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UNITED STATES
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, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF
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:
(713) 795-2500
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
- --------------------------------- -----------------------------------------
COMMON STOCK, PAR VALUE $0.01 AMERICAN STOCK EXCHANGE
WARRANTS TO PURCHASE COMMON STOCK AMERICAN STOCK EXCHANGE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
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, 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. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X].
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, 2004 as
reported on the American Stock Exchange was approximately $25,196,736.
The number of shares of common stock, $0.01 par value, outstanding as of March
29, 2005 was 5,454,534.
DOCUMENTS INCORPORATED BY REFERENCE.
NONE
PART I
ITEM 1. BUSINESS
SPECIAL NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995 relating to future events or
our future financial performance including, but not limited to, statements
contained in Item 7. - "Management's Discussion and Analysis of Financial
Condition and Results of Operations." Readers are cautioned that any statement
that is not a statement of historical fact, including but not limited to,
statements which 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,
are predictions or estimations and are subject to known and unknown risks and
uncertainties. Numerous factors, including factors that we have little or no
control over, may affect I-Sector's actual results and may cause actual results
to differ materially from those expressed in the forward-looking statements
contained herein. In evaluating such statements, readers should consider the
various factors identified in I-Sector's annual report on Form 10-K, as filed
with the Securities and Exchange Commission including the matters set forth in
Item 1. - "Risks Related to our Business," which could cause actual events,
performance or results to differ materially from those indicated by such
statements.
GENERAL
We are a leading regional provider of IP telephony and other network
infrastructure and 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. 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 subsidiary Internetwork Experts, Inc., which
we refer to in this report as "INX." Our computer telephony business is
conducted through our subsidiary Stratasoft, Inc., which we refer to in this
report 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. Based on revenue, our largest business segment is our IP
telephony and network infrastructure business. INX provided approximately 83.1%
of our revenues in 2004 net of intercompany eliminations. Computer telephony
software provided by Stratasoft accounted for approximately 9.5% of our revenues
in 2004 net of intercompany eliminations. The third business segment is our
remote information technology management business of Valerent, which provided
approximately 7.4% of our revenues in 2004 net of intercompany eliminations.
IP TELEPHONY INDUSTRY BACKGROUND
Terminology
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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, or
"LAN," or a wide area network, or "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.
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 towards
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
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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 software applications designed to take full advantage of convergence
technology.
Competing IP Telephony Solutions
Cisco promotes the use of a network server running their call management
software, also called a "soft switch," which enables their system to perform IP
telephony functions without the use of a PBX. While other manufacturers,
including Avaya, Inc. and Nortel Networks Corp. are moving towards
packet-switched technology, we believe that Cisco has established an early
competitive advantage in the market for packet-switched, telephony solutions
that have no need to resort to older, circuit-switched PBX technology.
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. We believe 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, in our experience, doubts about the perceived quality of
service offered by an IP-based telephony system, including concerns about audio
quality, reliability, privacy and security have also been barriers to adoption
of the technology by some enterprises, but in our experience, while still
existing, these concerns have decreased over the past year.
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.
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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, 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 routing and switching 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 infrastructure technology
as well as 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 towards 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 services revenue and generally
depressed gross margins for our services. Additionally, our engineering staff
was often not fully utilized between projects. During 2003 and 2004 customers
began to adopt IP telephony technology and we began to perform full
implementations of the technology, which has resulted in our ability to more
fully employ our engineering staff. This increased demand has improved our
service revenues and our service margins.
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 that 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 problems detected either remotely or onsite. Our Netsurant network support
center is staffed with technical staff that are specifically trained and
experienced in both complex network infrastructure and Cisco IP telephony
technology.
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Historicaly, when most customers were only testing IP telephony
technology, post-implementation support services were not a high priority for
those customers. But as customers transition to the full implementation of IP
telephony, 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 significant factors for enterprises when they
are choosing a service provider. Through our Netsurant service offering, we
believe we will be positioned to provide support services that customers desire
and 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 choose to 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,
as well as our engineering staff, is more focused and knowledgeable about the
products we sell.
We believe that most sales of Cisco IP telephony systems are market share
gains by Cisco. This is because Cisco only entered the voice communications
market in 1998, and does not have a large traditional PBX telephone systems
customer base to protect against encroachment by competitors. Because sales of
IP telephony systems to enterprises will be largely systems replacing existing
traditional PBX telephone systems, the 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
shares gains by Cisco.
The majority of the enterprise organization 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, 2004
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 against its competitors as
the move towards full adoption of IP telephony technology by enterprises
continues. 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 against its competitors, we believe that we will be able to
substantially increase our revenues.
