FONIX CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

[X]

Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended March 31, 2004, or

[ ]

Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______________ to _____________.

Commission File No. 0-23862

Fonix Corporation

(Exact name of registrant as specified in its charter)

Delaware

22-2994719

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

9350 South 150 East, Suite 700

Sandy, Utah 84070

(Address of principal executive offices with zip code)

(801) 553-6600

(Registrant's telephone number, including area code)

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 Exchange Act). Yes [ ] No [X].

As of May 6, 2004, there were issued and outstanding 87,594,231 shares of our Class A common stock.

FONIX CORPORATION

FORM 10-Q

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

Page

Item 1.

Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets – As of March 31, 2004 and December 31, 2003

Condensed Consolidated Statements of Operations and Comprehensive Loss for the

Three Months Ended March 31, 2004 (Pro Forma and Historical) and 2003 (Historical)

Condensed Consolidated Statements of Cash Flows for the Three Months Ended

March 31, 2004 and 2003

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.

Evaluation of Disclosure Controls and Procedures

PART II - OTHER INFORMATION

Item 1.

Legal Proceedings

Item 2.

Changes in Securities and Use of Proceeds

Item 6.

Exhibits and Reports on Form 8-K

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

	March 31, 2004	December 31, 2003

ASSETS

Current assets
Cash and cash equivalents	$ 2,931,000	$ 50,000
Deposit in escrow	113,000	-
Subscriptions receivable	1,314,000	245,000
Accounts receivable	2,132,000	4,000
Inventory	-	3,000
Prepaid expenses and other current assets	366,000	40,000

Total current assets	6,856,000	342,000

Long-term investments	245,000	-

Property and equipment, net of accumulated depreciation of $1,220,000 and $1,176,000, respectively	263,000	125,000

Other assets	1,058,000	75,000

Intangible assets, net of accumulated amortization of $593,000 and $0, respectively	18,638,000	-

Goodwill, net of accumulated amortization of $2,296,000	2,631,000	2,631,000

Total assets	$ 29,691,000	$ 3,173,000

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

Current liabilities
Accrued payroll and other compensation	$ 4,723,000	$ 6,964,000
Accounts payable	5,365,000	2,650,000
Accrued liabilities - related parties	1,443,000	1,443,000
Accrued liabilities	4,610,000	1,189,000
Deferred revenues	1,092,000	540,000
Notes payable - related parties	467,000	467,000
Advance on Series I Preferred Stock	-	240,000
Current portion of notes payable other	326,000	30,000
Deposits and other	194,000	7,000

Total current liabilities	18,220,000	13,530,000

Long-term notes payable, net of current portion	5,226,000	40,000

Total liabilities	23,446,000	13,570,000

Commitments and contingencies

Stockholders' equity (deficit)
Preferred stock, $0.0001 par value; 50,000,000 shares authorized;
Series A, convertible; 166,667 shares outstanding (aggregate liquidation preference of $6,055,012)	500,000	500,000
Series H, nonconvertible; 2,000 shares outstanding (aggregate liquidation preference of $20,000,000)	4,000,000	-
Series I, convertible; 3,250 shares outstanding (aggregate liquidation preference of $3,250,000)	3,250,000	-
Common stock, $0.0001 par value; 800,000,000 shares authorized;
Class A voting, 85,440,231 and 12,306,333 shares outstanding, respectively	9,000	5,000
Class B non-voting, none outstanding	-	-
Additional paid-in capital	209,752,000	195,284,000
Outstanding warrants to purchase Class A common stock	1,595,000	1,334,000
Cumulative foreign currency translation adjustment	17,000	30,000
Accumulated deficit	(212,878,000)	(207,550,000)

Total stockholders' equity (deficit)	6,245,000	(10,397,000)

Total liabilities and stockholders' equity (deficit)	$ 29,691,000	$ 3,173,000

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(Unaudited)

		2004
		Pro Forma -
Three Months Ended March 31,		Note 1	2004	2003


Revenues		$ 5,029,000	$ 1,925,000	$ 590,000
Cost of revenues		2,313,000	792,000	80,000

Gross profit		2,716,000	1,133,000	510,000

Expenses:
	Selling, general and administrative	5,908,000	2,924,000	2,251,000
	Product development and research	799,000	799,000	1,675,000

