10-Q 1 e-8511.txt QUARTERLY REPORT FOR THE QTR ENDED 3/31/2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended Commission File Number: March 31, 2002 0-10211 INTER-TEL, INCORPORATED Incorporated in the State of Arizona I.R.S. No. 86-0220994 1615 S. 52ND STREET TEMPE, ARIZONA 85281 (480) 449-8900 ---------- Title of Class Outstanding as of March 31, 2002 -------------- -------------------------------- Common Stock, no par value 24,192,832 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 periods 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 [ ] INDEX INTER-TEL, INCORPORATED AND SUBSIDIARIES PAGE FINANCIAL INFORMATION PART I. Item 1. Financial Statements (unaudited) Condensed consolidated balance sheets--March 31, 2002 and December 31, 2001 3 Condensed consolidated statements of income--three months ended March 31, 2002 and March 31, 2001 4 Condensed consolidated statements of cash flows--three months ended March 31, 2002 and March 31, 2001 5 Notes to condensed consolidated financial Statements-- March 31, 2002 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 27 PART II. OTHER INFORMATION 27 SIGNATURES 29 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS INTER-TEL, INCORPORATED AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts) March 31 December 31, 2002 2001 (Unaudited) (Note A) ----------- -------- ASSETS CURRENT ASSETS Cash and equivalents $ 84,737 $ 61,795 Accounts receivable, less allowances of $12,315 in 2002 and $11,858 in 2001 42,291 45,962 Inventories, less allowances of $14,138 in 2002 and $13,202 in 2001 20,524 20,848 Net investment in sales-leases 15,173 13,799 Income taxes receivable -- 3,257 Deferred income taxes 8,563 8,467 Prepaid expenses and other assets 6,278 4,891 --------- --------- TOTAL CURRENT ASSETS 177,566 159,019 PROPERTY, PLANT & EQUIPMENT 24,123 23,905 GOODWILL, NET 17,764 13,711 PURCHASED INTANGIBLE ASSETS, NET 5,106 4,948 NET INVESTMENT IN SALES-LEASES 23,771 21,735 OTHER ASSETS 3,339 4,144 --------- --------- $ 251,669 $ 227,462 --------- --------- LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 25,431 $ 21,812 Other current liabilities 48,507 44,051 --------- --------- TOTAL CURRENT LIABILITIES 73,938 65,863 DEFERRED TAX LIABILITY 17,634 17,390 LEASE RECOURSE LIABILITY 9,365 8,890 RESTRUCTURING RESERVE 3,060 3,060 OTHER LIABILITIES 5,347 5,422 SHAREHOLDERS' EQUITY Common stock, no par value - authorized 100,000,000 shares; issued 27,161,823; outstanding - 24,192,832 shares at March 31, 2002 and 24,166,430 shares at December 31, 2001 108,968 108,968 Less: Shareholder loans (865) (942) Retained earnings 69,692 54,877 Accumulated other comprehensive income 431 151 --------- --------- 178,226 163,054 Less: Treasury stock at cost - 2,968,991 shares at March 31, 2002 and 2,995,393 shares at December 31, 2001 (35,901) (36,217) --------- --------- TOTAL SHAREHOLDERS' EQUITY 142,325 126,837 --------- --------- $ 251,669 $ 227,462 --------- ---------
See accompanying notes. 3 INTER-TEL, INCORPORATED AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
Three Months Ended (In thousands, except ---------------------------------- per share amounts) March 31, 2002 March 31, 2001 -------------- -------------- NET SALES $ 90,070 $ 93,703 Cost of sales 45,016 54,055 -------- -------- GROSS PROFIT 45,054 39,648 Research & development 4,317 4,139 Selling, general, and administrative 30,657 31,447 Amortization of goodwill -- 451 Amortization of purchased intangible assets 257 157 -------- -------- 35,231 36,194 OPERATING INCOME 9,823 3,454 Litigation settlement (net of costs except for taxes) 15,302 -- Interest and other income 439 167 Write-down of investment in Inter-Tel.NET/Vianet (600) -- Loss on foreign translation adjustments (84) (303) Interest expense (34) (227) -------- -------- INCOME BEFORE INCOME TAXES 24,846 3,091 Income tax provision 9,451 1,143 -------- -------- NET INCOME $ 15,395 $ 1,948 -------- -------- NET INCOME PER SHARE Basic $ 0.64 $ 0.08 Diluted $ 0.60 $ 0.08 Weighted average basic common shares 24,179 25,500 Weighted average diluted common shares 25,550 25,843 -------- --------
See accompanying notes. 4 INTER-TEL, INCORPORATED AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended --------------------------------- (In thousands) March 31, 2002 March 31, 2001 -------------- -------------- OPERATING ACTIVITIES Net income $ 15,395 $ 1,948 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 1,879 2,337 Amortization of goodwill and purchased intangible assets 257 608 Amortization of patents included in R&D expenses 55 55 Provision for losses on receivables 2,462 2,575 Provision for inventory valuation (201) 535 Decrease in other liabilities 464 607 Loss on sale of property and equipment 16 25 Deferred income taxes 148 (1,394) Effect of exchange rate changes 280 342 Changes in operating assets and liabilities 11,792 (3,725) -------- -------- NET CASH PROVIDED BY OPERATING ACTIVITIES 32,549 3,913 -------- -------- INVESTING ACTIVITIES Additions to property and equipment (1,250) (3,088) Proceeds from disposal of property and equipment 66 18 Cash used in acquisitions (8,000) (11,520) -------- -------- NET CASH USED IN INVESTING ACTIVITIES (9,184) (14,590) -------- -------- FINANCING ACTIVITIES Cash dividends paid (449) (260) Treasury stock purchases -- (14,141) Payments on term debt (268) (319) Proceeds from term debt -- 1,095 Proceeds from exercise of stock options 296 313 -------- -------- NET CASH USED IN FINANCING ACTIVITIES (421) (13,312) -------- -------- INCREASE (DECREASE) IN CASH AND EQUIVALENTS 22,942 (23,989) -------- -------- CASH AND EQUIVALENTS AT BEGINNING OF PERIOD 61,795 27,103 -------- -------- CASH AND EQUIVALENTS AT END OF PERIOD $ 84,737 $ 3,114 -------- --------
See accompanying notes. 5 INTER-TEL, INCORPORATED AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) March 31, 2002 NOTE A--BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results for the interim periods presented have been included. Operating results for the three months ending March 31, 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002. The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2001. Certain prior year amounts have been reclassified to conform with the current period presentation. ADOPTION OF ACCOUNTING STANDARD. On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. When we account for acquired businesses as purchases, we allocate purchase prices to the assets and liabilities acquired based on the estimated fair values on the respective acquisition dates. Based on these values, any excess purchase price over the fair value of the net assets acquired is allocated to goodwill. Prior to January 1, 2002, we amortized goodwill over the useful life of the underlying asset, not to exceed 40 years. On January 1, 2002, we began accounting for goodwill under the provisions of SFAS Nos. 141 and 142. As of March 31, 2002 and December 31, 2001, we had the following intangible assets: (in thousands) March 31, 2002 December 31, 2001 -------------- ----------------- Goodwill $24,591 $20,538 Less: Accumulated Amortization 6,827 6,827 ------- ------- Goodwill, net 17,764 13,711 ------- ------- Purchased Intangible Assets 6,240 5,770 Less: Accumulated Amortization 1,134 822 ------- ------- Purchased Intangible Assets, net 5,106 4,948 ------- ------- Total Intangible Assets 30,831 26,308 Less: Accumulated Amortization 7,961 7,649 ------- ------- Total Intangible Assets, net $22,870 $18,659 ======= ======= We completed one acquisition in the fourth quarter of 2001 in which the Company acquired purchased intangible assets, but no goodwill. Accordingly, we amortized the purchased intangible assets, but recorded no goodwill amortization from the date of this acquisition. Application of the non-amortization provisions of SFAS No. 142 is expected to result in an increase in income from continuing operations before income taxes of approximately $1.8 million in 2002. In assessing the recoverability of our goodwill and other intangibles, we must make assumptions about estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded. Some factors we 6 consider important which could trigger an impairment review include the following: * Significant underperformance relative to expected historical or projected future operating results; * Significant changes in the manner of our use of the acquired assets or the strategy for our overall business; * Our market capitalization relative to net book value; and * Significant negative industry or economic trends. We have tested goodwill for impairment using the two-step process prescribed in SFAS No. 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. We performed the first of the required impairment tests for goodwill as of January 1, 2002, and determined that the carrying amount of our goodwill is not impaired. In addition, we will be reviewing our classification of intangible assets between goodwill and other identifiable intangibles. During the quarter ended March 31, 2002, we did not record any impairment losses related to goodwill and other intangible assets. RECENT ACCOUNTING PRONOUNCEMENT. In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). SFAS 144 establishes a single accounting model, based on the framework established in Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" ("SFAS 121"), for long-lived assets to be disposed of by sale, and resolves implementation issues related to SFAS 121. The Company adopted SFAS 144 effective January 1, 2002. The Company does not expect the adoption of this standard to have a material impact on its operating results and financial condition. NOTE B--EARNINGS PER SHARE Diluted earnings per share assume that outstanding common shares were increased by shares issuable upon the exercise of all outstanding stock options for which the market price exceeds exercise price, less shares which could have been purchased with related proceeds, if the effect would not be antidilutive. The following table sets forth the computation of basic and diluted earnings per share:
