10QSB 1 d17743e10qsb.txt FORM 10-QSB U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 [ ] 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: 000-27031 FULLNET COMMUNICATIONS, INC. ---------------------------- (Exact name of registrant as specified in its charter) OKLAHOMA 73-1473361 -------- ---------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 201 Robert S. Kerr Avenue, Suite 210,Oklahoma City, Oklahoma 73102 ------------------------------------------------------------------ (Address of principal executive offices) (405) 236-8200 -------------- (Issuer's telephone number) CHECK WHETHER THE ISSUER (1) FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE EXCHANGE ACT DURING THE PAST 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 [ ] The number of shares outstanding of the Issuer's Common Stock, $.00001 par value, as of August 10, 2004 was 6,713,135. Transitional Small Business Disclosure Format (Check one): YES [ ] NO [X] FORM 10-QSB TABLE OF CONTENTS
Page PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets (Unaudited) - June 30, 2004 and December 31, 2003................. 3 Consolidated Statements of Operations - Three and six months ended June 30, 2004 and 2003 (Unaudited).......................................................................... 4 Consolidated Statement of Stockholders' Deficit - Six months ended June 30, 2004 (Unaudited)................................................................................... 5 Consolidated Statements of Cash Flows - Six months ended June 30, 2004 and 2003 (Unaudited)................................................................................... 6 Notes to Consolidated Financial Statements (Unaudited)........................................ 7 Item 2. Management's Discussion and Analysis or Plan of Operation..................................... 14 Item 3. Controls and Procedures....................................................................... 23 PART II. OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds..................................................... 24 Item 3. Defaults Upon Senior Securities............................................................... 24 Item 4. Submission of Matters to a Vote of Security Holders........................................... 24 Item 6. Exhibits and Reports on Form 8-K.............................................................. 24 Signatures............................................................................................. 29
- 2 - FULLNET COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED)
JUNE 30, DECEMBER 31, 2004 2003 ----------- ------------ ASSETS CURRENT ASSETS Cash $ 15,780 $ 11,480 Accounts receivable, net 93,199 29,510 Prepaid expenses and other current assets 84,430 60,163 ----------- ------------ Total current assets 193,409 101,153 PROPERTY AND EQUIPMENT, net 957,956 995,730 INTANGIBLE ASSETS, net 195,123 269,482 OTHER ASSETS 7,470 6,771 ----------- ------------ TOTAL $ 1,353,958 $ 1,373,136 =========== ============ LIABILITIES AND STOCKHOLDERS' DEFICIT CURRENT LIABILITIES Accounts payable - trade $ 440,211 $ 464,903 Accrued and other current liabilities 686,369 548,027 Notes payable, current portion 1,030,228 1,184,845 Capital lease obligations, current portion 39,218 31,722 Deferred revenue 177,424 171,876 ----------- ------------ Total current liabilities 2,373,450 2,401,373 NOTES PAYABLE, less current portion 279,320 330,322 CAPITAL LEASE OBLIGATIONS, less current portion 31,951 17,325 OTHER 166,310 145,329 STOCKHOLDERS' DEFICIT Commonstock - $.00001 par value; authorized, 10,000,000 shares; issued and outstanding, 6,642,878 shares in 2004 and 2003 66 66 Common stock issuable, 70,257 shares in 2004 and 2003 57,596 57,596 Additional paid-in capital 8,327,504 8,327,294 Accumulated deficit (9,882,239) (9,906,169) ----------- ------------ Total stockholders' deficit (1,497,073) (1,521,213) ----------- ------------ TOTAL $ 1,353,958 $ 1,373,136 =========== ============
See accompanying notes to financial statements. - 3 - FULLNET COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED ----------------------------- ----------------------------- JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2004 JUNE 30, 2003 ------------- ------------- ------------- ------------- REVENUES Access service revenues $ 186,202 $ 264,246 $ 395,359 $ 547,416 Co-location and other revenues 390,224 255,328 691,684 513,940 ------------- ------------- ------------- ------------- Total revenues 576,426 519,574 1,087,043 1,061,356 OPERATING COSTS AND EXPENSES Cost of access service revenues 52,751 117,859 103,344 363,460 Cost of co-location and other revenues 38,188 27,379 94,456 60,845 Selling, general and administrative expenses 302,840 270,699 610,912 557,262 Loss (gain) on sale of assets 7,024 (35,697) 7,024 (31,000) Depreciation and amortization 99,537 125,730 196,156 255,870 ------------- ------------- ------------- ------------- Total operating costs and expenses 500,340 505,970 1,011,892 1,206,437 ------------- ------------- ------------- ------------- INCOME (LOSS) FROM OPERATIONS 76,086 13,604 75,151 (145,081) GAIN ON DEBT FORGIVENESS 46,383 - 46,383 - INTEREST EXPENSE (41,809) (143,751) (97,604) (265,201) ------------- ------------- ------------- ------------- NET INCOME (LOSS) $ 80,660 $ (130,147) $ 23,930 $ (410,282) ============= ============= ============= ============= Net income (loss) per share -basic $ .01 $ (.02) $ NIL $ (.06) ============= ============= ============= ============= Net income (loss) per share - assuming dilution $ .01 $ (.02) $ NIL $ (.06) ============= ============= ============= ============= Weighted average shares outstanding - basic 6,713,135 6,663,135 6,713,135 6,663,135 ============= ============= ============= ============= Weighted average shares outstanding - assuming dilution 7,600,325 6,663,135 7,600,325 6,663,135 ============= ============= ============= =============
See accompanying notes to financial statements. - 4 - FULLNET COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT (UNAUDITED) SIX MONTHS ENDED JUNE 30, 2004
Common stock Common -------------------- Stock Additional Accumulated Shares Amount Issuable paid-in capital Deficit Total --------- -------- -------- --------------- ----------- ----------- Balance at January 1, 2004 6,642,878 $ 66 $ 57,596 $ 8,327,294 $(9,906,169) $(1,521,213) Intrinsic value of beneficial conversion feature on debt - - - 210 - 210 Net income - - - - 23,930 23,930 --------- -------- -------- --------------- ----------- ----------- Balance at June 30, 2004 6,642,878 $ 66 $ 57,596 $ 8,327,504 $(9,882,239) $(1,497,073) ========= ======== ======== =============== =========== ===========
See accompanying notes to financial statements. - 5 - FULLNET COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
SIX MONTHS ENDED ----------------------------- JUNE 30, 2004 JUNE 30, 2003 ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ 23,930 $ (410,282) Adjustments to reconcile net loss to net cash provided by (used in) operating Activities Depreciation and amortization 196,156 255,870 Warrants issued related to financing - 2,403 Options issued in exchange for compensation - 213 Amortization of discount and costs relating to financing 1,757 168,364 Gain on debt forgiveness (46,383) - Loss (gain) on sale of assets 7,024 (31,000) Provision for uncollectible accounts receivable 46,440 331 Net (increase) decrease in Accounts receivable (110,129) (44,814) Prepaid expenses and other current assets (24,267) (26,003) Other assets (699) 8,743 Net increase (decrease) in Accounts payable - trade (20,288) 108,789 Accrued and other liabilities 138,504 66,779 Deposits 23,938 - Deferred revenue 5,548 (16,945) ------------- ------------- Net cash provided by operating activities 241,531 82,448 CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property and equipment (45,074) (43,872) Proceeds from sale of assets, net of closing costs 5,900 56,485 ------------- ------------- Net cash (used in) provided by investing activities (39,174) 12,613 CASH FLOWS FROM FINANCING ACTIVITIES Principal payments on borrowings under notes payable (160,034) (76,921) Principal payments on note payable to related party (5,153) (4,735) Principal payments on capital lease obligations (32,870) (28,408) ------------- ------------- Net cash used in financing activities (198,057) (110,064) ------------- ------------- NET INCREASE (DECREASE) IN CASH 4,300 (15,003) Cash at beginning of period 11,480 26,955 ------------- ------------- Cash at end of period $ 15,780 $ 11,952 ============= ============= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid for interest $ 42,693 $ 41,628 Assets acquired through issuance of capital lease 54,992 - Assets acquired through issuance of note payable - 202,200
See accompanying notes to financial statements. - 6 - FULLNET COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. UNAUDITED INTERIM FINANCIAL STATEMENTS The unaudited financial statements and related notes have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. The accompanying financial statements and related notes should be read in conjunction with the audited consolidated financial statements of the Company and notes thereto for the year ended December 31, 2003. The information furnished reflects, in the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results of the interim periods presented. Operating results of the interim period are not necessarily indicative of the amounts that will be reported for the year ending December 31, 2004. Certain reclassifications have been made to prior period balances to conform with the presentation for the current period. 2. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures; accordingly, actual results could differ from those estimates. 3. INCOME (LOSS) PER SHARE Income (loss) per share - basic is calculated by dividing net income (loss) by the weighted average number of shares of stock outstanding during the period, including shares issuable without additional consideration. Income (loss) per share - assuming dilution is calculated by dividing net income (loss) by the weighted average number of shares outstanding during the period adjusted for the effect of dilutive potential shares calculated using the treasury stock method.
