UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





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 February 28, 2011





OR





 ̈ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the transition period from ____ to ___





Commission File Number 1-13436





TELETOUCH COMMUNICATIONS, INC.


(Exact name of registrant in its charter)





Delaware

75-2556090(State or other jurisdiction of

Incorporation or Organization)

(I.R.S. Employer Identification No.)





5718 Airport Freeway, Fort Worth, Texas  76117   (800) 232-3888


(Address and telephone number of principal executive offices)







Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.





Yes  x  No  ̈





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).





Yes   ̈  No  ̈





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.





Large accelerated filer   ̈     Accelerated filer   ̈    Non-accelerated filer   ̈    Smaller reporting company  x





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  ̈  No x





Indicate the number of shares outstanding of each of the Registrant’s classes of Common Stock, as of the latest practicable date:  Common Stock, $0.001 par value, 48,739,002 shares at April 14, 2011.











TELETOUCH COMMUNICATIONS, INC.





TABLE OF CONTENTS





Page No.Part I.  Financial InformationItem 1.
Financial Statements - Teletouch Communications, Inc .
4Consolidated Balance Sheets as of February 28, 2011 (unaudited)and May 31, 2010 (unaudited)
4Consolidated Statements of Operations – Three and Nine Months Ended February 28, 2011 (unaudited) and February 28, 2010 (unaudited)
6Consolidated Statements of Cash Flows - Nine Months Ended February 28, 2011 (unaudited) and February 28, 2010 (unaudited)
7Notes to Consolidated Financial Statements (unaudited)
8Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
30Item 3.
Quantitative and Qualitative Disclosures About Market Risk
54Item 4.
Controls and Procedures
54Part II.  Other InformationItem 1.
Legal Proceedings
56Item 1A.
Risk Factors
57Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
62Item 3.
Defaults Upon Senior Securities
62Item 4.
[Removed and Reserved]
62Item 5.
Other Information
62Item 6.
Exhibits
62Signatures
63




2




Forward-Looking Statements





This Quarterly Report on Form 10-Q contains forward-looking statements and information relating to Teletouch Communications, Inc. and its subsidiaries that are based on management’s beliefs as well as assumptions made by and information currently available to management. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to Teletouch Communications, Inc. or its management, are forward-looking statements. Although these statements are based upon assumptions management considers reasonable, they are subject to certain risks, uncertainties and assumptions, including, but not limited to, those factors set forth below under the captions  “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors.” Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results or outcomes may vary materially from those described herein as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or revise any forward-looking statements. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the discussion included in this report.




3




PART 1 – FINANCIAL INFORMATION





Item 1.   Financial Statements





TELETOUCH COMMUNICATIONS, INC.


CONSOLIDATED BALANCE SHEETS


(unaudited)


(in thousands, except share data)


ASSETS





February 28,


May 31,2011


2010CURRENT ASSETS:Cash

$
2,059


$
4,932Certificates of deposit-restricted


50



150Accounts receivable, net of allowance of $311 at February 28, 2011 and $407 at May 31, 2010


3,624



3,967Accounts receivable-related party


23



-Unbilled accounts receivable


2,125



2,592Inventories, net of reserve of $253 at February 28, 2011 and $232 at May 31, 2010


1,701



1,049Notes receivable


1



15Prepaid expenses and other current assets


455



1,288Patent held for sale


257



257Total Current Assets


10,295



14,250PROPERTY AND EQUIPMENT, net of accumulated depreciationof $6,234 at February 28, 2011 and $6,039 at May 31, 2010


2,705



2,749GOODWILL


343



343INTANGIBLE ASSETS, net of accumulated amortizationof $9,678 at February 28, 2011 and $8,964 at May 31, 2010


3,808



4,342TOTAL ASSETS

$
17,151


$
21,684





See Accompanying Notes to Consolidated Financial Statements





4





TELETOUCH COMMUNICATIONS, INC.


CONSOLIDATED BALANCE SHEETS


(unaudited)


(in thousands, except share data)





LIABILITIES AND SHAREHOLDERS’ DEFICIT





February 28,


May 31,2011


2010CURRENT LIABILITIES:Accounts payable

$
7,685


$
7,964Accounts payable-related party


-



111Accrued expenses and other current liabilities


4,226



5,517Current portion of long-term debt


1,498



1,412Current portion of trademark purchase obligation


150



150Deferred revenue


339



336Total Current Liabilities


13,898



15,490LONG-TERM LIABILITIES:Long-term debt, net of current portion


13,228



14,487Long-term trademark purchase obligation, net of current portion


200



350Total Long Term Liabilities


13,428



14,837TOTAL LIABILITIES


27,326



30,327COMMITMENTS AND CONTINGENCIES (NOTE 11)


-



-SHAREHOLDERS' DEFICIT:Common stock, $.001 par value, 70,000,000 shares authorized, 49,916,189 shares issued and 48,739,002 shares outstanding at February 28, 2011 and May 31, 2010


50



50Additional paid-in capital


51,531



51,186Treasury stock, 1,177,187 shares held at February 28, 2011 and May 31, 2010


(216
)


(216
)Accumulated deficit


(61,540
)


(59,663
)Total Shareholders' Deficit


(10,175
)


(8,643
)TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT

$
17,151


$
21,684





See Accompanying Notes to Consolidated Financial Statements




5




TELETOUCH COMMUNICATIONS, INC.


CONSOLIDATED STATEMENTS OF OPERATIONS


(in thousands, except shares and per share amounts)


(unaudited)





Three Months Ended


Nine Months EndedFebruary 28,


February 28,2011


2010


2011


2010Operating revenues:Service and installation revenue

$
4,950


$
6,308


$
15,814


$
19,522Product sales revenue


4,407



10,251



11,465



22,375Total operating revenues


9,357



16,559



27,279



41,897Operating expenses:Cost of service and installation (exclusive of depreciation and amortization included below)


1,528



1,693



4,575



5,569Cost of products sold


4,125



8,719



10,480



19,791Selling and general and administrative


3,767



4,421



11,429



12,594Depreciation and amortization


281



311



844



956Loss (gain) on disposal of assets


-



-



(1
)


1Total operating expenses


9,701



15,144



27,327



38,911Income (loss) from operations


(344
)


1,415



(48
)


2,986Interest expense, net


(553
)


(602
)


(1,672
)


(1,674
)Income (loss) before income tax expense


(897
)


813



(1,720
)


1,312Income tax expense


45



60



157



183Net income (loss)

$
(942
)

$
753


$
(1,877
)

$
1,129Basic income (loss) per share applicable to common shareholders

$
(0.02
)

$
0.02


$
(0.04
)

$
0.02Diluted income (loss) per share applicable to common shareholders

$
(0.02
)

$
0.02


$
(0.04
)

$
0.02Weighted average shares outstanding:Basic


48,739,002



48,739,002



48,739,002



48,791,738Diluted


48,739,002



48,830,618



48,739,002



48,791,738





See Accompanying Notes to Consolidated Financial Statements




6




TELETOUCH COMMUNICATIONS, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands)


(unaudited)





Nine Months EndedFebruary 28,2011


2010Operating Activities:Net income (loss)

$
(1,877
)

$
1,129Adjustments to reconcile net income (loss) to net cash used in operating activities:Depreciation and amortization


844



956Non-cash compensation expense


345



204Non-cash interest expense


94



57Provision for losses on accounts receivable


276



765Provision for inventory obsolescence


98



89Loss (gain) on disposal of assets


(1
)


1Changes in operating assets and liabilities:Accounts receivable


507



539Inventories


(750
)


83Prepaid expenses and other assets


833



(396
)Accounts payable


(390
)


(2,938
)Accrued expenses and other current liabilities


(1,291
)


(1,539
)Deferred revenue


3



82Net cash used in operating activities


(1,309
)


(968
)Investing Activities:Capital expenditures


(179
)


(77
)Purchase of intangible asset


(31
)


-Redemption of certificates of deposit


100



200Net proceeds from sale of assets


1



2Receipts from notes receivable


3



598Net cash (used in) provided by investing activities


(106
)


723Financing Activities:Proceeds from long-term debt


-



1,373Payments on long-term debt


(1,308
)


(1,884
)Purchase of trademark license


(150
)


-Purchase of treasury stock


-



(31
)Net cash used in financing activities


(1,458
)


(542
)Net decrease in cash


(2,873
)


(787
)Cash at beginning of period


4,932



4,642Cash at end of period

$
2,059


$
3,855Supplemental Cash Flow Data:Cash payments for interest

$
1,579


$
1,617Cash payments for income taxes

$
43


$
273Non-Cash Transactions:Capitalization of loan origination fees

$
135


$
244Intangible asset received for payment of note receivable

$
10


$
257Intangible asset received for payment of accounts receivable

$
4


$
-Fixed assets received for payment of note receivable

$
-


$
25





See Accompanying Notes to Consolidated Financial Statements




7




TELETOUCH COMMUNICATIONS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(unaudited)




NOTE 1 – BASIS OF PRESENTATION AND NATURE OF BUSINESS





Nature of Business: Teletouch Communications, Inc. was incorporated under the laws of the State of Delaware on July 19, 1994 and its corporate headquarters are in Fort Worth, Texas. References to Teletouch or the Company as used throughout this document mean Teletouch Communications, Inc. or Teletouch Communications, Inc. and its subsidiaries, as the context requires.





For over 46 years, Teletouch together with its predecessors has offered a comprehensive suite of telecommunications products and services including cellular, two-way radio, GPS-telemetry, wireless messaging and public safety equipment. As of February 28, 2011, the Company operated 20 retail and agent locations in Texas.  Locations include both “Teletouch” and “Hawk Electronics” branded in-line and free-standing stores and service centers. The Teletouch branded locations offer primarily the Company’s two-way radio products and services as well as public safety equipment to state, city and local entities as well as commercial businesses. Teletouch’s wholly-owned subsidiary, Progressive Concepts, Inc. (“PCI”) is a Master Distributor and Authorized Provider of cellular voice, data and entertainment services though AT&T Mobility (“AT&T”) to consumers, businesses and government agencies and markets these services under the Hawk Electronics brand name. For over 26 years, PCI has offered various communication services on a direct bill basis and today services approximately 50,000 cellular subscribers. PCI sells consumer electronics products and cellular services through its stores, its own network of Hawk-branded sub-agents stores, its own direct sales force and on the Internet at various sites, including its primary consumer-facing sites: www.hawkelectronics.com, www.hawkwireless.com and www.hawkexpress.com. The Company handles all aspects of the wireless customer relationship, including:





•  Initiating and maintaining all subscribers’ cellular, two-way radio and other service agreements;


•  Determining credit scoring standards and underwriting new account acquisitions;


•  Handling all billing, collections, and related credit risk through its own proprietary billing systems;


•  Providing all facets of real-time customer support, using a proprietary, fully integrated Customer Relationship Management (CRM) system through its own 24x7x365 capable call centers and the Internet.





In addition, PCI operates a national wholesale distribution business, “PCI Wholesale,” which serves major carrier agents, rural cellular carriers, smaller consumer electronics and automotive retailers and auto dealers throughout the country and internationally, with ongoing product and sales support through its direct sales representatives, call center, and the Internet through www.pciwholesale.com and www.pcidropship.com, among other sites. Teletouch also sells public safety equipment and services under the brand “Teletouch PSE” (Public Safety Equipment), through direct sales and distribution including the United States General Services Administration (“GSA”), BuyBoard (a State of Texas website operated by the Local Government Purchasing Cooperative), and a Texas multiple awards contract (“TXMAS”) facility also run by the State of Texas, which allows products to be sold to all State agencies and authorized local public entities.





Basis of Presentation: The consolidated financial statements include the consolidated accounts of Teletouch Communications, Inc. and our wholly-owned subsidiaries (collectively, the “Company” or “Teletouch”). Teletouch Communications, Inc. owns all of the shares of Progressive Concepts, Inc., a Texas corporation (“PCI”), Teletouch Licenses, Inc., a Delaware corporation (“TLI”), Visao Systems, Inc., a Delaware corporation (“Visao”) and TLL Georgia, Inc., a Delaware corporation (“TLLG”). PCI is the primary operating business of Teletouch. TLI is a company formed for the express purpose of owning all of the FCC licenses utilized by Teletouch to operate its two-way radio network. Visao is a company formed to develop and distribute the Company’s telemetry products, which as of the date of this Report are no longer being sold.  Currently Visao is maintained as a shell company with no operations. TLLG was formed for the express purpose of entering into an asset purchase agreement with Preferred Networks, Inc. in May 2004 and ceased operations following the sale of the Company’s paging business in August 2006.  TLLG is currently a shell company. All significant intercompany accounts and transactions have been eliminated in consolidation.




8




NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Use of Estimates:The consolidated financial statements have been prepared using the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America.  Preparing financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions.  Those assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.





Cash:We deposit our cash with high credit quality institutions.  Periodically, such balances may exceed applicable FDIC insurance limits.  Management has assessed the financial condition of these institutions and believes the possibility of credit loss is minimal.





Certificates of Deposit-Restricted:  From time to time, the Company is required to issue standby letters of credit to it suppliers to secure purchases made under the credit terms provided by these suppliers. The Company deposits funds into a certificate of deposit and instructs that bank to issue the standby letter of credit to the benefit of the supplier. All such funds are reported as restricted funds until such time as the supplier releases the letter of credit requirement. As of February 28, 2011 and May 31, 2010, the Company had $50,000 and $150,000 deposited in certificate of deposits, respectively, securing standby letters of credit with its suppliers.





Allowance for Doubtful Accounts: The Company performs periodic credit evaluations of its customer base and extends credit to virtually all of its customers on an uncollateralized basis.





In determining the adequacy of the allowance for doubtful accounts, management considers a number of factors, including historical collections experience, aging of the receivable portfolio, financial condition of the customer and industry conditions.  The Company considers an account receivable past due when customers exceed the terms of payment granted to them by the Company.  The Company writes-off its fully reserved accounts receivable when it has exhausted all internal collection efforts, which is generally within 90 days following the last payment received on the account.





Accounts receivable are presented net of an allowance for doubtful accounts of $311,000 and $407,000 at February 28, 2011 and May 31, 2010, respectively.  Based on the information available to the Company, management believes the allowance for doubtful accounts at the end of both periods are adequate.  However, actual write-offs may exceed the recorded allowance.





The Company evaluates its write-offs on a monthly basis.  The Company determines which accounts are uncollectible, and those balances are written-off against the Company’s allowance for doubtful accounts.




9




Reserve for Inventory Obsolescence:Inventories are stated at the lower of cost (primarily on a moving average basis), which approximates actual cost determined on a first-in, first-out (“FIFO”) basis, or fair market value and are comprised of finished goods. In determining the adequacy of the reserve for inventory obsolescence, management considers a number of factors including recent sales trends, industry market conditions and economic conditions. In assessing the reserve, management also considers price protection credits the Company expects to recover from its vendors when the vendor cost on certain inventory items is reduced shortly after the purchase of the inventory by the Company. In addition, management establishes specific valuation allowances for discontinued inventory based on its prior experience liquidating this type of inventory.  Through the Company’s wholesale and internet distribution channels, it is successful in liquidating the majority of any inventory that becomes obsolete.  The Company has many different cellular handset, radio and other electronics suppliers, all of which provide reasonable notification of model changes, which allows the Company to minimize its level of discontinued or obsolete inventory. Inventories are presented net of a reserve for obsolescence of $253,000 and $232,000 at February 28, 2011 and May 31, 2010, respectively. Actual obsolescence could differ from those estimates.





Property and Equipment:  Property and equipment are recorded at cost. Depreciation is computed using the straight-line method. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. Upon the sale or abandonment of an asset, the cost and related accumulated depreciation are removed from the Company’s balance sheet, and any gains or losses on those assets are reflected in the accompanying consolidated statement of operations of the respective period. The Company’s estimated useful lives for its major classes of property and equipment assets are as follows:


Buildings and improvements
5-30 yearsTwo-way network infrastructure
5-15 yearsOffice and computer equipment
3-5 yearsSigns and displays
5-10 yearsOther equipment
3-5 yearsLeasehold improvements
Shorter of estimated useful life or term of lease





Intangible Assets:The Company’s intangible assets are comprised of certain definite lived assets as well as two indefinite lived assets. Indefinite lived intangible assets are not amortized but evaluated annually (or more frequently) for impairment under ASC 350, Intangibles-Goodwill and Other, (“ASC 350”).  Definite lived intangible assets, including capitalized loan origination costs, the purchase and development of key distribution agreements, purchased subscriber bases and acquisition costs related to FCC licenses and the Government Services Administration (“GSA”) contract and are amortized over the estimated useful life of the asset and reviewed for impairment upon any triggering event that gives rise to any question as to the assets’ ultimate recoverability as prescribed under ASC 360, Property, Plant and Equipment, (“ASC 360”).





Indefinite Lived Intangible Assets: The Company has two indefinite lived intangible assets, goodwill and a purchased perpetual trademark license. Goodwill acquired in a business combination and intangible assets determined to have an indefinite useful life are not amortized but instead tested for impairment at least annually in accordance with the provisions of ASC 350.  The goodwill impairment model prescribed by ASC 350 is a two-step process. The first step compares the fair value of a reporting unit that has goodwill assigned to its carrying value. The fair value of a reporting unit using discounted cash flow analysis is estimated. If the fair value of the reporting unit is determined to be less than its carrying value, a second step is performed to compute the amount of goodwill impairment, if any. Step two allocates the fair value of the reporting unit to the reporting unit’s net assets other than goodwill. The excess of the reporting unit’s fair value over the amounts assigned to its net assets other than goodwill is considered the implied fair value of the reporting unit’s goodwill. The implied fair value of the reporting unit’s goodwill is then compared to the carrying value of its goodwill. Any shortfall represents the amount of goodwill impairment. The goodwill recorded in the Company’s consolidated balance sheet was acquired in January 2004 for $894,000 as part of the purchase of the two-way radio assets of DCAE, Inc.  During the fourth quarter of fiscal year 2005, this goodwill was deemed impaired as a result of losses in revenues and profitability in the Company’s two-way radio segment (the “reporting unit” under ASC 350) and the goodwill was written down to $343,000.  The Company tests this goodwill annually on March 1st, the first day of its fourth fiscal quarter, of each year unless an event occurs that would cause the Company to believe the value is impaired at an interim date.




10





In May 2010, Progressive Concepts, Inc., purchased a perpetual trademark license to use the trademark “Hawk Electronics” (see Note – 9 “Trademark Purchase Obligation” for additional discussion). In accordance with ASC 350, an entity shall evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events and circumstances continue to support an indefinite useful life. As mentioned above, the guidance under ASC 350 also states an intangible asset that is not subject to amortization shall be tested for impairment annually or more frequently if events or changes in circumstances indicate the asset might be impaired.  The impairment test shall consist of a comparison of the fair value of an intangible asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to the excess.





The Company initially evaluated PCI’s perpetual trademark license asset at May 31, 2010, and determined the fair value of the license exceeded its carrying value; therefore, no impairment was recorded. The fair value of the perpetual trademark license was based upon the discounted estimated future cash flows of the Company’s cellular business. The Company will continue to evaluate whether events and circumstances occur that would no longer support an indefinite life for its perpetual trademark license.  The Company will test this license annually on March 1st, the first day of its fourth fiscal quarter, of each year for impairment unless an event occurs that would cause the Company to believe the value is impaired at an interim date.




Definite Lived Intangible Assets:Definite lived intangible assets consist of the capitalized cost associated with acquiring the AT&T distribution agreements, purchased subscriber bases, FCC licenses, Government Services Administration (“GSA”) contract, internally developed software and loan origination costs. The Company does not capitalize customer acquisition costs in the normal course of business but would capitalize the purchase costs of acquiring customers from a third party. Intangible assets are carried at cost less accumulated amortization. Amortization on the AT&T distribution agreements is computed using the straight-line method over the contract’s expected life.  The estimated useful lives for the intangible assets are as follows:




AT&T distribution agreements and subscriber bases

1-13 yearsFCC licenses

9 yearsGovernment Services Administration contract

5 yearsInternally developed software

3 years





The Company defers certain direct costs in obtaining loans and amortizes such amounts using the straight-line method over the expected life of the loan, which approximates the effective interest method as follows:




Loan origination costs

2-5 years





As of February 28, 2011, the most significant intangible assets remaining that continue to be amortized are the AT&T distribution agreements and subscriber bases.  The DFW and San Antonio AT&T cellular distribution agreements will continue to be amortized through August 31, 2014 and December 31, 2013, respectively, or for approximately 3.5 and 2.8 years, respectively.




