10-K 1 intertel010473_10k.txt INTER-TEL CORPORATIOIN 10-K YEAR ENDED 12-31-00 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------------- FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED COMMISSION FILE NUMBER: DECEMBER 31, 2000 0-10211 INTER-TEL, INCORPORATED INCORPORATED IN THE STATE OF ARIZONA I.R.S. NO. 86-0220994 120 NORTH 44TH STREET, SUITE 200 PHOENIX, ARIZONA 85034-1826 (602) 302-8900 ---------------------------------- Securities registered pursuant to Section 12(g) of the Act: Common Stock (24,555,622 shares outstanding as of March 9, 2001) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (S 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K - [ ]. The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the last reported sales price of the Company's Common Stock reported on the Nasdaq National Market System on March 9, 2001 was approximately $177.9 million. Shares of Common Stock held by each executive officer and director have been excluded in that such persons may be deemed to be affiliates. Items 10 (as to Directors), 11 and 12 of Part III incorporate by reference information from the Registrant's Proxy Statement relating to its 2001 Annual Meeting of Shareholders. INTER-TEL, INCORPORATED 2000 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS PART I Page Item 1 Business 3 Item 2 Properties 24 Item 3 Legal Proceedings 24 Item 4 Submission of Matters to a Vote of Security Holders 24 PART II Item 5 Market for the Registrant's Common Stock 24 and Related Shareholder Matters Item 6 Selected Financial Data 25 Item 7 Management's Discussion and Analysis of Financial Condition 25 and Results of Operations Item 7A Quantitative and Qualitative Disclosures About Market Risk 26 Item 8 Financial Statements and Supplementary Data 26 Item 9 Changes in and Disagreements with Accountants on Accounting and 26 Financial Disclosure PART III Item 10 Directors and Executive Officers of the Registrant 26 Item 11 Executive Compensation 27 Item 12 Security Ownership of Certain Beneficial Owners and Management 27 Item 13 Certain Relationships and Related Transactions 27 PART IV Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K 27 2 PART I ITEM 1. BUSINESS THE COMPANY THIS ANNUAL REPORT TO SHAREHOLDERS ON FORM 10-K ("10-K") CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE STATEMENTS CONTAINED IN THIS 10-K THAT ARE NOT PURELY HISTORICAL ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, INCLUDING WITHOUT LIMITATION STATEMENTS REGARDING THE COMPANY'S EXPECTATIONS, BELIEFS, INTENTIONS OR STRATEGIES REGARDING THE FUTURE. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS DOCUMENT ARE BASED ON INFORMATION AVAILABLE TO THE COMPANY ON THE DATE HEREOF, AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE ANY SUCH FORWARD-LOOKING STATEMENTS. THE CAUTIONARY STATEMENTS MADE IN THIS 10-K SHOULD BE READ AS BEING APPLICABLE TO ALL RELATED FORWARD-LOOKING STATEMENTS WHEREVER THEY APPEAR IN THIS DOCUMENT. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH UNDER "FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS" BELOW AND ELSEWHERE IN THIS DOCUMENT. IN EVALUATING THE COMPANY'S BUSINESS, SHAREHOLDERS AND PROSPECTIVE INVESTORS SHOULD CONSIDER CAREFULLY THE FOLLOWING FACTORS IN ADDITION TO THE OTHER INFORMATION SET FORTH IN THIS DOCUMENT. Inter-Tel, incorporated in Arizona in 1969, is a single point of contact, full service provider of digital business telephone systems, call processing software, voice processing software, call accounting software, Internet Protocol ("IP") telephony software, computer telephone integration ("CTI") applications, IP and traditional long distance calling, and other communications services. Inter-Tel's products and services include the AXXESS and ECLIPSE2 digital business communication software platforms, with integrated voice processing and unified messaging systems, InterPrise voice and data routers, ClearConnect Talk-to-Agent e-Commerce software, and IP telephony communications services. The Company also provides maintenance, leasing and support services for its products. The Company's Common Stock is quoted on the Nasdaq National Market System under the symbol "INTL." The Company has developed a distribution network of direct sales offices, dealers and value added resellers, or VARs, which sell the Company's products to small-to-medium-size organizations and to divisions or departments of larger organizations, including Fortune 500 companies, large service organizations and governmental agencies. As of December 31, 2000, the Company had 47 direct sales offices in the United States, one in Japan and a network of hundreds of dealers and VARs around the world who purchase directly from the Company. The Company also maintains a wholesale distribution office in the United Kingdom that supplies Inter-Tel's dealers and distributors throughout the UK and parts of mainland Europe. In January 2001, the Company acquired selected assets and liabilities of Convergent, Technologies, Inc. ("Convergent"). As a result of the Convergent acquisition, the Company added 8 more direct sales offices in the United States. PRODUCTS AND SERVICES The Company offers a broad range of products and services designed to support the needs of businesses and other organizations requiring voice and data communications systems. The Company's principal products are digital telephone systems which support networked installations up to 20,000 ports, IP telephony products and services, CTI applications, unified messaging software and voice processing software. The Company principally sells systems supporting 10 to 4,000 telephones with suggested retail prices of larger systems in excess of $1,000,000 per system, depending on configuration. The Company also offers long distance calling services, network design and implementation services, maintenance, leasing and support services, and resells other telecommunications products. 3 DIGITAL COMMUNICATION PLATFORMS Inter-Tel offers an extensive line of digital communication systems, including hardware platforms and C++ software applications. Because these platforms are based upon open architecture and conform to established computer and telephone industry standard programming interfaces and protocols (such as TAPI, TSAPI and TCP/IP), customers can choose from a variety of either server level or desktop applications. AXXESS BY INTER-TEL AND ECLIPSE2 BY INTER-TEL. The AXXESS and ECLIPSE2 platforms, incorporate advanced technology for computer and telephone integration. These platforms are designed to provide businesses with the ability to customize applications to enhance their operations and to increase productivity. The current system releases support up to 20,000 ports and include such advanced capabilities as primary rate ISDN, integrated call recording, voice prompts in different languages, transparent networking and a Windows-based attendant's console. The platforms allow, through fully transparent digital networking, two or more systems to operate as one integrated system, currently with capacity up to 20,000 ports. The AXXESS and ECLIPSE2 systems incorporate fully-digital processing and transmission to the desktop and open architecture interfaces, which allow the systems to be integrated with and controlled by attached computers such as PCs and workstations. The systems incorporate object-oriented C++ software developed by the Company, which facilitates upgrades and the incorporation of additional features and functionality. AXXESS and ECLIPSE2 system telephones feature user-friendly, 6-by-16 character LCD displays with menu keys that permit the user to select from multiple menu choices or access additional menu screens. These systems also feature integrated voice processing, which permits push-button selection of voice processing commands to appear on the telephone's LCD display, as well as voice-prompted selections through the telephone keypad. The systems currently offer English, Japanese and Spanish voice prompts and LCD displays and allows the user to switch from one language to another. The systems can support the addition of other languages that the Company expects to add in the future. The AXXESS and ECLIPSE2 systems' open architecture interfaces permit tight integration with a PC or workstation system bus, using several industry-standard interfaces to provide efficient access to voice processing and other applications on the PC or workstation. Applications include database look-up (which utilizes Caller-ID information to retrieve customer information automatically from a computerized database), automated attendant, interactive voice response, automatic call distribution (which queues and prioritizes incoming calls), and call accounting (which permits the monitoring of telephone usage and toll cost). The system is managed through a Microsoft Windows-based graphical user interface on a PC. The AXXESS and ECLIPSE2 systems utilize advanced software to configure and utilize real-time digital signal processor semiconductor components ("DSPs") incorporated into the system hardware. The use of DSPs and related software lowers system costs, permits higher functionality and increases system flexibility. For example, DSPs can be configured by the system manager for different combinations of speakerphones, conference capabilities and other DSP-based facilities. The system's speakerphones incorporate full-duplex technology, which permits speakerphones to transmit in both directions at the same time without the need to override one speaker's voice to prevent feedback interference. Inter-Tel has evolved the AXXESS and ECLIPSE2 SYSTEMS to server-based communication systems by developing a Windows-NT server-based Central Processing Unit, or CPU for the Inter-Tel systems. This CPU is designed to handle call processing with greater speed and efficiency. By combining server-based technology and Inter-Tel AXXESS and ECLIPSE2 technology, Inter-Tel leverages the benefits of a standards-based computer server and the benefits of a PBX, such as equipment maintenance during system operation. Because this server-based CPU integrates with the Inter-Tel systems, current 4 customers can benefit from the new functionality and call handling capacity, while retaining their current system investment. INTER-TEL AXXENT. Small businesses are demanding advanced telephony applications formerly within reach of only large corporations. The Inter-Tel Axxent is designed to bring many of the advanced features and functionality of the AXXESS system to smaller installations on a cost-effective basis while enabling users to migrate to an AXXESS system as their telecommunications needs evolve. The Inter-Tel Axxent supports 24 lines and 12 trunks and provides capabilities such as computer telephone integration, DSP technology, real-time ACD reporting, and integrated voice processing. Housed in a compact, PC-type mid-tower chassis, the Inter-Tel Axxent platform also offers the convenience of a default database, allowing the system to be fully operational as soon as it is plugged in. Basic database programming can also be performed through the digital telephone terminals. IP TELEPHONY PRODUCTS AND INTER-TEL.NET NETWORK IP TELEPHONY VOICE AND DATA GATEWAYS/ROUTERS. Voice and data routers are transition points between two different network types, such as between the public circuit switched telephone network and a packet switched IP network such as the Internet. IP Router products convert regular voice and facsimile transmissions to or from the compressed data packets that travel over packetized networks. The Company markets a line of voice and data routers under the InterPrise brand. INTERPRISE BY INTER-TEL. This product line consists of the InterPrise 400 (four analog PSTN access ports), the InterPrise 3200D (up to twenty-four digital PSTN access ports), and the InterPrise 3200N (up to thirty access ports using AXXESS networking protocol). These products incorporate high speed embedded DSP technology and a proprietary Inter-Tel operating system, and are used primarily by business customers over their wide-area networks, or WANs, and virtual private networks, or VPNs. The InterPrise Voice and Data Routers enable phone-to-phone and PC-to-phone calling over IP networks. INTERPRISE 400. The InterPrise 400 is designed for corporate use over a WAN. The InterPrise 400 can be attached to analog trunk or station interfaces on most US PBX systems. The PBX can then be programmed to use Automatic Route Selection or Least Cost Routing features to automatically route calls through that trunk interface for other locations that also have InterPrise routers/gateways. When phone users wish to place a call, they simply dial the desired telephone number like any other call. The PBX will route the call to the InterPrise 400, which converts it into the compressed or uncompressed, digitized data packets used by the corporate WAN, and routes the call via the WAN to another InterPrise gateway. The second gateway connects with the far-end PBX and dials either the extension number of the desired party or accesses a trunk on the PBX and makes a call into the switched network. Because IP telephony converts all transmissions to the same type of packets, both voice and data information can be transmitted using the same data circuits, thereby increasing efficiency and maximizing the use of bandwidth. Bandwidth utilization can be maximized to an extent such that some users may be able to reduce the overall number of circuits needed. INTERPRISE 3200D. The InterPrise 3200D is designed for corporate use over a WAN or VPN and can be connected to a T1 interface on most US PBX systems. The 3200D provides the same functionality as the InterPrise 400, but has a capacity of 24 channels. CLEARCONNECT - SOFTPHONE is PC-client software that acts as a single port IP telephony gateway and allows callers the ability to make real-time, two-way voice communications over IP networks. Callers connected to an IP network on their PC dial the destination phone number from a familiar Windows graphical user interface. Using the PC's microprocessor and multimedia capabilities, the PC-client software converts the caller's voice into compressed, digitized data packets and routes the call via the IP network to an Inter-Tel InterPrise voice and data router. The InterPrise voice and data router connects with the traditional telephone network and dials the final destination. 