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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2005 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from January 1, 2005 to March 31, 2005 Commission file number: 1-31949 I-Sector Corporation  Delaware
    
    76-0515249(State of incorporation)
    
    (I.R.S. Employer Identification Number)
 6401 Southwest Freeway
Houston, Texas 77074
(Address of principal executive offices)
(Zip code) (713) 795-2000
Registrants telephone number including area code Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ       No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes o       No þ The Registrant has 5,454,534 shares of common stock outstanding as of May 12, 2005.




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I-Sector Corporation
FORM 10-Q for the Quarter Ended March 31, 2005
INDEX Part I. Financial InformationItem 1. Financial Statements (Unaudited):Condensed Consolidated Statements of Income for the three months ended March 31, 2004 and 2005Condensed Consolidated Balance Sheets at December 31, 2004 and March 31, 2005Condensed Consolidated Statement of Stockholders Equity for the three months ended March 31, 2005Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2005Notes to Condensed Consolidated Financial StatementsItem 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures about Market RiskItem 4. Controls and ProceduresPart II. Other InformationItem 1. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security HoldersItem 5. Other InformationItem 6. ExhibitsSignatureLetter Re: Change in Accounting PrincipleRule 13a-14(a) Certification of Principal Executive OfficerRule 13a-14(a) Certification of Principal Financial OfficerSection 1350 Certification of Principal Executive OfficerSection 1350 Certification of Principal Financial Officer




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements (Unaudited): 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share amounts)
(Unaudited) Three months ended March 31,2004
    
    
    2005Revenue:Products
    
    $
    10,194
    
    
    $
    23,534Services
    
    
    1,944
    
    
    
    2,793Custom projects
    
    
    2,137
    
    
    
    1,441Total revenue
    
    
    14,275
    
    
    
    27,768Cost of goods and services:Products
    
    
    8,491
    
    
    
    20,188Services
    
    
    1,286
    
    
    
    1,936Custom projects
    
    
    962
    
    
    
    732Total cost of goods and services
    
    
    10,739
    
    
    
    22,856Gross profit
    
    
    3,536
    
    
    
    4,912Selling, general and administrative expenses
    
    
    3,499
    
    
    
    10,784Operating income (loss)
    
    
    37
    
    
    
    (5,872
    )Interest and other income (expense), net
    
    
    19
    
    
    
    (47
    )Income (loss) from continuing operations before income taxes
    
    
    56
    
    
    
    (5,919
    )Income taxes
    
    
    5
    
    
    
    Net income (loss) from continuing operations before minority
interest
    
    
    51
    
    
    
    (5,919
    )Minority interest
    
    
    
    
    
    
    (23
    )Net income (loss) from continuing operations
    
    
    51
    
    
    
    (5,942
    )Discontinued operations:Loss on disposal of discontinued operations, net of taxes
    
    
    (12
    )
    
    
    Net income (loss) before cumulative effect of change in
accounting method
    
    
    39
    
    
    
    (5,942
    )Cumulative effect of change in application of
percentage of completion method
    
    
    
    
    
    
    (566
    )Net income (loss)
    
    $
    39
    
    
    $
    (6,508
    )Net income (loss) per share:Basic:Income (loss) from continuing operations before
minority interest
    
    $
    0.01
    
    
    $
    (1.14
    )Minority interest
    
    
    
    
    
    
    Loss on disposal of discontinued operations, net of taxes.
    
    
    
    
    
    
    Cumulative effect of change in accounting method
    
    
    
    
    
    
    (.11
    )Net income (loss) per share
    
    $
    0.01
    
    
    $
    (1.25
    )Diluted:Income (loss) from continuing operations before
minority interest
    
    $
    0.01
    
    
    $
    (1.14
    )Minority interest
    
    
    
    
    
    
    Loss on disposal of discontinued operations, net of taxes.
    
    
    
    
    
    
    Cumulative effect of change in accounting method
    
    
    
    
    
    
    (.11
    )Net income (loss) per share
    
    $
    0.01
    
    
    $
    (1.25
    )Shares used in computing net income (loss) per share:Basic
    
    
    3,978,407
    
    
    
    5,210,794Diluted
    
    
    4,544,406
    
    
    
    5,210,794
 The accompanying notes are an integral part of the condensed consolidated financial statements




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CONDENSED CONSOLIDATED BALANCE SHEETS I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and par value amounts) December 31,
    
    
    March 31,2004
    
    
    2005(Unaudited)ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    4,773
    
    
    $
    7,185Accounts and notes receivable, net of allowance of $2,146 and $2,366
    
    
    30,127
    
    
    
    26,921Inventory
    
    
    1,159
    
    
    
    849Cost and estimated earnings in excess of billings
    
    
    1,663
    
    
    
    948Other current assets
    
    
    310
    
    
    
    355Total current assets
    
    
    38,032
    
    
    
    36,258Property and equipment, net of accumulated depreciation of $2,397 and $2,511
    
    
    1,787
    
    
    
    1,778Notes receivable, long-term, net of allowance of $250 and $250
    
    
    207
    
    
    
    60Intangible assets, net of accumulated amortization of $1,005 and $1,111
    
    
    1,113
    
    
    
    2,415Total Assets
    
    $
    41,139
    
    
    $
    40,511LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Notes payable and current portion of long-term debt
    
    $
    8,220
    
    
    $
    101Accounts payable
    
    
    10,675
    
    
    
    15,926Billings in excess of cost and estimated earnings
    
    
    63
    
    
    
    786Other current liabilities
    
    
    5,931
    
    
    
    6,992Total current liabilities
    
    
    24,889
    
    
    
    23,805Long-term debt
    
    
    122
    
    
    
    94Minority interest
    
    
    279
    
    
    
    Commitments and contingenciesStockholders Equity:Preferred stock, $.01 par value, 5,000,000 shares authorized,
no shares issued
    
    
    
    
    
    
    Common stock, $.01 par value, 15,000,000 shares authorized,
5,201,354 and 5,454,534 shares issued
    
    
    52
    
    
    
    54Additional paid in capital
    
    
    17,513
    
    
    
    24,782Retained deficit
    
    
    (1,716
    )
    
    
    (8,224
    )Total stockholders equity
    
    
    15,849
    
    
    
    16,612Total Liabilities and Stockholders Equity
    
    $
    41,139
    
    
    $
    40,511
 The accompanying notes are an integral part of the condensed consolidated financial statements




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CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY I-SECTOR CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
(In thousands, except share amounts)
(Unaudited) $.01 par value
    
    
    AdditionalCommon Stock
    
    
    Paid-In
    
    
    RetainedShares
    
    
    Amount
    
    
    Capital
    
    
    Deficit
    
    
    TotalBalance at December 31, 2004
    
    
    5,201,354
    
    
    $
    52
    
    
    $
    17,513
    
    
    $
    (1,716
    )
    
    $
    15,849Exercise of common stock options
    
    
    8,290
    
    
    
    
    
    
    
    12
    
    
    
    
    
    
    
    12Exchange of INX and I-Sector options
    
    
    
    
    
    
    
    
    
    
    5,729
    
    
    
    
    
    
    
    5,729Exchange of INX and I-Sector common stock
    
    
    244,890
    
    
    
    2
    
    
    
    1,528
    
    
    
    
    
    
    
    1,530Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,508
    )
    
    
    (6,508
    )Balance at March 31, 2005
    
    
    5,454,534
    
    
    $
    54
    
    
    $
    24,782
    
    
    $
    (8,224
    )
    
    $
    16,612
 The accompanying notes are an integral part of the condensed consolidated financial statements




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CONSOLIDATED STATEMENTS OF CASH FLOWS I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) Three months ended March 31,2004
    
    
    2005CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    39
    
    
    $
    (6,508
    )Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:Net loss from discontinued operations
    
    
    12Tax benefit from discontinued operations
    
    
    5Minority interests
    
    
    
    
    
    
    23Depreciation and amortization
    
    
    201
    
    
    
    238Loss on retirement of assets
    
    
    18
    
    
    
    12Bad debt expense (recoveries)
    
    
    (182
    )
    
    
    30Exchange of INX and I-Sector options
    
    
    
    
    
    
    5,729Changes in operating assets and liabilities:Accounts and notes receivable
    
    
    275
    
    
    
    3,176Accounts payable
    
    
    618
    
    
    
    5,251Other assets and liabilities
    
    
    (844
    )
    
    
    2,729Net cash provided by operating activities
    
    
    142
    
    
    
    10,680CASH FLOWS FROM INVESTING ACTIVITIES:Capital expenditures
    
    
    (139
    )
    
    
    (133
    )Net cash used in investing activities
    
    
    (139
    )
    
    
    (133
    )CASH FLOWS FROM FINANCING ACTIVITIES:Exercise of stock options
    
    
    59
    
    
    
    12Payments on notes payable
    
    
    (1,714
    )
    
    
    (8,147
    )Notes payable  interest bearing borrowings on credit line
    
    
    1,204
    
    
    
    Net cash used in financing activities
    
    
    (451
    )
    
    
    (8,135
    )NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    (448
    )
    
    
    2,412CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
    
    
    2,172
    
    
    
    4,773CASH AND CASH EQUIVALENTS AT END OF PERIOD
    
    $
    1,724
    
    
    $
    7,185SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Cash paid for interest
    
    $
    24
    
    
    $
    219SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES:Acquisition of INX minority interest:Issuance of common stock
    
    
    
    
    
    
    1,530Transaction costs accrued
    
    
    
    
    
    
    180Minority interest acquired
    
    
    
    
    