11


The AT&T distribution agreement assets represent contracts that the Company has with AT&T, under which the Company is allowed to provide cellular services to its customers. Although the Company has sustained losses in recent years, management has evaluated this asset in light of the fair value of each of the cellular subscribers that the Company services.  Included in the provisions of the primary contract with AT&T (DFW market) is a liquidated damages provision, which defines a value of $1,000 for each cellular telephone number assigned to a customer and billed by the Company (“Subscriber”, as defined in the agreement) to be paid to the Company if AT&T were to solicit or take any or all of the Subscribers from PCI. Under the terms of the DFW market distribution agreement with AT&T, which expired on August 31, 2009, AT&T must continue to provide airtime to the Company as long as the subscribers choose to remain on service, or at AT&T’s option, AT&T could “buy-back” the subscribers from the Company for the $1,000 liquidated damages per subscriber line provided for by the agreement. The total value of the cellular subscriber base provided for by the liquidated damages provision contained in the contract exceeds the carrying value of the asset at all periods presented herein.  The Company regularly forecasts the expected cash flows to be derived from this cellular subscriber base and as of the date of this Report those expected cash flows also exceed the carrying value of the asset.





Amortization of the AT&T distribution agreements, subscriber bases, FCC licenses, GSA contract and internally developed software is considered an operating expense and included in “Depreciation and Amortization” in the accompanying consolidated statements of operations.  The Company periodically reviews the estimated useful lives of its identifiable intangible assets, taking into consideration any events or circumstances that might result in a lack of recoverability or revised useful life.





Impairment of Long-lived Tangible Assets: In accordance with ASC 360, the Company evaluates the recoverability of the carrying value of its tangible long-lived assets based on estimated undiscounted cash flows to be generated from such assets. If the undiscounted cash flows indicate an impairment, then the carrying value of the assets evaluated is written-down to the estimated fair value of those assets. In assessing the recoverability of these assets, the Company must project estimated cash flows, which are based on various operating assumptions, such as average revenue per unit in service, disconnect rates, sales productivity ratios and expenses. Management develops these cash flow projections on a periodic basis and reviews the projections based on actual operating trends.  The projections assume that general economic conditions will continue unchanged throughout the projection period and that their potential impact on capital spending and revenues will not fluctuate. Projected revenues are based on the Company’s estimate of units in service and average revenue per unit as well as revenue from various new product initiatives. Projected revenues assume a declining cellular service revenue while projected operating expenses are based upon historic experience and expected market conditions adjusted to reflect an expected decrease in expenses resulting from cost saving initiatives.





The most significant tangible long-lived asset owned by the Company is the Fort Worth, Texas corporate office building and the associated land. The Company has received periodic appraisals of the fair value of this property, and in each instance the appraised value exceeds the carrying value of the property.





Asset Held for Sale: In accordance with ASC 360, the Company will reclassify certain long-lived assets as a current asset held for sale on the Company’s consolidated balance sheets if certain requirements are met.  In order for an asset to be held for sale under the provisions of ASC 360, management must determine the asset is to be held for sale in its current condition, an active plan to complete the sale of the asset has been initiated and the sale of the asset is probable within one year. The Company evaluated the hotspot network patent it acquired during the public auction of Air-bank, Inc.’s assets in July 2009 and has determined this asset met all the criteria for an asset held for sale under ASC 360.  At February 28, 2011, the patent is recorded as a current asset held for sale on the Company’s consolidated balance sheet for approximately $257,000 as the Company is actively pursuing the sale of this patent through a broker. The Company has received no formal offers to purchase the patent from potential buyers but has received several expressions of interest from qualified buyers who have indicated the market value of the patent exceeds the carrying value as of February 28, 2011. The Company is attempting to sell the patent by the end of fiscal year 2011.  In the event the Company is unable to sell the patent by the end of fiscal year 2011, the patent will be re-classified to long-lived intangible assets and the carrying value will be adjusted to the patent’s fair value giving consideration to our inability to sell this asset since June 2009.


12


Contingencies:The Company accounts for contingencies in accordance with ASC 450, Contingencies (“ASC 450”). ASC 450 requires that an estimated loss from a loss contingency shall be accrued when information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and when the amount of the loss can be reasonably estimated. Accounting for contingencies such as legal and contract dispute matters requires us to use our judgment. We believe that our accruals or disclosures related to these matters are adequate. Nevertheless, the actual loss from a loss contingency might differ from our estimates.





Provision for Income Taxes:The Company accounts for income taxes in accordance with ASC 740, Income Taxes, (“ASC 740”) using the asset and liability approach, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of such assets and liabilities. This method utilizes enacted statutory tax rates in effect for the year in which the temporary differences are expected to reverse and gives immediate effect to changes in income tax rates upon enactment. Deferred tax assets are recognized, net of any valuation allowance, for temporary differences, net operating loss and tax credit carry forwards. Deferred income tax expense represents the change in net deferred assets and liability balances. Deferred income taxes result from temporary differences between the basis of assets and liabilities recognized for differences between the financial statement and tax basis thereon and for the expected future tax benefits to be derived from net operating losses and tax credit carry forwards. A valuation allowance is recorded when it is more likely than not that deferred tax assets will be unrealizable in future periods.  As of February 28, 2011 and May 31, 2010, the Company has recorded a valuation allowance against the full amount of its net deferred tax assets. Although the Company had taxable income for fiscal year 2010, it is currently unable to reasonably forecast taxable income beyond fiscal year 2010.  The inability to forecast taxable income in future years makes it more likely than not that the Company will not realize its recorded deferred tax assets in future periods.





Revenue Recognition:Teletouch recognizes revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” and ASC 605, Revenue Recognition, (“ASC 605”). In general, ASC 605 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable and (4) collectability is reasonably assured. Teletouch believes, relative to sales of products, that all of these conditions are met; therefore, product revenue is recognized at the time of shipment.





The Company primarily generates revenues by providing recurring cellular services and through product sales.  Cellular services include cellular airtime and other recurring services provided through a master distributor agreement with AT&T.  Product sales include sales of cellular telephones, accessories, car and home audio products and other services and two-way radio equipment through the Company’s retail, wholesale and two-way operations.





Cellular and other service revenues and related costs are recognized during the period in which the service is rendered.  Associated subscriber acquisition costs are expensed as incurred. Product sales revenue is recognized at the time of shipment, when the customer takes title and assumes risk of loss, when terms are fixed and determinable and collectability is reasonably assured.  The Company does not generally grant rights of return.  However, PCI offers customers a 30 day return / exchange program for new cellular subscribers in order to match programs put in place by most of the other cellular carriers.  During the 30 days, a customer may return all cellular equipment and cancel service with no penalty.  Reserves for returns, price discounts and rebates are estimated using historical averages, open return requests, recent product sell-through activity and market conditions.  No reserves have been recorded for the 30 day cellular return program since only a very small number of customers utilize this return program and many fail to meet all of the requirements of the program, which include returning the phone equipment in new condition with no visible damage.


13


Since 1984, Teletouch’s subsidiary, PCI, has held agreements with AT&T or one of its predecessor companies, which allowed PCI to offer cellular service and provide the billing and customer services to its subscribers. PCI is compensated for the services it provides based upon sharing a portion of the monthly billings revenues with AT&T.  PCI is responsible for the billing and collection of cellular charges from these customers and remits the majority of the cellular billings generated to AT&T and keeps the remainder of these billings as compensation for providing the billing and customer service functions for these customers.  Based on its relationship with AT&T, the Company has evaluated its reporting of revenues under ASC 605-45, Revenue Recognition, Principal Agent Considerations (“ASC 605-45”) associated with its services attached to the AT&T agreements.  Included in ASC 605-45 are eight indicators that must be evaluated to support reporting gross revenue.  These indicators are (i) the entity is the primary obligor in the arrangement, (ii) the entity has general inventory risk before customer order is placed or upon customer return, (iii) the entity has latitude in establishing price, (iv) the entity changes the product or performs part of the service, (v) the entity has discretion in supplier selection, (vi) the entity is involved in the determination of product or service specifications, (vii) the entity has physical loss inventory risk after customer order or during shipment and (viii) the entity has credit risk.  In addition, ASC 605-45 includes three additional indicators that support reporting net revenue.  These indicators are (i) the entity’s supplier is the primary obligor in the arrangement, (ii) the amount the entity earns is fixed and (iii) the supplier has credit risk. Based on its assessment of the indicators listed in ASC 605-45, the Company has concluded that the AT&T services provided by PCI should be reported on a net basis. Also in accordance with ASC 605-45, sales tax amounts invoiced to our customers have been recorded on a net basis and have no impact on our consolidated financial statements.





Deferred revenue represents monthly service fees primarily access charges for cellular services that are billed in advance by the Company.





Concentration of Credit Risk:  Teletouch provides cellular and other wireless telecommunications services to a diversified customer base of small to mid-size businesses and individual consumers, primarily in the DFW and San Antonio markets in Texas.  In addition, the Company sells cellular equipment and consumer electronics products to large base of small to mid-size cellular carriers, agents and resellers as well as a large group of smaller electronics and car audio dealers throughout the United States.  As a result, no significant concentration of credit risk exists.  The Company performs periodic credit evaluations of its customers to determine individual customer credit risks and promptly terminates services or ceases shipping products for nonpayment.





Financial Instruments:  The Company’s financial instruments consists of certificates of deposit-restricted, accounts receivable, accounts payable and debt. Management believes the carrying value of its financial instruments approximates fair value due to the short maturity of the current assets and liability and the reasonableness of the interest rates on the Company’s debt.





Advertising and Pre-opening Costs:Labor costs, costs of hiring and training personnel and certain other costs relating to the opening of new retail locations are expensed as incurred. Additionally, advertising costs are expensed as incurred although the Company is partially reimbursed based on various vendor agreements.  Advertising reimbursements are accrued when earned and committed to by the Company’s vendor and are recorded as a reduction to advertising cost in that period.


14


Stock-based Compensation:At February 28, 2011 the Company had two stock-based compensation plans for employees and nonemployee directors, which authorize the granting of various equity-based incentives including stock options and stock appreciation rights.





The Company accounts for stock-based awards to employees in accordance with ASC 718, Compensation-Stock Compensation, (“ASC 718”) and for stock based awards to non-employees in accordance with ASC 505-50, Equity, Equity-Based Payments to Non-Employees (“ASC 505-50”). Under both ASC 718 and ASC 505-50, the Company uses a fair value based method to determine compensation for all arrangements where shares of stock or equity instruments are issued for compensation. For share option instruments issued, compensation cost is recognized ratably using the straight-line method over the expected vesting period.





Cash flows resulting from excess tax benefits are classified as a financing activity. Excess tax benefits are realized from tax deductions for exercised options in excess of the deferred tax asset attributable to stock compensation costs for such options. The Company did not record any excess tax benefits as a result of any exercises of stock options in the nine months ended February 28, 2011 and 2010 because the Company provided for a full valuation allowance against all accrued future tax benefits for all periods presented until its operations improve and the Company is able to forecast taxable income in the future sufficient to utilize its deferred tax assets.





For the nine months ended February 28, 2011 and 2010, the Company has elected to use the Black-Scholes option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The Company is required to make various assumptions in the application of the Black-Scholes option pricing model. The Company has determined that the best measure of expected volatility is based on the historical daily volatility of the Company’s common stock. Historical volatility factors utilized in the Company’s Black-Scholes computations for options issued in the nine months ended February 28, 2011 ranged from 127.22% to 135.33% and was 240.4% for the options issued in the nine months ended February 28, 2010.  The Company has elected to estimate the expected life of an award based upon the SEC approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 107 with the continued use of this method extended under the provisions of Staff Accounting Bulletin No. 110. Under this formula, the expected term is equal to: ((weighted-average vesting term + original contractual term)/2). The expected term used by the Company as computed by this method for options issued in the nine months ended February 28, 2011 ranged from 5.0 years to 6.0 years and was 5.0 years for the options issued in the nine months ended February 28, 2010. The interest rate used is the risk free interest rate and is based upon U.S. Treasury rates appropriate for the expected term. Interest rates used in the Company’s Black-Scholes calculations for options issued in the nine months ended February 28, 2011 ranged from 2.05% to 2.42% and was 2.55% for the options issued in the nine months ended February 28, 2010. Dividend yield is zero for these options as the Company does not expect to declare any dividends on its common shares in the foreseeable future.





In addition to the key assumptions used in the Black-Scholes model, the estimated forfeiture rate at the time of valuation is a critical assumption.  The Company has estimated an annualized forfeiture rate of 0.0% for the stock options granted to senior management and the Company’s directors in the nine months ended February 28, 2011 and 2010.  The Company reviews the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.





Options exercisable at February 28, 2011 and May 31, 2010 totaled 4,651,432 and 3,054,545, respectively.  The weighted-average exercise price per share of options exercisable at February 28, 2011 and May 31, 2010 was $0.27 with remaining weighted-average contractual terms of approximately 7.0 years.





The weighted-average grant date fair value of options granted during the nine months ended February 28, 2011 and 2010 was $0.30 and $0.11, respectively.


15





At February 28, 2011, the total remaining unrecognized compensation cost related to unvested stock options amounted to approximately $109,000, which will be amortized over the weighted-average remaining requisite service period of 1.0 years.





Income (loss) Per Share:In accordance with ASC 260, Earnings Per Share,basic income (loss) per share (“EPS”) is calculated by dividing net income (loss) by the weighted average number of common shares outstanding.  Diluted EPS is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding including any dilutive securities outstanding.  At February 28, 2011, the Company’s outstanding common stock options totaled 5,655,817 and were not included in the computation of diluted earnings per share due to their antidilutive effect as a result of the net loss incurred during the three and nine months ended February 28, 2011. At February 28, 2010, the Company’s outstanding common stock options totaled 4,563,316. For the three months ended February 28, 2010, 91,616 common stock options were dilutive securities and were included in the diluted earnings per share calculation due to the Company’s market price of its common stock at February 28, 2010 exceeding the options’ exercise price.  For the nine months ended February 28, 2010, the Company’s common stock options were excluded from the diluted earnings per share calculation because the options’ exercise price exceeded the Company’s market price of its common stock at February 28, 2010.





Recently Issued Accounting Standards:





In  December 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2010-28, Intangibles-Goodwill and Other (Topic 350) – When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts, (“ASU 2010-28”). ASU 2010-28 modifies the two-step goodwill impairment testing process for entities that have a reporting unit with a zero or negative carrying amount. For those reporting units, an entity is required to perform step 2 of the goodwill impairment test if it is more likely than not that goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment exists. This new standard is effective for the Company beginning June 1, 2011. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial positions or results of operations.





In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements, (“ASU 2009-13”).  ASU 2009-13 impacts the determination of when the individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting. Additionally, these new standards modify the manner in which the transaction consideration is allocated across the separately identified deliverables by no longer permitting the residual method of allocating arrangement consideration. These new standards are effective for the Company beginning June 1, 2011. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial positions or results of operations.





NOTE 3 – RELATIONSHIP WITH CELLULAR CARRIER





The Company has historically had six distribution agreements with AT&T which provide for the Company to distribute AT&T wireless services, on an exclusive basis, in major markets in Texas and Arkansas, including the Dallas-Fort Worth, Texas Metropolitan Statistical Area (“MSA”), San Antonio, Texas MSA, Austin, Texas MSA, Houston, Texas MSA, East Texas Regional MSA and Arkansas, including primarily the Little Rock, Arkansas MSA. During fiscal year 2010 and following the Company’s commencement of an arbitration proceeding against AT&T (discussed further below), AT&T notified the Company it is cancelling or not renewing three of the six distribution agreements including those agreements that cover the Austin, Texas MSA, Houston, Texas MSA and Arkansas.  The Company is disputing these cancellations and has had these matters included to be resolved in the arbitration hearing related to the DFW Agreement. The distribution agreements permit the Company to offer AT&T cellular phone service with identical pricing characteristics to AT&T and provide billing customer services to its customers on behalf of AT&T in exchange for certain predetermined compensation and fees, which are primarily in the form of a revenue sharing of the core wireless services the Company bills on behalf of AT&T. In addition, the Company bills the same subscribers several additional features and products that it offers and retains all revenues and gross margins related to those certain services and products.


16


The Company is responsible for all of the billing and collection of cellular charges from its customers and remains liable to AT&T for pre-set percentages of all AT&T related cellular service customer billings. Because of the volume of business transacted with AT&T, as well as the revenue generated from AT&T services, there is a significant concentration of credit and business risk involved with having AT&T as a primary vendor. The Company’s largest distribution agreement with AT&T for the Dallas / Fort Worth, Texas MSA was amended effective September 1, 1999 with an initial term of 10 years (the “DFW Agreement”). The DFW Agreement provided for two 5-year extensions unless either party provides written notice to the other party at least six months prior to the expiration of the initial term or the additional renewal term. Specifically, under the terms of its distribution agreement with AT&T, the Company is allowed to continue to service its existing subscribers (each telephone number assigned to a customer is deemed to be a separate subscriber) at the time of expiration until the subscribers, of their own free will, independently and without any form of encouragement or inducement from AT&T, have their services terminated with the Company. The initial term of the DFW Agreement expired on August 31, 2009, and the Company received the required six month notice from AT&T in February 2009 stating it would not extend the DFW Agreement. As a result of the expiration of the initial term of the DFW Agreement, the exclusivity requirements under this agreement terminated in August 2009, which allows the Company to expand its cellular offerings in the previously AT&T exclusive areas, under new agreements with one or more carriers.





On September 30, 2009, Teletouch’s subsidiary, PCI, commenced an arbitration proceeding against AT&T seeking at least $100 million in damages. The binding arbitration was commenced to seek relief for damages incurred as AT&T has prevented the Company from selling the popular iPhone and other “AT&T exclusive” products and services that PCI believes it is contractually entitled to provide to its customers.  In addition, the Company’s initial statement of claim alleges, among other things, that AT&T has violated the longstanding non-solicitation provisions under the DFW Agreement by and between the companies by actively inducing customers to leave PCI for AT&T. While PCI has attempted to negotiate with AT&T for the purpose of obviating the need for legal action, such attempts have failed.  Accordingly, PCI initiated this arbitration.  AT&T subsequently filed certain counterclaims with the arbitrator seeking an unspecified amount of damages from PCI and claiming that PCI was operating in violation of certain provisions of the distribution agreements and such agreements should therefore be cancellable by AT&T.  In March 2011, both the Company’s and AT&T’s independent valuation experts filed initial damages computations with the arbitrator which valued each party’s respective damages as a result of the other party’s actions.   The Company’s expert provided damages computations under several scenarios which included damages assuming PCI’s damages were limited to the liquidated damages provision included in the distribution agreement and several alternate computation of lost profits depending on the timing of which it was determined that PCI should have been allowed to sell the iPhone.  Under the liquidated damages limitation, PCI’s damages are estimated to be $48.9 million.  Under the lost profits computations, PCI’s damages are estimated to be as high as $35.0 million due to lost profits on subscriber transferred to AT&T and those subscribers that PCI did not get because of it not being allowed to sell the iPhone.  Additionally, if it is determined that PCI should also be compensated for the fair value of its subscriber base as of August 31, 2009 (the date of the expiration of the DFW and San Antonio distribution agreements), damages could be increased by $51.8 million, resulting in total damages and compensation due to PCI totaling $86.8 million.  AT&T’s expert computed AT&T’s damages in the range of $7.6 million to $9.9 million, depending on the arbitrator’s interpretation of the San Antonio distribution agreement.   See Item 1. Legal Proceedings for further discussion on the arbitration with AT&T.


17


The Company reports its revenues related to the AT&T services on a net basis in accordance with ASC 605-45 as follows (in thousands):





Three Months Ended


Nine Months EndedFebruary 28,


February 28,2011


2010


2011


2010Gross service and installation billings

$
10,044


$
12,907


$
31,920


$
41,083Less: Direct costs paid to AT&T


(5,094
)


(6,599
)


(16,106
)


(21,561
)Net service and installation revenue

$
4,950


$
6,308


$
15,814


$
19,522





Gross service and installation billings include gross cellular subscription billings, which are measured as the total recurring monthly cellular service charges invoiced to PCI’s cellular subscribers from which a fixed percentage of the dollars invoiced are retained by PCI as compensation for the billing and support services it provides to these subscribers. PCI remits a fixed percentage of the gross cellular subscription billings to AT&T and absorbs 100% of any bad debt associated with the gross cellular subscription billings under the terms of its distribution agreement with AT&T.





