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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10 - K
Annual Report pursuant to Section 13 or 15 (d) of the Securities Exchange Act
of 1934
For the Year Ended December 31, 1996
Commission file number 0-11630
INTELECT COMMUNICATIONS SYSTEMS LIMITED
(Exact Name of Registrant as Specified in Its Charter)
BERMUDA N/A
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1100 EXECUTIVE DRIVE, RICHARDSON, TEXAS 75081
(Address of Principal Executive Offices) (Zip Code)
972-437-1888
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12 (b) of the Act
NONE
Securities registered pursuant to Section 12 (g) of the Act
COMMON SHARES PAR VALUE US$0.01 PER SHARE
(Title of Class)
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
------ ------
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [ ]
The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $40,726,569 as of March 31, 1997 (based upon the
average of the highest bid and lowest asked prices on such date as reported on
the Nasdaq National Market).
There were 17,148,029 shares of Common Stock outstanding as of March 31, 1997.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed pursuant to
Regulation 14A not later than 120 days after the end of the fiscal year
(December 31, 1996) are incorporated by reference in items 10, 11, 12 and 13 of
PART III hereof.
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PART I
ITEM 1 - BUSINESS
INTRODUCTION
Intelect Communications Systems Limited, a Bermuda company ("Intelect"
or the "Company"), designs, manufactures and sells information technology
products and services focusing on (i) switching products, (ii) network
transmission products and (iii) videoconferencing products. Through its
product lines, the Company believes that it can enable its customers -- public
and private network operators -- to provide enhanced services at reduced costs.
The Company's fiber optic, SONET-based multiplexing network
transmission product, known as SONETLYNX, which the Company began shipping in
July 1996, simultaneously supports voice, data, video and local or wide area
networking connectivity with one centralized network management system. The
Company's LANscape videoconferencing systems provide near television quality
video and audio and support both traditional video and audio conferences as
well as PC software functionality. Commercial shipments of these systems in
sample quantities began in June 1996. The Company's S4 Special Services
Switching System ("S4") is a multimedia, digital voice/data switch used
primarily for air traffic control, air defense, teleconferencing and other
mission critical applications. The S4 has been commercially marketed by the
Company since September 1995. The Company also provides a full range of
support for the design, development, testing and evaluation of advanced
telecommunications software, hardware, and products to customers in the
telecommunications industry and for the Company's ongoing product development
activities.
The Company is developing an intelligent, programmable switch,
designated CS4, to meet the demand for a distributed reliable network
architecture and to provide advanced intelligent call and service applications
for public and private wireline and wireless communications networks. This
switch is based on the architecture of the S4. The Company currently expects
the development program to lead to commercial availability in 1998, subject to
availability of financing and/or a development partner.
PRODUCTS AND SERVICES
Network Transmission Products
In the first quarter of 1996, the Company introduced its fiber optic,
SONET-based multiplexing network transmission products, known as SONETLYNX,
which combine transmission, multiplexing and protocol conversion in a single
unit. SONETLYNX is a SONET/SDH-based OC-1 or OC-3 bandwidth digital
multiplexer that simultaneously supports voice, data, video and local or wide
area networking connectivity with one robust centralized network management
system. SONETLYNX seeks to complement the reliability of fiber with the
redundancy built into its critical components, including the backplane and
control modules. A SONETLYNX network can be as basic as two nodes or expand to
a virtually unlimited number of nodes at different geographic locations. A
node consists of a 14 or 17 module chassis, containing one or more protocol
interface cards. Node design incorporates universal module slots so that any
protocol or auxiliary module fits in any slot, minimizing the investment in
hardware. Configuration, monitoring and maintenance of every SONETLYNX module
in every SONETLYNX node is managed from one central location. SONETLYNX's
modular design facilitates the expansion of any SONETLYNX network by installing
a small, cost-effective and extremely adaptable module into the node. In the
event of transmission
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difficulties, protection switching occurs in under 50 milliseconds and is
virtually transparent to network traffic. The SONETLYNX Network Management
System ("NMS") provides comprehensive network control over networks using
SONETLYNX. The NMS operates in the Microsoft Windows or Windows for Workgroups
environments over Hewlett-Packard's OpenView. The Company plans to expand the
NMS in 1997 to accommodate the Interexchange and Competitive Access
environments on a UNIX platform.
SONETLYNX complies with the OC-1 and OC-3 SONET/SDH standards as
defined by the American National Standards Institute ("ANSI") and the
International Telecommunications Union ("ITU"). SONET/SDH are the current
fiber optic standards, which the Company believes will continue as standards
for the foreseeable future. The Company believes that products adhering to
these specifications provide the open connectivity and data rates that network
managers require.
The Company released OC-1 SONETLYNX products during 1996, including
T1, Voice, 2 wire and 4 wire FXO, FXS and low speed data (RS232, RS422, RS449,
V.35). The Company intends to add ethernet and video interfaces and OC-3
versions of the products in 1997 as well as options permitting interoperability
with the public switched network. Ethernet will enable LANscape to operate
with SONETLYNX.
Videoconferencing Products
The Company designs, manufactures, markets and sells its LANscape
videoconferencing systems for use in the boardroom, roll about and desktop
environments. Sales of the Company's videoconferencing systems commenced in
sample quantities in June of 1996. The Company believes that its proprietary
video transmission and compression/decompression techniques provide exceptional
picture and audio quality. The Company has designed its videoconferencing
systems to include (i) standard interfaces in order to permit compatibility
with "legacy" videoconferencing systems of other providers and (ii) features
that allow operation on various operating systems.
The Company's videoconferencing products support both traditional
video and audio conferences and PC software functionality, such as the
transmission of data, text, and graphics. The products are the LANscape(TM)
and Panorama(TM) desktop communications product and the VuBridge(TM) gateway
product.
LANscape(TM) is a desktop video communications product that combines
boards that fit into the customer's computer with software. It uses the TCP/IP
protocol and M-JPEG video compression to allow users within a local-area
network ("LAN") to communicate using real-time video and audio. The key
feature of this product is superior quality video over the LAN, especially when
compared to the ISDN H.320 standard now prevalent on the desktop.
Panorama(TM) is a desktop video communications product that
communicates over specialized (ISDN) telephone lines and uses the standard
H.320 protocol to communicate with other users whose hardware supports the same
standard. The key feature of this product is its ability to interchange
information with a wide range of other products.
The VuBridge(TM) gateway and conference manager is a hardware and
software product that allows the LANscape user to communicate with H.320 ISDN
systems. VuBridge(TM) provides the translation between compression algorithms
and the network signaling bridging that is needed to convert the LAN TCP/IP
packets to an H.320 encoded ISDN stream.
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Switching Products
Voice/Data Switches
The Company designs, manufactures, markets and sells the S4
Special Services Switching System, a digital voice/data switch used primarily
for special service applications such as air traffic control, air defense,
teleconferencing and other mission critical applications. Commercial sales of
the S4 commenced in September 1995. The Company believes that the S4
represents the next generation of digital switches to be used to provide
reliable voice, data and video switching and conferencing capabilities in
private or public networks. The S4 incorporates extensive administration and
configuration control, diagnostics, statistical data gathering and alarm
facilities. Both direct access and indirect access modes interface with
intercom, interphone and radio circuits. Consequently, the S4 can interface
with other telephone switches or with any type of telephone or radio circuit,
and is designed to conference together hundreds of outside parties, including
radio circuits, simultaneously at the push of a button. The S4 provides (i)
advanced processing power, (ii) fault-tolerance, (iii) a peer-to-peer multiple
processor architecture allowing simultaneous communications between a large
number of parties, and (iv) switch architecture allowing conferencing of a wide
range of devices, including telephones, radios and communications consoles.
The Company also supports predecessor analog products in the
air traffic control and air defense markets served by the digital S4.
Intelligent Programmable Switches
The Company has previously played a key architectural role in
the development of highly sophisticated public network switching equipment,
including DSC Communications Corporation's Class IV and Class V switches, and
has been retained to assist a major interexchange carrier in the development of
specifications for its future network needs.
The Company is developing an intelligent, programmable switch,
known as the CS4, that is being designed to provide Advanced Intelligent
Network ("AIN") applications for public and private telephone networks and
wireless communications systems. The Company believes that the CS4 switch will
form the foundation for an AIN that will allow network operators to implement
new features and services much more rapidly than with traditional switch
products. The CS4 is being designed to operate individually as an adjunct
processor, intelligent peripheral and service switching point or as a
combination of all of these elements in a single switch. In 1996, the Company
brought the development project to the prototype stage. The first beta site
models of the CS4 are currently planned for late 1997 and commercial production
is currently anticipated in 1998. Scheduling of CS4 development and
achievement of these milestones are contingent on the availability of
additional financing and/or a development partner that can bring marketing
support as well as funding to the project.
The CS4 is based on a revolutionary architecture to meet an
aggressive cost goal, but the Company believes it can leverage the strengths of
the existing S4 to assist in the development of the CS4. Control configuration
information is sent among parts by separate redundant packet buses and each
part is assigned its own discrete time slot on a bus, thereby eliminating
traditional blocking between switches. The Company's currently projected
hardware architecture goals for the CS4 include 2,000 ports per node,
expandable to 32,000 ports, and Enhanced Digital Signal Processor ("DSP")
design and multiple redundancy options. Currently projected software
architecture goals for the CS4 include Signalling System 7 (SS7
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advanced network protocol built on distributed architecture), integrated voice
prompt and playback, a service creation environment ("SCE") and maintenance
capabilities.
The Company anticipates that the CS4 pricing will be competitive and
will be based on the number of ports supported by the switch.
Advanced Information Technology Products and Services
The Company provides a full-range of support for the design,
development, testing, and evaluation of advanced telecommunications products to
customers in the telecommunications industry, such as DSC Communications and
many smaller companies. The Company offers a broad array of products and
services to the telecommunications industry, ranging from concept evaluation to
full system development. The Company's products include software technology,
hardware technology, systems architecture and custom DSP product design
services for clients who wish to use the Company's experience to reduce their
time-to-market for DSP-based systems.
Digital Signal Processing Products
The Company's DSP product group design center seeks to develop
state-of-the-art DSP computing products for off- the-shelf sale through
distribution channel partners. DSP microprocessors have progressed to the
point where multimedia processing is now possible with DSP processors such as
the Texas Instruments TMS320C80. The Company's standard DSP products are based
on the TMS320C80, which enables users to effect complex processing functions
involving voice, data, image, and video signals in a flexible, programmable
environment. This multimedia processing capability is provided within standard
PCI and VME bus architectures in the Company's DSP board products, which serve
a wide range of functions such as videoconferencing, image enhancement, machine
vision, medical imaging, and digital wireless communications.
ENGINEERING AND DEVELOPMENT
The Company seeks to maintain the capability to design leading edge
telecommunications equipment for switching, transmission, and videoconferencing
applications.
The present portfolio of SONETLYNX capabilities was achieved by
spending $2,857,000 on product development in 1996. The OC-3, video, and
Public Switched Telephone Network ("PSTN") interoperability improvements
scheduled for 1997 are expected to cost an additional $3,700,000. This
spending will also support path switching, interface to OC-12 and other
features which will not impact sales until after 1997.
The S4 switching product was sustained by development spending of
$300,000 in 1996.
CS4 development described above ("Intelligent Programmable Switches")
was brought to the prototype stage at the end of 1996 at an expense to date of
$5,804,000. The Company plans during 1997 to spend at least an additional
$6,000,000 to bring the product into beta test with one or more customers in
"live" applications. Achievement of this development schedule is contingent on
the participation of a partner or alliance that can bring marketing support as
well as funding to the project.
LANscape and VuBridge videoconferencing systems were materially
modified and improved, at a cost of $1,875,000, from technology acquired during
1996. Present versions of the products operate in the
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Microsoft Windows 3.X and 95 environments. The Company is extending that
compatibility to the Windows NT operating system to capitalize on the full
range of private network opportunities.
The DSP product line was initiated at a cost of $239,000 in 1996. The
Company plans to add industry-leading designs, including a quad, C80 processor
board and one of the first products to use the Texas Instruments TMS320C6X.
MARKETS AND CUSTOMERS
Switching Products
The Company generally markets its S4 switching products through system
integrators and directly through its own sales force, enhanced by attendance at
trade shows and by advertising.
Voice/Data Switches (S4)
The Company's S4 customers generally are large systems
integrators, distributors and end users. They include GTE, Westinghouse,
Hughes Aircraft Company, Lockheed Missiles & Space Company, the United States
Government and numerous international customers, including the Iceland CAA,
Siemens, Newcastle UK Airport, the Indonesian Air Force, the Aruba CAA, and US
West.
Commercial Programmable Switch Systems (CS4)
The initial target markets and customers for the CS4 are
expected to include IXCs, LECs and Wireless/PCS providers. Although the
primary application is designed to be a Computer Telephony Integration ("CTI")
system, specific feature development will vary depending on specific customers
and markets.
Network Transmission Products
The Company markets its network transmission product (SONETLYNX)
directly and through VARs. SONETLYNX is targeted for markets and applications
where multiple protocol communication mandates the capacity and reliability of
fiber, further strengthened by the critical component and architectural
redundancy of SONETLYNX. Target markets for SONETLYNX include utilities,
airports, transportation, security services, prisons, health services,
academia, local and state government, as well as public and private bypass
networks.
Videoconferencing Products
The Company generally markets its videoconferencing products (IVC
product line) through VARs. The Company believes that the key target markets
for its videoconferencing products are businesses that are geographically
dispersed (particularly Fortune 1000 companies and educational and government
institutions).
Advanced Information Technology Products and Services
The Company generally markets its advanced information technology
products and services through direct marketing to existing customers and new
prospects, enhanced by participation in tradeshows. Markets for advanced
technology products and services include internationally known
telecommunications switching
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companies, telecommunications network providers, and hardware and software
companies desiring to develop or enhance products for the telecommunications
market.
COMPETITION
The market for the Company's products and services is intensely
competitive and rapidly changing. The Company competes, or may in the future
compete, directly or indirectly for customers in the following categories of
companies: (i) voice-data switch manufacturers such as Thomson CSF, Inc., Denro
Inc. and Frequentis; (ii) intelligent programmable switch manufacturers such as
Summa Four, Inc. and Excel; (iii) network transmission product manufacturers
such as AT&T Network Systems, Prism Systems, Inc. and Positron Fiber Systems;
(iv) videoconferencing product manufacturers such as PictureTel, Compression
Laboratories, Inc., VTEL Corporation, and Intel's ProShare Video System; and
(v) advanced information technology products manufacturers and service
providers such as DGM&S. The Company believes that the principal competitive
factors affecting the market for its products and services include
effectiveness, scope of product offerings, technical features, ease of use,
reliability, customer service and support, distribution channels and price.
Certain competitors have greater resources than the Company and, accordingly,
may have a competitive advantage in selling and in product development.
MANUFACTURING
The basis of the Company's manufacturing strategy is to identify and
use the appropriate technology to obtain the most favorable combination of
quality and end product cost.
The Company's products consist largely of assembled printed circuit
boards. These are sold either as stand- alone products (such as LANscape) or
as larger assembled systems (such as S4 switches or SONETLYNX multiplexers).
The cost of printed circuit board assembly varies significantly by
technology. With the introduction of Surface-Mount Technology ("SMT"), printed
circuit boards are now robotically assembled. The low cost and low labor
content of SMT manufacture are changing the economics of electronic assembly,
making onshore SMT assembly cost- competitive with offshore assembly.
In early 1996, the Company determined that prices of equipment
designed for the low-volume, intermittent production market had reached a point
where it was economically beneficial to install in-house SMT manufacturing
capacity.
Savings from the installation of this equipment are realized in direct
improvements in board assembly cost, in the avoidance of markup on the purchase
of production tooling, in a reduction in the amount of inventory required to
support production, in an improvement in the cycle time of both production and
prototype material, and in an improvement in product quality.
During 1996, the Company started to implement the process of automated
in-circuit testing ("ICT") as an integral part of the manufacture of the
assembly of printed circuit boards. In this process, the boards are
electrically tested as an integral part of assembly. Since ICT is an automated
test methodology, the cost per board tested is significantly lower than if a
similar test is manually performed. During 1997, the Company plans to continue
this effort. In-circuit test is expected to be developed as a matter of course
for all new products and tests are expected to be developed retroactively for
all older products where the volume of production warrants the investment.
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As the Company's product lines expand and mature, the Company expects
to increase manufacturing capacity by means that could include adding
employees, expanding its current facilities or leasing or purchasing additional
facilities and expanding and adding outsourcing relationships (See
"Properties").
The Company buys a fiber optic interface card, for the SONETLYNX OC-3
product, from a small company which is the sole source for the component. The
Company also buys a video codec card, used in SONETLYNX video applications,
from another small company which is the sole source. Delays in delivery of
either component would restrict the Company's ability to increase sales. In
the event either vendor fails to meet commitments, the Company intends to rely
on its in- house manufacturing capabilities. However, the conversion to
in-house backup supply would not be without some interruption.
