EXHIBIT 13.0
EXCERPTS FROM ANNUAL REPORT TO SECURITY HOLDERS
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
SHAREHOLDERS AND BOARD OF DIRECTORS
INTER-TEL, INCORPORATED
We have audited the accompanying consolidated balance sheets of Inter-Tel,
Incorporated and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of income, shareholders' equity, and cash flows for each
of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Inter-Tel,
Incorporated and subsidiaries at December 31, 1998 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
/s/ Ernst & Young LLP
Phoenix, Arizona
February 26, 1999
32
INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 1998 and 1997
(In thousands, except share amounts) 1998 1997
---- ----
ASSETS
CURRENT ASSETS
Cash and equivalents $ 63,124 $ 88,805
Accounts receivable, less allowances of
$4,604 in 1998 and $3,722 in 1997 41,116 32,234
Inventories, less allowances of $5,453 in
1998 and $5,740 in 1997 19,663 21,539
Net investment in sales-leases 13,979 9,196
Prepaid expenses and other assets 2,781 5,625
--------- ---------
TOTAL CURRENT ASSETS 140,663 157,399
PROPERTY, PLANT & EQUIPMENT 28,969 19,559
OTHER ASSETS 27,398 18,030
--------- ---------
$ 197,030 $ 194,988
--------- ---------
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 14,956 $ 14,864
Other current liabilities 29,390 18,721
--------- ---------
TOTAL CURRENT LIABILITIES 44,346 33,585
DEFERRED TAX LIABILITY 5,026 11,343
OTHER LIABILITIES 4,972 4,555
SHAREHOLDERS' EQUITY
Common stock, no par value - authorized
100,000,000 shares, issued and outstanding -
26,029,987 shares in 1998 and 26,687,766
shares in 1997 104,539 99,229
Retained earnings 54,194 46,547
Accumulated other comprehensive income (196) (271)
--------- ---------
158,537 145,505
Less: Treasury stock at cost (15,851) --
--------- ---------
TOTAL SHAREHOLDERS' EQUITY 142,686 145,505
--------- ---------
$ 197,030 $ 194,988
--------- ---------
See accompanying notes.
33
INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 1998, 1997 and 1996
(In thousands, except per share data) 1998 1997 1996
---- ---- ----
NET SALES $ 274,504 $ 223,569 $ 185,884
Cost of sales 140,946 122,363 104,966
--------- --------- ---------
GROSS PROFIT 133,558 101,206 80,918
Research and development 11,373 7,998 6,581
Selling, general and administrative 86,554 69,942 56,386
Special charge 22,755 -- 4,542
--------- --------- ---------
OPERATING INCOME 12,876 23,266 13,409
--------- --------- ---------
Other income 3,018 1,383 1,974
Interest expense (60) (47) (77)
--------- --------- ---------
INCOME BEFORE INCOME TAXES 15,834 24,602 15,306
INCOME TAXES
Current 13,390 8,850 3,480
Deferred (6,600) 1,070 2,784
--------- --------- ---------
6,790 9,920 6,264
--------- --------- ---------
NET INCOME $ 9,044 $ 14,682 $ 9,042
--------- --------- ---------
NET INCOME PER SHARE
Basic $ 0.34 $ 0.59 $ 0.35
Diluted $ 0.32 $ 0.57 $ 0.34
--------- --------- ---------
Average common shares outstanding 26,602 24,836 25,780
Average common shares outstanding
assuming dilution 27,846 25,983 26,572
--------- --------- ---------
See accompanying notes.
34
INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF
SHAREHOLDERS' EQUITY
Years Ended December 31, 1998, 1997 and 1996
Accumulated
Other Receivable
(In thousands, except Common Treasury Retained Comprehensive From
share amounts) Stock Stock Earnings Income ESOP Total
-------------- ----- ----- -------- ------ ---- -----
BALANCE AT DECEMBER 31, 1995 $ 58,966 $ -- $ 26,422 $ (112) $ (159) $ 85,117
Exercise of stock options 611 611
Tax benefit from stock options 417 417
Escrow share cancellation from
prior stock acquisition (119) (119)
Collection from ESOP 113 113
Net income 9,042 9,042
Loss on currency translation (247) (247)
--------
Comprehensive income 8,795
- -------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1996 59,875 -- 35,464 (359) (46) 94,934
Stock repurchase (27,194) (27,194)
Exercise of stock options 642 4,533 (3,332) 1,843
Tax benefit from stock options 1,967 1,967
Collection from ESOP 46 46
Stock issued under
Employee Stock Purchase Plan 256 256
Issuance of 3,000,000 shares of
common stock 36,489 22,661 59,150
Net income 14,682 14,682
Gain on currency translation 88 88
--------
Comprehensive income 14,770
Dividends (267) (267)
- -------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1997 99,229 -- 46,547 (271) -- 145,505
Stock repurchase (16,815) (16,815)
Exercise of stock options 1,487 642 (368) 1,761
Tax benefit from stock options 1,979 1,979
Issuance of 140,000 shares in
acquisition 1,485 1,485
Stock issued under
Employee Stock Purchase Plan 359 322 30 711
Net income 9,044 9,044
Gain on currency translation 75 75
--------
Comprehensive income 9,119
Dividends (1,059) (1,059)
- -------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1998 $ 104,539 $(15,851) $ 54,194 $ (196) $ -- $142,686
=======================================================================================================
See accompanying notes.
35
INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1998, 1997 and 1996
- --------------------------------------------------------------------------------
(In thousands) 1998 1997 1996
---- ---- ----
OPERATING ACTIVITIES:
Net income $ 9,044 $ 14,682 $ 9,042
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization 6,718 4,578 4,097
Provision for losses on receivables 5,851 4,104 3,746
Provision for inventory valuation 1,828 4,021 609
Net contribution to ESOP -- 46 113
Increase/(decrease) in other liabilities 586 1,269 (604)
(Gain)/loss on sale of property and equipment 36 (25) 3,421
Deferred income taxes (6,600) 1,070 2,784
Effect of exchange rate changes 74 88 (247)
Purchased in-process research and development 22,755 -- --
Changes in operating assets and liabilities (8,541) (1,633) (15,704)
-------- -------- --------
NET CASH PROVIDED BY OPERATING ACTIVITIES 31,751 28,200 7,257
-------- -------- --------
INVESTING ACTIVITIES:
Additions to property and equipment (15,175) (12,449) (6,951)
Proceeds from sale of property and equipment 117 63 159
Cash used in acquisitions (25,362) -- (1,780)
-------- -------- --------
NET CASH USED IN INVESTING ACTIVITIES (40,420) (12,386) (8,572)
-------- -------- --------
FINANCING ACTIVITIES:
Net proceeds from stock offering -- 59,150 --
Cash dividends paid (1,059) -- --
Proceeds from exercise of stock options 1,761 1,843 611
Proceeds from stock issued under the
Employee Stock Purchase Plan 711 256 --
Payments on acquired long-term debt (1,610) -- --
Treasury stock purchases (16,815) (27,194) --
-------- -------- --------
NET CASH (USED IN) / PROVIDED BY
FINANCING ACTIVITIES (17,012) 34,055 611
-------- -------- --------
INCREASE (DECREASE)
IN CASH AND EQUIVALENTS (25,681) 49,869 (704)
CASH AND EQUIVALENTS AT BEGINNING
OF YEAR 88,805 38,936 39,640
-------- -------- --------
CASH AND EQUIVALENTS AT END OF YEAR $ 63,124 $ 88,805 $ 38,936
======== ======== ========
Noncash transaction: acquisition of
ITS for stock $ 1,485 $ -- $ --
See accompanying notes.
