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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 [  ] TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE EXCHANGE ACT For the transition period from to Commission file number 0-22190   VERSO TECHNOLOGIES, INC.  MINNESOTA
    
    41-1484525(State or Other Jurisdiction
    
    (I.R.S. Employer Identification No.)of Incorporation or Organization)
 400 Galleria Parkway, Suite 300, Atlanta, GA 30339
(Address of Principal Executive Offices) (678) 589-3500
(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 [X] No [  ]. Indicated by check mark whether registrant is an accelerated filer (as defined
in Rule 12b-2 of the Exchange Act) Yes [X] No [  ] . Shares of the registrants common stock, par value $.01 per share, outstanding
as of August 6, 2004: 133,101,805.




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VERSO TECHNOLOGIES, INC.
FORM 10-Q INDEX Page No.Part I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of June 30, 2004 and
December 31, 2003
    
    
    2Condensed Consolidated Statements of Operations for the three months
and the six months ended June 30, 2004 and 2003
    
    
    3Condensed Consolidated Statements of Cash Flows for the six months
ended June 30, 2004 and 2003
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    32Item 4. Controls and Procedures
    
    
    32PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    33Item 6. Exhibits and Reports on Form 8-K
    
    
    33Signature Page
    
    
    34Exhibit Index
    
    
    35EX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION OF THE CEOEX-32.2 SECTION 906 CERTIFICATION OF THE CFO
  1




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data)
 June 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETS:Current assets:Cash and cash equivalents
    
    $
    18,185
    
    
    $
    7,654Restricted cash
    
    
    93
    
    
    
    2,290Accounts receivable, net of allowance for doubtful accounts of $1,851
and $1,995, respectively
    
    
    7,185
    
    
    
    13,620Inventories
    
    
    9,471
    
    
    
    8,727Other current assets
    
    
    1,411
    
    
    
    1,003Total current assets
    
    
    36,345
    
    
    
    33,294Property and equipment, net of accumulated depreciation and amortization
of $7,663 and $6,277, respectively
    
    
    5,135
    
    
    
    5,749Investment
    
    
    610
    
    
    
    673Other intangibles, net of accumulated amortization of $3,307 and $2,145,
respectively
    
    
    6,146
    
    
    
    7,308Goodwill
    
    
    16,228
    
    
    
    16,228Total assets
    
    $
    64,464
    
    
    $
    63,252LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Accounts payable
    
    $
    3,185
    
    
    $
    4,418Accrued compensation
    
    
    1,814
    
    
    
    1,564Accrued expenses
    
    
    3,303
    
    
    
    3,007Current portion of notes payable
    
    
    
    
    
    
    347Current portion of accrued costs of MCK acquisition
    
    
    564
    
    
    
    4,464Current portion of liabilities of discontinued operations
    
    
    814
    
    
    
    1,039Unearned revenue and customer deposits
    
    
    4,714
    
    
    
    5,718Total current liabilities
    
    
    14,394
    
    
    
    20,557Liabilities of discontinued operations, net of current portion
    
    
    795
    
    
    
    834Other long-term liabilities
    
    
    1,498
    
    
    
    1,637Notes payable, net of current portion
    
    
    2,681
    
    
    
    2,652Convertible subordinated debentures
    
    
    4,116
    
    
    
    3,979Total liabilities
    
    
    23,484
    
    
    
    29,659Shareholders equity:Preferred stock,no par value, 1,000,000 shares authorized;
780,000 shares issued and none outstanding
    
    
    
    
    
    
    Common stock, $.01 par value, 200,000,000 shares authorized;
133,094,005 and 122,781,117 shares issued and outstanding
    
    
    1,331
    
    
    
    1,228Additional paid-in capital
    
    
    322,948
    
    
    
    306,293Stock payable
    
    
    61
    
    
    
    130Accumulated deficit
    
    
    (283,160
    )
    
    
    (273,144
    )Deferred compensation
    
    
    (187
    )
    
    
    (1,012
    )Accumulated
other comprehensive income (loss) - foreign currency translation
    
    
    (13
    )
    
    
    98Total shareholders equity
    
    
    40,980
    
    
    
    33,593Total liabilities and shareholders equity
    
    $
    64,464
    
    
    $
    63,252
 The accompanying notes are an integral part of these condensed consolidated financial statements. 2




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VERSO TECHNOLOGIES, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except share data)
 For the three months ended June 30,
    
    For the six months ended June 30,2004
    
    2003
    
    2004
    
    2003Revenue:Products
    
    $
    5,711
    
    
    $
    9,856
    
    
    $
    16,721
    
    
    $
    17,124Services
    
    
    5,625
    
    
    
    6,002
    
    
    
    11,176
    
    
    
    11,731Total revenue
    
    
    11,336
    
    
    
    15,858
    
    
    
    27,897
    
    
    
    28,855Cost of revenue:Products:
    
    
    
    
    
    
    
    
    
    
    Product costs
    
    
    2,566
    
    
    
    3,613
    
    
    
    7,007
    
    
    
    6,525Amortization of intangibles
    
    
    446
    
    
    
    153
    
    
    
    892
    
    
    
    305Total cost of product
    
    
    3,012
    
    
    
    3,766
    
    
    
    7,899
    
    
    
    6,830Services
    
    
    3,178
    
    
    
    2,711
    
    
    
    6,349
    
    
    
    5,224Total cost of revenue
    
    
    6,190
    
    
    
    6,477
    
    
    
    14,248
    
    
    
    12,054Gross profit:Products
    
    
    2,699
    
    
    
    6,090
    
    
    
    8,822
    
    
    
    10,294Services
    
    
    2,447
    
    
    
    3,291
    
    
    
    4,827
    
    
    
    6,507Total gross profit
    
    
    5,146
    
    
    
    9,381
    
    
    
    13,649
    
    
    
    16,801Operating expenses:General and administrative
    
    
    3,522
    
    
    
    3,927
    
    
    
    7,284
    
    
    
    7,248Sales and marketing
    
    
    3,616
    
    
    
    2,201
    
    
    
    6,786
    
    
    
    4,092Research and development
    
    
    3,074
    
    
    
    2,383
    
    
    
    5,885
    
    
    
    4,279Depreciation and amortization of property and
equipment
    
    
    784
    
    
    
    543
    
    
    
    1,589
    
    
    
    1,196Amortization of intangibles
    
    
    135
    
    
    
    60
    
    
    
    270
    
    
    
    120Amortization of deferred compensation, related to
sales, general and administrative
    
    
    90
    
    
    
    194
    
    
    
    256
    
    
    
    393Reorganization costs
    
    
    
    
    
    
    
    
    
    
    584
    
    
    
    114Reorganization costs - stock related
    
    
    
    
    
    
    
    
    
    
    570
    
    
    
    80Total operating expenses
    
    
    11,221
    
    
    
    9,308
    
    
    
    23,224
    
    
    
    17,522Operating
(loss) income
    
    
    (6,075
    )
    
    
    73
    
    
    
    (9,575
    )
    
    
    (721
    )Other income (expense), net:Other income
    
    
    103
    
    
    
    9
    
    
    
    151
    
    
    
    18Equity in loss of investment
    
    
    (45
    )
    
    
    (19
    )
    
    
    (63
    )
    
    
    (52
    )Interest expense, net
    
    
    (263
    )
    
    
    (454
    )
    
    
    (529
    )
    
    
    (761
    )(205
    )
    
    
    (464
    )
    
    
    (441
    )
    
    
    (795
    )Loss before income taxes
    
    
    (6,280
    )
    
    
    (391
    )
    
    
    (10,016
    )
    
    
    (1,516
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (6,280
    )
    
    $
    (391
    )
    
    $
    (10,016
    )
    
    $
    (1,516
    )Net loss per
common share - basic and diluted
    
    $
    (0.05
    )
    
    $
    (0.00
    )
    
    $
    (0.08
    )
    
    $
    (0.02
    )Weighted
average shares outstanding - basic and diluted
    
    
    132,952,430
    
    
    
    91,062,189
    
    
    
    129,923,784
    
    
    
    90,246,011
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands, except share data)(Unaudited)
 For the six months ended June 30,2004
    
    2003Operating Activities:Continuing operations:Net loss
    
    $
    (10,016
    )
    
    $
    (1,516
    )Adjustments to reconcile net loss to net cash
(used in) provided by continuing operating activities:Equity in loss of investment
    
    
    63
    
    
    
    52Depreciation and amortization of property and equipment
    
    
    1,589
    
    
    
    1,196Amortization of intangibles
    
    
    1,162
    
    
    
    425Amortization of deferred compensation
    
    
    255
    
    
    
    393Provision for doubtful accounts
    
    
    433
    
    
    
    1,268Amortization of loan fees and discount on convertible subordinated debentures
    
    
    258
    
    
    
    205Reorganization costs-stock related
    
    
    570
    
    
    
    Other
    
    
    18
    
    
    
    (83
    )Changes in current operating assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    6,002
    
    
    
    (2,028
    )Inventories
    
    
    (744
    )
    
    
    2,058Other current assets
    
    
    (497
    )
    
    
    (576
    )Accounts payable
    
    
    (1,233
    )
    
    
    619Accrued compensation
    
    
    250
    
    
    
    673Accrued expenses
    
    
    116
    
    
    
    (2,117
    )Unearned revenue and customer deposits
    
    
    (1,004
    )
    
    
    (340
    )Net cash (used in) provided by continuing operating activities
    
    
    (2,778
    )
    
    
    229Discontinued operations:Payments of discontinued operations liabilities
    
    
    (264
    )
    
    
    (525
    )Net cash used in discontinued operating activities
    
    
    (264
    )
    
    
    (525
    )Net cash (used in) provided by operating activities
    
    
    (3,042
    )
    
    
    (296
    )Investing Activities:Purchases of property and equipment
    
    
    (1,041
    )
    
    
    (297
    )Purchased software development
    
    
    
    
    
    
    (320
    )Decrease in restricted cash
    
    
    2,197
    
    
    
    Payment of assumed liabilities and costs of acquisition of MCK Communications, Inc.
    
    
    (3,859
    )
    
    
    Acquisition of certain assets of Clarent Corporation, net of cash acquired
    
    
    
    
    
    
    (1,026
    )Net cash used in investing activities
    
    
    (2,703
    )
    
    
    (1,643
    )Financing Activities:Net
borrowings on line of credit
    
    
    
    
    
    
    2,048Payments of notes payable
    
    
    (350
    )
    
    
    (1,050
    )Proceeds from private placement, net
    
    
    16,474
    
    
    
    Proceeds from issuances of common stock in connection with the
exercise of options, net
    
    
    151
    
    
    
    812Net cash provided by financing activities
    
    
    16,275
    
    
    
    1,810Effect of exchange rate changes on cash
    
    
    1
    
    
    
    42Increase (decrease) in cash and cash equivalents
    
    
    10,531
    
    
    
    (87
    )Cash and cash equivalents at beginning of period
    
    
    7,654
    
    
    
    1,294Cash and cash equivalents at end of period
    
    $
    18,185
    
    
    $
    1,207Supplemental disclosure of cash flow information:Cash
payments (receipts) during the periods for:Interest
    
    $
    178
    
    
    $
    447Income taxes
    
    $
    (222
    )
    
    $
    10Non-cash investing and financing activitiesCompensatory options fully-vested and/or
extended in reorganization
    
    $
    570
    
    
    $
    80Issuance of common stock in litigation settlement
    
    
    
    
    
    
    264Issuance of warrants in exchange for services
    
    
    
    
    
    
    119Issuance of common stock in exchange for services
    
    
    133
    
    
    
    Assets acquired and liablities assumed in conjunction with business acquisitions:Fair value of assets acquired, excluding cash and restricted cash
    
    
    
    
    
    
    10,966Liabilities assumed
    
    
    
    
    
    
    986Notes payable for acquisition of certain assets of Clarent Corporation
    
    $
    
    
    
    $
    9,800
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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VERSO TECHNOLOGIES, INC AND SUBSIDIARIES. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2004 (Unaudited)  1.
    