NOTE 4 – INVENTORY





The following table reflects the components of inventory (in thousands):





February 28, 2011


May 31, 2010Cost


Reserve


Net Value


Cost


Reserve


Net ValuePhones and related accessories

$
1,196


$
(80
)

$
1,116


$
557


$
(69
)

$
488Automotive products


258



(33
)


225



284



(42
)


242Satellite products


16



(4
)


12



18



(4
)


14Two-way products


478



(135
)


343



418



(115
)


303Other


6



(1
)


5



4



(2
)


2Total inventory and reserves

$
1,954


$
(253
)

$
1,701


$
1,281


$
(232
)

$
1,049





NOTE 5 – PROPERTY AND EQUIPMENT





Property and equipment consisted of the following (in thousands):





February 28, 2011


May 31, 2010Land

$
774


$
774Buildings and leasehold improvements


3,113



3,056Two-way network infrastructure


1,055



1,055Office and computer equipment


2,808



2,716Signs and displays


793



790Other equipment


396



397$
8,939


$
8,788Less:Accumulated depreciation and amortization


(6,234
)


(6,039
)$
2,705


$
2,749





Depreciation and amortization expense related to property and equipment was approximately $76,000 and $87,000 for the three months ended February 28, 2011 and 2010, respectively and $225,000 and $285,000 for the nine months ended February 28, 2011 and 2010, respectively.


18





Property and equipment are recorded at cost.  Depreciation and amortization is computed using the straight-line method.  The following table contains the property and equipment by estimated useful life, net of accumulated depreciation and amortization as of February 28, 2011 (in thousands):





Less than


3 to 4


5 to 9


10 to 14


15 to 19


20 years


Total Net3 years


years


years


years


years


and greater


ValueBuildings and leasehold improvements

$
16


$
59


$
114


$
-


$
9


$
1,156


$
1,354Two-way network infrastructure


8



145



86



-



-



-



239Office and computer equipment


161



71



15



-



-



-



247Signs and displays


38



11



5



-



-



-



54Land


-



-



-



-



-



774



774Other


17



20



-



-



-



-



37$
240


$
306


$
220


$
-


$
9


$
1,930


$
2,705





NOTE 6 – GOODWILL AND OTHER INTANGIBLE ASSETS





Goodwill:  The reported goodwill of the Company at February 28, 2011 and May 31, 2010 relates entirely to the two-way radio segment. The goodwill was acquired in January 2004 for $894,000 as part of the purchase of the two-way radio assets of DCAE, Inc.  During the fourth quarter of fiscal year 2005, this goodwill was deemed impaired as a result of losses in revenues and profitability in the Company’s two-way radio segment (the “reporting unit” under ASC 350) and the goodwill was written down to $343,000.  The $343,000 carrying value of the goodwill is reported on its consolidated balance sheet at February 28, 2011 and May 31, 2010.





Other intangible assets: The following is a summary of the Company’s intangible assets as of February 28, 2011 and May 31, 2010 excluding goodwill (in thousands):





February 28, 2011


May 31, 2010Gross





Net


Gross





NetCarrying


Accumulated


Carrying


Carrying


Accumulated


CarryingAmount


Amortization


Value


Amount


Amortization


ValueDefinite lived intangible assets:Wireless contracts and subscriber bases

$
10,289


$
(7,671
)

$
2,618


$
10,258


$
(7,091
)

$
3,167FCC licenses


103



(81
)


22



104



(73
)


31PCI marketing list


1,235



(1,235
)


-



1,235



(1,235
)


-Loan origination fees


774



(519
)


255



639



(395
)


244Government Services Administration contract


15



(2
)


13



-



-



-Internally developed software


170



(170
)


-



170



(170
)


-Total amortizable intangible assets


12,586



(9,678
)


2,908



12,406



(8,964
)


3,442Indefinite lived intangible assets:Perpetual trademark license agreement


900



-



900



900



-



900Total intangible assets

$
13,486


$
(9,678
)

$
3,808


$
13,306


$
(8,964
)

$
4,342




Amortization is computed using the straight-line method based on the following estimated useful lives:





Wireless contracts and subscriber bases

1-13 yearsFCC licenses

9 yearsGovernment Administration Services contract

5 yearsLoan origination fees

2-5 yearsInternally-developed software

3 years





Total amortization expense for the three months ended February 28, 2011 and 2010 was approximately $205,000 and $224,000, respectively and $619,000 and $671,000 for the nine months ended February 28, 2011 and 2010, respectively.


19





In September 2010, Teletouch was awarded a multi-year contract with the General Services Administration (“GSA”) initially for the Company's comprehensive product line of public safety, emergency vehicle lighting and siren equipment manufactured by Whelen Engineering, Inc.  The contract allows the Company the opportunity to compete in the public and emergency products category nationwide, allowing any federal, state and / or local government agencies to purchase items from the Company’s public safety product line quickly and cost effectively. The Company’s contract with the GSA was effective on October 1, 2010, for an initial period of five years, with the GSA having the option to extend the contract for three additional 5-year periods.  The Company capitalized the costs associated with acquiring the GSA contract and will amortize those costs over the contract’s initial term of five years.





NOTE 7 – ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES





Accrued expenses and other current liabilities consist of (in thousands):





February 28,


May 31,2011


2010Accrued payroll and other personnel expense

$
695


$
1,957Accrued state and local taxes


592



527Unvouchered accounts payable


2,210



1,953Customer deposits payable


338



427Other


391



653Total

$
4,226


$
5,517





NOTE 8 – LONG-TERM DEBT





Long-term debt at February 28, 2011 and May 31, 2010 consists of the following (in thousands):





February 28,


May 31,2011


2010Thermo revolving credit facility

$
11,330


$
12,189East West Bank (formerly United Commerical Bank)


2,283



2,361Jardine Capital Corporation bank debt


574



585Warrant redemption notes payable


539



764Total long-term debt


14,726



15,899Less: Current portion


(1,498
)


(1,412
)Long-term debt, net

$
13,228


$
14,487





Current portion of long-term debt at February 28, 2011 and May 31, 2010 consists of the following (in thousands):





February 28,


May 31,2011


2010Thermo revolving credit facility

$
833


$
1,016East West Bank (formerly United Commerical Bank)


108



105Jardine Capital Corporation bank debt


18



16Warrant redemption notes payable


539



275Total current portion of  long-term debt

$
1,498


$
1,412





Thermo Revolving Credit Facility:On August 28, 2009, Teletouch finalized amending, effective August 1, 2009, the terms of its $5,250,000 revolving credit facility with Thermo Credit, LLC, resulting in, among other changes, the availability under the revolving credit facility being increased from $5,250,000 to $18,000,000 and the maturity of the revolver being extended from April 30, 2010 to January 31, 2012 (the “Second Amended Thermo Revolver”).


20





The Second Amended Thermo Revolver provides for the Company to obtain revolving credit loans from Thermo from time to time up to $18,000,000.  Borrowings against the Second Amended Thermo Revolver are limited to specific advance rates against the aggregate fair value of the Company’s assets, as defined in the amendment, including real estate, equipment, infrastructure assets, inventory, accounts receivable, intangible assets and notes receivable (collectively, the “Borrowing Base”). The Company is allowed to borrow the lesser of the borrowing base amount or the initial commitment amount of $18,000,000, less the cumulative amount of minimum monthly principal repayment amounts defined in the agreement.  If the Company were to borrow the maximum amount available under its credit line, beginning in December 31, 2009, the availability under the Second Amended Thermo Revolver would be reduced monthly by an amount equal to the average principal balance of loans outstanding against the non-accounts receivable assets in the Borrowing Base for that month divided by sixty (60) (the “Monthly Step Down”).  The loans outstanding on the accounts receivable component of the Borrowing Base will be increased or decreased through periodic reporting of the Borrowing Base to Thermo. The balance of all principal and interest outstanding under the Second Amended Thermo Revolver was due January 31, 2012.  The annual interest rate on the Second Amended Thermo Revolver is the lesser of: (a) the maximum non-usurious rate of interest per annum permitted by applicable Louisiana law or (b) the greater of (i) the prime rate plus 8% or (ii) fourteen percent (14%). Under the terms of the Second Amended Thermo Revolver, the Company must maintain certain financial covenants including a net worth of at least $5,000,000, computed on a fair value basis, at each fiscal quarter, a debt service coverage ratio that ranges between 1.10 and 1.20 over the remaining life of the revolver and an operating income no less than zero at any fiscal quarter. The purpose of the Second Amended Thermo Revolver was to retire the former factoring debt facility with Thermo and to provide additional availability to the Company for its ongoing working capital needs.





Under the Company’s former debt facility with Thermo (the “Thermo Factoring Debt”), the Company had adequate credit availability under the facility but was limited in its ability to borrow additional funds due to declining levels of accounts receivable.  With the Second Amended Thermo Revolver, the Company can finance other non-accounts receivable asset purchases by including them in the Borrowing Base.  Borrowings by the Company against non-accounts receivable assets are limited to 33.3% of the total amount of loans outstanding under the terms of the Second Amended Thermo Revolver.





In February 2010, the Company began making principal payments on the Second Amended Thermo Revolver due to the Company’s having borrowings outstanding against the non-accounts receivable assets in excess of the 33.3% limit on such borrowings as measured against the total borrowings outstanding. This situation resulted due to a decline in the Company’s accounts receivable and its related borrowings against these receivables in 2010. In March 2010, Thermo agreed to let the Company begin making monthly principal payments of approximately $53,000 through the remainder of the term of the loan to reduce the outstanding loan balance against the non-accounts receivable assets.  The monthly principal payments reduce the commitment amount under the revolver.





Under the terms of the Second Amended Thermo Revolver, the Company must maintain certain financial covenants including a net worth of at least $5,000,000, computed on a fair value basis, at each fiscal quarter, a debt service coverage ratio that ranges between 1.10 and 1.20 over the remaining life of the revolver and an operating income no less than zero at any fiscal quarter.





Under the Second Amended Thermo Revolver, Thermo maintains a lien and security interest in substantially all of the Company’s assets, properties, accounts, inventory, goods and the like.


21


On March 9, 2011, the Company amended its revolving credit facility with Thermo Credit, LLC, effective December 31, 2010, which resulted in (i) extending the maturity date of the revolver from January 31, 2012 to January 31, 2013, (ii) an additional commitment fee of $135,000 due and payable on or before January 31, 2012, (iii) the deferral of monthly step down payments for the period December 2010 to June 2011 to be due and payable on or before August 31, 2011 and (iv)  the deferral of an over advance of $433,747 as of December 31, 2010 to be due and payable on or before August 31, 2011 after consideration of the Company’s borrowing base as of that date (the “Third Amended Thermo Revolver”). All other terms of the revolver remain unchanged.





As of February 28, 2011, the Company had approximately $11,300,000 in loans outstanding under the Third Amended Thermo Revolver which included loan commitment fees due on August 1, 2011 and January 31, 2012 of approximately $68,000 and $135,000, respectively.





As of February 28, 2011, the Company had a maximum availability of $5,800,000 against non-accounts receivable assets and $11,599,000 against accounts receivable for a total maximum availability of borrowings under the revolver of $17,399,000. Additionally, As of February 28, 2011, $6,604,000 was advanced against accounts receivable and $4,725,000 was advanced against non-accounts receivable assets. The availability to the Company as of February 28, 2011 under the Third Amended Thermo Revolver is approximately $4,995,000 to be borrowed against future accounts receivable and $1,075,000 to be borrowed against non-accounts receivable asset future purchases.





For the three months ended February 28, 2011, the Company was not in compliance with the debt service coverage ratio and had negative operating income.  The Company has obtained waivers of these covenants through February 28, 2011. If the Company does not comply with the covenants of its debt agreement with Thermo in the future, and if future waivers or loan modifications are not obtained, Thermo will have certain remedies available to them which include increasing the interest rates and acceleration of payments due under the loan.





NOTE 9 – TRADEMARK PURCHASE OBLIGATION





On May 4, 2010, Progressive Concepts, Inc., entered in a certain Mutual Release and Settlement Agreement (the “Agreement”) with Hawk Electronics, Inc. (“Hawk”). The settlement followed a litigation matter styledProgressive Concepts, Inc. d/b/a Hawk Electronics v. Hawk Electronics, Inc. Case No. 4-08CV-438-Y, by the Company against Hawk in the US District Court for the Northern District of Texas which alleged, among other things, infringement on the trade nameHawk Electronics, as well as counterclaims by Hawk against the Company of, among other things, trademark infringement and dilution.





Under terms of the Agreement, the parties executed mutual releases of claims against each other and agreed to file a stipulation of dismissal in connection with the pending litigation matter.  The Company agreed to, among other things, the purchase a perpetual license from Hawk to use the trademark “Hawk Electronics” for $900,000. Under the terms of the license agreement, the Company paid $400,000 by May 31, 2010 and $150,000 by July 1, 2010, and is obligated to pay $150,000 by July 1, 2011, $100,000 by July 1, 2012 and $100,000 by July 1, 2013.





As of February 28, 2011, the Company has recorded $150,000 as current portion of trademark purchase obligation (July 1, 2011 payment) as a current liability and has recorded $200,000 (payments due thereafter) under long-term trademark purchase obligation as a long-term liability.





NOTE 10 - INCOME TAXES





Teletouch uses the liability method to account for income taxes. Under this method, deferred income tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates that are expected to be in effect when the differences reverse.


22





Significant components of the Company’s deferred taxes are as follows (in thousands):


February 28, 2011


May 31, 2010Deferred Tax Assets:Current deferred tax assets:Accrued liabilities

$
654


$
826Deferred revenue


67



55Inventories


94



83Allowance for doubtful accounts


106



138921



1,102Valuation allowance


(921
)


(1,102
)Current deferred tax assets, net of valuation allowance


-



-Non-current deferred tax assets:Net operating loss


10,524



9,769Intangible assets


250



228Fixed assets


190



174Licenses


13



15Other


40



4711,017



10,233Valuation allowance


(11,017
)


(10,233
)Non-current deferred tax assets, net of valuation allowance

$
-


$
-





NOTE 11 – COMMITMENTS AND CONTINGENCIES





Commitments





Teletouch leases buildings, transmission towers, and equipment under non-cancelable operating leases ranging from one to twenty years.  These leases contain various renewal terms and restrictions as to use of the property.  Some of the leases contain provisions for future rent increases.  The total amount of rental payments due over the lease terms is charged to rent expense on the straight-line method over the term of the leases.  The difference between rent expense recorded and the amount paid is recorded as deferred rental expense, which is included in accrued expenses and other liabilities in the accompanying consolidated balance sheets.  Future minimum rental commitments under non-cancelable leases are as follows (in thousands):





Twelve Months Ending February 28,Total


2012


2013


2014


2015


ThereafterOperating leases

$
4,919


$
704


$
440


$
339


$
254


$
3,182





Sales and Use Tax Audit Contingency





In October 2010, the Company became subject to a sales and use tax audit covering the period of January 2006 to October 2009. During the second quarter of fiscal year 2011 and while preparing for this audit, the Company identified issues with the prior application and interpretation of sales tax rates assessed on services billed to its cellular subscribers. Prior sales tax audits on these billings have not detected these issues although the methodology for computing sales taxes was similar in these prior periods.  The Company concluded that it is probable that these issues will be identified and challenged in the current audit based on the initial inquiries by the sales tax auditor.  As February 28, 2011 and through the date of this Report, we are unable to estimate the outcome of the audit but can estimate a range of potential liability between $22,000 and $2,490,000. This range includes a low estimate based on similar audit results in prior periods to a high estimate based on a conservative application of sales tax rates to all cellular services billed and including underpayment penalties and interest.  The application of the various sales tax laws and rates on the Company’s cellular services is complex and the actual liability could fall outside of our estimated range due to items identified during the audit but not considered by us.


23





Since the sales tax audit is ongoing and the Company is unable make a reasonable estimate of the outcome of this audit, under ASC 450, Contingencies,the Company has concluded that the appropriate accrual would be the lower end of the range.  Based on the immateriality of the $22,000 estimated liability at the lower end of the range, the Company has not recorded an accrual for this loss as of February 28, 2011.  As the audit progresses and if the Company can better estimate the outcome of the audit, it will record this accrual and a charge against earnings in that period.





Legal Proceeding Contingencies





Teletouch is party to various legal proceedings arising in the ordinary course of business. The Company believes there is no proceeding, either threatened or pending, against it that will result in a material adverse effect on its results of operations or financial condition or that requires accrual or disclosure in its financial statements under ASC 450.





NOTE 12 – SHAREHOLDERS’ EQUITY





Capital Structure:  Teletouch’s authorized capital structure allows for the issuance of 70,000,000 shares of common stock with a $0.001 par value and 5,000,000 shares of preferred stock with a $0.001 par value.





Series C Preferred Stock:At February 28, 2011, no shares of Series C Preferred Stock with a par value of $0.001 are issued and outstanding.





NOTE 13 - STOCK OPTIONS





Teletouch’s 1994 Stock Option and Stock Appreciation Rights Plan (the “1994 Plan”) was adopted in July 1994 and provides for the granting of incentive and non-incentive stock options and stock appreciation rights to officers, directors, employees and consultants to purchase not more than an aggregate of 400,000 shares of common stock. The Compensation Committee or the Board of Directors administers the 1994 Plan and has authority to determine the optionees to whom awards will be made, the terms of vesting and forfeiture, the amount of the awards, and other terms.  Under the terms of the 1994 Plan, the option price approved by the Board of Directors shall not be less than the fair market value of the common stock at date of grant.   Exercise prices in the following table have been adjusted to give effect to the repricing that took effect in December 1999 and November 2001.





On November 7, 2002, the Company’s common shareholders voted to adopt and ratify the Teletouch 2002 Stock Option and Appreciation Rights Plan (the “2002 Plan”).  Under the 2002 Plan, Teletouch may issue options, which will result in the issuance of up to an aggregate of 10,000,000 shares of Teletouch’s common stock. The 2002 Plan provides for options, which qualify as incentive stock options (Incentive Options) under Section 422 of the Code, as well as the issuance of non-qualified options (Non-Qualified Options). The shares issued by Teletouch under the 2002 Plan may be either treasury shares or authorized but unissued shares as Teletouch’s Board of Directors may determine from time to time.  Pursuant to the terms of the 2002 Plan, Teletouch may grant Non-Qualified Options and Stock Appreciation Rights (SARs) only to officers, directors, employees and consultants of Teletouch or any of Teletouch’s subsidiaries as selected by the Board of Directors or the Compensation Committee.  The 2002 Plan also provides that the Incentive Options shall be available only to officers or employees of Teletouch or any of Teletouch’s subsidiaries as selected by the Board of Directors or Compensation Committee. The price at which shares of common stock covered by the option can be purchased is determined by Teletouch’s Compensation Committee or Board of Directors; however, in all instances the exercise price is never less than the fair market value of Teletouch’s common stock on the date the option is granted.  To the extent that an Incentive Option or Non-Qualified Option is not exercised within the period in which it may be exercised in accordance with the terms and provisions of the 2002 Plan described above, the Incentive Option or Non-Qualified Option will expire as to the then unexercised portion.  In addition, employees that cease their services with the Company and hold vested options will have the ability to exercise their vested options for a period three months after their termination date with the Company.


24


As of February 28, 2011, approximately 27,329 Non-Qualified Options and 12,000 Incentive Options are outstanding under the 1994 Plan, and approximately 496,998 Non-Qualified Options and 5,119,490 Incentive Options are outstanding under the 2002 Plan.





A summary of option activity for the nine months ended February 28, 2011 is as follows:





WeightedWeighted


AverageAverage


Remaining


AggregateExercise


Contractual


IntrinsicShares


Price


Term


ValueOutstanding at June 1, 2010


4,563,316


$
0.25



7.36


$
401,150Nine months ended February 28, 2011Granted


1,093,167



0.33Exercised


-



-Forfeited


(666
)


0.24Outstanding at February 28, 2011


5,655,817



0.26



7.13



921,826Options exercisable at February 28, 2011


4,651,432


$
0.27



6.97


$
724,818





The following table summarizes the status of the Company’s non-vested stock options since June 1, 2010:





Non-vested OptionsWeighted-Number of


Average FairShares


ValueNon-vested at June 1, 2010


1,508,771


$
0.18Granted


1,093,167



0.30Vested


(1,597,553
)


0.25Forfeited


-



-Non-vested at February 28, 2011


1,004,385


$
0.21





The Company estimates the fair value of employee stock options on the date of grant using the Black-Scholes model. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards and the actual and projected employee stock option exercise behaviors. The Company has elected to estimate the expected life of an award based on the SEC approved “simplified method.” The Company calculated its expected volatility assumption required in the Black-Scholes model based on the historical volatility of its stock.  The Company recorded approximately $40,000 and $35,000 in stock based compensation expense in the consolidated financial statements for the three months ended February 28, 2011 and 2010, respectively.  The Company recorded approximately $345,000 and $204,000 in stock based compensation expense in the consolidated financial statements for the nine months ended February 28, 2011 and 2010, respectively.