36
INTER-TEL, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
- -------------------------------------------------------------------------------
NOTE A -- SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS. Inter-Tel is a single point of contact, full
service provider of digital business telephone systems, call processing
software, voice processing software, call accounting software, Internet Protocol
(IP) telephony software, computer telephone integration applications and long
distance calling services. Inter-Tel's products and services include the AXXESS
and Inter-Tel Axxent digital business communication software platforms, the
AXXESSORY TALK voice processing platform, the Inter-Tel Vocal'Net IP telephony
gateway, InterPrise gateway, the Inter-Tel Vocal'Net Service Provider Software
and Centralized Accounting Software and Inter-Tel.net, an IP telephony packet
switched long distance service. The Company also provides maintenance, leasing
and support services for its products.
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements
include the accounts of Inter-Tel, Incorporated and all significant subsidiaries
(collectively, the "Company"). Intercompany accounts and transactions have been
eliminated in consolidation.
CASH AND EQUIVALENTS. Cash and equivalents include all highly liquid
investments with a remaining maturity of three months or less at date of
acquisition. Excess cash and equivalents are primarily invested in mutual funds
comprised of foreign and domestic high quality dollar denominated money market
instruments rated A-1 by Standard & Poor's Ratings Group, or equivalent.
INVENTORIES. Inventories, consisting principally of telephone systems,
computer equipment and related components, are stated at the lower of cost
(first-in, first-out method) or market.
PROPERTY, PLANT AND EQUIPMENT. Property, plant and equipment is stated
at cost. Depreciation is computed using the straight-line method over the
estimated useful lives of the related property which range from 3 years to 12
years. Leasehold improvements are depreciated over the shorter of the related
lease terms or the estimated useful lives of the improvements.
EXCESS OF PURCHASE PRICE OVER NET ASSETS ACQUIRED. Purchase prices of
acquired businesses that are accounted for as purchases have been allocated to
the assets and liabilities acquired based on the estimated fair values on the
respective acquisition dates. Based on these values, the excess purchase prices
over the fair value of the net assets acquired are being amortized over 3 to 40
years. Accumulated amortization through December 31, 1998 was $1,343,000.
SALES-LEASES. The discounted present values of minimum rental payments
under sales-type leases are recorded as sales, net of provisions for continuing
administration and other expenses over the lease period. The costs of systems
installed under these sales-leases, net of residual values at the end of the
lease periods, are recorded as costs of sales. Gains or losses resulting from
the sale of rental income from such leases are recorded as adjustments to the
original sales amounts.
INCOME TAXES. Deferred income taxes result from temporary differences
in the recognition of revenues and expenses for financial reporting and income
tax purposes.
ADVERTISING. The cost of advertising is expensed as incurred. The
Company incurred $616,000; $577,000 and $437,000 in advertising costs during
1998, 1997, and 1996, respectively.
STOCK BASED COMPENSATION. The Company grants stock options for a fixed
number of shares to employees with an exercise price equal to the fair market
value of the shares at the date of grant. The Company accounts for stock option
grants in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," ("APB 25") and accordingly,
recognizes no compensation expense for these stock option grants. Refer to note
J regarding additional disclosures.
37
FOREIGN CURRENCY TRANSLATION. For the Company's foreign operations, the
local currency is the functional currency. All assets and liabilities are
translated at period-end exchange rates and all income statement amounts are
translated at an average of month-end rates. Adjustments resulting from this
translation are recorded in accumulated other comprehensive income.
CONTINGENCIES. The Company is a party to certain litigation in the
normal course of business. Management does not anticipate that the resolution of
such matters will have a material adverse effect on the Company's consolidated
financial position.
USE OF ESTIMATES. The preparation of the consolidated financial
statements in conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes. Actual results
could differ from those estimates.
RECLASSIFICATIONS. Certain reclassifications have been made to the 1997
and 1996 financial statements to conform to the 1998 presentation.
RECENTLY ISSUED ACCOUNTING STANDARDS.
COMPREHENSIVE INCOME. Effective January 1, 1998, the Company adopted
Statement of Financial Accounting Standards No. 130, ("SFAS 130"), "Reporting
Comprehensive Income." SFAS 130 established new standards for the reporting and
display of comprehensive income and its components. Comprehensive income
includes certain non-owner changes in equity that are currently excluded from
net income (i.e., foreign currency translation adjustments). The adoption of
SFAS 130 had no impact on the Company's net income or stockholders' equity.
SEGMENT INFORMATION. The Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" ("SFAS 131") in the fiscal year ended December 31, 1998.
SFAS 131 establishes standards for reporting information regarding operating
segments in annual financial statements and requires selected information for
those segments to be presented in interim financial reports issued to
stockholders. SFAS 131 also establishes standards for related disclosures about
products and services and geographic areas. To date, the Company has viewed its
operations as principally one segment; telephone systems, software and related
long distance calling services. Refer to Note M for more information regarding
segment disclosures.
CAPITALIZATION OF COSTS OF COMPUTER SOFTWARE. On January 1, 1999, the
Company will adopt the accounting provisions required by the American Institute
of Certified Public Accountants' Statement of Position ("SOP") 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use,"
issued in March 1998. SOP 98-1, among other things, requires that certain costs
of internal use software, whether purchased or developed internally, be
capitalized and amortized over the estimated useful life of the software. Based
on information currently available, the adoption of the SOP is not expected to
have a material impact on the Company's consolidated results of operations,
financial position or cash flows.