    BASIS OF PRESENTATIONVerso Technologies, Inc. and subsidiaries (the Company), is a
communications technology and solutions provider for communications
service providers and enterprises seeking to implement application-based
telephony services, Internet usage management tools and outsourced
customer support services. The Companys operations include three
separate business segments, the Carrier Solutions Group, which includes
the Companys Clarent softswitching division and the Companys subsidiary
NACT Telecommunications, Inc. (NACT), the Enterprise Solutions Group,
which includes the Companys Clarent Netperformer division and the
Companys subsidiaries Telemate.Net Software, Inc. (Telemate.Net) and
MCK Communications, Inc. (MCK) and the Advanced Applications Services
Group, which includes the Companys technical applications support group
which was previously included as part of the Enterprise Solutions Group.
The Carrier Solutions Group includes domestic and international sales of
hardware and software, integration, applications and technical training
and support. The Enterprise Solutions Group offers hardware-based
solutions (which include software) for companies seeking to build private,
packet-based voice and data networks. Additionally, the Enterprise
Solutions Group offers software-based solutions for Internet access and
usage management that include call accounting and usage reporting for
Internet protocol network devices. The Advanced Applications Services
Group includes outsourced technical application services and application
installation and training services to outside customers, as well as
customers of the Companys Carrier Solution Group and Enterprise Solution
Group segments. The Company acquired MCK in September 2003 and
substantially all the business assets of Clarent Corporation (Clarent)
in February 2003. These acquisitions were both accounted for as purchases
(see Note 2).The condensed consolidated financial statements include the accounts of
Verso Technologies, Inc. and its wholly-owned subsidiaries, MCK,
Telemate.Net, NACT, and Clarent Canada Ltd.Certain prior year amounts in the consolidated financial statements have
been reclassified to conform with the current year presentation. These
reclassifications had no effect on previously reported net loss.The condensed consolidated quarterly financial statements are unaudited.
These statements include all adjustments, including recurring adjustments,
considered necessary by management to present a fair statement of the
results of the Companys operations, financial position and cash flows.
The results reported in these condensed consolidated financial statements
should not be regarded as necessarily indicative of results that may be
expected for the entire year.The year-end condensed consolidated balance sheet was derived from audited
consolidated financial statements. The accompanying condensed
consolidated unaudited quarterly financial statements are presented in
accordance with the rules and regulations of the Securities and Exchange
Commission (SEC) and do not include all disclosures normally required by
accounting principles generally accepted in the United States of America.
For further information, refer to the audited consolidated financial
statements and footnotes thereto included in the Companys Annual Report
on Form 10-K for the year ended December 31, 2003.2.
    
    MERGERS AND ACQUISITIONSMCK Communications, Inc.On September 26, 2003, to increase capital and to enhance the Companys
ability to provide technology that allows enterprises the ability to
migrate to next-generation environments, the Company acquired all of the
outstanding capital stock of MCK by means of a merger. The acquisition
cost was approximately $25.1 million, consisting of 18,278,423 shares of
the Companys common stock with a fair value of $24.1 million and
acquisition costs of approximately $1.0 million. 5




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  2.
    
    MERGERS AND ACQUISITIONS, ContinuedMCK Communications, Inc.  ContinuedThe acquisition was treated as a purchase for accounting purposes, and
accordingly, the assets and liabilities were recorded at their fair value
at the date of the acquisition.The Company prepared an allocation of the purchase price based on the
estimated fair values of the acquired assets and liabilities. The Company
anticipates the fair value assessments and allocation of the purchase
price to be finalized in 2004. Intangible assets relating to channels of
distribution, strategic licenses and current technology total $3.6 million
and are being amortized over three years.In April 2003, the Company negotiated the original agreement to acquire
MCK in which the MCK stockholders would be entitled to receive
approximately 20.0 million shares of the Companys common stock which was
valued at $13.0 million, based on the volume weighted average closing
price per share of the Companys common stock as reported on the Nasdaq
SmallCap Market for the twenty trading day period beginning March 19,
2003 and ending April 15, 2003. As part of the original agreement, the
Company was to receive $7.5 million in cash. The terms of the agreement
were amended on June 13, 2003. Under the amended terms, MCK stockholders
were entitled to receive approximately 18.3 million shares of the
Companys common stock and the cash MCK was required to have at the
closing of the merger was reduced from $7.5 million to approximately $6.4
million. Although the number of shares of the Companys common stock to
be issued in the merger was reduced by the amendment, the amendment
changed the measurement date for valuing such shares. As a result of the
increase in the price of the Companys common stock prior to June 13,
2003, the revised valuation for the shares of the Companys common stock
to be issued in the merger increased to $24.1 million. As a result of
this increase in value, the goodwill recorded in the merger was impaired
upon closing the merger. The Company completed an impairment analysis in
accordance with Statement of Financial Accounting Standards (SFAS) No.
142, Goodwill and Other Intangible Assets (SFAS No. 142). Based upon
this analysis, the Company recorded a write-off of approximately $10.9
million during the quarter ended September 30, 2003.Clarent CorporationOn February 12, 2003, to enhance the Companys position in the
next-generation networking and technology market, the Company acquired
substantially all the business assets and certain related liabilities of
Clarent. The purchase consideration was approximately $10.8 million,
consisting of $9.3 million in discounted seller notes issued by the
Company and acquisition costs of approximately $1.5 million. At the
closing of the acquisition, the Company issued three promissory notes to
Clarent: a $5.0 million secured note due February 13, 2004, which bore
interest at 10% per annum and a $1.8 million non-interest bearing
unsecured note due February 13, 2004, which was discounted at 6.25% per
annum, both of which were paid in full at June 30, 2004; and a $3.0
million secured note due February 12, 2008, which bears interest at 5% per
annum, discounted at 7.5% per annum. The unamortized discount totaled
approximately $319,000 at June 30, 2004. The assets the Company purchased
from Clarent secure the secured notes.The acquisition was treated as a purchase for accounting purposes, and
accordingly, the assets and liabilities were recorded at their fair value
at the date of the acquisition. Gross intangible assets acquired totaling
$821,000 primarily consist of current technology and are being amortized
over three years. 6




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  2.
    
    MERGERS AND ACQUISITIONS, ContinuedClarent Corporation  ContinuedThe preliminary allocations of the costs of acquisitions of MCK and the
net assets of Clarent, as adjusted, are as follows (in thousands): MCK
    
    ClarentCash
    
    $
    10,575
    
    
    $
    571Restricted cash
    
    
    2,015
    
    
    
    115Accounts receivable
    
    
    1,045
    
    
    
    2,717Inventories
    
    
    423
    
    
    
    5,465Other current assets
    
    
    453
    
    
    
    613Property and equipment
    
    
    365
    
    
    
    1,650Other intangilbes
    
    
    3,600
    
    
    
    821Goodwill (1)
    
    
    14,473
    
    
    
    Accounts payable
    
    
    (508
    )
    
    
    (103
    )Accrued compensation
    
    
    (195
    )
    
    
    (198
    )Current portion of accrued costs of MCK purchase
    
    
    (5,810
    )
    
    
    Accrued expenses
    
    
    (782
    )
    
    
    (331
    )Deferred revenue
    
    
    (524
    )
    
    
    (480
    )Cost of acquisition
    
    $
    25,130
    
    
    $
    10,840
 (1) Prior to MCK goodwill write-down of $10.9 million  Pro Forma Effect of MCK and Clarent TransactionsThe results of MCK have been included in the Companys consolidated
results beginning October 1, 2003 and the results of Clarent have been
included in the Companys consolidated results subsequent to February 12,
2003. The write-down of goodwill in 2003 for MCK of $10.9 million is
excluded from the amounts for the quarter ended and six months ended June
30, 2003. The following unaudited pro forma information presents the
results of continuing operations of the Company for the three months and
six months ended June 30, 2003, as if the acquisition of MCK and Clarent
had taken place on January 1, 2003, (in thousands, except per share
amounts): Three months
    
    Six monthsended June 30,
    
    ended June 30,2003
    
    2003Revenues
    
    $
    19,089
    
    
    $
    36,631Net loss
    
    $
    (1,067
    )
    
    $
    (8,192
    )Net loss per
common share - basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.08
    )Weighted average shares outstanding
- basic and diluted
    
    
    109,341
    
    
    
    108,524
 7




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  3.
    
    EQUITY INVESTMENTOn October 1, 2002, the Company acquired a 51% interest in Shanghai BeTrue
Infotech Co., Ltd. (BeTrue). The remaining 49% interest in BeTrue is
owned by Shanghai Tangsheng Investments & Development Co. Ltd (Shanghai
Tangsheng). The joint venture provides the Company with an immediate
distribution channel into the China and Asia-Pacific region for the
Companys application-based voice over Internet protocol (VoIP) gateway
solutions, billing systems, value-added applications and web filtering
solutions. Due to the shared decision making between the Company and
Shanghai Tangsheng, the results of BeTrue are treated as an equity
investment rather than being consolidated. The Company determined that,
since BeTrue was a business, BeTrue did not fall under the scope of the
Financial Accounting Standards Board Interpretation No. 46, Consolidation
of Variable Interest Entities and there was no impact on the Companys
financial position or results of operations.The Company purchased the 51% interest in BeTrue for $100,000 from NeTrue
Communications, Inc., Shanghai Tangshengs former joint venture partner.
The Company also contributed to the joint venture certain next-generation
communication equipment and software valued at approximately $236,000 and
cash in the amount of $100,000.Summarized financial information reported by this affiliate for the three
and six months ended June 30, 2004 and 2003 (in thousands) are as follows: Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Operating results:Revenues
    
    $
    130
    
    
    $
    581
    
    
    $
    534
    
    
    $
    660Operating loss
    
    $
    (88
    )
    
    $
    (39
    )
    
    $
    (123
    )
    
    $
    (116
    )Net loss
    
    $
    (88
    )
    
    $
    (38
    )
    
    $
    (123
    )
    
    $
    (103
    )
 8




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  4.
    
