UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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

FOR THE PERIOD ENDED JANUARY 31, 2004

OR

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

For the transition period from              to

Commission File Number 0-8141

NORSTAN, INC.

5101 Shady Oak Road, Minnetonka, Minnesota 55343-4100

Telephone: (952) 352-4000       Fax: (952) 352-4949       Internet: www.norstan.com

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   [X]   No   [  ]

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

On March 8, 2004, there were 13,289,497 shares outstanding of the registrant’s common stock, par value $0.10 per share, its only class of equity securities.

Table of Contents

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1.

NORSTAN, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
UNAUDITED
(In thousands, except per share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

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NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
UNAUDITED
(In thousands, except share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

2

NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
UNAUDITED
(In thousands, except share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

3

NORSTAN, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED

(In thousands)

The accompanying notes are an integral part of these consolidated financial statements.

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NORSTAN, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED

     The information furnished in this report is unaudited and reflects normal recurring adjustments and such other adjustments which, in the opinion of management, are necessary to present fairly the operating results for the interim periods identified herein pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. This report should be read in conjunction with our Annual Report on Form 10-K for the year ended April 30, 2003. The operating results for the interim periods presented are not necessarily indicative of the operating results to be expected for the full fiscal year. When we refer to the “Company”, “Norstan”, “we”, “us” or “our”, we mean Norstan, Inc. and its subsidiaries.

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Principles of Consolidation:

     The accompanying consolidated financial statements include the accounts of Norstan, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates:

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the periods presented. Estimates are used for such items as allowances for doubtful accounts, inventory valuation, depreciable lives of property and equipment, valuation of deferred tax assets, warranty reserves, estimates of percentage of completion under long-term contracts and others. Ultimate results may differ from those estimates.

Goodwill:

     The components of goodwill and other intangible assets were as follows (in thousands):

     Amortization related to intangible assets is included in selling, general and administrative expenses within the accompanying consolidated statements of operations.

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     The change in the gross carrying amounts of goodwill and other intangible assets for the nine months ended January 31, 2004 were as follows (in thousands):

Warranty:

     We are subject to warranty claims for products and overall solutions that may fail to perform as expected due to design, installation or manufacturing deficiencies. Customers continue to require their outside suppliers to guarantee or warrant their products/solutions and bear the cost of repair or replacement of such products/solutions. Depending on the terms under which we supply products/solutions to our customers, a customer may hold us responsible for some or all of the repair, replacement or redesign/reinstallation costs of defective products/solutions, when the product/solution supplied did not perform as represented. We generally provide customers a warranty on products consistent with the warranty we receive from the original equipment manufacturer. In most instances, the original equipment manufacturer bears the cost to replace defective products. We provide the necessary labor to redesign, reinstall or replace products/solutions that did not perform as represented. Our policy is to reserve for estimated future costs based upon historical trends of actual costs incurred. The warranty reserve is included in other accrued liabilities within our consolidated balance sheet.

     The following table presents a summary of the warranty provision (in thousands):

Foreign Currency:

     For our Canadian operations, assets and liabilities are translated at exchange rates as of the balance sheet date, and revenues and expenses are translated at average exchange rates prevailing during the period. Translation adjustments are recorded as a separate component of shareholders’ equity within accumulated other comprehensive loss.

Earnings Per Share Data:

     Norstan reports net income (loss) per share pursuant to the requirements of the Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings per Share”. SFAS No. 128 requires presentation of basic and diluted earnings (loss) per share (EPS). Basic EPS is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted EPS reflects potential dilution from outstanding stock options and other securities using the treasury stock method.

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     A reconciliation of EPS calculations under SFAS No. 128 was as follows (in thousands, except per share amounts):

     For the quarters ended January 31, 2004 and January 25, 2003, common stock equivalents of 2.1 million and 1.9 million, respectively, have been excluded from the computation of diluted earnings per share, as required under SFAS No. 128, as the effect of their inclusion would be anti-dilutive. For the comparable nine month periods then ended, 2.5 million and 1.8 million shares have been excluded as the effect of their inclusion would be anti-dilutive.

Comprehensive Income:

     We report comprehensive income and its components pursuant to the requirements of SFAS No. 130, “Reporting Comprehensive Income”. For Norstan, comprehensive income consists of net income (loss) adjusted for foreign currency translation adjustments. Comprehensive income, as defined by SFAS No. 130, was approximately $543,000 for the quarter ended January 31, 2004 and approximately $571,000 for the similar period ended January 25, 2003. For the nine month period ended January 31, 2004, our comprehensive loss was $4.7 million as compared to comprehensive income of $3.4 million for the nine months ended January 25, 2003.

New Accounting Pronouncements:

     In December 2003, the FASB issued SFAS No. 132(R), a revision to SFAS No. 132, “Employers’ Disclosure about Pensions and Other Postretirement Benefits.” SFAS No. 132(R) does not change the measurement or recognition related to pension and other postretirement plans required by SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and retains the disclosure requirements contained in SFAS No. 132. SFAS No. 132(R) requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. SFAS No. 132(R) is effective for financial statements with fiscal years ending after December 15, 2003, with the exception of disclosure requirements related to foreign plans and estimated future benefit payments which are effective for fiscal years ending after June 15, 2004. The adoption of SFAS No. 132(R) will have no impact on our consolidated balance sheet or results of operations.

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     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 requires issuers to classify as liabilities (or assets in some circumstances) freestanding financial instruments that embody obligations for the issuer. Generally, SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 will have no impact on our consolidated balance sheet or results of operations.

     In January 2003, the FASB issued FASB Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities.” The Interpretation addresses the consolidation of variable interest entities, including entities commonly referred to as special purpose entities. The Company is required to apply FIN 46 to all new variable interest entities created or acquired after January 31, 2003. In October 2003, the FASB issued FASB Staff Position (“FSP”) FIN 46-6, “Effective Date of FIN 46, Consolidation of Variable Interest Entities.” FSP FIN 46-6 extended the required effective date of FIN 46 for variable interest entities created or acquired prior to February 1, 2003. The adoption of FIN 46 will have no impact on our consolidated balance sheet or results of operations.

Supplemental Cash Flow Information:

     Supplemental disclosure of cash flow information was as follows (in thousands):

Vendor Agreements:

     We have been a distributor of Siemens communication equipment since 1976 and are one of Siemens’ largest independent distributors in North America. The term of the distributor agreement with Siemens, signed in January 1999, was five years and has recently been extended for one year and currently runs through January 2005. Norstan and Siemens are also parties to an agreement pursuant to which we are authorized to refurbish and market previously owned Siemens equipment through an alliance with Siemens. This agreement was also extended for a one-year period and currently runs through July 2004. Our relationship with Siemens is integral to our business and any disruption of this relationship could have a material adverse impact on our financial condition and results of operations.

     In addition, we maintain relationships with a wide range of leading technology companies including Ascom Wireless Solutions, Aspect Communications, Captaris, Cisco Systems, Ericsson, Intervoice, Latitude, MobileAccess Networks, Nortel Networks, SpectraLink, SpeechWorks, and Witness Systems.

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NOTE 2 - ACQUISITION:

     On March 7, 2003, we announced that we purchased from NetCom Systems, Inc. certain assets including intellectual property, effective March 1, 2003 related to NetCom’s voice over Internet Protocol (IP) telephony applications software operations. The acquisition consideration totaled $3.0 million, consisting of a cash payment of $1.1 million at closing, $1.1 million paid in the first quarter of fiscal 2004 and guaranteed payments of $800,000 payable over the next two years. The purchase agreement provides that we m