate
that I-Sector's ownership in INX could be reduced to 69.5%, assuming that all of
the INX options are exercised, we exercise the I-Sector Warrant and there are no
other changes in INX's equity.
While the existence of the unexercised INX options and the contingent
obligation to issue INX stock does not result in a minority interest for
accounting purposes through March 2004, the actual issuance of INX stock in
April 2004 did result in a minority interest. Because I-Sector will own less
than all of INX's stock, its interest in INX's future profits and losses will be
reduced. Under U.S. generally accepted accounting principles, I-Sector's
consolidated financial statements in future periods will reflect a minority
interest adjustment of the otherwise reportable profits and losses of INX by the
percentage of minority ownership in INX. I-Sector's percentage share of any cash
dividends or other distributions paid by INX to its stockholders will likewise
be reduced by the percentage of minority ownership in INX. Additionally, if the
percentage of minority ownership of INX's stock grows as a result of future
exercises of INX options, that increase will cause a corresponding decrease in
the reportable share of INX's profits and losses included in our consolidated
financial statements, and our share of cash dividends and other distributions
from INX.
Unlike the boards of directors of our wholly-owned subsidiaries, the board
of directors of INX will be required to be mindful of the interests of INX's
minority stockholders, in addition to our interests, when considering whether to
approve business and financing transactions involving INX. For example, we may
be unable to cause the assets of INX to be pledged as collateral security for
indebtedness if the proceeds of that indebtedness disproportionately benefit us
or our wholly-owned subsidiaries in relation to INX. Conflicts of interest may
reduce our flexibility in structuring business and financing transactions
beneficial to us and our wholly-owned subsidiaries.
Contributions of capital to INX by us, in the form of stock purchases,
which may be necessary to fund INX's growth, could increase our percentage
ownership of INX, but would use capital. Because of the potential minority
interest in INX, we will be required to make capital contributions to INX on a
basis that is, in the good faith judgment of our board of directors, fair to us
and the holders of the minority interest.
17
Minority stock ownership in INX could also subject us to lawsuits from its
minority stockholders complaining of our actions with respect to INX and its
minority stockholders, even if the actions complained of are ultimately
determined to have been proper. For example, if we choose to cause INX to merge
with, or sell all or substantially all of its assets to, another entity, the
minority stockholders of INX may bring lawsuits seeking to block the transaction
or seeking to exercise statutory dissenters' rights with respect to the
transaction. Whether or not successful, any such actions would cause us to incur
litigation costs and potentially reduce the benefit of any such transaction to
us.
The stock of INX is not publicly-traded. Accordingly, any shares of INX
stock issued, including those issued to the former owners of Digital Precision
upon exercise of INX options, are, and will be for the foreseeable future,
relatively illiquid. For this reason, and to eliminate the other consequences of
having a minority interest in a subsidiary, we believe that in the future we
will offer to exchange INX stock and stock options for common stock or stock
options to acquire our common stock. If we conclude such a transaction, the
aggregate ownership percentage of our common stock by our stockholders
immediately before the conversion or exchange transaction will be reduced by the
percentage of post-transaction ownership acquired by the former minority
stockholders of INX. Their post-transaction ownership may be further reduced by
subsequent exercises of I-Sector stock options that we may choose to exchange
for INX stock options.
We cannot predict the percentage of ownership reduction to our
stockholders that may result from any future exchange or conversion of INX stock
and INX options. The ownership reduction resulting from any such transaction
may, however, be significant. We believe this may be the case principally
because:
o we expect that the total number of shares of our common stock
that we would be required to issue in any such transaction
would be approximately equivalent in value, as determined at a
future date, to the value of the INX stock and INX options to
be exchanged at the same future date;
o the historical financial effect of INX on our business is
significant, as compared with our other subsidiaries; and
o we expect INX will continue to generate most of our revenue.
If in the future we propose to exchange or convert INX stock and INX
options into I-Sector common stock or options, we intend to appoint a special
committee of our independent directors to negotiate any exchange ratio for the
transaction with the principal INX minority stockholders and option holders. The
facts and circumstances that the special committee may choose to consider and
the relative weights to be accorded them in negotiating the relative values of
our common stock and INX stock and in negotiating the exchange ratio for any
future transaction are matters that we intend to delegate to the discretion of
the special committee. Accordingly, presently we cannot quantify the amount of
any future ownership reduction that our stockholders may experience in an
exchange transaction with INX stockholders and option holders.
Under some circumstances, we may be required by United States generally
accepted accounting principles to record substantial non-cash expenses if we
choose to exchange INX stock or INX options into our common stock or options. We
are not now able to determine the amount or timing of any such charges. This is
because those matters will largely depend upon the timing and terms on which any
future exchange would occur, particularly the exchange ratio negotiated at the
time. Because most of our revenues in 2003 were generated by INX and our
expectation is that this will continue for the foreseeable future, we believe
that any resulting non-cash expense charges could be substantial. Any such
future non-cash expenses charges could materially and adversely affect our
financial results of operations.
If we determine to undertake a transaction to exchange INX stock or INX
options into our common stock or stock options, we also plan to submit any such
transaction to our stockholders for their approval, even if not required by
Delaware law or the rules of the American Stock Exchange. Even if we believe
that such transaction is in our best interest, our stockholders may refuse to
approve it. If that were to occur, it could disappoint the expectations of those
INX minority stockholders and INX option holders in favor of the transaction,
some of who are currently, and are expected to remain, key employees. This could
cause employee morale and retention problems for us.