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
their "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 what we believe to be the leading regional Cisco-centric
IP telephony solutions provider for Texas, with offices in Austin, Dallas,
Houston and San Antonio, Texas. In February of 2005, we also opened an office in
Washington, D.C. Our target customers for Cisco-centric IP telephony solutions
are enterprise organizations with approximately 300 to 10,000 users. Because of
being a dominant provider of Cisco-based IP telephony solutions for our target
customers in the Texas market, without geographic expansion, our growth will
begin to slow. With full adoption of IP telephony technology by enterprises at
an early stage, we intend to expand nationally, establishing offices in other
major U.S. markets in order to create a national presence, with the goal of
eventually becoming the leading focused, national provider of Cisco-based IP
telephony solutions to our target customers. 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, if
necessary, towards the opportunities created by the
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trend toward full adoption of IP telephony technology. We were successful in
entering the Austin, Texas market by buying the operations of Digital Precision,
Inc. in April 2003, and we have since become a dominant participant in that
market. We believe there are opportunities in other markets to repeat the
success we had entering Austin, Texas.
OUR COMPUTER TELEPHONY SOFTWARE BUSINESS
We have developed and marketed our own proprietary computer telephony
software applications through our Stratasoft subsidiary since 1995.
Traditionally, our computer-telephony software applications have primarily
consisted of products used by professional contact centers. More recently, we
have migrated our traditional contact center products to take advantage of the
trend towards the use of voice over IP technology. We have been developing new
products that we hope will allow us to take advantage of the opportunity that we
believe exists for computer telephony software applications for enterprise
organizations that use IP telephony.
Existing Products
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;
- automatic call distribution for processing inbound calls;
- call blending between inbound and outbound activity;
- voice mail and auto attendant applications;
- text-to-speech capabilities;
- Web-based text chatting;
- fax on demand;
- interactive voice response;
- rapid application development and scripting;
- local / remotes agent using SIP soft phone technology;
- support for IP Telephony telephone lines.
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 awards 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 2004, the Customer Interaction Solutions product of the year award for
2004, and the IP Contact Center Technology Pioneer award for 2005.
Stratasoft's products are currently sold and used in over 20 countries
worldwide,, including contact centers in the United States, Canada, the United
Kingdom, Germany, Greece, India, Egypt, Japan, the Philippines and Grenada.
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
processes and traditional business applications in ways that were not possible
before. These software applications are often called
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"convergence applications." Therefore 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
We offer a variety of services related to cost reduction and performance
improvement of information technology through Internet-based remote service and
support of information technology. These services include the following:
- remote end user and server management;
- data and network management; and
- security and internet services.
We operate this third of our three business segments through our Valerent,
Inc. subsidiary and under the trade name "Valerent."
CUSTOMERS
We had one customer that represented 10% or more of our revenue for the
year ended December 31, 2004. Micro System Enterprise, Inc. / Acclaim
Professional Services ("MSE"), an agent related to the Dallas Independent School
District E-Rate funded program, which represented approximately 16.1% of our
consolidated revenue for the year ended December 31, 2004 and approximately
49.5% of our consolidated net accounts receivable at December 31, 2004. We had
no customer that represented 10% or more of our total consolidated revenue
during the years ended December 31, 2002 or 2003.
IP Telephony and Network Infrastructure
Customers for our Cisco-centric IP telephony and other network solutions
are typically medium- to larger-sized corporate organizations, schools and
governmental agencies that use large network infrastructures. Presently, a
majority of our customers are located in, 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 has also provided technical consulting and project
management services as a sub-contractor 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 2004, we performed an increased amount of business with educational
and governmental customers, including schools that receive funding for network
infrastructure under a federal program, 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 is extended and our
working capital requirements are increased as a percent of our revenue.
Computer Telephony Software
Customers for our computer telephony software are typically contact
centers or companies or organizations that operate a contact center, including
political and non-profit organizations. A majority of our customers have
historically been located in the United States, but we have increasingly sold
and installed call center systems internationally. In 2002, 2003 and 2004,
approximately 28.2%, 42.2% and 23.7%, respectively, of Stratasoft's revenue, and
4.4%, 5.1% and 2.3%, 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 contact center 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 contract contact center
industry. We believe the new legislation created these incentives because it
permits companies to contact their own customers for the
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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.
If we are successful developing and marketing new software applications
for use by enterprise customers that use IP telephony for other than contact
center operations, we expect that a higher percentage of Stratasoft's revenues
will come from enterprise customers, rather than smaller contact center
businesses.
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,
based on productivity, specifically 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, who 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 sometimes, particularly governmental and educational customers, 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. In the
past 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. The proceeds from our public equity offering in May 2004
and posting several quarters of profitability, coupled with a generally
improving market for performance bonding, has improved our ability to obtain
bonding. In July 2004 we established a bonding line with SureTec Insurance
Company. However, we expect that our ability to bid and win certain larger
projects will continue to be adversely affected by our bonding capabilities,
which are defined by our financial strength and the level of, and history of,
profitability.
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 makes up the substantial majority of product purchases,
and 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 a 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. Additionally, Stratasoft 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. We attempt to ship products directly from our supplier to our customer
when possible in order to shorten the business cycle and avoid handling the
product in our facility.
COMPETITION
The market for communications systems, including network infrastructure,
IP telephony solutions and computer telephony software for contact centers is
evolving rapidly, is highly competitive and is 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.
Our competition for IP telephony and network infrastructure solutions is
highly fragmented, and we compete with numerous large and small competitors. In
our efforts to market Cisco-centric IP telephony solutions we compete with
manufacturers of IP telephony equipment such as Avaya, Inc. and
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Nortel Networks Corporation as well as with such manufacturer's integrators and
solution providers. 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.