The Company uses fiber optic connectors made by a single vendor in the
SONETLYNX OC-3 product. Equivalent components are available from other vendors
but their use would require a redesign of the method of connecting to fiber.
Such a redesign would cause significant delays in delivery of the product.
Accordingly, the Company's strategy is to forecast requirements and build
inventories which comprehend vendor lead times.
INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS
While the Company relies on a combination of patent, copyright,
trademark and trade secret laws and confidentiality procedures to protect its
proprietary rights, the Company believes that factors such as technological and
creative skills of its personnel, new product developments, frequent product
enhancements, name recognition and reliable product maintenance are more
essential to establishing and maintaining a technology leadership position. In
connection with the acquisition of DNA Enterprises and Intelect Visual
Communications, and transactions with certain individuals, licenses were
acquired to support the development of SONETLYNX, videoconferencing, and DSP
products. The Company currently has two United States patents pending relating
to the S4 product, has filed a patent application dealing with the SONETLYNX
product, and anticipates filing patent applications relating to the CS4
technology. "INTELECT(R)", "S4(R)," and "Special Services Switching System(R)"
are registered trademarks of the Company and "SONETLYNX(TM)," "LANSCAPE(TM),"
"VISIONARY(TM)," "VUBRIDGE(TM)," and "PANORAMA(TM)" are trademarks of the
Company in the United States. According to federal and state law, the
Company's trademark protection will continue for as long as the Company
continues to use its trademarks in connection with the products and services of
the Company. The Company seeks to protect its software, documentation and
other written materials under trade secret and copyright laws, which only
afford limited protection.
Litigation may be necessary to enforce the Company's patents and other
intellectual property rights, to protect the Company's trade secrets, to
determine the validity of and scope of the proprietary rights of others, or to
defend against claims of infringement or invalidity. Such litigation could
result in substantial costs and diversion of resources and could have a
material adverse effect on the Company's business, financial condition or
results of operations. If any claims or actions are asserted against the
Company, the Company may seek to obtain a license under a third party's
intellectual property rights. There can be no assurance, however, that a
license will be available under reasonable terms or at all. In addition, the
Company could decide to litigate such claims, which could be extremely
expensive and time consuming and could materially adversely affect the
Company's business, financial condition or results of operations.
The Company incorporates third-party licenses into its products.
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In connection with the acquisition of IVC, certain assets and
licenses, which constituted the design of a videoconferencing product, were
purchased from a major computer company. The design proved to be flawed and
market introduction was delayed approximately nine months. The Company has not
made any payment under the technology license since September 1996 and the
license agreement is in dispute. The Company is seeking to renegotiate the
technology license agreement and believes it has meritorious claims against the
licensor. The ultimate resolution of this matter cannot be predicted but could
result in the loss of the license. See Note 8 to the Consolidated Financial
Statements.
EMPLOYEES
The Company had 273 full-time employees at December 31, 1996, of which
141 were engaged in engineering and development, 49 were engaged in sales,
marketing and customer support, 51 were engaged in manufacturing operations and
32 were engaged in administration and finance. None of the Company's employees
is represented by a labor union. The Company has experienced no material work
stoppages and believes its relations with its employees to be good.
GOVERNMENT REGULATION
The telecommunications industry, including many of the Company's
customers, is subject to regulation from Federal and state agencies, including
the FCC and various state public utility and service commissions. While such
regulation does not affect the Company directly, the effects of such
regulations on the Company's customers may, in turn, adversely impact the
Company's business and results of operations. For example, FCC regulatory
policies affecting the availability of services and other terms on which
telecommunications service providers ("Telcos") conduct their business may
impede the Company's penetration of certain markets. Current FCC regulations
restrict Telcos' ability to charge their customers based on access cost to
local subscribers and may affect the timing of Telcos' investment in the
Company's technology. These FCC regulations and policies are under continuous
review by the federal government and the courts and are subject to change.
Although many FCC restrictions on providing services in previously restricted
markets have been eliminated or modified, the failure to change, or a
substantial delay in changing, the existing restrictions on telcos may
materially adversely affect Telcos' demand for products based upon the
Company's technology.
The Telecommunications Act of 1996 removed certain restrictions
relating to the RBOCs. The Company believes that this has created and will
continue to create increased competition in the markets served by the Company's
products.
In addition, the Company's business and operating results may also be
adversely affected by the imposition of certain tariffs, duties and other
import restrictions on components that the Company obtains from non-domestic
suppliers or by the imposition of export restrictions on products that the
Company sells internationally. Internationally, governments of the United
Kingdom, Canada, Australia, and numerous other countries actively promote and
create competition in the telecommunications industry. Changes in current or
future laws or regulations, in the United States or elsewhere, could materially
and adversely affect the Company's business and results of operations.
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ITEM 2 - PROPERTIES
All of the Company's facilities are leased. The facilities are in
Richardson, Texas, New York, New York, and London, England. The Company's
principal operations are serviced from three leased facilities in Richardson,
Texas (comprising 75,000 square feet) and one in New York (comprising 20,000
square feet). These facilities include manufacturing, engineering, sales,
marketing, and administrative offices. All of the Company's manufacturing
operations are relocating to a 28,000 square foot Richardson, Texas facility.
Recently, the Company moved its headquarters from Hamilton, Bermuda to
Richardson, Texas.
The Company believes these facilities, which total 125,000 square
feet, are adequate for its present needs. However, the Company expects it will
require additional space in 1998 and beyond for sales, manufacturing, and
assembly activities.
ITEM 3 - LEGAL PROCEEDINGS
The Company is involved in various legal proceedings and claims
arising in the ordinary course of business.
In March 1997, Peter G. Leighton, former president, and Rhianon M.
Pedro, former vice president finance, initiated actions against the Company,
seeking damages of $2,130,000 and $150,000, respectively, related to their
separations from the Company. The Company will vigorously contest these
actions. Due to the recent initiation of these actions, the Company cannot
predict their outcome.
The Company is contingently liable for certain potential liabilities
related to its discontinued operations. Specifically, under a stock purchase
agreement dated October 3, 1995 ("1995 Agreement"), the Company agreed to
indemnify Savage Sports Corporation, the purchaser of Savage Arms, Inc. (a
manufacturer of fire arms), for certain product liability, environmental
clean-up costs and other contractual liabilities, including certain asserted
successor liability claims. One of the liabilities assumed involves a firearms
product liability lawsuit filed by Jack Taylor individually and as father of
Kevin Taylor in Alaska Superior Court (the "Taylor litigation"). The Company
is informed that a defendant in the Taylor litigation, Western Auto Supply Co.,
settled the lawsuit for $5 million and, in turn, has asserted a third-party
claim against Savage Arms, Inc. for indemnification in the amount of the
settlement plus attorneys' fees and related costs. Savage Arms has asserted
defenses to the claims and the Company believes additional defenses may be
available. Based on the information available to date, it is impossible to
predict the outcome of this litigation or to assess the probability of any
verdict.
The Company also has been notified that Savage Sports Corporation
seeks indemnification under the 1995 Agreement in connection with certain other
product liability claims. Most notably, the Company has undertaken the defense
of a lawsuit filed against Savage Arms, Inc. by Emhart Industries, Inc.
("Emhart") in the United States District Court for the District of
Massachusetts (the "Emhart litigation"). In the lawsuit, Emhart requests
indemnification under an agreement it allegedly executed in 1981 with Savage
Industries, Inc., an entity Emhart alleges is a predecessor to Savage Arms,
Inc. In particular, to date, Emhart has claimed indemnification of
approximately $2.2 million for five lawsuits it has defended or settled and
also seeks a declaratory judgment that it is entitled to indemnification for
losses and expenses related to firearms product liability actions which may be
filed against Emhart in the future. Savage Arms has asserted the
responsibility of a third party to the 1981 agreement but remains a defendant.
The Company intends to assert additional
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defenses. The parties are in the early stages of discovery and the Company
cannot at this time predict the outcome of the litigation.
In the event the former employee actions, the Taylor litigation and/or
Emhart litigation were to be resolved adversely to the Company, there would be
a material adverse effect on the Company's financial condition and results of
operations. See Note 19 to the Consolidated Financial Statements.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of the Company's security holders
during the fourth quarter of the fiscal year ended December 31, 1996.
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PART II
ITEM 5 - MARKETS FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Shares of the Company are traded over-the-counter in the
United States on the Nasdaq National Market under the symbol "ICOMF." The high
and low bid prices for the Common Shares for the Transition Period and each
full quarter of the last two fiscal years, as reported on Nasdaq, are as
follows:
High Low
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1ST quarter 1995 - period ended January 31, 1995 $2.500 $1.75
2nd quarter 1995 - period ended April 30, 1995 2.625 2.00
3rd quarter 1995 - period ended July 31, 1995 4.1875 2.00
4th quarter 1995 - period ended October 31, 1995 6.625 3.50
Two month period 1995 - period ended December 31, 1995 5.5625 3.8125
1st quarter 1996 - period ended March 31, 1996 5.625 4.50
2nd quarter 1996 - period ended June 30, 1996 15.375 5.3125
3rd quarter 1996 - period ended September 30, 1996 11.75 6.625
4th quarter 1996 - period ended December 31, 1996 8.125 4.25
Period from January 1, 1997 to March 31, 1997 5.25 1.875
The Company's shares were also listed on the Toronto Stock Exchange
from April 1, 1981 to November 9, 1995.
The Company believes that as of March 31, 1997, its outstanding shares
of Common Shares are held by approximately 8,600 owners of record.
The closing price of the Common Shares on the Nasdaq National Market
on March 31, 1997 was $2.25.
There are presently no limitations imposed by Bermuda law on the
rights of foreign owners of the Company's Common Shares, including those who
are non-residents of Bermuda, to hold or vote such shares. Foreign owners and
Bermuda residents are subject to the same limitations on voting provided by the
Company's Bye-laws.
Although organized in Bermuda, the Company has been classified as a
non-resident by the Bermuda Monetary Authority Foreign Exchange Control.
Accordingly, currencies held for the account of the Company are freely
convertible to other currencies and there are no Bermuda exchange control
restrictions or other Bermuda laws, decrees or regulations affecting the
remittance by the Company of dividends or other payments to the holders of
Common Shares who are non- residents of Bermuda.
Bermuda currently imposes no corporate or personal income taxes.
Therefore, U.S. citizens or residents who own the Company's Common Shares will
not be subject to any Bermuda income tax on dividends or other payments by the
Company with respect to its Common Shares or on dispositions of such shares.
There are no other Bermuda taxes, including withholding taxes, imposed on U.S.
citizens or residents
12
13
by virtue of ownership of the Company's Common Shares. No reciprocal tax
treaty exists between the United States and Bermuda with respect to withholding
of taxes on payments by the Company to the holders of the Common Shares.
DIVIDEND POLICY
No dividends were paid by the Company during fiscal 1993, 1994, 1995
or 1996. The Company does not currently plan to pay any dividends in the
foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
On October 15, 1996, the Registrant issued and sold an aggregate of
$10,000,000 of 7% Convertible Debentures, due October 15, 1998 (the "Debenture
Placement"), to Infinity Investors Limited and Seacrest Capital Limited, each a
Nevis, West Indies corporation (the "Investors"), in exchange for gross
proceeds of $10,000,000 (less issuance costs). The Debenture Placement was not
underwritten and was made in reliance on the exemption from registration
provided by Section 4(2) of the Securities Act of 1933, as amended. In
connection with its evaluation of the availability of this exemption, the
Registrant relied on a series of factual representations made by each of the
Investors relating to, among other things, the nature of each Investor's
investment and the sophisticated nature and accredited status of each Investor.
The debentures issued in the Debenture Placement are convertible by the holder
in whole or in part at the option of the holder into common shares of the
Registrant by dividing the principal amount of each such debenture to be
converted by the then applicable conversion price. The conversion price in
effect from time to time is equal to the lesser of (i) $12.00 per common share
or (ii) the product of (x) the market price of the common shares on the date of
conversion multiplied by (y) 82.5%. The Registrant may redeem the debentures
at any time by paying an amount equal to the remaining unpaid principal amount
of the debenture multiplied by 117.5% plus accrued and unpaid interest thereon.
13
14
ITEM 6 - SELECTED FINANCIAL DATA
The following tables set forth certain historical consolidated financial
data for the Company.
Two months
Year ended ended
December 31 December 31 Years ended October 31
----------- ----------- --------------------------------------------
1996 1995 1995 1994 1993 1992
-------- -------- -------- -------- -------- --------
STATEMENT OF OPERATIONS: (Thousands of U.S. Dollars Except Per Share Data)
Product, service and contract revenue $ 9,352 $ 734 $ 2,030 $ -- $ -- $ --
Other income 653 190 168 20 126 289
-------- -------- -------- -------- -------- --------
Total revenues 10,005 924 2,198 20 126 289
-------- -------- -------- -------- -------- --------
Loss from continuing operations (42,983) (2,776) (5,194) (538) (446) (248)
Income from discontinued operations (1) -- -- 3,546 3,410 1,517 1,564
Income (loss) on disposal of
discontinued operations (1) (56) (236) 3,546 -- -- --
-------- -------- -------- -------- -------- --------
Income (loss) before extraordinary item $(43,039) $ (3,012) $ 12,176 $ 2,872 $ 1,071 $ 1,316
======== ======== ======== ======== ======== ========
Two months
Year ended ended
December 31 December 31 Years ended October 31
------------ ------------ ---------------------------------------------------------
1996 1995 1995 1994 1993 1992
------------ ------------ ------------ ------------ ------------ ------------
EARNINGS (LOSS) PER SHARE DATA:
Continuing operations $ (3.32) $ (0.24) $ (0.46) $ (0.05) $ (0.04) $ (0.05)
============ ============ ============ ============ ============ ============
Discontinued operations
$ (0.01) $ (0.02) $ 1.52 $ 0.31 $ 0.14 $ 0.32
============ ============ ============ ============ ============ ============
Net income (loss) for period $ (3.33) $ (0.26) $ 1.12 $ 0.26 $ 0.10 $ 0.27
============ ============ ============ ============ ============ ============
Weighted average shares (thousands) 12,943 11,385 11,451 11,061 10,715 4,942
============ ============ ============ ============ ============ ============
Cash dividends per share $ -- $ -- $ -- $ -- $ -- $ --
============ ============ ============ ============ ============ ============
December 31 October 31
----------------------- -------------------------------------------------
1996 1995 1995 1994 1993 1992
---------- ---------- ---------- ---------- ---------- ----------
BALANCE SHEET: (Thousands of U.S. Dollars)
ASSETS:
Current assets $ 11,594 $ 19,957 $ 24,587 $ 2,599 $ 1,049 $ 3,655
Excess of cost over assets of
companies acquired 14,573 8,685 9,349 -- -- --
Net assets of discontinued operations -- -- -- 9,573 7,207 1,178
Other long-term assets 9,851 2,597 1,786 -- -- --
---------- ---------- ----------
Total assets $ 36,018 $ 31,239 $ 35,722 $ 12,172 $ 8,256 $ 4,833
========== ========== ========== ========== ========== ==========
LIABILITIES & SHAREHOLDERS' EQUITY:
Current liabilities including
current maturities of long-term debt $ 9,810 $ 5,331 $ 7,091 $ 269 $ 175 $ 491
Long-term liabilities 18,477 368 365 -- -- --
Shareholders' equity 7,731 25,540 28,266 11,903 8,081 4,342
---------- ---------- ---------- ---------- ---------- ----------
$ 36,018 $ 31,239 $ 35,722 $ 12,172 $ 8,256 $ 4,833
========== ========== ========== ========== ========== ==========
(1) See Note 9 to the Consolidated Financial Statements under Item 8
14
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ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Results of continuing operations in 1995 and 1996 consist of:
o the fiber optic multiplexer and special services switch businesses
of Intelect Network Technologies Company ("INT") from its April
24, 1995 acquisition,
o the information security business of Intelect Europe Limited
("IEL") from its August 31, 1995 acquisition,
o the engineering services business of DNA Enterprises, Inc. ("DNA")
from its February 13, 1996 acquisition, and
o the videoconferencing system business of Intelect Visual
Communications Corp. ("IVC") from its March 29, 1996 acquisition.
During the years ended October 31, 1994 and 1995, the Company was
engaged in the manufacturing and marketing of sporting arms, through its
subsidiary Savage Arms, Inc. ("Savage"). The results of operations of Savage
are accounted for as discontinued operations due to the sale of Savage on
October 31, 1995. The Company's fiscal year was changed to December 31 in
1995.
Accordingly, due to the disposition of Savage, the change in fiscal
year, and the schedule of acquisitions above, any comparison of financial
results to prior year periods would not be meaningful to determine a trend.
