UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998 COMMISSION FILE NO. 0-12386
INCOMNET, INC.
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(Exact name of registrant as specified in its Charter)
California 95-2871296
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(State of Incorporation) (IRS Employer Identification No.)
2801 Main Street, Irvine, CA 92614
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(Address of Principal Executive Offices)
(949) 224-7300
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(Registrant's Telephone number, including area code)
21031 Ventura Blvd. #1100, Woodland Hills, CA 92614
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. YES X NO
--- ---
Number of shares of registrant's common stock outstanding as of
September 30, 1998...................................................20,000,000
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INCOMNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS) September 30, December 31,
1998 1997
(unaudited)
---- ----
ASSETS
Current assets:
Cash & cash equivalents $ 1,331 $ 776
Accounts receivable, less allowance for doubtful accounts of
$2,830 at Sept. 30, 1998 and $2,764 at Dec. 31, 1997 9,204 13,850
Notes receivable -- 237
Notes receivable from employees & shareholders, net of reserves
of $816 at Sept. 30, 1998 and $378 at Dec. 31, 1997 -- 840
Inventories -- 315
Other current assets 557 876
--------- ----------
Total current assets 11,092 16,894
Property, plant and equipment, at cost, net (Note 8) 10,714 16,248
Goodwill, net 4,024 6,484
Investments and other assets 720 888
--------- ----------
Total assets $ 26,550 $40,514
========= ==========
See accompanying "Notes to Consolidated Financial Statements."
2
INCOMNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONT'D)
(DOLLARS IN THOUSANDS) September 30, December 31,
1998 1997
(unaudited)
---- ----
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $8,983 $ 9,792
Accrued expenses 6,621 7,366
Current portion of notes payable (Note 4) 8,719 9,383
Deferred income and other liabilities 4,155 1,989
--------- ----------
Total current liabilities 28,478 28,530
Long-term liabilities
Notes payable (Note 4) 1,481 2,855
Liabilities in excess of assets of Rapid Cast (Note 9) -- 3,600
Shareholders' equity/(deficit):
Preferred stock, no par value; 100,000 shares authorized;
2,045.1 shares issued and outstanding September 30, 1998 and
3,995 shares issued and outstanding at December 31, 1997
(liquidation preference of $2,134 at September 30, 1998) 1,676 3,758
Common stock, no par value; 20,000,000 shares
authorized; 20,000,000 shares issued and outstanding
at September 30, 1998 and 14,259,000 shares at
December 31, 1997 73,205 70,811
Treasury stock (5,492) (5,492)
Accumulated deficit (72,798) (63,548)
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Total shareholders' equity/(deficit) (3,409) 5,529
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Total liabilities & shareholders' equity/(deficit) $26,550 $ 40,514
========= ==========
See accompanying "Notes to Consolidated Financial Statements."
3
INCOMNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED SEPTEMBER 30,
(DOLLARS IN THOUSANDS)
1998 1997
---- ----
SALES (Note 2) $ 12,931 $ 33,318
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OPERATING COSTS & EXPENSES:
Cost of sales 7,999 23,384
General & administrative 8,345 6,730
Depreciation & amortization 916 821
Bad debt expense 859 1,600
Impairment of long-lived assets (Note 8) 4,865 --
Other expense, net 1,712 11,238
---------- ----------
Total operating costs and expenses 24,696 43,773
Gain on sale of investment in Rapid Cast 2,700 --
Gain on reversal of liability in excess of assets of Rapid Cast (Note 9) 3,600 --
Loss on sale of AutoNETWORK (28) --
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Loss before income taxes (5,493) (10,455)
Income tax (benefits)/expense 48 (887)
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Net loss (5,541) $ (9,568)
========== ==========
BASIC AND DILUTED LOSS PER COMMON SHARE:
Net loss (Note 2) ($0.28) $ (0.70)
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Weighted average number of common shares outstanding 20,000,000 13,687,977
========== ==========
See accompanying "Notes to Consolidated Financial Statements."
4
INCOMNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30,
(DOLLARS IN THOUSANDS)
1998 1997
---- ----
SALES (Note 2) $ 47,982 $99,341
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OPERATING COSTS & EXPENSES:
Cost of sales 30,226 69,525
General & administrative 20,115 20,740
Depreciation & amortization 2,784 2,218
Bad debt expense 3,123 3,448
Impairment of long-lived assets (Note 8) 4,865 --
Other expense, net 2,453 11,297
---------- -----------
Total operating costs and expenses 63,566 107,228
Gain on sale of investment in Rapid Cast 2,700 --
Gain on reversal of liability in excess of assets of Rapid Cast (Note 9) 3,600 --
Gain on sale of AutoNETWORK 535 --
---------- -----------
Loss before income taxes (8,749) (7,887)
Income tax (benefits) (50) (679)
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Net loss $ (8,699) $ (7,208)
========== ===========
BASIC AND DILUTED LOSS PER COMMON SHARE:
Net loss $ (0.50) $ (0.53)
========== ===========
Weighted average number of common shares outstanding 17,504,000 13,687,977
========== ===========
See accompanying "Notes to Consolidated Financial Statements."
5
INCOMNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30,
(DOLLARS IN THOUSANDS)
1998 1997
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (8,699) $ (7,207)
Depreciation & amortization 2,784 2,524
Provisions for receivables, inventories and investments 833 --
Asset impairments 4,865 --
Disposal of assets 1,035 --
Sale of Rapid Cast stock (2,700) --
Sale of AutoNETWORK (535) --
Gain on reversal of liability in excess of assets of Rapid Cast (3,600) --
Other 110 --
--------- ----------
Net cash inflow/(outflow) from operating activities (5,907) (4,683)
CASH FLOWS FROM (INCREASE)/DECREASE
IN OPERATING ASSETS:
Accounts receivable 5,464 (5,777)
Notes receivable - current 265 (122)
Notes receivable - due from employees and shareholders -- (571)
Inventories 468 2,261
Other current assets 58 (1,486)
--------- ----------
Net cash inflow/(outflow) from changes in operating assets 6,255 (5,695)
CASH FLOWS FROM INCREASE/(DECREASE)
IN OPERATING LIABILITIES:
Accounts payable (808) (149)
Accrued expenses 2,039 (1,715)
Deferred income (707) (850)
--------- ----------
Net cash inflow/(outflow) from changes in operating liabilities 524 (2,714)
--------- ----------
Net cash inflow/(outflow) from operations 872 (13,092)
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of plant and equipment (1,224) (3,725)
Goodwill from acquisition of GenSource -- (2,223)
Sale of Rapid Cast stock 1,500 --
Sale of AutoNETWORK 1,299 --
Liability in excess of assets of Rapid Cast -- 3,600
Investments and other assets 14 --
--------- ----------
Net cash inflow/(outflow) from investing activities $ 1,589 $ (2,348)
6
1998 1997
---- ----
CASH FLOWS FROM FINANCING ACTIVITIES:
Notes payable - current $ (1,531) $ --
Settlement of class action lawsuit -- 8,651
Sale of common stock, net 185 --
Preferred stock -- 1,343
Notes payable - long term (507) 4,391
Other - net (53) 10
--------- ----------
Net cash inflow/(outflow) from financing activities (1,906) 14,395
--------- ----------
Net cash inflow/(outflow) from investing and financing (317) 12,047
--------- ----------
Net increase/(decrease) in cash and cash equivalents 555 (1,045)
Cash at beginning of period 776 2,214
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Cash at end of period $1,331 $ 1,169
========= ==========
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING
AND FINANCING ACTIVITIES
The company recorded the following in connection with the
change in the method of accounting of Rapid Cast from the
consolidated to equity method
Accounts receivable $ (1,139)
Inventory (2,449)
Prepaid expenses and other (245)
Property and equipment - net (888)
Intangible assets (1,241)
Other assets (35)
Accounts payable 2,656
Accrued expenses 862
Notes payable 3,630
Cash received from Rapid Cast private placement 2,449
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$3,600
----------
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See accompanying "Notes to Consolidated Financial Statements."
7
INCOMNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1998
1. Management's Representation:
The management of Incomnet, Inc. (the "Company") has prepared the
consolidated financial statements included herein without audit. Certain
information and note disclosures normally included in the consolidated
financial statements prepared in accordance with generally accepted
accounting principles have been omitted pursuant to the regulations of the
SEC for presentation of interim period financial information in Form 10-Q.
In the opinion of the management of the Company, all adjustments considered
necessary for fair presentation of the consolidated financial statements have
been included and were of a normal recurring nature, except for non-recurring
items, including the gain on the sale of Rapid Cast stock, the gain on the
sale of AutoNETWORK, the gain on the reversal of the liability in excess of
assets of Rapid Cast, Inc. ("Rapid Cast"), and charges relating to asset
impairments. Management believes that the accompanying consolidated financial
statements present fairly the financial position of the Company and its
consolidated subsidiaries as of September 30, 1998, and the results of
operations for the three months and nine months ended September 30, 1998 and
1997, and cash flows for the nine months ended September 30, 1998 and 1997.
It is suggested that these consolidated financial statements be read in
conjunction with the consolidated audited financial statements and notes for
the three years ended December 31, 1997, included in the Company's Annual
Report on Form 10-K/A filed with the Securities and Exchange Commission on
April 30, 1998, as amended (the "1997 Annual Report"). The interim results
are not necessarily indicative of the results for a full year.
2. Summary of Significant Accounting Policies:
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include
the accounts of the Company and its wholly-owned subsidiaries, National
Telephone & Communications-TM-, Inc. ("NTC") and GenSource Corporation-TM-
("GenSource").
REVENUE RECOGNITION - The Company recognizes revenue during the month in
which services or products are delivered, as follows:
(1) NTC's long distance telecommunications service revenues are generated
when customers make long distance telephone calls from their business or
residential telephones or by using any of NTC's telephone calling cards.
Proceeds from prepaid telephone calling cards are recorded as deferred
revenues when the cash is received, and recognized as revenue as the
telephone service is utilized. Long distance telephone service sales in the
three and nine months ended September 30, 1998 totaled $12.0 million and
$44.0 million, respectively, versus long distance telephone service sales of
$28.7 million and $83.5 million in the three and nine months ended September
30, 1997, respectively.
(2) NTC's marketing-related revenues are derived from programs and material
sold to the Company's base of independent sales representatives, including
forms and supplies, fees for account executive and training executive
renewals, and the Company's account executive and training executive
programs. The Company requires that all such services and materials be paid
at the time of purchase. Revenues from marketing-related materials, net of
amounts deferred for future services provided to the representatives, are
booked as revenues when the cash is received. A portion of the revenues from
marketing related programs and materials is deferred and recognized over a
twelve-month period as the Company provides customer support to its
independent representatives. For the three and nine months ended September
30, 1998, marketing sales totaled $0.3 million and $1.5 million,
respectively, versus marketing sales of $3.6 million and $13.6 million for
the three and nine months ended September 30, 1997.
(3) Revenues from the Company's GenSource subsidiary are derived from the
sale of computer software and from related services, such as software
maintenance fees, custom programming and customer training. Revenues are
recognized when software is shipped to customers and when services are
performed and accepted by customers. Revenues in the three and nine months
ended September 30, 1998 totaled $0.6 million and $2.1 million, respectively,
versus revenues of $0.6 million for the three months ended September 30,
1997. Since the Company acquired GenSource in May 1997, revenues for the five
months ended September 30, 1997 were $1.1 million. When maintenance or
custom programming fees are billed annually or received in advance, the
revenues are deferred and recognized when services are rendered.
8
INCOMNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1998
CONCENTRATION OF CREDIT RISK - The Company sells its telephone, network
services and insurance-related software and related services to individuals
and small businesses throughout the United States and does not require
collateral. Reserves for uncollectible amounts are provided, which management
believes are sufficient.
