FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ________ to ___________
Commission file number: 0-21479
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, TEXAS 77074
Address of principal executive offices) (Zip code)
Registrant's telephone number including area code: (713) 795-2000
(Former name, former address, and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No___
APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes ____ No ____
APPLICABLE ONLY TO CORPORATE REGISTRANTS:
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.
Title Outstanding
Common Stock, $.01 par value per share As of November 7, 2003
3,707,155 shares outstanding
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
I-SECTOR CORPORATION
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2003
Part I. Financial Information
Item 1. Condensed Consolidated Financial Statements - I-Sector Corporation
(Unaudited):
Condensed Consolidated Balance Sheets at September 30, 2003 and
December 31, 2002
Condensed Consolidated Statements of Income for the three months ended
September 30, 2003 and 2002
Condensed Consolidated Statements of Income for the nine months ended
September 30, 2003 and 2002
Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2003 and 2002
Notes to Condensed Consolidated Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
Part II. Other Information
Item 1. Legal Proceedings
Item 2. Other Information
Item 6. Exhibits
Exhibit 31 Certification
Exhibit 32 Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
Signatures
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and par value amounts)
September 30, December 31,
2003 2002
---- ----
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 1,954 $ 3,491
Accounts receivable-trade, net of
allowance of $1,965 and $2,153 10,951 6,525
Accounts receivable - affiliates 38 99
Accounts receivable - other 30 57
Notes receivable 655 898
Inventory 1,543 781
Cost and estimated earnings in
excess of billings 1,370 709
Income taxes receivable - 488
Other current assets 465 356
---------- -----------
Total current assets 17,006 13,404
Property and equipment, net 1,221 1,115
Patent licenses, net of amortization
of $236 and $148 879 955
Other intangible assets, net of amortization
of $546 and $356 487 207
Other assets 232 70
---------- -----------
Total $ 19,825 $ 15,751
========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long term debt $ 525 $ 157
Accounts payable 8,801 4,844
Billings in excess of cost
and estimated earnings 105 75
Accrued expenses 3,157 1,803
Net liabilities related to
discontinued operations 600 904
Deferred revenue 157 81
---------- -----------
Total current liabilities 13,345 7,864
Long term debt, net of current maturities 203 247
Commitments and contingencies - -
Stockholders' equity:
Preferred stock, $.01 par value,
5,000,000 shares
authorized, no shares issued
Common stock, $.01 par value,
15,000,000 shares authorized,
4,518,955 and 4,441,325 shares
issued at September 30, 2003
and December 31, 2002 45 44
Additional paid-in capital 10,473 10,379
Deferred compensation 78 -
Treasury stock, 811,800 shares, at cost (1,373) (1,373)
Retained deficit (2,946) (1,410)
---------- -----------
Total stockholders' equity 6,277 7,640
---------- -----------
Total $ 19,825 $ 15,751
========== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements
I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share amounts)
(Unaudited)
Three Months Ended September 30,
2003 2002
---- ----
Revenues:
Products $ 16,302 $ 8,326
Services 2,264 1,538
Custom projects 2,415 1,743
---------- ----------
Total revenues 20,981 11,607
---------- ----------
Cost of sales and services:
Products 14,066 7,435
Services 1,396 1,064
Custom projects 728 781
---------- ----------
Total cost of sales and services 16,190 9,280
---------- ----------
Gross profit 4,791 2,327
Selling, general and administrative expenses 4,621 2,619
---------- ----------
Operating income (loss) 170 (292)
Interest and other income (expense) (11) 3
---------- ----------
Income (loss) from continuing
operations before benefit for
income taxes 159 (289)
Benefit for income taxes (12) -
---------- ----------
Net income (loss) from continuing
operations 171 (289)
Discontinued operations:
Gain (loss) on disposal of
discontinued operations, net of taxes 23 (1)
---------- ----------
Net income (loss) $ 194 $ (290)
========== ==========
Net income (loss) per share:
Basic:
Net income (loss) from
continuing operations $ 0.04 $ (0.08)
Gain on disposal of discontinued
operations, net of taxes 0.01 0.00
--------- ----------
Net income (loss) per share $ 0.05 $ (0.08)
========= ==========
Diluted:
Net income (loss) from continuing
operations $ 0.03 $ (0.08)
Gain on disposal of discontinued
operations, net of taxes 0.01 0.00
--------- ----------
Net income (loss) per share $ 0.04 $ (0.08)
========= ==========
Shares used in computing net income (loss)
per share:
Basic 3,703,206 3,629,525
========== ==========
Diluted 3,974,298 3,629,525
========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements
I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share amounts)
(Unaudited)
Nine Months Ended September 30,
2003 2002
---- ----
Revenues:
Products $ 35,655 $ 21,284
Services 5,282 4,220
Custom projects 5,995 5,571
---------- ----------
Total revenue 46,932 31,075
Cost of sales and services:
Products 31,181 18,964
Services 3,852 3,355
Custom projects 2,104 2,488
---------- ----------
Total cost of sales and services 37,137 24,807
---------- ----------
Gross profit 9,795 6,268
Selling, general and administrative
expenses 11,556 7,255
---------- ----------
Operating loss (1,761) (987)
Interest and other income 93 1
---------- ----------
Loss from continuing operations before
benefit for income taxes (1,668) (986)
Benefit for income taxes (93) (1,189)
---------- ----------
Net (loss) income from continuing
operations (1,575) 203
Discontinued operations:
Gain on disposal of discontinued
operations, net of taxes 39 17
---------- ----------
Net (loss ) income $ (1,536) $ 220
========== ==========
Net (loss) income per share:
Basic:
Net (loss) income from continuing
operations $ (0.43) $ 0.05
Gain on disposal of discontinued
operations,
net of taxes 0.01 0.01
--------- ----------
Net (loss) income per share $ (0.42) $ 0.06
========= ==========
Diluted:
Net (loss) income from continuing
operations $ (0.43) $ 0.05
Gain on disposal of discontinued
operations, net of taxes 0.01 0.01
--------- ----------
Net (loss) income per share $ (0.42) $ 0.06
========= ==========
Shares used in computing net income (loss)
per share:
Basic 3,643,346 3,736,704
========== ==========
Diluted 3,643,346 3,783,345
========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements
I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine Months Ended September 30,
2003 2002
---- ----
Net (loss) income $ (1,536) $ 220
Adjustments to reconcile net (loss) income
to net cash
provided by (used in) operating activities:
Gain on disposal of discontinued operations (39) (17)
Depreciation and amortization 548 425
(Gain) loss on retirement of assets (157) 21
Bad debt expense (recoveries) 1,051 (340)
Current tax benefit on gain on disposal
of discontinued operations (20) (9)
Changes in assets and liabilities that
provided (used) cash:
Accounts receivable-trade (4,821) (1,491)
Accounts receivable - affiliates 61 39
Accounts receivable - other 27 (92)
Inventory (661) (162)
Income tax receivable 488 (56)
Notes receivable (575) (622)
Other current assets (38) (67)
Cost and estimated earnings in excess
of billings (661) 393
Accounts payable 4,404 2,319
Accrued expenses 1,354 112
Billings in excess of cost and
estimated earnings 30 118
Deferred revenue 76 (5)
---------- -----------
Net cash (used in) provided by continuing
operating activities (469) 786
Net cash used in discontinued activities (231) (417)
---------- -----------
Net cash (used in) provided by operating
activities (700) 369
Cash flows from investing activities:
Proceeds on sale of fixed assets 80 -
Acquisition of Digital Precision, Inc
(inclusive of acquisition costs) (566) -
Capital expenditures (323) (265)
---------- -----------
Net cash used in investing activities (809) (265)
---------- -----------
Cash flows from financing activities:
Exercise of stock options 95 -
Purchase of treasury stock - (186)
Payments on long-term debt (123) (151)
---------- -----------
Net cash used in financing activities (28) (337)
---------- -----------
Net decrease in cash and cash equivalents (1,537) (233)
Cash and cash equivalents at beginning of period 3,491 3,434
---------- -----------
Cash and cash equivalents at end of period $ 1,954 $ 3,201
========== ===========
Supplemental disclosures of cash flow informatio
Non-cash items supplemental disclosure:
Other receivable for proceeds of sale of
fixed assets $ 30 $ 0
========== ===========
Options granted for consulting services $ 78 $ 0
========== ===========
Supplemental Schedule of Noncash Investing and
Financing Activities:
Additional paid in capital from
expiration of stock warrants $ 0 $ 195
========== ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
I-Sector Corporation and subsidiaries ("I-Sector") is engaged in the
business of providing network integration services and certain managed IT
services and of selling associated network hardware and telephony software
products. I-Sector's operations are conducted through three segments:
o Internetwork Experts, Inc. ("INX"), a wholly-owned subsidiary, is a
network professional services and integration organization with areas
of practice that include large-scale enterprise network engineering
consulting, network security, network management, wireless networking,
and IP Telephony.
o Stratasoft, Inc. ("Stratasoft"), a wholly-owned subsidiary, creates and
markets software related to the integration of computer and telephone
technologies.
o Valerent, Inc. ("Valerent"), a wholly owned subsidiary, provides
information technology solutions that lowers its client's expense by
utilizing centralized, remote enabled computing management tools which
predict, announce and manage service interruptions. Additionally
Valerent provides customers with traditional computer services such as
application support, operating system and network migration services,
turnkey outsourced IT helpdesk solutions, technical staff augmentation
for IT helpdesk operations and helpdesk solutions consulting services.