    
    (302
    )Revaluation of options granted to consultants
    
    
    150Offering costs accrued
    
    
    486
 The accompanying notes are an integral part of the condensed consolidated financial statements




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts) 1. DESCRIPTION OF BUSINESS I-Sector Corporation and subsidiaries (I-Sector or the Company) are engaged in the sale and
support of IP communications solutions, IP communications network infrastructure, proprietary call
center computer-telephony software, and centralized management of remote-enabled computer networks
and helpdesks. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying unaudited financial data as of March 31, 2005 and for the three months ended March
31, 2004 and 2005 have been prepared by the Company, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures normally included
in financial statements prepared in accordance with accounting principles generally accepted in the
United States have been condensed or omitted pursuant to such rules and regulations. The December
31, 2004 Condensed Consolidated Balance Sheet was derived from audited financial statements, but
does not include all disclosures required by accounting principles in the United States. However,
the Company believes the disclosures are adequate to make the information presented not misleading.
These Condensed Consolidated Financial Statements should be read in conjunction with the
Consolidated Financial Statements and the notes thereto, included in the Companys Annual Report on
Form 10-K for the year ended December 31, 2004. In the opinion of management, all adjustments (which include normal recurring adjustments, except
as disclosed herein) necessary to present a fair presentation of financial position as of March 31,
2005, results of operations for the three months ended March 31, 2004 and 2005, cash flows for the
three months ended March 31, 2004 and 2005, and stockholders equity for the three months ended
March 31, 2005, have been included. The results of the interim periods are not necessarily
indicative of results for the full year or any future period. Revenue Recognition I-Sector has a number of different revenue components, which vary between its reportable operating
segments. Each reportable operating segment has more than one revenue component, and revenue is
recognized differently for each component of revenue earned by operating segment. The material
revenue earned by I-Sector, some of which are earned by more than one operating segment, and some
by only one operating segment, are: Products Revenue.Each of I-Sectors operating segments earn revenue from product shipments.
I-Sector recognizes revenue from product shipments when the product is shipped or delivered to
the customer. Services Revenue.All of I-Sectors operating segments earn revenue from providing stand-alone
services revenue. This revenue consists of billings for engineering and technician time,
programming services, which are provided on either an hourly basis or a flat-fee basis, support
contracts and the service component of maintenance and repair service ticket transactions. These
services are contracted for separately from any product sale, and are generally completed in
less than three months. Service revenues are recognized when the service is performed and when
collection is reasonably assured. Two of I-Sectors segments sometimes earn agency fee revenue
from various sources, the primary source of which is referring customers to other organizations
for which an agency fee is received. This revenue is recognized at the earlier of when payment
is received or when notification of amounts due is received from the entity paying such agency
fee and collectibility is reasonably assured. One of I-Sectors segments, Internetwork Experts, Inc. (INX), has certain fixed and flat fee
services contracts that extend over three months or more, and are accounted for on the
percentage of completion method of accounting. The percentage of revenue recognized in any
particular period is determined on the basis of the




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relationship of the actual hours worked to estimated total hours to complete the contract.
Revisions of the estimated hours to complete are reflected in the period in which the facts
necessitating the revisions become known. When a contract indicates a loss, a provision is made
for the total anticipated loss. Custom Project Revenue.One of I-Sectors segments, Stratasoft, earns revenue from projects that
are recognized using the percentage of completion method of accounting. The majority of
Stratasofts revenue consists of system sales in which it bundles its proprietary software,
along with third-party hardware products and material related software customization services,
installation, training services, warranty services and incidental post contract support (PCS)
together under a single contract with the customer. PCS is insignificant on such contracts for
one year or less, and therefore, we have determined that the value of such PCS should not be
unbundled from the project revenue as set forth in paragraph 59 of SOP 97-2. Accordingly, such
PCS revenue is recognized together with the project revenue, and the estimated cost to provide
the PCS is accrued. The value of the PCS is determinable within the contract, which defines the
period that the PCS is granted and offers renewals at stated amounts, thereby defining the value
of the PCS. The software customization, together with the hardware customization and
integration, represent a significant modification, customization and/or production of the
product and, therefore, the entire arrangement is required to be accounted for using the
percentage of completion method of accounting pursuant to SOP 81-1. The Company follows this
method since reasonably dependable estimates of the revenue and costs applicable to various
stages of a contract can be made. Revisions of estimates are reflected in the period in which
the facts necessitating the revisions become known. When a contract indicates a loss, a
provision is made for the total anticipated loss. The percentage-of-completion method relies on
estimates of expected contract revenue and costs. Prior to January 1, 2005, the percentage of
revenue recognized in any particular period was determined principally on the basis of the
relationship of the cost of work performed on the contract compared to the estimated total costs
expected to be incurred under the contract. Effective January 1, 2005, the Company changed its
method of computing the percentage of completion from total project costs to total labor costs,
as further discussed in Note 4. The following reflects the amounts relating to uncompleted contracts at: December 31,
    
    
    March 31,2004
    
    
    2005Costs incurred on uncompleted contracts
    
    $
    1,675
    
    
    $
    627Estimated earnings
    
    
    4,862
    
    
    
    3,450Less: Billings to date
    
    
    (4,937
    )
    
    
    (3,915
    )Total
    
    $
    1,600
    
    
    $
    162Included in accompanying balance sheets under the following captions:Cost and estimated earnings in excess of billings
    
    $
    1,663
    
    
    $
    948Billings in excess of cost and estimated earnings
    
    
    (63
    )
    
    
    (786
    )Total
    
    $
    1,600
    
    
    $
    162
 Vendor Incentives INX participates in a significant vendor incentive program. The incentives are generally earned
based on sales volume, sales growth and customer satisfaction levels. The amounts earned under
these programs are accrued when realization is deemed probable and can be reasonably measured;
otherwise, they are recorded when they are declared by the vendor or the cash is received,
whichever is earlier. The incentives are recorded as a reduction of cost of goods and services.
Selling, general and administrative expenses are increased for any associated commission expense
and payroll tax related to the incentives. When vendor incentives are not recognized until vendor
declaration or cash receipt, then their effect on cost of goods can vary significantly among
quarterly and annual reporting periods. Vendor incentives of $622 and $664 were recognized during
the three-month periods ended March 31, 2004 and 2005, respectively. Vendor incentives reported
for the 2004 period relate to the six-month measurement period ended January 31, 2004 and vendor
incentives for the 2005 period are for the three months ended March 31, 2005 Stock-Based Compensation The Company has elected to account for employee stock-based compensation using the intrinsic value
method of accounting in accordance with Accounting Principles Bulletin (APB) No. 25 Accounting
for Stock Issued to




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Employees. Under this method no compensation expense is recognized when the number of shares
granted is known and the exercise price of the stock option is equal to or greater than the fair
value of the common stock on the grant date. For the three months ended March 31, 2004, the Company
recorded no stock-based compensation associated with stock options granted to employees and
directors in its consolidated statement of operations. For the three months ended March 31, 2005,
$5,729 of expense was recorded for stock options remeasured as discussed in Note 6. I-Sector and
its subsidiaries apply the fair value method as prescribed by SFAS No. 123, as interpreted and
amended, for stock and stock options issued to non-employees and during the three months ended
March 31, 2004 and 2005, recorded $(63) and $0, respectively, of other additional paid in capital
related to compensation to non-employees. If compensation cost for all option issuances had been determined consistent with the fair value
method, I-Sectors net income (loss) and net income (loss) per share would have increased to the
pro-forma amounts indicated below.
For purposes of the disclosures below, the fair value of each stock option has been estimated on
the grant date with a Black-Scholes option pricing model using the following weighted-average
assumptions for the 2004 and 2005 periods; dividend yield of 0% for all periods; expected
volatility of 106.0% and 78.6%, respectively; risk-free interest rate of 3.63% and 3.63%,
respectively; and expected lives of 8.4 and 8.0 years, respectively, from the original date of
the stock option grants. Three months endedMarch 31,2004
    
    
    2005Basic and diluted:Net income (loss) as reported
    
    $
    39
    
    
    $
    (6,508
    )Deduct: Total stock-based employee
compensation determined under fair value
based method for all awards, net of related
tax effects
    
    
    22
    
    
    
    40Pro forma net income (loss)
    
    $
    17
    
    
    $
    (6,548
    )Earnings per share:Basic  as reported
    
    $
    0.01
    
    
    $
    (1.25
    )Basic  pro forma
    
    $
    0.00
    
    
    $
    (1.26
    )Diluted  as reported
    
    $
    0.01
    
    
    $
    (1.25
    )Diluted  pro forma
    
    $
    0.00
    
    
    $
    (1.26
    )
 In December 2004, the FASB issued SFAS No. 123(R), which amends SFAS No. 123 and supersedes APB
Opinion No. 25. SFAS No. 123(R) requires compensation expense to be recognized for all share-based
payments made to employees based on the fair value of the award at the date of grant, eliminating
the intrinsic value alternative allowed by SFAS No. 123. Generally, the approach for determining
fair value under the original pronouncement has not changed. However, there are revisions to the
accounting guidelines established, such as accounting for forfeitures, that will change the
Companys accounting for stock-based awards in the future. SFAS No. 123(R) must be adopted in the first annual period beginning after June 15, 2005. The
statement allows companies to adopt its provisions using either of the following transition
alternatives:  
    The modified prospective method, which results in the recognition of compensation
expense using SFAS No. 123(R) for all share-based awards granted after the effective date
and the recognition of compensation expense using SFAS No. 123 for all previously granted
share-based awards that remain unvested at the effective date; or
    The modified retrospective method, which results in applying the modified prospective
method and restating prior periods by recognizing the financial statement impact of
share-based payments in a manner consistent with the pro forma disclosure requirements of
SFAS No. 123. The modified retrospective method may be
applied to all prior periods presented or previously reported interim periods of the year of
adoption.