RESULTS OF OPERATIONS
Overview
Sources of Revenue. Our revenue is derived from three segments represented
by our three operating subsidiaries, INX, Stratasoft and Valerent. During the
quarter ended March 31, 2004, INX, Stratasoft and Valerent accounted for 76.9%,
15.0% and 9.6%, respectively, of total consolidated revenue, and (1.5)% of
subsidiary revenue was eliminated in consolidation due to inter-company
transactions.
18
INX revenue consists of product and service revenue. Product revenue
consists of reselling Cisco products and limited amounts of complementary
products by other manufacturers. Service revenue is generated by fees from a
variety of implementation and support services. Product prices for INX are set
by the market for Cisco products, and provide our lowest gross margins. Service
revenue for INX has recently provided a higher gross margin that has generally
improved over the past several years as the cost of INX's technical resources,
which are reflected as a cost of service, has decreased as a percentage of
services revenue. Also, certain fixed and flat fee service contracts that extend
over three months or more are accounted for on the percentage of completion
method of accounting. Historically, the majority of INX's services revenue has
been generated from implementation services, which is project oriented and tends
to be volatile as projects are completed and new projects commence. As the
number, frequency and size of INX projects has grown, INX has achieved better
utilization of its engineering resources resulting in improved services gross
margins. The normal sales cycles for corporate customers typically ranges from
three to six months depending on the nature, scope and size of the deal
involved. But our direct experience with school districts involved in eRate
funding (a governmental funding program for schools) indicates that the sales
lead time is generally about six to twelve months. In mid-2003, INX introduced
Netsurant, its branded support service that consists primarily of customer
service personnel and a support center that we believe could further improve
overall services gross margins. Through March 31, 2004, Netsurant service
revenue was not significant.
Stratasoft revenue consists primarily of custom project revenue from the
sale of proprietary computer-telephony software. Our Stratasoft revenue is
reported as custom project revenue in our financial statements, because it
consists of product and services which cannot be accounted for separately.
Stratasoft has traditionally provided our highest gross margin since it is
primarily sales of our proprietary computer-telephony software. Our cost of
goods sold for Stratasoft's custom project revenue includes the costs of
developing our computer-telephony software products, installation costs, and the
cost of hardware and other equipment bundled with our software applications and
included in a sale to a customer. Stratasoft revenue also includes sales to
resellers. The sales to resellers are recorded when the sale becomes fixed or
determinable; otherwise revenue from resellers is recorded when payments become
due.
Valerent revenue consists of both product revenue and services revenue.
Product revenue consists of reselling primarily software products, and to a
lesser degree, hardware products, that facilitate Valerent's managed services,
including remote management software products from Altiris, Inc., and security
software products from Network Associates, Inc. Product sales prices for
Valerent are set by the market for these products, and Valerent's product sales
have typically provided lower gross profit margins than its services revenue.
Valerent's services revenue consists of remote and onsite technical assistance
to its customers. Valerent's gross margin on service revenue, much like INX's
implementation services revenue, is subject to variability based upon the
utilization of Valerent's billable technical resources. Recurring service
agreements exist with some customers, but usually with varying terms and
conditions that conform to their year over year business changes and their
specific needs, and while these agreements provide predictable and stable
sources of revenue, the loss of a recurring agreement could disrupt the
stability of that revenue stream for Valerent.
Gross Profit and Gross Profit Margin. The mix of our various revenue
components, each of which has substantially different levels of gross margin,
materially influences our overall gross profit and gross margin in any
particular quarter. In periods in which service revenue or Stratasoft custom
project revenue are high, as compared to INX and Valerent product sales, our
gross margin generally improves as compared to periods in which we have higher
levels of product sales. Our gross margin for product sales also varies
depending on the type of product sold, the mix of large revenue product
contracts, which typically have lower gross margin, as compared to smaller
revenue product contacts, which typically have higher gross margin.
In addition, our quarterly gross profit and gross margin can be materially
affected by vendor incentives received in certain quarterly periods, most of
which are Cisco incentives received by INX. The incentive programs sponsored by
Cisco currently enable us to qualify for cash rebates or product pricing
discounts. These incentives are generally earned based on sales volume, sales
growth and, customer satisfaction levels. The amounts earned under these
programs are recorded as a reduction of cost of goods and can vary significantly
between periods. Currently, incentives by Cisco are paid semiannually, and are
typically paid in the first and third quarters of each calendar year. Incentives
are recognized when we receive payment from the supplier or when we have earned
and can reasonably estimate the amount due from the supplier. During the three
months ended March 31, 2004 we recognized $622,000 in vendor incentives, and we
accrued approximately $100,000 in commission expense earned by sales personnel
in association with this vendor incentive program.
Expenses. A significant portion of our cost of services for each of our
service businesses is comprised of labor. Labor cost related to permanent
employees is generally fixed in the short-term so that higher levels of service
revenue produce higher gross margins while lower levels of service revenue
produce lower gross margins. Our gross margin on services revenue fluctuates
from period to period depending not only upon the prices charged to customers
for our services, but also upon the level of utilization of our technical staff.
Management of labor cost is therefore important in order to
19
prevent erosion of gross margin. Our gross margin is also impacted by such
factors as contract size, time and material pricing versus fixed fee pricing,
discounting, vendor incentives and other business and marketing factors normally
incurred during the conduct of business.
Selling, General and Administrative Expenses. Our selling, general and
administrative expenses include both fixed and variable expenses. Relatively
fixed expenses in selling, general and administrative expenses include rent,
utilities, promotion and advertising, and administrative wages. Variable
expenses in selling, general and administrative expenses include sales
commissions and travel, which will usually vary based on our sales and gross
profit. Selling general and administrative expenses also include expenses which
vary significantly from period to period but not in proportion to sales or gross
profit. These include legal expenses and bad debt expense both of which vary
based on factors that are difficult to predict.