Total expenses		6,707,000	3,723,000	3,926,000

Other income (expense):
	Interest income	5,000	5,000	-
	Gain on forgiveness of liabilities	481,000	481,000	-
	Interest expense	(337,000)	(238,000)	(742,000)
	Equity in net loss of affiliate	-	-	(112,000)

Other income (expense), net		149,000	248,000	(854,000)

Net loss		(3,842,000)	(2,342,000)	(4,270,000)

Other comprehensive income - foreign currency translation		(13,000)	(13,000)	18,000

Comprehensive loss		$ (3,855,000)	$ (2,355,000)	$ (4,252,000)


Basic and diluted net loss per common share		$ (0.10)	$ (0.08)	$ (0.30)

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

		Three Months Ended
		March 31,
		2004	2003
Cash flows from operating activities
Net loss		$ (2,342,000)	$ (4,270,000)
Adjustments to reconcile net loss to net cash used in operating activities:
Accretion of discount on notes payable		66,000	618,000
Amortization of deferred loan costs		-	38,000
Loss on disposal of property and equipment		-	1,000
Gain on forgiveness of liabilities		(481,000)	(26,000)
Amortization of intangibles		593,000	42,000
Depreciation and amortization		33,000	134,000
Equity in net loss of affiliate		-	70,000
Foreign exchange gain		(13,000)	15,000
Changes in assets and liabilities:
Accounts receivable		150,000	(1,000)
Inventory		3,000	1,000
Prepaid expenses and other current assets		(261,000)	68,000
Other assets		7,000	4,000
Accounts payable		(1,233,000)	368,000
Accrued payroll and other compensation		(2,241,000)	982,000
Other accrued liabilities		308,000	(124,000)
Deferred revenues		(67,000)	(5,000)

Net cash used in operating activities		(5,478,000)	(2,085,000)

Cash flows from investing activities
Cash received in connection with LTEL acquisition		47,000	-
Collection of principal on notes receivable		-	403,000
Payment of deposit into escrow		(113,000)	-
Purchase of property and equipment		(18,000)	(2,000)

Net cash provided by investing activities		(84,000)	401,000

Cash flows from financing activities
Proceeds from issuance of Class A common stock, net		5,624,000	2,440,000
Proceeds from Issuance of Series I Preferred		3,010,000	-
Payment of dividend on Series H Preferred		(100,000)	-
Principal payments on notes payable		(91,000)	(116,000)
Proceeds from long-term debt		-	6,000
Principal payments on Series D debentures		-	(650,000)

Net cash provided by financing activities		8,443,000	1,680,000

Net increase (decrease) in cash and cash equivalents		2,881,000	(4,000)

Cash and cash equivalents at beginning of period		50,000	24,000

Cash and cash equivalents at end of period		$ 2,931,000	$ 20,000


Supplemental disclosure of cash flow information
	Cash paid during the period for interest	$ 177,000	$ 19,000

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

Supplemental schedule of noncash investing and financing activities

For the Three Months Ended March 31, 2004:

Issued 3,730,196 shares of Class A common stock for $1,314,000 in subscriptions receivable.

Issued 1,463,753 shares of Class A common stock in full satisfaction of $292,000 of liabilities.

Acquired $23,009,000 of assets and assumed $9,459,000 liabilities of LTEL Holdings Corporation by the issuance of 7,036,801 shares of Class A common stock valued at $4,926,000, the issuance of 2,000 shares of 5% Series H nonvoting, nonconvertible preferred stock valued at $4,000,000 and the issuance of a 5% $10,000,000 promissory note valued at $4,624,000.

For the Three Months Ended March 31, 2003:

Issued 627,087 shares of Class A common stock in conversion of $242,933 of Series D Debentures principal and $20,067 of related accrued interest.

Issued 237,584 shares of Class A common stock valued at $285,100 as consideration for deferment of Series D Debentures; issuance of shares represented an increase to the discount amortized over the revised term of the Series D Debentures.

Converted $113,768 of accounts payable into a note payable.

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The accompanying unaudited condensed consolidated financial statements of Fonix Corporation and subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). 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, although the Company believes that the following disclosures are adequate to make the information presented not misleading.

These condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary to present fairly the financial position and results of operations of the Company for the periods presented. The Company’s business strategy is not without risk, and readers of these condensed consolidated financial statements should carefully consider the risks set forth under the heading “Certain Significant Risk Factors” in the Company’s 2003 Annual Report on Form 10-K together with any amendments thereto.

Operating results for the three months ended March 31, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s 2003 Annual Report on Form 10-K together with any amendments thereto.

Nature of Operations – The Company and its subsidiaries are engaged in developing, acquiring and marketing proprietary speech-enabling technologies and in operating LecStar, a regional provider of telecommunications services in the Southeastern United States. The Company’s speech-enabling technologies include automated speech recognition and text-to-speech. The Company offers its speech-enabling technologies to markets for embedded automotive and wireless and mobile devices, computer telephony and server solutions and personal software for consumer applications. The Company seeks to develop relationships and strategic alliances with third-party developers and vendors in telecommunications, computers, electronic devices and related industries, including producers of application software, operating systems, computers and microprocessor chips. Revenues are generated through licensing of speech-enabling technologi es, maintenance contracts and services.

LecStar’s telecommunications services include wireline voice, data, and long distance and Internet services to business and residential customers. LecStar Telecom, Inc. is certified by the Federal Communications Commission and nine states–Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee–as a competitive local exchange carrier to provide regulated local, long distance and international telecommunications services.

Pro Forma Financial Information - On February 24, 2004, Fonix acquired all of the capital stock of LTEL Holdings Corporation ("LTEL") and its wholly-owned subsidiaries, LecStar Telecom, Inc. and LecStar DataNet, Inc., as discussed in Note 2. The unaudited pro forma condensed consolidated statement of operations for the three months ended March 31, 2004 has been prepared to present the effects of the acquisition of LTEL as though it had occurred on January 1, 2004. The unaudited pro forma financial information is illustrative of the effects of the acquisition and does not necessarily reflect the results of operations that would have resulted had the acquisition occurred at that date. In addition, the pro forma financial information is not necessarily indicative of the results that may be expected for the year ending December 31, 2004, or any other period.

Business Condition - For the three months ended March 31, 2004 and 2003, the Company generated revenues of $1,925,000 and $590,000, respectively, incurred net losses of $2,342,000 and $4,270,000, respectively, and had negative cash flows from operating activities of $5,478,000 and $2,085,000, respectively. As of March 31, 2004, the Company had an accumulated deficit of $212,878,000, negative working capital of $11,364,000, accrued employee wages of $4,723,000, accrued liabilities of $6,053,000, and accounts payable of $5,365,000. The Company expects to continue to incur significant losses and negative cash flows from operating activities through at least December 31, 2004, primarily due to significant expenditure requirements associated with marketing and developing its speech-enabling technologies and developing its telecommunications services business.

The Company’s cash resources, limited to collections from customers draws on the fifth equity line, proceeds from the issuance of Series I Preferred stock and loan proceeds, are only sufficient to cover current operating expenses and payments of current liabilities. The Company has entered into certain term payment plans with current and former employees and vendors. As a result of cash flow deficiencies, payments to former employees and vendors not on a payment plan have been delayed. The Company significantly reduced its workforce during 2002 and 2003. At March 31, 2004, unpaid compensation payable to current and former employees amounted to approximately $4,723,000 and vendor accounts payable amounted to approximately $5,365,000. The Company has not been declared in default under the terms of any material agreements.

These factors, as well as the risk factors set out elsewhere in the Company’s Annual Report on Form 10-K, raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. During the first quarter of 2004, Fonix acquired LecStar. Management plans that LecStar will provide the Company with an additional revenue stream that will increase funds available for working capital. Management also intends to utilize LecStar’s customer base as a marketing channel for the Company’s speech-enabling technologies.

During 2003, the Company agreed to issue to Breckenridge 3,250 shares of 8% Series I convertible preferred stock for an aggregate purchase price of $3,250,000, net of the private placement funds which the Company had already received (see Note 7 to Condensed Consolidated Financial Statements). The Company intends to use the net proceeds from the Series I preferred shares for working capital and for repayment of certain of the Company’s deeply discounted liabilities. . Management plans to fund further operations of the Company through proceeds from additional issuance of debt and equity securities, from cash flows from future license and royalty arrangements and from LecStar’s telecommunication operations. There can be no assurance that management’s plans will be successful.