The following table shows the revenue and gross profits for the
Company's products:
Two Months
Year Ended Ended Years Ended
December 31 December 31 October 31
------------------------ ------------------------
1996 1995 1995 1994
---------- ---------- ---------- ----------
(Thousands of U.S. Dollars)
Revenue:
Product sales $ 2,116 $ 676 $ 949 $ --
Services 5,563 -- -- --
Contract revenue 1,673 58 1,081 --
Interest and other income 653 190 168 20
---------- ---------- ----------
$ 10,005 $ 924 $ 2,198 $ 20
---------- ---------- ---------- ----------
Gross profit (loss):
Products (662) 129 267
Services 1,323 -- -- --
Contracts (2,263) (772) (805) --
---------- ---------- ---------- ----------
(1,602) (643) (538) --
---------- ---------- ---------- ----------
NET SALES AND SERVICES
Revenues in the year ended December 31, 1996 consisted primarily of
engineering services revenues from the newly acquired DNA and product sales at
INT.
15
16
Sales of the S4 digital switch were the principal component of product
sales in 1996 and in 1995. During the second half of 1996, sales of SONETLYNX
fiber optic multiplexers made a significant contribution to the total for the
first time since the product's introduction in the second quarter.
While not relevant to the year-to-year comparison, sales of DNA
services to external customers were up 12% from the prior year when DNA was not
owned by the Company.
The LANscape videoconferencing product was introduced in October 1996
after material and extensive improvements were made to the purchased
technology. The VuBridge product was introduced in March 1996. LANscape made
a small contribution to 1996 sales as initial shipments were primarily for
demonstration and testing purposes.
Contract revenues (from longer term contracts for Special Services
Switches) represent the completion of projects for Iceland and Greece. Sales
increased in 1996 over 1995 due to the inclusion of the entire project for
Greece in 1996 (see Gross Profit (Loss) below).
Information security products sold primarily to the UK military market
were phased out as those operations in England were closed and submitted to
liquidation at year end.
GROSS PROFIT (LOSS)
Inclusion of the DNA engineering services business in 1996 made a
positive contribution to gross profit. However, the margin was restrained
because more than half the engineering services staff was dedicated to
development of the CS4, a project on which intercompany sales and profit are
eliminated.
Losses on contract revenues were primarily attributable to the Iceland
project which was completed in 1996 and experienced a greater loss in 1996 than
in 1995. In addition, the losses and costs on product sales were increased by
maintaining or increasing costs of operations and engineering infrastructure in
order to prepare for the expected growth in sales and production of SONETLYNX
and LANscape. The Company believed these costs were prudently incurred because
of the imminent receipt of significant orders. That belief was confirmed by
orders received in January and February 1997 for SONETLYNX.
SELLING, GENERAL, AND ADMINISTRATIVE (SG&A) EXPENSES
SG&A expenses were $14,601,000 in the year ended December 31, 1996,
$854,000 in the two month ended December 31, 1995, and $2,461,000 in the year
ended October 31, 1995. The increased spending in 1996 is attributable to (1)
increased sales and marketing spending to launch new products and (2)
acquisition of new businesses.
The Company spent $6,412,000 on sales and marketing in 1996 to develop
markets and provide promotional support for all product lines. Spending,
primarily in advance of sales, was approximately $1,300,000 for SONETLYNX and
$1,000,000 for LANscape. At the same time, sales and marketing activities
resulted in a $3,632,000 backlog of unfilled orders at December 31, 1996, up
from $2,469,000 at the prior year end. By March 1997, the backlog had grown
substantially.
G&A expenses were $8,189,000 in 1996 due primarily to the inclusion of
newly acquired businesses. INT expenses of $1,589,000 were in line with the
prior year. DNA contributed $1,370,000 to the total, IEL $1,758,000 and IVC
$1,417,000. Corporate expenses were $2,055,000, including legal and other
costs related to external financing.
16
17
ENGINEERING AND DEVELOPMENT (E&D) EXPENSES
E&D expenses in the three months ending December 31, 1996 include a
one time charge in December of $2,442,000 to expense CS4 software development
costs previously capitalized. The evolution of the CS4 project led to a
reassessment of the product definition in December 1996. A necessary
consequence of the redefined product was to cause the expensing of previously
capitalized costs because technological feasibility had not been attained for
all the inter- related modules of the product.
E&D expenses for the year were $8,719,000 and an additional $1,395,000
(representing SONETLYNX software development cost) was capitalized. Total
costs of major projects in 1996 were (including E&D expense, software
capitalized, and additional amounts charged to cost of sales or to technology
amortization):
o $5,496,000 for development of the CS4 smart programmable switch to
the prototype stage,
o $2,857,000 for development of the initial components of SONETLYNX,
o $1,875,000 for development of a viable LANscape product from
purchased technology, and
o $239,000 for development of two standard DSP products.
ASSET WRITE DOWNS
In connection with the acquisition of IVC, certain assets and
licenses, which constituted the design of a videoconferencing product, were
purchased from a major computer company. The design proved to be flawed and
market introduction was delayed approximately nine months. (See Note 8 to the
Consolidated Financial Statements regarding the technology purchase.) The
Company deemed the recoverability of IVC goodwill to be significantly impaired
by the delay in introduction of the product to a rapidly changing market and
accordingly reduced the carrying value of IVC goodwill by $4,175,000 (its
remaining unamortized net book value at the time) and wrote off $51,000 of
fixed assets deemed of no value.
The Company's assessment of the future prospects for the information
security products business in the United Kingdom led to a complete shut down of
those operations in Chesterfield, England at the end of 1996. In January 1997,
liquidation proceedings began. The Company was an unsecured creditor of IEL
and wrote off all net assets related to those operations in England in the
amount of $1,807,000.
AMORTIZATION AND DEPRECIATION
Amortization and depreciation expenses were:
Two Months
Year Ended Ended Years Ended
December 31 December 31 October 31
------------------------- -------------------------
1996 1995 1995 1994
----------- ----------- ----------- -----------
(Thousands of U. S. Dollars)
Depreciation of Property and Equipment $ 898 $ 42 $ 174 $ --
Amortization of Goodwill 1,664 64 312 --
Technology Amortization 1,019 -- -- --
----------- ----------- ----------- -----------
$ 3,581 $ 106 $ 486 $ --
=========== =========== =========== ===========
Depreciation is included in cost of sales and selling, general and
administration expense in the Consolidated Financial Statements.
17
18
Depreciation of property and equipment has increased due to
acquisitions and due to purchases of new manufacturing, engineering, and office
equipment. Goodwill is amortized over periods from 10 to 15 years. The
increase in 1996 is due to the purchase of DNA and IVC. In December 1996,
goodwill related to the acquisition of INT was increased $660,000 due to the
payment of certain contingent consideration due to former INT shareholders (see
Note 7(a) to Consolidated Financial Statements). Technology amortization
relates to intellectual properties purchased in 1995 and 1996. The amounts of
amortization and depreciation expenses in 1996 are not indicative of the
continuing rates because (1) capital purchases are planned to exceed
depreciation and cause some increase in the current rate, (2) goodwill of IVC
and IEL will not be available for amortization, and (3) license payments to the
vendor of technology used by IVC are being curtailed. (See Note 8 to the
Consolidated Financial Statements.)
INTEREST EXPENSE
Interest expense of $9,911,000 in the year ended December 31, 1996
consists of (1) interest on the face value of the June, August and October
Debentures of $501,000, (2) non-cash financing costs associated with the
issuance of the Debentures of $9,105,000, and (3) other interest of $305,000.
On March 28, 1997, the Securities and Exchange Commission first issued
a Staff Announcement entitled "Debt or Preferred Stock Convertible at Discount
to the Market" which requires (1) recognition as interest expense an amount
which measures the "beneficial conversion feature" of certain convertible
debentures, and (2) accounting treatment which accelerates the recognition as
interest expense of deferred financing costs. The Staff Announcement also
required immediate implementation necessitating the retroactive restatement of
financial statements. Accordingly, the Company retroactively conformed its
accounting for the June, August, and October Debentures to the requirements of
the Staff Announcement. This had the effects of (1) recognizing as interest
expense a $4,592,000 amount allocated to the beneficial conversion feature, and
(2) changing the accounting for and accelerating the recognition of deferred
financing costs in the amount of $3,862,000. These non-cash expenses, together
with $651,000 deferred financing costs recognized as interest expense prior to
the Staff Announcement, constitute the $9,105,000 total Debenture-related
interest expense.
Cash financing costs attributable to the issuance of the June, August,
and October Debentures were $328,000, $986,000, and $309,000, respectively.
Non-cash costs in the form of warrants for common stock valued using the Black-
Scholes pricing model were $1,058,000, $1,014,000, and $1,045,000,
respectively. Additionally, allocations of proceeds to the beneficial
conversion features of the Debentures were $1,061,000, $1,765,000, and
$2,121,000, respectively. The Debentures were considered to be "in the money"
on the date of issue due to the conversion discount. Therefore, all financing
costs are being amortized over the periods bounded by the issuance dates and
the earliest conversion dates, resulting in total amortization of $2,447,000,
$3,765,000, and $2,893,000, respectively, in 1996. An additional amount of
$582,000 of deferred financing costs will be recognized as interest expense in
the first quarter of 1997 due to the exercisability of the balance of the
October Debentures.
INCOME (LOSS) FROM DISCONTINUED OPERATIONS
The Company sold Savage Corporation (and its subsidiaries, including
Savage Arms, Inc.) ("Savage") on October 31, 1995. The results of Savage are
accounted for as discontinued operations and, accordingly, comparative
presentations reflect the Company's equity in the earnings of Savage for the
relevant periods. The gain on the disposition of Savage occurred in the fourth
quarter of 1995.
18
19
LIQUIDITY AND CAPITAL RESOURCES
In the year ended December 31, 1996, cash used in operations
($23,106,000) and by investing activities ($11,253,000) was funded by using
$10,176,000 of available cash balances and by securing new financing, net of
repayments, of $24,183,000. As a result, working capital decreased from
$14,626,000 to $1,784,000 at December 31, 1996.
Operating Activities
Net cash used in operations was $23,106,000 for 1996, consisting
primarily of operating losses partly attributable to the following costs:
o $3,223,000 of E&D to bring new products to market in 1996 and 1997
o $5,496,000 of E&D to develop the CS4 smart programmable switch
with no product sales currently expected to be derived until 1998
o Approximately $2,300,000 of sales and marketing expenses for
market development in advance of sales based on expected increases
for SONETLYNX and LANscape products in 1997
o Approximately $1,100,000 of manufacturing overhead costs
maintained at a higher level than required by 1996 sales in order
to prepare an operations infrastructure, including a computer
system startup to support the higher levels of production
currently expected in 1997.
Of these four sources of spending, the discretionary portions were
approximately:
o 50% of new product development for air traffic control features
and early SONETLYNX
o 100% of CS4 development
o 100% of advance sales and marketing
o 100% of advance infrastructure building
The Company committed these discretionary amounts because (1) the
product developments were directed at markets believed to have very large
growth potential, and (2) near term sales and production growth opportunities
appeared to justify some investment to stimulate the sales and prepare for
production. The anticipated near-term growth is expected to be realized in
1997, especially for SONETLYNX products.
Investing Activities
Investment spending included $3,660,000 for fixed assets, primarily
equipment for product design and for manufacturing. As much as 20% of this
spending may have been discretionary. $4,377,000 was spent on the acquisitions
of DNA and IVC including working capital advances prior to acquisition.
Financing Activities
In addition to cash balances at the beginning of the year, operations
and investments in 1996 were funded by the issuance of three series of
convertible debentures in the amount of $25,000,000. By the end of the year,
$10,087,000 of the debentures were converted to common shares and by March 31,
1997, an additional $8,539,000 of the debentures were converted (See Note 11 to
Consolidated Financial Statements).
19
20
Outlook and Financial Strategy
The Company currently expects ongoing product sales and production
activity to increase significantly over the levels of 1996. These increases
are expected to create increased working capital requirements. In addition,
the Company intends to continue investing in certain product development
activities. The financial plan which results from these expectations currently
indicates a peak cash requirement from external sources of approximately
$12,000,000 in 1997. This plan assumes that the $2,300,000 balance of
obligations to pay former owners of DNA can be extended (See Note 24 to
Consolidated Financial Statements) and that no payments will be made to the
licensor of video conferencing technology pursuant to a license agreement which
is in dispute (see Note 8 to Consolidated Financial Statements and
"Intellectual Property" in ITEM 1). In the event that working capital
requirements exceed sources, the Company has contingency plans to curtail
spending on product development and marketing activities, with priority given
to spending that is not in pursuit of near term benefits.
The Company currently plans to fund its external requirements by
completing a $15,000,000 credit facility of which it has executed binding
agreements for up to $5,000,000 as of March 31, 1997. (See Note 24 to the
Consolidated Financial Statements.) The Company considers it prudent to pursue
financing of amounts greater than its most likely expected cash requirements in
order to have the flexibility to respond to additional product development and
growth opportunities or to respond to other cash needs. For those reasons, the
Company is pursuing additional funding through private or public financings and
through collaborative arrangements with existing and potential customers.
Financial plans do not anticipate any significant payments for maturing
Convertible Debentures in August or October 1998. Due to the experience of
$10,087,000 converted in 1996 and $8,539,000 converted in the first quarter of
1997, the Company expects the debenture holders to convert the balance of
$6,374,000 before maturity.
A collaborative approach is being pursued with respect to the CS4
product development. The Company has begun discussions with several major
telecommunications companies regarding the possibility of forming an alliance
or partnering for the combined purposes of (a) endorsing or branding the CS4
product with a major trade name, (b) permitting some preferred access to the
product by one or more large customers, and (c) funding a substantial portion
of continuing development expenses. Any funding from such sources would likely
be accompanied by an upward revision in planned expenses so that market entry
could be accelerated. Funding by the proposed partnering process would be in
addition to traditional financing previously discussed.
Conclusion
Considering the financing resources available and potentially
available, the outlook for cash available from customer collections, the
outlook for cash uses in operations and investing, and the options available to
reduce spending, the Company believes it has the financial resources to meet
its business requirements through the current year. There can be no assurance,
however, that the proposed financings or the business results assumed in the
financial plan will be realized. The financial statements have been prepared
assuming the Company will continue as a going concern and do not include any
adjustments that might result from the unfavorable outcome of such an
uncertainty.
20
21
CONTINGENT LIABILITIES
As discussed in ITEM 3, Legal Proceedings, the Company is exposed to
certain contingent liabilities, which, if resolved adversely to the Company,
would adversely affect its liquidity, its results of operations and/or its
financial position.
ADDITIONAL FACTORS THAT MAY AFFECT FUTURE LIQUIDITY AND OPERATING RESULTS
This Form 10-K contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section
21E of the Securities Exchange Act of 1934 as amended. Actual events and
results could differ materially from those set forth in the forward-looking
statements. In particular, the recent growth in production and sales may not be
sustained if production is interrupted by a planned facility relocation,
materials (including those supplied from sole sources) are not available, the
sales force does not identify new customers, the Company's credit condition
inhibits major customers, or new SONETLYNX and videoconferencing product
developments are delayed. The financial plan includes commitments to
significant amounts of spending for product development, sales and marketing
activity, and manufacturing capacity predicated on a high rate of sales growth
each quarter. If the rate of sales growth is not sustained, certain of the
expenses will not be sufficiently controllable in the short term to avoid a
negative cash flow impact. There can be no assurance that the currently high
level of credit quality among the Company's customers can be sustained.
Accordingly, customer collections may not achieve the assumptions of the plan.
In order to meet increasing levels of demand for manufactured products the
Company must make estimates of future orders with enough precision to insure
the availability of certain components with long lead times. Any inaccuracy in
such estimates could affect the expected operating results. In general, there
can be no assurance that component parts will be available in sufficient
quantity and on suitable credit terms to support the planned growth in
production rates. Adequacy of the financial plan is partly dependent on the
Company's ability to renegotiate payment obligations to former owners of DNA
and to renegotiate a technology license with a major computer company. There
can be no assurance that either of these assumed negotiations will be
accomplished with the cash flow consequences assumed in the plan. External
business conditions may also contribute risk to achieving the plan, especially
the rate at which telecommunications companies adopt certain new products and
the demand for engineering design services which are contingent on the
development budgets of others. Funding plans include uncertainties, namely,
the balance of the Credit Facility may not become available, alternative
external sources of financing may not be secured in a timely manner or on terms
acceptable to the Company or at all, availability of external sources may be
affected by general market price volatility, holders of Convertible Debentures
may not convert remaining balances to equity, and/or partner funding of CS4
development may not be secured soon enough to avoid development delays. The
Company's ability to raise funds from external sources may be restricted by
adverse resolution of legal proceedings discussed in Contingent Liabilities.
21
22
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Chartered Accountants .......... 23
Consolidated Balance Sheets .......................... 24
Consolidated Statements of Operations ................ 25
Consolidated Statements of Shareholders' Equity ...... 27
Consolidated Statements of Cash Flows ................ 29
Notes to Consolidated Financial Statements ........... 31
Schedule II - Valuation and Qualifying Accounts ...... 60
22
23
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of
Intelect Communications Systems Limited
We have audited the accompanying consolidated financial statements of Intelect
Communications Systems Limited and its subsidiaries as listed in the
accompanying index. In connection with our audits of the consolidated financial
statements, we have also audited the financial statement schedule as listed in
the accompanying index. These consolidated financial statements and financial
statement schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule based on our audits.
