I SECTOR CORP - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 1-31949

I-SECTOR CORPORATION
(Exact name of Registrant as specified in its charter)

DELAWARE 76-0515249
(State of Incorporation) (I.R.S. Employer
Identification No.)

6401 SOUTHWEST FREEWAY
HOUSTON, TX 77074
(Address of principal executive offices) (Zip code)

REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE: (713) 795-2000

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE
(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). [ ] Yes [X] No

The aggregate market value of the voting stock held by non-affiliates of
the registrant, based upon the closing price of the common stock on June 30,
2003 as reported on the NASDAQ Small Cap Market was approximately $3,629,681.

The number of shares of common stock, $.01 par value, outstanding as of
March 11, 2004 was 3,988,294.

DOCUMENTS INCORPORATED BY REFERENCE
NONE

PART I

ITEM 1. BUSINESS

SPECIAL NOTICE REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements within the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995. All
statements included in this annual report, other than statements that are purely
historical, are forward-looking statements. Forward-looking statements may be
identified by words including, but not limited to, "anticipate," "appear,"
"believe," "could," "estimate," expect," "hope," "indicate," "intend," "likely,"
"may," "might," "plan," "potential," "seek," "should," "will," "would," and
other variations or negative expressions thereof. These forward-looking
statements are subject to known and unknown risks and uncertainties. Numerous
factors, including factors over which we have little or no control, may cause
actual results to differ materially from those expressed in the forward-looking
statements contained in this report. In evaluating such statements, we urge you
to consider the various factors identified in this annual report on Form 10-K,
including matters set forth in "-- Risks Related to Our Business," which could
cause actual events, performance or results to differ materially from those
indicated by our forward-looking statements.

GENERAL

We are a leading regional provider of network infrastructure and IP
telephony solutions including related implementation and support services for
enterprises. The network and IP telephony solutions we offer are
"Cisco-centric," meaning they are based on the products and technology of Cisco
Systems, Inc., which we refer to as "Cisco." These solutions include design,
implementation and support of IP telephony, LAN/WAN routing and switching,
virtual private networks, voice over IP, network security, and wireless
networks. Because of our substantial experience and technical expertise in the
design, implementation and support of IP telephony solutions, we believe we are
well-positioned to take advantage of what we believe to be the growing trend of
implementation by enterprises of IP telephony in general and, in particular, the
pure, packet-switched IP telephony solutions of Cisco. We also develop and
market our own computer telephony integration software and provide remote
information technology services. Our operations are managed from offices in
Houston, Dallas and Austin, Texas. Our long term goal is to become one of the
leading national providers of Cisco-centric networks and IP telephony solutions
for enterprises.

I-Sector Corporation is a holding company, and we operate each of our three
business segments through separate subsidiaries. We sometimes refer to our
business segments in this report by referring to the name of the subsidiary that
operates that business segment. We operate our IP telephony and network
infrastructure business through our Internetwork Experts, Inc. subsidiary, which
we refer to as "INX." Our computer telephony business is conducted through our
subsidiary Stratasoft, Inc., which we refer to as "Stratasoft." Our remote
information technology management business is operated by our subsidiary
Valerent, Inc., which we refer to as "Valerent."

Each of our three business segments derives revenues from sales of both
products and services. As a percentage of revenue, our largest business segment
is INX, our IP telephony and network infrastructure business. INX provided
approximately 80% of our revenues in 2003. Computer telephony software provided
by Stratasoft accounted for approximately 12% of our revenues in 2003. The third
and smallest business segment is our remote information technology management
business of Valerent, which provided approximately 8% of our revenues in 2003.

FUTURE MINORITY INTEREST IN INX

Each of INX, Stratasoft and Valerent is currently a wholly-owned
subsidiary. Beginning in April 2004, however, we expect that INX will cease to
be a wholly-owned subsidiary as the result of anticipated issuances of INX
common stock to Digital Precision, Inc., which we refer to as "Digital
Precision," who sold their business to INX in April 2003. In connection with
that acquisition, we agreed to issue to the seller 1.8 million shares of INX
common stock as additional purchase consideration for its business if certain
employees remain
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employed through April 4, 2004, the first anniversary of the acquisition. When
that occurs, we anticipate that our ownership percentage of INX's common stock
then outstanding will be approximately 92.4%.

We have also granted 8,290,692 stock options to employees of INX to acquire
INX common stock pursuant to a stock option plan for INX employees. We refer to
these options as the "INX options." The exercise prices for the INX options
range from $0.01 to $0.25 with a weighted average of $0.16. I-Sector Corporation
also holds a warrant to acquire 1.2 million additional shares of INX common
stock, which we refer to as the "I-Sector Warrant," at an exercise price of
$0.25 per share. We estimate that our ownership in INX would be reduced to
69.5%, assuming that the INX stock is issued in April 2004 as we expect, all INX
options become fully vested and are exercised, and the I-Sector Warrant is
exercised. If the I-Sector warrant is not exercised, we estimate that our
ownership in INX would be reduced to 68.4% assuming the INX stock is issued in
April 2004 and all INX options become fully vested and are exercised.

We do not intend to issue any additional shares of INX common stock to
persons other than I-Sector, except to the holders of presently outstanding INX
options if those options become vested and are exercised. We also do not intend
to grant any additional INX options and have amended the INX stock option plan
to so provide. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Future Minority Interest in INX."

IP TELEPHONY INDUSTRY BACKGROUND

TERMINOLOGY

IP telephony is a general term for an existing and rapidly expanding
technology that uses Internet Protocol, or "IP," for exchanging voice
communications, faxes, and other types of information that have traditionally
been carried by conventional private, branch exchange ("PBX") telephone systems
used by enterprises and by the public switched telephone network ("PSTN"). The
term IP telephony generally encompasses a narrower term frequently used in our
industry called "VoIP," or voice over Internet Protocol. We refer to VoIP as
including only the exchange of voice communication by means of IP technology,
while we refer to IP telephony as including not only VoIP but also the broader
range of voice and other communications over IP-based networks, and the systems
that enable those communications.

Internet Protocol, or IP, is a set of industry standard procedures that are
used to:

- format large volumes of data into smaller, discrete units or "packets";

- give each packet both the sender's and the recipient's network address;
and

- send those packets over the Internet or through the enterprise's own
network to the recipient's address.

Sometimes the packets are sent by different routes and arrive out of proper
sequence. At their destination, the multiple packets are reassembled into their
correct order by another protocol known as Transmission Control Protocol, or
TCP, to produce a coherent communication.

IP telephony uses "packet-switched" connections, instead of using the
conventional "circuit-switched" connections traditionally employed by PBXs and
PSTNs. Because IP telephony uses packet-switching, multiple users can share the
same path for voice, data and other communications. In contrast, conventional
circuit-switched telephony is carried over a circuit dedicated only to the use
of the specific senders and recipients that are a part of the communication then
in progress.

IP telephony uses network infrastructure, such as a local area network (a
"LAN") or a wide area network (a "WAN"), employing IP technology to either
enhance the telephony functions performed by the enterprise's existing PBX
telephone system or to replace the existing PBX entirely. We refer to IP
telephony systems that incorporate and augment an enterprise's existing PBX as a
"hybrid" system, and to the PBX retained by the enterprise as a "legacy PBX." We
refer to a "pure" or "packet-switched" IP telephony system as one in which
network infrastructure totally supplants the enterprise's existing PBX with a
packet-switched solution.

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In addition to offering potential long-term cost savings, implementation of
IP telephony allows enterprises to reap the benefits of participating in a
growing trend in communications technology called "convergence."

CONVERGENCE TREND

We believe the market for enterprise communications is moving from the
"traditional model" to what industry observers sometimes term the "converged
model." IP telephony is expected to be an important part of the trend toward
convergence.

In the traditional enterprise communications model, different types of
communication are conducted by different means:

- data communication is performed using LAN/WAN network infrastructure,
including the Internet;

- telephone/voice communication is carried over traditional
circuit-switched PBX systems and PSTNs; and

- video communications are often accomplished using stand-alone video
conferencing systems using either multiple circuit-switched telephone
lines or network communications.

In contrast, the converged communications model will enable voice, video
and data to be carried by a single, unified IP-based network. IP telephony and
data communication over IP-based network infrastructures is already being used
by many enterprises. We believe that technology to enable video teleconferencing
over IP-based networks is rapidly developing, and that it will become available
for commercial implementation in the near future.

Today, implementation of converged IP telephony and data communications
networks can offer both significant long-term cost savings and increased
productivity to enterprises. Among the potential long-term savings that an
enterprise might experience are:

- elimination of redundant traditional telephone line circuits and cabling
systems as internal voice communications move to the enterprise's
IP-based network cabling system;

- reduced cost resulting from consolidation of PSTN circuits to a central
location so that all external communications to and from the enterprise
occur through fewer or only one point of interface to the PSTN;

- more efficient support of telephone and data functions by a single
support organization rather than multiple service providers and in-house
support departments;

- simplified administration and lower costs for moves, adds and changes of
the telephone system because an IP telephony handset can be moved or
changed within an enterprise without rewiring the PBX or re-programming
the telephone number as is required in a conventional PBX system; and

- elimination or reduction of long distance toll charges as enterprises
operating a converged solution move their internal voice communications
to the fixed-cost data network that often already exists between the
enterprise's remote facilities.

Later, as convergence progresses, we expect it to further improve the
productivity and cost savings of enterprises. We believe that much of these
long-term productivity enhancements and cost savings will come from yet-to-be
created applications designed to take full advantage of convergence technology.

