-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, W2JXGOtgHaLz7xUKhcK7FgDfMXEg+87I88aQ0M7bzZO7trEOI/XpUWn2jMyQrai5 DBDqAH5vbO+vRNl2gQ0c4g== 0000950147-98-000236.txt : 19980331 0000950147-98-000236.hdr.sgml : 19980331 ACCESSION NUMBER: 0000950147-98-000236 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980330 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: INTER TEL INC CENTRAL INDEX KEY: 0000350066 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE & TELEGRAPH APPARATUS [3661] IRS NUMBER: 860220994 STATE OF INCORPORATION: AZ FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-10211 FILM NUMBER: 98579644 BUSINESS ADDRESS: STREET 1: 120 N 44TH ST STREET 2: STE 200 CITY: PHOENIX STATE: AZ ZIP: 85034-1822 BUSINESS PHONE: 6023028900 MAIL ADDRESS: STREET 1: 120 N 44TH ST STREET 2: STE 200 CITY: PHOENIX STATE: AZ ZIP: 85034-1822 10-K 1 ANNUAL REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------------------- FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended Commission File Number: December 31, 1997 0-10211 INTER-TEL, INCORPORATED Incorporated in the State of Arizona I.R.S. No. 86-0220994 120 North 44th Street, Suite 200 Phoenix, Arizona 85034-1822 (602) 302-8900 ---------------------------------- Securities registered pursuant to Section 12(g) of the Act: Common Stock (26,796,272 shares outstanding as of March 13, 1998) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (S 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K - [ ]. The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the last reported sales price in NASDAQ National Market System on March 13, 1998, was approximately $543,688,355. Shares of Common Stock held by each executive officer and director have been excluded in that such persons may be deemed to be affiliates. Materials have been incorporated by reference into this Report from the following documents: (1) materials from the registrant's Proxy Statement relating to its 1998 Annual Meeting of Shareholders have been incorporated by reference into Part III and Part IV and (2) documents from the registrant's Form S-1 Registration Statements (Nos. 2-70437 and 33-70054), Form S-3 Registration Statements (Nos. 33-58161, 33-61437, 333-01735, 333-12433 and 333-39221), Form S-8 Registration Statements (Nos. 2-94805, 33-40353, 33-73620 and 333-41197), Annual Reports on Form 10-K for the years December 31, 1984, 1988 and 1994, and current reports on Form 8-K dated July 17, 1987, August 3, 1988 have been incorporated by reference into Part IV, Item 14. Portions of the Annual Report to Shareholders for the year ended December 31, 1996 are incorporated by reference into Part II. INTER-TEL, INCORPORATED 1997 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS
PART I Page Item 1 Business 3 Item 2 Properties 25 Item 3 Legal Proceedings 26 Item 4 Submission of Matters to a Vote of Security Holders 26 PART II Item 5 Market for the Registrant's Common Stock and Related Stockholder Matters 26 Item 6 Selected Financial Data 26 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 27 Item 7A Quantitative and Qualitative Disclosures About Market Risk 27 Item 8 Financial Statements and Supplementary Data 27 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 27 PART III Item 10 Directors and Executive Officers of the Registrant 27 Item 11 Executive Compensation 27 Item 12 Security Ownership of Certain Beneficial Owners and Management 27 Item 13 Certain Relationships and Related Transactions 27 PART IV Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K 28 2
PART I ITEM 1. BUSINESS The Company This Annual Report to Shareholders on Form 10-K ("10-K") contains forward-looking statements that involve risks and uncertainties. The statements contained in this 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including without limitation statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The cautionary statements made in this 10-K should be read as being applicable to all related forward-looking statements wherever they appear in this document. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under "Factors That May Affect Results of Future Operations" below and elsewhere in this document. In evaluating the Company's business, shareholders and prospective investors should consider carefully the following factors in addition to the other information set forth in this document. Inter-Tel, incorporated in Arizona in 1969, is a single point of contact, full service provider of digital business telephone systems, call processing software, voice processing software, call accounting software, Internet Protocol (IP) telephony software, computer telephone integration ("CTI") applications and long distance calling services. Inter-Tel's products and services include the AXXESS and Inter-Tel Axxent digital business communication software platforms, the AXXESSORY Talk voice processing platform, the Inter-Tel Vocal'Net IP telephony gateway, the Inter-Tel Vocal'Net Service Provider Software and Centralized Accounting Software and Inter-Tel.net, an IP telephony packet switched long distance service. The Company also provides maintenance, leasing and support services for its products. The Company's Common Stock is quoted on the Nasdaq National Market System under the symbol INTL. The Company has developed a distribution network of direct sales offices, dealers and value added resellers (VARs) which sell the Company's products to small-to-medium-size organizations and to divisions or departments of larger organizations, including Fortune 500 companies, large service organizations and governmental agencies. The Company has 30 direct sales offices in the United States, one in the United Kingdom, one in Japan and a network of hundreds of dealers and VARs who purchase directly from the Company. Industry Background In recent years, advances in telecommunications technologies have facilitated the development of increasingly sophisticated telephone systems and applications. Users rely upon a variety of applications, including conference calling, speaker phones, automated attendant, voice processing and unified messaging (the integration of voice mail, facsimile and electronic mail), to improve communications within their organizations and with customers and vendors. Digital technology has facilitated the integration of computing and telecommunications technologies, which has made possible a number of new applications that further enhance productivity. Examples of these applications include automatic call distribution (which provides for queuing and prioritization of incoming calls), call accounting (which permits accounting for telephone usage and toll calls), unified messaging, electronic data interchange between customers and vendors and the use of automatic number identification coupled with database look-up (where customer information is retrieved automatically from a computerized database when the customer calls). 3 The emergence of high-performance, low-cost computers and the growth of the Internet and other digital IP networks have enabled real-time voice communications to be transmitted on digital packet switched networks rather than over traditional circuit switched telephone networks. This development of voice applications for the Internet and other IP networks reflects a broader convergence of standard voice communications and data networks. Because IP network telephony converts all transmissions to the same type of packets, both voice and data can use the same data circuits, thereby increasing efficiency and maximizing the use of available bandwidth. The lowering of federal regulatory barriers to competition across traditionally distinct sectors of the telecommunications industry has opened new markets for and increased competitive pressures on telecommunications companies. In response to these factors, telecommunications companies have begun to establish a presence in Internet and other IP network voice communications services. Following the breakup of the Bell system in 1984, which removed restrictions on the ability of the RBOCs to purchase telecommunications equipment from independent suppliers and to resell such equipment to end users, the market for telecommunications systems and applications became increasingly fragmented. The number of independent suppliers and distributors of telecommunications equipment initially increased, but increased levels of competition subsequently led to consolidation among suppliers and distributors. In addition, different telecommunications systems and applications were often available from only one or a limited number of suppliers, which required businesses seeking complete systems to work with a number of different suppliers. A business seeking a telephone system, voice mail and long distance services would most likely purchase the products and services from three separate vendors. As business telecommunications requirements have become more advanced, the integration of different systems has become increasingly difficult. Strategy Inter-Tel's objective is to continue to strengthen its position as a leading single-source provider of telecommunications equipment, software applications and network services. The Company's strategy incorporates the following key elements: Offer Total Telephony Solution The Company intends to continue to offer a broad range of products and services that incorporates advanced technologies and provides customers with a single source to fulfill their telecommunications needs on a cost-effective basis. Inter-Tel couples this solution-oriented approach with a high level of customer service and support and a commitment to quality throughout the Company's operations. The Company's telephone systems are integrated with the Company's long distance calling services, voice mail, automated attendant and other telecommunications applications, support for interactive voice response. Because of the modular design of the Company's systems and the high level of software content in its products, customers can readily increase the size and functionality of their systems as their needs change by adding software and hardware applications or services or by upgrading to new systems or advanced versions of existing systems. The Company believes that its customers prefer to purchase telecommunications equipment and services from a single source because of the convenience, consistency of service, ease of upgrade, availability of financing alternatives and confidence in the performance of integrated systems and services. Accelerate Adoption of Inter-Tel Vocal'Net Gateway In September 1997, Inter-Tel commercially released Inter-Tel Vocal'Net, a gateway for bridging public circuit switched telephone networks and IP packet switched networks such as the Internet. The Company intends to focus its initial marketing efforts on existing customers as well 4 as other multi-location companies and international enterprises. Inter-Tel Vocal'Net can be used to reduce an enterprise's communications costs through more effective use of its data network and reduced use of traditional long distance services. In addition, the Company plans to pursue relationships with ISPs, long distance resellers, cable television companies and other service providers that choose to establish alternative networks to compete with traditional long distance services and to provide additional applications to their customers. Expand Inter-Tel.net Network The Company is currently developing and implementing its own private IP telephony network, Inter-Tel.net, to carry telephone traffic at rates typically lower than those of standard telephone networks. To date, the Inter-Tel.net network has established points of presence in the San Francisco Bay Area, Washington, D.C., Chicago, Reno, New York, Phoenix and Los Angeles. The Company intends to expand the number of points of presence, both domestically and internationally, as well as increase capacity in existing cities. Inter-Tel.net is designed to carry long distance traffic originated from Inter-Tel's customer base and provide other exchange carriers, individuals, and enterprises a cost-effective alternative to current offerings of the conventional circuit switched long distance carriers. Continue to Develop Advanced Communications Products The Company commits substantial research and development resources in order to provide its customers with advanced telecommunications technologies on a cost-effective basis. The Company has developed an extensive C++ library and significant telecommunications expertise. In many cases, the Company develops new technologies as software upgrades or add-ons to existing products. In this regard, the AXXESS 5.0 platform, which is currently scheduled for release in the first half of 1998, will provide an extensive enhancement of AXXESS, the Company's primary product. Ongoing research and development efforts are directed to the development of new products, applications and services for sale into the Company's existing customer base and to new customers. Through CTI applications and advanced network services, Inter-Tel provides technology that is designed to enable its customers to improve their efficiency and enhance their competitiveness. Expand Distribution Channels The Company continues to expand its distribution channels through a growing network of direct dealers, expansion of the Company's direct sales presence, hiring additional direct sales personnel and extension into international markets. The Company has established sales relationships with hundreds of direct dealers and continues to expand this network. The Company is in the process of establishing dealer networks in Japan and other parts of Asia and is expanding its dealer network in the United Kingdom and Europe. The Company has expanded its direct sales activity in recent periods through strategic acquisitions of resellers of telephony products and services in areas where the Company has existing direct sales offices and other strategic markets, and considers additional acquisition opportunities on an ongoing basis. The Company also is expanding its distribution into other channels such as computer equipment dealers, resellers of data communications equipment and software resellers. Products and Services The Company offers a broad range of products and services designed to support the needs of businesses and other organizations requiring voice and data communications systems. The Company's principal products are digital telephone systems which support installations up to 512 ports, IP telephony products and services, CTI applications, unified messaging software and voice processing software. The Company's principal system sales consist of systems supporting 10 to 300 telephones with suggested retail prices of up to $300,000 per system, depending on 5 configuration. The Company also offers long distance calling services, network design and implementation services, maintenance, leasing and support services, and resells other telecommunications products. Digital Communication Platforms Inter-Tel offers an extensive line of digital communication systems, including hardware platforms and C++ software applications. Because these platforms are based upon open architecture and conform to established computer and telephone industry standard programming interfaces and protocols (such as TAPI, TSAPI and TCP/IP), customers can choose from a variety of either server level or desktop applications. AXXESS. Inter-Tel's primary product, the AXXESS platform, incorporates advanced technology for computer and telephone integration providing businesses with the ability to customize applications to enhance their operations and increase productivity. The current AXXESS system release supports up to 512 ports and includes such advanced capabilities as primary rate ISDN, integrated call recording, voice prompts in different languages, and a Windows-based attendant's console. The AXXESS 5.0 platform, which is currently scheduled for release in the first half of 1998, is designed to allow, through fully transparent digital networking, two or more systems to operate as one, and to increase capacity to 5,000 ports. AXXESS 5.1, currently scheduled for release in the second half of 1998, is designed to increase capacity to 20,000 ports. The system incorporates fully-digital processing and transmission to the desktop and open architecture interfaces which allow the system to be integrated with and controlled by attached computers such as PCs and workstations. The system incorporates object-oriented C++ software developed by the Company, which facilitates upgrades and the incorporation of additional features and functionality. AXXESS system telephones incorporate user-friendly, 6-by-16 character LCD displays with menu keys that permit the user to select from multiple menu choices or access additional menu screens. AXXESSORY Talk, permits push-button selection of voice processing commands to appear on the telephone's LCD display, as well as voice-prompted selections through the telephone keypad. The AXXESS system is multi-lingual, currently offering English or Japanese voice prompts and LCD displays and allowing the user to switch from one language to the other. Spanish is scheduled for controlled product introduction in the second quarter of 1998. Additional languages can be added in the future. The open architecture interface permits tight integration with a PC or workstation system bus, using several industry-standard interfaces to provide efficient access to voice processing and other applications on the PC or workstation. Applications include database look-up (which utilizes Caller-ID information to retrieve customer information automatically from a computerized database), automated attendant, interactive voice response, automatic call distribution (which queues and prioritizes incoming calls), and call accounting (which permits the monitoring of telephone usage and toll cost). The AXXESS system is managed through a Microsoft Windows-based graphical user interface on a PC to facilitate installation, system configuration and programming. The AXXESS system utilizes advanced software to configure and utilize real-time digital signal processor semiconductor components ("DSPs") incorporated into the system hardware. The use of DSPs and related software lowers system costs, permits higher functionality and increases system flexibility. For example, DSPs can be configured by the system manager for different combinations of speakerphones, conference capabilities and other DSP-based facilities. The system's speakerphones incorporate full-duplex technology, which permits speakerphones to transmit in both directions at the same time without the necessity to override one speaker's voice to prevent feedback interference. 6 The AXXESS software is written in a high-level, object-oriented language which can operate on many commonly used processors. Accordingly, the software can be readily ported to other hardware platforms. The Company intends to port the AXXESS software to faster microprocessors which will permit the AXXESS to grow to a much larger size, in order to enhance the functionality and performance of these larger systems and to permit a migration path from the smaller AXXESS system as a customer's system requirements increase. Inter-Tel Axxent. Small businesses are demanding advanced telephony applications formerly within reach of only large corporations. The Inter-Tel Axxent is designed to bring many of the advanced features and functionality of the AXXESS system to smaller installations on a cost-effective basis while enabling users to migrate to an AXXESS system as their telecommunications needs evolve. The Inter-Tel Axxent supports 24 lines and 12 trunks and provides capabilities such as computer telephone integration, DSP technology, real-time ACD reporting, and integrated voice processing. Housed in a compact, PC-type mid-tower chassis, the Inter-Tel Axxent platform also offers the convenience of a default database so the system is fully operational as soon as it is plugged in. Basic database programming can also be performed through the digital telephone terminals. IP Network Gateway and Inter-Tel.net Network Gateway products are designed as transition points between two different network types, such as between the public circuit switched telephone network and a packet switched IP network such as the Internet. Gateway products convert regular voice transmissions to or from the compressed data packets that travel over packetized networks. In September 1997, the Company released Inter-Tel Vocal'Net, a stand-alone IP network telephony solution available for use with the AXXESS system or other traditional telephone systems equipped with T-1/E-1, ISDN or analog capability. It provides a gateway for bridging the telephone network and a company's intranet or the Internet. With the Inter-Tel Vocal'Net gateway, users can conduct real-time, two-way voice communications over the Internet and realize potential savings compared to standard long distance telephone service. Designed to meet the needs of most businesses, the Inter-Tel Vocal'Net gateway is available in multiple port sizes. Inter-Tel Vocal'Net does not require customized telephone sets or specialized software or cards in each desktop computer. Further, Inter-Tel Vocal'Net does not rely on the central processing unit of the computer for the compression or packetization of information, but instead uses high speed DSPs, enabling the server to handle additional functions such as unified messaging. A caller can dial from a standard telephone to the Inter-Tel Vocal'Net gateway, which connects the call from the circuit switched telephone network, converts it into the compressed, digitized data packets used by an IP network, and routes the call via the IP network to another Inter-Tel Vocal'Net gateway. The second gateway connects with the regular telephone system and dials the final destination. When used in a corporate environment, Inter-Tel Vocal'Net can be attached to a T-1/E-1, ISDN or analog trunk interface on the PBX, and the PBX's Automatic Route Selection or Least Cost Routing features will be programmed to automatically route calls for other locations that have Inter-Tel Vocal'Net Servers through that trunk interface. When phone users wish to place a call, they simply dial the desired telephone number like any other call. The PBX will route the call to Inter-Tel Vocal'Net, which converts it into the compressed, digitized data packets used by an IP network, and routes the call via the IP network to another Inter-Tel Vocal'Net gateway. The second gateway connects with the far-end PBX and dials either the extension number of the desired party or accesses a trunk on the PBX and makes a call into the switched network. 7 Because IP network telephony converts all transmissions to the same type of packets, both voice and data can use the same data circuits, thereby increasing efficiency and maximizing the use of bandwidth. Bandwidth utilization can be maximized to a point that some users may be able to reduce the overall number of circuits needed. In its initial commercial release, Inter-Tel Vocal'Net is designed to work with business telephone systems that operate over T-1/E-1, ISDN and analog lines, and to handle up to 24 simultaneous calls per server. Inter-Tel Vocal'Net servers can also be networked to operate seamlessly in configurations consisting of thousands of ports. The Company is currently developing additional enhancements, including industry standard compatibility (H.323) for integration with PC-based software applications and other types of gateways as well as a fax gateway to provide fax and broadcast fax capabilities across the Internet. Other planned enhancements to the Inter-Tel Vocal'Net include functionality designed to allow businesses to create virtual offices, enabling traveling or off-site employees to connect to the main office from remote locations. Another planned application is "Touch-To-Talk" telephony-enabled web pages, which will allow users to press a link on a web page and to automatically connect over an IP network to talk to customer service agents. In addition to the Vocal'Net Gateway Server, Inter-Tel has developed the Inter-Tel Vocal'Net Service Provider and Centralized Accounting System which provides a centralized pre-paid and post-paid billing system for IP Telephony service providers. This system provides back-office support necessary to run an IP Telephony service business. Future planned enhancements to the Service Provider and Centralized Accounting System include the integration of an H.323 Gatekeeper to allow the system to provide pre-paid and post-paid billing services for compatible H.323 gateways, routers, or software clients. Utilizing Inter-Tel Vocal'Net technology, Inter-Tel continues to develop and expand Inter-Tel.net, a private IP network designed to carry long distance telephone traffic at rates typically lower than traditional long distance providers. Inter-Tel.net is currently being used by the Company's employees for calls between Inter-Tel.net's seven points of presence: the San Francisco Bay Area, Washington D.C., Chicago, Reno, New York, Phoenix and Los Angeles. In its initial commercial release, the Inter-Tel Vocal'Net gateway supports calls placed from telephone to telephone. Later releases are planned to support communications from telephone to computer, computer to telephone, computer to computer and a facsimile machine to facsimile machine. See "Factors That May Affect Future Operating Results--Developing Market for IP Network Telephony; Uncertain Regulatory Environment," "--Risks Associated with Inter-Tel Vocal'Net; Dependence upon IP Network Infrastructures; Risk of System Failure; Security Risks" and "--Development and Maintenance of Inter-Tel.net Network." Computer-Telephone Integration Through CTI, the computer and the telephone are linked into one environment. Inter-Tel's AXXESSORY Connect software for the AXXESS system enables users to receive phone calls through their desktop PC. Using Caller I.D., a caller's information can be retrieved from the company's database even before the call is accepted. On an individual desktop or a company-wide network basis, Inter-Tel offers a variety of products, such as AXXESSORY ACD, that can manage automatic call distribution at peak efficiency or route incoming telephone calls, based on various parameters, to a specific person. It can also collect, analyze and report real-time call processing information for staff forecasting and analysis. Inter-Tel's software applications integrate, through the use of Novell's TSAPI and Microsoft's TAPI standard interfaces, with other "off-the-shelf" Windows applications such as personal information managers, call routing or call management software that can further enhance customer service while increasing call efficiency and employee productivity. Inter-Tel has formed relationships 8 with a number of third party software developers to integrate with their existing applications to create a working environment for database, personal organizer, or terminal emulation programs. If these "off-the-shelf" applications do not adequately meet the needs of a customer, the open design of Inter-Tel's software enables independent software developers to write custom applications through Inter-Tel's Developer's Program. Alternatively, Inter-Tel's CTI Solutions Group can provide professional consulting services or development of individual customer applications, for either desktop or local area network ("LAN")-based applications. Unified Messaging and Voice Processing Software Inter-Tel's unified messaging software, Visual Mail, works in conjunction with a variety of messaging platforms, including the Microsoft Exchange messaging application, Lotus Notes, Lotus cc:Mail, Novell's GroupWise and Internet mail applications such as Qualcomm's Eudora. Visual Mail integrates all types of messages into a single-user interface on a PC, supports both voice mail and facsimile mail and provides another means for improving workplace productivity and retrieving messages from a PC connected to a modem. Inter-Tel's AXXESSORY Talk, Axxent Talk and IVX500 are voice processing platforms that work with Inter-Tel's communication platforms. All three applications use the Multi-Vendor Interface Protocol ("MVIP"), an industry standard for connecting multi-vendor PC-based boards in voice processing, data switching and video systems. Other Services and Products Networking Technologies Integration. To develop a solid foundation for state-of-the-art data and telecommunications networking, customers require strategic network expertise from their networking provider. Inter-Tel designs, installs and supports the complete integration of a customer's complex data and telecommunications network, from land-based LANs to geographically dispersed wide area networks ("WANs"). By forming relationships with major manufacturers of hardware and software technologies, Inter-Tel provides the routers, ATM, LAN and WAN switches, file servers, intelligent hubs and any other device required for the customer's intranet or for usage of the Internet. Pre-sale design support, project coordination for implementation, and installation support are offered on the full line of Inter-Tel server-based telephony products and services. Network and Long Distance Services. The Company, through its Inter-Tel NetSolutions, Inc. subsidiary, resells a variety of long distance calling services, including domestic and international calling services, 800 calling services, dedicated services, voice and video conferencing, customized billing and a variety of other telecommunication services. The Company believes that certain of its customers desire the convenience of acquiring long distance calling services through the same vendor that the customer uses to purchase its other telephony equipment and services. The Company currently resells long distance services pursuant to contracts with four of the six largest U.S. long distance carriers. There can be no assurance that the Company will meet its minimum use commitments, will be able to negotiate lower rates with carriers in the event of any decrease in end user rates or will be able to extend its contracts with long distance carriers on prices favorable to the Company. Call centers using T-1 access for incoming toll-free traffic, sales offices using NetSolutions' switched long distance or companies linking multiple offices throughout the country on a frame relay network are examples of the applications currently supported by Inter-Tel NetSolutions. 