COMPUTER HARDWARE, FURNITURE AND OFFICE EQUIPMENT - Computer hardware,
furniture and office equipment are stated at cost. Depreciation is provided
by the straight-line method over the assets' estimated useful lives of 3 to
10 years.
COMPUTER SOFTWARE - The Company capitalizes the costs associated with
purchasing, developing and enhancing its computer software. All software
costs are amortized using the straight-line method over the assets' estimated
useful lives of 3 to 10 years.
LEASEHOLD IMPROVEMENTS - All leasehold improvements are stated at cost and
are amortized using the straight-line method over the expected lease term.
The Company's new management is evaluating the utilization and carrying value
of $5.1 million of leasehold improvements at its headquarters in Irvine,
California. The Company expects to complete this evaluation in the 4th
Quarter of 1998.
NET LOSS PER SHARE - Net loss per common share, basic and diluted, is based
on the weighted average number of common shares outstanding. Common
equivalent shares have been excluded as their effect is anti-dilutive.
ACQUISITION AMORTIZATION - The excess of purchase price over net assets of
NTC have been recorded as an intangible asset and is being amortized by the
straight-line method over twenty years. In the three months ended September
30, 1998, the Company recorded a charge of $2.0 million associated with the
excess of purchase price over net assets of GenSource [see Note 8].
DEFERRED TAX LIABILITY - Deferred income taxes result from temporary
differences in the basis of assets and liabilities reported for financial
statement and income tax purposes.
USE OF ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the
date of the financial statements, as well as the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from
those estimates.
IMPAIRMENT OF LONG-LIVED ASSETS - In accordance with the provisions of SFAS
No. 121, the Company regularly reviews long-lived assets and intangible
assets for impairment whenever events or changes in circumstances indicate
that the carrying amount to the assets may not be recoverable. In the three
months ended September 30, 1998, the Company recorded a charge of $4.9
million associated with the impairment of assets [see Note 8].
3. Funding of Marketing Commissions and Deferred Income:
The Company's subsidiary, NTC, maintains separate bank accounts for the
payment of marketing commissions. Funding of these accounts is adjusted
regularly to provide for management's estimates of required reserve balances.
NTC estimates the total commissions owed to active independent
representatives ("IR Earned Compensation") each week for all monies collected
that week due to the efforts of those active independent representatives.
All IR Earned Compensation is then paid to the independent representatives,
when due, directly out of the separate bank account.
4. Notes Payable:
Short-term and long-term notes payable consist of the following:
9
INCOMNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1998
($ THOUSANDS)
September 30, December 31,
1998 1997
---- ----
Short-term Notes Payable:
Notes payable to founding stockholders of GenSource,
interest at 8% $1,240 $ 373
Notes payable to bank for line of credit to NTC,
interest at prime plus 1.5%, due as current liability 6,911 8,440
Capitalized lease obligations 568 570
------- -------
Total Short-term portion of Notes Payable 8,719 9,383
------- -------
Long-term Notes Payable:
Notes payable to founding stockholders of GenSource,
interest at 8% 570 1,537
Capitalized lease obligations 911 1,318
------- -------
Total Long-term portion of Notes Payable 1,481 2,855
------- -------
Total Notes Payable $10,200 $12,238
======= =======
Approximately $1.2 million in long-term notes owed to two former owners of
GenSource has been reclassified as short-term notes because the Company is in
default on paying the notes [see "Note 7. Commitments and Contingencies and
Item 1. Legal Proceedings - Lawsuit By Two Former Owners of GenSource
Corporation"]. Subsequent to September 30, 1998, NTC has made additional
payments on its notes payable to bank for line of credit, so that the remaining
balance as of November 13, 1998 is approximately $4.9 million.
5. Network Marketing Costs:
Marketing sales of $0.3 million and $1.5 million for the three and nine month
periods ended September 30, 1998, respectively, and $3.6 million and $13.6
million for the three and nine month periods ended September 30, 1997,
respectively, were generated by the sale of materials, training and support
services to assist NTC independent sales representatives in signing up new
retail customers and enrolling other representatives in the NTC program.
During the three and nine months ended September 30, 1998, NTC's net costs to
operate its network marketing program were $0.8 million and $2.3 million,
respectively, versus net costs of $0.7 million and $1.7 million for the three
and nine months ended September 30, 1997, respectively, as summarized below:
3 Months Ended 3 Months Ended
($ MILLIONS) September 30, 1998 September 30, 1997
------------------ ------------------
Marketing Sales $0.3 $ 3.6
------- -----
Cost of marketing sales 0.4 3.0
Operating expenses for support services 0.7 1.3
------- -----
Total marketing-related costs 1.1 4.3
------- -----
Net marketing cost $0.8 $ 0.7
===== =====
10
INCOMNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1998
% of total NTC (long distance &
marketing) sales 6.2% 2.2%
9 Months Ended 9 Months Ended
($ MILLIONS) September 30, 1998 September 30, 1997
------------------- ------------------
Marketing Sales $1.5 $ 13.6
------- -----
Cost of marketing sales 1.5 11.2
Operating expenses for support services 2.3 4.1
------- -----
Total marketing-related costs 3.8 15.3
------- -----
Net marketing cost $2.3 $ 1.7
===== =====
% of total NTC (long distance &
marketing) sales 4.8% 1.8%
6. COMPENSATION OF INDEPENDENT SALES REPRESENTATIVES:
The Company's subsidiary, NTC, compensates its independent sales
representatives by an earned commission structure based upon signing up new
telephone customers and based upon the telephone usage generated by those
customers. In the three and nine months ended September 30, 1998, expenses
associated with commissions, bonuses and overrides paid to NTC's independent
representatives were $1.1 million and $3.9 million, respectively, versus
commissions, bonuses and overrides paid to NTC's independent representatives
of $4.4 million and $15.3 million, respectively, for the three months and
nine months ended September 30, 1997.
7. COMMITMENTS AND CONTINGENCIES:
LITIGATION - The Company is a defendant in a class action matter and related
lawsuits that were filed in 1995 and 1996 alleging securities violations with
respect to alleged false denial and non-disclosure of a Securities and
Exchange Commission investigation and alleged non-disclosure of purchases and
sales of the Company's stock by an affiliate of the former Chairman of the
Board. In October 1997, the Company reached a settlement of the class action
lawsuit and established a reserve of $8.65 million associated with the
settlement. In September 1998, the Company's new management renegotiated the
settlement on more favorable terms [see "Item 1. Legal Proceedings - Class
Action and Related Lawsuits"]. The proposed settlement has not received final
Court approval and, unless the Company receives additional financing, it may
be unable to make the payment required by the proposed settlement.
Accordingly, there are no assurances that the settlement will be completed as
proposed. As a result, no changes have been made to the reserve provided in
anticipation of the settlement. It does not appear that the Company or NTC
has any insurance in place to cover either the cost of the class action
matter and related lawsuits or other pending and threatened litigation or the
cost of their potential losses. The Company is unable to estimate the outcome
of its other lawsuits and is unable to predict a range of potential loss.
Accordingly, no amounts have been provided for these additional lawsuits in
the accompanying financial statements.
WORLDCOM CONTRACT - Since September 1995, the Company's subsidiary, NTC, has
had a carrier contract with WorldCom Network Services, Inc. ("WorldCom"). The
contract was renegotiated in October 1998 by the Company's new management.
The new contract has revised the former minimum purchase requirements in
excess of $1.1 billion and also revised wholesale rates. Under the new terms,
the Company has agreed to purchase $250 million in telephone service over a
three-year period, with the ability to extend the purchase requirement for an
additional two years if required. In February 1998, WorldCom extended credit
to NTC of up to $3 million at an
11
INCOMNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1998
interest rate of 18% per annum by allowing NTC to deduct from payments owing
to WorldCom under terms of the old carrier contract. NTC is presently in
default on obligations to make payments of approximately $3.4 million. On
October 30, 1998, NTC and WorldCom entered into an agreement under which
WorldCom agreed to forbear from taking any action against NTC and also agreed
to reschedule the payment of amounts in default. Under the terms of the
forbearance agreement, WorldCom will have a first priority lien on NTC's
subscriber base and a second priority lien on accounts receivable as long as
the amount in default is outstanding. The forbearance and repayment schedule
are contingent upon the Company completing a $20 million secured financing
expected to be provided by Ironwood Telecom LLC ("Ironwood") by December 15,
1998 [see "Item 5. Other Information -Funding Commitment From Ironwood
Telecom"].
FIRST BANK LOAN - As of September 30, 1998, NTC was in default on a note to
First Bank & Trust of Newport Beach ("First Bank") of approximately $6.9
million. NTC has subsequently made several payments to First Bank that
reduced the note to approximately $4.9 million as of November 13, 1998. First
Bank has a first priority lien on the Company's accounts receivable until the
note is repaid. On October 30, 1998, the Company and First Bank reached an
agreement under which First Bank agreed to forbear from taking any action
against NTC until December 15, 1998. The forbearance and repayment schedule
are contingent upon the Company completing a $20 million secured financing
expected to be provided by Ironwood by December 15, 1998 [see "Item 5. Other
Information - Funding Commitment From Ironwood Telecom"].
NOTES TO FORMER OWNERS OF GENSOURCE CORPORATION -- In May 1997, the Company
entered into promissory notes to four former owners of GenSource associated
with the acquisition of GenSource in May 1997. The notes obligated the
Company to pay the four former owners an aggregate of $1.9 million over a
period of five years, plus interest of 8%, with payments commencing in May
1998. In June 1998, the Company defaulted on payments to two of the former
owners, who have filed a lawsuit against the Company seeking full payment of
their notes, which total approximately $1.2 million. The Company is presently
negotiating with the two former owners who have filed the lawsuit to resolve
the issue. There can be no assurances that there will be a favorable outcome
to these negotiations [see "Item 1. Legal Proceedings - Lawsuit From Former
Owners of GenSource"]. The Company is unable to estimate the outcome of this
lawsuit and is unable to predict a range of potential loss. Accordingly,
no amounts have been provided for this lawsuit in the accompanying financial
statements.
8. NON-RECURRING CHARGES:
In the three months ended September 30, 1998, the Company completed its
evaluation of the recoverability of certain long-lived assets at NTC and
GenSource. In connection with this evaluation, the Company has recorded a
$4.9 million non-cash write-down of the carrying value of certain long-lived
assets to their estimated fair value, consisting primarily of a write-off of
$1.6 million at NTC taken for leasehold improvements at one of its
facilities, and $3.2 million associated with GenSource, consisting primarily
of approximately $2.0 million of goodwill resulting from the Company's
acquisition of GenSource and $1.2 million of property, plant and equipment at
GenSource.
9. INVESTMENT IN UNCONSOLIDATED AFFILIATE:
In the three months ended September 30, 1998, the Company sold 4.5 million
shares of its investment in Rapid Cast for $2.7 million. Cash of $1.5 million
was received in August 1998 and cash of $1.1 million was received in October
1998. The remaining $0.1 million is to be received in November 1998. In 1997,
the basis for accounting for Rapid Cast was changed from the consolidation to
the equity method of accounting, when Incomnet's ownership interest
diminished from 51% to 33%. At that time, the liabilities of Rapid Cast
exceeded its assets, as recorded in the Company's consolidated balance sheet,
by approximately $3.6 million. Accordingly, this $3.6 million liability was
recorded in 1997. In the three months ended September 30, 1998, management
determined that it no longer believes that there would be any further
obligation of the Company to Rapid Cast and, in accordance with generally
accepted accounting principles for equity investments, the liability amount
of $3.6 million was reversed to income.
12
INCOMNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1998
10. YEAR 2000 COMPLIANCE:
The Company has completed a preliminary assessment for Year 2000 compliance
at its NTC and GenSource subsidiaries. The management of GenSource believes
that it has achieved Year 2000 compliance in its software products that are
currently offered for sale to its customers and has a plan in place to
achieve Year 2000 compliance for its internal operations. NTC has identified
the major applications and systems that must either be upgraded or replaced
in order to achieve Year 2000 compliance. A preliminary budget of $2.6
million has been established at NTC for the necessary changes [see "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Year 2000 Readiness Disclosure"]. The Company has recorded no
charge or reserve to achieve Year 2000 compliance and will recognize expense
associated with Year 2000 compliance as it occurs.