The condensed consolidated financial statements presented herein as of
and for the three-month and nine-month periods ended September 30, 2003 and 2002
are unaudited; however, all adjustments which are, in the opinion of management,
necessary for a fair presentation of the financial position, results of
operations, and cash flows for the periods covered have been made and are of a
normal, recurring nature. The results of the interim periods are not necessarily
indicative of results for the full year. The consolidated balance sheet at
December 31, 2002 is derived from audited consolidated financial statements but
does not include all disclosures required by accounting principles generally
accepted in the United States of America. Although management believes the
disclosures are adequate, certain information and disclosures normally included
in the notes to the financial statements have been condensed or omitted as
permitted by the rules and regulations of the Securities and Exchange
Commission. These interim financial statements should be read in conjunction
with the consolidated financial statements and notes thereto included in
I-Sector's 2002 Annual Report on Form 10-K.
Reclassifications - Certain prior period amounts in the consolidated
financial statements presented herein have been reclassified to conform to
current period presentation.
Use of Estimates - The preparation of the 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 disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amount
of revenue and expense during the reporting period. Actual results could differ
from these estimates.
Revenue Recognition - I-Sector has a number of different revenue
components, which vary between its three reportable operating segments. Each
reportable operating segment has more than one revenue component, and revenue is
recognized differently for each component (or "stream") of revenue earned by
operating segment. The material revenue streams earned by I-Sector, some of
which are earned by more than one operating segment, and some by only one
operating segment, are:
Products Revenue. Three of I-Sector's segments earn revenue
from product shipments. Product shipment revenue occurs when products
manufactured by other parties are purchased and resold to a customer
and such products are contracted for independently of material
services. I-Sector recognizes revenue from product shipments when the
product is shipped or delivered to the customer. In all three of these
segments, the four criteria for revenue recognition has been met
because: (1) there are written, executed contracts, or in the case of
Valerent in some situations there are binding purchase orders; (2)
delivery has occurred or services have been rendered. Stratasoft,
however, recognizes revenues on the percentage of completion method, as
described below; (3) the price is fixed or determinable, and (4)
collectibility is reasonably assured. Each of I-Sector's business
segments perform credit research prior to extending credit. In
Stratasoft's business segment, a substantial portion of the total
contract price is received in cash or letter of credit when the unit is
installed.
Custom Project Revenue. One of I-Sector's segments,
Stratasoft, earns revenues from projects that are recognized using the
percentage of completion method of accounting for such revenues. The
majority of Stratasoft's revenues consist of system sales in which it
bundles its proprietary software, along with third-party hardware
products and material related software customization services,
installation, training services, warranty services and incidental post
contract support ("PCS") together under a single contract with the
customer. PCS is insignificant on such contracts for one year or less,
and therefore, we have determined that the value of such PCS should not
be unbundled from the project revenue as set forth in paragraph 59 of
SOP 97-2. Accordingly, such PCS revenue is recognized together with the
project revenue, and the estimated cost to provide the PCS is accrued.
The value of the PCS is determinable within the contract, which defines
the period that the PCS is granted and offers renewals at stated
amounts, thereby defining the value of the PCS. The software
customization, together with the hardware customization and
integration, represent a significant modification, customization and/or
production of the product and, therefore, the entire arrangement is
required to be accounted for using the percentage of completion method
of accounting pursuant to SOP 81-1. The percentage of revenue
recognized in any particular period is determined principally on the
basis of the relationship of the cost of work performed on the contract
to estimated total costs. The percentage-of-completion method relies on
estimates of total expected contract revenue and costs. We follow this
method since reasonably dependable estimates of the revenue and costs
applicable to various stages of a contract can be made. Revisions of
estimates are reflected in the period in which the facts necessitating
the revisions become known. When a contract indicates a loss, a
provision is made for the total anticipated loss. The following
reflects the amounts relating to uncompleted contracts at September 30,
2003 and December 31, 2002:
September 30, December 31,
2003 2002
------------ ------------
Costs incurred on uncompleted
contracts $ 904 $ 429
Estimated earnings 2,847 1,478
-------- --------
3,751 1,907
Less: Billings to date 2,492 1,273
-------- --------
Total $ 1,265 $ 634
======== ========
Included in accompanying balance
sheets under the following captions:
Cost and estimated earnings in
excess of billings $ 1,370 $ 709
Billings in excess of cost and
estimated earnings (105) (75)
-------- --------
Total $ 1,265 $ 634
======== ========
During the quarter ended June 30, 2003, the Company recorded
adjustments to defer revenue for certain custom projects that had more
than one year of free PCS and certain renewals of PCS paid in advance.
The adjustment includes approximately $152 related to years prior to
2003. Management determined that the effect of these adjustments was
not material to the previously reported results or to the results
expected for 2003.
During 2002 and 2003 I-Sector has recognized revenues on the
percentage-of-completion basis for several projects associated with one
reseller in South Asia. For these projects, Stratasoft entered into a
three-party contract between Stratasoft, the South Asia reseller and
the end-user customers. Stratasoft was responsible for performing the
substantial majority of the project for the end-user customer, from
whom Stratasoft was directly obligated to be paid for such project by
the end-user customer.
Services Revenue. All of I-Sector's segments earn revenue from
providing stand-alone services revenue. These revenues consist of
billings for engineering and technician time, programming services,
which are provided on either an hourly basis or a flat-fee basis, and
the service component of maintenance and repair service ticket
transactions. These services are contracted for separately from any
product sale, and are recognized when the service is performed and when
collection is reasonably assured. One of I-Sector's segments sometimes
earns agency fee revenue from various sources, the primary source of
which is referring customers to other organizations for which an agency
fee is received. These revenues are recognized at the earlier of when
payment is received or when notification of amounts being due is
received from the entity paying such agency fee and collectiblity is
reasonably assured.
Credit Risk - The Company extends credit to its customers in the normal
course of business and generally does not require collateral or other security.
The Company performs ongoing credit evaluations of its customers' financial
condition and, in some instances, requires letters of credit or additional
guarantees in support of contracted amounts. Earnings are charged with a
provision for doubtful accounts based on a current review of the collectibility
of the accounts. Accounts deemed uncollectible are applied against the allowance
for doubtful accounts.
Warranty Reserve - I-Sector records a warranty reserve related to
certain software products sold by its Stratasoft subsidiary. This reserve is
classified in accrued expenses and is amortized over the life of the warranty,
which is generally twelve months, against actual warranty expenditures. This
warranty reserve relates to the estimate of warranty obligations from sales of
call center telephony systems, which consist of Stratasoft's software,
configured hardware components as well as telephone support relating to
Stratasoft's software products. This liability amount has been consistently
recorded within each period as a charge to cost of sales based upon 5% of period
revenue. This percentage was based upon a review of the costs of providing the
warranty work, which was initially performed in connection with the acquisition
of the Stratasoft technology. Stratasoft incurs numerous types of costs related
to the warranty work, which includes labor cost of technicians and programmers,
hardware cost, the cost of developing and uploading software patches related to
"bug fixes", telephone support, and hardware parts cost related to defective
hardware sold as a part of a complete Stratasoft system. The majority of these
costs are individually insignificant amounts for which the cost/benefit
relationship does not warrant tracking, but which we periodically assess and
continue to estimate at approximately five percent of Stratasoft sales. As the
actual costs are not tracked, Stratasoft amortizes the recorded amounts to cost
of sales over the average life of the contractual warranty period as costs are
believed to be incurred ratably over the warranty period. The difference between
the actual warranty costs incurred and the amount of amortization is not
considered to be materially different. The following table depicts the
composition of the warranty reserve at September 30, 2003 and December 31, 2002:
Nine Months Ended Year Ended
September 30, December 31,
2003 2002
------------ -----------
Balance, beginning of year $ 305 $ 263
Additions to reserve 270 373
Expenses offset against reserve (253) (331)
--------- ----------
Balance, end of period $ 322 $ 305
========= ==========
Stock-Based Compensation - The Company has elected to account for
stock-based compensation using the intrinsic value method of accounting in
accordance with Accounting Principles Bulletin ("APB") No. 25 "Accounting for
Stock Issued to Employees". Under this method no compensation expense is
recognized when the number of shares granted is known and the exercise price of
the stock option is equal to or greater than the fair value of the common stock
on the grant date. The Company has recorded no stock-based compensation
associated with stock options granted to employees and directors in its
consolidated statement of operations. I-Sector and its subsidiaries apply the
fair value method as prescribed by SFAS No. 123, as interpreted and amended, for
stock and stock options issued to non-employees and during the three and
nine-month periods ended September 30, 2003, recorded $4 and $7 of expense,
respectively. If compensation cost for all option issuances had been determined
consistent with the fair value method, I-Sector's net loss and net loss per
share would have increased to the pro-forma amounts indicated below for the
three and nine-month periods ended September 30, 2003 and 2002, respectively.