9 Leasing Services. The Company offers its Totalease program through its Inter-Tel Leasing, Inc. subsidiary. Totalease enables an end user to acquire a full range of telephony systems, applications, maintenance and support services, as well as lease financing, from a single vendor. The Totalease contract provides a total system solution to the customer at a set monthly cost, with system expansion available at predictable additional fees. The typical Totalease contract has a term of 60 months, with the customer entitled to renew the contract at a specified price for up to an additional 36 months. Inter-Tel also offers a line of low cost lease purchase financing. Lease terms range from 24 to 84 months with $1.00, fixed and fair market value purchase options. In addition, Inter-Tel will customize financing packages to suit customers with special financial needs. By offering this type of financing to acquire Inter-Tel products and services, the customer is able to lease directly from the manufacturer and Inter-Tel, or the Inter-Tel dealer, is able to maintain a close customer relationship. Other Products. Inter-Tel also distributes other leading telecommunications products from its Factored Products Division through its direct sales offices, dealers and VARs. Factored Products represents products that Inter-Tel has endorsed as leading communications peripherals utilized in many day-to-day functions. Businesses require telecommunications products to provide increased productivity, ease of operations and reliability. Many of these products interface with Inter-Tel telephone systems. Inter-Tel's product selection consists of videoconferencing, battery backup, headsets, surge protection, paging equipment, wireless communications and data multiplexers. Sales and Distribution The Company has developed a distribution network of direct sales offices, dealers and VARs which market the Company's products to small to medium size organizations and divisions or departments of larger organizations. In the United States, the Company has 30 direct sales offices and a network of hundreds of dealers who purchase systems directly from the Company. Direct dealers are typically located in geographic areas in which the Company does not maintain direct sales offices. The Company also distributes its products through VARs. These resellers have traditionally sold complex data solutions to customers, and the Company is seeking to leverage this distribution network to capitalize on the merging of the computer and telephony industries. The Company maintains a dealer support office and direct sales office in the United Kingdom and has a network of dealers in the United Kingdom and Europe. In addition, the Company maintains a dealer support office and direct sales office in Japan. The Company believes that its success depends in part upon the strength of its distribution channels and the ability of the Company to maintain close access to its end user customers. In recent periods, the Company has sought to improve its access to end user customers by effecting strategic acquisitions of resellers of telephony products and services in markets in which the Company has existing direct sales offices and in other strategic markets. The Company has expanded its direct sales office personnel from a total of 374 persons at December 31, 1993 to a total of 822 at December 31, 1997. The Company's sales through its direct sales offices as a percentage of total sales have decreased from 66.4% of net sales in 1994 to 56.7% of net sales in 1997. Sales to distributors, dealers, and VARs have increased from 24.5% of net sales in 1994 to 28.0% of net sales in 1997. Sales through the Company's long distance and network services operation have increased from 3.4% of net sales in 1994 to 8.1% of net sales in 1997. Direct dealers and VARs typically enter into non-exclusive reseller contracts for a term of one or more years. The Company generally provides support and other services to the reseller pursuant to the terms of the agreement. The agreements often include requirements that the reseller meet or use its best efforts to meet minimum annual purchase quotas. The Company faces intense 10 competition from other telephone system and voice processing system manufacturers for its dealers' attention, as most of the Company's dealers carry products which compete with the Company's products. There can be no assurance that any such dealer will not promote the products of the Company's competitors to the detriment of the Company's products. The loss of any significant dealer or group of dealers, or any event or condition adversely affecting the Company's dealer network, could have a material adverse effect on the Company's business, financial condition and operating results. See "Factors That May Affect Future Operating Results--Reliance on Dealer Network." International sales, which to date have been made through the Company's United Kingdom and Japan subsidiaries, accounted for approximately 2.3%, of net sales in 1997. In order to sell its products to customers in other countries, the Company must comply with local telecommunications standards. The Company's AXXESS system can be readily altered through software modifications, which the Company believes will facilitate compliance with these local regulations. In addition, the AXXESS system has been designed to support multi-lingual functionality, and currently supports English and Japanese. The Company is presently establishing dealer networks in Japan and other parts of Asia and is working to expand its dealer network in the United Kingdom and Europe. International sales are subject to a number of risks, including changes in foreign government regulations and telecommunications standards, export license requirements, tariffs and taxes, other trade barriers, fluctuations in currency exchange rates, difficulty in collecting accounts receivable, difficulty in staffing and managing foreign operations and political and economic instability. Fluctuations in currency exchange rates could cause the Company's products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. In addition, the costs associated with developing international sales may not be offset by increased sales in the short term, or at all. Customer Service and Support The Company believes that customer service and support are critical components of customer satisfaction and the success of the Company's business. The Company operates a technical support hotline to provide a range of telephone support to its distributors, dealers and end user customers through a toll-free number. The Company also provides on-site customer support and, through remote diagnostic procedures, has the ability to detect and correct system problems from its technical support facilities. Information taken from customer call records allows feedback into Inter-Tel's Quality First continuous improvement process, thus providing a road map for continuous product and service enhancements. Each direct sales office is given a periodic service activity report summarizing the reasons that technicians are asking for assistance and common issues that give rise to technical inquiries. This allows them to analyze trends in their service operations and provide better customer service. Research and Development The Company believes that its ability to enhance its current products, develop and introduce new products on a timely basis, maintain technological competitiveness and meet customer requirements are essential to the Company's success. The Company's research and development efforts over the last several years have been focused primarily on development of and enhancements to the existing AXXESS and AXXESSORY Talk systems with additional applications, capacity and features, developing a unified messaging software application, developing a telecommunications networking package, and developing new products like the Inter-Tel Vocal'Net Server. Current efforts are related to support the development and enhancement of IP telephony products like the Inter-Tel Vocal'Net Gateway Server, the Vocal'Net Service Provider Package, the support of H.323 on both the gateway and service provider products, development of additional applications and features 11 of the AXXESS and AXXESSORY Talk communications products. The software-based architecture of the AXXESS system facilitates maintenance and support, upgrades, and incorporation of additional features and functionality. The Company had a total of 97 personnel engaged in research and development as of December 31, 1997. Research and development expenses were $7,998,000; $6,581,000 and $5,764,000 for 1997, 1996, and 1995, respectively. Manufacturing The Company manufactures substantially all of its systems through third party subcontractors located in the United States, China and the Philippines. These subcontractors use both standard and proprietary integrated circuits and other electronic devices and components to produce telephone switches, telephones and printed circuit boards to the Company's engineering specifications and designs. The suppliers also inspect and test the equipment before delivering them to the Company, which in some cases then performs systems integration, software loading, final testing and shipment. Varian, a multinational electronic company, currently manufacturers a significant portion of the Company's products, including substantially all of the printed circuit boards used in the AXXESS and Inter-Tel Axxent systems, at Varian's Tempe, Arizona facility. If Varian or any of the Company's other manufacturers were unable or unwilling to manufacture the Company's products in the future, the Company could experience substantial delays in finding alternative sources, which could have a material adverse effect on the Company's business and operating results. The Company maintains written agreements with its principal suppliers. The Company provides a forecast schedule to its suppliers and revises the forecast on a periodic basis. Foreign manufacturing facilities are subject to changes in governmental policies, imposition of tariffs and import restrictions, and other factors beyond the Company's control. Certain of the microprocessors, integrated circuits and voice processing interface cards used in the Company's systems are currently available from a single or limited sources of supply. From time to time, the Company experiences delays in the supply of components and finished goods. Delay or lack of supply from existing sources or the inability to develop alternative sources if and when required in the future could materially and adversely affect operating results. See "Risk Factors--Dependence on Contract Manufacturers and Component Suppliers." Quality The Company believes that the quality of its systems, customer service and support, and other aspects of its organization is a critical element of meeting the needs of its customers. Through its Quality First continuous improvement process initiated in 1991, Inter-Tel implements quality processes throughout its business operations. The Company has established formal procedures to ensure responsiveness to customer requests, to monitor response times and to measure customer satisfaction. The Company has also established means by which all end users, including customers of the Company's resellers, can make product enhancement requests directly to the Company. The Company supports its dealers and VARs through an extensive training program at the Company's facility and at dealer sites, a toll-free telephone number for sales and technical support, and the provision of end user marketing materials. The Company typically provides a one year warranty on its systems to end users. In manufacturing, the Company continuously monitors the quality of the products produced on its behalf by the Company's manufacturing subcontractors, and is extending the Company's Quality First continuous improvement process to its suppliers. 12 Competition The market for the Company's products is highly competitive and in recent periods has been characterized by pricing pressures and business consolidations. The Company's competitors include Lucent Technologies, Inc. ("Lucent") and Northern Telecom Limited ("NorTel"), as well as Comdial Corporation ("Comdial"), EXECUTONE Information Systems, Inc. ("Executone"), Iwatsu America, Inc. ("Iwatsu"), Mitel Corporation ("Mitel"), NEC Corporation ("NEC"), Nitsuko Corporation ("Nitsuko"), Matsushita Electric Industrial Co., Ltd. ("Panasonic"), Siemens Rolm Communications, Inc. ("Siemens"), Toshiba America, Inc. ("Toshiba") and others. Many of these competitors have significantly greater financial, marketing and technical resources than the Company. The Company also competes against the regional Bell operating companies ("RBOCs"), which offer systems produced by one or more of the aforementioned competitors and also offer Centrex systems in which automatic calling facilities are provided through equipment located in the telephone company's central office. The Telecommunications Act of 1996 (the "Telecommunications Act") and AT&T Corporation's ("AT&T") announcement to divide itself into three enterprises has had an impact on competition in the communications industry. The Telecommunications Act opened the market for telephone and cable television services, forcing telephone companies to open their networks to competitors and giving consumers a choice of local phone carriers. Conversely, local phone companies are now able to offer long distance services. In addition, cable television companies can offer telephone services and Internet access. These changes have increased competition in the communications industry and have created additional competition and opportunities in customer premise equipment, as these new services and interfaces have become available. In the market for voice processing applications, including voice mail, the Company competes against Applied Voice Technology, Inc. ("AVT"), Active Voice Corporation ("Active Voice"), Centigram Communications Corporation ("Centigram"), Lucent and other competitors, certain of which have significantly greater resources than the Company. In the market for long distance services, the Company competes against AT&T, MCI Communication Corporation, Sprint Corporation, Qwest Communications Corporation and other competitors, many of which have significantly greater resources than the Company. The Company also expects to compete with RBOCs, cable television companies, satellite and other wireless broadband service providers and others for long distance business as those companies gradually respond to the Telecommunications Act. Key competitive factors in the sale of telephone systems and related applications include price, performance, features, reliability, service and support, name recognition and distribution capability. The Company believes that it competes favorably in its markets with respect to the price, performance and features of its systems, as well as the level of service and support that the Company provides to its customers. Certain of the Company's competitors have significantly greater name recognition and distribution capabilities than the Company. The Company expects that competition will continue to be intense in the markets addressed by the Company, and there can be no assurance that the Company will be able to continue to compete successfully. In the market for IP telephony products, the Company competes against existing IP telephony gateway providers such as Lucent, NetSpeak Corporation, VocalTec Communications Ltd., Vienna Systems Corporation and others. Several of these competitors have been active in developing and marketing IP telephony products for a greater period of time than the Company and have already established relationships with customers within their market. In addition, the Company could face significant competition from vendors such as Cisco Systems, Inc., Bay Networks, Inc., 3Com Corporation, Motorola, Inc. and MICOM Communications Corp., should such established data vendors choose to enter the market for IP telephony products. Such companies currently produce products that, if equipped with voice capabilities, could represent a considerable threat to the Company within that market. Moreover, should the market for IP telephony 13 products become fully developed or develop at a rapid rate, large companies such as IBM Corporation ("IBM") and Microsoft Corporation ("Microsoft") could choose to develop proprietary software designed to facilitate voice communication over an IP network. As the Company enters the markets for local telephone service and IP network access, it will face additional competition from RBOCs and other providers, which have larger marketing and sales organizations, significantly greater financial and technical resources and a larger and more established customer base than the Company. In addition, RBOCs and other providers have greater name recognition, more established positions in the market and long standing relationships with customers. Therefore, there can be no assurance that the Company will compete successfully in these markets. Intellectual Property Rights The Company's future success will depend in part upon its proprietary technology. Although the Company has applied to the U.S. Patent and Trademark Office for a patent related to certain aspects of the Inter-Tel Vocal'Net technology, the Company currently has no issued patents and relies principally on copyright and trade secret law and contractual provisions to protect its intellectual property. There can be no assurance that any patent, trademark or copyright owned by the Company will not be invalidated, circumvented or challenged or that the rights granted thereunder will provide meaningful protection or any commercial competitive advantage to the Company. Further, there can be no assurance that others will not develop technologies that are similar or superior to the Company's technology or that duplicate the Company's technology. As the Company expands its international operations, effective intellectual property protection may be unavailable or limited in certain foreign countries. There can be no assurance that the steps taken by the Company will prevent misappropriation of its technology. Litigation may be necessary in the future to enforce the Company's intellectual property rights, to protect the Company's trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the Company's business and operating results. From time to time, the Company is subject to proceedings alleging infringement by the Company of intellectual property rights of others. If any such claim is asserted against the Company, the Company may seek to obtain a license under the third party's intellectual property rights. There can be no assurance that a license will be available on terms acceptable to the Company or at all. In the alternative, the Company could resort to litigation to challenge any such claim. Any such litigation could require the Company to expend significant sums and could require the Company to pay significant damages, develop non-infringing technology or acquire licenses to the technology which is the subject of the asserted infringement, any of which could have a material adverse effect on the Company's business and operating results. In the event that the Company is unable or chooses not to license such technology or decides not to challenge such third party's rights, the Company could encounter substantial and costly delays in product introductions while attempting to design around such third party rights, or could find that the development, manufacture or sale of products requiring such licenses could be foreclosed. Employees As of December 31, 1997, the Company had a total of 1,248 employees, of whom 1,029 were engaged in sales, marketing and customer support, 47 in quality, manufacturing and related operations, 97 in research and development, and 75 in finance and administration. The Company's future success will depend upon its ability to attract, retain and motivate highly qualified employees, who are in great demand. The Company believes that its employee relations are excellent. 