11. COMPREHENSIVE INCOME:
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS 130"),
which establishes standards for reporting and displaying comprehensive income
and its components in the financial statements. For the three and nine month
periods ended September 30, 1998 and 1997, the Company did not have any
components of other comprehensive income as defined in SFAS 130.
12. SUBSEQUENT EVENTS:
FUNDING COMMITMENT FROM IRONWOOD TELECOM - On October 30, 1998, the Company
received a commitment letter from Ironwood to provide the Company with a
secured credit facility of $20 million less certain amounts to be loaned or
paid to third parties for the benefit of the Company. As part of the secured
credit facility, the Company has already received a bridge loan that is due
and payable on December 15, 1998 when the secured credit facility is expected
to be funded. Ironwood's commitment is subject to the completion of certain
conditions. If the secured financing is completed, the principal amount will
be due and payable on December 31, 2000 [see "Item 5. Other Information -
Funding Commitment From Ironwood Telecom."].
IRONWOOD LOAN TO CASEY; COHEN OPTION EXERCISE - In connection with the
exercise of an option to acquire preferred stock pursuant to a previous
agreement reached between the Company's Chairman, John P. Casey and certain
preferred stock owners on November 5, 1998, Ironwood loaned Mr. Casey
approximately $2.1 million, the proceeds of which were used to exercise the
option. The Company will either redeem the preferred stock on or before the
one-year anniversary of the date the Company's Articles of Incorporation are
amended to increase the number of authorized shares of common stock, if it is
financially able, or the preferred stock will be converted to common stock and
offered to the Company's shareholders on a pro-rata basis [see "Item 5. Other
Information - Ironwood Loan to Casey; Cohen Option Exercise"].
TRANSACTIONS WITH OTHER PREFERRED HOLDERS - On November 4, 1998, Ironwood
entered into transactions similar to the Casey Option transaction with five
others holders of preferred stock. Under these transactions, Ironwood paid
an aggregate amount of approximately $1.1 million to these five holders to
purchase shares of preferred stock convertible into an aggregate of
approximately 2.3 million shares of the Company's Common Stock or
approximately 7% of the Company's Common Stock on a fully diluted basis. The
Company will either redeem the preferred stock on or before the one-year
anniversary of the date the Company's Articles of Incorporation are amended
to increase the number of authorized shares of common stock, if it is
financially able, or the preferred stock will be converted to common stock and
offered to the Company's shareholders on a pro-rata basis [see "Item 5. Other
Information -Transactions with Other Preferred Holders"].
RENEGOTIATION OF SEVERANCE AGREEMENTS WITH FORMER MANAGEMENT; AMENDED EMPLOYMENT
AGREEMENT - On October 30, 1998 and November 1, 1998, the Company renegotiated
severance agreements with the Company's former President and Chief Executive
Officer, NTC's former President and Chief Executive Officer, NTC's former Senior
Vice President and Chief Financial Officer and with a present employee of the
Company. As a result of these negotiations, the Company's severance payments and
employment contractual commitments to those individuals were reduced [see "Item
5. Other Information -- Renegotiation of Severance Agreements With Former
Management; Amended Employment Agreement"].
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CAUTIONARY STATEMENTS:
This Quarterly Report on Form 10-Q contains certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933
and Section 21E of the Securities Exchange Act of 1934. The Company intends
that such forward-looking statements be subject to the safe harbors created
by such statutes. The forward-looking statements included herein are based on
current expectations that involve a number of risks and uncertainties.
Accordingly, to the extent that this Quarterly Report contains
forward-looking statements regarding the financial condition, operating
results, business prospects or any other aspect of the Company and its
subsidiaries, please be advised that the Company and its subsidiaries' actual
financial condition, operating results and business performance may differ
materially from that projected or estimated by the Company in forward-looking
statements. The differences may be caused by a variety of factors, including
but not limited to adverse economic conditions, intense competition,
including intensification of price competition and entry of new competitors
and products, adverse federal, state and local government and agency
regulation, inadequate capital, unexpected costs and operating deficits,
increases in general and administrative costs, lower sales and revenues than
forecast, loss of customers, loss of suppliers, technical problems with the
Company's products, failure to obtain new customers, litigation and
administrative proceedings involving the Company, including the pending class
action and related lawsuits, the possible acquisition of new businesses that
result in operating losses or that do not perform as anticipated, resulting
in unanticipated losses, inability of the Company to continue as a going
concern, adverse publicity and news coverage, inability to carry out
marketing and sales plans, loss of key executives, loss of independent sales
representatives, changes in interest rates, inflationary factors, default on
indebtedness and other specific risks that may be aluded to in this Quarterly
Report or in other reports issued by the Company. The inclusion of forward-
looking statements in this Quarterly Report should not be regarded as a
representation by the Company or any other person that the objectives or
plans of the Company will be achieved.
GENERAL:
The Company has two subsidiaries, NTC and GenSource. NTC is engaged in the
business of providing discount long distance telephone communication services
to residential and commercial customers in the United States. GenSource is
in the business of developing and marketing software programs used to
administer insurance-related claims, such as workers' compensation and
short-term and long-term disability.
LOSSES AT NTC -- Beginning in August 1997, and continuing through the nine
months ended September 30, 1998, NTC has continued to experience declining
revenues due to losses in the number of telephone customers and the number of
active independent sales representatives. Those losses were the result of a
number of factors (the "NTC Loss Factors"), including the following:
- Sanctions imposed by the California Public Utilities Commission in the
first quarter of 1998 and related compliance obligations imposed under
a stipulation among NTC, the California Attorney General and the
Orange County District Attorney. The sanctions and compliance
obligations followed findings that NTC had engaged in unauthorized
switching of customers' interexchange carrier during 1997. The order
also required that several former senior executives and directors
leave the Company.
- NTC's failed attempt at a public offering of its common stock in
September 1997.
- The termination of the proposed sale of all or substantially all of
NTC's assets to a third party as previously disclosed in July 1998.
- The operational distraction caused by the Company's focus on the
failed IPO and sale of NTC,
14
- The departure of Jerry Ballah, Christopher Mancuso and several key
independent sales representatives to form a competitive
telecommunications marketing company and their efforts to hire away
employees and to induce independent sales representatives and
telephone customers to leave NTC and join them in their new operations
[see "Item 1. Legal Proceedings - Lawsuit Against Jerry Ballah"].
- The financial difficulties at the Company and NTC as a result of the
above factors and the resulting issuance of a going concern opinion by
the Company's independent auditors in the 1997 Annual Report.
OPPOSITION TO THE SALE OF NTC; CASEY OPTION TO ACQUIRE PREFERRED STOCK -
During the second quarter of 1998, John P. Casey, a significant shareholder
of the Company, announced his opposition to the proposed sale of NTC. Mr.
Casey also announced that he was evaluating his options, including
replacement of a majority of the Company's then board members. By mid-July
1998, Mr. Casey owned 6.1 million shares of the Company's common stock,
representing 31% of the then outstanding shares, and acquired an option to
purchase 1,598 shares of preferred stock, or 78% of the Company's outstanding
convertible preferred stock (the "Cohen Preferred Stock"), from 13 holders
(collectively, the "Cohen Parties"). Mr. Casey attempted, but was not
successful, in obtaining the balance of the outstanding convertible preferred
stock (i.e., 445 shares or approximately 22% of the outstanding convertible
preferred stock (the "Other Preferred Shares")) from five additional owners
(the "Other Preferred Holders").
The Cohen Parties and the Other Preferred Holders (collectively, the "Preferred
Holders") had attempted to convert their preferred shares into common stock in
June 1998, when the Company's common stock price was in the range of $0.19 per
share. The Company did not have sufficient authorized common stock to effect
those conversions. If the Company had sufficient authorized common stock in
June 1998, the Preferred Holders would have received an aggregate of 11,387,806
shares of the Company's common stock, representing approximately 30% of the
Company's common stock on a fully diluted basis.
DEFAULTS ON NOTES TO FORMER OWNERS OF GENSOURCE -- In June 1998, the Company
defaulted on payments under promissory notes to two former owners of GenSource
and has not made any further payments to them under these notes. These two
noteholders have sued the Company seeking full payments under their notes of
$1.2 million [see "Item 1. Legal Proceedings - Lawsuit By Two Former Owners of
GenSource Corporation"].
NTC DEFAULTS - In August 1998, NTC received a notice from WorldCom, the
provider of NTC's telecommunications services, that WorldCom intended to
disconnect those services if certain conditions could not be satisfied and
defaults could not be cured. At the same time, NTC was in default on its
loan with its primary lender, First Bank. On August 27, 1998, WorldCom and
First Bank informed the Company and NTC that, as a condition to continuing
service and forbearance on amounts owed to them, they would require, among
other things, that the Company and its former Board of Directors enter into
an agreement with John Casey with respect to changing the composition of the
Company's Board of Directors.
THE BOARD CHANGE AGREEMENT - During August and September 1998, Mr. Casey
engaged in negotiations with the Company's board regarding a change in a
majority of the board members and management. Those negotiations resulted in a
Board Change Agreement that was consummated on September 29, 1998 (the "Board
Change Agreement") [see Item 5. Other Information - Change of Control of the
Company's Board of Directors and Chief Executive Officer"]. The Board Change
Agreement provided for the resignation of five of the Company's six directors
and the appointment of Mr. Casey and two of Mr. Casey's designees, John P. Hill,
Jr. and Michael A. Stein, as new directors. Howard Silverman agreed to continue
to serve as a director of the Company. Since the Board Change Agreement, the
new board appointed Denis Richard as the new President and Chief Executive
Officer of the Company and NTC. The new board appointed Mr. Richard and R.
Scott Eisenberg as additional board members.
15
RECENT DEVELOPMENTS -- In the third quarter of 1998 and since the change in
composition of the Company's Board of Directors, the following improvements
have taken place in the Company's business activities and operations:
- On October 30, 1998, the Company received a commitment from Ironwood,
subject to certain conditions, to provide the Company with up to $20
million in a secured credit facility by December 15, 1998 [see "Item
5. Other Information - Funding Commitment From Ironwood Telecom"].
The proceeds from this financing principally will be used to satisfy
the Company's obligations to WorldCom and First Bank and pay
certain other accrued liabilities.
- In September 1998, the Company entered into a revised settlement
agreement in connection with its pending class action lawsuit on more
favorable terms than those proposed in the original settlement in
December 1997 [see "Item 1. Legal Proceedings. Class Action and
Related Lawsuits"]. This settlement is subject to final court
approval.
- In September 1998, the District Attorney of Orange County lifted a
restriction that required NTC to wait 24 hours before verifying that a
new customer wanted to sign up for NTC's telephone service. Lifting
this restriction has eliminated a major disadvantage that NTC had in
signing up new telephone customers.
- In July 1998, NTC settled a lawsuit with one of its leading former
representatives, who has rejoined the Company and is playing an
important role in the effort to revitalize NTC's network marketing
operations.
- In October 1998, NTC renegotiated its contract with WorldCom. The
renegotiation has resulted in a decrease of the "take or pay"
provisions of the contract from $1.1 billion to $250 million over a
three year period, with the ability to extend for two additional years
if necessary [see "Notes To Consolidated Financial Statements - Note
7. Commitments and Contingencies"]. The new contract also has resulted
in an immediate decrease in the Company's telephone rates, which have
been passed on to new customers through the introduction of new
marketing programs that management believes are among the most
competitive in the industry.