We conducted our audits in accordance with United States generally accepted
auditing standards. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Intelect
Communications Systems Limited and its subsidiaries as of December 31, 1996 and
1995 and the results of their operations and their cash flows for the year
ended December 31, 1996, the two month period ended December 31, 1995 and the
years ended October 31, 1995 and 1994, in conformity with United States
generally accepted accounting principles. Also in our opinion, the related
financial statement schedule, when considered in relation to the basic
consolidated financial statements, taken as a whole, presents fairly, in all
material respects, the information set forth therein.
The accompanying consolidated financial statements and financial statement
schedule have been prepared assuming that the Company will continue as a going
concern. As discussed in Note 1 to the consolidated financial statements, the
Company has suffered recurring losses from continuing operations and is
dependent upon the successful development and commercialization of its products
and its ability to secure adequate sources of capital until the Company is
operating profitably. These matters raise substantial doubt about the Company's
ability to continue as a going concern. Management's plans with regard to these
matters are also described in note 1. The consolidated financial statements and
financial statement schedule do not include any adjustments that might result
from the outcome of this uncertainty.
/S/ KPMG PEAT MARWICK
Chartered Accountants
Hamilton, Bermuda
April 9, 1997
23
24
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1996 and 1995
(Thousands of dollars, except share data)
Assets 1996 1995
------ -------- --------
Current assets:
Cash and cash equivalents (note 3) $ 4,863 15,039
Investments in marketable securities (note 4) 854 --
Receivables:
Accounts, net of allowance of $542 and $25 in 1996 and 1995 2,427 1,375
Loan -- 600
Inventories (note 5) 2,978 2,537
Prepaid expenses 472 406
-------- --------
Total current assets 11,594 19,957
Property and equipment, net (note 6) 4,285 1,839
Goodwill, net (note 7) 14,573 8,685
Software development costs, net (note 2(g)) 1,389 --
Deferred financing costs, net (note 11) 582 --
Other intangible assets, net (note 8) 2,879 500
Other assets 716 258
-------- --------
$ 36,018 31,239
======== ========
Liabilities and Shareholders' Equity
------------------------------------
Current liabilities:
Accounts payable $ 1,878 1,685
Accrued liabilities 3,302 1,989
Net liabilities of discontinued operations (note 9) 400 476
Deferred income taxes (note 14) 48 --
Current maturities of long-term debt (note 10) 4,125 1,036
Current installments of obligations under capital leases (note 12) 57 145
-------- --------
Total current liabilities 9,810 5,331
Long-term obligations under capital leases,
net of current installments (note 12) 59 200
Deferred income taxes (note 14) 267 --
Long-term debt, net of current maturities (note 10) 3,238 168
Convertible debentures (note 11) 14,913 --
-------- --------
28,287 5,699
-------- --------
Shareholders' equity:
Common shares, $.01 par value, 80,000,000 shares authorized
15,027,728 and 11,385,117 shares issued and outstanding
in 1996 and 1995 (note 15) 150 114
Additional paid-in capital (note 15) 36,849 11,673
Unrealized gain on marketable securities (note 4) 18 --
Retained earnings (accumulated deficit) (note 18) (29,286) 13,753
-------- --------
Total shareholders' equity 7,731 25,540
Commitments and contingencies (notes 12, 13 and 19)
-------- --------
$ 36,018 31,239
======== ========
See accompanying notes to consolidated financial statements.
24
25
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Consolidated Statements of Operations
(Thousands of dollars, except share data)
Year Two months Years ended
ended ended October 31
December 31, December 31, --------------------
1996 1995 1995 1994
------------ ------------ -------- --------
Net revenues:
Product sales $ 2,116 676 949 --
Services 5,563 -- -- --
Contract revenue 1,673 58 1,081 --
Interest and other income 653 190 168 20
------------ ------------ -------- --------
Net revenues 10,005 924 2,198 20
------------ ------------ -------- --------
Costs and expenses:
Cost of product sales 2,778 547 682 --
Cost of services 4,240 -- -- --
Cost of contracts 3,936 830 1,886 --
Selling, general and administrative 14,601 854 2,461 558
Engineering and development 8,719 732 1,653 --
Asset writedowns (notes 2(l), 6 and 7(b)) 6,033 338 -- --
Amortization of intangible assets (notes 2(l)
and 8) 2,683 376 -- --
Equity in loss of investee -- -- 280 --
Interest (notes 10 and 11) 9,911 23 430 --
------------ ------------ -------- --------
52,901 3,700 7,392 558
------------ ------------ -------- --------
Loss from continuing operations
before income taxes and extra-
ordinary item (42,896) (2,776) (5,194) (538)
Income taxes (note 14) 87 -- -- --
------------ ------------ -------- --------
Loss from continuing operations (42,983) (2,776) (5,194) (538)
Discontinued operations (note 9):
Income from discontinued operations -- -- 3,546 3,410
Income (loss) on disposal of discontinued
operations (56) (236) 13,824 --
------------ ------------ -------- --------
Income (loss) before
extraordinary item (43,039) (3,012) 12,176 2,872
Equity in extraordinary gain of investee -- -- 646 --
------------ ------------ -------- --------
Net income (loss) $ (43,039) (3,012) 12,822 2,872
============ ============ ======== ========
(Continued)
25
26
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Consolidated Statements of Operations, Continued
(Thousands of dollars, except share data)
Year Two months Years ended
ended ended October 31
December 31, December 31, ----------------
1996 1995 1995 1994
------------ ------------ ------ ------
Earnings (loss) per share:
Primary and fully diluted earnings:
Income (loss) per share:
Continuing operations $ (3.32) (0.24) (0.46) (0.05)
Discontinued operations (.01) (0.02) 1.52 0.31
------------ ------------ ------ ------
Income (loss) before
extraordinary item (3.33) (0.26) 1.06 0.26
Extraordinary item -- -- 0.06 --
------------ ------------ ------ ------
Net income (loss) $ (3.33) (0.26) 1.12 0.26
============ ============ ====== ======
Weighted average number of shares and common
stock equivalents outstanding (in thousands)
(note 17) 12,943 11,385 11,451 11,061
============ ============ ====== ======
See accompanying notes to consolidated financial statements.
26
27
INTELECT COMMUNICATIONS SYSTEMS LIMITED and SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Year ended December 31, 1996, two months ended December 31, 1995 and
years ended October 31, 1995 and 1994
(Thousands of dollars, except share data)
Unrealized
Additional gain on Total
Common stock paid-in Retained marketable shareholders'
Shares Par capital earnings securities equity
----------- -------- -------- -------- ---------- -------------
Balances at October 31, 1993 9,863,142 $ 99 6,911 1,071 -- 8,081
Conversion of Savage
Corporation preferred stock
(note 15) 600,000 6 419 -- -- 425
Financing costs (note 15) 110,000 1 87 -- -- 88
Exercise of employee stock
options (note 16) 10,000 -- 10 -- -- 10
Quasi reorganization
(note 18) -- -- 427 -- -- 427
Net income -- -- -- 2,872 -- 2,872
----------- -------- -------- -------- ---------- ----------
Balance at October 31, 1994 10,583,142 106 7,854 3,943 -- 11,903
Acquisition of Lakefield
Arms Limited (note 9) 416,666 4 925 -- -- 929
Exercise of convertible
preferred shares of Savage
Corporation (note 9) 160,991 2 400 -- -- 402
Private placement (note 21) 150,000 1 524 -- -- 525
Exercise of employee
stock options (note 16) 74,318 1 139 -- -- 140
Quasi reorganization
(note 18) -- -- 1,545 -- -- 1,545
Net income -- -- -- 12,822 -- 12,822
----------- -------- -------- -------- ---------- ----------
Balances at October 31, 1995 11,385,117 114 11,387 16,765 -- 28,266
Stock option
compensation (note 16) -- -- 286 -- -- 286
Net loss -- -- -- (3,012) -- (3,012)
----------- -------- -------- -------- ---------- ----------
Balances at December 31, 1995 11,385,117 114 11,673 13,753 -- 25,540
(Continued)
27
28
INTELECT COMMUNICATIONS SYSTEMS LIMITED and SUBSIDIARIES
Consolidated Statements of Shareholders' Equity, Continued
(Thousands of dollars, except share data)
Unrealized
Common stock Additional gain on Total
------------------------ paid-in Retained marketable shareholders'
Shares Par capital earnings securities equity
----------- -------- -------- -------- ---------- ----------
Conversion of debentures
(note 11) 1,837,205 $ 18 10,069 -- -- 10,087
Acquisition of Intelect Visual
Communications Corp.
(note 7(d)) 545,420 5 2,747 -- -- 2,752
Exercise of employee stock
options (note 16) 530,000 5 1,012 -- -- 1,017
Exercise of warrants from
acquisition of Savage
Corporation (note 15) 360,000 4 1,076 -- -- 1,080
Settlement of subordinated
debt and contingent
purchase consideration of
Intelect, Inc. (note 7(a)) 169,986 2 848 -- -- 850
Purchase of other assets
(note 15) 100,000 1 374 -- -- 375
Employee compensation -
Intelect Visual
Communications Corp.
(note 7(d)) 100,000 1 499 -- -- 500
Allocation of proceeds to
beneficial conversion
features of convertible
debentures (note 11) -- -- 4,947 -- -- 4,947
Detachable warrants issued
with convertible debentures
(notes 11 and 15) -- -- 3,117 -- -- 3,117
Stock option compensation
(note 16) -- -- 487 -- -- 487
Unrealized gain on
marketable securities -- -- -- -- 18 18
Net loss -- -- -- (43,039) -- (43,039)
----------- -------- -------- -------- ---------- ----------
Balances at December 31, 1996 15,027,728 $ 150 36,849 (29,286) 18 7,731
=========== ======== ======== ======== ========== ==========
See accompanying notes to consolidated financial statements.
28
29
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Thousands of dollars, except share data)
Year Two months Years ended
ended ended October 31
December 31, December 31, --------------------
1996 1995 1995 1994
------------ ------------ -------- --------
Cash flows from operating activities:
Net income (loss) $ (43,039) (3,012) 12,822 2,872
Adjustments to reconcile net income (loss) to
net cash used in operating activities:
Equity in income of investee -- -- (366) --
Depreciation and amortization of intangible
assets 3,581 106 486 --
Deferred income taxes 87 -- -- --
(Income) loss on disposal of discontinued
operations -- 236 (13,824) --
(Income) loss from discontinued operations 56 -- (3,546) (3,410)
Noncash compensation 500 -- -- --
Assets writedowns 6,033 338 -- --
Stock option compensation 487 50 -- --
Amortization of deferred financing costs 9,105 -- -- --
Other (100) -- 9 --
Change in operating assets and liabilities,
net of effects of acquired companies:
Accounts receivable (898) (662) 136 --
Inventories (350) 277 196 --
Other assets (95) (282) (102) 24
Accounts payable and accrued liabilities 1,603 (926) (1,472) 94
Net liabilities of discontinued operations (76) (795) 1,271 --
------------ ------------ -------- --------
Net cash used in operating activities (23,106) (4,670) (4,390) (420)
------------ ------------ -------- --------
Cash flows from investing activities:
Proceeds from sale of discontinued operations -- -- 33,000 --
Investment in discontinued operations -- -- (3,249) 1,878
Purchase of other intangible assets (1,075) -- -- --
Capital expenditures (3,660) (293) (238) --
Purchase of marketable securities (836) -- -- --
Payments for other assets (110) (240) (518) --
Software development costs (1,395) -- -- --
Proceeds on sale of fixed assets 200 -- 12 --
Payment for acquisition of DNA, net of cash
acquired (3,009) -- -- --
Loan to IVC, prior to acquisition (700) (600) -- --
Payment for acquisition of IVC, net of cash
acquired (668) -- -- --
Payment for acquisition of Intelect, net of cash
acquired -- -- (632) --
Payment for acquisition of IEL, net of cash
acquired -- -- (391) --
------------ ------------ -------- --------
Net cash provided by (used in) investing
activities (11,253) (1,133) 27,984 1,878
------------ ------------ -------- --------
(Continued)
29
30
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Consolidated Statements of Cash Flows, Continued
(Thousands of dollars, except share data)
Year Two months Years ended
ended ended October 31
December 31, December 31, --------------------
1996 1995 1995 1994
------------ ------------ -------- --------
Cash flows form financing activities:
Proceeds from issuance of convertible debentures $ 25,000 -- -- --
Debt issuance costs (1,623) -- -- --
Proceeds from issuance of notes payable -- -- 9,880 --
Payments on notes payable (880) (70) (15,530) --
Payments of principal on capital lease obligations (311) (24) (18) --
Payments of long-term debt (100) -- (271) --
Proceeds from issuance of common shares -- -- 665 103
Exercise of warrants 1,080 -- -- --
Exercise of employee stock options 1,017 -- -- --
Quasi-reorganization -- -- 45 13
------------ ------------ -------- --------
Net cash provided by (used in)
financing activities 24,183 (94) (5,229) 116
------------ ------------ -------- --------
Net increase (decrease) in cash and cash equivalents (10,176) (5,897) 18,365 1,574
Cash and cash equivalents, beginning of period 15,039 20,936 2,571 997
------------ ------------ -------- --------
Cash and cash equivalents, end of period $ 4,863 15,039 20,936 2,571
============ ============ ======== ========
See accompanying notes to consolidated financial statements.
30
31
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Description of Business
Intelect Communications Systems Limited (the "Company") was incorporated
under the laws of Bermuda on April 1, 1980 and operated under the name of
Coastal International, Ltd. until September 1985 and as Challenger
International, Ltd. until December 1995. The Company operates in one
industry segment and is an international communications technology and
products company that develops, manufactures and markets multimedia
transport and switching systems for telecommunications and networking
applications. The Company's products include digital switching, fiber
optic multiplexing, video conferencing equipment, and telecommunications
system design and development services.
Former subsidiaries of the Company were engaged in the manufacture and
marketing of sporting arms (from 1989 to 1995) and in various energy
related activities (from 1981 to 1988). These subsidiaries were sold or
liquidated as of October 31, 1995 (see note 9 below).
The Company's year end was changed in 1995 from October 31 to December 31
in order to coincide with the year ends of its newly-acquired operating
subsidiaries. The two-month period from November 1, 1995 to December 31,
1995 is hereinafter referred to as the "Transition Period".
The Company has incurred losses from continuing operations of $42,983,000,
$2,776,000 and $5,194,000 during the year ended December 31, 1996, the two
months ended December 31, 1995, and the year ended October 31, 1995,
respectively. During these same periods, the Company's operating
activities have used net cash of $23,106,000, $4,670,000 and $4,390,000,
respectively.
The Company currently expects ongoing product sales and production
activity to increase significantly over the levels of 1996. These
increases are expected to create increased working capital requirements.
In addition, the Company intends to continue investing in certain product
development activities. The financial plan which results from these
expectations currently indicates a peak cash requirement from external
sources of approximately $12,000,000 in 1997. This plan assumes that the
$2,300,000 balance of obligations to pay former owners of DNA can be
extended (note 24) and that no payments will be made to the licensor of
video conferencing technology pursuant to a license agreement which is in
dispute (note 8). In the event that working capital requirements exceed
sources, the Company has contingency plans to curtail spending on product
development and marketing activities, with priority given to spending that
is not in pursuit of near term benefits.
The Company currently plans to fund its external requirements by
completing a $15,000,000 credit facility of which it has executed binding
agreements for up to $5,000,000 as of March 31, 1997 (note 24). The
Company considers it prudent to pursue financing of amounts greater than
its most likely expected cash requirements in order to have the
flexibility to respond to additional product development and growth
opportunities or to respond to other cash needs. For those reasons, the
Company is pursuing additional funding through private or public
financings and through collaborative arrangements with existing and
potential customers. Financial plans do not anticipate any significant
payments for maturing Convertible Debentures in August or October 1998.
Due to
31
(Continued)
32
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
the experience of $10,087,000 converted in 1996 and $8,539,000 converted
in the first quarter of 1997, the Company expects the debenture holders to
convert the balance of $6,374,000 before maturity.
Considering the financing resources available and potentially available,
the outlook for cash available from customer collections, the outlook for
cash uses in operations and investing, and the options available to reduce
spending, the Company believes it has the financial resources to meet its
business requirements through the current year. There can be no assurance,
however, that the proposed financings or the business results assumed in
the financial plan will be realized.
The accompanying financial statements have been prepared assuming the
Company will continue as a going concern and do not include any
adjustments that might result from the unfavorable outcome of such an
uncertainty.
(2) Significant Accounting Policies and Practices
The accompanying consolidated financial statements have been prepared in
accordance with United States generally accepted accounting principles.