    DISCONTINUED OPERATIONSFollowing the acquisition of NACT in July 2001, the Company determined
that its value added reseller business and associated consulting practice
(legacy VAR business) was not strategic to the Companys ongoing
objectives and discontinued capital and human resource investment in its
legacy VAR business. Accordingly, the Company elected to report its legacy
VAR business as discontinued operations by early adoption of SFAS No. 144,
Accounting for the Impairment of Disposal of Long-Lived Assets (SFAS
No. 144). There were no results of discontinued operations for the three
and six months ended June 30, 2004 and 2003, respectively.The liabilities of discontinued operations included in the accompanying
condensed consolidated balance sheet (in thousands) are as follows: June 30,
    
    December 31,2004
    
    2003Accrued restructuring costs
    
    $
    1,322
    
    
    $
    1,472Other current liabilities
    
    
    287
    
    
    
    401Liabilities of discontinued operations
    
    $
    1,609
    
    
    $
    1,873
  Accrued restructuring costs relate primarily to several leases for
buildings and equipment that are no longer being utilized in continuing
operations. The accrual is for all remaining payments due on these
leases, less estimated amounts to be paid by any sublessors. The accrual
for one of the leases with total payments remaining through January 31,
2010 of $2.2 million is offset by sublease receipts totaling $1.0 million
through the end of the Companys lease term and assumes an amount of
$240,000 for the extension of one of the subleases through the end of the
Companys lease term.The activity in the restructuring accrual for discontinued operations was
as follows: Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Balance beginning of period
    
    $
    1,814
    
    
    $
    2,538
    
    
    $
    1,873
    
    
    $
    3,131Lease payments, net of
sublease receipts
    
    
    (150
    )
    
    
    (224
    )
    
    
    (167
    )
    
    
    (464
    )Other (payments)/receipts
    
    
    (55
    )
    
    
    28
    
    
    
    (97
    )
    
    
    (325
    )Balance end of period
    
    $
    1,609
    
    
    $
    2,342
    
    
    $
    1,609
    
    
    $
    2,342
 9




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  5.
    
    INVENTORIESInventories consist primarily of purchased electronic components, and are
stated at the lower of cost or market. Cost is determined by using the
first-in, first-out method.Inventories as of June 30, 2004 and December 31, 2003, are comprised of
the following (in thousands): June 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    6,314
    
    
    $
    5,610Work in process
    
    
    571
    
    
    
    1,028Finished goods
    
    
    2,586
    
    
    
    2,089Total inventories
    
    $
    9,471
    
    
    $
    8,727
  6.
    
    GOODWILL AND OTHER INTANGIBLESIntangible assets represent the excess of cost over the fair value of net
tangible assets acquired and identified other intangible assets, which
consist of purchased software development, channels of distribution,
strategic licenses, current technology and customer relationship.
Purchased software development is amortized on a straight-line basis over
an estimated useful life of three years once the projects are placed in
service. The channels of distribution, strategic licenses and current
technology are amortized on a straight-line basis over their estimated
useful life of three years. The customer relationship is amortized on a
straight-line basis over its estimated useful life of ten years. Goodwill
associated with acquisitions is not being amortized in accordance with
SFAS No. 142.Goodwill and other intangible assets consist of the following (in
thousands): Amortization
    
    June 30,
    
    December 31,Intangibles subject to amortization:
    
    Period in months
    
    2004
    
    2003Purchased software development
    
    36 months
    
    $
    2,629
    
    
    $
    2,629Channels of distribution
    
    36 months
    
    
    900
    
    
    
    900Strategic licenses
    
    36 months
    
    
    1,800
    
    
    
    1,800Current technology
    
    36 months
    
    
    1,721
    
    
    
    1,721Customer relationship
    
    120 months
    
    
    2,403
    
    
    
    2,403Weighted average months
    
    57 months
    
    
    9,453
    
    
    
    9,453Accumulated amortization:Purchased software development
    
    
    
    
    (1,743
    )
    
    
    (1,438
    )Channels of distribution
    
    
    
    
    (225
    )
    
    
    (75
    )Strategic licenses
    
    
    
    
    (450
    )
    
    
    (150
    )Current technology
    
    
    
    
    (529
    )
    
    
    (242
    )Customer relationship
    
    
    
    
    (360
    )
    
    
    (240
    )Net intangibles subject to amortization
    
    
    
    
    6,146
    
    
    
    7,308Goodwill
    
    
    
    
    16,228
    
    
    
    16,228Total goodwill and other intangibles
    
    
    
    $
    22,374
    
    
    $
    23,536
 10




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  7.
    
    LOAN FACILITY WITH SILICON VALLEY BANKIn February 2003, the Company amended its original credit agreement (the
Original Credit Agreement) with its primary lender, Silicon Valley Bank
(Silicon), to increase the Companys credit line with Silicon from $5.0
million to $10.0 million, subject to borrowing availability. The Company
also entered into certain additional arrangements with Silicon including
an export-import (EX-IM) facility that will provide for working capital
based on the Companys international accounts receivable and inventory
related to export sales. The Company and Silicon further amended the
credit facility in connection with the acquisition of MCK and the
acquisition of substantially all of the business assets along with certain
related liabilities of Clarent (as amended, the Amended Credit
Agreement). The Companys borrowings under the Amended Credit Agreement
are secured by substantially all of the assets of the Company. Interest
on borrowings under the Amended Credit Agreement is computed at 2.0% above
Silicons Base Rate, with a minimum Base Rate of 4.25% (6.25% at June 30,
2004). The Amended Credit Agreement provides for up to $2.5 million in
letters of credit. Advances are limited by a formula based on eligible
receivables, inventories, certain cash balances, outstanding letters of
credit and certain subjective limitations. Interest payments are due
monthly, and the Amended Credit Agreement expires in August 2004. The
Amended Credit Agreement includes a loan fee of $170,000 and .375% per
annum on unused available borrowings. In February 2004, the Company and
Silicon further amended the credit facility. Under the terms of the
Amended Credit Agreement, the Company must maintain a minimum tangible net
worth covenant, computed monthly, and may not declare dividends or incur
any additional indebtedness without the consent of Silicon, and must
comply with other financial covenants, as defined in the Amended Credit
Agreement. In August 2004, at the Companys request, Silicon further
amended the credit facility to extend the term to January 2005. The
Company requested this extension versus a renewal to give the Company time
to determine how best to size its line of credit to cover its expected
borrowing base in 2005 and give the Company maximum financing flexibility.
In addition, the Company was not in compliance with the minimum tangible
net worth covenant as of June 30, 2004, and Silicon waived such
non-compliance.Pursuant to the loan commitment letter with Silicon, on February 12, 2003,
the Company issued to Silicon a warrant to purchase 350,000 shares of the
Companys common stock at an exercise price of $0.44 per share. The fair
value of the warrant issued totaled approximately $119,000, using the
Black-Scholes option pricing method based on the following
weighted-average assumptions: expected volatility  104%; expected life 
five years; risk-free interest rate  3.0%; and expected dividend yield 
0%. The loan fees and fair value of the warrants issued are being
amortized to interest expense over the term of the Amended Credit
Agreement.The Company had no borrowings under the Amended Credit Agreement as of
June 30, 2004. The availability under the Amended Credit Agreement at
June 30, 2004 was $4.7 million. The Company has outstanding letters of
credit in the amount of $1.6 million at June 30, 2004, which reduces
borrowing capacity under the Amended Credit Agreement.8.
    
    OTHER COMPREHENSIVE LOSSComprehensive loss for the three and six months ended June 30, 2004 and
2003 is shown in the following table (in thousands): Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (6,280
    )
    
    $
    (391
    )
    
    $
    (10,016
    )
    
    $
    (1,516
    )Other comprehensive loss:Foreign currency translation
    
    
    (52
    )
    
    
    (78
    )
    
    
    (111
    )
    
    
    (27
    )Comprehensive loss
    
    $
    (6,332
    )
    
    $
    (469
    )
    
    $
    (10,127
    )
    
    $
    (1,543
    )
 11




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATIONThe Company reports information for three segments, the Carrier Solutions
Group, the Enterprise Solutions Group and the Advanced Applications
Services Group. Previously the Company reported two segments, the Carrier
Solutions Group and the Enterprise Solutions Group. In 2004, the Company
changed its internal reporting and decision-making for the Enterprise
Solutions Group and segregated the activity of the Advanced Applications
Services Group. Management evaluates the business segment performance
based on contributions before unallocated items. Inter-segment sales and
transfers are not significant. CarrierSolutionsGroup:
    
    The Companys Carrier Solutions Group consists of the operations of
the Companys Clarent softswitching division and the Companys
subsidiary, NACT. The Companys Carrier Solutions Group includes
hardware and software, integration, applications and technical
training and support.EnterpriseSolutionsGroup:
    
    The Companys Enterprise Solutions Group consists of the operations
of the Companys Clarent Netperformer division, the Companys
subsidiary Telemate.Net and the Companys subsidiary MCK. The
Enterprise Solutions Group offers hardware-based solutions (which
include software) for companies seeking to build private,
packet-based voice and data networks. Additionally, the Enterprise
Group offers software-based solutions for Internet access and usage
management that include call accounting and usage reporting for
Internet protocol network devices, as well as customer support.Advanced ApplicationsServicesGroup:
    
    The Companys Advanced Applications Services Group, consists of the
Companys technical applications support group which was previously
included as part of the Enterprise Solutions Group, and includes
outsourced technical application services and application
installation and training services to outside customers, as well as
customers of the Companys Carrier Solution Group and Enterprise
Solutions Group segments.
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATION, ContinuedSummarized financial information concerning the Companys reportable
segments is shown in the following table (in thousands): Carrier
    
    Enterprise
    
    ApplicationsSolutions
    
    Solutions
    
    ServicesGroup
    
    Group
    
    Group
    
    TotalFor the Three Months Ended June 30, 2004Revenue
    
    $
    3,754
    
    
    $
    4,301
    
    
    $
    3,281
    
    
    $
    11,336Contribution before unallocated items
    
    
    (836
    )
    
    
    745
    
    
    
    980
    
    
    
    889For the Three Months Ended June 30, 2003Revenue
    
    $
    9,129
    
    
    $
    3,470
    
    
    $
    3,259
    
    
    $
    15,858Contribution before unallocated items
    
    
    2,393
    
    
    
    1,285
    
    
    
    1,341
    
    
    
    5,019At June 30, 2004Goodwill
    
    $
    10,170
    
    
    $
    4,605
    
    
    $
    1,453
    
    
    $
    16,228Total Assets
    
    
    22,953
    
    
    
    15,052
    
    
    
    4,267
    
    
    
    42,272At December 31, 2003Goodwill
    
    $
    10,170
    
    
    $
    4,605
    
    
    $
    1,453
    
    
    $
    16,228Total Assets
    
    
    28,279
    
    
    
    16,545
    
    
    
    4,382
    
    
    
    49,206
  The following table reconciles the contribution before unallocated items
to the loss before income taxes (in thousands): Three Months Ended June 30,2004
    
    2003Contribution before unallocated items, per above
    
    $
    889
    
    
    $
    5,019Corporate general and administrative expenses
    
    
    (2,228
    )
    
    
    (1,948
    )Sales and marketing
    
    
    (3,616
    )
    
    
    (2,201
    )Corporate research and development
    
    
    (111
    )
    
    
    Depreciation and amortization of property and equipment
    
    
    (784
    )
    
    
    (543
    )Amortization of intangibles
    
    
    (135
    )
    
    
    (60
    )Amortization of deferred compensation, related to
sales, general and administrative
    
    
    (90
    )
    