NOTE B -- ACQUISITIONS
Effective June 1998, the Company acquired certain assets and
liabilities of TMSI for cash. The transaction has been accounted for as a
purchase transaction. The purchase price of approximately $25 million plus
related acquisition costs has been allocated to the acquired assets and
liabilities based on fair values at acquisition. In connection with this
purchase, the Company recorded a charge to net income of $13.7 million, for the
write-off of in-process research and development and acquisition related
expenses. The purchase price over net assets acquired (goodwill) is being
amortized over 10 years.
38
At the end of the second quarter of 1998, the Company acquired 100% of
the stock of ITS in exchange for 140,000 shares of the Company's common stock.
The transaction has been accounted for as a purchase transaction. The purchase
price has been allocated to the acquired assets and liabilities based on fair
values at acquisition. The purchase price over net assets acquired (goodwill) is
being amortized over 10 years.
In November 1998, the Company acquired certain assets and liabilities
of Telesystems for cash and a short term note. The transaction has been
accounted for as a purchase transaction. The purchase price of approximately
$300,000 has been allocated to the acquired assets and liabilities based on fair
values at acquisition. The purchase price over net assets acquired (goodwill) is
being amortized over 10 years.
In December 1998, the Company acquired certain assets and liabilities
of Southcom for cash and a short term note. The transaction has been accounted
for as a purchase transaction. The purchase price of approximately $2.3 million
has been allocated to the acquired assets and liabilities based on fair values
at acquisition. The purchase price over net assets acquired (goodwill) is being
amortized over 10 years.
TMSI, ITS, Southcom, and Telesystems did not constitute significant
subsidiaries as defined by the Securities and Exchange Commission. Goodwill from
these acquisitions totaled $5.0 million.
NOTE C -- NET INVESTMENT IN SALES-LEASES
Net investment in sales-leases represents the value of sales-leases
presently held under the Company's Totalease program. The Company currently
sells the rental income from some of the sales-leases. The Company maintains
reserves against potential recourse following the resales based upon loss
experience and past due accounts. Activity during the years was as follows:
Year Ended December 31
(In thousands) 1998 1997 1996
---- ---- ----
Sales of rental income $ 68,375 $57,812 $42,985
Sold income remaining
unbilled at end of year $131,292 $99,900 $65,970
Allowance for uncollectible
minimum lease payments
and recourse liability at
end of year $ 5,716 $ 3,969 $ 2,706
The Company does not expect any significant losses from the recourse
provisions related to the sale of rental income. The Company is compensated for
administration and servicing of rental income sold.
NOTE D -- PROPERTY, PLANT & EQUIPMENT
December 31
(In thousands) 1998 1997
---- ----
Computer systems and equipment $32,255 $27,886
Transportation equipment 1,644 1,665
Furniture and fixtures 4,611 4,043
Leasehold improvements 2,323 1,693
Operating leases (telephone equipment) 7,970 684
Building 1,822 --
Land 2,629 2,619
------- -------
53,254 38,590
Less: Accumulated depreciation
and amortization 24,285 19,031
------- -------
$28,969 $19,559
======= =======
39
NOTE E -- OTHER ASSETS
December 31
(In thousands) 1998 1997
---- ----
Net investment in sales-leases $17,141 $13,402
Excess of purchase price over net
assets acquired, net 8,715 4,380
Other assets 1,542 248
------- -------
$27,398 $18,030
======= =======
NOTE F-- OTHER CURRENT LIABILITIES
December 31
(In thousands) 1998 1997
---- ----
Compensation and employee benefits $10,829 $ 8,163
Deferred revenues 2,947 2,947
Other accrued expenses 15,614 7,611
------- -------
$29,390 $18,721
======= =======
NOTE G -- CREDIT LINE
The Company maintains a $7,000,000 unsecured bank credit line at prime
rate to cover international letters of credit and for other purposes. The credit
agreement matures June 1, 2000 and contains certain restrictions and financial
covenants. At December 31, 1998, $1,692,000 of the credit line was committed
under letter of credit arrangements.
NOTE H -- LEASES
Rental expense amounted to $5,060,000; $4,342,000 and $3,538,000; in
1998, 1997 and 1996, respectively. Noncancellable operating leases are primarily
for buildings. Certain of the leases contain provisions for renewal options and
scheduled rent increases. At December 31, 1998, future minimum commitments under
noncancellable leases, including a five year lease for its headquarters facility
and a 15 year lease for its distribution and support facility, are: 1999 --
$3,262,000; 2000 -- $2,255,000; 2001 -- $1,588,000; 2002 -- $1,083,000; 2003 --
$590,000; thereafter -- $2,523,000.
NOTE I -- INCOME TAXES
The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under
SFAS 109, the liability method is used in accounting for income taxes. Under
this method, deferred tax assets and liabilities are determined (and classified
as current or long-term) based on differences between financial reporting and
tax bases of assets and liabilities and are measured using the enacted tax rates
and laws that will be in effect when the differences are expected to reverse.
40
Significant components of the Company's deferred tax liabilities and
assets as of December 31, are as follows:
(In thousands) 1998 1997
---- ----
DEFERRED TAX LIABILITIES:
Lease--sales and reserves $21,029 $15,624
------- -------
TOTAL DEFERRED TAX LIABILITIES 21,029 15,624
------- -------
DEFERRED TAX ASSETS:
Inventory basis differences 3,097 2,580
Accounts receivable reserves 1,782 1,357
Maintenance reserve 200 259
Accrued vacation pay 750 604
Book over tax depreciation 1,058 5
Foreign loss carryforwards 1,160 1,047
In-process R&D write-off 9,102 --
Other -- net 2,674 1,853
------- -------
Deferred tax assets 19,823 7,705
Less valuation reserve 1,160 1,047
------- -------
Net deferred tax assets 18,663 6,658
------- -------
NET DEFERRED TAX LIABILITIES $ 2,366 $ 8,966
======= =======
During 1998 and 1997, the Company incurred losses of $322,000 and
$722,000 with respect to foreign operations. At December 31, 1998, the Company
had foreign loss carryforwards of approximately $3,466,000, which will begin to
expire in 1999. The valuation allowance increased by $113,000 in 1998 and
$253,000 in 1997 due to increases in foreign loss carryforward benefits.