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from
those estimates.
(a) Principles of Consolidation
The consolidated financial statements include the financial
statements of the Company and its subsidiaries, all of which are
wholly owned, since their dates of acquisition. All significant
intercompany balances and transactions have been eliminated in
consolidation.
(b) Fair Value of Financial Instruments
Statement of Financial Accounting Standards No. 107, "Disclosures
about Fair Value of Financial Instruments" requires disclosure of the
fair value of certain financial instruments for which it is
practicable to estimate fair value. For purposes of the disclosure
requirements, the fair value of a financial instrument is the amount
at which the instrument could be exchanged in a current transaction
between willing parties, other than in a forced sale or liquidation.
The carrying values of cash, accounts receivable, marketable
securities and accounts payable are reasonable estimates of their
fair value due to the short-term maturity of their financial
instruments. It was not practical to estimate the fair value of the
Company's long-term debt and convertible debentures because quoted
market prices do not exist and comparable securities are not
available.
32
(Continued)
33
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(c) Revenue and Expense Recognition
Revenue from product sales is recognized upon shipment of products.
Reserves for estimated sales returns and allowances are recorded in
the same accounting period as the related revenues.
Revenue from services for engineering is recognized as the services
are provided to the customers.
Contracts that are expected to be completed within three months are
generally considered short-term contracts and revenue is recognized
upon shipment to the customer. Revenue on longer-term contracts is
generally recognized using the percentage-of-completion method. Under
the percentage-of-completion method, revenue recognition is measured
by the proportion of the contract costs incurred to date to estimated
total costs for each contract. Contract costs include all direct
material and labor costs and those indirect costs related to contract
performance, such as indirect labor, supplies, tools and repair
costs. General, administrative and engineering and development costs
are charged to expense as incurred. Changes in estimated profit on
contracts are recognized in the period in which the revisions are
determined. Provisions for estimated losses on uncompleted contracts
are charged to earnings in the period in which such losses first
become apparent.
(d) Inventories
Inventories consist of raw materials, work in progress and finished
goods, and are stated at the lower of standard cost (which
approximates cost determined on a first-in, first-out basis) or
market.
(e) Property and Equipment
Property and equipment are stated at cost. Equipment under capital
leases are stated at the present value of minimum lease payments.
Depreciation on equipment is calculated on the straight-line method
over the estimated useful lives of the assets. Equipment held under
capital leases and leasehold improvements are amortized on a
straight-line basis over the shorter of the lease term or estimated
useful life of the assets. The Company's useful lives are as follows:
Estimated useful
life (years)
----------------
Machinery and equipment 5 to 7
Computer equipment and software 3 to 5
Furniture and fixtures 5 to 7
Motor vehicles 3
33
(Continued)
34
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(f) Deferred Financing Costs
A portion of the proceeds from the issuance of convertible debt
securities with beneficial conversion features is recognized as
additional paid-in capital and as a deferred finance cost and
amortized to interest expense ratably from the date of issuance to
the date the related debt first becomes convertible. Other costs in
connection with the issuance of the same securities are also deferred
and amortized in the same manner (note 11). Deferred financing costs
in connection with the issuance of other debt are amortized to
interest expense using the interest method over the term of the
related debt instrument.
(g) Engineering and Development and Software Development Costs
Engineering and development costs, as well as advertising costs, are
expensed as incurred. Capitalization of software development costs
commences upon the establishment of technological feasibility. Both
the establishment of technological feasibility and the ongoing
assessment of recoverability of capitalized development costs involve
judgments by management with respect to certain external factors,
including, but not limited to, anticipated future revenues, estimated
economic life and possible developments in software and hardware
technologies. The Company has not capitalized any costs in prior
periods because eligible amounts were immaterial for those periods.
The Company believes that technological feasibility and future
revenue potential has now been established for the Company's
SONETLYNX product line. During the year ended December 31, 1996, the
Company capitalized $1,395,000 of software development costs and
charged operations for $6,000 of amortization. Amortization is taken
based on estimated related revenues over the next five years.
During the first three quarters of 1996, the Company capitalized
software development costs associated with the development of the CS4
programmable switch, having established technological feasibility
early in 1996. In December 1996, a reassessment of the product
definition rendered invalid the establishment of technological
feasibility because feasibility had not been attained for all the
inter-related modules of the product. Accordingly, all costs that had
been capitalized in previous quarters, totaling $2,442,000, were
charged to engineering and development expense in the fourth quarter.
During the year ended December 31, 1996, the Company advanced
$396,000 to a software developer in connection with the development
of certain software and related technology. Such amounts were charged
to 1996 engineering and development expense.
(h) Earnings (Loss) Per Common Share
The calculation of earnings (loss) per share in the consolidated
statements of operations is based on the weighted average number of
common shares outstanding during the period,
34
(Continued)
35
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
adjusted for the effects of the weighted average number of common
share equivalents outstanding during the period if their inclusion is
dilutive.
(i) Foreign Currency Translation
The Company's United Kingdom subsidiary, Intelect Europe Limited
("IEL"), uses the local currency as the functional currency and
translates net assets at the exchange rates in effect on the balance
sheet date, while income and expense accounts are translated at
average rates. Foreign transaction exchange gains and losses are
recognized as income or expense. Foreign currency translation
adjustments and transaction amounts were not significant.
(j) Income Taxes
The Company accounts for income taxes under the liability method as
required by Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes" ("SFAS 109"). Under this method,
deferred tax assets and liabilities are determined based on
differences between the financial reporting and income tax bases of
assets and liabilities and are measured using the enacted tax rates
and laws expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled.
The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the
enactment date.
(k) Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, cash and
cash equivalents include cash held in banks and time deposits having
maturity within three months of the date of purchase by the Company.
(l) Goodwill
Goodwill, which represents the excess of purchase price over fair
value of net assets acquired, is amortized on a straight-line basis
over 10 to 15 years. Accumulated amortization at December 31, 1996
and 1995 is $1,968,000 and $376,000, respectively.
The Company assesses the recoverability of goodwill by determining
whether the amortization of the goodwill balance over its remaining
life can be recovered through undiscounted future operating cash
flows of the acquired operation. The amount of the goodwill
impairment, if any, is measured based on projected discounted future
operating cash flows using a discount rate reflecting the Company's
average cost of funds. The assessment of the recoverability of
goodwill will be impacted if estimated future operating cash flows
are not achieved.
During the year ended December 31, 1996, the Company charged
$4,175,000 to operations for the writedown of goodwill in connection
with the 1996 acquisition of Intelect Visual Communications (see note
7(d)). The goodwill was considered impaired due to design flaws in
35
(Continued)
36
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
the products acquired, which required design changes and enhancements
and delayed market introduction. In addition, because of management's
intention to liquidate the IEL operation, as described in note 7(b),
goodwill of $740,000 associated with the 1995 acquisition of IEL was
charged to 1996 operations. The aforementioned writedowns were
measured in accordance with the policy described above.
At this time, the Company believes that no significant impairment of
the remaining goodwill has occurred and that no reduction of the
estimated useful lives is warranted.
(m) Other Intangible Assets
Other intangible assets consist of a software license from a vendor
and purchased product technology. These assets are being amortized by
the straight-line method over periods ranging from three to five
years.
(n) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed
Of
The Company adopted the provisions of SFAS No. 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of, on January 1, 1996. This Statement requires that
long-lived assets and certain identifiable intangibles be reviewed
for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash
flows expected to be generated by the asset. If such assets are
considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets
exceed the fair value of the assets. Assets to be disposed of are
reported at the lower of the carrying amount or fair value less costs
to sell. The initial adoption of this Statement as of January 1, 1996
did not have a material impact on the Company's financial position,
results of operations, or liquidity.
(o) Stock Option Plan
Prior to January 1, 1996, the Company accounted for its stock option
plan in accordance with the provisions of Accounting Principles Board
("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. As such, compensation expense would be
recorded on the date of grant only if the current market price of the
underlying stock exceeded the exercise price. On January 1, 1996, the
Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation, which permits entities to recognize as expense over the
vesting period the fair value of all stock-based awards on the date
of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of APB Opinion No. 25 and provide
pro forma net income and pro forma earnings per share disclosures for
employee stock option grants made in 1995 and future years as if the
fair-value-based method defined in SFAS No. 123 had been applied. The
Company has elected to continue to apply the provisions of APB
Opinion No. 25 and provide the pro forma disclosure provisions of
SFAS No. 123.
36
(Continued)
37
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(p) Reclassification
Certain prior period balances have been reclassified to conform to
the current year presentation.
(3) Cash and Cash Equivalents
Cash and cash equivalents are comprised of the following (thousands of
U.S. dollars):
December 31
---------------
1996 1995
------ ------
Cash $1,304 104
Interest-bearing deposits 3,559 14,935
------ ------
Total $4,863 15,039
====== ======
(4) Investments in Marketable Securities
Marketable securities are considered available-for-sale and are stated at
fair value as of December 31, 1996. Unrealized holding gains and losses,
net of the related tax effect, on available-for-sale securities are
excluded from earnings and are reported as a separate component of
shareholders' equity until realized. Realized gains and losses from the
sale of such securities are determined on a specific identification basis.
There were no sales of securities during any of the periods presented.
Certificates of deposit are interest-bearing and are pledged in the course
of contractual performance and for the purpose of obtaining operating
leases. A summary of such securities at December 31, 1996 (1995: $ nil)
follows (thousands of U.S. dollars):
Gross
unrealized Fair
Cost holding gains value
------ ------------- -----
Equity securities $ 52 18 70
Certificates of deposit 784 -- 784
---- ---- ----
Total $836 18 854
==== ==== ====
37
(Continued)
38
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(5) Inventories
The components of inventories are as follows (thousands of U.S. dollars):
December 31
---------------
1996 1995
------ ------
Raw materials $2,727 1,878
Work in progress 292 682
Finished goods 1,213 707
------ ------
4,232 3,267
Less allowance for obsolescence 1,254 730
------ ------
Total $2,978 2,537
====== ======
(6) Property and Equipment
Property and equipment is summarized as follows (thousands of U.S.
Dollars):
December 31
--------------------
1996 1995
-------- --------
Machinery and equipment $ 2,816 1,106
Computer equipment and software 2,537 525
Furniture and fixtures 711 188
Motor vehicles 76 209
-------- --------
6,140 2,028
Less:
Accumulated depreciation and amortization (1,094) (189)
Provision for loss on liquidation (note 7(b)) (761) --
-------- --------
Total $ 4,285 1,839
======== ========
In 1996, the Company wrote-off $51,000 in technologically obsolete
equipment.
(7) Acquisitions
During 1995, the Company purchased Intelect, Inc. ("INT") and Intelect
Europe Limited ("IEL"), and during 1996, the Company purchased DNA
Enterprises, Inc. ("DNA") and Intelect Visual Communications Corp.
("IVC"). A summary of these acquisitions is as follows:
(a) Intelect, Inc.
On January 13, 1995, the Company acquired 16% of the capital stock of
INT for $400,000. On March 31, 1995, the Company entered into an
agreement to purchase the remaining 84% of
38
(Continued)
39
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
the capital stock of INT (the "Option Agreement"). Under the terms of
the Option Agreement the Purchase Price was payable as follows:
(i) $2,500,000 payable in debentures (the "Debentures") of INT plus
the amount by which certain of INT's debts to two major
customers (the "Debts") were settled for less than $6,000,000.
The Debts were settled by the Company for $5,180,000 and,
accordingly, the face value of the Debentures was increased to
$3,320,000 ($2,500,000 plus $6,000,000 minus $5,180,000). The
face value of the Debentures was reduced by the amount that
defined net assets at the acquisition date (April 24, 1995) was
less than $1,268,000. The amount of this reduction was
$3,013,000 and, accordingly, the face value of the Debentures at
December 31, 1995 was $307,000.
(ii) $4,000,000 in "Contingent Purchase Consideration" calculated on
the future profitability of INT over the four year period from
January 1, 1995. The Additional Payments were payable in cash or
Common Shares, at the Company's option. The Contingent Purchase
Consideration will be reflected in the cost of acquisition and
resulting goodwill at the time the profitability contingencies
are resolved.
The first step of the acquisition of INT involved the purchase of a
minority interest (16%) for cash. The Company's equity in the
earnings of INT prior to acquisition of the remaining 84%, the second
step, amounted to a loss of $280,000 and equity in the extraordinary
gain arising from the restructuring of certain notes payable of
$646,000, which have been stated separately in the accompanying 1995
Consolidated Statements of Operations.
On October 7, 1996, the Company reached an agreement with the holders
of the Debentures (the "Vendors"), under which the Vendors exchanged
their remaining rights to the Debentures and Contingent Purchase
Consideration in exchange for 169,986 shares of common shares. The
transaction increased Goodwill by $660,000.
(b) Intelect Europe Limited
On August 31, 1995, the Company acquired 100% of the capital stock of
IEL for $391,000 in cash and up to 300,000 of the Company's common
shares in additional payments based on the future profitability of
IEL over the five year period commencing August 31, 1995.
In December 1996 management made the decision to close the operations
of IEL, which was subsequently placed in voluntary liquidation. The
liquidation represents a disposal of a part of a line of business.
Asset impairments have been recorded and estimated liabilities to be
incurred as a result of the liquidation have been accrued, resulting
in a charge to expense of $1,807,000 in 1996, including a writedown
of $740,000 of unamortized goodwill.
39
(Continued)
40
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(c) DNA Enterprises. Inc.
On February 13, 1996, the Company acquired 100% of the capital stock
of DNA for $8,000,000, plus costs, payable as follows:
1. $3,000,000 cash at closing.
2. $1,000,000 cash on the first anniversary of closing.
3. $400,000 cash on the second anniversary of closing.
4. Warrants to purchase 300,000 common shares at $5.00 per share on
the first anniversary of closing.
5. Warrants to purchase 300,000 common shares at $7.00 per share on
the second anniversary of closing.
The Company has agreed to redeem the $5.00 warrants at prices of
$5.00, $5.50 and $6.00 per warrant share on the first, second, and
third anniversaries of closing, respectively, and redeem the $7.00
warrants at prices of $5.50 and $6.00 per warrant share on the second
and third anniversaries of closing, respectively, in each such case
at the option of the warrant holders. The warrants are classified
similar to redeemable preferred stock and included in long-term debt
at their highest redemption price, totaling $3,600,000 (note 10). On
the first anniversary, the warrant holders elected to redeem all
300,000 common share warrants available on that date.
(d) Intelect Visual Communications Corporation
On March 29, 1996, the Company acquired 100% of the capital stock of
IVC (formerly known as Mosaic Information Technologies, Inc.) for
479,370 common shares valued at $5.00 per share. The Company also
paid $695,000 cash, and issued 66,050 common shares, valued at $5.375
per share, as payment of certain other acquisition costs. The total
cost of the acquisition, including working capital advances prior to
acquisition, was $4,747,000. An additional 50,000 common shares,
valued at $5.00 per share, were issued to each of two selling
shareholders pursuant to employment agreements, and charged to
compensation expense. In addition, 1,100,000 common shares of
"Additional Purchase Consideration" may be earned by the selling
shareholders if certain performance achievements are met during the
three years after the closing. The Additional Purchase Consideration
will be reflected in the cost of acquisition and resulting goodwill
at the time the performance contingencies are resolved.
All acquisitions have been accounted for by the purchase method of
accounting and, accordingly, the purchase prices have been allocated to
the assets acquired and the liabilities assumed based on the estimated
fair values at the dates of acquisition. The excess of purchase price over
the estimated fair values of the net assets acquired has been recorded as
goodwill, which is being amortized over 15 years for INT and 10 years for
DNA. As discussed in note 2, all goodwill in connection with the
acquisitions of IVC and IEL was written off in 1996.
40
(Continued)
41
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
The estimated fair values of assets acquired and liabilities assumed are
summarized as follows (thousands of U.S. dollars):
DNA IVC INT IEL
------- ------- ------- -------
Cash $ 3 27 40 --
Accounts receivable 621 19 454 388
Inventory -- 245 2,683 278
Property and equipment 502 81 700 492
Goodwill 7,280 4,514 8,260 812
Accounts payable and accruals (166) (123) (4,721) (1,293)
Deferred taxes (228) -- -- --
Debt -- (16) (6,530) (286)
------- ------- ------- -------
$ 8,012 4,747 886 391
======= ======= ======= =======
Purchase prices include legal and other costs associated with the
acquisitions.
Operating results of the acquisitions are included in the Company's
consolidated results of operations from the effective dates of the
acquisitions. The following unaudited pro-forma summary presents the
consolidated results of operations as if the acquisitions had occurred at
January 1, 1996 and November 1, 1994, after giving effect to certain
adjustments, including amortization of goodwill, additional interest
expense on the acquisition debt and related income tax effects. These
pro-forma results have been prepared for comparative purposes only and do
not purport to be indicative of what would have occurred had the
acquisitions been made as of those dates or of results which may occur in
the future (thousands of U.S. dollars, except per share amounts).