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The Company currently plans to adopt SFAS No. 123(R) on January 1, 2006 using the modified
prospective method. This change in accounting is not expected to materially impact the Companys
financial position. However, because the Company currently accounts for share-based payments to
employees using the intrinsic value method, the results of operations generally have not included
the recognition of compensation expense for the issuance of stock option awards. The Company has
not calculated the impact of this statement on our previous or future operating results as it is
still determining the appropriate fair value method to be used. The Company will be required to recognize expense related to stock options and other types of
equity-based compensation beginning in 2006 and such cost must be recognized over the period
during which an employee is required to provide service in exchange for the award. The requisite
service period is usually the vesting period. The standard also requires the Company to estimate
the number of instruments that will ultimately be issued, rather than accounting for forfeitures
as they occur. Additionally, the Company may be required to change the method used to determine
the fair value of stock options. 3. SEGMENT INFORMATION I-Sector has four reportable segments: INX, Stratasoft, Valerent and Corporate. Corporate is not a
revenue generating operating segment. The accounting policies of the business segments are the
same as those for I-Sector. I-Sector evaluates performance of each segment based on operating
income. Management views trade accounts receivable and inventory and not total assets in their
decision-making. Inter-segment sales and transfers are not significant and are shown in the
Eliminations column in the following table. The tables below show the results of the four
reportable segments: For the quarter ended March 31, 2005: INX
    
    
    Stratasoft
    
    
    Valerent
    
    
    Corporate
    
    
    Eliminations
    
    
    ConsolidatedRevenue:Products
    
    $
    23,153
    
    
    $
    
    
    
    $
    402
    
    
    $
    
    
    
    $
    (21
    )
    
    $
    23,534Services
    
    
    1,508
    
    
    
    
    
    
    
    1,285
    
    
    
    
    
    
    
    
    
    
    
    2,793Custom projects
    
    
    
    
    
    
    1,441
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,441Total revenue
    
    
    24,661
    
    
    
    1,441
    
    
    
    1,687
    
    
    
    
    
    
    
    (21
    )
    
    
    27,768Gross profit:Products
    
    
    3,337
    
    
    
    
    
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    3,346Services
    
    
    324
    
    
    
    
    
    
    
    533
    
    
    
    
    
    
    
    
    
    
    
    857Custom projects
    
    
    
    
    
    
    709
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    709Total gross profit
    
    
    3,661
    
    
    
    709
    
    
    
    542
    
    
    
    
    
    
    
    
    
    
    
    4,912Selling, general
and administrative
expenses
    
    
    2,947
    
    
    
    1,234
    
    
    
    540
    
    
    
    6,063
    
    
    
    
    
    
    
    10,784Operating income
(loss)
    
    $
    714
    
    
    $
    (525
    )
    
    $
    2
    
    
    $
    (6,063
    )
    
    $
    
    
    
    
    (5,872
    )Interest and other
income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (47
    )Loss before income
taxes and minority
interest
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,919
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Minority interest
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (23
    )Net loss before
cumulative effect
of change in
accounting method
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,942
    )Cumulative effect
of change in
application of
percentage of
completion method
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (566
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (6,508
    )




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##### Table of Contents



For the quarter ended March 31, 2004: INX
    
    
    Stratasoft
    
    
    Valerent
    
    
    Corporate
    
    
    Eliminations
    
    
    ConsolidatedRevenue:Products
    
    $
    10,061
    
    
    $
    
    
    
    $
    334
    
    
    $
    
    
    
    $
    (201
    )
    
    $
    10,194Services
    
    
    913
    
    
    
    
    
    
    
    1,031
    
    
    
    
    
    
    
    
    
    
    
    1,944Custom projects
    
    
    
    
    
    
    2,137
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,137Total revenue
    
    
    10,974
    
    
    
    2,137
    
    
    
    1,365
    
    
    
    
    
    
    
    (201
    )
    
    
    14,275Gross profit:Products
    
    
    1,679
    
    
    
    
    
    
    
    24
    
    
    
    
    
    
    
    
    
    
    
    1,703Services
    
    
    324
    
    
    
    
    
    
    
    334
    
    
    
    
    
    
    
    
    
    
    
    658Custom projects
    
    
    
    
    
    
    1,175
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,175Total gross profit
    
    
    2,003
    
    
    
    1,175
    
    
    
    358
    
    
    
    
    
    
    
    
    
    
    
    3,536Selling, general
and administrative
expenses
    
    
    1,884
    
    
    
    1,020
    
    
    
    390
    
    
    
    205
    
    
    
    
    
    
    
    3,499Operating income
(loss)
    
    $
    119
    
    
    $
    155
    
    
    $
    (32
    )
    
    $
    (205
    )
    
    $
    
    
    
    
    37Interest and other income, net
    
    
    
    
    
    
    19Income from continuing operations before income taxes
    
    
    
    
    
    
    56Income taxes
    
    
    
    
    
    
    5Net income from continuing operations
    
    
    
    
    
    
    51Net loss on disposal of discontinued operations, net of taxes
    
    
    
    
    
    
    (12
    )Net income
    
    
    
    
    
    $
    39
 4. CHANGE IN APPLICATION OF ACCOUNTING METHOD Prior to 2005, the Stratasoft segment recognized revenue under the percentage of completion method
based on the relationship of total cost incurred to total estimated cost over the duration of the
project. Effective January 1, 2005, the Stratasoft segment changed its method of applying the
percentage of completion accounting method to the relationship of labor cost incurred to total
estimated labor cost over the duration of the project. Management believes the newly adopted
method of applying the accounting principle is preferable in Stratasofts circumstances because
using labor cost as the input measure more accurately reflects the labor intensive customization
and modification that now occurs to the Stratasoft hardware and software more evenly over the
duration of Stratasofts projects. Accordingly, the labor cost input method more appropriately
measures the progress towards completion over the duration of Stratasofts projects. The change in accounting method was applied by recording the cumulative effect of the change
amounting to $566 in the condensed consolidated statement of income for the three months ended
March 31, 2005. Had the change in accounting method not been made, net income would have increased
by $87, or $ .02 per share (basic and diluted). The pro forma effect has not been presented for
prior periods due to the inability to accurately compute the effect of the change prior to December
31, 2004. Due to the Companys net operating loss carryforward position, there is no income tax
effect to the cumulative effect adjustment. 5. EARNINGS PER SHARE Basic EPS is computed by dividing net income (loss) by the weighted-average number of common shares
outstanding for the period. Diluted EPS is based on the weighted-average number of shares
outstanding during each period and the assumed exercise of dilutive stock options and warrants less
the number of treasury shares assumed to be purchased from the proceeds using the average market
price of the Companys common stock for each of the periods presented. In the three months ended March 31, 2004, net income from continuing operations for purposes of
computing the income per share decreased $4 for the assumed exercise of INX options under the
treasury method. For the three




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months ended March 31, 2005, I-Sectors potentially dilutive
options of 1,236,614 were not used in the calculation of diluted earnings since the effect of
potentially dilutive securities in computing a loss per share is antidilutive. Three months endedMarch 31,2004
    
    
    2005Numerator for basic earnings per share:Net income (loss) from continuing operations
    
    $
    51
    
    
    $
    (5,942
    )Gain (loss) on disposal of discontinued operations, net of taxes
    
    
    (12
    )
    
    
    Cumulative effect of change in accounting method
    
    
    
    
    
    
    (566
    )Net income (loss)
    
    $
    39
    
    
    $
    (6,508
    )Numerator for diluted earnings per share:Net income (loss) from continuing operations
    
    $
    51
    
    
    $
    (5,942
    )INX income attributable to potential minority interest net
income (loss) from continuing operations used in computing loss
per share
    
    
    4Loss on disposal of discontinued
operations, net of taxes
    
    
    (12
    )Cumulative effect of change in accounting method
    
    
    
    
    
    
    (566
    )Net income (loss)
    
    $
    34
    
    
    $
    (6,508
    )Denominator for basic earnings per share  weighted-average
shares outstanding
    
    
    3,978,407
    
    
    
    5,210,794Effect of dilutive securities  shares issuable from assumed
conversion of common stock options and restricted stock
    
    
    565,999
    
    
    
    Denominator for diluted earnings per share  weighted-average
shares outstanding
    
    
    4,544,406
    
    
    
    5,210,794
 6. STOCKHOLDERS EQUITY Elimination of Minority Interest in INX On March 18, 2005, the Company acquired all of the INX shares held by a minority shareholder group
in exchange for 244,890 shares of I-Sector common stock. The transaction was recorded using the
purchase method of accounting, resulting in recognition of goodwill of $1,408 including transaction
costs of $180, elimination of $302 in minority interests, and an increase in common stock and
additional paid-in-capital of $1,530. In connection with the transaction, INX stock options were
exchanged for I-Sector stock options, requiring remeasurement of the stock options as of the date
of exchange. The resulting $5,729 charge to earnings was reflected as an increase in selling,
general, and administrative expenses with a corresponding increase in additional paid-in-capital
and therefore had no impact on total stockholders equity. Common Stock Repurchase Plan Effective March 31, 2005, the Board of Directors authorized the repurchase of up to 200,000 shares
of the Companys common stock. Under the repurchase plan, any shares repurchased must be purchased
on or before July 31, 2005. These repurchases will be made in open market or privately negotiated
transactions in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended,
subject to market and business conditions, applicable legal
requirements and other factors. The plan does not obligate the Company to purchase any particular
amount of common stock, and may be suspended at any time at the Companys discretion. Warrants Included in the units issued by I-Sector in a public offering that closed on May 7, 2004 were
575,000 warrants to