With regard to our computer telephony software applications for contact
centers, we compete primarily with manufacturers of specialized contact center
systems, such as Avaya, Concerto, Interactive Intelligence, 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.
EMPLOYEES
At March 24, 2005 we employed approximately 194 people. Of these,
approximately 44 were employed in sales, marketing and customer service, 88 were
employed in engineering and technical positions and 62 were employed in
administration, finance and MIS. Approximately 38% of our network engineering
staff in our INX subsidiary hold the Cisco Certified Internetwork Engineer
certification, the highest level of Cisco technical certification. 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.
CERTAIN MILESTONES IN OUR CORPORATE DEVELOPMENT
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 1999, we decided to sell both our computer products reselling business
and our traditional PBX telephone systems business, which together accounted for
approximately 90% of our total revenue at the 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 PBX IP telephony technology
in the enterprise market.
10
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, 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 reasonably practicable following the time they
are filed with or furnished to the SEC.
RISKS RELATED TO OUR BUSINESS
We have a history of losses and may continue to incur losses.
We incurred a net loss in each fiscal year since 1998, except fiscal 2004.
As of December 31, 2004, our accumulated deficit was $1.7 million. During 2004
our income was $1.5 million, but we cannot assure you that profitability will
continue in upcoming quarters or years. In order to continue profitability, we
will have to maintain or increase our operating margin. Improvements in
operating margin could result from increases in revenue without comparable
increases in operating expense, from changes in the mix of products and services
we sell, or from other factors. Our profitability improved in 2004 compared to
2003,primarily due to increased gross margin percentage and the fact that our
operating expenses increased at a lower rate than revenue growth. We cannot
assure you that we will be able to continue to achieve improved operating
margins, or that operating margin will not decrease in the future. If we were
unable to increase revenue, if our gross margin decreases, or if we are unable
to control our operating expenses, our business could produce losses. We have
only recently become profitable and are in a rapidly changing industry. In
addition, our business depends upon winning new contracts with new customers,
the size of which may vary from contract to contract. Whether we are able to
remain 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 is dependent on maintaining our relationship with Cisco
Approximately 77% of our revenue for the year ended December 31, 2004 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 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 to 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 are comparable to the terms we
currently receive, our business would be harmed and our operating results and
financial condition would be materially and adversely affected.
Our success depends upon broad market acceptance of IP telephony.
The market for IP telephony products and services is relatively new 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;
11
- 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 will be adversely affected.
Although our success is generally dependent upon 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 broad 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 our customers decrease their level of spending on
communications systems and the related products and services, our revenue and
operating results may be adversely affected.
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 in Texas 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
12
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, including expansion
through acquisitions. 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 obtain financing if required, or if financing is available, there is no
assurance that the terms would be favorable to existing shareholders. Our
ability to obtain additional financing is subject to a number of factors,
including general market conditions, investor acceptance of our business plan,
our operating performance and financial condition, and investor sentiment. These
factors may affect the timing, amount, terms or conditions of additional
financing available to us.
We may be unable to 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, to integrate new employees into our operations and to 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 2004 increased by approximately 49%
from the second quarter, and it increased over 56% from the third quarter of
2003. Our revenue for the fourth quarter of 2004 decreased by approximately 26%
from the third quarter of 2004, but increased over 59% from the fourth quarter
of 2003. 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;
- 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.
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.
13
The markets for our all of products and services, and especially 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.
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;
- difficulty retaining key personnel of the acquired business;
- difficulty retaining customers of the acquired businesses;
- difficulties in managing the financial and strategic position
of acquired or developed products, services and technologies;
- difficulties in maintaining customer relationships, in
particular where 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.
14
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 the anticipated level of
revenue and earnings 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 5.1% and 2.3% for the years ended December 31, 2003 and 2004,
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;
- risk of loss in currency exchange transactions;
- 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 Stes;
- 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, our President
and Chief Operating Officer, Mark T. Hilz, our President of Stratasoft, Bob
Hennessey, our President of Valerent, Frank Cano and our Vice President and
Chief Financial Officer, Brian Fontana. 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.