    
    (194
    )Other
    
    
    (205
    )
    
    
    (464
    )Loss before income taxes
    
    $
    (6,280
    )
    
    $
    (391
    )
 13




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATION, Continued Carrier
    
    Enterprise
    
    ApplicationsSolutions
    
    Solutions
    
    ServicesGroup
    
    Group
    
    Group
    
    TotalFor the Six Months Ended June 30, 2004Revenue
    
    $
    12,203
    
    
    $
    9,268
    
    
    $
    6,426
    
    
    $
    27,897Contribution before unallocated items
    
    
    1,359
    
    
    
    1,603
    
    
    
    1,800
    
    
    
    4,762For the Six Months Ended June 30, 2003Revenue
    
    $
    15,851
    
    
    $
    6,639
    
    
    $
    6,365
    
    
    $
    28,855Contribution before unallocated items
    
    
    3,400
    
    
    
    2,724
    
    
    
    2,623
    
    
    
    8,747
  The following table reconciles the contribution before unallocated items
to the loss before income taxes (in thousands): Six Months Ended June 30,2004
    
    2003Contribution before unallocated items, per above
    
    $
    4,762
    
    
    $
    8,747Corporate general and administrative expenses
    
    
    (4,126
    )
    
    
    (3,473
    )Sales and marketing
    
    
    (6,786
    )
    
    
    (4,092
    )Corporate research and development
    
    
    (156
    )
    
    
    Depreciation and amortization of property and equipment
    
    
    (1,589
    )
    
    
    (1,196
    )Amortization of intangibles
    
    
    (270
    )
    
    
    (120
    )Amortization of deferred compensation, related to
sales, general and administrative
    
    
    (256
    )
    
    
    (393
    )Reorganization costs
    
    
    (584
    )
    
    
    (114
    )Reorganization costs-stock related
    
    
    (570
    )
    
    
    (80
    )Other
    
    
    (441
    )
    
    
    (795
    )Loss before income taxes
    
    $
    (10,016
    )
    
    $
    (1,516
    )
 14




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATION, ContinuedThe following table reconciles the segment total assets to the Companys
total assets: June 30,
    
    December 31,2004
    
    2003Total assets before unallocated items, per above
    
    $
    42,272
    
    
    $
    49,206Corporate assets:Cash and cash equivalents
    
    
    18,075
    
    
    
    7,654Restricted cash
    
    
    93
    
    
    
    2,290Other current assets
    
    
    447
    
    
    
    144Property and equipment, net
    
    
    2,967
    
    
    
    3,285Investment
    
    
    610
    
    
    
    673$
    64,464
    
    
    $
    63,252
  The Company conducts research and development in Canada. International
sales of the Companys products and services originate only from the
United States. The geographic distribution of the Companys revenues and
contribution before unallocated items (in thousands) are as follows: Canada
    
    United States
    
    TotalFor the Three Months Ended June 30, 2004Revenue
    
    $
    
    
    
    $
    11,336
    
    
    $
    11,336Contribution before unallocated items
    
    
    (1,350
    )
    
    
    2,239
    
    
    
    889For the Three Months Ended June 30, 2003Revenue
    
    $
    
    
    
    $
    15,858
    
    
    $
    15,858Contribution before unallocated items
    
    
    (947
    )
    
    
    5,966
    
    
    
    5,019For the Six Months Ended June 30, 2004Revenue
    
    $
    
    
    
    $
    27,897
    
    
    $
    27,897Contribution before unallocated items
    
    
    (2,756
    )
    
    
    7,518
    
    
    
    4,762For the Six Months Ended June 30, 2003Revenue
    
    $
    
    
    
    $
    28,855
    
    
    $
    28,855Contribution before unallocated items
    
    
    (1,888
    )
    
    
    10,635
    
    
    
    8,747At June 30, 2004Total assets
    
    $
    1,179
    
    
    $
    63,285
    
    
    $
    64,464At December 31, 2003Total assets
    
    $
    1,514
    
    
    $
    61,738
    
    
    $
    63,252
 15




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  10.
    
    REORGANIZATION COSTSIn the first quarter of 2004, the Company terminated a senior executive.
As a result of this action, the Company recorded reorganization costs of
$1.2 million during the six months ended June 30, 2004. The
reorganization costs consist of severance costs of $584,000 and non-cash
stock compensation of $570,000 related to the write-off of unamortized
deferred compensation.In the first quarter of 2003, the Company initiated a reorganization to
accommodate the acquisition of the assets of Clarent and eliminated 14
positions held by employees. As a result of these actions, the Company
recorded reorganization costs of $194,000 during the six months ended June
30, 2003. The reorganization costs consist of severance costs of $114,000
and non-cash stock compensation of $80,000.11.
    
    PRIVATE PLACEMENTOn February 24, 2004, the Company completed a private placement of
securities pursuant to which it issued 9.8 million shares of its common
stock and warrants to purchase 2.5 million shares of its common stock for
an aggregate purchase price of $17.7 million, or $1.80 per share. The
warrants issued in connection with the private placement are exercisable
for a period of seven years at an exercise price of $2.30 per share. The
Company received approximately $16.5 million, net of expenses, from the
private placement of these securities.12.
    
    STOCK OPTIONS AND WARRANTSThe Company has a stock option plan for employees, board of directors,
consultants, and other individual contributors to the Company. In
addition, in connection with various financing and acquisition
transactions, and for services provided to the Company, the Company has
issued warrants to purchase the Companys common stock. A summary of
stock options and warrants outstanding at June 30, 2004 is as follows:OPTIONS AND WARRANTS ISSUED TO EMPLOYEES Options and Warrants Outstanding
    
    Options and Warrants ExercisableRange of Exercise
    
    Outstanding at
    
    Weighted Average
    
    Exercisable at
    
    Weighted AveragePrices
    
    June 30, 2004
    
    Exercise Price
    
    June 30, 2004
    
    Exercise Price$0.19-$0.50
    
    
    3,360,927
    
    
    $
    0.43
    
    
    
    2,759,552
    
    
    $
    0.42$0.51-$1.00
    
    
    714,807
    
    
    $
    0.64
    
    
    
    630,183
    
    
    $
    0.64$1.01-$1.50
    
    
    1,420,849
    
    
    $
    1.37
    
    
    
    747,764
    
    
    $
    1.34$1.51-$2.13
    
    
    1,011,730
    
    
    $
    1.72
    
    
    
    65,230
    
    
    $
    1.66$2.14-$2.14
    
    
    4,573,619
    
    
    $
    2.14
    
    
    
    4,026,744
    
    
    $
    2.14$2.15-$3.05
    
    
    291,690
    
    
    $
    2.74
    
    
    
    282,226
    
    
    $
    2.75$3.06-$4.00
    
    
    1,755,234
    
    
    $
    3.49
    
    
    
    919,109
    
    
    $
    3.44$4.01-$5.00
    
    
    1,375,435
    
    
    $
    4.24
    
    
    
    1,155,310
    
    
    $
    4.25$5.01-$18.00
    
    
    683,075
    
    
    $
    6.77
    
    
    
    683,075
    
    
    $
    6.77Total
    
    
    15,187,366
    
    
    $
    2.15
    
    
    
    11,269,193
    
    
    $
    2.20
  Options and warrants issued to employees generally terminate ten years
from the date of grant. Termination dates on the options and warrants
listed above range from July 8, 2004 to June 24, 2014. 16




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of stock options and warrants granted to employees
as of June 30, 2004, and the changes during the six months ended June 30,
2004 is presented below: Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseOptions
    
    PricesOutstanding at
beginning of the period
    
    
    14,727,764
    
    
    $
    2.13Granted
    
    
    1,062,730
    
    
    
    1.70Exercised
    
    
    (367,809
    )
    
    
    0.53Forfeited
    
    
    (235,319
    )
    
    
    1.36Expired
    
    
    
    
    
    
    Outstanding at end of period
    
    
    15,187,366
    
    
    $
    2.15Exercisable at end of period
    
    
    11,269,193
    
    
    $
    2.20
  A summary of warrants issued primarily in connection with financing is as
follows: Number of
    
    Weighted AverageExercise Price
    
    Outstanding Warrants
    
    Exercise Price
    
    Expiration Date$0.01
    
    
    37,532
    
    
    $
    0.01
    
    
    September 2005-October 2006$1.50-$1.82
    
    
    1,244,106
    
    
    $
    1.63
    
    
    August 2005-January 2006$2.30-$3.09
    
    
    2,462,861
    
    
    $
    2.30
    
    
    February 2005-February 2011$3.80-$5.51
    
    
    2,122,469
    
    
    $
    4.98
    
    
    July 2005-October 2006$5.62-$5.65
    
    
    4,534,839
    
    
    $
    5.65
    
    
    February 2005-September 2006$6.00
    
    
    150,000
    
    
    $
    6.00
    
    
    October 2006Total
    
    
    10,551,807
    
    
    $
    4.25
  All warrants are vested.The exercise price and number of outstanding warrants for certain warrants
previously issued have been adjusted according to their antidilution
provisions. 17




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##### Table of Contents



VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of warrants issued primarily in connection with
financing as of June 30, 2004, and the changes during the six months ended
June 30, 2004 is presented below: Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseOptions
    
    PricesOutstanding at beginning of period
    
    
    8,010,196
    
    
    $
    4.90Granted
    
    
    2,457,525
    
    
    
    2.30Exercised
    
    
    
    
    
    
    Expired
    
    
    (25,000
    )
    
    
    5.00Effects of anti-dilutive provisions
    
    
    109,086Outstanding and exercisable at end of period
    
    
    10,551,807
    
    
    $
    4.25
  If the Company had used the fair value-based method of accounting for its
stock option and incentive plans and charged compensation cost against
income, over the vesting period, based on the fair value of options at the
date of grant, then the pro-forma net loss and net loss per common share
would have been as follows (in thousands, except for per share amounts): Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (6,280
    )
    
    $
    (391
    )
    
    $
    (10,016
    )
    
    $
    (1,516
    )Add: Stock-based compensation
expense included in net loss
    
    
    90
    
    
    
    194
    
    
    
    256
    
    
    
    393Less: Total stock-based employee
compensation expense determined
under fair value based method
for all awards
    
    
    (767
    )
    
    
    (673
    )
    
    
    (1,230
    )
    
    
    (1,643
    )Pro forma net loss
    
    $
    (6,957
    )
    
    $
    (870
    )
    
    $
    (10,990
    )
    
    $
    (2,766
    )Net loss per common shareAs reported
    
    $
    (0.05
    )
    
    $
    
    
    
    $
    (0.08
    )
    
    $
    (0.02
    )Pro forma
    
    
    (0.05
    )
    
    
    (0.01
    )
    
    
    (0.08
    )
    
    
    (0.03
    )
 18




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##### Table of Contents



VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) June 30, 2004 (Unaudited)  13.
    