- NTC is taking steps to revitalize its network marketing organization,
including developing new telecommunications products that are more
competitive, working closer with its independent sales representatives
to help them better understand the products and services provided by
NTC, developing new commission and bonus programs that will make NTC
more competitive in attracting new independent sales representatives
and expanding its focus on recruiting representatives primarily from
Southern California to a nationwide focus. Management is hopeful that
the aggressive, new marketing plan will revitalize its recruiting
efforts for additional representatives.
- As a condition to obtaining financing from Ironwood, the Company has
renegotiated severance agreements with former executives of the
Company and NTC and with a present employee of the Company [see "Item
5. Other Information - Renegotiation of Severance Agreements With
Former Management; Amended Employment Agreement"]. These executives
have also agreed to terminate options to purchase stock from the
Company.
- John P. Casey and Ironwood purchased all of the outstanding
convertible preferred stock and associated rights from the Preferred
Holders under arrangements that require Mr. Casey and Ironwood to
hold the stock for approximately one year to enable the Company to
redeem such stock for a price representing no actual profit except,
in the case of Ironwood, for a carrying cost factor. That redemption
price is currently estimated at $3.9 million (the "Preferred Price").
The Company hopes to redeem the preferred stock, if financially able,
prior to expiration of the redemption period. Those transactions have
the effect of avoiding a dilution to the Company's shareholders of
more than 10 million shares, or approximately 28%, of the Company's
common stock on a fully-diluted basis. If the Company is not
financially able to redeem the preferred stock, Ironwood and Mr.
Casey are obligated to make the common
16
stock underlying the Preferred Stock available for sale to
shareholders on a pro-rata basis at the Preferred Price [see
"Item 5. Other Information - Ironwood Loan to Casey; Cohen Option
Exercise and Transactions With Other Preferred Holders"].
- The Company is pursuing a variety of options in attempting to secure
additional sources of equity and debt financing to permit the Company
to meet its liquidity needs. The Company currently believes that it
will need to secure additional financing during the first quarter of
1999 to continue its operations [see "Liquidity and Capital Resources"
in this section].
LIQUIDITY AND CAPITAL RESOURCES:
Overall, the Company experienced positive cash flow of $0.6 million during
the nine months ended September 30, 1998, resulting from a cash inflow from
operations of $0.9 million and cash used in investing and financing
activities of $0.3 million. The Company, however, will need to raise
additional capital in 1998 and 1999 to repay obligations owing to WorldCom
and First Bank, to fund settlement costs related to pending litigation, to
pay off severance agreements to former management, to pay for costs incurred
associated with the change in the composition of the Company's Board of
Directors and to fund the cost of revitalizing the Company's business
operations.
SHORT-TERM FINANCING -- In September and October 1998, the Company sold 4.5
million shares of its holdings of 10.6 million shares of Rapid Cast, raising a
total of $2.7 million. The Company has no immediate plans to sell additonal
shares of Rapid Cast stock, although it may do so in the future to meet its
liquidity needs.
On November 4, 1998, the Company received a commitment from Ironwood Telecom
LLC to provide up to $20 million (less amounts loaned or paid to third
parties for the benefit of the Company) through a secured credit facility, a
portion of which the Company has already received in the form of a bridge
loan. The Company anticipates that the secured credit facility will be
funded on or before December 15, 1998 [see "Item 5. Other Information -
Funding Commitment From Ironwood Telecom"]. The funds from the secured credit
facility will be used principally to pay off WorldCom, First Bank and certain
other accrued liabilities. The remainder will be used to fund the Company's
operations. Completion of the secured credit facility is subject to a number
of conditions. No assurance can be given that the Company will be able to
complete the secured credit facility. If such facility is not completed, no
assurance can be given that the Company will be able to continue in operation
in the absence of such a facility.
LONG-TERM FINANCING - The secured credit facility to be provided by Ironwood
is designed to meet the Company's short-term financing needs. By the first
quarter of 1999, the Company anticipates that it will require additional
financing to revitalize its operations. To that end, the Company is taking
steps to arrange additional financing. Such financing may take the form of
either additional debt or equity. If the Company is successful in raising new
financing, the Company plans to use the proceeds to revitalize NTC's network
marketing organization, to develop new marketing channels and to introduce
new telecommunication products. The Company also anticipates selling its
remaining ownership of 6.1 million shares of Rapid Cast when appropriate,
although it presently has no specific plans to sell such shares.
There is no assurance that the Company and NTC will be able to raise
sufficient capital or financing to meet their needs through additional
sources of funding. There is no assurance that the Company will be able to
sell its shares in Rapid Cast, which is a privately held company.
Furthermore, there is no assurance that the Company will receive appropriate
financing to meet its needs even if NTC receives financing. Finally, there is
no assurance that the Company's revitalization plan will succeed even if the
Company obtains financing.
GENSOURCE CORPORATION - The Company is in default on promissory notes of
approximately $1.2 million to two former owners of GenSource. These former
owners have filed a lawsuit against the Company for failure to pay the notes
[see "Item 1. Legal Proceedings - Lawsuit By Two Former Owners of GenSource
Corporation"]. As part of ongoing discussions with these noteholders, the
Company is assessing various alternatives, including the possible disposition
of its interests in GenSource. In the nine months ended September 30, 1998, the
Company funded the development of GenSource's GenCOMP-TM- for Windows
workers' compensation claims administration software system. The development
of GenCOMP-TM- for Windows has been completed and the product is now actively
being sold by GenSource. The Company is negotiating with the former owners of
GenSource and with GenSource's management
17
to determine the appropriate steps to resolve the situation regarding the
defaulted notes and the Company's commitment to GenSource as a subsidiary.
CAPITAL EXPENDITURES - The Company spent approximately $1.2 million in the
nine months ended September 30, 1998 for the acquisition of plant and
equipment at NTC and GenSource. To meets its capital needs for the future,
the Company believes that it will have to spend approximately $2.6 million in
the next 12 months to upgrade certain equipment and software used in its
operations. These upgrades will also assist the Company in meeting its Year
2000 compliance requirements. Because the Company presently does not have the
capital for such anticipated expenditures, it will have to receive loans to
finance these expenditures or to raise funds through the sale of equity
[see "Long-Term Financing" in this section].
YEAR 2000 READINESS DISCLOSURE -- Many existing computer systems and
applications use only two digits to identify a year in their respective date
fields without considering the impact of the upcoming change in the century.
These systems need to be corrected or replaced with systems that are Year
2000 ("Y2K") compliant.
GenSource has completed a preliminary assessment of its Y2K compliance.
Management of the Company's GenSource subsidiary, after completion of a Y2K
testing program, believes that it has achieved Y2K compliance in the software
products that are currently offered for sale to its customers and has taken
steps with its customers to have any required software patches or upgrades
installed on prior products sold. GenSource has also identified internal
systems that may require upgrades to be Y2K compliant and believes that such
related costs will not be material. GenSource has already contacted its key
software suppliers to receive information on their Y2K compliance plans. No
assurance can be given that a Y2K compliance problem will not be discovered
in the future relating to GenSource's current products, or to patches and
upgrades made on prior products sold.
The Company's NTC subsidiary has identified the major applications and
systems that must either be upgraded or replaced to better meet the needs of
NTC's operations and for Y2K compliance. These changes will result in a
combination of software and/or hardware upgrades or replacement. Several key
systems that must be addressed by NTC are: its internal financial system, the
billing and customer service system, the independent representative tracking
and commission system, the calling card system, the Local Exchange Carrier
("LEC") billing system, the internal corporate telephone exchange, the
security and HVAC systems at NTC's facilities, and other systems.
NTC has established a preliminary budget of $2.6 million for the necessary
changes identified to date. NTC has dedicated internal resources to the Y2K
problem and has acquired software upgrades to existing equipment. NTC is also
considering engaging an outside consulting firm to prepare a final assessment
and, possibly, to act as Y2K project manager. NTC has also begun discussions
with its key suppliers and vendors with respect to their own Y2K compliance
plans, including: WorldCom, its underlying carrier; USBI, a LEC billing
clearing house; and GTE and SBC Communications, with whom NTC has direct LEC
billing and collection agreements.
NTC intends to address its Y2K issues by upgrading or replacing its software
and hardware as required, as well as its non-information-technology systems.
However, there can be no assurance at this time that NTC will be able to make
any such changes, that any of NTC's systems or applications are or will be
Y2K compliant, that such upgrades will be completed on a timely basis at
reasonable costs, or that such upgrades will be able to anticipate and
correct all of the problems triggered by the actual impact of Y2K. There can
be no assurance, even if the Company and its subsidiaries achieve Y2K
compliance in their own products and services, that systems provided to the
Company by outside suppliers will be Y2K compliant. There also can be no
assurance that such impact will not result in a material disruption or have a
material adverse effect on the Company's business, results of operation or
financial condition.
The most likely worst case Y2K scenario at NTC which management has
identified to date is that, due to unanticipated Y2K compliance problems, NTC
may be unable to bill its customers, in full or in part, for services used.
Should this occur, it would result in a material loss of some or all gross
revenue to NTC for an indeterminable amount of time, which could cause NTC to
cease operations. The Company has not yet developed a contingency plan to
address this worst case Y2K scenario, but with new anticipated financing, the
Company plans to develop such a plan by September 1999.
18
CASH FLOW FROM OPERATIONS - The Company experienced $0.9 million in positive
cash flow from operations during the first nine months of 1998 compared to
$13.1 million in negative cash flow from operations during the prior year's
comparable period. This year-to-year increase in cash flow from operations
resulted primarily from (1) a net cash inflow of $6.3 million from changes in
operating assets, primarily $5.5 million from accounts receivable, which
decline in accounts receivable was caused by the NTC Loss Factors; (2) a net
cash inflow of $0.5 million from changes in operating liabilities, primarily
a cash inflow of $2.0 million from accrued expenses offset by cash outflows
of $0.8 million and $0.7 million, respectively, from accounts payable and
deferred income, which were caused by the NTC Loss Factors; and (3) a net
cash outflow of $5.9 million from other operating activities, primarily the
Company's net loss of $8.7 million, the sale of Rapid Cast stock of $2.7
million and the deferred gain from the write-off of Rapid Cast of $3.6
million, partially offset by asset impairment of $4.9 million, depreciation
and amortization of $2.8 million, and disposal of assets of $1.0 million.
CASH FLOW FROM INVESTING - The Company experienced a cash inflow from
investing activities of $ 1.6 million in the first nine months of 1998 as
compared with a negative cash flow of $2.3 million in the first nine months
of 1997. The positive cash flow in the first nine months of 1998 resulted
primarily from (1) a cash inflow of $1.3 million for the sale of the
Company's AutoNETWORK subsidiary in April 1998 and (2) a cash inflow of $1.5
million from the sale of 4.5 million shares of stock in Rapid Cast for $2.7
million in September 1998 versus a cash outflow of $1.2 million for the
acquisition of plant and equipment. The remaining $1.2 million for the sale
of Rapid Cast stock was booked as a receivable in September 1998, most of
which was received in October 1998.
CASH FLOW FROM FINANCING - The Company had negative cash flows from financing
activities of $1.9 million during the nine months ended September 30, 1998
compared with positive cash flow of $14.4 million during the nine months
ended September 30, 1997. The negative cash flow during the first nine
months of 1998 resulted primarily from repayments of short-term and long-term
debt, including a reduction in debt owed to First Bank from $8.4 million on
December 31, 1997 to $6.9 million on September 30, 1998 and a reduction in
long-term capital lease obligations from $1.3 million on December 31, 1997 to
$0.9 million on September 30, 1998.
LITIGATION - The Company is subject to pending litigation. Management is not
yet able to predict the impact of the pending litigation on its financial
condition and results of operations. Other pending litigation may have a
material adverse effect on the Company's financial condition and results of
operation [see "Part II. Item 1. Legal Proceedings"].