5 The Company believes the ClearConnect SoftPhone could provide telecommunications savings for mobile employees by providing long-distance communication through Inter-Tel.NET at a lower total cost than standard long distance telephone service. The Company believes that the opportunity to leverage the potential for reduced cost phone calls is only one of the many opportunities for IP telephony. For this reason, the Company continues to enhance its product line. CLEARCONNECT - TALK TO AGENT. The Company has created web communications software that can be integrated with e-commerce web sites to provide real-time, two-way voice conversations. A Talk to Agent button automatically connects e-commerce customers to call center agents that can address their questions or provide sales assistance. INTER-TEL.NET. The Company through its subsidiary, Inter-Tel.NET, Inc., provides high quality communications services over data networks using IP with domestic points of presence (POPs) in Reno, New York, Los Angeles, Phoenix, Dallas and Miami/Ft. Lauderdale and International POPs in Mexico City, Monterrey, Guadalajara and Puebla Mexico and Hong Kong. Inter-Tel continues to develop its IP network of high capacity switches/gateways and privately managed bandwidth which can accommodate large volumes of traffic and provide quality and reliable service at levels difficult to achieve over unmanaged networks using the public internet. The managed network, routing structure and bandwidth capacity are designed to create a cost-effective solution. Through international alliances, Inter-Tel.NET is participating with businesses in Asia, Europe, Mexico and South America to provide international IP telephony service. The Company's core customer base includes telecommunication service providers, such as long distance carriers, resellers, Competitive Local Exchange Carriers, or CLECs, and data network providers that offer their end users access to voice, fax and other enhanced service. Where Inter-Tel.NET or one of its network partners does not have a POP, Inter-Tel.NET utilizes other IP networks or traditional Long Distance Carriers to complete the call. For risks associated with our Inter-Tel.NET business, see "Factors That May Affect Future Operating Results." COMPUTER-TELEPHONE INTEGRATION (CTI) Through CTI, the computer and the telephone are linked into one environment. Inter-Tel's AXXESS and Eclipse2 digital communication systems and software enable users to receive phone calls through their desktop PC. Using Caller I.D., a caller's information can be retrieved from a company's database even before the call is accepted. On an individual desktop or a company-wide network basis, Inter-Tel offers a variety of Call Center Suite products that can manage automatic call distribution at peak efficiency or route incoming telephone calls, based on various parameters, to a specific person. Inter-Tel's Call Center Suite products can also collect, analyze and report real-time call processing information for staff forecasting and analysis. Through the use of Microsoft's TAPI and Novell's TSAPI standard interfaces, Inter-Tel's software applications work with other "off-the-shelf" Windows applications such as personal information managers, call routing or call management. Inter-Tel has formed relationships with a number of third party software developers to integrate with their existing applications to create a working environment for database, personal organizer, or terminal emulation programs. If these off-the-shelf applications do not adequately meet the needs of a customer, the open design of Inter-Tel's software enables independent software developers to write custom applications through Inter-Tel's Developer Program. Alternatively, Inter-Tel's CTI Solutions Group can provide professional consulting services or can develop individual customer applications, for either desktop or local area network or LAN-based applications. UNIFIED MESSAGING AND VOICE PROCESSING SOFTWARE Inter-Tel's AXXESS and Eclipse2 Unified Messaging Software works in conjunction with a variety of messaging platforms, including the Microsoft Exchange messaging application, Lotus Notes, Lotus cc:Mail, Novell's GroupWise and Internet mail applications such as Qualcomm's 6 Eudora. Unified Messaging Software integrates all types of messages into a single-user interface on a PC, supports both voice mail and facsimile mail and provides another means for improving workplace productivity. Inter-Tel's Voice Processing Unit and Unified Messaging Software, IVX500, and Executone DVX, EVX, and VX2 voice processing platforms work with Inter-Tel's AXXESS-brand, Eclipse2, and Executone communication platforms. These voice processing platforms provide advanced voice mail, auto attendant, recorded announcements, and messaging notification features for businesses. OTHER SERVICES AND PRODUCTS NETWORKING TECHNOLOGIES INTEGRATION. To develop a solid foundation for advanced data and telecommunications networking, customers require strategic network expertise from their networking provider. Inter-Tel designs, installs and supports the complete integration of a customer's complex data and telecommunications network, from land-based LANs to geographically dispersed WANs. By forming relationships with major manufacturers of hardware and software technologies, Inter-Tel provides the routers, ATM, LAN and WAN switches, file servers, intelligent hubs and other devices required for the customer's intranet or for usage of the Internet. Pre-sale design support, project coordination for implementation, and installation support are offered on the full line of Inter-Tel server-based telephony products, InterPrise products, and services. NETWORK AND LONG DISTANCE SERVICES. The Company, through its Inter-Tel NetSolutions, Inc. subsidiary, resells a variety of long distance calling services, including domestic and international calling services, 800 calling services, dedicated services, voice and video conferencing, customized billing and a variety of other telecommunication services. Inter-Tel NetSolutions also provides long distance calling services that are a blend of IP Telephony long distance and traditional circuit-switched long distance. The Company believes that certain of its customers desire the convenience of acquiring long distance calling services through the same vendor that the customer uses to purchase its other telephony equipment and services. The Company currently resells long distance services pursuant to contracts with major U.S. long distance carriers. Examples of the applications currently supported by Inter-Tel NetSolutions include call centers using T-1 access for incoming toll-free traffic, sales offices using NetSolutions' switched long distance and companies linking multiple offices throughout the country on a frame relay network. LEASING SERVICES. The Company offers its Totalease program through its Inter-Tel Leasing, Inc. subsidiary. Totalease enables an end user to acquire a full range of telephony systems, applications, maintenance and support services from affiliated vendors. The Totalease contract provides a total system financing solution to the customer at a set monthly cost, with system expansion available at predictable additional fees. The typical Totalease contract has a term of 60 months, with the customer entitled to renew the contract at a specified price for up to an additional 36 months. Inter-Tel also offers a line of low-cost lease purchase financing. Lease terms range from 24 to 84 months with $1.00, fixed and fair market value purchase options. Inter-Tel can also customize financing packages to suit customers with special financial needs. By offering this type of financing to acquire Inter-Tel products and services, the customer is able to lease directly from an affiliate of the manufacturer, thereby allowing Inter-Tel, or the Inter-Tel dealer, to maintain a direct relationship with customers. OTHER PRODUCTS. Inter-Tel also distributes other leading telecommunications products from its Factored Products Division through its direct sales offices, dealers and Value Added Resellers, or VARs. The Factored Products Division represents products that Inter-Tel has endorsed as leading communications peripherals utilized in many day-to-day functions. Businesses require telecommunications products to provide increased productivity, ease of operations and reliability. 7 Many of these products interface with Inter-Tel telephone systems. Inter-Tel's product selection consists of videoconferencing, battery backup, headsets, surge protection, paging equipment, wireless communications and data multiplexers. 8 SALES AND DISTRIBUTION The Company has developed a distribution network of direct sales offices, dealers and VARs which market the Company's products to small to medium size organizations and divisions or departments of larger organizations. As of December 31, 2000, in the United States, the Company had 47 direct sales offices and a network of hundreds of dealers which purchase systems directly from Inter-Tel. These resellers have traditionally sold complex data solutions to customers, and the Company is seeking to leverage its distribution network to capitalize on the convergence of data communications and telecommunications. The Company also maintains a wholesale distribution office in the United Kingdom that supplies its dealers and distributors throughout the UK and parts of mainland Europe. In addition, the Company maintains a direct sales office and a dealer in Japan. In January 2001, the Company acquired selected assets and liabilities of Convergent. As a result of the Convergent acquisition, the Company added 8 more direct sales offices in the United States. The Company believes that its success depends in part upon the strength of its distribution channels and its ability to maintain close access to its end user customers. In recent periods, the Company has sought to improve its access to end user customers by effecting strategic acquisitions of resellers of telephony products and services in markets in which the Company has existing direct sales offices and in other strategic markets. As of December 31, 2000, the Company's direct sales office personnel consisted of a total of 1,035 persons. The Company's sales through its direct sales offices and government and national accounts group as a percentage of total sales have decreased from 56.7% of net sales in 1999 to 52.6% of net sales in 2000. Sales to distributors, dealers, and VARs have increased from 26.6% of net sales in 1999 to 27.0% of net sales in 2000. Sales through the Company's long distance, IP and network services operations have increased from 10.6% of net sales in 1999 to 13.5% of net sales in 2000. Direct dealers and VARs typically enter into non-exclusive reseller contracts for a term of one or more years. The Company generally provides support and other services to the reseller pursuant to the terms of the agreement. The agreements often include requirements that the reseller meet or use its best efforts to meet minimum annual purchase quotas. The Company faces intense competition from other telephone system and voice processing system manufacturers for its dealers' attention, as most of the Company's dealers carry products which compete with the Company's products. International sales, which include digital communications platforms and IP telephony products, accounted for approximately 2.6% of net sales in 2000, compared to 2.5% in 1999. In order to sell its products to customers in other countries, the Company must comply with local telecommunications standards. The Company's AXXESS system, ECLIPSE2, and IP telephony products can be readily altered through software modifications, which the Company believes would facilitate compliance with these local regulations. In addition, the AXXESS and ECLIPSE2 systems have been designed to support multi-lingual functionality, and both currently support English, Japanese and Spanish. The Company is working to expand its dealer network in the United