15
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 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. In the past, we met
the requirements of the "Controlled Company" exemption under Section 801 (a) of
the American Stock Exchange Company Guide (the "Guide"). However, as of May
2004, when we completed a public equity offering, we were no longer able to use
this exception and must comply with certain additional requirements under the
Guide, including the guidance requiring director independence. Failure to comply
with the Sarbanes-Oxley Act, Securities and Exchange Commission ("SEC")
regulations or American Stock Exchange listing requirements may result in
penalties, fines or delisting of our securities 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 the Houston office for our Corporate, INX, Stratasoft and
Valerent segments, and it is housed in a freestanding building of approximately
48,000 square feet. On November 30, 1999, the building was acquired by a
16
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 relocated during 2004. The Dallas facility was
originally a space of approximately 8,960 square feet before occupying a newly
leased facility with 23,332 square feet. The initial Dallas facility lease term
began July 2000 and expired in July 2003, but upon expiration the lease was
continued on a month to month basis until June of 2004. During June 2004 the
Dallas facility relocated to the newly leased facility subject to a lease that
expires in May 2010. The Dallas facility is leased for our INX and Valerent
segments. Our Austin office is leased for our INX segment, and it 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. The San Antonio office is leased for out INX segment, and it
is a space of approximately 2,040 square feet which began in July 2004 and
expires in July 2007. The Washington D. C. office is leased for our INX segment,
and it is a space of approximately 1,004 square feet which began in February
2005 and expires in February 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 ("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
On December 30, 2004, we held our annual meeting of stockholders. The
aggregate number of shares of common stock of the Company entitled to vote at
the meeting was 5,177,154. Present at the meeting, in person and by proxy, were
the holders of 5,038,567 shares of common stock representing 97.32% of the total
number of shares entitled to vote and constituting a quorum. The holders of our
common stock elected James H. Long, Donald R. Chadwick, Cary M. Grossman and
John B. Cartwright as directors and approved an amendment to the company's
incentive stock plan to increase the number of shares of common stock reserved
for issuance under the plan from 600,000 shares to 900,000 shares as follows.
ELECTION OF DIRECTORS:
NAME OF NOMINEE NUMBER OF VOTES VOTED FOR NUMBER OF VOTES WITHHELD
- ------------------------------------------------------- ------------------------- ------------------------
James H. Long.......................................... 4,773,751 264,816
Donald R. Chadwick..................................... 4,817,151 221,416
Cary M. Grossman....................................... 4,891,367 147,200
John B. Cartwright..................................... 4,778,751 259,816
AMENDMENT TO THE INCENTIVE STOCK PLAN:
NUMBER OF VOTES NUMBER OF VOTES NUMBER OF VOTES BROKER
VOTED FOR VOTED AGAINST WITHHELD NON-VOTE
--------------- --------------- --------------- ---------
Amend the Incentive Stock Plan............... 2,539,959 312,282 675 2,185,651
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
17
On December 29, 2003, our common stock began trading 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." As of June 8, 2004, our warrants began
trading on the American Stock Exchange under the symbol "ISR.WS." Our units
traded under the symbol "ISR.U" for a limited period beginning on May 7, 2004
and ending on June 7, 2004.
COMMON STOCK
The following table set forth the price range of our common stock.
HIGH LOW
------- ------
2003
First Quarter........................... $ 2.06 $ 1.64
Second Quarter.......................... $ 2.40 $ 1.75
Third Quarter........................... $ 4.40 $ 2.60
Fourth Quarter.......................... $ 15.97 $ 4.14
2004
First Quarter........................... $ 15.87 $ 6.25
Second Quarter.......................... $ 9.90 $ 7.61
Third Quarter........................... $ 8.36 $ 6.43
Fourth Quarter.......................... $ 10.12 $ 6.75
WARRANTS
The following table set forth the high and low sales prices of our
warrants as quoted by the American Stock Exchange commencing on June 8, 2004,
the first day of trading.
HIGH LOW
------- ------
2004
Second Quarter........................ $ 1.85 $ 1.20
Third Quarter......................... $ 1.60 $ 1.00
Fourth Quarter........................ $ 2.35 $ 1.16
UNITS
The following table set forth the high and low sales prices of our units
as quoted by the American Stock Exchange during their limited 32 day trading
period beginning on May 7, 2004, and ending on June 7, 2004.
HIGH LOW
------- ------
2004
Second Quarter........................ $ 19.95 $16.15
18
As of March 18, 2005, we had 43 stockholders of record of our common
stock. On March 25, 2005, the closing sales price of our common stock and
warrants as reported by the American Stock Exchange was $5.60 per share and
$0.80 per warrant.
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.
19
ITEM 6. SELECTED FINANCIAL DATA
The following sets forth the selected data of the company for the five
years ended December 31, 2004.