    NET LOSS PER SHAREBasic and diluted net loss per share are computed in accordance with SFAS
No. 128, Earnings Per Share, using the weighted average number of common
 shares outstanding. The diluted net loss per share for the three and six
months ended June 30, 2004 does not include the effect of the common stock
equivalents, calculated by the treasury stock method, as their impact
would be antidilutive. Using the treasury stock method, common stock
equivalents are as follows: For the three months ended
    
    For the six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Shares issuable under stock options
    
    
    3,198,440
    
    
    
    3,688,933
    
    
    
    3,611,830
    
    
    
    2,913,553Shares issuable pursuant to warrants
to purchase common stock
    
    
    41,008
    
    
    
    7,076,784
    
    
    
    147,345
    
    
    
    6,013,1903,239,448
    
    
    
    10,765,717
    
    
    
    3,759,175
    
    
    
    8,926,743
  14.
    
    LITIGATIONExcept for the pending matters described in Note 17 to the Companys
audited consolidated financial statements included in the Companys Annual
Report on Form 10-K for the year ended December 31, 2003, the Company is not a
party to any material legal proceedings other than ordinary routine claims and
proceedings incidental to its business, and the Company does not expect these
ordinary routine claims and proceedings, either individually or in the
aggregate, to have a material adverse effect on the Company.There have been no material developments regarding the pending matters
described in Note 17 to the Companys audited consolidated financial statements
included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2003 during the six months ended June 30, 2004. 19




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##### Table of Contents



ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS Certain statements in this Quarterly Report on Form 10-Q and in future
filings by the Company with the SEC and in the Companys written and oral
statements that are not statements of historical facts are forward-looking
statements within the meaning of the Private Securities Litigation Reform Act
of 1995. The words believe, expect, anticipate, intend, will and
similar expressions are examples of words that identify forward-looking
statements. Forward-looking statements include, without limitation, statements
regarding our future financial position, business strategy and expected cost
savings. These forward-looking statements are based on our current beliefs, as
well as assumptions we have made based upon information currently available to
us. Each forward-looking statement reflects our current view of future events
and is subject to risks, uncertainties and other factors that could cause
actual results to differ materially from any results expressed or implied by
our forward-looking statements. Important factors that could cause actual
results to differ materially from the results expressed or implied by any
forward-looking statements include: - the volatility of the price of the Companys common stock; - the Companys ability to fund future growth; - the Companys ability to be profitable; - the Companys ability to attract and retain qualified personnel; - general economic conditions of the telecommunications market; - market demand for and market acceptance of the Companys products; - legal claims against the Company, including, but not limited to claims of
patent infringement; - the Companys ability to protect the Companys intellectual property; - defects in the Companys products; - the Companys obligation to indemnify certain customers; - the Companys exposure to risks inherent in international operations; - the Companys dependence on contract manufacturers and suppliers; - the Companys ability to integrate the operations of the businesses recently
acquired by the Company; - the Companys dependence on a small number of customers for revenue with
respect to certain of the Companys products; - the Companys ability to develop and maintain relationships with key
vendors; - new regulation and legislation; - general economic and business conditions; and - other risks and uncertainties disclosed in the Companys Annual Report on
Form 10-K for the year ended December 31, 2003 and in the Companys other
filings with the SEC. All subsequent forward-looking statements relating to the matters
described in this document and attributable to us or to persons acting on our
behalf are expressly qualified in their entirety by such factors. We have no
obligation to publicly
update or revise these forward-looking statements to reflect new
information, future events, or otherwise, except as required by applicable
Federal securities laws, and we caution you not to place undue reliance on
these forward-looking statements. 20




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##### Table of Contents



Overview Following the acquisition of NACT in 2001, the Company began selling
products to the carrier market and focusing its strategic direction on
developing and marketing next-generation communications products. The
Companys current business was built on acquisitions made by the Company by
leveraging the economic downturn in the telecommunications area. In the second
half of 2001, the Company acquired NACT and Telemate.Net; Telemate.Net products
are sold to enterprise customers. Both of these companies sold products almost
exclusively in domestic markets. In the first quarter of 2003, the Company
acquired substantially all of the operating assets of Clarent, which provided
the Company with patented VoIP technologies for both the carrier and enterprise
markets (primarily serving international markets) and significantly increased
the Companys market share in the worldwide softswitch market. At the end of
the third quarter of 2003, the Company acquired MCK and added MCKs integrated
access routers and distributed telephony devices products to the Companys
enterprise segment. For the six months ended June 30, 2004, 77% of the
Companys consolidated revenues are attributable to the
businesses acquired in
these four acquisitions and 47% of the Companys consolidated revenues are
attributable to the businesses acquired by the Company in 2003. The Companys strategy through 2003 was to add next-generation
communications products to its suite of products through strategic acquisitions
and to leverage these operations through cost reductions to enhance cash flow.
With the acquisition of substantially all of the operating assets of Clarent,
the Company enhanced its strategy to move growth toward international markets.
International revenue increased to 37% of the Companys consolidated revenues
for the six months ended June 30, 2004 versus 8% of the Companys consolidated
revenues for 2002. As the acquisition of substantially all of the operating
assets of Clarent was funded primarily by short-term seller financing,
generating cash flow during 2003 was extremely important to the Company. As
such, the Company leveraged its combined operations, reducing sales, general
and administrative costs (as compared to costs prior to the acquisition), while
preserving the research and development expenditures, which are necessary for
the Companys long-term growth and viability. Through 2003, the Companys focus had been on completing strategic
acquisitions, integrating these acquisitions and enhancing cash flow through
cost containment, especially in the areas of sales and marketing. In 2004, the
Company has significantly increased its expenditures for sales and marketing to
focus on long-term sustainable revenue growth. In the first quarter of 2004,
the Company completed a private placement and raised approximately $16.5
million, net of expenses, to fund the expanded sales and marketing programs.
The Company expects that these additional expenditures will significantly
increase the operating loss in 2004 as compared to 2003, excluding the
write-down of goodwill in 2003. General The Company is a communications technology and solutions provider for
communications service providers and enterprises seeking to implement
application-based telephony services, Internet usage management tools and
outsourced customer support services. The Companys continuing operations
include three separate business segments, the Carrier Solutions Group, which
includes the Companys Clarent softswitching division and the Companys
subsidiary NACT, the Enterprise Solutions Group, which includes the Companys
Clarent Netperformer division and the Companys subsidiaries Telemate.Net and
MCK, and the Advanced Applications Services Group, which includes the Companys
technical application support group which was previously included as part of
the Enterprise Solutions Group. The Carrier Solutions Group includes domestic
and international sales of hardware and software, integration, applications and
technical training and support. The Enterprise Solutions Group offers
hardware-based solutions (which include software) for companies seeking to
build private, packet-based voice and data networks. Additionally, the
Enterprise Solutions Group offers software-based solutions for Internet access
and usage management that include call accounting and usage reporting for
Internet protocol network devices. The Advanced Applications Services Group
includes customers of the Companys Carrier Solution Group and Enterprise
Solution Group segments, as well as outsourced technical application customers
and includes application installation and training services. The Company
acquired MCK in September 2003 and substantially all the business assets of
Clarent in February 2003. The consolidated financial statements include the accounts of Verso
Technologies, Inc. and its wholly-owned subsidiaries, MCK, Telemate.Net, NACT
and Clarent Canada Ltd. The Company believes that the foregoing events significantly affect the
comparability of the Companys results of operations from year to year. You
should read the following discussion of the Companys results of operations and
financial
condition in conjunction with the Companys audited consolidated financial
statements and notes thereto included in the Companys Annual Report on Form
10-K for the year ended December 31, 2003. 21




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##### Table of Contents



Results of Operations Three Months Ended June 30, 2004, compared to Three Months Ended June 30, 2003 For the three months ended June 30, 2004, the Companys net loss totaled
$6.3 million, or $.05 per share, compared with a net loss of $391,000, or $.00
per share, for the same period in 2003. Total revenue was $11.3 million in the three months ended June 30, 2004,
reflecting a 29% decrease from the same period in 2003. Products revenue
decreased from $9.9 million in the three months ended June 30, 2003, to $5.7
million in the three months ended June 30, 2004. In 2003, the Company began
redirecting its focus for NACT products sales away from its historic market,
primarily emerging domestic carriers (which market was consolidating), towards
carriers in the international market. During the three months ended June 30,
2003, the Companys Clarent (softswitch) division had a large sale of software
to a single customer; this did not occur in the three months ended June 30,
2004. Services revenue was $5.6 million for the three months ended June 30,
2004, reflecting a 6% decrease from the same period in 2003. Gross profit was
45% of revenue in the three months ended June 30, 2004, compared with 59% of
revenue for the same period in 2003. The decrease in gross profit dollars
resulted primarily from the decrease in revenues. The decrease in gross profit
percentage is due to a decline in revenues across all product lines in relation
to fixed departmental costs (primarily personnel and related costs) related to
the production and support departments and the increase in amortization of
intangibles related to the MCK and Clarent acquisitions. Total operating expenses incurred for the three months ended June 30,
2004, were $11.2 million, an increase of $1.9 million compared to the same
period in 2003. The increase is primarily attributable to the following items:
increases in sales and marketing expenses of $1.4 million, research and
development expenses of $691,000, depreciation expenses of $241,000 and
amortization of intangibles of $75,000 and offset by decrease in general and
administrative expenses of $405,000 and amortization of deferred compensation
of $104,000. The decrease in general and administrative expenses resulted from a
decrease in bad debt expense offset by an increase in expenses related to the
acquisition of MCK in September 2003. The increase in sales and marketing and research and development expenses
resulted from the Companys intention to expand its sales and marketing
programs in 2004 and the addition of personnel and related costs related to the
acquisition of MCK in September 2003. The increase in depreciation expense is primarily related to the fixed
assets recorded in connection with the acquisition of MCK, as well as, the
increases related to the purchase of furniture and equipment of approximately
$1.0 million and $1.2 million during the first six months of 2004 and the last
six months of 2003, respectively, offset by decreases related to fully
depreciated assets. Capital expenditures are primarily depreciated on a
straight-line basis over their estimated useful lives of three years. The increase in intangible amortization is related to the amortization of
the channels of distribution related to the acquisition of MCK in September
2003. The $104,000 decrease in amortization of deferred compensation primarily
related to the termination of certain options and full vesting of other options
outstanding since the Companys acquisitions of Telemate.Net in November 2001
and Cereus Technology Partners, Inc. (Cereus) in September 2000. The
deferred compensation represents the intrinsic value of the Telemate.Net and
Cereus unvested options outstanding at the date of the acquisitions of
Telemate.Net and Cereus and is amortized over the remaining vesting period of
the options. As a percent of revenue, operating expenses were 99% during the three
months ended June 30, 2004 up from 59% for the same period in 2003. Other income was $103,000 during the three months ended June 30, 2004
compared with $9,000 for the same period in 2003. Equity in loss of investment was $45,000 during the three months ended
June 30, 2004, compared to $19,000 for the same period in 2003. This amount
represents the Companys portion of BeTrues income or losses. Due to the
shared decision making between the Company and its equity partner, the results
of BeTrue are treated as an equity investment rather than being consolidated. 22




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##### Table of Contents



Net interest expense was $263,000 during the three months ended June 30,
2004, a decrease of $191,000 compared to the same period in 2003. The decrease
was attributable to payments made on the Companys notes payable for the
acquisition of assets from Clarent. Business Unit Performance Carrier
    
    Enterprise
    
    AdvancedSolutions
    
    Solutions
    
    ApplicationsDollars in thousands
    
    Group
    
    Group
    
    Services Group
    
    ConsolidatedFor the Three MonthsEnded June 30,
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    3,754
    
