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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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 MARCH 31, 1999
COMMISSION FILE NO. 0-12386
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INCOMNET, INC.
(Exact Name of Registrant as Specified in Its Charter)
CALIFORNIA 95-2871296
(State of Incorporation) (IRS Employer Identification No.)
2801 MAIN STREET, IRVINE, CA 92614
(Address of Principal Executive Offices)
(949) 224-7300
(Registrant's Telephone Number, Including Area Code)
(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 / / No /X/
Number of shares of registrant's common stock outstanding as of May 14, 1999
was 19,933,000 shares.
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INDEX
PAGE
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PART I FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets..................................................... 1
Condensed Consolidated Statements of Operations........................................... 2
Condensed Consolidated Statements of Cash Flows........................................... 3
Notes to Condensed Consolidated Financial Statements...................................... 4
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..... 15
ITEM 3. Quantitative and Qualitative Disclosure of Market Risk.................................... 21
PART II OTHER INFORMATION
ITEM 1. Legal Proceedings......................................................................... 22
ITEM 2. Changes In Securities..................................................................... 22
ITEM 6. Exhibits and Reports on Form 8-K.......................................................... 23
SIGNATURES................................................................................................. 25
i
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INCOMNET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
1999 1998
----------- ------------
(UNAUDITED) (NOTE 1)
(IN THOUSANDS, EXCEPT
SHARE DATA)
ASSETS
Current assets:
Cash............................................................................ $ 2,578 $ 3,772
Accounts receivable, less allowance for doubtful accounts of $1,043 at March 31,
1999 and $3,298 at December 31, 1998.......................................... 4,725 5,579
Net assets of discontinued operations........................................... 200 531
Prepaid expenses and other current assets....................................... 319 424
----------- ------------
Total current assets.......................................................... 7,822 10,306
Facilities and equipment, net of accumulated depreciation and amortization of
$7,537 at March 31, 1999 and $7,527 and December 31, 1998....................... 8,815 9,287
Goodwill, net of accumulated amortization of $1,905 at March 31, 1999 and $1,830
at December 31, 1998............................................................ 3,875 3,950
Deposits and other assets......................................................... 959 877
----------- ------------
Total assets.................................................................. $ 21,471 $ 24,420
----------- ------------
----------- ------------
LIABILITIES AND SHAREHOLDERS' DEFICIT
Current liabilities:
Accounts payable................................................................ $ 2,809 $ 3,002
Accrued expenses................................................................ 2,147 2,188
Accrued litigation settlement................................................... 8,500 8,500
Accrued excise tax.............................................................. 3,160 3,009
Current portion of long-term debt............................................... 495 2,307
Deferred revenue................................................................ 960 1,007
Other current liabilities....................................................... 3,727 3,386
----------- ------------
Total current liabilities..................................................... 21,798 23,399
Long-term debt, excluding current portion......................................... 16,989 16,819
Contingencies (Notes 2 and 5)
Shareholders' deficit:
Preferred stock, no par value; 100,000 shares authorized; 2,056 shares issued and
outstanding at March 31, 1999 and December 31, 1998 (aggregate liquidation
preference of $2,226,000 at March 31, 1999)..................................... 1,802 1,802
Common stock, no par value; 20,000,000 shares authorized; 19,933,000 shares issued
and outstanding at March 31, 1999 and December 31, 1998......................... 67,132 67,114
Accumulated deficit............................................................... (86,250) (84,714)
----------- ------------
Total shareholders' deficit....................................................... (17,316) (15,798)
----------- ------------
Total liabilities and shareholders' deficit....................................... $ 21,471 $ 24,420
----------- ------------
----------- ------------
SEE ACCOMPANYING NOTES.
1
INCOMNET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
----------------------
1999
---------
1998
-----------
(RESTATED)
(IN THOUSANDS, EXCEPT
PER SHARE AMOUNTS)
Net sales:
Telephone services...................................................... $ 8,136 $ 17,217
Marketing program....................................................... 597 215
--------- -----------
Total net sales........................................................... 8,733 17,432
Cost of sales:
Telephone services...................................................... 4,448 10,888
Marketing program....................................................... 1,005 332
--------- -----------
Total cost of sales....................................................... 5,453 11,220
--------- -----------
Gross profit.............................................................. 3,280 6,212
Operating expenses:
General and administrative.............................................. 4,508 5,783
Bad debt expense........................................................ 279 1,400
Depreciation and amortization........................................... 824 872
Other operating expenses................................................ 150 82
--------- -----------
Total operating expenses.................................................. 5,761 8,137
--------- -----------
Operating loss............................................................ (2,481) (1,925)
Interest expense and amortization of original issue discount, net of
interest income of $46 and $33 for 1999 and 1998, respectively.......... 557 232
--------- -----------
Loss from continuing operations before income tax benefit................. (3,038) (2,157)
Income tax benefit........................................................ -- (14)
--------- -----------
Loss from continuing operations........................................... (3,038) (2,143)
Discontinued operations:
Loss from operations of discontinued optical systems, network services
and computer software businesses...................................... (236) (872)
Gain on disposal of network services and computer software businesses... 1,738 535
--------- -----------
Income (loss) from discontinued operations.............................. 1,502 (337)
--------- -----------
Net loss.................................................................. $ (1,536) $ (2,480)
--------- -----------
--------- -----------
Basic and diluted income (loss) per common share:
Continuing operations................................................... $ (0.15) $ (0.16)
Discontinued operations................................................. 0.07 (0.03)
--------- -----------
Net loss per share...................................................... $ (0.08) $ (0.19)
--------- -----------
--------- -----------
Weighted average number of shares outstanding............................. 19,933 13,331
--------- -----------
--------- -----------
SEE ACCOMPANYING NOTES.
2
INCOMNET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
----------------------
1999
---------
1998
-----------
(RESTATED)
(IN THOUSANDS)
OPERATING ACTIVITIES:
Net loss.................................................................. $ (1,536) $ (2,480)
Less income (loss) from discontinued operations......................... 1,502 (337)
--------- -----------
Loss from continuing operations......................................... (3,038) (2,143)
Adjustments to reconcile loss from continuing operations to net cash
provided by (used in) operating activities:
Depreciation and amortization........................................... 824 872
Provision for uncollectible accounts receivable......................... 279 1,400
Amortization of original issue discount................................. 70 --
Compensation expense related to stock option grants..................... 18 --
Changes in operating assets and liabilities:
Accounts receivable................................................... 575 1,769
Prepaid expenses and other current assets............................. 105 (314)
Accounts payable...................................................... (193) 302
Accrued expenses...................................................... (41) (1,187)
Accrued excise taxes.................................................. 151 (37)
Deferred revenue...................................................... (47) (157)
Other current liabilities............................................. 423 160
--------- -----------
Net cash provided by (used in) operating activities....................... (874) 665
INVESTING ACTIVITIES:
Additions to facilities and equipment, net................................ (277) (228)
Increase in notes receivable.............................................. -- (47)
Increase in deposits and other assets..................................... (82) (181)
--------- -----------
Net cash used in investing activities..................................... (359) (456)
FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt.................................. 185 223
Repayment of long-term debt............................................... (121) (334)
Proceeds from issuance of common stock.................................... -- 81
--------- -----------
Net cash provided by (used in) financing activities....................... 64 (30)
Net cash provided by (used in) continuing operations...................... (1,169) 179
Net cash provided by (used in) discontinued operations.................... (25) 884
--------- -----------
Net increase (decrease) in cash........................................... (1,194) 1,063
Cash at beginning of period............................................... 3,772 754
--------- -----------
Cash at end of period..................................................... $ 2,578 $ 1,817
--------- -----------
--------- -----------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Non-cash investing and financing transactions:
Retirement of debt and accrued interest in connection with the sale of
GenSource............................................................. $ (1,858) $ --
SEE ACCOMPANYING NOTES.
3
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 1999
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of
Incomnet, Inc. ("Incomnet") have been prepared in accordance with generally
accepted accounting principles for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for the
three month period ended March 31, 1999 are not necessarily indicative of the
results that may be expected for the year ended December 31, 1999.
The balance sheet at December 31, 1998 has been derived from the audited
consolidated financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto included in Incomnet's Annual Report on Form 10-K for the year
ended December 31, 1998.