GOING CONCERN - As a result of the substantial net losses incurred by the
Company and its subsidiaries in 1997, and because its current liabilities
exceeded its current assets by $11.6 million on December 31, 1997, the
Company's independent certified public accountants stated in their report
included in the 1997 Annual report, that there is substantial doubt regarding
the Company's ability to continue as a going concern. Since current
liabilities exceeded current assets by $17.4 million as of September 30,
1998, the Company believes that its independent certified public accountants
would issue a similar going concern qualification regarding the Company's
financial condition if the accountants were engaged to review and report on
the Company's financial status.
RESULTS OF OPERATIONS:
SALES - Sales of $12.9 million in the third quarter ended September 30, 1998
decreased 61% versus sales of $33.3 million in the third quarter ended
September 30, 1997. For the nine months ended September 30, 1998, sales
decreased to $48.0 million from $99.3 million in the nine months ended
September 30, 1997, a decrease of 52%. This decrease was attributable to a
decrease in sales at NTC to $12.3 million in the three months ended September
30, 1998 from sales at NTC of $32.3 million in the three months ended
September 30, 1997. The decline in sales is primarily due to the NTC Loss
Factors which are discussed in more detail under "General" in this section.
For the nine months ended September 30, 1998, sales at NTC decreased to $45.4
million from $97.1 million in the nine months ended September 30, 1997, a
decrease of 53%. The following table summarizes the Company's sales
performance by subsidiary and segment during the comparable third quarters in
1998 and 1997:
19
$ in millions
----------------------
Subsidiary Segment 1998 1997
- - ------------ ----------------------------------------- ------- -------
NTC Telephone (telecommunications services) $12.0 $ 28.7
NTC Telephone (marketing programs) 0.3 3.6
GenSource Software 0.6 0.6
AutoNETWORK Network -- 0.4
------ -------
Total Company Sales $12.9 $ 33.3
====== =======
COST OF SALES - Total Company cost of sales decreased to $8.0 million or 62% of
sales during the quarter ended September 30, 1998 verses $23.4 million or 70% of
sales during the quarter ended September 30, 1997. For the nine months ended
September 30, 1998, cost of sales decreased to $30.2 million from $69.5 million
for the nine months ended September 30, 1997. The decrease in cost of sales
resulted largely from decreasing carrier costs associated with decreased
telephone service sales by NTC and decreasing commissions paid to NTC's
independent sales representatives.
The following table summarizes the Company's changes in three major cost
components for the three months ended September 30, 1998 and 1997, respectively:
($ in millions)
--------------------------
September September
30, 1998 30, 1997
----------- -----------
Commissions paid to NTC independent
sales representatives $ 1.1 $ 4.4
Carrier costs for NTC's long distance
telephone service 6.4 17.8
All other costs of sales 0.5 1.2
------- -------
Total Company Cost of Sales $ 8.0 $ 23.4
======= =======
NTC's total commission expense decreased to $1.1 million in the third quarter
of 1998 compared to $4.4 million in the same quarter of 1997. The decrease in
commissions is directly related to the decline in NTC's telephone revenues to
$12.0 million and to the decline in NTC's marketing revenues to $0.3 million.
Representatives receive a percentage of long distance revenues in commissions
and receive bonuses when new independent sales representatives sign up a
certain number of new telephone customers. NTC's carrier costs to deliver
long distance telephone service to its telephone customers decreased to $6.4
million in the third quarter of 1998 compared to $17.8 million in the third
quarter of 1997. This decrease in carrier costs reflects a decline in sales.
In the third quarter of 1998, the gross margin for telecommunication services
was 47%, while in the third quarter of 1997, gross margin was 38%. The
increase in gross margin reflects improved margins on both domestic and
international rates.
The third cost component shown in the table above is "all other costs of
sales" which represents: (1) NTC's costs of producing sales materials for its
independent sales representatives; and (2) GenSource's cost of producing
software products and related services.
GENERAL & ADMINISTRATIVE - Total general and administrative costs increased to
$8.3 million in the quarter ended September 30, 1998 or 64% of sales compared to
$6.7 million for the three months ended September 30, 1997 or 20% of sales.
General and administrative expenses were $20.1 million for the nine months ended
September 30, 1998 versus $20.7 million for the nine months ended September 30,
1997. General and administrative costs generally include the costs of employee
salaries, fringe benefits, supplies, and related support costs which are
required in order to provide such operating functions as customer service,
billing, marketing, product development, information systems, collections of
accounts receivable, and accounting. The increase in general and administrative
20
costs in the current quarter were primarily attributable to expenses of
approximately $1.1 million incurred during the quarter by the Company associated
with the change in composition of the Company's Board of Directors [see "Item
5. Other Information - Change of Control of the Company's Board of Directors"]
and reserves of approximately $1.8 million for related expenses, including (1)
$1.1 million for legal and related expenses and (2) $0.2 million for the
severance agreement with the Company's former CEO.
Costs for salaries, fringe benefits, supplies and related support costs at
NTC decreased to $14.7 million in the nine months ended September 30, 1998
versus $19.5 million for the nine months ended September 30, 1997, a decrease
of 25%. In the three month ended September 30, 1998, salaries, fringe
benefits, supplies and related support costs at NTC decreased to $4.7 million
versus $6.5 million in the three months ended September 30, 1998, a decline
of 28%. This decrease reflects NTC's efforts to lower its overhead because of
decreasing sales.
DEPRECIATION & AMORTIZATION - Total Company depreciation and amortization
expense was $0.9 million in the third quarter ended September 30, 1998 versus
$0.8 million in the third quarter ended September 30, 1997. Depreciation and
amortization expense for the nine months ended June 30, 1998 was $2.8 million
versus $2.2 million for the nine months ended September 30, 1997. This
increase was caused by increased investment by NTC in computer hardware and
software, furniture and equipment, and leasehold improvements in 1997 prior
to a decline in its sales and by an increase in investment in computer
software and hardware by GenSource.
BAD DEBT EXPENSE - Total Company bad debt expense decreased to $0.9 million
in the third quarter of 1998 from $1.6 million in the third quarter of 1997,
a decrease of 44%. Bad debt expense for the nine months ended September 30,
1998 decreased to $3.1 million versus bad debt of $3.4 million for the nine
months ended September 30, 1997, a decrease of 8.8%. The decrease in bad
debt expense reflects declined level of telephone sales at NTC. Bad debt
expense in the third quarter of 1998 also includes $0.6 million associated
with the write-off of a loan to a former officer of NTC. As a percentage of
sales, bad debt expense for the nine months ended September 30, 1998 was 6.5%
of sales versus 3.5% of sales for the nine months ended September 30, 1997.
The increase in the percentage of bad debt expense in relationship to sales
is related primarily to the write-off of a loan to a former officer of NTC.
IMPAIRMENT OF LONG-LIVED ASSETS - In the three months ended September 30,
1998, the Company completed its evaluation of the recoverability of certain
long-lived assets at its NTC and GenSource subsidiaries. In connection with
this evaluation, the Company has recorded a $4.9 million non-cash write-down
of the carrying value of certain long-lived assets to their estimated fair
value. The write-offs include approximately $1.7 million at NTC, primarily
leasehold improvements at one of its facilities, and $3.2 million associated
with GenSource, consisting primarily of $2.0 million of goodwill resulting
from the Company's acquisition of GenSource and $1.2 million of property,
plant and equipment at GenSource.
OTHER EXPENSE - The Company's other expense was $1.7 million in the quarter
ended September 30, 1998 versus an expense of $11.2 million in the third
quarter of 1997. Other expense for the nine months ended September 30, 1998
was $2.5 million versus other expenses of $11.3 million for the nine months
ended September 30, 1997. Other expense in the third quarter ended September
30, 1998 consisted primarily of write downs of $1.1 million associated with
fixed assets and organization cost and interest expense of $0.5 million. For
the nine months ended September 30, 1998, other expense of $2.4 million
consisted primarily of $1.1 million associated with fixed assets and
organization cost, interest expense of $1.1 million and $0.2 million for a
legal settlement. For the nine months ended September 30, 1997, the $11.3
million in other expense was primarily related to a charge of $8.7 million
taken for the settlement of the class action lawsuit and $1.6 million for the
settlement of the civil consumer protection lawsuit against NTC.
OTHER - There were certain other non-recurring expenses in the quarter ended
September 30, 1998 that consisted primarily of a gain of $3.6 million
associated with the reversal of the liability in excess of assets related to
the Company's investment in Rapid Cast and a gain of $2.7 million associated
with the sale of Rapid Cast stock.
21
NET LOSS - The Company had a net loss of $5.5 million for the three months
ended September 30, 1998 compared to a loss of $9.6 million for the three
months ended September 30, 1997. For the nine months ended September 30,
1998, the Company had a net loss of $8.7 million versus a net loss of $7.2
million in the nine months ended September 30, 1997. The net loss for the
nine months ended September 30, 1998 was due primarily to: (1) a charge of
$4.9 million associated with the impairment of assets at the Company's NTC
and GenSource subsidiaries; (2) a decline in sales at the Company's NTC
subsidiary that has resulted in operating losses at NTC; and (3) expenses
associated with the proposed sale of the Company's NTC subsidiary and the
change of in composition of the Company's Board of Directors [see "General" in
this section and "Item 5. Other Information - Change of Control of the
Company's Board of Directors"].
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
SECURITIES AND EXCHANGE COMMISSION INVESTIGATION:
The investigation of the Company by the SEC has been settled with respect to
the Company and two former directors of the Company, Stephen A. Caswell and
Joel W. Greenberg. Mr. Caswell is presently employed by the Company. The
SEC's investigation with respect to the Company focused on press releases
issued by the Company on January 17 and 18, 1995, and September 6, 1995,
which the SEC alleged contained untrue statements of material fact, and a
report on Form 8-K issued by the Company on August 28, 1995, which the SEC
also alleged contained untrue statements of material fact. On May 14, 1998,
the Company, Mr. Caswell and Mr. Greenberg entered into an Offer of
Settlement and Order with the Securities and Exchange Commission pursuant to
which they agreed, without admitting or denying any wrongdoing, not to
violate Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 12b-2,
13a-11 and 13a-13 thereunder of the Securities Exchange Act of 1934 as
amended. No civil penalties or other financial sanctions were imposed on any
of the parties. The final administrative order was entered by the SEC on July
30, 1998.
CLASS ACTION AND RELATED LAWSUITS:
The Company has been sued in a class action lawsuit entitled SANDRA GAYLES
ET AL., VS. SAM D. SCHWARTZ AND INCOMNET, INC., Case No. CV95-0399 AWT
(BQRx), initially filed in January 1995 in the United States District Court
for the Central District of California (the "Gayles Class Action Lawsuit").
The Gayles Class Action Lawsuit relates to claims alleging that the Company
violated certain sections of the federal securities laws because it did not
disclose and falsely denied the existence of the non-public investigation of
the Company commenced by the SEC in August 1994. The Gayles Class Action
Lawsuit also includes additional claims against Sam D. Schwartz, the
Company's former Chairman and Chief Executive Officer. The Gayles Class
Action Lawsuit is more fully described in the Company's 1997 Annual Report
under "Item 3. Legal Proceedings," which description is hereby incorporated
by this reference.
In September 1998, the Company entered into a new written settlement
agreement with the plaintiffs in the Gayles Class Action Lawsuit. The
settlement agreement is subject to court approval and satisfaction of certain
other conditions. The terms of the settlement include payment to the
plaintiffs of a total of $500,000, reimbursement of certain expenses up to a
maximum of $100,000 and issuance of a certain number of shares of the
Company's Common Stock based on a formula. The maximum number of shares of
Common Stock that will be issued in accordance with the formula under the
settlement agreement is 4,125,000, assuming a $1 per share trading price at
the time the formula is applied, and the minimum number of shares of Common
Stock that will be issued under the settlement agreement is 1,375,000 shares,
assuming a $3 per share trading price at the time the formula is applied.