14 Factors That May Affect Results of Future Operations Rapid Technological Change; Dependence On Recently Introduced Products The market for the Company's software, products and services is characterized by rapid technological change and continuing demand for new products, features and applications. Current competitors or new market entrants may develop new products or product features that could adversely affect the competitive position of the Company's products. Accordingly, the timely introduction of new products and product features, as well as new telecommunications applications, will be key factors in the Company's future success. During the past eighteen months, the Company introduced unified messaging on its AXXESSORY Talk platform, developed a number of enhancements to its existing AXXESS and AXXESSORY Talk platforms and introduced Inter-Tel Vocal'Net. The Company is also currently in the later stages of developing the AXXESS 5.0 platform, which is a significant software upgrade and enhancement to its AXXESS and AXXESSORY Talk platforms. The Company's future success will depend, in large part, upon the timely and successful introduction of the AXXESS 5.0 platform. The Company's future success will also depend upon market acceptance of the Company's other new products or enhancements, including Inter-Tel Vocal'Net. There can be no assurance that these introduced products and enhancements will be successful. In the event that the Company were to fail to successfully introduce new software, products or services or upgrades to its existing systems or products on a regular and timely basis, demand for the Company's existing software, products and services could decline, which could have a material adverse effect on the Company's business and operating results. Further, if the markets for IP network products or CTI applications fail to develop or grow more slowly than the Company anticipates, or if the Company is unable for any reason to capitalize on either of these emerging market opportunities, the Company's business, financial condition and results of operations could be materially adversely affected. Occasionally, new products contain undetected program errors or "bugs" when released. Such bugs may result from defects contained in software products offered by the Company's suppliers or other third parties that are intended to be compatible with the Company's products, over which the Company has little or no control. Although the Company seeks to minimize the number of bugs in its products by its test procedures and quality control, there can be no assurance that its new products will be error free when introduced. Any significant delay in the commercial introduction of the Company's products due to bugs, any design modifications required to correct bugs or any impairment of customer satisfaction as a result of bugs could have a material adverse effect on the Company's business and operating results. In addition, new products often take several months before their manufacturing costs stabilize, which may adversely affect operating results for a period of time following introduction. Developing Market for IP Network Telephony; Uncertain Regulatory Environment The market for IP network voice communications products has only recently begun to develop, is rapidly evolving 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 in the case of a new and rapidly evolving industry, the demand for and market acceptance of recently introduced IP network products and services are subject to a high degree of uncertainty. There can be no assurance that voice communications over IP networks will become widespread. Further, even if voice communications over IP networks achieve broad market acceptance, there can be no assurance that the Company's products, in particular Inter-Tel Vocal'Net, will achieve market acceptance. The adoption of voice communications over IP networks generally requires the acceptance of a new way of exchanging information. In particular, enterprises that have already invested 15 substantial resources in other means of communicating information may be reluctant or slow to adopt a new approach to communications. The lack of control over IP network infrastructure and each user's system configuration may cause users of IP network voice communications delays in the transmission of speech, loss of voice packets and inferior sound quality relative to standard telephony networks. If these factors cause the market for IP network voice communications to fail to develop or to develop more slowly than the Company anticipates, the Company's IP network telephony products could fail to achieve market acceptance, which in turn could have a material adverse effect on the Company's business, financial condition and results of operations. The regulatory environment for IP network telephony is subject to substantial uncertainty. There can be no assurance that the sale and use of IP network telephony products such as Inter-Tel Vocal'Net will not violate telecommunications or other regulations in any of the countries in which such products are or will be marketed and used. In the United States, the Company believes that there are currently few laws or regulations directly applicable to voice communications over IP networks or to access to, or commerce on, IP networks generally. However, changes in the regulatory environment, particularly in regulations relating to the telecommunications industry, could have a material adverse effect on the Company's business. The increased commercial acceptance of voice communications over IP networks could result in intervention by governmental regulatory agencies in the United States or elsewhere in the world under existing or newly enacted legislation and in the imposition of fees, charges or taxes on users and providers of products and services in this area. There can be no assurance that such intervention or imposition of fees, charges or taxes would not have a material adverse effect upon the acceptance and attractiveness of IP network voice communications. Moreover, legislative proposals from international, federal and state government bodies could impose additional regulations and obligations upon on-line service providers. The growing popularity and use of the Internet has increased public focus and could lead to increased pressure on legislatures to impose such regulations. The Company cannot predict the likelihood that any future legislation or regulation will be enacted, nor the financial impact, if any, of such resulting legislation or regulation. In the future, the Company may also develop and introduce other products with new or additional telecommunications capabilities or services, which could be subject to existing federal government regulations or result in the imposition of new government regulations, either in the United States or elsewhere. Risks Associated with Inter-Tel Vocal'Net; Dependence Upon IP Network Infrastructures; Risk of System Failure; Security Risks In September 1997, the Company began commercial shipment of Inter-Tel Vocal'Net, its stand-alone IP telephony gateway product and, to date, revenues from the sale of this product have not been significant. To achieve market acceptance, Inter-Tel Vocal'Net will be required to demonstrate its functionality, scalability and reliability, of which there can be no assurance. In addition, there can be no assurance that Inter-Tel Vocal'Net will comply with industry standards or that industry standards will not change and render Inter-Tel Vocal'Net obsolete. In the event that Inter-Tel Vocal'Net fails to achieve market acceptance, the Company's business, financial condition and results of operations could be materially and adversely affected. The success of Inter-Tel Vocal'Net will also depend upon, among other things, the continued expansion of the Internet and other IP networks and their network infrastructures. There can be no assurance that the infrastructure or complementary products necessary to make the Internet a viable commercial network will continue to be developed. In addition, there can be no assurance that IP networks will retain their current volume, distance and time-of-day-independent pricing structure, or that the costs of access to IP networks, lack of capacity or poor voice transmission quality of IP networks will not adversely affect the market for IP network products and services. Moreover, critical issues concerning the commercial use of the Internet (including security, reliability, cost, ease of use and access and quality of service) remain unresolved and may affect the growth of IP network use. 16 There can be no assurance that the Internet will be able to meet additional demand or its users' changing requirements on a timely basis, at a commercially reasonable cost, or at all. The Inter-Tel Vocal'Net gateway can 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. Further, inappropriate use of the Internet or other IP networks by third parties could potentially jeopardize the security of confidential information, such as credit card or bank account information or the content of conversations over the IP network, which may deter certain persons from ordering and using the Company's products. Until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential users may inhibit the growth of IP networks in general and the market for the Company's IP network products in particular. Development and Maintenance of Inter-Tel.net Network The Company is currently utilizing its Inter-Tel Vocal'Net technology to develop and expand its own IP network, Inter-Tel.net, to carry telephone traffic. The Inter-Tel.net network is in its initial stages of deployment and, accordingly, is subject to a high degree of risk. To date, the Inter-Tel.net network has established points of presence in the San Francisco Bay Area, Washington, D.C., Chicago, New York, Phoenix, Reno and Los Angeles. If the market for IP network products fails to develop or develops more slowly than the Company anticipates, the Company's Inter-Tel.net network could become financially burdensome to maintain or obsolete, either of which could materially and adversely affect the Company's business, financial condition and results of operations. The Company is dependent on third-party suppliers of telecommunications and Internet network transmission services for implementation of Inter-Tel.net and does not currently have long-term contracts with such suppliers. The Company's ability to expand Inter-Tel.net is dependent upon its ability to obtain services from such suppliers. Certain of these third party suppliers are or may become competitors of the Company, and such suppliers generally are not subject to restrictions upon their ability to compete with the Company. To the extent that any of these suppliers raise their rates or change their pricing structure, the Company may be materially adversely affected. Also, the Company faces the risk that there will be a disruption in the service provided by these suppliers, and can give no assurance that there will not be a significant disruption in such service in the future, thereby causing a disruption in the services provided by the Company to its customers. Moreover, although the Company has devoted, and intends to continue to devote, substantial resources to improve the quality of telephone conversations using Inter-Tel Vocal'Net and the Inter-Tel.net network, there can be no assurance that the problems of voice communications over the Inter-Tel.net network that exist today, including delays in the transmission of speech, loss of voice packets and sound quality inferior to that of standard telephony networks, will be eliminated or reduced. In the event that the Company is unable to improve upon the sound quality and other limitations of voice communications over the Inter-Tel.net network and to offer such improvements to its customers on a cost-effective basis, the Inter-Tel.net network could fail to achieve market acceptance, and the Company's business, financial condition and results of operations could be materially and adversely affected. Highly Competitive Industry The market for the Company's products is highly competitive and in recent periods has been characterized by pricing pressures and business consolidations. The Company's competitors include Lucent and NorTel, as well as Comdial, Executone, Iwatsu, Mitel, NEC, Nitsuko, Panasonic, Siemens, Toshiba and others. Many of these competitors have significantly greater financial, marketing and technical resources than the Company. The Company also competes against the RBOCs, which offer systems produced by one or more of the aforementioned competitors and also 17 offer Centrex systems in which automatic calling facilities are provided through equipment located in the telephone company's central office. The Telecommunications Act and AT&T's announcement to divide itself into three enterprises has had an impact on competition in the communications industry. The Telecommunications Act opened the market for telephone and cable television services, forcing telephone companies to open their networks to competitors and giving consumers a choice of local phone carriers. Conversely, local phone companies are now able to offer long distance services. In addition, cable companies can offer telephone services and Internet access. These changes have increased competition in the communications industry and have created additional competition and opportunities in customer premise equipment, as these new services and interfaces have become available. In the market for voice processing applications, including voice mail, the Company competes against AVT, Active Voice, Centigram, Lucent and other competitors, certain of which have significantly greater resources than the Company. In the market for long distance services, the Company competes against AT&T, MCI, Sprint Corporation, Qwest Communications Corporation and other competitors, many of which have significantly greater resources than the Company. The Company will also compete with RBOCs, cable television companies, satellite and other wireless broadband service providers, and others for long distance business as those companies gradually respond to the Telecommunications Act. Key competitive factors in the sale of telephone systems and related applications include price, performance, features, reliability, service and support, name recognition and distribution capability. The Company believes that it competes favorably in its markets with respect to the price, performance and features of its systems, as well as the level of service and support that the Company provides to its customers. Certain of the Company's competitors have significantly greater name recognition and distribution capabilities than the Company, although the Company believes that it has developed a competitive distribution presence in certain markets, particularly those where the Company has direct sales offices. The Company expects that competition will continue to be intense in the markets addressed by the Company, and there can be no assurance that the Company will be able to continue to compete successfully. In the market for IP telephony products, the Company competes against existing IP telephony gateway providers such as Lucent, NetSpeak Corporation, VocalTec Communications Ltd., Vienna Systems Corporation and others. Several of these competitors have been active in developing and marketing IP telephony products for a greater period of time than the Company and have already established relationships with customers within their market. In addition, the Company could face significant competition from vendors such as Cisco Systems, Inc., Bay Networks, Inc., 3Com Corporation, Motorola, Inc. and MICOM Communications Corp., should such established data vendors choose to enter the market for IP telephony products. Such companies currently produce products that, if equipped with voice capabilities, could represent a considerable threat to the Company within that market. Moreover, should the market for IP telephony products become fully developed or develop at a rapid rate, large companies such as IBM and Microsoft could choose to develop proprietary software designed to facilitate voice communication over an IP network. As the Company enters the markets for local telephone service and IP network access, it will face additional competition from RBOCs and other providers, which have larger marketing and sales organizations, significantly greater financial and technical resources and a larger and more established customer base than the Company. In addition, RBOCs and other providers have greater name recognition, more established positions in the market and long standing relationships with customers. Therefore, there can be no assurance that the Company will compete successfully in these markets. Many of the Company's current and potential competitors have longer operating histories, are substantially larger, and have greater financial, manufacturing, marketing, technical and other resources. A number also have greater name recognition and a larger installed base of products than the Company. Competition in the Company's markets may result in significant price 18 reductions. As a result of their greater resources, many current and potential competitors may be better able than the Company to initiate and withstand significant price competition or downturns in the economy. There can be no assurance that the Company will be able to continue to compete effectively, and any failure to do so would have a material adverse effect on the Company's business, financial condition and operating results. Management of Growth; Implementation of New Management Information Systems The growth in the Company's business has placed, and is expected to continue to place, a significant strain on the Company's personnel, management and other resources. The Company's ability to manage any future growth effectively will require it to attract, train, motivate and manage new employees successfully, to integrate new employees into its overall operations and to continue to improve its operational, financial and management information systems. The Company implemented a new MIS system late in 1995. The MIS system significantly affected many aspects of the Company's business, including its accounting, operations, purchasing, sales and marketing functions. Following the date of implementation, the Company experienced difficulty with the new MIS software, which increased the Company's costs, had an adverse effect on the Company's ability to provide products and services to its customers on a timely basis and caused delays in coordinating accounting and financial results. During the fourth quarter of 1996, the Company determined that the limitations of the existing system software would prevent Inter-Tel from establishing an integrated and centralized dispatch and telemarketing center. As a result, the Company signed an agreement with a large, established software and database vendor to replace its existing MIS software and implement, maintain and support alternate MIS software to be utilized throughout the Company. Accordingly, during the fourth quarter of 1996, the Company wrote off the software license and implementation costs relating to the system software being replaced. The actions to replace the MIS software could result in additional costs and delays associated with obtaining a fully functional MIS system, including but not limited to the costs of procuring additional or alternate hardware and software required but not available in the current system configuration, and additional personnel. Any such cost or delay could have a material adverse effect on the Company's business, financial condition and operating results. In addition, implementation of this system software and the transition from the current system software to the new information system software will require substantial financial resources, time and personnel. The Company has made strategic acquisitions in the past and expects to continue to do so in the future. Acquisitions require a significant amount of the Company's management attention and financial and operational resources, all of which are limited. The integration of acquired entities may also result in unexpected costs and disruptions and significant fluctuations in, or reduced predictability of, operating results from period to period. There can be no assurance that an acquisition will not adversely affect the business relationships of the Company or the acquired entity with its respective suppliers or customers. Further, there can be no assurance that the Company will be able to successfully integrate any acquired operations or achieve any of the intended benefits of an acquisition. The Company's failure to manage its growth effectively could have a material adverse effect on its business, financial condition and operating results. Dependence Upon Contract Manufacturers and Component Suppliers The Company currently procures certain components used in its digital communication platforms, including certain microprocessors, integrated circuits, power supplies, voice processing interface cards and IP telephony cards from a single source or limited sources of supply and, accordingly, product availability could be limited. As the Company deploys its IP telephony products and the Inter-Tel.net network, the Company expects that it will be required to increasingly rely upon third party software and hardware suppliers. The Company currently manufactures its 19 products through a limited number of contract manufacturers located in the United States, the Philippines and the People's Republic of China. Foreign manufacturing facilities are subject to changes in governmental policies, imposition of tariffs and import restrictions and other factors beyond the Company's control. Varian Associates, Inc. ("Varian") currently manufactures a significant portion of the Company's products at Varian's Tempe, Arizona facility, including substantially all of the printed circuit boards used in the AXXESS and Inter-Tel Axxent digital communication platforms. From time to time, the Company has experienced delays in the supply of components and finished goods, and there can be no assurance that the Company will not experience such delays in the future. The Company's reliance on third party manufacturers involves a number of additional risks, including reduced control over delivery schedules, quality assurance and costs. Any delay in delivery or shortage of supply of components or finished goods from Varian or any other supplier, or the Company's inability to develop in a timely manner alternative or additional sources if and when required, could damage the Company's relationships with current and prospective customers and could materially and adversely affect the Company's business, financial condition and operating results. The Company has no long term agreements with its suppliers that require such suppliers to provide fixed quantities of components or finished goods at set prices. There can be no assurance that the Company will be able to continue to obtain components or finished goods in sufficient quantities or quality or on favorable pricing and delivery terms in the future. Product Protection and Infringement The Company's future success will depend in part upon its proprietary technology. Although the Company has applied to the U.S. Patent and Trademark Office for a patent related to certain aspects of the Inter-Tel Vocal'Net technology, the Company currently has no issued patents and relies principally on copyright and trade secret law and contractual provisions to protect its intellectual property. There can be no assurance that any patent, trademark or copyright owned by the Company will not be invalidated, circumvented or challenged or that the rights granted thereunder will provide meaningful protection or any commercial competitive advantage to the Company. Further, there can be no assurance that others will not develop technologies that are similar or superior to the Company's technology or that duplicate the Company's technology. As the Company expands its international operations, effective intellectual property protection may be unavailable or limited in certain foreign countries. There can be no assurance that the steps taken by the Company will prevent misappropriation of its technology. Litigation may be necessary in the future to enforce the Company's intellectual property rights, to protect the Company's trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the Company's business, financial condition and operating results. From time to time, the Company is subject to proceedings alleging infringement by the Company of intellectual property rights of others. If any such claim is asserted against the Company, the Company may seek to obtain a license under the third party's intellectual property rights. There can be no assurance that a license will be available on terms acceptable to the Company or at all. In the alternative, the Company could resort to litigation to challenge any such claim. Any such litigation could require the Company to expend significant sums, divert management's attention and require the Company to pay significant damages, develop non-infringing technology or acquire licenses to the technology which is the subject of the asserted infringement, any of which could have a material adverse effect on the Company's business, financial condition and operating results. In the event that the Company is unable or chooses not to license such technology or decides not to challenge such third party's rights, the Company could encounter substantial and costly delays in product introductions while attempting to design around such third party rights, or could find that the development, manufacture or sale of products requiring such licenses could be foreclosed. 20 Reliance on Dealer Network A substantial portion of the Company's net sales are made through its network of independent dealers. The Company faces intense competition from other telephone system and voice processing system manufacturers for such dealers' business, as most of the Company's dealers carry products which compete with the Company's products. The Company has no exclusive agreements with any of its dealers. The loss of any significant dealer or group of dealers, or any event or condition adversely affecting the Company's dealer network, could have a material adverse effect on the Company's business, financial condition and operating results. Dependence on Key Personnel The Company is dependent on the continued service of, and its ability to attract and retain, qualified technical, marketing, sales and managerial personnel. The competition for such personnel is intense, and the loss of any of such persons, as well as the failure to recruit additional key technical and sales personnel in a timely manner, would have a material adverse effect on the Company's business and operating results. There can be no assurance that the Company will be able to continue to attract and retain the qualified personnel necessary for the development of its business. Risks of Providing Long Distance and Network Services Inter-Tel depends on its supply of telecommunications services and information from several long distance carriers. Because it does not own transmission facilities, the Company relies on long distance carriers to provide network services to the Company's customers and for billing information. Long distance services are subject to extensive and uncertain governmental regulation on both the federal and state level. There can be no assurance that the promulgation of certain regulations will not materially and adversely affect the Company's business, financial condition and operating results. Contracts with the long distance carriers from which the Company currently resells services typically have a one year term in which the Company's prices are relatively fixed and have minimum use requirements. The market for long distance services is currently experiencing and is expected to experience in the future significant price competition, resulting in decreasing end-user rates. There can be no assurance that the Company will meet minimum use commitments, will be able to negotiate lower rates with carriers in the event of any decrease in end user rates or will be able to extend its contracts with long distance carriers at prices favorable to the Company. The Company's ability to continue to expand its long distance services depends upon its ability to continue to secure reliable long distance services from a number of long distance carriers and the willingness of such carriers to continue to provide telecommunications services and billing information to the Company on favorable terms. Potential Fluctuations In Quarterly Results; Limited Backlog The Company's quarterly operating results depend upon a variety of factors, including the volume and timing of orders received during the quarter, the mix of products sold, mix of distribution channels, general economic conditions, patterns of capital spending by customers, the timing of new product announcements and releases by the Company and its competitors, pricing pressures, the cost and effect of acquisitions, and the availability and cost of products and components from the Company's suppliers. The Company's customers typically require immediate shipment and installation of platforms and software. As a result, the Company has historically operated with a relatively small backlog, and sales and operating results in any quarter are principally dependent on orders booked and shipped in that quarter. Historically, a substantial portion of the Company's 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. Market demand for investment in capital equipment such as digital communication platforms and associated call processing and voice processing software applications is largely dependent on general economic 21 conditions, and can vary significantly as a result of changing conditions in the economy as a whole. The Company's expense levels are based in part on expectations of future sales and, if sales levels do not meet expectations, operating results could be adversely affected. Because sales of digital communication platforms through the Company's dealers produce lower gross margins than sales through the Company's direct sales organization, operating results have varied, and will continue to vary based upon the mix of sales through direct and indirect channels. Although the Company to date has been able to resell the rental streams from leases under its Totalease program profitably and on a substantially current basis, the timing and profitability of lease resales from quarter to quarter could impact operating results, particularly in an environment of fluctuating interest rates. Long distance sales, which have lower gross margins than the Company's core business, have grown in recent periods at a faster rate than the Company's overall net sales. As a result, gross margins could be adversely affected in the event that long distance calling services continue to increase as a percentage of net sales. In addition, the Company is subject to seasonality in its operating results, as net sales for the first and third quarters are frequently less than those experienced, in the fourth and second quarters, respectively. As a result of these and other factors, the Company has in the past experienced, and could in the future experience, fluctuations in sales and operating results on a quarterly basis. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Volatility of Stock Price The market price for the Company's Common Stock has been highly volatile. The Company believes that factors such as announcements of developments relating to the Company's business, fluctuations in the Company's operating results, shortfalls in revenue or earnings relative to securities analysts' expectations, announcements of technological innovations or new products or enhancements by the Company or its competitors, general conditions in the telecommunications industry or the national or worldwide economy, changes in legislation or regulation affecting the telecommunications industry, an outbreak of hostilities, developments in intellectual property rights and developments in the Company's relationships with its customers and suppliers could cause the price of the Company's Common Stock to fluctuate, perhaps substantially. Many of such factors are beyond the Company's control. In addition, in recent years the stock market in general, and the market for shares of technology stocks in particular, have experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies. There can be no assurance that the market price of the Company's Common Stock will not experience significant fluctuations in the future, including fluctuations that are unrelated to the Company's performance. Year 2000 Compliance Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning in the year 2000, these date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than two years, computer systems and/or software used by many companies may need to be upgraded to comply with such "Year 2000" requirements. Significant uncertainty exists in the software industry concerning the potential effects associated with such compliance. The Company has established procedures for evaluating and managing the risks and costs associated with Year 2000 problems for its internal information systems, as well as its software, and, although the Company currently offers software designed to be Year 2000 compliant, there can be no assurance that the Company's software products contain all necessary date code changes necessary to prevent processing errors potentially arising from calculations using the Year 2000 date. The Company has completed an assessment of its internal information systems and believes the current software being implemented will function properly with respect to dates in the Year 2000. The total costs of the new software implementation are being capitalized as the Company has abandoned its current MIS software in favor of a different system. The software is being replaced with 22 an integrated solution from a more established vendor and was not in response to the Year 2000 issue. The Company believes that with conversions to new software, the Year 2000 will not pose significant operational problems for its computer systems, based in part on the vendor's assurance that the software is Year 2000 compliant. The software conversion is estimated to be completed in phases in 1998 and 1999, which is prior to any estimated impact on its operating systems. However, if such conversions are not completed timely, the Year 2000 issue could have a material impact on the operations of the Company. The Company believes that the purchasing patterns of customers and potential customers may be affected by Year 2000 issues in a variety of ways. Many companies are expending significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase software products such as those offered by the Company. Many potential customers may also choose to defer purchasing Year 2000 compliant products until they believe it is absolutely necessary, thus resulting in potentially stalled market sales within the industry. Conversely, Year 2000 issues may cause other companies to accelerate purchases, thereby causing an increase in short-term demand and a consequent decrease in long-term demand for software products. Additionally, Year 2000 issues could cause a significant number of companies, including existing customers of the Company, to reevaluate their current communications platform, IP network telephony or voice processing software needs, and as a result consider switching to other systems or suppliers. Concentration of Ownership As of March 13, 1998, Steven G. Mihaylo, the Company's Chairman of the Board of Directors and Chief Executive Officer beneficially owned approximately 20.0% of the outstanding shares of the Common Stock. As a result, he has the ability to exercise significant influence over matters requiring shareholder approval. In addition, the concentration of ownership could have the effect of delaying or preventing a change in control of the Company. Any of the foregoing could result in a material adverse effect on the Company's business, financial condition and operating results. 23 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Position - ---- --- -------- Steven G. Mihaylo 54 Chairman of the Board of Directors and Chief Executive Officer Thomas C. Parise 43 President and Chief Operating Officer Craig W. Rauchle 42 Executive Vice President Ross McAlpine 46 Sr. Vice President Kurt R. Kneip 35 Chief Financial Officer, Vice President and Secretary J. Robert Anderson 61 Director Gary Edens 56 Director Maurice H. Esperseth 72 Director C. Roland Haden 57 Director Norman Stout 40 Director MR. MIHAYLO, the founder of the Company, has served as Chairman of the Board of Directors of the Company since September 1983 and as Chief Executive Officer of the Company since its formation in July 1969. Mr. Mihaylo served as President of the Company from 1969 to 1983 and from 1984 to December 1994, and as Chairman of the Board of Directors from July 1969 to October 1982. Mr. Mihaylo also is a director of MicroAge, Inc. and Microtest, Inc. MR. PARISE was elected President and Chief Operating Officer of the Company in December 1994. He served as Senior Vice President of the Company from 1986 to 1994. He is also President of Inter-Tel Integrated Services, Inc., a wholly owned research and development, manufacturing and distribution subsidiary of the Company. Mr. Parise joined the Company in 1981 and became Branch General Manager of the Phoenix Direct Sales Office in 1982. In 1983, he became the Mountain Regional Vice President, and in January 1985 he was appointed Vice President of Operations and Sales Support. Mr. Parise also is a director of Globe Business Resources, Inc. MR. RAUCHLE was elected Executive Vice President in December 1994. He had been Senior Vice President of the Company and continues as President of Inter-Tel Technologies, Inc., a wholly owned sales subsidiary of the Company. In addition, he currently serves the Company and all subsidiaries in corporate strategic planning and mergers and acquisitions activities. Mr. Rauchle joined the Company in 1979 as Branch General Manager of the Denver Direct Sales Office and in 1983 was appointed the Central Region Vice President and subsequently the Western Regional Vice President. From 1990 to 1992, Mr. Rauchle served as President of Inter-Tel Communications, Inc. He is also a director of Prologic Management Systems, Inc. MR. MCALPINE was elected Senior Vice President in September 1997. He also has served as President of Inter-Tel Leasing, Inc., a wholly-owned subsidiary of the Company, since April 1993, and President of Inter-Tel.net, Incorporated and Inter-Tel NetSolutions, Inc. since 1997. He also served as Vice President of Inter-Tel Communications, Inc. from April 1991 to April 1992 and Treasurer since April 1992. He joined the Company in July 1991 when Inter-Tel acquired Telecommunications Specialists, Inc. Prior to joining Inter-Tel, Mr. McAlpine worked 17 years in the leasing and financial services industry. Mr. McAlpine holds an undergraduate degree in Accounting from Southwest Texas State University. MR. KNEIP has served as Vice President and Chief Financial Officer of the Company since September 1993. He was elected Secretary and Treasurer in October 1994. In May 1996 he was elected Assistant Treasurer, as John Abbott was elected Treasurer. He joined the Company in May 24 1992 as Director of Corporate Tax, after seven years with the accounting firm of Ernst & Young. Mr. Kneip is a Certified Public Accountant, and holds an undergraduate degree in Commercial Economics from South Dakota State University and a Masters Degree in Professional Accountancy from the University of South Dakota. MR. ANDERSON has been a director of the Company since February 1997. Mr. Anderson held various positions at Ford Motor Company from 1963 to 1983, serving from 1978 to 1983 as President of the Ford Motor Land Development Corporation. He served as Senior Vice President, Chief Financial Officer and a member of the Board of Directors of The Firestone Tire and Rubber Company from 1983 to 1989, and as Vice Chairman of Bridgestone/Firestone, Inc. from 1989 through 1991. He most recently served as Vice Chairman, Chief Financial Officer and a member of the Board of Directors of the Grumman Corporation from 1991 to 1994. Mr. Anderson is currently semi-retired, and he is an active leader in various business, civic and philanthropic organizations. MR. EDENS has been a director of the Company since October 1994. He was a broadcasting media executive from 1970 to 1994, serving as Chairman and Chief Executive Officer of Edens Broadcasting, Inc. from 1984 to 1994, when that corporation's nine radio stations were sold. He is currently President of The Hanover Companies, Inc., an investment firm. He is an active leader in various business, civic and philanthropic organizations. MR. ESPERSETH has been a director of the Company since October 1986. Mr. Esperseth joined the Company in January 1983 as Senior Vice President-Research and Development, after a 32-year career with GTE, and served as Executive Vice President of Inter-Tel from 1986 to 1988. Mr. Esperseth retired as an officer of the Company on December 31, 1989. DR. HADEN has been a director of the Company since 1983. Dr. Haden has been Vice Chancellor and Dean of Engineering of Texas A&M University since 1993. Previously, he served as Vice Chancellor of Louisiana State University from 1991 to 1993, Dean of the College of Engineering and Applied Sciences at Arizona State University from 1989 to 1991, Vice President for Academic Affairs at Arizona State University from 1987 to 1988, and Dean of the College of Engineering and Applied Sciences from 1978 to 1987. Dr. Haden holds a doctoral degree in Electrical Engineering from the University of Texas and has also served on the faculty of the University of Oklahoma. MR. STOUT has been a director of the Company since October 1994. Mr. Stout has been President of Superlite Block, a manufacturer of concrete block, since February 1993. Since 1996 Mr. Stout has also been President of Oldcastle Architectural West, the parent company of Superlite Block and four other concrete products plants. Prior thereto he was employed by Boorhem-Fields, Inc. of Dallas, Texas, a manufacturer of crushed stone, as Chief Executive Officer from 1990 to 1993 and as Chief Financial Officer from 1986 to 1990. Previously, Mr. Stout was a Certified Public Accountant with Coopers & Lybrand. The Board of Directors has an Audit Committee and a Compensation Committee. The Audit Committee, consisting of Directors Anderson, Stout and Esperseth, is charged with reviewing the Company's annual audit and meets with the Company's independent auditors to review the Company's internal controls and financial management practices. The Compensation Committee, consisting of Messrs. Esperseth, Edens and Stout, recommends to the Board of Directors compensation for the Company's key employees and administers the Company's stock option plans. ITEM 2. PROPERTIES The Company maintains its corporate headquarters in 23,000 square feet of a building located in Phoenix, Arizona pursuant to a lease that expires in 2000, and its principal manufacturing operations in an 96,000 square foot building located in Chandler, Arizona pursuant to a lease that 25 expires in 2008. The Company also leases sales and support offices in a total of 30 locations in the United States and two locations overseas. The Company's aggregate monthly payments under these leases are currently approximately $271,000. The Company believes that its facilities will be adequate to meet its current needs and that additional or alternative space will be available as necessary in the future on commercially reasonable terms. See "Risk Factors--Management of Growth; Implementation of New Management Information Systems." ITEM 3. LEGAL PROCEEDINGS The Company is involved from time to time in litigation incidental to its business. The Company believes that the outcome of current litigation will not have a material adverse effect upon its business, financial condition or results of operations and will not disrupt the normal operations of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 1. On November 12, 1997, the Company called a Special Meeting of Shareholders for a proposal to approve an amendment to the Company's Restated Articles of Incorporation to increase the authorized number of Common Shares to 100,000,000. A quorum was not present at the meeting. 2. On November 13, 1997, the Company again called a Special Meeting of Shareholders for a proposal to approve an amendment to the Company's Restated Articles of Incorporation to increase the authorized number of Common Shares to 100,000,000. A quorum was not present at the meeting. 3. On November 14, 1997, the Company again called a Special Meeting of Shareholders for a proposal to approve an amendment to the Company's Restated Articles of Incorporation to increase the authorized number of Common Shares to 100,000,000. A quorum was present at the meeting. The proposal to approve an amendment to the Company's Restated Articles of Incorporation to increase the authorized number of Common Shares to 100,000,000 received the following votes: Votes Percentage ----- ---------- For: 9,899,140 82.71% Against: 1,751,065 14.63% Abstain: 318,963 2.66% PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information required by this Item is incorporated by reference to Exhibit 13.0 and Page 38 of the Company's 1997 Annual Report to Shareholders. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is incorporated by reference to Exhibit 13.0 and Page 18 of the Company's 1997 Annual Report to Shareholders. 26 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is incorporated by reference to Exhibit 13.0 and Pages 30 through 37 of the Company's 1997 Annual Report to Shareholders. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not Applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is incorporated by reference to Exhibit 13.0 and Pages 19 through 29 of the Company's 1997 Annual Report to Shareholders. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III Certain information required by Part III is omitted from this report in that the Registrant will file a definitive proxy statement pursuant to Regulation 14A (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Report, and the information included therein is incorporated herein by reference. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to directors and executive officers is included at the end of Part I, Item 1 on Pages 24 to 25 of this report under the caption "Directors and Executive Officers of the Registrant." ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to Pages 6 to 8 of the Company's Proxy Statement relating to its 1998 Annual Meeting of Shareholders. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to Pages4 and 5 of the Company's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. 27 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: 1. Financial Statements The following consolidated financial statements of Inter-Tel, Incorporated, and subsidiaries, are incorporated by reference to Exhibit 13.0 and Pages 19 to 29 of the Company's Annual Report: Report of Ernst & Young LLP, Independent Auditors Consolidated balance sheets--December 31, 1997 and 1996 Consolidated statements of income--years ended December 31, 1997, 1996 and 1995 Consolidated statements of shareholders' equity--years ended December 31, 1997, 1996 and 1995 Consolidated statements of cash flows--years ended December 31, 1997, 1996 and 1995 Notes to consolidated financial statements 2. Financial Statement Schedules The following consolidated financial statement schedule of Inter-Tel, Incorporated, and subsidiaries is filed as part of this Report and should be read in conjunction with the Consolidated Financial Statements of Inter-Tel, Incorporated and subsidiaries, and the notes thereto. Schedule for the three years ended December 31, 1997: Page No. -------- Schedule II--Valuation and Qualifying Accounts 31 Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto. 3. Exhibits 3.1(10) Articles of Incorporation, as amended. 3.2(16) By-Laws, as amended. 10.15(1) Registrant's form of standard Distributor Agreement. 10.16(1) Registrant's form of standard Service Agreement. 28 10.34(2) 1984 Incentive Stock Option Plan and forms of Stock Option Agreement. 10.35(3) Agreement between Registrant and Samsung Semiconductor and Telecommunications Company, Ltd. dated October 17, 1984. 10.37(3) Tax Deferred Savings Plan. 10.51(11) 1990 Directors' Stock Option Plan and form of Stock Option Agreement. 10.52(15) Inter-Tel, Incorporated Long-Term Incentive Plan and forms of Stock Option Agreements. 10.53(12) Agreement between Registrant and Maxon Systems, Inc. dated February 27, 1990. 10.54(12) Agreement between Registrant and Varian Tempe Electronics Center dated February 26, 1991. 10.55(12) Agreement between Registrant and Jetcrown Industrial Ltd. dated February 18, 1993. 10.56(13) Employee Stock Ownership Plan. 10.57(14) Loan and Security Agreement dated March 4, 1997 between Bank One, Arizona, N.A. and Registrant and Modification Agreement dated July 25, 1997. 10.58 (16) Development, Supply and License Agreement between Registrant and QUALCOMM dated January 17, 1996. - --------------------- (1) Previously filed with Registrant's Registration Statement on Form S-1 (File No. 2-70437). (2) Previously filed with Registrant's Registration Statement on Form S-8 (File No. 2-94805). (3) Previously filed with Registrant's Annual Report on Form 10-K for the year ended November 30, 1984 (File No. 0-10211). (10) Previously filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 0-10211). (11) Previously filed with Registrant's Registration Statement on Form S-8 (File No. 33-40353). (12) Previously filed with Registrant's Registration Statement on Form S-1 (File No. 33-70054). (13) Previously filed with Registrant's Registration Statement on Form S-8 (File No. 33-73620). (14) Filed herewith. (15) Previously filed with Registrant's Proxy Statement dated March 23, 1994. (16) Previously filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 0-10211). 29 (17) Filed herewith, except as noted. (b) Reports on Form 8-K. None. (c) Exhibits. 13.0 Excerpts from Annual Report to Security Holders. (not attached herewith; a copy of the excerpts of the Company's Annual Report to Security Holders was filed with the Securities and Exchange Commission and a complete copy of the Annual Report is available upon request by writing to Shareholder Relations, Inter-Tel, Incorporated, 120 N. 44th Street, Suite 200, Phoenix, Arizona 85034) 23.0 Consent of Ernst & Young LLP, Independent Auditors. (Page 33) 24.1 Power of Attorney. (Page 31) See Item 14(a) (3) also. (d) Financial Statement Schedules The response to this portion of Item 14 is submitted as a separate section of this report. See Item 8. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Inter-Tel, Incorporated, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. INTER-TEL, INCORPORATED DATED: March 23, 1998 BY: /S/ Steven G. Mihaylo ----------------------- Steven G. Mihaylo Chairman and Chief Executive Officer 30 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (in thousands)
- -------------------------------------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E - -------------------------------------------------------------------------------------------------------- ADDITIONS - -------------------------------------------------------------------------------------------------------- Charged Charged to Balance at to Other Charged to Balance Beginning Costs & Accounts Deductions at End of DESCRIPTION of Period Expenses Describe Describe Period - -------------------------------------------------------------------------------------------------------- Year ended December 31, 1997 Deducted from asset accounts: Allowance for doubtful accounts $3,096 $2,194 $ 17 $1,585(1) $3,722 ----- ----- --- ----- ----- Allowance for lease accounts $2,706 $1,910 $ -- $ 647(1) $3,969 ----- ----- --- ----- ----- Inventory allowance $2,979 $4,021 $ -- $1,260(2) $5,740 ----- ----- --- ----- ----- Year ended December 31, 1996 Deducted from asset accounts: Allowance for doubtful accounts (4) $1,822 $1,801 $ 87 (3) $ 614(1) $3,096 ----- ----- --- ----- ----- Allowance for lease accounts $1,513 $1,945 $(87)(3) $ 665(1) $2,706 ----- ----- --- ----- ----- Inventory allowance (4) $2,499 $ 609 $175 (5) $ 304(2) $2,979 ----- ----- --- ----- ----- Year ended December 31, 1995 Deducted from asset accounts: Allowance for doubtful accounts (4) $1,181 $ 814 $ 71 (3) $ 244(1) $1,822 ----- ----- --- ----- ----- Allowance for lease accounts $1,198 $ 780 $(71)(3) $ 394(1) $1,513 ----- ----- --- ----- ----- Inventory allowance (4) $1,795 $1,109 $ -- $ 405(2) $2,499 ----- ----- --- ----- ----- - --------------------------------------------------------------------------------------------------------