THREE MONTHS ENDED SIX MONTHS ENDED ------------------------------- ------------------------------ JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2004 JUNE 30, 2003 ------------- -------------- ------------ ------------- Numerator: Net income $ 80,660 $ (130,147) $ 23,930 $ (410,282) Denominator: Weighted average shares outstanding - basic 6,713,135 6,663,135 6,713,135 6,663,135 Effect of dilutive stock options 318,714 - 318,714 - Effect of dilutive warrants 852,846 - 852,846 - ------------- -------------- ------------- ------------- Weighted average shares outstanding - assuming dilution 7,884,695 6,663,135 7,884,695 6,663,135 ============= ============== ============= ============= Net income (loss) per share - basic $ .01 $ (.02) $ NIL $ (.06) ============= ============== ============= ============= Net income (loss) per share - assuming dilution $ .01 $ (.02) $ NIL $ (.06) ============= ============== ============= =============
-7- Stock options to purchase 1,453,588 shares of common stock at exercise prices ranging from $.05 to $3.00 per share were outstanding for the three and six months ended June 30, 2004, but were not included in the calculation of income (loss) per share - assuming dilution because the options were not dilutive. Warrants to purchase 1,135,623 shares of common stock at exercise prices ranging from $.05 to $2.77 per share were outstanding for the three and six months ended June 30, 2004, but were not included in the calculation of income (loss) per share - assuming dilution because the warrants were not dilutive. Convertible promissory notes to purchase 1,003,659 shares of common stock at an exercise price of $1.00 per share were outstanding for the three and six months ended June 30, 2004, but were not included in the calculation of income (loss) per share - assuming dilution because the convertible notes were not dilutive. Basic and diluted loss per share were the same for each period in 2003 because the outstanding convertible promissory notes, stock options and warrants were not dilutive. 4. INTANGIBLE ASSETS Intangible assets consist primarily of acquired customer bases and covenants not to compete and are carried net of accumulated amortization. Upon initial application of SFAS 142 as of January 1, 2002, the Company reassessed useful lives and began amortizing these intangible assets over their estimated useful lives and in direct relation to any decreases in the acquired customer bases to which they relate. Management believes that such amortization reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. Amortization expense for the three months ended June 30, 2004 and 2003 relating to intangible assets was $37,913 and $63,633, respectively. Amortization expense for the six months ended June 30, 2004 and 2003 relating to intangible assets was $74,359 and $136,503, respectively. 4. NOTES PAYABLE During the three months ended June 30, 2004, the Company negotiated and settled four notes that had principal and accrued interest totaling $68,018. This settlement generated $41,979 of forgiveness of debt income. - 8 - Notes payable consist of the following:
June 30, December 31, 2004 2003 ---------- ------------ Three notes payable to a bank, payable in monthly installments aggregating $10,010, including interest ranging from 9.5% to 11.5%, maturing September 2008; collateralized by property and equipment, accounts receivable and Company common stock owned by the founder and CEO of the Company; guaranteed by the founder and CEO of the Company; partially guaranteed by the Small Business Administration $ 354,515 $ 394,600 Interim loan, interest at 10%, requires payments equal to 50% of the net proceeds received by the Company from its private placement of convertible promissory notes, matured December 2001; unsecured (1) 320,000 320,000 Convertible promissory notes; interest at 12.5% of face amount, payable quarterly; these notes are unsecured and are matured at June 30, 2004 ($510,636 face amount less unamortized discount of $1,439 for 2003); effective rate of 20% (convertible into approximately 1,003,659 shares at June 30, 2004 and December 31, 2003) (2) 510,636 509,197 Note payable to an individual, payable in monthly installments of $1,277 until paid in full, including interest at a variable rate (prime plus 2.25%; 6.5% at June 30, 2004), matures September 2014; collateralized by substantially all assets acquired in conjunction with the acquisition of Harvest Communications, Inc. 16,793 23,775 Note payable to the Company's founder and CEO, payable in monthly installments of $1,034 including interest at 8.5%, maturing May 2006; unsecured 21,665 26,818 Note payable, interest at 10%, requires monthly installments of $9,330 for 12 months then $18,209 for the remainder of the note, maturing August 2004, secured by a telephone switch (3) 35,968 122,818 Other notes payable (4) 49,971 117,959 ---------- ------------ 1,309,548 1,515,167 ---------- ------------ Less current portion 1,030,228 1,184,845 ---------- ------------ $ 279,320 $ 330,322 ========== ============
(1) This loan and accrued interest of $104,066 was past due on June 30, 2004; the Company has not made payment or negotiated an extension of the loan and the lender has not made any demands. - 9 - (2) During 2000 and 2001, the Company issued 11% convertible promissory notes or converted other notes payable or accounts payable to convertible promissory notes in an amount totaling $2,257,624. The terms of the Notes are 36 months with limited prepayment provisions. The Notes may be converted by the holder at any time at $1.00 per share and by the Company upon registration and when the closing price of the Company's common stock has been at or above $3.00 per share for three consecutive trading days. Additionally, the Notes are accompanied by warrants exercisable for the purchase of the number of shares of Company common stock equal to the number obtained by dividing 25% of the face amount of the Notes purchased by $1.00. These warrants are exercisable at any time during the five years following issuance at an exercise price of $.01 per share. Under the terms of the Notes, the Company was required to register the common stock underlying both the Notes and the detached warrants by filing a registration statement with the Securities and Exchange Commission within 45 days following the Final Expiration Date of the Offering (March 31, 2001). On May 31, 2001, the Company exchanged 2,064,528 shares of its common stock and warrants (exercisable for the purchase of 436,748 shares of common stock at $2.00 per share) for convertible promissory notes in the principal amount of $1,746,988 (recorded at $1,283,893) plus accrued interest of $123,414. The warrants expire on May 31, 2006. This exchange was accounted for as an induced debt conversion and a debt conversion expense of $370,308 was recorded. Pursuant to the provisions of the convertible promissory notes, the conversion price was reduced from $1.00 per share on January 15, 2001 to $.49 per share on December 31, 2003 for failure to register under the Securities Act of 1933, as amended, the common stock underlying the convertible promissory notes and underlying warrants on December 15, 2001. Reductions in conversion price are recognized at the date of reduction by an increase to additional paid-in capital and an increase in the discount on the convertible promissory notes. Furthermore, the interest rate was increased to 12.5% per annum from 11% per annum because the registration statement was not filed before March 1, 2001. At June 30, 2004, the outstanding principal and interest of the convertible promissory notes was $664,030. On January 1, 2002, the Company recorded 11,815 shares of common stock issuable in payment of $11,815 accrued interest on a portion of the Company's convertible promissory notes. In November 2003, December 2003 and March 2004, $455,000, $50,000 and $5,636, respectively, of these convertible promissory notes matured. The Company has not made payment nor negotiated an extension of these notes, and the lenders have not made any demands. The Company is currently developing a plan to satisfy these notes which will be subject to the approval of each individual note holder. (3) During February 2003, upon the receipt and installation of a telephone switch the Company made a down payment of $14,950. The remaining balance of $202,200 was financed by the supplier at 10% interest to be paid in 18 monthly payments beginning in March 2003. (4) Includes one note with past due principal and accrued interest totaling $27,648 at June 30, 2004. The Company has not made payment or negotiated an extension of this note and the lender has not made any demands. 6. COMMON STOCK OPTIONS AND WARRANTS The Company's employee stock options are accounted for under APB Opinion No. 25 and related interpretations. Had compensation cost for the Company's stock options been determined based on the fair value at the grant dates consistent with the method of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, the Company's net income (loss) and income (loss) per share for the three and six months ended June 30, 2004 and 2003 would have changed to the pro forma amounts indicated below: - 10 -