NOTE 14 – RELATED PARTY TRANSACTIONS





The commonly controlled companies owning or affiliated with Teletouch are as follows:





Progressive Concepts Communications, Inc., a Delaware corporation (“PCCI”) – PCCI has no operations and is a holding company formed to acquire the stock of PCI (Teletouch’s subsidiary as of August 2006) in 2001.  Robert McMurrey, Chairman and Chief Executive Officer of Teletouch, controls approximately 94% of the stock of PCCI. In 2004, PCCI acquired 100% of the outstanding common units of TLL Partners, LLC (see below).


25


TLL Partners, LLC, a Delaware LLC (“TLLP”) – TLLP has no operations and is a holding company formed in 2001 to acquire certain outstanding Series A Preferred stock and subordinated debt obligations of Teletouch.  The purchased subordinated debt obligations were forgiven, and in November 2002, all of the outstanding Series A Preferred stock was redeemed by Teletouch by the issuance of 1,000,000 shares of Teletouch’s convertible Series C Preferred stock.  In November 2005, TLLP converted all of its shares of Series C Preferred stock into 44,000,000 shares of Teletouch’s common stock gaining a majority ownership of Teletouch’s outstanding common stock.  As of February 28, 2011, TLLP owns 37,983,334 shares of Teletouch common stock, representing approximately 78% of Teletouch’s outstanding common stock.  During our third fiscal quarter, TLLP informed the Company of its intent to sell some of its holdings of Teletouch common stock.  During the quarter ended February 28, 2011, TLLP sold 1,166,666 shares of Teletouch stock to certain non-affiliated parties.  As of the date of this Report, and following the end of the quarter,  TLLP has sold an additional 1,450,000 shares of Teletouch stock.  The Company has been informed that TLLP will be continuing to sell a portion of its shares of Teletouch stock until it has raised sufficient funds to settle certain debt obligations at TLLP.  As a result of these sales, the Company has entered into various Registration Rights Agreements with the buyers to provide for a subsequent registration of these shares with the SEC.





The Company received certain dividend payments from investments belonging to TLLP in the periods presented in this Report and paid certain consulting fees on behalf of TLLP in the three and nine months ended February 28, 2011. These transactions resulted in a receivable due from TLLP of approximately $23,000 as of February 28, 2011.  TLLP paid the receivable in March 2011.





NOTE 15 – SEGMENT INFORMATION





ASC 280, Segment Reporting, establishes standards for reporting information about operating segments.  Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.





Using this criteria, the Company's three reportable segments are cellular services, wholesale distribution and two-way radio services.





The Company’s cellular business segment represents its core business, which has been acquiring, billing, and supporting cellular subscribers under a revenue sharing relationship with AT&T and its predecessor companies for over 27 years. The consumer services and retail business within the cellular segment is operated primarily under the Hawk Electronics brand name, with additional business and government sales provided by a direct sales group operating throughout all of the Company’s markets. As a master distributor for AT&T wireless services, the Company controls the entire customer experience, including initiating and maintaining the cellular service agreements, rating the cellular plans, providing complete customer care, underwriting new account acquisitions and providing multi-service billing, collections, and account maintenance.  In January 2009, Teletouch entered into a new distribution agreement with T-Mobile USA, Inc. (“T-Mobile”). The Company closed its last two Oklahoma retail locations selling T-Mobile branded cellular services and products in October 2009. Subsequent to these closings, in January 2010, the Company mutually agreed to terminate its agreement with T-Mobile due to lower than expected activations and a variety of sales, commissions and operational support issues encountered.


26


On January 19, 2010, the Company signed a new two-year, national distribution agreement with Clearwire Communications (NASDAQ: CLWR) to sell its 4G service called CLEAR.  On January 26, 2010, the Company announced that it had recently entered into a two-year, Authorized Representative Agreement with Sprint (NYSE:S) subsidiary, Sprint Solutions, Inc.  In December 2010, the Company mutually agreed to terminate its agreement with Sprint due to lower than expected activations and a variety of sales and operational support issues encountered.





The Company’s wholesale business segment represents its distribution of cellular telephones, accessories, car audio and car security products to major carrier agents, rural cellular carriers, smaller consumer electronics and automotive retailers and auto dealers throughout the United States.





The two-way business segment includes radio services provided on the Company’s Logic Trunked Radio (“LTR”) system and the related radio equipment sales as well as radio equipment sales to customers operating their own two-way radio system.  Public safety equipment sales and services are also included in the two-way business segment.





Corporate overhead is reported separate from the Company’s identified segments.  The Corporate overhead costs include expenses for the Company’s accounting, information technology, human resources, marketing and executive management functions.





As of May 31, 2010, the Company combined its car dealer expediter business which was previously reported as other operations with its wholesale segment operations for segment presentation purposes. The segment information presented for the three and nine months ended February 28, 2010 in this Report has been conformed to be comparable to the current year’s segment information.





The following tables summarize the Company’s operating financial information by each segment for the three and nine months ended February 28, 2011 and 2010 (in thousands):


27





Three Months Ended


Nine Months EndedFebruary 28,


February 28,2011


2010


2011


2010Operating revenues:Service and installation revenueCellular

$
4,578


$
5,835


$
14,556


$
18,000Wholesale


16



22



62



58Two-way


339



434



1,138



1,384Corporate


17



17



58



80Total


4,950



6,308



15,814



19,522Product sales revenueCellular


676



950



2,392



3,454Wholesale


3,089



8,585



6,942



16,862Two-way


640



714



2,126



2,054Corporate


2



2



5



5Total


4,407



10,251



11,465



22,375Operating revenueCellular


5,254



6,785



16,948



21,454Wholesale


3,105



8,607



7,004



16,920Two-way


979



1,148



3,264



3,438Corporate


19



19



63



85Total


9,357



16,559



27,279



41,897Operating expenses:Cost of service and installation(exclusive of depreciation and amortization included below)Cellular


1,090



1,285



3,311



4,338Wholesale


45



17



75



49Two-way


393



391



1,189



1,182Total


1,528



1,693



4,575



5,569Cost of products soldCellular


1,044



1,130



3,179



3,691Wholesale


2,644



7,005



5,787



14,512Two-way


437



590



1,515



1,605Corporate


-



(6
)


(1
)


(17
)Total


4,125



8,719



10,480



19,791Selling and general and administrativeCellular


696



969



2,484



3,411Wholesale


382



702



1,178



1,441Two-way


188



156



535



410Corporate


2,501



2,594



7,232



7,332Total


3,767



4,421



11,429



12,594Depreciation and amortizationTwo-way


23



29



68



92Corporate


258



282



776



864Total


281



311



844



956Loss (gain) on disposal of assetsCorporate


-



-



(1
)


1Total Operating expenses


9,701



15,144



27,327



38,911Income (loss) from operationsCellular


2,424



3,401



7,974



10,014Wholesale


34



883



(36
)


918Two-way


(62
)


(18
)


(43
)


149Corporate


(2,740
)


(2,851
)


(7,943
)


(8,095
)Total


(344
)


1,415



(48
)


2,986Interest expense, netCorporate


(553
)


(602
)


(1,672
)


(1,674
)Net income (loss) before income tax expense


(897
)


813



(1,720
)


1,312Income tax expenseCorporate


45



60



157



183Net income (loss)Cellular


2,424



3,401



7,974



10,014Wholesale


34



883



(36
)


918Two-way


(62
)


(18
)


(43
)


149Corporate


(3,338
)


(3,513
)


(9,772
)


(9,952
)Total

$
(942
)

$
753


$
(1,877
)

$
1,129





The Company identifies its assets by segment. Significant assets of the Company’s corporate offices include cash, property and equipment, loan origination costs and the patent held for sale.  The Company’s assets by segment as of February 28, 2011 and May 31, 2010 are as follows:


28




February 28, 2011


May 31, 2010Total Assets


Property and

Equipment, net


Intangible Assets,

net


Total Assets


Property and

Equipment, net


IntangibleAssets,

netSegmentCellular

$
8,669


$
100


$
3,519


$
10,362


$
124


$
4,068Wholesale


1,681



10



-



837



2



-Two-way


1,665



389



378



1,599



401



373Corporate


5,136



2,206



254



8,886



2,222



244Totals

$
17,151


$
2,705


$
4,151


$
21,684


$
2,749


$
4,685





During the three and nine months ended February 28, 2011 and 2010, the Company did not have a single customer that represented more than 10% of total segment revenues.





NOTE 16 – SUBSEQUENT EVENT





The employment agreements for the Company’s current Chairman and Chief Executive Office, Robert M. McMurrey (“Mr. McMurrey”) and President and Chief Operating Officer, Thomas A. “Kip” Hyde (“Mr. Hyde”) will automatically renew for an additional one (1) year term on June 1, 2011 since the Company nor the employees (collectively the “Parties” or individually the “Party”) gave the other Party written advance notice of an intent not to renew their agreements at least sixty (60) days prior to their expiration on May 31, 2011.  The Parties had until April 1, 2011 to notice the other Party of their intent not to renew.





As of June 1, 2011, the Company will be obligated to pay an annual base salary to Mr. McMurrey and Mr. Hyde of $380,000 and $325,000, respectively.  In addition, Mr. McMurrey and Mr. Hyde will be able to participate in benefits available to all full-time employees of the Company, subject to eligibility requirements, which include medical, dental, life and disability insurance as well as the Company’s defined contribution plan and other applicable employment terms and conditions.


29





Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations





The following discussion and analysis of the results of operations and financial condition of the Company should be read in conjunction with the consolidated financial statements and the related notes and the discussions under “Critical Accounting Estimates,” which describes key estimates and assumptions we make in the preparation of our financial statements.





Overview





For over 46 years, Teletouch has offered a comprehensive suite of telecommunications products and services, including cellular, two-way radio, GPS-telemetry, wireless messaging and public safety equipment.  As of February 28, 2011, the Company operated 20 retail and agent locations in Texas under the “Teletouch” and “Hawk Electronics” brand names supporting over 50,000 current monthly billed subscribers and other customers.





Teletouch’s core-business is acquiring, billing and supporting cellular subscribers under a long-term recurring revenue relationship with AT&T. The distribution agreements with AT&T and its predecessor companies have been in place for over 27 years. Through its subsidiary, Progressive Concepts Inc., (“PCI”), the Company provides AT&T cellular services (voice, data and entertainment), as well as other mobile, portable and personal electronics products and services to individuals, businesses and government agencies. PCI operates a chain of retail stores and sells cellular and other products and services under the “Hawk Electronics” brand, through Hawk-branded sub-agents, its own direct sales force, call center and the Internet. As a master distributor and Authorized Services Provider for AT&T, the Company controls the entire customer relationship, including initiating and maintaining the cellular service agreements, rating the cellular plans, providing complete customer care, underwriting new account acquisitions and providing multi-service billing, collections and account maintenance. PCI also operates a national wholesale distribution business, known as PCI Wholesale that serves major carrier agents, rural cellular carriers, smaller consumer and electronic retailers and automotive dealers throughout the United States. The Company also maintains certain international customer relationships, primarily in Asia, Europe and Latin America for its cellular related wholesale equipment sales business. Teletouch’s original business is maintained as an integral component of the Company’s wireless solutions, by providing two-way radio products and services on its own network in North and East Texas. In its first attempt at expanding the Company’s cellular related business, in January 2009, Teletouch entered into an Exclusive Retailer Agreement with T-Mobile USA, Inc. (“T-Mobile”) for markets outside its AT&T exclusive territories. The initial agreement provided for Teletouch to open, operate and manage mall locations, with the Company's first locations opening in major markets in Oklahoma in February 2009. After opening five (5) new mall locations under the T-Mobile brand banner, the Company found that long-term customer traffic for T-Mobile products and services to be inadequate and the Company closed its last two Oklahoma retail locations in October 2009. Subsequent to these closings, in January 2010, the T-Mobile agreement was cancelled. On January 19, 2010, the Company signed a new two-year, national distribution agreement with Clearwire Communications (NASDAQ: CLWR) to sell its 4G service called CLEAR. On January 26, 2010, the Company announced that it had also entered into a two-year, Authorized Representative Agreement with Sprint (NYSE:S) subsidiary, Sprint Solutions, Inc. In December 2010, the Company mutually agreed to terminate its agreement with Sprint due to lower than expected activations and a variety of sales and operational support issues encountered.  In late 2007, Teletouch began selling public safety equipment and services under the brand Teletouch PSE (“PSE”). The PSE business is a complementary offering to the Company’s two-way radio business, and the Company has expanded its product lines to include light bars, sirens and other accessories used in or on emergency response vehicles through a number of distribution agreements with manufacturers of these products. In September 2010, Teletouch was awarded a multi-year contract with the General Services Administration (“GSA”) to sell its public safety equipment to federal, state and local government agencies. In addition, the Company has recently been awarded listings on BuyBoard (a State of Texas website operated by the Local Government Purchasing Cooperative), and the Texas multiple awards contract (“TXMAS”) facility, also run by the State of Texas, which allows products to be sold to all State agencies and authorized local public entities.


30




During the three and nine months ended February 28, 2011, Teletouch focused its efforts on producing documents and other evidence to support its litigation against AT&T in preparation for the hearing scheduled for June 2011 with AT&T. In addition, the Company’s executive management team and other key personnel were deposed by AT&T during the third quarter of fiscal year 2011. Due to the actions mentioned above, the Company continued to incur significant professional fees during the third quarter of fiscal year 2011 to defend itself in the arbitration with AT&T. The Company also continued to concentrate on maximizing its profitability in its existing cellular operations and other business units while pursuing new business acquisitions. Limited supply of cellular phones available for resale caused sales to be significantly lower than the same periods in fiscal year 2010 but the Company has experienced an increase in product revenues in its wholesale business during the third quarter of fiscal year 2011 compared to the two previous quarters of fiscal year 2011 due to an increase in brokering cellular phone handsets.





Furthermore, the Company implemented business restructuring plans in December 2010 and February 2011 in an effort to realign its costs with its declining cellular revenues. The Company estimates monthly cost reductions going forward of approximately $170,000 from its previous fiscal year 2011 levels as a result of the cost reduction actions taken. The Company has restructured its existing key sales personnel by creating new sales teams, regional sales managers and product managers in an effort to promote the cross-training of all products lines sold within the Company.  The product managers will focus on growing the Company’s product lines with the development of new sales strategies and continually analyzing the Company’s product mix for increased sales.  The product managers will also assist the sales teams and managers with back-end support such as creating and updating price lists, quoting specialty jobs and supplying technical knowledge of the products sold within the Company.





Throughout the remainder of fiscal year 2011, the Company will focus on resolving its dispute with AT&T while working to minimize the operating and cash impact on the business being caused by the continuing loss of subscribers to AT&T. Although, the Company anticipates incurring significant professional fees throughout the remainder of fiscal year 2011 as it continues to defend itself in the arbitration with AT&T.  In September 2009, PCI commenced an arbitration proceeding against AT&T to seek relief for damages the Company incurred because it was prohibited to sell the iPhone as well as other “AT&T exclusive” products and services (see Item 1. Legal Proceedings for discussion of the action brought against AT&T related to the iPhone and other matters).  The Arbitration hearing was originally scheduled for November 2010 and was delayed at the request of AT&T until March 2011 and was most recently delayed further at AT&T’s request to June 13, 2011. Until the arbitration is complete, the Company will focus on retaining and preserving its existing subscriber base in the DFW and San Antonio markets while expanding its cellular subscriber base in available markets covered by the Company’s various other AT&T distribution agreements.





In addition, during fiscal year 2011, the Company has been focused on negotiating one or more direct relationships with cellular handset manufacturers in an effort to grow its wholesale cellular distribution business. To date, the Company’s efforts to negotiate terms of a direct relationship with a prominent cellular handset manufacturer have proven to be difficult and much slower than anticipated given the complexities created by certain manufacturer’s relationships with the primary cellular carriers, including AT&T. Although the Company has not executed a distribution agreement with a direct manufacturer as of the date of this Report, the Company anticipates wholesale revenues will continue to expand throughout the remainder of fiscal year 2011 due to its ability to purchase more products from indirect channels of distribution.  The Company will continue to concentrate on developing new direct purchasing relationships as it sees them as an immediate growth opportunity for its wholesale business and capable of generating enough volume and margins to offset the losses in its cellular service revenues.


31




Although the Company believes it can maintain a profitable, but declining cellular business in the future with its existing subscriber base, organic growth in its other business units or new business acquisitions will be necessary to offset expected losses of revenue and profits from its core legacy cellular business. Since the Company has not been successful in acquiring a new business or had the ability to significantly increase the revenues in its different business units, the Company will continue to monitor its business units throughout the remainder of fiscal year 2011 to determine if additional costs need to be eliminated from the business. The Company has been in discussion with an acquisition target that is complementary to its existing business operations and capable of replacing the majority of the revenues lost in the Company’s cellular business. During the third quarter of fiscal year 2011, the Company engaged an investment banking firm to negotiate this transaction and secure financing for the acquisition. As of the date of this Report, the Company has received non-binding term sheets from several financing sources but has not issued a letter of intent to the acquisition target. Assuming the financing for this acquisition is secured, the Company will enter into a non-binding letter of intent while it completes its diligence.  There is no assurance that any of the acquisitions will be concluded by the end of fiscal year 2011, that the Company will be successful growing revenues in any of its business units or the AT&T arbitration will not be delayed beyond June 2011.





Discussion of Business Strategy by Operating Segment





During fiscal year 2010, the Company was successful in initiating new national and international wholesale distribution channels, increasing the Company’s product sales by over 40% when compared to fiscal year 2009. This additional sales volume, in addition to ongoing management of operating expenses, contributed to the Company’s achieving net income in fiscal year 2010 for the first time in many years. Throughout fiscal year 2010, Teletouch better positioned itself for future growth by optimizing the efficiency of its operations by re-allocating resources to business units capable of achieving meaningful growth for the Company versus supporting many of the Company’s prior smaller businesses and product lines with limited potential for growth. Key to this strategy in fiscal year 2011 has been to focus on leveraging the Company’s various customer relationships, including PCI’s approximately 50,000 cellular subscribers, and previous customers which are generally comprised of individuals and businesses of higher than average credit worthiness (due to PCI’s relatively stringent credit standards).





During fiscal year 2010, the Company was successful in improving its operating results through aggressive cost management and improved product sales from its wholesale and two-way businesses.  During fiscal year 2011, the Company has continued to manage its costs closely and will focus on developing new sources of revenue for its wholesale distribution and its two-way radio business units and on retaining its recurring cellular subscriber base.  These new revenue sources are expected from several product distribution agreements and, potentially, the acquisition of one or more complementary businesses. There is no assurance that any new distribution agreements or any of the acquisitions will be finalized.





Certain non-recurring expenses are expected to be incurred in fiscal year 2011 related to the arbitration proceeding against AT&T, the business restructuring plans as well as the startup and expansion costs related to possible new products and services.  The Company believes that these non-recurring expenses will not materially impair its operating results during fiscal year 2011. In addition, on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law and a permanent delay of the implementation of section 404(b) of the Sarbanes-Oxley Act of 2002 (“SOX”) for companies with non-affiliated public float under $75,000,000 (“non-accelerated filer”). Section 404(b) under SOX is the requirement to have an independent accounting firm audit and attest to the effectiveness of a Company’s internal controls. As Teletouch currently qualifies as a non-accelerated filer under the SEC rules and expects to remain one through fiscal year 2011, there are no additional costs anticipated for complying with Section 404(b) under SOX.