YEAR ENDED DECEMBER 31
-----------------------------------------------------
2000 2001 2002 2003 2004
------- ------- ------- -------- --------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
OPERATING DATA:
Revenue:
Products......................................... $ 1,670 $ 9,925 $29,805 $ 46,900 $ 72,680
Services......................................... 8,757 6,477 5,647 7,725 11,393
Custom projects.................................. 6,660 7,218 6,569 7,527 8,996
------- ------- ------- -------- --------
Total revenue................................... 17,087 23,620 42,021 62,152 93,069
Cost of sales and services:
Products......................................... 2,104 8,685 26,437 41,060 61,694
Services......................................... 7,291 5,322 4,395 5,383 7,273
Custom projects.................................. 3,573 3,318 2,920 2,982 4,150
------- ------- ------- -------- --------
Total cost of sales and services................. 12,968 17,325 33,752 49,425 73,117
Gross profit:
Products......................................... (434) 1,240 3,368 5,840 10,986
Services......................................... 1,466 1,155 1,252 2,342 4,120
Custom projects.................................. 3,087 3,900 3,649 4,545 4,846
------- ------- ------- -------- --------
Total gross profit............................... 4,119 6,295 8,269 12,727 19,952
Selling, general and administrative expenses.......... 9,479 10,573 10,625 15,061 18,254
------- ------- ------- -------- --------
Operating income (loss)........................ (5,360) (4,278) (2,356) (2,334) 1,698
Interest and other income (expense), net.............. 239 316 115 107 (108)
------- ------- ------- -------- --------
Income (loss) from continuing operations before
income tax benefit................................ (5,121) (3,962) (2,241) (2,227) 1,590
Tax benefit........................................... 1,493 87 1,595 181 19
------- ------- ------- -------- --------
Net income (loss) from continuing operations
before minority interests......................... (3,628) (3,875) (646) (2,046) 1,609
Minority interests................................... - - - - (117)
------- ------- ------- -------- --------
Net income (loss) from continuing operations.......... (3,628) (3,875) (646) (2,046) 1,492
Gain on disposal of discontinued operations,
net of taxes...................................... 3,585 170 262 210 38
------- ------- ------- -------- --------
Net income (loss)..................................... $ (43) $(3,705) $ (384) $ (1,836) $ 1,530
======= ======= ======= ======== ========
Net income (loss) per share:
Basic:
Net income (loss) from continuing operations
before minority interests......................... $ (0.90) $ (0.99) $ (0.17) $ (0.55) $ 0.35
Minority interests.............................. - - - - (0.03)
Gain on disposal of discontinued operations,
Net of taxes.............................. 0.89 0.04 0.07 0.06 0.01
------- ------- ------- -------- --------
Net income (loss) per share..................... $ (0.01) $ (0.95) $ (0.10) $ (0.49) $ 0.33
======= ======= ======= ======== ========
Diluted:
Net income (loss) from continuing operations
before minority interests......................... $ (0.90) $ (0.99) $ (0.17) $ (0.56) $ 0.32
Minority interests.............................. - - - - (0.02)
Gain on disposal of discontinued operations,
Net of taxes.............................. 0.89 0.04 0.07 0.06 0.01
------- ------- ------- -------- --------
Net income (loss) per share..................... $ (0.01) $ (0.95) $ (0.10) $ (0.50) $ 0.31
======= ======= ======= ======== ========
BALANCE SHEET DATA:
Working capital....................................... $10,098 $ 5,983 $ 5,540 $ 3,724 $ 13,143
Total assets.......................................... 17,142 13,548 15,751 19,207 41,139
Current portion of long-term debt (1)................. - 213 157 1,784 8,220
Long-term debt........................................ - 410 247 229 122
Stockholders' equity.................................. $11,912 $ 8,015 $ 7,640 $ 6,619 $ 15,849
(1) Excludes non-interest borrowings under Textron Flooplan Loan. (See Note 7
of consolidated financial statements).
20
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- Risk Factors" and elsewhere in this report.
GENERAL
We are a leading regional provider of IP telephony and other network
infrastructure and related implementation and support services. The IP telephony
industry is characterized by rapidly evolving and competing technologies. We
compete with larger and better financed entities. 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 improving profitability. 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 improve profitability by implementing the strategies discussed
below. We believe that our strategies will allow us to continue to increase
total revenues. We also believe our strategies will enable us to improve our
gross margins on INX revenue. At the same time, we will seek to limit the growth
of relatively fixed components of our selling, general and administrative
expenses relative to the growth of revenue so that those expenses become a
relatively smaller percentage of total revenues. Through a combination of
increased revenue, slightly increased gross margin and somewhat decreased growth
of selling, general and administrative expenses, relative to the growth of
revenue, we hope to be able to increase our operating margin and increase
profitability at a more rapid rate than revenue increases. We expect that
selling expenses can generally be expected to increase in proportion to our
revenues increases. For example, our sales staff earns sales commissions that
are typically calculated as a percentage of gross profit produced. Historically,
sales commissions have been approximately 22% to 24% of gross profit and we
expect sales commissions to continue to consume similar percentages of total
gross profit. However, 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 because we believe we can achieve some levels
of leverage on certain of these operating expenses.
Our key operating strategies include:
- 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 services and Stratasoft custom projects,
as opposed to product sales, which typically produce smaller
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;
- developing and marketing our own computer telephony software
products that operate with and augment Cisco-centric IP
telephony products; and
21
- Developing and marketing our own proprietary equipment for
certain IP communications solutions.
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.
Increases in the size and volume of the IP telephony projects we undertake
can also challenge our cash management. For example, larger projects can reduce
our available cash by requiring that we carry higher levels of inventory. Larger
projects can also require other investments in working capital. This is because,
in some cases, we do not receive payments from our customers for extended
periods of time. Until we invoice the customer and are paid, all of the cash
expended on labor and products on the project remains invested in
work-in-progress and accounts receivable. We expect that we will need increasing
levels of working capital in the future if we are successful in growing our
business as we intend.
To meet our cash requirements to support planned 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.
In May 2004, we raised capital through a public equity offering with net
proceeds of $7.5 million. We used the net proceeds of this equity offering
primarily for working capital and to repay interest-bearing debt then
outstanding under our credit facility.