Three Months Three Months Six Months Six Months Ended Ended Ended Ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ------------- ------------- Net income (loss) As reported $ 80,660 $ (130,147) $ 23,930 $ (410,282) Pro forma $ 75,217 $ (152,309) $ 9,206 $ (480,596) Basic and diluted income (loss) per share As reported $ .01 $ (.02) $ NIL $ (.06) Pro forma $ .01 $ (.02) $ NIL $ (.07)
The fair value of each option grant prior to February 2000 was estimated on the date of grant using the minimum value method because there was no public trading market for the Company's securities. During February 2000, the Company's common stock began trading on the OTC Bulletin Board under the symbol FULO. The fair values of the options granted subsequent to February 2000 have been estimated at the date of grant using the Black-Scholes option pricing model. The following table summarizes the Company's employee stock option activity for the three and six months ended June 30, 2004:
Three Months Weighted Six Months Weighted Ended Average Ended Average June 30, 2004 Exercise Price June 30, 2004 Exercise Price ------------- -------------- ------------- -------------- Options outstanding, beginning of period 2,903,366 $ .45 2,903,366 $ .45 Options granted during the period 15,000 .05 15,000 .05 Options outstanding, end of period 2,918,366 $ .45 2,918,366 $ .45 ============= ============== ============= =======
The following table summarizes the Company's common stock purchase warrant and certain stock option activity for the three and six months ended June 30, 2004:
Three Months Weighted Six Months Weighted Ended Average Ended Average June 30, 2004 Exercise Price June 30, 2004 Exercise Price ------------- -------------- ------------- ------------- Warrants and certain stock options outstanding, beginning and end of the period 2,201,681 $ .66 2,201,681 $ .66 ========= ========= ========= =========
7. RECENTLY ISSUED ACCOUNTING STANDARDS During April 2003, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standard ("SFAS") 149 - "Amendment of Statement 133 on Derivative Instruments and Hedging Activities", effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. In addition, except as stated below, all provisions of this Statement should be applied prospectively. The provisions of this Statement that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, paragraphs 7(a) and 23(a), which relate to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to both existing contracts and new contracts entered into after June 30, 2003. The Company - 11 - does not participate in such transactions. There was no material impact on its consolidated financial statements, results of operations or liquidity resulting from the adoption of this statement. During May 2003, the FASB issued SFAS 150 - "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a freestanding financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. There was no material impact on the Company's consolidated financial statements, results of operations or liquidity resulting from the adoption of this statement. During October 2003, the FASB issued Staff Position No. FIN 46 deferring the effective date for applying the provisions of FIN 46 until the end of the first interim or annual period ending after December 31, 2003 if the variable interest was created prior to February 1, 2003 and the public entity has not issued financial statements reporting that variable interest entity in accordance with FIN 46. The FASB also indicated it would be issuing a modification to FIN 46 prior to the end of 2003. Accordingly, the Company has deferred the adoption of FIN 46 with respect to variable interest entities created prior to February 1, 2003. There was no material impact on the Company's consolidated financial statements, results of operations or liquidity resulting from the adoption of this interpretation. 8. MANAGEMENT'S PLANS At June 30, 2004, current liabilities exceed current assets by $2,180,041. The Company does not have a line of credit or credit facility to serve as an additional source of liquidity. The ability of the Company to continue as a going concern is dependent upon continued operations of the Company that in turn is dependent upon the Company's ability to meet its financing requirements on a continuing basis, to maintain present financing, to achieve the objectives of its business plan and to succeed in its future operations. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence. The Company's business plan includes, among other things, expansion of its Internet access services through mergers and acquisitions and the development of its web hosting and co-location services. Execution of the Company's business plan will require significant capital to fund capital expenditures, working capital needs and debt service. Current cash balances will not be sufficient to fund the Company's current business plan beyond the next few months. As a consequence, the Company is currently focusing on revenue enhancement and cost cutting opportunities as well as working to sell non-core assets and to extend vendor payment terms. The Company continues to seek additional convertible debt or equity financing as well as the placement of a credit facility to fund the Company's liquidity. There - 12 - can be no assurance that the Company will be able to raise additional capital on satisfactory terms or at all. 9. CREDITOR SETTLEMENTS AND DEBT FORGIVENESS During the three months ended June 30, 2004, the Company negotiated and settled $68,018 of notes payable including accrued interest and $6,878 of accounts payable. These settlements generated a total of $46,383 of forgiveness of debt income of which $41,979 was related to notes payable and $4,404 was related to accounts payable. 10. SUBSEQUENT EVENT On July 30, 2004, the Company purchased approximately 1,318 of the dial-up Internet access customers of CWIS Internet Services, Inc. (CWIS), an Oklahoma corporation. Pursuant to the terms of the asset purchase agreement, the Company paid $25,000 at closing. In addition, the Company will pay CWIS an amount based upon the future collected revenues received from all active CWIS customers transferred at the time of closing for eighteen months following the closing. - 13 - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion is qualified in its entirety by the more detailed information in our Form 10-KSB and the financial statements contained therein, including the notes thereto, and our other periodic reports filed with the Securities and Exchange Commission since December 31, 2003 (collectively referred to as the "Disclosure Documents"). Certain forward-looking statements contained herein and in such Disclosure Documents regarding our business and prospects are based upon numerous assumptions about future conditions which may ultimately prove to be inaccurate and actual events and results may materially differ from anticipated results described in such statements. Our ability to achieve these results is subject to certain risks and uncertainties, such as those inherent generally in the Internet service provider and competitive local exchange carrier industries, the impact of competition and pricing, changing market conditions, and other risks. Any forward-looking statements contained in this Report represent our judgment as of the date of this Report. We disclaim, however, any intent or obligation to update these forward-looking statements. As a result, the reader is cautioned not to place undue reliance on these forward-looking statements. References to us in this report include our subsidiaries: FullNet, Inc. ("FullNet"), FullTel, Inc. ("FullTel") and FullWeb, Inc. ("FullWeb"). OVERVIEW We are an integrated communications provider offering integrated communications and Internet connectivity to individuals, businesses, organizations, educational institutions and government agencies. Through our subsidiaries, we provide high quality, reliable and scalable Internet access, web hosting, and equipment co-location. Our overall strategy is to become the dominant integrated communications provider for residents and small to medium-sized businesses in Oklahoma. Our principal executive offices are located at 201 Robert S. Kerr Avenue, Suite 210, Oklahoma City, Oklahoma 73102, and our telephone number is (405) 236-8200. We also maintain an Internet