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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended
    
    Commission File Number:December 31, 2003
    
    0-10211
 INTER-TEL, INCORPORATED Incorporated in the State of Arizona
    
    I.R.S. No. 86-0220994
 1615 S. 52nd Street
Tempe, Arizona 85281
(480) 449-8900   Securities registered pursuant to Section 12(g) of the Act: Common Stock
(25,626,871 shares outstanding as of March 5, 2004) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes[X] No[  ] Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (S 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrants knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K - [X]. Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [  ]. The aggregate market value of the voting stock held by non-affiliates of the
registrant, based upon the last reported sales price of Inter-Tels Common
Stock reported on the Nasdaq National Market System on June 30, 2003 was
approximately $417.0 million. Shares of Common Stock held by each executive
officer and director have been excluded in that such persons may be deemed to
be affiliates. Selected portions of
Item 10, and Items 11, 12, 13 and 14 of Part III incorporate
by reference information from the Registrants Proxy Statement relating to its
2004 Annual Meeting of Shareholders. The Proxy Statement relating to the
Registrants 2004 Annual Meeting of Shareholders will be filed within 120 days
of the Registrants fiscal year ended December 31, 2003.




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TABLE OF CONTENTS  PART IITEM 1. BUSINESSITEM 2. PROPERTIESITEM 3. LEGAL PROCEEDINGSITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSPART IIITEM 5. MARKET FOR THE REGISTRANTS COMMON STOCK AND RELATED SHAREHOLDER MATTERSITEM 6. SELECTED FINANCIAL DATAITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREITEM 9A. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURESPART IIIITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTITEM 11. EXECUTIVE COMPENSATIONITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICESPART IVITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-KSIGNATURESExhibit IndexEX-10.63EX-10.64EX-13.0EX-21EX-23EX-31.1EX-31.2EX-32.1EX-32.2    Table of Contents  INTER-TEL, INCORPORATED
2003 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS PagePART IItem 1
    
    Business
    

    
    3Item 2
    
    Properties
    
    
    23Item 3
    
    Legal Proceedings
    
    
    23Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    23PART IIItem 5
    
    Market for the Registrants Common Stock and Related Shareholder Matters
    
    
    24Item 6
    
    Selected Financial Data
    
    
    25Item 7
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    26Item 7A
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    43Item 8
    
    Financial Statements and Supplementary Data
    
    
    44Item 9
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    44Item 9A
    
    Evaluation of Disclosure Controls and Procedures
    
    
    44PART IIIItem 10
    
    Directors and Executive Officers of the Registrant
    
    
    44Item 11
    
    Executive Compensation
    
    
    46Item 12
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    46Item 13
    
    Certain Relationships and Related Transactions
    
    
    46Item 14
    
    Principal Accountant Fees and Services
    
    
    46PART IVItem 15
    
    Exhibits, Financial Statement Schedule and Reports on Form 8-K
    
    
    47Signatures
    
    
    50
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PART I 
 ITEM 1. BUSINESS The Company This Annual Report to Shareholders onForm 10-K(10-K) contains
forward-looking statements that involve risks and uncertainties. The
statements contained in this 10-K that are not purely historical are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of
1934, as amended, including without limitation statements regarding the
Companys expectations, beliefs, intentions or strategies regarding the future.
All forward-looking statements included in this document are based on
information available to the Company on the date hereof, and the Company
assumes no obligation to update any such forward-looking statements. The
cautionary statements made in this 10-K should be read as being applicable to
all related forward-looking statements wherever they appear in this document.
The Companys actual results could differ materially from those anticipated in
these forward-looking statements as a result of certain factors, including
those set forth under Factors That May Affect Future Operating Results below
and elsewhere in this document. In evaluating the Companys business,
shareholders and prospective investors should consider carefully the following
factors in addition to the other information set forth in this document. Inter-Tel, incorporated in 1969, is a single point of contact,
full-service provider of converged voice and data business communications
systems; related networking applications; and presence management,
collaboration, and messaging applications. Our diverse suite of applications
includes unified communications; voice processing and unified messaging
software; audio, video and Web conferencing applications; workgroup and call
center management solutions; Internet Protocol (IP) telephony software;
Computer Telephony Integration (CTI) applications; and other communications
services. Our communications platforms include Inter-Tel Axxess® and EncoreCX®
business communication systems. We also provide managed services such as,
local and long distance calling services; networking; maintenance; leasing; and
support services for our products. Our customers include business enterprises,
government agencies and non-profit organizations. Our common stock is quoted on
the Nasdaq National Market under the symbol INTL. We have developed a distribution network of direct sales offices, dealers
and value added resellers (VARs), which sell our products to organizations
throughout the United States and internationally, primarily targeting
small-to-medium enterprises, service organizations and governmental agencies.
As of March 5, 2004, we had fifty (50) direct sales offices in the United
States, one (1) in Japan, and a network of hundreds of dealers and VARs
primarily in the United States, that purchase directly from us. Included in
our sales office in Phoenix is the primary location for our national and
government accounts division, as well as our local, long distance and network
services divisions. Our wholesale distribution center is located in Tempe,
Arizona, which is the primary location from which we distribute products to our
network of direct sales offices, dealers and VARs. In addition, we maintain a
wholesale distribution office in the United Kingdom that supplies Inter-Tels
dealers and distributors throughout the UK and other parts of Europe, and we
have dealers in Japan and Mexico. We also maintain a research and development
and software sales office in the United Kingdom. PRODUCTS AND SERVICES Inter-Tel is focused on the enterprise telecommunications market and has a
track record of technological innovation and leadership. Inter-Tel serves
business enterprise customers, such as manufacturers, healthcare providers, the
automotive industry, financial institutions, government agencies, non-profit
organizations and other service organizations with value-driven solutions. Our
core products include converged business communications systems supporting
scalable networked installations, IP telephony products and services, audio,
video and Web conferencing solutions, computer telephony applications, unified
messaging and voice processing software. Inter-Tel addresses current industry-standard terminology by categorizing
its software and endpoints under the following four technology categories:
Infrastructure, Presence, Collaboration and Messaging. 3




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We also offer a complete line of managed services, including custom
development, local and long distance calling services, network design and
implementation services, maintenance services, leasing and support services.
In addition, we resell peripheral data and telecommunications products. Infrastructure Axxess® Converged Communications Platform Designed for business enterprises, the Axxess converged communications
platform provides tightly integrated voice processing, IP telephony
functionality and transparent networking throughout an organization. With an
Inter-Tel converged system, our customers can network up to 63 systems together
with full-feature transparency, allowing customers to choose between
traditional T-1 lines, frame relay, managed bandwidth or the Internet to
network sites. Our commercially available systems support up to 40,000 ports,
which enables flexible growth options up to this level. The Axxess platform incorporates open interfaces, employs the standard
programming languages C++ and JAVA, and is built on a computer telephony
interface, which enables the seamless integration of Computer Telephony (CT)
applications, development and customization. The modular platform can be
tailored around the way an organization does business with the flexibility to
modify the solution with growth or change. Our converged system combines Internet Protocol (IP), digital, analog and
wireless into a single platformgiving our customers a choice of technologies
based on their organizations needs. Whether our customers want to blend
traditional and IP solutions or deploy full IP solutions, Inter-Tel offers a
collection of applications and endpoints that enable them to benefit from IP
telephony. The distributed architecture enables the connectivity of several
phones in an office, of hundreds of phones in a building or on a campus, for
remote and telecommuting associates, or even for geographically-dispersed
offices. All advanced features of the Axxess system, such as Automated Call
Distribution (ACD) hunt groups, call center applications, paging zones,
centralized attendants and tightly integrated voice mail, remain in place even
when an organization is networking over IP. By using IP-based endpoints and data networks, our customers can connect
their local employees, remote staff and satellite offices as if they were all
located in a single site. Our IP phones enable remote users to have access to
advanced features, such as transferring calls, conferencing, accessing voice
mail, record-a-call and more. Even call center agents working off-site do not
sacrifice functionality. They can be members of ACD hunt groups or call
routing patterns, and supervisors can monitor their calls as if they were in
the same office. Additionally, our IP phones eliminate the need for a separate
phone system in geographically dispersed locations. Inter-Tels IP Resource Card (IPRC) allows our customers to transparently
network their locations over IP or Frame Relay networks. The IPRC is a
multipurpose card for IP-based communications. Controlled through software,
the IPRC can be used to network multiple locations without the need for a
separate gateway, to connect IP endpoints or to connect remote IP gateways. In
November 2003, Inter-Tel incorporated numerous enhancements to the IPRC. The
IPRC now supports up to 32 IP devices, effectively doubling the capacity of
each modular slot within the chassis. As businesses move toward the converged communications model, a common
concern remainshow best to leverage existing hardware and software.
Connectivity protocolsSIP (Session Initiation Protocol) in particularprovide
the architecture of how infrastructure and applications connect. SIPs primary
role is that of a communications pathconnecting diverse communication tools
together so that they can speak to each other. SIP enables simple, flexible
connectivity that allows infrastructures, applications and endpoints to
interact in a standard manner. Standards-based convergence solutions enable businesses to maintain their
current communications investments during transition to the converged model.
The open nature of SIP presents interoperability opportunities that make
transport and connectivity transparent. SIP provides immediate impact and
enhancement to existing communications platforms, leveraging the benefits of
todays integrated applications. Inter-Tels convergence approach to communications enables us to deliver
dynamic, blended, custom-tailored communications solutions that address unique
enterprise needs. 4