The condensed consolidated financial statements include the accounts of
Incomnet and its wholly owned subsidiary, Incomnet Communications Corp. ("ICC").
All significant intercompany accounts and transactions have been eliminated in
consolidation.
The preparation of the condensed consolidated financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Significant estimates made in preparing the
condensed consolidated financial statements include the allowance for doubtful
accounts, income tax valuation allowance, litigation settlement costs, certain
accrued liabilities and future undiscounted cash flows used in the analysis of
the impairment of long-lived assets. Actual results could differ from those
estimates.
Certain amounts reported in prior periods have been reclassified to conform
with the current period presentation.
2. OPERATIONS AND FINANCING
During the preceding three years and the quarter ended March 31, 1999,
Incomnet has recognized significant net losses from continuing operations. As a
result, at March 31, 1999, Incomnet has an accumulated deficit and net capital
deficiency of $86.3 million and $17.3 million, respectively, and its current
liabilities exceed its current assets by approximately $14.0 million.
Incomnet is taking steps to revitalize ICC's network marketing organization,
including developing new telecommunications products that are more competitive,
working closer with its Representatives to help them better understand the
products and services provided by ICC, developing new commission and bonus
programs that will make ICC more competitive in attracting new Representatives,
and expanding its focus on Representative recruiting from primarily a Southern
California focus to a nationwide program. Management believes its new marketing
plans have and will continue to revitalize ICC's efforts to attract additional
representatives. In addition to revitalizing its network marketing organization,
ICC also is continuing a cost control program that is anticipated to result in a
more efficient operation and a reduced cost structure overall.
4
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
2. OPERATIONS AND FINANCING (CONTINUED)
In April 1999, Incomnet obtained a line-of-credit facility providing for
borrowings, based on eligible accounts receivable, up to a maximum of $12.5
million from Foothill Capital Corporation. In addition, Incomnet has had recent
discussions with Ironwood Telecom LLC ("Ironwood") regarding the possible
conversion into equity of some or all of Incomnet's $16.8 million debt
obligation owing to Ironwood. Incomnet is also seeking additional financing that
may take the form of either additional debt or equity. To assist in its
financing efforts, Incomnet has engaged a financial advisor to help identify
additional sources of equity financing. No assurances can be given that Incomnet
will be successful in raising additional debt or equity financing either through
this financial advisor or at all.
Management believes Incomnet has sufficient sources of financing to continue
operations throughout 1999 at planned levels of operations. However, due to
uncertainties inherent in the achievement of management's strategic plan, there
are no assurances that Incomnet will attain planned levels of operations.
Ultimately, Incomnet's long-term success is dependent upon its ability to
successfully execute its strategic plan, obtain additional long-term financing,
complete its Year 2000 remediation, and ultimately attain sustained profitable
operations.
3. DISCONTINUED OPERATIONS AND RESTATEMENTS
DISCONTINUED OPERATIONS AND RAPID CAST, INC. EQUITY ACCOUNTING RESTATEMENT
Incomnet sold most of its interest in three businesses previously reported
as business segments. Accordingly, these segments have been accounted for as
discontinued operations in 1998 and 1999. Incomnet has also reclassified the
quarter ended March 31, 1998 to present the operating results of the three
businesses as discontinued operations.
GenSource--In March 1999, Incomnet sold its interest in the common stock of
the computer software business segment, consisting of GenSource Corporation
("GenSource"), a developer and marketer of software programs used to administer
insurance-related claims, such as workers' compensation and short-term and
long-term disability. The sale was made to a group of private investors in
exchange for the release from liability of Incomnet under promissory notes to
the former owners of GenSource of approximately $1,776,000 plus accrued
interest. In addition, Incomnet paid $25,000 in cash for certain transaction
expenses and received 15,507 shares of convertible preferred stock in GenSource
with a stated value of $32.25 per share. No value was assigned to the preferred
stock which represents an approximately 15% interest in GenSource on a
fully-diluted basis. In connection with the disposition of GenSource, Incomnet
recognized a gain of approximately $1,738,000. Incomnet has no expectation of
continuing involvement with GenSource.
AutoNetwork--In March 1998, Incomnet sold the network services business
segment to a group of private investors for $1,254,000 in cash and notes. The
segment consisted of Auto Dismantler Network (AutoNetwork), a monthly
subscription service that auto dismantlers use to buy, sell and trade used parts
that have been salvaged from automobiles. During the year ended December 31,
1998, Incomnet recognized a gain on the disposition of AutoNetwork of $535,000.
Rapid Cast--Incomnet acquired 51% of the common stock of Rapid Cast, Inc.
("RCI") (10.2 million of the 20 million then outstanding shares) in February
1995. Initially, RCI was accounted for using the equity method of accounting.
However, by the second quarter of 1995, control was determined to be other than
temporary and RCI was consolidated with Incomnet. In January 1997, RCI sold 8
million new shares
5
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
3. DISCONTINUED OPERATIONS AND RESTATEMENTS (CONTINUED)
of its common stock in a private placement and issued an additional 2.3 million
shares in other transactions, reducing Incomnet's investment in RCI to
approximately 33% and requiring the equity method of accounting for its
remaining interest in RCI. In its consolidated financial statements for the
quarter ended March 31, 1998 as originally reported, Incomnet gave no
recognition to the increase in its share of RCI's net equity resulting from the
sale by RCI of its common stock because prior management was not satisfied that
the sale would provide sufficient resources to allow RCI to become successful.
However, Incomnet's consolidated financial statements have been restated to
reflect a $7.2 million increase in consolidated stockholders' equity in
accordance with the equity method of accounting. Additionally, operating results
for Incomnet for 1997 and for the first nine months of 1998 were restated to
reflect additional losses of $2.0 million and $1.3 million, respectively, to
account for Incomnet's share of RCI's net losses under the equity method of
accounting. The restatement increased the net loss and loss per share for the
three month period ended March 31, 1998 by $1,032,000 and $0.08, respectively,
from the amounts previously reported. In the third quarter of 1998, Incomnet
sold a portion of its investment in RCI to outside investors, which resulted in
a net gain on the disposition of $2.6 million. In the fourth quarter of 1998,
Incomnet decided to streamline its operations to focus solely on its
telecommunications business. As part of that effort, Incomnet has determined to
dispose of its remaining investment in RCI and expects that this will occur in
1999. At March 31, 1999, Incomnet holds a 17.4% ownership interest in RCI, with
a carrying value of $200,000, and warrants for the purchase of 2.6 million
additional RCI shares of common stock at exercise prices ranging from $0.75 to
$2.25 per share. Incomnet has no expectation of continuing involvement with RCI.
Summarized financial information for the discontinued operations are as
follows (in thousands):
MARCH 31, DECEMBER 31,
1999 1998
----------- -------------
Current assets...................................................... $ 200 $ 992
Total assets........................................................ 200 1,433
Total liabilities (current)......................................... -- (902)
Net assets of discontinued operations............................... 200 531
THREE MONTHS ENDED MARCH
31,
--------------------------
1999 1998
----------- -------------
Revenues............................................................ $ 354 $ 1,140
----- ------
----- ------
The net assets of the discontinued operations as of December 31, 1998
represent the net assets of GenSource of $331,000 and RCI of $200,000, which
have been classified as current assets as of December 31, 1998. The net assets
of discontinued operations at March 31, 1999 are comprised of the remaining
investment in RCI.
CHANGE IN ESTIMATE--DEFERRED MARKETING REVENUES
During the fourth quarter of 1998, the Company changed its method of
estimating deferred marketing revenue. The impact of adopting this change in
estimation methodology resulted in the restatement of the
6
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
3. DISCONTINUED OPERATIONS AND RESTATEMENTS (CONTINUED)
previously filed interim report on Form 10-Q for the quarterly period ended
March 31, 1998 to reduce marketing revenues recognized by $435,000 and loss per
share reported by $0.03.