Prior to completion of the settlement agreement and issuance of the shares in
accordance with that agreement, the Company's shareholders must approve an
amendment to the Company's Articles of Incorporation to increase the
authorized number of shares of Common Stock. It is anticipated that the
closing of the settlement agreement and issuance of shares will occur no
earlier than March 1999. No assurance can be given that the settlement
agreement will be consummated. Further, no assurance can be given that this
lawsuit will not have a material adverse impact on the business, financial
condition or results of operation of the Company.
22
In a matter related to the claims alleged in the Gayles Class Action Lawsuit,
the Company was sued in an action entitled JAMES A. BELTZ, ET AL, VS. SAMUEL
D. SCHWARTZ AND RITA SCHWARTZ; INCOMNET, INC ET AL., filed in the United
States District Court, District of Minnesota in July 1997 and also filed as a
parallel action in the State Court of Minnesota (collectively, the "Beltz
Lawsuit"). The plaintiffs in the Beltz Lawsuit purportedly opted out of the
Gayles Class Action Lawsuit and brought similar claims against the Company
and its former Chairman and Chief Executive Officer, Mr. Schwartz. The Beltz
Lawsuit is more fully described in the Company's 1997 Annual Report under
"Item 3. Legal Proceedings," which description is hereby incorporated by this
reference. In addition, Mrs. Rita Schwartz has filed a lawsuit against the
Company alleging that she is entitled to reimbursement from the Company of
expenses she incurred in connection with the Beltz Lawsuit and the
above-described SEC investigation.
In September 1998, Mr. Caswell, Mr. Greenberg, Mr. Bodner and Mr. Huberfeld
were dismissed from the federal action in the Beltz Lawsuit, while the
Company was dismissed from all counts in the Beltz federal action except for
one count. The Company, Mr. Caswell, Mr. Greenberg, Mr. Huberfeld and Mr.
Bodner remain as defendants in the Beltz state court action. No assurance
can be given that the Beltz Lawsuit will not have a material adverse impact
on the business, financial condition or results of operation of the Company.
In another matter related to the claims alleged in the Gayles Class Action
Lawsuit, the Company was sued in an action entitled SILVA RUN WORLDWIDE
LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ ET AL., filed in the United
States District Court for the Southern District of New York in November 1996
(the "Silva Run Lawsuit"). In 1997, the claims against the Company and Mr.
Schwartz were transferred to the same court hearing the Gayles Class Action
lawsuit. The plaintiffs in the Silva Run Lawsuit purportedly opted out of the
Gayles Class Action Lawsuit and brought claims against the Company and Mr.
Schwartz based on alleged violations of the securities laws. The Silva Run
Lawsuit is more fully described in the Company's 1997 Annual Report under
"Item 3. Legal Proceedings," which description is hereby incorporated by
this reference.
On November 9, 1998, except for one breach of fiduciary duty claim, the court
dismissed all federal and state claims asserted by plaintiffs in the Silva
Run Lawsuit on the ground that the Silva Run plaintiffs had failed to
properly opt-out of the GAYLES Class Action Lawsuit.
In September 1998, Robert Zivitz and Nancy Zivitz, a former member of the
Company's Board of Directors filed a lawsuit against Sam D. Schwartz, Rita
Schwartz and Joel W. Greenberg, et al. in the United States District Court,
Northern District of Illinois. Mr. Schwartz is the former Chairman and Chief
Executive Officer of the Company, while Mrs. Schwartz and Mr. Greenberg are
former directors of the Company. The lawsuit alleges, among other things,
that defendants fraudulently promoted the Company's securities in 1995. The
Company is not named in the lawsuit. Mr. Schwartz, Mrs. Schwartz and Mr.
Greenberg have requested that the Company indemnify them from the claims
brought against them in this lawsuit and that the Company advance them legal
fees. The Company is presently reviewing the request for indemnification and
advancement of legal fees.
INCOMNET, INC. VS. SAM D. SCHWARTZ:
The Company filed a lawsuit in April 1997 in the Superior Court of California
in the County of Los Angeles against Sam D. Schwartz, the Company's former
Chairman and Chief Executive Officer, in an action entitled INCOMNET, INC.
VS. SAM D. SCHWARTZ (the "Schwartz Lawsuit"). The Schwartz Lawsuit is more
fully described in the Company's 1997 Annual Report under "Item 3. Legal
Proceedings," which description is hereby incorporated by this reference.
The Company claims in this lawsuit that Mr. Schwartz, among other things,
failed to disclose material information to the Company as required by law
that resulted in damages to the Company. The Company seeks to recover damages
from Mr. Schwartz in the amount of the losses incurred by the Company.
LAWSUITS BY FORMER INDEPENDENT SALES REPRESENTATIVES:
The Company is involved in three lawsuits by former independent sales
representatives filed in the Superior Court of California in the County of
Orange. The lawsuits allege that the Company and NTC breached various duties
and made material misrepresentations in its dealings with the plaintiffs
generally during the period from August 1993 to March 1998, and also allege
that the Company failed to pay certain commissions owed to the plaintiffs.
The lawsuits seek general damages, compensatory damages, special damages and
punitive damages. The Company believes that these claims are without merit
and plans to defend itself
23
vigorously against the lawsuits. No assurance can be given that this lawsuit
will not have a material adverse impact on the business, financial condition
or results of operation of the Company.
LAWSUIT AGAINST JERRY BALLAH:
In July 1998, NTC sued a former consultant and others in the Orange County
Superior Court in a matter entitled NATIONAL TELEPHONE & COMMUNICATIONS, INC.
VS. JERRY BALLAH, WORLD TECHNOLOGIES MARKETING, INC., ET AL. (the "Ballah
Lawsuit"). The Ballah Lawsuit is more fully described under "Item 1. Legal
Proceedings" set forth in the Company's Form 10-Q for its fiscal quarter
ended June 30, 1998, as filed with the Securities & Exchange Commission on
August 14, 1998, which description is hereby incorporated by this reference.
In this lawsuit, NTC is asserting claims against Mr. Ballah and other
defendants for breach of contract, misappropriation of trade secrets,
intentional interference with business relationships, fraud and related
claims in connection with their start-up of a competing business and
solicitation of NTC's employees and independent sales representatives, as
well as the alleged diversion of NTC's telephone customers to businesses
owned or controlled by defendants. In a cross-complaint for damages, Mr.
Ballah alleges that NTC breached its consulting agreement with him and World
Technologies, Inc. ("World Tech") alleges that NTC breached an agreement
under which World Tech would become the exclusive network marketing company
for NTC.
On July 21, 1998, a stipulated restraining order was entered by the court
enjoining the defendants in the Ballah/Mancuso Lawsuit from directly or
indirectly attempting to induce any NTC employee or independent sales
representative to work or perform services for the defendants. NTC's motion
for preliminary injunction is currently scheduled for hearing in December
1998. NTC is subject to potential claims by Mr. Ballah [see "Part 1. Legal
Proceedings - Potential Lawsuits - Former Officers of NTC"].
LAWSUIT BY COMMUNICATIONS CONSULTING, INC.:
NTC has been sued in an action entitled COMMUNICATIONS CONSULTING, INC. VS.
NATIONAL TELEPHONE & COMMUNICATIONS, INC., filed June 1998 in the Superior
Court of California in the County of Orange (the "CCI Lawsuit"). The CCI
Lawsuit is more fully described under "Item 1. Legal Proceedings" set forth
in the Company's Form 10-Q for its fiscal quarter ended June 30, 1998, as
filed with the SEC on August 14, 1998, which description is hereby
incorporated by this reference. In the CCI Lawsuit, the plaintiff alleges
that NTC violated the terms of a consulting agreement entered into between
CCI and NTC on July 24, 1996. There has been no material change in the status
of this lawsuit.
LAWSUIT BY TWO FORMER OWNERS OF GENSOURCE CORPORATION:
On September 23, 1998, Jerry C. Buckley and Ralph Flygare, two former owners
of GenSource Corporation, filed a lawsuit entitled JERRY BUCKLEY, RALPH
FLYGARE ET AL VS. INCOMNET, INC., GENSOURCE CORPORATION AND MARK RICHARDSON,
in the Superior Court of the County of Los Angeles (the "GenSource Lawsuit").
In the GenSource Lawsuit, the plaintiffs allege that the Company defaulted on
payments under promissory notes between the Company and the plaintiffs, and
seek payment of approximately $1.2 million. The Company is presently
negotiating with the two former owners to resolve the claims alleged in the
lawsuit. There can be no assurances that there will be a favorable outcome to
these negotiations or that the lawsuit will not have a material adverse
impact on the business, financial condition or results of operations of the
Company.
POTENTIAL LAWSUITS:
From time to time, the Company is also involved in litigation arising from
the ordinary course of business, the ultimate resolution of which may or may
not have a material adverse effect on the business, financial condition or
results of operation of the Company.
On June 30, 1998, NTC terminated its employment agreement with Edward Jacobs
for cause. Mr. Jacobs has notified NTC that he intends to assert claims under
the employment agreement or other agreements between Mr. Jacobs and the
Company [see "Certain Relationships and Related Transactions - Settlement
Agreement With NTC
24
Directors" in the Company's Proxy Statement, filed with the Securities and
Exchange Commission on November 19, 1997]. The Company believes that it has
adequate defenses against such potential claims and would defend itself
vigorously against such a lawsuit. There is no assurance that such a lawsuit
would not have a material adverse impact on the business, financial condition
or results of operation of the Company.
ITEM 2. CHANGES IN SECURITIES
On September 29, 1998, the Company granted: (1) 13 shares of a new class of
restricted convertible preferred stock to Denis Richard, the Company's
President and Chief Executive Officer, which is convertible into 1.3 million
shares of common stock (the "Richard Grant") [see "Item 5. Other Information -
Change of Control of the Company's Board of Directors; Appointment of New
Chief Executive Officer - Richard Employment Agreement"] and (2) an option to
purchase 75,000 shares of the Company's common stock at $2.00 per share
(i.e., the closing market price on September 29, 1998) to a consultant to the
Company (the "Consultant Option"). The shares of common stock issuable under
the Richard Grant and the Consultant Option are subject to approval of the
Company's shareholders of an increase in the number of authorized shares of
common stock (the "Stock Approval"). The Consultant Option may be exercised
at any time during the five-year period following Stock Approval.
On September 29 and October 2, 1998 the board approved the grant of an option
to purchase 10 shares of a new class of preferred stock to each of the
Company's new outside directors (the "Director Options"). The Director
Options vest over a two-year period. Each share of preferred stock is
convertible into 10,000 shares of common stock, subject to Stock Approval.
The exercise price for the Director Options was based on the closing price
for the Company's common stock at the time of the grants. In the case of
three directors that price is $2.1875 per share and in the case of the fourth
director that price is $2.25 per share. The options may be exercised over a
ten year period.
The Richard Grant, Consultant Option and Director Options were granted
pursuant to an exemption form registration under section 4(2) of the
Securities Act of 1933 on the basis that each of the recipients had the
appropriate investment intent and the offering was targeted to a select group
of officers, directors and one consultant.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
NTC is in default on notes to WorldCom and First Bank & Trust and the Company
is in default on notes to two former owners of GenSource Corporation
[see Notes To Consolidated Financial Statement - Note 7. Commitments and
contingencies"]. The Company and NTC have reached agreement with WorldCom and
First Bank to repay amounts due, pending completion of a Term Loan to be
received from Ironwood Telecom LLC [see "Item 5. Other Information - Funding
Commitment From Ironwood Telecom"]. The Company is presently negotiating with
the former owners of GenSource regarding the repayment of their notes [see
"Item 1. Legal Proceedings - Lawsuit By Two Former Owners of GenSource
Corporation"].
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Item 4 is not applicable for the three months ended September 30, 1998.