(1) Uncollectible accounts written off, net of recoveries. (2) Inventory written off. (3) Reclassed between appropriate valuation and qualifying accounts. (4) Adjusted for pooling of Florida Telephone Systems, Inc. (5) Acquired in purchase of NTL Corporation (dba ComNet of Ohio). 31 EX-10.57 2 LOAN AND SECURITY AGREEMENT DATED MARCH 4, 1997 Exhibit 10.57 Loan and Security Agreement dated March 4, 1997 between Bank One, Arizona, N.A. and Registrant and Modification Agreement dated July 25, 1997. MODIFICATION AGREEMENT ---------------------- DATE: July 25, 1997 - ----- PARTIES: Borrower: INTER-TEL, INCORPORATED, - -------- an Arizona corporation Bank: BANK ONE, ARIZONA, NA, a national banking association RECITALS: - --------- A. Bank has extended to Borrower credit ("Loan") in the principal amount of $7,000,000.00 pursuant to the Loan Agreement, dated March 4, 1997 ("Loan Agreement"), and evidenced by the Promissory Note, dated March 4, 1997 ("Note"). The unpaid principal of the Loan as of the date hereof is $0.00. B. The Loan and/or guaranty of Loan is unsecured. C. The Note, the Loan Agreement, any arbitration resolution, and all other agreements, documents, and instruments evidencing, securing, or otherwise relating to the Loan, are sometimes referred to individually and collectively as the "Loan Documents". D. Borrower has requested that Bank modify the Loan and the Loan Documents as provided herein. Bank is willing to so modify the Loan and the Loan Documents, subject to the terms and conditions herein. AGREEMENT: - ---------- For good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Borrower and Bank agree as follows: 1. ACCURACY OF RECITALS. --------------------- Borrower acknowledges the accuracy of the Recitals. 2. MODIFICATION OF LOAN DOCUMENTS. ------------------------------- 2.1 The Loan Documents are modified as follows: 2.1.1 The maturity date of the Loan and the Note is changed from July 31, 1997, to July 31, 1998. On the maturity date Borrower shall pay to Bank the unpaid principal, accrued and unpaid interest, and all other amounts payable by Borrower under the Loan Documents as modified herein. 2.1.2 The reference to Section 3.1 in Section 1 of the Loan Agreement is modified to read in its entirety as follows: 3.1 Scheduled Commitment expiration date: July 31, 1998 2.1.3 The reference to Section 6.11.1 in Section 1 of the Loan Agreement is modified to read in its entirety as follows: 6.11.1 Minimum Tangible Net Worth: $30,000,000.00 2.1.4 The reference to Section 6.11.3 in Section 1 of the Loan Agreement is modified to read in its entirety as follows: 6.11.3 Minimum Fixed Coverage Ratio: 1.75 to 1.0 2.1.5 The reference to Section 6.11.4 in Section 1 of the Loan Agreement is modified to read in its entirety as follows: 6.11.4 Debt to Worth Ratio: 3.0 to 1.0 2.1.6 The reference to Section 7.7 in Section 1 of the Loan Agreement is modified to read in its entirety as follows: 7.7 Capital Expenditures Limit: $10,000,000.00 2.1.7 Section 6.11.1 of the Loan Agreement is modified to read in its entirety as follows: 6.11.1 Tangible Net Worth. Tangible Net Worth, calculated as of the end of each fiscal quarter, of not less than the sum of (i) the amount for "Minimum Tangible Net Worth" set forth in Section 1, plus (ii) an amount equal to fifty percent (50%) of the aggregate net income (not less than zero) of Borrower and its Subsidiaries for each fiscal quarter ending during the period (the "Calculation Period") commencing on July 1, 1997 and ending on the date of calculation, plus (iii) all net proceeds of any equity financing entered into by Borrower or any of its Subsidiaries during the Calculation Period. 2.2 Each of the Loan Documents is modified to provide that it shall be a default or an event of default thereunder if Borrower shall fail to comply with any of the covenants of Borrower herein or if any representation or warranty by Borrower herein is materially incomplete, incorrect, or misleading as of the date hereof. 2.3 Each reference in the Loan Documents to any of the Loan Documents shall be a reference to such document as modified herein. 3. RATIFICATION OF LOAN DOCUMENTS AND COLLATERAL. ---------------------------------------------- The Loan Documents are ratified and affirmed by Borrower and shall remain in full force and effect as modified herein. Any property or rights to or interests in property granted as security in the Loan Documents shall remain as security for the Loan and the obligations of Borrower in the Loan Documents. 4. BORROWER REPRESENTATIONS AND WARRANTIES. ---------------------------------------- Borrower represents and warrants to Bank: 4.1 No default or event of default under any of the Loan Documents as modified herein, nor any event, that, with the giving of notice or the passage of time or both, would be a default or an event of default under the Loan Documents as modified herein has occurred and is continuing. 4.2 There has been no material adverse change in the financial condition of Borrower or any other person whose financial statement has been delivered to Bank in connection with the Loan from the most recent financial statement received by Bank. 4.3 Each and all representations and warranties of Borrower in the Loan Documents are accurate on the date hereof. 4.4 Borrower has no claims, counterclaims, defenses, or set-offs with respect to the Loan or the Loan Documents as modified herein. 4.5 The Loan Documents as modified herein are the legal, valid, and binding obligations of Borrower, enforceable against Borrower in accordance with their terms. 4.6 Borrower is validly existing under the laws of the State of its formation or organization and has the requisite power and authority to execute and deliver this Agreement and to perform the Loan Documents as modified herein. The execution and delivery of this Agreement and the performance of the Loan Documents as modified herein have been duly authorized by all requisite action by or on behalf of Borrower. This Agreement has been duly executed and delivered on behalf of Borrower. 5. BORROWER COVENANTS. ------------------- Borrower covenants with Bank: 5.1 Borrower shall execute, deliver, and provide to Bank such additional agreements, documents, and instruments as reasonably required by Bank to effectuate the intent of this Agreement. 5.2 Borrower fully, finally, and forever releases and discharges Bank and its successors, assigns, directors, officers, employees, agents, and representatives from any and all actions, causes of action, claims, debts, demands, liabilities, obligations, and suits, of whatever kind or nature, in law or equity of Borrower, whether now known or unknown to Borrower, (i) in respect of the Loan, the Loan Documents, or the actions or omissions of Bank in respect of the Loan or the Loan Documents and (ii) arising from events occurring prior to the date of this Agreement. 5.3 Contemporaneously with the execution and delivery of this Agreement, Borrower has paid to Bank: 5.3.1 All accrued and unpaid interest under the Note and all amounts, other than interest and principal, due and payable by Borrower under the Loan Documents as of the date hereof. 5.3.2 All the internal and external costs and expenses incurred by Bank in connection with this Agreement (including, without limitation, inside and outside attorneys, title, filing, and recording costs, expenses, and fees). 5.3.3 A commitment fee of $17,500.00. 6. EXECUTION AND DELIVERY OF AGREEMENT BY BANK. -------------------------------------------- Bank shall not be bound by this Agreement until (i) Bank has executed and delivered this Agreement, (ii) Borrower has performed all of the obligations of Borrower under this Agreement to be performed contemporaneously with the execution and delivery of this Agreement, (iii) if required by Bank, Borrower and any guarantor(s) of the Loan have executed and delivered to Bank an arbitration resolution, and (iv) each guarantor of the Loan has executed the Consent of Guarantor(s) below. 7. INTEGRATION, ENTIRE AGREEMENT, CHANGE, DISCHARGE, TERMINATION, OR WAIVER. ------------------------------------------------------------------------- The Loan Documents as modified herein contain the complete understanding and agreement of Borrower and Bank in respect of the Loan and supersede all prior representations, warranties, agreements, arrangements, understandings, and negotiations. No provision of the Loan Documents as modified herein may be changed, discharged, supplemented, terminated, or waived except in a writing signed by the parties thereto. 8. BINDING EFFECT. ---------------- The Loan Documents as modified herein shall be binding upon and shall inure to the benefit of Borrower and Bank and their respective successors and assigns. 9. CHOICE OF LAW. -------------- This Agreement shall be governed by and construed in accordance with the laws of the State of Arizona, without giving effect to conflicts of law principles. 10. COUNTERPART EXECUTION. ---------------------- This Agreement may be executed in one or more counterparts, each of which shall be deemed an original and all of which together shall constitute one and the same document. Signature pages may be detached from the counterparts and attached to a single copy of this Agreement to physically form one document. DATED as of the date first above stated. INTER-TEL, INCORPORATED, an Arizona corporation By __________________________ Name Kurt R. Kneip Title Vice President, Chief Financial Officer, Secretary, and Assistant Treasurer BANK ONE, ARIZONA, NA, a national banking association By __________________________ Name Craig S. Hoskin Title Vice President LOAN AGREEMENT -------------- DATE: March 4, 1997 - ----- PARTIES: Borrower: INTER-TEL, INCORPORATED, an Arizona corporation - -------- --------- Bank: BANK ONE, ARIZONA, NA, a national banking association ----- AGREEMENT: For good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Borrower and Bank agree as follows: 1. SCHEDULE OF TERMS. The terms in Section 1 relate to the designated sections of this Agreement. 2. Commitment Amount: $7,000,000.00. 3.1 Scheduled Commitment expiration date: July 31, 1997 3.3 Each of the following Persons acting alone is authorized to request Advances: Steven G. Mihaylo, Chairman and Chief Executive Officer Kurt R. Kneip, Vice President, Chief Financial Officer, Secretary, and Assistant Treasurer John C. Abbott, Treasurer Margaret Hollingsed, Assistant Treasurer Each of the following Persons acting alone is authorized to request Letters of Credit and to execute Letter of Credit Agreements: Steven G. Mihaylo, Chairman and Chief Executive Officer Kurt R. Kneip, Vice President, Chief Financial Officer, Secretary, and Assistant Treasurer John C. Abbott, Treasurer Margaret Hollingsed, Assistant Treasurer 3.5.1 Commitment fee: $5,143.91. 3.5.2 Letter of Credit Issuance Fee:Rate: 1.00% per annum. 5.1 and 6.1 Purpose of Advances and Letters of Credit: Advances are to be used to pay reimbursement Amounts under Letter of Credit Agreements and to support working capital. Letters of Credit are to be used to finance inventory purchases. 5.1.2 Fiscal year of Borrower: From January 1 to December 31. 6.4.1 Financial statements due within 45 days after the end of each fiscal quarter, except the last in each fiscal year. Financial statements requirements: Accrual Basis and GAAP. Certification requirements: Borrower prepared financial statements. Person(s) to sign financial statements on behalf of Borrower: Name: Kurt R. Kneip Title: Vice President, Chief Financial Officer, Secretary, and Asst. Treasurer 6.4.2 Financial statements due within 90 days after the end of each fiscal year of Borrower. Financial statements requirements: Accrual Basis and GAAP. Certification requirements: Independent certified public accountant satisfactory to Bank to audit financial statements and deliver an unqualified opinion on the financial statements. 6.11.1 Minimum Tangible Net Worth: $40,000,000.00 6.11.2 Current Ratio: 1.5 to 1.0 6.11.3 Minimum Fixed Coverage Ratio 2.0 to 1.0 6.11.4 Debt to Worth Ratio 0.8 to 1.0 7.7 Capital expenditures limit: $8,000,000.00 7.8 Indebtedness limit: $1,000,000.00 7.9 Maximum Net Loss: $1,250,000.00 2. DEFINITIONS. In this Agreement, the following terms shall have the following meanings and all capitalized financial terms used and not defined in this Agreement shall have the meanings determined in accordance with GAAP: "Advance" means an advance by Bank to Borrower hereunder. "Agreement" means this Loan Agreement as it may be amended, modified, extended, renewed, restated, or supplemented from time to time. "Approvals and Permits" means each and all approvals, authorizations, bonds, consents, certificates, franchises, licenses, permits, registrations, qualifications, and other actions and rights granted by or filings with any Persons necessary, appropriate, or desirable for ownership, lease, or use by Borrower of its assets and property or for the conduct of the business and operations of Borrower. "Borrower Loan Documents" means the Loan Documents executed or delivered by Borrower from time to time. "Business Day" means a day of the year on which banks are not required or authorized to close in Phoenix, Arizona. "Collateral" means the property, interests in property, and rights to property securing any or all Obligations from time to time. "Commitment" means the agreement of Bank in Sections 3.1 and 3.2 to issue Letters of Credit and to make Advances pursuant to the terms and conditions in Letter of Credit Agreements and herein. "Commitment Amount" means the amount specified in Section 1. "Current Ratio" means the ratio calculated by dividing Current Assets by Current Liabilities. "Customer" means a customer of Borrower. "Debt to Worth Ratio" means the ratio calculated by dividing (i) the sum of Total Liabilities plus outstanding Letters of Credit, by (ii) Tangible Net Worth. "ERISA" means the Employee Retirement Income Security Act of 1974 and the regulations and published interpretations thereunder, as in effect from time to time. "Event of Default" has the meaning specified in the Note and the other Loan Documents. "Existing Letter(s) of Credit" means any and all letter(s) of credit issued by Bank at the request of Borrower prior to the date of this Agreement, as to which letter(s) of credit the date that is the Standard Number of Days after the last date for payment of drafts drawn or drawn and accepted thereunder is after the date of this Agreement. "Fixed Coverage Ratio" means the ratio calculated by dividing (i) Net Income before Interest, Lease and Tax Expense, by (ii) Interest, Lease and Current Maturities Long Term Debt on a rolling four quarter basis. "GAAP" means generally accepted accounting principles consistently applied. "Governmental Authority" means any government, any court, and any agency, authority, body, bureau, department, or instrumentality of any government. "Letter of Credit Agreement" means Bank's standard form Application and Agreement for Commercial Letter of Credit, Bank's standard form Application for Standby Letter of Credit and Standby Letter of Credit Agreement, or other standard application and agreement for letters of credit in use by Bank from time to time. "Letters of Credit" means the letters of credit in Bank's standard form from time to time issued pursuant to Section 3.1 and any Existing Letters of Credit. "Lien or Encumbrance" and "Liens and Encumbrances" mean, respectively, each and all of the following: (i) any lease or other right to use; (ii) any assignment as security, conditional sale, grant in trust, lien, mortgage, pledge, security interest, title retention arrangement, other encumbrance, or other interest or right securing the payment of money or the performance of any other liability or obligation, whether voluntarily or involuntarily created and whether arising by agreement, document, or instrument, under any law, ordinance, regulation, or rule (federal, state, local, or foreign), or otherwise; and (iii) any option, right of first refusal, other right to acquire, or other interest, or right. "Loan Documents" means this Agreement, the Note, the Letter of Credit Agreements executed and delivered by Borrower in connection with Letters of Credit from time to time, and any other agreements, documents, or instruments from time to time evidencing, guarantying, securing, or otherwise relating to the Note, as they may be amended, modified, extended, renewed, or supplemented from time to time. "Loan Party" means Borrower and each other Person that from time to time is or becomes obligated to Bank under any Loan Document or grants any Collateral. "Material Adverse Change" means any change in the assets, business, financial condition, operations, prospects, or results of operations of any Loan Party or any other event or condition that (i) materially and adversely affects the likelihood of performance by any Loan Party of any of the Obligations, (ii) materially and adversely affects the ability of any Loan Party to perform any of the Obligations, (iii) materially and adversely affects the legality, validity, or binding nature of any of the Obligations or any Lien or Encumbrance securing any of the Obligations, or (iv) materially and adversely affects the priority of any Lien or Encumbrance securing any of the Obligations. "Note" means the Promissory Note, dated of even date herewith, of Borrower payable to Bank, as it may be amended, modified, extended, renewed, restated, or supplemented from time to time. "Obligations" means the obligations of the Loan Parties under the Loan Documents (including, without limitation, the obligation to pay Reimbursement Amounts). "Permitted Exceptions" means Liens and Encumbrances in favor of Bank, leases of inventory for fair consideration in the ordinary course of Borrower's business, Liens and Encumbrances shown on financial statements of Borrower delivered to Bank prior to the date of this Agreement, Liens and Encumbrances otherwise disclosed to Bank in writing prior to the date of this Agreement, other Liens and Encumbrances consented to by Bank in writing from time to time in its absolute and sole discretion and purchase money security interests. "Person" means a natural person, a partnership, a joint venture, an unincorporated association, a limited liability company, a corporation, a trust, any other legal entity, or any Governmental Authority. "Reimbursement Amount" means the amount Borrower is obligated to pay to Bank under a Letter of Credit Agreement in respect of a draft drawn or drawn and accepted under the respective Letter of Credit, which amount shall be the amount of the draft or acceptance and all costs, expenses, fees, and other amounts then payable by Borrower to Bank under the Letter of Credit Agreement. "Standard Number of Days" means the standard number of days established by Bank from time to time to allow for delivery to Bank of drafts drawn under letters of credit issued by Bank and presented to financial institutions other than Bank for delivery to Bank. Bank may change such number of days at any time and from time to time in its absolute and sole discretion without notice to Borrower and may have a different number of days for commercial letters of credit and standby letters of credit. "Subsidiary" means any company, foreign or domestic, more than 50% of the voting shares of which are owned by Borrower. "Tangible Net Worth" means Total Assets less the sum of total Intangible Assets and Total Liabilities. "Total Assets" means all assets calculated in accordance with GAAP. "Total Liabilities" means all liabilities calculated in accordance with GAAP. "Unmatured Event of Default" means any condition or event that with notice, passage of time, or both would be an Event of Default. 3. LETTERS OF CREDIT AND LOAN FACILITY 3.1 Letters of Credit. 3.1.1 Issuance of Letters of Credit. Subject to the terms and conditions of this Agreement and the Letter of Credit Agreements and subject to the policies, procedures, and requirements of Bank in effect from time to time for issuance of Letters of Credit (including, without limitation, payment of letter of credit fees), Bank agrees to issue, from time to time on or before the scheduled Commitment expiration date set forth in Section 1, Letters of Credit upon request by and for the account of Borrower, provided that as to each requested Letter of Credit Borrower has delivered to Bank a completed and executed Letter of Credit Agreement, and provided further that the date that is the Standard Number of Days after the last date for payment of drafts drawn or drawn and accepted under a requested Letter of Credit is before the scheduled Commitment expiration date set forth in Section 1. Each reference in this Agreement to "issue" or "issuance" or other forms of such words in relation to Letters of Credit shall also include any extension or renewal of a Letter of Credit. Upon occurrence of an Event of Default or an Unmatured Event of Default, Bank, in its absolute and sole discretion and without notice, may suspend the commitment to issue Letters of Credit. In addition, upon occurrence of an Event of Default, Bank, in its absolute and sole discretion and without notice, may terminate the commitment to issue Letters of Credit. 3.1.2 Issuance Procedure. To obtain a Letter of Credit, Borrower shall complete and execute a Letter of Credit Agreement and submit it to the letter of credit department of Bank. Upon receipt of a completed and executed Letter of Credit Agreement, Bank will process the application in accordance with the policies, procedures, and requirements of Bank then in effect. If the application meets the requirements of Bank and is within the policies of Bank then in effect, Bank will issue the requested Letter of Credit. 3.1.3 Reimbursement of Bank for Payment of Drafts Drawn or Drawn and Accepted Under Letters of Credit. The obligation of Borrower to reimburse Bank for payment by Bank of drafts drawn or drawn and accepted under a Letter of Credit shall be as provided in the respective Letter of Credit Agreement. Bank will notify Borrower of payment by Bank of a draft drawn or drawn and accepted under a Letter of Credit and of the respective Reimbursement Amount and will give Borrower the election (i) to pay the Reimbursement Amount pursuant to the respective Letter of Credit Agreement or (ii) to pay the Reimbursement Amount by Bank making an Advance subject to the terms and conditions of this Agreement and applying the proceeds of the Advance to pay the Reimbursement Amount. If Borrower does not communicate to Bank its election within two Business Days after notification by Bank of payment of the draft or acceptance, Borrower shall be deemed to have elected to pay the Reimbursement Amount by Bank making an Advance hereunder, provided that if the terms and conditions in this Agreement for an Advance hereunder are not satisfied, Borrower shall be deemed to have elected to pay the Reimbursement Amount pursuant to the Letter of Credit Agreement. Each Advance to pay a Reimbursement Amount shall be dated the date that Bank pays the respective draft or acceptance and shall accrue interest from and after such date. If Borrower is to pay the Reimbursement Amount pursuant to the Letter of Credit Agreement, Borrower shall also pay to Bank interest on the Reimbursement Amount from and including the date Bank pays the respective draft or acceptance at the Interest Rate (defined in the Note) until the Reimbursement Amount and such interest are paid in full, provided that if Borrower fails to pay the Reimbursement Amount and accrued interest thereon within five (5) days after notification by Bank to Borrower of payment of the respective draft or acceptance, interest thereafter shall accrue at the Default Rate (as such term is defined in the Note). Such interest shall be computed on the basis of a 360-day year and accrue on a daily basis for the actual number of days elapsed. Notwithstanding the above, if Borrower elects or is deemed to have elected to pay the Reimbursement Amount pursuant to the Letter of Credit Agreement and fails to pay the Reimbursement Amount and interest thereon within five (5) days after notification by Bank to Borrower, Bank, in its absolute and sole discretion and without notice to Borrower and regardless of whether the terms and conditions in this Agreement for Advances are satisfied, may make an Advance under this Agreement in the amount of the Reimbursement Amount and accrued interest thereon and apply the proceeds of such Advance to pay the Reimbursement Amount and accrued interest. 3.2 Loan Facility. Subject to the terms and conditions of this Agreement, Bank agrees to make Advances to Borrower from time to time on or before the scheduled Commitment expiration date specified in Section 1. Advances shall be on a revolving basis. Advances repaid may be re-borrowed subject to the terms and conditions herein. Although the outstanding principal of the Note may be zero from time to time, the Loan Documents shall remain in full force and effect until the Commitment terminates and all Obligations are paid and performed in full. Upon occurrence of an Event of Default or an Unmatured Event of Default, Bank, in its absolute and sole discretion and without notice, may suspend the commitment to make Advances. In addition, upon occurrence of an Event of Default, Bank, in its absolute and sole discretion and without notice, may terminate the commitment to make Advances. The obligation of Borrower to repay Advances is evidenced by the Note. 3.3 Letters of Credit and Advances. Letters of Credit may be issued and Advances may be made by Bank at the oral or written request of the respective Person or Persons designated in Section 1. Such Person or Persons are hereby authorized by Borrower to request Letters of Credit and Advances, to execute and deliver Letter of Credit Agreements on behalf of Borrower, and to direct disposition of the proceeds of Advances until written notice of the revocation of such authority is received from Borrower by Bank and Bank has had a reasonable time to act upon such notice. Bank shall have no duty to monitor for Borrower or to report to Borrower the use of Letters or Credit or proceeds of Advances. Advances shall be disbursed by Bank in the manner agreed upon by Bank and Borrower from time to time. 3.4 Limit on Letters of Credit and Advances. Anything in the Loan Documents to the contrary notwithstanding, the sum from time to time of (i) the aggregate amount of outstanding and undrawn Letters of Credit, (ii) the aggregate amount of outstanding and unpaid drafts drawn or drawn and accepted under Letters of Credit, (iii) the aggregate amount of unpaid Reimbursement Amounts, and (iv) the amount of outstanding and unpaid Advances shall not exceed the Commitment Amount. 3.5 Fees. Borrower agrees to pay to Bank the following fees, which shall be earned by Bank on the date due under the Loan Documents and shall be non-refundable to Borrower: 3.5.1 Commitment Fee. A fee for the Commitment in the amount set forth in Section 1, payable on or before the date hereof. 3.5.2 Attorneys' Costs, Expenses, and Fees. Attorneys costs, expenses, and fees for Bank's counsel in the amount specified by Bank, payable on or before the date hereof. 3.5.3 Letter of Credit Issuance Fee. A fee for the issuance of the Letter of Credit computed on the amount of the Letter of Credit and at the rate per annum set forth in Section 1, payable upon issuance of the Letter of Credit. 3.6 Mandatory Prepayments. If for any reason at any time the sum of (i) the aggregate amount of outstanding and undrawn Letters of Credit, (ii) the aggregate amount of outstanding and unpaid drafts drawn or drawn and accepted under Letters of Credit, (iii) the aggregate amount of unpaid Reimbursement Amounts, and (iv) the amount of outstanding and unpaid Advances exceeds the Commitment Amount, Borrower, without notice or demand, shall immediately make a payment to Bank in an amount equal to the sum of (A) such excess and (B) accrued and unpaid interest thereon. 3.7 Collateral Upon Event of Default. Upon an Event of Default and demand by Bank in its absolute and sole discretion, Borrower shall immediately deliver to Bank as security for all Obligations immediately available funds in an amount equal to the sum of (i) aggregate amount of outstanding and undrawn letters of Credit, and (ii) the aggregate amount of outstanding and unpaid drafts drawn or drawn and accepted under Letters of Credit. Borrower hereby grants to Bank a security interest in all such funds delivered to Bank to secure payment and performance of the Obligations. 4. CONDITIONS PRECEDENT TO EACH ADVANCE AND LETTER OF CREDIT. Bank shall be obligated to issue a Letter of Credit or make an Advance when requested by Borrower only if the representations and warranties by the Loan Parties in the Loan Documents are accurate on and as of this Agreement and on and as of the date of issuance of the Letter of Credit or of making the Advance before and after giving effect to the Letter of Credit or the Advance and the application of the proceeds of the Advance. Delay or failure by Bank to insist on satisfaction of any condition of issuance of a Letter of Credit or making an Advance shall not be a waiver of such condition precedent or any other condition precedent. If Borrower is unable to satisfy any condition precedent of issuance of a Letter of Credit or making an Advance, the issuance of the Letter of Credit or the making of the Advance shall not preclude Bank from thereafter declaring the condition or event causing such inability to be an Event of Default. 5. BORROWER REPRESENTATIONS AND WARRANTIES. 5.1 Closing Representations and Warranties. Borrower represents and warrants to Bank as of the date of this Agreement: 5.1.1 Purpose of Advances and Letters of Credit. Borrower intends to use Advances and Letters of Credit only for the purposes described in Section 1. 5.1.2 Accurate Information. All information in any loan application, financial statement, certificate, or other document and all other information delivered by or on behalf of Borrower to Bank in obtaining the Commitment is correct and complete. There are no omissions therefrom that result in any such information being incomplete, incorrect, or misleading as of the date thereof. There has been no Material Adverse Change as to Borrower since the date of such information. All financial statements heretofore delivered to Bank by Borrower accurately present the financial condition and results of operations of Borrower as at the dates thereof and for the periods covered thereby. The fiscal year of Borrower is as set forth in Section 1. 