Kingdom, Europe, Japan and Latin America. International sales are subject to a number of risks, including changes in foreign government regulations and telecommunications standards, export license requirements, tariffs and taxes, other trade barriers, difficulties in protecting intellectual property, fluctuations in currency exchange rates, difficulty in collecting accounts receivable, difficulty in staffing and managing foreign operations and political and economic instability. Fluctuations in currency exchange rates could cause the Company's products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. In addition, the costs associated with developing international sales may not be offset by increased sales in the short term, or at all. CUSTOMER SERVICE AND SUPPORT The Company believes that customer service and support are critical components of customer satisfaction and the success of the Company's business. The Company operates a technical 9 support hotline to provide a range of telephone support to its distributors, dealers and end user customers through the web and a toll-free number. The Company also provides on-site customer support and, through remote diagnostic procedures, has the ability to detect and correct system problems from its technical support facilities. In 2000, The Company began an initiative to greatly enhance its Internet and Extranet capabilities. The Company designed its new website to offer state-of-the-art support for sales and technical support activities, for both associates in our direct sales offices and dealer channel. The Company is also designing the website to offer a wide array of sales and technical information, including an on-line product and service catalog, more efficient order processing, PDF sales brochures, competitive information, on-line technical manuals, FAQ's in important areas, and convenient "touch-to-talk" live operator help employing our own ClearConnect two-way voice over IP technology. The new website launched in conjunction with The Company's major annual dealer conference in January 2001. Information taken from customer service call records allows feedback into Inter-Tel's Quality First continuous improvement process, thus providing direction for product and service enhancements. The Company's direct sales offices and resellers can receive service activity reports summarizing the reasons that technicians are asking for assistance and common issues that give rise to technical inquiries. This allows our direct sales offices and resellers to analyze trends in their service operations and provide better customer service. RESEARCH AND DEVELOPMENT The Company believes that its ability to enhance its current products, develop and introduce new products on a timely basis, maintain technological competitiveness and meet customer requirements are essential to the Company's success. The Company's research and development efforts over the last several years have been focused primarily on development of and enhancements to AXXESS and Eclipse2 Call Processing and Voice Processing with additional applications, incorporating IP convergence features into these platforms including IP telephones, development of Unified Messaging Software applications, and expanding the telecommunications networking package to include networking over IP and frame relay networks. Over the last several years, the research and development efforts have also focused on the development of the InterPrise product line, the ClearConnect SoftPhone, and the ClearConnect Talk to Agent Web Communications Software. The Company's current efforts are focused on the development and enhancement of IP telephony products and features for the AXXESS and ECLIPSE2 digital communication platforms, enhancements to Unified Messaging Software, the IP PhonePlus digital telephone, the InterPrise voice and data router product line, and enhancements to Inter-Tel's NT-CPU PBX. The software-based architecture of the AXXESS and Eclipse2 systems facilitate maintenance and support, upgrades, and incorporation of additional features and functionality. The Company had a total of 193 personnel engaged in research and development and related technical service and support functions as of December 31, 2000. Research and development expenses were $19,489,000; $14,798,000; and $11,373,000; for 2000, 1999, and 1998, respectively. MANUFACTURING The Company manufactures substantially all of its systems through third party subcontractors located in the United States, the Philippines, the People's Republic of China and Mexico. These subcontractors use both standard and proprietary integrated circuits and other electronic devices and components to produce telephone switches, telephones and printed circuit boards to the Company's engineering specifications and designs. The suppliers also inspect and test the equipment before delivering them to the Company, which in some cases then performs systems integration, software loading, final testing and shipment. Varian Associates, Inc. ("Varian"), a multinational electronic company, currently manufacturers a significant portion of the Company's products, including substantially all of the printed circuit boards used in the AXXESS and ECLIPSE2 products, the Inter-Tel Axxent systems, and most of the Executone products at the Varian Tempe, Arizona or Poway, California facilities. The Company sold its manufacturing operation for the Executone line of products to Varian on January 31, 2000. The Company maintains written agreements with its principal suppliers. The Company provides a forecast schedule to its suppliers and revises the forecast on a periodic basis. Delays by our 10 suppliers in delivering components integral to our manufacturing processes could cause us to fail to produce our products in a timely manner, which could harm our business. QUALITY The Company believes that the quality of its systems, customer service and support, and other aspects of its organization are a critical element of meeting the needs of its customers. Through its Quality First continuous improvement process initiated in 1991, Inter-Tel implements quality processes throughout its business operations. The Company has established formal procedures to ensure responsiveness to customer requests, monitor response times and measure customer satisfaction. The Company has also established means by which all end users, including customers of the Company's resellers, can make product enhancement requests directly to the Company. The Company supports its dealers and VARs through an extensive training program at the Company's facility and at dealer sites, a toll-free telephone number for sales and technical support, an Extranet site offering up-to-date sales and support information, and the provision of end user marketing materials. The Company typically provides a one year warranty on its systems to end users. In manufacturing, the Company continuously monitors the quality of the products produced on its behalf by the Company's manufacturing subcontractors, and is extending the Company's Quality First continuous improvement process to its suppliers. COMPETITION The market for the Company's products is highly competitive and in recent periods has been characterized by pricing pressures and business consolidations. The Company's PABX and key systems products competitors include Avaya, a spin-off of Lucent Technologies, Inc. ("Lucent") and Northern Telecom Limited ("NorTel"), as well as Comdial Corporation ("Comdial"), Iwatsu America, Inc. ("Iwatsu"), Mitel Corporation ("Mitel"), NEC Corporation ("NEC"), Nitsuko Corporation ("Nitsuko"), Matsushita Electric Industrial Co., Ltd. ("Panasonic"), Siemens Rolm Communications, Inc. ("Siemens"), Toshiba America, Inc. ("Toshiba") and others. Many of these competitors have significantly greater financial, marketing and technical resources than the Company. The Company also competes against the regional Bell operating companies (RBOCs), which offer systems produced by one or more of the aforementioned competitors and also offer Centrex systems in which automatic calling facilities are provided through equipment located in the telephone company's central office. In the market for voice processing applications, including voice mail, the Company competes against Applied Voice Technology, Inc. ("AVT"), Active Voice Corporation ("Active Voice"), ADC Telecommunication, Inc. ("ADC") (via acquisition of Centigram Communications Corporation), Lucent, Avaya and other competitors, certain of which have significantly greater resources than the Company. In the market for long distance services, the Company competes against AT&T, MCI WorldCom, Inc. ("MCI"), Sprint Corporation, Qwest Communications Corporation ("Qwest") and other competitors, many of which have significantly greater resources than the Company. The Company also expects to compete with RBOCs, cable television companies, satellite and other wireless broadband service providers and others for long distance business as those companies gradually respond to the Telecommunications Act. Key competitive factors in the sale of telephone systems and related applications include price, performance, features, reliability, service and support, name recognition and distribution capability. The Company believes that it competes favorably in its markets with respect to the price, performance and features of its systems, as well as the level of service and support that the Company provides to its customers. Certain of the Company's competitors have significantly greater name recognition and distribution capabilities than the Company. In the market for IP telephony products geared toward the enterprise markets, the Company competes against existing IP telephony gateway providers such as Lucent, Avaya, NorTel, CISCO Systems, 3Com, ADC, Motorola, and others. The Company competes against existing IP long distance service providers such as Concert, deltathree.com, iBasis, ITXC, Net2Phone and traditional telephone carriers such as AT&T and others. Several of these competitors have been active in developing and marketing IP telephony products and have established relationships with customers within their market. Should the market for IP telephony products become fully developed or develop at a rapid rate, large 11 computer companies such as IBM Corporation ("IBM") and Microsoft Corporation ("Microsoft"), or large telephone companies such as AT&T, MCI, Sprint Corporation or Qwest, could choose to develop proprietary software designed to facilitate voice communication over an IP network or they may choose to develop their own IP network. In addition, Inter-Tel's router IP solutions may also compete with Cirilium products. As the Company competes for local telephone service, long distance service and IP network access, it faces additional competition from established foreign and domestic long distance carriers, RBOCs and other providers. Many of these competitors have larger marketing and sales organizations, significantly greater financial and technical resources and a larger and more established customer base than the Company. In addition, RBOCs and other providers have greater name recognition, more established positions in the market and long standing relationships with customers. Accordingly, the Company cannot assure its investors that the Company will compete successfully in these markets. The Company expects that competition will continue to be intense in the markets addressed by the Company, and the Company cannot assure its investors that the Company will be able to continue to compete successfully. INTELLECTUAL PROPERTY RIGHTS The Company's future success will depend in part upon its proprietary technology. The Company currently holds patents for 17 telecommunications and unified messaging products. The remaining life of these patents ranges from 5 to 17 years in duration. The Company has also applied to the U.S. Patent and Trademark Office for 6 additional patents. The Company also relies on copyright and trade secret law and contractual provisions to protect its intellectual property. EMPLOYEES As of December 31, 2000, the Company had a total of 1,763 employees, of whom 1,418 were engaged in sales, marketing and customer support; 63 in quality, manufacturing and related operations; 193 in research and development and related technical service and support functions; and 89 in finance and administration. The Company's future success will depend upon its ability to attract, retain and motivate highly qualified employees, who are in great demand. The Company believes that its employee relations are good. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS In addition, to the other information in this Report on Form 10-K, the following are important factors that should be considered in evaluating Inter-Tel and our business. This Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of many risk factors including, without limitation, those set forth under "Factors That May Affect Future Results Of Operations" below. In evaluating the Company's business, shareholders and prospective investors should consider carefully the following factors in addition to the other information set forth in this document. OUR MARKET IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE AND TO COMPETE SUCCESSFULLY, WE MUST CONTINUALLY INTRODUCE NEW AND ENHANCED PRODUCTS AND SERVICES THAT ACHIEVE BROAD MARKET ACCEPTANCE. The market for our products and services is characterized by rapid technological change, evolving industry standards and vigorous customer demand for new products, applications and services. To compete successfully, we must continually enhance our existing telecommunications products, related software and customer services as well as develop new technologies and applications in a timely and cost-effective manner. If we fail to introduce new products and services that achieve broad market acceptance, or do not adapt our existing products and services to customer demands or evolving industry standards, our business could be significantly harmed. In addition, current competitors or new market 12 entrants may offer products, applications or services that are better adapted to changing technology or customer demands and could render our products and services obsolete. In addition, if the markets for IP network products, CTI applications or related products fail to develop or continue to develop more slowly than we anticipate, or if we are unable for any reason to capitalize on any of these emerging market opportunities, our business, financial condition and operating results could be significantly harmed. OUR FUTURE SUCCESS LARGELY DEPENDS ON INCREASING COMMERCIAL ACCEPTANCE OF OUR AXXESS AND ECLIPSE2 PLATFORMS, INTERPRISE PRODUCTS, AND RELATED COMPUTER TELEPHONY PRODUCTS. During the past few years, we have introduced transparent networking and unified messaging on our AXXESS and ECLIPSE2 platforms and introduced our InterPrise family of voice and data convergence products. In 2000, we introduced ClearConnect, a software-based telephone that runs on a PC, ClearConnect Talk-to-Agent, an e-commerce "touch-to-talk" web call product, a line of IP voice terminals that add IP telephony to the AXXESS and ECLIPSE2 platforms, and several other telephony-related products. During the past 12 months, sales of our AXXESS digital communications platforms and related software have comprised a substantial portion of our net sales. We expect that our future success will continue to depend, in large part, upon the increasing commercial acceptance of the InterPrise and related Computer Telephony products, the AXXESS platform, and the ECLIPSE2 platform, as well as future upgrades and enhancements to these products and networking platforms. We cannot assure that these products or platforms will succeed in the future. OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN ERRORS OR DEFECTS THAT ARE DETECTED ONLY AFTER THEIR RELEASE, WHICH MAY CAUSE US TO INCUR SIGNIFICANT UNEXPECTED EXPENSES AND LOST SALES. Our telecommunications products are highly complex. Although our new products and upgrades are examined and tested prior to release, they can only be fully tested when used by a large customer base. Consequently, our customers may discover program errors or other defects after new products and upgrades have been released. Some of these errors or "bugs" may result from defects contained in component parts or software from our suppliers or other third parties that are intended to be compatible with our products and over which we have little or no control. Although we have test procedures and quality control standards designed to minimize the number of errors or other defects in our products, we cannot assure that our new products and upgrades will be free of bugs when released. If we are unable to quickly or successfully correct bugs identified after release, we could experience: * costs associated with the remediation of any problems; * costs associated with design modifications; * loss of or delay in revenues; * loss of customers; * failure to achieve market acceptance or loss of market share; * increased service and warranty costs; * legal actions by our customers; and * increased insurance costs. THE COMPLEXITY OF OUR PRODUCTS COULD CAUSE DELAYS IN THE DEVELOPMENT AND RELEASE OF NEW PRODUCTS AND SERVICES. AS A RESULT, CUSTOMER DEMAND FOR OUR PRODUCTS COULD DECLINE, WHICH COULD CAUSE OUR BUSINESS TO BE HARMED. Due to the complexity of our products, we have in the past and expect in the future to experience delays in the development and release of new products or product enhancements. If we fail to introduce new software, products or services in a timely manner, or fail to release upgrades to our existing systems or products on a regular and efficient basis, customer demand for our products could decline and our business would be harmed. 13 THE EMERGING MARKET FOR INTERNET PROTOCOL NETWORK TELEPHONY IS SUBJECT TO MARKET RISKS AND UNCERTAINTIES THAT COULD CAUSE SIGNIFICANT DELAYS AND EXPENSES. The market for IP network voice communications products has begun to develop only recently, is evolving rapidly and is characterized by an increasing number of market entrants who have introduced or developed products and services for Internet or other IP network voice communications. As is typical of a new and rapidly evolving industry, the demand for and market acceptance of recently introduced IP network products and services are highly uncertain. We cannot assure that packet switched technology networks will become widespread. Even if packet switched technology networks become widespread in the future, we cannot assure that our products, particularly the Inter-Tel InterPrise product lines, will successfully compete against other market players and attain broad market acceptance. Moreover, the adoption of packet switched technology networks generally requires the acceptance of a new way of exchanging information. In particular, enterprises that have already invested substantial resources in other means of communicating information may be reluctant or slow to adopt a new approach to communications. If the market for IP network voice communications fails to develop or to develop more slowly than we anticipate, our IP network telephony products could fail to achieve market acceptance, which in turn could significantly harm our business, financial condition and operating results. This growth may be inhibited by a number of factors, such as quality of infrastructure; security concerns; equipment, software or other technology failures; regulatory encroachments; inconsistent quality of service; and lack of availability of cost-effective, high-speed network capacity. Moreover, as IP-based data communications and telephony usage grow, the infrastructure used to support these IP networks, whether public or private, may not be able to support the demands placed on them and their performance or reliability may decline. The technology that allows voice and fax communications over the Internet, and the delivery of other value-added services, is still in the early stages of development. Historically, the sound quality of calls placed over IP-based networks was poor. As the IP-based telephony industry has grown, sound quality has improved, but the technology requires further refinement. Data-based networks have not achieved the levels of quality and reliability of the public-switched telephone network. We cannot assure you that the data network will ever achieve the reliability that the public-switched network has historically delivered. Accordingly, we cannot assure you that communications service providers and their end-user customers will be receptive to, and subscribe for, any other additional services we elect to deploy on our network. Any problems, perceived or real, with the reliability or functionality of any new services that we offer could discourage communications service providers from offering these services to their customers. In addition, the development of new services, such as unified communications services, may require substantial capital expenditures to be made well in advance of generating any revenue from such services or demonstrating any market acceptance of such services. If carriers and communications service providers do not employ our network to offer any new services to their customers, or if their customers do not subscribe for the services when offered, our financial condition and results of operations would be materially adversely affected. BUSINESS ACQUISITIONS OR JOINT VENTURES MAY DISRUPT OUR BUSINESS, DILUTE SHAREHOLDER VALUE OR DISTRACT MANAGEMENT ATTENTION. As part of our business strategy, we consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Such acquisitions could materially adversely affect our operating results and/or the price of our common stock. Acquisitions also entail numerous risks, including: * difficulty of assimilating the operations, products and personnel of the acquired business; * potential disruption of our ongoing business; * unanticipated costs associated with the acquisition; * inability of management to manage the financial and strategic position of acquired or developed products, services and technologies; * the division of management's attention from our core business; * inability to maintain uniform standards, controls, policies and procedures; and 14 * impairment of relationships with employees and customers which may occur as a result of integration of the acquired business. In particular, in January 2000, we acquired certain assets and assumed certain liabilities of Executone Information Systems, Inc. We were adversely affected by several of the risks described above relating to our Executone acquisition, including the risks related to unanticipated acquisition costs and impairment of employee and customer relationships, as well as the erosion of gross and operating margins, which risks substantially harmed our operating results. For these and other reasons noted in the footnotes to our financial statements and in the section titled Management's Discussion and Analysis of Financial Condition and Results of Operations, we wrote-off our investment in Executone during the second quarter of 2000. In addition to the Executone losses discussed above, for the quarter ended September 30, 2000, we also recorded a pre-tax loss of $2.0 million related to our equity share of Cirilium's net losses. As of the close of the third quarter, the Company wrote off its remaining investment in Cirilium of $2.0 million. Total pre-tax losses from Cirilium from all sources were $8.6 million for 2000. In January 2001, we acquired certain assets and assumed certain liabilities of Convergent. Generally, Inter-Tel acquired the voice customer base, accounts receivable, some inventory and fixed assets along with assumption of liabilities for warranty, maintenance and specified leased premises costs. In connection with the Convergent acquisition, we hired approximately 210 Convergent employees, and opened 8 Inter-Tel branch offices in previous Convergent locations. In addition to the foregoing risks and uncertainties we face generally in our acquisitions, we may experience the following difficulties or risks associated with the Convergent acquisition: * substantially all of Convergent's sales were of our competitor's products and services, and these manufacturers may make our service and maintenance of such products expensive and difficult; * a large number of Convergent's customers may decline the assignment of their maintenance contracts to us; * any number of the approximately 210 employees hired by Inter-Tel may not integrate successfully or timely into the Inter-Tel business model and plans; and * some or all of the independent contractors who performed projects for Convergent may not assume similar roles with Inter-Tel. Moreover, to the extent that shares of our stock or the rights to purchase stock are issued in connection with any future acquisitions, dilution to our existing shareholders will result and our earnings per share may suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business, and we may not achieve a satisfactory return on our investment in any acquired businesses. WE MAY NOT BE ABLE TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY AND MAY BE INFRINGING UPON THIRD-PARTY INTELLECTUAL PROPERTY RIGHTS. Our success depends upon our proprietary technology. We currently hold patents for 17 telecommunication and unified messaging products and have also applied to the U.S. Patent and Trademark Office for six additional patents. We also rely on copyright and trade secret law and contractual provisions to protect our intellectual property. Despite these precautions, third parties could copy or otherwise obtain and use our technology without authorization, or develop similar technology independently. We cannot assure that any patent, trademark or copyright that we own or have applied to own, will not be invalidated, circumvented or challenged by a third party. Effective protection of intellectual property rights may be unavailable or limited in foreign countries. We cannot assure that the protection of our proprietary rights will be adequate or that competitors will not independently develop similar technology, duplicate our services or design around any patents or other intellectual property rights we hold. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation could be costly, absorb significant management time and harm our business. 