A significant portion of our selling, general and administrative expenses
relate to personnel costs, some of which are variable and others that are
relatively fixed. Our variable personnel costs consist primarily of sales
commissions. Sales commissions are typically calculated based upon our gross
profit on a particular sales transaction and thus generally fluctuate because of
the size of the deal and the mix of associated products and services with our
overall gross profit. Bad debt expense generally fluctuates somewhat in
proportion to sales levels, although not always in the same periods as increases
or decreases in sales. Legal expense varies based on legal issue activity, which
can vary substantially from period to period. The remainder of selling, general
and administrative expenses are relatively fixed and do not vary in direct
proportion to increases in revenue.
Acquisition and Disposition. In the second quarter of 2003, INX acquired
the fixed assets, inventory, intellectual property, customer lists, trademarks,
trade names service marks, contract rights and other intangibles of Digital
Precision. In connection with that acquisition we also assumed leases for
equipment and office space. Our results of operations include those attributable
to Digital Precision on and after April 7, 2003. The purchase price for Digital
Precision was $540,000 in cash and 1.8 million shares of INX common stock which
we agreed to issue if certain employees remain employed through April 4, 2004,
the first anniversary of the acquisition. We did not recognize goodwill at the
time of the acquisition of Digital Precision, however, we will record
approximately $300,000 in intangible assets in connection with the 1.8 million
shares of INX stock we issued in April 2004.
The sale of our computer reselling and PBX telephone systems reselling
business in early 2000 and the sale of our IT Staffing business in 2001 resulted
in a gain on disposal. Since the sale of these businesses, we have realized, in
various periods, income and expense from discontinued operations that has been
primarily a result of litigation expenses and settlement of litigation related
to our discontinued operations. We expect the income and expense from
discontinued operations to decrease over time and to eventually be eliminated
after these matters are fully resolved.
Tax Loss Carryforward. Because of our operating losses in 2003, we have
accumulated a net operating loss carryforward for federal income tax purposes
that, as of March 31, 2004, was approximately $2.4 million and is available to
offset future federal and state taxable income. This carryforward expires in
2023. In addition to potential expiration, there are several factors that could
limit or eliminate our ability to use these carryforwards. For example, under
Section 382 of the Internal Revenue Code of 1986, as amended, use of prior net
operating loss carryforwards is limited after an ownership change. This type of
change could result from the offering we completed during May 2004, either alone
or in combination with other prior or subsequent offerings of equity securities.
If we achieve sustained profitability, which may not happen, the use of net
operating loss carryforwards would reduce our tax liability and increase our net
income and available cash resources. When all operating loss carryforwards have
been used or have expired, we would again be subject to increased tax expense
and reduced earnings due to such tax expense.
Period Comparisons. The following table sets forth, for the periods
indicated, certain financial data derived from our consolidated statements of
operations. Percentages shown in the table below are percentages of total
revenue, except for each individual segment's cost of sales and services, gross
profit, selling, general and administrative expenses, and operating income,
which are percentages of the respective segment's revenue, and the product and
service components of the INX and Valerent segments' cost of goods sold and
gross profit, which are percentages of such segment's respective product and
service revenue.
20
Three months ended March 31,
-----------------------------------------------------
2003 2004
---------------------- ----------------------
Amount % Amount %
-------- ----- -------- -----
(DOLLARS IN THOUSANDS)
Revenue:
INX product ................................................ $ 6,661 66.1 $ 10,061 70.5
INX service ................................................ 477 4.7 913 6.4
-------- ----- -------- -----
Total INX revenue ................................. 7,138 70.8 10,974 76.9
-------- ----- -------- -----
Stratasoft - Custom projects ............................... 2,069 20.5 2,137 15.0
-------- ----- -------- -----
Valerent product ........................................... 193 1.9 334 2.4
Valerent service ........................................... 812 8.1 1,031 7.2
-------- ----- -------- -----
Total Valerent revenue ............................ 1,005 10.0 1,365 9.6
Eliminations revenue ....................................... (132) (1.3) (201) (1.5)
-------- ----- -------- -----
Total revenue ................................. 10,080 100.0 14,275 100.0
Cost of sales and service:
INX product ................................................ 5,844 87.7 8,382 83.3
INX service ................................................ 516 108.2 589 64.5
-------- ----- -------- -----
Total INX cost of sales and service ................ 6,360 89.1 8,971 81.7
Stratasoft - Custom projects ............................... 801 38.7 962 45.0
-------- ----- -------- -----
Valerent product ........................................... 192 99.5 310 92.8
Valerent service ........................................... 584 71.9 697 67.6
-------- ----- -------- -----
Total Valerent cost of sales and service ........... 776 77.2 1,007 73.8
Eliminations of cost of sales and service .................. (132) 100.0 (201) 100.0
-------- ----- -------- -----
Total cost of sales and service .................... 7,805 77.4 10,739 75.2
Gross profit:
INX product ................................................ 817 12.3 1,679 16.7
INX service ................................................ (39) (8.2) 324 35.5
-------- ----- -------- -----
Total INX gross profit ............................. 778 10.9 2,003 18.3
Stratasoft - Custom projects ............................... 1,268 61.3 1,175 55.0
-------- ----- -------- -----
Valerent product ........................................... 1 0.5 24 7.2
Valerent service ........................................... 228 28.1 334 32.4
-------- ----- -------- -----
Total Valerent gross profit ........................ 229 22.8 358 26.2
-------- ----- -------- -----
Total gross profit ........................... 2,275 22.6 3,536 24.8
Selling, general and administrative expenses:
INX ........................................................ 945 13.2 1,884 17.2
Stratasoft ................................................. 1,596 77.1 1,020 47.7
Valerent ................................................... 560 55.7 390 28.6
Corporate .................................................. 275 (NA) 205 (NA)
-------- ----- -------- -----
Total selling, general and administrative expenses ............ 3,376 33.5 3,499 24.5
Operating income (loss):
INX ........................................................ (167) (2.3) 119 1.1
Stratasoft ................................................. (328) (15.9) 155 7.3
Valerent ................................................... (331) (32.9) (32) (2.3)
Corporate .................................................. (275) (NA) (205) (NA)
-------- ----- -------- -----
Total operating income (loss) ...................... (1,101) (10.9) 37 0.3
Interest and other income, net ................................ 10 (0.1) 19 0.1
-------- ----- -------- -----
Income (loss) from continuing operations before income taxes .. (1,091) (10.8) 56 0.4
Income taxes .................................................. -- 0.0 5 0.0
-------- ----- -------- -----
Net income (loss) from continuing operations .................. (1,091) (10.8) 51 0.4
Discontinued operations:
Loss on disposal, net of taxes ................................ -- 0.0 (12) (0.1)
-------- ----- -------- -----
Net income (loss) ............................................. $ (1,091) (10.8) $ 39 0.3
-------- ----- -------- -----
21
QUARTER ENDED MARCH 31, 2003 COMPARED TO QUARTER ENDED MARCH 31, 2004
Total Revenue. Our total revenue, net of intercompany eliminations,
increased by $4.2 million, or 41.6%, from $10.1 million to $14.3 million.