4. NET LOSS PER SHARE
Basic and diluted loss per share is computed based on the weighted average
number of common shares outstanding during each period since common stock
equivalents are anti-dilutive. Because the number of options, warrants, and
other convertible instruments outstanding (22,572,330 and 11,612,345 at March
31, 1999 and 1998, respectively) are anti-dilutive, there is no difference
between the loss per share amounts computed for basic and diluted purposes. Loss
per share from continuing operations has been increased as follows (in
thousands):
THREE MONTHS ENDED
MARCH 31,
--------------------
1999 1998
--------- ---------
Loss from continuing operations............................................ $ 3,038 $ 2,143
Preferred stock dividends.................................................. -- 16
Preferred stock dividends in arrears....................................... 23 36
--------- ---------
Loss from continuing operations applicable to common shareholders.......... $ 3,061 $ 2,195
--------- ---------
--------- ---------
The weighted average common shares originally used in the loss per share
computation for the three month period ended March 31, 1998 has been restated
from 14,508,000 to 13,331,000. The impact on the loss per share was ($0.01).
5. LITIGATION
The following is a description of pending legal proceedings in which
Incomnet is a party. No assurance is given that any of these legal proceedings
will not have a material adverse impact on the business, financial condition or
results of operation of Incomnet.
SANDRA GAYLES, ET AL. V. SAM D. SCHWARTZ, ET AL. On October 17, 1995,
Incomnet was served with a complaint in a class action lawsuit ENTITLED SANDRA
GAYLES, ET AL. V. SAM D. SCHWARTZ AND INCOMNET, INC., Case No. CV95-0399 AWT
(BQRx), filed in the United States District Court for the Central District of
California. As amended, the complaint alleges that Incomnet violated Sections
10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder because Incomnet failed to disclose and falsely denied
the existence of a non-public investigation of Incomnet by the Securities and
Exchange Commission. The complaint also claims that Incomnet and its President
and former Chairman of the Board of Directors, Sam D. Schwartz, violated
Sections 10(b), 16(a), 20(a) and 23(a) of the Securities Exchange Act of 1934,
and Section 25400 of the California Corporations Code, because they did not
disclose until August 1995 purchases and sales of Incomnet's stock made in the
open market by an affiliate of Mr. Schwartz between September 1994 and August
1995. The amended complaint seeks compensatory damages, interest, attorneys'
fees and costs, and other extraordinary, equitable and
7
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
injunctive relief as may be appropriate. On January 11, 1996, the court
certified the case as a class action pursuant to the parties' stipulation.
On October 7, 1997, Incomnet reached a tentative settlement of the lawsuit.
The proposed 1997 settlement consisted of an agreement by Incomnet to pay
$500,000 in cash plus securities with a value of $8.15 million for a total
settlement value of $8.65 million. Because of a decline in the value of
Incomnet's stock beginning in July 1997, this proposed settlement could not
proceed under its terms. In 1998, Incomnet and the class plaintiffs began to
negotiate new settlement terms.
In September 1998, Incomnet entered into a new written settlement agreement
with the class plaintiffs. 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 Incomnet's common stock based on a formula. The maximum number of
shares of Incomnet common stock that are to 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. The minimum number of shares
of common stock that are to 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, Incomnet's shareholders must approve
an amendment to Incomnet'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 June
1999. The Court has preliminarily approved the settlement. A hearing on final
approval was scheduled for May 20, 1999. The parties recently agreed to extend
the date of the hearing on final approval of the settlement agreement between
Incomnet and the class plaintiffs from May 20, 1999 to June 14, 1999. There is
no assurance that this new settlement will be approved and consummated. Should
the settlement not be approved, Incomnet intends to vigorously defend the
lawsuit. The case is still in the discovery phase. Incomnet accrued the original
settlement amount of $8.65 million in Incomnet's balance sheet and statement of
operations for the year ended December 31, 1997. During 1998, Incomnet accrued
for the reimbursement of certain expenses for the maximum amount of $100,000 and
paid $250,000 towards the settlement payment to the plaintiffs included in the
terms of the agreement. Incomnet does not intend to adjust the accrued
litigation settlement in the consolidated financial statements until closing and
final approval of the settlement agreement, approval of the related amendments
to the articles of incorporation to increase the authorized number of shares of
common stock of Incomnet and elimination of any other uncertainties related to
the settlement.
In separate litigation pending in California state court, Mr. Schwartz seeks
indemnification from Incomnet with respect to any judgments, legal fees or other
costs incurred in connection with his defense of this lawsuit. Incomnet intends
to vigorously defend against Mr. Schwartz's indemnification claims.
The following lawsuits are in varying stages of the legal process and, as a
result, Incomnet is unable to estimate the probability of the outcome or a range
of potential loss, if any.
JAMES A. BELTZ, ET AL. V. SAMUEL D. SCHWARTZ, ET AL. On July 22, 1997,
Incomnet was named in a lawsuit, JAMES A. BELTZ, ET. AL. V. SAMUEL D. SCHWARTZ,
RITA SCHWARTZ STEPHEN A. CASWELL, JOEL W. GREENBERG, INCOMNET, INC., DAVID
BODNER AND MURRAY HUBERFELD, Case No. 97-1678 (MJD/AJB), in the United States
District Court for the District of
8
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
Minnesota. The lawsuit was filed by approximately twenty plaintiffs who were
allowed to opt out of the GAYLES class action lawsuit to pursue a lawsuit on
their own. The complaint alleges that Mr. Schwartz and the other defendants
created a fraudulent scheme to drive up the price of Incomnet's stock in
violation of Sections 9, 10(b) and 20(a) of the Securities Exchange Act of 1934,
Rule 10b-5 promulgated thereunder, and Minnesota law. The lawsuit alleges losses
by the plaintiffs of approximately $1.5 million and seeks unspecified damages.
The case is in the discovery phase. On or about March 24, 1998, the plaintiffs
in this suit plus several additional plaintiffs commenced a parallel state court
action entitled JAMES A. BELTZ, ET. AL. V. SAMUEL D. SCHWARTZ AND RITA L.
SCHWARTZ, STEPHEN A. CASWELL, JOEL W. GREENBERG, INCOMNET, INC., DAVID BODNER,
AND MURRAY HUBERFELD, Case No. MC 98-00674, in the State of Minnesota, County of
Hennepin. This state lawsuit brings causes of action for violations of Minnesota
statutes covering securities fraud, consumer fraud, control person liability and
conspiracy to defraud based on the same factual allegations pleaded in the
federal suit. Plaintiffs allege losses of over $1.8 million and the lawsuit
seeks unspecified damages. The case will enter the discovery phase should
court-sponsored mediation efforts fail to resolve the parties' disputes.
Incomnet plans to vigorously defend this lawsuit. The court in the state action
recently scheduled a mediation and settlement conference for June 9, 1999. The
court also scheduled the matter for trial this year.
In separate litigation pending in California state court, Mr. Schwartz and
Rita Schwartz seek indemnification from Incomnet with respect to any judgments,
legal fees or other costs incurred in their defense of these two lawsuits.
Incomnet intends to vigorously defend against the Schwartzs' indemnification
claims.
SILVA RUN WORLDWIDE LIMITED V. INCOMNET, INC., ET AL. Incomnet was a
defendant in a lawsuit entitled SILVA RUN WORLDWIDE LIMITED V. INCOMNET, INC.,
SAM D. SCHWARTZ, KALIBER MANAGEMENT, INC., BEAR STEARNS & CO., INC., LESLIE
SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO
ANTILLANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS
SCHUETZ, originally filed in the United States District Court for the Southern
District of New York. The complaint stated that the plaintiff was a purchaser of
Incomnet's stock in July 1995. The complaint alleged that Incomnet and Mr.
Schwartz, violated Sections 10(b) and 20(a) of the Securities Exchange Act of
1934, and Rule 10b-5 promulgated thereunder, and committed common law fraud, as
a result of false and misleading statements made by the defendants and
undisclosed trading in Incomnet's stock engaged in by Mr. Schwartz and his
affiliate. The complaint also alleged that Mr. Schwartz and his affiliate owed a
fiduciary duty to the plaintiff that was breached by their conduct. The
complaint also alleged other causes of action against other unrelated
defendants. Plaintiff claimed economic losses of approximately $2.7 million.
Incomnet answered the complaint in November 1996 and moved to have it
transferred to California. In March 1997, the claims relating to Incomnet, Sam
Schwartz and Kaliber Management, Inc. were ordered severed and transferred from
the court in New York to the same federal court in California which is hearing
the GAYLES class action lawsuit. In November 1998, this transferee court
dismissed all of the federal claims and all but one of the state law claims on
the ground that plaintiff had not opted out of the GAYLES class action lawsuit.