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Standards-based Architecture Inter-Tels CT Enablers, Open Architecture Interface (OAI), TAPI Service
Provider, Intel/Dialogic CT-Connect interface and Computer Supported Telephony
Application (CSTA) Service Provider, allow for smooth integrations with
off-the-shelf, shrink-wrapped applications or custom developed software
packages that help organizations increase customer satisfaction and employee
productivity. Open Architecture Interfaces allow our converged systems to easily
integrate with off-the-shelf or custom software applications. There are two
types of Open Architecture Interfaces: Desktop OAI and System OAI. The
flexibility of our open platform allows for seamless integration of CT
applications, customization and development, which protect our customers
investments as technology evolves and their needs change. Inter-Tels support for industry standards, such as CSTA, TAPI and
Intel/Dialogic CT-Connect allow our Converged Communications Systems to
integrate with Customer Relationship Management (CRM) database software
applications in order to maximize telephony features such as screen pops,
outbound dialing, etc. Inter-Tel is committed to developing standards-based IP telephony
solutions. In the first quarter of 2003, Inter-Tel introduced support of Media
Gateway Control Protocol (MGCP) and Session Initiation Protocol (SIP) in our
Axxess communications platform. SIP and MGCP are industry-standard protocols
for transmitting voice over IP networks. Through our support of these two
standard protocols, Axxess can interoperate with other industry-standard
devices such as SIP and MGCP gateways for converting IP voice calls to standard
telephone lines, and for using standard SIP telephones as extension numbers on
the system. Support of SIP also allows our Axxess system to interoperate with
public SIP networks and services like MSN Passport and to use Microsoft®
Messenger as an extension number on the system. Inter-Tel adopted several other standard protocols this year as well,
including IEEE standards, such as 802.11b and 802.3af. Inter-Tels adoption of
802.11b enables our customers to access system features from devices, such as
the Inter-Tel Model 8601 SIP SoftPhone for Pocket PC or Models 8664 and 8665
wireless endpoints, while theyre mobile within their enterprises 802.11b
network. The IEEE standard 802.3af enables customers to implement power over
Ethernet, eliminating the need for customers to supply power to their IP phones
at their desktops. This year, Inter-Tel incorporated other enabling technologies as well,
such as Wireless Application Protocol (WAP) and ActiveX, which format the Web
experience for various end-user tools. Additionally, Inter-Tel continued to
develop products that leverage LDAP, a protocol for accessing database
information in a standard format, as well as adopted .NET, Microsofts
development framework. Standards-based convergence solutions enable businesses to maintain their
current communications investments during their transition to the converged
model. Our future product strategy is focused on continuing to provide support
for these and other industry-standard interfaces. Endpoints Tightly integrated with the Axxess converged platform, our suite of IP
systems, software and digital endpoints deliver exceptional voice quality,
powerful features and intuitive interfaces. Whether our customers have
associates onsite, mobile, or working from remote locations, our endpoints help
them to perform their functions with continuity. Inter-Tel added several new IP endpoints to its suite in December 2003.
Our powerful, IP endpoints connect local employees, remote staff and satellite
offices as if they were all in the same building. Inter-Tels IP endpoints are
available in two modes: Axxess® IP mode or SIP mode. Axxess IP mode enables an
IP endpoint access to the features and functionality of a traditional Inter-Tel
endpoint. Implementing SIP mode allows an enterprise to access the Shared
Extension feature, which allows multiple endpoints to use the same extension
number on the Axxess converged system. Incoming calls to a shared extension are
sent to SIP endpoints simultaneously; offering customers dynamic mobility when
theyre away from their main desks. Additionally, SIP mode enables IP endpoints
to interoperate with third-party SIP solutions.
Inter-Tels diverse suite of IP endpoints include advanced functionality
and one-touch access to frequently used features. 5




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Inter-Tel also released wireless solutions, such as the Models 8664 and
8665, in early 2004, as well as Inter-Tels Model 8601 SIP SoftPhone for Pocket
PC, in 2003. Users can receive and initiate calls and access features and
messages from these handheld devices, while mobile within an 802.11b wireless
network. Additionally, Inter-Tels Model 8690 multi-protocol, multimedia endpoint
(released in March 2004) is designed to enable users to access systems features
and integrated Unified Communicator software, as well as manage messages via a
touch-screen. Model 8690 was designed to allow users to initiate, hold,
transfer and conference calls with the soft phone interface. The Integrated
Unified Communicator software was designed to enable users to control their
presence and availability status, monitor the status of coworkers, speed-dial
contacts, conference associates and clients, and view call history and
messages. Inter-Tel offers several software-based endpoint solutions that increase
the productivity and enhance the communications of mobile and remotely-based
employees. Whether our customers are deploying IP or traditional telephony,
our soft phones give users control of the features and functionality of the
Axxess system on desktop PCs or laptops. Users can initiate, answer, transfer,
conference and forward calls and moreall with the click of a mouse. To complement our Axxess converged system, Inter-Tel offers a variety of
fully-featured digital endpoints to suit most organizations needs. Our
digital phones deliver exceptional voice quality, advanced digital features and
a range of programmable keys for high-speed, high-quality call processing. The
user-friendly, liquid crystal displays (LCDs), with up to 6-by-16 characters,
lead users through system features and capabilitiesserving as built-in user
guides. Menu-driven, one-touch soft keys allow users to reduce the time it
takes to initiate and receive calls, retrieve messages, leave messages and
access features. Presence Tools Inter-Tels Presence tools enable our customers to control how, when and
where they communicate. Since many enterprises have multiple locations or
campuses, and require their employees to be connected while mobile, the ability
to control and view information about individuals availability is important.
Inter-Tels Presence tools, such as Unified Communicator® software, Connection
Assistant and Enterprise Instant Messaging, facilitate communications among
individuals and groups and can convey the individuals availability, location
and the tools currently available to him or her. These tools also allow
employees to have communications controlled or enhanced on his or her
behalfstreamlining the communication process. Businesses can use presence
tools most appropriate to enterprise goals. Users can stay connected to
geographically separated associates, customers, partners and vendors, creating
a virtual enterprise. Collaboration Tools Inter-Tels Collaboration tools enable real-time interaction among two or
more people. A business and its resources face many challenges in the pursuit
to share ideas, exchange pertinent information, make critical business
decisions and respond to customer needs. Connectivity offers our customers
enterprises better collaboration with their distributed work forces, partners,
suppliers and customers. Inter-Tel provides many tools that enable businesses
to collaborate cost-effectively and easily, such as Enterprise Conferencing,
Enterprise Instant Messaging, Call Center Suite and Connection Assistant. Messaging Tools Messaging Tools facilitate the exchange of information between people and
locations. Enterprises need to be able to respond uniquely to employees,
suppliers, partners and customers, as well as offer 24/7 coverage to capture
incoming requests from external sources. Inter-Tels Messaging tools, such as
Enterprise Instant Messaging, Enterprise Conferencing, Unified Messaging and
Voice Processing, can address the challenges faced by enterprises with
distributed resources and customers across state, national and international
boundaries. Complex information can be exchanged via video or through graphics
instead of voice. Inter-Tel offers flexible choices to provide channels of
communication no matter the time of day or geographic location. Inter-Tels Complete Suite of Presence, Collaboration & Messaging Tools
(Business Applications for the Enterprise) 6




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As an integral part of our Managed Services offerings, Inter-Tel provides
an extensive lineup of applications designed for business use, enhanced
productivity and operational performance. Inter-Tels applications can
facilitate audio conferencing and real-time document sharing; automate
repetitive tasks, enable call handling tasks from a personal computer (PC),
generate historical and real time call statistics, enable intelligent call
routing, manage communications via Web browser or Wireless Application Protocol
(WAP) device and more. Specific applications are highlighted in additional
detail below. Enterprise Conferencing Released in October 2003, Enterprise Conferencing is a SIP-based audio
conferencing and Web presentation solution. This collaboration tool features an
intuitive, browser-based control interface, which allows users to create and
manage conferences, meetings, training sessions and more. Call leaders can
navigate the interface to perform various tasks using drop-down menus, type-in
text fields and check boxes. Users can initiate and set-up a variety of
conference calls such as ad hoc, reoccurring or one-time only. Once a
conference is set up, call leaders can e-mail an invitation to conference
participants, containing all of the necessary information for a hassle-free
conference. When a conference is in progress, the leader has control over each
call participant. Call control buttons allow the call leader to mute, hold and
drop each participant or the collective group of participants. Enterprise Conferencing also allows users to instantly set-up
presentations, web-based seminars or training sessions that require little
coordination. Call leaders can present information to fellow co-workers,
customers or vendors, allowing customers to reduce travel expenses. Enterprise Instant Messaging Also released in October 2003, this browser-based instant messaging (IM)
tool for the business environment seamlessly integrates with Inter-Tels
Enterprise Conferencing, creating a powerful solution. The intuitive user
interface enables users to create a list of contacts or groups to communicate
more efficiently. From the same interface, users can send e-mails or conduct
business chat sessions, as well as send documents to quickly address changing
business situations. This solution enables busy employees to better manage
their work flows and respond to imperative business matters. When integrated
with Enterprise Conferencing, users can quickly escalate IM sessions into
conference calls and Web presentation sessions. Unified Communicator® v2.1 Software/SIP Server v1.1 In July 2003, Inter-Tel released Unified Communicator v2.1 software, which
provides our customers with control of their endpoints through multiple user
interfaces including speech recognition, touch-tone, PC Web browser and WAP
devices. Unified Communicator provides users with a powerful set of tools
designed to enhance the control and flexibility of the desktop environment.
Users can manage their presence by controlling how and where they can be
reachedrouting calls to their current location, or by forwarding calls to a
specified number. They can access their personal address book and the System
Directory, control availability and location, check availability of colleagues
and initiate calls from a Web browser or WAP-enabled device. Our mobile
customers can manage communications through speech recognition or with a
touch-tone phone if a Web browser is unavailable. In 2003, Inter-Tel combined
the Unified Communicator and the SIP Server to provide an integrated SIP and
presence management platform. Applications Platform: IVR Inter-Tels Applications Platform is a scaleable, flexible platform that
enables the customization of applications according to the specific needs of an
organization. It includes a signaling and services engine, plus a graphical
service creation environment. Inter-Tels Interactive Voice Response (IVR)
integrates computer, telephony, Automatic Speech Recognition (ASR) and
Text-To-Speech (TTS) capabilities, and allows for customization for different
types of environment. Inter-Tels IVR platform includes a starter pack with
two IVR applications for general business purposes, and can be expanded or
customized. Our customers have the choice of having their custom applications
developed by an authorized Inter-Tel reseller or engaging Inter-Tels Custom
Solutions group. Interactive Voice Response can be deployed as a front-end to Automatic Call
Distribution (ACD) systems, which can ask questions that help routing and
enable more intelligent and informed call processing. By using IVRs as
front-ends, recordings can be used for repetitive messages, and transactions
can even be performed without involving customer service personnel. Connection Assistant 7