    
    $
    9,129
    
    
    $
    4,301
    
    
    $
    3,470
    
    
    $
    3,281
    
    
    $
    3,259
    
    
    $
    11,336
    
    
    $
    15,858Gross profit
    
    
    1,598
    
    
    
    5,687
    
    
    
    2,312
    
    
    
    2,143
    
    
    
    1,236
    
    
    
    1,551
    
    
    
    5,146
    
    
    
    9,381Gross margin
    
    
    43
    %
    
    
    62
    %
    
    
    54
    %
    
    
    62
    %
    
    
    38
    %
    
    
    48
    %
    
    
    45
    %
    
    
    59
    %General and administrative
    
    
    633
    
    
    
    1,553
    
    
    
    405
    
    
    
    216
    
    
    
    256
    
    
    
    210
    
    
    
    1,294
    
    
    
    1,979Research and development
    
    
    1,801
    
    
    
    1,741
    
    
    
    1,162
    
    
    
    642
    
    
    
    
    
    
    
    
    
    
    
    2,963
    
    
    
    2,383Contribution before
unallocated items
    
    $
    (836
    )
    
    $
    2,393
    
    
    $
    745
    
    
    $
    1,285
    
    
    $
    980
    
    
    $
    1,341
    
    
    $
    889
    
    
    $
    5,019Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,228
    
    
    
    1,948Sales and marketing
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,616
    
    
    
    2,201Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    111
    
    
    
    Depreciation and amortization of
property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    784
    
    
    
    543Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    135
    
    
    
    60Amortization of deferred compensation,
related to
sales, general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    90
    
    
    
    194Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,075
    )
    
    
    73Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (205
    )
    
    
    (464
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (6,280
    )
    
    $
    (391
    )
 Carrier Solutions Group Total revenue from the Companys Carrier Solutions Group revenue was $3.8
million in the three months ended June 30, 2004, a 59% decrease from the same
period in 2003. In 2003, the Company began redirecting its focus for NACT
product sales away from its historic market, primarily emerging domestic
carriers (which market was consolidating) towards carriers in the international
market. At the same time, the Company reduced its sales and marketing
expenditures for NACT, in a broad cost reduction initiative required to enable
the Clarent acquisition. During the three months ended June 30, 2003, the
Companys Clarent softswitching division had a large sale of software to a
single customer; this did not occur in the three months ended June 30, 2004.
In addition, during the three months ended June 30, 2004, the Company has
concentrated on larger international deals that require a longer time period to
close. Gross profit decreased by $4.1 million in the three months ended June 30,
2004, and was 43% percent of revenue, compared to 62% in the same period in
2003. The decrease in gross profit dollars is attributable to the decrease in
revenue. The decrease in gross margin is due to a decline in revenues in
relation to fixed departmental costs (primarily personnel and related costs)
related to the production and support departments and the increase in
amortization of intangibles related to the Clarent acquisition. In addition,
during the three months ended June 30, 2003, the Clarent softswitching division
experienced a higher proportion of unusually high gross-margin deals. 23




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##### Table of Contents



Allocated operating expenses incurred in the Carrier Solutions Group for
the three months ended June 30, 2004, were $2.4 million, a decrease of $860,000
compared to the same period in 2003. The decrease in general and
administrative expenses is attributable to a reduction in bad debt expense and
personnel costs. The increase in research and development expenses during the
three months ended June 30, 2004, reflects increases related to increased
personnel costs. As a percent of revenue, operating expenses for the Carrier
Solutions Group were 65% during the three months ended June 30, 2004, up from
36% during the same period in 2003. Enterprise Solutions Group Total revenue for the Companys Enterprise Solutions Group was $4.3
million in the three months ended June 30, 2004, a 24% increase from the same
period in 2003. The increase in revenue is primarily related to the Companys
acquisition of MCK in September 2003. Gross profit increased by $169,000 in the three months ended June 30,
2004, and was 54% percent of revenue, compared with 62% of revenue in the same
period in 2003. The increase in gross profit dollars is attributable to the
increase in revenue. The decrease in gross margin is related to the increase
in amortization of intangibles related to MCK technology and the mix of
business, particularly the addition of MCK which has lower margins. Allocated operating expenses incurred in Enterprise Solutions Group for
the three months ended June 30, 2004, were $1.6 million, an increase of
$709,000 compared to the same period in 2003. The increases in general and
administrative expenses and research and development expenses relate to the
acquisition of MCK in September 2003. As a percent of revenue, allocated
operating expenses for Enterprise Solutions Group were 36% during the three
months ended June 30, 2004, up from 25% during the same period in 2003. The
increase is primarily attributable to the increase in research and development
expenses as a percentage of revenue related to the acquisition of MCK in
September 2003. Advanced Applications Services Group Total revenue for the Companys Advanced Applications Services Group was
$3.3 million in the three months ended June 30, 2004, a 1% increase from the
same period in 2003. Gross profit decreased by $315,000 in the three months ended June 30,
2004, and was 38% of revenue, compared with 48% of revenue in the same period
in 2003. The decrease in gross profit dollars and gross margin is due to
increased personnel and related costs related to the Advanced Applications
Services Groups performance of consulting work to assist a large customer in
its conversion to a new software platform. Allocated operating expenses incurred in Advanced Applications Services
Group for the three months ended June 30, 2004, were $256,000, an increase of
$46,000 compared to the same period in 2003. The increase in general and
administrative expenses primarily relate to an increase in personnel and
related costs. Six Months Ended June 30, 2004, compared to Six Months Ended June 30, 2003 For the six months ended June 30, 2004, the Companys net loss totaled
$10.0 million, or $.08 per share, compared with a net loss of $1.5 million, or
$.02 per share, for the same period in 2003. The 2004 results included
$584,000 of reorganization costs and $570,000 of stock-related reorganization
costs. The 2003 results included $114,000 of reorganization costs and $80,000
of stock-related reorganization costs. Total revenue was $27.9 million in the six months ended June 30, 2004,
reflecting a 3% decrease from the same period in 2003. Products revenue
decreased from $17.1 million in the six months ended June 30, 2003, to $16.7
million in the six months ended June 30, 2004. In 2003, the Company began
redirecting its focus for NACT products sales away from its historic market,
primarily emerging domestic carriers (which market was consolidating), towards
carriers in the international market. Services revenue was $11.2 million for
the six months ended June 30, 2004, reflecting a 5% decrease from the same
period in 2003. Gross profit decreased for the six months ended June 30, 2004,
and was 49% of revenue in 2004, compared with 58% of revenue in 2003. The
increase in gross profit dollars resulted from the decrease in revenues,
increased service costs and increased amortization
of intangibles. The decrease in gross profit percentage is due to the
increase in amortization of intangibles and reduced margins on services
revenues in all the segments of the business. Total operating expenses incurred for the six months ended June 30, 2004,
were $23.2 million, an increase of $5.7 million compared to the same period of
2003. The increase is primarily attributable to the following items: increases
in general and administrative expenses of $36,000, sales and marketing expenses
of $2.7 million, research and development expenses of $1.6 million,
depreciation expenses of $393,000, amortization of intangibles of $150,000 and
reorganization costs of $960,000, offset by decrease in amortization of
deferred compensation of $137,000. 24




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##### Table of Contents



The increase in general and administrative, sales and marketing and
research and development expenses resulted from the addition of personnel and
related costs related to the acquisitions of MCK in September 2003 and
substantially all of the business assets of Clarent in February 2003. The increase in depreciation expense is primarily related to the fixed
assets recorded in connection with the acquisition of MCK and substantially all
the business assets of Clarent, as well as, the increases related to the
purchase of furniture and equipment of approximately $1.0 million and $1.2
million during the first six months of 2004 and the last six months of 2003,
respectively, offset by decreases related to fully depreciated assets. Capital
expenditures are primarily depreciated on a straight-line basis over their
estimated useful lives of three years. The increase in intangible amortization is related to the amortization of
the channels of distribution related to the acquisition of MCK in September
2003. The $137,000 decrease in amortization of deferred compensation primarily
related to the termination of certain options and full vesting of other options
outstanding since the Companys acquisitions of Telamate.Net in November 2001
and Cereus Technology in September 2000. The deferred compensation represents
the intrinsic value of the Telemate.Net and Cereus unvested options outstanding
at the date of the acquisitions of Telemate.Net and Cereus and is amortized
over the remaining vesting period of the options. The $470,000 increase in reorganization costs and $490,000 increase in
stock related reorganization costs is related to the termination of a senior
executive in the first quarter of 2004. As a result of these actions, the
Company recorded total reorganization costs of $1.2 million during the six
months ended June 30, 2004. The Company initiated a reorganization to
accommodate the acquisition of the assets of Clarent in the six months ended
March 31, 2003 and eliminated 14 positions held by employees. As a result of
these actions, the Company recorded total reorganization costs of $194,000
during the six months ended June 30, 2003. The reorganization costs consist of
severance costs and non-cash stock compensation. As a percent of revenue, operating expenses were 83% during the six months
ended June 30, 2004, up from 61% for the same period in 2003. Other income was $151,000 during the six months ended June 30, 2004,
compared with $18,000 for the same period in 2003. Equity in loss of investment was $63,000 during the six months ended June
30, 2004, compared to $52,000 for the same period in 2003. This amount
represents the Companys portion of BeTrues income or losses. Due to the
shared decision making between the Company and its equity partner, the results
of BeTrue are treated as an equity investment rather than being consolidated. Net interest expense was $529,000 during the six months ended June 30,
2004, a decrease of $232,000 compared to the same period in 2003. The decrease
was attributable to payments made on the Companys notes payable for the
acquisition of assets from Clarent. 25




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##### Table of Contents



Business Unit Performance Carrier
    
    Enterprise
    
    AdvancedSolutions
    
    Solutions
    
    ApplicationsDollars in thousands
    
    Group
    
    Group
    
    Services Group
    
    ConsolidatedFor the Six MonthsEnded June 30,
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    12,203
    
    
    $
    15,851
    
    
    $
    9,268
    
    
    $
    6,639
    
    
    $
    6,426
    
    
    $
    6,365
    
    
    $
    27,897
    
    
    $
    28,855Gross profit
    
    
    6,508
    
    
    
    9,493
    
    
    
    4,841
    
    
    
    4,288
    
    
    
    2,300
    
    
    
    3,020
    
    
    
    13,649
    
    
    
    16,801Gross margin
    
    
    53
    %
    
    
    60
    %
    
    
    52
    %
    
    
    65
    %
    
    
    36
    %
    
    
    47
    %
    
    
    49
    %
    
    
    58
    %General and administrative
    
    
    1,681
    
    
    
    2,890
    
    
    
    977
    
    
    
    488
    
    
    
    500
    
    
    
    397
    
    
    
    3,158
    
    
    
    3,775Research and development
    
    
    3,468
    
    
    
    3,203
    
    
    
    2,261
    
    
    
    1,076
    
    
    
    
    
    
    
    
    
    
    
    5,729
    
    
    
    4,279Contribution before
unallocated items
    
    $
    1,359
    
    
    $
    3,400
    
    
    $
    1,603
    
    
    $
    2,724
    
    
    $
    1,800
    
    
    $
    2,623
    
    
    $
    4,762
    
    
    $
    8,747Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,126
    
    
    