COMPETING IP TELEPHONY SOLUTIONS

We believe there are two primary technologies competing for enterprise IP
telephony market share. One is offered primarily by Cisco, the leading
manufacturer of network routing and switching equipment. Cisco promotes the use
of a network server running its call management software, also called a "soft
switch," which enables its system to perform IP telephony functions without the
use of a PBX. This approach is often referred to as a "packet-switched"
solution. While other manufacturers are moving toward this technology, we
believe

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that Cisco has established an early competitive advantage in the market for
packet-switched telephony solutions.

The competing technology is promoted by manufacturers of conventional
circuit-switched PBX systems, such as Avaya Inc. and Nortel Networks Corp. These
manufacturers have many customers with traditional circuit-switched PBX
telephone systems. Consequently, their current products generally feature hybrid
IP telephony solutions that promote retaining and upgrading their customers'
legacy PBXs to make them "IP enabled," thus avoiding the immediate obsolescence
of their older PBX telephone systems.

IP telephony is a comparatively new communication technology that we
believe is rapidly gaining acceptance by enterprises. There are, however,
barriers to its immediate acceptance by many enterprises. We believe one of the
most common barriers is the cash expense to an enterprise of upgrading or
replacing existing network infrastructure and legacy PBX systems. A related
concern of some enterprises is the non-cash expense associated with writing off
the undepreciated cost of their legacy PBX system, particularly when substantial
undepreciated costs of that system remain on an enterprise's balance sheet.
Additionally, doubts about the perceived quality of service offered by an
IP-based telephony system are a barrier to some enterprises. In our experience,
these concerns generally focus on features such as audio quality, reliability,
privacy and security.

IP telephony as implemented by most enterprises typically requires upgraded
or new network infrastructure, regardless of whether the enterprise chooses a
hybrid or pure IP telephony solution. Most networks designed solely for data
communications are inadequate to accommodate IP telephony functions featuring
the quality of telephony service demanded by most customers. For example, most
customers demand that voice communications be given priority over data
communication in the allocation of their network's available resources. To do
this, the enterprise's network infrastructure must be able to distinguish
between data communication and voice communication. It must also be capable of
prioritizing and allocating the use of system resources between voice and data
to achieve the enterprise's quality-of-service expectations.

We believe that the many complexities associated with IP telephony networks
require specialized knowledge and skills not generally available to service
providers experienced only in data networks or traditional telephone systems.
The optimal design, implementation and support of IP telephony requires a
service provider that is experienced and proficient in many different
technologies, including data networking, telephony, and various industry
protocols, as well as the software and hardware needed to integrate those
technologies.

OUR IP TELEPHONY AND NETWORK INFRASTRUCTURE BUSINESS

We offer a complete range of products and services for Cisco-centric IP
telephony solutions through our INX subsidiary. Until recently, most IP
telephony solutions work we did involved our customer testing the technology
rather than full-scale implementation of IP telephony. As the market for IP
telephony solutions for enterprises matures from testing to full-scale
deployment, we believe that offering a comprehensive range of products and
services to our customers will be critical in differentiating us from our
competitors. Because services typically provide higher margins than the sale of
products, we plan to emphasize recurring support services in our marketing
strategy.

NETWORK INFRASTRUCTURE PRODUCTS

Our products consist principally of network infrastructure components
manufactured by Cisco, including switching and routing equipment, and related
Cisco software, including Cisco Call Manager IP Telephony Software. We also
offer software products to augment Cisco technology that are available from
vendors other than Cisco, including our own software products.

DESIGN AND IMPLEMENTATION SERVICES

We design and implement Cisco-centric IP telephony solutions. To provide
these services, we employ highly trained network engineering staff, who are
trained and experienced in both large, complex network

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infrastructure technology and Cisco IP telephony technology. Our technical and
engineering staffs are also experienced in essential related technology such as
network security. We have developed not only expertise in the area of enterprise
IP telephony solutions and converged communications, but also methodologies for
designing and implementing large, complex, converged communications
infrastructures for enterprises.

During 2001 and 2002, as the move toward IP telephony technology by
enterprises began to develop, the majority of our customer engagements were
limited to the installation of pilot projects in which our customers tested the
technology. These types of projects required long selling cycles, substantial
pre-sale involvement by skilled engineers and significant IP network design and
upgrade services. Our IP telephony implementation services were a comparatively
small component of the total services we provided in these pilot projects
because our customers were implementing only relatively small "test" sites.
These projects were characterized by sporadic service revenue and generally
depressed gross margins for our services. Additionally, our engineering staff
was often not fully utilized between projects. We expect to be able to more
fully employ our engineering staff if we begin to perform more large-scale
implementations as IP telephony gains greater acceptance by enterprises. This
increased demand should improve our service revenue and service margin if we
properly manage these larger installations.

We have installed many trial IP telephony solutions for enterprises, and we
believe that many of these enterprise customers will eventually choose to adopt
a Cisco-centric IP telephony solution for their entire organization. If they do,
we believe we will have a competitive advantage when those customers select a
provider to design and implement their new system.

POST-IMPLEMENTATION SUPPORT SERVICES

In our view, there are two main support models for IP telephony: the
current model used to support traditional PBX systems and the model used to
support computer networks. We believe that neither the traditional PBX telephone
support model nor the existing computer network support model best suits the
needs of customers operating a converged communications infrastructure. We have
created a specialized support model for supporting Cisco-centric converged
communications systems, which we have branded under the Netsurant name. These
services include remote monitoring and management of the customer's IP telephony
and related IP network infrastructure, using specialized toolsets and a network
support center with technical staff who are specifically trained and experienced
in the area of Cisco IP telephony and complex, state-of-the-art IP network
infrastructure. Customers are notified of system problems and we solve the
detected problems either remotely or onsite.

Until recently, when most customers were interested only in testing IP
telephony technology, post-implementation support services were not a high
priority for those customers. But as customers make the decision to fully
implement this relatively new technology, we believe that post-implementation
support will become a higher priority. Additionally, we believe that the quality
of support services is likely to become among the more substantial concerns of
enterprises when they are choosing a service provider. We believe we will be
positioned to provide support services that the customers require.

WHY WE OFFER CISCO-CENTRIC IP TELEPHONY SOLUTIONS EXCLUSIVELY

We offer only Cisco-centric network infrastructure solutions and
Cisco-centric IP telephony solutions. We do this because we believe it enables
us to compete more effectively for large Cisco-centric IP telephony projects.
Our sales force works closely with Cisco's sales organization to identify and
close IP telephony projects. By deliberately refraining from selling products
that are competitive with Cisco's products, we believe our relationship with
Cisco is enhanced, and our sales staff and sales management are more focused and
knowledgeable about the products that we sell.

We believe that most sales of Cisco IP telephony systems are market share
gains by Cisco and the packet-switched IP telephony technology it promotes over
PBX manufacturers and their hybrid solution. This is because Cisco recently
entered the voice communications market and does not have a large traditional
PBX telephone systems customer base to protect against encroachment by
competitors. Because IP telephony systems sold to enterprises will be largely
systems replacing existing traditional PBX telephone systems, the
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traditional PBX manufacturers will be seeking to retain their existing customers
while each system sold by Cisco will be a new customer for Cisco at the expense
of a competitor, resulting in market share gains by Cisco.

The majority of the IP-based routing and switching equipment installed
today is manufactured by Cisco. For that reason, we believe Cisco has a
competitive advantage with respect to implementing pure, packet-switched IP
telephony solutions. According to Infotech's April 2003 report on enterprise IP
telephony titled "Enterprise Convergence -- The Race for IP Telephony
Supremacy," Cisco had over a 50% share of the installed IP telephony handsets,
but less than a 2% market share of all enterprise handsets installed, including
traditional circuit-switched systems. Because of this, we believe Cisco has the
potential to gain market share from its competitors as the move toward full
adoption of IP telephony technology by enterprises accelerates. If we are able
to grow to become a national rather than a regional provider of Cisco-centric
network infrastructure, and if, as we expect, Cisco gains market share, we
believe that we will be able to substantially increase our revenues and our
significance to Cisco.

Because the IP telephony and network infrastructure solutions we offer are
based on the IP telephony products and technology of Cisco, it is critical to
our business that we maintain a good working relationship with Cisco. We believe
that because of our focus on Cisco's products, and our commitment to their
strategy, our relationship with Cisco is excellent. Cisco awarded us its
Regional Direct Value Added Reseller for its Southern Region for 2002, and its
Regional Direct Value Added Reseller for the entire United States for 2003.

We are an authorized reseller of Cisco products and have been awarded its
"Gold" level status, which enables us to obtain the best published pricing
discounts on the Cisco products that we sell, which in turn enables us to be
competitive with other large Cisco product resellers.

GEOGRAPHIC EXPANSION AND ACQUISITIONS

We have grown to be what we believe is the leading regional Cisco-centric
IP telephony solutions provider for Texas, with offices in Houston, Dallas and
Austin, Texas. With full adoption of IP telephony technology by enterprises just
now beginning to occur, we intend to expand nationally, establishing offices in
other major U.S. markets in order to rapidly create a national presence. We
intend to do this, when feasible, by acquiring select Cisco-centric network
infrastructure solutions companies in major markets, and adjusting the focus of
those companies toward the opportunities created by the trend toward full
adoption of IP telephony technology.

OUR COMPUTER TELEPHONY SOFTWARE BUSINESS

EXISTING PRODUCTS

We develop and market computer telephony software through our Stratasoft
subsidiary. This software is used by professional contact centers and other
complex, high volume telephony environments and is marketed under the trade name
"Stratasoft." Our current complete contact center product offering allows our
customers to rapidly customize our software to their business applications. Our
Stratasoft products provide telephony functionality essential to contact center
operations including:

- outbound predictive dialing;

- inbound automatic call distribution;

- call blending between inbound and outbound activity;

- voice mail and auto attendant applications;

- text-to-speech capabilities;

- Web-based text chatting;

- fax on demand;

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- interactive voice response; and

- rapid application development.