32




Cellular Operations




In August 2009, the initial term of the primary distribution agreement between Teletouch’s subsidiary, PCI and AT&T expired.  Under this agreement, PCI distributes AT&T cellular services and serves as billing agent for AT&T in the DFW market.  With the expiration of this agreement, the Company is no longer exclusive to AT&T in DFW, which allows the Company to expand it cellular service offerings in this market for the first time in over 26 years.  The expiration of the DFW distribution agreement also restricts PCI from growing its subscriber base in DFW by limiting new activations and prohibiting AT&T subscribers from moving their service to PCI, but the majority of the provisions of the agreement remained intact at the option of PCI, including the right for PCI to continue servicing its existing DFW subscribers until there are no more subscribers remaining as customers of PCI.  Based on its current subscriber attrition rates, the Company estimates that it will maintain Subscribers in DFW for at least the next five years. The Company has historically had five distribution agreements with AT&T in addition to the distribution agreement covering the DFW market discussed above. Under these other distribution agreements, the Company is allowed to distribute AT&T wireless services, on an exclusive basis, in certain major markets in Texas and Arkansas, including the San Antonio, Texas Metropolitan Statistical Area (“MSA”), Austin, Texas MSA, Houston, Texas MSA, East Texas Regional MSA and Arkansas, including primarily the Little Rock, Arkansas MSA. These distribution agreements have varying terms with the longest extending through October 2013.





In August 2009, the Company received notice from AT&T of its intent not to renew the Houston distribution agreement, but let it naturally expire in February 2010, which would allow the Company to continue servicing its small subscriber base in the Houston area through February 2011. In September 2009, the Company received notice from AT&T of its intent to terminate the Arkansas distribution agreement substantially on the grounds the Company did not maintain a sufficient number of retail outlets in that market. The Arkansas agreement would otherwise expire in July 2012. Additionally, AT&T has claimed the San Antonio distribution agreement should have been previously conformed to an agreement similar to the Houston agreement in accordance with a related agreement reached between the parties in connection with a settlement agreement completed in June 2007. In January 2008, the Company elected to renew its legacy San Antonio distribution agreement with AT&T through August 2009, which provided rights to the Company to enter into a reseller agreement with AT&T and purchase the subscriber base at the expiration of the agreement. To date, neither AT&T nor the Company have been able to agree on the value for the subscriber base and the next steps following the August 2009 expiration of the San Antonio agreement, so the Company has continued to service this customer base and operates under the terms of the legacy agreement. The Company is aggressively disputing the contract matters with AT&T and expects that these matters will all be resolved through the arbitration in process over matters related to its DFW distribution agreement (see discussion below).  With the exception of the San Antonio and DFW distribution agreements, none of the other distribution agreements are deemed material to the current operations of the Company. The Company cannot provide any assurance that it will be successful in maintaining its Houston, Arkansas or San Antonio distribution agreements beyond their contractual expiration dates.




33


On September 30, 2009, the Company commenced an arbitration proceeding against AT&T seeking at least $100 million in damages. The binding arbitration was commenced to seek relief for damages incurred as AT&T has prevented the Company from selling the popular iPhone and other “AT&T exclusive” products and services that PCI is and has been contractually entitled to provide to its customers under the distribution agreements. While PCI has attempted to negotiate with AT&T for the purpose of obviating the need for legal action, such attempts have failed. Accordingly, PCI initiated this arbitration. AT&T subsequently filed certain counterclaims with the arbitrator seeking an unspecified amount of damages from PCI and claiming that PCI was operating in violation of certain provisions of the distribution agreements and such agreements should therefore be cancellable by AT&T. The Arbitration hearing was originally scheduled for November 2010 and was delayed at the request of AT&T until March 2011 and was most recently delayed further at AT&T’s request to June 2011. In March 2011, both the Company’s and AT&T’s independent valuation experts filed initial damages computations with the arbitrator which valued each party’s respective damages as a result of the other party’s actions. The Company’s expert provided damages computations under several scenarios which included damages assuming PCI’s damages were limited to the liquidated damages provision included in the distribution agreement and several alternate computation of lost profits depending on the timing of which it was determined that PCI should have been allowed to sell the iPhone. Under the liquidated damages limitation, PCI’s damages are estimated to be $48.9 million. Under the lost profits computations, PCI’s damages are estimated to be as high as $35.0 million due to lost profits on subscriber transferred to AT&T and those subscribers that PCI did not get because of it not being allowed to sell the iPhone. Additionally, if it is determined that PCI should also be compensated for the fair value of its subscriber base as of August 31, 2009 (the date of the expiration of the DFW and San Antonio distribution agreements), damages could be increased by $51.8 million, resulting in total damages and compensation due to PCI totaling $86.8 million. AT&T’s expert computed AT&T’s damages in the range of $7.6 million to $9.9 million, depending on the arbitrator’s interpretation of the San Antonio distribution agreement. See Item 1. Legal Proceedings for further discussion on the arbitration with AT&T.





With PCI’s exclusivity to AT&T in the DFW market lifted in August 2009 and after being unable to reach an alternate form of agreement with AT&T, the Company began actively negotiating final terms under a variety of new cellular carriers, WiFi, WiMax and related wireless communications relationships. The Company began launching these new cellular carrier services and products in the latter part of fiscal year 2010. On January 19, 2010, the Company signed a new two-year, national distribution agreement with Clearwire Communications (NASDAQ: CLWR) to sell its 4G service called CLEAR.  On January 26, 2010, the Company announced that it had entered into a two-year, Authorized Representative Agreement with Sprint (NYSE:S) subsidiary, Sprint Solutions, Inc.  In December 2010, the Company mutually agreed to terminate its agreement with Sprint due to lower than expected activations and a variety of sales and operational support issues encountered.





Throughout fiscal year 2011, the Company will focus on the retention of its approximately 50,000 cellular subscribers, which primarily reside in the DFW and San Antonio markets in Texas.  In addition, the Company will focus on developing the other markets covered by its existing AT&T distribution agreements, starting with the East Texas market where Teletouch currently has personnel and existing infrastructure in place. Through new carrier relationships, the Company will offer its customers a choice in services and additional products which it expects will help in its efforts to retain its cellular customers in DFW and San Antonio.





Wholesale Business





During fiscal year 2010, the Company’s focus in the wholesale business was managing credit exposure on sales, pricing methodology, improving margins and increasing inventory turnover. The extensive re-evaluation of the wholesale business in 2009 resulted in certain sustainable operating changes to the business, including office staff reductions, new sales hiring, re-pricing of new and non-current inventory, as well as identified the necessity to grow market share and focus on more exclusive product offerings. Beginning October 2009, the Company materially increased its cellular handset broker business by selling to volume buyers both domestically and internationally.  Initially the Company primarily brokered phones manufactured by Research In Motion, better known as the manufacturer of Blackberry® cellular handsets. This broker business contributed to the increase in product sales for the Company’s wholesale business during the second and third quarter of fiscal year 2010, which correspond to the traditional holiday selling season. The Company’s handset broker business then declined throughout the remainder of fiscal year 2010 following the purchasing restrictions imposed on the Company by AT&T in late December 2009. The Company is pursuing new suppliers of cellular handsets to support the wholesale broker business and anticipates it will ramp up this business quickly once a supplier agreement is in place. To date, the Company’s efforts to negotiate terms of a direct relationship with a prominent cellular handset manufacturer have proven to be difficult and much slower than anticipated given the complexities created by certain manufacturer’s relationships with the primary cellular carriers, including AT&T. Although the Company has not executed a distribution agreement with a direct manufacturer, the Company anticipates wholesale revenues will continue to expand throughout the remainder of fiscal year 2011 due to its ability to purchase more products from indirect channels of distribution. The Company will continue to focus on developing new direct purchasing relationships as it sees them as an immediate growth opportunity for its wholesale business and capable of generating enough volume and margins to offset the losses in its cellular service revenues.  The Company is hopeful that it will be successful completing one or more of these distribution agreements prior to the end of fiscal year 2011.




34





Two-Way Radio Operations





In fiscal year 2010, the Company’s two-way division secured a contract in support of the re-banding efforts undertaken nationally to migrate public safety communications to frequencies that will not experience interference from certain radio channels operated by Sprint/Nextel.  This project covers the East Texas market and generated approximately $406,000 in installation revenues during fiscal year 2010. The Company expects to generate at least an additional $200,000 in installation revenues in fiscal year 2011 from the re-banding project.  Furthermore, during the third quarter of fiscal year 2011, the Company earned an additional $70,000 in commission revenue from certain Motorola sales. Teletouch’s long-term relationships and reputation with the various governmental entities over its roughly 46 year presence in East Texas has allowed the Company to procure this business to date. Throughout the remainder of fiscal year 2011, the Company believes it will be successful in expanding its two-way business in different markets by focusing on government entities and business customers in the DFW area that are long-term cellular customers of PCI.  During the last quarter of fiscal year 2010, PCI’s direct business cellular salespeople began promoting two-way products to new and existing business customers in an effort to offer a wider range of wireless products to fit their customer’s needs.





As a complement to and embedded in its two-way radio segment, the Company began selling public safety equipment in late 2007 under several master distributor agreements with its suppliers.  The product lines include various aftermarket accessories that are added to vehicles in the public safety industry, but primarily includes light bars, sirens and computer equipment supports mounted in-vehicle.  During fiscal year 2011, the Company will be focusing on expanding the distribution of these product lines to other markets by cross-training existing sales personnel in those other markets as well as by opening new distribution points in those markets.  In addition, the Company is working with its manufacturers to secure approval to sell these products into other protected markets and to potentially acquire other existing distribution in these markets.





In September 2010, Teletouch was awarded a multi-year contract with the General Services Administration (“GSA”) initially for the Company's comprehensive product line of public safety, emergency vehicle lighting and siren equipment manufactured by Whelen Engineering, Inc.   The contract allows the Company the opportunity to compete in the public and emergency products category nationwide, allowing federal, state and / or local government agencies to purchase items from the Company’s public safety product line quickly and cost effectively. In addition, the contract enables the Company to streamline its purchasing process for its current government customers and will allow the Company to serve new customers around the country in the same manner.  Furthermore, in the near future, the Company will offer additional products and services from its different businesses through the GSA. The GSA Schedule is a government-wide procurement system. Teletouch will be providing all government agencies with the contracted "best value" pricing, as well as simplifying procurement for its products and services. When government agencies place orders with Teletouch, it will allow the agencies to fulfill their bidding and quote comparison requirements, without having to prepare new bids, which will increase overall purchasing efficiency and lower costs. The GSA contract award criteria were stringent and Teletouch was evaluated on its overall quality, pricing, financial, corporate stability and customer references. Teletouch's public safety products will fall under Schedule 84 which includes Total Solutions for Law Enforcement, Security, Facilities Management, Fire, Rescue, Clothing, Marine Craft and Emergency/Disaster Response. The Company’s contract with the GSA was effective on October 1, 2010, for an initial period of five years, with the GSA having the option to extend the contract for three additional 5-year periods.





35





The Company is currently pursuing contracts with other agencies in an effort to sell its public safety product line with city, county and state government agencies which do not procure their products through the GSA system.  These alternative sales outlets would allow government agencies to purchase products in the same cost effective manner as if they were utilizing the GSA system. In March 2011, the Company was approved to have its two-way radio and emergency vehicle products listed on BuyBoard, a website operated by the Local Government Purchasing Cooperative, an administrative agency in the State of Texas tasked with identifying and approving qualified vendors, products and services for purchase by all cities, counties and schools in the State.  Also, in March 2011, the Company was notified that it is in the final stages of being awarded a Texas multiple awards contract (TXMAS) by the State of Texas which would allow its products to be sold to all State agencies and authorized local public entities.  Both BuyBoard and TXMAS provide additional means for the Company’s products to be purchased by public entities in the State of Texas without being subjected to the lengthy bidding process required to purchase these products from other non-approved companies in the State.  The Company anticipates it will be successful in obtaining these and other contracts and subsequently expects to increase its public safety equipment sales.





Results of Operations for the three and nine months ended February 28, 2011 and 2010





Overview of Operating Results for the Three and Nine Months ended February 28, 2011 and 2010





The consolidated operating results for the three and nine months ended February 28, 2011 and 2010 are as follows:




36





(dollars in thousands)February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedOperating resultsService and installation revenue

$
4,950


$
6,308


$
(1,358
)


-22
%Product sales revenue


4,407



10,251



(5,844
)


-57
%Total operating revenues


9,357



16,559



(7,202
)


-43
%Cost of service and instalation (exclusive of depreciation and amortization)


1,528



1,693



(165
)


-10
%Cost of products sold


4,125



8,719



(4,594
)


-53
%Other operating expenses


4,048



4,732



(684
)


-14
%Operating income (loss)

$
(344
)

$
1,415


$
(1,759
)


-124
%Net income (loss)

$
(942
)

$
753


$
(1,695
)


-225
%Nine Months EndedOperating resultsService and installation revenue

$
15,814


$
19,522


$
(3,708
)


-19
%Product sales revenue


11,465



22,375



(10,910
)


-49
%Total operating revenues


27,279



41,897



(14,618
)


-35
%Cost of service and instalation (exclusive of depreciation and amortization)


4,575



5,569



(994
)


-18
%Cost of products sold


10,480



19,791



(9,311
)


-47
%Other operating expenses


12,272



13,551



(1,279
)


-9
%Operating income (loss)

$
(48
)

$
2,986


$
(3,034
)


-102
%Net income (loss)

$
(1,877
)

$
1,129


$
(3,006
)


-266
%





Net income (loss) by operating segment for the three and nine months ended February 28, 2011 and 2010 are as follows:




37





(dollars in thousands)February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedNet Income (Loss)Cellular segment

$
2,424


$
3,401


$
(977
)


-29
%Wholesale segment


34



883



(849
)


-96
%Two-way segment


(62
)


(18
)


(44
)


244
%Corporate operations


(3,338
)


(3,513
)


175



-5
%Total

$
(942
)

$
753


$
(1,695
)


-225
%Nine Months EndedNet Income (Loss)Cellular segment

$
7,974


$
10,014


$
(2,040
)


-20
%Wholesale segment


(36
)


918



(954
)


-104
%Two-way segment


(43
)


149



(192
)


-129
%Corporate operations


(9,772
)


(9,952
)


180



-2
%Total

$
(1,877
)

$
1,129


$
(3,006
)


-266
%





The decrease in net income for the three and nine months ended February 28, 2011 compared to the three and nine months ended February 28, 2010 is primarily attributable to the reduction in net income in the Company’s cellular and wholesale operating segments.  The Company’s cellular operations experienced a decrease in net income of $977,000 and $2,040,000 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year.  In spite of a loss of more than 14,000 cellular subscribers since February 28, 2010, the Company did not realize the full impact of this loss of subscribers on its earnings as a result of improving its profit margins on its cellular service revenues by selling more profitable cellular features provided by PCI to its remaining subscriber base and by controlling expenses in this business unit.  Of the 14,000 cellular subscribers lost since February 28, 2010, approximately, 8,300 of those subscribers were lost to AT&T and of these, approximately 4,600 subscribers transferred to AT&T to purchase the iPhone.  These significant losses of cellular subscribers to AT&T are the basis for our ongoing litigation against AT&T.  The decrease in net income from the Company’s wholesale operations for the three and nine months ended February 28, 2011 compared to the three and nine months ended February 28, 2010 is due to additional margin on broker sales of cellular handsets sold in the third quarter of fiscal year 2010 compared to a much lower volume of similar sales in the current fiscal year due to the Company’s inability to locate a new direct supplier for cellular phones after the supply of these phones to the Company’s wholesale business was cut off by AT&T in December 2009.  The decrease in earnings in the two radio segment is due to a larger portion of the installation revenues related to the City of Tyler radio frequency re-banding project that were earned in the prior year compared to the project wind down revenues that were recorded during the first half of fiscal year 2011.





Due to the predicted decline in cellular revenues, the Company forecasted fiscal year 2011 would not have positive operating results without the acquisition of a new business or a direct relationship with a manufacturer for increased wholesale broker sales. The Company believed that it would be able to complete one or both of these initiatives prior to the end of the second quarter.  However, these matters along with the ongoing arbitration with AT&T and the implementation of PSE sales through the GSA contract are taking longer than anticipated and we currently do not expect to realize any significant improvement in earnings from these growth initiatives through the remainder of the fiscal year.  By the second quarter of fiscal year 2011, it became apparent that the operations could not sustain the loss of cellular revenues without some significant growth in revenues from another source or without significant cost reductions. Therefore, with no significant revenue or margin growth forecasted in the immediate future, the Company began restructuring its operations in the third quarter of fiscal year 2011 to align its costs with the reduction in revenues.  The restructuring resulted in the closure of 4 Hawk branded service centers in the Dallas / Fort Worth area and a reduction of approximately 48 personnel.  The Company estimates monthly cost reductions going forward of approximately $170,000 from previous fiscal year 2011 levels due to the restructuring plans and will continue to monitor the revenues and expenses from its different businesses for potential changes going forward.





38





Significant Components of Operating Revenues and Expenses





Operating revenues are primarily generated from the Company’s cellular, wholesale and two-way radio operations and are comprised of a mix of service and installation revenues as well as product revenues.  Service and installation revenues are generated primarily from the Company’s cellular and two-way radio operations.  Within the cellular operations, the primary service revenues are generated by PCI from the sale of recurring cellular subscription services under several master distributor agreements with AT&T. Since 1984, the Company’s subsidiary, PCI, has held agreements with AT&T and its predecessor companies, which allowed PCI to offer cellular service and customer service to AT&T customers in exchange for certain compensation and fees.  PCI is responsible for the billing and collection of cellular charges from these customers and remits a percentage of the cellular billings generated to AT&T. Within the two-way radio operations, service revenues are generated by the sale of subscription radio services on the Company’s own radio network as well as from the sale of maintenance services on customer owned radio equipment.  The Company’s wholesale business generates service revenues from its car dealer expediter operations.





The majority of the Company’s product sales are generated by PCI’s wholesale operations and are comprised of cellular telephones, cellular accessories and 12-volt (automotive) mobile electronics, which are sold to smaller dealers and carriers throughout the United States. In addition, the wholesale business includes product sales from its car dealer expeditor business, which primarily consists of vehicle parts and accessories. Within the cellular operations of the Company, product sales are comprised primarily of cellular telephones and accessories sold through PCI’s retail stores, outside salespeople and agents to generate recurring cellular subscription revenues. The two-way radio operations’ products are comprised of radios and service parts for radio communication systems and public safety equipment.





Cost of providing service and installation consists primarily of costs related to supporting PCI’s cellular subscriber base under the master distributor agreement with AT&T including:





§
Costs of recurring revenue features that are added to the cellular subscribers’ accounts by PCI which are not subject to the revenue sharing arrangement with AT&T; such features include roadside and emergency assistance program, handset and accessory warranty programs and certain custom billing services.


§
Cost of third-party roaming charges that are passed through to PCI by AT&T.  Roaming charges are incurred when a cellular subscriber leaves the designated calling area and utilizes a carrier, other than AT&T, to complete the cellular call.  PCI is charged by AT&T for 100% of these “off-network” roaming charges incurred by its customer base.


§
Costs to operate and maintain PCI’s customer service department to provide billing support and facilitate account changes for cellular service subscribers.  These costs primarily include the related payroll and benefits costs as well as telecommunication charges for inbound toll-free numbers and outbound long distance.


§
Costs of the Company’s retail stores including personnel, rents and utilities.


§
Costs of bad debt related to the cellular service billings.




39




Cost of products sold consists of the net book value of items sold from the Company’s operating segments, which are cellular telephones, accessories, two-way radio, public safety equipment and 12-volt mobile electronics and their related accessories as well as the expenses and write-downs of equipment and accessory inventory for shrinkage and obsolescence.  We recognize cost of products sold, other than costs related to write-downs of equipment and accessory inventory for shrinkage and obsolescence, when title passes to the customer.  In PCI’s wholesale operations, products and accessories are sold to customers at pricing above PCI’s cost. However, PCI will generally sell cellular telephones below cost to new and existing cellular service customers as an inducement to enter into one-year and two-year subscription contracts, to upgrade service and extend existing subscription contracts or in connection with other promotions.  The resulting equipment subsidy to the majority of PCI’s cellular customers is consistent with the cellular industry and is treated as an acquisition cost of the related recurring cellular subscription revenues.  This acquisition cost is expensed by the Company when the cellular equipment is sold with the expectation that the subsidy will be recovered through margins on the cellular subscription revenues over the contract term with the customer.





Selling and general and administrative costs primarily consist of customer acquisition costs, including the costs of our retail stores, sales commissions paid to internal salespeople and agents, payroll costs associated with our retail and direct sales force, marketing expenses, billing costs, information technology operations, bad debt expense and back office support activities, including customer retention, legal, finance, marketing, human resources, strategic planning and technology and product development, along with the related payroll and facilities costs.  Also included in selling and general and administrative costs are the ongoing costs of maintaining Teletouch as a public company, which include audit, legal, other professional and regulatory fees.