15 We also cannot assure that third parties will not claim our current or future products or services infringe upon their rights. Occasionally, we are subject to proceedings alleging that certain of our key products infringed upon third party intellectual property rights, including patents, trademarks, copyrights, or other intellectual property rights. We have viewed presentations from two of our primary competitors, Lucent and Avaya, a spin-off of Lucent, alleging that our AXXESS digital communications platform utilizes inventions covered by certain of such competitor's patents. We are continuing the process of investigating this matter. Additionally, we recently received a letter from AT&T alleging that certain of our IP products infringe upon certain intellectual property protected by AT&T's patents. This matter is also being investigated. When any such claims are asserted against us, we may seek to license the third party's intellectual property rights. Purchasing such licenses can be expensive, and we cannot assure that a license will be available on prices or other terms acceptable to us, if at all. Alternatively, we could resort to litigation to challenge such a claim. Litigation could require us to expend significant sums of cash and divert our management's attention. In the event that a court renders an enforceable decision with respect to our intellectual property, we may be required to pay significant damages, develop non-infringing technology or acquire licenses to the technology that is the subject of the infringement. Any of these actions or outcomes could harm our business, financial condition and operating results. If we are unable or choose not to license technology, or decide not to challenge a third party's rights, we could encounter substantial and costly delays in product introductions. These delays could result from efforts to design around asserted third party rights or our discovery that the development, manufacture or sale of products requiring these licenses could be foreclosed. OUR IP NETWORK PRODUCTS MAY BE VULNERABLE TO VIRUSES, OTHER SYSTEM FAILURE RISKS AND SECURITY CONCERNS. The Inter-Tel InterPrise, ClearConnect, AXXESS NT-CPU, Voice Processing Software, and Unified Messaging Software products may be vulnerable to computer viruses or similar disruptive problems. Computer viruses or problems caused by third parties could lead to interruptions, delays or cessation of service that could harm our operations and revenues. In addition, we may lose customers if inappropriate use of the Internet or other IP networks by third parties jeopardized the security of confidential information, such as credit card or bank account information or the content of conversations over the IP network. User concerns about privacy and security may cause IP networks in general to grow more slowly, and impair market acceptance of our IP network products in particular, until more comprehensive security technologies are developed. WE MAY EXPERIENCE DIFFICULTIES DEVELOPING, MAINTAINING AND IMPROVING THE QUALITY OF THE INTER-TEL.NET NETWORK, AND REQUIRE MORE DEPENDENCE ON THIRD-PARTY SUPPLIERS OF TELECOMMUNICATIONS AND NETWORK TRANSMISSION SERVICES We may be vulnerable to the risk of network failure. Despite the use of security measures, our network is susceptible to damage or interruption from earthquake, fire, flood and other natural disasters; and power loss, network failure, improper operation by employees, physical and electronic break-ins, and similar events. We presently have no off-site back-up facilities for our Network Operating Center (NOC), which handles all monitoring of our network, including trouble reporting, network analysis and network testing. We also use our NOC for monitoring our partners' networks. Any network interruption that impairs our ability to transmit and complete calls, as well as conduct adequate monitoring of our network and our partners' networks could damage our reputations and reduce demand for our services. We have installed new Cisco Systems and new Cirilium 6200 technology in the Inter-Tel.NET network. We are also utilizing Inter-Tel InterPrise products to develop our own IP long-distance network to carry voice and data traffic. The Inter-Tel.NET network is still in the process of deployment and, accordingly, is subject to risks and uncertainties. As noted earlier, we have replaced some and expect to replace additional Vocal'Net Servers in the Inter-Tel.NET network with new technology to improve the reliability, functionality and interoperability of the network. We rely upon third-party vendors to provide us with the equipment and software that we use to transfer and translate calls from traditional voice networks to the IP-based networks, and vice versa. For example, we purchase substantially all of our IP-based telephony 16 equipment and software from Cisco Systems, Inc., Cirilium, Inc., Info Directions, Inc., XACCT Technologies, Inc. and Simplified Telesys. We cannot assure you that we will be able to continue purchasing such equipment and software from these vendors on acceptable terms, if at all or that these vendors will continue to support their products. If we become unable to purchase from these vendors the equipment needed to maintain and expand our network as currently configured, or if these vendors discontinue support we may not be able to maintain or expand our network to accommodate growth and we may consequently be unable to grow revenues sufficiently to become profitable. Some of these vendors are smaller companies with limited resources and capitalization, and may not be able to sustain their business in the future. We also cannot assure that products developed by our suppliers will not suffer from speed and scalability problems that could harm our business. In addition to its own network, Inter-Tel.NET has alliances with other third party domestic and international IP long distance and local communications service providers to originate and terminate calls. The successful expansion of our IP network depends on our ability to obtain services from these suppliers. Some of these suppliers are or may become our competitors and have not agreed to restrict competition against us. If these suppliers raise rates, change pricing structures, or experience power or bandwidth outages, our operations and business may be harmed. There is a risk that the local communications service providers may be slow, or fail, to provide lines, which would affect our ability to complete calls to those destinations. We also may not be able to enter into relationships with enough overseas local service providers to handle increases in the volume of calls that we receive from our customers. We cannot assure that there will not be a significant disruption of service provided by these suppliers, now or in the future. If the domestic or international market for IP network products fails to develop or develops more slowly than we anticipate, or if we experience difficulty in the integration of technology, our Inter-Tel.NET network could become financially burdensome to maintain or obsolete, which could harm our business. WE HAVE MANY COMPETITORS AND EXPECT NEW COMPETITORS TO ENTER OUR MARKET, WHICH COULD PUT PRESSURES ON US. The markets for our products and services are extremely competitive and we expect competition to increase in the future. Our current and potential competitors primarily include: * PABX and core systems providers such as Avaya (formerly part of Lucent), Nortel, Comdial, Iwatsu, Mitel, NEC, Nitsuko, Panasonic, Siemens and Toshiba; * large data routing companies such as Cisco Systems and 3Com; * voice processing applications providers such as AVT, Active Voice, ADC, Lucent and Avaya; * long distance services providers such as AT&T, MCI WorldCom, Sprint and Qwest Communications; * IP telephony product and service providers such as Lucent, Nortel, ADC, iBasis, Concert, DeltaThree, ITXC, deltasix.com, Net2Phone, Cirilium and others; * large computer corporations such as Microsoft and IBM; and * regional Bell operating companies, or RBOCs, cable television companies and satellite and other wireless broadband service providers. These and other companies may form strategic relationships with each other to compete with us. These relationships may take the form of strategic investments, joint-marketing agreements, licenses or other contractual arrangements, which arrangements increase our competitors' ability to address customer needs with their product and service offerings. Many of our competitors and potential competitors have substantially greater financial, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. We cannot be sure that we will have the resources or expertise to compete successfully in the future. Our competitors may be able to: * develop and expand their product and service offerings more quickly; * adapt to new or emerging technologies and changing customer needs faster; * take advantage of acquisitions and other opportunities more readily; 17 * negotiate more favorable licensing agreements with vendors; * devote greater resources to the marketing and sale of their products; and * address customers' service-related issues better. Some of our competitors may also be able to provide customers with additional benefits at lower overall costs or to reduce their application service charges aggressively in an effort to increase market share. We cannot be sure that we will be able to match cost reductions by our competitors. In addition, we believe that there is likely to be consolidation in our markets, which could lead to increased price competition and other forms of competition that could cause our business to suffer. OUR RELIANCE ON A LIMITED NUMBER OF SUPPLIERS FOR KEY COMPONENTS AND OUR INCREASING DEPENDENCE ON CONTRACT MANUFACTURERS COULD IMPAIR OUR ABILITY TO MANUFACTURE AND DELIVER OUR PRODUCTS AND SERVICES IN A TIMELY MANNER. We currently obtain certain key components for our digital communication platforms, including certain microprocessors, integrated circuits, power supplies, voice processing interface cards and IP telephony cards, from a limited number of suppliers and manufacturers. Our reliance on these limited suppliers and contract manufacturers involves certain risks and uncertainties, including the possibility of a shortage or delivery delay for certain key components, although we believe that alternate sources are available for most key components. We currently manufacture our products through manufacturers located in the United States, the Philippines, the People's Republic of China and Mexico. Foreign manufacturing facilities are subject to changes in governmental policies, imposition of tariffs and import restrictions and other factors beyond our control. Varian currently manufactures a significant portion of our products at Varian's Tempe, Arizona and Poway, California facilities, including substantially all of the printed circuit boards used in the AXXESS, the ECLIPSE2, the Inter-Tel Axxent, as well as substantially all of the Executone Computer Telephony products. We have occasionally experienced delays in the supply of components and finished goods. We cannot assure that we will not experience similar delays in the future. Our reliance on third party manufacturers involves a number of additional risks, including reduced control over delivery schedules, quality assurance and costs. Our business may be harmed by any delay in delivery or any shortage of supply of components or finished goods from a supplier. Our business may also be harmed if we cannot efficiently develop alternative or additional sources if necessary. To date, we have been able to obtain supplies of components and products in a timely manner even though we do not have long-term supply contracts with any of our contract manufacturers. However, we cannot assure that we will be able to continue to obtain components or finished goods in sufficient quantities or quality or on favorable pricing and delivery terms in the future. WE RELY ON OUR DEALER NETWORK FOR A SUBSTANTIAL PORTION OF OUR NET SALES AND IF THESE DEALERS DO NOT EFFECTIVELY PROMOTE AND SELL OUR PRODUCTS, OUR BUSINESS AND OPERATING RESULTS COULD BE HARMED. A substantial portion of our net sales is made through our network of independent dealers. We face intense competition from other telephone, voice processing, and voice/data router system manufacturers for these dealers' business, as most of our dealers carry products that compete with our products. We cannot assure that any of our dealers will not promote the products of our competitors to our detriment. The loss of any significant dealer or group of dealers, or any event or condition harming our dealer network, could harm our business, financial condition and operating results. IF WE LOSE KEY PERSONNEL OR ARE UNABLE TO HIRE ADDITIONAL QUALIFIED PERSONNEL AS NECESSARY, WE MAY NOT BE ABLE TO EFFECTIVELY MANAGE GROWTH IN OUR BUSINESS OR ACHIEVE OUR OBJECTIVES. We depend on the continued service of, and our ability to attract and retain, qualified technical, marketing, sales and managerial personnel, many of whom would be difficult to replace. Competition for