Although over 79% of our revenue in 2004 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 2004, for example, the gross profit
margin on sales of products by INX was 15.1%, while the gross profit margin on
sales of services by INX for that year was 33.4%. We 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 purchase products
directly from Cisco on a timely basis. 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 upon which 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 such incentives. There is a risk that we may not meet the
incentive criteria in the future. In addition, we are typically reliant on Cisco
and their product pricing. The respective timing of when vendor incentives
become earned and determinable creates significant fluctuations in our gross
margin.
We also plan to grow our business in other geographic areas through
strategic acquisitions 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
consideration paid for an acquisition exceeds the estimated fair value of the
net identified tangible and intangible assets acquired, which we expect is
likely. To the extent an acquisition results in goodwill, we will reevaluate the
value of that goodwill at least annually and adjust the value as appropriate. If
we determine that the value of the goodwill has decreased, the resulting
adjustment could result in a non-cash charge to earnings in the periods of
revaluation.
22
Developing new or substantially improved computer telephony software
products will require us to expend cash and record software development
expenses. Software development costs have been, and we expect will continue to
be expensed because we expect to incur substantially all costs prior to
achieving technological feasibility in developing a new or substantially
improved software product.
ELIMINATING MINORITY INTEREST IN INX
Between April 2004 and March 18, 2005, our INX subsidiary had a minority
interest. The minority interest was eliminated through an exchange of the
minority interest for an interest in I-Sector on March 18, 2005.
Prior to April 2004, INX had been our wholly-owned subsidiary. In April
2004, INX ceased to be a wholly-owned subsidiary as the result of the issuance
of INX common stock to the former owners of Digital Precision, Inc., 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 their business if certain employees remained employed through
April 4, 2004, the first anniversary of the acquisition. This condition was met
and the INX stock was issued in April 2004. At the time of issuance of that INX
common stock, we recognized additional customer list value of $234,000 as an
intangible asset to be amortized over a two year period. When that issuance
occurred, our ownership percentage of INX's common stock declined to
approximately 92.4%, and we recognized $162,000 of minority interest on our
balance sheet upon issuance.
Since we owned 92.4% of INX's stock for December 31, 2004, our interest in
INX's future profits and losses have been reduced for the minority share. Under
accounting principles generally accepted in the United States of America, our
consolidated financial statements for the period through the exchange will
reflect a minority interest adjustment of the reportable profits and losses of
INX attributable to the minority ownership. For 2004, we reported income
attributable to minority interest of $117,000 in our statement of operations and
a minority interest balance of $279,000 in our balance sheet.
On February 1, 2005 we entered into an agreement with the INX minority
shareholder group to merge INX into I-Sector, contingent upon I-Sector
stockholder approval. Upon stockholder approval on March 18, 2005, INX became a
wholly-owned subsidiary of the Company. The exchange of the minority interest
resulted in a remeasurement of the stock options that were part of the minority
interest and such remeasurement resulted in a $5.7 million one-time non-cash
charge to earnings, which was equal to the intrinsic value of the stock options
on March 18, 2005. This one-time non-cash charge to earnings, which does not
impact assets or liabilities, will reduce reported net income and earnings per
share in our first quarter ending March 31, 2005. The elimination of the
minority interest will simplify our capital structure and eliminate the minority
interest on our financial statements, but will increase the shares used to
compute diluted earnings per share due to the shares of our common stock issued
in the exchange and because of the increased number of stock options resulting
from exchanging INX stock options for our stock options. Based on the closing
stock price of $6.25 on March 18, 2005, we expect shares used in computing
diluted earnings per share to increase by approximately 1,161,592 shares as a
result of the exchange of the minority interest.
RESULTS OF OPERATIONS
Overview
Sources of Revenue. Our revenue is derived from three segments represented
by our three operating subsidiaries, INX, Stratasoft and Valerent. During the
year ended December 31, 2004, INX, Stratasoft and Valerent accounted for 83.1%,
9.5% and 7.4%, respectively, of total consolidated revenue.
INX revenue consists of product and service revenue. Product revenue
consists of reselling Cisco products and limited amounts of complementary
products from 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 generally increased 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 services revenue. Certain fixed and flat fee
service contracts that extend over three months or more are accounted for on the
percentage of completion method of accounting.
23
Historically, the majority of INX's services revenue has been generated
from implementation services, which is project oriented and tends to be
volatile. As the number, frequency and size of INX projects has grown, INX has
achieved better utilization of its engineering resources, resulting in improved
gross margins on services. The normal sales cycle for corporate customers
typically ranges from three to six months depending on the nature, scope and
size of the project. Our experience with educational organizations utilizing
E-Rate funding, which is a federal government funding program for schools
administered by the Schools and Libraries Division Universal Services
Administrative Corporation (the "SLD") indicates that the sales cycle is
generally about six to twelve months or longer.