INX revenue increased by $3.9 million, or 53.7%, from $7.1 million to
$11.0 million. As a percentage of total revenue, INX revenue increased from
70.8% to 76.9%. Product revenue increased $3.4 million, or 51.0% from $6.7
million to $10.1 million. INX service revenue increased $436,000, or 91.4% from
$477,000 to $913,000. The increase in services is attributed to an increase in
the number of IP Telephony projects which have higher service content than
traditional network infrastructure projects, as well as the IP telephony service
contract in Iraq. The increase in product sales is attributed to the adoption of
IP telephony technology by our customers requiring equipment upgrades for
implementation, and the addition of the Austin, Texas office resulting from the
Digital Precision acquisition of April 2003.
Stratasoft revenue increased by $68,000, or 3.3%. As a percentage of total
revenue, Stratasoft revenue decreased from 20.5% to 15.0%. Stratasoft's
international sales accounted for 30.6% of Stratasoft's revenue as compared to
21.8% in 2003. Stratasoft has its own internally managed sales force, but it
also utilizes dealer agreements from time to time with certain established
resellers in domestic and international markets that do not require the
continued involvement of our personnel. Stratasoft derived $132,000 or 6.2% of
its revenue from sales to resellers during the quarter which compares with
$124,000 or 6.0% of its revenue in 2003. Sales to resellers are included in
revenue when the fees are fixed and determinable; otherwise revenue from
resellers is deferred and recognized when the payment becomes due.
Valerent revenue increased by $360,000, or 35.8%, from $1.0 million to
$1.4 million. As a percentage of total revenue, Valerent revenue decreased from
10.0% to 9.6%. The increase in Valerent revenue was primarily attributable to
increased service revenue of $219,000 and increased product sales of $141,000.
The increase in service revenue is primarily attributable to development of
remote services for clients to operate themselves, the sale of the underlying
technology to support remote management, and Valerent delivered remote managed
services on behalf of clients, which was primarily related to Valerent making
changes to its business model so that it no longer pursued certain non-strategic
sources of services revenue. Valerent's business model now focuses on
identifying and developing markets with enterprise customers.
Gross Profit. Our total gross profit increased by $1.2 million, or 55.4%,
from $2.3 million to $3.5 million. Gross margin increased from 22.6% to 24.8%,
primarily because of the increase in gross margin in our INX subsidiary
discussed below.
INX gross profit increased $1.2 million, or 157.5%, from $778,000 to $2.0
million. INX's gross margin increased from 10.9% to 18.3%. INX's gross profit on
its product sales component increased $862,000 or 105.5%, from $817,000 to $1.7
million due to increased product sales revenue and a vendor rebate of $622,000.
INX's gross profit on its service component increased $363,000, from ($39,000)
to $324,000, and service gross margin improved from (8.2%) to 35.5%, as a result
of increased service revenue of $436,000 with a somewhat fixed cost of service
component due to improved utilization of technical personnel.
Stratasoft gross profit decreased by $93,000, or 7.3%, from $1.3 million
to $1.2 million. Stratasoft's gross margin decreased from 61.3% to 55.0%.
Stratasoft gross profit was impacted by the mix of sales between "systems
sales", which include a hardware component, as compared to "software only"
sales, which do not have a hardware component. Stratasoft's decreased gross
profit is primarily due to a decreased "software only" component relative to the
"systems sales" component of total Stratasoft sales. Software only sales include
sales to reseller customers and do not require the continuing involvement of our
personnel.
Valerent gross profit increased by $129,000, or 56.3%, from $229,000 to
$358,000. Valerent's gross margin increased from 22.8% to 26.2%. Valerent's cost
of service consists primarily of fixed labor cost that does not fluctuate
directly with changes in revenue. Valerent improved its utilization of its labor
pool by reducing the number of technicians employed, relative to revenue, and
lowered its fixed cost, which contributed to improved gross profits.