qualified personnel is intense, and we have had difficulty hiring employees in the timeframe that we desire, particularly skilled engineers. Our loss of any key personnel or our failure to effectively recruit additional key personnel could make it difficult for us to manage our business, make timely product introductions and meet other key objectives and therefore harm our business. For example, our inability 18 to retain key executives of Executone following our Executone acquisition impaired our ability to benefit from the Executone business and to grow revenues from the Executone assets. Moreover, our operating results will be impaired if we lose a substantial number of Convergent employees in the months to come following the Convergent acquisition. We cannot assure that we will be able to continue attracting and retaining the qualified personnel necessary for the development of our business. Moreover, the growth in our business has placed, and is expected to continue to place, a significant strain on our personnel, management and other resources. Our ability to manage any future growth effectively will require us to successfully attract, train, motivate and manage new employees, to integrate new employees into our overall operations and to continue to improve our operational, financial and management information systems. WE MAY BECOME SUBJECT TO GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES THAT COULD HARM OUR BUSINESS. The regulatory environment for IP network telephony is subject to substantial uncertainty. In the United States, we believe that there are currently few laws or regulations directly applicable to packet switched technology networks or to access to, or commerce on, IP networks generally. Future changes in the regulatory environment, particularly in regulations relating to the telecommunications industry, could significantly harm our business. The increasing commercial acceptance of packet switched technology networks, as well as other factors, may result in the future application or adoption of a number of laws and regulations relating to the conduct of our business as it relates to telecommunications, such as: * fees or charges on users and providers of products and services; * pricing; * characteristics and quality of services; * taxes; * copyrights; and * additional regulations and obligations upon on-line service providers. Substantial government regulation or government imposition of fees, charges, taxes or regulation may significantly harm the acceptance and attractiveness of IP network voice communications. Also, we cannot predict the likelihood that any future legislation or regulation will be enacted, nor the financial impact, if any, of such resulting legislation or regulation. In addition, we may develop and release other products with new telecommunications capabilities or services which could be subject to existing federal government regulations or which could trigger the enactment of additional domestic or foreign government regulations. The regulatory treatment of IP-based telephony outside of the United States varies widely from country to country. A number of countries currently prohibit or limit competition in the provision of traditional voice telephony services. Some countries prohibit, limit or regulate how companies provide IP-based telephony. Increased regulation of the Internet and/or IP-based telephony providers, or the prohibition of IP-based telephony in one or more countries could limit our ability to provide our services or make them more expensive. If foreign governments or other bodies begin to regulate or prohibit IP-based telephony, this regulation could have a material adverse effect on our ability to attain or maintain profitability. GOVERNMENT REGULATION OF THIRD PARTY LONG DISTANCE AND NETWORK SERVICE ENTITIES ON WHICH WE RELY MAY HARM OUR BUSINESS Our supply of telecommunications services and information depends on several long distance carriers, RBOCs, local exchange carriers, or LECs, and competitive local exchange carriers, or CLECs. We rely on these carriers to provide network services to our customers and to provide us with billing information. Long distance services are subject to extensive and uncertain governmental regulation on both the federal and state level. We cannot assure that the increase in regulations will not harm our business. Our current contracts for the resale of services through long distance carriers include multi-year periods during which we have minimum use requirements and/or costs. The market for long distance services is experiencing, and is expected to continue experiencing significant price competition, and this may cause 19 a decrease in end-user rates. We cannot assure that we will meet minimum use commitments, that we will be able to negotiate lower rates with carriers if end-user rates decrease or that we will be able to extend our contracts with carriers at favorable prices. If we are unable to secure reliable long distance and network services from certain long distance carriers, RBOCs, LECs and CLECs, or if these entities are unwilling to provide telecommunications services and billing information to us on favorable terms, our ability to expand our own long distance and network services will be harmed. THE INTRODUCTION OF NEW PRODUCTS AND SERVICES HAS RESULTED IN CHANGES TO OUR SALES CYCLES AND BACKLOG WHICH MAY CAUSE FLUCTUATIONS IN OUR QUARTERLY RESULTS. In the past few years, we introduced AXXESS networking systems and software which are typically sold to larger customers at a higher average selling price. Our AXXESS networking products have a relatively high sales price per unit, and often represent a significant and strategic decision by an enterprise regarding our communications infrastructure. Accordingly, the purchase of our products typically involves significant internal procedures associated with the evaluation, testing, implementation and acceptance of new technologies. This evaluation process frequently results in a lengthy sales process, typically ranging from six months to more than nine months, and subjects the sales cycle associated with the purchase of our products to a number of significant risks, including budgetary constraints and internal acceptance reviews. The length of our sales cycle also may vary substantially from customer to customer. While our customers are evaluating our products and before placing an order with us, we may incur substantial sales and marketing expenses and expend significant management effort. Consequently, if sales forecasted from a specific customer for a particular quarter are not realized in that quarter, our operating results could be materially adversely affected. Our quarterly operating results have historically depended on, and may fluctuate in the future as a result of, many factors including: * volume and timing of orders received during the quarter; * the mix of products sold; * the mix of distribution channels; * general economic conditions; * patterns of capital spending by customers; * the timing of new product announcements and releases by us and our competitors; * the operating results of Cirilium, which are largely beyond our ability to control; * pricing pressures, the cost and effect of acquisitions, in particular the Executone acquisition; and * the availability and cost of products and components from our suppliers. In addition, we have historically operated with a relatively small backlog, with sales and operating results in any quarter principally dependent on orders booked and shipped in that quarter. This results primarily from our customers' desire for immediate shipment and installation of platforms and software. In the past, we have recorded a substantial portion of our net sales for a given quarter in the third month of that quarter, with a concentration of such net sales in the last two weeks of the quarter. Market demand for investment in capital equipment such as digital communication platforms and associated call processing and voice processing software applications is largely dependent on general economic conditions, and can vary significantly as a result of changing conditions in the economy as a whole. We cannot assure that historical trends for small backlog will continue in the future. Our expense levels are based in part on expectations of future sales and, if sales levels do not meet expectations, operating results could be harmed. Because sales of digital communication platforms through our dealers produce lower gross margins than sales through our direct sales organization, operating results have varied, and will continue to vary based upon the mix of sales through direct and indirect channels. Also, the timing and profitability of lease resales from quarter to quarter could impact operating results, particularly in an environment of fluctuating interest rates. Long distance sales, which have lower gross margins than our core business, have grown in recent periods at a faster rate than our overall net sales. As a result, gross margins could be harmed if long distance calling services continue to increase as a percentage of net sales. In addition, we experience seasonal fluctuations in our operating results, as net sales for the first and third quarters are frequently less than those experienced in the fourth 20 and third quarters, respectively. As a result of these and other factors, we have historically experienced, and could continue to experience in the future, fluctuations in sales and operating results on a quarterly basis. OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VOLATILE, IMPAIRING YOUR ABILITY TO SELL YOUR SHARES AT OR ABOVE PURCHASE PRICE. The market price for our Common Stock has been highly volatile. We cannot assure that you will be able to sell your shares at or above purchase price. The volatility of our stock could be subject to continued wide fluctuations in response to many risk factors listed in this section, and others beyond our control, including: * announcements of developments relating to our business; * fluctuations in our operating results; * shortfalls in revenue or earnings relative to securities analysts' expectations; * announcements of technological innovations or new products or enhancements by us or our competitors; * announcements of acquisitions or planned acquisitions of other companies or businesses; * investors' reactions to acquisition announcements; * general conditions in the telecommunications industry; * the market for Internet-related products and services * changes in the national or worldwide economy; * changes in legislation or regulation affecting the telecommunications industry; * an outbreak of hostilities; * developments relating to our and third party intellectual property rights; and * changes in our relationships with our customers and suppliers. In addition, stock prices of technology companies in general, and for Internet-based voice and data communications companies of technology stocks in particular, have experienced extreme price fluctuations in recent years which have often been unrelated to the operating performance of affected companies. We cannot assure that the market price of our Common Stock will not experience significant fluctuations in the future, including fluctuations that are unrelated to our performance. OUR CHAIRMAN OF THE BOARD OF DIRECTORS, CEO AND PRESIDENT CONTROLS 21.5% OF OUR COMMON STOCK AND BE ABLE TO SIGNIFICANTLY INFLUENCE MATTERS REQUIRING SHAREHOLDER APPROVAL As of December 31, 2000 Steven G. Mihaylo, the Company's Chairman of the Board of Directors, Chief Executive Officer and President beneficially owned approximately 20.3% of the outstanding shares of the Common Stock. As of March 9, 2001 Mr. Mihaylo owned approximately 21.5% of the outstanding shares of the Company's Common Stock. As a result, he has the ability to exercise significant influence over all matters requiring shareholder approval. In addition, the concentration of ownership could have the effect of delaying or preventing a change in control of the Company. ANY OF THE FOREGOING COULD RESULT IN A MATERIAL ADVERSE EFFECT ON THE COMPANY'S BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS. 21 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information regarding Inter-Tel's directors and executive officers as of March 1, 2001. Name Age Position ---- --- -------- Steven G. Mihaylo 57 Chairman of the Board of Directors, Chief Executive Officer and President Norman Stout 43 Executive Vice President/Chief Administrative Officer Craig W. Rauchle 45 Executive Vice President Jeffrey T. Ford 39 Senior Vice President/Chief Technology Officer Kurt R. Kneip 38 Chief Financial Officer, Vice President and Secretary J. Robert Anderson 64 Director Jerry W. Chapman 60 Director Gary Edens 59 Director C. Roland Haden 60 Director MR. MIHAYLO, the founder of the Company, has served as Chairman of the Board of Directors of the Company since September 1983, as President since May 1998 and as Chief Executive Officer of the Company since its formation in July 1969. Mr. Mihaylo served as President of the Company from 1969 to 1983 and from 1984 to December 1994, and as Chairman of the Board of Directors from July 1969 to October 