The open architecture design of our Stratasoft products allows for
integration with the customer's existing systems and software applications, thus
minimizing implementation expenses. Stratasoft's products have been awarded
numerous awards by industry trade journals, including Call Centers Editors
Choice Award for 1998, Call Center Solutions Product of the Year Award for 1998,
Customer Interaction Solutions Product of the Year Award for both 2001 and for
2002, and Communications Solutions Product of the Year Award for 2002. Recently,
Technology Marketing Corporation's TMC Labs presented Stratasoft its Innovation
Award for 2003.

Stratasoft's products are currently being used primarily to operate call
centers internationally, including centers in the United States, Canada, the
United Kingdom, Germany, Greece, India, Egypt, the Philippines and Granada.

CONVERGENCE SOFTWARE RESEARCH AND DEVELOPMENT

We intend to use our computer telephony software development expertise to
create and market new software products that augment and enhance Cisco-centric
IP telephony solutions. We believe that IP telephony and convergence will create
an environment where there will be an opportunity to create new software
applications to integrate voice, video and data into a customer's business
process and traditional business applications in ways that could not have been
possible before. These software applications are often called "convergence
applications." We believe our extensive experience in developing and marketing
complex computer telephony software applications positions us to take advantage
of this opportunity.

REMOTE INFORMATION TECHNOLOGY MANAGEMENT

Through Valerent we offer a variety of services related to cost reduction
and performance improvement of information technology through Internet-based
remote service and support of that technology. These services include the
following:

- remote end user and server management;

- data and network management; and

- security and internet services.

CUSTOMERS

We had no single customer that represented 10% or more of our total
continuing revenue during the years ended December 31, 2001, 2002 or 2003. In
2001, however, end-user customers that purchased our Stratasoft software through
a single reseller of our computer telephony software products collectively
represented 10% of our total consolidated revenue in 2001.

IP TELEPHONY AND NETWORK INFRASTRUCTURE

Customers for our Cisco-centric IP telephony and other network solutions
are typically large corporate organizations, schools and governmental agencies
that use large network infrastructures, a majority of which are located, or make
significant network infrastructure decisions in Texas. They include private
enterprises in various industries such as healthcare, legal, banking, energy and
utilities, hospitality, transportation, manufacturing and entertainment. In
addition to its direct sales model, INX also provides technical consulting and
project management services as a subcontractor for companies such as EDS, IBM
and Sprint. Although our customers are generally based in Texas, we have
performed work at their locations in other parts of the United States and, on
occasion, internationally.

During 2003, we performed an increasing amount of business with educational
and governmental customers, including schools that receive funding for network
infrastructure under a federal program,

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commonly referred to as the "e-Rate" program. These customers typically pay more
slowly than our commercial customers, and to the extent a greater portion of our
revenue is derived from these customers, our business cycle and collections
cycle are extended and our working capital requirements are increased, relative
to revenue.

COMPUTER TELEPHONY SOFTWARE

Customers for our computer telephony software are typically contact centers
or companies or organizations that operate contact centers, including political
and non-profit organizations. Most of our customers have historically been
located in the United States, but we have increasingly sold and installed call
center systems internationally. In 2001, 2002 and 2003, approximately 42.9%,
28.2% and 42.2%, respectively, of Stratasoft's revenue and 13.2%, 4.4% and 5.1%,
respectively, of our consolidated revenue, were with customers outside the
United States, including customers in India, Egypt, the United Kingdom, Canada,
Japan, Germany, Greece and the Philippines.

We believe that Stratasoft's typical customers may change in the future due
to changes in the contact industry that are occurring as a result of the
"National Do Not Call" legislation. This may occur because the new legislation
created unintended incentives for large companies or organizations that have
large numbers of customers to enter the contact center industry. We believe the
new legislation created these incentives because the new legislation permits
companies to contact their own customers for the purpose of marketing. If this
trend develops as we expect, our typical customer could become a larger
enterprise rather than a smaller contact center business.

REMOTE INFORMATION TECHNOLOGY MANAGEMENT

Customers for our remote information technology management consist
primarily of commercial businesses as well as state and local governmental
organizations, primarily in Houston and Dallas.

SALES AND MARKETING

We market our products and services primarily through sales personnel,
including account managers and customer service representatives. These sales
personnel are partially compensated, and in some cases are solely compensated,
on either the revenue or the profitability of sales that they participate in
developing. In addition, Stratasoft markets its computer telephony software
applications through a network of value added resellers, which often integrate
their products and services with Stratasoft's software products. We also promote
our products and services through general and trade advertising, and
participation in trade shows. INX's sales organization works closely with the
Cisco sales organization to identify opportunities for IP telephony and network
infrastructure solutions.

Potential customers for our IP telephony and network infrastructure
business, particularly governmental and educational customers, sometimes specify
that bid and performance bonds must be provided in order to be considered for
the award of their projects, particularly in the case of larger projects. We
have been unable to obtain bid bonds or performance bonds requested by potential
customers in connection with some large potential transactions. In some cases,
we have lost business because of this. In other cases, we were able to obtain
only a smaller portion of the overall project by acting as a subcontractor, to a
larger, better financed organization that was able to obtain the necessary
bonding.

Our difficulty in obtaining bonds is caused principally by two factors. The
first is that we have not been financially capable of providing a bonding
company with the necessary collateral to issue bonds on larger projects. We
believe that the proceeds of this offering will partially alleviate, but not
eliminate entirely, this problem, provided that our financial condition does not
deteriorate.

We have also had difficulty establishing a relationship with bonding
companies because we believe there are fewer bonding companies today than there
were in the past and that the current bonding companies prefer to bond only
their larger, existing customers.

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SUPPLY AND DISTRIBUTION

We purchase equipment that is sold in conjunction with Stratasoft's
software products and by INX as part of network infrastructure and/or IP
telephony solutions. INX purchases the majority of the Cisco products that it
resells directly from Cisco. We also purchase some of our products through
various distribution channels when product is not available directly from Cisco.
In addition, Valerent and INX purchase or exchange service parts typically with
the product manufacturer or its authorized parts distributor. Also, Stratasoft
sometimes uses resellers to distribute its software products. We attempt to keep
minimal inventory on hand and attempt to purchase inventory only as needed to
fulfill orders.

COMPETITION

The market for communications systems, including network infrastructure, IP
telephony solutions and computer telephony software for contact centers, is
evolving rapidly, highly competitive and subject to rapid technological change.
Many of our competitors are substantially larger than we are and have
significantly greater financial, sales, marketing, technical and other
resources. We expect to face increasing competitive pressures from both current
and future competitors in the markets we serve. Our competition varies by
business segment.

For Cisco-centric IP telephony solutions and network infrastructure
solutions, we compete with large, well established Cisco equipment integrators
and solution providers, including most of the major national and international
solution providers such as EDS, IBM, SBC and others. Our competition for IP
telephony and network infrastructure solutions is highly fragmented, and we
compete with numerous large and small competitors.

With regard to our computer telephony software applications for contact
centers, we compete primarily with manufacturers of specialized contact center
systems, such as Avaya Inc., Concerto Software, Inc., Interactive Intelligence,
Inc., and others. If we are successful in developing other software applications
to augment and enhance Cisco-centric IP telephony solutions, we expect to face
competition from numerous early stage companies focused in this area as well as
many large, well-established software companies and telephone systems
manufacturers.

For our remote managed services business, we compete with numerous large,
well established IT services and support organizations, large IT equipment
manufacturers, and numerous smaller IT services and support organizations.

We believe that the principal competitive factor in all segments of our
business is price. Other important factors include technical competence, the
perception of the customer regarding our financial and operational ability to
manage a project, and the quality of our relationship with Cisco. In our
computer telephony software business, the array of features offered by our
software products as compared to those of our competitors is also an important
competitive factor. Additionally, the IP telephony products we offer compete
with hybrid systems.

MANAGEMENT INFORMATION SYSTEMS

We use an internally developed, highly customized management information
system ("MIS") to manage most aspects of our business. All of our subsidiaries
use our MIS, which is customized to their specific needs. We use our MIS to
manage accounts payable, accounts receivable and collections, general ledger,
sales order processing, purchasing, service contracts, service calls and work
orders, engineer and technician scheduling and time tracking, service parts
acquisition and manufacturer warranties, and project management. Reporting can
be generated for project profitability, contract and customer analysis, parts
and inventory tracking and employee time tracking. The system provides for
separate company accounting and also for consolidation of all subsidiary company
financial information.

9

EMPLOYEES

At February 27, 2004 we employed approximately 189 people. Of these,
approximately 54 were employed in sales, marketing and customer service; 87 were
employed in engineering and technical positions; and 48 were employed in
administration, finance and MIS. Our management, sales management and sales
staff work closely with Cisco representatives to plan and execute sales and
marketing strategies. We believe that our ability to recruit and retain highly
skilled and experienced technical, sales and management personnel has been, and
will continue to be, critical to our ability to execute our business plans. None
of our employees are represented by a labor union nor are any subject to a
collective bargaining agreement. We believe that our relations with our
employees are good.

HISTORY

We started business as a computer reseller and service provider in 1983. We
added a traditional PBX telephone systems business unit in 1994 and founded
Stratasoft in 1995. We conducted an initial public offering and became a public
company in 1997. By 1999, we had grown to over $200 million in revenue,
operating from five offices in Texas, with over 500 employees.

In 2000, we sold both our computer products reselling business and our
traditional PBX telephone systems business, which together accounted for
approximately 90% of our total revenue at that time, and reposition our company
to take advantage of what we then believed would become a significant
opportunity in the area of converged communications using network
infrastructure. We closed the sale of these two business units by mid-2000 and
started the process of building our current Cisco-centric network infrastructure
solutions organization with a significant focus on IP telephony technology in
the enterprise market.