Service and Installation Revenue for the Three and Nine Months Ended February 28, 2011 and 2010





The service and installation revenues shown below have been grouped and are discussed by the Company’s reportable operating segments as defined under GAAP. The corporate category includes the service revenues that are not generated by the business operations of the Company that meet the quantitative requirements for segment reporting under GAAP.  The corporate service revenues primarily consist of revenues earned from a mineral rights lease the Company executed with Chesapeake Exploration, LLC, in June 2008.




40





(dollars in thousands)February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedService and installation revenueCellular operationsGross cellular subscription billings

$
9,672


$
12,434


$
(2,762
)


-22
%Net revenue adjustment (revenue share due AT&T)


(5,094
)


(6,599
)


1,505



-23
%Cellular operations total service revenues:


4,578



5,835



(1,257
)


-22
%Wholesale operations


16



22



(6
)


-27
%Two-way radio operations


339



434



(95
)


-22
%Corporate


17



17



-



0
%Service and installation revenue

$
4,950


$
6,308


$
(1,358
)


-22
%Nine Months EndedService and installation revenueCellular operationsGross cellular subscription billings

$
30,662


$
39,561


$
(8,899
)


-22
%Net revenue adjustment (revenue share due AT&T)


(16,106
)


(21,561
)


5,455



-25
%Cellular operations total service revenues:


14,556



18,000



(3,444
)


-19
%Wholesale operations


62



58



4



7
%Two-way radio operations


1,138



1,384



(246
)


-18
%Corporate


58



80



(22
)


-28
%Service and installation revenue

$
15,814


$
19,522


$
(3,708
)


-19
%





Gross cellular subscription billings are measured as the total recurring monthly cellular service charges invoiced to PCI’s cellular subscribers from which a fixed percentage of the dollars invoiced are retained by PCI as compensation for the billing and support services it provides to these subscribers. PCI remits a fixed percentage of the gross cellular subscription billings to AT&T and absorbs 100% of any bad debt associated with the gross cellular subscription billings under the terms of its distribution agreement with AT&T.  The Company uses the calculation of gross cellular subscription billings to measure the overall growth of its cellular business and to project its future cash receipts from the subscriber base.





The decrease in the cellular operation’s gross cellular subscriptions billings for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is primarily due to a decrease in gross monthly access charges billed of approximately $1,521,000 and $4,839,000, respectively which is a direct result of the Company’s declining cellular subscriber base.  The reduction in subscribers is primarily due to the Company’s inability to offer the iPhone to its cellular customers resulting in PCI’s cellular subscribers being forced to transfer their service to AT&T or as of February 2011, Verizon,  in order to purchase the iPhone.  The Company had approximately 50,000 cellular subscribers as of February 28, 2011 compared to approximately 64,000 cellular subscribers as of February 28, 2010. Of the 14,000 subscribers lost since February 28, 2010, approximately 8,300 of these subscribers were lost to AT&T and of these, approximately 4,600 subscribers transferred to AT&T to purchase the iPhone.  In addition, the Company had a decrease in gross cellular service billings of $1,029,000 in the three months ended February 28, 2011 compared to the same period in the prior fiscal year which was comprised of reductions in custom feature, data, penalty and toll charges of $370,000, $332,000, $179,000 and $148,000, respectively. The Company had a decrease in cellular service billings of $3,296,000 in the nine months ended February 28, 2011 compared to the same period in the prior fiscal year which was comprised of reductions in custom feature, data, penalty and toll charges of $1,301,000, $966,000, $554,000 and $475,000, respectively.




41




The decrease in service and installation revenue related to the Company’s two-way operations for the three and nine months ended February 28, 2011 compared to the same period in the prior fiscal year is primarily due to a decrease in billings related to the City of Tyler radio frequency re-banding project.  The total billings for this project decreased by approximately $45,000 and $129,000 for the three and nine months ended February 28, 2011, respectively compared to the three and nine months ended February 28, 2010. In addition, LTR and maintenance service revenue decreased by approximately $33,000 and $113,000 for the three and  nine months ended February 28, 2011, respectively compared to the same period in the prior fiscal year primarily due to a decrease in two-way LTR subscribers and maintenance contracts.





Cost of Service and Installation for the Three and Nine Months Ended February 28, 2011 and 2010





Cost of service and installation expense consists of the following significant components:





(dollars in thousands)February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedCost of service and installationCellular operations

$
1,090


$
1,285


$
(195
)


-15
%Wholesale operations


45



17



28



165
%Two-way operations


393



391



2



1
%Total cost of service and installation

$
1,528


$
1,693


$
(165
)


-10
%Nine Months EndedCost of service and installationCellular operations

$
3,311


$
4,338


$
(1,027
)


-24
%Wholesale operations


75



49



26



53
%Two-way operations


1,189



1,182



7



1
%Total cost of service and installation

$
4,575


$
5,569


$
(994
)


-18
%





The decrease in cost of service and installation related to the Company’s cellular operations for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year corresponds with the decrease in cellular service revenues, which is a result of the Company’s declining cellular subscriber base. The Company experienced cost reductions in bad debt expense and costs associated with the Company’s phone warranty program in the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year.  The Company experienced a decrease in bad debt expense related to its cellular business of $85,000 and $445,000 in the three and nine months ended February 28, 2011, respectively and a decrease in phone warranty program costs of approximately $78,000 and $259,000 in the three and nine months ended February 28, 2011, respectively.  In addition, salaries and other personnel benefits decreased by approximately $63,000 in the nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year due to a reduction in the cellular operations personnel.  The cellular customer service department had 39 employees as of February 28, 2011 compared to 54 employees as of February 28, 2010.





42





Sales Revenue and Cost of Products Sold for the Three and Nine Months ended February 28, 2011 and 2010





(dollars in thousands)

February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedProduct Sales RevenueCellular

$
676


$
950


$
(274
)


-29
%Wholesale


3,089



8,585



(5,496
)


-64
%Two-Way


640



714



(74
)


-10
%Corporate


2



2



-



0
%Total product sales revenue

$
4,407


$
10,251


$
(5,844
)


-57
%Cost of products soldCellular


1,044



1,130



(86
)


-8
%Wholesale


2,644



7,005



(4,361
)


-62
%Two-Way


437



590



(153
)


-26
%Corporate


-



(6
)


6



0
%Cost of products sold

$
4,125


$
8,719


$
(4,594
)


-53
%Nine Months EndedProduct Sales RevenueCellular

$
2,392


$
3,454


$
(1,062
)


-31
%Wholesale


6,942



16,862



(9,920
)


-59
%Two-Way


2,126



2,054



72



4
%Corporate


5



5



-



0
%Total product sales revenue

$
11,465


$
22,375


$
(10,910
)


-49
%Cost of products soldCellular


3,179



3,691



(512
)


-14
%Wholesale


5,787



14,512



(8,725
)


-60
%Two-Way


1,515



1,605



(90
)


-6
%Corporate


(1
)


(17
)


16



0
%Cost of products sold

$
10,480


$
19,791


$
(9,311
)


-47
%





Product sales revenue: The  decrease in product sales from the Company’s cellular operations for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is primarily due to a decrease in cellular phone activations. Cellular phone activations decreased by 402 and 2,073 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year.    The reduction is primarily attributable to the termination of the Company’s Dallas / Fort Worth distribution agreement with AT&T on August 31, 2009. Subsequent to that date, the Company is prohibited from adding new customers to its Dallas / Fort Worth subscriber base.Furthermore, product sales from the cellular operations decreased by approximately $236,000 in the nine months ended February 28 2011 compared to the same period in the prior fiscal year due to Company’s closing its Oklahoma T-Mobile locations during the second quarter of fiscal year 2010.





43





The decrease in product sales from the Company’s wholesale operations for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is primarily related to a decrease in  brokering cellular handsets to domestic and international cellular distributors. Sales of cellular handsets from the Company’s wholesale business decreased by approximately $5,052,000 and $8,992,000 for the three and nine months ended February 28, 2011, respectively compared to the three and nine months ended February 28, 2010. The Company is currently pursuing new direct suppliers of cellular handsets to support the wholesale broker business. Although the Company has not executed a distribution agreement with a direct manufacturer as of the date of this Report, the Company anticipates wholesale revenues will continue to expand throughout the remainder of fiscal year 2011 due to its ability to purchase more products from indirect channels of distribution. In addition, sales of car audio equipment from the Company’s wholesale business decreased by approximately $380,000 and $869,000 in the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year due to the Company experiencing a weak demand for aftermarket car audio products due to a saturated market and fewer small to mid-size electronic retailers.





The decrease in product sales from the Company’s two-way radio operations for the three months ended February 28, 2011 compared to the same period in the prior fiscal year is primarily due to a decrease in sales of two-way radios and radio accessories.  For the three months ended February 28, 2011, sales of two-way radios and radio accessories decreased by approximately $86,000 and $49,000, respectively compared to the three months ended February 28, 2010.  The decrease in revenues is partially offset by an increase in commission revenues of approximately $63,000 for the three months ended February 28, 2011 compared to the same period in the prior fiscal year primarily from certain Motorola sales.  The increase in product sales from the Company’s two-way radio operations for the nine months ended February 28, 2011 compared to the same period in the prior fiscal year is attributable to an increase in commission revenues of approximately $86,000 due to certain Motorola sales.  The increase in revenues is partially offset by a decrease in two-way radio and radio accessory sales of approximately $13,000 in the nine months ended February 28, 2011 compared to the same period in the prior fiscal year.





Cost of products sold:  The decrease in total cost of products sold is primarily a result of the decrease in product sales revenues from the cellular and wholesale operations. The decrease in product costs from the Company’s cellular operations is a direct result of fewer cellular product sales due to the Company’s declining cellular subscriber base. Due to the pricing established across the cellular industry and the Company’s efforts to retain its existing cellular subscribers, cellular equipment sold in conjunction with a new service activation or the renewal of a service contract results in the Company’s subsidizing a substantial portion of the cost of the handset. Although the Company’s wholesale operations experienced a decrease in sales in all periods presented, wholesale profit margins improved in the nine months ended February 28, 2011 compared to the same period in the prior fiscal year due to the cellular handset broker sales transactions in the nine months ended February 28, 2010. The Company experienced an increase in two-way product sales for the nine months ended February 28, 2011 but the costs related to these product sales did not increase accordingly due to the Company receiving an annual sales volume rebate of approximately $35,000 for achieving certain Public Safety Equipment (“PSE”) sales based objectives and the Company increasing commission revenues related to certain Motorola sales with no corresponding costs.  In addition, the Company experienced a decrease in inventory obsolescence expense of approximately $43,000 in the nine months ended February 28, 2011 compared to the same period in the prior fiscal year.




44





Selling and General and Administrative Expenses for the Three and Nine Months ended February 28, 2011 and 2010





Selling and general and administrative expenses consist of the following significant components:





(dollars in thousands)February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedSelling and general and administrativeSalaries and other personnel expenses

$
1,929


$
2,804



(875
)


-31
%Office expense


395



446



(51
)


-11
%Advertising expense


232



111



121



109
%Professional fees


777



461



316



69
%Taxes and licenses fees


17



24



(7
)


-29
%Stock-based compensation expense


40



35



5



14
%Other expenses


377



540



(163
)


-30
%Total selling and general and administrative

$
3,767


$
4,421


$
(654
)


-15
%Nine Months EndedSelling and general and administrativeSalaries and other personnel expenses

$
6,412


$
7,826



(1,414
)


-18
%Office expense


1,262



1,432



(170
)


-12
%Advertising expense


539



456



83



18
%Professional fees


1,629



1,368



261



19
%Taxes and licenses fees


142



117



25



21
%Stock-based compensation expense


345



204



141



69
%Other expenses


1,100



1,191



(91
)


-8
%Total selling and general and administrative

$
11,429


$
12,594


$
(1,165
)


-9
%





The decrease in salaries and other personnel expenses for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is primarily related to the reduction in the Company’s accruals related to the executive’s annual incentive bonus plan.  The executive bonus plan is based upon the Company’s financial performance and whether certain targets are met during the fiscal year. The executive bonus accrual is monitored throughout the fiscal year and adjusted quarterly. Bonus expenses decreased by approximately $525,000 and $875,000 for the three and nine months ended February 28, 2011, respectively compared to the three and nine months ended February 28, 2010.  In addition, the Company experienced a decrease in employee commission expense of approximately $208,000 and $478,000 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year which is attributable to the decrease in sales from the Company’s cellular and wholesale businesses.  Furthermore, the Company’s business restructuring plans decreased the number of employees during the third quarter of fiscal year 2011 which contributed to the additional decrease in salaries and other personnel expenses of approximately $140,000 and $82,000 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year.  The decrease in salaries and other personnel benefits for the nine months ended February 28, 2011 is partially offset by forfeitures the Company utilized in the nine months ended February 28, 2010 due to the forfeiture of certain funds included in the Company’s defined contribution plan.  There were no similar occurring transactions in the nine months ended February 28, 2011.





The decrease in office expense for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is primarily related to a reduction in lease expenses.  The Company had lease expenses of approximately $60,000 in the nine months ended February 28, 2010 related to the Oklahoma T-Mobile locations with no similar occurring transactions in the periods from the prior fiscal year since the locations were closed in the second quarter of fiscal year 2010. In addition, the Company decreased telecommunication expenses of approximately $22,000 and $63,000 in the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year due to consolidating its corporate phone lines.  Furthermore, the Company reduced expenses related to building maintenance and office supplies by approximately $20,000 and $40,000 in the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year.





45





The increase in advertising expense for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is attributable to an increase in sponsorship expenses.  For the three and nine months ended February 28, 2011, the Company increased sponsorship expenses by approximately $94,000 and $42,000, respectively compared to the same periods in the prior fiscal year.  In addition, the Company experienced a decrease in advertising reimbursements from certain vendors of approximately $50,000 and $78,000 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year. The increase in advertising expenses is partially offset by a reduction in general advertising expenses of approximately $22,000 and $28,000 for the three and nine months ended February 28, 2011, respectively compared to the three and nine months ended February 28, 2010.





The increase in professional fees for the three months ended February 28, 2011 compared to the same period in the prior fiscal year is primarily due to an increase in legal fees of approximately $181,000 due to legal costs associated with the pending arbitration with AT&T.  In addition, the increase in professional fees for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is  due to an increase in investor relation expenses and accounting fees. The Company experienced an increase in investor relation expenses of approximately $27,000 and $148,000 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year. The investor relation fees are attributable to the Company hiring a public relations firm to help promote the Company within the investment community.  Furthermore, the Company experienced an increase of accounting fees of approximately $91,000 and $137,000 for the three and nine months ended February 28, 2011, respectively compared to the same periods in the prior fiscal year due to fees associated with completing the Company’s federal and state tax returns as well as the Company reversing accounting fee accruals in fiscal year 2010 primarily due to the SEC granting the Company relief of filing its 2007 Form 10-Q Reports.




The increase in taxes and license fees for the nine months ended February 28, 2011 is attributable to additional sales tax expense recorded related to the Company’s October 2010 cellular billings.





The increase in stock-based compensation expense for the three and nine months ended February 28, 2010 compared to the same periods in the prior fiscal year is due to an increase in the number of stock options granted to the Company’s executive management and Board of Directors in June 2010 as well as an increase in the market value of the underlying common stock since the prior year which drove an increase in the computed fair value of the options. During the first quarter of fiscal year 2011, the Company granted an additional 1,093,167 in stock options which contributed to the increase in stock compensation expense for the three and nine months ended February 28, 2011 compared to the three and nine months ended February 28, 2010.





The decrease in other expenses for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is attributable to a decrease in bad debt expense due to the reclassification of bad debt expenses related to the wholesale operations to the selling and general and administrative category from the cost of services category in third quarter of fiscal year 2010. In addition the Company experienced a decrease in business insurance expense, bank and credit card fees and data processing fees primarily attributable to the reduction in sales for the three and nine months ended February 28, 2011 compared to the three and nine months ended February 28, 2010.  The decrease in the above mentioned expenses are partially offset by an increase in corporate travel and entertainment expenses for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year primarily due to investor related functions.




46





Other Operating Expenses for the Three and Nine Months Ended February 28, 2011 and 2010





(dollars in thousands)February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedOther Operating ExpensesDepreciation and amortization:Depreciation

$
76


$
87


$
(11
)


-13
%Amortization


205



224



(19
)


-8
%Total other operating expenses

$
281


$
311


$
(30
)


-10
%Nine Months EndedOther Operating ExpensesDepreciation and amortization:Depreciation

$
225


$
285


$
(60
)


-21
%Amortization


619



671



(52
)


-8
%Total depreciation and amortization


844



956



(112
)


-12
%Loss (gain) on disposal of assets


(1
)


1



(2
)


0
%Total other operating expenses

$
843


$
957


$
(114
)


-12
%





The decrease in depreciation expense for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is attributable to the Company’s minimal purchases of fixed assets for its corporate offices and retail locations. In addition, the age of certain existing capital assets also contributed to the decrease in depreciation expense in all periods presented. The decrease in amortization expense for the three and nine months ended February 28, 2011 compared to the three and nine months ended February 28, 2010 is due to certain loan origination fees that became fully amortized in fiscal year 2010.





Interest Expense, Net of Interest Income for the Three and Nine Months Ended February 28, 2011 and 2010





(dollars in thousands)

February 28,


2011 vs 20102011


2010


$ Change


% ChangeThree Months EndedInterest Expense (Income)Mortgage debt

$
37


$
41


$
(4
)


-10
%Thermo revolving credit facility


494



528



(34
)


-6
%Warrant redemption notes payable


21



31



(10
)


-32
%Other


1



2



(1
)


-50
%Total interest expense, net

$
553


$
602


$
(49
)


-8
%February 28,


2011 vs 20102011



2010


$ Change


% ChangeNine Months EndedInterest Expense (Income)Mortgage debt

$
114


$
123


$
(9
)


-7
%Thermo factoring debt


-



306



(306
)


-100
%Thermo revolving credit facility


1,484



1,163



321



28
%Warrant redemption notes payable


70



101



(31
)


-31
%Other


4



(19
)


23



-121
%Total interest expense, net

$
1,672


$
1,674


$
(2
)


0
%





The decrease in net interest expense for the three and nine months ended February 28, 2011 compared to the same periods in the prior fiscal year is due to a reduction in the amount of Company’s outstanding debt.  During fiscal year 2011, the Company reduced its outstanding debt by approximately $1,173,000.





47





Income Tax Expense for the Three and Nine Months Ended February 28, 2011 and 2010





In all the periods presented, the Company recorded state tax expense. In the three months ended February 28, 2011 and 2010, the Company recorded approximately $45,000 and $60,000 in state tax expenses, respectively. In the nine months ended February 28, 2011 and 2010, the Company recorded approximately $157,000 and $183,000 in state tax expenses, respectively. The state tax expense relates primarily to the Texas margin tax, which was initially implemented by the state effective January 1, 2008.  The margin tax is calculated by using the Company’s gross receipts from business conducted in Texas each fiscal year less a cost of goods sold deduction.  Due to a reduction in the Company’s gross receipts in Texas, the Texas state tax expense decreased in the three and nine months ended February 28, 2011 compared to the three and nine months ended February 28, 2010.




Financial Condition as of February 28, 2011





(dollars in thousands)

Nine Months Ended February 28,


2011 vs 20102011


2010


$ ChangeCash used in operating activities

$
(1,309
)

$
(968
)

$
(341
)Cash (used in) provided by investing activities


(106
)


723



(829
)Cash used in financing activities


(1,458
)


(542
)


(916
)Net decrease in cash

$
(2,873
)

$
(787
)

$
(2,086
)





Liquidity and Capital Resources





As of February 28, 2011, the Company had approximately $2,059,000 cash on hand and a working capital deficit of approximately $3,603,000 compared to a deficit of approximately $1,240,000 as of May 31, 2010. Although the Company recorded a net loss in the three and nine months ended February 28, 2011 it has had sufficient cash cash to service its liabilities, including its fiscal year 2010 accrued bonuses as well as increase its investment in inventory to support its wholesale and cellular operations.