site on the World Wide Web ("WWW") at www.fullnet.net. Information contained on our Web site is not and should not be deemed to be a part of this Report. COMPANY HISTORY We were founded in 1995 as CEN-COM of Oklahoma, Inc., an Oklahoma corporation, to bring dial-up Internet access and education to rural locations in Oklahoma that did not have dial-up Internet access. We changed our name to FullNet Communications, Inc. in December 1995, and shifted our focus from offering dial-up services to providing wholesale and private label network connectivity and related services to other Internet service providers. During 1995 and 1996, we furnished wholesale and private label network connectivity services to Internet service providers in Bartlesville, Cushing, Durant, Perry, Tahlequah, and Tulsa. During 1996, we sold our Internet service provider operations in Enid, Oklahoma and began Internet service provider operations in Ponca City, Oklahoma. In 1997 we continued our focus on being a backbone provider by upgrading and acquiring more equipment. We also started offering our own Internet service provider brand access and services to our wholesale customers. As of June 30, 2004, there was one Internet service provider in Oklahoma that used the FullNet brand name for whom we provide the backbone to the Internet. There was also one Internet service provider that used a private label brand name, for whom we are its access backbone and provide on an outsource basis technical support, systems management and - 14 - operations. Additionally, we provide high-speed broadband connectivity, website hosting, network management and consulting solutions to over 100 businesses in Oklahoma. In 1998 our gross revenues exceeded $1,000,000 and we made the Metro Oklahoma City Top 50 Fastest Growing Companies list. In 1998 we commenced the process of organizing a competitive local exchange carrier ("CLEC") through FullTel, and acquired Animus Communications, Inc. ("Animus"), a wholesale Web-service company, which enabled us to become a total solutions provider to individuals and companies seeking a "one-stop shop" in Oklahoma. Animus was renamed FullWeb in January 2000. With the incorporation of FullTel and the acquisition of FullWeb, our current business strategy is to become the dominant integrated communications provider in Oklahoma, focusing on rural areas. We expect to grow through the acquisition of additional customers for our carrier-neutral co-location space, the acquisition of Internet service providers, as well as through a FullNet brand marketing campaign. During 2000 and 2001, we completed eight separate acquisitions of Internet service provider companies, with customers in the Oklahoma cities of Tahlequah, Bartlesville, Enid, Nowata, Lawton, Oklahoma City, Adair, Jay Pryor, Wyandotte, Leach, Colcord and Moseley. During the month of February 2000, our common stock began trading on the OTC Bulletin Board under the symbol FULO. While our common stock trades on the OTC Bulletin Board, it is very thinly traded, and there can be no assurance that our stockholders will be able to sell their shares should they so desire. Any market for the common stock that may develop, in all likelihood, will be a limited one, and if such a market does develop, the market price may be volatile. In June 2000, we began providing co-location services to KMC Telecom V, Inc. ("KMC"), a facilities-based competitive local exchange carrier pursuant to an agreement that ends on December 31, 2005. Under the terms of this agreement, we receive $42,275 per month to provide co-location and support services for KMC's telecommunications equipment at our network operations center in Oklahoma City, Oklahoma. We completed our network operations center during the first quarter of 2001. KMC moved into our network operations center and began making payments during the third quarter of 2000. We plan to market additional carrier neutral co-location solutions in our network operations center to other competitive local exchange carriers, Internet service providers and web-hosting companies. Our co-location facility is carrier neutral, allowing customers to choose among competitive offerings rather than being restricted to one carrier. Our network operations center is Telco-grade and provides customers a high level of operative reliability and security. We offer flexible space arrangements for customers, 24-hour onsite support with both battery and generator backup. Through FullTel, our wholly owned subsidiary, we are a fully licensed competitive local exchange carrier or CLEC in Oklahoma. The FullTel data center telephone switching equipment was installed in March 2003. At which time, FullTel began the process of activating local access telephone numbers for every city in which we will market, sell and operate our retail FullNet Internet service provider brand, wholesale dial-up Internet service and our business-to-business network design, connectivity, domain and Web hosting businesses. At June 30, 2004 FullTel provided us with local telephone access in approximately 229 cities. - 15 - RESULTS OF OPERATIONS The following table sets forth certain statement of operations data as a percentage of revenues for the three and six months ended June 30, 2004 and 2003:
THREE MONTHS ENDED SIX MONTHS ENDED ---------------------------------------- ---------------------------------------------- JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2004 JUNE 30, 2003 ------------------ ------------------- -------------------- ----------------------- AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT --------- ------- --------- ------- ---------- ------- ----------- --------- Revenues: Access service revenues $ 186,202 32.3% $ 264,246 50.9% $ 395,359 36.4% $ 547,416 51.6% Co-location and other revenues 390,224 67.7 255,328 49.1 691,684 63.6 513,940 48.4 --------- ------- --------- ------- ---------- ------- ----------- --------- Total revenues 576,426 100.0 519,574 100.0 1,087,043 100.0 1,061,356 100.0 Cost of access service revenues 52,751 9.2 117,859 22.7 103,344 9.5 363,460 34.3 Cost of co-location and other 38,188 6.6 27,379 5.3 94,456 8.7 60,845 5.7 Revenues Selling, general and 302,840 52.5 270,699 52.1 610,912 56.2 557,262 52.5 administrative expenses Loss (gain) on sale of assets 7,024 1.2 (35,697) (6.9) 7,024 0.6 (31,000) (2.9) Depreciation and amortization 99,537 17.3 125,730 24.2 196,156 18.1 255,870 24.1 --------- ------- --------- ------- ---------- ------- ----------- --------- Total operating costs and Expenses 500,340 86.8 505,970 97.4 1,011,892 93.1 1,206,437 113.7 --------- ------- --------- ------- ---------- ------- ----------- --------- Income (loss) from operations 76,086 13.2 13,604 2.6 75,151 6.9 (145,081) (13.7) Gain on debt forgiveness 46,383 8.1 - - 46,383 4.3 - - Interest expense (41,809) (7.3) (143,751) (27.7) (97,604) (9.0) (265,201) (25.0) --------- ------- --------- ------- ---------- ------- ----------- --------- Net income (loss) $ 80,660 14.0% $(130,147) (25.1)% $ 23,930 2.2% $ (410,282) (38.7)% ========= ======= ========= ======= ========== ======= =========== =========
THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30, 2003 Revenues Access service revenues decreased $78,044 or 29.5% to $186,202 for the three-month period ended June 30, 2004 from $264,246 for the same period in 2003 primarily due to a net reduction in the number of customers, including the sale of approximately 160 customers in 2003. Co-location and other revenues increased $134,896 or 52.8% to $390,224 for the three-month period ended June 30, 2004 from $255,328 for the same period in 2003. This increase was attributable to selling additional services to existing customers, the addition of new customers and reciprocal compensation billed to SBC. On June 30, 2004, we billed SBC approximately $97,000 for reciprocal compensation (fees for terminating SBC customers' local calls onto our network). This is the first reciprocal compensation billing that we have presented to SBC and covers the period March 1, 2003 through May 31, 2004. Subsequent to June 30, 2004, and without explanation SBC has failed to pay approximately $38,000 of our billing. We will be pursuing SBC for the balance due, however there is significant uncertainty as to whether or not we will be successful. Consequently, we have established a reserve of $38,000 and have not recorded any revenue associated with the reserve. Upon the ultimate resolution of its challenge, we will recognize the associated revenue, if any. On a going forward basis we do not believe that reciprocal compensation revenues will be material. - 16 - Operating Costs and Expenses Cost of access service revenues decreased $65,108 or 55.2% to $52,751 for the three-month period ended June 30, 2004 from $117,859 for