Three months ended September 30, Nine Months ended September 30,
2003 2002 2003 2002
---------------------- ----------------------
Basic:
Net income (loss) as reported $ 194 $ (290) $ (1,536) $ 220
Deduct: Total stock-based employee compensation
determined under fair value based method for
all awards, net of related tax effects 5 6 29 26
------ ------ -------- -------
Pro forma net income (loss) $ 189 $ (296) $ (1,565) $ 194
====== ====== ======== =======
Diluted:
Net income (loss) as reported $ 194 $ (290) $ (1,536) $ 220
Deduct:
Adjustment for subsidiary dilution 44 - - -
Total stock-based employee compensation
determined under fair value based method for
all awards, net of related tax effects 5 6 29 26
------ ------ -------- ------
Pro forma net (loss) income $ 145 $ (296) $ (1,565) $ 194
====== ======= ======== ======
Earnings per share:
Basic - as reported $ 0.05 $ (0.08) $ (0.42) $ 0.06
Basic - pro forma $ 0.05 $ (0.08) $ (0.43) $ 0.05
Diluted - as reported $ 0.04 $ (0.08) $ (0.42) $ 0.06
Diluted - pro forma $ 0.04 $ (0.08) $ (0.43) $ 0.05
Earnings Per Share - Basic net income per share is computed on the
basis of the weighted-average number of common shares outstanding during the
periods. Diluted net income per share is computed based upon the
weighted-average number of common shares plus the assumed issuance of common
shares for all potentially dilutive securities using the treasury stock method
(See Note 4).
Fair Value of Financial Instruments - I-Sector's financial instruments
consist of cash and cash equivalents, accounts receivable and accounts payable
for which the carrying values approximate fair values given the short-term
maturity of the instruments. The carrying value of the Company's debt
instruments approximate their fair value based on estimates of rates offered to
the Company for instruments with the same maturity dates and security
structures.
Accounting Pronouncements -
In April 2002, the FASB issued Statement of Financial Accounting
Standards No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment
of FASB Statement No. 13, and Technical Corrections." SFAS No. 145, among other
things, amends SFAS No. 4 and SFAS No. 64, to require that gains and losses from
the extinguishments of debt generally be classified within continuing
operations. The provisions of SFAS No. 145 are effective for fiscal years
beginning after May 15, 2002 and early application is encouraged. The Company
adopted SFAS No. 145 on January 1, 2003. The adoption of this statement had no
impact on the financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 replaces Emerging
Issues Task Force (EITF Issue 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity". This standard
requires companies to recognize costs associated with exit or disposal
activities when they are incurred rather than at the date of a commitment to an
exit or disposal plan. The Company adopted SFAS No. 146 on January 1, 2003. The
adoption of this statement had no impact on the financial statements.
In February 2003, the FASB issued SFAS No. 148, "Accounting for Stock
Based Compensation: A Comparison of FASB Statement No. 123, Accounting for
Stock-Based Compensation and Its Related Interpretations, and IASB Proposed
IFRS, Share-based Payments." SFAS No. 148 amends SFAS 123 to provide alternative
methods of transition for an entity that voluntarily changes to the fair value
based method of accounting for stock-based employee compensation. It also amends
the disclosure provisions of that Statement to require prominent disclosure
about the effects on reported net income of an entity's accounting policy
decisions with respect to stock-based compensation. The statement also amends
APB Opinion No. 28, "Interim Financial Reporting", to require disclosure about
those effects in interim financial information. The Company has chosen not to
voluntarily change to the fair value based methods of accounting for stock-based
employee compensation but has adopted the disclosure rules of SFAS 148.
In April 2003 The FASB issued SFAS No. 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies when a derivative contains a financing component that warrants special
reporting in the statement of cash flows and amends certain other existing
pronouncements, resulting in more consistent reporting of contracts that are
derivatives in their entirety or that contain embedded derivatives that warrant
separate accounting. SFAS No. 149 is effective for contracts entered into or
modified after June 30, 2003. The Company does not believe that the adoption of
SFAS No. 149 will have a significant impact on its financial statements.
In January 2003, the FASB issued FASB Interpretation 46 ("FIN 46"),
"Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51".
FIN 46 addresses consolidation by business enterprises of variable interest
entities. This Interpretation applies immediately to variable interest entities
created after January 31, 2003, and to variable interest entities in which an
enterprise obtains an interest after that date. It applies in the first fiscal
year or interim period beginning after June 15, 2003, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. On October 9, 2003, the FASB issued FSP FIN 46-6,
"Effective Date of FASB Interpretation No. 46, Consolidation of Variable
Interest Entities, providing a deferral of application of FIN 46 for interests
held by public entities in a variable interest entity or potential variable
interest entity until December 31, 2003 for qualified entities with a calendar
year-end. The Company has not fully assessed the impact of FIN 46 on its
financial statements, particularly its relationship with Allstar Equities, Inc.,
but the adoption of this statement is not expected to have a material impact on
the Company's financial statements.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on EITF Issue 00-21, "Revenue Arrangements with Multiple
Deliverables". EITF 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which it will perform multiple revenue-generating
activities. Issue 00-21 is effective for revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. The Company does not expect that
the adoption of EITF 00-21 will have a significant impact on the Company's
financial statements.
In July 2003, the EITF reached a preliminary consensus on EITF 03-05,
"Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables
in an Arrangement Containing More-Than-Incidental Software". EITF 03-05 requires
revenue recognition under SOP 97-2 for all arrangements in which the software
sold is essential to the functionality of the hardware. The EITF Board has not
ratified the consensus, but the adoption of the EITF consensus once ratified is
not expected to have a material impact on the Company's financial statements.
2. DISCONTINUED OPERATIONS
On November 6, 2001, I-Sector approved a plan to sell or close its IT
Staffing business. A sale was finalized on December 31, 2001. Under the terms of
the sale I-Sector received a note receivable for $52. The note receivable bears
interest at 5% per annum and is collectible in installments based on the total
monthly revenue of the buyer over 24 months beginning in March, 2002.
Previously, on March 16, 2000, I-Sector entered into an agreement to sell
certain assets of and the ongoing operations of its Computer Products Division.
The sale transaction closed on May 19, 2000 after shareholder and other required
consents were obtained. Additionally on November 2, 1999, I-Sector approved a
plan to sell or close its Telecom Division and that business was sold on March
16, 2000.
During the nine months ended September 30, 2003 and 2002, I-Sector
recognized a gain (loss) on disposal, net of income tax provision (benefit), of
these three businesses as follows:
2003 2002
IT Staffing, Inc.
(net of taxes of $14 and $0) $ 26 $ 1
Computer Products Division
(net of taxes of $(27) and $3) (53) 5
Telecom Division
(net of taxes of $33 and $6) 66 11
------- -------
Net gain on disposal $ 39 $ 17
======= =======
The balance sheet caption "Net Liabilities related to discontinued
operations" contains $600 and $904 at September 30, 2003 and December 31, 2002,
respectively, of estimated future expenses related to the winding up of the IT
Staffing business, the Telecom Division and the Computer Products Division, and
includes amounts related to settlement of pending litigation and to Telecom
warranties.
3. SEGMENT INFORMATION
I-Sector has four reportable segments: INX, Stratasoft, Valerent and
Corporate. Corporate is not an operating segment. The accounting policies of the
business segments are the same as those for I-Sector. I-Sector evaluates
performance of each segment based on operating income. Management views accounts
receivable and inventory and not total assets in their decision-making.