5.1.3 Legal Proceedings; Hearings, Inquiries, and Investigations. Except as disclosed to Bank in writing prior to the date of this Agreement, (i) no legal proceeding is pending or, to the best knowledge of Borrower, threatened before any arbitrator, other private adjudicator, or Governmental Authority to which Borrower is a party or by which Borrower or any assets or property of Borrower may be bound or affected that if resolved adversely to Borrower could result in a Material Adverse Change, and (ii) no hearing, inquiry, or investigation relating to Borrower or any assets or property of Borrower is pending or, to the best knowledge of Borrower, threatened by any Governmental Authority. 5.1.4 Taxes. Borrower has filed or caused to be filed all tax returns (federal, state, local, and foreign) required to be filed by Borrower and has paid all taxes and other amounts shown thereon to be due (including, without limitation, any interest and penalties). 5.1.5 No Event of Default or Unmatured Event of Default. No Event of Default and no Unmatured Event of Default has occurred and is continuing. 5.1.6 No Approvals. No approval, authorization, bond, consent, certificate, franchise, license, permit, registration, qualification, or other action or grant by or filing with any Person is required in connection with the execution, delivery, or performance by Borrower of the Borrower Loan Documents. 5.1.7 No Conflicts. The execution, delivery, and performance by Borrower of the Borrower Loan Documents will not conflict with, or result in a violation of or a default under: any applicable law, ordinance, regulation, or rule (federal, state, or local); any judgment, order, or decree of any arbitrator, other private adjudicator, or Governmental Authority to which Borrower is a party or by which Borrower or any of the assets or property of Borrower is bound; any of the Approvals or Permits; or any agreement, document, or instrument to which Borrower is a party or by which Borrower or any of the assets or property of Borrower is bound. 5.1.8 Execution and Delivery and Binding Nature of Borrower Loan Documents. The Borrower Loan Documents have been duly executed and delivered by or on behalf of Borrower. The Borrower Loan Documents are legal, valid, and binding obligations of Borrower, enforceable in accordance with their terms against Borrower, except as such enforceability may be limited by bankruptcy, insolvency, moratorium, reorganization, or similar laws and by equitable principles of general application. 5.1.9 Approvals and Permits; Assets and Property. Borrower has obtained and there are in full force and effect all Approvals and Permits. Borrower owns or leases all assets and property necessary for conduct of the business and operations of Borrower. Such assets and property are not subject to any Liens and Encumbrances, other than Permitted Exceptions. 5.1.10 ERISA. Borrower is in compliance with ERISA. No Reportable Event or Prohibited Transaction (as defined in ERISA) or termination of any plan has occurred and no notice of termination has been filed with respect to any plan established or maintained by Borrower and subject to ERISA. Borrower has not incurred any material funding deficiency within the meaning of ERISA or any material liability to the Pension Benefit Guaranty Corporation in connection with any such plan established or maintained by Borrower. Borrower is not a party to any Multiemployer Plan (as defined in ERISA). 5.1.11 Environmental Matters. To the best knowledge of Borrower after due investigation, Borrower is in compliance in all material respects with all environmental, all health, and all safety laws, ordinances, regulations, and rules (federal, state, and local) applicable to Borrower, the assets or property of Borrower, the business or operations of Borrower, or the products or services of Borrower. Borrower does not have any material existing or contingent liability in connection with any disposal, generation, manufacture, processing, production, release, storage, transportation, treatment, or use of any hazardous or toxic substance or waste. 5.1.12 Investment Company Act; Public Utility Holding Company Act. Borrower is not an "investment company" or a company controlled by an "investment company" within the meaning of the Investment Company Act of 1940, as amended. Borrower is not a "holding company" within the meaning of the Public Utility Holding Company Act of 1935, as amended. 5.1.13 Margin Securities. Borrower is not engaged in the business of extending credit for the purpose of purchasing or carrying margin stock (within the meaning of Regulation U issued by the Board of Governors of the Federal Reserve System). No proceeds of any Advance will be used to purchase or carry any margin stock or extend credit to others for the purpose of purchasing or carrying margin stock or for any purpose that violates or is inconsistent with Regulation X of the Board of Governors. 5.1.14 Corporation, Limited Liability Company, or Partnership Existence, Authority, and Authorization. If Borrower is a corporation, a limited liability company, or a partnership, Borrower is validly existing, and in the case of a corporation or limited liability company is in good standing, under the laws of the jurisdiction of its formation or organization and has the requisite power and authority to execute, deliver, and perform the Borrower Loan Documents. The execution, delivery, and performance by Borrower of the Borrower Loan Documents have been duly authorized by all requisite action by or on behalf of Borrower and will not conflict with, or result in a violation of or a default under, the certificate of incorporation or bylaws, the limited liability company operating agreement, or the partnership agreement of Borrower, as the case may be. If Borrower is not formed or organized under the law of the State of Arizona, Borrower is qualified to do business as a foreign corporation, limited liability company, or partnership, as the case may be, and in the case of a corporation or limited liability company is in good standing, under the law of the State of Arizona. 5.2 Representations and Warranties Upon Requests for Advances or Letters of Credit. Each request for an Advance or a Letter of Credit shall be a representation and warranty by Borrower to Bank that the representations and warranties in this Section 5 are correct and complete as of the date of the Advance or Letter of Credit and that the conditions precedent in Section 4 are satisfied as of the date of the Advance or Letter of Credit. 5.3 Representations and Warranties Upon Delivery of Financial Statements, Documents, and Other Information. Each delivery by Borrower to Bank of financial statements, other documents, or information after the date of this Agreement (including, without limitation, documents and information delivered in obtaining an Advance) shall be a representation and warranty that such financial statements, other documents, or information is correct and complete, that there are no omissions therefrom that result in such financial statements, other documents, or information being incomplete, incorrect, or misleading as of the date thereof, and that such financial statements accurately present the financial condition and results of operations of Borrower as at the dates thereof and for the periods covered thereby. 6. BORROWER AFFIRMATIVE COVENANTS. Until the Commitment terminates in full, until all Letters of Credit expire or are drawn in full, until all drafts drawn under or drawn and accepted under Letters of Credit are paid in full, and until the Obligations are paid and performed in full, Borrower agrees that: 6.1 Use of Advances. Borrower shall use Advances only for the purposes described in Section 1. 6.2 Further Assurances, Costs and Expenses of Borrower's Performance of Covenants and Satisfaction of Conditions. Borrower shall promptly, or shall cause each Subsidiary to promptly, execute, acknowledge, and deliver and, as appropriate, cause to be duly filed and recorded such additional agreements, documents, and instruments and do or cause to be done such other acts as Bank may reasonably request from time to time to better assure, perfect, preserve, and protect the rights and remedies of Bank under the Loan Documents. Borrower shall, or shall cause each Subsidiary to, perform all of its obligations and satisfy all conditions under the Loan Documents at its sole cost and expense. 6.3 Books and Records; Access By Bank. Borrower shall, or shall cause each Subsidiary to, maintain a single, standard, modern system of accounting (including, without limitation, a single, complete, and accurate set of books and records of its assets, business, financial condition, liabilities, operations, property, prospects, and results of operations) in accordance with good accounting practices. Borrower shall furnish, or cause to be furnished, to Bank all information concerning Borrower and each Subsidiary and the assets, business, financial condition, liabilities, operations, property, prospects, and results of operation of Borrower and each Subsidiary as Bank reasonably requests from time to time. During business hours Borrower shall give, or cause each Subsidiary to give, representatives of Bank access to all assets, property, books, records, documents and personnel of Borrower and each Subsidiary and shall permit Bank representatives to inspect such assets and property, to audit, copy, examine, and make excerpts from the books, records, and documents, and to make inquiry of Borrower and Borrower's personnel, and each Subsidiary and Subsidiary's personnel, and receive answers. Borrower shall, and shall cause the personnel of Borrower and each Subsidiary to, cooperate and assist Bank and Bank's representatives. In this regard, without limitation, Bank shall have the right to conduct semi-annual inspections of the receivables and inventory of Borrower and each Subsidiary. In addition, Bank shall have the right to verify any information provided by Borrower and each Subsidiary to Bank by inquiry to any appropriate third Persons. 6.4 Information and Statements. Borrower shall furnish to Bank: 6.4.1 Fiscal Period Financial Statements. As soon as available and in any event within the number of days set forth in Section 1 after the end of each fiscal period of Borrower set forth in Section 1, except the last period in each fiscal year of Borrower, copies of the balance sheet of Borrower and each Subsidiary on a consolidated basis as of the end of such fiscal period and statements of income and retained earnings and a statement of cash flow of Borrower and each Subsidiary on a consolidated basis for such fiscal period and for the portion of the fiscal year of Borrower and each Subsidiary ending with such fiscal period, in each case setting forth in comparative form the figures for the corresponding period for the preceding fiscal year, all in reasonable detail, prepared in accordance with the requirements in Section 1, containing the certifications specified in Section 1 and signed on behalf of Borrower and each Subsidiary by the person(s) named in Section 1. 6.4.2 Annual Financial Statements. As soon as available and in any event within the number of days set forth in Section 1 after the end of each fiscal year of Borrower and each Subsidiary, copies of the balance sheet of Borrower and each Subsidiary on a consolidated basis as of the end of such fiscal year and statements of income and retained earnings and a statement of cash flow of Borrower and each Subsidiary on a consolidated basis for such fiscal year, in each case setting forth in comparative form the figures for the preceding fiscal year of Borrower and each Subsidiary, all in reasonable detail and prepared in accordance with the requirements in Section 1, containing the certifications specified in Section 1. 6.5 Law; Judgments; Material Agreements; Approvals and Permits. Borrower shall comply, or shall cause each Subsidiary to comply, with all laws, ordinances, regulations, and rules (federal, state, local, and foreign) and all judgments, orders, and decrees of any arbitrator, other private adjudicator, or Government Authority relating to Borrower and each Subsidiary or the assets, business, operations, or property of Borrower and each Subsidiary. Borrower shall comply, or shall cause each Subsidiary to comply, in all material respects with all material agreements, documents, and instruments to which Borrower and each Subsidiary is a party or by which Borrower and each Subsidiary or any of the assets or property of Borrower and each Subsidiary is bound or affected. Borrower shall, or shall cause each Subsidiary to, obtain and maintain in full force and effect all Approvals and Permits and shall comply with all conditions and requirements of all Approvals and Permits. 6.6 Taxes and Other Indebtedness. Borrower shall, or shall cause each Subsidiary to, pay and discharge (i) before delinquency all taxes, assessments, and governmental charges or levies imposed upon it, upon its income or profits, or upon any of its assets or property, (ii) when due all lawful claims (including, without limitation, claims for labor, materials, and supplies), that, if unpaid, might become a Lien or Encumbrance upon any of its assets or property, and (iii) when due, all its other indebtedness. 6.7 Assets and Property. Borrower shall, or shall cause each Subsidiary to, maintain, keep, and preserve all of its assets and property (tangible and intangible) necessary or useful in the proper conduct of its business and operations in good working order and condition, ordinary wear and tear excepted. 6.8 Insurance. In addition to any insurance required under any of the other Loan Documents, Borrower shall maintain workmen's compensation insurance, product and public liability insurance, insurance on its assets and property now or hereafter owned, and such other forms of insurance as is customary in the industry of Borrower, against such casualties, risks, and contingencies, in such amounts, and with such insurance companies as are satisfactory to Bank, in its reasonable discretion. Borrower shall deliver to Bank from time to time as Bank may request, schedules setting forth all insurance then in effect and copies of the policies. 6.9 Environmental Laws. Without limiting the generality of Section 6.5, Borrower shall comply, or shall cause each Subsidiary to comply, with all environmental, all health, and all safety laws, ordinances, regulations, and rules (federal, state, local, and foreign) applicable to Borrower and each Subsidiary, the business or operations of Borrower and each Subsidiary, the assets or property of Borrower and each Subsidiary, or the products or services of Borrower and each Subsidiary. Borrower and each Subsidiary may use and store for its own use hazardous or toxic substances. Borrower shall not, and shall not permit each Subsidiary to, dispose of, generate, manufacture, process, produce, release, transport, or treat or otherwise store or use any hazardous or toxic substances or wastes. Borrower shall notify, or shall cause each Subsidiary to notify, Bank immediately of any environmental inquiry or claim from any Governmental Authority or other Person relating to Borrower and each Subsidiary or any assets, property, business, operations, product, or service of Borrower and each Subsidiary. 6.10ERISA. Borrower shall fund, or shall cause each Subsidiary to fund, each Defined Benefit Plan and Defined Contribution Plan (as such terms are defined in ERISA) established or maintained by or for Borrower and each Subsidiary so that there is never an Accumulated Funding Deficiency (as defined in Section 412 of the Internal Revenue Code of 1986, as amended). 6.11Financial Covenants. Except as otherwise noted, all financial computations shall be made in accordance with GAAP. Until the Commitment terminates in full and until the Obligations are paid and performed in full, or, if so specified in Section 1, for the respective period(s) specified in Section 1, Borrower agrees that Borrower and each Subsidiary shall maintain on a consolidated basis: 6.11.1 Tangible Net Worth. Tangible Net Worth of not less than the amount set forth in Section 1. 6.11.2 Current Ratio. A Current Ratio of not less than the ratio set forth in Section 1. 6.11.3 Fixed Coverage Ratio. A Fixed Coverage Ratio of not less than the amount set forth in Section 1. 6.11.4 Debt to Worth Ratio. A Debt to Worth ratio not to exceed the amount set forth in Section 1. 6.12Corporation, Limited Liability Company, or Partnership Existence. If Borrower and any Subsidiary is a corporation, a limited liability company, or a partnership, Borrower and each such Subsidiary shall continue to be validly existing, and in the case of a corporation or a limited liability company in good standing, under the law of the jurisdiction of its organization or formation. If any Subsidiary is not formed or organized under the laws of the State of Arizona, each such Subsidiary shall continue to be qualified to do business as a foreign corporation, limited liability company, or partnership, as the case may be, and in the case of a corporation or limited liability company, to be in good standing, under the law of the jurisdiction of its organization or formation. 7. BORROWER NEGATIVE COVENANTS. Until the Commitment terminates in full, until all Letters of Credit expire or are drawn in full, until all drafts drawn or drawn and accepted under Letters of Credit are paid in full, and until the Obligations are paid and performed in full, Borrower agrees, without first obtaining Bank's written consent: 7.1 Corporation, Limited Liability Company, and Partnership Restrictions. If Borrower and any Subsidiary is a corporation, a limited liability company, or a partnership, Borrower shall not, and shall not permit any such Subsidiary to, issue any material amount of capital stock or other securities of or any limited liability company interest or partnership interest in Borrower and each Subsidiary or grant any material amount of option(s), right-of-first-refusal, warrant, or other right to purchase or acquire any capital stock or other securities of or any limited liability company interest or partnership interest in Borrower and each Subsidiary. Borrower shall not be dissolved or liquidated. Borrower shall not amend, modify, restate, supplement, or terminate its certificate of incorporation or bylaws, its limited liability company operating agreement, or its partnership agreement, as the case may be. If a corporation, Borrower shall not reorganize itself or consolidate with or merge into any other corporation or any limited liability company or permit any other corporation or any limited liability company to be merged into Borrower; provided that a merger of any Subsidiary into another Subsidiary shall not constitute a violation of this restriction. With respect to any transactions described in this paragraph between or among Borrower and its Subsidiaries, Bank's consent shall not be unreasonably withheld or delayed. Anything in the foregoing to the contrary notwithstanding, Borrower may make such changes to its certificate of incorporation and by-laws without Bank's prior consent as may from time to time be required by a governmental authority with jurisdiction over Borrower, so long as such changes do not result in a change of ownership or control of Borrower, or any other change which may materially adversely affect Bank's rights under the Loan Documents. 7.2 Change in or Reacquisition of Ownership Interests in Borrower. In addition to any requirement in any other Loan Document, if Borrower and any Subsidiary is a corporation, a limited liability company, or a partnership, Borrower shall not, and shall not permit any such Subsidiary to, repurchase any material amount of capital stock of or any limited liability company interest or partnership interest in Borrower and each Subsidiary or any material amount of option(s), right-of-first refusal, warrant or other right to purchase any material amount of capital stock or other securities of or any limited liability company interest or partnership interest in Borrower and each Subsidiary. In addition, Borrower shall not, and shall not permit any such Subsidiary to, suffer to occur or exist, whether occurring voluntarily or involuntarily, after the date of this Agreement any change in the legal or beneficial ownership of any capital stock of or limited liability company interest or partnership interest in Borrower and each Subsidiary, without the prior written consent of Bank in its absolute and sole discretion. For the purposes of the foregoing, repurchase by Borrower during any calendar year of an amount of its capital stock not in excess of 15% of its aggregate issued and outstanding capital stock shall not be considered a "material amount" of the capital stock of Borrower. 7.3 Name, Fiscal Year, Accounting Method, and Lines of Business. Borrower shall not, and shall not permit each Subsidiary to, change its name (Bank's consent to such change not to be unreasonably withhold or delayed). Borrower shall not, and shall not permit each Subsidiary to, change its fiscal year, or method of accounting. Borrower shall not, and shall not permit each Subsidiary to, directly or indirectly, engage in any business other than the telecom products, telecom networks, voice processing software, long distance services, specialized computer-telephone software applications, telephone systems, telephonic switches and telephones, maintenance, leasing and support services, long distance calling services, and voice mail and other telecommunications applications business, discontinue any material lines(s) of business, or substantially alter its method of doing business. 7.4 Acquisitions, Loans, Investments, Guaranties, Subordinations. Borrower shall not, and shall not permit each Subsidiary to, directly or indirectly (i) acquire by purchase, lease, or otherwise all or substantially all the assets of any other Person, (ii) make any loan or advance to any other Person, (iii) purchase or otherwise acquire any capital stock or other securities of any other Person, any limited liability company interest or partnership interest in any other Person, or any warrants or other options or rights to acquire any capital stock or securities of any other Person or any limited liability company interest or partnership interest in any other Person, (iv) make any capital contribution to any other Person, (v) otherwise invest in or acquire any interest in any other Person, (vi) guaranty or otherwise become obligated in respect of any indebtedness of any other Person, or (vii) subordinate any claim against or obligation of any other Person to Borrower to any other indebtedness of such Person. For purposes of clarification as used in this paragraph 7.4, the term "Person" shall include, without limitation, Borrower and/or each Subsidiary, as the case may be. With respect to any transactions described in this paragraph between or among Borrower and its Subsidiaries, Bank's consent shall not be unreasonably withheld or delayed. Notwithstanding the above, Borrower may otherwise invest in or acquire any interest in any other Person, not to exceed $10,000,000.00 in any one instance or $30,000,000.00 in the aggregate in any one year. 7.5 Disposition of All or Substantially All Assets. Borrower shall not, and shall not permit each Subsidiary to, sell, transfer, lease, or otherwise dispose of all or any substantial part of the assets, business, operations, or property of Borrower or each Subsidiary. With respect to any transactions described in this paragraph between or among Borrower and its Subsidiaries, Bank's consent shall not be unreasonably withheld or delayed. 7.6 Negative Pledge. Except for Permitted Exceptions, Borrower shall not, and shall not permit each Subsidiary to, grant or suffer to exist any Lien or Encumbrance upon any assets or property of Borrower or each Subsidiary. 7.7 Capital Expenditures. Borrower shall not, and shall not permit each Subsidiary to, in any twelve (12) month period, acquire additional fixed assets that have an aggregate total cost to Borrower and Subsidiaries in excess of the amount set forth in Section 1, excluding acquisitions. Compliance with the foregoing covenant shall be measured annually as of the end of each fiscal year of Borrower. 7.8 Indebtedness. Borrower shall not, and shall not permit each Subsidiary to, assume, create, incur, or permit to exist any indebtedness, except (i) existing indebtedness disclosed on financial statements delivered to Bank prior to the date of this Agreement, (ii) the Obligations, and (iii) other indebtedness and trade obligations and normal accruals in the ordinary course of business not yet due and payable, in the case of (i), (ii), and (iii) in excess in the aggregate of the amount set forth in Section 1. 7.9 Maximum Net Loss. The maximum net loss for any quarter, cumulative for any four quarters or any two consecutive quarters shall not exceed the amount-set forth in Section 1. 8. BANK'S OBLIGATIONS TO BORROWER ONLY. The obligations of Bank under this Agreement are for the benefit of Borrower only. No other Person shall have any rights hereunder or be a third-party beneficiary hereof. 9. PROVISIONS IN NOTE GOVERN THIS AGREEMENT. This Agreement is subject to certain terms and provisions in the Note, to which reference is made for a statement of such terms and provisions. 10. COUNTERPART EXECUTION AND FACSIMILE DELIVERY. This Agreement may be executed in one or more counterparts, each of which shall be deemed an original and all of which together shall constitute one and the same document. Signature pages may be detached from the counterparts and attached to a single copy of this Agreement to physically form one document. Delivery of executed copies of this Agreement may be made by facsimile transmission with the same effect as delivery of executed originals of this Agreement. DATED as of the date first above stated. BANK ONE, ARIZONA, NA, a national banking association By:____________________________________ Name: Craig S. Hoskin Title: Vice President INTER-TEL, INCORPORATED, an Arizona corporation By:_____________________________________ Name: Kurt R. Kneip Title: Vice President, Chief Financial Officer, Secretary, and Assistant Treasurer EX-13 3 EXCERPTS FROM ANNUAL REPORT TO SECURITY HOLDERS EXHIBIT 13.0 EXCERPTS FROM ANNUAL REPORT TO SECURITY HOLDERS FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Ernst & Young LLP, Independent Auditors Shareholders and Board of Directors Inter-Tel, Incorporated We have audited the accompanying consolidated balance sheets of Inter-Tel, Incorporated and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Inter-Tel, Incorporated and subsidiaries at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. /s/Ernst & Young LLP Phoenix, Arizona February 20, 1998 INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996 - -------------------------------------------------------------------------------- (In thousands, except share amounts) 1997 1996 ASSETS CURRENT ASSETS Cash and equivalents $ 88,805 $ 38,936 Accounts receivable, less allowances of $3,722 in 1997 and $3,096 in 1996 32,234 29,998 Inventories, less allowances of $5,740 in 1997 and $2,979 in 1996 21,539 21,280 Net investment in sales-leases 9,196 8,243 Prepaid expenses and other assets 5,625 7,008 - -------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 157,399 105,465 PROPERTY, PLANT & EQUIPMENT 19,559 11,189 OTHER ASSETS` 18,030 15,957 - -------------------------------------------------------------------------------- $ 194,988 $ 132,611 - -------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 14,864 $ 8,915 Other current liabilities 18,721 16,841 - -------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 33,585 25,756 DEFERRED TAX LIABILITY 11,343 8,635 OTHER LIABILITIES 4,555 3,286 SHAREHOLDERS' EQUITY Common stock, no par value - authorized 100,000,000 shares, issued and outstanding - 26,687,766 shares in 1997 and 25,888,572 shares in 1996 99,229 59,875 Retained earnings 46,547 35,464 Currency translation adjustment (271) (359) - -------------------------------------------------------------------------------- 145,505 94,980 Less receivable from Employee Stock Ownership Trust - (46) - -------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 145,505 94,934 - -------------------------------------------------------------------------------- $ 194,988 $ 132,611 ================================================================================ See accompanying notes. INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1997, 1996 and 1995 - -------------------------------------------------------------------------------- (In thousands, except per share data) 1997 1996 1995 NET SALES $ 223,569 $ 185,884 $ 150,533 Cost of sales 122,363 104,966 87,696 - -------------------------------------------------------------------------------- GROSS PROFIT 101,206 80,918 62,837 Research and development 7,998 6,581 5,764 Selling, general and administrative 69,942 56,386 43,578 Special charge -- 4,542 1,315 - -------------------------------------------------------------------------------- OPERATING INCOME 23,266 13,409 12,180 - -------------------------------------------------------------------------------- Other income 1,383 1,974 1,674 Interest expense (47) (77) (106) - -------------------------------------------------------------------------------- INCOME BEFORE INCOME TAXES 24,602 15,306 13,748 INCOME TAXES Current 8,850 3,480 1,007 Deferred 1,070 2,784 4,242 - -------------------------------------------------------------------------------- 9,920 6,264 5,249 - -------------------------------------------------------------------------------- NET INCOME $ 14,682 $ 9,042 $ 8,499 - -------------------------------------------------------------------------------- NET INCOME PER SHARE Basic $ 0.59 $ 0.35 $ 0.37 Diluted $ 0.57 $ 0.34 $ 0.36 - -------------------------------------------------------------------------------- Average common shares outstanding 24,836 25,780 23,056 Average common shares outstanding assuming dilution 25,983 26,572 23,766 - -------------------------------------------------------------------------------- See accompanying notes. INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 1997, 1996 and 1995