Years ended
----------------------------
December 31, October 31,
1996 1995
------------ ------------
Net revenues $ 10,320 9,330
============ ============
Loss from continuing operations $ (43,251) (4,580)
============ ============
Net loss per common share $ (3.34) (0.40)
============ ============
Unaudited pro forma amounts have not been presented for the two-month
period ended December 31, 1995 because presentation of such information is
not considered meaningful.
41
(Continued)
42
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(8) Other Intangible Assets
Other intangible assets is summarized as follows (thousands of U.S.
Dollars):
December 31
----------------
1996 1995
------ ------
Investment in technology associated with
SONETLYNX products $ 500 500
Technology license fees associated with video-
conferencing products, acquired via debt 3,267 --
Other intellectual property 125 --
------ ------
3,892 500
Less accumulated amortization 1,013 --
------ ------
$2,879 500
====== ======
At December 31, 1996, the Company's remaining technology license asset
associated with its videoconferencing product and related liability were
in dispute. The Company has not made any payment under the applicable
license agreement since September 1996. The Company has notified the
licensor that due to significant design flaws in the technology delivered,
the resulting nine month delay in market introduction, and the significant
costs incurred to modify and improve the purchased technology, it is
seeking to renegotiate the agreement. Management believes it will be
successful in its negotiations, and once finalized, any future payments
will result in an equivalent asset to the Company, which will be
recoverable based upon future sales. Although the Company believes it has
meritorious claims against the licenser, the ultimate resolution of this
matter could result in a loss of up to $2,550,000, representing the
remaining payments under the existing technology license agreement through
September 1998 (note 10).
(9) Discontinued Operations - Sale of Savage Corporation
On October 3, 1995 the Company signed a Stock Purchase Agreement (the
"Agreement") to sell its wholly-owned subsidiary Savage Corporation
("Savage") to Savage Sports Corporation (the "Buyer"), a newly-formed
company owned by Ronald Coburn, the President of Savage Arms, Inc. (a
wholly-owned subsidiary of Savage) and Fleet Equity Partners of
Providence, Rhode Island. The Agreement reflected a base purchase price of
$33,000,000 and the assumption by the buyer of up to $6,000,000 of defined
debt. The Company was required to retire certain convertible preferred
shares of Savage which required a cash payment of $500,000 and the
issuance of 160,991 shares ($425,000 fair value at date) of the Company
and to retire a specific debt of Savage aggregating $9,447,000 of
principal and interest.
On October 31, 1995, the Closing Date of the sale of Savage (the
"Closing"), Savage's debts, as defined above, were less than $6,000,000
and, accordingly, the net cash proceeds to the Company on the sale of
Savage amounted to $23,053,000 (being the gross proceeds of $33,000,000
less
42
(Continued)
43
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
$9,447,000 used to retire a specific debt and $500,000 to retire 160,991
convertible preferred shares).
The Company recorded a gain on the sale of Savage, for the year ended
October 31, 1995, as follows (thousands of U.S. Dollars):
Base sale price $ 33,000
Investment in and advances to Savage (17,605)
--------
Gross gain 15,395
Less:
Product liability and environmental costs (675)
Legal, financing and other costs (896)
--------
Net gain on sale $ 13,824
========
In connection with the sale of Savage, the Company has retained customary
environmental and product liability contingent liabilities relating to
Savage's operations prior to the Closing. The Company has purchased tail
insurance to cover certain of these contingent liabilities. There are no
assurances that the insurance coverage will be sufficient to settle all
claims (note 19). The net liabilities of discontinued operations represent
provisions for costs associated with the sale of Savage related
principally to product and environmental liabilities of $400,000 and
$476,000 at December 31, 1996 and 1995, respectively.
Operating results of discontinued operations have been reclassified from
amounts previously reported in the consolidated statement of operations
and have been reported separately in the consolidated statements of
operations. During the year ended December 31, 1996, the Company recorded
an adjustment of $56,000 to the gain on disposal representing legal fees
(note 19).
During the year ended October 31, 1995, the Company acquired Lakefield
Arms Limited for $1,923,000, comprised of $998,000 cash and 416,666 common
shares, valued at $2.22 per share. Lakefield Arms Limited was sold along
with the other assets of Savage Corporation in October 1995.
During the Transition Period ended December 31, 1995, the Company recorded
an adjustment to the gain of $236,000 representing non-cash compensation.
43
(Continued)
44
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
The results of discontinued operations are as follows (thousands of U.S.
Dollars):
Years ended
October 31,
--------------------
1995 1994
-------- --------
Net sales and other revenues $ 35,009 26,556
Costs and expenses 28,857 22,035
-------- --------
Income before income taxes 6,152 4,521
Income taxes 2,606 1,111
-------- --------
Income from discontinued operations $ 3,546 3,410
======== ========
Net cash provided by (used in) discontinued operations $ (1,349) 1,282
======== ========
(10) Long-term Debt
Long-term debt is comprised of (thousands of U.S. Dollars):
December 31
------------------
1996 1995
------- -------
Subordinated debentures with a face value of $307,000 payable in
annual installments of $72,916, including interest at 6%, issued
to previous shareholders of Intelect, Inc. (note 7(a)) $ -- 224
Due to customer - bearing interest at 6% and payable in April 1996 -- 880
Due to customer - bearing interest at 8% and payable on demand
which was paid in January 1996 -- 100
Contract for acquisition of technology license with original face
value of $3,500,000, payable in quarterly installments of
$325,000 through June 1998 and a final payment in September 1998
of $275,000 (note 8) 2,363 --
Repurchase agreements for common stock warrants held by former
shareholders of DNA Enterprises, Inc. payable in two installments
- $1,500,000 in February 1997 and $2,100,000 in February 1998
(notes 7(c) and 24) 3,600 --
Partial purchase price of DNA Enterprises, Inc. payable in two
installments - $1,000,000 in February 1997 and $400,000 in
February 1998 (notes 7(c) and 24) 1,400 --
------- -------
7,363 1,204
Less current installments (4,125) (1,036)
------- -------
$ 3,238 168
======= =======
44
(Continued)
45
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
The subordinated debentures have been discounted in the accompanying
consolidated financial statements to an effective interest rate of 15% and
the technology contract has been discounted to an effective interest rate
of 7%. Accordingly, the carrying amounts approximate fair value at
December 31, 1996 and 1995.
(11) Convertible Debentures
During the year ended December 31, 1996, the Company had three issues of
convertible debentures: "June Debentures" in the aggregate principal
amount of $5,000,000 bearing interest at 7.5%, "August Debentures" in the
aggregate principal amount of $10,000,000 bearing interest at 7.5%, and
"October Debentures" in the aggregate principal amount of $10,000,000
bearing interest at 7%. At December 31, 1996, the June Debentures were
fully converted into 773,514 shares of common stock, the August Debentures
were partially converted into 883,691 shares of common stock, and the
October Debentures were partially converted into 180,000 shares of common
stock.
Convertible debentures were comprised of the following at December 31,
1996 (thousands of U.S. dollars):
7.5% debentures, due August 8, 1998, interest payable quarterly,
redeemable at the Company's option after August 8, 1997, at 125% of
the face amount for six months and 120% thereafter, or at the Nasdaq
market price of the common stock if the stock price falls below the
fixed conversion price of $11.0825, and convertible into common
shares, at the holder's option, at the lesser of 85% of the Nasdaq
five day average closing bid prior to the notice of conversion date,
or $11.0825, subject to a maximum of 2,582,107 shares $ 5,723
7% debentures, due October 15, 1998, interest payable quarterly,
redeemable at any time at the Company's option at 117.5% of the face
amount, and convertible into common shares, at the holder's option,
in equal one-third amounts of principal sixty, ninety and one
hundred twenty days after October 15, 1996, at the lesser of 82.5%
of the Nasdaq five day average closing bid prior to the notice of
conversion date, or $12.00 9,190
-------
Total $14,913
=======
Financing costs incurred in 1996 in connection with the issuance of
debentures were $9,687,000, including $4,947,000 allocated to beneficial
conversion features, $3,117,000 in the fair value of detachable warrants
(note 15) to purchase 420,063 shares of common stock, valued using the
Black-Scholes model, and $1,623,000 in cash. In 1996, $9,105,000 was
charged to interest expense.
A further $8,539,000 of debentures were converted into 2,398,210 shares of
common stock through March 31, 1997.
45
(Continued)
46
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(12) Lease Commitments
The Company is obligated under various capital leases, for equipment and
vehicles, that expire during the next two years. At December 31, 1996 and
1995, the gross amount of equipment and vehicles and related accumulated
amortization recorded under capital leases were as follows (thousands of
U.S. dollars):
1996 1995
---- ----
Equipment $160 261
Vehicles -- 224
---- ----
160 485
Less accumulated amortization 39 118
---- ----
$121 367
==== ====
Amortization of assets held under capital leases is included with
depreciation and amortization expense.
The Company leases office space and certain office equipment under leases
expiring at various dates through 2004. Rental expense under operating
leases was approximately $1,032,000 for the year ended December 31, 1996,
$48,000 for the two months ended December 31, 1995 and $107,000 for the
year ended October 31, 1995 ($ nil in 1994).
Future calendar year minimum commitments as of December 31, 1996 under
capital and operating leases are as follows (thousand of U.S. dollars):
December 31, 1996
-------------------
Capital Operating
Years ending December 31, leases leases
-------- ---------
1997 $ 57 1,045
1998 59 1,059
1999 - 1,044
2000 - 329
2001 and thereafter - 658
-------- ---------
Total minimum lease payments $ 116 4,135
======== =========
Imputed interest included in future minimum commitments on capital leases
is not material.
(13) Employee Benefit Plans
The Company sponsors defined contribution 401(k) plans for substantially
all employees. Pursuant to the plans, employees may request the Company to
deduct and contribute amounts from their salary on a pre-tax basis.
Employee contributions are subject to certain limitations and the Company
may
46
(Continued)
47
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
make matching contributions, at its discretion. The Company may also make
discretionary contributions in addition to matching contributions. Company
contributions vest ratably over periods of four to five years, beginning
in the second or first year of employment, respectively. Company
contributions to the plans were $459,000 for the year ended December 31,
1996, $16,000 for the two month period ended December 31, 1995 and $26,000
for the year ended October 31, 1995 (nil in 1994).
(14) Income Taxes
Bermuda currently imposes no corporate income taxes. Under the provisions
of the exempted Undertaking Tax Protection Act, 1966 of Bermuda, the
Company, in the event that Bermuda legislation imposes corporate income
taxes, is exempted from such tax until March, 2016.
The Company does not consider itself to be engaged in trade or business in
the United States. As such, the Company does not expect to be subject to
direct United States taxation.
Beginning with the year ended December 31, 1995, the United States
subsidiaries of the Company began filing a consolidated United States
Federal income tax return.
In prior years, the benefit from the utilization of the net operating
losses from discontinued operations in existence as of the date of the
quasi-reorganization was recorded as a component of shareholders' equity.
Total income tax expense for the year ended December 31, 1996, the two
month period ended December 31. 1995, and for the years ended October 31,
1995 and 1994 was allocated as follows (in thousands of U.S. dollars):
Two months Year ended
Year ended ended October 31
December 31, December 31, ---------------
1996 1995 1995 1994
------------ ------------ -------- --------
Loss from continuing operations $ 87 -- -- --
Income from discontinued
operations -- -- 2,606 1,111
Goodwill, for initial recognition
of acquired tax liabilities 228 -- -- --
Shareholder's equity (use of net
operating loss carryforwards in
existence at date of quasi-
reorganization -- -- (1,472) (726)
------------ ------------ -------- --------
$ 315 -- 1,134 385
============ ============ ======== ========
47
(Continued)
48
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
Income tax expense for the year ended December 31, 1996 attributable to
loss from continuing operations was $87,000. All components of income tax
expense (current, deferred, and other) attributable to loss from
continuing operations were $ nil for the two months ended December 31,
1995, and the years ended October 31, 1995 and 1994. The difference
between the actual income tax expense (benefit) and the expense (benefit)
computed by applying the statutory corporate income tax rate of 34% to
pretax loss from continuing operations is attributable to the following
(in thousands of U.S. dollars):
Two months Year ended
Year ended ended October 31
December 31, December 31, -----------
1996 1995 1995 1994
------------ ------------ -------- --------
Computed expected tax benefit $ (14,585) (1,024) (1,766) (183)
Increase in net operating loss
carryforwards not providing
current benefit 7,530 880 1,292 --
Permanent items 1,776 -- 390 --
Tax effect of loss not subject to
U.S. taxation 4,517 144 117 183
Other 849 -- (33) --
------------ ------------ -------- --------
Tax expense $ 87 -- -- --
============ ============ ======== ========
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at
December 31, 1996 and 1995 are as follows (in thousands of U.S. dollars):
1996 1995
-------- --------
Deferred tax assets:
Preacquisition net operating loss carryforwards $ 4,831 3,788
Postacquisition net operating loss carryforwards 8,762 2,632
Inventories - due to reserves and additional costs
capitalized for tax 374 248
Accrued contract completion costs 110 143
Goodwill 71 --
License fees and intelectual property 257 --
Other expenses 423 307
Alternative minimum tax and other credit carryforwards 298 299
-------- --------
Gross deferred tax assets 15,126 7,417
Less valuation allowance (15,126) (7,417)
-------- --------
Deferred tax assets $ -- --
======== ========
48
(Continued)
49
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
1996 1995
---- ----
Deferred tax liabilities:
Depreciation $ 87 --
Other 228 --
---- ----
Deferred tax liabilities $315 --
==== ====
Net deferred tax liability $315 --
==== ====
The valuation allowance for deferred tax assets was $6,282,000 at October
31, 1995 and it was established in that year. During the two month period
ended December 31, 1995 and the year ended December 31, 1996, the
valuation reserve was increased $1,135,000 and $7,709,000, respectively.
At December 31, 1996, the Company had federal net operating loss
carryforwards of approximately $39,980,000, and tax credit carryforwards
of $298,000. The future utilization of $14,210,000 of these net operating
losses and the credit carryforwards will be limited under Internal Revenue
Code sections 382 and 383 as a result of the acquisition of Intelect, Inc.
and Intelect Visual Communications Corp. The tax benefits from the
utilization of the preacquisition operating loss carryforwards and the tax
credits will be credited to goodwill when they are realized. The following
is a summary of the carryforwards and the expiration dates as of December
31, 1996 (in thousands of U.S. dollars):
December 31, 1996
---------------------
Expiration
Amounts dates
------- ----------
Postacquisition net operating loss carryforwards $25,770 2011
Preacquisition net operating loss carryforwards 14,210 2008-2009
Alternative minimum tax credit 38 --
General business credit 260 1997-2000
(15) Share Capital
Authorized share capital of $0.01 par value, for all periods presented,
was as follows:
Serial Preference Shares 15,000,000
Common Shares 80,000,000
During the year ended December 31, 1996, the Company issued 180,000 common
shares at $2.50 per share and 180,000 common shares at $3.50 per share
upon the exercise of warrants issued to the previous owners of Savage
Corporation. The warrants had been issued in connection with the
acquisition of Savage Corporation. The Company also issued 100,000 common
shares at $3.75 per share in consideration for an investment of $375,000
in debentures with a CDN $500,000 face value,
49
(Continued)
50
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
previously issued by Lakefield Arms Limited. The debentures are unsecured,
bear interest at 8% per annum, and mature August 4, 1999.
In 1996, in conjunction with the issuance of convertible debentures, and
in conjunction with the acquisition of DNA Enterprises, Inc., the Company
issued warrants exercisable for common shares. At December 31, 1996,
outstanding warrants were as follows:
Exercise
Grant Date Warrants Prices Exercise Periods
----------------- --------- -------- -------------------------------
February 13, 1996 300,000 $ 5.00 February 1997 - February 1999
February 13, 1996 300,000 7.00 February 1998 - February 1999
June 7, 1996 125,000 13.1875 June 1996 - June 2001
August 8, 1996 70,063 8.56375 August 1996 - August 2001
September 9, 1996 125,000 9.5625 September 1996 - September 2001
October 15, 1996 225,000 7.50 October 1996 - October 2001
---------
Total 1,145,063
=========
The fair value of warrants issued in conjunction with the convertible
debentures was determined using the Black-Scholes option pricing model
with the following assumptions:
Stock Exercise Interest Fair
Issue price price Term Volatility rate value
- - ----------------- ------- -------- ---- ---------- -------- -----------
June 7, 1996 13.1875 13.1875 5.0 70.5% 7.05% $1,058,000
August 8, 1996 9.5625 8.56375 5.0 73.1 7.05% 453,000
September 9, 1996 7.50 9.5625 5.0 71.6 7.05% 561,000
October 15, 1996 7.50 7.50 5.0 68.3 6.00% 1,045,000
-----------
Total $3,117,000
===========
Pursuant to the acquisition agreement of Intelect Visual Communications
Corp., 1,100,000 shares of common stock may be issued based on performance
achievements to be met during a three year post closing period (see note
7(d)).
