UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

FOR THE PERIOD ENDED JULY 31, 2004

OR

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 September 7, 2004, there were 13,543,196 shares outstanding of the registrant’s common stock, par value $0.10 per share, its only class of equity securities.

INDEX

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PART I. FINANCIAL INFORMATION

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, 2004. 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 our financial statements, in conformity with accounting principles generally accepted in the United States of America, requires us 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 could differ from those estimates.

Revenue Recognition:

     Within our Communications Solutions and Services business segment, revenues from the sale and installation of products and systems are recognized under the percentage-of-completion method of accounting for long-term contracts. Revenues from maintenance service contracts, moves, adds, and changes, and network integration services, are recognized as the services are provided and financial services’ revenues are recognized over the life of the related lease receivables using the effective interest method. Resale Services’ revenues are generated from the secondary equipment market and are recognized upon performance of contractual obligations, which is generally upon shipment. In addition, we grant credit to our customers and generally do not require collateral or any other security to support amounts due.

Inventories:

     Inventories include purchased parts and equipment and are stated at the lower of cost, determined on a weighted-average cost basis, or estimated realizable value.

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Property and Equipment:

     Property and equipment are stated at cost and include expenditures that increase the useful lives of existing property and equipment. Maintenance, repairs and minor renewals are charged to operations as incurred. When property and equipment are disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss is reflected in operations. Property and equipment is depreciated over the estimated useful lives of two to ten years under the straight-line method for financial reporting purposes. Accelerated methods of depreciation are used for income tax reporting.

     Pursuant to the requirements of Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment of Long-Lived Assets,” in determining whether an impairment has occurred, our policy is to evaluate, at each balance sheet date, whether events and circumstances have taken place to indicate that the book value of our assets may not be recoverable. If such indicators were present, impairment would be assessed using estimates of undiscounted cash flows attributable to the assets. In the event such cash flows are not expected to be sufficient to recover the book values of the assets, the assets would be written down to their estimated fair values. There were no writedowns recorded under SFAS No. 144 in the first quarter of fiscal 2005 or fiscal 2004, except for those included in restructuring and other charges (see Note 7).

Goodwill and Other Intangible Assets:

     Pursuant to the requirements of SFAS No. 142, we test goodwill for impairment on an annual basis or more frequently if circumstances warrant using a fair value approach. No circumstances occurred during the first quarter of fiscal 2005 that warranted testing goodwill for impairment. In addition, we recorded amortization expense of $133,000 in the first quarter of fiscal 2005 and $134,000 in the first quarter of fiscal 2004, related to the intangible assets acquired as part of our fiscal 2003 internet protocol (IP) telephony applications software acquisition from NetCom Systems, Inc. (see Note 2). All of these intangible assets were sold at the end of the first quarter of fiscal 2005. The amortization expense is included in our selling, general and administrative expenses in the consolidated statements of operations.

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

     The change in the gross carrying amounts of goodwill and other intangible assets were as follows (in thousands):

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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 sheets.

     The following table presents a summary of the warranty reserve (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 (Loss) Per Share Data:

     Norstan reports net income (loss) per share pursuant to the requirements of 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.

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

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     For the quarters ended July 31, 2004 and August 2, 2003, common stock equivalents of 2.0 million and 3.3 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.

Comprehensive Income (Loss):

     We report comprehensive income (loss) and its components pursuant to the requirements of SFAS No. 130, “Reporting Comprehensive Income”. For Norstan, comprehensive income (loss) consists of net income (loss) adjusted for foreign currency translation adjustments. Comprehensive income, as defined by SFAS No. 130, was approximately $1.3 million for the quarter ended July 31, 2004 and was a loss of approximately $1.9 million for the similar period ended August 2, 2003.

Supplemental Cash Flow Information:

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

NOTE 2 – NORSTAN CONVERGENCE DEVELOPMENT GROUP:

     In March 2003, we purchased certain assets and intellectual property from NetCom Systems, Inc. (NetCom) related to NetCom’s voice over IP telephony applications software operations. The acquisition consideration totaled $3.0 million, consisting of a cash payment of $1.1 million at closing and $1.1 million 120 days after the closing and guaranteed payments of $800,000 payable over the next two years ($400,000 paid April 2004 with the remaining $400,000 due April 2005). The purchase agreement provided that we may pay NetCom contingent consideration up to $3.0 million based on the amount of new software license fees received by Norstan during the two-year period following the closing. We funded the purchase of these assets from borrowings under our credit facility. We also hired certain key NetCom personnel who were involved in NetCom’s development of IP telephony applications software. This group comprised our Norstan Convergence Development Group (Norstan CDG) and its results of operations are included in our Communications Solutions and Services segment.