22
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $123,000, or 3.6% from $3.4 million to $3.5
million. As a percentage of total revenue, these expenses decreased 9.0%, from
33.5% to 24.5%. Sales compensation increased $461,000 due to additional
personnel as the result of the Digital Precision acquisition in April 2003 and
increased commissions generated from the increase in gross profit, and it also
includes approximately $100,000 in earned commissions by sales personnel in
association with the Cisco vendor incentive program. Bad debt expense decreased
$664,000 due to recoveries of bad debt and decreases in allowances based on the
aging of receivables and credit worthiness of customers. Legal and professional
fees increased $88,000 primarily from the amortizaion of prepaid consultant
expenses of $91,000, which was offset by a $20,000 decrease resulting from the
revaluation of a non-employee stock option compensation for a different
consultant in addition to a $3,000 decrease in various attorney fees for
collection matters for a total net increase of $68,000. Administrative
compensation expense increased $168,000 due to hiring additional INX and
Stratasoft personnel in Houston, Texas, Dallas, Texas, Canada, India and the
addition of Austin, Texas office resulting from the Digital Precision
acquisition of April 2003. Payroll tax expense increased $34,000 in line with
the increase in compensation expenses. Employee benefits increased $39,000 as a
result of additional personnel and policy rate changes. Contract labor expense
decreased $46,000 primarily from Stratasoft terminating contract labor in India.
Travel expense decreased $14,000 due to reduced Stratasoft international travel
and INX travel for technical staff and management. General office expenses
increased $48,000 due to increased printing and general Company growth.
Insurance expense decreased $50,000 because of policy and rate changes.
Shareholer relations expense increased $56,000, due to employing a shareholder
relations firm, attending investor conferences and visiting investor groups,
however this expense was partially offset by a $43,000 reduction related to the
revaluation of the non-employee stock option compensation for the investor
relation consultant for an overall net increase of $13,000. Depreciation expense
increased $36,000 due to asset additions and the Digital Precision acquisition
in April 2003. Rents increased $51,000 due to additional office space in Austin,
Texas and Dallas, Texas resulting from the Digital Precision acquisition in
April 2003. Advertising and promotion decreased $23,000 because Stratasoft
decreased its promotion expense. Other corporate expenses increased $2,000 due
to company growth.
Operating Profit. Operating profit increased $1.1 million, or 103.4% from
a $1.1 million loss to a $37,000 profit, primarily due to the $1.2 million
increase in gross profit being offset by the $123,000 increase in selling,
general and administrative expenses. INX's operating profit increased $286,000,
or 171.3% from a loss of $167,000 to a profit of $119,000. Stratasoft's
operating profit increased $483,000, or 147.3% from a loss of $328,000 to a
profit of $155,000. Valerent's operating loss decreased $299,000 or 90.3%, from
$331,000 to $32,000. The operating loss for the Corporate Segment decreased
$70,000, from a loss of $275,000 to a loss of $205,000.
Interest and Other Income, Net. Interest and other income, net, increased
by $9,000, from $10,000 to $19,000, primarily due to an increase in interest
income of $50,000 from $ - to $50,000 on notes receivables and a foreign
transaction gain increase $18,000 from $0 to a gain of $18,000 which was offset
by a loss of $22,000 on the disposal of fixed assets resulting from the
downsizing of Stratasoft's operations in India and an increase in interest
expense of $22,000 from $5,000 to $27,000 due to increased borrowings used to
finance inventory purchases related to increased business activity. Our
borrowings under the Textron credit facility decreased from $7.6 million to $6.9
million while the interest bearing portion of our borrowings decreased from $1.7
million at December 31, 2003 to $1.2 million at March 31, 2003.
Net income. Net income increased $1.1 million, or 103.6% from a $1.1
million net loss to a $39,000 net income. The income tax expense for the period
was $5,000, and there is a net operating tax loss carryforward of approximately
$2.4 million as of March 31, 2004
Discontinued Operations. During 1999, we discontinued our Telecom Systems
business. On March 16, 2000, we entered into an agreement to sell certain assets
of, and the ongoing operation of, our Computer Products Division. The sale
transaction closed on May 19, 2000. On December 31, 2000, we sold our IT
Staffing business. As a consequence of these events, the operations of these
businesses are reported as discontinued operations. For the quarter ended March
31, 2003, the gain (loss) on disposal related to these three businesses was
($5,000), $5,000 and $0, net of taxes and tax benefits of ($3,000), $2,000 and
$0, for a net total of $0. For the quarter ended March 31, 2004 the loss on
disposal related to these three businesses was $3,000, $9,000 and $0, net of tax
benefits of $1,000, $4,000 and $0, for a total loss of $12,000. The gains and/or
losses on disposal in 2003 related to these discontinued operations are
primarily related to collections of accounts receivables retained when these
businesses were sold. The expense in 2004 relates to legal expenses associated
with pending litigation.
23
LIQUIDITY AND CAPITAL RESOURCES
Sources of Liquidity
Our principal sources of liquidity are collections from our accounts and
notes receivable, and our credit facility with Textron Financial Corporation
(the "Textron Facility"). We use the Textron Facility to finance the majority of
our purchases of inventory, and to provide working capital when our cash flow
from operations is insufficient. During the three month period ending March 31,
2004, we experienced positive cash flow from operating activities of $142,000 as
compared to negative cash flow of $1.0 million for the three months ended March
31, 2003. Our working capital was $3.7 million and $3.5 million at December 31,
2003 and March 31, 2004, respectively.
Accounts and Notes Receivable. The timing of our collection of accounts
and notes receivable and payments of our accounts payable is one of the
principal influences on our cash flow from operations. We typically sell our
products and services on short-term credit terms. We try to minimize our credit
risk by performing credit checks, obtaining letters of credit in certain
instances, and conducting our own collection efforts.