As a result of this ruling, Silva Run Worldwide Limited moved to extend the time
by which it may opt out of the class. The court granted this motion and allowed
Silva Run Worldwide Limited the opportunity to opt out and continue its action
against Incomnet and Mr. Schwartz based upon alleged violations of both federal
and state law. Incomnet plans to vigorously defend this lawsuit.
9
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
In separate litigation pending in California state court, Mr. Schwartz seeks
indemnification from Incomnet with respect to any judgments, legal fees or other
costs incurred in connection with his defense of this lawsuit. Incomnet intends
to vigorously defend against Mr. Schwartz's indemnification claims.
INCOMNET, INC. V. SAM D. SCHWARTZ. Incomnet filed a lawsuit against Mr.
Schwartz, on April 25, 1997, alleging fraud, breach of fiduciary duty,
negligence, and breach of contract, and seeking declaratory relief and the
imposition of a constructive trust. The lawsuit, entitled INCOMNET, INC., V. SAM
D. SCHWARTZ, Case No. LC 040 840, was filed in the Superior Court of California,
Los Angeles County. In the lawsuit, Incomnet alleges that Mr. Schwartz failed to
disclose to Incomnet or its Board of Directors that he would obtain a direct
financial benefit in connection with certain transactions considered or entered
into by Incomnet during the period from 1993 to 1995. Incomnet further alleges
that Mr. Schwartz fraudulently induced it to enter into a severance agreement
with him on November 27, 1995, and that he breached his fiduciary duty to
Incomnet by self dealing, acting in bad faith and concealing material facts.
Incomnet seeks payment from Mr. Schwartz of the actual damages incurred by it as
a result of Mr. Schwartz's conduct, as well as interest, punitive damages,
attorney's fees and costs, and reimbursement of all payments previously made to
Mr. Schwartz pursuant to the severance agreement. Furthermore, Incomnet seeks a
declaratory judgment that Mr. Schwartz committed acts or omissions involving
known misconduct, the absence of good faith, an improper personal benefit, a
reckless disregard of his duties to Incomnet and its shareholders, an unexcused
pattern of inattention, and a violation of Sections 310 and 317 of the
California Corporations Code.
On June 24, 1997, Mr. Schwartz answered Incomnet's lawsuit against him
denying the allegations and counterclaiming for (i) enforcement of any payments
due under his severance agreement with Incomnet, (ii) indemnification against
third party claims, and payment of the same settlement to him as was paid to
certain prior noteholders who purchased convertible notes from Incomnet on
February 8, 1995. Incomnet intends to vigorously prosecute this action and
defend against Mr. Schwartz's counterclaims. The lawsuit is in the discovery
phase. A trial date is set for February 2, 2000.
RITA SCHWARTZ V. INCOMNET, INC. On or about December 2, 1997, Rita
Schwartz, a former member of the Board of Directors of Incomnet and the wife of
Mr. Schwartz, filed the case of RITA SCHWARTZ V. INCOMNET, INC., Case No. BC 182
151, in the Superior Court of California, Los Angeles County. Mrs. Schwartz
seeks reimbursement of the legal expenses which she incurred as a result of an
investigation by the Securities and Exchange Commission of Incomnet and as a
defendant in the BELTZ opt-out cases, which are ongoing. Mrs. Schwartz claims
that because she is a former member of the Board of Directors, she is entitled
to reimbursement for her legal fees based upon the Articles of Incorporation of
Incomnet. The lawsuit is presently in the discovery phase. Incomnet plans to
vigorously defend this lawsuit. A trial date is set for February 2, 2000.
ROBERT AND NANCY ZIVITZ V. JOEL GREENBERG, ET AL. On August 27, 1998, Nancy
Zivitz, a former director of Incomnet, and her husband, filed a lawsuit entitled
ROBERT AND NANCY ZIVITZ V. JOEL GREENBERG, ET AL, Case No. 98C 5350, in the
United States District Court for the Northern District of Illinois, against Mr.
Schwartz, his wife Rita Schwartz, a former director of Incomnet, and Joel
Greenberg, a former director and officer of Incomnet. The complaint asserts
claims of common law fraud and civil conspiracy based on allegations that
defendants conspired to drive up the price of Incomnet stock by making false
statements regarding Incomnet and that defendants engaged in insider trading.
While
10
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
Incomnet has not been named in the lawsuit, Mr. and Mrs. Schwartz have commenced
a third party action against Incomnet seeking indemnification with respect to
costs incurred in defending the lawsuit. Incomnet intends to vigorously oppose
this claim. Mr. Greenberg has made written demands for indemnification and seeks
an advance to cover his legal fees in the case. In April 1999, the United States
District Court granted Incomnet's motion to dismiss this case. On April 7, 1999,
the court, upon Incomnet's motion, dismissed without prejudice, Mr. and Mrs.
Schwartz' third party action against Incomnet for indemnification of costs
incurred by them in defense of the lawsuit. In declining to exercise its
jurisdiction, the court referenced the litigation between Mr. and Mrs. Schwartz
and Incomnet presently pending in California state court.
JACOBS V. INCOMNET, INC. On December 23, 1998, Edward Jacobs, former
President and Chief Executive Officer of ICC, filed an action against Incomnet
in the Superior Court of the State of California, Los Angeles County, entitled
EDWARD R. JACOBS V. INCOMNET, INC., Case No. BC 202857. Mr. Jacobs claims that
Incomnet has failed to pay amounts allegedly owed to him pursuant to a
settlement agreement with Incomnet, dated November 13, 1996. Mr. Jacobs seeks
compensatory damages of $453,000, unspecified consequential damages, interest
and attorneys' fees and costs. Incomnet has answered the complaint and has
asserted a cross-complaint against Mr. Jacobs. Incomnet intends to vigorously
defend the lawsuit.
LAWSUITS 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, Case No. LC 046 449,
in the Superior Court of the State of California, Los Angeles County. In the
lawsuit, the plaintiffs alleged that Incomnet defaulted on payments under
promissory notes between Incomnet and the plaintiffs and sought damages of
approximately $1.2 million. This lawsuit was settled and dismissed as part of
the sale of GenSource back to the former owners in March 1999. The sale of
GenSource also resolved potential lawsuits by two other former shareholders of
GenSource.
ICC V. JERRY BALLAH, ET AL. On July 21, 1998, ICC sued Jerry Ballah, a
former officer, director and consultant, and others in an action entitled
NATIONAL TELEPHONE & COMMUNICATIONS, INC. V. JERRY BALLAH, WORLD TECHNOLOGIES
MARKETING, INC., ET AL., Case No. 797154, in the Superior Court of California,
Orange County. ICC asserts 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
defendants' start-up of a competing business and solicitation of ICC's employees
and independent sales representatives and diversion of ICC's telephone customers
to businesses owned or controlled by defendants. ICC filed its second amended
complaint in February 1999.
In September 1998, Mr. Ballah answered the original complaint and filed a
cross-complaint against ICC alleging that ICC failed to make payments of
$250,000 under a consulting agreement with him. Mr. Ballah alleges claims for
breach of contract and breach of the implied covenant of good faith and fair
dealing and asserts a claim based on work, labor and services rendered. In the
same cross-complaint, an affiliate of Mr. Ballah, defendant World Technologies,
Inc. ("World Tech"), alleges that ICC breached an agreement under which World
Tech would become the exclusive network marketing company for ICC.
11
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
World Tech also alleges claims of fraud, negligent misrepresentation and unjust
enrichment, and seeks an accounting. Incomnet plans to continue to vigorously
prosecute this action.
ACTIONS BY FORMER INDEPENDENT SALES REPRESENTATIVES. On May 22, 1998,
former ICC independent sales representatives Mercedes Chan and Chatri
Jhunjhnuwala filed a lawsuit in the Superior Court of the State of California,
Orange County, against Incomnet, ICC, and others entitled MERCEDES CHAN AND
CHATRI JHUNJHNUWALA VS. INCOMNET, INC., NATIONAL TELEPHONE & COMMUNICATIONS,
INC. ET. AL., Case No. 794636. In the lawsuit, the plaintiffs allege that
defendants induced them to become independent representatives of ICC and to
incur sign-up fees and other costs based on false representations concerning the
business of ICC and the amount of commission and bonus payments that could be
earned as independent representatives of ICC. Plaintiffs assert claims for
fraud, breach of contract, wrongful discharge, negligent misrepresentation and
other causes of action and seek general, compensatory, special and punitive
damages. The case is in the discovery phase. A trial date is set for August 30,
1999. Incomnet intends to vigorously defend this lawsuit.
On October 29, 1998, former ICC independent sales representative Chutapa
Varavarn commenced an action in the Superior Court of the State of California,
Orange County, entitled CHUTAPA VARAVARN V. INCOMNET, INC., ET AL., Case No.