Three Months Ended (In thousands, except ------------------------------- per share amounts) March 31, 2002 March 31, 2001 -------------- -------------- Numerator: Net Income $15,395 $ 1,948 ------- ------- Denominator: Denominator for basic earnings per share - weighted average shares 24,179 25,500 Effect of dilutive securities: Employee and director stock options 1,371 343 ------- ------- Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions 25,550 25,843 Basic earnings per share $ 0.64 $ 0.08 ------- ------- Diluted earnings per share $ 0.60 $ 0.08 ------- -------
7 NOTE C - ACQUISITIONS, DISPOSITIONS AND RESTRUCTURING CHARGES MCLEOD. On January 24, 2002, the Company acquired certain assets of McLeodUSA Integrated Business Systems, Inc. ("McLeod") for cash plus the assumption of various specific liabilities and related acquisition costs. Inter-Tel acquired McLeod's voice customer base in Minnesota, Iowa and Colorado and DataNet operations in South Dakota, which also included the related accounts receivable, inventory and fixed assets along with assumption of scheduled specific liabilities for warranty and maintenance obligations. The aggregate purchase price of $8 million was allocated to the fair value of the assets and liabilities acquired. The McLeod transaction was accounted for using the purchase method of accounting. The Company recorded goodwill of approximately $4.0 million and other purchased intangible assets of $0.5 million, for a total of $4.5 million, in connection with the McLeod acquisition. The goodwill balance will be accounted for in accordance with SFAS 141 and 142. The balances included in the $0.5 million in other purchased intangible assets will be amortized over periods ranging from two to five years from the date of the acquisition. During the first quarter ended March 31, 2002, the amortization of purchased intangible assets was approximately $25,000. INTER-TEL.NET/VIANET. On July 24, 2001, Inter-Tel agreed to sell 83% of its Inter-Tel.NET subsidiary to Comm-Services Corporation for a note of $4.95 million, secured by Comm-Services stock, other marketable securities of the shareholders of Comm-Services and 100% of the net assets of Inter-Tel.NET. The marketable securities held as collateral may be exchanged for cash or other readily marketable assets as long as the fair market value of the collateral exceeds $2.5 million. Interest accruing under the note is due and payable from October 16, 2001 through July 15, 2002; then, a principal payment of $250,000 due July 15, 2002, and monthly principal and interest payments based on 1% of collected monthly revenues from July 16, 2002 to October 15, 2002 and based on 2% of collected monthly revenues are due from October 16, 2002 until paid in full. Any funds due Comm-Services for services rendered can be applied against the note. The note is fully due and payable on December 31, 2007, or earlier in certain circumstances. In connection with the sale of 83% of Inter-Tel.NET, we assessed the fair value of the remaining 17% investment in Inter-Tel.NET. Pursuant to SFAS 121, we recorded a charge as of the close of the second quarter of 2001 of $5.4 million ($3.4 million after tax) associated with the impairment of our investment in Inter-Tel.NET. The impairment was measured as the difference between the carrying value of Inter-Tel's 17% interest in Inter-Tel.NET/Comm-Services and the estimated current fair market value of the note plus the 17% ownership interest in Inter-Tel.NET. The charge was primarily non-cash. Inter-Tel's management has not participated in the management of Inter-Tel.NET since the sale in July 2001. As a result, since July 24, 2001, we have accounted for the remaining Inter-Tel.NET/Comm-Services investment using the cost method of accounting. On December 30, 2001, Comm-Services entered into a merger agreement with Vianet. Inter-Tel's 17% investment in Comm-Services was converted to approximately 10% of Vianet stock. The $4.95 million loan was assumed by Vianet and Inter-Tel continues to hold collateral from the former shareholders of Comm-Services. Inter-Tel will account for the remaining 10% investment in Vianet (formerly Comm-Services) using the cost method of accounting. The net investment in the note receivable and 10% interest in Vianet was recorded in other assets for approximately $3.7 million as of December 31, 2001. Inter-Tel assessed the value of this investment at March 31, 2002 and wrote-down this investment by $600,000 to approximately $3.1 million as of March 31, 2002. During 1999, 2000 and 2001, Inter-Tel.NET entered into operating lease agreements totaling approximately $6.5 million from an equipment vendor for network equipment and software. The lease agreements required Inter-Tel.NET to purchase vendor maintenance on their products. Inter-Tel originally guaranteed the indebtedness. In the second quarter of 2001, Inter-Tel.NET notified the vendor of network and network equipment problems encountered due to equipment and software recommended by the vendor, and supplied and financed by this vendor. Inter-Tel.NET requested that the vendor not only solve the problems, but also compensate Inter-Tel.NET for the problems and the resulting lost customers, lost revenues and lost profits. Pursuant to Inter-Tel's sale of 83% of Inter-Tel.NET, Comm-Services assumed the vendor lease and maintenance obligations and, accordingly, Inter-Tel has not recorded any liability for these 8 obligations. However, the vendor has not released Inter-Tel from its guarantee of these obligations and Inter-Tel has not released the vendor from Inter-Tel's claims, nor did we assign our rights to these claims to Comm-Services. In April 2002, Inter-Tel received a notice letter from the financing affiliate of the Inter-Tel.NET equipment vendor notifying Inter-Tel of default in lease payments due the financing affiliate. Inter-Tel responded to the affiliate advising them that Inter-Tel was no longer the Lessee of the equipment, the correct name and address of the Lessee of the equipment and the losses to Inter-Tel because of the non performance of the equipment and vendor related third party software providers' breach of contract. EXECUTONE RESTRUCTURING CHARGE. During the second quarter of 2000, the Company recognized a restructuring charge related to acquired Executone operations. The Company accounted for the restructuring of the Executone operations, including severance and related costs, the shut down and consolidation of the Milford facility and the impairment of assets associated with the restructuring as identified in the table below. Accrued costs associated with this plan were estimates, although the original estimates made for the second quarter of 2000 for reserve balances have not changed significantly in 2002. Exit costs associated with the closure of the Milford facility also included liabilities for building, furniture and equipment lease, and other contractual obligations. We are liable for the lease on the Milford buildings through January 2005. Various furniture leases run concurrently through March 2002. Other capital leases for computer and other equipment terminate on varying dates through September 2002. To date, we have entered into sublease agreements with third parties to sublease portions of the facility and equipment. The reserve for lease and other contractual obligations is identified in the table below. The following table summarizes details of the restructuring charge taken in the second quarter of 2000 in connection with the Executone acquisition, including the description of the type and amount of liabilities assumed, and activity in the reserve balances from the date of the charge through March 31, 2002.