We had accounts receivable, net of allowance for doubtful accounts, of
$9.8 million and $9.4 million at December 31, 2003 and March 31, 2004,
respectively.
Our Stratasoft subsidiary has accepted customer notes receivable as part
of its consideration for certain of its custom projects sales. At December 31,
2003 and March 31, 2004, Stratasoft had net notes receivable of $928,000 and
$1.2 million, respectively. The following table shows the breakdown of the total
notes receivable:
DECEMBER 31 MARCH 31
2003 2004
----------- --------
(DOLLARS IN THOUSANDS)
Current portion of notes receivable, gross .. $ 1,049 $ 1,404
Allowance for doubtful notes ................ (373) (342)
------- -------
Current portion of notes receivable, net .... 676 1,062
------- -------
Long term portion of notes receivable, gross 502 375
Allowance for doubtful notes ................ (250) (250)
------- -------
Long-term portion of notes receivable, net .. 252 125
------- -------
Total notes receivable, net ................. $ 928 $ 1,187
------- -------
Alternatively, our Stratasoft subsidiary also has other sales that require
payment to occur after more than 90 days but less than twelve months from the
date of the sale. Those outstanding balances are classified as accounts
receivable on the accompanying balance sheets.
Inventory. We had inventory of $1.0 million and $1.3 million at December
31, 2003 and March 31, 2004, respectively. We try to minimize the amount of
inventory on hand to reduce the risk that the inventory will become obsolete or
decline in value. We have been able to do this by relying on the ready
availability of products from our principal suppliers. As noted above, we rely
principally on our Textron Facility to finance our inventory purchases.
Textron Facility. On January 31, 2002, we entered into the Textron
Facility to provide financing for our inventory purchases. The total credit
available under the Textron facility, as amended, is $15 million and it is
collateralized by substantially all of our assets other than our patent
licenses.
As of March 31, 2004, we owed $6.9 million under the Textron Facility and
had an additional $8.1 million available subject to borrowing base restrictions.
The borrowing base amount under the Textron facility is generally the sum of 80%
of eligible accounts receivable (the "Accounts Advance Amount") plus the lesser
of: (a) 90% of eligible inventory purchased by us from manufactures with whom
Textron has acceptable repurchase agreements, plus 40% of other eligible
inventory; (b) $4,000,000; or 30% of the Accounts Advance Amount. An account
receivable will not qualify as an eligible accounts receivable if, among other
things, it is not paid within 90 days after our invoice date, the customer has
failed to pay more than 25% of all accounts receivable owed by the customer to
us within 90 days after the invoice date, or to the extent that the customer's
total accounts receivable exceed 15% of all of our eligible accounts receivable.
We use the Textron Facility to finance purchases of Cisco products from
Cisco and from certain wholesale distributors. Cisco provides 60-day terms, and
other wholesale distributors typically provide 30-day terms. Balances under the
Textron Facility that are within those respective 60- and 30-day periods (the
"Free Finance Period") do not accrue interest and are classified as accounts
payable in our balance sheet. We refer to non-interest bearing balances as
"inventory floor plan borrowings."
24
To the extent that we can borrow under the Textron Facility, it gives us
the ability to extend the payment terms past the Free Finance Period. Amounts
extended past the Free Finance Period accrue interest and are classified as
notes payable on our balance sheet. These extended payment balances under the
Textron Facility accrue interest at the prime rate (4.0% at March 31, 2004) plus
2.5%. Working capital advances under the Textron Facility accrue interest at the
same rate as extended payment balances. Because payment cycles of sales to
school districts under the eRate program extend beyond 60 days, we expect we
will continue to carry extended payment balances under the Textron Facility
during 2004. The total outstanding balance under the Textron Facility at March
31, 2004 was $6.9 million. Approximately, $5.7 million of that was within the
Free Finance Period and therefore is reflected as accounts payable on our
balance sheet at March 31, 2004 and approximately $1.2 million consisted of
extended payment balances that bear interest and therefore is reflected as notes
payable on our balance sheet at March 31, 2004.
The Textron Facility contains restrictive covenants that are measured at
each quarter end. These covenants require us to:
o maintain Minimum Tangible Capital Funds of $2.2 million, which
is defined to be the sum of cash, trade accounts receivable,
inventory and fixed net assets, minus subordinated liabilities
minus total liabilities, with total liabilities being defined
as accounts payable, accrued expenses and short- and long-term
notes payable;
o maintain a maximum Debt to Tangible Capital Funds ratio of 6.0
to 1; and
o to achieve a fixed charge coverage ratio of no less than 1.1
to 1.0, the fixed charge coverage ratio being defined as (a)
quarterly net income plus interest expense, taxes, and lease
and rental expense divided by (b) [the sum of] (1) quarterly
interest expense, lease and rental expense, and (2) quarterly
current maturities of long-term debt divided by 1-tax rate.
At March 31, 2004, we were in compliance with the loan covenants, and we
anticipate that we will be able to comply with the loan covenants during the
next twelve months. If we violate any of the loan covenants, we would be
required to seek waivers from Textron and Silicon Valley Bank for those
non-compliance events. If Textron or Silicon Valley Bank refused to provide
waivers, the amount due under the Textron Facility could be accelerated and we
could be required to seek other sources of financing.