    3,473Sales and marketing
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,786
    
    
    
    4,092Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    156
    
    
    
    Depreciation and amortization of
property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,589
    
    
    
    1,196Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    270
    
    
    
    120Amortization of deferred compensation,
related to
sales, general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    256
    
    
    
    393Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    584
    
    
    
    114Stock related reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    570
    
    
    
    80Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,575
    )
    
    
    (721
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    441
    
    
    
    795Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (10,016
    )
    
    $
    (1,516
    )
 Carrier Solutions Group Total revenue from the Companys Carrier Solutions Group revenue was $12.2
million in the six months ended June 30, 2004, a 23% decrease from the same
period in 2003. In 2003, the Company began redirecting its focus for NACT
product sales away from its historic market, primarily emerging domestic
carriers (which market was consolidating), towards carriers in the
international market. Gross profit decreased by $3.0 million in the six months ended June 30,
2004, and was 53% percent of revenue, compared to 60% in the same period in
2003. The decrease in gross profit dollars is attributable to the decrease in
revenue. The decrease in gross margin is due to a decline in revenues in
relation to fixed departmental costs (primarily personnel and related costs)
related to the production and support departments and the increase in
amortization of intangibles related to the Clarent acquisition. Allocated operating expenses incurred in the Carrier Solutions Group for
the six months ended June 30, 2004, were $5.2 million, a decrease of $943,000
compared to the same period in 2003. The decrease in general and
administrative expenses is attributable to a reduction in bad debt expense,
personnel costs and facility expenses. The increase in research and
development expenses reflects increases related to increased personnel costs.
As a percent of revenue, operating expenses for
the Carrier Solutions Group were 42% during the six months ended June 30,
2004, down from 38% during the same period in 2003. 26




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Enterprise Solutions Group Total revenue for the Companys Enterprise Solutions Group was $9.3
million in the six months ended June 30, 2004, a 40% increase from the same
period in 2003. The increase in revenue is primarily related to the Companys
acquisition of MCK in September 2003. Gross profit increased by $553,000 in the six months ended June 30, 2004,
and was 52% percent of revenue, compared with 65% of revenue in the same period
in 2003. The increase in gross profit dollars is attributable to the increase
in revenue. The decrease in gross margin is related to the increase in
amortization of intangibles related to MCK technology, inventory obsolescence
adjustments and the mix of business, particularly the addition of MCK which has
lower margins. Allocated operating expenses incurred in Enterprise Solutions Group for
the six months ended June 30, 2004, were $3.2 million, an increase of $1.7
million compared to the same period in 2003. The increases in general and
administrative expenses and research and development expenses relate to the
acquisition of MCK in September 2003 and Clarents Netperformer division in
February 2003. As a percent of revenue, allocated operating expenses for
Enterprise Solutions Group were 35% during the six months ended June 30, 2004,
up from 24% during the same period in 2003. The increase is primarily
attributable to the increase in research and development expenses as a
percentage of revenue related to the acquisitions of MCK in September 2003 and
Clarents Netperformer division in February 2003. Advanced Applications Services Group Total revenue for the Companys Advanced Applications Services Group was
$6.4 million in the six months ended June 30, 2004, a 1% increase from the same
period in 2003. Gross profit decreased by $720,000 in the six months ended June 30, 2004,
and was 36% of revenue, compared with 47% of revenue in the same period in
2003. The decrease in gross profit dollars and gross margin is due to
increased personnel and related costs related to the Advanced Applications
Services Groups performance of consulting work to assist a large customer in
its conversion to a new software platform. Allocated operating expenses incurred in Advanced Applications Services
Group for the six months ended June 30, 2004, were $499,000, an increase of
$102,000 compared to the same period in 2003. The increase in general and
administrative expenses primarily relate to an increase in personnel and
related costs. Critical Accounting Policies The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
of America requires management to make judgments, assumptions and estimates
that affect the amounts reported in the consolidated financial statements and
accompanying notes. Factors that could affect the Companys future operating
results and cause actual results to vary from expectations include, but are not
limited to, lower than anticipated growth from existing customers, an inability
to attract new customers, an inability to successfully integrate acquisitions
and technology changes, or a decline in the financial stability of the
Companys customers. Negative developments in these or other risk factors
could have a material adverse affect on the Companys financial position and
results of operations. A summary of the Companys critical accounting policies follows: Allowance for Doubtful Accounts The Company is required to estimate the collectibility of its trade
receivables. Considerable judgment is required in assessing the ultimate
realization of these receivables, including the creditworthiness of each
customer. The evaluation is based on credit information and collection history
concerning the customer up and through the determination date. The Company
determines the allowance for doubtful accounts based on a specific review of
outstanding customer balances and a general reserve based upon aging of
customer accounts and write-off history. Significant changes in required
reserves have been recorded in recent periods and may occur in the future due
to the current telecommunications and general economic environments and updates
to customer credit information and collection activity. 27




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Inventory Obsolescence The Company is required to state its inventories at the lower of cost or
market. In assessing the ultimate realization of inventories, the Company
makes judgments as to future demand requirements and compares that with the
current and committed inventory levels. The Company has recorded changes in
net realizable values in recent periods due to the impact of current and future
technology trends and changes in strategic direction, such as discontinuances
of product lines, as well as, changes in market conditions due to changes in
demand requirements. Estimates of the future demand for inventory are based on
sales projections for different products, as well as estimates of inventory
required to fulfill maintenance requirements for products previously sold. It
is possible that changes in the net realizable value of inventory may continue
to occur in the future due to the current market conditions. Restructuring Accruals- Discontinued Operations During 2001, the Company initiated certain restructuring plans. In
conjunction with these restructuring plans, the Company established a
restructuring reserve account for the estimated costs related to the plans.
These costs primarily related to facilities closings, severance costs and other
businesses exiting costs. For the facilities closings cost, a reserve was
established for all remaining lease payments due on buildings and equipment
that were no longer being utilized in continuing operations, less assumptions
for sub-leases. The accrual for one of the leases with total payments
remaining through January 31, 2010 of $2.2 million is offset by sublease
receipts totaling $1.0 million through the end of the lease term and assumes an
amount of $240,000 for the extension of one of the subleases through the end of
the lease term. As of June 30, 2004, the Company had a remaining reserve
balance of approximately $1.3 million, which is included in liabilities of
discontinued operations. The Company currently believes that this remaining
estimated balance is appropriate to cover future obligations associated with
the restructurings; however, changes in these estimates could occur based on
changes in the financial condition of the subleases. Deferred Tax Asset Valuation Allowance The Company currently has significant deferred tax assets, which are
subject to periodic recoverability assessment. Realization of the Companys
deferred tax assets is principally dependant upon achievement of projected
future taxable income. The Companys judgments regarding future profitability
may change due to market conditions, its ability to continue to successfully
execute its strategic plan and other factors. These changes, if any, may
require possible material adjustments to these deferred tax asset balances.
Due to the uncertainty of the Companys ability to recognize the entire tax
benefit, the Company established an offsetting provision for the tax assets. Litigation and Related Contingencies The Company is subject to proceedings, lawsuits and other claims related
to labor, product and other matters. The Company is required to assess the
likelihood of any adverse judgments or outcomes to these matters, as well as,
potential ranges of probable losses. A determination of the amount of reserves
required, if any, for these contingencies is made by the Company with
assistance of its legal counsel after careful analysis of each individual issue
based upon the then-current facts and circumstances. The required reserves may
change in the future due to new developments in each matter or changes in
approach such as a change in settlement strategy in dealing with these matters. Goodwill, Intangible Assets and Long-Lived Assets Goodwill represents the excess of costs over the fair value of net assets
of businesses acquired. Goodwill and intangible assets acquired in a purchase
business combination and determined to have an indefinite useful life are not
amortized, but instead are tested for impairment at least annually in
accordance with provisions of SFAS No. 142. Significant estimates are made
with respect to the impairment testing. SFAS No. 142 also requires that
intangible assets with estimable useful lives be amortized over their
respective estimated useful lives to their estimated residual values, and
reviewed for impairment in accordance with SFAS No. 144. In accordance with SFAS No. 144, long-lived assets, such as property,
plant and equipment and purchased assets subject to amortization, are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable. Recoverability of assets
to be held and used is measured by a comparison of the carrying amount of an
asset to estimated undiscounted future cash flows expected to be generated by
the asset. If the carrying amount of an asset exceeds its estimated future
cash flows, an impairment charge is recognized by the amount by which the
carrying amount of the asset exceeds the fair value of the asset. Significant
estimates are made with respect to recoverability and fair value assessments. 28




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Liquidity and Capital Resources Summary Liquidity is the measurement of the Companys ability to have adequate
cash or access to cash at all times in order to meet financial obligations when
due, as well as to fund corporate expansion and other activities. For the last
three years, the Company has met its liquidity requirements through a
combination of cash provided by debt from third party lenders, issuances of
debt and equity securities and purchases of other businesses. At June 30, 2004, the Company had a positive working capital position
(excess of current assets over current liabilities) of $22.0 million compared
to a positive working capital position of $12.7 million at December 31, 2003.
The Companys cash and cash equivalents totaled $18.2 million at June 30, 2004,
and $7.7 million at December 31, 2003. Total long-term debt, net of discount,
was $6.8 million at June 30, 2004 and $6.6 million at December 31, 2003. At
June 30, 2004 and December 31, 2003, the Company had no borrowings under its
$10.0 million Amended Credit Agreement with Silicon. The Companys borrowing
availability under the Amended Credit Agreement at June 30, 2004 was $4.7
million. The Company has outstanding stand-by letters of credit in the amount
of $1.6 million at June 30, 2004, which reduce borrowing capacity under the
Amended Credit Agreement. On February 12, 2003, in connection with the Companys acquisition of the
assets of Clarent, the Company amended its existing Original Credit Agreement
with Silicon, and in connection therewith, the Company and Silicon entered into
certain amendments to the existing credit facility and certain additional
credit agreements. Such amendments and additional agreements increased the
Companys asset-based revolving credit line from $5.0 million to $10.0 million
and include an EX-IM facility that will provide for working capital based on
the Companys international accounts receivable and inventory related to export
sales primarily associated with Clarents assets. The amendments and
additional agreements also extended the term of the Original Credit Agreement
for 18 months (through August 13, 2004). On April 7, 2003, the Company and
Silicon further amended the credit facility to increase the EX-IM facility and
to modify certain financial covenants related to the timing of the closing of
the acquisition of the business assets of Clarent. In February 2004, the Company and Silicon further
amended the credit facility. Under the terms of the Amended Credit Agreement,
the Company must maintain a minimum tangible net worth covenant, computed
monthly, and may not declare dividends or incur any additional indebtedness
without the consent of Silicon, and must comply with other financial covenants,
as defined in the Amended Credit Agreement. In August 2004, at the Companys
request, Silicon further amended the credit facility to extend the term to
January 2005. The Company requested this extension versus a renewal to give
the Company time to determine how best to size its line of credit to cover its
expected borrowing base in 2005 and give the Company maximum financing
flexibility. In addition, the Company was not in compliance with the minimum
tangible net worth covenant as of June 30, 2004, and Silicon waived such
non-compliance. On February 12, 2003, the Company acquired substantially all the business
assets and assumed certain related liabilities of Clarent for $9.8 million in
notes. At June 30, 2004, a $3.0 million secured note due February 12, 2008,
which bears interest at 5% per annum, remains outstanding. The assets the
Company purchased from Clarent secure the note. Cash Flow Cash used in the Companys continuing operations in the six months ended
June 30, 2004 totaled approximately $2.8 million compared with cash provided by
continuing operations of $229,000 in the same period in 2003. The cash used in
continuing operations during the six months ended June 30, 2004 resulted
primarily from cash used by continuing operations of $5.7 million (net loss
from continuing operations of $10.0 million reduced by non-cash charges
totaling $4.3 million, including depreciation and amortization of $3.3 million,
stock-related reorganization costs of $570,000 and provision for doubtful
accounts of $433,000) which was offset by changes in current operating assets
and liabilities of approximately $2.9 million. Cash used in the Companys discontinued operations in the six months ended
June 30, 2004 totaled $264,000 compared with cash used in discontinued
operations of $525,000 in the same period in 2003. The Company used cash in investing activities in the six months ended June
30, 2004 of approximately $2.7 million, compared to $1.6 million in the same
period of 2003. In the six months ended June 30, 2004, the Company used $3.9
million in cash related to the payment of accrued liabilities assumed in the
acquisition of MCK. During the six months ended June 30, 2004, restricted cash
decreased by $2.2 million. The Company spent $1.0 million and $297,000 on
capital expenditures in the six months ended June 30, 2004 and 2003,
respectively. The Company also invested $320,000 on purchased software
development costs in the six months ended June 30, 2003. 29