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Released in April 2003, Connection Assistant enables work group members to
receive screen pops of key client or customer information, applications, and
Web applications, designed to enable individuals to provide personalized
service and enhance productivity levels. Work group members can receive call
notes from their group members, automatically displaying pertinent customer and
account information. Connection Assistant also provides group members with the
ability to view the programmed status of any colleague. Call control buttons
allow users to quickly call colleagues, pickup inbound calls and perform blind
or screened transfers. Additionally, Connection Assistant provides users with
flexible control of their extensions to better manage communications. Using a
rules-based system, users can assign actions to specific events occurring at
their extensions. Associates can divert unidentified calls at a particular time
or from a specific number to another extension or to voice mail. Call Center Suite Call Center Suite is a collection of modular CT software applications that
help businesses optimize call center and workgroup performance. Whether an
organization has a department workgroup environment with extensions or a call
center with agents at a single or multiple locations, Call Center Suite offers
a variety of solutions. Combined with a flexible infrastructure, the suite of

applications encompasses Management Tools for reporting and activity
monitoring, plus Agent and Workgroup Tools to aid in increasing productivity
and delivering consistent customer service. Attendant Console Inter-Tels Attendant Console, provides attendants and employees with
knowledge of station and hunt group status, such as Do-Not-Disturb messages,
forwarding information and busy or available status. The unique user-friendly
interface allows users to view the real-time status of employees, enabling them
to process calls quickly via touch screen, mouse or keyboard. Voice Processing Integrated with the Axxess Converged Communications Platform, our Voice
Processing software provides an automated attendant to guide callers to the
person or information they need. This electronic employee answers incoming
calls, transfers calls, records messages, screens calls and returns calls using
caller identification software. The Voice Processing software provides Call
Routing Announcements, voice mail, the ability to record a call and various
call handling functions. Additionally, voice mail messages can be retrieved
using the Voice Processing software from any location using a touch-tone phone.
Inter-Tel offers Voice Processing in two varietiesembedded in the chassis and
in an external server. Unified Messaging Designed to run in a Microsoft® Windows® environment, our Unified
Messaging software combines e-mail, voice mail and fax into a single, mail
management program. Depending on the level of integration our customers
choose, messages are either converted to standard file formats, or seamlessly
integrated so that users can view, access and process messages through a
variety of devices, including Microsofts Exchange messaging application, Lotus
Notes and cc:Mail and Novells GroupWise, as well as other Internet mail
applications. 8




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Small Business Communications Systems EncoreCX In the fourth quarter of 2003, Inter-Tel launched EncoreCX, a converged
voice and data telephone system designed for businesses with up to 40
employees, or large residences. The EncoreCX includes feature-rich telephones
that have a large intuitive display. The flexible EncoreCX system allows our
customers to integrate a mix of standard analog devices, such as cordless
telephones and fax machines. In addition, EncoreCX can be programmed and
maintained remotely, minimizing the costs associated with on-site technician
visits. The EncoreCX is targeted for retail or small business, multi-branch
businesses, or even home-based businesses. Other Services and Products Inter-Tel offers a broad range of products and a complete and
comprehensive Managed Services program that incorporates advanced technologies
while providing customers a single source provider and designed to
cost-effectively fulfill their business communications needs. The Inter-Tel
Managed Services program offers business solutions for professional services,
provisioning and facilities management, and custom development services. We couple this solution-oriented approach with a high level of customer
service and support and a commitment to quality throughout our operations. Our
business communications systems are integrated with our integrated
computer-telephone applications and include voice mail, auto attendant, unified
messaging, call center applications, Interactive Voice Response (IVR), wireless
applications, Automatic Call Distribution (ACD), long distance and networking
services, together with a variety of other communications applications. Because of the modular design of our systems and the high level of
software content in our products, customers can readily increase the size and
functionality of their systems as their needs change by adding new services,
software and hardware applications, or by upgrading to new systems or advanced
versions of their existing systems. We believe our customers prefer to purchase business communications
systems and services from a single-source because of the convenience,
consistency of service, ease of upgrade, availability of financing alternatives
and confidence in the performance of integrated systems and services all
incorporated into a total managed services solution package. Network, Local and Long Distance Services Through our subsidiary, Inter-Tel NetSolutions, we resell a variety of
telecommunications services, including local communications services, domestic
and international long distance services, calling card services, 800 services,
dedicated data services, Internet, frame-relay and voice and video
conferencing, disaster recovery solutions, and network monitoring and
management. We resell these services through our agreements with major U.S.
long distance carriers. These services are then billed to the end-user customer
by Inter-Tel NetSolutions. Through our subsidiary, Inter-Tel Network Services Agency (INSA), we sell
services as an Agent of various Regional Bell Operating Companies (RBOCs) and
Competitive Local Exchange Carriers (CLECs). These services include primarily
local communications services, data services and Internet access. These
services are billed to the end user by the Local Exchange Carrier (LEC) or
CLEC, providing they and INSA receive compensation from the provider for
marketing these services. We support telecommunications applications such as T-1 access for incoming
toll-free traffic at call centers, switched long distance and frame relay
networks linking together multiple offices of an enterprise. Customers who
desire the convenience of acquiring long distance and other related calling
services through the same vendor they use to purchase separate telephony
equipment and services can do so with Inter-Tel. Networking Technologies Integration Inter-Tel DataNet designs, installs and supports an integrated,
comprehensive solution for our customers complex data and telecommunications
networks, from local area networks, or LANs, to geographically dispersed wide
area networks, or WANs. 9




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By forming relationships with major manufacturers of hardware and software
technologies, Inter-Tel provides the routers, ATM, LAN and WAN switches,
wire-less WAN connections, file servers, intelligent hubs and other devices
required for the customers intranet or for access to the Internet. We offer
pre-sale design support, project coordination for implementation, and
installation support on our full line of server-based telephony products and IP
telephony products and services. Custom Professional Services and Solutions Inter-Tel Custom Solutions (ICS) is an Inter-Tel division that delivers
professional services to our customers a variety of custom IVR and CT solutions
built with our industry-leading software and hardware products. ICS can also
customize CT applications and extend the capabilities of existing Inter-Tel
converged platforms and Call Center Suite installations, as well as assist in
the integration of third-party hardware and software that may be required to
deliver complete call center telephony solutions. ICS is also a resource for pre-sales help, specifying and selling the
Inter-Tel Applications Platform, or IVR product line, the foundation on which
both ICS and our channel partners can deploy flexible and customized
speech-enabled IVR solutions for market sectors and business applications.
Additionally, the ICS team provides support and coordination of on-site
installations and/or remote installation support, as well as comprehensive
sales engineering and sales support services for all of the above, including
customer calls, visits and videoconferences, product demonstrations, request
for proposal and requirements analysis, functional specification development,
quotations and full sales cycle support. Leasing Services Inter-Tel offers its Total Solutions (formerly TotaLease) program through
our subsidiary, Inter-Tel Leasing, Inc. The Total Solutions program enables
end users to acquire a full range of business communications systems and
applications designed and manufactured by Inter-Tel, as well as maintenance and
support services. This program provides a total system financing package to
the customer at a set monthly cost, with system expansion available for an
additional fee. The typical Total Solutions contract has a term of 60 months,
and allows the customer to renew the contract at a specified price for up to an
additional 36 months. Inter-Tel also offers a line of low-cost lease purchase financing. Lease
terms range from 24 to 84 months with $1.00, fixed and fair market value
purchase options. Inter-Tel can also customize financing packages to suit
customers with special financial needs. By offering this type of financing to
acquire our products and services, our customers are able to lease directly
from Inter-Tel or an authorized third-party leasing company supporting an
Inter-Tel dealer, thereby allowing us, or one of our dealers to maintain a
direct relationship with our customers. This direct relationship allows
Inter-Tel to provide maintenance and support services and information regarding
other Inter-Tel products and services. Peripheral Products Through our CommSource division, Inter-Tel distributes peripheral
telecommunications products, applications and services developed by third
parties to our direct sales offices, dealers and VARs. We offer a selection of
products including the following: analog and cordless telephones;
audio-conferencing, bridges and accessories; call accounting; call
logging/recording; CT Products; data equipment; headsets; installation
equipment; message-on-hold; paging equipment; power protection and backup;
premise wireless and videoconferencing systems and other accessories. Our
CommSource division sells and distributes products we have endorsed as leading
communications peripherals widely deployed within organizations. Many of these
products and services interface with our telephone systems. 10