Net Loss Per Common Share - Basic and diluted net loss per common share are calculated by dividing net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period. As of March 31, 2004 and 2003, there were outstanding common stock equivalents to purchase 17,293,911 and 3,653,378 shares of common stock, respectively, that were not included in the computation of diluted net loss per common share as their effect would have been anti-dilutive, thereby decreasing the net loss per common share.

The following table is a reconciliation of the net loss numerator of basic and diluted net loss per common share for the three months ended March 31, 2004 and 2003:

	2004				2003
		Amount	Per Share Amount	Amount		Per Share Amount
Net loss		$ (2,342,000)		$ (4,270,000)
Preferred stock dividends		(2,986,000)		-
Net loss attributable to common Stockholders		$ (5,328,000)	$ (0.08)	$ (4,270,000)		$ (0.30)
Weighted-average common shares outstanding		66,167,869		14,457,162

Imputed Interest Expense and Income- Interest is imputed on long-term debt obligations where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics.

Comprehensive Loss - Other comprehensive loss presented in the accompanying condensed consolidated financial statements consists of cumulative foreign currency translation adjustments.

Intangible Assets – Intangible assets are amortized over their estimated useful lives unless they are deemed to have indefinite useful lives. Intangible assets are assessed for impairment on a quarterly basis and impairment is recognized if the carrying amount is not recoverable or exceeds its fair value.

Revenue Recognition - The Company recognizes revenues from its speech-enabling business in accordance with the provisions of Statement of Position No. 97-2, “Software Revenue Recognition” and related interpretations. The Company generates revenues from licensing the rights to its software products to end-users and from royalties. It also generates service revenues from the sale of consulting and development services.

Revenues of all types are recognized when acceptance of functionality, rights of return, and price protection are confirmed or can be reasonably estimated, as appropriate. Revenues from development and consulting services are recognized on a completed-contract basis when the services are completed and accepted by the customer. The completed-contract method is used because the Company’s contracts are either short-term in duration or the Company is unable to make reasonably dependable estimates of the costs of the contracts. Revenue for hardware units delivered is recognized when delivery is verified and collection assured.

Revenue for products distributed through wholesale and retail channels and through resellers is recognized upon verification of final sell-through to end users, after consideration of rights of return and price protection. Typically, the right of return on such products has expired when the end user purchases the product from the retail outlet. Once the end user opens the package, it is not returnable unless the medium is defective.

When arrangements to license software products do not require significant production, modification, or customization of software, revenue from licenses and royalties are recognized when persuasive evidence of a licensing arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectibility is probable. Post-contract obligations, if any, generally consist of one year of support including such services as customer calls, bug fixes, and upgrades. Related revenue is recognized over the period covered by the agreement. Revenues from maintenance and support contracts are also recognized over the term of the related contracts.

Revenues applicable to multiple-element fee arrangements are bifurcated among the elements such as license agreements and support and upgrade obligations using vendor-specific, objective evidence of fair value. Such evidence consists primarily of pricing of multiple elements as if sold as separate products or arrangements. These elements vary based upon factors such as the type of license, volume of units licensed, and other related factors.

Revenues from telecommunication services are derived principally from monthly service fees to customers for usage of their telecommunications services. The service fees are charged to customers at a fixed rate per month. Service fees are billed one month in advance but recognized when earned, in the period in which the service is provided.

Deferred revenue as of March 31, 2004 and December 31, 2003, consisted of the following:

Description	Criteria for Recognition	March 31, 2004	December 31, 2003
Deferred unit royalties and license fees	Delivery of units to end users or expiration of contract	$ 432,000	$ 535,000
Telecom services	Service provided for customer	597,000	--
Deferred customer support agreements	Expiration of period covered by support agreement	63,000	5,000
Total Deferred revenue		$ 1,092,000	$ 540,000

Cost of revenues from license, royalties, and maintenance consists of costs to distribute the product, installation and support personnel compensation, amortization and impairment of capitalized speech software costs, licensed technology, and other related costs. Cost of service revenues consists of personnel compensation and other related costs.