Federal and state income taxes consisted of the following:
(In thousands) 1998 1997 1996
---- ---- ----
Federal $4,910 $8,290 $5,414
State 1,880 1,630 850
------ ------ ------
$6,790 $9,920 $6,264
====== ====== ======
The principal reasons for the difference between total income tax
expense and the amount computed by applying the statutory federal income tax
rate to income before taxes are as follows:
1998 1997 1996
---- ---- ----
Federal tax at statutory rates
applied to pre-tax income 35% 35% 34%
State tax net of federal benefit 5 4 4
Valuation reserve increase
for foreign losses 1 1 2
Other - net 2 -- 1
--- --- ---
43% 40% 41%
=== === ===
NOTE J -- EQUITY TRANSACTIONS
TREASURY STOCK. During the third quarter of 1998, the Company initiated
a stock repurchase program under which the Board of Directors authorized the
repurchase of up to 2,500,000 shares of the Company's Common Stock. The Company
purchased 1,203,600 shares and expended approximately $16.8 million for stock
repurchases during 1998, which was funded primarily through existing cash
balances. The Company reissued shares through December through stock option
exercises and issuances. The proceeds received for the stock reissued was less
than its cost basis. Accordingly, the difference was recorded as a reduction to
retained earnings. The Company also expended approximately $27.2 million for
repurchases of 1,470,000 shares of the Company's Common Stock during 1997, which
was funded primarily through existing cash balances.
PUBLIC STOCK OFFERING. In a public offering in December 1997, the
Company sold 3,000,000 shares of Common Stock. Net proceeds from the offering
were approximately $59,150,000. In conjunction with the offering, all remaining
treasury shares were reissued first and the remaining shares issued from
previously unissued Common Stock.
41
DIVIDEND POLICY. On September 24, 1997, the Company's Board of
Directors declared a cash dividend (the "Cash Dividend") of $0.01 for every
share of Common Stock, payable quarterly to shareholders of record beginning
December 31, 1997, with dividend payments to commence on or about 15 days after
the end of each fiscal quarter. The Company has made quarterly dividend payments
for each quarter since the dividend was declared. Prior to the Cash Dividend,
the Company had declared no cash dividends on its Common Stock since
incorporation.
STOCK OPTION PLANS. In July 1990, the Company adopted the Director
Stock Option Plan ("the Director Plan") and reserved a total of 500,000 shares
of Common Stock for issuance thereunder. Options must be granted at not less
than 100% of the fair market value of the Company's stock at the dates of grant.
Commencing with the adoption of the Plan, each Eligible Director received a
one-time automatic grant of an option to purchase 5,000 shares of the Company's
Common Stock. In addition, each Eligible Director shall be granted an option to
purchase 5,000 shares upon the date five (5) days after such person became
Director, and an additional option to purchase 5,000 shares five (5) days after
the date of annual reelection as Director. All options granted have a five-year
term and fully vest at the end of six months from the grant date.
In November 1993, the Board of Directors authorized the Inter-Tel,
Incorporated Long-Term Incentive Plan ("the 1994 Long Term Plan"). A total of
2,000,000 shares of Common Stock has been reserved for issuance under the 1994
Long Term Plan to selected officers and key employees. Options must be granted
at not less than 100% of the fair market value of the Company's stock at the
dates of grant. Options generally vest over four or five years and expire five
to ten years from the date of grant.
In February 1997, the Board of Directors authorized the Inter-Tel,
Incorporated 1997 Long-Term Incentive Plan ("the 1997 Long Term Plan"). A total
of 2,400,000 shares of Common Stock has been reserved for issuance under the
1997 Long Term Plan to selected officers and key employees. Options must be
granted at not less than 100% of the fair market value of the Company's stock at
the dates of grant. Options generally vest over four or five years and expire
ten years from the date of grant.
Under the 1994 and 1997 Incentive Plans, in some instances,
predetermined performance goals and share market value increases must be met to
allow the options to be exercised before the end of the option term.
Option activity for the past three years under all plans is as follows:
Number of Shares
1998 1997 1996
---- ---- ----
Outstanding at beginning of year 2,962,524 2,192,300 1,695,000
Granted 576,928 1,523,000 788,000
Exercised (370,770) (511,426) (205,000)
Expired or canceled (220,650) (241,350) (85,700)
------------ ------------ ------------
Outstanding at end of year 2,948,032 2,962,524 2,192,300
------------ ------------ ------------
Exercise price range $2.24-$26.00 $2.88-$25.88 $2.88-$10.22
Exercisable at end of year 882,310 587,774 578,700
Weighted-average fair value of
options granted $ 9.75 $ 8.42 $ 2.36
At December 31, 1998, the Company has reserved 4,111,708 shares of
Common Stock for issuance in connection with the stock option plans.
For the stock option plans discussed above, the Company has adopted the
disclosure only provisions of Statement of Financial Accounting Standards No.
123 "Accounting for Stock-Based Compensation," ("SFAS 123"). Accordingly, no
compensation cost has been recognized in the accompanying financial statements
for the stock option plans.
42
The following table summarizes information about stock options
outstanding at December 31, 1998:
Options Outstanding Options Exercisable
Number Number
Range Outstanding at Weighted-Average Weighted Exercisable at Weighted
of Exercise December 31, Remaining Average December 31, Average
Price 1998 Contractual Life Exercise Price 1998 Exercise Price
----- ---- ---------------- -------------- ---- --------------
$2.24 - $4.31 556,328 6 years $2.98 385,900 $3.00
$4.81 - $7.06 593,200 6 years $5.75 168,400 $6.01
$7.25 - $13.44 1,153,510 6 years $8.16 285,710 $8.26
$15.13 - $26.00 644,994 9 years $22.12 42,300 $23.90
During 1998, the weighted average exercise price of options granted,
exercised, and expired or canceled was $20.89, $4.99 and $8.22, respectively.
Had compensation cost for the Company's stock option plans been
determined based on the fair value at the grant date for awards in 1998, 1997
and 1996 consistent with the provisions of SFAS 123, the estimated fair value of
the options would be amortized to expense over the option's vesting period and
the Company's net income and net income per share would have been decreased to
the pro forma amounts indicated below for the year ended December 31:
(in thousands, except per share amounts) 1998 1997 1996
------ ------- ------
Net income as reported $9,044 $14,682 $9,042
Pro forma net income $8,319 $14,345 $8,950
Pro forma earnings per diluted share $ 0.30 $ 0.55 $ 0.34
Pro forma results disclosed are based on the provisions of SFAS 123
using the Black-Scholes option valuation model and are not likely to be
representative of the effects on pro forma net income for future years. In
addition, the Black-Sholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the estimating models do not necessarily provide a
reliable single measure of the fair value of its employee stock options.