- ------------------------------------------------------------------------------------------------------------------------- Currency Receivable (In thousands, except Common Treasury Retained Translation From share amounts) Stock Stock Earnings Adjustment ESOP Total - ------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1994 $ 27,585 $ -- $ 17,923 $ (122) $ (264) $ 45,122 Issuance of 4,000,000 shares of common stock 30,670 30,670 Exercise of stock options 503 503 Tax benefit from stock options 208 208 Net income 8,499 8,499 Gain on currency translation 10 10 Collection from ESOP 105 105 - ------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1995 58,966 -- 26,422 (112) (159) 85,117 Exercise of stock options 611 611 Tax benefit from stock options 417 417 Escrow share cancellation from prior stock acquisition (119) (119) Net income 9,042 9,042 Loss on currency translation (247) (247) Collection from ESOP 113 113 - ------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1996 59,875 -- 35,464 (359) (46) 94,934 Stock repurchase (27,194) (27,194) Exercise of stock options 642 4,533 (3,332) 1,843 Tax benefit from stock options 1,967 1,967 Net income 14,682 14,682 Gain on currency translation 88 88 Collection from ESOP 46 46 Stock issued under Employee Stock Purchase Plan 256 256 Issuance of 3,000,000 shares of common stock 36,489 22,661 59,150 Dividends (267) (267) - ------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1997 $ 99,229 $ -- $ 46,547 $ (271) $ -- $ 145,505 =========================================================================================================================
See accompanying notes. INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1997, 1996 and 1995
- ---------------------------------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 OPERATING ACTIVITIES: Net income $ 14,682 $ 9,042 $ 8,499 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 4,578 4,097 2,267 Provision for losses on receivables 4,104 3,746 1,594 Provision for inventory valuation 4,021 609 1,109 Net contribution to ESOP 46 113 105 Increase/(decrease) in other liabilities 1,269 (604) 1,111 (Gain)/loss on sale of property and equipment (25) 3,421 16 Deferred income taxes 1,070 2,784 4,242 Effect of exchange rate changes 88 (247) 10 Changes in operating assets and liabilities (1,633) (15,704) (18,141) - ---------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 28,200 7,257 812 - ---------------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES: Additions to property and equipment (12,449) (6,951) (7,921) Proceeds from sale of property and equipment 63 159 9 Cash used in acquisitions -- (1,780) -- - ---------------------------------------------------------------------------------------------------------- NET CASH USED IN INVESTING ACTIVITIES (12,386) (8,572) (7,912) - ---------------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES: Net proceeds from stock offering 59,150 -- 30,670 Proceeds from exercise of stock options 1,843 611 503 Proceeds from stock issued under the Employee Stock Purchase Plan 256 -- -- Treasury stock purchases (27,194) -- -- - ---------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY FINANCING ACTIVITIES 34,055 611 31,173 - ---------------------------------------------------------------------------------------------------------- INCREASE (DECREASE) IN CASH AND EQUIVALENTS 49,869 (704) 24,073 CASH AND EQUIVALENTS AT BEGINNING OF YEAR 38,936 39,640 15,567 - ---------------------------------------------------------------------------------------------------------- CASH AND EQUIVALENTS AT END OF YEAR $88,805 $ 38,936 $ 39,640 - ----------------------------------------------------------------------------------------------------------
See accompanying notes. INTER-TEL, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1997, 1996 and 1995 - -------------------------------------------------------------------------------- NOTE A -- SIGNIFICANT ACCOUNTING POLICIES Description of Business. Inter-Tel is a single point of contact, full service provider of digital business telephone systems, call processing software, voice processing software, call accounting software, Internet Protocol (IP) telephony software, computer telephone integration applications and long distance calling services. Inter-Tel's products and services include the AXXESS and Inter-Tel Axxent digital business communication software platforms, the AXXESSORY Talk voice processing platform, the Inter-Tel Vocal'Net IP telephony gateway, the Inter-Tel Vocal'Net Service Provider Software and Centralized Accounting Software and Inter-Tel.net, an IP telephony packet switched long distance service. The Company also provides maintenance, leasing and support services for its products. Principles of Consolidation. The consolidated financial statements include the accounts of Inter-Tel, Incorporated and all significant subsidiaries (the Company). Intercompany accounts and transactions have been eliminated in consolidation. Cash and Equivalents. Cash and equivalents include all highly liquid investments with a remaining maturity of three months or less at date of acquisition. Excess cash and equivalents are primarily invested in mutual funds comprised of foreign and domestic high quality dollar denominated money market instruments rated A-1 by Standard & Poor's Ratings Group, or equivalent. Inventories. Inventories, consisting principally of telephone systems, computer equipment and related components, are stated at the lower of cost (first-in, first-out method) or market. Property, Plant and Equipment. Property, plant and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful life of the related property which range from 3 years to 12 years. Leasehold improvements are depreciated over the shorter of the related lease terms or the estimated useful lives of the improvements. Excess of Purchase Price Over Net Assets Acquired. Purchase prices of acquired businesses that are accounted for as purchases have been allocated to the assets and liabilities acquired based on the estimated fair values on the respective acquisition dates. Based on these values, the excess purchase prices over the fair value of the net assets acquired are being amortized over 3 to 40 years. Accumulated amortization through December 31, 1997 was $866,744. Sales-Leases. The discounted present values of minimum rental payments under sales-type leases are recorded 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 adjustments to the original sales amounts. Income Taxes. Deferred income taxes result from temporary differences in the recognition of revenues and expenses for financial reporting and income tax purposes. Advertising. The cost of advertising is expensed as incurred. The Company incurred $577,000; $437,000 and $318,000 in advertising costs during 1997, 1996, and 1995, respectively. Stock Based Compensation. The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. The company accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25") and accordingly, recognizes no compensation expense for these stock option grants. Recently Issued Accounting Standards. In 1996, the Company adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS No. 121"), which requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. SFAS 121 also addresses the accounting for long-lived assets that are expected to be disposed of. The Company adopted SFAS 121 in the first quarter of 1996 and the adoption did not have a material impact to the operations of the Company. During the fourth quarter of 1996, the Company decided to replace its management information system ("MIS") software with an integrated solution from a more established vendor and accordingly wrote off the software license and implementation costs relating to the system software being replaced. The special pre-tax charge of $4.5 million reflects the costs associated with the Company's decision to abandon its current MIS software in favor of different system software. In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share" ("SFAS No. 128"), adopted by the Company on December 31, 1997. SFAS No. 128 replaced the previously reported primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants, and convertible securities. Diluted earnings per share is very similar to the previously reported primary earnings per share. All earnings per share amounts for all periods have been presented, and where necessary, restated to conform to the SFAS No. 128 requirements. The impact of SFAS No. 128 on the calculation of fully diluted earnings per share for each of the periods presented was not material. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131 is effective for financial statements for fiscal years beginning after December 15, 1997. The adoption of SFAS 131 will have no impact on the Company's consolidated results of operations, financial position or cash flows. Recent Pronouncements. In October 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-2, "Software Revenue Recognition" ("SOP 97-2"). SOP 97-2 provides guidance on when revenue should be recognized and in what amounts for licensing, selling, leasing, or otherwise marketing computer software. SOP 97-2 is effective for financial statements for fiscal years beginning after December 15, 1997. Earlier application for financial statements or information that has not been issued is encouraged. The Company is in the process of evaluating if the adoption of SOP97-2 will have an impact, if any, on its software revenue recognition practices. Contingencies. The Company is a party to certain litigation in the normal course of business. Management does not anticipate that the resolution of such matters will have a material adverse effect on the Company's consolidated financial position. Use of Estimates. The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Reclassifications. Certain reclassifications have been made to the 1996 and 1995 financial statements to conform to the 1997 presentation. NOTE B -- ACQUISITIONS Effective November 29, 1996, the Company acquired 100% of the stock of NTL Corporation ("ComNet") for cash and a short-term note. The transaction has been accounted for as a purchase transaction, and accordingly, the results of its operations have been included in the consolidated results of operations since the transaction date. The purchase price has been allocated to the assets and liabilities based on fair values at acquisition. The purchase price over net assets acquired (goodwill) is being amortized over 5 to 10 years, based on the lives of the underlying assets. The acquisition did not include certain components of ComNet's business. Accordingly, separate operating results for ComNet's telecommunications business are not available. ComNet's telecommunication revenues for 1996 were approximately $9.0 million. NOTE C -- NET INVESTMENT IN SALES-LEASES Net investment in sales-leases represents the value of sales-leases presently held under the Company's Totalease program. The Company currently sells the rental income from some of the sales-leases. The Company maintains reserves against potential recourse following the resales based upon loss experience and past due accounts. Activity during the years was as follows: Year Ended December 31 (In thousands) 1997 1996 1995 Sales of rental income $ 57,812 $ 42,985 $ 25,106 Sold income remaining unbilled at end of year $ 99,900 $ 65,970 $ 37,256 Allowance for uncollectible minimum lease payments and recourse liability at end of year $ 3,969 $ 2,706 $ 1,513 The Company does not expect any significant losses from the recourse provisions related to the sale of rental income. The Company is compensated for administration and servicing of rental income sold. NOTE D -- PROPERTY, PLANT & EQUIPMENT December 31 (In thousands) 1997 1996 Computer systems and equipment $28,570 $20,236 Transportation equipment 1,665 1,737 Furniture and fixtures 4,043 3,301 Leasehold improvements 1,693 1,037 Land 2,619 321 ----- ------- 38,590 26,632 Less: Accumulated depreciation and amortization 19,031 15,443 ------ ------ $19,559 $11,189 ====== ====== NOTE E -- OTHER ASSETS December 31 (In thousands) 1997 1996 Net investment in sales-leases $13,402 $11,497 Excess of purchase price over net assets acquired, net 4,380 4,334 Other assets 248 126 ------ ------- $18,030 $15,957 ======= ======= NOTE F-- OTHER CURRENT LIABILITIES December 31 (In thousands) 1997 1996 Compensation and employee benefits $8,163 $6,176 Deferred revenues 2,947 2,889 Other accrued expenses 7,611 7,776 ----- ------- $18,721 $16,841 ======= ======= NOTE G -- CREDIT LINE The Company maintains a $7,000,000 unsecured bank credit line at prime rate to cover international letters of credit and for other purposes. The credit agreement matures July 31, 1998 and contains certain restrictions and financial covenants. At December 31, 1997, $390,000 of the credit line was committed under letter of credit arrangements. NOTE H -- LEASES Rental expense amounted to $4,342,000; $3,538,000; and $2,995,000; in 1997, 1996 and 1995, respectively. Noncancellable operating leases are primarily for buildings. Certain of the leases contain provisions for renewal options and scheduled rent increases. At December 31, 1997, future minimum commitments under noncancellable leases, including a five year lease for its headquarters facility and a 15 year lease for its distribution and support facility, are: 1998 -- $3,444,000; 1999 -- $2,570,000; 2000 -- $1,788,000; 2001 -- $1,230,000; 2002 -- $733,000; thereafter -- $2,610,000. NOTE I -- INCOME TAXES The Company accounts for income taxes under SFAS Statement No. 109, "Accounting for Income Taxes" ("Statement No. 109"). Under Statement No. 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined (and classified as current or long-term) based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Significant components of the Company's deferred tax liabilities and assets as of December 31, are as follows: (In thousands) 1997 1996 Deferred tax liabilities: Lease--sales and reserves $15,624 $ 12,502 Accelerated depreciation -- 179 ------- -------- Total deferred tax liabilities 15,624 12,681 ------- -------- Deferred tax assets: Inventory basis differences 2,580 1,553 Accounts receivable reserves 1,357 1,135 Maintenance reserve 259 317 Accrued vacation pay 604 557 Foreign loss carryforwards 1,047 794 Other -- net 1,858 1,223 ------- -------- Deferred tax assets 7,705 5,579 Less valuation reserve 1,047 794 ------- -------- Net deferred tax assets 6,658 4,785 ------- -------- Net deferred tax liabilities $ 8,966 $ 7,896 ======= ======= During 1997 and 1996, the Company incurred losses of $722,000 and $730,000 with respect to foreign operations. At December 31, 1997, the Company had foreign loss carryforwards of approximately $3,100,000, which will begin to expire in 1999. The valuation allowance increased by $253,000 in 1997 and $248,000 in 1996 due to increases in foreign loss carryforward benefits. Federal and state income taxes consisted of the following: (In thousands) 1997 1996 1995 Federal $ 8,290 $ 5,414 $ 4,789 State 1,630 850 460 ----- --- --- $ 9,920 $ 6,264 $ 5,249 ===== ===== ===== The principal reasons for the difference between total income tax expense and the amount computed by applying the statutory federal income tax rate to income before taxes are as follows: 1997 1996 1995 Federal tax at statutory rates applied to pre-tax income 35% 34% 34% State tax net of federal benefit 4 4 2 Valuation reserve increase for foreign losses 1 2 2 Other - net -- 1 -- --- --- --- 40% 41% 38% === === === NOTE J -- EQUITY TRANSACTIONS Stock Split. Retroactive adjustments have been made, as appropriate, to Common Stock and per share amounts to reflect the 2-for-1 stock split effected in the form of a stock dividend in October 1997. Treasury Stock. During the second quarter of 1997, the Company initiated a stock repurchase program under which the Board of Directors authorized the repurchase of up to 1,470,000 shares (on a pre-Stock Split basis) of the Common Stock. The Company expended approximately $27.2 million for stock repurchases during 1997, which was funded primarily through existing cash balances. The Company reissued shares through November through stock option exercises and issuances. The proceeds received for the stock reissued was less than its cost basis. Accordingly, the difference was recorded as a reduction to retained earnings. Public Stock Offering. In a public offering in December 1997, the Company sold 3,000,000 shares of Common Stock. Net proceeds from the offering were approximately $59,150,000. In conjunction with the offering, all remaining treasury shares were reissued first and the remaining shares issued from previously unissued Common Stock. Dividend Policy. On September 24, 1997, the Company's Board of Directors declared a cash dividend (the "Cash Dividend") of $0.01 for every share of Common Stock, payable to shareholders of record as of December 31, 1997, with dividend payments to commence on or about January 15, 1998. Prior to the Cash Dividend, the Company had declared no cash dividends on its Common Stock since incorporation. Stock Option Plans. Under the Company's 1994 and 1997 Long-Term Incentive Plans, selected officers and key employees are granted options to purchase Common Stock of the Company at not less than fair market value at date of grant. The options are exercisable at the end of their ten-year term, but may become exercisable in annual installments. In some instances, predetermined performance goals and share market value increases must be met to allow the options to be exercised before the end of the option term. Under other previous stock option plans, directors, officers and key employees may purchase Common Stock of the Company at amounts not less than the fair market value at the date of grant. These options generally have a term of five to ten years and are exercisable over four to five years commencing one year from the date of grant, except for director stock option grants, which are exercisable commencing six months from the date of grant. In November 1993, the Board of Directors authorized the Inter-Tel, Incorporated Long-Term Incentive Plan ("the 1994 Long Term Plan"). A total of 2,000,000 shares of Common Stock has been reserved for issuance under the 1994 Long Term Plan. Options must be granted at not less than 100% of the fair market value of the Company's stock at the dates of grant. Options generally vest over four or five years and expire five to ten years from the date of grant. In July 1990, the Company adopted the Director Stock Option Plan ("the Director Plan") and reserved a total of 500,000 shares of Common Stock for issuance thereunder. Commencing with the adoption of the Plan, each Eligible Director received a one-time automatic grant of an option to purchase 5,000 shares of the Company's Common Stock. In addition, each Eligible Director shall be granted an option to purchase 5,000 shares upon the date five (5) days after such person became Director, and an additional option to purchase 5,000 shares five (5) days after the date of annual reelection as Director. All options granted have a five-year term and fully vest at the end of six months from the grant date. In February 1997, the Board of Directors authorized the Inter-Tel, Incorporated 1997 Long-Term Incentive Plan ("the 1997 Long Term Plan"). A total of 2,400,000 shares of Common Stock has been reserved for issuance under the 1997 Long Term Plan. Options must be granted at not less than 100% of the fair market value of the Company's stock at the dates of grant. Options generally vest over four or five years and expire ten years from the date of grant. Option activity for the past three years under all plans is as follows: Number of Shares 1997 1996 1995 Outstanding at beginning of year 2,192,300 1,695,000 1,649,000 Granted 1,523,000 788,000 321,024 Exercised (511,426) (205,000) (217,774) Expired or canceled (241,350) (85,700) (57,250) --------- -------- -------- Outstanding at end of year 2,962,524 2,192,300 1,695,000 --------- --------- --------- Exercise price range $2.88-$25.88 $2.88-$10.22 $1.13-$7.25 Exercisable at end of year 587,774 578,700 334,166 Weighted-average fair value of options granted $8.42 $2.36 $1.72 At December 31, 1997, the Company has reserved 4,400,050 shares of Common Stock for issuance in connection with the stock option plans. For the stock option plans discussed above, the Company has adopted the disclosure only provisions of SFAS No. 123 "Accounting for Stock-Based Compensation," ("SFAS No. 123"). Accordingly, no compensation cost has been recognized in the accompanying financial statements for the stock option plans. The following table summarizes information about stock options outstanding at December 31, 1997:
Options Outstanding Options Exercisable Number Number Outstanding at Weighted-Average Weighted Exercisable at Weighted Range of December 31, Remaining Average December 31, Average Exercise Price 1997 Contractual Life Exercise Price 1997 Exercise Price $2.88 - $4.31 718,579 6 years $3.01 410,579 $3.01 $4.81 - $7.06 698,950 7 years $5.79 74,700 $6.43 $7.25 - $10.25 1,432,995 8 years $8.14 102,495 $8.41 $15.13 - $25.88 112,000 9 years $22.14 -- N/A