RESERVE CASH/ RESTRUCTURING 2000 2001 2002 BALANCE DESCRIPTION NON-CASH CHARGE ACTIVITY ACTIVITY ACTIVITY AT 3/31/02 ----------- -------- ------ -------- -------- -------- ---------- PERSONNEL COSTS: Severance and termination costs Cash $ (1,583) $ 1,558 $ 2 $ -- $ (23) Other Plant closure costs Cash (230) 30 200 -- -- LEASE TERMINATION AND OTHER CONTRACTUAL OBLIGATIONS (NET OF ANTICIPATED RECOVERY): Building and equipment leases Cash (7,444) 1,348 1,489 603 (4,004) Other contractual obligations Cash (1,700) -- 1,700 -- -- IMPAIRMENT OF ASSETS: Inventories Non-Cash (3,454) 1,376 209 -- (1,869) Prepaid inventory and other expenses Non-Cash (2,485) 2,485 -- -- -- Accounts receivable Non-Cash (1,685) 521 245 -- (919) Fixed assets Non-Cash (3,151) 2,942 -- -- (209) Net intangible assets Non-Cash (29,184) 29,184 -- -- -- -------- -------- -------- -------- -------- TOTAL $(50,916) $ 39,444 $ 3,845 $ 603 $ (7,024) ======== ======== ======== ======== ========
9 NOTE D - SEGMENT INFORMATION Inter-Tel adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131") in the fiscal year ended December 31, 1998. SFAS 131 establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to shareholders. SFAS 131 also establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions as to how to allocate resources and assess performance. The Company's chief decision maker, as defined under SFAS 131, is the Chief Executive Officer. We currently view our operations as primarily composed of two segments: (1) telephone systems, telecommunications software and hardware, and (2) local and long distance calling services. These services are provided through the Company's direct sales offices and dealer network to business customers throughout the United States, Europe, Asia, Mexico and South America. As a result, financial information disclosed represents substantially all of the financial information related to the Company's two principal operating segments. Results of operations for the local and long distance calling services segment, if the operations were not included as part of the consolidated group, could differ materially, as the operations are integral to the total telephony solution offered by us to our customers. In addition to the two primary segments discussed above, the Inter-Tel.NET operations/investment, Inter-Tel's former IP long distance subsidiary, is separately disclosed as a business segment. The operations represented a more significant component of the consolidated operations in 2000 compared to prior years and had a significant impact on the revenues and net losses. On July 24, 2001, Inter-Tel agreed to sell 83% of Inter-Tel.NET to Comm-Services Corporation. As a result, since July 24, 2001, we have accounted for the remaining 17% Inter-Tel.NET/Comm-Services investment using the cost method of accounting. On December 30, 2001, Comm-Services entered into a merger agreement with Vianet. Inter-Tel's 17% investment in Inter-Tel.NET/Comm-Services was converted to approximately 10% of Vianet stock. Inter-Tel will account for the remaining 10% investment in Vianet (formerly Comm-Services) using the cost method of accounting. Inter-Tel assessed the value of this investment at March 31, 2002 and wrote-down this investment by $600,000 to approximately $3.1 million. For the quarters ended March 31, 2002 and 2001, we generated income from business segments, including our investment in Inter-Tel.NET/Vianet, as follows:
THREE MONTHS ENDED MARCH 31, 2002 ---------------------------------------------------- RESALE OF LOCAL AND LONG PRINCIPAL INTER-TEL.NET/ DISTANCE (In thousands, except per share amounts) SEGMENT VIANET SERVICES TOTAL ------- ------ -------- ----- Net sales $ 83,280 $ -- $ 6,790 $ 90,070 Gross profit (loss) 43,597 -- 1,457 45,054 Charge (see Note B) -- -- -- -- Operating income (loss) 9,340 -- 483 9,823 Interest and other, net 15,712 (600) 29 15,141 Loss on foreign translation adjustments (84) -- -- (84) Interest expense (34) -- -- (34) Net income (loss) $ 15,421 $ (378) $ 352 $ 15,395 Net income (loss) per diluted share (1) $ 0.60 $ (0.02) $ 0.01 $ 0.60 Weighted average diluted shares (1) 25,550 24,179 25,550 25,550 Total assets $ 240,323 $ -- $ 12,035 $ 252,358 Depreciation and amortization 2,161 -- 30 2,191 THREE MONTHS ENDED MARCH 31, 2001 ---------------------------------------------------- Net sales $ 82,877 $ 4,410 $ 6,416 $ 93,703 Gross profit (loss) 41,651 (3,566) 1,563 39,648 Charge (see Note B) -- -- -- -- Operating income (loss) 7,140 (4,491) 805 3,454 Interest and other, net 160 -- 8 168 Loss on foreign translation adjustments (303) -- -- (303) Interest expense (145) (82) -- (227) Net income (loss) $ 4,325 $ (2,881) $ 504 $ 1,948 Net income (loss) per diluted share (1) $ 0.17 $ (0.11) $ 0.02 $ 0.08 Weighted average diluted shares (1) 25,843 25,500 25,843 25,843 Depreciation and amortization 2,156 802 42 3,000
10 1) Options that are antidilutive because the exercise price was greater than the average market price of the common shares are not included in the computation of diluted earnings per share when a net loss is recorded. See Note L for additional information. Our revenues are generated predominantly in the United States. Total revenues generated from U.S. customers totaled $87.4 million or 97.1% of total revenues, and $90.9 million or 97.0% of total revenues for the quarters ended March 31, 2002 and 2001, respectively. The Company's revenues from international sources were primarily generated from customers located in the United Kingdom, Europe, Asia and South America. In the first quarters of 2002 and 2001, revenues from customers located internationally accounted for 2.9% and 3.0% of total revenues, respectively. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS QUARTERLY REPORT TO SHAREHOLDERS ON FORM 10-Q ("10-Q") CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE STATEMENTS CONTAINED IN THIS 10-Q 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-Q 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 RESULTS OF FUTURE OPERATIONS" BELOW AND ELSEWHERE IN THIS DOCUMENT. OVERVIEW Inter-Tel, incorporated in 1969, is a single point of contact, full service provider of business communications systems, voice mail systems and networking applications. We market and sell voice processing and unified messaging software, call accounting software, Internet Protocol (IP) telephony software, computer-telephone integration (CTI) applications, long distance calling services, and other communications services. Our products and services include the AXXESS by Inter-Tel and ECLIPSE(2) by Inter-Tel business communication systems, with integrated voice processing and unified messaging systems, IP telephony voice and data routers, and ClearConnect Talk-to-Agent e-commerce software. We also provide maintenance, leasing and support services for our products. Our customers include business enterprises, government agencies and non-profit organizations. Our common stock is quoted on the Nasdaq National Market System under the symbol "INTL." We have developed a distribution network of direct sales offices, dealers and value added resellers (VARs), which sell our products to organizations throughout the United States and internationally, including to divisions of Fortune 500 companies, large service organizations and governmental agencies. As of December 31, 2001, we had 49 direct sales offices in the United States and one in Japan, and a network of hundreds of dealers and VARs around the world that purchase directly from us. We also maintain a wholesale distribution office 11 in the United Kingdom that supplies Inter-Tel's dealers and distributors throughout the UK and parts of Europe. In January 2002, we acquired selected assets and assumed certain selected liabilities of McLeod USA, Inc. (McLeod). As a result, we added 5 new direct sales offices and added personnel to 3 other existing offices. We integrated several of these offices into our existing sales offices during 2002. Sales of systems through our dealers and VARs typically generate lower gross margins than sales through our direct sales organization, although direct sales typically require higher levels of selling, general and administrative expenses. In addition, our long distance and network services typically generate lower gross margins than sales of software and system products. Accordingly, our margins may vary from period to period depending upon distribution channel and product mix. In the event that sales through dealers or sales of long distance services increase as a percentage of net sales, our overall gross margin could decline. Our operating results depend upon a variety of factors, including the volume and timing of orders received during a period, the mix of products sold and 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, pricing pressures, the cost and effect of acquisitions and the availability and cost of products and components from our suppliers. Historically, a substantial portion of our net sales in a given quarter have been recorded in the third month of the quarter, with a concentration of such net sales in the last two weeks of the quarter. In addition, we are subject to seasonal variations in our operating results, as net sales for the first and third quarters are frequently less than those experienced during the fourth and second quarters, respectively. The markets we serve are characterized by rapid technological change and evolving customer requirements. We have sought to address these requirements through the development of software enhancements and improvements to existing systems and the introduction of new products and applications. Inter-Tel's research and development efforts over the last several years have been focused primarily on the development of and enhancements to our AXXESS and ECLIPSE(2) systems, including adding new applications, incorporating IP convergence applications and IP telephones, developing Unified Messaging Software applications, and expanding the telecommunications networking package to include networking over IP and frame relay networks. Over the last several years, our research and development efforts have also focused on the development of the ClearConnect SoftPhone and the related ClearConnect Talk-to-Agent web communications software. Inter-Tel's current efforts are focused on developing and enhancing the IP telephony products and applications for our AXXESS and ECLIPSE(2) systems, increasing single-site node capacity using an Asynchronous Transfer Mode backbone using version 6.0 AXXESS and ECLIPSE(2) software, enhancing our Unified Messaging Software, developing a speech-recognition and text-to-speech enabled unified communications product, developing an