801412. The factual and legal allegations are substantially similar to the
allegations in the CHAN lawsuit and plaintiff seeks damages, including punitive
damages. Incomnet intends to vigorously defend this lawsuit.
On August 20, 1998, former ICC independent sales representative Rick Bergen
commenced an action in the Superior Court of the State of California, Orange
County, entitled RICK BERGEN V. INCOMNET, ET AL., Case No. 798468. Plaintiff
contends that ICC failed to make certain payments and commissions based on his
development of sales territories and wrongfully deprived him of other income.
Plaintiff asserts claims for fraud, unfair business practices, negligence,
wrongful discharge and unpaid wages and seeks compensatory and punitive damages.
The case is in the discovery phase and a trial date is set for October 4, 1999.
Incomnet intends to vigorously defend this lawsuit.
On May 26, 1998, former ICC independent sales representative Chuanxu Zang
and another party commenced an action against ICC in state court in Fairfax
County, Virginia, entitled CHUANXU ZANG, ET AL. V. NATIONAL TELEPHONE &
COMMUNICATIONS, INC., Circuit Court Case No. 171965, involving a dispute
regarding the Plaintiff's purchase of long distance telephone calling cards from
ICC. On March 5, 1999, the Fairfax County Circuit Court stayed the action and
ordered that Plaintiffs submit their dispute to arbitration in Orange County,
California, in accordance with the arbitration provision contained in Mr. Zang's
independent representative agreement. Plaintiffs have not yet commenced an
arbitration proceeding. Incomnet intends to continue to vigorously defend this
action.
On February 17, 1999, former ICC independent sales representatives Kevin
Porter, Robin Kasten, and Larry Tate attempted to commence separate arbitration
proceedings against Incomnet and ICC, alleging, INTER ALIA, that Incomnet and
ICC failed to make payments owed to them. The complaints in these arbitration
proceedings purport to assert various causes of action against Incomnet and ICC,
including claims for purported fraud, unfair business practices, breach of
contract, negligence and conversion. The plaintiffs in these separate
arbitration proceedings seek unspecified damages, including punitive damages.
Plaintiffs are required under the terms of their independent representative
agreements with ICC to commence any proceedings against ICC before the American
Arbitration Association, but have not yet
12
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
done so. Incomnet and ICC have not yet filed answering statements in these
actions, and no trial date has been set. Incomnet intends to vigorously defend
these arbitration proceedings.
JACOBS ARBITRATION. On March 19, 1999, Edward Jacobs, former President and
Chief Executive Officer of ICC, commenced an arbitration action against ICC
before the American Arbitration Association, seeking relief in the amount of
$549,777, plus interest and attorneys' fees, based upon an alleged breach of an
employment agreement by ICC. ICC has not yet filed an answering statement, and a
trial date has not yet been set. Incomnet plans to vigorously defend this
arbitration proceeding.
JACOBS V. ICC (LABOR COMMISSION). On August 12, 1998, Edward Jacobs, former
President and Chief Executive Officer of ICC, initiated a proceeding against ICC
before the Labor Commissioner of the California Department of Industrial
Relations, known as EDWARD R. JACOBS V. NATIONAL TELEPHONE & COMMUNICATIONS,
INC., Case No. 18-34441-002-182/031. In this Labor Commission proceeding, Mr.
Jacobs claims that he is owed compensation for earned and unused vacation time
totaling $106,154, plus penalties and attorneys' fees. ICC denies that it has
any such obligation to Mr. Jacobs. The hearing on Mr. Jacobs' claims commenced
on March 11, 1999, but was not completed. The hearing is currently set to
continue on June 21, 1999. Incomnet intends to continue to vigorously defend
this proceeding.
LAWSUIT BY COMMUNICATIONS CONSULTING, INC. On June 23, 1998, Communications
Consulting, Inc. ("CCI"), filed a lawsuit against National Telephone &
Communications, Inc. entitled COMMUNICATIONS CONSULTING, INC. V. NATIONAL
TELEPHONE & COMMUNICATIONS, INC., Case No. 795910, in the Superior Court of the
State of California, Orange County. CCI claims that ICC improperly terminated a
consulting agreement between CCI and ICC and owes CCI a sum of $127,038,
interest and reasonable costs, fees and expenses associated with its lawsuit.
The case is in the discovery phase and a trial date is set for July 26, 1999.
Incomnet intends to vigorously defend this lawsuit.
POTENTIAL LAWSUITS. Approximately 50 members of the class in the GAYLES
class action lawsuit against Incomnet have opted out of the class and may file
separate lawsuits against Incomnet. If such claims are filed as legal
complaints, Incomnet will seek to have them consolidated with other pending
lawsuits, if appropriate, or will defend them separately.
A claim may be asserted against Incomnet by Jerry Ballah with respect to a
settlement agreement Incomnet entered into in November 1996. Mr. Jacobs, who was
a party to the settlement, has already commenced a lawsuit in connection with
the settlement agreement. The amount of the damages that may be asserted by Mr.
Ballah is estimated to be approximately $535,000 plus accrued interest, and
possible consequential damages. Incomnet intends to vigorously defend any claims
made against it or ICC by Mr. Ballah.
John R. Dennis and JRD, Inc. may commence an action against ICC based upon
an alleged breach of a purported agreement by which Mr. Dennis and JRD, Inc.
were to provide consulting services to ICC. Absent the existence of such
agreement, Mr. Dennis and JRD, Inc. seek recovery based on alleged benefits they
claim to have provided to ICC as a result of certain alleged activities.
Incomnet believes this case lacks merit and is preparing to respond to any
litigation that may be brought.
13
INCOMNET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
MARCH 31, 1999
5. LITIGATION (CONTINUED)
In April 1999, Stephen A. Caswell, a former officer of Incomnet, threatened
to commence an arbitration against Incomnet with respect to amounts allegedly
owed to him pursuant to his employment agreement with Incomnet.
From time to time, Incomnet is also involved in litigation arising from the
ordinary course of business, the ultimate resolution of which is not expected to
have a material adverse effect on the financial condition, results of operations
or cash flows of Incomnet.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Quarterly Report on Form 10-Q contains statements that are based upon
certain estimates, projections and other forward-looking statements within the
meaning of the Securities Litigation Reform Act of 1995 with respect to
Incomnet, Inc. ("Incomnet") and its subsidiary, Incomnet Communications
Corporation ("ICC"). Forward-looking statements give Incomnet's expectations or
forecast of future events. These statements can be identified by the fact that
they do not relate strictly to historical or current facts. They use words such
as "estimate," "expect," "project," "plan," "believe," "anticipate," "intend,"
and other words and terms of similar meanings in connection with disclosures of
future operating or financial performance. In particular, these statements
relate to future actions, prospective performance or results of current and
anticipated products, sales, efforts, expenses, the outcome of contingencies
such as legal proceedings, and financial results.
All of the forward-looking statements contained in the Quarterly Report on
Form 10-Q or in other Incomnet publications may turn out to be wrong. They can
be affected by inaccurate assumptions or by known or unknown risks and
uncertainties. Many such factors will be important in determining actual or
future results. Consequently, no forward-looking statement can be guaranteed.
Incomnet's actual results may vary materially and there are no guarantees about
the performance of Incomnet stock.
Incomnet undertakes no obligation to correct or update any forward-looking
statements, whether as a result of new information, future events or otherwise.
Future disclosures on related subjects in Incomnet's reports to the Securities
and Exchange Commission ("SEC") may update some of Incomnet's disclosures
(including Forms 10-Q and 8-K filed in the future) contained herein.