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purchase common stock at an exercise price of $12.45 per share. These warrants
are exercisable through May 7, 2009 and are subject to redemption by I-Sector at a price of $0.25
per warrant upon 30 days notice to the holders; however, the Company may only redeem the warrants
if the closing price for the Companys common stock, as reported on the principal exchange on which
such shares trade, for any five consecutive days has equaled or exceeded $16.60. On May 7, 2004 I-Sector issued warrants to the underwriters to purchase up to 50,000 units at an
exercise price equal to $19.92 per unit. These warrants are exercisable during the four-year period
beginning May 7, 2005 which is one year from the date of the prospectus. Pursuant to NASD Rule
2710(g), these warrants cannot be sold, transferred, assigned, pledged or hypothecated by any
person for a period of one year following the effective date of the offering, except to any NASD
member participating in the offering, to bona fide officers, by operation of law or if the Company
is reorganized, so long as the securities so transferred remain subject to the same transfer
restriction for the remainder of the one-year period. The holder of the representatives warrant
will have, in that capacity, no voting, dividend or other stockholder rights. 7. STOCK OPTION PLANS Under the 1996 Incentive Stock Plan (the 1996 Incentive Plan) and the 1996 Non-Employee Director
Stock Option Plan (the Director Plan) as approved by the shareholders, I-Sectors Compensation
Committee may grant up to 417,500 shares of common stock, which have been reserved for issuance to
certain employees of I-Sector. At March 31, 2005, 5,150 shares were available for future grant
under the 1996 Incentive Plan. The 1996 Incentive Plan provides for the granting of incentive
awards in the form of stock options, restricted stock, phantom stock, stock bonuses and cash
bonuses in accordance with the provisions of the plan. Additionally, no shares may be granted after
the tenth anniversary of the 1996 Incentive Plans adoption. I-Sector has reserved for issuance,
under the Director Plan, 100,000 shares of common stock, subject to certain anti-dilution
adjustments, of which no shares were available for future grants at March 31, 2005. The Director
Plan provides for a one-time option by newly elected directors to purchase up to 5,000 common
shares, after which each director is entitled to receive an option to purchase up to 5,000 common
shares upon each date of re-election to I-Sectors Board of Directors. Options granted under the
Director Plan and the 1996 Incentive Plan have an exercise price equal to the fair market value on
the date of grant and generally expire ten years after the grant date. The I-Sector Corporation Incentive Plan provides for the granting of incentive awards in the form
of stock-based awards and cash bonuses in accordance with the provisions of the plan. All
employees, including officers, and consultants and non-employee directors are eligible to
participate in the I-Sector Corporation Incentive Plan. Generally, the Compensation Committee has
the discretion to determine the exercise price of each stock option under the I-Sector Corporation
Incentive Plan, and they must be exercised within ten years of the grant date, except those
classified as Incentive Stock Option (ISO) grants to a 10% or greater stockholder. ISO options
grants to a 10% or greater stockholder must be exercised within five years of the grant date. The
exercise price of each ISO option grant may not be less than 100% of the fair market value of a
share of common stock on the date of grant (110% in the case of a 10% or greater stockholder). At
the special shareholders meeting held on March 18, 2005, the plan was amended to increase the
number of shares of common stock available for stock option grants to 2,023,103 to accommodate the
1,023,103 options that were assumed in the exchange of INX stock options discussed in Note 6. At
the annual shareholders meeting held on May 11, 2005, the plan was amended to increase the number
of shares of common stock available for stock option grants to 2,273,103 At March 31, 2005, 254,500
shares were available for future option grants under the I-Sector Corporation Incentive Plan. The activity of employees and non-employees in all plans for the three months ended March 31, 2005
is summarized below:




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##### Table of Contents



WeightedAverageExerciseShares
    
    
    PriceOptions outstanding at beginning of the period
    
    
    652,921
    
    
    $
    3.37Granted during the period
    
    
    85,000
    
    
    $
    7.33INX options assumed at conversion rate
    
    
    1,123,103
    
    
    $
    1.15Exercised during the period
    
    
    (8,290
    )
    
    $
    1.39Options outstanding at end of period
    
    
    1,852,734
    
    
    $
    2.21Options exercisable at end of period
    
    
    1,643,300
    
    
    $
    1.71Options outstanding price range
    
    $
    0.07 to $8.06Weighted average fair value of options granted
during the period
    
    $
    7.33Options weighted average remaining life
    
    7.43 Years
 Outstanding
    
    
    
    
    
    
    ExercisableWeightedAverage
    
    
    Weighted
    
    
    
    
    
    
    WeightedRemaining
    
    
    Average
    
    
    
    
    
    
    AverageOutstanding
    
    
    Contractual
    
    
    Exercise
    
    
    Exercisable
    
    
    ExerciseShares
    
    
    Life
    
    
    Price
    
    
    Shares
    
    
    Price$0.07 to $0.99
    
    
    127,447
    
    
    
    5.35
    
    
    $
    0.10
    
    
    
    127,447
    
    
    $
    0.10$1.00 to
$1.99
    
    
    1,265,287
    
    
    
    7.13
    
    
    
    1.35
    
    
    
    1,244,821
    
    
    
    1.34$2.00 to $2.99
    
    
    97,200
    
    
    
    7.84
    
    
    
    2.61
    
    
    
    97,030
    
    
    
    2.61$3.00 to $3.99
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $4.00 to $4.99
    
    
    182,800
    
    
    
    8.59
    
    
    
    4.18
    
    
    
    130,668
    
    
    
    4.20$5.00 to $8.06
    
    
    180,000
    
    
    
    9.59
    
    
    
    7.61
    
    
    
    43,334
    
    
    
    7.60Total
    
    
    1,852,734
    
    
    
    7.43
    
    
    $
    2.21
    
    
    
    1,643,300
    
    
    $
    1.71
 8. DEBT Inventory floor plan borrowings of $16,024 and $11,996 as of December 31, 2004 and March 31, 2005,
respectively, under the agreement with Textron are reflected in accounts payable in the
accompanying consolidated balance sheets, except for $8,122 that is interest bearing and reflected
in short term debt in the accompanying consolidated balance sheet at December 31, 2004. As of
March 31, 2005, there are no amounts reflected as short-term debt related to the Textron agreement. 9. RECLASSIFICATIONS Certain prior period amounts in the balance sheet presented herein have been reclassified to
conform to the current period presentation. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following discussion is qualified in its entirety by, and should be read in conjunction with,
our consolidated financial statements, including the notes thereto included elsewhere in this Form
10-Q and our annual report on Form 10-K for the fiscal year ended December 31, 2004 previously
filed with the Securities and Exchange Commission. Special notice regarding forward-looking statements This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995 relating to future events or our future financial
performance including, but not limited to, statements contained in Item 2. Managements Discussion
and Analysis of Financial Condition and Results of Operations. Readers are cautioned that any
statement that is not a statement of historical fact, including but not




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limited to, statements
which may be identified by words including, but not limited to, anticipate, appear, believe,
could, estimate, expect, hope, indicate, intend, likely, may, might, plan,
potential, seek, should, will, would, and other variations or negative expressions
thereof, are predictions or estimations and are subject to known and unknown risks and
uncertainties. Numerous factors, including factors that we have little or no control over, may
affect I-Sectors actual results and may cause actual results to differ materially from those
expressed in the forward-looking statements contained herein. In evaluating such statements,
readers should consider the various factors identified in I-Sectors annual report on Form 10-K for
our fiscal year ended December 31, 2004, as filed with the Securities and Exchange Commission
including the matters set forth in Item 1.  Risks Related to Our Business, which could cause
actual events, performance or results to differ materially from those indicated by such statements. General We are a leading regional provider of IP telephony and other network infrastructure and related
implementation and support services. The IP telephony industry is characterized by rapidly
evolving and competing technologies. We compete with larger and better financed entities. Our
principal offices are currently all located in Texas, and we primarily market to potential
customers headquartered in, or making purchasing decisions from, Texas. Our long-term goal,
however, is to become one of the leading national providers of Cisco-centric network and IP
telephony solutions to enterprises. We begin Managements Discussion and Analysis of Financial Condition and Results of Operations with
an overview of a key financial transaction and a change in application of an accounting principle
that have important implications for our results of operations and financial condition. Elimination of Minority Interest in INX Between April 2004 and March 18, 2005, our INX subsidiary had a minority interest. The minority
interest was eliminated through an exchange of the minority interest for 244,890 shares of I-Sector
common stock on March 18, 2005. Prior to April 2004, INX had been our wholly-owned subsidiary. In April 2004, INX ceased to be a
wholly-owned subsidiary as the result of the issuance of INX common stock to the former owners of
Digital Precision, Inc., which INX acquired in April 2003. In connection with that acquisition, we
agreed to issue to the seller 1.8 million shares of INX common stock as additional purchase
consideration for their business if certain employees remained employed through April 4, 2004, the
first anniversary of the acquisition. This condition was met and the INX stock was issued in April
2004. At the time of issuance of that INX common stock, we recognized additional customer list
value of $234,000 as an intangible asset to be amortized over a two year period. When that issuance
occurred, our ownership percentage of INXs common stock declined to approximately 92.4%, and we
recognized $162,000 of minority interest on our balance sheet upon issuance. On February 1, 2005, we entered into an agreement with the INX minority shareholder to eliminate
the minority interest through an exchange of the INX minority shareholder interest for a similar
interest in I-Sector, contingent upon I-Sector stockholder approval. Upon stockholder approval on
March 18, 2005, INX became a wholly-owned subsidiary of the Company. The exchange of the minority
interest resulted in a remeasurement of the stock options that were part of the minority interest
and such remeasurement resulted in a $5.7 million one-time non-cash charge to earnings, which was
equal to the intrinsic value of the stock options on March 18, 2005. The charge to earnings was
reflected as an increase in selling, general, and administrative expenses with a corresponding
increase in additional paid-in-capital. As a result, the exchange of options had no impact on
total stockholders equity. The elimination of the minority interest simplifies our capital structure and eliminates the
minority interest on our financial statements, but increases the shares used to compute diluted
earnings per share due to the shares of our common stock issued in the exchange and because of the
increased number of stock options resulting from exchanging INX stock options for our stock
options. Our consolidated financial statements for periods prior to March 18, 2005, the date of the
exchange, reflected a minority interest adjustment of the profits and losses of INX attributable to
the minority ownership. For 2004, we