the same period in 2003. This decrease was primarily due to the restructuring of our network in order to operate in a more cost effective manner. During the three-month period ended March 31, 2003 we received approximately $76,000 in back billings from SBC. During the three-month period ended March 31, 2004 we received a credit on these billings of approximately $13,000. We are in the process of reviewing these bills and at June 30, 2004 we had paid approximately $10,000, received credit from SBC of approximately $27,000 and accrued the balance of approximately $39,000. Cost of co-location and other revenues increased $10,809 or 39.5% to $38,188 for the three-month period ended June 30, 2004 over $27,379 for the same period in 2003. This increase was primarily due to taxes and other telecommunications fees mandated by certain governmental agencies. These taxes and telecommunications fees were not included in the 2003 period because we had originally concluded these revenues were not subject to these taxes and telecommunications fees. However after consultation with legal counsel, we concluded that the revenues were subject to these taxes and other telecommunications fees and recorded the $21,000 liability for the year ended December 31, 2003, along with approximately $10,000 of associated penalties and interest in the first quarter of 2004. Selling, general and administrative expenses increased $32,141 or 11.9% to $302,840 for the three-month period ended June 30, 2004 from $270,699 for the same period in 2003. This increase was primarily due to an increase in employee costs. Employee costs increased $20,941 for the period ended June 30, 2004 from the same period in 2003. This increase was primarily due to increases in health insurance costs, annual wage increases and deferred compensation of $8,034, $8,850 and $2,614, respectively. Selling, general and administrative expenses as a percentage of total revenues increased to 52.5% during 2004 from 52.1% during 2003. During the three months ended June 30, 2004 we recorded a loss on sale of assets of $7,024 that was primarily attributable to the trade-in of equipment. During the same period in 2003 we recorded a gain on sale of assets of $35,697 that was primarily attributable to the sale of a block of our access service revenue business located in a part of Oklahoma that was outside our primary geographic area of focus. Depreciation and amortization expense decreased $26,193 or 20.8% to $99,537 for the three-month period ended June 30, 2004 from $125,730 for the same period in 2003. In January 2002, upon initially applying Statement of Financial Account Standards 142, Goodwill and Intangible Assets ("SFAS 142"), we reassessed useful lives and we began amortizing our intangible assets over their estimated useful lives and in direct relation to any decreases in the acquired customer bases to which they relate. Amortization expense for the periods ended June 30, 2004 and 2003 relating to intangible assets was $37,913 and $63,633, respectively. Gain on Debt Forgiveness During the three months ended June 30, 2004, we negotiated and settled $68,018 of notes payable including accrued interest and $6,878 of accounts payable. These settlements generated a total of $46,383 of forgiveness of debt income of which $41,979 was related to notes payable and $4,404 was related to accounts payable. - 17 - Interest Expense Interest expense decreased $101,942 or 70.9% to $41,809 for the three-month period ended June 30, 2004 from $143,751 for the same period in 2003. This decrease was primarily attributable to the decrease in amortization of the discount on our convertible promissory notes payable. Pursuant to the provisions of the convertible promissory notes, the conversion price decreased from $.59 at March 31, 2003 to $.49 at June 30, 2004. Reductions in conversion price are recognized as an interest expense at the date of reduction by an increase to additional paid-in capital and an increase in the discount on the convertible promissory notes. The majority of these convertible promissory notes matured in 2003 and the remaining note matured in March 2004. Therefore no additional interest from these conversion prices will be recognized. SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDED JUNE 30, 2003 Revenues Access service revenues decreased $152,057 or 27.8% to $395,359 for the six-month period ended June 30, 2004 from $547,416 for the same period in 2003 primarily due to a net reduction in the number of customers, including the sale of approximately 160 customers in 2003. Co-location and other revenues increased $177,744 or 34.6% to $691,684 for the six-month period ended June 30, 2004 from $513,940 for the same period in 2003. This increase was attributable to selling additional services to existing customers, the addition of new customers and reciprocal compensation billed to SBC. On June 30, 2004, we billed SBC approximately $97,000 for reciprocal compensation (fees for terminating SBC customers' local calls onto our network). This is the first reciprocal compensation billing that we have presented to SBC and covers the period March 1, 2003 through May 31, 2004. Subsequent to June 30, 2004, and without explanation SBC has failed to pay approximately $38,000 of our billing. We will be pursuing SBC for the balance due, however there is significant uncertainty as to whether or not we will be successful. Consequently, we have established a reserve of $38,000 and have not recorded any revenue associated with the reserve. Upon the ultimate resolution of its challenge, we will recognize the associated revenue, if any. On a going forward basis we do not believe that reciprocal compensation revenues will be material. Operating Costs and Expenses Cost of access service revenues decreased $260,116 or 71.6% to $103,344 for the six-month period ended June 30, 2004 from $363,460 for the same period in 2003. This decrease was primarily due to the restructuring of our network in order to operate in a more cost effective manner. During the period ended June 30, 2003 we received approximately $76,000 in back billings from SBC. During the same period in 2004, we received a credit on these billings of approximately $13,000. We are in the process of reviewing these bills and at June 30, 2004 we had paid approximately $10,000, received credit from SBC of approximately $27,000 and accrued the balance of approximately $39,000. Cost of co-location and other revenues increased $33,611 or 55.2% to $94,456 for the six-month period ended June 30, 2004 over $60,845 for the same period in 2003. This increase was primarily due to taxes and other telecommunications fees mandated by certain governmental agencies. These taxes and telecommunications fees were not included in the 2003 period because we had originally concluded these revenues were not subject to these taxes and telecommunications - 18 - fees. However after consultation with legal counsel, we concluded that the revenues were subject to these taxes and other telecommunications fees and recorded the $21,000 liability for the year ended December 31, 2003, along with approximately $10,000 of associated penalties and interest in the first quarter of 2004. Selling, general and administrative expenses increased $53,650 or 9.6% to $610,912 for the six-month period ended June 30, 2004 from $557,262 for the same period in 2003. This increase was primarily due to an increase in employee costs. Employee costs increased $39,644 for the period ended June 30, 2004 from the same period in 2003. This increase was primarily due to increases in health insurance costs, annual wage increases and deferred compensation of $14,340, $10,739 and $10,597, respectively. Selling, general and administrative expenses as a percentage of total revenues increased to 56.2% during 2004 from 52.5% during 2003. During the six months ended June 30, 2004 we recorded a loss on sale of assets of $7,024 that was primarily attributable to the trade-in of equipment. During the same period in 2003 we recorded a gain on sale of assets of $31,000 primarily attributable to the sale of a block of our access service revenue business located in a part of Oklahoma that was outside our primary geographic area of focus. Depreciation and amortization expense decreased $59,714 or 23.3% to $196,156 for the period ended June 30, 2004 from $255,870 for the same period in 2003. In January 2002, upon initially applying SFAS 142 we reassessed useful lives and we began amortizing our intangible assets over their estimated useful lives and in direct relation to any decreases in the acquired customer bases to which they relate. Amortization expense for the periods ended June 30, 2004 and 2003 relating to intangible assets was $74,359 and $136,503, respectively. Gain on Debt