ITEM 5. OTHER INFORMATION
CHANGE OF CONTROL OF THE COMPANY'S BOARD OF DIRECTORS; APPOINTMENT OF NEW CHIEF
EXECUTIVE OFFICER:
On September 30, 1998, the Company consummated a change in the composition of
the Company's Board of Directors in accordance with a Board Change Agreement
that was entered into on August 24, 1998 between John P. Casey and Incomnet's
former Board of Directors [see "Report on Form 8-K - Changes in Control of
Registrant, dated August 28, 1998 and filed with the Securities and Exchange
Commission on August 31, 1998]. A copy of the Board Change Agreement is attached
to the Form 8-K filed on August 31, 1998. The description of the Board Change
Agreement contained therein is hereby incorporated by reference into this
Quarterly Report on Form 10-Q.
25
The Company's new Board of Directors consists of John P. Casey, Scott Eisenberg,
John Hill, Jr, Denis Richard, Dr. Howard Silverman and Michael A. Stein. Mr.
Casey is the Chairman of the Board. Denis Richard is the President and Chief
Executive Officer. As part of the Agreement, Richard Horowitz, Melvyn Reznick,
David Wilstein and Nancy Zivitz resigned from the Board of Directors. Melvyn
Reznick also resigned as President and Chief Executive Officer [see "Item 5.
Other Information - Renegotiation of Severance Agreements With Former
Management; Amended Employment Agreement"]. Mr. Casey is the largest shareholder
in the Company, owning approximately 31% of the outstanding shares of the
Company, not including shares of preferred Stock owned by Mr. Casey, which he is
required to hold for redemption or a rights offering. Mr. Richard was previously
Vice President, Law & Corporate Affairs of Teleglobe International Corporation,
and has over ten years of experience in the telecommunications industry.
RICHARD EMPLOYMENT AGREEMENT -- On September 29, 1998, the Company and NTC
entered into an employment agreement with Denis Richard (the "Richard
Employment Agreement"). The terms of the Richard Employment Agreement are
more fully described in the Company's Report on Form 8-K dated September 29,
1998, filed with the Securities and Exchange Commission on October 14, 1998
(the "October 1998 Form 8-K") under the caption "Item 5. Other Information --
Richard Employment Agreement". A copy of the Richard Employment Agreement is
attached to the October 1998 Form 8-K. The description of the Richard
Employment Agreement contained in, and the entire Richard Employment
Agreement attached to, the October 1998 Form 8-K is hereby incorporated by
reference into this Quarterly Report on Form 10-Q. The following summary of
the Richard Employment Agreement is qualified in its entirety by the full
text of that agreement contained in the October 1998 Form 8-K.
Under the Richard Employment Agreement, Mr. Richard agreed to serve as the
President and Chief Executive Officer of the Company and NTC. Mr. Richard is
also a director of Incomnet and the Chairman of the Board of NTC. During the
term of the agreement, which terminates on December 31, 2001, Mr. Richard
will receive an annual base salary of no less than $325,000. In addition,
Mr. Richard is entitled to receive a one-time signing bonus of $353,000 and
certain other fringe benefits. Mr. Richard is also entitled to certain
severance benefits if his employment is terminated without "Good Reason" as
defined in the Richard Employment Agreement.
Under the Richard Employment Agreement, the Company has agreed to issue to
Mr. Richard 13 shares of the Company's new series of Preferred Stock (the
"Richard Preferred Stock") as compensation to him, which will be convertible
into an aggregate of 1.3 million shares of the Company's Common Stock at
such time as the Company's Articles of Incorporation have been amended to
increase the authorized number of shares of the Company's Common Stock to
permit such conversion. The holder of the Richard Preferred Stock will be
entitled to vote with the holders of the Company's Common Stock on all
matters submitted to shareholders on an as-converted-to-Common basis (i.e.,
the right vote as if the shares of the Richard Preferred Stock were converted
into 1.3 million shares of Common Stock). Mr. Richard has certain rights to
require the Company to register the Common Stock issuable upon conversion of
the Richard Preferred Stock under the Securities Act of 1933, as amended,
following the first anniversary of the commencement of his employment with
the Company. The Company has a right of first refusal to purchase the shares
of the Richard Preferred Stock and the shares of the Company's Common Stock
issuable upon conversion thereof.
CASEY SERVICES AGREEMENT -- On September 29, 1998, the Company entered into
an agreement with Mr. Casey (the "Casey Services Agreement"). The terms of
the Casey Services Agreement are more fully described in the Company's
October 1998 Form 8-K under the caption "Item 5. Other Information -- Casey
Services Agreement". A copy of the Casey Services Agreement is attached to
the October 1998 Form 8-K. The description of the Casey Services Agreement
contained in, and the entire Casey Services Agreement attached to the October
1998 Form 8-K is hereby incorporated by reference into this Quarterly Report
on Form 10-Q. The following summary of the Casey Services Agreement is
qualified in its entirety by the full text of that agreement contained in the
October 1998 Form 8-K.
Under the Casey Services Agreement, Mr. Casey agreed to perform certain duties
as the Chairman of the Board of Directors of the Company. The term of the Casey
Services Agreement is three years ending on September 29, 2001. However, the
agreement does not obligate Mr. Casey to remain as Chairman of the Board nor
does it obligate the
26
Company to retain Mr. Casey as Chairman of the Board. Under the Casey
Services Agreement, for so long as Mr. Casey acts as Chairman of the Board,
Mr. Casey will be entitled to a quarterly service fee based on a certain
formula derived from the fair market value of the Company's Common Stock at
the end of each fiscal quarter during the term of the agreement. Generally,
this formula will result in a $25,000 quarterly service fee payable to Mr.
Casey if the market price of the Common Stock is $4, and an additional
$25,000 for each additional $4 increase in the market price of the Common
Stock. The maximum fee Mr. Casey would be entitled to in any fiscal quarter
is $250,000. If Mr. Casey resigns or is not elected or otherwise retained by
the Company as Chairman of the Board during the term of the Casey Services
Agreement, he will not be entitled to any quarterly services fee after such
resignation or termination of services. Under the Casey Services Agreement,
Mr. Casey has waived any right to receive retainer fees, meeting fees or
other remuneration given to other directors of the Company.
DIRECTOR STOCK OPTION GRANTS -- On September 29, 1998, as part of the Change
of Control of the Company's Board of Directors, the new Board of Directors
granted an option to purchase 10 shares of a new series of the Company's
Preferred Stock to each non-employee director of the Company then in office
(i.e., options were granted to Mr. Hill, Dr. Silverman and Mr. Stein). On
October 2, 1998, the Board of Directors granted an option to purchase 10
shares of the Company's Preferred Stock to Mr. Eisenberg upon his appointment
to the Board of Directors (the options granted to Messrs. Hill, Eisenberg and
Stein and Dr. Silverman are referred to in this Current Report as the
"Nonemployee Director Options"). No options were granted to either Mr. Casey
or Mr. Richard.
The Nonemployee Director Options have a term of ten years and vest over a
two-year period. Each share of Preferred Stock will be convertible into
10,000 shares of the Company's Common Stock. Since all of the Company's
authorized Common Stock is currently issued and outstanding, the right to
convert the Preferred Stock into Common Stock is subject to the approval by
the Company's shareholders of an amendment to the Company's Articles of
Incorporation to increase the number of authorized shares of Common Stock
available for issuance.
For Mr. Hill, Dr. Silverman and Mr. Stein, the exercise price of each share
of Preferred Stock is $21,875, which represents $2.1875 per share of the
underlying Common Stock into which such Preferred Stock can be converted. The
exercise price for these options is based on the closing price per share of
the Company's Common Stock as reported by the Nasdaq Stock Market on the
second day following the announcement of the change in composition of the
Company's Board of Directors (October 1, 1998). For Mr. Eisenberg, the
exercise price of each share of Preferred Stock is $22,500, which represents
$2.25 per share of the underlying Common Stock into which such Preferred
Stock can be converted. The exercise price of Mr. Eisenberg's options is
based on the closing price per share of the Company's Common Stock as
reported by the Nasdaq Stock Market on the date of grant (October 2, 1998).
FUNDING COMMITMENT FROM IRONWOOD TELECOM:
On October 30, 1998, the Company received a commitment letter from Ironwood
Telecom LLC to provide the Company with a secured credit facility of $20
million, less the amount Ironwood would lend to Mr. Casey to exercise the option
to acquire the Cohen Preferred Stock (the "Casey Loan") and the amounts Ironwood
would pay to the Other Preferred Holders to acquire the Other Preferred Shares
for the benefit of the Company (the "Payments to Other Preferred Holders") [see
"Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operation - The Change in Ownership of the Company's Common Stock"]. Under
the commitment letter, Ironwood agreed to provide an aggregate of $5 million by
November 4, 1998 and an additional net amount of $15 million by December 15,
1998 for these purposes. The amount provided to the Company on November 4, 1998
was in the form of a secured bridge loan (the "Bridge Loan"), and the amount to
be provided to the Company by December 15, 1998 will be in the form of a secured
term loan (the "Term Loan"), each of which is described below.
THE BRIDGE LOAN -- Ironwood loaned the Company approximately $2.3 million on
November 4, 1998 under the Bridge Loan (and loaned Mr. Casey approximately
$2.1 million under the Casey Loan and paid $600,000 to certain of the Other
Preferred Holders on or about the same date). The proceeds from the Bridge
Loan were used to make a partial payment of amounts in default owing by NTC
to WorldCom. The Bridge Loan accrues interest at the rate of 15% per annum
and principal and accrued interest is due on December 15, 1998. The Bridge
Loan is secured by the proceeds from any future sale of capital stock of
Rapid Cast currently owned by the Company as well as certain other assets of
the Company. For arranging the Bridge Loan and making the Casey Loan and
Payments to Other Preferred Holders for the benefit of the Company,
27
Ironwood received an origination fee of $100,000 and warrants to purchase
500,000 shares of the Company's common stock at an exercise price of $1.00.
On November 16, 1998, Ironwood made an additional loan of $1 million to the
Company under the Bridge Loan, and Ironwood received warrants to purchase
100,000 shares of the Company's common stock at an exercise price of $1.00
relating to this loan. All of the warrants issued in connection with the
Bridge Loan have a five-year term. Completion of the Bridge Loan was
contingent upon satisfaction of a number of conditions, including (i)
renegotiation of severance and employment agreements with former management
on terms acceptable to Ironwood, (ii) reaching agreement with the Other
Preferred Holders on terms acceptable to Ironwood and (iii) reaching
agreement with WorldCom and First Bank to forbear taking action concerning
NTC defaults until at least December 15, 1998 on terms acceptable to
Ironwood. These conditions were satisfied prior to making the Bridge Loan.
THE TERM LOAN -- Upon satisfaction of certain conditions, Ironwood has agreed
to provide the Company with a Term Loan of $20 million, less the principal
amount of the Casey Loan and the Payments to Other Preferred Holders. The
Term Loan will bear interest at the rate of 12%, payable quarterly, and the
principal and any unpaid interest will be due on December 31, 2000. Proceeds
from the Term Loan will be used, among other things, to pay-off in full
amounts owing by NTC to First Bank, to make payments of all amounts in
default owing by NTC to WorldCom and for general corporate purposes. For
arranging the Term Loan, Ironwood will receive an origination fee of $400,000
and warrants in two tranches. The first tranche of warrants will entitle
Ironwood to purchase 2 million shares of the Company's Common Stock at an
exercise price of $1.00 per share. These warrants are exercisable
immediately and for a period of five years thereafter. The second tranche of
warrants will entitle Ironwood to purchase 1 million shares of the Company's
Common Stock at an exercise price of $2.25 per share. These warrants will be
exercisable on December 15, 1999 and for a period of five years thereafter.
The exercise price will be reduced and the number of warrants will be
increased on both tranches of warrants if the Company does not meet certain
performance targets in the fourth quarter of 1999 and 2000. The Term Loan
will be secured by substantially all of the assets of the Company and NTC.
Completion of the Term Loan is subject to several conditions, including the
dismissal or settlement of the Beltz and Silva Run lawsuits against the
Company on terms acceptable to Ironwood [see "Item 1. Legal Proceedings - Class
Action and Related Lawsuits"].