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##### Table of Contents



Cash provided by financing activities totaled approximately $16.3 million
in the six months ended June 30, 2004 compared to $1.8 million in the same
period of 2003. For the six months ended June 30, 2004, the Company received
proceeds from a private placement, net of associated fees of $16.5 million,
received proceeds from the issuance of the Companys common stock related to
the exercise of stock options of $151,000 and paid $350,000 on the notes
payable for the purchase of the assets of Clarent in 2003. For the six months
ended June 30, 2004, the Company borrowed $2.0 million on the Companys credit
line, received proceeds from the issuance of the Companys common stock related
to the exercise of stock options of $812,000 and paid $1.1 million on the notes
payable for the purchase of the assets of Clarent in 2003. Contractual Obligations and Commercial Commitments The following summarizes the Companys future contractual obligations at June
30, 2004 (in thousands): Less than
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    1 year
    
    1-3 years
    
    4-5 years
    
    5 yearsLine of credit
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Additional payments for the acquisition of
Encore Group
    
    
    761
    
    
    
    422
    
    
    
    339
    
    
    
    
    
    
    
    Notes payable for the purchase of Clarent
    
    
    3,000
    
    
    
    
    
    
    
    
    
    
    
    3,000
    
    
    
    Accrued costs of MCK acquisition
    
    
    3,833
    
    
    
    1,298
    
    
    
    2,535
    
    
    
    
    
    
    
    Convertible subordinated debentures
    
    
    4,500
    
    
    
    
    
    
    
    4,500
    
    
    
    
    
    
    
    Operating leases:Continuing operations
    
    
    13,256
    
    
    
    2,995
    
    
    
    4,959
    
    
    
    4,135
    
    
    
    1,167Discontinued operations
    
    
    2,428
    
    
    
    689
    
    
    
    739
    
    
    
    770
    
    
    
    230Total contractual cash obligations
    
    $
    27,778
    
    
    $
    5,404
    
    
    $
    13,072
    
    
    $
    7,905
    
    
    $
    1,397
 Note, this table excludes interest expense and sublease rentals and
assumes that leases are not renewed. The Company has outstanding stand-by
letters of credit in the amount of $1.6 million at June 30, 2004. Sources of Cash For 2004, the Company expects that its primary sources of cash will be
from cash on hand and borrowings under its Amended Credit Agreement with
Silicon. The Company expects that its current operations will not generate
positive income from operations before interest, taxes, depreciation,
amortization of intangibles and amortization of deferred compensation for 2004
as the Company is investing in additional sales and marketing and research and
development costs. However, the Company believes that it will have sufficient
liquidity from its cash on hand and its unused credit facility to meet its
current financial obligations during the next twelve months. The Amended Credit Agreement with Silicon, however, is subject to certain
financial covenants (including a minimum tangible net worth covenant) and
limitations on the Companys ability to access funds under the Amended Credit
Agreement. If the Company is in violation of the Amended Credit Agreement, or
does not have sufficient eligible accounts receivable and inventories to
support the level of borrowings it may need, then the Company may be unable to
draw on the Amended Credit Agreement to the extent necessary. To the extent
the Company does not have borrowing availability under the Amended Credit
Agreement, the Company may be required to obtain additional sources of capital,
sell assets, obtain an amendment to the Amended Credit Agreement or otherwise
restructure its outstanding indebtedness. Additional borrowings other than
pursuant to the Amended Credit Agreement must be approved by Silicon and may
have to be approved by the holders of the Clarent secured note due in 2008. If
the Company is unable to obtain additional capital, sell assets, obtain an
amendment to the Amended Credit Agreement or otherwise restructure its
outstanding indebtedness, then the Company may not be able to meet its
obligations. The Amended Credit Agreement, if not extended or replaced,
expires January 12, 2005. The Companys short-term cash needs are for working capital, including
cash operating losses, capital expenditures, remaining unpaid transaction costs
and assumed liabilities related to the acquisition of MCK and payments related
to discontinued operations. At June 30, 2004, accrued costs of MCK acquisition
and other long-term liabilities include $1.6 million in lease payments related
to lease obligations for excess space at the date of acquisition. The Company
expects to pay out
approximately $692,000 related to these obligations in the next twelve
months. At June 30, 2004, liabilities of discontinued operations included $1.3
million in lease payments related to discontinued operations. The Company
expects to pay out approximately $262,000 related to discontinued operations in
the next twelve months. 30




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##### Table of Contents



The Companys long-term cash needs are related to the costs of growing its
current business as well as prospective businesses to be acquired, including
capital expenditures and working capital. The Company expects to meet these
cash needs through cash from operations, if any, cash on hand, borrowings under
the Amended Credit Agreement or other debt facilities, if available, as well as
through possible issuances of equity or debt securities. If sufficient
borrowing capacity under a working capital line of credit is unavailable (or if
the Company is unable to restructure its existing Amended Credit Agreement in
the event that the Company requires additional borrowing capacity), or if the
Company is otherwise unable to obtain additional capital or sell assets, then
the Company may not be able to meet its obligations and growth plans. 31




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##### Table of Contents



ITEM 3: QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk The Company is exposed to various market risks, including changes in interest
rates and foreign currency exchange rates. Market risk is the potential loss
arising from adverse changes in market rates and prices, such as interest rates
and foreign currency exchange rates. The Company does not enter into
derivatives or other financial instruments for trading or speculative purposes.
The Company has also not entered into financial instruments to manage and
reduce the impact of changes in interest rates and foreign currency exchange
rates although the Company may enter into such transactions in the future. Interest Rate Risks The Companys notes payable and convertible subordinated debentures at June 30,
2004, carry interest rates, which are fixed. The Companys line of credit with
Silicon carries interest rates, which vary with the prime rate. Accordingly,
if the Company has any indebtedness outstanding under its line of credit with
Silicon, then any increases in Silicons prime rate will reduce the Companys
earnings. At June 30, 2004, the Company did not have any indebtedness
outstanding under its line of credit with Silicon. Foreign Currency Risks Products sold outside of the United States of America are transacted in U.S.
dollars and, therefore, the Company is not exposed to foreign currency exchange
risk. Transactions with Clarent Canada Ltd., MCKs subsidiary, MCK
Telecommunications, Inc. and NACTs subsidiary, NACT, Ltd. present foreign
currency exchange risk. The principal transactions are personnel and related
costs. The intercompany balance is denominated in U.S. dollars and changes in
foreign currency rates would result in foreign currency gains and losses.
Using the intercompany balance at June 30, 2004, a 10% strengthening of the
U.S. dollar against the Canadian dollar and the British pound would result in a
foreign currency transaction loss of approximately $48,000. To date, foreign
exchange gains and losses have not been significant. 
 ITEM 4: CONTROLS AND PROCEDURES The Companys Chief Executive Officer and Chief Financial Officer have
evaluated the effectiveness of the Companys disclosure controls and procedures
(as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the
period covered by this report, as required by paragraph (b) of Rules 13(a)-15
or 15(d)-15 of the Exchange Act. Based on such evaluation, such officers have
concluded that, as of the end of the period covered by this report, the
Companys disclosure controls and procedures are effective in alerting them on
a timely basis to material information relating to the Company (including its
consolidated subsidiaries) required to be included in the Companys periodic
filings under the Exchange Act. 32




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##### Table of Contents



PART II  OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS Except for the pending matters described in Note 17 to the Companys
Consolidated Financial Statements included in the Companys Annual Report on
Form 10-K for the year ended December 31, 2003, the Company is not a party to
any material legal proceedings other than ordinary routine claims and
proceedings incidental to its business, and the Company does not expect these
ordinary routine claims and proceedings, either individually or in the
aggregate, to have a material adverse effect on the Company. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a)
    
    Exhibits31.1
    
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Executive Officer.31.2
    
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Financial Officer.32.1
    
    
    Section 1350 Certification by the Companys Chief Executive Officer.32.2
    
    
    Section 1350 Certification by the Companys Chief Financial Officer.* Incorporated by reference to the Companys Current Report on Form 8-K filed on February 26, 2004.(b)
    
    Reports on Form 8-K.During the quarter ended June 30, 2004, the Company filed with the SEC the following Current Reports on Form 8-K:(i)
    
    
    Current Report on Form 8-K filed on April 29, 2004,
reporting under Item 12 of such report information regarding
the Companys results of operations and financial condition for
the first quarter 2004;(ii)
    
    Current Report on Form 8-K filed on May 25, 2004,
(a) reporting under Item 5 of such report the reorganization of
the Companys existing, ongoing business segments and the
modification of Companys Managements Discussion and Analysis
of Financial Condition and Results of Operations for the years
ended December 31, 2003, 2002 and 2001 to the extent such
discussion and analysis relates to segments and Note 15 set
forth in the notes to the Companys audited consolidated
financial statements for the years ended December 31, 2003,
2002 and 2001 and (b) filing as an exhibit to such report the
Companys audited consolidated financial statements for the
years ended December 31, 2003, 2002 and 2001; and(iii)
    
    Current Report on Form 8-K filed on June 14, 2004,
reporting under Item 4 of such report the Companys change of
independent accountants.
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##### Table of Contents



SIGNATURE 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. VERSO TECHNOLOGIES, INC.Date: August 6, 2004
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer(duly authorized signatory andPrincipal Financial and Accounting Officer)
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##### Table of Contents



EXHIBIT INDEX 31.1
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Executive Officer.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Financial Officer.32.1
    
    Section 1350 Certification by the Companys Chief Executive Officer.32.2
    
    Section 1350 Certification by the Companys Chief Financial Officer.
 35