Inter-segment sales and transfers are not significant and are shown in the
Elimination column in the following table. The tables below show the results of
the four reportable segments:
For the quarter ended September 30, 2003:
INX Stratasoft Valerent Corporate Eliminations Consolidated
Revenues:
Products $ 15,954 $ - $ 515 $ - $ (167) $ 16,302
Services 1,392 - 877 - (5) 2,264
Custom projects - 2,415 - - - 2,415
--------- --------- --------- --------- --------- ---------
Total revenues 17,346 2,415 1,392 - (172) 20,981
--------- --------- --------- --------- --------- ---------
Cost of sales and services
Products 13,758 - 474 - (166) 14,066
Service 795 - 606 - (5) 1,396
Custom projects - 728 - - - 728
--------- --------- --------- --------- --------- ---------
Total cost of sales and service 14,553 728 1,080 - (171) 16,190
--------- --------- --------- --------- --------- ---------
Gross profit 2,793 1,687 312 - (1) 4,791
Selling, general and administrative
expenses 2,126 1,754 455 287 (1) 4,621
--------- --------- --------- --------- --------- ---------
Operating income (loss) $ 667 $ (67) $ (143) $ (287) $ - 170
========= ========= ========= ========= ========= =========
Interest and other income (11)
---------
Income from continuing operations
before benefit for income taxes 159
Benefit for income taxes (12)
---------
Net income from continuing operations 171
Net gain on disposal of discontinued
operations, net of taxes 23
---------
Net income $ 194
=========
Accounts receivable, net $ 9,281 $ 795 $ 710 $ - $ - $ 10,786
========= ========= ========= ========= ========= =========
Accounts receivable retained from
discontinued operations, net 165
---------
Total accounts receivable, net $ 10,951
=========
Inventory $ 812 $ 702 $ 29 $ - $ - $ 1,543
========= ========= ========= ========= ========= =========
For the quarter ended September 30, 2002:
INX Stratasoft Valerent Corporate Eliminations Consolidated
Revenues:
Products $ 8,034 $ - $ 303 $ - $ (11) $ 8,326
Services 550 988 - - 1,538
Custom projects - 1,743 - - - 1,743
--------- --------- --------- --------- --------- ---------
Total revenues 8,584 1,743 1,291 - (11) 11,607
--------- --------- --------- --------- --------- ---------
Cost of sales and services
Products 7,150 - 296 - (11) 7,435
Service 377 - 687 - - 1,064
Custom projects - 781 - - - 781
--------- --------- --------- --------- --------- ---------
Cost of sales and services 7,527 781 983 - (11) 9,280
--------- --------- --------- --------- --------- ---------
Gross profit 1,057 962 308 2,327
Selling, general and
administrative expenses 966 914 569 170 - 2,619
--------- --------- --------- --------- --------- ---------
Operating (loss) income $ 91 $ 48 $ (261) $ (170) $ - (292)
========= ========= ========= ========= ========= =========
Interest and other income (expense) 3
---------
Loss from continuing operations before
benefit for income taxes (289)
Benefit for income taxes -
---------
Net loss from continuing operations (289)
Net loss on disposal of discontinued
operations, net of taxes (1)
---------
Net loss $ (290)
=========
Accounts receivable, net $ 863 $ 3,943 $ 1,303 $ 23 $ - $ 6,132
========= ========= ========= ========= ========= =========
Inventory $ 60 $ 324 $ 416 $ 0 $ - $ 801
========= ========= ========= ========= ========= =========
For the nine months ended September 30, 2003:
INX Stratasoft Valerent Corporate Eliminations Consolidated
Revenues:
Products $ 34,795 $ - $ 1,219 $ - $ (359) $ 35,655
Services 2,725 - 2,562 - (5) 5,282
Custom projects - 5,995 - - - 5,995
--------- --------- --------- --------- --------- ---------
Total revenues 37,520 5,995 3,781 - (364) 46,932
--------- --------- --------- --------- --------- ---------
Cost of sales and services
Products 30,448 - 1,090 - (357) 31,181
Service 2,068 - 1,789 - (5) 3,852
Custom projects - 2,104 - - 2,104
--------- --------- --------- --------- --------- ---------
Cost of sales and services 32,516 2,104 2,879 - (362) 37,137
--------- --------- --------- --------- --------- ---------
Gross profit 5,004 3,891 902 - (2) 9,795
Selling, general and
administrative expenses 4,518 4,694 1,551 795 (2) 11,556
--------- --------- --------- --------- --------- ---------
Operating (loss) income $ 486 $ (803) $ (649) $ (795) $ - (1,761)
========= ========= ========= ========= ========= =========
Interest and other income 93
---------
Loss from continuing operations
before benefit for income taxes (1,668)
Benefit for income taxes (93)
---------
Net loss from continuing operations (1,575)
Net gain on disposal of discontinued
operations, net of taxes 39
---------
Net loss $ (1,536)
=========
For the nine months ended September 30, 2002:
INX Stratasoft Valerent Corporate Eliminations Consolidated
Revenues:
Product $ 20,550 $ - $ 940 $ - $ (206) $ 21,284
Services 1,177 - 3,043 - - 4,220
Custom projects - 5,571 - - - 5,571
--------- --------- --------- --------- --------- ---------
Total revenue 21,727 5,571 3,983 - (206) 31,075
--------- --------- --------- --------- --------- ---------
Cost of sales and services
Product 18,270 - 900 - (206) 18,964
Service 1,208 - 2,147 - - 3,355
Custom projects - 2,488 - - - 2,488
--------- --------- --------- --------- --------- ---------
Total cost of sales and services 19,478 2,488 3,047 - (206) 24,807
--------- --------- --------- --------- --------- ---------
Gross profit 2,249 3,083 936 - - 6,268
Selling, general and
administrative expenses 2,446 2,600 1,723 486 - 7,255
--------- --------- --------- --------- --------- ---------
Operating (loss) income $ (197) $ 483 $ (787) $ (486) $ - (987)
========= ========= ========= ========= ========= =========
Interest and other income 1
---------
Loss from continuing operations before
benefit for income taxes (986)
Benefit for income taxes (1,189)
---------
Net income from continuing operations 203
Net gain on disposal of discontinued
operations, net of taxes 17
---------
Net income $ 220
=========
International sales accounted for $681 or 3.2% and $378 or 3.3% of consolidated
revenues and 28.2% and 21.7% of the Stratasoft segment revenues in the three
months ended September 30, 2003 and 2002, respectively. In the nine months ended
September 30, 2003 and 2002, international sales accounted for $2,627 or 5.6 %
and $1,247 or 20.0% of consolidated revenues and 43.8% and 73.9% of the
Stratasoft segment sales, respectively. International sales are derived from
Southern Asia, Africa, United Kingdom, Greece, Europe, Granada, Japan and
Canada.
4. EARNINGS PER SHARE
Basic EPS is computed by dividing net income (loss) by the
weighted-average number of common shares outstanding for the period. Diluted EPS
is based on the weighted-average number of shares outstanding during each period
and the assumed exercise of dilutive stock options and warrants less the number
of treasury shares assumed to be purchased from the proceeds using the average
market price of the Company's common stock for each of the periods presented.
The potentially dilutive options of 134,503 for the three months ended
September 30, 2002, and the potentially dilutive options of 201,473 for the nine
months ended September 30, 2003 were not used in the calculation of diluted
earnings since the effect of potentially dilutive securities in computing a loss
per share is antidilutive. The potentially dilutive options totaling 271,092 for
the three months ended September 30, 2003 and 46,641 and nine months ended
September 30, 2002 were calculated under the treasury stock method.
The potentially dilutive options of the Company's wholly-owned
subsidiary, Internetwork Experts, Inc., (see Note 9) did impact the calculation
of I-Sector's earnings per share in the quarter ended September 30, 2003 as
indicated in the following table. The potentially dilutive options of
Internetwork Experts, Inc. were not used in the calculation of diluted earnings
attributable to the Company for the three months ended September 30, 2002, and
for the nine months ended September 30, 2003 and 2002, respectively, since the
effect would have been antidilutive.
Three Months Nine Months
2003 2002 2003 2002
----------------------- -----------------------
Numerator:
Basic:
Net income (loss) from continuing operations $ 171 $ (289) $ (1,575) $ 203
Gain (loss) on disposal of discontinued
operations, net of taxes 23 (1) 39 17
--------- --------- --------- ---------
Net (loss) income $ 194 $ (290) $ (1,536) $ 220
========= ========= ========= =========
Diluted:
Net income (loss) from continuing operations $ 171 $ (289) $ (1,575) $ 203
Deduct:
Adjustment for subsidiary dilution 44
--------- --------- --------- ---------
Adjusted net income (loss) from continuing
Operations 127 (289) (1,575) 203
Gain (loss) on disposal of discontinued
Operations, net of taxes 23 (1) 39 17
--------- --------- --------- ---------
Net (loss) income adjusted for subsidiary dilution $ 150 $ (290) $ (1,536) $ 220
========= ========= ========= =========
Denominator for basic earnings per share - .
weighted-average shares outstanding.... 3,703,206 3,629,525 3,643,346 3,736,704
Effect of dilutive securities:..............