GENERAL INFORMATION

Our corporate headquarters are located at 6401 Southwest Freeway, Houston,
Texas 77074, and our telephone number is (713) 795-2000. Our annual report on
Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K and
all amendments to those reports are available without charge from us on our
website at http://www.I-Sector.com, as soon as reasonably practicable following
the time they are filed with or furnished to the SEC. Information on our website
is not part of this document.

RISKS RELATED TO OUR BUSINESS

WE HAVE A HISTORY OF LOSSES AND MAY CONTINUE TO INCUR LOSSES.

We have incurred a net loss in each fiscal year since 1998. As of December
31, 2003, our accumulated deficit was $3.2 million. Our loss in 2003 was $1.8
million, and we cannot assure you when we will be profitable, if at all. In
order to achieve profitability, we will have to improve operating margins. Those
improvements could result from increases in revenue without comparable increases
in expense, from changes in the mix of product and services we sell favoring
higher margin services, or from other factors. Although our revenues from 2003
increased by approximately 47.9% from 2002, our operating margins did not
improve significantly in 2003, and we cannot assure you that they will do so in
the future. Whether we are able to be profitable in the future will depend on
many factors, but primarily upon the commercial acceptance of IP telephony
products and services, specifically those developed and marketed by Cisco.

OUR SUCCESS DEPENDS LARGELY ON THE MAINTENANCE OF OUR RELATIONSHIP WITH CISCO.

Approximately 80.4% of our revenue for the year ended December 31, 2003 was
derived from the sale of Cisco products, network products and related services.
We anticipate that these products and related services will account for a
significant portion of our revenue for the foreseeable future. We have a
contract with Cisco to purchase the products that we resell, and we purchase
substantially all of our Cisco products directly from Cisco. Cisco can terminate
this agreement on relatively short notice. Cisco has designated us an authorized
reseller, and we receive certain benefits from this designation, including
special pricing and payment terms. We have in the past, and may in the future,
purchase Cisco-centric products from other sources. When we

10

purchase Cisco-centric products from sources other than Cisco, the prices are
typically higher and the payment terms are not as favorable. Accordingly, if we
are unable to purchase directly from Cisco, maintain our status as an authorized
reseller of Cisco network products and expand our relationship with Cisco, our
business could be significantly harmed. If we are unable to purchase Cisco
products from other sources on terms that we feel are commercially reasonable,
our business would be harmed and our operating results and financial condition
would be materially and adversely affected.

OUR SUCCESS DEPENDS ON BROAD MARKET ACCEPTANCE OF IP TELEPHONY.

The market for IP telephony products and services has begun to develop only
recently and is characterized by rapid technological change, evolving industry
standards and strong customer demand for new products, applications and
services. As is typical of a new and rapidly evolving industry, the demand for,
and market acceptance of, recently introduced IP telephony products and services
are highly uncertain. We cannot assure you that the use of IP telephony will
become widespread. The commercial acceptance of IP telephony products, including
Cisco-centric products, may be affected by a number of factors including:

- quality of infrastructure;

- security concerns;

- equipment, software or other technology failures;

- government regulation;

- inconsistent quality of service;

- poor voice quality over IP networks; and

- lack of availability of cost-effective, high-speed network capacity.

If the market for IP telephony fails to develop, develops more slowly than
we anticipate, or if IP telephony products fail to achieve market acceptance,
our business could be adversely affected.

ALTHOUGH OUR SUCCESS IS GENERALLY DEPENDENT ON THE MARKET ACCEPTANCE OF IP
TELEPHONY, OUR SUCCESS ALSO DEPENDS UPON A BROAD MARKET ACCEPTANCE OF
CISCO-CENTRIC IP TELEPHONY.

We cannot assure you that the Cisco-centric IP telephony products we offer
will obtain market acceptance. Competition, technological advances and other
factors could reduce demand for, or market acceptance of, the Cisco-centric IP
telephony products and services we offer. In addition, new products,
applications or services may be developed that are better adapted to changing
technology or customer demands and that could render our Cisco-centric products
and services unmarketable or obsolete. To compete successfully, the
Cisco-centric IP telephony products we offer must achieve broad market
acceptance and we must continually enhance our related software and customer
services in a timely and cost-effective manner. If the Cisco-centric IP
telephony products we offer fail to achieve broad market acceptance, or if we do
not adapt our existing services to customer demands or evolving industry
standards, our business, financial condition and results of operation could be
significantly harmed.

OUR BUSINESS DEPENDS ON THE LEVEL OF CAPITAL SPENDING BY ENTERPRISES FOR
COMMUNICATIONS PRODUCTS AND SERVICES.

As a supplier of IP telephony products, applications and services for
enterprises, our business depends on the level of capital spending for
communications products and services by enterprises in our markets. We believe
that an enterprise's investment in communications systems and related products
and services depends largely on general economic conditions that can vary
significantly as a result of changing conditions in the economy as a whole. The
market for communications products and services may continue to grow at a modest
rate or not at all. If the level of spending by our customers on communications
systems and related products and services decreases, our revenue and operating
results may be adversely affected.

11

A MAJORITY OF OUR CUSTOMERS ARE BASED IN TEXAS.

We offer our IP telephony products and services primarily to businesses in
Texas. Because a majority of the enterprises that we offer our IP telephony
products to are geographically concentrated in Texas, our customers' level of
spending on communication products may be affected by economic condition in
Texas, in addition to general economic conditions in the United States. If
demand for IP telephony products by enterprises decreases our business,
financial condition and results of operations could be significantly harmed.

OUR STRATEGY CONTEMPLATES RAPID GEOGRAPHIC EXPANSION, WHICH WE MAY BE UNABLE
TO ACHIEVE, AND WHICH IS SUBJECT TO NUMEROUS UNCERTAINTIES.

A component of our strategy is to become one of the leading national
providers of Cisco-centric IP telephony products. To achieve this objective, we
must either acquire existing businesses or hire qualified personnel in various
locations throughout the country, fund a rapid increase in operations and
implement corporate governance and management systems that will enable us to
function efficiently on a national basis. Identifying and acquiring existing
businesses is a time-consuming process and is subject to numerous risks.
Qualified personnel are in demand, and we expect the demand to increase as the
market for IP telephony grows. We will also likely face competition from our
existing competitors and from local and regional competitors in the markets we
attempt to enter. A rapid expansion in the size and geographical scope of our
business is likely to introduce management challenges that may be difficult to
overcome. We cannot assure you that we will be successful in expanding our
operations beyond Texas or achieving our goal of becoming a national provider.
An unsuccessful expansion effort would consume capital and human resources
without achieving the desired benefit and would have an adverse affect on our
business.

WE MAY REQUIRE ADDITIONAL FINANCING TO ACHIEVE EXPANSION OF OUR BUSINESS
OPERATIONS, AND FAILURE TO OBTAIN FINANCING MAY PREVENT US FROM CARRYING OUT
OUR BUSINESS PLAN.

We may need additional capital to grow our business. Our business plan
calls for the expansion of sales of our IP telephony products to enterprises in
geographical markets where we currently do not operate. If we do not have
adequate capital or are not able to raise the capital to fund our business
objectives, we may have to delay the implementation of our business plan. We can
provide no assurance that we will be able to find financing if required. Our
ability to obtain additional financing would be subject to a number of factors,
including general market conditions, investor acceptance of our business plan
and investor sentiment. These factors may affect the timing, amount, terms or
conditions of additional financing available to us.

WE MAY BE UNABLE TO ACHIEVE OR MANAGE OUR GROWTH EFFECTIVELY, WHICH MAY HARM
OUR BUSINESS.

The ability to operate our business in a rapidly evolving market requires
effective planning and management. Our efforts to grow have placed, and are
expected to continue to place, a significant strain on our personnel, management
systems, infrastructure and other resources. Our ability to manage future growth
effectively will require us to successfully attract, train, motivate and manage
new employees, integrate new employees into our operations and continue to
improve our operational, financial and management controls and procedures. If we
are unable to implement adequate controls or integrate new employees into our
business in an efficient and timely manner, our operations could be adversely
affected and our growth could be impaired.

OUR OPERATING RESULTS HAVE HISTORICALLY BEEN VOLATILE, AND MAY CONTINUE TO BE
VOLATILE, PARTICULARLY FROM QUARTER TO QUARTER.

Our revenue for the third quarter of 2003 increased by approximately 32%
from the second quarter, and it increased over 81% from the third quarter of
2002. Our revenue for the fourth quarter of 2003 decreased by approximately 27%
from the third quarter of 2003, but increased over 39% from the fourth quarter
of 2002. Our quarterly operating results have historically depended on, and may
fluctuate in the future as a result of, many factors including:

- volume and timing of orders received during the quarter;
12

- amount and timing of supplier incentives received in any particular
quarter, which can vary substantially;

- gross margin fluctuations associated with the mix of products sold;

- general economic conditions;

- patterns of capital spending by enterprises for communications products;

- the timing of new product announcements and releases;

- pricing pressures;

- the cost and effect of acquisitions;

- the amount and timing of sales incentives we may receive from our
suppliers, particularly Cisco; and

- the availability and cost of products and components from our suppliers.

As a result of these and other factors, we have historically experienced,
and may continue to experience, fluctuations in sales and operating results. In
addition, it is possible that in the future our operating results may fall below
the expectations of analysts and investors, and as a result, the price of our
securities may fall.

ANTICIPATED ISSUANCES OF INX COMMON STOCK TO EMPLOYEES AND OTHERS WILL
MATERIALLY REDUCE OUR INTEREST IN INX AND WILL MATERIALLY AFFECT OUR FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.