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reported income attributable to minority interest of $117,000
in our statement of operations and a minority interest balance of $279,000 in our balance sheet.
For the period January 1, 2005 through March 18, 2005 we reported income attributable to minority
interest of $23,000 in our statement of operations. The elimination of the minority interest
through the issuance of Company stock was recorded under the purchase method of accounting.
Goodwill of $1.4 million and the elimination of the $302,000 minority interest balance were
recorded, offset by an increase in common stock and additional paid-in-capital of $1.5 million. Change in the Application of Accounting Method for Stratasoft Projects Effective January 1, 2005 we began accounting for the percentage of completion of our Stratasoft
projects based upon the percentage of labor cost incurred as compared to total estimated labor cost
rather than total cost incurred compared to total estimated cost. Management believes the newly
adopted accounting method is preferable for Stratasoft projects because using labor cost as the
input measure more accurately reflects the labor intensive customization and modification that now
occurs to the Stratasoft hardware and software more evenly over the duration of a project.
Accordingly, the labor cost input method more appropriately measures the progress towards
completion over the duration of Stratasoft projects. The change in accounting method was applied by recording the cumulative effect of the change
amounting to $566,000 in the condensed consolidated statement of income for the three months ended
March 31, 2005. Had the change in accounting method not been made, net income for the period would
have increased by $87,000, or $ .02 per share (basic and diluted). The pro forma effect has not
been presented for prior periods due to the inability to accurately compute the effect of the
change prior to December 31, 2004. Due to the Companys net operating loss carryforward position,
there is no income tax effect to the cumulative effect adjustment. Results Of Operations Overview Sources of Revenue.Our revenue is derived from three segments represented by our three operating
subsidiaries, INX, Stratasoft and Valerent. During the quarter ended March 31, 2005, INX,
Stratasoft and Valerent accounted for 88.8%, 5.2% and 6.1%, respectively, of total consolidated
revenue, and (0.1)% of subsidiary revenue was eliminated in consolidation due to intercompany
transactions. INX revenue consists of product and service revenue. Product revenue consists of reselling Cisco
products and limited amounts of complementary products by other manufacturers. Service revenue is
generated by fees from a variety of implementation and support services. Product prices for INX
are set by the market for Cisco products, and provide our lowest gross margins. Service revenue
for INX has recently provided a higher gross margin that has generally increased over the past
several years as the cost of INXs technical resources, which are reflected as a cost of service,
has decreased as a percentage of services revenue. Also, certain fixed and flat fee service
contracts that extend over three months or more are accounted for on the percentage of completion
method of accounting. Historically, the majority of INXs services revenue has been generated from
implementation services, which is project oriented and tends to be volatile. As the number,
frequency and size of INX projects has grown, INX has achieved better utilization of its
engineering resources resulting in improved gross margins or services. The normal sales cycles for
corporate customers typically ranges from three to six months depending on the nature, scope and
size of the deal involved. However, our direct experience with school districts involved in E-Rate
funding (a governmental funding program for schools) indicates that the sales lead time is
generally about six to twelve months. In mid-2003, INX introduced Netsurant, its branded support
service that consists primarily of customer service personnel and a support center, and such new
support service offering required an upfront fixed cost to operate a network operations center to
monitor customers systems. This has created negative gross margins from this new
Netsurant service offering, which we expect will continue until such time as Netsurant support
services revenue exceeds the fixed cost of operating the network operations center. Eventually, we
anticipate that the Netsurant support offering could further improve overall services gross
margins. Through March 31, 2005, Netsurant service revenue was not material. Stratasoft revenue consists primarily of custom project revenue from the sale of proprietary
computer-telephony software. Our Stratasoft revenue is reported as custom project revenue in our
financial statements, because it consists of products and services which cannot be accounted for
separately. Stratasoft has traditionally provided our




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highest gross margin since it is primarily
sales of our proprietary computer-telephony software. Our cost of goods sold for Stratasofts
custom project revenue includes the costs of developing our computer-telephony software products,
installation costs, and the cost of hardware and other equipment bundled with our software
applications and included in a sale to a customer. Stratasoft revenue also includes sales to
resellers. The sales to resellers are recorded when the sale becomes fixed or determinable;
otherwise revenue from resellers is recorded when payments become due. Valerent revenue consists of both product revenue and services revenue. Product revenue consists
of reselling primarily software products, and to a lesser degree, hardware products, that
facilitate Valerents managed services, including remote management software products from Altiris,
Inc., and security software products from Network Associates, Inc. Product sales prices for
Valerent are set by the market for these products, and Valerents product sales have typically
provided lower gross profit margins than its services revenue. Valerents services revenue
consists of remote and onsite technical assistance to its customers. Valerents gross margin on
service revenue, much like INXs implementation services revenue, is subject to variability based
upon the utilization of Valerents billable technical resources. Recurring service agreements
exist with some customers, but usually with varying terms and conditions that conform to their year
over year business changes and their specific needs, and while these agreements provide somewhat
predictable and stable sources of revenue, the loss of a recurring agreement could disrupt the
stability of that revenue component for Valerent. Gross Profit and Gross Profit Margin. The mix of our various revenue components, each of which has
substantially different levels of gross margin, materially influences our overall gross profit and
gross margin in any particular quarter. In periods in which service revenue or Stratasoft custom
project revenue are high, as compared to INX and Valerent product sales, our gross margin generally
improves as compared to periods in which we have higher levels of product sales. Our gross margin
for product sales also varies depending on the type of product sold, the mix of large revenue
product contracts, which typically have lower gross margin, as compared to smaller revenue product
contacts, which typically have higher gross margin. In addition, our quarterly gross profit and gross margin can be materially affected by vendor
incentives received in certain quarterly periods, most of which are Cisco incentives received by
INX. The incentive programs sponsored by Cisco currently enable us to qualify for cash rebates or
product pricing discounts. These incentives are generally earned based on sales volume, sales
growth and customer satisfaction levels. The amounts earned under these programs are recorded as a
reduction of cost of goods and can vary significantly between periods. Currently, incentives by
Cisco are paid semiannually, and are typically paid in the first and third quarters of each
calendar year. Incentives are recognized when we receive payment from the supplier or when we have
earned and can reasonably estimate the amount due from the supplier. During the three months ended
March 31, 2005, we recognized $664,000 in vendor incentives, and we accrued $138,000 in commission
expense related to the vendor incentives earned by sales personnel in association with this vendor
incentive program for the quarter. A significant portion of our cost of services for each of our service businesses is comprised of
labor. Labor cost related to permanent employees is generally fixed in the short-term so that
higher levels of service revenue produce higher gross margins while lower levels of service revenue
produce lower gross margins. Our gross margin on services revenue fluctuates from period to period
depending not only upon the prices charged to customers for our services, but also upon the level
of utilization of our technical staff. Management of labor cost is therefore important in order to
maximize gross margin. Our gross margin is also impacted by such factors as contract size, time
and material pricing versus fixed fee pricing, discounting, vendor incentives and other business
and marketing factors normally incurred during the conduct of business. Selling, General and Administrative Expenses. Our selling, general and administrative expenses
include both fixed and variable expenses. Relatively fixed expenses in selling, general and
administrative expenses include rent, utilities,
promotion and advertising, and administrative wages. Variable expenses in selling, general and
administrative expenses include sales commissions and travel, which will usually vary based on our
sales and gross profit. Selling, general and administrative expenses also include expenses which
vary significantly from period to period but not in proportion to sales or gross profit. These
include legal expenses and bad debt expense both of which vary based on factors that are difficult
to predict. A significant portion of our selling, general and administrative expenses relate to personnel
costs, some of which are variable and others that are relatively fixed. Our variable personnel
costs consist primarily of sales commissions. Sales commissions are typically calculated based
upon our gross profit on a particular sales transaction and thus




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generally fluctuate because of the
size of the deal and the mix of associated products and services with our overall gross profit.
Bad debt expense generally fluctuates somewhat in proportion to sales levels, although not always
in the same periods as increases or decreases in sales. Legal expense varies based on legal issue
activity, which can vary substantially from period to period. The remainder of selling, general
and administrative expenses are relatively fixed and do not vary in direct proportion to increases
in revenue. Tax Loss Carryforward.Because of our prior operating losses we have accumulated a net operating
loss carryforward for federal income tax purposes that, as of March 31, 2005, was approximately
$2.5 million and is available to offset future federal and state taxable income. This carryforward
expires during the period 2023 through 2025. In addition to potential expiration, there are
several factors that could limit or eliminate our ability to use these carryforwards. For example,
under Section 382 of the Internal Revenue Code of 1986, as amended, use of prior net operating loss
carryforwards is limited after an ownership change. If we achieve sustained profitability, which
may not happen, the use of net operating loss carryforwards would reduce our tax liability and
increase our net income and available cash resources. When all operating loss carryforwards have
been used or have expired, we would again be subject to increased tax expense and reduced earnings
due to such tax expense. Period Comparisons.The following tables set forth, for the periods indicated, certain financial
data derived from our consolidated statements of operations. Percentages shown in the table below
are percentages of total revenue, except for each individual segments cost of sales and services,
gross profit, selling, general and administrative expenses, and operating income, which are
percentages of the respective segments revenue, and the product and service components of the INX
and Valerent segments cost of goods sold and gross profit, which are percentages of such segments
respective product and service revenue.