Shares issuable from assumed conversion of
common stock options and restricted stock 271,092 - - 46,641
--------- --------- --------- ---------
Denominator for diluted earnings per share.. 3,974,298 3,629,525 3,643,346 3,783,345
========= ========= ========= =========
The adjustment for subsidiary dilution was calculated using the treasury stock
method of calculating the dilutive effect of INX's granted and outstanding
options on INX's net income.
There were warrants to purchase 176,750 shares of common stock for the
six months ended June 30, 2002 which were not included in computing diluted
earnings per share because the inclusion would have been antidilutive. During
the three months ended September 30, 2002 such warrants expired and the carrying
value of the warrants was recognized as additional paid in capital.
5. CURRENT DEBT OBLIGATIONS
On September 27, 2001, Stratasoft, a subsidiary of I-Sector, signed a
note payable to a third party for $725, payable in monthly installments through
February 2007. The note does not bear interest and I-Sector has imputed interest
at 5.5% to record the debt and related patent license asset and has recorded
interest of $4 and $8 in the three months and $13 and $24 in the nine months
ended September 30, 2003 and 2002, respectively. This note is collateralized by
Stratasoft's patent license assets and Stratasoft has granted a security
interest in its pending patent application and the next two patent applications
filed by Stratasoft. In connection with this note payable, I-Sector has
short-term debt maturing within one year of $66 and $144 and long-term debt of
$203 and $236 at September 30, 2003 and December 31, 2002, respectively.
In October 2001, I-Sector signed a non-interest bearing note payable
for $39 payable in monthly installments through October 2004. In connection with
this note payable, I-Sector has short-term debt maturing within one year of $13
and $13 and long-term debt of $0 and $14 at September 30, 2003 and December 31,
2002, respectively.
In connection with its credit agreement for the purchase of inventory
discussed immediately below, $447 of the outstanding balance on such credit line
was interest bearing at September 30, 2003 and is reflected as short-term debt
on the accompanying balance sheet.
On January 31, 2002 I-Sector entered into a credit agreement with
Textron Financial Corporation ("Textron") for a revolving line of credit (the
"Textron Facility"). The total credit available under the Textron facility, as
amended, was $7,500 subject to borrowing base limitations that are generally
computed as 80% of eligible accounts receivable, and 90% of identifiable
inventory purchased under this agreement and 40% of all other inventory. The
borrowing base limitations restrict the eligibility of accounts receivable for
collateralization by disallowing as eligible any customer's receivables in their
entirety that have balances over 90 days old and that exceed 25% of their total
balance. On November 6, 2003 Textron informed the Company that they have
conditionally approved an increase in the credit facility from $7,500 to an
inventory financing facility of $15,000. The conditions of approval to be
satisfied include the execution of certain documents, including syndication loan
documents and an activation of syndication for $5,000 with Silicon Valley Bank.
Inventory floor plan borrowings are reflected in accounts payable on the
accompanying balance sheets, except for $447 that is interest bearing and is
reflected in short term debt on the accompanying balance sheets at September 30,
2003. I-Sector may use up to $500 of the line for working capital advances under
approved conditions. Borrowings accrue interest at the prime rate plus 2.5% on
outstanding balances that extend beyond the vendor approved free interest period
and on working capital advances from date of advance. This agreement is
collateralized by substantially all of I-Sector's assets except its patent
license assets. The agreement contains restrictive covenants measured at each
quarter end, which require us to maintain minimum tangible capital funds and a
minimum debt to tangible capital funds ratio. At September 30, 2003 I-Sector was
not in compliance with all of the loan covenants, however the Company
subsequently received a waiver on such non-compliance for that date. I-Sector is
in negotiations with Textron to modify the loan covenants and currently believes
it will be able to comply with the applicable covenants in future reporting
periods. In the event I-Sector does not maintain compliance, it would be
required to seek waivers from Textron for those events, which, if not obtained,
could accelerate repayment and require I-Sector to seek other sources of
finance. At September 30, 2003, I-Sector had $7,112 outstanding on inventory
floor plan finance borrowings, $0 outstanding on working capital advances and
had total credit availability of $388.
6. LITIGATION
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 I-Sector owed the sum of approximately $570
to Inacom Corp. ("Inacom") as a result of Inacom's termination of a Vendor
Purchase Agreement between Inacom and I-Sector. I-Sector believes that the claim
is without merit and intends to vigorously contest the demand.
The Equal Employment Opportunity Commission ("EEOC") filed a Charge of
Discrimination against Stratasoft on behalf of Jennifer R. Bond on August 1,
2002 in the EEOC Minneapolis, Minnesota office. Stratasoft reached agreement to
settle this claim, without admitting or denying, in September, 2003 for
$130,000, and general and administrative expense of $130,000 was recognized in
the three months ended September 30, 2003.
I-Sector is also party to other litigation and claims which management
believes are normal in the course of its operations. While the results of such
litigation and claims cannot be predicted with certainty, I-Sector believes the
final outcome of such matters will not have a materially adverse effect on its
results of operations or financial position.
7. INCOME TAX BENEFIT
On March 9, 2002, President Bush signed into law the Job Creation and
Worker Assistance Act of 2002. The law provides for the carryback of net
operating losses for any taxable year ending during 2001 and 2002 to each of the
5 tax years preceding the loss year. Previously, a net operating loss was only
eligible to be carried back to the 2 years preceding the year of loss. As a
result of the change in the carryback period, I-Sector recognized a tax benefit
of $73 and $1,179 in the six months ended June 30, 2003 and 2002, respectively.
On July 26, 2002 the Company received $1,123 in tax refunds. Additionally, on
July 24, 2003 the Company received $561 in tax refunds.
8. RELATED PARTY TRANSACTIONS
The Company leases office space from Allstar Equities, Inc., a Texas
corporation ("Equities"),a company wholly owned by the CEO. On December 1, 1999
Equities purchased the Company's corporate office building and executed a direct
lease with us with an expiration date of December 31, 2004. In conjunction with
Equities obtaining new financing on the building, a new lease was executed with
the Company on February 1, 2002 with an expiration date of January 31, 2007. The
new lease has rental rates of $37,192 per month.
From time to time I-Sector has obtained an independent survey of real
estate rental rates and has consulted with real estate consulting firms to
determine market rates of facilities that are comparable to the Houston
headquarters facility. The Company believes that the rental rate and other terms
of our lease from Equities are at least as favorable as those that could have
been obtained in an arms-length transaction with an unaffiliated third party.
From time to time I-Sector makes short-term loans and travel advances
to its employees. The balance of approximately $2 and $12 relating to these
loans and advances is included in the Company's balance sheet and reported as
part of Accounts receivable - other at September 30, 2003 and December 31, 2002,
respectively.
9. STOCK OPTION PLANS
The Company has three stock-based option plans, the 1996 Incentive
Stock Plan, the 1996 Non-Employee Director Stock Option Plan and the Incentive
Plan. Under the Incentive Plan, all of I-Sector employees, including officers,
consultants and non-employee directors are eligible to participate.
Additionally, each of I-Sector's subsidiaries has an incentive stock
option plan in place. The subsidiary plans have not been presented to the
shareholders of I-Sector for approval. The only subsidiary with options granted
under its plan incurred net income for the three months ended September 30, 2003
and 2002, respectively. The net income of the subsidiary in the three months
ended September 30, 2003 were considered in the calculation of the Company's
earnings per share (see Note 4). The net income of the subsidiary in the three
months ended September 30, 2002 was anti-dilutive since the Company incurred a
net loss. The subsidiary incurred a net loss for each of the nine month periods
presented, and as a result I-Sector's share of the subsidiary net loss does not
change for purposes of computation of I-Sector's earnings per share in those
periods because the effect of the net loss of the subsidiary would be
anti-dilutive.
Only one of I-Sector's subsidiaries, INX, has granted incentive awards
under its incentive plan, and such awards have been granted to certain employees
and to management of INX. Under INX's plan such options vest ratably over three
to five years. The quantity of incentive options that are eligible to vest each
year for INX's two most senior executives is determined based on the percentage
of attainment of predefined financial goals by INX. Any unvested stock options
may vest immediately upon the occurrence of a liquidity event for that
subsidiary. The subsidiary options expire ten years after the grant date if they
are not exercised. The subsidiary stock option grants are subject to dilution
when I-Sector purchases additional shares of the subsidiary stock in order to
keep the subsidiary sufficiently capitalized. INX has 7,381,942 options granted
and outstanding, of which 3,603,609 are vested at September 30, 2003. There are
1,618,058 shares in INX's plan available to be issued at September 30, 2003. The
tables below reflect the ownership INX at September 30, 2003 and summarize the
potential dilutive effect on I-Sector's ownership in INX if all options granted
at September 30, 2003 were fully vested and option grants were exercised, and
include the effects of the issuance of stock in 2004 relating to INX's
acquisition of certain assets and liabilities of Digital Precision, Inc. (See
note 10).