Since the latter part of 2004, INX has experienced payment delays for
amounts due from educational organization projects that are being partially
funded by the SLD. The SLD has informed us that these payment delays are due to
administrative issues within the SLD. In November 2004, pending a satisfactory
resolution of the issues causing the payment delays, or payment of a substantial
portion of the past due amounts, we temporarily suspended product shipments for
certain SLD-funded projects in November 2004. Based on communications from the
SLD that payments were being processed, limited amounts of product shipments
were made in December 2004 for a significant project that was previously
suspended. After December 31, 2004 the SLD made significant payments on past due
accounts and we resumed product shipments for the previously suspended
SLD-funded projects. At December 31, 2004 our total net accounts receivable of
$28.2 million included approximately $17.1 million of net E-Rate funded accounts
receivable, approximately $14.0 million of which were amounts related to a
single SLD-funded project that had been temporarily suspended due to a past due
balance of $11.8 million, however, as of March 23, 2005 approximately $10.7
million of the past due balance had been collected. For the year ending December
31, 2004 INX has approximately $18.7 million of revenue derived from E-Rate
funded projects included in its $77.9 million of total annual revenue. While
collections have occurred for our more significantly aged invoices, we
anticipate that we will continue to experience payment delays for SLD-funded
educational projects due to increased administration standards imposed upon the
SLD and continued changes at the SLD and the E-Rate program.
In mid-2003, INX introduced Netsurant, its branded support service that
consists primarily of customer service personnel and a support center. This new
support service offering requires that we incur the fixed cost to operate a
network operations center to monitor customer's systems. The fixed operating
cost has resulted in negative gross margins from this new Netsurant service
offering. We recognize the support service revenue evenly over the entire
service period for the customer. Eventually, we expect that the Netsurant
support offering will improve overall services gross margins. Through December
31, 2004, Netsurant service revenue was insignificant.
Stratasoft revenue consists primarily of custom project revenue from the
sale of proprietary computer-telephony software. Stratasoft revenue is reported
as custom project revenue in our statements of operations, because it consists
of bundled products and services which cannot be accounted for separately.
Stratasoft has traditionally produced our highest gross margin since it's
revenues consists primarily of sales of our proprietary computer-telephony
software. Our cost of goods sold for Stratasoft's custom project revenue
includes the costs 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
utilizes the percentage of completion method of accounting to recognize the
majority of its revenue. 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 services revenue.
Valerent's service revenue consists of remote and onsite technical assistance to
its customers. Valerent's gross margin on service revenue, much like INX's
implementation services 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 their
specific needs. While these agreements provide
24
somewhat predictable and stable sources of revenue, the loss of a recurring
agreement could disrupt the stability of Valerent's revenues.
Gross Profit and Gross Profit Margin. The mix of our various revenue
components, each of which has substantially different levels of 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 are 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, the mix of large revenue product
contracts, which typically have lower gross margin, as compared to smaller
revenue product contracts, which typically have higher gross margin. Our gross
margin percentage on product sales and services revenue has generally improved
over the past several years.
Gross margin percentage on product sales have improved primarily due to
increased repeat business with existing customers, which are typically smaller
transactions that generate slightly higher levels of gross margin as compared to
large, competitively bid projects. In addition, we have benefited from increased
levels of vendor incentives, which lower our cost of goods sold.
Our annual and quarterly gross profits and gross margins on INX product
sales are materially affected by vendor incentives recognized in certain
accounting periods, most of which are Cisco incentive programs initiated in
2003. The incentive programs sponsored by Cisco currently enable us to qualify
for cash rebates or product pricing discounts. The most significant incentive is
a Cisco incentive that is generally earned based on sales volumes of particular
Cisco products; sales growth and customer satisfaction levels, and beginning in
our fourth quarter ended December 31, 2004 this incentive program could be
readily monitored by us via access to the vendor's website. The amounts earned
and costs incurred under these programs are recorded as a reduction of cost of
goods sold, and the increased gross profit results in an increase in selling,
general and administrative expenses related to sales commissions. In reporting
periods prior to our fourth quarter ended December 31, 2004, we recognized the
Cisco incentives on the earlier of when payment was received or declared by the
vendor; as such amounts were not determinable by us prior to then. Prior to
2004, there had only been one incentive program measurement period, and we had
not met all of the qualification criteria for such incentive period. Cisco pays
incentives earned under this program semi-annually for the six-month measurement
periods that end one month following the end of our second and fourth quarters.
This caused significant fluctuations in gross profit and operating profits from
quarter to quarter because these incentives were recognized semi-annually in our
first and third quarters. Beginning in the fourth quarter of 2004, the
information became readily available from the vendor so that the amount of
incentive earned from the vendor was determinable. Furthermore, we determined
that collection of the incentive was probable and therefore recognizable. For
2004, the INX products cost of goods was $60.8 million (84.9% of INX product
revenue), which is net of $3.4 million of vendor incentives recognized. For
2003, the INX product cost of goods was $40.1 million (87.6% of INX product
revenue), which is net of $313,000 in vendor incentives recognized. Our product
cost and resulting gross profit can vary significantly depending upon vendor
pricing incentives and our ability to qualify for and recognize such incentives.