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SALES AND DISTRIBUTION We have developed a distribution network of direct sales offices, dealers
and value added resellers (VARs), which sell our products to organizations
throughout the United States and internationally, primarily targeting
small-to-medium enterprises, service organizations and governmental agencies.
As of March 5, 2004, we had 50 direct sales offices in the United States, one
in Japan, and a network of hundreds of dealers and VARs primarily in the United
States, that purchase directly from us. We also have a sales office in Phoenix
that is the primary location for our national and government accounts division,
as well as our local, long distance and network services divisions. Our
wholesale distribution center is located in Tempe, Arizona, which is the
primary location from which we distribute products to our network of direct
sales offices, dealers and VARs. In addition, we maintain a wholesale
distribution office in the United Kingdom that supplies Inter-Tels dealers and
distributors throughout the UK and other parts of Europe, and we have dealers
in Japan and Mexico. We also maintain a research and development and software
sales office in the United Kingdom. Distribution Channels Our success depends in part upon the strength of our distribution channels
and our ability to maintain close access to our end user customers through our
distribution channels. In recent periods, we have sought to improve our access
to end users through strategic acquisitions of resellers of telephony products
and services, some of which are located in markets in which we have existing
direct sales offices. As of December 31, 2003, Inter-Tels direct sales office
personnel and national and government accounts personnel consisted of 1056 and
55 persons, respectively. Direct dealers and VARs enter into reseller agreements with us for a term
of one or more years. These agreements often include requirements that the
reseller meet, or use their best efforts to meet, minimum annual purchase
quotas. We generally provide support and other services to our resellers
under the terms of the agreements. We face intense competition from other
telephone system and voice processing system manufacturers, as many of our
dealers carry other products that compete with our products. We offer additional incentives, programs and support resources to dealers
that agree to sell Inter-Tel systems and solutions on an exclusive basis. We
launched an exclusive business partner program during 2001. This program was
designed to reward dealers who sell only Inter-Tel products to all new
prospects and aggressively seek to upgrade their non-Inter-Tel customer base.
For this commitment from the dealers, we have offered our expertise to help
them manage their business. This includes operational business reviews, shared
human resource forms and policies, additional sales, marketing and training
support, enhanced co-op benefits as well as special sales promotions and
awards. In addition, we allow exclusive dealers to use our branch sales offices
and demonstration rooms to help them in the sales process. We believe this
program offers us an opportunity to expand our wholesale channel of
distribution. National, Government and Education Accounts Inter-Tels National, Government, and Education Accounts Division (NGEA)
services large commercial companies; the Federal Government and its agencies;
state, municipal and local governments; and educational institutions throughout
the United States. NGEA offers the full line of Inter-Tel converged
communications solutions to its customers, as well as consulting, financial
planning and assistance. NGEA support programs, including the Special Handling ® Program and
Managed Services Rental Program, are comprehensive and flexible, providing
companies, government agencies, and educational organizations technical
solutions, with a level of support provided to allow them to concentrate on
building future infrastructure needs, with support for previously installed
products. Lease Financing Services Inter-Tel offers lease financing options, including its Total Solutions
(formerly TotaLease) program through our subsidiary, Inter-Tel Leasing, Inc.
and a line of low-cost lease purchase financing from Inter-Tel or an authorized
third-party leasing company supporting Inter-Tel dealers. These programs enable
end users to acquire a full range of telephony systems and applications
designed and manufactured by Inter-Tel, as well as maintenance and support
services. Please refer to Leasing Services in PRODUCTS AND SERVICES above
for additional information regarding these programs. International Sales 11




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We currently have dealers in the UK, parts of Europe, Japan and Mexico,
and we are currently working to expand our international dealer network.
International sales, which include business communications systems and IP
telephony and peripheral products, accounted for approximately 3.0% and 2.7% of
our net sales in 2003 and 2002, respectively. In order to sell our products to
customers in other countries, Inter-Tel must comply with local
telecommunications standards. Our Axxesssystem and IP telephony products can
be modified using our software to facilitate compliance with these local
regulations. In addition, the Axxessplatform has been designed to support
multi-lingual functionality, and both currently support American English,
British English, Japanese and Spanish languages. Customer Service and Support Customer service and support are critical components of customer
satisfaction and the success of our business. We operate a technical support
group that provides a range of support services to our distributors, dealers
and end user customers through the Internet and through a toll-free telephone
number. Inter-Tel provides on-site customer support through our direct sales
offices and dealers and, using remote diagnostic procedures, we have the
ability to detect and correct system problems from our technical support
facilities. In 2000, Inter-Tel began an initiative to greatly enhance our
Internet, intranet and extranet capabilities. Through this initiative, we
re-designed our Web site to offer to our direct sales offices and dealer
channel support for sales and technical support activities. Our Web site also
offers a wide array of sales and technical information, including an on-line
product and service catalog, efficient order processing,
portable-document-format sales brochures, competitive information, on-line
technical manuals and frequently-asked-questions on important topics. In 2003,
Inter-Tel enhanced the ability to initiate and track the status of tech support
tickets from our web site and continued to develop and enhance our sales
proposal platform. We intend to further develop our Web site to add additional
information and services. We analyze feedback from our customer service call records to provide
direction for product and service enhancements. Our direct sales offices and
resellers can receive service activity reports summarizing the reasons that
technicians are asking for assistance and common issues that give rise to
technical inquiries. This allows our direct sales offices and resellers to
track trends in their service operations and to thereby provide better customer
service. We believe we can best serve our customers by continually improving the
quality of our systems, customer service and support, and other aspects of our
organization. Through our continuous improvement process initiated in 1991,
Inter-Tel implements quality processes throughout its business operations. We
have established formal procedures to provide responsiveness to customer
requests, monitor response times and measure customer satisfaction. We have
also established means by which all end users, including customers of our
resellers, can request product enhancements directly from us. Inter-Tel
supports its dealers and VARs through extensive training programs offered at
Inter-Tels facilities and through virtual remote training courses tied into
Inter-Tel University. Inter-Tel also provides a toll-free telephone number for
sales and technical support, an extranet site offering up-to-date sales and
support information, and end-user marketing materials. We typically provide a
one-year warranty on our systems to end users. We offer eighteen-month
warranties on our systems to our dealers, which in turn are responsible for
providing a warranty to their end users. RESEARCH AND DEVELOPMENT We believe that our ability to enhance our current products, develop and
introduce new products on a timely basis, maintain technological
competitiveness and meet customer requirements is essential to our success.
Inter-Tels research and development efforts over the last several years have
been focused primarily on the development of, and enhancements to, our Axxess
system, including adding new applications, enhancing our IP convergence
applications and IP endpoints, developing Unified Communications applications,
developing presence management applications, and developing speech-recognition
and text-to-speech applications. More recently, Inter-Tels research and
development efforts have been focused on the development of Session Initiation
Protocol (SIP) interfaces and application as well as the development and a new
line of multi-protocol SIP IP endpoints. As of December 31, 2003, we had a total of 230 personnel engaged in
research and development and related technical service and support functions.
Research and development expenses were $21,978,000; $19,340,000; and
$17,556,000, 2003, 2002, and 2001, respectively. 12




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MANUFACTURING Inter-Tel manufactures substantially all of its systems through third
party subcontractors located in the United States, Mexico, the Peoples
Republic of China and the United Kingdom. These subcontractors use both
standard and proprietary integrated circuits and other electronic devices and
components to produce our communications systems, physical endpoints and
printed circuit boards to our engineering specifications and designs. In some
cases, our suppliers perform systems integration, software loads, perform
functional tests and make final shipment. Varian, Inc., a multinational
electronics company, currently manufactures a significant portion of our
products, including substantially all of the printed circuit boards used in the
Axxessplatform, at Varians Tempe, Arizona facility. We provide our
manufacturing contractors with forecasted schedules of our manufacturing needs
and revise the forecasts on a periodic basis. We continuously monitor the
quality of the products produced on our behalf by our manufacturing
subcontractors. COMPETITION The market for our products is highly competitive and has in recent
periods been characterized by rapid technological change, business
consolidations and decreasing prices. Competitors for our converged
communication products geared toward the enterprise market include Avaya,
Nortel Networks, 3Com, Altigen, Cisco Systems, Comdial, Iwatsu America, Inc.,
Mitel Networks, NEC Corporation, Panasonic, Shoreline, Siemens, Toshiba and
Vodavi, among numerous other resellers of these and similar products. Several
of these competitors have been active in developing and marketing IP networking
products and have established relationships with customers within their
markets. During the later half of 2003, Microsoft released the Microsoft Live
Communications Server, which is proprietary software that facilitates voice
communication and collaboration over IP networks. This platform could be
further enhanced in the future to compete with our IP convergence products. We
also compete against the RBOCs, which typically offer systems produced by one
or more of our competitors listed above and also typically offer Centrex
systems in which automatic calling facilities are provided through equipment
located in the telephone companys central office. We also compete with RBOCs
and next-generation service providers, such as DSL providers and cable
companies, that offer IP Centrex services as well as bundled telephony and data
services in an application service provider telephony model. In the market for voice processing applications, including voice mail, we
compete against Captaris, Active Voice (subsidiary of NEC America),
InterVoice-Brite, Avaya, Nortel Networks, Comdial and other competitors. In
the market for long distance services, we compete against AT&T, Sprint, Qwest
and others. We also expect to compete with RBOCs, cable television companies,
satellite and other wireless broadband service providers for long distance
business. Key competitive factors in the sale of converged communications
systems and related applications include price, performance, features,
reliability, service and support, brand recognition and distribution
capability. We believe that we compete favorably in our markets with respect
to the price, performance and features of our systems, as well as the level of
service and support that we provide to our customers. However, certain of our
competitors have significantly greater resources, brand recognition and
distribution capabilities than we do. As we compete for local telephone service, long distance service and IP
network access, we face additional competition from established foreign and
domestic long distance carriers, RBOCs and other providers. Many of these
competitors have larger marketing and sales organizations, significantly
greater financial and technical resources and a larger and more established
customer base than we do. In addition, RBOCs and other providers have greater
name recognition, more established positions in the market and long standing
relationships with customers. INTELLECTUAL PROPERTY RIGHTS We currently hold patents for 23 telecommunications and unified messaging
products. The remaining life of these patents ranges from six months to 14
years in duration. We have also applied to the U.S. Patent and Trademark
Office for 13 additional patents. We also rely on copyright, trademark, trade
secret law and contractual provisions to protect our intellectual property. EMPLOYEES 13