advanced IVR and CT application development tool, enhancing the IP digital telephones, and enhancing Inter-Tel's server-based PBX offering. We offer to our customers a package of lease financing and other services under the name Total Solution (formerly, Totalease). Total Solution provides our customers lease financing, maintenance and support services, fixed price upgrades and other benefits. We finance this program through the periodic resale of lease rental streams to financial institutions. RESULTS OF OPERATIONS The following table sets forth certain statement of operations data expressed as a percentage of net sales for the periods indicated: Three months Ended March 31, 12 2002 2001 ----- ----- Net sales 100.0% 100.0% Cost of sales 50.0 57.7 ----- ----- Gross Profit 50.0 42.3 ----- ----- Research and development 4.8 4.4 Selling, general and administrative 34.0 33.6 Amortization 0.3 0.6 ----- ----- Operating income 10.9 3.7 Litigation settlement (net of costs except for taxes) 17.0 -- Interest and other income 0.5 0.2 Write-down of investment in Inter-Tel.NET/Vianet (0.7) -- Loss on foreign translation adjustments (0.1) (0.3) Interest expense (0.0) (0.2) ----- ----- Income before income taxes 27.6 3.3 Income Taxes 10.5 1.2 ----- ----- Net Income 17.1% 2.1% ===== ===== NET SALES. Net sales decreased 3.9% to $90.1 million in the first quarter of 2002 from $93.7 million in the first quarter of 2001, including the operations of Inter-Tel.NET in 2001. Since the sale of 83% of our interest in Inter-Tel.NET in July 2001, we have not recorded revenues or expenses from Inter-Tel.NET. By contrast, net sales attributable to Inter-Tel.NET operations were $4.4 million for the first quarter of 2001. Excluding sales from Inter-Tel.NET in 2001, net sales in 2002 increased 0.9% compared to 2001. Since July 24, 2001, the date of the sale of 83% of Inter-Tel.NET, we have used the cost method of accounting for our remaining investment in Inter-Tel.NET/Comm-Services. For the quarter ended March 31, 2002, sales from the Company's direct sales offices, government and national accounts and from wholesale distribution increased approximately $436,000 compared to the first quarter of 2001. This increase is largely the result of sales generated from operations we acquired from McLeod, which represented an increase of approximately $3.6 million in net sales in 2002 compared to 2001. Sales from our network services group, including NetSolutions and Network Services agency, increased $760,000 over the same periods. These increases were offset by sales decreases of $419,000 attributable to decreases from leasing and foreign operations. The 2002 decrease in net sales was also attributable to delayed customer buying decisions related to a deterioration in macroeconomic conditions and competitive pressures. In some instances, prices of various telecommunications systems decreased, and discounts or other promotions that were offered to customers to generate sales resulted in lower revenues. Please refer to Note D of Notes to Consolidated Financial Statements for additional segment reporting information. GROSS PROFIT. Gross profit for the first quarter of 2002 increased 13.6% to $45.1 million, or 50.0% of net sales, from $39.6 million, or 42.3% of net sales, in the first quarter of 2001. The increase in gross profit as a percentage of sales (or gross margin) was primarily attributable to the sale of 83% of Inter-Tel.NET, which generated negative margins in 2001. In addition, sales through direct channels, including the acquired McLeod direct sales operations, represented a higher percentage of total sales and higher gross margins. Gross margins also increased in 2002 as a result of a higher percentage of sales generated from recurring sales to existing customers, which generally have higher margins than sales to new customers. These increases were offset by greater competitive pricing pressures and by pricing discounts on telephone system sales. Excluding the operations of Inter-Tel.NET in 2001, gross profit in 2002 increased 4.3% compared to gross profit of $43.2 million, or 48.4% of net sales, in 2001. Inter-Tel.NET generated negative gross profit of $3.6 million in the first quarter of 2001. RESEARCH AND DEVELOPMENT. Research and development expenses for the first quarter of 2002 increased 4.3% to $4.3 million, or 4.8% of net sales, from $4.1 million, or 4.4% of net sales, for the first quarter of 2001. Included in research and development expenses in both 2002 and 2001 is amortization of patents totaling $55,000 in each period. The increase was primarily attributable to the increase in engineers hired in connection with our acquisition of Mastermind Technologies, Inc. in October 2001. In addition, we continued development efforts to release the new version 6.0 of AXXESS and ECLIPSE networking software and systems, and incurred research and development expenses relating to the design and development of our Unified Communicator and Computer Telephony Applications platforms. We expect that for the foreseeable future 13 research and development expenses will increase sequentially in absolute dollars as we continue to enhance existing and develop new technologies and products. These expenses may vary, however, as a percentage of net sales. SELLING, GENERAL AND ADMINISTRATIVE. In the first quarter of 2002, selling, general and administrative expenses, excluding amortization, decreased 2.5% in absolute dollars to $30.7 million, or 34.0% of net sales, from $31.45 million, or 33.6% of net sales, in the first quarter of 2001. The decrease in absolute dollars was primarily due to lower net sales, reflecting in part the sale of 83% of Inter-Tel.NET in July 2001. Excluding the operations of Inter-Tel.NET in 2001, 2002 selling, general and administrative expenses increased 1.1% compared to $30.6 million, or 34.2% of net sales, in 2001. Selling, general and administrative expenses increased, as a percentage of net sales, primarily as a result of a higher percentage of total sales through direct sales channels and a lower absorption of fixed costs on lower total net sales. We also accrued higher relative profit sharing costs, reflecting rewards for higher earnings per share achievements. We expect that for the foreseeable future selling, general and administrative expenses will increase in absolute dollars, but may vary as a percentage of net sales. AMORTIZATION OF GOODWILL AND PURCHASED INTANGIBLE ASSETS. We adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142") effective the beginning of fiscal 2002. In accordance with SFAS 142, we ceased amortizing goodwill. We are required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. As of March 31, 2002, no impairment of goodwill has been recognized. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings. For additional information regarding SFAS 142, see "Adoption of Accounting Standard" in Note A of Notes to the Consolidated Financial Statements. Amortization of purchased intangible assets included in operating expenses was $257,000 in the first quarter of 2002, compared to $157,000 in the first quarter of 2001. The increase in the amortization of purchased intangible assets for the first quarter 2002 compared to the same period last year was primarily related to the additional amortization from recent acquisitions. For additional information regarding purchased intangible assets, see Note A "Adoption of Accounting Standard" and Note C "Acquisitions, Dispositions and Restructuring Charges " to the Consolidated Financial Statements. LITIGATION SETTLEMENT. In May 2001, Inter-Tel entered into an agreement to submit a lawsuit filed by Inter-Tel in 1996 to binding arbitration. The arbitration was completed in January 2002 and, as a result of the arbitration, Inter-Tel received a gross cash award of $20 million in February 2002. Direct costs for attorney's fees, expert witness costs, arbitration costs and additional costs and expenses, including $1.3 million in bonus payments to employees who assisted in the litigation and arbitration, totaled approximately $4.7 million in the first quarter 2002, excluding income taxes, for a net award of approximately $15.3 million. Estimated net proceeds from this arbitration settlement are approximately $9.3 million after taxes, or $0.37 per diluted share. INTEREST AND OTHER INCOME. Other income in 2002 included an expense of $600,000 related to the write-down of Inter-Tel's investment in Inter-Tel.NET/Vianet. Other than the write-down, both periods consisted primarily of interest income and foreign exchange rate gains and losses. Income from interest increased in 2002 compared to 2001 based on a higher level of invested funds, due to cash received from the litigation settlement noted above, offset by expenditures relating to the McLeod acquisition. Other changes in other income primarily reflected lower net foreign exchange rate losses and lower interest expense. INCOME TAXES. The Company's income tax rate for the first quarter of 2002 increased to 38% compared to 37% for 2001. The rate increased primarily as a result of higher marginal tax rates anticipated from the receipt of the cash litigation settlement award. The Company expects the full-year 2002 tax rate to be slightly higher than the tax rate effective for 2001. NET INCOME. Net income for the first quarter of 2002 was $15.4 million ($.60 per diluted share), an increase of 690.3% compared to net income of $1.9 million ($0.08 per diluted share) in 2001. The increase was primarily attributable to the litigation settlement award received in 2002. Excluding the 14 2002 litigation settlement and 2001 operations of Inter-Tel.NET, the Company reported net income of $6.0 million, or $0.24 per diluted share in 2002, compared to net income of $4.8 million, or $0.19 per diluted share, in 2001. This increase is the result of higher gross profit and reduced operating expenses in the first quarter of 2002 relative to the first quarter of 2001. INFLATION/CURRENCY FLUCTUATION Inflation and currency fluctuations have not previously had a material impact on Inter-Tel's operations. International procurement agreements have traditionally been denominated in U.S. currency. Moreover, a significant amount of our contract manufacturing has been moved to domestic sources. The expansion of international operations in the United Kingdom and Europe and anticipated increased sales in Japan and Asia and elsewhere could result in higher international sales as a percentage of total revenues, but international revenues are currently not significant. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2002, the Company had $85.4 million in cash and equivalents, which represented a increase of approximately $23.6 million from December 31, 2001. We maintain a $10 million unsecured, revolving line of credit with Bank One, NA, that is available through June 1, 2003. Under the credit facility, we have the option to borrow at a prime rate or adjusted LIBOR interest rate. Historically, we have used the credit facility primarily to support international letters of credit to suppliers. Inter-Tel received a gross cash award of $20 million in February 2002 in settlement of a dispute submitted to binding arbitration. Costs relating to attorney's fees, expert witnesses, and arbitration and additional costs and expenses, including $1.3 million in bonus payments to employees who assisted in the litigation and arbitration, totaled approximately $4.7 million in the first quarter of 2002, resulting in a net award of $15.3 million before income taxes. During the first quarter of 2002, $8.0 million of available cash was used to fund acquisitions. During the first quarter of 2001, approximately $14.1 million of available cash was used to repurchase our common stock and an additional $11.5 million of available cash was used to fund acquisitions. Of the $11.5 million used in the first quarter of 2001 to fund acquisitions, $6.0 million was subsequently returned to us in the third quarter of 2001 to reduce the net cash used in the Convergent acquisition. The remaining cash balances may be used for acquisitions, strategic alliances, working capital and general corporate purposes. Net cash provided by operating activities totaled $33.2 million for the three months ended March 31, 2002, compared to $3.9 million for the same period in 2001. Cash provided by operating activities in the first quarter of 2002 was the result of cash generated from operations, including non-cash depreciation and amortization charges, as well as proceeds from the litigation settlement discussed above. Cash generated by the change in operating assets and liabilities in 2002 was $12.5 million, compared to cash used by the change in operating assets and liabilities of $3.7 million in 2001. At March 31, 2002, we achieved lower accounts receivable and inventory than at December 31, 2001, which was primarily a result of close management of receivables and inventory. Net cash provided by operating activities was offset by increases in accounts payable and other accrued expenses at March 31, 2002, primarily reflecting higher tax accruals and liabilities assumed from the McLeod acquisition. We expect to expand sales through our direct sales office and dealer networks, which is expected to require the expenditure of working capital for increased accounts receivable and inventories. Net cash used in investing activities totaled $9.2 million for the quarter ended March 31, 2002, compared to $14.6 million for the quarter ended March 31, 2001. During the first quarter of 2002, net cash used in acquisitions totaled approximately $8.0 million and capital expenditures totaled approximately $1.3 million. During the first quarter of 2001, net cash used in acquisitions totaled approximately $11.5 million, $10.6 of which was attributable to the Convergent acquisition. Of the $11.5 million used in the first quarter of 2001 to fund acquisitions, $6.0 million was subsequently returned to us in the third quarter of 2001 to reduce the net cash used in the Convergent acquisition. Capital expenditures totaled approximately $3.1 million in the first quarter of 2001. We anticipate incurring additional capital expenditures during 2002, principally relating to expenditures for equipment and management information systems used in its operations, facilities expansion and acquisition activities. 15 Net cash used in financing activities totaled $421,000 in the three months ended March 31, 2002, compared to $13.3 million for the same period in 2001. Net cash used for dividends totaled approximately $449,000 and $260,000, respectively, during the first quarter of 2002 and 2001, which was offset in each period by cash provided by the exercise of stock options totaling $296,000. During 2002 and 2001, we reissued treasury shares through stock option exercises and issuances, with the proceeds received totaling less than the cost basis of the treasury stock reissued. Accordingly, the difference was recorded as a reduction to retained earnings. During the first quarter of 2001, we purchased treasury stock using approximately $14.1 million. We issued long-term debt, net of repayments, of $1.1 million in 2001 primarily in the form of long-term capital leases to support capital additions to Inter-Tel.net prior to our divestiture of our majority ownership in July 2001. We offer to our customers lease financing and other services, including our Total Solution (formerly Totalease) program, through our Inter-Tel Leasing, Inc. subsidiary. We fund our Total Solution program in part through the sale to financial institutions of rental income streams under the leases. Resold lease rentals totaling $201.7 million and $202.7 million remain unbilled at March 31, 2002 and December 31, 2001, respectively. We are obligated to repurchase such income streams in the event of defaults by lease customers on a limited basis and, accordingly, maintain reserves based on loss experience and past due accounts. Although we to date have been able to resell the rental streams from leases under the Total Solution program profitably and on a substantially current basis, the timing and profitability of lease resales could impact our business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If we are required to repurchase rental streams and realizes losses thereon in amounts exceeding our reserves, our operating results will be adversely affected. We believe that our working capital and credit facilities, together with cash generated from operations, will be sufficient to develop and expand our business operations, to finance acquisitions of additional resellers of telephony products and other strategic acquisitions or corporate alliances, and to provide adequate working capital for the next twelve months. However, we may seek additional financing in the future to address working capital needs and to provide funding for capital expenditures, expansion of the business or additional acquisitions. There can be no assurance that additional financing will be available when required or on acceptable terms. 16 CRITICAL ACCOUNTING POLICIES AND ESTIMATES The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our financial statements and they require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements: REVENUE RECOGNITION. We recognize revenue pursuant to Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements." Accordingly, revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is both fixed and determinable and; (iv) collectibility is reasonably probable. Revenue derived from sales of systems and services to end-user customers is recognized upon installation of the systems and performance of the services, respectively. Pre-payments for communications services are deferred and recognized as revenue as the communications services are provided. For shipments to dealers and other distributors, our revenues are recorded as products are shipped and services are rendered, because the sales process is complete. These shipments are primarily to third-party dealers and distributors and title passes when goods are shipped (free-on-board shipping point). Long distance services revenues are recognized as service is provided. SALES-LEASES. For our sales-type lease accounting, we follow the guidance provided by FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - A Replacement of FASB Statement No. 125. We record the discounted present values of minimum rental payments under sales-type leases as sales, net of provisions for continuing administration and other expenses over the lease period. The costs of systems installed under these sales-leases, net of residual values at the end of the lease periods, are recorded as costs of sales. Gains or losses resulting from the sale of rental income from such leases are recorded as net sales. We maintain reserves against potential recourse following the resales based upon loss experience and past due accounts. The allowance for uncollectible minimum lease payments and recourse liability at the end of the year represent reserves against the entire lease portfolio or allowance for collectibility from customers. These reserves are either netted in the current and long-term components of "Net investments in Sales-Leases" on the balance sheet, or included in long-term liabilities on our balance sheet for off-book leases. GOODWILL AND OTHER IDENTIFIABLE INTANGIBLES. We assess the impairment of goodwill and other identifiable intangibles whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include the following: * Significant under-performance relative to historical, expected or projected future operating results; * Significant changes in the manner of our use of the acquired assets or the strategy for our overall business; * Our market capitalization relative to net book value, and * Significant negative industry or economic trends. When we determine that the carrying value of goodwill and other identified intangibles may not be recoverable, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," on January 1, 2002 we ceased to amortize goodwill arising from acquisitions 17 completed prior to July 1, 2001. Inter-Tel has tested goodwill for impairment using the two-step process prescribed in SFAS 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. Inter-Tel has performed the first of the required impairment tests for goodwill as of January 1, 2002 and has determined that the carrying amount of goodwill is not impaired. Application of the nonamortization provisions of SFAS 142 is expected to result in an increase in income from continuing operations before income taxes of approximately $1.8 million in 2002, excluding acquisitions completed in 2002. Had we adopted SFAS 142 effective January 1, 2001, income from operations before income taxes would have increased approximately $1.8 million for 2001. ALLOWANCE FOR DOUBTFUL ACCOUNTS. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers or channel partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Additional reserves or allowances for doubtful accounts are recorded for our sales-type leases, discussed above in "Sales-Leases." INVENTORIES. We value our inventories at lower of cost or market. Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead. Significant management judgment is required to determine the reserve for obsolete or excess inventory. Inventory on hand may exceed future demand either because the product is outdated, or obsolete, or because the amount on hand is more than can be used to meet future need, or excess. We currently consider to be excess all inventory that has no activity within one year, or quantities in excess of one year's usage, as well as any additional specifically identified inventory. We also provide for the total value of inventories that we determine to be obsolete based on criteria such as customer demand, product life-cycles, changing technologies and market conditions. We write down our excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value. At March 31, 2002, our inventory reserves were $14.1 million of our $34.7 million gross inventories. If actual customer demand, product life-cycles, changing technologies and market conditions are less favorable than those projected by management, additional inventory write-downs may be required. CONTINGENCIES. We are a party to various claims and litigation in the normal course of business. Management's current estimated range of liability related to various claims and pending litigation is based on claims for which our management can estimate the amount and range of loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending claims and litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our pending litigation and revise our estimates. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial position. We received correspondence during 1999 from a major competitor and subsidiary inviting us to negotiate a license agreement regarding the competitors' patents. We have continued to negotiate with these competitors regarding their patent claims and have made claims for our patents. We received additional correspondence from another competitor in 2000 alleging that we violated their intellectual property rights. Inter-Tel responded by providing a copy of a notice of consent to transfer the license, which was previously granted by this competitor. During 1999, 2000 and 2001, Inter-Tel.NET also entered into operating lease agreements totaling approximately $6.5 million from an equipment vendor for network equipment and software. The lease agreements required Inter-Tel.NET to have vendor maintenance on their products. Inter-Tel originally guaranteed the indebtedness. In the second quarter of 2001, Inter-Tel.NET notified the vendor of network and network equipment problems encountered due to vendor equipment and software recommended, supplied and financed by this vendor. Inter-Tel.NET requested that the vendor not only solve the problems, but also compensate Inter-Tel.NET for the problems and the resulting lost customers, lost revenues and lost profits. Pursuant to Inter-Tel's sale of 83% of Inter-Tel.NET, Comm-Services assumed the vendor lease and maintenance obligations and as such Inter-Tel has not recorded any liability for these obligations. However, the vendor has not released Inter-Tel from its guarantee of these obligations and Inter-Tel has not released the vendor from Inter-Tel's claims, nor did we assign our rights to these claims to Comm-Services. In April 2002, Inter-Tel received a notice letter from the financing affiliate of the Inter-tel.NET equipment vendor notifying Inter-Tel of default in lease payments due the financing affiliate. Inter-Tel responded to the affiliate advising them that Inter-Tel was not the 18 Lessee of the equipment, the correct name and address of the Lessee of the equipment and the losses to Inter-Tel because of the non performance of the equipment and vendor related third party software providers' breach of contract. We do not anticipate that the resolution of such matters will have a material adverse effect on our consolidated financial position. FACTORS THAT MAY AFFECT RESULTS OF FUTURE OPERATIONS THIS REPORT ON FORM 10-Q 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. RISKS RELATED TO OUR BUSINESS 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, and 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 if we 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 entrants may offer products, applications or services that are better adapted to changing technology or customer demands and that could render our products and services unmarketable or obsolete. In addition, if the markets for computer-telephony (CT) applications, Internet Protocol (IP) network products, 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 INCREASED COMMERCIAL ACCEPTANCE OF OUR AXXESS AND ECLIPSE(2) SYSTEMS, ENCORE PRODUCT, INTERPRISE PRODUCTS, NEW SPEECH RECOGNITION AND INTERACTIVE VOICE RESPONSE PRODUCTS, AND RELATED COMPUTER-TELEPHONY PRODUCTS. During the past few years, we have introduced transparent networking and unified messaging capabilities on our AXXESS and ECLIPSE(2) systems and introduced our Encore product and 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 and IP soft phones that add IP telephony to the AXXESS and ECLIPSE(2) systems, and several other telephony-related products. During the past 12 months, sales of our AXXESS business communications systems and related software have comprised a substantial portion of our net sales. Our future success depends, in large part, upon increased commercial acceptance and adoption of the InterPrise and related computer-telephony products, the AXXESS and ECLIPSE(2) systems, Encore products, new speech recognition and Interactive Voice Response products, as well as future upgrades and enhancements to these products and networking platforms. We cannot assure you that these products or platforms will achieve commercial acceptance 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 and software 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 "bugs," or other defects after new products and upgrades have been released. Some of these bugs may result from defects contained in component parts or software from our suppliers or other 19 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 in place designed to minimize the number of errors and defects in our products, we cannot assure you 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 the following, any of which would harm our business: * 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; * liabilities to 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 HARM OUR BUSINESS. Due to the complexity of our products and software, we have in the past experienced 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 and software on a regular and timely basis, customer demand for our products and software could decline, which would harm our business. BUSINESS ACQUISITIONS, DISPOSITIONS OR JOINT VENTURES ENTAIL NUMEROUS RISKS AND 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: * unanticipated costs and liabilities; * difficulty of assimilating the operations, products and personnel of the acquired business; * difficulties in managing the financial and strategic position of acquired or developed products, services and technologies; * the diversion of management's attention from the core business; * inability to maintain uniform standards, controls, policies and procedures; and * impairment of relationships with acquired employees and customers occurring as a result of integration of the acquired business. In January 2002, we acquired selected assets and liabilities of McLeodUSA, Inc. (McLeod). In connection with the McLeod acquisition, we hired approximately 100 McLeod employees and opened two Inter-Tel branch offices in previous McLeod locations. We cannot predict whether we will be able to integrate the employees and business of McLeod into our operations successfully. In January 2001, we acquired certain assets and assumed certain liabilities of Convergent Technologies, Inc. In connection with the Convergent acquisition, we hired over 200 Convergent employees and opened eight Inter-Tel branch offices in previous Convergent locations. Among potential other risks and uncertainties, difficulties or risks associated with the Convergent acquisition include service and maintenance of competitors products, and the successful integration of employees, independent contractors and customers. Similar risks could apply to the recently completed McLeod acquisition. In July 2001, Inter-Tel agreed to sell 83% of Inter-Tel.NET to Comm-Services Corporation. In connection with this transaction, Inter-Tel assessed the fair value of the net assets of Inter-Tel.NET as of June 30, 2001 under FAS 121 to arrive at an adjustment to the remaining investment in Inter-Tel.NET. The charge recorded as of the close of the second quarter of 2001 totaled $5.4 million ($3.4 million after tax), associated with the impairment of Inter-Tel's investment in Inter-Tel.NET. The recording of this charge adversely 20 affected our operating results for the second quarter of 2001. On December 30, 2001, Comm-Services entered into a merger agreement with Vianet Technologies, Inc. (Vianet). Inter-Tel's 17% investment in Comm-Services was converted to approximately 10% of Vianet stock. As of March 31, 2002, we assessed the value of our investment in Vianet and we recorded an expense of $600,000 related to the write-down of this investment. Our financial condition will be adversely affected to the extent that the Vianet business is unsuccessful. During 1999, 2000 and 2001, Inter-Tel.NET also entered into operating lease agreements totaling approximately $6.5 million from an equipment vendor for network equipment and software. The lease agreements required Inter-Tel.NET to have vendor maintenance on their products. Inter-Tel originally guaranteed the indebtedness. In the second quarter of 2001, Inter-Tel.NET notified the vendor of network and network equipment problems encountered due to vendor equipment and software recommended, supplied and financed by this vendor. Inter-Tel.NET requested that the vendor not only solve the problems, but also compensate Inter-Tel.NET for the problems and the resulting lost customers, lost revenues and lost profits. Pursuant to Inter-Tel's sale of 83% of Inter-Tel.NET, Comm-Services assumed the vendor lease and maintenance obligations and as such Inter-Tel has not recorded any liability for these obligations. However, the vendor has not released Inter-Tel from its guarantee of these obligations and Inter-Tel has not released the vendor from Inter-Tel's claims, nor did we assign our rights to these claims to Comm-Services. In April 2002, Inter-Tel received a notice letter from the financing affiliate of the Inter-tel.NET equipment vendor notifying Inter-Tel of default in lease payments due the financing affiliate. Subsequently, Inter-Tel responded to the affiliate advising them that Inter-Tel was not the Lessee of the equipment, the correct name and address of the Lessee of the equipment and the