Some of the facts that could cause uncertainties are:
- New competitors and intensification of price competition from other
long-distance providers;
- New products that make ICC's products and services obsolete;
- Adverse state, federal and local government regulations governing the
telecom industry;
- Inability to obtain additional capital as needed;
- Loss of customers;
- Technical problems with ICC's billing system, products and services;
- Departure of key independent sales representatives ("Representatives") and
inability to attract new Representatives;
- Litigation and administrative proceedings;
- Departure or retirement of key executives; and
- Costs and risks of entering and expanding into new markets and new
services.
OVERVIEW
Incomnet is the parent company of ICC, a provider of long distance and
telecommunication services to residential customers and businesses throughout
the United States. ICC's telecommunication services are sold by ICC's network of
Representatives.
In March 1999, Incomnet sold all of its common stock of GenSource
Corporation ("GenSource") in exchange for the cancellation of approximately $1.8
million in debt plus accrued interest owed by Incomnet to the former owners of
GenSource. Incomnet has retained an approximate 15% interest in GenSource on a
fully diluted basis in the form of 15,507 shares of convertible preferred stock
of GenSource. As part of
15
the sale of GenSource stock, Incomnet settled litigation brought by the former
holders of the debt that was cancelled as part of the transaction.
In March 1999, the court presiding over Incomnet's class action securities
litigation entered an order granting preliminary approval of the class action.
The settlement calls for cash payment of $500,000, payment of up to $100,000 of
costs, and the issuance of 1.375 million to 4.125 million shares of Incomnet
Common Stock, depending upon the price at the time of issuance. A hearing to
obtain final court approval is scheduled for June 14, 1999.
In April 1999, ICC obtained a $12.5 million credit facility from Foothill
Capital Corporation. This facility was obtained to assist in executing
Incomnet's strategic plan and to fund ICC's operations.
ICC has taken steps to revitalize its network marketing organization and has
expanded to a nationwide focus on recruiting new Representatives. Since
mid-December 1998, at which time Incomnet obtained additional debt financing,
through April 1999 ICC has added approximately 3,400 new Representatives and
22,600 customers. While ICC views its network of Representatives as its primary
source for obtaining new customers, ICC has taken steps to target certain
markets and customers with other channels of marketing such as telemarketing,
affinity programs and direct sales. However, such channels have not yet been
developed.
RESULTS OF CONTINUING OPERATIONS
The following table sets forth, as a percentage of total net sales, certain
consolidated statements of operations data for the periods indicated:
THREE MONTHS ENDED
MARCH 31,
--------------------
1999 1998
--------- ---------
Total net sales.......................................................... 100% 100%
Cost of sales............................................................ 62 64
--------- ---------
Gross profit......................................................... 38 36
Operating expenses:
General and administrative............................................. 52 33
Bad debt expense....................................................... 3 8
Depreciation and amortization.......................................... 9 5
Other operating expenses............................................... 2 1
--------- ---------
Total operating expenses............................................. 66 47
--------- ---------
Operating loss........................................................... (28) (11)
Interest expense......................................................... 7 1
--------- ---------
Loss from continuing operations.......................................... (35) (12)
Income (loss) from discontinued operations............................... 17 (2)
--------- ---------
Net loss................................................................. (18)% (14)%
--------- ---------
--------- ---------
Incomnet reported a loss from continuing operations of $3.0 million in the
quarter ended March 31, 1999, compared to a loss from continuing operations of
$2.2 million for the same period in 1998. For the comparative periods presented,
Incomnet's results of continuing operations include Incomnet, Inc. and its
subsidiary ICC. The results of operations for the discontinued business segments
is reported separately as discontinued operations.
16
NET SALES
Incomnet's revenues consist primarily of revenues from long distance
telephone services and marketing program fees paid by Representatives for
marketing materials, services and pre-paid calling cards. A portion of marketing
program revenues are deemed related to continuing support obligations and are
deferred and recognized over the twelve-month contractual service periods.
Net sales in the quarter ended March 31, 1999 declined $8.7 million or 50%
from $17.4 million in the comparable quarter in 1998 to $8.7 million in 1999.
This decline was primarily due to a decline in business during 1998 and to a
lesser extent in 1999. Incomnet lost existing Representatives and had difficulty
attracting new Representatives at a sufficient rate to maintain the size of the
customer base during 1998. The loss of Representatives who generally sold to a
"warm" market (i.e., friends, business associates and family members) resulted
in higher than normal customer attrition and reduced the Incomnet's ability to
add customers. These factors caused a reduction in Incomnet's customer base
during 1998 and the first quarter of 1999. The reduction in Incomnet's customer
base caused telephone services revenue to decrease $9.1 million or 53% in the
three month period ended March 31, 1999 from $17.2 million during the comparable
period in 1998 to $8.1 million in 1999.
Marketing program revenues in the quarter ended March 31, 1999 increased
approximately $0.4 million from $0.2 million during the comparable period in
1998 to $0.6 million in 1999. During the same period, the number of new
Representatives added increased 736 from 1,207 during the comparable quarter in
1998 to 1,943 in 1999 primarily due to the Company's efforts to revitalize the
network marketing organization (See "Liquidity and Capital Resources" below).
GROSS PROFIT
Telephone services gross margins are principally affected by changes in
product mix, telephone services average per unit cost, and changes in
commissions paid on telephone usage. Marketing program gross margins are
principally affected by the promotional and customer acquisition bonuses paid to
the Representatives.
Gross profit in the quarter ended March 31, 1999 declined $2.9 million or
47%, from $6.2 million for the comparable prior year period to $3.3 million in
1999. The primary reasons for the decline are the decrease in sales volume
(discussed above), which is slightly offset by improved gross margin
percentages. Gross margins for telephone services increased from 37% in the
comparable prior year period to 45% in 1999. Marketing program gross margins
decreased from a negative 54% for the comparable prior year period to a negative
68% for 1999. The increase in telephone services gross margins is primarily
attributable to changes in Incomnet's sales mix and lower average per unit
telephone service carrier costs in 1999. The change in sales mix is primarily
attributable to a decline in calling card sales from 6.4% of total telephone
services for the comparable prior year period to 5.1% in 1999. The calling card
product line has historically had significantly lower gross margins than long
distance service. The lower average per unit telephone services carrier cost is
primarily due to ICC renegotiating its contract with WorldCom Network Services,
Inc. ("WorldCom") in October 1998.
The decrease in marketing program margins is primarily attributable to costs
associated with the efforts to revitalize the network marketing organization.
These efforts include promotional programs designed to increase customer
acquisition and generate growth in the network marketing organization. As a
result of these efforts, the network marketing organization has added
approximately 3,400 new Representatives and approximately 22,600 new customers
since obtaining additional debt financing in mid-December 1998.
17
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist of costs to provide billing and
collection of telephone services, support services for subscribers, cost of the
information systems and personnel to support Incomnet's operations.
Although general and administrative costs for Incomnet decreased to $4.5
million in the quarter ended March 31, 1999 from $5.8 million in the comparable
quarter in 1998, they increased as a percentage of net sales to 52% in the 1999
period from 33% in the comparable quarter in 1998. This increase as a percentage
of net sales was primarily attributable to an increase in legal and consulting
costs associated with defending Incomnet against certain claims and complying
with certain regulatory requirements. These were partially offset by larger than
anticipated recoveries from outside billing agencies.
Total general and administrative costs for 1999 will continue to be high as
a percentage of net sales due to the base level of infrastructure required for
operations, including facilities, customer service, and other back office
operations. Although Incomnet is undertaking a prudent cost reduction plan,
significant cost reductions could negatively impact support services needed to
rebuild the business. If Incomnet is successful in rebuilding its business and
exceeding break-even, substantial growth should be supported with incrementally
marginal cost increases.
BAD DEBT EXPENSE
Bad debt expense decreased in the three month period ended March 31, 1999 to
3.4% of telephone services sales or $279,000 compared to 8.1% of telephone
services sales or $1.4 million in the comparable period in 1998. The decrease in
bad debt expense as a percentage of telephone services sales was primarily the
result of ICC outsourcing its telephone services collection function during the
latter part of 1998 which improved the collection rate and the result of ICC
experiencing better than estimated collection rates during the three month
period ended March 31, 1999.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization decreased $48,000 from $872,000 in the
comparable 1998 period to $824,000 in 1999. This decrease was attributable to
the write-down of the carrying value of certain leasehold improvements in late
1998, partially offset by 1999 investments in computer hardware and software,
and furniture and equipment.