Ownership of INX shares at September 30, 2003:
Percent
Outstanding Shares of INX Common Stock of Total
Common Stock owned by I-Sector 21,834,333 100.0%
-----
Total Common Stock Outstanding 21,834,333 100.0%
========== =====
Potential Future I-Sector Dilution of Ownership of INX:
Common Stock owned by I-Sector 21,834,333 68.4%
At September 30, 2003
Options granted and outstanding
at September 30, 2003 (1) 7,381,942 23.1%
Contingent obligation to issue
Common Stock related to
acquisition (2) 1,800,000 5.6%
Contingent obligation to grant
options in April, 2004 (3) 900,000 2.8%
Other options promised to new employees 25,000 0.1%
---------- -----
Total 31,941,275 100.0%
========== =====
(1) Options granted and outstanding at September 30, 2003 include option
grants for 4,100,000 shares of INX granted to the two senior executives
of INX and vesting of these option grants is performance-based relating
to the percentage of predefined financial goals attained by INX while
these two senior executives remain employed. Any of the shares
associated with this group of option grants that become eligible for
vesting, but do not vest due to financial performance, as compared to
predefined goals, are forfeited and will no longer be eligible for
vesting unless there is a liquidity event that returns a pre-defined
return on investment to I-Sector. Additionally, included in the option
grants outstanding at September 30, 2003 are grants for 500,000 shares
granted to key employees related to an acquisition (see Note 10), and
this group of option grants vested immediately upon grant. During the
quarter ended September 30, 2003 INX granted fully vested options to
purchase 1,500,000 shares of INX to the President, CEO and Chairman of
the Board of I-Sector Corporation and to a senior executive of INX. The
remainder of the shares included in option grants outstanding at
September 30, 2003 vest over either three or five years based upon
continued employment by INX of the individuals to whom such grants have
been made. All options granted by INX expire in ten years if
unexercised.
(2) In connection with the acquisition of certain assets and liabilities of
Digital Precision, Inc. (see note 10), a portion of the consideration
given by INX was the contingent obligation to issue 1,800,000 shares of
INX Common Stock to Digital Precision, Inc. when and if three key
employees complete one year of employment with INX. If any of such key
employees terminates employment without cause before completion of one
year of employment, the number of shares of Common Stock to be issued
is decreased by scheduled and agreed upon percentages. (3)
INX entered into employment agreements with certain of the former
owners and employees of Digital Precision, Inc. that set forth that if
they met certain performance goals during the first two calendar
quarters following the completion of the Digital Precision transaction
and for the twelve months subsequent to the acquisition, that certain
option grants would be made. As of September 30, 2003, there is the
potential that options for 900,000 shares of INX will be granted to
them on or after April 4, 2004 at fair value at that date.
10. ACQUISITION
On April 7, 2003, I-Sector's subsidiary, INX, acquired certain assets
and liabilities of one of its competitors, Digital Precision, Inc. ("Digital").
Under the terms of the purchase, INX acquired fixed assets, inventory,
intellectual property, customer lists, trademarks, tradenames and service marks,
contract rights and other intangibles of Digital, as well as assumed certain
operating leases of equipment and office space. The purchase price was $540 in
cash and, contingent upon the retention of certain key employees, the obligation
to issue 1,800,000 shares of INX common stock in April 2004. When that
contingency is resolved in April 2004, I-Sector could recognize a minority
interest related to the issuance of INX's common stock (see Note 9). No goodwill
was recognized in the acquisition. The results of operations subsequent to April
7, 2003 are included in I-Sector's consolidated statement of income.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION
I-SECTOR CORPORATION
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion is qualified in its entirety by, and should be
read in conjunction with, our consolidated financial statements, including the
notes thereto included elsewhere in this Form 10-Q and our Form 10-K previously
filed with the Securities and Exchange Commission. All monetary amounts
discussed in Items 2 through 5 are in thousands.
Overview
Our revenue is derived from three segments. Internetwork Experts, Inc.
("INX") focuses on the design, deployment and support of networking
infrastructure. INX provides professional services for customers that have
large-scale network infrastructure requirements that are Cisco centric. The
areas of practice for INX include network design, implementation, turnkey
support, security audits and firewall design, network infrastructure management
and network infrastructure consulting services. Stratasoft, Inc. ("Stratasoft")
develops and markets proprietary software that integrates business telephone
systems and networked computer systems. Stratasoft's basic products are often
customized to suit a customer's particular needs and are sometimes bundled with
computer hardware supplied by Stratasoft at the customer's request. Stratasoft
products include software for call center management, both in-bound and
out-bound, as well as interactive voice response software. Valerent, Inc.
("Valerent") provides information technology solutions that lower the client's
expense by utilizing centralized, remote enabled computing management tools
which predict, announce and manage service interruptions. Additionally Valerent
sells computer products and provides customers with certain managed IT services
such as application support, operating system and network migration services,
turnkey outsourced IT helpdesk solutions, technical staff augmentation for IT
helpdesk operations and helpdesk solutions consulting services.
Valerent and INX market their services to businesses in Texas from
locations in the Houston and Dallas-Fort Worth metropolitan areas. Stratasoft
markets its products worldwide through a direct sales force and an authorized
dealer network. During the nine months ended September 30, 2003, INX and
Stratasoft produced 79.9 % and 12.8%, respectively, of total revenues, while
Valerent produced 8.1 % of total revenues. Gross margin varies substantially
between each of these business segments.
Our ability to attract and retain qualified professional and technical
personnel is critical to the success of all of our services operations. The most
significant portion of the costs associated with the delivery of services is
personnel costs. Therefore, in order to be successful, our billable rates must
be in excess of the personnel costs and our margin is dependent upon maintaining
high utilization of our service personnel. In markets where we do not maintain
branch offices, we often subcontract for necessary technical personnel.
A significant portion of our cost of services for each of our service
businesses is comprised of labor. Labor cost related to permanent employees has
a somewhat fixed nature such that higher levels of service revenue produces
higher gross margin while lower levels of service revenue produces less gross
margin. Management of labor cost is important in order to prevent erosion of
gross margin.
A significant portion of our selling, general and administrative
expenses in all of our businesses relate to personnel costs, some of which are
variable and others of which are relatively fixed. Our variable personnel costs
are substantially comprised of sales commissions, which are typically calculated
based upon our gross profit on a particular sales transaction and thus generally
fluctuate with our overall gross profit. The remainder of selling, general and
administrative expenses are relatively fixed and does not vary in proportion to
increases in revenue as directly.
Special notice regarding forward-looking statements
This quarterly report on Form 10-Q 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 2. - "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 the 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 the 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.- "Factors Which May Affect The Future
Results Of Operations," which could cause actual events, performance or results
to differ materially from those indicated by such statements.
Three Months Ended September 30, 2003 Compared To Three Months Ended September
30, 2002
The following table sets forth, for the periods indicated, certain
financial data derived from our unaudited consolidated statements of operations
for the three months ended September 30, 2003 and 2002. The discussion below
relates only to our continuing operations, unless otherwise noted.
Three months ended September 30,
2003 2002
---- ----
Amount % Amount %
------ ----- ------ -----
Revenues:
INX $ 17,346 82.7 $ 8,584 74.0
Stratasoft 2,415 11.5 1,743 15.0
Valerent 1,392 6.6 1,291 11.1
Eliminations (172) (0.8) (11) (0.1)
--------- ----- --------- -----
Total revenue 20,981 100.0 11,607 100.0
Gross profit:
INX 2,793 16.1 1,057 12.3
Stratasoft 1,687 69.9 962 55.2
Valerent 312 22.4 308 23.9
Eliminations (1) 0.0 0 0.0
--------- ----- --------- -----
Total gross profit 4,791 22.8 2,327 20.0
Selling, general and administrative expenses:
INX 2,126 12.3 966 11.3
Stratasoft 1,754 72.6 914 52.4
Valerent 455 32.7 569 44.1
Corporate 287 N/A 170 N/A
Eliminations (1) 0.0 0 0.0
--------- ----- --------- -----
Total selling, general and administrative
expenses 4,621 22.0 2,619 22.6
Operating income (loss):
INX 667 3.8 91 1.1
Stratasoft (67) (27.7) 48 2.8
Valerent (143) (10.3) (261) (20.2)
Corporate (287) N/A (170) N/A
--------- ----- --------- -----
Total operating income (loss) 170 0.8 (292) (2.5)
Interest and other income (expense) (11) (0.0) 3 (0.0)
--------- ----- --------- -----
Income (loss) before benefit for income taxes 159 0.8 (289) (2.5)
Benefit for income taxes (12) (0.0) 0.0
--------- ----- --------- -----
Net income (loss) from continuing operations 171 0.8 (289) (2.5)
Discontinued operations:
Gain on disposal 23 0.1 (1) (0.0)
--------- ----- --------- -----
Net income (loss) $ 194 0.9 $ (290) (2.5)
========= ===== ========= =====
TOTAL REVENUE. Total revenue, net of intercompany eliminations,
increased by $9,374 (80.8%) to $20,981 in 2003 from $11,607 in 2002.