INX is obligated to issue shares of INX common stock representing up to an
approximate 31.6% post-issuance interest in INX to certain employees upon
vesting and exercise of options and to others upon the fulfillment of certain
conditions that we expect will be fulfilled. We expect that many of the INX
options may be considered to be in the money, based on the relatively low
exercise price of the options. We also expect that the other outstanding INX
options may become in the money assuming that our expectations for INX's
business growth are met. It is not a certainty, however, that all of the INX
Options will be exercised because the stock of INX is not publicly traded and is
therefore relatively illiquid and because vesting of some of the options may not
occur. If INX issues common stock in satisfaction of the INX options and INX's
other obligations to issue INX stock, those issuances will materially reduce our
ownership interest in INX and will materially reduce our participation in any
earnings that INX may produce. The possible effect of these issuances on our
financial condition and results of operations is more fully discussed in "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Future Minority Interest in INX."

THE EXISTENCE OF A MINORITY INTEREST IN INX MAY LIMIT OUR MANAGEMENT
FLEXIBILITY, SUBJECT US TO LITIGATION AND OTHERWISE INCREASE OUR COSTS.

The existence of a minority interest in INX will create potential conflict
of interest issues between I-Sector and the INX minority stockholders. Such
conflicts of interest may arise in connection with intercompany financing or
other transactions, INX dividend payments, allocation of business or combined
company resources among the various subsidiaries, or other reasons. The need to
respond appropriately to actual and potential conflict of interest situations
can be expected to reduce management flexibility and increase the time and cost
required to engage in transactions in which such conflicts arise. If the INX
minority stockholders disagree with I-Sector's resolution of any conflict issue,
they could bring a lawsuit against I-Sector that could be costly and
time-consuming and could further limit management's flexibility. Any such events
could materially and adversely affect I-Sector's financial condition and results
of operations.

WE MAY, IN THE FUTURE, ELECT TO EXCHANGE MINORITY SHARES IN INX OR INX OPTIONS
FOR I-SECTOR STOCK OR OPTIONS, WHICH MAY RESULT IN MATERIAL DILUTION TO
I-SECTOR STOCKHOLDERS.

To resolve the conflict of interest issues described above and to provide
liquidity to the INX minority stockholders, I-Sector and the INX minority
stockholders may, in the future, agree to exchange the minority INX stock or
options for I-Sector stock, stock options, cash or any combination of those.
I-Sector
13

management has discussed the possibility of such an exchange with Mark Hilz, who
is the President and Chief Operating Officer of I-Sector, the President of INX,
and the largest holder of INX options. No specific proposal has been made or
agreed to with respect to any such future exchange.

If a future exchange transaction does occur, the value of the consideration
for the INX minority stock and stock options would be determined by negotiations
between a committee of I-Sector's board of directors (the "Board"), composed of
disinterested, independent members of the Board and the principal INX minority
stockholders and option holders. We cannot predict the outcome of those future
negotiations, if any, and thus cannot predict the financial impact on us or our
stockholders of any future exchange transaction. We expect, however, that any
such negotiations would involve negotiating the value at the time of the
exchange, of INX and, in the case of consideration in the form of I-Sector
equity, the negotiated value at the time of the exchange of I-Sector equity
securities. Because INX's financial significance to us is currently high, and we
expect it to remain so, any future exchange transaction could result in
significant dilution to existing I-Sector stockholders.

IF IN THE FUTURE WE EXCHANGE OR CONVERT INX STOCK OR INX OPTIONS FOR I-SECTOR
STOCK OR STOCK OPTIONS, WE COULD BE REQUIRED TO RECORD SUBSTANTIAL NON-CASH
EXPENSES IN CONNECTION WITH THE TRANSACTION, THE AMOUNT OF WHICH WE CANNOT
QUANTIFY.

If we choose to exchange or convert INX stock or INX options into I-Sector
stock or stock options, we may be required by generally accepted accounting
principles to record substantial non-cash expenses. We are not now able to
determine the amount or timing of any such charges. This is because those
charges would largely depend upon the timing and terms on which any future
exchange or conversion would occur, particularly the exchange or conversion
ratio used. Based on the presently high financial significance to us of INX
relative to our other business segments, and our expectation that its
significance to us will remain high, we believe that any resulting non-cash
expense charges could be substantial. Any such future non-cash expenses charges
could materially and adversely affect our financial results of operations.

WE HAVE MANY COMPETITORS AND EXPECT NEW COMPETITORS TO ENTER OUR MARKET, WHICH
COULD INCREASE PRICE COMPETITION AND MAY AFFECT THE AMOUNT OF BUSINESS
AVAILABLE TO US AND THE PRICES THAT WE CAN CHARGE FOR OUR PRODUCTS AND
SERVICES.

The markets for our IP telephony products and services are extremely
competitive and subject to rapid change. Substantial growth in demand for IP
telephony solutions has been predicted, and we expect competition to increase as
existing competitors enhance and expand their products and services and as new
participants enter the IP telephony market. IP telephony involves the
application of traditional computer-based technology to voice communication, and
the hardware component of the solution is readily available. Accordingly, there
are relatively few barriers to entry to companies with computer and network
experience. A rapid increase in competition could negatively affect the amount
of business that we get and the prices that we can charge.

Additionally, many of our competitors and potential competitors have
substantially greater financial resources, customer support, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships than we do. We cannot be
sure that we will have the resources or expertise to compete successfully.
Compared to us, our competitors may be able to:

- develop and expand their products and services more quickly;

- adapt faster to new or emerging technologies and changing customer needs;

- take advantage of acquisitions and other opportunities more readily;

- negotiate more favorable agreements with vendors;

- devote greater resources to marketing and selling their products; and

- address customer service issues more effectively.

14

Some of our competitors may also be able to increase their market share by
providing customers with additional benefits or by reducing their prices. We
cannot be sure that we will be able to match price reductions by our
competitors. In addition, our competitors may form strategic relationships with
each other to better compete with us. These relationships may take the form of
strategic investments, joint-marketing agreements, licenses or other contractual
arrangements that could increase our competitors' ability to serve customers.

BUSINESS ACQUISITIONS, DISPOSITIONS OR JOINT VENTURES ENTAIL NUMEROUS RISKS
AND MAY DISRUPT OUR BUSINESS, DILUTE SHAREHOLDER VALUE OR DISTRACT MANAGEMENT
ATTENTION.

As part of our business strategy, we plan to consider acquisitions of, or
significant investments in, businesses that offer products, services and
technologies complementary to ours. Any acquisition could materially adversely
affect our operating results and/or the price of our securities. Acquisitions
involve numerous risks, some of which we have experienced and may continue to
experience, including:

- unanticipated costs and liabilities;

- difficulty of integrating the operations, products and personnel of the
acquired business;

- difficulties in managing the financial and strategic position of acquired
or developed products, services and technologies;

- difficulties in maintaining customer relationships, in particular when a
substantial portion of the target's sales were derived from products that
compete with products that we currently offer;

- the diversion of management's attention from the core business;

- inability to maintain uniform standards, controls, policies and
procedures; and

- damage to relationships with acquired employees and customers as a result
of integration of the acquired business.

Finally, to the extent that shares of our common stock or rights to
purchase common stock are issued in connection with any future acquisitions,
dilution to our existing stockholders will result and our earnings per share may
suffer. Any future acquisitions may not generate additional revenue or provide
any benefit to our business, and we may not achieve a satisfactory return on our
investment in any acquired businesses.

OUR INTERNATIONAL OPERATIONS, WHICH WE PLAN TO EXPAND, WILL SUBJECT US TO
ADDITIONAL RISKS THAT MAY ADVERSELY AFFECT OUR OPERATING RESULTS DUE TO
INCREASED COSTS.

Our revenue generated outside the United States, as a percentage of our
total revenue, was 4.4% and 5.1% for the years ended December 31, 2002 and 2003,
respectively. We intend to continue to pursue international opportunities.
Pursuit of international opportunities may require us to make significant
investments for an extended period before returns on such investments, if any,
are realized. International operations are subject to a number of risks and
potential costs, including:

- unexpected changes in regulatory requirements and telecommunication
standards;

- tariffs and other trade barriers;

- exchange controls or other currency restrictions;

- difficulty in collecting receivables;

- difficulty in staffing and managing foreign operations;

- the need to customize marketing and products;

- inadequate protection of intellectual property in countries outside the
United States;

15

- adverse tax consequences; and

- political and economic instability.

Any of these factors could prevent us from increasing our revenue and
otherwise adversely affect our operating results. We may not be able to overcome
some of these barriers and may incur significant costs in addressing others.

IF WE LOSE KEY PERSONNEL WE MAY NOT BE ABLE TO ACHIEVE OUR OBJECTIVES.

We are dependent on the continued efforts of our senior management team,
including our Chairman and Chief Executive Officer, James H. Long, and our
President and Chief Operating Officer, Mark T. Hilz. If for any reason, our
senior executives do not continue to be active in management; our business,
financial condition or results of operations could be adversely affected. We
cannot assure you that we will be able to continue to retain our senior
executives or other personnel necessary for the development of our business.

WE MAY NOT BE ABLE TO HIRE AND RETAIN HIGHLY SKILLED TECHNICAL EMPLOYEES,
WHICH COULD AFFECT OUR ABILITY TO COMPETE EFFECTIVELY AND COULD ADVERSELY
AFFECT OUR OPERATING RESULTS.

We depend on highly skilled technical personnel to research and develop and
to market and service our products. To succeed, we must hire and retain
employees who are highly skilled in rapidly changing communications
technologies. In particular, as we implement our strategy of focusing on IP
telephony, we will need to:

- hire more employees with experience developing and providing advanced
communications products and services;

- retrain our current personnel to sell IP telephony products and services;
and

- retain personnel to service our products.