Forgiveness During the six months ended June 30, 2004, we negotiated and settled $68,018 of notes payable including accrued interest and $6,878 of accounts payable. These settlements generated a total of $46,383 of forgiveness of debt income of which $41,979 was related to notes payable and $4,404 was related to accounts payable. Interest Expense Interest expense decreased $167,597 or 63.2% to $97,604 for the period ended June 30, 2004 from $265,201 for the same period in 2003. This decrease was primarily attributable to the decrease in amortization of the discount on our convertible promissory notes payable. Pursuant to the provisions of the convertible promissory notes, the conversion price decreased from $.56 at June 30, 2003 to $.49 at December 31, 2003. Reductions in conversion price were recognized as an interest expense at the date of reduction by an increase to additional paid-in capital and an increase in the discount on the convertible promissory notes. The majority of these convertible promissory notes matured in 2003 and the remaining note matured in March 2004. Therefore no additional interest from these conversion prices will be recognized. LIQUIDITY AND CAPITAL RESOURCES As of June 30, 2004, we had $15,780 in cash and $2,373,450 in current liabilities, including $177,424 of deferred revenues that will not require settlement in cash. - 19 - At June 30, 2004, we had a deficit working capital of $2,180,041, while at December 31, 2003 we had a deficit working capital of $2,300,220. We do not have a line of credit or credit facility to serve as an additional source of liquidity. Historically we have relied on shareholder loans as an additional source of funds. As of June 30, 2004, $406,360 of the $440,211 we owed to our trade creditors was past due. We have no formal agreements regarding payment of these amounts. At June 30, 2004, we had outstanding principal and interest owed on matured notes totaling $1,115,744. We have not made payment or negotiated an extension of the notes and the lenders have not made any demands. We are currently developing a plan to satisfy these notes on terms acceptable to the note holders. Cash provided by operations was $241,531 and $82,448, respectively, for the six months ended June 30, 2004 and 2003. Cash used for the purchases of equipment was $45,074 and $43,872, respectively, for the six months ended June 30, 2004 and 2003. Cash provided by the sales of surplus equipment was $5,900 and $56,485, respectively, for the six months ended June 30, 2004 and 2003. Cash used for principal payments on notes payable and capital lease obligations was $198,057 and $110,064, respectively, for the six months ended June 30, 2004 and 2003. The planned expansion of our business will require significant capital to fund capital expenditures, working capital needs and debt service. Our principal capital expenditure requirements will include: - mergers and acquisitions and - further development of operations support systems and other automated back office systems Because our cost of developing new networks and services, funding other strategic initiatives, and operating our business depend on a variety of factors (including, among other things, the number of subscribers and the service for which they subscribe, the nature and penetration of services that may be offered by us, regulatory changes, and actions taken by competitors in response to our strategic initiatives), it is almost certain that actual costs and revenues will materially vary from expected amounts and these variations are likely to increase our future capital requirements. Our current cash balances will not be sufficient to fund our current business plan beyond a few months. As a consequence, we are currently focusing on revenue enhancement and cost cutting opportunities as well as working to sell non-core assets and to extend vendor payment terms. We continue to seek additional convertible debt or equity financing as well as the placement of a credit facility to fund our liquidity needs. There is no assurance that we will be able to obtain additional capital on satisfactory terms or at all or on terms that will not dilute our shareholders' interests. In the event that we are unable to obtain additional capital or to obtain it on acceptable terms or in sufficient amounts, we will be required to delay the further development of our network or take other actions. This could have a material adverse effect on our business, operating results and financial condition and our ability to achieve sufficient cash flows to service debt requirements. Our ability to fund the capital expenditures and other costs contemplated by our business plan and to make scheduled payments with respect to bank borrowings will depend upon, among other things, our ability to seek and obtain additional financing in the near term. Capital will be - 20 - needed in order to implement our business plan, deploy our network, expand our operations and obtain and retain a significant number of customers in our target markets. Each of these factors is, to a large extent, subject to economic, financial, competitive, political, regulatory, and other factors, many of which are beyond our control. There is no assurance that we will be successful in developing and maintaining a level of cash flows from operations sufficient to permit payment of our outstanding indebtedness. If we are unable to generate sufficient cash flows from operations to service our indebtedness, we will be required to modify our growth plans, limit our capital expenditures, restructure or refinance our indebtedness or seek additional capital or liquidate our assets. There is no assurance that (i) any of these strategies could be effectuated on satisfactory terms, if at all, or on a timely basis or (ii) any of these strategies will yield sufficient proceeds to service our debt or otherwise adequately fund operations. FINANCING ACTIVITIES During February 2003, upon the receipt and installation of a telephone switch we made a down payment of $14,950. The remaining balance of $202,200 was financed by the supplier requiring 18 monthly installments beginning in March 2003, plus interest at 10% per annum. As additional consideration we issued the supplier a warrant to purchase 50,000 shares of our common stock for $.01 per share for a period of five years from the date of issuance. At June 30, 2004, the outstanding principal and interest of the loan was $36,067. On January 5, 2001, we obtained a $250,000 interim loan. This loan bears interest at 10% per annum and requires payments equal to 50% of the net proceeds received by us from our private placement of convertible notes payable. Subsequently, the principal balance of the loan was increased to $320,000 and the due date was extended to December 31, 2001. Through June 30, 2004 we had made aggregate payments of principal and interest of $35,834 on this loan. Pursuant to the terms of this loan the balance was due on December 31, 2001 and we have not made payment or negotiated an extension of the loan and the lender has not made any demands. At June 30, 2004, the outstanding principal and interest of the loan was $424,066. Pursuant to the provisions of the convertible promissory notes, the conversion price was reduced from $1.00 per share on January 15, 2001 to $.49 per share on June 15, 2004 for failure to register under the Securities Act of 1933, as amended, the common stock underlying the convertible promissory notes and underlying warrants on February 15, 2001. Reductions in conversion price are recognized at the date of reduction by an increase to additional paid-in capital and an increase in the discount on the notes payable. Furthermore, the interest rate was increased to 12.5% per annum from 11% per annum because the registration statement was not filed before March 1, 2001. At June 30, 2004, the outstanding principal and interest of the convertible promissory notes was $664,030. RECENTLY ISSUED ACCOUNTING STANDARDS During April 2003, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standard ("SFAS") 149 - "Amendment of Statement 133 on Derivative Instruments and Hedging Activities", effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. In addition, except as stated below, all provisions of this Statement should be applied prospectively. The provisions of this Statement that relate to Statement 133 Implementation Issues that have been - 21 - effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, paragraphs 7(a) and 23(a), which relate to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to both existing contracts and new contracts entered into after June 30, 2003. We do not participate in such transactions. There was no material impact on our consolidated financial statements, results of operations or liquidity resulting from the adoption of this statement. During May 2003, the FASB issued SFAS 150 - "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a freestanding financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. There was no material impact on our consolidated financial statements, results of operations or liquidity resulting from the adoption of this statement. During October 2003, the FASB issued Staff Position No. FIN 46 deferring the effective date for applying the provisions of FIN 46 until the end of the first interim or annual period ending after December 31, 2003 if the variable interest was created prior to February 1, 2003 and the public entity has not issued financial statements reporting that variable interest entity in accordance with FIN 46. The FASB also indicated it would be issuing a modification to FIN 46 prior to the end of 2003. Accordingly, we have deferred the adoption of FIN 46 with respect to variable interest entities created prior to February 1, 2003. There was no material impact on our consolidated financial statements, results of operations or liquidity resulting from the adoption of this interpretation. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect certain reported amounts and disclosures. In applying our accounting principles, we must often make individual estimates and assumptions regarding expected outcomes or uncertainties. As you might expect, the actual results or outcomes are generally different than the estimated or assumed amounts. These differences are usually minor and are included in our consolidated financial statements as soon as they are known. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates. We periodically review the carrying value of our intangible assets when events and circumstances warrant such a review. One of the methods used for this review is performed using estimates of future cash flows. If the carrying value of our intangible assets is considered impaired, an impairment charge is recorded for the amount by which the carrying value of the intangible assets exceeds its fair value. We believe that the estimates of future cash flows and fair value are reasonable. Changes in estimates of such cash flows and fair value, however, could affect the calculation and result in additional impairment charges in future periods. - 22 - ITEM 3. CONTROLS AND PROCEDURES Our Chief Executive Officer and Chief Financial Officer are responsible primarily for establishing and maintaining disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission. These controls and procedures are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Furthermore, our Chief Executive Officer and Chief Financial Officer are responsible for the design and supervision of our internal controls over financial reporting that are then effected by and through our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. These policies and procedures (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements. Our Executive Officer and Chief Financial Officer, based upon their evaluation of the effectiveness of our disclosure controls and procedures and the internal controls over financial reporting as of the last day of the period covered by this report, concluded that our disclosure controls and procedures and internal controls over financial reporting were fully effective during and as of the last day of the period covered by this report and reported to our auditors and the audit committee of our board of directors that no change in our disclosure controls and procedures and internal control over financial reporting occurred during the period covered by this report that would materially affected or is reasonably likely to materially affect our disclosure controls and procedures or internal control over financial reporting. In conducting their evaluation of our disclosure controls and procedures and internal controls over financial reporting, these executive officers did not discover any fraud that involved management or other employees who have a significant role in our disclosure controls and procedures and internal controls over financial reporting. Furthermore, there were no significant changes in our disclosure controls and procedures, internal controls over financial reporting, or other factors that could significantly affect our disclosure controls and procedures or internal controls over financial reporting subsequent to the date of their evaluation. Because no significant deficiencies or material weaknesses were discovered, no corrective actions were necessary or taken to correct significant deficiencies and material weaknesses in our internal controls and disclosure controls and procedures. - 23 - PART II-OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES We are in default on an interim loan that matured December 31, 2001. This loan bears interest at 10% per annum and requires payments equal to 50% of the net proceeds received by us from our private placement of convertible notes payable. Through June 30, 2004, we had made aggregate payments of principal and interest of $35,834 on this loan. At June 30, 2004, the outstanding principal and accrued interest of the loan was $424,066. We have not made payment or negotiated an extension of the loan and the lender has not made any demands. We are in default on convertible promissory notes that matured in November 2003, December 2003 and March 2004. These notes bear interest at 12.5% per annum and are convertible into approximately 1,003,659 shares of our common stock. We were unable to pay these notes at maturity and are currently developing a plan to satisfy these notes on terms acceptable to the note holders. At June 30, 2004, the outstanding principal and accrued interest of the notes was $664,030. We have neither made payment nor negotiated an extension of these notes, and the lenders have not made any demands. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits are filed as part of this Report:
Exhibit Number Exhibit -------- ------- 3.1 Certificate of Incorporation, as amended (filed as Exhibit 2.1 to Registrant's Registration Statement on Form 10-SB, file number 000-27031 and incorporated herein by reference). # 3.2 Bylaws (filed as Exhibit 2.2 to Registrant's Registration Statement on Form 10-SB, file number 000-27031 and incorporated herein by reference) # 4.1 Specimen Certificate of Registrant's Common Stock (filed as Exhibit 4.1 to the Company's Form 10-KSB for the fiscal year ended December 31, 1999, and incorporated herein by reference). # 4.2 Certificate of Correction to the Amended Certificate of Incorporation and the Ninth Section of the Certificate of Incorporation (filed as Exhibit 2.1 to Registrant's Registration Statement on form 10-SB, file number 000-27031 and incorporated by reference). # 4.3 Certificate of Correction to Articles II and V of Registrant's Bylaws (filed as Exhibit 2.1 to Registrant's Registration Statement on Form 10-SB, file number 000-27031 and incorporated herein by reference). # 4.4 Form of Warrant Agreement for Interim Financing in the amount of $505,000 (filed as Exhibit 4.1 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). #
- 24 - 4.5 Form of Warrant Certificate for Florida Investors for Interim Financing in the amount of $505,000 (filed as Exhibit 4.2 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.6 Form of Promissory Note for Florida Investors for Interim Financing in the amount of $505,000 (filed as Exhibit 4.3 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.7 Form of Warrant Certificate for Georgia Investors for Interim Financing in the amount of $505,000 (filed as Exhibit 4.4 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.8 Form of Promissory Note for Georgia Investors for Interim Financing in the amount of $505,000 (filed as Exhibit 4.5 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.9 Form of Warrant Certificate for Illinois Investors for Interim Financing in the amount of $505,000 (filed as Exhibit 4.6 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.10 Form of Promissory Note for Illinois Investors for Interim Financing in the amount of $505,000 (filed as Exhibit 4.7 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.11 Form of Warrant Agreement for Interim Financing in the amount of $500,000 (filed as Exhibit 4.8 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.12 Form of Warrant Certificate for Interim Financing in the amount of $500,000 (filed as Exhibit 4.9 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.13 Form of Promissory Note for Interim Financing in the amount of $500,000 (filed as Exhibit 4.10 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 4.14 Form of Convertible Promissory Note for September 29, 2000, private placement (filed as Exhibit 4.13 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000 and incorporated herein by reference). # 4.15 Form of Warrant Agreement for September 29, 2000, private placement (filed as Exhibit 4.13 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000 and incorporated herein by reference). # 4.16 Form of 2001 Exchange Warrant Agreement (filed as Exhibit 4.16 to Registrant's Form 10-QSB for the quarter ended June 30, 2001 and incorporated herein by reference) # 4.17 Form of 2001 Exchange Warrant Certificate (filed as Exhibit 4.17 to Registrant's Form 10-QSB for the quarter ended June 30, 2001 and incorporated herein by reference) # 10.1 Financial Advisory Services Agreement between the Company and National Securities Corporation, dated September 17, 1999 (filed as Exhibit 10.1 to Registrant's Form 10-KSB for the fiscal year ended December 31, 1999, and incorporated herein by reference). # 10.2 Lease Agreement between the Company and BOK Plaza Associates, LLC, dated December 2, 1999 (filed as Exhibit 10.2 to Registrant's Form 10-KSB for the fiscal year ended December 31, 1999, and incorporated herein by reference). #