The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model using the low end of reasonable
assumptions for input variables rather than attempting to identify a best-point
estimate. The option pricing model utilized the following weighted average
assumptions for 1998, 1997 and 1996, respectively: risk free interest rates of
5.0% in each year; dividend yields of 0.25% in 1998 and 1997 and 0% in 1996;
volatility factors of the expected market price of the Company's stock averaged
.30; and a weighted average expected life of the option of 3.0 years for
employee stock options which vest over four to five year periods with a weighted
average vesting period of 2.5 years and 1.5 years for Company director options
which vest at the end of six months from the grant date.
1997 EMPLOYEE STOCK PURCHASE PLAN. In April 1997, the Board of
Directors and stockholders adopted the Employee Stock Purchase Plan (the
"Purchase Plan") and reserved 500,000 shares for issuance to eligible employees.
Under the Purchase Plan, employees are granted the right to purchase shares of
Common Stock at a price per share that is 85% of the lesser of the fair market
value of the
43
shares at: (i) the participant's entry date into each six-month offering period,
or (ii) the end of each six-month offering period. Employees may designate up to
10% of their compensation for the purchase of stock. Under the Plan, the Company
sold 45,654 shares for approximately $711,000 ($15.57 per share) to employees in
1998, and 36,018 shares for approximately $256,000 ($7.12 per share) in 1997. At
December 31, 1998, 418,328 shares remained authorized under the Plan.
NOTE K - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share:
(in thousands, except per share amounts) 1998 1997 1996
---- ---- ----
Numerator:
Net Income $ 9,044 $14,682 $ 9,042
------- ------- -------
Denominator:
Denominator for basic earnings per
share - weighted average shares 26,602 24,836 25,780
Effect of dilutive securities:
Employee and director stock options 1,244 1,147 792
------- ------- -------
Denominator for diluted earnings per
share - adjusted weighted average
shares and assumed conversions 27,846 25,983 26,572
------- ------- -------
Basic earnings per share $ 0.34 $ 0.59 $ 0.35
======= ======= =======
Diluted earnings per share $ 0.32 $ 0.57 $ 0.34
======= ======= =======
Options which are antidilutive because the exercise price was greater
than the average market price of the common shares, are not included in the
computation of diluted earnings per share. The number of options to purchase
shares of Common Stock that were outstanding during 1998 that were antidilutive
were immaterial, because the market price of the Company's stock was generally
higher during the course of the year than the prices at which options were
granted.
NOTE L -- RETIREMENT PLANS
The Company has two retirement plans for the benefit of all of its
employees. Under its 401(k) Retirement Plan, participants may contribute an
amount not exceeding 15 percent of compensation received during participation in
the Plan. The Company makes voluntary annual contributions to the Plan based on
a percentage of contributions made by Plan participants of up to 10 percent of
compensation. Contributions to the Plan totaled $621,000; $491,000 and $394,000
in 1998, 1997 and 1996, respectively.
In 1992, the Company initiated an Employee Stock Ownership Plan (ESOP),
advancing $500,000 to the ESOP Trust for the purpose of purchasing Common Stock
of the Company. The Trust purchased 307,000 shares of the Company's Common Stock
in July 1992. The loan was paid in full during 1997. As the principal amount of
the loan was repaid to the Company through Company annual contributions, the
equivalent number of shares released were allocated to employees' accounts to be
held until retirement. Total shares so allocated were 32,380 and 69,424 in 1997
and 1996, respectively. Contributions to the ESOP totaled $62,500 in 1997, and
$125,000 in 1996 and are based upon the historic cost of the shares purchased by
the ESOP. After the final allocation of shares in 1997, the ESOP plan was
"frozen," so that all eligible participants as of July 1, 1997 became 100%
vested in their accounts, regardless of length of service. No further purchases
are anticipated through the ESOP, and the Company does not anticipate making
future allocations of shares from this plan.
44
NOTE M - SEGMENT INFORMATION
The Company adopted Statement of Financial Accounting Standards No.
131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131") in the fiscal year ended December 31, 1998. SFAS 131 establishes
standards for reporting information regarding operating segments in annual
financial statements and requires selected information for those segments to be
presented in interim financial reports issued to stockholders. SFAS 131 also
establishes standards for related disclosures about products and services and
geographic areas. Operating segments are identified as components of an
enterprise about which separate discrete financial information is available for
evaluation by the chief operating decision maker, or decision making group, in
making decisions how to allocate resources and assess performance. The Company's
chief decision maker, as defined under SFAS 131, is the Chief Executive Officer.
To date, the Company has viewed its operations as principally one segment;
telephone systems, software and related long distance calling services. These
services are provided through the Company's direct sales offices and dealer
network to business customers throughout the United States, Europe, Asia and
South America. As a result, the financial information disclosed herein
materially represents all of the financial information related to the Company's
principal operating segment.
The Company's revenues are generated predominantly in the United
States. Total revenues generated from U.S. customers totaled $263.9 million,
$217.8 million and $183.1 million of total revenues for the years ended December
31, 1998, 1997 and 1996, respectively. The Company's revenues from international
sources were primarily generated from customers located in the United Kingdom,
Europe, Asia and South America. In 1998, 1997 and 1996, revenues from customers
located internationally accounted for 3.9%, 2.6% and 1.5% of total revenues,
respectively.
NOTE N -- FINANCIAL INSTRUMENTS
CONCENTRATION OF CREDIT RISK. Financial instruments that potentially
subject the Company to significant concentrations of credit risk consist
principally of cash investments, trade accounts receivable, and net investment
in sales-leases. The Company maintains cash and equivalents not invested in
money market funds with a major bank in its marketplace. The Company performs
periodic evaluations of the relative credit standing of the financial
institution. Concentrations of credit risk with respect to trade accounts
receivable and net investment in sales-leases are limited due to the large
number of entities comprising the Company's customer base.
FAIR VALUE OF FINANCIAL INSTRUMENTS. The carrying amount of cash and
equivalents, accounts receivable, net investment in sales-leases, and accounts
payable reported in the consolidated balance sheets approximate their fair
value.