     The following table summarizes the fair value of the assets acquired as determined by an independent appraisal (in thousands):

     The amortizable intangible assets relating to proprietary technology were being amortized over five years on a straight-line basis. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the goodwill acquired in the acquisition has not been amortized. The intangible assets and goodwill acquired have been allocated to our Communications Solutions and Services business segment. Pro forma results related to the acquisition were not material to our financial condition or results of operations.

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     On July 30, 2004, we sold the assets and the intellectual property related to Norstan CDG to IPcelerate, Inc. (IPcelerate), a privately held developer of voice over IP applications, for $2.5 million in cash and promissory notes, and the assumption by the purchaser of approximately $400,000 in liabilities. Pursuant to the terms of the purchase agreement, we received $1.25 million at closing and $1.25 million evidenced by non-interest bearing promissory notes in favor of Norstan ($1.05 million due January 30, 2005 and $200,000 due February 28, 2005). We recorded a pre-tax gain of $88,000 from the sale in the first quarter of fiscal 2005 in the accompanying consolidated statement of operations. This gain is comprised of total consideration received and liabilities assumed by IPcelerate (including the payable to NetCom for approximately $400,000 due April 2005) less assets sold (consisting primarily of the remaining unamortized portion of the technology intangible assets) as well as the write-off of the goodwill recorded as part of the original CDG purchase.

NOTE 3 — DISCONTINUED OPERATIONS:

     In July 2002, we sold our Network Services business to NetWolves Corporation (NASDAQ: WOLV) for $7.5 million. Pursuant to the terms of the purchase agreement, $3.75 million was received at closing and the remaining $3.75 million was due one year from closing, evidenced by a non-interest bearing promissory note in favor of Norstan. We recorded a pre-tax gain on this sale of $2.7 million in the first quarter of fiscal 2003 based on the $3.75 million cash received. During the fourth quarter of fiscal 2003, we received payment of $2.9 million in cash as well as other non-monetary assets in early settlement of the promissory note. We recorded a pre-tax gain of $2.8 million in the fourth quarter of fiscal 2003 based on the amount of cash received in settlement of the promissory note. The non-monetary asset, consisting of 300,000 shares of unregistered NetWolves Corporation common stock, had been reflected at a zero value until such time as the unregistered common stock was monetized or monetizable. On June 2, 2004, these shares were registered with the Securities and Exchange Commission and, accordingly, we recorded an additional gain on the sale of discontinued operations of $87,000, net of tax, in the first quarter of fiscal 2005. Any adjustment to the final amount received relating to these shares will be recorded in the applicable future period. Network Services provided multiple source long distance services and related consulting and professional services.

     In the first quarter of fiscal 2004, we recorded a gain on the disposal of discontinued operations of $154,000, net of tax. This gain, resulted from the sale of certain property we received as part of the Vadini settlement related to the February 2002 arbitration award (see Note 8).

     Net assets (liabilities) of discontinued operations included the following (in thousands):

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NOTE 4 — INCOME TAXES:

     Deferred income taxes are provided for differences between the financial statement carrying amounts and the tax basis of assets and liabilities at currently enacted income tax rates.

     Realization of our net deferred tax assets is dependent on our ability to generate sufficient future taxable income. Should our operating strategies fail to produce sufficient taxable income in the future, we would need to record a valuation allowance in the appropriate future reporting period as required by generally accepted accounting principles. Norstan’s U.S. net operating loss carryforwards expire from 2020 to 2021, and the Canadian net operating loss carryforwards expire through fiscal 2011.

     For the first quarter ended July 31, 2004, we recorded a tax provision of 38.0% on the net income generated from continuing operations. In addition, we recorded a tax provision of 38.0% on the current quarter gain on disposal of discontinued operations. For the first quarter of fiscal 2004, we recorded a tax benefit of 39.0% on the net loss incurred from continuing operations and a 39.0% tax provision on the gain on disposal of discontinued operations. These effective rates represent our federal statutory rate adjusted for state income taxes and other permanent tax items.

NOTE 5 — STOCK-BASED COMPENSATION:

     We apply Accounting Principles Board (APB) Opinion No. 25 “Accounting for Stock Issued to Employees” and related interpretations in accounting for our stock-based compensation plans. Accordingly, no compensation cost has been recognized in the accompanying statements of operations. Had compensation cost been recognized based on the fair values of options at the grant dates consistent with the provisions of SFAS No. 123 “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, our net income (loss) (in thousands) and net income (loss) per common share would have changed to the following pro forma amounts:

NOTE 6 – DEBT OBLIGATIONS:

     In December 2003, we entered into a five year $27.5 million secured credit agreement with Wells Fargo Foothill, Inc. consisting of the following components: A) a $5.0 million revolving line of credit, and B) a $22.5 million term loan payable in 30 monthly installments of $333,333 beginning on February 1, 2004, with the remaining $12.5 million principal due and payable upon maturity at December 9, 2008. Availability under the revolving line of credit is generally based on a percentage of eligible recurring service and maintenance revenues, as defined. This credit agreement is secured by sub