INX revenue increased by $8,762 (102.1%) to $17,346 from $8,584. As a
percentage of total revenue, INX revenue increased to 82.7% from 74.0%. Of the
increase in revenues, $5,681 was attributed to the Houston office, $434 was
attributed to an increase in the Federal government sector, and $1,668 was
attributed to a new office in Austin, Texas, formerly a Digital Precision
office. Additionally, the Dallas office realized an increase of $978. The total
increase in revenues attributable to the Digital Precision acquisition and
including the revenues of the Austin office is $3,588. The significant increase
in the Houston office revenues is attributed to three large projects involving
both product and service.
Stratasoft revenue increased by $672 (38.6%) to $2,415 from $1,743.
Stratasoft revenue, as a percentage of total revenue, decreased to 11.5% from
15.0%. During the quarter ended September 30, 2003, the Company deferred certain
revenue for custom projects that included fees that we determined to not be
fixed and determinable, for certain custom projects that had more than one year
of free PCS, and for certain renewals of PCS paid in advance. The increase in
revenues relates primarily to three large projects that were begun in the
quarter ended September 30, 2003 and from an overall increase in the estimated
revenues of custom projects in process at September 30, 2003 as compared to
September 30, 2002 of $1,121. Stratasoft's international sales accounted for
28.2% of Stratasoft's revenues in the quarter ended September 30, 2003 as
compared to 13.1% in the same quarter of 2002.
Valerent revenue increased by $101 (7.8%) to $1,392 from $1,291. As a
percentage of total revenue Valerent revenue decreased to 6.6% from 11.1%. The
increase in Valerent revenue was primarily attributable to increased product
sales of $212 offset by decreased service revenues of $111 in the quarter ended
September 30, 2003. The increase in revenue was attributable to sales efforts
beginning to come to fruition in the area of specialized information technology
solutions involving managed services.
GROSS PROFIT. Gross profit increased by $2,464 (105.9%) to $4,791 from
$2,327. Gross margin increased to 22.8% from 20.0%, primarily because a greater
portion of the INX revenues were from its service component, which has higher
margins and because Stratasoft experienced higher margins in the 2003 quarter.
INX gross profit increased $1,736 (164.2%) to $2,793 from $1,057. Gross
margin for INX increased to 16.1% from 12.3%. INX's product gross profit has
increased $1,313 to $2,196 from $883 due to both sales volume increase and due
to improved gross margin rates. Improved product gross margin rates were
partially due to a vendor rebate of $313 that was based partially on volume
sales of certain product and partially on customer satisfaction ratings. INX's
gross profit on its service component increased by $424 to $597 as compared to
$173 due to increased revenues of $842 and because of better utilization of
personnel.
Stratasoft gross profit increased by $725 (75.4%) to $1,687 from $962
as revenue increased by 38.6% and gross margin for Stratasoft improved to 69.9%
from 55.2%. Gross margin is impacted by the mix of sales between custom systems
sales, which include a hardware component, as compared to software only sales,
which do not have a hardware cost of goods component. Stratasoft's increased
gross margin rate in the 2003 quarter, as compared to the 2002 quarter, is
primarily due to an increased mix of software only sales.
Valerent gross profit increased by $4 (1.3%) to $312 from $308. Gross
margin for Valerent decreased to 22.4% from 23.9%. Valerent's cost of service
consists primarily of labor cost that has a fixed component. The fixed component
of labor causes gross profit and gross margin not to fluctuate directly with the
change in revenues. Valerent's gross profit on product increased by $34 while
its gross profit on service decreased $30.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $2,002 (76.4%) to $4,621 from $2,619. As a
percentage of revenue, these expenses decreased by 0.6%, to 22.0% of revenue
from 22.6% of revenue. Sales compensation increased by $589, primarily due to
the increased revenue volumes of INX and Stratasoft. Bad debt expense increased
by $519 and legal and accounting expense increased by $267, the most significant
portion of which is $130 for settlement of litigation. Administrative
compensation and related payroll taxes were higher by $248, primarily due to an
acquisition by INX, bonuses paid by INX and to Stratasoft opening an office in
India. Travel increased $63 in 2003 as compared to the same period in 2002,
primarily in INX due to an increased level of travel related to management
travel. Shareholder relations expenses increased $55 due to employing a
shareholder relations firm, attending investor conferences and visiting investor
groups. Telephone expense increased due to the new offices in both Stratasoft
and INX. Depreciation and amortization expense increased $59. General office
expenses increased $27. Rent was $54 higher, primarily because of new offices
related to the INX acquisition and the Stratasoft India and Canada office. Other
expenses increased $90.
INTEREST AND OTHER INCOME (NET). We had interest income of $20 compared
to interest income of $18, primarily due to interest on notes receivable.
Additionally, we had interest expense of $19, loss on disposition of assets of
$7, foreign exchange expense of $18 and other income of $13 in 2003 as compared
to interest expense of $9 and a loss on disposition of assets of $6 in 2002.
DISCONTINUED OPERATIONS. During 1999 we discontinued our Telecom
Systems business. On March 16, 2000 we entered into an agreement to sell certain
assets of, and the ongoing operation of, our Computer Products Division. The
sale transaction closed on May 19, 2000. As a consequence of these events, the
operations of these businesses are reported as discontinued operations. At
December 31, 2000 we sold our IT Staffing business. For the quarters ended
September 30, 2003 and 2002, respectively, the gain (loss) on disposal related
to these business was $56, $(33), and $0, net of taxes of $29, $(17) and $0 and
$3, $2 and $(6) (net of taxes of $2, $1 and $(3)). The gains and/or losses on
disposal related to these discontinued operations is primarily related to
collections of accounts receivables retained when these businesses were sold.
NET LOSS. Net income in the quarter ended September 30, 2003 was $194
and net loss in the quarter ended September 30, 2002 was $290. No tax benefit
had been recorded for the loss in the three months ended September 30, 2002
because, due to our recurring losses, a valuation allowance was recorded.
Nine Months Ended September 30, 2003 Compared To Nine Months Ended September
30, 2002
The following table sets forth, for the periods indicated, certain
financial data derived from our unaudited consolidated statements of operations
for the nine months ended September 30, 2003 and 2002. The discussion below
relates only to our continuing operations, unless otherwise noted.
Nine months ended September 30,
2003 2002
---- ----
Amount % Amount %
------ ----- ------ -----
Revenue:
INX $ 37,520 79.9 $ 21,727 69.9
Stratasoft 5,995 12.8 5,571 17.9
Valerent 3,781 8.1 3,983 12.8
Eliminations (364) (0.8) (206) (0.6)
--------- ----- --------- -----
Total revenue 46,932 100.0 31,075 100.0
Gross profit:
INX 5,004 13.3 2,249 10.4
Stratasoft 3,891 64.9 3,083 55.3
Valerent 902 23.9 936 23.5
Eliminations (2) 0.0 0 0.0
--------- ----- --------- -----
Total gross profit 9,795 20.9 6,268 20.2
Selling, general and administrative expenses:
INX 4,518 12.0 2,446 11.3
Stratasoft 4,694 78.3 2,600 46.7
Valerent 1,551 41.0 1,723 43.3
Corporate 795 N/A 486 N/A
Eliminations (2) 0.0 0 0.0
--------- ----- --------- -----
Total selling, general and administrative
Expenses 11,556 24.6 7,255 23.3
Operating (loss) income:
INX 486 1.3 (197) (0.9)
Stratasoft (803) (13.4) 483 8.7
Valerent (649) (17.2) (787) (19.8)
Corporate (795) N/A (486) N/A
--------- ----- --------- -----
Total operating loss (1,761) (3.8) (987) (3.2)
Interest and other income 93 0.2 1 (0.0)
--------- ----- --------- -----
Loss before benefit for income taxes (1,668) (3.6) (986) (3.2)
Benefit for income taxes (93) (0.2) (1,189) (3.8)
--------- ----- --------- -----
Net (loss) income from continuing operations (1,575) (3.4) 203 0.6
Discontinued operations:
Gain on disposal 39 0.1 17 0.1
--------- ----- --------- -----
Net (loss) income $ (1,536) (3.3) $ 220 0.7
========= ===== ========= =====
TOTAL REVENUE. Total revenue, net of intercompany eliminations,
increased by $15,857 (51.0%) to $46,932 from $31,075.