Individuals who can perform the services we need to provide our products
and services are scarce. Because the competition for qualified employees in our
industry is intense, hiring and retaining qualified employees is both
time-consuming and expensive. We may not be able to hire enough qualified
personnel to meet our needs as our business grows or to retain the employees we
currently have. Our inability to hire and retain the individuals we need could
hinder our ability to sell our existing products, systems, software or services
or to develop and sell new ones. If we are not able to attract and retain
qualified employees, we will not be able to successfully implement our business
plan and our business will be harmed.

IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, OUR BUSINESS MAY
BE HARMED.

Although we attempt to protect our intellectual property through patents,
trademarks, trade secrets, copyrights, confidentiality and non-disclosure
agreements and other measures, intellectual property is difficult to protect and
these measures may not provide adequate protection. Patent filings by third
parties, whether made before or after the date of our patent filings, could
render our intellectual property less valuable. Competitors may misappropriate
our intellectual property, disputes as to ownership of intellectual property may
arise and our intellectual property may otherwise become known or independently
developed by competitors. The failure to protect our intellectual property could
seriously harm our business because we believe that developing new products and
technology that are unique to us is important to our success. If we do not
obtain sufficient international protection for our intellectual property, our
competitiveness in international markets could be significantly impaired, which
would limit our growth and future revenue.

WE MAY BE FOUND TO INFRINGE ON THIRD-PARTY INTELLECTUAL PROPERTY RIGHTS.

Third parties have in the past and may in the future assert claims or
initiate litigation related to their patent, copyright, trademark and other
intellectual property rights in technology that is important to us. The asserted
claims and/or litigation could include claims against us or our suppliers
alleging infringement of intellectual property rights with respect to our
products or components of those products. Regardless of the
16

merit of the claims, they could be time consuming, result in costly litigation
and diversion of technical and management personnel, or require us to develop a
non-infringing technology or enter into license agreements. There can be no
assurance that licenses will be available on acceptable terms, if at all.
Furthermore, because of the potential for high court awards, which are not
necessarily predictable, it is not unusual to find even arguably unmeritorious
claims resulting in large settlements. If any infringement or other intellectual
property claim made against us by any third party is successful, or if we fail
to develop non-infringing technology or license the proprietary rights on
commercially reasonable terms and conditions, our business, operating results
and financial condition could be materially adversely affected.

COSTS OF COMPLIANCE WITH THE SARBANES-OXLEY ACT OF 2002 AND THE RELATED SEC
REGULATIONS MAY HARM OUR RESULTS OF OPERATIONS.

The Sarbanes-Oxley Act of 2002 requires heightened financial disclosure and
corporate governance for all publicly traded companies. Although costs of
compliance with the Sarbanes-Oxley Act are uncertain due to several factors, we
expect that our general and administrative expenses will increase. Furthermore,
the American Stock Exchange has adopted amendments to its listing standards that
will impose additional corporate governance requirements. We are a "controlled
company" and are only required to comply with certain of the American Stock
Exchange's recently adopted corporate governance requirements. We may not always
qualify as a "controlled company." If we cease to qualify as a "controlled
company," we will have to comply with all of the American Stock Exchange's
corporate governance requirements, which may cause us to incur additional
expense. Although we expect to comply with these corporate governance listing
requirements, if we are unable to comply in a timely manner, we may incur
penalties or fines, and our securities may be delisted from the American Stock
Exchange, which could limit our ability to access the capital markets, having a
negative impact on our financial condition and results of operations.

ITEM 2. PROPERTIES

We do not own any real property and currently lease all of our existing
facilities. We lease our Houston office that is housed in a freestanding
building of approximately 48,000 square feet. On November 30, 1999, the building
was acquired by a corporation owned by our Chairman and Chief Executive Officer.
A new lease at reduced rental rates was signed on February 1, 2002, which
expires on January 31, 2007. Our Dallas office is a space of approximately 8,960
square feet. The Dallas facility lease term began July 2000 and expired in July
2003 and is currently leased on a month-to-month basis. Our Austin office is a
space of approximately 2,845 square feet. The Austin facility lease was acquired
in conjunction with our acquisition of Digital Precision in April 2003 and
expires October 31, 2006.

ITEM 3. LEGAL PROCEEDINGS

We are party to litigation and claims that management believes are normal
in the course of our operations; while the results of such litigation and claims
cannot be predicted with certainty, we believe the final outcome of such matters
will not have a material adverse effect on our results of operations or
financial position.

In August 2002, Inacom Corp. filed a lawsuit in the District Court of
Douglas County, Nebraska styled Inacom Corp. v. I-Sector Corporation, f/k/a
Allstar Systems, Inc., claiming that we owed the sum of approximately $570,000
to Inacom Corp. ("Inacom") as a result of Inacom's termination of a Vendor
Purchase Agreement between Inacom and us. We believe that the lawsuit is without
merit, and we intend to vigorously contest it.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders, through the
solicitation of proxies or otherwise during the fourth quarter of the fiscal
year covered by this report.

17

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

PRICE RANGE FOR COMMON STOCK

On Monday, December 29, 2003, we listed our common stock on the American
Stock Exchange under the ticker symbol ISR. Prior to December 29, 2003 and since
the change of the corporate name on July 11, 2000, our common stock was traded
on the NASDAQ Small Cap Market under the symbol "ISEC." Prior to July 11, 2000,
our shares traded under the symbol "ALLS." Below are ranges of the stock trading
price:

As of March 10, 2004, we had 38 stockholders of record. On March 11, 2004,
the closing sales price of our common stock as reported by the American Stock
Exchange was $12.65 per share.

DIVIDEND POLICY

We have never declared or paid any cash dividends on our common stock and
do not anticipate declaring or paying dividends on our common stock in the
foreseeable future. Any future determination as to the payment of dividends will
be made at the discretion of the Board and will depend on our operating results,
financial condition, capital requirements, general business conditions and such
other factors as the Board deems relevant.

18

ITEM 6. SELECTED FINANCIAL DATA

The following sets forth the selected data of the company for the five
years ended December 31, 2003.

(continued on following page)

19

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Please read the following discussion of our financial condition and results
of operations together with "Item 6. Selected Financial Data" and our
consolidated financial statements and the notes to those statements included
elsewhere in this report. The following discussion and analysis contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from those anticipated in these forward-looking
statements as a result of certain factors, including, but not limited to, those
set forth under "Item 1. Business -- Risks Related to Our Business" and
elsewhere in this report.

GENERAL

We are a leading regional provider of network infrastructure and IP
telephony solutions including related implementation and support services. The
IP telephony industry is characterized by rapidly evolving and competing
technologies. Our three principal offices are located in Texas, and we primarily
market to potential customers headquartered in, or making purchasing decisions
from, Texas. Our long-term goal, however, is to become one of the leading
national providers of Cisco-centric network and IP telephony solutions to
enterprises.

We begin Management's Discussion and Analysis of Financial Condition and
Results of Operations with an overview of our strategies for achieving this goal
and becoming profitable. From a financial perspective, these operating
strategies have a number of important implications for our results of operations
and financial condition.

STRATEGY

We plan to become profitable in 2004 by implementing the strategies
discussed below. We believe that our strategies will allow us to continue to
increase total revenues in 2004. Importantly, we also believe our strategies
will enable us to improve our gross profit in 2004 by improving our gross
margins on INX revenue. At the same time, we will seek to contain the relatively
fixed components of our selling, general and administrative expenses so that
those components become a relatively smaller percentage of total revenues.
Although selling expenses can generally be expected to increase as our revenues
increase, we believe that if we are successful in implementing our strategies,
many general and administrative expenses (such as management salaries,
administrative wages and professional expenses) will decrease as a percentage of
our total revenues.

Our key operating strategies are as follows:

- seeking larger, full-scale IP telephony implementation projects, as
opposed to smaller pilot projects;

- increasing the gross revenues from our higher gross margin operations,
such as INX services and Stratasoft custom projects, as opposed to
product sales, which typically produce lower gross margins;

- aligning ourselves with Cisco as our exclusive supplier for the network
and IP telephony equipment and technology that we offer;

- expanding geographically by acquiring complementary businesses and by
opening our own offices; and

20

- developing and marketing our own computer telephony software that
operates with and augments Cisco-centric IP telephony products.

If we are successful in obtaining larger, full-scale IP telephony
implementation projects, we expect that our gross revenues from both products
and services will increase because these projects, by their nature, typically
require a substantially higher level of our services and more products than do
smaller projects. Larger projects, however, can strain our financial resources.
For example, a potential customer for a major IP telephony project may require
that we post a bid bond or performance bond in order for us to be awarded the
project. This often occurs on competitive bids. Because of our financial
condition, bonding companies typically require that we provide security to
collateralize the issuance of its bond. We have been financially unable to
provide sufficient collateral in some instances, and as a result have not been
able to obtain the bond. We believe we have occasionally lost business that we
might have otherwise been awarded because we were unable to obtain the bond
required by the potential customer. We compete with larger and better financed
entities that do not face the same difficulties obtaining bonds.

Increases in the size and volume of IP telephony projects we undertake can
also challenge our cash management. For example, larger projects can reduce our
available cash by causing us to carry higher levels of inventory. Larger
projects can also require us to invest our available cash in labor costs. This
is because, in some cases, we do not receive payments from our customers for
extended periods of time. Until they pay us, all the cash we previously invested
in labor and products on the project remains tied up. We expect that greater
amounts of our cash will become invested in accounts receivable in the future if
we are successful in growing our business as we intend.

To meet our cash requirements to support this growth, we expect to rely on
capital provided from our operations and our credit facility, which is
collateralized by our accounts receivable and substantially all of our assets.
We also expect to raise capital through a public offering of our equity
securities.