- 25 - 10.3 Interconnection agreement between Registrant and Southwestern Bell dated March 19, 1999 (filed as Exhibit 6.1 to Registrant's Registration Statement on Form 10-SB, file number 000-27031 and incorporated herein by reference). # 10.4 Stock Purchase Agreement between the Company and Animus Communications, Inc. (filed as Exhibit 6.2 to Registrant's Registration Statement on Form 10-SB, file number 000-27031 and incorporated herein by reference). # 10.5 Registrar Accreditation Agreement effective February 8, 2000, by and between Internet Corporation for Assigned Names and Numbers and FullWeb, Inc. d/b/a FullNic f/k/a Animus Communications, Inc. (filed as Exhibit 10.1 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended March 31, 2000 and incorporated herein by reference). # 10.6 Master License Agreement For KMC Telecom V, Inc., dated June 20, 2000, by and between FullNet Communications, Inc. and KMC Telecom V, Inc. (filed as Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-QSB for the Quarter ended June 30, 2000 and incorporated herein by reference). # 10.7 Domain Registrar Project Completion Agreement, dated May 10, 2000, by and between FullNet Communications, Inc., FullWeb, Inc. d/b/a FullNic and Think Capital (filed as Exhibit 10.2 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended June 30, 2000 and incorporated herein by reference). # 10.8 Amendment to Financial Advisory Services Agreement between Registrant and National Securities Corporation, dated April 21, 2000 (filed as Exhibit 10.3 to Registrant's Quarterly Report on Form 10-QSB for the Quarter ended June 30, 2000 and incorporated herein by reference). # 10.9 Asset Purchase Agreement dated June 2, 2000, by and between FullNet of Nowata and FullNet Communications, Inc. (filed as Exhibit 99.1 to Registrant's Form 8-K filed on June 20, 2000 and incorporated herein by reference). # 10.10 Asset Purchase Agreement dated February 4, 2000, by and between FullNet of Bartlesville and FullNet Communications, Inc. (filed as Exhibit 2.1 to Registrant's Form 8-K filed on February 18, 2000 and incorporated herein by reference). # 10.11 Agreement and Plan of Merger Among FullNet Communications, Inc., FullNet, Inc. and Harvest Communications, Inc. dated February 29, 2000 (filed as Exhibit 2.1 to Registrant's Form 8-K filed on March 10, 2000 and incorporated herein by reference). # 10.12 Asset Purchase Agreement dated January 25, 2000, by and between FullNet of Tahlequah, and FullNet Communications, Inc. (filed as Exhibit 2.1 to Registrant's Form 8-K filed on February 9, 2000 and incorporated herein by reference). # 10.13 Promissory Note dated August 2, 2000, issued to Timothy J. Kilkenny (filed as Exhibit 10.13 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.14 Warrant Agreement dated August 2, 2000, issued to Timothy J. Kilkenny (filed as Exhibit 10.14 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.15 Warrant Certificate dated August 2, 2000 issued to Timothy J. Kilkenny (filed as Exhibit 10.15 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.16 Stock Option Agreement dated December 8, 2000, issued to Timothy J. Kilkenny (filed as Exhibit 10.16 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.17 Warrant Agreement dated November 9, 2000, issued to Roger P. Baresel (filed as Exhibit 10.17 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). #
- 26 - 10.18 Warrant Agreement dated December 29, 2000, issued to Roger P. Baresel (filed as Exhibit 10.18 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.19 Stock Option Agreement dated February 29, 2000, issued to Wallace L Walcher (filed as Exhibit 10.19 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.20 Stock Option Agreement dated February 17, 1999, issued to Timothy J. Kilkenny (filed as Exhibit 3.1 to Registrant's Registration Statement on Form 10-SB, file number 000-27031 and incorporated herein by reference). # 10.21 Stock Option Agreement dated October 19, 1999, issued to Wesdon C. Peacock (filed as Exhibit 10.21 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.22 Stock Option Agreement dated April 14, 2000, issued to Jason C. Ayers (filed as Exhibit 10.22 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.23 Stock Option Agreement dated May 1, 2000, issued to B. Don Turner (filed as Exhibit 10.23 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.24 Form of Stock Option Agreement dated December 8, 2000, issued to Jason C. Ayers, Wesdon C. Peacock, B. Don Turner and Wallace L. Walcher (filed as Exhibit 10.24 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.25 Warrant Certificate Dated November 9, 2000, issued to Roger P. Baresel (filed as Exhibit 10.25 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.26 Warrant Certificate Dated November 9, 2000, issued to Roger P. Baresel (filed as Exhibit 10.26 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.27 Warrant Certificate Dated December 29, 2000, issued to Roger P. Baresel (filed as Exhibit 10.27 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.28 Stock Option Agreement dated October 13, 2000, issued to Roger P. Baresel (filed as Exhibit 10.28 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.29 Stock Option Agreement dated October 12, 1999, issued to Travis Lane (filed as Exhibit 10.29 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.30 Promissory Note dated January 5, 2001, issued to Generation Capital Associates (filed as Exhibit 10.30 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.31 Placement Agency Agreement dated November 8, 2000 between FullNet Communications, Inc. and National Securities Corporation (filed as Exhibit 10.31 to Registrant's Form 10-KSB for the fiscal year ended December 31, 2000). # 10.32 Promissory Note dated January 25, 2000, issued to Fullnet of Tahlequah, Inc. # 10.33 Promissory Note dated February 7, 2000, issued to David Looper # 10.34 Promissory Note dated February 29, 2000, issued to Wallace L. Walcher # 10.35 Promissory Note dated June 2, 2000, issued to Lary Smith # 10.36 Promissory Note dated June 15, 2001, issued to higganbotham.com L.L.C. # 10.37 Promissory Note dated November 19, 2001, issued to Northeast Rural Services # 10.38 Promissory Note dated November 19, 2001, issued to Northeast Rural Services # 10.39 Form of Convertible Promissory Note dated September 6, 2002 #
- 27 - 10.40 Employment Agreement with Timothy J. Kilkenny dated July 31, 2002 # 10.41 Employment Agreement with Roger P. Baresel dated July 31, 2002 # 10.42 Letter from Grant Thornton LLP to the Securities and Exchange Commission dated January 30, 2003 # 10.43 Form 8-K dated January 30, 2003 reporting the change in certifying accountant # 22.1 Subsidiaries of the Registrant # 31.1 Certification pursuant to Rules 13a-14(a) and 15d-14(a) of Timothy J. Kilkenny * 31.2 Certification pursuant to Rules 13a-14(a) and 15d-14(a) of Roger P. Baresel * 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Timothy J. Kilkenny * 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Roger P. Baresel *
-------------------------------- # Incorporated by reference. * Filed herewith. (b) Reports on Form 8-K Registrant filed no reports on Form 8-K during the three months ended June 30, 2004. - 28 - SIGNATURES Pursuant to the requirements of the Exchange Act, the Registrant caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. REGISTRANT: FULLNET COMMUNICATIONS, INC. Date: August 16, 2004 By: /s/ TIMOTHY J. KILKENNY ------------------------------------- Timothy J. Kilkenny Chief Executive Officer Date: August 16, 2004 By: /s/ ROGER P. BARESEL ------------------------------------- Roger P. Baresel President and Chief Financial and Accounting Officer - 29 -