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As of December 31, 2003, we had a total of 1,817 employees, of whom 678
were engaged in sales, marketing, e-business and customer support; 244 in
direct sales office and wholesale administrative and other management
personnel; 553 in manufacturing, quality and related operations, including
direct sales office operations personnel; 230 in research and development and
related technical service and support functions; and 112 in finance,
information systems, administration and executive management. We believe our
relations with our employees are good. ACCESS TO INFORMATION Our Internet address is www.inter-tel.com. We make available at this
address, free of charge, our annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as
reasonably practicable after we electronically file such material with, or
furnish it to, the SEC. We will also provide paper copies of this annual
report on Form 10-K, available upon written request to Shareholder Relations,
1615 S. 52nd Street, Tempe, Arizona 85281. Factors That May Affect Future Operating Results This Report onForm 10-Kcontains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section
21E of the Securities Exchange Act of 1934, as amended. Actual results could
differ materially from those projected in the forward-looking statements as a
result of many risk factors including, without limitation, those set forth
under Factors That May Affect Future Results Of Operations below. In
evaluating Inter-Tels business, shareholders and prospective investors should
consider carefully the following factors in addition to the other
information set forth in this document. Risks Related to Our Business Our operating results have historically depended on a number of factors, and
these factors may cause our operating results to fluctuate in the future. Our quarterly operating results have historically depended on, and may
fluctuate in the future as a result of, many factors including:  
    
    volume and timing of orders received during the quarter;  
    
    gross margin fluctuations associated with the mix of products sold;  
    
    the mix of distribution channels;  
    
    general economic conditions and the condition of the markets our business addresses;  
    
    patterns of capital spending by customers;  
    
    the timing of new product announcements and releases by us and our competitors;  
    
    pricing pressures;  
    
    the cost and effect of acquisitions;  
    
    the availability and cost of products and components from our suppliers; and  
    
    national and regional weather patterns. In addition, we have historically operated with a relatively small
backlog, with sales and operating results in any quarter depending principally
on orders booked and shipped in that quarter. In the past, we have recorded a
substantial portion of our net sales for a given quarter in the third month of
that quarter, with a concentration of such net sales in the last two weeks of
the quarter. Market demand for investment in capital equipment such as
business communications systems and associated call processing and voice
processing software applications depends largely on general economic
conditions, and can vary significantly as a result of changing conditions in
the economy as a whole. We cannot assure you that we can continue to be
successful operating with a small backlog or whether historical backlog trends
will continue in the future. Our expense levels are based in part on expectations of future sales and,
if sales levels do not meet expectations, our operating results could be
harmed. In addition, because sales of business
communications systems through our dealers typically produce lower gross
margins than sales through our direct sales organization, operating results
have varied, and will continue to vary based upon the mix of sales through
direct and indirect channels. In addition, in the past we have derived a
significant part of our revenue from recurring revenue streams, which typically
produce higher gross margins. If we do not maintain recurring 14




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revenue streams
at current or historic levels, our operating results will suffer if we do not
significantly increase sales to new customers. For example, in the most recent
quarter ended December 31, 2003, sales to new customers through our direct
sales offices, dealer network, network services and leasing divisions declined
as a percentage of total sales, resulting in decreased net sales and operating
income compared to the quarter ended December 31, 2002. Moreover, particularly
in an environment of fluctuating interest rates, the timing and profitability
of lease resales from quarter to quarter could impact operating results. Long
distance and Datanet sales, which typically have lower gross margins than our
core business, have grown in recent periods at a faster rate than our overall
net sales. Consolidated gross margins could be harmed if long distance calling
services continue to increase as a percentage of net sales. We also experience
seasonal fluctuations in our operating results, as net sales for the first
quarter is frequently less than the fourth quarter and the third quarter is
frequently less than the second quarter. As a result of these and other
factors, we have historically experienced, and could continue to experience in
the future, fluctuations in net sales and operating results on a quarterly
basis. Our market is subject to rapid technological change and to compete
successfully, we must continually introduce new and enhanced products and
services that achieve broad market acceptance. The market for our products and services is characterized by rapid
technological change, evolving industry standards and vigorous customer demand
for new products, applications and services. To compete successfully, we must
continually enhance our existing telecommunications products, related software
and customer services, and develop new technologies and applications in a
timely and cost-effective manner. If we fail to introduce new products and
services that achieve broad market acceptance, or if we do not adapt our
existing products and services to customer demands or evolving industry
standards, our business could be significantly harmed. Problems and delays
associated with new product development have in the past contributed to lost
sales. In addition, current competitors or new market entrants may offer
products, applications or services that are better adapted to changing
technology or customer demands and that could render our products and services
unmarketable or obsolete. In addition, if the markets for computer-telephony applications, Internet
Protocol network products, or related products fail to develop or continue to
develop more slowly than we anticipate, or if we are unable for any reason to
capitalize on any of these emerging market opportunities, our business,
financial condition and operating results could be significantly harmed. Our future success largely depends on increased commercial acceptance of our
Axxesssystem, EncoreCX products, speech recognition, Interactive Voice
Response, presence management, collaboration, messaging products, and related
computer-telephony products. Over the past 18 months, we have introduced Unified Communicator, a
web-based, speech-recognition, wireless PDA, and Wireless Application Protocol
(WAP) software application for controlling and managing your calls, contacts
and presence status; Inter-Tel Application Platform, a highly flexible
speech-recognition, text-to-speech and CTI application generation platform;
enhanced convergence features on the Axxesssystem, including support of
standard Session Initiation Protocol (SIP) endpoints and trunk gateways; and
several other telephony-related products. During the past 12 months, sales of
our Axxessbusiness communications systems and related software have comprised
a substantial portion of our net sales. Our future success depends, in large
part, upon increased commercial acceptance and adoption of the Axxesssystem,
the Application Platform, the Unified Communicator and related
computer-telephony products, EncoreCX products, SIP standards-based
applications and devices, new speech recognition and Interactive Voice Response
products, as well as future upgrades and enhancements to these products and
networking platforms. We cannot assure you that these products or platforms
will achieve commercial acceptance in the future. Our products are complex and may contain errors or defects that are detected
only after their release, which may cause us to incur significant unexpected
expenses and lost sales. Our telecommunications products and software are highly complex. Although
our new products and upgrades are examined and tested prior to release, they
can only be fully tested when used by a large customer base. Consequently, our
customers have in the past and may in the future discover program
errors, or bugs, or other defects after new products and upgrades have
been released. Some of these bugs may result from defects contained in
component parts or software from our suppliers or other third parties that are
intended to be compatible with our products and over which we have little or no
control. Although we have test procedures and quality control standards in
place designed to minimize the number of errors and defects in our products, we
cannot assure you that our new products and upgrades will be free of 15




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bugs when
released. If we are unable to quickly or successfully correct bugs identified
after release, we could experience the following, any of which would harm our
business:  
    
    costs associated with the remediation of any problems;  
    
    costs associated with design modifications;  
    
    loss of or delay in revenues;  
    
    loss of customers;  
    
    failure to achieve market acceptance or loss of market share;  
    
    increased service and warranty costs;  
    
    liabilities to our customers; and  
    
    increased insurance costs. The complexity of our products could cause delays in the development and
release of new products and services. As a result, customer demand for our
products could decline, which could harm our business. Due to the complexity of our products and software, we have in the past
experienced and expect in the future to experience delays in the development
and release of new products or product enhancements. If we fail to introduce
new software, products or services in a timely manner, or fail to release
upgrades to our existing systems or products and software on a regular and
timely basis, customer demand for our products and software could decline,
which would harm our business. Business acquisitions, new business ventures, dispositions or joint ventures
entail numerous risks and may disrupt our business, dilute shareholder value
and distract management attention. As part of our business strategy, we consider acquisitions of, or
significant investments in, businesses that offer products, services and
technologies complementary to ours. Such acquisitions could materially
adversely affect our operating results and/or the price of our common stock.
Acquisitions also entail numerous risks, some of which we have experienced and
may continue to experience, including:  
    
    unanticipated costs and liabilities;  
    
    difficulty of assimilating the operations, products and personnel of the acquired business;  
    
    difficulties in managing the financial and strategic position of acquired or developed products, services and technologies;  
    
    difficulties in maintaining customer relationships;  
    
    difficulties in servicing and maintaining acquired products, in particular where a substantial portion of the targets
sales were derived from our competitors products and services;  
    
    difficulty of assimilating the vendors and independent contractors of the acquired business;  
    
    the diversion of managements attention from the core business;  
    
    inability to maintain uniform standards, controls, policies and procedures; and  
    
    impairment of relationships with acquired employees and customers occurring as a result of integration of the acquired
business. In particular, in recent years our operating results were materially
adversely affected by several of the factors described above, including
substantial acquisition-related charges, operating losses or impairment losses
from the Executone acquisition and Inter-Tel.NET operations. Refer to
Managements Discussion and Analysis and notes to the consolidated financial
statements for additional information regarding these transactions. We completed four acquisitions during 2001 and 2002, and one acquisition
during December 2003. During 2001, we acquired certain assets and assumed
certain liabilities of Convergent Communication Services and Mastermind
Technologies. During 2002, we acquired certain assets and assumed certain
liabilities of McLeodUSA Integrated Business Systems and we acquired 100% of
the stock of Swan Solutions Limited (Swan) in the United Kingdom. In December
2003, we acquired selected assets and
assumed certain liabilities of a former Inter-Tel dealer in the
Philadelphia metropolitan area. These acquisitions are subject to risks and
uncertainties including those indicated above. Finally, to the extent that shares of our stock or the rights to purchase
stock are issued in connection with any future acquisitions, dilution to our
existing shareholders will result and our earnings per share may 16