Although over 75% of our revenue in 2003 was attributable to product sales,
the gross profit margins on sales of our services have been substantially higher
than those for sales of products, with the exception of sales of our proprietary
Stratasoft software products. In 2003, for example, the gross profit margin on
sales of products by INX was 12.4%, while the gross profit margin on sales of
services by INX for that year was 29.6%. We therefore plan to increase revenue
from services, particularly our post-implementation services for IP telephony.
The success of this aspect of our strategy largely depends on our ability to
attract and retain highly skilled and experienced employees.

For the last three years, the largest component of our total cost of sales
and service has been purchases of Cisco-centric IP telephony products by INX.
The majority of those purchases were directly from Cisco. We typically purchase
from various wholesale distributors only when we cannot timely purchase products
directly from Cisco. Our reliance on Cisco as the primary supplier for the
network and IP telephony equipment and technology we offer means that our
results of operations from period to period depend substantially on the terms
that we are able to purchase these products from Cisco and, to a much lesser
extent, from wholesale distributors of Cisco's products. Therefore, our ability
to manage the largest component of our cost of sales and service is very limited
and depends to a large degree on maintaining and growing our relationship with
Cisco. Our cost of products purchased from Cisco can be substantially influenced
by whether Cisco sponsors sales incentive programs and whether we qualify for
the incentives that Cisco offers.

We plan to also grow our business in other geographic areas through
strategic acquisition of similar businesses or by opening our own offices. This
aspect of our strategy can affect our financial condition and results of
operations in many ways. The purchase price for business acquisitions and the
costs of opening offices may require substantial cash and may require us to
incur long-term debt. The expenses of a geographic expansion in an area may well
exceed the revenues attributable to a new business or office for some time, even
if it performs as we expect. Additionally, it is possible that our acquisition
activities may require that we record substantial amounts of goodwill if the
purchase consideration paid for an acquisition exceeds the estimated fair value
of the net identified tangible and intangible assets acquired. To the extent an
acquisition results in goodwill, we will reevaluate the realizability of that
goodwill at least annually and adjust it as appropriate. The resulting
adjustment could result in significant charges to earnings in future periods.
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Developing new or substantially improved computer telephony software
products will likely require us to expend cash and record software development
expenses. Software development costs will likely be expensed as incurred because
we expect to incur substantially all costs prior to achieving technological
feasibility in developing a new or substantially improved software product.

FUTURE MINORITY INTEREST IN INX

Since its formation in 2000, INX has been our wholly-owned subsidiary.
Beginning in April 2004, however, we expect INX will cease to be a wholly-owned
subsidiary as the result of the anticipated issuance of INX common stock to
Digital Precision, which INX acquired in April 2003. In connection with that
acquisition, we agreed to issue to the seller 1.8 million shares of INX common
stock as additional purchase consideration for its business if certain employees
remain employed through April 4, 2004, the first anniversary of the acquisition.
We expect that these conditions will be met and that the INX stock will be
issued in April 2004. When that occurs, we anticipate that our ownership
percentage of INX's common stock then outstanding will decline to approximately
92.4%.

INX has also granted 8,290,692 stock options to employees of INX to acquire
INX common stock pursuant to a stock option plan for INX employees. The exercise
prices for the INX options range from $0.01 to $0.25 with a weighted average of
$0.16. Additionally, the I-Sector Warrant entitles us to acquire an additional
1.2 million shares of INX common stock at an exercise price of $0.25 per share.
We estimate that I-Sector's ownership in INX could be reduced to 69.5%, assuming
that all of the INX options are exercised, we exercise the I-Sector Warrant and
there are no other changes in INX's equity. If the I-Sector Warrant is not
exercised, we estimate that our ownership in INX would be reduced to 68.4%
assuming the INX stock is issued in April 2004 and all INX options are
exercised. The terms of the INX options and the I-Sector Warrant are discussed
further in Note 14 to the Consolidated Financial Statements and in "Executive
Compensation."

While the existence of the unexercised INX options and the contingent
obligation to issue INX stock do not result in a minority interest for
accounting purposes, the actual issuance of INX stock in April 2004 will result
in a minority interest. Because I-Sector will own less than all of INX's stock,
its interest in INX's future profits and losses will be reduced. Under U.S.
generally accepted accounting principles, we expect that I-Sector's consolidated
financial statements will reflect a minority interest adjustment of the
otherwise reportable profits and losses of INX by the percentage of minority
ownership in INX during the period covered by the financial statements.
I-Sector's percentage share of any cash dividends or other distributions paid by
INX to its stockholders will likewise be reduced by the percentage of minority
ownership in INX. Additionally, if the percentage of minority ownership of INX's
stock grows as a result of future exercises of INX options, that increase will
cause a corresponding decrease in the reportable share of INX's profits and
losses included in our consolidated financial statements, and our share of cash
dividends and other distributions from INX.

The following table summarizes the pro forma effect on our consolidated net
loss for 2003 if, as of January 1, 2003, we exercised the I-Sector Warrant, all
INX options were exercised and all the INX shares we expect to issue in
connection with the Digital Precision acquisition were issued:

As a result of the adjustment to net income, our pro forma consolidated balance
sheet would include a liability entitled "Minority Interest" of $559,000 and our
stockholders' equity would be reduced by $559,000.

Unlike the boards of directors of our wholly-owned subsidiaries, the board
of directors of INX will be required to be mindful of the interests of INX's
minority stockholders, in addition to our interests, when considering whether to
approve business and financing transactions involving INX. For example, we may
be

22

unable to cause the assets of INX to be pledged as collateral security for
indebtedness if the proceeds of that indebtedness disproportionately benefit us
or our wholly-owned subsidiaries in relation to INX. Conflicts of interest may
reduce our flexibility in structuring business and financing transactions
beneficial to us and our wholly-owned subsidiaries.

Contributions of capital to INX by us, in the form of stock purchases,
which may be necessary to fund INX's growth, could increase our percentage
ownership of INX but would use capital. Because of the potential minority
interest in INX, we will be required to make capital contributions to INX on a
basis that is, in the good-faith judgment of our board of directors, fair to us
and the holders of the minority interest.

Minority stock ownership in INX could also subject us to lawsuits from its
minority stockholders complaining of our actions with respect to INX and its
minority stockholders, even if the actions complained of are ultimately
determined to have been proper. For example, if we choose to cause INX to merge
with, or sell all or substantially all of its assets to, another entity, the
minority stockholders of INX may bring lawsuits seeking to block the transaction
or seeking to exercise statutory dissenters' rights with respect to the
transaction. Whether or not successful, any such actions would cause us to incur
litigation costs and potentially reduce the benefit of any such transaction to
us.

The stock of INX is not publicly traded. Accordingly, any shares of INX
stock issued, including those issued to the former owners of Digital Precision
upon exercise of INX options, are, and will be for the foreseeable future,
relatively illiquid. For this reason, and to eliminate the other consequences of
having a minority interest in a subsidiary, we believe that in the future we
will offer to exchange INX stock and stock options for common stock or stock
options to acquire our common stock. If we conclude such a transaction, the
aggregate ownership percentage of our common stock by our stockholders
immediately before the conversion or exchange transaction will be reduced by the
percentage of post-transaction ownership acquired by the former minority
stockholders of INX. Their post-transaction ownership may be further reduced by
subsequent exercises of I-Sector stock options that we may choose to exchange
for INX stock options.

We cannot predict the percentage of ownership reduction to our stockholders
that may result from any future exchange or conversion of INX stock and INX
options. The ownership reduction resulting from any such transaction may,
however, be significant. We believe this may be the case principally because:

- we expect that the total number of shares of our common stock that we
would be required to issue in any such transaction would be approximately
equivalent in value, as determined at a future date, to the value of the
INX stock and INX options to be exchanged at the same future date;

- the historical financial effect of INX on our business is significant, as
compared with our other subsidiaries; and

- we expect INX will continue to generate most of our revenue.

If in the future we propose to exchange or convert INX stock and INX
options into I-Sector common stock or options, we intend to appoint a special
committee of our independent directors to negotiate any exchange ratio for the
transaction with the principal INX minority stockholders and option holders. The
facts and circumstances that the special committee may choose to consider and
the relative weights to be accorded them in negotiating the relative values of
our common stock and INX stock and in negotiating the exchange ratio for any
future transaction are matters that we intend to delegate to the discretion of
the special committee. Accordingly, presently we cannot quantify the amount of
any future ownership reduction that our stockholders may experience in an
exchange transaction with INX stockholders and option holders.

Under some circumstances, we may be required by generally accepted
accounting principles to record substantial non-cash expenses if we choose to
exchange INX stock or INX options into our common stock or options. We are not
now able to determine the amount or timing of any such charges. This is because
those matters will largely depend upon the timing and terms on which any future
exchange would occur, particularly the exchange ratio negotiated at the time.
Because most of our revenues in 2003 were generated by INX and our expectation
is that this will continue for the foreseeable future, we believe that any
resulting non-cash

23

charges could be substantial. Any such future non-cash charges could materially
and adversely affect our financial results.

If we determine to undertake a transaction to exchange INX stock or INX
options into our common stock or stock options, we also plan to submit any such
transaction to our stockholders for their approval, even if not required by
Delaware law or the rules of the American Stock Exchange. Even if we believe
that such transaction is in our best interest, our stockholders may refuse to
approve it. If that were to occur, it could disappoint the expectations of those
INX minority stockholders and INX option holders in favor of the transaction,
some of who are currently, and are expected to remain, key employees. This could
cause employee morale and retention problems for us.

RESULTS OF OPERATIONS

OVERVIEW

Sources of Revenue. Our revenue is derived from three segments represented
by our three operating subsidiaries, which are INX, Stratasoft and Valerent.
During the year ended December 31, 2003, INX, Stratasoft and Valerent accounted
for 80.4%, 12.1% and 8.2%, respectively, of total consolidated revenue, and
(0.7)% of subsidiary revenue was eliminated in consolidation due to intercompany
transactions.