During the remainder of fiscal year 2011, the Company expects its wholesale and two-way operations to continue to improve by increasing the wholesale broker business due to the Company’s ability to purchase more product from indirect channels of distribution and expects increased two-way sales since the Company was awarded the GSA contract in September 2010. In addition, the Company believes it can maintain a profitable cellular business, although its cellular subscriber base continues to decline, through aggressive cost management. Throughout the remainder of the fiscal year, the Company will continue to focus on providing superior customer service to its existing cellular subscriber base while maximizing revenues through the cellular services offered by PCI and adding additional subscribers in the markets where permitted by AT&T. In addition, the Company is actively pursuing business acquisitions and believes those businesses, once acquired, will add additional revenue and profits to the Company’s existing operations. Throughout the remainder of fiscal year 2011, the Company will continue to monitor its business units to ensure appropriate costs reduction measures are enforced to maximize profitability in all its business units.  In December 2010 and February 2011, the Company restructured its operations to align costs with its declining cellular revenues and estimates monthly cost reductions going forward of approximately $170,000 from its previous fiscal year 2011 levels due to the reduction of overhead and personnel costs. For the remainder of fiscal year 2011, the total debt service obligations for the Company are approximately $620,000. In March 2011, the Company’s independent valuation expert filed initial damages computations with the arbitrator which valued the Company’s damages as a result of AT&T’s actions.  The Company’s expert provided damages computations under several scenarios which included damages assuming PCI’s damages were limited to the liquidated damages provision included in the distribution agreement and several alternate computation of lost profits depending on the timing of which it was determined that PCI should have been allowed to sell the iPhone.  Under the liquidated damages limitation, PCI’s damages are estimated to be $48.9 million.  Under the lost profits computations, PCI’s damages are estimated to be as high as $35.0 million due to lost profits on subscriber transferred to AT&T and those subscribers that PCI did not get because of it not being allowed to sell the iPhone.  Additionally, if it is determined that PCI should also be compensated for the fair value of its subscriber base as of August 31, 2009 (the date of the expiration of the DFW and San Antonio distribution agreements), damages could be increased by $51.8 million, resulting in total damages and compensation due to PCI totaling $86.8 million.





48





Considering the cash on hand, cash forecast to be generated from the cellular subscriber  billings under the continuing portion of the AT&T distribution agreements, cash forecast to be generated from the projected increase in wholesale sales, the payment terms available for obligations owing to AT&T, the impact of recent cost reduction initiatives and the third amendment executed under the Thermo loan facility, the Company believes it will have sufficient cash to meet its obligations for at least the 12 months following the date of this Report.  Furthermore, once the arbitration is complete, regardless of the outcome, the Company’s professional fees will be significantly reduced which will contribute to the cash available to the Company to meet its other obligations. Historically, the Company has demonstrated its ability to aggressively manage expenses in periods of declining revenues or cash shortfalls to generate sufficient cash to run its operations adequately and currently plans to operate in this manner for the foreseeable future and at least through the completion of its litigation against AT&T.  If the Company is unable to significantly reduce its operating costs and if certain vendor payment obligations were accelerated or the current debt holders of the Company are unwilling to offer repayment flexibility to the Company or re-negotiate the terms of the debt in the future, the Company may be unable to service its existing debt obligations, under the terms of the current debt agreements, or fund its operations in the 12 months following the date of this Report. The Company cannot provide assurance it will have a successful outcome or receive monetary award as a result of the pending upcoming conclusion of the arbitration proceedings against AT&T.





Operating Activities





The increase in cash used in the Company’s operating activities during the nine months ended February 28, 2011 compared to the nine months ended February 28, 2010 is primarily attributable to the Company generating a net loss of approximately $1,877,000 for the nine months ended February 28, 2011.  In addition, the Company increased its investment in cellular handset inventories during the three months ended February 28, 2011 compared to the same period in the prior fiscal year in order to keep sufficient inventory on hand for the Company’s wholesale broker business.  The Company was able to offset the  decrease in cash in the nine months ending February 28, 2011 compared to the same period in the previous fiscal year by reducing payments made against the Company’s accounts payable and accrued liabilities balances.





Investing Activities





The decrease in cash provided by the Company’s investing activities for the nine months ended February 28, 2011 compared to nine months ended February 28, 2010 is due to cash receipts received during the first quarter of fiscal year 2010 against former notes receivable. In addition, the Company increased its capital expenditures by approximately $102,000 in the nine months ended February 28, 2011 compared to the nine months ended February 28, 2010.




49





Financing Activities





The increase in cash used in the Company’s financing activities for the nine months ended February 28, 2011 compared to the nine months ended February 28, 2010 is primarily attributable to the receipt of approximately $1,373,000 in cash proceeds during the second quarter of fiscal year 2010.  In November 2009, the Company received an additional draw against the Thermo revolving credit facility primarily to purchase inventory related to the Company’s wholesale broker business. There was no similar occurring transaction in the nine months ended February 28, 2010. In addition, the Company made a payment of $150,000 related to the trademark license (see Note 9 – “Trademark Purchase Obligation” for addition information on the trademark license) in the nine months ended February 28, 2011 with no similar occurring transactions in the nine months ended February 28, 2010.





Off-Balance Sheet Transactions




The Company does not engage in off-balance sheet transactions.




Critical Accounting Estimates





The preceding discussion and analysis of financial condition and results of operations are based upon Teletouch's consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, Teletouch evaluates its estimates and assumptions, including but not limited to those related to the impairment of long-lived assets, reserves for doubtful accounts, provision for income taxes, revenue recognition and certain accrued liabilities. Teletouch bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.





Allowance for Doubtful Accounts: The Company performs periodic credit evaluations of its customer base and extends credit to virtually all of its customers on an uncollateralized basis.





In determining the adequacy of the allowance for doubtful accounts, management considers a number of factors including historical collections experience, aging of the receivable portfolio, financial condition of the customer and industry conditions.  The Company considers an account receivable past due when customers exceed the terms of payment granted to them by the Company.  The Company writes off its fully reserved accounts receivable when it has exhausted all collection efforts, which is typically 90 days following the last payment received from the customer.





Accounts receivable are presented net of an allowance for doubtful accounts of $311,000 and $407,000 at February 28, 2011 and May 31, 2010, respectively.  Based on the information available to the Company, management believes the allowance for doubtful accounts as of those periods are adequate.  However, actual write-offs may exceed the recorded allowance.





The Company evaluates its write-offs on a monthly basis.  The Company determines which accounts are uncollectible, and those balances are written-off against the Company’s allowance for doubtful accounts balance.





Reserve for Inventory Obsolescence:Inventories are stated at the lower of cost (primarily on a moving average basis), which approximates actual cost determined on a first-in, first-out (“FIFO”) basis, or fair market value and are comprised of finished goods. In determining the adequacy of the reserve for inventory obsolescence, management considers a number of factors, including recent sales trends, industry market conditions and economic conditions. In assessing the reserve, management also considers price protection credits the Company expects to recover from its vendors when the vendor cost on certain inventory items is reduced shortly after purchase of the inventory by the Company.  In addition, management establishes specific valuation allowances for discontinued inventory based on its prior experience of liquidating this type of inventory.  Through the Company’s wholesale and Internet distribution channels, it is successful in liquidating the majority of any inventory that becomes obsolete.  The Company has many different electronics suppliers, all of which provide reasonable notification of model changes, which allows the Company to minimize its level of discontinued or obsolete inventory. Actual results could differ from those estimates.  Inventories are stated on the Company’s consolidated balance sheet net of a reserve for obsolescence of $253,000 and $232,000 at February 28, 2011 and May 31, 2010, respectively.




50





Impairment of Long-Lived Assets:In accordance with ASC 360, Property, Plant and Equipment, (“ASC 360”), the Company evaluates the recoverability of the carrying value of its long-lived assets based on estimated undiscounted cash flows to be generated from such assets. If the undiscounted cash flows indicate an impairment, then the carrying value of the assets being evaluated is written-down to the estimated fair value of those assets.  In assessing the recoverability of these assets, the Company must project estimated cash flows, which are based on various operating assumptions, such as average revenue per unit in service, disconnect rates, sales productivity ratios and expenses. Management develops these cash flow projections on a periodic basis and reviews the projections based on actual operating trends. The projections assume that general economic conditions will continue unchanged throughout the projection period and that their potential impact on capital spending and revenues will not fluctuate. Projected revenues are based on the Company's estimate of units in service and average revenue per unit as well as revenue from various new product initiatives. Projected revenues assume a continued decline in cellular service revenue while projected operating expenses are based upon historic experience and expected market conditions adjusted to reflect an expected decrease in expenses resulting from cost saving initiatives.





The Company’s review of the carrying value of its tangible long-lived assets at May 31, 2010 indicated the carrying value of these assets were recoverable through estimated future cash flows.  Because of the sustained losses the Company has incurred during the past several years, the Company also reviewed the market values of these assets.  The review indicated the market value exceeded the carrying value at May 31, 2010.  However, if the cash flow estimates or the significant operating assumptions upon which they are based change in the future, Teletouch may be required to record impairment charges related to its long-lived assets.





The most significant long-lived tangible asset owned by the Company is the Fort Worth, Texas corporate office building and the associated land.  The Company has received periodic appraisals of the fair value of this property. In each instance, the appraised value exceeded the carrying value of the property.





In accordance with ASC 360, Teletouch evaluates the recoverability of the carrying value of its long-lived assets and certain intangible assets based on estimated undiscounted cash flows to be generated from such assets.





The evaluation of the Company’s long-lived intangible assets is discussed in Note 2 under “Intangible Assets.” Under the same premise as the long-lived tangible assets, their market values were also evaluated at May 31, 2010, and the Company determined that based primarily on the market value and supported by the Company’s cash flow projections, there was no impairment of these assets. If the cash flow estimates or the significant operating assumptions upon which they are based change in the future, Teletouch may be required to record impairment charges related to its long-lived assets.





Contingencies:The Company accounts for contingencies in accordance with ASC 450, Contingencies(“ASC 450”). ASC 450 requires that an estimated loss from a loss contingency shall be accrued when information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and when the amount of the loss can be reasonably estimated. Accounting for contingencies such as legal and contract dispute matters requires us to use our judgment. We believe that our accruals or disclosures related to these matters are adequate. Nevertheless, the actual loss from a loss contingency might differ from our estimates.




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Provision for Income Taxes:The Company accounts for income taxes in accordance with ASC 740, Income Taxes, (“ASC 740”) using the asset and liability approach, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of such assets and liabilities. This method utilizes enacted statutory tax rates in effect for the year in which the temporary differences are expected to reverse and gives immediate effect to changes in income tax rates upon enactment. Deferred tax assets are recognized, net of any valuation allowance, for temporary differences and net operating loss and tax credit carry forwards. Deferred income tax expense represents the change in net deferred assets and liability balances. Deferred income taxes result from temporary differences between the basis of assets and liabilities recognized for differences between the financial statement and tax basis thereon and for the expected future tax benefits to be derived from net operating losses and tax credit carry forwards. A valuation allowance is recorded when it is more likely than not that deferred tax assets will be unrealizable in future periods.  On November 1, 2005, the Company became a member of the consolidated tax group of Progressive Concepts Communications, Inc. (“PCCI”) as a result of PCCI’s gaining control of over 80% of the outstanding common stock of Teletouch on that date.  PCCI gained control of Teletouch’s common stock through the conversion by TLL Partners, LLC (“TLLP”), PCCI’s wholly-owned subsidiary, of all of its shares of the Company’s outstanding Series C Preferred Stock into 44,000,000 shares of common stock on November 1, 2005.  As of November 1, 2005, TLLP was a disregarded entity for federal tax purposes since it was at that time a single member limited liability company (“LLC”). Therefore, the parent company of Teletouch for federal tax purposes was deemed to be PCCI.   The Company continued to account for its taxes under ASC 740 and record its deferred taxes on a stand-alone basis while part of PCCI’s consolidated tax group.  In August 2006 as a result certain debt restructuring activities involving TLLP, Teletouch’s direct parent and PCCI’s wholly-owned subsidiary, the Company broke from the PCCI tax group due to new TLLP shares that were issued as part of this restructuring, which resulted in TLLP no longer being disregarded for tax purposes.  Beginning in August 2006, TLLP is taxed as a partnership, and the Company is again separately liable for its federal income taxes.





Goodwill: Goodwill represents the excess of costs over fair value of assets of businesses acquired.  Goodwill and intangible assets acquired in a 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 the provisions of ASC 350, Intangibles-Goodwill and Other, (“ASC 350”). Teletouch’s goodwill was recorded in January 2004 as part of the purchase of the two-way radio assets of Delta Communications, Inc.  The Company decided to test this goodwill annually on March 1st, the first day of its fourth fiscal quarter, of each year unless an event occurs that would cause the Company to believe the value is impaired at an interim date.





At March 1, 2010, the Company evaluated the carrying value of its goodwill associated with its two-way business and concluded that no impairment of its goodwill was required in fiscal year 2010.  The Company estimates the fair value of its two-way business using a discounted cash flow method. The Company continually evaluates whether events and circumstances have occurred that indicate the remaining balance of goodwill may not be recoverable. In evaluating impairment the Company estimates the sum of the expected future cash flows derived from such goodwill. Such evaluations for impairment are significantly impacted by estimates of future revenues, costs and expenses and other factors. A significant change in cash flows in the future could result in an additional impairment of goodwill. No changes occurred in the two-way business during the current quarter that warranted an impairment to goodwill.





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Revenue Recognition:Teletouch recognizes revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements" and ASC 605, Revenue Recognition, (“ASC 605”). In general, ASC 605 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Teletouch believes, relative to sales of products, that all of these conditions are met; therefore, product revenue is recognized at the time of shipment.





The Company primarily generates revenues by providing and billing recurring cellular services and product sales.  Cellular services include cellular airtime and other recurring services provided through a master distributor agreement with AT&T.  Product sales include sales of cellular telephones, accessories, car and home audio products and services and two-way radio equipment through the Company’s retail, wholesale and two-way radio operations.





Cellular and other service revenues and related costs are recognized during the period in which the service is rendered.  Associated subscriber acquisition costs are expensed as incurred.  Product sales revenue is recognized when delivery occurs, the customer takes title and assumes risk of loss, terms are fixed and determinable and collectability is reasonably assured.  The Company does not generally grant rights of return.  However, PCI offers customers a 30 day return/exchange program for new cellular subscribers in order to match programs in place by most of the other cellular carriers.  During the 30 days, a customer may return all cellular equipment and cancel service with no penalty.  Reserves for returns, price discounts and rebates are estimated using historical averages, open return requests, recent product sell-through activity and market conditions.  No reserves have been recorded for the 30 day cellular return program since only a very small number of customers utilize this return program and many fail to meet all of the requirements of the program, which include returning the phone equipment in new condition with no visible damage.  In addition, it is typical to incur losses on the sale of the cellular phone equipment related to signing up customers under a cellular airtime contract; therefore, any reserves recorded for customer returns would be an accrual of gains via reversing the losses incurred on the original cellular phone sale transaction.  The Company does not believe accruing for the potential gains would be in accordance with GAAP but rather records this gain in the period that it is actually realized.





Since 1984, Teletouch’s subsidiary, PCI, has held agreements with AT&T or one of its predecessor companies, which allowed PCI to offer cellular service and customer service to its subscribers.  PCI is responsible for the billing and collection of cellular charges from these customers and remits a percentage of the cellular billings generated to AT&T.  Based on PCI’s relationship with AT&T, the Company has evaluated its reporting of revenues, under ASC 605-45, Revenue Recognition, Principal Agent Considerations, (“ASC 605-45”) associated with its services attached to the AT&T agreements.





Based on its assessment of the indicators listed in ASC 605-45, the Company has concluded that the AT&T services provided by PCI should be reported on a net basis.  Also in accordance with ASC 605-45, sales tax amounts invoiced to our customers have been recorded on a net basis and have no impact on our consolidated financial statements.





Deferred revenue represents prepaid monthly service fees billed to customers, primarily monthly access charges for cellular services that are billed in advance by the Company.





Stock-Based Compensation:We account for stock-based awards to employees in accordance with ASC 718, Compensation-Stock Compensation, (“ASC 718”) and for stock based awards to non-employees in accordance with ASC 505-50, Equity, Equity-Based Payments to Non-Employees (“ASC 505-50”). Under both ASC 718 and ASC 505-50, we use a fair value based method to determine compensation for all arrangements where shares of stock or equity instruments are issued for compensation. For share option instruments issued, compensation cost is recognized ratably using the straight-line method over the expected vesting period. The Company estimates the fair value of employee stock options on the date of grant using the Black-Scholes model. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards and the actual and projected employee stock option exercise behaviors. The Company has elected to estimate the expected life of an award based on the SEC approved “simplified method”. We calculated our expected volatility assumption required in the Black-Scholes model based on the historical volatility of our stock. We will update these assumptions on at least an annual basis and on an interim basis if significant changes to the assumptions are warranted.




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Item 3.  Quantitative and Qualitative Disclosures About Market Risk





The Company did not have any foreign currency hedges or other derivative financial instruments as of February 28, 2011.  We do not enter into financial instruments for trading or speculative purposes and do not currently utilize derivative financial instruments.  Our operations are conducted primarily in the United States and as such are not subject to material foreign currency exchange rate risk.





Item 4. Controls and Procedures





Evaluation of Disclosure Controls and Procedures





As of the end of the period covered by this Report, the Company conducted an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer, President and Chief Operating Officer and Chief Financial Officer (the “Certifying Officers”) of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on this evaluation, the Certifying Officers concluded that, as of February 28, 2011 and through the filing of this quarterly report, the Company’s disclosure controls and procedures were not effective due to material weaknesses in internal control over financial reporting as described below.





Material Weaknesses in Internal Control Over Financial Reporting





A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of interim or annual financial statements will not be prevented or detected on a timely basis by the company’s internal controls. Management has concluded that the following control deficiency constitutes a material weakness as of February 28, 2011:





Controls over Sales and Use Taxes: During the quarter ended November 30, 2010, the Certifying Officers determined that control procedures were not effective in providing adequate review and oversight of the calculation of the sales tax payables.  The Company’s billing system does not incorporate any type of automated sales tax rate verification process or external rate table database and currently relies on manual entry of sales tax rates when a customer and billing services are setup.  In part, due to the manual nature of this process, errors were made in the tax rates rate setup and the computation of sales taxes on certain services that were billed.  These errors were not detected in a timely manner due to lack of experience of the personnel assigned to manage the Company’s sales tax processes. The Company also believes there was no  sufficient oversight of the changes to the billing system as they pertained to sales tax computations.  The control deficiency was discovered during the preparation for a sales and use tax audit by the State of Texas. This control deficiency may result in additional payments to the State of Texas for incorrectly calculated taxes and taxes not collected on services provided.





Remediation Steps to Address Material Weakness





The Company’s remediation efforts, as outlined below, were implemented in a timely fashion and were designed to address the material weaknesses identified and to strengthen the Company’s internal control over financial reporting.




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During the quarter ending November 30, 2010, the Company’s management, with the assistance of third party consultants, initiated the following activities to address the root causes of the sales and use tax material weakness:




•
The Company’s billing system was modified to default to the maximum sales tax rate allowed by the State of Texas unless a more correct rate was able to be determined through a specific review of customer information and the products and services being billed.


•
The Company’s billing system was set to default to apply sales tax to all sales transactions and access to make changes to the tax status in the billing system was limited to group of personnel responsible for verification of customer exemption status.





•
Responsibility for sales tax processing was transferred from the Company’s information technology department to the finance department under the direction of personnel with expertise in sales and use tax compliance.  In addition, a sales tax consulting firm was engaged to provide support for specific applications of sales and use taxes related to the Company’s sales transactions.





•
Established a monthly process was established to manually re-compute the taxes on a random sampling of invoices to ensure that the billing system computations are correct.





•
A sales tax consulting firm has been engaged to integrate sales tax processing system into the Company’s billing system that will maintain current tax rates and automatically determine taxability of products or services when they are invoiced.





At this time, the Company has completed all of the remediation steps listed above with the exception of applying a process to re-compute the taxes on a random sampling of invoices on a monthly basis and implementing a third party sales tax processing system. Through the date of the Report, the Company is working on executing these two activities and effecting a procedure to test and monitor all the activities listed above during the fourth quarter of the fiscal year ending May 31, 2011.





Changes in Internal Controls Over Financial Reporting





Other than the changes noted above related to the Company’s remediation efforts with respect to the material weaknesses it identified, there was no change in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.




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Part II.  Other Information





Item 1.    Legal Proceedings





Teletouch is subject to various legal proceedings arising in the ordinary course of business. Except as set forth below, the Company believes there is no proceeding, either threatened or pending, against it that could result in a material adverse effect on its results of operations or financial condition.