Contractual Obligations
The following table summarizes certain of our contractual cash obligations
and related payments due as of March 31, 2004:
PAYMENTS DUE BY PERIOD
--------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
LESS THAN 1
CONTRACTUAL OBLIGATIONS TOTAL YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS
- ------------------------------------- ------ ------ --------- ---------- -------------
Lease obligations ................... $1,569 $ 418 $1,151 $ -- $ --
Textron, interest bearing debt ...... 1,204 1,204 -- -- --
Other debt obligations
299 95 204 -- --
------ ------ ------ --------- ---------
$3,072 $1,717 $1,355 $ -- $ --
------ ------ ------ --------- ---------
During the second quarter of 2004 the INX and Valerent Dallas offices will
occupy new office space under a six year lease obligation. Expected payments for
base lease obligation are approximately $ - for 2004, $157,000 for 2005,
$205,000 for 2006, $241,000 for 2007, $255,000 for 2008, $264,000 for 2009 and
$110,000 for 2010. The approximate previous annual lease payment for the INX was
$108,000.
We do not have any material contractual purchase obligations. We purchase
inventory to fulfill in-hand orders from customers and we try to minimize the
amount of inventory on hand to reduce risk that the inventory will become
obsolete or decline in value. We are able to do this by relying on the ready
availability of products from our principal suppliers.
We expect to be able to meet our contractual cash payment obligations by
their due dates through cash generated from operations, augmented, if needed, by
borrowings under the Textron Facility, and through the proceeds from this
offering.
Cash Flows. During the first quarter of 2004, our cash decreased by
$448,000. Operating activities provided $142,000, investing activities used
$139,000 and financing activities used $451,000.
25
Operating Activities. Operating activities provided $142,000 in the first
quarter of 2004 as compared to using cash of $1.3 million in 2003. The cash
provided in 2004 was primarily related to the net income of $39,000. Adjustments
to the net income for non-cash expenses included a reduction of bad debt expense
of $182,000, which was attributable to recovery of bad debt and decreases in
allowances for notes receivable and the allowance for doubtful accounts
receivable due to the shorter aging periods.
Changes in asset and liability accounts used $19,000. The most significant
use related to an increase in net working capital used for contracts in
progress which increased $902,000 due to an increase in cost and estimated
earnings in excess of billings of $752,000, which was primarily related to
an increase in the Stratasoft custom projects in process at quarter-end.
Inventory increased $277,000 primarily due INX staging Cisco products for
upcoming projects. Accrued expenses increased primarily for accrued sales
commissions and other payroll related costs. These uses of cash were
partially offset by an increase in accounts payable of $618,000, which
related primarily to increased purchases of Cisco products for sales by
INX. The decrease in other current assets of $245,000 primarily related to
the return of bid deposits for INX bids on school projects. The decrease
in accounts receivable of $431,000 was partially related a $91,000
reclassification of an INX account receivable to a note receivable and
partially related to improved collections during March 2004. Days sales
outstanding increased by 3 days from December 31, 2003 to 60 days at March
31, 2004. In addition, deferred revenue increased $180,000 for software
products sold on a note that was not due within twelve months of the note
origination. Revenue from this sale will be recognized in the accounting
periods that payments from the customer are received.
Investing Activities. Investing activities used $139,000 in 2004 compared
to a use of $173,000 for 2003. Our investing activities related to capital
expenditures in both periods were primarily related to purchases of computer
equipment and software, and to a lesser degree, leasehold improvements. During
the next twelve months, we do not expect to incur significant capital
expenditures requiring cash, except possibly for acquisitions, of which we
cannot predict the certainty or magnitude.
Financing Activities. Financing activities used $451,000 in 2004 as
compared to using $67,000 in 2003. In 2003, our stock price increased
substantially, resulting in stock option holders exercising stock options, which
provided $59,000.
During January 2004, the company repaid $1.7 million of interest-bearing
debt under the Textron Facility, however, at March 31, 2004, $1.2 million of
debt under the Textron Facility was interest-bearing and was classified as notes
payable rather than accounts payable.
On May 12, 2004 we closed a public offering of 500,000 Units. The Units
began trading on May 7, 2004, on the American Stock Exchange under the symbol
ISR.U. Each Unit consists of two shares of common stock and one warrant to
purchase one share of common stock at a price of $12.45. The Units were offered
at a public offering price of $16.60 per Unit resulting in $6.5 million in
estimated net proceeds. The underwriters have an option to purchase up to 75,000
additional Units to cover over-allotments. We intend to use the net proceeds of
this offering primarily for working capital and to repay interest-bearing debt
RELATED PARTY TRANSACTIONS
We lease office space from Allstar Equities, Inc., a Texas corporation
("Equities"), a company wholly owned by James H. Long, our chief executive
officer. On December 1, 1999 Equities purchased our corporate office building
and executed a direct lease with us with an expiration date of December 31,
2004. In conjunction with Equities obtaining new financing on the building, a
new lease was executed with us on February 1, 2002 with an expiration date of
January 31, 2007. The new lease has a rental rate of $37,192 per month.
From time to time we make short-term loans and travel advances to our
employees. The balance of approximately $16,000 and $6,000 relating to these
loans and advances is included in the Company's balance sheet and reported as
part of Accounts receivable - affiliates at December 31, 2003 and March 31,
2004, respectively.
26
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We incur certain market risks related to interest rate variations because
we hold floating rate debt. Based upon the average amount of debt outstanding
during the three months ended March 31, 2004, a one-percent increase in interest
rates paid by us on our floating rate debt would not have resulted in an
increase in interest for the period.
Our business depends upon our ability to obtain an adequate supply of
products and parts at competitive prices and on reasonable terms. Our suppliers
are not obligated to have product on hand for timely delivery to us nor can they
guarantee product availability in sufficient quantities to meet our demands.