During 1997, the weighted average exercise price of options granted, exercised, and expired or canceled was $8.42, $4.36 and $5.62, respectively. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards in 1997, 1996 and 1995 consistent with the provisions of SFAS No. 123, the estimated fair value of the options would be amortized to expense over the option's vesting period and the Company's net income and net income per share would have been decreased to the pro forma amounts indicated below for the year ended December 31: (in thousands, except per share amounts) 1997 1996 1995 Net income as reported $14,682 $9,042 $8,499 Pro forma net income $14,345 $8,950 $8,455 Pro forma earnings per diluted share $0.55 $0.34 $0.36 Pro forma results disclosed are based on the provisions of SFAS No. 123 using the Black-Scholes option valuation model and are not likely to be representative of the effects on pro forma net income for future years. In addition, the Black-Sholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the estimating models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model using the low end of reasonable assumptions for input variables rather than attempting to identify a best-point estimate. The option pricing model utilized the following weighted average assumptions for 1997, 1996 and 1995, respectively: risk free interest rates of 5.0% in each year; dividend yields of 0.25% in 1997 and 0% in 1996 and 1995; volatility factors of the expected market price of the Company's stock averaged .30; and a weighted average expected life of the option of 3.0 years for employee stock options which vest over four to five year periods with a weighted average vesting period of 2.5 years and 1.5 years for Company director options which vest at the end of six months from the grant date. 1997 Employee Stock Purchase Plan. In April 1997, the Board of Directors and stockholders adopted the Employee Stock Purchase Plan (the "Purchase Plan") and reserved 500,000 shares for issuance to eligible employees. Under the Purchase Plan, employees are granted the right to purchase shares of Common Stock at a price per share that is 85% of the lesser of the fair market value of the shares at: (i) the participant's entry date into each six-month offering period, or (ii) the end of each six-month offering period. Employees may designate up to 10% of their compensation for the purchase of stock. Under the Plan, the Company sold 36,018 shares for approximately $256,000 ($7.12 per share) to employees in 1997. At December 31, 1997, 463,982 shares remained authorized under the Plan. NOTE K - EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share: (in thousands, except per share amounts) 1997 1996 1995 Numerator: Net Income $14,682 $9,042 $8,499 ------ ----- ----- Denominator: Denominator for basic earnings per share - weighted average shares 24,836 25,780 23,056 Effect of dilutive securities: Employee and director stock options 1,147 792 710 ----- --- --- Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions 25,983 26,572 23,766 ------ ------ ------ Basic earnings per share $ 0.59 $ 0.35 $ 0.37 ====== ====== ====== Diluted earnings per share $ 0.57 $ 0.34 $ 0.36 ====== ====== ====== Options which 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. The number of options to purchase shares of Common Stock that were outstanding during 1997 that were antidilutive were immaterial, because the market price of the Company's stock was generally higher during the course of the year than the prices at which options were granted. NOTE L -- RETIREMENT PLANS The Company has two retirement plans for the benefit of all of its employees. Under its 401(k) Retirement Plan, participants may contribute an amount not exceeding 15 percent of compensation received during participation in the Plan. The Company makes voluntary annual contributions to the Plan based on a percentage of contributions made by Plan participants of up to 10 percent of compensation. Contributions to the Plan totaled $491,000; $394,000 and $328,000 in 1997, 1996 and 1995, respectively. In 1992, the Company initiated an Employee Stock Ownership Plan (ESOP), advancing $500,000 to the ESOP Trust for the purpose of purchasing Common Stock of the Company. The Trust purchased 307,000 shares of the Company's Common Stock in July 1992. The loan was paid in full during 1997. As the principal amount of the loan was repaid to the Company through Company annual contributions, the equivalent number of shares released were allocated to employees' accounts to be held until retirement. Total shares so allocated were 32,380; 69,424 and 64,580 in 1997, 1996 and 1995, respectively. Contributions to the ESOP totaled $62,500 in 1997, and $125,000 each 1996 and 1995 and are based upon the historic cost of the shares purchased by the ESOP. After the final allocation of shares in 1997, the ESOP plan was "frozen," so that all eligible participants as of July 1, 1997 became 100% vested in their accounts, regardless of length of service. No further purchases are anticipated through the ESOP, and the Company does not anticipate making future allocations of shares from this plan. NOTE M -- FINANCIAL INSTRUMENTS Concentration of Credit Risk. Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash investments, trade accounts receivable, and net investment in sales-leases. The Company maintains cash and equivalents not invested in money market funds with a major bank in its marketplace. The Company performs periodic evaluations of the relative credit standing of the financial institution. Concentrations of credit risk with respect to trade accounts receivable and net investment in sales-leases are limited due to the large number of entities comprising the Company's customer base. Fair Value of Financial Instruments. The carrying amount of cash and equivalents, accounts receivable, net investment in sales-leases, and accounts payable reported in the consolidated balance sheets approximate their fair value. NOTE N -- SUPPLEMENTAL CASH FLOW (In thousands) 1997 1996 1995 Cash paid for: Interest $ 47 $ 77 $ 106 Income taxes $ 5,914 $ 4,213 $ 1,885 -------- -------- -------- Changes in operating assets and liabilities: Increase in receivables $ (7,294) $ (8,569) $(16,368) Increase in inventories (4,280) (1,309) (5,997) (Increase) decrease in prepaid expenses and other assets 4,407 (6,268) (500) Increase in long-term other assets (2,028) (4,024) (1,676) Increase in accounts payable and other current liabilities 7,562 4,466 6,400 -------- -------- -------- $ (1,633) $(15,704) $(18,141) ======== ======== ======== NOTE O -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) A summary of the quarterly results of operations for the years ended December 31, 1997 and 1996 follows: (In thousands, except per share amounts)
1997 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Net sales $50,322 $54,823 $56,915 $61,508 Gross margin 22,170 24,401 26,298 28,336 Net income 2,670 3,424 3,978 4,610 Net income per share Basic $0.10 $0.13 $0.17 $0.19 Diluted $0.10 $0.13 $0.16 $0.18 Average number of common shares outstanding -- Basic 25,901 25,438 23,397 24,606 Average number of common shares outstanding -- Diluted 26,450 26,623 24,682 26,179
1996 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Net sales $42,213 $43,736 $47,435 $52,500 Gross margin 19,312 19,108 19,616 22,882 Net income 2,899 2,784 2,689 670 Net income per share Basic $0.11 $0.11 $0.10 $0.03 Diluted $0.11 $0.10 $0.10 $0.03 Average number of common shares outstanding -- Basic 25,546 25,748 25,858 25,885 Average number of common shares outstanding -- Diluted 26,341 26,567 26,607 26,579
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report to Shareholders on Form 10-K contain forward-looking statements that involve risks and uncertainties. The words "expects," "anticipates," "believes," "intends," "will" and similar expressions identify forward-looking statements which 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 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 in "Factors That May Affect Results of Future Operations" and else where in this 10-K. General Inter-Tel is a single point of contact, full service provider of digital business telephone systems, IP telephony products, CTI applications, voice processing software and long distance calling services. Inter-Tel's products and services include the AXXESS and Inter-Tel Axxent digital business communication platforms, the AXXESSORY Talk voice processing platform, the Inter-Tel Vocal'Net IP telephony gateway and the Inter-Tel.net private IP telephony network. The Company also provides maintenance, leasing and support services for its products. The Company's Common Stock is quoted on the NASDAQ National Market System under the symbol INTL. The Company has developed networks of direct sales offices, dealers and value added resellers (VARs) which sell the Company's products. In recent periods, the Company has focused on expanding its direct sales capabilities and its dealer and VAR network. The Company has acquired a number of resellers of telephony products and integrated these operations with its existing direct sales operations in the same geographic areas and in other strategic markets. Sales of systems through the Company's dealers and VARs typically generate lower gross margins than sales through the Company's direct sales organization, although direct sales typically require higher levels of selling, general and administrative expenses. In addition, the Company's long distance and network services typically generate lower gross margins than sales of software and system products. Accordingly, the Company's 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, the Company's overall gross margin could decline. The Company's 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 the Company and its competitors, pricing pressures, the cost and effect of acquisitions and the availability and cost of products and components from the Company's suppliers. Historically, a substantial portion of the Company's 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, the Company is subject to seasonal variations in its 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 served by the Company have been characterized by rapid technological changes and increasing customer requirements. The Company has sought to address these requirements through the development of software enhancements and improvements to existing systems and the introduction of new products and applications. The Company's research and development efforts over the last several years have been focused primarily on developing new products such as the Inter-Tel Vocal'Net Server, Inter-Tel Axxent system and Inter-Tel VisualMail; enhancing the CTI capabilities of the AXXESS digital communications platform; and expanding the capacity of the Company's AXXESS and AXXESSORY Talk systems. Current efforts are related to the support of industry standard CTI interfaces, the development of additional applications and features, the enhancement of the Inter-Tel Vocal'Net Gateway Server and Service Provider Package, and the development of a LAN-based Communications Server incorporating the Company's Call Processing and Voice Processing software. New applications under development also include Basic Rate ISDN, PBX networking, the Inter-Tel.net private IP telephony service and enhanced unified messaging. The software-based architecture of the AXXESS system facilitates maintenance and support, upgrades, and incorporation of additional features and functionality. The Company offers to its customers a package of lease financing and other services under the name Totalease. Totalease provides to customers lease financing, maintenance and support services, fixed price upgrades and other benefits. The Company finances this program through the periodic resale of lease rental streams to financial institutions. Net sales of the Company have increased substantially in each of the past three years. Such increases were 20.3%, 23.5%, and 21.5% in 1997, 1996 and 1995, respectively, over the preceding year. Results of Operations The following table sets forth certain statement of operations data of the Company expressed as a percentage of net sales for the periods indicated: Year Ended December 31 1997 1996 1995 ---- ---- ---- Net sales 100.0% 100.0% 100.0% Cost of sales 54.7 56.5 58.3 ---- ---- ---- Gross margin 45.3 43.5 41.7 Research and development 3.6 3.5 3.8 Selling, general and administrative 31.3 30.3 28.9 Special charge -- 2.5 0.9 ---- ---- ---- Operating income 10.4 7.2 8.1 Interest and other income 0.6 1.1 1.1 Interest expense 0.0 0.0 0.1 Income taxes 4.4 3.4 3.5 ---- ---- ---- Net income 6.6% 4.9% 5.6% ---- ---- ---- Year Ended December 31, 1997 Versus Year Ended December 31, 1996 Net Sales. Net sales increased 20.3% to $223.6 million in 1997 from $185.9 million in 1996. Sales from the Company's direct sales offices and from wholesale distribution accounted for approximately $26.3 million of the increase. The remaining increases occurred in long distance sales and other operations. Gross Profit. Gross profit increased to $101.2 million, or 45.3% of net sales in 1997 from $80.9 million, or 43.5% of net sales in 1996. This increase was primarily a result of higher sales, as a percentage of total net sales, of AXXESS digital communication platforms, call processing software and voice processing software. In addition, gross margin increased based on a percentage increase in sales through the Company's direct sales offices compared to its dealer network. Research and Development. Research and development expenses increased to $8.0 million, or 3.6% of net sales in 1997 from $6.6 million, or 3.5% of net sales, in 1996. These expenses in both 1997 and 1996 were directed principally toward the continued development of the AXXESS and Inter-Tel Axxent software and systems, unified messaging and voice processing software, Inter-Tel Vocal'Net and certain CTI applications. The Company expects that research and development expenses will continue to increase in absolute dollars as the Company continues to develop and enhance existing and new technologies and products. These expenses may vary, however, as a percentage of net sales. Selling, general and administrative. Selling, general and administrative expenses increased to $69.9 million, or 31.3% of net sales in 1997 from $56.4 million, or 30.3% of net sales, in 1996. This reflected increased selling, incentive, training and other compensation costs attributable to the increased sales through the Company's direct sales offices, additional personnel to support the direct dealer network and expansion of long distance operations, development of the Inter-Tel.net network and expenses associated with international operations. Such increase is also attributable to the hiring of additional sales and technical training staff, expansion of its credit management group, and increases in reserves for accounts receivable. The Company expects that selling, general and administrative expenses will increase in absolute dollars, but may vary as a percentage of net sales. Interest and Other Income. Other income decreased approximately $591,000 in 1997 principally as a result of lower levels of cash available for investment. Net Income. Net income increased 62.4% to $14.7 million, or $.57 per diluted share, in 1997 compared to net income of $9.0 million, or $.34 per diluted share, in 1996. Excluding the special charge in 1996 related to the write-off of its MIS software, net income would have been $11.8 million, or $.44 per diluted share. Year Ended December 31, 1996 Versus Year Ended December 31, 1995 Net Sales. Net sales increased 23.5% to $185.9 million in 1996 from $150.5 million in 1995. Sales from direct sales offices accounted for approximately $14.7 million of the increase, with wholesale distribution sales increasing approximately $12.2 million. The remaining increases occurred in long distance sales and other operations. Gross Profit. Gross profit increased to $80.9 million, or 43.5% of net sales in 1996 from $62.8 million, or 41.7% of net sales in 1995. This reflected the transition to the direct dealer network and the expansion of AXXESS software and systems sales. Research and Development. Research and development expenses increased to $6.6 million, or 3.5% of net sales in 1996 from $5.8 million, or 3.8% of net sales, in 1995. These expenses in both 1996 and 1995 were directed principally to the continued development of the AXXESS and Inter-Tel Axxent software and systems, unified messaging and voice processing software, Inter-Tel Vocal'Net and Inter-Tel Vocal'Net server, and certain CTI applications. Selling, general and administrative. Selling, general and administrative expenses increased to $56.4 million, or 30.3% of net sales in 1996, from $43.6 million, or 28.9% of net sales, in 1995. This reflected increased incentive and other compensation, costs associated with the implementation of the Company's information systems, additional personnel to support the direct dealer network and expanded long distance operations, and expenses associated with the expansion of international operations. Special Charge. During the fourth quarter of 1996, the Company decided to replace its MIS system software with an integrated solution from a more established vendor and accordingly wrote off the software license and implementation costs relating to the system software being replaced. The special pre-tax charge of $4.5 million ($.10 per share after tax), reflects the costs associated with the Company's decision to abandon its current MIS software in favor of different system software. Interest and Other Income. Other income increased in 1996 principally from the investment of the funds received from the August 1995 public offering and funds generated through operating cash flow. Net Income. Net income increased 6.4% to $9.0 million, or $.34 per diluted share, in 1996 including the special charge recognized in the fourth quarter compared to $8.5 million, or $.36 per diluted share, in 1995. Excluding the special charges in both periods, net income would have been $11.8 million, or $.44 per diluted share, for 1996 compared to $9.3 million, or $.39 per diluted share for 1995. In addition, net income per diluted share in 1996 was based on additional average shares outstanding in 1996, primarily reflecting the public stock offering of 4.0 million shares of Common Stock in August 1995. 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 contract manufacturing has been or is expected to be moved to domestic sources. The expansion of international operations in the United Kingdom and Europe and increased sales, if any, in Japan and other parts of Asia could result in higher international sales as a percentage of total revenues; however, international revenues are currently not significant. Liquidity and Capital Resources At December 31, 1997, the Company had $88.8 million in cash and equivalents, which represents a increase of approximately $49.9 million from December 31, 1996. The Company maintains a $7.0 million unsecured revolving line of credit with Bank One, Arizona, NA. This credit facility is annually renewable and is available through July 31, 1998. Under the credit facility, the Company has the option to borrow at a prime rate or adjusted LIBOR interest rate. Historically, the credit facility has been used primarily to support international letters of credit to suppliers. In December 1997, the Company received net proceeds of approximately $59.2 million from a public stock offering of 3,000,000 shares. The proceeds may be used to develop and expand Inter-Tel.net and for potential acquisitions, strategic alliances, working capital and general corporate purposes. Net cash provided by operating activities totaled $28.2 million for the year ended December 31, 1997, compared to $7.3 million for the same period in 1996. The increase in cash generated in 1997 was primarily the result of profitable operations including non cash depreciation charges. In addition, cash used in operating assets and liabilities declined significantly in 1997 to $1.6 million, compared to cash used of $15.7 million in 1996. During 1997, increases in accounts receivable and inventory were principally funded by accounts payable. The Company continues to expand its dealer network, which has required and is expected to continue to require working capital for increased accounts receivable and inventories. Net cash used in investing activities, primarily in the form of capital expenditures, totaled $12.5 million and $7.0 million in 1997 and 1996, respectively. These capital expenditures were related primarily to the expansion of facilities, equipment and management information systems used in operations. Net cash provided by financing activities totaled $34.1 million in 1997 compared to $611,000 for the same period in 1996. During the second quarter of 1997, the Company initiated a stock repurchase program under which the Board of Directors authorized the repurchase of up to 1,470,000 shares (on a pre-Stock Split basis) of the Common Stock. The Company expended approximately $27.2 million for stock repurchases during 1997, which was funded primarily through existing cash balances. The Company reissued shares through November through stock option exercises and issuances. The proceeds received for the stock reissued was less than its cost basis. Accordingly, the difference was recorded as a reduction to retained earnings. The Company reissued all remaining authorized, but then unissued shares upon the completion of the Company's offering of 3,000,000 shares of Common Stock in December 1997. The Company received net proceeds of $59.2 million from the offering. Such stock was reissued from the offering at greater than the cost basis. The difference was recorded as an increase to Common Stock. The Company offers to its customers lease financing and other services, including its Totalease program, through its Inter-Tel Leasing subsidiary. The Company funds its Totalease program in part through the sale to financial institutions of rental income streams under the leases. Resold Totalease rentals totaling $99.9 million remain unbilled at December 31, 1997. The Company is obligated to repurchase such income streams in the event of defaults by lease customers and, accordingly, maintains reserves based on loss experience and past due accounts. Although the Company to date has been able to resell the rental streams from leases under the Totalease program profitably and on a substantially current basis, the timing and profitability of lease resales could impact the Company's business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If the Company is required to repurchase rental streams and realizes losses thereon in amounts exceeding its reserves, its operating results will be adversely affected. The Company believes that the net proceeds from the Company's offering of 3,000,000 shares of Common Stock completed on December 1, 1997 and its working capital and credit facilities, together with cash generated from operations, will be sufficient to develop and expand its Inter-Tel.net network, to finance acquisitions of additional resellers of telephony products and other strategic acquisitions or corporate alliances, and to provide adequate working capital for at least the next twelve months. However, to the extent that additional funds are required in the future to address working capital needs and to provide funding for capital expenditures, expansion of the business or the Inter-Tel.net network or additional acquisitions, the Company will seek, if at all, additional financing. There can be no assurance that additional financing will be available when required or on acceptable terms. Impact of Recently Issued Accounting Standards In February 1997, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 128, "Earnings Per Share" ("SFAS No. 128"), adopted by the Company on December 31, 1997. Statement 128 replaced the previously reported primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants, and convertible securities. Diluted earnings per share is very similar to the previously reported primary earnings per share. All earnings per share amounts for all periods have been presented, and where necessary, restated to conform to the Statement 128 requirements. The impact of SFAS No. 128 on the calculation of fully diluted earnings per share for each of the periods presented was not material. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131 is effective for financial statements for fiscal years beginning after December 15, 1997. The adoption of SFAS 131 will have no impact on the Company's consolidated results of operations, financial position or cash flows. EX-22.1 4 SUBSIDIARIES OF INTER-TEL, INCORPORATED EXHIBIT 22.1 SUBSIDIARIES OF INTER-TEL, INCORPORATED Listed below are all the subsidiaries of Inter-Tel, Incorporated, as well as the jurisdiction under the laws of which each was organized, and the percentage of the outstanding voting stock of each owned by Inter-Tel, Incorporated. Percentage State or of Voting Jurisdiction Name Stock Owned of Organization - ---- ----------- --------------- Inter-Tel Integrated Systems, Inc. 100% Arizona Inter-Tel Technologies, Inc. (formerly Inter-Tel Communications, Inc.) 100% Arizona Inter-Tel Leasing, Inc. 100% Arizona Inter-Tel Midwest, Inc. 100% Delaware Inter-Tel Incorporated-New Jersey 100% Delaware Inter-Tel NetSolutions, Inc. 100% Texas Inter-Tel DataCom, Inc. 100% Delaware Southwest Telephone Systems, Inc. 100% New Mexico American Telcom Corp. of Georgia, Inc. 100% Georgia Access West, Inc. 100% Delaware Inter-Tel Integrated Systems (UK), Ltd. 100% United Kingdom Inter-Tel Japan, Inc. 100% Japan Florida Telephone Systems, Inc. 100% Florida NTL Corporation dba ComNet of Ohio 100% Ohio EX-23 5 CONSENT OF ERNST & YOUNG LLP, EXHIBIT 23.0--CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference on page 34 in this Annual Report (Form 10-K) of our report dated February 20, 1998 included in the 1997 Annual Report to Shareholders of Inter-Tel, Incorporated. Our audit also included the financial statement schedule of Inter-Tel, Incorporated listed in Item 14(a). This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based upon our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in Registration Statement (Form S-3 No. 33-58161), Registration Statement (Form S-3 No. 33-61437), Registration Statement (Form S-3 No. 333-01735), Registration Statement (Form S-3 No. 333-12433), Registration Statement (Form S-3 No. 333-39221), Registration Statement (Form S-8 No. 2-94805), Registration Statement (Form S-8 No. 33-40353), Registration Statement (Form S-8 No. 33-73620) and in Registration Statement (Form S-8 No. 333-41197) of our report dated February 20, 1998, with respect to the consolidated financial statements incorporated herein by reference and our report included in the preceding paragraph with respect to the financial statement schedule included in this Annual Report (Form 10-K) of Inter-Tel, Incorporated. Phoenix, Arizona /S/ ERNST & YOUNG LLP March 27, 1998 EX-24.1 6 POWER OF ATTORNEY EXHIBIT 24.1--POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven G. Mihaylo and Kurt R. Kneip, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. Signature Title Date /S/ Steven G. Mihaylo Chairman and Chief March 23, 1998 - --------------------- Executive Officer Steven G. Mihaylo /S/ Kurt R. Kneip Vice President and March 23, 1998 - --------------------- Chief Financial Officer Kurt R. Kneip /S/ J. Robert Anderson Director March 23, 1998 - --------------------- J. Robert Anderson /S/ Gary D. Edens Director March 23, 1998 - --------------------- Gary D. Edens /S/ Maurice H. Esperseth Director March 23, 1998 - ------------------------ Maurice H. Esperseth /S/ C. Roland Haden Director March 23, 1998 - --------------------- C. Roland Haden /S/ Norman Stout Director March 23, 1998 - --------------------- Norman Stout EX-27 7 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE INTER-TEL, INCORPORATED AND SUBSIDIARIES FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS 1,000 U.S. DOLLARS 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 1 88,805 0 35,956 3,722 21,539 157,399 38,590 19,031 194,988 33,585 0 0 0 99,229 46,276 194,988 223,569 223,569 122,363 122,363 0 4,104 0 24,602 9,920 14,682 0 0 0 14,682 0.59 0.57
EX-27.1 8 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS RESTATED SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE INTER-TEL, INCORPORATED AND SUBSIDIARIES FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS ALL INFORMATION FOR THIS PERIOD IS THE SAME AS PREVIOUSLY STATED, WITH THE EXCEPTION OF THE NEW EARNINGS PER SHARE REPORTING REQUIREMENTS (SHOWN BELOW): 1,000 U.S. DOLLARS 12-MOS DEC-31-1996 JAN-01-1996 DEC-31-1996 1 38,936 0 33,094 3096 21,280 105,465 26,632 15,443 132,611 25,756 0 0 0 59,875 35,059 132,611 185,884 185,884 104,966 104,966 0 3,746 0 15,306 6,264 9,042 0 0 0 9,042 0.35 0.34
EX-27.2 9 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS RESTATED SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE INTER-TEL, INCORPORATED AND SUBSIDIARIES FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1995 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS ALL INFORMATION FOR THIS PERIOD IS THE SAME AS PREVIOUSLY STATED, WITH THE EXCEPTION OF THE NEW EARNINGS PER SHARE REPORTING REQUIREMENTS (SHOWN BELOW): 1,000 U.S. DOLLARS 12-MOS DEC-31-1995 JAN-01-1995 DEC-31-1995 1 39,640 0 31,611 1,822 20,580 98,139 24,747 12,934 118,767 22,516 0 0 0 58,966 26,151 118,767 150,533 150,533 87,696 87,696 0 1,594 0 13,748 5,249 8,499 0 0 0 8,499 0.37 0.36
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