During the year ended October 31, 1994, the Company issued 110,000 common
shares at $0.80 per share as a result of a commitment to the underwriters
of a public offering on October 31, 1992, and 600,000 common shares in
connection with certain conversion rights of preferred shares of Savage
Corporation.
There have been no dividends declared for any of the periods reported.
50
(Continued)
51
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(16) Employee Stock Option Plan
In 1995, the Company adopted a stock option plan (the "Plan") pursuant to
which the Company's Board of Directors may grant stock options to
directors, officers and key employees. The Plan authorizes grants of
options to purchase up to 3,000,000 shares of authorized common stock. The
exercise price for stock options granted may range from 25% to 110% of the
fair market value of the shares at the date of grant. All stock options
have 10-year terms and vest and become fully exercisable ratably on each
of the first, second and third anniversaries of the date of the grant. At
December 31, 1996, there were 928,500 additional shares available for
grant under the Plan. The Plan replaced a predecessor plan which continues
only to the extent that there are 505,000 unexercised options outstanding
at December 31, 1996.
The per share weighted-average fair value of stock options granted during
1996 and the transition period ended December 31, 1995, was $4.66 and
$7.07, respectively, on the dates of grants. The fair value of each option
grant is estimated on the date of grant using the Black-Scholes option
pricing model, with the following weighted-average assumptions:
Two months
Year ended ended
December 31, December 31,
1996 1995
------------ ------------
Expected dividend yield 0% 0%
Stock price volatility 68% 68%
Risk free interest rate 6.1% 6.7%
Expected option term 3 years 3 years
The Company applies APB Opinion No. 25 in accounting for its Plan and,
accordingly, has recognized compensation expense with respect to certain
options granted at exercise prices less than the stock's market value at
the date of grant. During the year ended December 31, 1996, and the two
months ended December 31, 1995, the Company recognized compensation
expense of $487,000 and $286,000, respectively, of which $236,000 in the
transition period was allocated to the gain on sale of discontinued
operations. Had the Company determined compensation cost based on the fair
value at the grant date for its stock options under SFAS No. 123, the
Company's
51
(Continued)
52
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
net losses would have been increased to the pro forma amounts indicated
below (thousands of U.S. dollars, except for per share data):
Two months
Year ended ended
December 31, December 31,
1996 1995
------------ ------------
Net loss:
As reported $ (43,039) (3,012)
Pro forma (51,787) (6,420)
Loss per share:
As reported $ (3.33) (0.26)
Pro forma (4.00) (0.56)
Pro forma net loss reflects only options granted in 1996 and 1995.
Therefore, the full impact of calculating compensation cost for stock
options under SFAS No. 123 is not reflected in the pro forma net loss
amounts presented above because compensation cost is reflected over the
option's vesting period of three years and compensation cost for options
granted prior to November 1, 1995, is not considered. Furthermore, the
effects of applying SFAS No. 123 may not be representative of the effects
on reported net income for future years.
Stock option activity during the periods indicated is as follows:
Two months
Year ended ended Years ended
December 31, December 31, October 31
------------------------
1996 1995 1995 1994
------------ ------------ ----------- -----------
Number of options:
Outstanding, beginning of period 1,917,800 987,800 1,044,018 881,818
Granted 1,260,000 970,000 172,000 177,200
Exercised (530,000) - (74,318) (10,000)
Canceled (121,300) (40,000) (153,900) (5,000)
Outstanding, end of period 2,526,500 1,917,800 987,800 1,044,018
Weighted average exercise price:
Outstanding, beginning of period $ 2.56 1.94 1.86 1.75
Granted $ 6.85 3.22 4.16 2.42
Exercised $ 1.93 - 1.93 1.50
Canceled $ 7.77 3.00 3.93 2.55
Outstanding, end of period $ 4.58 2.56 1.94 1.86
At December 31, 1996 and 1995, the number of options exercisable was
734,332 and 806,867, respectively, and the weighted-average exercise price
of those options was $2.79 and $1.72, respectively.
52
(Continued)
53
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
At December 31, 1996, the range of exercise prices and weighted-average
remaining contractual life of outstanding options was $1.00 - $12.125 and
8.57 years, respectively, as shown in the following table:
Vested option
Option shares shares Exercise prices Expiration
outstanding outstanding per share dates
------------- ------------- --------------- ----------
175,000 175,000 $ 1.00 1999-2000
95,000 63,334 $ 2.375 2004
5,000 5,000 $ 2.55 2003
165,000 165,000 $ 2.66 2003
825,000 228,332 $ 3.00 2005
25,000 25,000 $ 3.08 2003-2005
23,200 7,733 $ 3.32 2005
20,000 -- $4.3125 2005
100,000 -- $ 4.375 2005
100,000 -- $ 5.35 2005
129,000 -- $ 5.375 2006
16,800 5,600 $ 5.40 2005
25,000 8,333 $ 5.625 2005
317,000 -- $ 6.50 2006
18,500 18,500 $ 7.25 2006
105,000 -- $ 7.50 2006
290,000 2,500 $7.8125 2006
30,000 30,000 $ 8.375 2006
35,000 -- $ 9.25 2006
22,000 -- $ 10.50 2006
5,000 -- $12.125 2006
------------- -------------
2,526,500 734,332
============= =============
53(Continued)
54
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(17) Earnings (Loss) Per Share
The weighted average number of shares outstanding during the period is
calculated as follows:
Two months
Year ended ended Years ended
December 31, December 31, October 31
------------------------
1996 1995 1995 1994
------------ ------------ ---------- ----------
Shares in issue beginning of
period 11,385,117 11,385,117 10,583,142 9,863,142
Shares issued (weighted average) 1,558,319 -- 441,360 78,815
------------ ------------ ---------- ----------
Weighted average shares in issue
end of period 12,943,436 11,385,117 11,024,502 9,941,957
Dilutive common stock
equivalents (weighted average):
Savage Arms Series A
convertible redeemable
preferred stock -- -- -- 591,781
Savage Arms Series AC
convertible redeemable
preferred stock -- -- -- 160,991
Other stock options using
treasury stock method -- -- 426,820 366,161
------------ ------------ ---------- ----------
Total weighted average common
shares and common stock
equivalents 12,943,436 11,385,117 11,451,322 11,060,890
============ ============ ========== ==========
For the year ended December 31, 1996, and the two-month period ended
December 31, 1995, the computation of both primary and fully diluted
earnings per share was based on the weighted average number of common
shares outstanding for the period. Common share equivalents relating to
the exercise of stock options and stock warrants or conversion of
convertible debt were excluded from the computation as the effects would
have been anti-dilutive.
For the years ended October 31, 1995 and 1994, the computation of primary
earnings per share was based upon the weighted average number of common
share and common share equivalents (stock options and convertible
redeemable preferred stock) outstanding during the period.
Contingent shares, which are part of the Intelect, Inc. and IVC
acquisitions were excluded from the calculations because it was considered
unlikely that the underlying performance criteria would be met.
Fully diluted earnings per share is considered to be the same as primary
earnings per share for all periods presented since the effect of certain
potentially dilutive securities would be anti-dilutive.
54
(Continued)
55
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(18) Quasi-Reorganization
A quasi-reorganization is an elective accounting procedure that permits a
company which has emerged from previous financial difficulty to establish
a fresh start in an accounting sense. The Company made such an election on
October 31, 1992. Assets and liabilities were established at fair values
at October 31, 1992 and a deficit of $16,132,000 was eliminated against
share premium. Quasi-reorganization adjustments in the years ended October
31, 1995 of $1,545,000 (1994: $427,000; 1993: $1,072,000) were the result
of the realization of deferred tax benefits on discontinued operations
(note 14) and valuation adjustments to liabilities existing prior to
October 31, 1992.
(19) Contingencies
The Company is contingently liable for certain potential liabilities
related to its discontinued operations. Specifically, under a stock
purchase agreement dated October 3, 1995 ("1995 Agreement"), the Company
agreed to indemnify Savage Sports Corporation, the purchaser of Savage
Arms, Inc. (a manufacturer of firearms), for certain product liability,
environmental clean-up costs and other contractual liabilities, including
certain asserted successor liability claims. One of the liabilities
assumed involves a firearms product liability lawsuit filed by Jack Taylor
individually and as father of Kevin Taylor in Alaska Superior Court (the
"Taylor litigation"). The Company is informed that a defendant in the
Taylor litigation, Western Auto Supply Co., settled the lawsuit for $5
million and, in turn, has asserted a third-party claim against Savage
Arms, Inc. for indemnification in the amount of the settlement plus
attorneys' fees and related costs. Savage Arms has asserted defenses to
the claims and the Company believes additional defenses may be available.
Based on the information available to date it is impossible to predict the
outcome of this litigation or to assess the probability of any verdict.
The Company also has been notified that Savage Sports Corporation seeks
indemnification under the 1995 Agreement in connection with certain other
product liability claims. Most notably, the Company has undertaken the
defense of a lawsuit filed against Savage Arms, Inc. by Emhart Industries,
Inc. ("Emhart") in the United States District Court for the District of
Massachusetts (the "Emhart litigation"). In the lawsuit, Emhart requests
indemnification under an agreement it allegedly executed in 1981 with
Savage Industries, Inc., an entity Emhart alleges is a predecessor to
Savage Arms, Inc. In particular, to date Emhart has claimed
indemnification of approximately $2.2 million for five lawsuits it has
defended or settled and also seeks a declaratory judgment that it is
entitled to indemnification for losses and expenses related to firearms
product liability actions which may be filed against Emhart in the future.
Savage Arms has asserted the responsibility of a third party to the 1981
agreement but remains a defendant. The Company intends to assert
additional defenses. The parties are in the early stages of discovery and
the Company cannot at this time predict the outcome of the litigation.
In March 1997, Peter G. Leighton, former president and Rhianon M. Pedro,
former vice president finance, initiated actions against the Company
seeking damages of $2,130,000 and $150,000, respectively, related to their
separations from the Company. The Company will vigorously contest
55
(Continued)
56
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
these actions. Due to the recent initiation of these actions, the Company
cannot predict their outcome.
At December 31, 1996, the Company has not made any specific provision for
these claims. In the event the Taylor litigation, the Emhart litigation,
and/or the former employee actions were to be resolved adversely to the
Company, there would be a material adverse effect on the Company's
financial condition and results of operations.
(20) Domestic and Foreign Operations
The Company operates in predominantly one business segment, which consists
of the design, manufacture and sale of telecommunications and related
equipment.
Revenue transfers between geographic areas are not material. Operating
profit is total revenue less operating expenses, excluding interest,
income taxes and engineering and development expenses which are considered
by management to be corporate expenses.
In the periods ended December 31, 1995 and October 31, 1995 and 1994,
substantially all the Company's revenues and assets were in the United
States. Discontinued operations were substantially in the United States.
Information about the company's operations in different geographic
locations as of and for the year ended December 31, 1996 follows
(thousands of U.S. dollars):
United Other
States Europe foreign Consolidated
--------- ------- ------- ------------
Net revenues $ 5,681 3,556 768 10,005
======== ====== ====== ===========
Operating losses $(13,095) (7,347) (1,347) (21,789)
======== ====== ======
General corporate expenses (11,196)
Interest expense (9,911)
-----------
Loss from continuing
operations before
income taxes $(42,896)
===========
Identifiable assets 30,308 221 -- 30,529
Corporate assets 5,489
-----------
Total assets $ 36,018
===========
Identifiable assets are those assets of the Company that are identified
with the operations in each geographic area. Identifiable assets for
Europe are disproportionately low due to the voluntary liquidation of IEL
(note 7(b)). The identifiable assets in Europe at December 31, 1996, are
those of Intelect Network Systems Limited, a sales and service company
chartered in November 1996. Corporate assets are principally cash and
deferred financing costs.
56
(Continued)
57
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
Direct export sales of $1,402,000 for the year ended December 31, 1996,
are included in the United States net sales.
(21) Related Party Transactions
During the year ended December 31, 1996, the following related party
transactions were recorded:
(a) Purchased patents, intellectual property and related proprietary
information from a company owned by an officer for $125,000 and
entered into a royalty agreement with respect to products sold by the
Company which are covered by the patents.
(b) Loaned an officer $135,000, of which $91,000, including accrued
interest, remains outstanding at December 31, 1996. The 5% note is
secured by a stock pledge agreement.
(c) Borrowed $500,000 from a company controlled by a director who was
also the Company's president in July, and repaid the loan in
September, including interest of $13,000.
(d) Paid $120,000 for management fees and rented facilities from a
company controlled by a director who was also the Company's president.
(e) Amended employment agreements with the now former president and
the present chairman which, generally upon termination, provide for
continuation of salaries for three years following the current year of
employment.
During the period ended December 31, 1995, there were no related party
transactions.
During the year ended October 31, 1995, a nonsalaried director was paid
$150,000 for services rendered in connection with the acquisitions of
Intelect, Inc. and Intelect Europe Limited.
The Company received a short-term loan from a company controlled by a
director who was also the Company's president, in the amount of $2,000,000
for a period of two months pending the sale of Savage. The loan was repaid
on October 31, 1995 with interest (calculated at 15%) of $22,000.
The Company also received short-term loans from three directors
aggregating $600,000 during the months of April through June 1995. These
loans were repaid by July 1995 with interest (calculated at 10%) of
$8,000.
In August 1995, the Company issued 150,000 shares to a director, who was
also the Company's president, at $3.50 per share which was the market
value of the Company's shares at the time.
(22) Significant Customers and Concentration of Credit Risk
In 1996, one customer represented 25% of the consolidated net revenue.
Three customers represented 49%, 24% and 11% of the consolidated net
revenues for the two month period ended December 31, 1995.
57
(Continued)
58
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
Four customers represented 27%, 15%, 13% and 13% of consolidated net
revenues for the year ended October 31, 1995.
None of these customers are expected to generate significant revenues in
fiscal 1997.
The Company is subject to credit risk through trade receivables. Credit
risk is minimized through advance and milestone payments on large
contracts, which are generally with large, well-established companies or
governmental units. The Company has never experienced significant credit
losses. At December 31, 1996, one customer accounted for 25% of the
accounts receivable.
(23) Supplemental Disclosure of Cash Flow Information (thousands of U.S.
dollars)
Two months
Year ended ended Years ended
December 31, December 31, October 31
------------------------
1996 1995 1995 1994
------------ ------------ -------- --------
Cash paid during the period for:
Interest $ 509 23 408 443
Taxes relating to continuing
operations -- -- -- 303
Noncash Items
During the year ended December 31, 1996, the Company recorded the
following noncash transactions:
(a) Converted convertible debentures into stock - $10,087,000 (note
11).
(b) Allocation of proceeds from convertible debentures to beneficial
conversion features - $4,947,000 (note 11).
(c) Issued common stock warrants in conjunction with convertible
debentures - $3,117,000 (notes 11 and 15).
(d) Obtained a technology license in exchange for a note - $3,267,000
(note 8).
(e) Issued stock in final settlement of the Intelect, Inc.
acquisition - $850,000 (note 7(a)).
(f) Issued stock as part of employment agreements - $500,000 (note
7(d)).
(g) Recognized compensation expense on stock options granted at less
than market price - $487,000 (note 16).
(h) Acquired an other asset with stock - $375,000 (note 15).
(i) Acquired equipment under capital leases - $111,000 (note 12).
During the Transition Period ended December 31, 1995, the Company acquired
equipment under capital leases of $330,000 and made an adjustment to the
purchase price of Intelect Europe of $75,000.
58
(Continued)
59
INTELECT COMMUNICATIONS SYSTEMS LIMITED AND SUBSIDIARIES
Notes to Consolidated Financial Statements
During the year ended October 31, 1995, the Company issued debentures with
a discounted fair value of $224,000 and $477,000 at December 31 and
October 31, 1995, respectively, to the sellers of Intelect, Inc. (see note
7 above). The Company issued 160,991 shares at October 31, 1995, to retire
certain preferred shares of Savage Arms (with a carrying value of
$402,478) (see note 9 above).
(24) Subsequent Events
(a) On February 18, 1997, the Company signed a letter of intent with a
private lender to provide a credit facility (the "Credit Facility"),
of up to $15,000,000. The initial portion of the Credit Facility has
been finalized, and permits the Company to borrow up to $5,000,000,
secured by all outstanding shares of DNA Enterprises, Inc. ("DNA"), a
wholly owned subsidiary of the Company. In conjunction with the
initial portion of the Credit Facility, the Company has issued
warrants to purchase 300,000 common shares at $5.00, at any time
until February 26, 2002, and warrants to purchase 300,000 common
shares at $3.25, at any time until March 28, 2002.
The subsequent portion of the Credit Facility, subject to completion
of the lender's due diligence and negotiation of certain terms and
conditions, provides for up to $10,000,000 subject to a formula based
on accounts receivable, inventory and fixed assets. The Credit
Facility is to be secured by the assets and by guarantees of
subsidiaries. In conjunction with the subsequent portion of the
Credit Facility, the Company will issue warrants to purchase 150,000
common shares for each $1,000,000 or portion thereof drawn against
the note, all exercisable at a price to be negotiated, at any time
for a five year period from the date of issuance.