INX revenue increased by $15,793 (72.7%) to $37,520 from $21,727. As a
percentage of total revenue, INX revenue increased to 79.9 % from 69.9%. Of the
increase in revenues, $10,911 was attributed to the Houston office, $2,595 was
attributed to a new office in Austin, $553 was attributed to sales in the
government sector and $1,734 was attributed to the Dallas office. The total
increase in revenues attributable to the Digital Precision acquisition,
including the revenues of the acquired Austin office is $5,570. INX's revenues
grew rapidly in the nine months ended September 30 2003 primarily due to large
sales to four school districts totaling $11,920 and due to synergy of $5,570
resulting from its acquisition of Digital Precision, Inc.
Stratasoft revenue increased by $424 (7.6%) to $5,995 from $5,571.
Stratasoft revenue, as a percentage of total revenue, decreased to 12.8% from
17.9%. During the nine months ended September 30, 2003, the Company deferred
revenue for certain custom projects that included fees that were determined to
not be fixed and determinable. Additionally, Stratasoft's increased revenues
were primarily the result of two large international custom projects that were
initiated during the three months ended September 30, 2003 and as compared to no
individually large custom projects initiated during the three months ended
September 30, 2003. Stratasoft's international sales accounted for 43.8% of
Stratasoft's revenues in the nine months ended September 30, 2003 as compared to
26.4% in the same period of 2002.
Valerent revenue decreased by $202 (5.1%) to $3,781 from $3,983. As a
percentage of total revenue Valerent revenue decreased to 8.1% from 12.8%. The
decrease in Valerent revenue was primarily attributable to decreased service
revenues of $481 offset by increased product sales of $279 in the nine months
ended September 30, 2003. The decrease in service revenue is primarily
attributable to the loss of revenue from certain customers of $273.
GROSS PROFIT. Gross profit increased by $3,527 (56.3%) to $9,795 from
$6,268. Gross margin increased to 20.9% from 20.2%, primarily because a greater
portion of the revenues were contributed by INX, which increased its margins in
2003 by 2.9% and because Stratasoft increased its margins by 9.6%.
INX gross profit increased $2,755 (122.5%) to $5,004 from $2,249. Gross
margin for INX increased to 13.3% from 10.4%. INX's product gross profit has
increased $2,067 to $4,347 from $2,280 due to both the sales volume increase, a
vendor rebate of $313 and the improved gross margin rates. INX's gross profit on
its service component improved to $657 in 2003 as compared to a gross loss of
$31 in 2002 as a result of increased service revenues of $1,548 and of better
utilization of technical personnel.
Stratasoft gross profit increased by $808 (26.2%) to $3,891 from $3,083
as revenue increased by 7.6%. Gross margin for Stratasoft increased to 64.9%
from 55.3 %. Gross margin is impacted by the mix of sales between systems sales,
which include a hardware component, as compared to software only sales, which do
not have a hardware cost of goods component. Stratasoft's increased gross margin
rate is primarily due to changing the mix of system sales to include a reduced
hardware component.
Valerent gross profit decreased by $34 (3.6%) to $902 from $936. Gross
margin for Valerent increased to 23.9% from 23.5%. Valerent cost of service
consists primarily of labor cost that has a fixed component. The fixed component
of labor causes gross profit and gross margin not to fluctuate directly with the
decrease in revenues. During the nine months ended September 30, 2003, Valerent
improved its utilization of its labor pool by reducing the number of technicians
employed, which contributed to improved gross margin.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $4,301 (59.3%) to $11,556 from $7,255. As a
percentage of revenue, these expenses increased by 1.3%, to 24.6% of revenue
from 23.3 % of revenue. Sales compensation increased by $739 in 2003 as compared
to 2002. As a percent of revenues, sales compensation decreased from 8.37% in
2002 to 7.11% in 2003. Bad debt expense increased by $1,392 and legal and
accounting expense increased by $471 in 2003 as compared to 2002. Administrative
compensation increased by $337 in 2003 as compared to 2002 and payroll tax
increased $95 in the same periods. Contract labor increased $127 in 2003 as
compared to 2002. Travel increased $239 in 2003 as compared to 2002, primarily
in Stratasoft due to international travel and in INX due to increased travel for
technical staff and management. General office expenses increased $254 in 2003
as compared to 2002 and general insurance expense increased $77 in 2003 as
compared to 2002. Shareholder relations increased $90 in 2003 as compared to
2002 due to employing a shareholder relations firm, attending investor
conferences and visiting investor groups. Employee benefits, depreciation and
rents increased $42, $119 and $113, respectively, in 2003 as compared to 2002.
Other Corporate expenses increased $206 in 2003 as compared to 2002.
INTEREST AND OTHER INCOME (NET). Interest income increased by $8 to $53
in 2003 compared to interest income of $45 in 2002, primarily due to interest on
notes receivable. Interest income was offset by interest expense of $32 in 2003
as compared to $24 in 2002. A foreign exchange loss of $18 was incurred in 2003,
but no foreign exchange was incurred in 2002. Additionally, other income of $13
and a gain on disposition of assets of $77 was recorded in 2003 as compared to a
loss of $21 in 2002.
DISCONTINUED OPERATIONS. During 1999 we discontinued our Telecom
Systems business. On March 16, 2000 we entered into an agreement to sell certain
assets of, and the ongoing operation of, our Computer Products Division. The
sale transaction closed on May 19, 2000. As a consequence of these events, the
operations of these businesses are reported as discontinued operations. At
December 31, 2000 we sold our IT Staffing business. For the nine months ended
September 30, 2003 the gain (loss) on disposal related to these businesses was
$65, $(53) and $26, net of taxes of $33, $(27) and $14. For the nine months
ended September 30, 2002, the gain (loss) on disposal related to these
businesses was $11, $5 and $0, net of taxes of $6, $3 and $0. The gains and/or
losses on disposal related to these discontinued operations is primarily related
to collections of accounts receivables retained when these businesses were sold.
NET LOSS. Net (loss) income in the nine months ended September 30, 2003
and 2002 was $(1,536) and $220. A benefit for income taxes of $81 and $1,189 was
recorded in the nine months ended September 30, 2003 and 2002 because, due to
the Job Creation and Worker Assistance Act of 2002 which provided for the
carryback of net operating losses for any taxable year ending during 2001 or
2002 to each of the 5 tax years preceding the loss year, we were able to utilize
our net operating loss carryback. Previously, a net operating loss was only
eligible to be carried back to the 2 years preceding the year of loss.
Asset Management
Our cash flow from operations has been affected primarily by the timing
of our collection of accounts and notes receivable. We have typically sold our
products and services on short-term credit terms and seek to minimize our credit
risk by performing credit checks, obtaining letters of credit in certain
instances, and conducting our own collection efforts. We had accounts
receivable, net of allowance for doubtful accounts, of $10,951 and $6,525 at
September 30, 2003 and December 31, 2002, respectively. Our Stratasoft
subsidiary has included notes receivable as part of its consideration for
certain of its custom projects sales. At September 30, 2003 and December 31,
2002, Stratasoft had net notes receivable of $655 and $898, respectively, as
reflected in the following table:
September 30, 2003 December 31, 2003
Current portion of notes receivable, gross $ 1,364 $ 1,236
Reserve for doubtful notes 709 338
---------- ---------
Current portion of notes receivable, net 655 898
----------- ---------
Long term portion of notes receivable, gross 482 64
Reserve for doubtful notes 250 -
---------- --------
Long-term portion of notes receivable, net 232 64
---------- ---------
Total notes receivable, net $ 887 $ 962
========= =========
The long-term portion of notes receivable, net is reported in Other assets in
the accompanying balance sheets.
Critical Accounting Policies
Revenue Recognition - I-Sector has a number of different revenue
components, which vary between its three reportable segments. Each reportable
segment has more than one revenue component, and revenue is recognized
differently for each component (or "stream") of revenue earned by segment. The
material revenue streams earned by I-Sector, some of which are earned by more
than one segment, and some by only one segment, are:
Products Revenue. All three of I-Sector's segments earn revenue from
product shipments. Product shipment revenue occurs when products
manufactured by other parties are purchased and resold to a customer
and such products are contracted for independently of material
services. I-Sector recognizes revenue from product shipments when the
product is shipped or delivered to the customer.