losses to Inter-Tel because of the non performance of the equipment and vendor related third party software providers' breach of contract. Our financial condition will be adversely affected to the extent that payments made under the guarantee exceed damages realized from our claim. Finally, 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 seventeen (17) telecommunication and unified messaging products and have also applied to the U.S. Patent and Trademark Office for seven (7) 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 you 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 you 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. We are also subject to third party claims that our current or future products or services infringe upon the rights of others. For example, we are subject to proceedings alleging that certain of our key products infringe upon third party intellectual property rights, including patents, trademarks, copyrights or other intellectual property rights. We have viewed presentations from one of our primary competitors, Lucent and subsequently Lucent's spin off Avaya, alleging that our AXXESS business communications system utilizes inventions covered by certain of their patents. We are continuing the process of investigating this matter and we have made claims against Avaya and Lucent for 21 infringement of our patents. Additionally, we recently received a letter from AT&T alleging that some of our IP products infringe upon intellectual property protected by AT&T's patents. Although we have denied AT&T's allegations and intend to defend our position vigorously, we cannot assure you that we will ultimately prevail in this dispute. When any such claims are asserted against us, among other means to resolve the dispute, we may seek to license the third party's intellectual property rights. Purchasing such licenses can be expensive, and we cannot assure you 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 subject to the alleged infringement. Any of these actions or outcomes could harm our business. 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, WHICH MAY RESULT IN LOST CUSTOMERS OR SLOW COMMERCIAL ACCEPTANCE OF OUR IP NETWORK PRODUCTS. Inter-Tel's IP telephony and network 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 jeopardize the security of confidential information, such as credit card or bank account information or the content of conversations over the IP network. In addition, 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 HAVE MANY COMPETITORS AND EXPECT NEW COMPETITORS TO ENTER OUR MARKET, WHICH COULD INCREASE PRICE COMPETITION AND SPENDING ON RESEARCH AND DEVELOPMENT AND WHICH MAY IMPAIR OUR ABILITY TO COMPETE SUCCESSFULLY. The markets for our products and services are extremely competitive and we expect competition to increase in the future. Our current and potential competitors in our primary business segments include: * PABX, IP and core systems providers such as Avaya, Cisco Systems, Comdial, 3Com, Iwatsu, Mitel, NEC, Nortel, Panasonic, Siemens, and Toshiba; * large data routing and convergence companies such as 3Com and Cisco Systems; * voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a subsidiary of NEC America), Avaya, Captaris (formerly AVT) and Lucent; * long distance services providers such as AT&T, MCI WorldCom, Qwest and Sprint; * large computer and software corporations such as IBM and Microsoft; 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 could 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. Compared to us, 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; * negotiate more favorable licensing agreements with vendors; * devote greater resources to the marketing and sale of their products; and * address customers' service-related issues more adequately. 22 Some of our competitors may also be able to provide customers with additional benefits at lower overall costs or to reduce their gross margins 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 AND COST-EFFECTIVE 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 risks and uncertainties, including the possibility of a shortage or delivery delay for some key components. We currently manufacture our products through third-party subcontractors located in the United States, the People's Republic of China, the United Kingdom and Mexico. The Encore system is manufactured by an OEM partner in the United Kingdom. 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 and ECLIPSE(2) systems, as well as substantially all of the computer-telephony products purchased in the Executone acquisition. We have experienced occasional delays in the supply of components and finished goods that have harmed our business. We cannot assure that we will not experience similar delays in the future. Our reliance on third party manufacturers and OEM partners 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 are unable to develop alternative or additional supply sources as 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 you that we will be able to continue to obtain components or finished goods in sufficient quantities or quality or on favorable pricing or delivery terms in the future. WE DERIVE A SUBSTANTIAL PORTION OF OUR NET SALES FROM OUR DEALER NETWORK AND IF THESE DEALERS DO NOT EFFECTIVELY PROMOTE AND SELL OUR PRODUCTS, OUR BUSINESS AND OPERATING RESULTS COULD BE HARMED. We derive a substantial portion of our net sales through our network of independent dealers. We face intense competition from other telephone, voice processing, and voice and data router system manufacturers for these dealers' business, as most of our dealers carry products that compete with our products. Our dealers may choose to 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. EXPANDING OUR INTERNATIONAL SALES EFFORTS MAY EXPOSE US TO ADDITIONAL BUSINESS RISKS, WHICH MAY RESULT IN REDUCED SALES OR PROFITABILITY IN OUR INTERNATIONAL MARKETS. We are in the process of attempting to expand our international dealer network both in the countries in which we already have a presence and in new countries and regions. International sales are subject to a number of risks, including changes in foreign government regulations and telecommunication standards, export license requirements, tariffs and taxes, other trade barriers, difficulties in protecting our intellectual property, fluctuations in currency exchange rates, difficulty in collecting receivables, difficulty in staffing and managing foreign operations, and political and economic instability. Fluctuations in currency exchange rates could cause our 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. Any of these risks could cause our products to become relatively more expensive to customers in a particular country, leading to reduced sales or profitability in that country. 23 IF WE LOSE KEY PERSONNEL OR ARE UNABLE TO HIRE ADDITIONAL QUALIFIED PERSONNEL AS NECESSARY, WE MAY NOT BE ABLE TO 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 historically had difficulty hiring employees in the timeframe that we desire, particularly skilled engineers. The loss of any of our key personnel or our failure to effectively recruit additional key personnel could make it difficult for us to manage our business, complete timely product introductions or meet other critical business objectives. For example, our inability 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 key Convergent and McLeod employees. We cannot assure you that we will be able to continue to attract and retain the qualified personnel necessary for the development of our business. WE MAY BE UNABLE TO MANAGE OUR GROWTH EFFECTIVELY, WHICH MAY HARM OUR BUSINESS. The ability to operate our business in a rapidly evolving market requires an effective planning and management process. The growth in our business has placed, and is expected to continue to place, a significant strain on our personnel, management systems, infrastructure 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 controls and procedures. Furthermore, we expect that we will be required to manage an increasing number of relationships with suppliers, manufacturers, customers and other third parties. If we are unable to implement adequate controls or integrate new employees into our business in an efficient and timely manner, our operations could be adversely affected and our growth could be impaired which could harm our business. THE INTRODUCTION OF NEW PRODUCTS AND SERVICES HAS LENGTHENED OUR SALES CYCLES, WHICH MAY RESULT IN SIGNIFICANT SALES AND MARKETING EXPENSES. In the past few years, we introduced the AXXESS and ECLIPSE(2) ATM business communications system and networking software, which are typically sold to larger customers at a higher average selling price and often represent a significant communications infrastructure capital expenditure by the prospective enterprise customer. Accordingly, the purchase of our products typically involves numerous internal approvals relating to the evaluation, testing, implementation and acceptance of new technologies. This evaluation process frequently results in a lengthy sales process, which can range from a few months to more than 12 months, thereby subjecting our sales cycle to a number of significant uncertainties concerning 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 OPERATING RESULTS HAVE HISTORICALLY DEPENDED ON A NUMBER OF FACTORS, AND THESE FACTORS MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE IN THE FUTURE. 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; * gross margin fluctuations associated with 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; * pricing pressures, the cost and effect of acquisitions, in particular the Executone and Convergent acquisitions; and * the availability and cost of products and components from our suppliers. 24 In addition, we have historically operated with a relatively small backlog, with sales and operating results in any quarter depending principally on orders booked and shipped in that quarter. 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 business communications systems and associated call processing and voice processing software applications depends largely on general economic conditions, and can vary significantly as a result of changing conditions in the economy as a whole. We cannot assure you 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, our operating results could be harmed. In addition, because sales of business communications systems through our dealers typically 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 typically 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 quarter is frequently less than the fourth quarter and the third quarter is frequently less than the second quarter. 