1982. Mr. Mihaylo is also a director of MicroAge, Inc. MR. STOUT was elected Executive Vice President and Chief Administrative Officer and President of Inter-Tel Software and Services in June 1998. From October 1994 to June 1998, he served as a director of the Company. Since 1996 Mr. Stout also had served as President of Oldcastle Architectural West, the parent company of Superlite Block and ten other concrete products plants. Mr. Stout had been President of Superlite Block, a manufacturer of concrete block, since February 1993. Prior thereto he was employed by Boorhem-Fields, Inc. of Dallas, Texas, a manufacturer of crushed stone, as Chief Executive Officer from 1990 to 1993 and as Chief Financial Officer from 1986 to 1990. Previously, Mr. Stout was a Certified Public Accountant with Coopers & Lybrand. Mr. Stout holds an undergraduate degree in Accounting from Texas A&M and an MBA from the University of Texas. MR. RAUCHLE was elected Executive Vice President in December 1994. He had been Senior Vice President of the Company and continues as President of Inter-Tel Technologies, Inc., a wholly owned sales subsidiary of the Company. In addition, he currently serves the Company and all subsidiaries in corporate strategic planning and in mergers and acquisitions. Mr. Rauchle joined the Company in 1979 as Branch General Manager of the Denver Direct Sales Office and in 1983 was appointed the Central Region Vice President and subsequently the Western Regional Vice President. From 1990 to 1992, Mr. Rauchle served as President of Inter-Tel Communications, Inc. Mr. Rauchle holds a Bachelor of Arts degree in Communications from the University of Denver. MR. FORD was elected Senior Vice President in May 1998 and has served as the Company's Chief Technology Officer since 1997. He was elected President of Inter-Tel Integrated Systems, Inc. ("IIS") in May 1998, after serving as Senior Vice President of IIS for one year and Vice President of Software Engineering from 1993 to 1997. He joined Inter-Tel in 1983 as a software design engineer. Mr. Ford holds a bachelor of science degree in Computer Systems Engineering from Arizona State University and holds an SEP certificate from the Stanford Graduate School of Business. MR. KNEIP has served as Vice President and Chief Financial Officer of the Company since September 1993. He was elected Secretary and Treasurer in October 1994. In May 1996 he was elected Assistant Treasurer, as John Abbott was elected Treasurer. He joined the Company in May 1992 22 as Director of Corporate Tax, after seven years with the accounting firm of Ernst & Young. Mr. Kneip is a Certified Public Accountant, and holds an undergraduate degree in Commercial Economics from South Dakota State University and a Masters Degree in Professional Accountancy from the University of South Dakota. MR. ANDERSON has been a director of the Company since February 1997. Mr. Anderson held various positions at Ford Motor Company from 1963 to 1983, serving from 1978 to 1983 as President of the Ford Motor Land Development Corporation. He served as Senior Vice President, Chief Financial Officer and a member of the Board of Directors of The Firestone Tire and Rubber Company from 1983 to 1989, and as Vice Chairman of Bridgestone/Firestone, Inc. from 1989 through 1991. He most recently served as Vice Chairman, Chief Financial Officer and a member of the Board of Directors of the Grumman Corporation from 1991 to 1994. Mr. Anderson is currently semi-retired, and he is an active leader in various business, civic and philanthropic organizations. MR. CHAPMAN was elected as a director in December 1999 and previously served as a director in the late 1980's and early 1990's. He recently retired as a partner with Arthur Andersen LLP after over 37 years in public accounting and consulting. During the first half of his career, Mr. Chapman focused his energies in the Audit and Assurance area of practice. In 1980, he moved into the Business and Strategic Consulting areas of practice as well as managing major practice areas for his firms. Mr. Chapman runs a consulting practice focusing on providing strategic and market driven services for his clients. MR. EDENS has been a director of the Company since October 1994. He was a broadcasting media executive from 1970 to 1994, serving as Chairman and Chief Executive Officer of Edens Broadcasting, Inc. from 1984 to 1994, when that corporation's nine radio stations were sold. He is currently President of The Hanover Companies, Inc., an investment firm. He is an active leader in various business, civic and philanthropic organizations. DR. HADEN has been a director of the Company since 1983. Dr. Haden has been Vice Chancellor and Dean of Engineering of Texas A&M University since 1993. Previously, he served as Vice Chancellor of Louisiana State University from 1991 to 1993, Dean of the College of Engineering and Applied Sciences at Arizona State University from 1989 to 1991, Vice President for Academic Affairs at Arizona State University from 1987 to 1988, and Dean of the College of Engineering and Applied Sciences from 1978 to 1987. Dr. Haden holds a doctoral degree in Electrical Engineering from the University of Texas and has also served on the faculty of the University of Oklahoma. The Board of Directors has an Audit Committee and a Compensation Committee. The Audit Committee consisted of directors Chapman, Anderson and Haden, through December 31, 2000. The Audit Committee met seven times during the last fiscal year. The Board of Directors adopted a charter governing the duties and responsibilities of the Audit Committee. A copy of the Audit Committee charter is included in the proxy statement filed on about March 23, 2001. The Audit Committee performs quarterly reviews of financial information prior to filing public documents with the Securities and Exchange Commission. This Committee also recommends engagement of the Company's independent public accountants and is primarily responsible for approving the services performed by the Company's independent public accountants and for reviewing and evaluating the Company's accounting principles, its system of internal controls and financial management practices. The Compensation Committee consisted of directors Anderson and Edens through December 31, 2000. The Compensation Committee met three times during the last fiscal year. The Compensation Committee reviews employee compensation and makes recommendations thereon to the Board of Directors and administers the Company's Stock Incentive Plans. The Compensation Committee also determines, upon review of relevant information, the employees to whom options shall be granted. 23 ITEM 2. PROPERTIES The Company maintains its corporate headquarters in 23,000 square feet of a building located in Phoenix, Arizona pursuant to a lease that expires in November 2001, and its principal development and distribution operations in a 96,000 square foot building located in Chandler, Arizona pursuant to a lease that expires in 2008. The Company also owns a 70,000 square foot facility located in Reno, Nevada that houses the Inter-Tel.net network operations center, credit and lease finance facilities, business development center and sales office. The Company also leases sales and support offices in a total of 54 locations in the United States, including approximately 147,000 square feet of office space in Milford, Connecticut pursuant to the Executone acquisition (a substantial portion of which has been subleased), and two locations overseas. The Company's aggregate monthly payments under these leases were approximately $555,286 at December 31, 2000. The Company believes that its facilities will be adequate to meet its current needs and that additional or alternative space will be available as necessary in the future on commercially reasonable terms. See "Factors That May Effect Future Operating Results." ITEM 3. LEGAL PROCEEDINGS The Company is involved from time to time in litigation incidental to its business. The Company believes that the outcome of current litigation will not have a material adverse effect upon its business, financial condition or results of operations and will not disrupt the normal operations of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Inter-Tel Common Stock is traded over-the-counter (symbol INTL) and since February 1983 has been included in the Nasdaq National Market System. As of March 9, 2001 there were of record approximately 1,237 shareholders of the Company's Common Stock. The Company believes there are approximately 13,500 additional beneficial holders of the Company's Common Stock. The following table sets forth high and low closing prices reported by Nasdaq. Until 1997, Inter-Tel had never paid a cash dividend on its Common Stock. During 1997, the Board of Directors declared a quarterly cash dividend of $.01 per share of Common Stock. A dividend has been paid to shareholders of record for each quarter since December 31, 1997. The continuation of this dividend policy will depend on Company earnings, capital requirements for growth, financial conditions and other factors. 2000 HIGH LOW 1999 HIGH LOW First Quarter 46 3/8 21 1/2 First Quarter 28 1/8 13 3/8 Second Quarter 28 12 7/8 Second Quarter 19 11 1/2 Third Quarter 16 5/16 11 Third Quarter 25 1/2 15 1/8 Fourth Quarter 13 1/4 6 3/16 Fourth Quarter 26 3/8 14 24 ITEM 6. SELECTED FINANCIAL DATA FINANCIAL SUMMARY
(In thousands, except per share amounts and ratios) For the years ended December 31, ------------------------------------------------------------------------------------------------------------------------ 2000 1999 1998 1997 1996 Net Sales $ 402,723 $ 314,221 $ 274,504 $ 223,569 $ 185,884 Cost of sales 243,685(1) 159,463 140,946 122,363 104,966 Research and development 19,489 14,798 11,373 7,998 6,581 Selling, general and administrative 127,468 98,430 86,554 69,942 56,386 Write-off in-process research and development 5,433(1) -- 22,755(2) -- -- Special charge 45,245(1) -- -- -- 4,542(3) ------------------------------------------------------------------------------------------------------------------------ Operating (loss) income (38,597) 41,530 12,876(2) 23,266 13,409(3) ======================================================================================================================== Equity share of Cirilium losses (5,938) -- -- -- -- Write-off of Cirilium investment (2,045) -- -- -- -- Interest and other income 1,053 2,345 3,018 1,383 1,974 Interest expense (213) (110) (60) (47) (77) ------------------------------------------------------------------------------------------------------------------------ (Loss) income before taxes (45,740)(1) 43,765 15,834(2) 24,602 15,306(3) Income taxes (16,817) 16,619 6,790 9,920 6,264 ======================================================================================================================== Net (loss) income (28,923)(1) $ 27,146 $ 9,044(2) $ 14,682 $ 9,042(3) ======================================================================================================================== Net (loss) income per share Basic $ (1.10)(1) $ 1.05 $ 0.34(2) $ 0.59 $ 0.35(3) Diluted $ (1.10)(1) $ 1.01 $ 0.32(2) $ 0.57 $ 0.34(3) ------------------------------------------------------------------------------------------------------------------------ Weighted average basic common shares 26,273 25,949 26,602 24,836 25,780 Weighted average diluted common shares 26,273 27,004 27,846 25,983 26,572 ------------------------------------------------------------------------------------------------------------------------ BALANCE SHEET DATA Total assets $ 243,126 $ 247,517 $ 197,030 $ 194,988 $ 132,611 Working capital 86,008 60,799 96,317 123,814 79,709 Shareholders' equity 136,436 168,121 142,686 145,505 94,934 ------------------------------------------------------------------------------------------------------------------------ KEY RATIOS Current ratio 2.05 1.93 3.17 4.69 4.09 Return on equity-continuing Operations (17.2)% 19.0% 6.2% 15.5% 10.6% Return on equity-excluding Charges 7.8%(1) 19.0% 15.6%(2) 15.5% 13.8%(3) ========================================================================================================================