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suffer. Any
future acquisitions may not generate additional revenue or provide any benefit
to our business, and we may not achieve a satisfactory return on our investment
in any acquired businesses. We may not be able to adequately protect our proprietary technology and may be
infringing upon third-party intellectual property rights. Our success depends upon our proprietary technology. We currently hold
patents for twenty-three (23) telecommunication and messaging products and have
also applied to the U.S. Patent and Trademark Office for thirteen (13)
additional patents. We also rely on copyright and trade secret law and
contractual provisions to protect our intellectual property. Despite these
precautions, third parties could copy or otherwise obtain and use our
technology without authorization, or develop similar technology independently. Any patent, trademark or copyright that we own or have applied to own is
subject to being invalidated, circumvented or challenged by a third party.
Effective protection of intellectual property rights may be unavailable or
limited in foreign countries. We cannot assure that the protection of our
proprietary rights will be adequate or that competitors will not independently
develop similar technology, duplicate our services or design around any patents
or other intellectual property rights we hold. Litigation may be necessary in
the future to enforce our intellectual property rights, to protect our trade
secrets, to determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or invalidity. Litigation
could be costly, absorb significant management time and harm our business. We are also subject to third party claims that our current or future
products or services infringe upon the rights of others. For example, we are
subject to proceedings initiated by Avaya, alleging that certain of our key
products infringe upon their intellectual property rights, including patents,
trademarks, copyrights or other intellectual property rights. We have viewed
presentations from Avaya, one of our primary competitors, alleging that our
Axxessbusiness communications system and associated applications utilize
inventions covered by certain of their patents. We are continuing the process
of investigating this matter and we have made claims against Avaya for
infringement of our patents. The ultimate outcomes by their nature are
uncertain and we cannot assure you that these matters, individually or
collectively, would not have a material adverse impact on our financial
position and future results of operations. When any such claims are asserted against us, among other means to resolve
the dispute, we may seek to license the third partys intellectual property
rights. Purchasing such licenses can be expensive, and we cannot assure you
that a license will be available on prices or other terms acceptable to us, if
at all. Alternatively, we could resort to litigation to challenge such a
claim. Litigation could require us to expend significant sums of cash and
divert our managements attention. In the event a court renders an enforceable
decision with respect to our intellectual property, we may be required to pay
significant damages, develop non-infringing technology or acquire licenses to
the technology subject to the alleged infringement. Any of these actions or
outcomes could harm our business. If we are unable or choose not to license
technology, or decide not to challenge a third partys rights, we could
encounter substantial and costly delays in product introductions. These delays
could result from efforts to design around asserted third party rights or our
discovery that the development, manufacture or sale of products requiring these
licenses could be foreclosed. We have many competitors and expect new competitors to enter our market, which
could increase price competition and spending on research and development and
which may impair our ability to compete successfully. The markets for our products and services are extremely competitive and we
expect competition to increase in the future. Our current and potential
competitors in our primary business segments include:  
    
    PABX and converged systems providers, distributors, or resellers such as Alcatel, Altigen, Avaya, Cisco Systems, Comdial,
3Com, Iwatsu, Mitel, NEC, Nortel, Panasonic, Shoreline, Siemens, Toshiba, Vertical Networks and Vodavi;  
    
    large data routing and convergence companies such as 3Com and Cisco Systems;  
    
    voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a subsidiary of NEC America), Avaya,
and Captaris (formerly AVT);  
    
    long distance services providers such as AT&T, MCI, Qwest and Sprint;
    
    large computer and software corporations such as IBM, HP, Intel and Microsoft;  
    
    regional Bell operating companies, or RBOCs, cable television companies, IP Centrex service providers, and satellite and
other wireless broadband service providers; and  
    
    independent leasing companies that provide telecom equipment financing. 17




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These and other companies may form strategic relationships with each other
to compete with us. These relationships may take the form of strategic
investments, joint-marketing agreements, licenses or other contractual
arrangements. Strategic relationships and business combinations could increase
our competitors ability to address customer needs with their product and
service offerings. Many of our competitors and potential competitors have substantially
greater financial, customer support, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. We cannot be sure that
we will have the resources or expertise to compete successfully. Compared to
us, our competitors may be able to:  
    
    develop and expand their product and service offerings more quickly;  
    
    offer greater price discounts or make substantial product promotions;  
    
    adapt to new or emerging technologies and changing customer needs faster;  
    
    take advantage of acquisitions and other opportunities more readily;  
    
    negotiate more favorable licensing agreements with vendors;  
    
    devote greater resources to the marketing and sale of their products; and  
    
    address customers service-related issues more adequately. Some of our competitors may also be able to provide customers with
additional benefits at lower overall costs or to reduce their gross margins
aggressively in an effort to increase market share. We cannot be sure we will
be able to match cost reductions by our competitors. In recent periods, due to
competitive pressures we have discounted pricing on our telephone systems and
offered promotions. In addition, we believe there is likely to be further
consolidation in our markets, which could lead to having even larger and more
formidable competition and other forms of competition that could cause our
business to suffer. Our reliance on a limited number of suppliers for key components and our
dependence on contract manufacturers could impair our ability to manufacture
and deliver our products and services in a timely and cost-effective manner. We currently obtain certain key components for our digital communication
platforms, including certain microprocessors, integrated circuits, power
supplies, voice processing interface cards and IP telephony cards, from a
limited number of suppliers and manufacturers. Our reliance on these limited
suppliers and contract manufacturers involves risks and uncertainties,
including the possibility of a shortage or delivery delay for some key
components. We currently manufacture our products through third-party
subcontractors located in the United States, Mexico, the Peoples Republic of
China and the United Kingdom. Varian, Inc. currently manufactures a
significant portion of our products at Varians Tempe, Arizona facility,
including substantially all of the printed circuit boards used in the Axxess
systems. Foreign manufacturing facilities are subject to changes in
governmental policies, imposition of tariffs and import restrictions and other
factors beyond our control. We have experienced occasional delays in the supply
of components and finished goods that have harmed our business. If inventory
levels are not adequately maintained and managed we are at risk of not having
the appropriate inventory quantities on hand to meet sales demand. We may
experience similar delays in the future. Our reliance on third party manufacturers and OEM partners involves a
number of additional risks, including reduced control over delivery schedules,
quality assurance and costs. Our business may be harmed by any delay in
delivery or any shortage of supply of components or finished goods from a
supplier. Our business may also be harmed if we are unable to develop
alternative or additional supply sources as necessary. To date, we have been
able to obtain supplies of components and products in a timely manner even
though we do not have long-term supply contracts with any of our contract
manufacturers. However, we cannot assure you we will be able to continue to
obtain components or finished goods in sufficient quantities or quality or on
favorable pricing or delivery terms in the future. We derive a substantial portion of our net sales from our dealer network and if
these dealers do not effectively promote and sell our products, our business
and operating results could be harmed. We derive a substantial portion of our net sales through our network of
independent dealers. We face intense competition from other telephone, voice
processing, and voice and data router system manufacturers for these dealers
business, as most of our dealers carry other products that compete with our
products. Our dealers may choose to promote the products of our competitors to
our detriment. We have developed programs and expended capital as incentives
to our dealers to promote our products, and we cannot assure you that these
techniques will continue to be successful. The loss of any significant dealer
or group of 18




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dealers, or any event or condition harming our dealer network,
could harm our business, financial condition and operating results. We are currently the target of government investigations and in the future we
may be subject to litigation, which if they result in any convictions,
sanctions or penalties against us, could harm our business. Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has provided Inter-Tel with only a limited description of the
evidence on which the investigations are based. Inter-Tel is presently unable to predict or determine the final outcome
of, or to estimate the potential range of loss with respect to, the
investigations. If Inter-Tel is convicted of any crime or subjected to
sanctions, or debarred from certain government contracts or if penalties,
damages or other monetary remedies are assessed against Inter-Tel in connection
with these and other investigations, our business and operating results could
be materially and adversely affected. The existence and disclosure of the
investigations may have already caused competitive harm to Inter-Tel, and any
unfavorable resolution to these matters may further harm Inter-Tels business. Inter-Tel is also subject to litigation in the ordinary course of
business. We cannot assure you that any adverse outcome in connection with
such litigation would not impair our business or financial condition. Managing our international sales efforts may expose us to additional business
risks, which may result in reduced sales or profitability in our international
markets. We are currently expending resources to maintain and expand our
international dealer network in the countries in which we already have a
presence and in new countries and regions. International sales are subject to
a number of risks, including changes in foreign government regulations and
telecommunication standards, export license requirements, tariffs and taxes,
other trade barriers, difficulties in protecting our intellectual property,
fluctuations in currency exchange rates, difficulty in collecting receivables,
difficulty in staffing and managing foreign operations, and political and
economic instability. In particular, the terrorist acts of September 11, 2001,
continued hostilities in Iraq and turmoil in the Middle East and North Korea,
have created an uncertain international economic environment and we cannot
predict the impact of these acts, any future terrorist acts or any related
military action on our efforts to expand our international sales. Fluctuations
in currency exchange rates could cause our products to become relatively more
expensive to customers in a particular country, leading to a reduction in sales
or profitability in that country. In addition, the costs associated with
developing international sales or an international dealer network may not be
offset by increased sales in the short term, or at all. Any of these risks
could cause our products to become relatively more expensive to customers in a
particular country, leading to reduced sales or profitability in that country. If we lose key personnel or are unable to hire additional qualified personnel
as necessary, we may not be able to achieve our objectives. We depend on the continued service of, and our ability to attract and
retain, qualified technical, marketing, sales and managerial personnel, many of
whom would be difficult to replace. Competition for qualified personnel is
intense, and we have historically had difficulty in hiring employees in the
timeframe we desire, particularly skilled engineers or sales personnel. The
loss of any of our key personnel or our failure to effectively recruit
additional key personnel could make it difficult for us to manage our business,
complete timely product introductions or meet other critical business
objectives. In addition, our operating results could be impaired if we lose a
substantial number of key employees from acquisitions, as was the case in our
acquisition of Executone. Moreover, our operating results could be impaired if
we lose a
substantial number of key employees from recent acquisitions, including
personnel from McLeod, Swan, Mastermind, Convergent and our recent Philadelphia
and Tennessee office acquisitions. We cannot assure you we will be able to
continue to attract and retain the qualified personnel necessary for the
development of our business. Our IP network products may be vulnerable to viruses, other system failure
risks and security concerns, which may result in lost customers or slow
commercial acceptance of our IP network products. Inter-Tels IP telephony and network products may be vulnerable to
computer viruses or similar disruptive problems. Computer viruses or problems
caused by third parties could lead to interruptions, delays 19