DISCONTINUED OPERATIONS
In March 1999, Incomnet sold its interest in the common stock of the
computer software business segment, consisting of GenSource Corporation
("GenSource"), a developer and marketer of software programs used to administer
insurance-related claims, such as workers' compensation and short-term and
long-term disability. The sale was made to a group of private investors in
exchange for the release from liability of Incomnet under promissory notes to
the former owners of GenSource of approximately $1.8 million plus accrued
interest. In addition, Incomnet paid $25,000 in cash for certain transaction
expenses and received 15,507 shares of convertible preferred stock in GenSource
with a stated value of $32.25 per share. No value was recorded related to the
preferred stock which represents an approximately 15% interest in GenSource on a
fully-diluted basis. In connection with the disposition of GenSource, Incomnet
recognized a gain of approximately $1.7 million. Incomnet has no expectation of
continuing involvement with GenSource.
LIQUIDITY AND CAPITAL RESOURCES
During the preceding three years and the quarter ended March 31, 1999,
Incomnet has recognized significant net losses from continuing operations. As a
result, at March 31, 1999, Incomnet has an
18
accumulated deficit and net capital deficiency of $86.3 million and $17.3
million, respectively, and its current liabilities exceed its current assets by
approximately $14.0 million.
Incomnet is taking steps to revitalize ICC's network marketing organization,
including developing new telecommunications products that are more competitive,
working closer with its Representatives to help them better understand the
products and services provided by ICC, developing new commission and bonus
programs that will make ICC more competitive in attracting new Representatives,
and expanding its focus on Representative recruiting from primarily a Southern
California focus to a nationwide program. Management believes its new marketing
plans have and will continue to revitalize ICC's efforts to attract additional
representatives. In addition to revitalizing its network marketing organization,
ICC also is continuing a cost control program that is anticipated to result in a
more efficient operation and a reduced cost structure overall.
In April 1999, Incomnet obtained a line-of-credit facility providing for
borrowings, based on eligible accounts receivable, up to a maximum of $12.5
million from Foothill Capital Corporation. In addition, Incomnet has had recent
discussions with Ironwood Telecom LLC ("Ironwood") regarding the possible
conversion into equity of some or all of Incomnet's $16.8 million debt
obligation owing to Ironwood. Incomnet is also seeking additional financing that
may take the form of either additional debt or equity. To assist in its
financing efforts, Incomnet has engaged a financial advisor to help identify
additional sources of equity financing. No assurances can be given that Incomnet
will be successful in raising additional debt or equity financing either through
this financial advisor or at all.
Management believes Incomnet has sufficient sources of financing to continue
operations throughout 1999 at planned levels of operations. However, due to
uncertainties inherent in the achievement of management's strategic plan, there
are no assurances that Incomnet will attain planned levels of operations.
Ultimately, Incomnet's long-term success is dependent upon its ability to
successfully execute its strategic plan, obtain additional long-term financing,
complete its Year 2000 remediation, and ultimately attain sustained profitable
operations.
CONTINUING OPERATIONS
Cash used in operating activities in the three month period ended March 31,
1999 was $0.9 million. This was primarily due to the loss from continuing
operations of $3.0 million offset by non-cash expenses of $1.2 million, a $0.6
million decline in accounts receivable and changes of $0.3 million in other
working capital accounts.
Incomnet used $359,000 in investing activities primarily consisting of
purchases of computer hardware and software and increases in certain other
non-current assets.
Cash provided by financing activities were $64,000. These were primarily a
release of a final $185,000 of Ironwood funding from escrow net of payments
under capital leases obligations.
DISCONTINUED OPERATIONS
Cash (used in) provided by discontinued operations was ($25,000) and $0.9
million for the quarters ended March 31, 1999 and 1998, respectively. The cash
provided by discontinued operations arose from normal operations and gains or
losses on disposition of the segments.
CAPITAL EXPENDITURES
Incomnet acquired approximately $0.3 million of facilities and equipment in
the quarter ended March 31, 1999. The capital for these acquisitions was
provided by debt financing obtained in mid-December 1998 and from operations. To
meet its planned capital expenditures in 1999, Incomnet believes that it will
spend approximately $3.6 million. Some of these capital expenditures will assist
Incomnet and ICC to modernize its information systems, broaden its product
offering and realize process
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efficiencies. Because Incomnet presently does not have the capital for such
anticipated expenditures, it will need to finance or lease these assets.
LITIGATION
Incomnet is subject to pending litigation and has taken a reserve of $8.5
million associated with anticipated legal settlement of the class action
lawsuit. Incomnet is a defendant in other pending litigation that may have a
material adverse effect on Incomnet's financial condition and results of
operation. No reserves have been set up for this other litigation (See "Note 5
of Notes to Condensed Consolidated Financial Statements").
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.
Incomnet and ICC have identified the major information technology (e.g.,
computer hardware and software) ("IT") and non-information technology (e.g.,
heating and air-conditioning systems) ("non-IT") systems that must either be
upgraded or replaced to meet the needs of operations and to be Y2K compliant.
These changes will result in a combination of software, hardware and equipment
upgrades or replacements. Some of the key systems identified by ICC were: the
internal financial system; the billing and customer care system; the independent
representative tracking and commission system; the calling card system; the
internal corporate telephone exchange, the security and communications systems.
Since the Board change in September 1998, Incomnet has spent or committed to
spend approximately $3 million to upgrade or replace certain of its IT and
non-IT systems for strategic business purposes (the "Strategic Systems
Commitment"). Many of these expenditures are expected to be paid out over a
number of years. As of March 31, 1999, approximately $200,000 of the Strategic
Systems Commitment has been spent on upgrades and replacements. An ancillary
benefit of those expenditures is that the new hardware and software is Y2K
compliant. In addition, ICC has budgeted approximately $226,000 to upgrade or
replace existing IT and non-IT systems (the "Upgrade Commitment") for the
specific purpose of becoming Y2K compliant. Approximately $90,000 of the upgrade
commitment was spent through the end of the first quarter of 1999. Incomnet and
ICC currently estimate that all key upgrades and replacements of IT and non-IT
systems will be completed and tested by October 1999.
Incomnet has dedicated internal resources and personnel to the Y2K problem
and has already acquired most of the IT and non-IT upgrades to existing
equipment.
During the first quarter of 1999, ICC sent out questionnaires to its key
suppliers and vendors, including WorldCom, its underlying carrier, USBI, a local
carrier clearing house, and LITE and SBC Communications with whom ICC has
billing and collection services agreements. To date, none of the responses to
the questionnaires has caused Incomnet or ICC to believe that its key service
providers or vendors are at risk of not being Y2K compliant before December 31,
1999; however, 5 vendors of non-critical systems or products have not yet
returned their questionnaires. Incomnet and ICC currently expect to receive
responses to all questionnaires by June 30, 1999.
One of ICC's most significant Y2K risks is its automated billing system. In
order to permit ICC to perform more direct and integrated billing, ICC invested
in a new billing system in the first quarter of 1999. ICC has received
assurances that the new billing system is Y2K compliant. ICC plans to commence
testing the new system in June and July 1999 and currently expects that it will
be fully operational by October 1999.
While Incomnet and ICC currently believe that all key IT and non-IT systems
will be Y2K compliant by October 1999, there can be no assurance at this time
that ICC will be able to make all necessary
20
changes, that all of Incomnet's and ICC'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 Incomnet and ICC achieve Y2K compliance in their own products
and services, that systems provided to Incomnet or ICC 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 Incomnet's or ICC's
business, results of operation or financial condition.
The most likely worst-case scenario at Incomnet which management has
identified to date is that, due to unanticipated implementation problems, ICC's
new billing system may not be fully operational by December 31, 1999. In the
event implementation of the new billing system is delayed, Incomnet has
developed a contingency plan which contemplates transferring the billing and
collection function to one or more of the local exchange carriers or third party
billing services that Incomnet currently uses to bill a portion of its customer
base. In the event Incomnet is unable to implement its contingency plan,
Incomnet may be unable to bill and collect some or all of its revenue for an
indeterminable amount of time, which could cause Incomnet to cease operations.
Incomnet plans to conduct Y2K testing of its new billing system in June and July
1999 to address this worst-case scenario.