(1) 2000 operating income includes charges of $66.8 million, which reduced net income by $42.0 million, or $1.60 per share after tax. These pre-tax charges reflect the write-off of the Executone acquisition of $50.9 million ($7.6 million of which is included in cost of sales) in the second quarter, the write-off of IPRD in connection with the Executone purchase of $5.4 million during the first quarter, the write-down to net realizable value of Inter-Tel.NET assets of $2.0 million during the second quarter, the equity share of Cirilium's losses of $5.9 million for the year, and write-off of the Company's investment in Cirilium of $2.6 million (including reserve adjustments) during the third quarter. Without these charges, the Company would have reported net income of $13.1 million ($0.50 per diluted share) for the year ended December 31, 2001. (2) 1998 operating income includes a special charge of $22.8 million, which reduced net income by $13.7 million or $.49 per diluted share after tax. This charge reflects the write-off of in-process research and development in connection with the purchase of certain assets and liabilities of Telecom Multimedia Systems, Inc. ("TMSI"). Without this write-off, the Company would have reported net income of $22.7 million ($.82 per diluted share) for the year ended December 31, 1998. (3) 1996 operating income includes a special charge of $4.5 million, which reduced net income by $2.7 million or $.10 per diluted share after tax. This special charge reflects the decision by the Company to replace its MIS system software. Without this special charge, the Company would have reported net income of $11.8 million ($.44 per diluted share) for the year ended December 31, 1996. 25 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is incorporated by reference to Exhibit 13.0. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following discussion about the Company's market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and foreign currency exchange rates. The Company does not use derivative financial instruments. INVESTMENT PORTFOLIO. The Company does not use derivative financial instruments in its non-trading investment portfolio. Inter-Tel maintains a portfolio of highly liquid cash equivalents typically maturing in three months or less as of the date of purchase. Inter-Tel places its investments in instruments that meet high credit quality standards, as specified in the Company's investment policy guidelines. Given the short-term nature of these investments, and that the Company has no borrowings outstanding other than short-term letters of credit, the Company is not subject to significant interest rate risk. LEASE PORTFOLIO. The Company offers to its customers lease financing and other services, including its Totalease program, through its Inter-Tel Leasing subsidiary. The Company funds these programs in part through the sale to financial institutions of rental income streams under the leases. Although the Company to date has been able to resell the rental streams from leases under its lease programs profitably and on a substantially current basis, the timing and profitability of lease resales could impact the Company's business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If the Company were required to repurchase rental streams and realize losses thereon in amounts exceeding its reserves, its operating results could be materially adversely affected. See "Liquidity and Capital Resources" in Management's Discussion and Analysis for more information regarding the Company's lease portfolio and financing. IMPACT OF FOREIGN CURRENCY RATE CHANGES. Inter-Tel invoices the customers of its international subsidiaries primarily in the local currencies of its subsidiaries for product and service revenues. Inter-Tel is exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. The impact of foreign currency rate changes have historically been insignificant. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is incorporated by reference to Exhibit 13.0. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III Certain information required by Part III is omitted from this report in that the Registrant will file a definitive proxy statement pursuant to Regulation 14A (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Report, and the information included therein is incorporated herein by reference to the extent stated below. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to directors and executive officers is included at the end of Part I, Item 1 on this report under the caption "Directors and Executive Officers of the Registrant." 26 ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Two of the Company's executive officers received loans from Inter-Tel during 1999 to acquire common stock in Cirilium, a company formed during 1999 that is jointly owned by Inter-Tel and Hypercom Corporation. Norman Stout and Craig Rauchle received loans on December 29, 1999 of $250,000 and $200,000, respectively, to acquire 375,000 and 300,000 shares, respectively, of voting common stock of Cirilium. The Promissory Notes are interest-only notes with balloon payments due or before March 15, 2004. The loans bear interest at the mid-term applicable federal interest rate, compounded annually. Interest payments are due on or before March 15 of each anniversary beginning on March 15, 2000. The notes are full recourse loans and the Company retains the Cirilium common stock certificates as collateral. In addition, in connection with their service as members of the board of directors of Cirilium, on January 31, 2000, Steven Mihaylo and Norman Stout were granted fully vested options to purchase stock in Cirilium of 50,000 shares each at a price of $1.20 per share. Cirilium is a corporation that was formed as a joint venture between the Company and Hypercom Corporation to develop and market IP telephony products and services. The Company owns approximately 19.9% of the outstanding capital stock of Cirilium. In addition, unrelated to Jerry Chapman's participation on the board of directors of Inter-Tel, Incorporated, but pursuant to a separate consulting agreement to provide professional services to Cirilium Corporation ("Cirilium"), on January 1, 2000, Mr. Chapman received rights to purchase 50,000 shares of Cirilium common stock at a price of $.667 per share. In addition, Mr. Chapman received cash compensation of $45,000, paid directly by Cirilium, for providing consulting services during 2000. On March 1, 2000, Mr. Chapman acquired 50,000 shares pursuant to the rights granted in January. Each of these events occurred prior to the date that Mr. Chapman joined the board of directors of Cirilium. In April 2000, Mr. Chapman was elected to Cirilium's board of directors. On June 1, 2000, for services as a member of the board of directors of Cirilium, Mr. Chapman was granted vested options to purchase an additional 50,000 shares of Cirilium common stock at a price of $1.20 per share. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: 1. FINANCIAL STATEMENTS The following consolidated financial statements of Inter-Tel, Incorporated, and subsidiaries, are incorporated by reference to Exhibit 13.0: Report of Ernst & Young LLP, Independent Auditors Consolidated balance sheets--December 31, 2000 and 1999 Consolidated statements of income--years ended December 31, 2000, 1999 and 1998 Consolidated statements of shareholders' equity--years ended December 31, 2000, 1999 and 1998 Consolidated statements of cash flows--years ended December 31, 2000, 1999 and 1998 Notes to consolidated financial statements 27 2. FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedule of Inter-Tel, Incorporated, and subsidiaries is filed as part of this Report and should be read in conjunction with the Consolidated Financial Statements of Inter-Tel, Incorporated and subsidiaries, and the notes thereto. Schedule for the three years ended December 31, 2000: Schedule II--Valuation and Qualifying Accounts Page No. 31 Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto. 3. EXHIBITS 3.1(10) Articles of Incorporation, as amended. 3.2(16) By-Laws, as amended. 10.15(1) Registrant's form of standard Distributor Agreement. 10.16(1) Registrant's form of standard Service Agreement. 10.34(2) * 1984 Incentive Stock Option Plan and forms of Stock Option Agreement. 10.35(3) Agreement between Registrant and Samsung Semiconductor and Telecommunications Company, Ltd. dated October 17, 1984. 10.37(3) * Tax Deferred Savings Plan. 10.51(11) * 1990 Directors' Stock Option Plan and form of Stock Option Agreement. 10.52(15) * Inter-Tel, Incorporated Long-Term Incentive Plan and forms of Stock Option Agreements. 10.53(12) Agreement between Registrant and Maxon Systems, Inc. dated February 27, 1990. 10.54(12) Agreement between Registrant and Varian Tempe Electronics Center dated February 26, 1991. 10.55(12) Agreement between Registrant and Jetcrown Industrial Ltd. dated February 18, 1993. 10.56(13) * Employee Stock Ownership Plan. 10.57(14) Loan and Security Agreement dated March 4, 1997 between Bank One, Arizona, N.A. and Registrant and Modification Agreement dated July 25, 1997. 10.58(16) Development, Supply and License Agreement between Registrant and QUALCOMM dated January 17, 1996. 10.59(17) * Inter-Tel, Incorporated 1997 Long-Term Incentive Plan. 10.60(17) * Inter-Tel, Incorporated 1997 Employee Stock Purchase Plan. 10.61(18) * Inter-Tel, Incorporated Acquisition Stock Option Plan and form of Stock Option Agreement. 28 10.61(19) Computer Telephony Asset Purchase Agreement dated as of October 17, 1999 by and between Executone Information Systems, Inc., Inter-Tel, Incorporated and Executone Inter-Tel Business Information Systems, Inc. 13.0 (20) Excerpts from Annual Report to Security Holders. --------------------- (1) Incorporated by reference to Registrant's Registration Statement on Form S-1 (File No. 2-70437). (2) Incorporated by reference to Registrant's Registration Statement on Form S-8 (File No. 2-94805). (3) Incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended November 30, 1984 (File No. 0-10211). (10) Incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 0-10211). (11) Incorporated by reference to Registrant's Registration Statement on Form S-8 (File No. 33-40353). (12) Incorporated by reference to Registrant's Registration Statement on Form S-1 (File No. 33-70054). (13) Incorporated by reference to Registrant's Registration Statement on Form S-8 (File No. 33-73620). (14) Incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1998 (File No. 0-10211). (15) Incorporated by reference to Registrant's Proxy Statement dated March 23, 1994. (16) Incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 0-10211). (17) Incorporated by reference to Registrant's Registration Statement on Form S-8 (File No. 333-41197). (18) Incorporated by reference to Registrant's Registration Statement on Form S-8 (File No. 333-67261). (19) Incorporated by reference to Registrant's Report on Form 8-K (File No. 333-67261). (20) Filed herewith, except as noted. * Management contracts or compensatory plan or arrangement required to be filed as an exhibit to this report on Form 10-K. (b) Reports on Form 8-K. The Company filed Form 8-K (File No. 333-67261) on January 14, 2000 in connection with the acquisition of selected assets and liabilities of the computer telephone division of Executone Business Information Systems, Inc. (c) Exhibits. 13.0 Excerpts from Annual Report to Security Holders. Filed herewith. 23.0 Consent of Ernst & Young LLP, Independent Auditors. 24.1 Power of Attorney. See Item 14(a) 3 also. (d) Financial Statement Schedules. The response to this portion of Item 14 is submitted as a separate section of this report. See Item 8. 29 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Inter-Tel, Incorporated, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. INTER-TEL, INCORPORATED BY: /S/ Steven G. Mihaylo --------------------- Steven G. Mihaylo Chairman and Chief Executive Officer Dated: March 23, 2001 EXHIBIT 24.1--POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven G. Mihaylo and Kurt R. Kneip, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /S/ Steven G. Mihaylo Chairman and Chief March 23, 2001 --------------------- Executive Officer Steven G. Mihaylo /S/ Kurt R. Kneip Vice President and March 23, 2001 ----------------- Chief Financial Officer Kurt R. Kneip /S/ J. Robert Anderson Director March 23, 2001 ----------------------- J. Robert Anderson /S/ Jerry W. Chapman Director March 23, 2001 -------------------- Jerry W. Chapman /S/ Gary D. Edens Director March 23, 2001 ----------------- Gary D. Edens /S/ C. Roland Haden Director March 23, 2001 ------------------- C. Roland Haden 30 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(in thousands) ---------------------------------------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E ---------------------------------------------------------------------------------------------------------- ADDITIONS Charged Charged to Balance at to Other Charged to Balance Beginning Costs & Accounts Deductions at End of DESCRIPTION of Period Expenses Describe Describe Period ---------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 2000 Deducted from asset accounts: Allowance for doubtful accounts $8,814 $6,793 $4,994(3) $3,414(1) $17,187 Allowance for lease Accounts $6,734 $4,927 $-- $2,791(1) $ 8,870 Inventory allowance $5,849 $1,653 $6,278(3) $1,883(2) $11,897 YEAR ENDED DECEMBER 31, 1999 Deducted from asset accounts: Allowance for doubtful accounts $4,604 $4,623 $2,628(3) $3,041(1) $8,814 Allowance for lease Accounts $5,716 $3,773 $ -- $2,755(1) $6,734 Inventory allowance $5,453 $1,508 $83 (3) $1,195(2) $5,849 YEAR ENDED DECEMBER 31, 1998 Deducted from asset accounts: Allowance for doubtful accounts $3,722 $2,963 $137 (3) $2,218(1) $4,604 ----- ----- ---- -------- ----- Allowance for lease Accounts $3,969 $2,688 $ -- $941 (1) $5,716 ----- ----- ---- -------- ----- Inventory allowance $5,740 $1,828 $ -- $2,115(2) $5,453 ----- ----- ---- -------- ----- ----------------------------------------------------------------------------------------------------------
(1) Uncollectible accounts written off, net of recoveries. (2) Inventory written off. (3) Acquired in purchase transaction. 31