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Three months ended March 31,2004
    
    
    2005Amount
    
    
    %
    
    
    Amount
    
    
    %(Dollars in thousands)Revenue:INX product
    
    $
    10,061
    
    
    
    70.5
    
    
    $
    23,153
    
    
    
    83.4INX service
    
    
    913
    
    
    
    6.4
    
    
    
    1,508
    
    
    
    5.4Total INX revenue
    
    
    10,974
    
    
    
    76.9
    
    
    
    24,661
    
    
    
    88.8Stratasoft  Custom projects
    
    
    2,137
    
    
    
    15.0
    
    
    
    1,441
    
    
    
    5.2Valerent product
    
    
    334
    
    
    
    2.4
    
    
    
    402
    
    
    
    1.5Valerent service
    
    
    1,031
    
    
    
    7.2
    
    
    
    1,285
    
    
    
    4.6Total Valerent revenue
    
    
    1,365
    
    
    
    9.6
    
    
    
    1,687
    
    
    
    6.1Eliminations revenue
    
    
    (201
    )
    
    
    (1.5
    )
    
    
    (21
    )
    
    
    (0.1
    )Total revenue
    
    
    14,275
    
    
    
    100.0
    
    
    
    27,768
    
    
    
    100.0Gross profit:INX product
    
    
    1,679
    
    
    
    16.7
    
    
    
    3,337
    
    
    
    14.4INX service
    
    
    324
    
    
    
    35.5
    
    
    
    324
    
    
    
    21.5Total INX gross profit
    
    
    2,003
    
    
    
    18.3
    
    
    
    3,661
    
    
    
    14.8Stratasoft  Custom projects
    
    
    1,175
    
    
    
    55.0
    
    
    
    709
    
    
    
    49.2Valerent product
    
    
    24
    
    
    
    7.2
    
    
    
    9
    
    
    
    2.2Valerent service
    
    
    334
    
    
    
    32.4
    
    
    
    533
    
    
    
    41.5Total Valerent gross profit
    
    
    358
    
    
    
    26.2
    
    
    
    542
    
    
    
    32.1Total gross profit
    
    
    3,536
    
    
    
    24.8
    
    
    
    4,912
    
    
    
    17.7Selling, general and administrative expenses:INX
    
    
    1,884
    
    
    
    17.2
    
    
    
    2,947
    
    
    
    12.0Stratasoft
    
    
    1,020
    
    
    
    47.7
    
    
    
    1,234
    
    
    
    85.6Valerent
    
    
    390
    
    
    
    28.6
    
    
    
    540
    
    
    
    32.0Corporate
    
    
    205
    
    
    
    N/A
    
    
    
    6,063
    
    
    
    N/ATotal selling, general and administrative expenses
    
    
    3,499
    
    
    
    24.5
    
    
    
    10,784
    
    
    
    38.8Operating income (loss):INX
    
    
    119
    
    
    
    1.1
    
    
    
    714
    
    
    
    2.9Stratasoft
    
    
    155
    
    
    
    7.3
    
    
    
    (525
    )
    
    
    (36.4
    )Valerent
    
    
    (32
    )
    
    
    (2.3
    )
    
    
    2
    
    
    
    0.1Corporate
    
    
    (205
    )
    
    
    N/A
    
    
    
    (6,063
    )
    
    
    N/ATotal operating (loss) income
    
    
    37
    
    
    
    0.3
    
    
    
    (5,872
    )
    
    
    (21.1
    )Interest and other income (expense), net
    
    
    19
    
    
    
    0.1
    
    
    
    (47
    )
    
    
    (0.2
    )Income (loss) from continuing operations before income taxes
    
    
    56
    
    
    
    0.4
    
    
    
    (5,919
    )
    
    
    (21.3
    )Income tax expense
    
    
    5
    
    
    
    0.0
    
    
    
    
    
    
    
    0.0Net income (loss) from continuing operations before
minority interest
    
    
    51
    
    
    
    0.4
    
    
    
    (5,919
    )
    
    
    (21.3
    )Minority interest
    
    
    
    
    
    
    0.0
    
    
    
    (23
    )
    
    
    (0.1
    )Loss on disposal of discontinued operations, net of taxes
    
    
    (12
    )
    
    
    (0.1
    )
    
    
    
    
    
    
    Net income (loss) before change in accounting method
    
    
    39
    
    
    
    0.3
    
    
    
    (5,942
    )
    
    
    (21.4
    )Cumulative effect of change in application of percentage of
completion method
    
    
    
    
    
    
    
    
    
    
    (566
    )
    
    
    (2.0
    )Net income (loss)
    
    $
    39
    
    
    
    0.3
    
    
    $
    (6,508
    )
    
    
    (23.4
    )
 Three Months Ended March 31, 2004 Compared To the Three Months Ended March 31, 2005 Total Revenue. Our total revenue, net of intercompany eliminations, increased by $13.5 million, or
94.5%, from $14.3 million to $27.8 million. INX revenue increased by $13.7 million, or 124.7%, from $11.0 million to $24.7 million. As a
percentage of total revenue, INX revenue increased from 76.9% to 88.8%. INX product revenue
increased $13.1 million, or 130.1% from $10.1 million to $23.2 million. The increase in product
revenue is attributed to the adoption of IP telephony technology by our customers requiring
equipment upgrades for implementation and INXs performance of the DISD contract. INX service
revenue increased $595,000 or 65.2% from $913,000 to $1.5 million. The increase in services is
generally associated with the increase in product sales and the related design and installation
services performed in conjunction with such product sales as well as an increase in post-sale
support services revenue. INX service revenue did not increase a much as product revenue primarily
because (i) a disproportionate amount of INX contracts were received late in the quarter, resulting
in product revenue being shipped to the customer, but the services associated with such product
contracts not being performed in the quarter; and (ii) reduced services revenue




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associated with a
services contract for work in Iraq that was delayed for a portion of the quarter as discussed below
in the discussion of gross profit. Stratasoft revenue decreased by $696,000, or 32.6%, from $2.1 million to $1.4 million. As a
percentage of total revenue, Stratasoft revenue decreased from 15.0% to 5.2%. The decrease in
Stratasoft revenue was substantially attributable to Stratasoft transactions that were delayed and
are now expected to result in revenue being recognized in the second quarter and beyond, although
new Stratasoft contract bookings in the quarter were generally lower than had been expected. Valerent revenue increased by $322,000, or 23.6%, from $1.4 million to $1.7 million. As a
percentage of total revenue, Valerent revenue decreased from 9.6% to 6.1%. The increase in Valerent
revenue was primarily attributable to increased service revenue of $254,000, although product sales
also increased $68,000. The increase in service revenue is primarily attributable to the
development of Valerents remote managed services offerings. Gross Profit. Our total gross profit increased by $1.4 million, or 38.9%, from $3.5 million to
$4.9 million. Gross margin decreased from 24.8% to 17.7% due to changes in the gross margin of our
INX and Stratasoft subsidiaries as discussed below, as well as an increase, as a percentage of
total revenue of product sales revenue as compared to (i) service revenue and (ii) custom project
revenue, each of which generate higher gross margins than product sales. INX gross profit increased $1.7 million, or 82.8%, from $2.0 million to $3.7 million. INXs gross
margin decreased from 18.3% to 14.8%. INXs gross profit on its product sales component increased
$1.6 million or 98.7%, from $1.7 million to $3.3 million due to increased product sales revenue
attributable to the increased quantities of contracts. However, gross margin on its product sales
decreased from 16.7% to 14.4%, which was primarily attributable to the fact that in our fourth
quarter ended December 31, 2004 we began recognizing a certain Cisco vendor incentive on an accrual
basis rather than when received. Because of this change, only three months of this particular
incentive, totaling $664,000, was recognized in the 2005 period compared to six months of the
incentive, totaling $622,000, having been recognized in the 2004 period, which while a higher
dollar amount, was a lower percentage of INX substantially higher product sales for the 2005
period. INXs gross profit on its service revenue component remained unchanged at $324,000 and
gross margin on INX service revenue decreased from 35.5% to 21.5%. This decrease in service gross
margin was substantially the result of a significant service contract for work in Iraq being
delayed early in the quarter due to contract renegotiations and customer budget delays, which
issues were resolved in the later part of the quarter such that INX restarted work under the
contract, but during the period in which the contract was delayed revenue generation ceased without
a commensurate decrease in cost of service. Stratasoft gross profit decreased by $466,000, or 39.7%, from $1.2 million to $709,000.
Stratasofts gross margin decreased from 55.0% to 49.2%. Stratasoft gross margin declined
primarily due to reduced revenue combined with a fixed component of cost of sales in the form of
software development programmer costs and technician costs, which do not decline during periods of
reduced revenue. Gross profit declined because of the reduced revenue and the reduced gross margin
on revenue. Valerent gross profit increased by $184,000, or 51.4%, from $358,000 to $542,000. Valerents gross
margin increased from 26.2% to 32.1%. Valerents cost of service consists primarily of fixed labor
cost that does not fluctuate directly
with changes in revenue. Valerent improved its utilization of its labor pool by reducing the
number of technicians employed, relative to revenue, and lowered its fixed cost of service, which
contributed to improved gross profits. Selling, General and Administrative Expenses. Selling, general and administrative expenses
increased by $7.3 million, or 208.2% from $3.5 million to $10.8 million. As a percentage of total
revenue, these expenses increased from 24.5% to 38.8%. These expenses were primarily increased by the following:  
    Management and administrative compensation expense increased $6.1 million due to a
one-time noncash charge of $5.7 million related to option remeasurement associated with the
INX minority interest exchange, increased administrative and management salaries and wages
of $179,000 related primarily to hiring additional personnel, and increased administrative
and management bonuses of $96,000.