NOTE O -- SUPPLEMENTAL CASH FLOW
(In thousands) 1998 1997 1996
---- ---- ----
CASH PAID FOR:
Interest $ 60 $ 47 $ 77
Income taxes $ 5,528 $ 5,914 $ 4,213
-------- -------- --------
CHANGES IN OPERATING ASSETS
AND LIABILITIES:
Increase in receivables $(17,887) $ (7,294) $ (8,569)
Decrease (increase) in inventories 1,151 (4,280) (1,309)
(Increase) decrease in prepaid
expenses and other assets 2,526 4,407 (6,268)
Increase in long-term other assets (3,635) (2,028) (4,024)
Increase in accounts payable
and other current liabilities 9,304 7,562 4,466
-------- -------- --------
$ (8,541) $ (1,633) $(15,704)
======== ======== ========
45
NOTE P -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
A summary of the quarterly results of operations for the years ended
December 31, 1998 and 1997 follows:
(In thousands, except per share amounts)
1998 1ST QTR 2ND QTR 3RD QTR 4TH QTR
------- ------- ------- -------
Net sales $63,758 $ 68,088 $70,389 $72,269
Gross profit 31,141 32,635 34,846 34,936
Net income 5,362 (8,643) (1) 5,791 6,534
Net income per share--Basic $ 0.20 $ (0.32) (1) $ 0.22 $ 0.25
Net income per share--Diluted $ 0.19 $ (0.32) (1) $ 0.21 $ 0.24
Average number of common
shares outstanding -- Basic 26,741 26,877 26,754 26,035
Average number of common
shares outstanding -- Diluted 28,242 26,877 27,489 27,225
(1) Reflects change to purchase from pooling accounting for the ITS
acquisition, and recalculation of the TMSI in-process research and
development write-off.
1997 1ST QTR 2ND QTR 3RD QTR 4TH QTR
------- ------- ------- -------
Net sales $50,322 $54,823 $56,915 $61,508
Gross profit 22,170 24,401 26,298 28,336
Net income 2,670 3,424 3,978 4,610
Net income per share--Basic $ 0.10 $ 0.13 $ 0.17 $ 0.19
Net income per share--Diluted $ 0.10 $ 0.13 $ 0.16 $ 0.18
Average number of common
shares outstanding -- Basic 25,901 25,438 23,397 24,606
Average number of common
shares outstanding -- Diluted 26,450 26,623 24,682 26,179
46
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS AND OTHER PARTS OF THIS REPORT ON FORM 10-K CONTAIN
FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE WORDS
"EXPECTS," "ANTICIPATES," "BELIEVES," "INTENDS," "WILL" AND SIMILAR EXPRESSIONS
IDENTIFY FORWARD-LOOKING STATEMENTS WHICH ARE BASED ON INFORMATION AVAILABLE TO
THE COMPANY ON THE DATE HEREOF, AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE
ANY SUCH FORWARD-LOOKING STATEMENTS. THE COMPANY'S ACTUAL RESULTS COULD DIFFER
MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A
RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH IN "FACTORS THAT MAY AFFECT
FUTURE OPERATING RESULTS" AND ELSEWHERE IN THIS 10-K.
GENERAL
Inter-Tel is a single point of contact, full service provider of
digital business telephone systems, call processing software, voice processing
software, call accounting software, Internet Protocol (IP) telephony software,
computer telephone integration ("CTI") applications and long distance calling
services. Inter-Tel's products and services include the AXXESS and Inter-Tel
Axxent digital business communication software platforms, the AXXESSORY TALK
voice processing platform, the Inter-Tel Vocal'Net IP telephony gateway, the
Inter-Tel Vocal'Net Service Provider Software and Centralized Accounting
Software and Inter-Tel.net, an IP telephony packet switched long distance
service. The Company also provides maintenance, leasing and support services for
its products. The Company's Common Stock is quoted on the Nasdaq National Market
System under the symbol INTL.
The Company has developed networks of direct sales offices, dealers and
value added resellers (VARs) which sell the Company's products. In recent
periods, the Company has focused on expanding its direct sales capabilities and
its dealer and VAR network. The Company has acquired a number of resellers of
telephony products and integrated these operations with its existing direct
sales operations in the same geographic areas and in other strategic markets.
Sales of systems through the Company's dealers and VARs typically
generate lower gross margins than sales through the Company's direct sales
organization, although direct sales typically require higher levels of selling,
general and administrative expenses. In addition, the Company's long distance
and network services typically generate lower gross margins than sales of
software and system products. Accordingly, the Company's margins may vary from
period to period depending upon distribution channel and product mix. In the
event that sales through dealers or sales of long distance services increase as
a percentage of net sales, the Company's overall gross margin could decline.
The Company's operating results depend upon a variety of factors,
including the volume and timing of orders received during a period, the mix of
products sold and the mix of distribution channels, general economic conditions,
patterns of capital spending by customers, the timing of new product
announcements and releases by the Company and its competitors, pricing
pressures, the cost and effect of acquisitions and the availability and cost of
products and components from the Company's suppliers. Historically, a
substantial portion of the Company's net sales in a given quarter have been
recorded in the third month of the quarter, with a concentration of such net
sales in the last two weeks of the quarter. In addition, the Company is subject
to seasonal variations in its operating results, as net sales for the first and
third quarters are frequently less than those experienced during the fourth and
second quarters, respectively.
The markets served by the Company have been characterized by rapid
technological changes and increasing customer requirements. The Company has
sought to address these requirements through the development of software
enhancements and improvements to existing systems and the introduction of new
products and applications. The Company's research and development efforts over
the last several years have been focused primarily on developing new products
such as the Inter-Tel Vocal'Net Server, Inter-Tel Axxent system and AXXESSORY
TALK CENTRAL; enhancing the CTI capabilities of the AXXESS digital
communications platform; and expanding the capacity of the
47
Company's AXXESS and AXXESSORY TALK systems. Current efforts are related to the
support of industry standard CTI interfaces, the development of additional
applications and features, the enhancement of the Inter-Tel Vocal'Net Gateway
Server and Service Provider Package, and the development of a LAN-based
Communications Server incorporating the Company's Call Processing and Voice
Processing software. New applications under development also include Basic Rate
ISDN, PBX networking, the Inter-Tel.net private IP telephony service and
enhanced unified messaging. The software-based architecture of the AXXESS system
facilitates maintenance and support, upgrades, and incorporation of additional
features and functionality.
The Company offers to its customers a package of lease financing and
other services under the name Totalease. Totalease provides to customers lease
financing, maintenance and support services, fixed price upgrades and other
benefits. The Company finances this program through the periodic resale of lease
rental streams to financial institutions.
Net sales of the Company have increased substantially in each of the
past three years. Such increases were 22.8%, 20.3% and 23.5% in 1998, 1997 and
1996, respectively, over the preceding year.