ITEM 3. QUANITITATIVE AND QUALITATIVE DISCUSSION OF MARKET RISK
Incomnet is exposed to changes in interest rate risk to the extent of its
borrowings under its $12.5 million credit facility with Foothill Capital
Corporation entered into in April 1999. Borrowings under that credit facility
bear interest at the prime rate plus one percent (1%). However, at March 31,
1999, that credit facility was not in existence and Incomnet's other existing
debt was at fixed interest rates. Therefore, for the three month period ended
March 31, 1999, Incomnet had no exposure to interest rate movement on its debt.
Under its current policies, Incomnet does not intend to use interest rate
derivative instruments to manage exposure to interest rate changes under its
credit facility with Foothill Capital.
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PART II--OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
LEGAL PROCEEDINGS
The pending and recently completed legal proceedings in which Incomnet or
ICC is a party are identified and described in this quarterly report on Form
10-Q (See Part I--Item 1. Notes to Condensed Consolidated Financial
Statements--Note 5. Litigation.)
ITEM 2. CHANGES IN SECURITIES
Incomnet has not paid cash dividends on its common stock during the past
three years. Payment of dividends is within the discretion of Incomnet's Board
of Directors and will depend, among other factors, on earnings, capital
requirements and operating and financial conditions. At the present time,
Incomnet has neither the plans nor the financial resources to declare or pay any
dividends on its common stock. Incomnet's ability to pay dividends is restricted
by the Foothill Credit Facility. The Foothill Credit Facility provides that as
long as (i) no event of default on the Foothill Credit Facility has occurred and
is continuing, and (ii) ICC has not less than $2 million of available funds
under the Facility after giving effect to any dividend, ICC may pay dividends to
Incomnet to cover the general administrative expenses as historically conducted
and to cover accrued dividends on Incomnet Preferred Stock up to a maximum of
$20 million of Preferred Stock.
In April 1999, ICC obtained a line-of-credit facility from Foothill Capital
Corporation. In connection with this credit facility, Foothill Capital was
granted a first priority security interest in substantially all the assets of
ICC. In order to permit this financing, Ironwood subordinated its existing
security interest in ICC's assets that secured the obligations to repay the
$16.8 million debt owing from Incomnet to Ironwood. In consideration for
subordinating its security interest in ICC's assets, Incomnet granted Ironwood
warrants to purchase 1,250,000 shares of Incomnet Common Stock at an exercise
price of $1.00 per share. The warrants may be exercised on the date Incomnet's
Articles of Incorporation are amended to allow for issuance of the shares of
Common Stock underlying the warrants and for five years thereafter. The warrants
were issued without registration under the Securities Act of 1933, as amended
(the "Securities Act"), in reliance on an exemption provided under Section 4(2)
of the Securities Act for offers and sales of securities not involving any
public offering.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
3.1 Certificate of Determination for Series C filed January 28, 1999. Incorporated by
reference from Exhibit 3.4 attached to Incomnet's Form 10-K for the year ended
December 31, 1998 filed with the Securities and Exchange Commission on April 19,
1999.
3.2 Certificate of Determination for Series D filed January 28, 1999. Incorporated by
reference from Exhibit 3.5 attached to Incomnet's Form 10-K for the year ended
December 31, 1998 filed with the Securities and Exchange Commission on April 19,
1999.
3.3 Revised Bylaws of Incomnet, Inc., dated January 18, 1999. Incorporated by reference
from Exhibit 3.6 attached to Incomnet's Form 10-K for the year ended December 31,
1998 filed with the Securities and Exchange Commission on April 19, 1999.
10.1 Incomnet, Inc. Equity Incentive Stock Plan, approved by the Board of Directors of
Incomnet, Inc. on January 18, 1999. Incorporated by reference from Exhibit 10.50
attached to Incomnet's Form 10-K for the year ended December 31, 1998 filed with the
Securities and Exchange Commission on April 19, 1999.
10.2 Incomnet, Inc. Employee Stock Purchase Plan, approved by the Board of Directors of
Incomnet, Inc. on January 18, 1999. Incorporated by reference from Exhibit 10.51
attached to Incomnet's Form 10-K for the year ended December 31, 1998 filed with the
Securities and Exchange Commission on April 19, 1999.
10.3 Amendment No. 1 to Telecommunications Services Agreement and Program Enrollment Terms
between ICC and WorldCom effective March 12, 1999. (Portions of this Agreement have
been redacted. Incomnet has requested that the Securities and Exchange Commission
grant confidential treatment to the redacted portions of the Agreement.) Incorporated
by reference from Exhibit 10.56 attached to Incomnet's Form 10-K for the year ended
December 31, 1998 filed with the Securities and Exchange Commission on April 19,
1999.
10.4 Loan and Security Agreement between ICC and Foothill Capital Corporation dated as of
April 9, 1999. Incorporated by reference from Exhibit 10.57 attached to Incomnet's
Form 10-K for the year ended December 31, 1998 filed with the Securities and Exchange
Commission on April 19, 1999.
10.5 Intellectual Property Security Agreement between ICC and Foothill Capital Corporation
dated as of April 9, 1999. Incorporated by reference from Exhibit 10.58 attached to
Incomnet's Form 10-K for the year ended December 31, 1998 filed with the Securities
and Exchange Commission on April 19, 1999.
10.6 Security Agreement between Incomnet, Inc. and Foothill Capital Corporation dated as
of April 9, 1999. Incorporated by reference from Exhibit 10.59 attached to Incomnet's
Form 10-K for the year ended December 31, 1998 filed with the Securities and Exchange
Commission on April 19, 1999.
10.7 Intercreditor and Subordination Agreement between Foothill Capital Corporation and
Ironwood Telecom LLC dated as of April 9, 1999. Incorporated by reference from
Exhibit 10.60 attached to Incomnet's Form 10-K for the year ended December 31, 1998
filed with the Securities and Exchange Commission on April 19, 1999.
10.8 Warrant issued to Ironwood Telecom LLC to purchase 1,250,000 shares of Incomnet
Common Stock dated April 9, 1999. Incorporated by reference from Exhibit 10.61
attached to Incomnet's
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Form 10-K for the year ended December 31, 1998 filed with the Securities and Exchange
Commission on April 19, 1999.
10.9 Amendment to Registration Rights Agreement between Ironwood and Incomnet dated as of
April 9, 1999. Incorporated by reference from Exhibit 10.78 attached to Incomnet's
Form 10-K for the year ended December 31, 1998 filed with the Securities and Exchange
Commission on April 19, 1999.
10.10 Consent and Amendment No. 1 to Loan and Security Agreement between Ironwood and
Incomnet dated as of April 9, 1999. Incorporated by reference from Exhibit 10.79
attached to Incomnet's Form 10-K for the year ended December 31, 1998 filed with the
Securities and Exchange Commission on April 19, 1999.
10.11 Employment Agreement between Incomnet, Inc. and George P. Blanco dated January 19,
1999. Incorporated by reference from Exhibit 10.49 attached to Incomnet's Form 10-K
for the year ended December 31, 1998 filed with the Securities and Exchange
Commission on April 19, 1999.
10.12 Settlement Agreement and Mutual General Release among Incomnet, Inc., GenSource
Corporation, Jerry C. Buckley, Ralph M. Flygare, Robert Reisbaum and E.V. Schmidt
dated as of March 9, 1999. Incorporated by reference from Exhibit 10.52 attached to
Incomnet's Form 10-K for the year ended December 31, 1998 filed with the Securities
and Exchange Commission on April 19, 1999.
27 Financial Data Schedule.
27.1 Amended and restated Financial Data Schedule.
(B) REPORTS ON FORM 8-K, FILED:
20.1 Report on Form 8-K regarding change in Incomnet's Certifying Accountant filed January
14, 1999.
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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: May 20, 1999 /s/ DENIS RICHARD
------------------------------------------
Denis Richard
President and Chief Executive Officer
(Principal Executive Officer)
Date: May 20, 1999 /s/ GEORGE P. BLANCO
------------------------------------------
George P. Blanco
Executive Vice President, Chief Financial
Officer and Secretary
(Principal Financial Officer)
Date: May 20, 1999 /s/ STEPHEN A. GARCIA
------------------------------------------
Stephen A. Garcia
Vice President Finance and Corporate
Controller
(Principal Accounting Officer)
25