INX's business is Cisco centric. Any material disruption in our supply of
products could have a material adverse effect on our financial condition and
results of operations.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of certain members of our
management, including our Chairman of the Board, Chief Executive Officer and
principal financial officer, we completed an evaluation of the effectiveness of
the design and operation of our disclosure controls and procedures (as defined
in Rules 13a-15(e) and 15d-15(e) to the Securities Exchange Act of 1934, as
amended (the "Exchange Act")). Based on that evaluation, we and our management
have concluded that, except as discussed in the following paragraph, our
disclosure controls and procedures at the end of the period covered by this
report were effective to ensure that information required to be disclosed by us
in the reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
rules and forms of the SEC, and are designed to ensure that information required
to be disclosed by us in these reports is accumulated and communicated to our
management, as appropriate to allow timely decisions regarding required
disclosures.
Grant Thornton LLP ("Grant Thornton"), our independent accountants,
identified and reported to the audit committee of the board of directors certain
internal control deficiencies that Grant Thornton considered to be significant
deficiencies under the standards established by the American Institute of
Certified Public Accountants and the SEC. The identified internal control
deficiencies relate to (i) a material weakness involving contemporaneous
documentation of all terms related to revenue transactions and conclusions
regarding customer creditworthiness and (ii) a significant deficiency with
respect to the review of significant agreements by our accounting personnel in
order to monitor compliance with their terms.
We took corrective actions to address these internal control deficiencies,
by implementing the following measures:
o established improved procedures for the review of revenue
recognition policies and contract management polices and procedures;
o held formalized training of finance and sales staff; and
o hired an additional person in our accounting department.
In the first quarter of 2004, there have been no other changes in our
internal control over financial reporting that have materially affected, or are
likely to affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In August 2002, Inacom Corp. ("Inacom") filed a lawsuit in the District
Court of Douglas County, Nebraska styled Inacom Corp v. I-Sector Corporation,
f/k/a Allstar Systems, Inc., claiming that I-Sector owed the sum of
approximately $570 to Inacom as a result of Inacom's termination of a Vendor
Purchase Agreement between Inacom and I-Sector. I-Sector believes that the claim
is without merit and intends to vigorously contest the demand.
27
In March 2003, I-Sector and other parties were notified of a demand for
return of payments relating to the business activities of a call center
customer. In March 2004, I-Sector was informed by the claimant that claims will
not be pursued at this time. I-Sector believes that the claims against it, if
re-initiated, are without merit and intends to vigorously contest any demands
related to this matter.
I-Sector is also party to other litigation and claims which management
believes are normal in the course of its operations. While the results of such
litigation and claims cannot be predicted with certainty, I-Sector believes the
final outcome of such matters will not have a materially adverse effect on its
results of operations or financial position.
ITEM 2. OTHER INFORMATION
None
ITEM 6. EXHIBITS
Exhibit 1.1 Underwriting Agreement by and between Paulson Investment Company,
Inc. and I-Sector Corporation dated May 6, 2004 **
Exhibit 1.2 Amendment to Underwriting Agreement by and between Paulson
Investment Company, Inc. and I-Sector Corporation, dated May 7,
2004 **
Exhibit 4.1 Specimen Unit Certificate **
Exhibit 4.2 Warrant Agreement, including Specimen Warrant Certificate by and
between I-Sector Corporation and American Stock Transfer & Trust
Company, dated May 7, 2004 **
Exhibit 4.3 Purchase Warrant issued to Paulson Investment Company, Inc. by
I-Sector Corporation, dated May 7, 2004 **
Exhibit 4.4 Purchase Warrant issued to Pali Capital, Inc. by I-Sector
Corporation, dated May 7, 2004 **
Exhibit 4.5 Purchase Warrant issued to S.W. Bach & Company by I-Sector
Corporation, dated May 7, 2004 **
Exhibit 31.1 Certification of CEO & CFO pursuant to Rule 13a-14(a) *
Exhibit 32.1 Certification pursuant to 18 U.S.C. Sec. 1350 *
* Filed herewith
** Previously filed with the Company's Quarterly Report on Form 10-Q, dated
May 17, 2004
28
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
I-Sector Corporation.
Date: May 27, 2004 By: /s/ JAMES H. LONG
------------------------------
James H. Long, Chief Executive Officer,
Chief Financial Officer, and
Chairman of the Board
By: /s/ JEFFREY A. SYLVESTER
-----------------------------------
Jeffrey A. Sylvester, Secretary and
Controller
29
EXHIBIT INDEX
Exhibit 1.1 Underwriting Agreement by and between Paulson Investment Company,
Inc. and I-Sector Corporation dated May 6, 2004 **
Exhibit 1.2 Amendment to Underwriting Agreement by and between Paulson
Investment Company, Inc. and I-Sector Corporation, dated May 7,
2004 **
Exhibit 4.1 Specimen Unit Certificate **
Exhibit 4.2 Warrant Agreement, including Specimen Warrant Certificate by and
between I-Sector Corporation and American Stock Transfer & Trust
Company, dated May 7, 2004 **
Exhibit 4.3 Purchase Warrant issued to Paulson Investment Company, Inc. by
I-Sector Corporation, dated May 7, 2004 **
Exhibit 4.4 Purchase Warrant issued to Pali Capital, Inc. by I-Sector
Corporation, dated May 7, 2004 **
Exhibit 4.5 Purchase Warrant issued to S.W. Bach & Company by I-Sector
Corporation, dated May 7, 2004 **
Exhibit 31.1 Certification of CEO & CFO pursuant to Rule 13a-14(a) *
Exhibit 32.1 Certification pursuant to 18 U.S.C. Sec. 1350 *
* Filed herewith
** Previously filed with the Company's Quarterly Report on Form 10-Q, dated
May 17, 2004