RESULTS OF OPERATIONS
The following table sets forth certain statement of operations data of
the Company expressed as a percentage of net sales for the periods indicated:
Year Ended December 31
1998 1997 1996
---- ---- ----
Net sales 100.0% 100.0% 100.0%
Cost of sales 51.3 54.7 56.5
----- ----- -----
Gross margin 48.7 45.3 43.5
Research and development 4.2 3.6 3.5
Selling, general and administrative 31.5 31.3 30.3
Special charge 8.3 -- 2.5
----- ----- -----
Operating income 4.7 10.4 7.2
Interest and other income 1.1 0.6 1.1
Interest expense 0.0 0.0 0.0
Income taxes 2.5 4.4 3.4
----- ----- -----
Net income 3.3% 6.6% 4.9%
----- ----- -----
YEAR ENDED DECEMBER 31, 1998 VERSUS YEAR ENDED DECEMBER 31, 1997
NET SALES. Net sales increased 22.8% to $274.5 million in 1998 from
$223.6 million in 1997. Sales from the Company's direct sales offices and from
wholesale distribution accounted for approximately $38.2 million of the
increase. The remaining increases occurred in long distance and IP sales and
other operations.
GROSS PROFIT. Gross profit increased 32.0% to $133.6 million, or 48.7%
of net sales in 1998 from $101.2 million, or 45.3% of net sales, in 1997. The
increases in gross profit and gross margin were primarily a result of higher
sales, as a percentage of total net sales, of AXXESS digital communication
platforms, call processing software and voice processing software. In addition,
gross margin increased despite a lower percentage increase in sales through the
Company's direct sales offices compared to its dealer network, as gross margins
are typically higher for sales through the Company's direct sales offices.
RESEARCH AND DEVELOPMENT. Research and development expenses increased
to $11.4 million, or 4.2% of net sales in 1998 from $8.0 million, or 3.6% of net
sales, in 1997. The increases in absolute dollars and as a percentage of net
sales were principally attributable to the continued development of the AXXESS
software and systems, unified messaging and voice processing software, Inter-Tel
IP
48
telephony products and certain CTI applications. The Company expects that
research and development expenses will continue to increase in absolute dollars
as the Company continues to develop and enhance existing and new technologies
and products. These expenses may vary, however, as a percentage of net sales.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and
administrative expenses increased to $86.6 million, or 31.5% of net sales in
1998 from $69.9 million, or 31.3% of net sales, in 1997. The increase in
absolute dollars reflected increased selling, incentive, training and other
compensation costs attributable to the increased sales through the Company's
direct sales offices, additional personnel to support the direct dealer network
and expansion of IP telephony and long distance operations, development and
expansion of the Inter-Tel.net network and expenses associated with
international operations. Such increase is also attributable to the hiring of
additional sales and technical training staff, and increases in reserves for
accounts receivable. The Company expects that selling, general and
administrative expenses will increase in absolute dollars, but may vary as a
percentage of net sales.
INTEREST AND OTHER INCOME. Other income increased approximately $1.6
million in 1998 principally as a result of higher levels of cash available for
investment due to the issuance of the Company's common stock from the secondary
public offering in the fourth quarter of 1997, offset by the payment of cash for
the purchase of TMSI assets, and the Company's stock repurchases made during the
last half of 1998.
NET INCOME. Including the special charge related to the write-off of
in-process research and development of TMSI during the second quarter of 1998,
net income decreased 38.4% to $9.0 million, or $0.32 per diluted share, in 1998
compared to net income of $14.7 million, or $.57 per diluted share, in 1997.
Excluding the 1998 special charge, net income would have been $22.7 million, or
$0.82 per diluted share, an increase of 44.2% over 1997.
YEAR ENDED DECEMBER 31, 1997 VERSUS YEAR ENDED DECEMBER 31, 1996
NET SALES. Net sales increased 20.3% to $223.6 million in 1997 from
$185.9 million in 1996. Sales from the Company's direct sales offices and from
wholesale distribution accounted for approximately $26.3 million of the
increase. The remaining increases occurred in long distance sales and other
operations.
GROSS PROFIT. Gross profit increased 25.1% to $101.2 million, or 45.3%
of net sales in 1997 from $80.9 million, or 43.5% of net sales, in 1996. This
increase was primarily a result of higher sales, as a percentage of total net
sales, of AXXESS digital communication platforms, call processing software and
voice processing software. In addition, gross margin increased based on a
percentage increase in sales through the Company's direct sales offices compared
to its dealer network.
RESEARCH AND DEVELOPMENT. Research and development expenses increased
to $8.0 million, or 3.6% of net sales in 1997 from $6.6 million, or 3.5% of net
sales, in 1996. These expenses in both 1997 and 1996 were directed principally
toward the continued development of the AXXESS and Inter-Tel Axxent software and
systems, unified messaging and voice processing software, Inter-Tel Vocal'Net
and certain CTI applications.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and
administrative expenses increased to $69.9 million, or 31.3% of net sales in
1997 from $56.4 million, or 30.3% of net sales, in 1996. This reflected
increased selling, incentive, training and other compensation costs attributable
to the increased sales through the Company's direct sales offices, additional
personnel to support the direct dealer network and expansion of long distance
operations, development of the Inter-Tel.net network and expenses associated
with international operations. Such increase is also attributable to the hiring
of additional sales and technical training staff, expansion of its credit
management group, and increases in reserves for accounts receivable.
49
INTEREST AND OTHER INCOME. Other income decreased approximately
$591,000 in 1997 principally as a result of lower levels of cash available for
investment.
NET INCOME. Net income increased 62.4% to $14.7 million, or $.57 per
diluted share, in 1997 compared to net income of $9.0 million, or $0.34 per
diluted share, in 1996. Excluding the special charge in 1996 related to the
write-off of its MIS software, net income would have been $11.8 million, or
$0.44 per diluted share.
INFLATION/CURRENCY FLUCTUATION
Inflation and currency fluctuations have not previously had a material
impact on Inter-Tel's operations. International procurement agreements have
traditionally been denominated in U.S. currency. Moreover, a significant amount
of contract manufacturing has been or is expected to be moved to domestic
sources. The expansion of international operations in the United Kingdom and
Europe and increased sales, if any, in Japan and other parts of Asia could
result in higher international sales as a percentage of total revenues; however,
international revenues are currently not significant.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1998, the Company had $63.1 million in cash and
equivalents, which represents a decrease of approximately $25.7 million from
December 31, 1997. The Company maintains a $7.0 million, unsecured revolving
line of credit with Bank One, Arizona, NA. The credit facility is annually
renewable and is available through June 1, 2000. Under the credit facility, the
Company has the option to borrow at a prime rate or adjusted LIBOR interest
rate. Historically, the credit facility has been used primarily to support
international letters of credit to suppliers. In December 1997, the Company
received net proceeds of approximately $59.2 million from a public stock
offering of 3,000,000 common shares. During the year ended December 31, 1998,
approximately $25 million plus acquisition costs was used to purchase certain
assets of TMSI and an additional $16.7 million was expended to repurchase shares
of the Company's Common Stock. The remaining cash balances may be used to
develop and expand Inter-Tel.net and for potential acquisitions, strategic
alliances, working capital and general corporate purposes.