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
    Sales compensation increased $512,000 due to increased commissions generated from the
increased gross profit dollars and additional personnel hired to generate continued revenue
growth.  
    Bad debt expense increased $212,000 due to bad debt expense being at more normal levels
in the 2004 period as compared to being negative in the 2005 period due to recoveries in
the prior year period.  
    Payroll tax expense increased $102,000 due to increased employee compensation expenses
as discussed above.  
    Shareholder relations increased $81,000 due to costs associated with printing and
mailing proxy statements related to the INX minority interest conversion, and due to
increased attendance at investor conferences and investor group visits.  
    Travel increased $71,000 primarily due to increased INX travel related to acquisitions
activity.  
    General and miscellaneous expenses increased $50,000 due to the generally increased size
of the organization, including increased expenses for dues and subscriptions, employee
meetings, employee recruitment, office expenses, repair and maintenance and director fees.  
    Office rent increased $50,000 due to the relocation of our Dallas, Texas office facility
and the addition of the San Antonio, Texas office in mid-2004.  
    Telephone and communication expenses increased $39,000 primarily due to INX office
growth and relocation.  
    Depreciation increased $37,000 due to asset additions and the additional purchase value
for the Digital Precision intangible in April 2004. We expect our future selling, general and administrative expenses to increase as we continue
expenditures for compliance with the provisions of the Sarbanes-Oxley Act of 2002 as well as our
continued ramp up for anticipated revenue growth. However, we do expect to be able to limit the
increase of selling, general and administrative expenses such that these operating expenses grow at
a lesser rate than expected revenue increases because we expect to be able to leverage certain
categories of our operating expenses as we grow in the future. Operating Profit. Operating profit decreased $6.0 million from a profit of $37,000 to a loss of
$5.9 million, primarily due to the one-time non-cash compensation charge of $5.7 million related to
the exchange of the INX minority interest. INXs operating profit increased $595,000, or 500.0%
from $119,000 to $714,000. Stratasofts operating profit decreased $680,000, or 438.7% from a
profit of $155,000 to a loss of $525,000. Valerents operating profit increased $34,000, from a
loss of $32,000 to a profit of $2,000. The operating loss for the Corporate Segment, which included
the one-time non-cash compensation charge of $5.7 million, increased $5.9 million, from a loss of
$205,000 to a loss of $6.1 million. Interest and Other Income (Expense), Net. Interest and other income (expense), net, changed by
$66,000 from income of $19,000 to expense of $47,000. Our total borrowings under the Textron
credit facility decreased from $16.0 million to $12.0 million and the interest bearing portion of
our borrowings under the Textron credit facility decreased
from $8.1 million at December 31, 2004 to $0 at March 31, 2005. During the 2005 quarter, interest
expense of $61,000, a $12,000 loss on disposition of assets and a foreign exchange loss of $3,000
were offset by interest income of $29,000. Minority interest. Income attributable to minority interest increased from $0 to $23,000. During
April 2004 the company issued 1,800,000 shares of INX common stock pursuant to the Digital
Precision purchase agreement of April 2003. These minority interest shares in INX were exchanged
for shares of I-Sector Common Stock on March 18, 2005 and the minority interest was eliminated on
March 18, 2005. Approximately .4% of INXs operating income is deducted from the consolidated net
income of I-Sector as a result of the minority interest in INX for the three months ended March 31,
2005. Cumulative Effect of Change in Accounting Method.As discussed in detail above, effective January
1, 2005 we began accounting for the percentage of completion of our Stratasoft projects based upon
the percentage of labor cost




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incurred as compared to total estimated labor cost rather than total
cost incurred compared to total estimated cost. The change in accounting method was applied by
recording the cumulative effect of the change amounting to $566,000 in the condensed consolidated
statement of income for the three months ended March 31, 2005. Had the change in accounting method
not been made, net income for the period would have increased by $87,000, or $ .02 per share (basic
and diluted). Net income (loss). Net income decreased $6.5 million from a profit of $39,000 to a loss of $6.5
million. Income tax expense for the period was $0, and there is a net operating tax loss
carryforward of approximately $2.5 million as of March 31, 2005, but net deferred tax assets are
fully offset by a valuation allowance at March 31, 2005. Liquidity and Capital Resources Sources of Liquidity Our principal sources of liquidity are cash flow from operations and our credit facility with
Textron Financial Corporation (the Textron Facility). In 2004, we also received approximately
$7.5 million in net proceeds from a public offering. We use the Textron Facility to finance the
majority of our purchases of inventory, and to provide working capital when our cash flow from
operations is insufficient. Our working capital was $13.1 million and $12.5 million at December
31, 2004 and March 31, 2005, respectively. Accounts and Notes Receivable.The timing of our collection of accounts and notes receivable and
payments of our accounts payable is one of the principal influences on our cash flow from
operations. We typically sell our products and services on short-term credit terms. We try to
minimize our credit risk by performing credit checks, obtaining letters of credit in certain
instances, and conducting our own collection efforts. The balance of trade accounts receivable, net of allowance for doubtful accounts, was $28.8 million
and $25.6 million at December 31, 2004 and March 31, 2005, respectively. The current portion of
notes receivable were $1.2 million and $1.2 million and the noncurrent portion of notes receivable
were $207,000 and $60,000, net of allowances, at December 31, 2004 and March 31, 2005,
respectively. Inventory.We had inventory of $1.2 million and $849,000 at December 31, 2004 and March 31, 2005,
respectively. We try to minimize the amount of inventory on hand to reduce the risk that the
inventory will become obsolete or decline in value. We are able to do this by relying on the ready
availability of products from our principal suppliers. As noted below, we rely principally on our
Textron Facility to finance our inventory purchases. Contractual Obligations The following table summarizes certain of our contractual cash obligations and related payments due
as of March 31, 2005: Payments Due by PeriodLess
    
    
    
    
    
    
    
    
    
    
    AfterThan
    
    
    1-3
    
    
    4-5
    
    
    5Contractual Obligations
    
    Total
    
    
    1 Year
    
    
    Years
    
    
    Years
    
    
    Years(Dollars in thousands)Lease obligations .
    
    $
    2,259
    
    
    $
    767
    
    
    $
    1,183
    
    
    $
    309
    
    
    $
    Other debt obligations
    
    
    171
    
    
    
    84
    
    
    
    87
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    2,430
    
    
    $
    851
    
    
    $
    1,270
    
    
    $
    309
    
    
    $
    
 We do not have any material contractual purchase obligations. We purchase inventory to fulfill
in-hand orders from customers and we try to minimize the amount of inventory on hand to reduce risk
that the inventory will become obsolete or decline in value. We are able to do this by relying on
the ready availability of products from our principal suppliers.