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. 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 or our forecasts of future results; * 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 or terrorist acts; * 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 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 you 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 21.7% OF OUR COMMON STOCK AND IS ABLE TO SIGNIFICANTLY INFLUENCE MATTERS REQUIRING SHAREHOLDER APPROVAL. As of March 31, 2002, Steven G. Mihaylo, Inter-Tel's Chairman of the Board of Directors, Chief Executive Officer and President, beneficially owned approximately 21.7% of the outstanding shares of the 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 Inter-Tel. 25 RISKS RELATED TO OUR INDUSTRY REDUCTIONS IN SPENDING ON ENTERPRISE COMMUNICATIONS EQUIPMENT MAY MATERIALLY AND ADVERSELY AFFECT OUR BUSINESS. The overall economic slowdown has had a harmful effect on the market for enterprise communications equipment. Our customers have reduced significantly their capital spending on communications equipment in an effort to reduce their own costs and bolster their revenues. The market for enterprise communications equipment may continue to grow at a modest rate and our financial performance has been and may continue to be materially and adversely affected by the reductions in spending on enterprise communications equipment. THE EMERGING MARKET FOR IP NETWORK TELEPHONY IS SUBJECT TO MARKET RISKS AND UNCERTAINTIES THAT COULD CAUSE SIGNIFICANT DELAYS AND EXPENSES. The market for IP network voice communications products 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 you that packet-switched voice networks will become widespread. Even if packet-switched voice networks become widespread in the future, we cannot assure you that our products, including the Inter-Tel InterPrise product line and IP telephony features of the AXXESS and ECLIPSE(2) systems, will successfully compete against other market players and attain broad market acceptance. Inter-Tel sold 83% of Inter-Tel.NET, an IP telephony provider, to Comm-Services in July 2001, and our remaining 17% investment was subsequently converted to approximately 10% interest in Vianet Technologies, Inc. via a merger between Comm-Services and Vianet. Accordingly, Inter-Tel continues to maintain an investment of 10% in Inter-Tel.NET through Vianet. Accordingly, our financial condition will be adversely affected if the Inter-Tel.NET/Vianet business is unsuccessful. Moreover, the adoption of packet-switched voice 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 develops 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; poor voice quality over IP networks as compared to circuit-switched networks; 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 facsimile communications over the Internet and other data networks, and the delivery of other value-added services, is still in the early stages of development. 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 to experience significant price competition, and this may cause a decrease in end-user rates. We cannot assure you 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, 26 or if these entities are unwilling or unable 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. Carriers that provide telecommunications services to us may also experience financial difficulties, up to and including bankruptcies, which could harm our ability to offer telecommunications services. CONSOLIDATION WITHIN THE TELECOMMUNICATIONS INDUSTRY COULD INCREASE COMPETITION AND REDUCE OUR CUSTOMER BASE. During the past year, there has been a trend in the telecommunications industry towards consolidation and we expect this trend to continue as the industry evolves. As a result of this consolidation trend, new stronger companies may emerge that have improved financial resources, enhanced research and development capabilities and a larger and more diverse customer base. The changes within the telecommunications industry may adversely affect our business, operating results and financial condition. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments. INVESTMENT PORTFOLIO. We do not use derivative financial instruments in our 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 our investment policy guidelines. Given the short-term nature of these investments, and that we have no borrowings outstanding other than short-term letters of credit, we are not subject to significant interest rate risk. LEASE PORTFOLIO. We offer to our customers lease financing and other services, including our Total Solutions program, through our Inter-Tel Leasing subsidiary. We fund these programs in part through the sale to financial institutions of rental income streams under the leases. Upon the sale of the rental income streams, we continue to service the leases and maintain limited recourse on the leases. We maintain reserves for loan losses on all leases based on historical loss experience and specific account analysis. Although to date we have been able to resell the rental streams from leases under our lease programs profitably and on a substantially current basis, the timing and profitability of lease resales could impact our business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If we were required to repurchase rental streams and realize losses thereon in amounts exceeding our reserves, our operating results could be materially adversely affected. See "Liquidity and Capital Resources" in Management's Discussion and Analysis and Notes A and D to the financial statements for more information regarding our lease portfolio and financing. IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our international subsidiaries primarily in the local currencies of our 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. INTER-TEL, INCORPORATED AND SUBSIDIARIES PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS--NOT APPLICABLE ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS--NOT APPLICABLE ITEM 3. DEFAULTS ON SENIOR SECURITIES--NOT APPLICABLE 27 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our Annual Meeting of Shareholders was held April 23, 2002 (the Annual Meeting). On March 25, 2002 we mailed a Proxy Statement, pursuant to Regulation 14A under the Securities Exchange Act of 1934, to our security holders to solicit their votes regarding the following matters that were discussed at our Annual Meeting: 1. Election of Directors: Steven G. Mihaylo, J. Robert Anderson, Jerry W. Chapman, Gary D. Edens and C. Roland Haden were elected to serve as directors until the 2003 Annual Meeting of Shareholders. The votes were as follows: Nominee For: Against: Abstain: Broker Non-Vote ------- ---- -------- -------- --------------- Steven G. Mihaylo 17,748,456 3,703,364 -- -- J. Robert Anderson 21,121,096 330,724 -- -- Jerry W. Chapman 21,035,221 416,599 -- -- Gary D. Edens 21,260,661 191,159 -- -- C. Roland Haden 20,964,647 487,173 -- -- 2. Inter-Tel's shareholders voted on and approved five amendments (the "Amendments") to the Inter-Tel, Incorporated Director Stock Option Plan (the "Director Plan") that were previously approved by the Board of Directors. These Amendments consist of the following: * Increasing the term of the Director Plan from ten (10) years to twenty (20) years, thereby extending the period in which the Company's outside directors are eligible to receive option grants thereunder; * Including the "Service Provider" concept in the Director Plan in order to allow grantees under the plan to continue to vest and exercise his or her options so long as such grantee remains a director, employee or consultant of the Company; * Changing the date of the annual grant of options to grantees under the Director Plan from five (5) days after the date of the Board meeting held during the third quarter of each year to five (5) days after the date of the re-election of Eligible Directors (defined in the Director Plan) at the Company's Annual Meeting of Shareholders to be effective in 2002; * Increasing each option grant to Eligible Directors by 2,500 shares, from an option to purchase 5,000 shares to an option to purchase 7,500 shares in response to changes in the market for outside directors; and * Increasing the term of options granted under the Director Plan from five (5) years to ten (10) years, thereby extending the period in which optionees may exercise their option grants. The votes were as follows: For: Against: Abstain: Broker Non-Vote ---- -------- -------- --------------- 13,582,660 7,815,559 53,601 -- 3. Inter-Tel's shareholders voted on and approved an amendment to the Inter-Tel, Incorporated Employee Stock Purchase Plan ("the "Purchase Plan") to increase the shares of Common Stock reserved for issuance under the Purchase Plan by 500,000 shares, bringing the total shares currently reserved for issuance under the Option Plan to 1,000,000 shares. The votes were as follows: For: Against: Abstain: Broker Non-Vote ---- -------- -------- --------------- 19,922,198 1,499,717 29,905 -- 28 4. The shareholders also voted on and approved a proposal to ratify the appointment of Ernst & Young LLP to act as the independent auditors to audit our and our subsidiaries' financial statements for the year 2001. The votes were as follows: For: Against: Abstain: Broker Non-Vote ---- -------- -------- --------------- 21,085,940 346,096 19,784 -- ITEM 5. OTHER INFORMATION Pursuant to Rule 14a-4(c)(1) under the Securities Exchange Act of 1934, in connection with the Company's annual meeting of shareholders, if a shareholder of the Company fails to notify the Company at least 45 days prior to the month and day of mailing of the prior year's proxy statement, then the proxies of management would be allowed to use their discretionary voting authority when any such proposal is raised at the Company's annual meeting of shareholders, without any discussion of the matter in the proxy statement. Since the Company mailed its proxy statement for the 2002 annual meeting of shareholders on March 25, 2002, the deadline for receipt of any such shareholder proposal for the 2003 annual meeting of shareholders is February 8, 2003. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K: Exhibits: None. Reports on Form 8-K: None. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. INTER-TEL, INCORPORATED May 13, 2002 /s/ Steven G. Mihaylo ------------ ---------------------------------------- Steven G. Mihaylo Chairman of the Board, Chief Executive Officer and President May 13, 2002 /s/ Kurt R. Kneip ------------ ---------------------------------------- Kurt R. Kneip Vice President and Chief Financial Officer 29