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or cessation of
service that could harm our operations and revenues. In addition, we may lose
customers if inappropriate use of the Internet or other IP networks by third
parties jeopardizes the security of confidential information, such as credit
card or bank account information or the content of conversations over the IP
network. In addition, user concerns about privacy and security may cause IP
networks in general to grow more slowly, and impair market acceptance of our IP
network products in particular, until more comprehensive security technologies
are developed. We may be unable to achieve or manage our growth effectively, which may harm
our business. The ability to operate our business in an evolving market requires an
effective planning and management process. Our efforts to achieve growth in
our business have placed, and are expected to continue to place, a significant
strain on our personnel, management systems, infrastructure and other
resources. In addition, our ability to manage any potential future growth
effectively will require us to successfully attract, train, motivate and manage
new employees, to integrate new employees into our overall operations and to
continue to improve our operational, financial and management controls and
procedures. Furthermore, we expect we will be required to manage an increasing
number of relationships with suppliers, manufacturers, customers and other
third parties. If we are unable to implement adequate controls or integrate
new employees into our business in an efficient and timely manner, our
operations could be adversely affected and our growth could be impaired. The introduction of new products and services has lengthened our sales cycles,
which may result in significant sales and marketing expenses. In the past few years, we introduced the AxxessATM business
communications system and multiple versions of our IP networking software,
which are typically sold to larger customers at a higher average selling price
and often represent a significant expenditure in communications infrastructure
by the prospective enterprise customer. Accordingly, the purchase of our
products typically involves numerous internal approvals relating to the
evaluation, testing, implementation and acceptance of new technologies. This
evaluation process frequently results in a lengthy sales process, which can
range from a few months to more than 12 months, thereby subjecting our sales
cycle to a number of significant uncertainties concerning budgetary constraints
and internal acceptance reviews. The length of our sales cycle also may vary
substantially from customer to customer and along product lines. While our
customers are evaluating our products before placing an order with us, we may
incur substantial sales and marketing expenses and expend significant
management effort. In addition, installation of multiple systems for large,
multi-site customers may occur over an extended period of time, and depending
on the contract terms with these customers, revenues may be recognized over
more than one quarter, as systems are completed in separate phases and accepted
by the customers. Consequently, if sales forecasted from a specific customer
for a particular quarter are not realized in that quarter, our operating
results could be materially adversely affected. We rely heavily upon third-party packaged software systems to manage and run
our business processes and to produce our financial statements. From time to
time we upgrade these systems to ensure continuation of support and to expand
the functionality of the systems to meet our business needs. The risks
associated with the upgrade process include disruption of our business
processes, which could harm our business. We currently run third-party applications for data processing in our
distribution center operations, shipping, materials movement, customer service,
invoicing, financial record keeping and reporting, and for other operations and
administrative functions. The nature of the software industry is to upgrade
software
systems to make architectural changes, increase functionality and address
software bugs. Over time, older versions of the software become less supported
by our vendors for financial and other reasons and eventually become obsolete.
Oracle, the primary supplier of our third-party applications, provides notice
of the dates that Oracle will de-support the software and companies are
expected to either make plans to upgrade to newer versions or operate without
Oracle support. While Oracle and other third-party vendors may provide
advanced notice of product upgrade schedules and take other steps to make the
upgrade process as straight-forward as possible, we are subject to risks
associated with the process. Our software systems could become unstable
following an upgrade process and impact our ability to process data properly in
these systems, including timely and accurate shipment of products, invoicing
our customers properly and the production of accurate and timely financial
statements. We also cannot assure you these software upgrades or enhancements
will operate as intended or be free from bugs. We upgraded our Oracle
applications during the fourth quarter of 2002 and expect to affect similar
software upgrades in the future. If 20




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we are unable to successfully integrate
the new software into our information systems, our operations, customer service
and financial reporting could be adversely affected and could harm our
business. Our stock price has been and may continue to be volatile, impairing your
ability to sell your shares at or above purchase price. The market price for our common stock has been highly volatile. The
volatility of our stock could be subject to continued wide fluctuations in
response to many risk factors listed in this section, and others beyond our
control, including:  
    
    announcements of developments relating to our business;  
    
    fluctuations in our operating results;  
    
    shortfalls in revenue or earnings relative to securities analysts expectations;  
    
    announcements of technological innovations or new products or enhancements by us or our competitors;  
    
    announcements of acquisitions or planned acquisitions of other companies or businesses;  
    
    investors reactions to acquisition announcements or our forecasts of future results;  
    
    general economic conditions in the telecommunications industry;  
    
    the market for Internet-related voice and data products and services;  
    
    changes in the national or worldwide economy;  
    
    changes in legislation or regulation affecting the telecommunications industry;  
    
    threats of or outbreaks of war, hostilities or terrorist acts;  
    
    developments relating to our intellectual property rights and the intellectual property rights or third parties;  
    
    litigation or governmental investigations of our business practices;  
    
    changes in our relationships with our customers and suppliers; and  
    
    national and regional weather patterns. In addition, stock prices of technology companies in general, and for
voice and data communications companies in particular, have experienced extreme
price fluctuations in recent years which have often been unrelated to the
operating performance of affected companies. We cannot assure you the market
price of our common stock will not experience significant fluctuations in the
future, including fluctuations unrelated to our performance. The Chairman of our Board of Directors, CEO and President controls 20.2% of our
Common Stock as of March 5, 2004 and is able to significantly influence matters
requiring shareholder approval. As of March 5, 2004, Steven G. Mihaylo, Inter-Tels Chairman of the Board
of Directors, Chief Executive Officer and President, beneficially owned
approximately 20.2% of the existing outstanding shares of the common stock. As
a result, he has the ability to exercise significant influence over all matters
requiring shareholder approval. In addition, the concentration of ownership
could have the effect of delaying or preventing a change in control of
Inter-Tel. Risks Related to Our Industry Reductions in spending on enterprise communications equipment may materially
and adversely affect our business. The overall economic slowdown has had and continues to have a harmful
effect on the market for enterprise communications equipment. Our customers
have reduced significantly their capital spending on communications equipment
in an effort to reduce their own costs. The market for enterprise
communications equipment may only grow at a modest rate or possibly not grow at
all, and our financial performance has been and may continue to be materially
and adversely affected by the reductions in spending on enterprise
communications equipment. The emerging market for IP network telephony is subject to market risks and
uncertainties that could cause significant delays and expenses. The market for IP network voice communications products is evolving
rapidly and is characterized by an increasing number of market entrants who
have introduced or developed products and services for Internet or other IP
network voice communications. As is typical of a new and rapidly evolving
industry, the demand for and market acceptance of recently introduced IP
network products and services are highly uncertain. We 21




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cannot assure you that
IP voice networks will become widespread. Even if IP voice networks become
more widespread in the future, we cannot assure that our products, including
the IP telephony features of the Axxesssystems and our IP endpoints and
related applications, will successfully compete against other market players
and attain broad market acceptance. Moreover, the adoption of IP voice networks and importance of development
of products using industry standards such as SIP, generally require the
acceptance of a new way of exchanging information. In particular, enterprises
that have already invested substantial resources in other means of
communicating information may be reluctant or slow to adopt a new approach to
communications. If the market for IP network voice communications fails to
develop or develops more slowly than we anticipate, our IP network telephony
products could fail to achieve market acceptance, which in turn could
significantly harm our business, financial condition and operating results.
This growth may be inhibited by a number of factors, such as quality of
infrastructure; security concerns; equipment, software or other technology
failures; regulatory encroachments; inconsistent quality of service; poor voice
quality over IP networks as compared to circuit-switched networks; and lack of
availability of cost-effective, high-speed network capacity. Moreover, as
IP-based data communications and telephony usage grow, the infrastructure used
to support these IP networks, whether public or private, may not be able to
support the demands placed on them and their performance or reliability may
decline. The technology that allows voice and facsimile communications over
the Internet and other data networks, and the delivery of other value-added
services, is still in the early stages of development. Government regulation of third party long distance and network service entities
on which we rely may harm our business. Our supply of telecommunications services and information depends on
several long distance carriers, RBOCs, local exchange carriers, or LECs, and
competitive local exchange carriers, or CLECs. We rely on these carriers to
provide network services to our customers and to provide us with billing
information. Long distance services are subject to extensive and uncertain
governmental regulation on both the federal and state level. We cannot assure
the increase in regulations will not harm our business. Our current contracts
for the resale of services through long distance carriers include multi-year
periods during which we have minimum use requirements and/or costs. The market
for long distance services is experiencing, and is expected to continue to
experience significant price competition, and this may cause a decrease in
end-user rates. We cannot assure you we will meet minimum use commitments,
that we will be able to negotiate lower rates with carriers if end-user rates
decrease or that we will be able to extend our contracts with carriers at
favorable prices. If we are unable to secure reliable long distance and
network services from certain long distance carriers, RBOCs, LECs and CLECs, or
if these entities are unwilling or unable to provide telecommunications
services and billing information to us on favorable terms, our ability to
expand our own long distance and network services will be harmed. Carriers that
provide telecommunications services to us may also experience financial
difficulties, up to and including bankruptcies, which could harm our ability to
offer telecommunications services. Consolidation within the telecommunications industry could increase competition
and reduce our customer base. There has been a trend in the telecommunications industry towards
consolidation and we expect this trend to continue as the industry evolves. As
a result of this consolidation trend, new stronger companies may emerge that
have improved financial resources, enhanced research and development
capabilities and a larger and more diverse customer base. The changes within
the telecommunications industry may adversely affect our business, operating
results and financial condition. lerrorist activities and resulting military and other actions could harm our
business. Terrorist attacks in New York and Washington, D.C. in September of 2001
disrupted commerce throughout the world. The continued threat of terrorism, the
conflict in Iraq and the potential for additional military action and
heightened security measures in response to these threats may continue to cause
significant disruption to commerce throughout the world. To the extent that
disruptions result in a general decrease in corporate spending on information
technology or communications solutions, our business and results of operations
could be harmed. We are unable to predict whether the conflict in Iraq and its
aftermath, the threat of terrorism or the responses thereto will result in any
long-term commercial disruptions or if such activities or responses will have a
long-term adverse effect on our business, results of operations or financial
condition. Additionally, if any future terrorist attacks were to affect the
operation of the Internet or key 22