AT&T Binding Arbitration: In late June 2007, Apple, Inc. introduced the iPhone to the United States in an exclusive distribution and wireless services partnership with AT&T. AT&T was at the time, and remains today, the only authorized carrier provider for the iPhone. Since that time, AT&T has refused to allow the Company to sell the iPhone as well as other products and services, despite AT&T’s contractual obligation to do so under its previously executed distribution agreements between AT&T and the Company. Furthermore, the Company asserts that AT&T has continued to make direct contact with Company customers and aggressively markets, advertises and promotes the iPhone and other AT&T exclusive products and services to Company customers in an attempt to induce them to switch to AT&T.





In June 2007, the Company serviced approximately 83,000 cellular subscribers. Through February 28, 2011, more than 26,100 subscribers have transferred their accounts to AT&T, with a significant percentage of these solely due to the exclusive availability of the iPhone through AT&T and Apple designated retail outlets only.





Since July 2007, the Company had attempted to negotiate with AT&T for the purpose of obviating the need for legal action. However, such attempts failed. Therefore, on September 30, 2009, the Company, through the legal entity Progressive Concepts, Inc. (“PCI”), commenced an arbitration proceeding against New Cingular Wireless PCS, LLC and AT&T Mobility Texas LLC (collectively, “AT&T”) seeking a minimum $100 million in damages. The binding arbitration was commenced to seek relief for damages incurred as AT&T has prevented PCI from selling the popular iPhone and other AT&T exclusive products and services that PCI is and has been contractually entitled to provide to its customers under distribution agreements between PCI and AT&T. The action further asserts that AT&T violated the longstanding non-solicitation provisions of the DFW market distribution agreement by and between the companies by actively inducing customers to leave PCI for AT&T. PCI is represented in the matter by the Company’s legal counsel, Bracewell & Giuliani, LLP.





Following the Company’s commencement of the arbitration proceeding, AT&T filed certain counterclaims with the arbitrator seeking an unspecified amount of damages from PCI and claiming that PCI was operating in violation of certain provisions of the distribution agreements and such agreements should therefore be cancellable by AT&T.




On February 28, 2010, Teletouch and its wholly-owned subsidiary, PCI, as Claimant and AT&T as Respondent received the Agreed Scheduling Order from the Judicial Arbitration and Mediation Services, Inc. (“JAMS”) Arbitrator assigned to the binding arbitration. Among other matters, including the provision of the Rules and Law governing the arbitration, the Agreed Scheduling Order set out the proposed completion dates for Discovery, Depositions, Dispositive Motions and Briefing Deadlines, culminating in an Arbitration hearing period scheduled for November 8, 2010 through November 12, 2010.





On August 10, 2010, the Agreed Scheduling Order was amended by the JAMS Arbitrator after being petitioned by AT&T for additional time to prepare for the hearing.  As a result, all interim completion dates to prepare for the hearing have been extended with the Arbitration hearing period re-scheduled for March 21, 2011 through March 25, 2011.




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On December 23, 2010, the Company received a second amended Agreed Scheduling Order by the JAMS Arbitrator after AT&T requested another extension of time to complete the required Depositions.  The Arbitration hearing period has been postponed to June 13, 2011 through June 17, 2011.





In March 2011, depositions of Company’s executive management team and other key personnel as well as the majority of the AT&T personnel selected were completed as required under the arbitration process.  Also in March 2011, both the Company’s and AT&T’s independent valuation experts filed initial damages computations with the arbitrator which valued each party’s respective damages as a result of the other party’s actions.   The Company’s expert provided damages computations under several scenarios which included damages assuming PCI’s damages were limited to the liquidated damages provision included in the distribution agreement and several alternate computation of lost profits depending on the timing of which it was determined that PCI should have been allowed to sell the iPhone.  Under the liquidated damages limitation, PCI’s damages are estimated to be $48.9 million.  Under the lost profits computations, PCI’s damages are estimated to be as high as $35.0 million due to lost profits on subscriber transferred to AT&T and those subscribers that PCI did not get because of it not being allowed to sell the iPhone.  Additionally, if it is determined that PCI should also be compensated for the fair value of its subscriber base as of August 31, 2009 (the date of the expiration of the DFW and San Antonio distribution agreements), damages could be increased by $51.8 million, resulting in total damages and compensation due to PCI totaling $86.8 million.  AT&T’s expert computed AT&T’s damages in the range of $7.6 million to $9.9 million, depending on the arbitrator’s interpretation of the San Antonio distribution agreement.





For a detailed description of the Company’s legal proceedings and legal action Notice and Initial Statement of Claim, please refer to the related Form 8-K, filed with the SEC October 1, 2009, which is incorporated by reference herein.




Item 1A.   Risk Factors





Certain additional risk factors have been identified during 2011, as disclosed below, and we have provided updates where necessary to those risk factors disclosed in our Annual Report for the fiscal year ended May 31, 2010 filed with the SEC on August 30, 2010.





Risk Factors Identified During Fiscal Year 2011





Our reduced cash balances may impede our ability to support our operations, service our debt or satisfy our vendors’ payment terms.





Due to our declining revenues and use of cash to sustain our ongoing operations, the Company cash balances have declined significantly since May 2010.  Extraordinary costs, including funding our ongoing arbitration with AT&T, and certain payment obligations have also contributed to the decline in our cash balances.  We believe that we currently have sufficient cash to operate our business for the next 12 months.  Our cash needs for the next 12 months are dependent on our ability to develop new sources of revenue and margins, further reduction in costs to improve profitability, securing financing to continue our existing operations, or securing financing to acquire a new business.  The completion of any of these activities to provide cash to continue the business cannot be assured but the Company has demonstrated prior success in managing its costs in times of declining revenues.  If our cash flows and cash balances continue to decrease, we may be unable to continue to service our current debt obligations which could also negatively affect our business.  In the event that our business initiatives do not materialize or additional financing is unable to be secured, we will be forced to continue to eliminate costs and delay payments to certain vendors in order to provide sufficient operating cash to sustain the business through the final hearing on the AT&T arbitration which is currently scheduled for June 2011.  We can provide no assurance of a favorable outcome resulting in an award of damages or such outcome being in the range we anticipate or previously estimated and updated herein at the conclusion of our arbitration with AT&T nor can we ensure that this hearing will not be delayed beyond June 2011.  An unfavorable ruling or further delays in the AT&T arbitration may have a material impact on our financial condition and impede our ability to sustain operations.


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Due to uncertainty in the application and interpretation of applicable state sales tax laws, we may be exposed to additional sales tax liability.





During the quarter ended November 30, 2010 and as a result of preparing for a sales and use tax audit, we identified issues with the prior application and interpretation of sales taxes rates assessed on services billed to its cellular subscribers. Prior sales tax audits on these billings have not detected these issues although the methodology for computing sales taxes was similar in these prior periods.  We believe it is probable that these issues will be identified and challenged in the current audit based on the initial inquiries by the sales tax auditor.  As of the date of this Report, we are unable to estimate the outcome of the audit but estimate a range of potential liability between $22,000 and $2,490,000. This range includes a low estimate based on similar audit results as in prior periods to a high estimate based on a conservative application of sales tax rates to all cellular services billed and including underpayment penalties and interest.  The application of various sales tax laws and rates to our cellular services previously billed is complex, however, the actual liability could fall outside of our range of estimates due to items identified during the audit but not considered by us. Any liability assessed as a result of this audit would negatively impact our financial condition but in the event the assessed liability is closer to the upper end of the range estimated, the Company would currently not have sufficient cash on hand to meet this obligation and would be forced to negotiate a payment plan.  If successful in securing financing on such a tax obligation, the assets of the Company would likely become subject to a tax lien which could have the effect of limiting our ability to secure new financing or by triggering a default under agreements with our current lenders.





We are exposed to credit risk, collection risk and payment delinquencies on its accounts receivable.





None of our outstanding accounts receivables are secured. Our standard terms and conditions permit payment within a specified number of days following the receipt of services or products. While we have procedures to monitor and limit exposure to credit risk on our receivables, there can be no assurance such procedures will effectively limit collection risk and avoid losses. To date, our losses on uncollectible receivables have been within historical trends and expectations but due to continuing poor economic conditions, certain of our customers have faced and may face liquidity concerns and have delayed and may delay or may be unable to satisfy their payment obligations.  Additionally, a sizable number of our cellular subscribers have transferred their services to AT&T to purchase the iPhone or other services that we have not been allowed to offer.  Balances due to us by customers that transfer to AT&T have proven difficult to collect once their service has been established with AT&T directly.  Both of these factors, among others, may have a material adverse effect on our financial condition and operating results in future periods.





Adverse conditions in the global economy and disruption of financial markets may significantly restrict our ability to generate revenues or obtain debt or equity financing.





The global economy continues to experience volatility and uncertainty. Such conditions could reduce demand for our products and services which would significantly jeopardize our ability to achieve our sales targets. These conditions could also affect our potential strategic partners, which, in turn, could make it much more difficult to execute a strategic collaboration. Moreover, volatility and disruption of financial markets could limit our customers’ ability to obtain adequate financing or credit to purchase and pay for our products and services in a timely manner, or to maintain operations, and result in a decrease in sales volume. General concerns about the fundamental soundness of domestic and international economies may also cause customers to reduce purchases. Changes in governmental banking, monetary and fiscal policies to restore liquidity and increase credit availability may not be effective. Economic conditions and market turbulence may also impact our suppliers’ ability to supply sufficient quantities of product components in a timely manner, which could impair our ability to fulfill sales orders. It is difficult to determine the extent of the economic and financial market problems and the many ways in which they may affect our suppliers, customers, investors, and business in general. Continuation or further deterioration of these financial and macroeconomic conditions could significantly harm sales, profitability and results of operations.  Economic downturns or other adverse economic changes (local, regional, or national) can also hurt our financial performance in the form of lower interest earned on investments and/or could result in losses of portions of principal in our investment portfolio.





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We may be unable to attract and retain key personnel.





Our future success depends on the ability to attract, retain and motivate highly skilled management, including sales representatives. To date, we have retained highly qualified senior and mid-level management team, but cannot provide assurance that we will be able to successfully retain all of them, or be successful in recruiting additional personnel as needed. Our inability to do so will materially and adversely affect the business prospects, operating results and financial condition. Our ability to maintain and provide additional services to our customers depends upon our ability to hire and retain business development and technical personnel with the skills necessary to keep pace with continuing changes in telecommunications industry. Competition for such personnel is intense.  Our ongoing litigation with AT&T and the necessary layoffs to align costs with our declining cellular revenues has created an environment of uncertainty for certain of our key personnel within this business segment.  Our inability to hire additional qualified personnel to support our existing cellular business may lead to higher levels of customer attrition or could result in higher recruiting, relocation and compensation costs for such personnel. These accelerated losses of revenues or increased costs may continue to erode our profit margins and make hiring new personnel impractical.





We are experiencing increasing competition in the marketplace for our cellular subscribers, and our primary competitor, AT&T, has significantly greater financial and marketing resources than us.





In the market for telecommunications products and services, we face competition from several competitors, but most notably from our primary supplier, AT&T.  AT&T continues to develop and is expected to continue developing products and services that may entice our cellular subscribers to move their services to AT&T directly.   Although this is the basis for our ongoing litigation with AT&T, the resolution to this litigation has been delayed for many months past our initial expectations (hearing delayed from November 2010 to June 2011 as of the date of this Report).  If we are not able to participate in these products and services, we will continue to lose subscribers to AT&T and possibly at an accelerated rate in the future and our financial condition will be materially and adversely affected. We cannot assure that we will be able to slow the rate of attrition of our cellular subscribers to AT&T or that AT&T will make any of its new products or services available to us in the future. AT&T has substantially greater capital resources, larger marketing staffs and more experience in commercializing products and services.  The losses of our cellular subscribers to AT&T to date has had a material but manageable impact on our financial condition but if we are unable to slow the subscriber losses, develop new revenues and margins to offset these losses or the litigation is further delayed and not settled in our favor, we will be forced to make further significant cost reductions in the business to sustain our operations which in turn may only accelerate our losses of revenues.




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Updated and Continuing Risk Factors Disclosed in Our Prior Annual Report
 
 Amounts due under our senior revolving credit facility could accelerate as a result of continued losses of our cellular subscribers which could result in an operating cash deficiency and an inability to continue servicing the debt obligation.





We have historically relied upon our revolving credit facility with Thermo Credit, LLC (“Thermo”) to fund our working capital and operating needs. Initially, this facility provided sufficient available borrowings for us since underlying assets pledged as collateral were growing.  The primary asset pledged as collateral is our accounts receivable.  The launch of the iPhone in June 2007 and AT&T’s refusal to allow us to sell the iPhone has resulted in a steady decline in our subscriber base, the related billings and accounts receivable.  This decline in the subscriber base and related billings was accelerated as a result of the expiration our primary DFW distribution agreement with AT&T in August 2009, which ended our ability to add new subscribers and to allow AT&T subscribers in the DFW market to move their cellular services to us.  Prior to August 2009, transfers of customers from AT&T had partially offset some of the losses of customers leaving to purchase the iPhone from AT&T or Apple.  This decline in cellular billings and accounts receivable has directly reduced the borrowings available under the credit facility resulting in over-advances outstanding against the credit facility. We had to borrow the maximum amount available against our assets for certain debt restructuring transactions in addition to fund our working capital needs so the majority of the borrowed funds are not held in cash or other short term assets that would allow us to service an accelerated repayment of the credit facility.  To date, Thermo has allowed us to remain periodically over-advanced on the facility, extended certain repayment terms, modified certain scheduled debt amortization and has continued to allow the inclusion of certain assets in the computation of its borrowing base, which in turn has allowed us to meet our obligations. In addition, Thermo has granted the Company periodic non-compliance waivers when the Company could not meet its prior agreed debt service coverage ratio and positive operating income covenants in the second and third quarters of fiscal year 2011. If Thermo were to require repayment of all current over-advanced funds, we would likely experience operating cash deficiencies up to and including being unable to meet its obligations under this revolving credit facility. To the extent that we are unable to refinance this debt, we would likely not have the means to fully repay Thermo from the cash on hand or generated from current operations resulting in the possibility of a foreclosure on all of the assets of the Company. In March 2011, the Company executed a third amendment under its credit facility agreement with Thermo which among other things extended the maturity date of the facility to January 2013 and deferred certain principal payments (see Note 8 – “Long-Term Debt” for further discussion on the third amendment to the Thermo credit facility). The Company cannot provide assurance Thermo would not accelerate the amount due under the credit facility if the Company is not in compliance with the covenants under its debt agreement with Thermo going forward.





An accelerated reduction in our cellular subscriber base could have a material adverse effect on our business.





The launch of the iPhone in June 2007 and AT&T’s refusal to allow us sell the iPhone has resulted in a steady decline in our cellular subscriber base (see Item 1. Legal Proceedings for discussion of the action brought against AT&T related to the iPhone and other matters). This decline in our cellular subscriber base was accelerated as a result of the expiration of our primary DFW distribution agreement with AT&T in August 2009. We continue lose subscribers to AT&T and are currently seeking relief through a binding arbitration process that it initiated in September 2009. As AT&T continues to release new products or services that are not made available to us, losses of cellular subscribers will continue. If any of these products or services become in extraordinary demand or are required by consumers or businesses, the result could be an acceleration of cellular subscriber losses to AT&T.  Although we maintain contracts varying from one to two years with our current cellular customers, the customer may voluntarily elect to transfer to another carrier, including AT&T, at any time and incur a penalty fee. If expenses related to our cellular operations are not adjusted accordingly due to a declining subscriber base, we will have to rely upon our other business units to replace the revenue and income loss from its cellular operations. We can provide no assurance that any of our other existing business units could generate enough revenue in a timely manner to cover the losses sustained from a rapidly declining cellular subscriber base. We also can provide no assurance that our customers will continue to purchase products or services from us or that their purchases will be at the same or greater levels than in prior periods.




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We may be unsuccessful in the arbitration with AT&T and could incur a significant obligation from the outcome of the arbitration or an unfavorable outcome from the arbitration could have a material adverse effect on the business.





Since July 2007, we have attempted to negotiate with AT&T for the purpose of obviating the need for legal action. However, such attempts have failed. Therefore, on September 30, 2009, the Company, through the legal entity Progressive Concepts, Inc. commenced an arbitration proceeding against New Cingular Wireless PCS, LLC and AT&T Mobility Texas LLC (collectively, “AT&T”) seeking at least $100 million in damages. The binding arbitration was commenced to seek relief for damages incurred as AT&T has prevented PCI from selling the popular iPhone and other “AT&T exclusive” products and services that PCI is and has been contractually entitled to provide to its customers under distribution agreements between PCI and AT&T. In response to PCI’s initiating its legal action, AT&T filed certain counterclaims in the arbitration, including seeking monetary damages for equipment transactions between the parties and certain alleged breaches of the distribution agreement by the Company. In March 2011, both the Company’s and AT&T’s independent valuation experts filed initial damages computations with the arbitrator which valued each party’s respective damages as a result of the other party’s actions.   AT&T’s expert computed AT&T’s damages to over a range of $7.6 million to $9.9 million depending on the arbitrator’s interpretation of the San Antonio distribution agreement.





If we do not prevail in our claim against AT&T, then the expected result is that we would continue to service our subscribers under the distribution agreement and would not be awarded any monetary damages. While we believe that AT&T’s counterclaims are baseless, if AT&T prevails in its counterclaims during the arbitration, we could potentially be held liable for certain payments to AT&T or it could be ruled that we had defaulted on certain terms and conditions of the distribution agreement as a result of actions alleged in these counterclaims which could give AT&T the right to terminate the distribution agreements. We can provide no assurance that we will prevail in the arbitration against AT&T or be able to defend against the counterclaims raised by AT&T or pay any obligations due to AT&T in the event they were to prevail in any of their counterclaims.





Our parent company may be unable to meet its future financial obligations resulting in a change in control of the Company.





Prior to the acquisition of PCI in August 2006, TLL Partners, LLC (“TLLP”), Teletouch’s parent company, assumed all of the remaining institutional debt of PCI, whereby the senior debt obligations formerly at PCI were transferred to TLLP as senior debt obligations and the subordinated debt obligations of PCI were partially settled by the issuance of Teletouch’s common stock owned by TLLP with the balance converted to redeemable Series A preferred units of TLLP. To secure the senior debt obligation, TLLP pledged all of its then held assets, which consist primarily of its holding of approximately 80% of the outstanding common stock of Teletouch. When the senior debt originally matured in August 11, 2007, TLLP did not have sufficient cash or other means to repay this debt and was successful in negotiating an initial extension of the maturity date through October 11, 2007. Subsequent extensions were granted by the senior debt holder to TLLP extending the maturity date through January 31, 2011. TLLP is a holding company with no operations with a minimal amount of cash on hand and may be dependent upon selling a sufficient number of shares it owns in Teletouch common stock or upon the cash flows of Teletouch through the receipt of future cash dividends to service its outstanding debt obligations. The Company has no current agreements with TLLP to fund cash obligations nor does it have any current plans to declare dividends in order to allow TLLP to meet the debt obligations. TLLP’s management has communicated to the Company that it is currently working to sell a sufficient number of shares of Teletouch’s common stock to retire its senior debt obligation. As of the date of this Report and to the best of the Company’s knowledge, TLLP has sold 2,616,666 shares of the Company’s common stock it beneficially owns, representing approximately 5.4% of the Company’s outstanding securities. If TLLP is unsuccessful in repaying its obligations and its lenders foreclose on Teletouch’s common stock owned by TLLP it may result in a change control of our Company, then there is a risk that these lenders could vote through matters that may not be in the best interest of the shareholders of Teletouch as a whole.





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Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds





None





Item 3.    Defaults Upon Senior Securities





None





Item 4.    [Removed and Reserved]





Item 5.    Other Information





None





Item 6.  Exhibits





ExhibitNumber

Title of Exhibit31.1

Certification pursuant to Rule 13a-14(a) and Rule 15d-14(a)31.2

Certification pursuant to Rule 13a-14(a) and Rule 15d-14(a)32.1

Certification pursuant to 1350, Chapter 63, Title 18 of United States Code32.2

Certification pursuant to 1350, Chapter 63, Title 18 of United States Code





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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.




Date: April 14, 2011
TELETOUCH COMMUNICATIONS, INC.RegistrantBy:
/s/ Robert M. McMurreyRobert M. McMurrey

Chief Executive Officer(Principal Executive Officer)By:
/s/ Douglas E. SloanDouglas E. Sloan

Chief Financial Officer

(Principal Financial and Accounting Officer)





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