IRONWOOD LOAN TO CASEY; COHEN OPTION EXERCISE:
In connection with the exercise of an option (the "Cohen Option") to acquire
the Cohen Preferred Stock pursuant to a previous agreement reached between
Mr. Casey and the Cohen Parties, on November 5, 1998 Ironwood loaned Mr.
Casey approximately $2.125 million, the proceeds of which were used to
exercise the Cohen Option. The Casey Loan accrues interest at the rate of
18% per annum. Under the Board Change Agreement, Mr. Casey is obligated to
allow the Company to redeem the Cohen Preferred Stock at his acquisition cost
(approximately $2.4 million in the aggregate or $0.29 per share of Common
Stock after conversion) plus expenses, including the interest charged under
the Casey Loan. NTC has guaranteed the obligations of Mr. Casey under the
Casey Loan. If the Company is not able to redeem the Cohen Preferred Stock
by November 5, 1999, under the Board Change Agreement, these share will be
converted into Common Stock and offered for sale in a rights offering to the
Company's shareholders at a purchase price equal to Mr. Casey's acquisition
cost plus expenses. The Cohen Preferred Stock is convertible into approximately
8.5 million shares of the Company's Common Stock or 26% of the Company's Common
Stock on a fully diluted basis.
TRANSACTIONS WITH OTHER PREFERRED HOLDERS:
Ironwood entered into transactions similar to the Casey Option transaction
with five holders of Preferred Stock. Under these transactions, Ironwood
agreed to purchase shares of Preferred Stock convertible into an aggregate of
approximately 2.3 million shares of the Company's Common Stock or
approximately 7% of the Company's Common Stock on a fully diluted basis.
Ironwood paid an aggregate amount of approximately $1.1 million to these five
holders. Under the agreements between the Company and Ironwood, Ironwood is
obligated to allow the Company to redeem the Other Preferred Stock at its
acquisition cost (approximately $1.1 million in the aggregate or $0.51 per
share of Common Stock after conversion) plus expenses, including a carrying
charge of 18% per annum on the purchase price paid by Ironwood. If the
Company is not able to redeem the Other Preferred Stock by the one-year
anniversary of the date the Company's Articles of Incorporation are amended
to increase the number of authorized shares of common stock, under these
agreements, the Other Preferred Stock will be converted into Common Stock and
offered for sale in a rights offering to the Company's shareholders at a
purchase price equal to Ironwood's acquisition cost plus expenses. In
consideration for the settlement of certain claims against the Company, the
Company also issued warrants to purchase 244,870 shares of Common Stock to
two holders of Other Preferred
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Stock, exercisable at $1.00 per share. The Company has also granted to these
two holders registration rights which will require the Company to register
the Common Stock underlying these warrants under certain circumstances.
RENEGOTIATION OF SEVERANCE AGREEMENTS WITH FORMER MANAGEMENT; AMENDED EMPLOYMENT
AGREEMENT:
On September 29, 1998, the Company reached a severance agreement with its
former President and Chief Executive Officer (the "Former CEO") to settle the
terms of an employment agreement between the Company and the former CEO that
would have required the Company to pay an aggregate of $1.1 million over a
period of four years to fulfill terms of the contract. Under the terms of the
severance agreement, the former CEO agreed to voluntarily leave his position
at the Company in consideration for severance payments of up to $500,000 over
a two-year period and he retained approximately 337,000 stock options in the
Company. On November 2, 1998, the Company's new management renegotiated the
severance agreement with the Former CEO under which he agreed to reduce his
severance payments to $162,499, which will be paid in full on December 15,
1998. In addition, the Former CEO agreed to voluntarily terminate all of his
stock options, except for 50,000 stock options at an exercise price of $4.37
per share.
On July 1, 1998, NTC reached a severance agreement with its former President
and Chief Executive Officer (the "Former NTC CEO") to settle the terms of an
employment agreement between NTC and the former NTC CEO that would have
required NTC to pay an aggregate of $960,000 over a period of two years to
fulfill terms of the contract. Under terms of the severance agreement, the
former NTC CEO agreed to voluntarily leave his position at NTC in
consideration for severance payments of up to $240,000 over a one-year
period. On November 2, 1998, the Company's new management renegotiated the
severance agreement with the Former NTC CEO under which he agreed to reduce
his severance payments to $144,061, which will be paid in full on December
15, 1998. NTC has also agreed to pay the Former NTC CEO a lump sum of
$50,000, on or before July 1, 2000, if (1) the Company enters a merger in
which the Company or its shareholders retain less than 50% interest in the
new Company, (2) the Company sells substantially all of its assets or (3)
there is a public offering of the Company's common stock. In addition, the
Former NTC CEO agreed to terminate all of his stock options in NTC pursuant
to their terms in connection with his voluntary termination of employment
with NTC.
On July 1, 1998, NTC reached a severance agreement with its former Senior
Vice President and Chief Financial Officer (the "Former NTC CFO) to settle
the terms of an employment agreement between NTC and the former NTC CFO that
would have required NTC to pay an aggregate of $480,000 over a period of two
years to fulfill terms of the contract. Under terms of the severance
agreement, the former NTC CFO agreed to voluntarily leave his position at NTC
in consideration for severance payments of up to $120,000 over a one-year
period. On November 2, 1998, the Company's new management renegotiated the
severance agreement with the Former NTC CFO under which he agreed to reduce
his severance payments to $75,185, which will be paid in full on December 15,
1998. NTC has also agreed to pay the Former CFO a lump sum of $37,500, on or
before July 1, 2000, if (1) the Company enters a merger in which the Company
or its shareholders retain less than 50% interest in the new Company, (2) the
Company sells substantially all of its assets or (3) there is a public
offering of the Company's common stock. In addition, the Former NTC CFO
agreed to terminate all of his stock options in NTC pursuant to their terms
in connection with his voluntary termination of employment with NTC.
Under an Employment Agreement between the Company and Stephen A. Caswell, a
former officer of the Company and current employee (the "Caswell Employment
Agreement"), Mr. Caswell was entitled in October 1998 to severance in the
aggregate amount of approximately $260,000, if his employment was terminated
without cause. On October 30, 1998, the Company and Mr. Caswell agreed to
amend the Caswell Employment Agreement. Under terms of the amended Caswell
Employment Agreement, Mr. Caswell will continue to be employed by the Company
until April 30, 1999 at a rate of $10,000 per month, after which his
employment may be extended at the option of the Company for an additional 6
months or Mr. Caswell will receive a severance in the aggregate amount of
$30,000. Mr. Caswell also agreed to cancel all outstanding stock options
(90,000 option shares) he held in the Company.
LOAN BY THE COMPANY TO FORMER DIRECTOR:
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On November 5, 1996, the Company extended to a director of the Company a loan
of $265,000 at an interest rate of 10% per annum until January 15, 1997. The
loan was repaid in full, including interest, in July 1998 and the pledged
stock was returned to the director.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS:
3.1 Revised Bylaws of Incomnet, Inc., dated September 30, 1998.
10.1 Commitment Letter provided by Ironwood Capital LLC to Incomnet, Inc.,
dated October 30, 1998.
10.2 Bridge Loan and Security Agreement between Incomnet, Inc. and
Ironwood Telecom LLC, dated November 4, 1998.
10.3 Bridge Loan Note executed by Incomnet, Inc. in favor of Ironwood
Telecom LLC, dated November 4, 1998.
10.4 Warrant Agreement between Incomnet, Inc. and Ironwood Telecom LLC,
dated November 4, 1998.
10.5 Guaranty executed by National Telephone & Communications, Inc. in
favor of Ironwood Telecom LLC, dated November 4, 1998, relating to
Incomnet Inc.'s Bridge Loan Note.
10.6 Guaranty executed by National Telephone & Communications, Inc. and
Ironwood Telecom LLC, dated November 4, 1998, relating to Mr. Casey's
Secured Promissory Note.
10.7 Severance Agreement between Incomnet, Inc. and Melvyn Reznick,
dated September 29, 1998, and amendment thereto dated November 1,
1998.
10.8 Separation Agreement between Incomnet, Inc. and James Quandt, dated
July 1, 1998, and amendment thereto dated October 30, 1998.
10.9 Separation Agreement between Incomnet, Inc. and Victor Streufert,
dated July 1, 1998, and amendment thereto dated October 30, 1998.
10.10 Amendment to Employment Agreement between Incomnet, Inc. and Stephen
A. Caswell, dated October 29, 1998.
10.11 Settlement and Release Agreement Among Incomnet, Inc. and the Cohen
Parties, including Dr. Robert Cohen, Stefanie Rubin, Allyson Cohen,
Jeffrey Cohen, Jeffrey Rubin, Dr. Alan Cohen, Lenore Katz, Broadway
Partners and Meryl Cohen, custodian for Gabrielle Cohen, Erica Cohen,
Jaclyn Cohen and Nicole Cohen, dated November 5, 1998.
10.12 Settlement and Release Agreement Among Incomnet, Inc., Ironwood
Telecom LLC, Ellen Cohen and Martin Fabrikant, dated November 5, 1998.
10.13 Stock Purchase and Release Agreement Among Gary Kaplowitz, Alan
Rothstein, S&R Holdings, Ironwood Telecom LLC, Incomnet, Inc. and John
P. Casey, dated November 4, 1998.
10.14 Employment Agreement Between Incomnet, Inc. and Denis Richard, dated
September 29, 1998. Incorporated by reference as an exhibit to the
Company's Form 8-K, as filed with the Securities and Exchange
Commission on October 15, 1998.
10.15 Services Agreement Between Incomnet, Inc. and John P. Casey, dated
September 29, 1998. Incorporated by reference as an exhibit to the
Company's Form 8-K, as filed with the Securities and Exchange
Commission on October 15, 1998.
10.16 Board Change Agreement Among Incomnet, Inc., The Directors of
Incomnet, Inc. and John P. Casey, dated 28, 1998. Incorporated by
reference as an exhibit to the Company's Form 8-K, as filed with the
Securities and Exchange Commission on August 31, 1998.
10.17 Sublease Between National Telephone & Communications and Vision
Capital Services Corporation and Performance Capital Management, Inc.,
dated July 28, 1998.
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27 Financial Data Schedule.
(b) REPORTS ON FORM 8-K, FILED IN 1998:
20.1 Report on Form 8-K/A - Stock Purchase Agreements and Promissory Notes
Between Incomnet, Inc. and Jerry C. Buckley, Ralph Flygare, Robert
Reisbaum, E.V. Schmidt, Diane Orendorff and Nora Kenner Hoffberg,
dated April 25, 1997, filed with the Securities and Exchange
Commission on January 16, 1998.
20.2 Report on Form 8-K/A - Escrow Agreements Between Incomnet, Inc. and
Jerry C. Buckley, Ralph Flygare, Robert Reisbaum, and E.V. Schmidt,
dated April 25, 1997, filed with the Securities and Exchange
Commission on January 21, 1998.
20.3 Report on Form 8-K - Agreement To Sell The Assets of National
Telephone & Communications, Inc. (NTC) Between NTC and NTC
Acquisition, Inc., dated March 31, 1998, filed with the Securities and
Exchange Commission on April 9, 1998.
20.4 Report on Form 8-K - Conversion of Convertible Preferred Stock Into
The Company's Common Stock Shares, dated June 10 and June 11, 1998 and
filed with the Securities and Exchange Commission on June 17, 1998.
20.5 Report of Form 8-K - Changes in Control of Registrant, dated August
28, 1998 and filed with the Securities and Exchange Commission on
August 31, 1998.
20.6 Report on Form 8-K - Changes in Control of Registrant, dated September
29, 1998 and filed with the Securities and Exchange Commission on
October 15, 1998.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
INCOMNET, INC.
Date: November 16, 1998 /s/ Denis Richard
------------------- ------------------
President, Chief Executive Officer &
Interim Chief Accounting Officer
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