INX revenue consists of product and service revenue. Product revenue
consists of reselling Cisco products and limited amounts of complementary
products by other manufacturers. Service revenue is generated by fees from a
variety of implementation and support services. Product prices for INX are set
by the market for Cisco products, and provide our lowest gross margins. Service
revenue for INX has recently provided a higher gross margin that has generally
improved over the past several years as the cost of INX's technical resources,
which are reflected as a cost of service, has decreased as a percentage of
service revenue. Also, certain fixed and flat fee service contracts that extend
over three months or more are accounted for using the percentage of completion
method of accounting.

Historically, the majority of INX's service revenue has been generated from
implementation services, which is project oriented and tends to be volatile as
projects are completed and new projects commence. As the number, frequency and
size of INX projects has grown, INX has achieved better utilization of its
engineering resources resulting in improved services gross margins. The normal
sales cycles for corporate customers typically ranges from three to six months
depending on the nature, scope and size of the deal involved. But our direct
experience with school districts involved in the e-Rate program (a governmental
funding program for schools) indicates that the sales lead time is generally
about six to 12 months. In mid-2003, INX introduced Netsurant, its branded
support service that consists primarily of customer service personnel and a
support center that we believe could further improve overall services gross
margins. Through 2003, Netsurant service revenue was not significant.

Stratasoft revenue consists primarily of custom project revenue from the
sale of proprietary computer-telephony software. Our Stratasoft revenue is
reported as custom project revenue in our financial statements, because it
consists of product and services which cannot be accounted for separately.
Stratasoft has traditionally provided our highest gross margin since it is
primarily sales of our proprietary computer-telephony software. Our cost of
goods sold for Stratasoft's custom project revenue includes the cost of
developing our computer-telephony software products, installation costs, and the
cost of hardware and other equipment bundled with our software applications and
included in a sale to a customer. Stratasoft revenue also includes sales to
resellers. The sales to resellers are recorded when the sale becomes fixed or
determinable; otherwise revenue from resellers is recorded when payments become
due.

Valerent revenue consists of both product revenue and service revenue.
Product revenue consists of reselling primarily software products and, to a
lesser degree, hardware products that facilitate Valerent's managed services,
including remote management software products from Altiris, Inc., and security
software products from Network Associates, Inc. Product sales prices for
Valerent are set by the market for these products, and Valerent's product sales
have typically provided lower gross profit margins than its service revenue.
Valerent's service revenue consists of remote and onsite technical assistance to
its customers.

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Valerent's gross margin on service revenue, much like INX's implementation
service revenue, is subject to variability based upon the utilization of
Valerent's billable technical resources. Recurring service agreements exist with
some customers, but usually with varying terms and conditions that conform to
their year-over-year business changes and specific needs. These agreements
provide predictable and stable sources of revenue, the loss of a recurring
agreement could disrupt the stability of that revenue stream for Valerent.

Gross Profit and Gross Profit Margin. The mix of our various revenue
components, each of which has substantially different gross margin, materially
influences our overall gross profit and gross margin in any particular quarter.
In periods in which service revenue or Stratasoft custom project revenue is
high, as compared to INX and Valerent product sales, our gross margin generally
improves as compared to periods in which we have higher levels of product sales.
Our gross margin for product sales also varies depending on the type of product
sold and the mix of large revenue product contracts, which typically have lower
gross margin, as compared to smaller revenue product contracts, which typically
have a higher gross margin.

In addition, our quarterly gross profit and gross margin can be materially
affected by vendor incentives received in certain quarterly periods, most of
which are Cisco incentives received by INX. The incentive programs sponsored by
Cisco currently enable us to qualify for cash rebates or product pricing
discounts. These incentives are generally earned based on sales volume, sales
growth and, in some cases, customer satisfaction levels. The amounts earned
under these programs are recorded as a reduction of cost of goods and can vary
significantly between periods. Currently, incentives by Cisco are paid
semiannually, and are typically paid in the first and third quarters of each
calendar year. Incentives are recognized when we receive payment from the
supplier or when we have earned and can reasonably estimate the amount due from
the supplier.

Expenses. A significant portion of our cost of services for each of our
service businesses is composed of labor. Labor cost related to permanent
employees is generally fixed in the short-term so that higher levels of service
revenue produce higher gross margins while lower levels of service revenue
produce lower gross margins. Our gross margin on service revenue fluctuates from
period to period depending not only upon the prices charged to customers for our
services, but also upon the level of utilization of our technical staff.
Management of labor cost is therefore important in order to prevent erosion of
gross margin. Our gross margin is also impacted by such factors as contract
size, time and material pricing versus fixed fee pricing, discounting, vendor
incentives and other business and marketing factors normally incurred during the
conduct of business.

Selling, General and Administrative Expenses. Our selling, general and
administrative expenses include both fixed and variable expenses. Relatively
fixed expenses in selling, general and administrative expenses include rent,
utilities, promotion and advertising, and administrative wages. Variable
expenses in selling, general and administrative expenses include sales
commissions and travel, which will usually vary based on our sales and gross
profit. Selling, general and administrative expenses also include expenses which
vary significantly from period to period but not in proportion to sales or gross
profit. These include legal expenses and bad-debt expense both of which vary
based on factors that are difficult to predict.

A significant portion of our selling, general and administrative expenses
relate to personnel costs, some of which are variable and others that are
relatively fixed. Our variable personnel costs consist primarily of sales
commissions. Sales commissions are typically calculated based upon our gross
profit on a particular sales transaction and thus generally fluctuate because of
the size of the deal and the mix of associated products and services with our
overall gross profit. Bad debt expense generally fluctuates somewhat in
proportion to increases or decreases in revenue levels, although not always in
the same periods as increases or decreases in revenue. Legal expense varies
based on legal issue activity, which can vary substantially from period to
period. The remainder of selling, general and administrative expenses are
relatively fixed and do not vary in direct proportion to increases or decreases
in revenue.

Acquisition and Disposition. In the second quarter of 2003, INX acquired
the fixed assets, inventory, intellectual property, customer lists, trademarks,
trade names service marks, contract rights and other intangibles of Digital
Precision. In connection with that acquisition we also assumed leases for
equipment and office space. Our results of operations include those attributable
to Digital Precision on and after April 4, 2003. The purchase price for Digital
Precision was $540,000 in cash and 1.8 million shares of INX common stock
25

that we agreed to issue if certain employees remain employed through April 4,
2004, the first anniversary of the acquisition. We did not recognize goodwill at
the time of the acquisition of Digital Precision, but we may recognize goodwill
in connection with the anticipated issuance of the 1.8 million shares of INX
stock in April 2004.

The sale of our computer reselling and PBX telephone systems reselling
business in early 2000 and the sale of our IT Staffing business in 2001 resulted
in a gain on disposal. Since the sale of these businesses, we have realized, in
various periods, income and expense from discontinued operations that have been
primarily a result of litigation expenses and settlement of litigation related
to our discontinued operations. We expect the income and expense from
discontinued operations to decrease over time and to eventually be eliminated
after these matters are fully resolved.

Tax Loss Carryforward. Because of our operating losses in 2003, we have
accumulated a net operating loss carryforward for federal income tax purposes
that, as of December 31, 2003, was approximately $2.4 million and is available
to offset future federal and state taxable income. This carryforward expires in
2023. In addition to potential expiration, there are several factors that could
limit or eliminate our ability to use these carryforwards. For example, under
Section 382 of the Internal Revenue Code of 1986, as amended, use of prior net
operating loss carryforwards is limited after an ownership change. This type of
change could result from an offering that we are contemplating, either alone or
in combination with other prior or subsequent offerings of equity securities. If
we achieve sustained profitability, which may not happen, the use of net
operating loss carryforwards would reduce our tax liability and increase our net
income and available cash resources. When all operating loss carryforwards have
been used or have expired, we would again be subject to increased tax expense
and reduced earnings due to such tax expense.

Period Comparisons. The following table sets forth, for the periods
indicated, certain financial data derived from our consolidated statements of
operations. Percentages shown in the table below are percentages of total
revenue, except for each individual segment's cost of sales and services, gross
profit, selling, general and administrative expenses, and operating income,
which are percentages of the respective segment's revenue, and the product and
service components of the INX and Valerent segments' cost of goods sold and
gross profit, which are percentages of such segment's respective product and
service revenue.

YEAR ENDED DECEMBER 31,
----------------------------------------------------
2001 2002 2003
---------------- --------------- ---------------
AMOUNT % AMOUNT % AMOUNT %
------- ------ ------- ----- ------- -----
(DOLLARS IN THOUSANDS)

Revenue:
INX product.................................. $ 8,853 37.5 $28,990 69.0 $45,749 73.6
INX service.................................. 1,922 8.1 1,748 4.1 4,226 6.8
------- ------ ------- ----- ------- -----
Total INX revenue....................... 10,775 45.6 30,738 73.1 49,975 80.4
------- ------ ------- ----- ------- -----
Stratasoft -- custom projects................ 7,257 30.7 6,569 15.6 7,527 12.1
Valerent product............................. 1,113 4.7 1,092 2.6 1,573 2.5
Valerent service............................. 4,555 19.3 3,900 9.3 3,503 5.6
------- ------ ------- ----- ------- -----
Total Valerent revenue.................. 5,668 24.0 4,992 11.9 5,076 8.2
Corporate revenue............................ (6) 0.0 -- 0.0 -- 0.0
Eliminations revenue...................... (74) (0.3) (278) (0.6) (426) (0.7)
------- ------ ------- ----- ------- -----
Total revenue........................ 23,620 100.0 42,021 100.0 62,152 100.0

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