Net cash provided by operating activities totaled $31.8 million for the
year ended December 31, 1998, compared to net cash provided by operating
activities of $28.2 million for the same period in 1997. This increase in cash
provided by operating activities in 1998 was primarily the result of profitable
operations (excluding the write-off of in-process research and development costs
associated with the TMSI acquisition), and lower inventory levels, offset in
part by increased accounts receivable. During 1998, accounts receivable
increased approximately $8.9 million, while inventories decreased approximately
$1.9 million. The Company continues to expand its dealer network, which has
required and is expected to continue to require working capital for increased
accounts receivable and inventories. During 1998, other current liabilities
increased primarily as a result of the change in taxes and other accrued
expenses.
Net cash used in investing activities, primarily in the form of
acquisitions and capital expenditures, totaled $40.4 million and $12.4 million
for the years ended December 31, 1998 and 1997, respectively. This net use of
cash in 1998 was primarily the result of the purchase of certain assets of TMSI
and the related write-off of in-process research and development costs, as well
as additions to property and equipment. Cash used in acquisitions totaled
approximately $25.4 million in 1998. Capital expenditures totaled approximately
$15.2 million for the same period. The Company anticipates additional capital
expenditures during 1999, principally relating to expenditures for equipment and
management information systems used in operations, facilities expansion,
acquisition activities and anticipated increased volumes of operating leases
offered by the Company to its customers, which must be capitalized as fixed
assets by the Company.
Net cash used in financing activities totaled $17.0 million during 1998
compared to net cash proceeds of $34.1 million in 1997. Net cash used in
financing activities during both periods was
50
primarily due to the initiation of separate stock repurchase programs under
which the Board of Directors authorized the repurchase of up to 2.5 million and
1.47 million shares of the Company's common stock during the year ended December
31, 1998 and 1997, respectively. The Company expended approximately $16.8
million and $27.2 million for stock repurchases during 1998 and 1997,
respectively, funded by existing cash balances during each period. Additionally,
in 1997 the Company raised approximately $59.2 million in a secondary stock
offering. During 1998, the Company reissued treasury shares through stock option
exercises and issuances, with the proceeds received totaling less than the cost
basis of the treasury stock reissued. Accordingly, the difference was recorded
as a reduction to retained earnings. Treasury shares reissued during 1997 were
reissued through stock option exercises and issuances, as well as through the
secondary stock offering. In 1997, the proceeds received totaled more than the
cost basis of the treasury stock reissued. Net cash used for cash dividends
totaled $1.1 million during 1998, which was offset by cash provided by the
exercise of stock options and stock issuances pursuant to the Company's Employee
Stock Purchase Plan.
The Company offers to its customers lease financing and other services,
including its Totalease program, through its Inter-Tel Leasing subsidiary. The
Company funds these programs in part through the sale to financial institutions
of rental income streams under the leases. Resold lease rentals totaling $131.3
million and $99.9 million remain unbilled at December 31, 1998 and December 31,
1997, respectively. The Company is obligated to repurchase such income streams
in the event of defaults by lease customers and, accordingly, maintains reserves
based upon loss experience and past due accounts. Although the Company to date
has been able to resell the rental streams from leases under its lease programs
profitably and on a substantially current basis, the timing and profitability of
lease resales could impact the Company's business and operating results,
particularly in an environment of fluctuating interest rates and economic
uncertainty. If the Company were required to repurchase rental streams and
realize losses thereon in amounts exceeding its reserves, its operating results
could be materially adversely affected.
The Company believes that its cash balances, working capital and available
credit facilities, together with anticipated ongoing cash generated from
operations, will be sufficient to develop and expand its Inter-Tel.net network,
to finance acquisitions of additional resellers of telephony products and other
strategic acquisitions or corporate alliances, and to provide adequate working
capital for at least the next twelve months. However, to the extent that
additional funds are required in the future to address working capital needs and
to provide funding for capital expenditures, expansion of the business or the
Inter-Tel.net network or additional acquisitions, the Company may seek
additional financing. There can be no assurance that such additional financing
will be available when required or on acceptable terms.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS.
Refer to Note A in the notes to consolidated financial statements.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT.
In connection with the TMSI asset purchase, the Company expensed in-process
research and development ("IPRD") totaling $22.8 million as a non-recurring
charge on the acquisition date. This was necessary because the acquired
technology had not yet reached technological feasibility and had no future
alternative uses. The Company is using the acquired IPRD to create new IP
products, which will become part of the Inter-Tel product suite over the next
several years. The Company expects that the acquired IPRD will be successfully
developed, but there can be no assurance of the commercial viability of these
products.
The value of the purchased in-process technology was determined using
management's estimates of the projected discounted net cash flows related to
such products, including costs to complete development and future revenues to be
earned upon commercialization. Calculations were revised after giving
consideration to the SEC Staff's views as set forth in its September 15, 1998
letter to the American Institute of Certified Public Accountants. Calculations
of value therefore gave consideration to
51
value creation efforts of TMSI prior to the purchase relative to the efforts of
the Company subsequent to the transaction. These efforts were estimated, giving
consideration to time-, cost- and complexity-based data. Time-based data is
measured in developer months. Cost-based data estimates dollar amounts spent and
to be spent to complete these projects. Complexity-based data considers the high
risk development issues and major milestones associated with the completion of
particular projects.
The purchased in-process technology acquired in the TMSI asset purchase
comprised five main projects, estimated at 49% to 97% complete. The discount
rates utilized for the developed and in-process technologies were 25% and 35%,
respectively. Revenues and operating profits were assumed to increase in the
first three years of the seven-year projection period at annual rates ranging
from 238% to 520% while decreasing over the remaining term. Projections were
based on assumed penetration of the existing customer base, synergies as a
result of the TMSI purchase, new customer transactions and historical retention
rates. Costs to complete the projects were estimated at $1 million plus
maintenance.
During 1998, revenues and operating profit attributable to in-process
technology were below original expectations. No assurance can be given that
additional deviations from these projections will not occur in the future. If
the projects to develop commercial products based on the acquired in-process
technology are not successfully completed, the sales and profitability of the
Company may be adversely affected in future periods, and the value of other
intangible assets may become impaired.
52