Our gross margin percentage on service revenue has also generally improved
over the past several years. A significant portion of our cost of services for
each of our service businesses is comprised of labor. 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 important to
maximize 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. Several years ago, early in INX's development,
we purposely over staffed technical and engineering staff in order to have the
technical competency necessary to gain market share and create a successful
organization. Over the past several years, as INX has grown, we have been able
to better utilize our technical and engineering staff and this has helped to
improve the gross margin percentage on service revenue.
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
25
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 transaction and the mix of associated products and services with
our overall gross profit. Historically, sales commission expense has been
approximately 22% to 24% of gross profit, and we expect that it will continue to
be approximately that level in the future. Bad debt expense generally fluctuates
somewhat in proportion to sales levels, although not always in the same periods
as increases or decreases in sales. 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 in revenue, but will generally increase
over time as the organization grows. We believe that we can achieve some level
of leverage on these somewhat fixed operating expenses, relative to revenue
growth, and if we are successful in doing so that this will help to increase our
net operating margin.
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 7, 2003. The initial purchase price for
Digital Precision was $540,000 in cash and contingent consideration of 1.8
million shares of INX common stock which we agreed to issue if certain employees
remained employed through April 4, 2004, the first anniversary of the
acquisition. In April 2004, we recorded $234,000 of additional intangible assets
in connection with the 1.8 million shares of INX stock we issued to satisfy the
contingent purchase price obligation.
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 has 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, 2004, was approximately $2.0 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. 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 tables set 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.
26
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------
2002 2003 2004
------------------- ------------------ ------------------
AMOUNT % AMOUNT % AMOUNT %
-------- ----- -------- ----- -------- -----
(DOLLARS IN THOUSANDS)
Revenue:
INX product............................................. $ 28,990 69.0 $ 45,749 73.6 $ 71,646 77.0
INX service............................................. 1,748 4.1 4,226 6.8 6,280 6.7
-------- ----- -------- ----- -------- -----
Total INX revenue.............................. 30,738 73.1 49,975 80.4 77,926 83.7
-------- ----- -------- ----- -------- -----
Stratasoft - Custom projects............................ 6,569 15.6 7,527 12.1 8,996 9.7
Valerent product........................................ 1,092 2.6 1,573 2.5 1,829 2.0
Valerent service........................................ 3,900 9.3 3,503 5.6 5,113 5.5
-------- ----- -------- ----- -------- -----
Total Valerent revenue......................... 4,992 11.9 5,076 8.2 6,942 7.5
Eliminations revenue................................. (278) (0.6) (426) (0.7) (795) (0.9)
-------- ----- -------- ----- -------- -----
Total revenue.............................. 42,021 100.0 62,152 100.0 93,069 100.0
Cost of sales and service:
INX product............................................. 25,659 88.5 40,060 87.6 60,802 84.9
INX service............................................. 1,658 94.9 2,976 70.4 4,183 66.6
-------- ----- -------- ----- -------- -----
Total INX cost of sales and service............ 27,317 88.9 43,036 86.1 64,985 83.4
Stratasoft - Custom projects............................ 2,920 44.5 2,982 39.6 4,150 46.1
Valerent product........................................ 1,055 96.6 1,421 90.3 1,687 92.2
Valerent service........................................ 2,738 70.2 2,412 68.9 3,090 60.8
-------- ----- -------- ----- -------- -----
Total Valerent cost of sales and service....... 3,793 76.0 3,833 75.5 4,777 69.1
Eliminations of cost of sales and service............ (278) 100.0 (426) 100.0 (795) 100.0
-------- ----- -------- ----- -------- -----
Total cost of sales and service............ 33,752 80.3 49,425 79.5 73,117 78.6
Gross profit:
INX product.......................................... 3,331 11.5 5,689 12.4 10,844 15.1
INX service.......................................... 90 5.1 1,250 29.6 2,097 33.4
-------- ----- -------- ----- -------- -----
Total INX gross profit.......................... 3,421 11.1 6,939 13.9 12,941 16.6
Stratasoft - Custom projects............................ 3,649 55.5 4,545 60.4 4,846 53.9
Valerent product........................................ 37 3.4 152 9.7 142 7.8
Valerent service........................................ 1,162 29.8 1,091 31.1 2,023 39.2
-------- ----- -------- ----- -------- -----
Total Valerent gross profit..................... 1,199 24.0 1,243 24.5 2,165 30.9
Eliminations gross profit............................ - 0.0 - 0.0 - 0.0
-------- ----- -------- ----- -------- -----
Total gross profit......................... 8,269 19.7 12,727 20.5 19,922 21.4
Selling, general and administrative expenses:
INX .................................................. 3,545 11.5 6,045 12.1 10,295 13.2
Stratasoft.............................................. 3,922 59.7 5,888 78.2 5,100 56.7
Valerent................................................ 2,236 44.8 1,963 38.7 1,886 27.3
Corporate............................................... 922 (NA) 1,165 (NA) 973 (NA)
Eliminations............................................ - 0.0 - 0.0 - 0.0
-------- ----- -------- ----- -------- -----
Total selling, general and administrative expenses......... 10,625 25.3 15,061 24.2 18,254 19.6
Operating income (loss):
INX .................................................. (124) (0.4) 894 1.8 2,646 3.4
Stratasoft............................