The entire Credit Facility is due March 27, 1998, including principal
and interest at the rate of 2% over prime. Proceeds of the Credit
Facility will be used for general corporate purposes, including the
settlement of contractual obligations related to the acquisition of
DNA.
(b) The $2,500,000 of contractual obligations related to the DNA
acquisition, due in February 1997, were not paid in full. The Company
paid $200,000 and is negotiating revised terms to pay the remaining
$2,300,000 during 1997 (note 10).
59
60
PART III
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Company will file with the Securities and Exchange Commission a
definitive Proxy Statement no later than 120 days after the close of its fiscal
year ended December 31, 1996 (the "Proxy Statement"). The information required
by this Item is incorporated by reference from the Proxy Statement.
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference
from the Proxy Statement.
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference
from the Proxy Statement.
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference
from the Proxy Statement.
PART IV
ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
A. The Financial Statements and Financial Statement Schedules
filed as part of this report are listed and indexed on Page 22. Schedules
other than those listed in the index have been omitted because they are not
applicable or the required information has been included elsewhere in this
report.
B. Listed below are all Exhibits filed as part of this report.
Certain Exhibits are incorporated by reference to documents previously filed by
the Registrant with the Securities and Exchange Commission pursuant to Rule
12b-32 under the Securities Exchange Act of 1934, as amended.
Exhibit No. Exhibit
----------- -------
3.1 Memorandum of Association of the Company, as amended (9)
3.2 Certificate of Incorporation of the Company, as amended (9)
3.3 Bye-laws of the Company (9)
4.1 Specimen common share certificate (1)
4.2 Form of 7.5% Convertible Debenture due June 7, 1998 of the Company (8)
4.3 Form of 7.5% Convertible Debenture due August 8, 1998 of the Company (10)
4.4 Form of 7% Series A Convertible Debenture due October 15, 1998 of Intelect Communications systems
Limited (10)
4.5 Form of 7% Series B Convertible Debenture due October 15, 1998 of Intelect Communications Systems
Limited (10)
10.1 Option Rights Agreement for Outstanding Shares of Intelect, Inc. and Stock Purchase Agreement dated
January 13, 1995 (11) (Note - this Agreement was replaced by the March 31, 1995 Option agreement)
10.2 Option Agreement dated March 31, 1995 by and among the Company, Sellers and Intelect, Inc. (3)
10.3 Stock Purchase Agreement dated October 3, 1995 by and among the Company, Savage Corporation and
Savage Sports Corporation (3)
10.4 Management Agreement dated as of October 1, 1995 between Intelect Systems Corp. and Herman
Frietsch* (7)
61
61
Exhibit No. Exhibit
----------- -------
10.5 Amendment No. One dated January 1, 1996 between Intelect Systems Corp. and Herman Frietsch to
Management Agreement referred to in Exhibit 10.4*
10.6 General Employment Agreement dated as of November 1, 1994 between the Company and Peter G.
Leighton* (8)
10.7 Amendment No. One dated as of January 2, 1996 between the Company and Peter G. Leighton to the
General Employment Agreement referred to in Exhibit 10.6*
10.8 Employment Agreement dated as of April 1, 1996 between the Company and Eugene Helms* (10)
10.9 Employment Agreement dated as of April 24, 1995 between the Company and Peter Ianace* (7)
10.10 Stock Purchase Agreement dated January 13, 1996 by and between Intelect Systems Corp., the Company,
Robert E. Nimon, Kim F. Nimon, Edgar L. Read, Gregory L. Mayhan and DNA Enterprises, Inc. (4)
10.11 Warrants dated February 13, 1996 issued to Edgar L. Read and Gregory L. Mayhan delivered at Closing
(4)
10.12 Warrants dated February 13, 1996 issued to Edgar L. Read and Gregory L. Mayhan to be delivered one
year after Closing (2)
10.13 Consulting Agreement dated as of February 13, 1996 between DNA Enterprises, Inc. and Nimon
Consulting, Inc. (4)
10.14 Employment Agreement dated as of February 13, 1996 between Edgar L. Read and DNA Enterprises, Inc.*
(4)
10.15 Employment Agreement dated as of February 13, 1996 between Gregory L. Mayhan and DNA Enterprises,
Inc.* (4)
10.16 Agreement and Plan of Merger dated March 19, 1996 among the Company, Mid-Ocean, Inc. and Mosaic
Information Technologies, Inc. (6)
10.17 Registration Rights Agreement dated as of March 29, 1996 among the Company and certain purchasers
(6)
10.18 Employment Agreement dated March 29, 1996 among Matthew Feldman, the Company and Mosaic Information
Technologies Inc.* (6)
10.19 Convertible Securities Agreement dated June 7, 1996 among the Company, Infinity Investors, Ltd. and
Seacrest Capital Limited (8)
10.20 Registration Rights Agreement dated June 7, 1996 among the Company, Infinity Investors, Ltd. and
Seacrest Capital Limited (8)
10.21 Letter Agreement dated July 31, 1996 among the Company, Infinity Investors, Ltd. and Seacrest
Capital Limited (8)
10.22 Convertible Securities Agreement dated August 8, 1996 among the Company and certain Investors (10)
10.23 Registration Rights Agreement dated August 8, 1996 among the Company and certain Investors (10)
10.24 Convertible Securities Agreement dated October 15, 1996 among the Company, Infinity Investors, Ltd.
and Seacrest Capital Limited (10)
10.25 Registration Rights Agreement dated October 15, 1996 among the Company, Infinity Investors, Ltd.
and Seacrest Capital Limited (10)
10.26 Book Entry Transfer Agent Agreement dated October 15, 1996 by and among the Company, Infinity
Investors, Ltd., Seacrest Capital Limited and American Stock Transfer & Trust Company (10)
10.27 Offer to Purchase the Five Year Six Percent (6%) Subordinated Debentures of Intelect, Inc. for an
Aggregate of 170,000 Shares of Common Stock, $0.01 Par Value, of the Company and the payment of
Certain Amounts in Lieu of Issuing Fractional Shares, Dated September 6, 1996 (10)
10.28 Letter of Transmittal to Accompany Five Year Six Percent (6%) Subordinated Debentures of Intelect,
Inc. (10)
10.29 Form of Release in Consideration of Exchange of Property (10)
10.30 Promissory Note dated as of February 26, 1997 to St. James Capital Corp. from the Company
10.31 Pledge Agreement dated as of February 26, 1997 between the Company and St. James Capital Corp.
10.32 Warrant to Purchase Common Stock of the Company Expiring February 26, 2002
10.33 Registration Rights Agreement dated February 26, 1997 between the Company and St. James Capital
Corp.
10.34 Amended and Restated Promissory Note dated as of February 26, 1997 to St. James Capital Corp. from
the Company
10.35 First Amendment to Pledge Agreement dated as of March 27, 1997 between the Company and St. James
Capital Corp.
10.36 Warrant to Purchase Common Stock of the Company Expiring March 27, 2002
10.37 Amendment No. 1 to Registration Rights Agreement dated as of March 27, 1997 between the Company and
St. James Capital Corp.
10.38 Employee Stock Option Plan adopted April 24, 1986*
10.39 Stock Incentive Plan adopted December 13, 1995*
62
62
Exhibit No. Exhibit
----------- -------
10.40 License Agreement between Digital Equipment Corp. and Mosaic Information Technologies dated June
13, 1996
21.0 Subsidiaries of the Company
23.0 Consent of Independent Auditors
27.0 Financial Data Schedule
*Management contract or other compensatory plan or arrangement.
(1) Incorporated herein by reference to the Registrant's Form 10-K for the
fiscal year ended October 31, 1995
(2) Incorporated herein by reference to the Registrant's Transition Report
on Form 10-K for the transition period ended December 31, 1995
(3) Incorporated herein by reference to the Registrant's Form 8-K dated
November 10, 1995
(4) Incorporated herein by reference to the Registrant's Form 8-K dated
February 20, 1996
(5) Incorporated herein by reference to the Registrant's Form 10-Q for the
fiscal quarter ended March 31, 1996
(6) Incorporated herein by reference to the Registrant's Form 8-K dated
April 12, 1996
(7) Incorporated herein by reference to the Registrant's Form 8-K/A dated
April 12, 1996
(8) Incorporated herein by reference to the Registrant's Form 10-Q for the
fiscal quarter ended June 30, 1996
(9) Incorporated herein by reference to the Registrant's Form S-3
(#333-9049)
(10) Incorporated herein by reference to the Registrant's Form 10-Q for the
fiscal quarter ended September 30, 1996
(11) Incorporated herein by reference to the Registrants Form 20-F for the
fiscal year ended October 31, 1994
C. The Registrant has not filed any reports on Form 8-K during the
last quarter of the period covered by this Report.
63
63
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
INTELECT COMMUNICATIONS SYSTEMS LIMITED
(Registrant)
Date: April 15, 1997 By: /s/ HERMAN M. FRIETSCH
-------------------------------
Herman M. Frietsch
Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.
/s/ HERMAN M. FRIETSCH /s/ ANTON VON AND ZU LIECHENSTEIN
- - ------------------------------------------- ----------------------------------
Herman M. Frietsch Anton von and zu Liechenstein,
Chief Executive Officer and Director Director
(Principal Executive Officer)
/s/ EDWIN J. DUCAYET, JR. /s/ PHILIP P. SUDAN, JR.
- - ------------------------------------------- ----------------------------------
Edwin J. Ducayet, Jr. Philip P. Sudan, Jr., Director
Chief Financial Officer
(Principal Financial and Accounting Officer)
64
64
INDEX TO EXHIBITS
Exhibit No. Exhibit
----------- -------
3.1 Memorandum of Association of the Company, as amended (9)
3.2 Certificate of Incorporation of the Company, as amended (9)
3.3 Bye-laws of the Company (9)
4.1 Specimen common share certificate (1)
4.2 Form of 7.5% Convertible Debenture due June 7, 1998 of the Company (8)
4.3 Form of 7.5% Convertible Debenture due August 8, 1998 of the Company (10)
4.4 Form of 7% Series A Convertible Debenture due October 15, 1998 of Intelect Communications systems
Limited (10)
4.5 Form of 7% Series B Convertible Debenture due October 15, 1998 of Intelect Communications Systems
Limited (10)
10.1 Option Rights Agreement for Outstanding Shares of Intelect, Inc. and Stock Purchase Agreement dated
January 13, 1995 (11) (Note - this Agreement was replaced by the March 31, 1995 Option agreement)
10.2 Option Agreement dated March 31, 1995 by and among the Company, Sellers and Intelect, Inc. (3)
10.3 Stock Purchase Agreement dated October 3, 1995 by and among the Company, Savage Corporation and
Savage Sports Corporation (3)
10.4 Management Agreement dated as of October 1, 1995 between Intelect Systems Corp. and Herman
Frietsch* (7)
10.5 Amendment No. One dated January 1, 1996 between Intelect Systems Corp. and Herman Frietsch to
Management Agreement referred to in Exhibit 10.4*
10.6 General Employment Agreement dated as of November 1, 1994 between the Company and Peter G.
Leighton* (8)
10.7 Amendment No. One dated as of January 2, 1996 between the Company and Peter G. Leighton to the
General Employment Agreement referred to in Exhibit 10.6*
10.8 Employment Agreement dated as of April 1, 1996 between the Company and Eugene Helms* (10)
10.9 Employment Agreement dated as of April 24, 1995 between the Company and Peter Ianace* (7)
10.10 Stock Purchase Agreement dated January 13, 1996 by and between Intelect Systems Corp., the Company,
Robert E. Nimon, Kim F. Nimon, Edgar L. Read, Gregory L. Mayhan and DNA Enterprises, Inc. (4)
10.11 Warrants dated February 13, 1996 issued to Edgar L. Read and Gregory L. Mayhan delivered at Closing
(4)
10.12 Warrants dated February 13, 1996 issued to Edgar L. Read and Gregory L. Mayhan to be delivered one
year after Closing (2)
10.13 Consulting Agreement dated as of February 13, 1996 between DNA Enterprises, Inc. and Nimon
Consulting, Inc. (4)
10.14 Employment Agreement dated as of February 13, 1996 between Edgar L. Read and DNA Enterprises, Inc.*
(4)
10.15 Employment Agreement dated as of February 13, 1996 between Gregory L. Mayhan and DNA Enterprises,
Inc.* (4)
10.16 Agreement and Plan of Merger dated March 19, 1996 among the Company, Mid-Ocean, Inc. and Mosaic
Information Technologies, Inc. (6)
10.17 Registration Rights Agreement dated as of March 29, 1996 among the Company and certain purchasers
(6)
10.18 Employment Agreement dated March 29, 1996 among Matthew Feldman, the Company and Mosaic Information
Technologies Inc.* (6)
10.19 Convertible Securities Agreement dated June 7, 1996 among the Company, Infinity Investors, Ltd. and
Seacrest Capital Limited (8)
10.20 Registration Rights Agreement dated June 7, 1996 among the Company, Infinity Investors, Ltd. and
Seacrest Capital Limited (8)
10.21 Letter Agreement dated July 31, 1996 among the Company, Infinity Investors, Ltd. and Seacrest
Capital Limited (8)
10.22 Convertible Securities Agreement dated August 8, 1996 among the Company and certain Investors (10)
10.23 Registration Rights Agreement dated August 8, 1996 among the Company and certain Investors (10)
10.24 Convertible Securities Agreement dated October 15, 1996 among the Company, Infinity Investors, Ltd.
and Seacrest Capital Limited (10)
10.25 Registration Rights Agreement dated October 15, 1996 among the Company, Infinity Investors, Ltd.
and Seacrest Capital Limited (10)
10.26 Book Entry Transfer Agent Agreement dated October 15, 1996 by and among the Company, Infinity
Investors, Ltd., Seacrest Capital Limited and American Stock Transfer & Trust Company (10)
10.27 Offer to Purchase the Five Year Six Percent (6%) Subordinated Debentures of Intelect, Inc. for an
Aggregate of 170,000 Shares of Common Stock, $0.01 Par Value, of the Company and the payment of
Certain Amounts in Lieu of Issuing Fractional Shares, Dated September 6, 1996 (10)
10.28 Letter of Transmittal to Accompany Five Year Six Percent (6%) Subordinated Debentures of Intelect,
Inc. (10)
10.29 Form of Release in Consideration of Exchange of Property (10)
10.30 Promissory Note dated as of February 26, 1997 to St. James Capital Corp. from the Company
10.31 Pledge Agreement dated as of February 26, 1997 between the Company and St. James Capital Corp.
10.32 Warrant to Purchase Common Stock of the Company Expiring February 26, 2002
10.33 Registration Rights Agreement dated February 26, 1997 between the Company and St. James Capital
Corp.
10.34 Amended and Restated Promissory Note dated as of February 26, 1997 to St. James Capital Corp. from
the Company
10.35 First Amendment to Pledge Agreement dated as of March 27, 1997 between the Company and St. James
Capital Corp.
10.36 Warrant to Purchase Common Stock of the Company Expiring March 27, 2002
10.37 Amendment No. 1 to Registration Rights Agreement dated as of March 27, 1997 between the Company and
St. James Capital Corp.
10.38 Employee Stock Option Plan adopted April 24, 1986*
10.39 Stock Incentive Plan adopted December 13, 1995*
65
Exhibit No. Exhibit
----------- -------
10.40 License Agreement between Digital Equipment Corp. and Mosaic Information Technologies dated June
13, 1996
21.0 Subsidiaries of the Company
23.0 Consent of Independent Auditors
27.0 Financial Data Schedule
*Management contract or other compensatory plan or arrangement.
(1) Incorporated herein by reference to the Registrant's Form 10-K for the
fiscal year ended October 31, 1995
(2) Incorporated herein by reference to the Registrant's Transition Report
on Form 10-K for the transition period ended December 31, 1995
(3) Incorporated herein by reference to the Registrant's Form 8-K dated
November 10, 1995
(4) Incorporated herein by reference to the Registrant's Form 8-K dated
February 20, 1996
(5) Incorporated herein by reference to the Registrant's Form 10-Q for the
fiscal quarter ended March 31, 1996
(6) Incorporated herein by reference to the Registrant's Form 8-K dated
April 12, 1996
(7) Incorporated herein by reference to the Registrant's Form 8-K/A dated
April 12, 1996
(8) Incorporated herein by reference to the Registrant's Form 10-Q for the
fiscal quarter ended June 30, 1996
(9) Incorporated herein by reference to the Registrant's Form S-3
(#333-9049)
(10) Incorporated herein by reference to the Registrant's Form 10-Q for the
fiscal quarter ended September 30, 1996
(11) Incorporated herein by reference to the Registrants Form 20-F for the
fiscal year ended October 31, 1994