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We expect to be able to meet our contractual cash payment obligations by their due dates through
cash generated from operations, augmented, if needed, by borrowings under the Textron Facility, and
with the proceeds of our recent public offering. Textron Facility.On January 31, 2002, we entered into the Textron Facility to provide financing
for our inventory purchases. On September 30, 2004 the agreement was amended and the maximum credit
available under the Textron facility is presently $25 million and it is collateralized by
substantially all of our assets other than our patent licenses.
As of March 31, 2005, we owed $12.0 million under the Textron Facility and had an additional $17.4
million available subject to borrowing base restrictions. The unused availability is the amount
not borrowed, but eligible to be borrowed. The unused portion of the facility is the amount not
borrowed, but that amount may not be eligible for borrowing because of the borrowing base
restrictions. The borrowing base restrictions generally restrict our borrowings under the Textron Facility to 80%
of the eligible receivables and 90% of our Floorplanned inventory which cannot exceed the lesser of
30% of our eligible accounts receivable or $6.0 million, however, while doing business with DISD
this is increased to 35% of our eligible accounts receivable or $9.0 million. We use the Textron Facility to finance purchases of Cisco products from Cisco and from certain
wholesale distributors. Cisco provides 60-day terms, and other wholesale distributors typically
provide 30-day terms. Balances under the Textron Facility that are within those respective 60-day
and 30-day periods (the Free Finance Period) do not accrue interest and are classified as
accounts payable in our balance sheet. We refer to non-interest bearing balances as inventory
floor plan borrowings. To the extent that we have credit availability under the Textron Facility, it gives us the ability
to extend the payment terms past the Free Finance Period. Amounts extended past the Free Finance
Period accrue interest and are classified as notes payable on our balance sheet. These extended
payment balances under the Textron Facility accrue interest at the prime rate (5.25% at December
31, 2004, and 5.75% at March 31, 2005) plus 2.5%. Because payment cycles of sales to school
districts under the E-Rate program often extend beyond 60 days, and because such payment cycles
have recently extended even further due to administrative issues with the organization that makes
payments to vendors for the E-Rate program, we expect we will continue to carry extended payment
balances under the Textron Facility for at least the next several quarters. The total outstanding
balance under the Textron Facility at March 31, 2005 was $12.0 million, all of which was within the
Free Finance Period and therefore is reflected as accounts payable in our balance sheet at March
31, 2005. As defined in the Textron Facility there are restrictive covenants that are measured at each
quarter and year end. These covenants require us to:  
    maintain Minimum Tangible Capital Funds of $9.5 million, which is defined to be the sum
of cash, receivables, inventory and fixed net assets, minus total liabilities, with total
liabilities being defined as accounts payable, accrued expenses and short- and long-term
notes payable;  
    maintain a maximum Debt to Tangible Capital Funds ratio of 4.0 to 1;  
    maintain Minimum Working Capital of not less than $8.0 million;  
    maintain Minimum Cash on Hand of not less than $2.0 million;  
    maintain a Current Ratio of not less than 1.25 to 1.0; and  
    achieve Earnings before Interest Expense, Taxes, Depreciation and Amortization exceeding $100,000. At March 31, 2005 we were in compliance with the loan covenants, and we anticipate that we will be
able to comply with the loan covenants during the next twelve months. If we violate any of the
loan covenants, we would be required to seek waivers from Textron and Silicon Valley Bank for those
non-compliance events. If Textron or Silicon Valley Bank refused to provide waivers, the amount due
under the Textron Facility could be accelerated and we could be required to seek other sources of
financing.




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##### Table of Contents



Cash Flows.During the quarter ended March 31, 2005 our cash increased by $2.4 million. Operating
activities provided cash of $10.7 million, investing activities used $133,000 and financing
activities used $8.1 million. Operating Activities.Operating activities provided $10.7 million in the three months ended March
31, 2005 as compared to providing cash of $142,000 in the comparable 2004 period.
Changes in asset and liability accounts provided $11.2 million. The most significant source of
working capital related to:  
    Increases in accounts payable of $5.3 million, which related primarily to increased
purchases of Cisco products for sales by INX and inventory by Stratasoft.  
    $3.2 million decrease in accounts and notes receivable. Days in sales outstanding
decreased by 29 days from 108 days at December 31, 2004 (using the exhaustive method of
calculation) to 79 days at March 31, 2005 primarily due to collections of amounts related
to an INX E-Rate program funded project relating to a school district.  
    Contracts in progress which, increased $1.4 million due to a $715,000 decrease in the
cost and estimated earnings in excess of billings and an $723,000 increase in billings in
excess of cost and estimated earnings, which was primarily due to change in application of
accounting method discussed in detail above.  
    The $1.1 million increase in accrued expense is primarily related to accruing for sales
commissions, wages and bonuses; third party commissions and professional fees. Investing Activities.Investing activities used $133,000 in the three months ended March 31, 2005
compared to a use of $139,000 for the comparable period in 2004. Our investing activities related
to capital expenditures in both years were primarily related to purchases of computer equipment and
software, and to a lesser degree, leasehold improvements. During the next twelve months, we do not
expect to incur significant capital expenditures requiring cash, except for acquisitions, of which
we cannot predict the certainty or magnitude. Financing Activities.Financing activities used $8.1 million in the three months ended March 31,
2005 as compared to using $451,000 in the comparable period in 2004. During the three months ended
March 31, 2005, the company repaid all of the $8.1 million of interest-bearing debt under the
Textron Facility through cash generated by operations. Related Party Transactions We lease office space from Allstar Equities, Inc., a Texas corporation (Equities), a company
wholly owned by James H. Long, our Chief Executive Officer. On December 1, 1999 Equities purchased
our corporate office building and executed a direct lease with us with an expiration date of
December 31, 2004. In conjunction with Equities obtaining new financing on the building, a new
lease was executed with us on February 1, 2002 with an expiration date of January 31, 2007. The new
lease has a rental rate of $37,192 per month. From time to time we make short-term loans and travel advances to our employees. The balance of
approximately $17,000 and $14,000 relating to these loans and advances is included in the
Companys balance sheet and reported as part of Accounts Receivable at December 31, 2004 and
March 31, 2005, respectively. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We incur certain market risks related to interest rate variations because we hold floating rate
debt. Based upon the average amount of debt outstanding during the three months ended March 31,
2005, a one-percent increase in interest rates paid by us on our floating rate debt would not
have resulted in an increase in interest for the period. Our business depends upon our ability to obtain an adequate supply of products and parts at
competitive prices and on reasonable terms. Our suppliers are not obligated to have product on
hand for timely delivery to us nor can they guarantee product availability in sufficient
quantities to meet our demands. INXs business is Cisco centric. Any material disruption in our
supply of products could have a material adverse effect on our financial condition and results of
operations. 
 Item 4. Controls and Procedures Under the supervision and with the participation of certain members of our management, including
our Chairman of




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the Board, Chief Executive Officer and principal financial officer, we completed an
evaluation of the effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) to the Securities Exchange Act of 1934, as
amended (the Exchange Act)). Based on that evaluation, we and our management have concluded that,
our disclosure controls and procedures at March 31, 2005 were effective to ensure that information
required to be disclosed by us in the reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified in the rules and
forms of the SEC, and are designed to ensure that information required to be disclosed by us in
these reports is accumulated and communicated to our management, as appropriate to allow timely
decisions regarding required disclosures. In the first quarter of 2005, there has been no change in
our internal control over financial reporting that has materially affected, or is reasonably likely
to affect, our internal control over financial reporting. We will consider further actions and continue to evaluate the effectiveness of our disclosure
controls and internal controls and procedures on an ongoing basis, taking corrective action as
appropriate. Our management does not expect that disclosure controls and procedures or internal
controls can prevent all error and all fraud. A control system, no matter how well conceived and
operated, can provide only reasonable and not absolute assurance that the objectives of the control
system are met. Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative to their costs.
While our management believes that its disclosure controls and procedures provide reasonable
assurance that fraud can be detected and prevented, because of the inherent limitations in all
control systems, no evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, have been detected. 
 PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings In August 2002, Inacom Corp. (Inacom) filed a lawsuit in the District Court of Douglas
County, Nebraska styled Inacom Corp v. I-Sector Corporation, f/k/a Allstar Systems, Inc., claiming
that I-Sector owed the sum of approximately $570 to Inacom as a result of Inacoms termination of a
Vendor Purchase Agreement between Inacom and I-Sector. I-Sector believes that the claim is without
merit and intends to vigorously contest the demand. In March 2003, I-Sector and other parties were notified of a demand for return of payments relating
to the business activities of a call center customer. In March 2004, I-Sector was informed by the
claimant that claims will not be pursued at this time. I-Sector believes that the claims against
it, if re-initiated, are without merit and intends to vigorously contest any demands related to
this matter. I-Sector is also party to other litigation and claims which management believes are normal in the
course of its operations. While the results of such litigation and claims cannot be predicted with
certainty, I-Sector believes the final outcome of such matters will not have a materially adverse
effect on its results of operations or financial position. 
 Item 4. Submission of Matters to a Vote of Security Holders On March 18, 2005, a special meeting of stockholders was held (a) to approve (i) the issuance of
shares of common stock and (ii) the assumption of options to acquire shares of common stock in the
Companys elimination of the minority interest in Internetwork Experts, Inc. (INX), a
majority-owned subsidiary of the Company (the Exchange); and (b) to approve an amendment to the
I-Sector Corporation Incentive Plan (the Plan) to increase by 1,123,103 the total number of
shares of common stock available for issuance under the Plan for the purpose of assuming the
options of INX in the Exchange. The aggregate number of shares of common stock of the Company
entitled to vote at the meeting was 5,207,604. Present at the meeting, in person and by proxy,
were the holders of 3,002,759 shares of common stock representing 57.66% of the total number of
shares entitled to vote and constituting a quorum. The holders of our common stock approved both
proposals as follows. Number of Votes
    
    
    Number of Votes
    
    
    Number of Votes
    
    
    BrokerVoted For
    
    
    Voted Against
    
    
    Withheld
    
    
    Non-VoteIssue common stock and stock options in
Exchange for INX minority
interest
    
    
    2,923,999
    
    
    
    73,360
    
    
    
    5,400
    
    
    
    Amend the I-Sector Corporation Incentive Plan
    
    
    2,914,999
    
    
    
    85,260
    
    
    
    5,400
    
    
    
    




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Item 5. Other Information None 
 Item 6. Exhibits 18.1
    
    Letter Re: Change in Accounting Principle31.1
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer31.2
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer32.1
    
    Section 1350 Certification of Principal Executive Officer32.2
    
    Section 1350 Certification of Principal Financial Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized. 
 I-Sector Corporation.Date: May 16, 2005
    
    By:
    
    /s/ BRIAN FONTANABrian Fontana, Vice Presidentand Chief Financial Officer




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Index to Exhibits 18.1
    
    Letter Re: Change in Accounting Principle31.1
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer31.2
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer32.1
    
    Section 1350 Certification of Principal Executive Officer32.2
    
    Section 1350 Certification of Principal Financial Officer