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data centers, our business could be harmed.
These and other developments arising out of the potential attacks may make the
occurrence of one or more of the factors discussed herein more likely to occur. 
 ITEM 2. PROPERTIES Our corporate headquarters in Tempe, Arizona is located in a 22,600 square
foot building pursuant to a lease that expires in May 2008. Our 68,000 square
foot operations and distribution center is also located in Tempe, Arizona
pursuant to a lease that expires in March 2006. The principal product
development and support operations remain in a 96,000 square foot building
located in Chandler, Arizona pursuant to a lease that expires in May 2008. We
also own a 74,000 square foot facility located in Reno, Nevada, which includes
portions of our credit and lease finance facilities, executive and
administrative functions, a business development center and a sales office. We
also lease sales and support offices and warehouses in a total of 55 lease
locations in the United States, including approximately 147,000 square feet of
office space in Milford, Connecticut that we acquired in the Executone
acquisition (a portion of which has been subleased), and three locations
overseas. In February 2003, we consolidated three Phoenix, Arizona area
offices with an aggregate of 31,300 square feet into a single Phoenix location
of 35,000 square feet pursuant to a lease, which expires in July 2008. Our
aggregate monthly payments under these leases were approximately $794,000 at
December 31, 2003. We believe our facilities will be adequate to meet our
current needs and that additional or alternative space will be available as
necessary in the future on commercially reasonable terms. 
 ITEM 3. LEGAL PROCEEDINGS We are involved from time to time in litigation incidental to our
business. We believe the outcome of current litigation will not have a
material adverse effect upon our business, financial condition or results of
operations. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 
 PART II 
 ITEM 5. MARKET FOR THE REGISTRANTS COMMON STOCK AND RELATED SHAREHOLDER MATTERS Inter-Tel Common Stock is traded over-the-counter (Nasdaq symbol: INTL)
and since February 1983 has been included in the Nasdaq National Market System.
As of March 5, 2004 there were of record
approximately 1,054 registered shareholders of our Common Stock. The following table
sets forth high and low sales prices reported by Nasdaq for each quarter in the
last two years. 2003
    
    High
    
    Low
    
    2002
    
    High
    
    LowFirst Quarter
    
    
    26.590
    
    
    
    14.255
    
    
    First Quarter
    
    
    22.77
    
    
    
    14.98Second Quarter
    
    
    22.240
    
    
    
    12.850
    
    
    Second Quarter
    
    
    21.70
    
    
    
    15.57Third Quarter
    
    
    28.350
    
    
    
    20.790
    
    
    Third Quarter
    
    
    27.00
    
    
    
    15.65Fourth Quarter
    
    
    29.560
    
    
    
    21.950
    
    
    Fourth Quarter
    
    
    28.98
    
    
    
    17.03
 Dividends.From December 31, 1997 through the third quarter of 2001, we
paid quarterly cash dividends (the cash dividend) of $0.01 for every share of
Common Stock, to shareholders of record. On October 23, 2001, our Board of
Directors increased the cash dividend from $0.01 to $0.02 for every share of
Common Stock, payable quarterly to shareholders of record beginning December
31, 2001. On July 16, 2002, our Board of Directors increased the cash dividend
from $0.02 to $0.03 for every share of Common Stock, payable quarterly to
shareholders of record beginning September 30, 2002. On July 21, 2003, our
Board of Directors increased the cash dividend from $0.03 to $0.06 for every
share of Common Stock, payable quarterly to shareholders of record beginning
September 30, 2003. Dividend payments commence on or about 15 days after the
end of each fiscal quarter. Attached below is a summary of our dividends
accrued and paid since December 31, 1997, the date we first declared cash
dividends on our Common Stock. The Company currently anticipates paying cash
dividends in the foreseeable future on its common stock. 23




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##### Table of Contents



Period
    
    Q1
    
    Q2
    
    Q3
    
    Q4
    
    Totals1997
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    0.01
    
    
    $
    0.011998
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.041999
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.042000
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.042001
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.02
    
    
    $
    0.052002
    
    $
    0.02
    
    
    $
    0.02
    
    
    $
    0.03
    
    
    $
    0.03
    
    
    $
    0.102003
    
    $
    0.03
    
    
    $
    0.03
    
    
    $
    0.06
    
    
    $
    0.06
    
    
    $
    0.18
 No Sales of Unregistered Securities We have not made any sales of unregistered securities during the past
three years, except for sales of our common stock to employees exercising their
stock options during the period prior to the effectiveness of a registration
statement on Form S-8 relating to such sales. Equity Compensation Plan Information Information regarding Inter-Tels equity compensation plans, including
both shareholder approved plans and non-shareholder approved plan, is set
forth in the section entitled Equity Compensation Plan Information in
Inter-Tels Notice of Annual Meeting of Shareholders and Proxy Statement, to be
filed within 120 days after Registrants fiscal year end of December 31, 2003. The table required by Item 201(d) of
Regulation S-K referred to under Item 12 herein is incorporated by
reference to the proxy statement. 24




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##### Table of Contents



ITEM 6. SELECTED FINANCIAL DATA Financial Summary The following selected consolidated financial data should be read in
conjunction with Item 7, Managements Discussion and Analysis of Financial
Condition and Results of Operations and Item 8, Financial Statements and
Supplementary Data. The table contains selected consolidated financial data
for the years ended December 31, 1999, 2000, 2001 2002 and 2003, derived from
our audited consolidated financial statements. (In thousands, except
per share amounts and ratios) For the years ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Net Sales
    
    $
    373,836
    
    
    $
    381,456
    
    
    $
    385,655
    
    
    $
    402,723
    
    
    $
    314,221Cost of sales
    
    
    176,763
    
    
    
    186,983
    
    
    
    211,161
    
    
    
    243,685
    (3)
    
    
    159,463Research and development
    
    
    21,978
    
    
    
    19,340
    
    
    
    17,556
    
    
    
    19,489
    
    
    
    14,798Selling, general and administrative
    
    
    128,964
    
    
    
    128,284
    
    
    
    128,604
    
    
    
    124,664
    
    
    
    97,163Amortization of goodwill
    
    
    
    
    
    
    
    
    
    
    1,876
    
    
    
    2,228
    
    
    
    856Amortization of purchased
intangible assets
    
    
    1,803
    
    
    
    1,122
    
    
    
    677
    
    
    
    576
    
    
    
    411In-process research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,433
    (3)
    
    
    Other charges
    
    
    
    
    
    
    
    
    
    
    5,357
    (2)
    
    
    45,245
    (3)
    
    
    Operating (loss) income
    
    
    44,328
    
    
    
    45,727
    
    
    
    20,424
    (2)
    
    
    (38,597
    )(3)
    
    
    41,530Litigation settlement (net of
costs except for taxes)
    
    
    
    
    
    
    15,516
    (1)
    
    
    
    
    
    
    
    
    
    
    Write-down/recovery of investment
in Inter-Tel.NET/Vianet
    
    
    124
    
    
    
    (1,200
    )
    
    
    
    
    
    
    
    
    
    
    Equity share of Cirilium Corp.s
net losses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,938
    )(3)
    
    
    Write-off of Cirilium Corp.
investment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,045
    )(3)
    
    
    Interest and other income
    
    
    1,683
    
    
    
    1,936
    
    
    
    1,081
    
    
    
    1,474
    
    
    
    2,391Foreign currency transaction gains
(losses)
    
    
    18
    
    
    
    330
    
    
    
    (337
    )
    
    
    (421
    )
    
    
    (46
    )Interest expense
    
    
    (155
    )
    
    
    (156
    )
    
    
    (468
    )
    
    
    (213
    )
    
    
    (110
    )Income (loss) before income taxes
(benefit)
    
    
    45,998
    
    
    
    62,153
    (1)
    
    
    20,700
    (2)
    
    
    (45,740
    )(3)
    
    
    43,765Income taxes (benefit)
    
    
    17,480
    
    
    
    23,516
    
    
    
    7,659
    
    
    
    (16,817
    )
    
    
    16,619Net income (loss)
    
    $
    28,518
    
    
    $
    38,637
    (1)
    
    $
    13,041
    (2)
    
    $
    (28,923
    )(3)
    
    $
    27,146Net income (loss) per shareBasic
    
    $
    1.14
    
    
    $
    1.58
    (1)
    
    $
    0.53
    (2)
    
    $
    (1.10
    )(3)
    
    $
    1.05Diluted
    
    $
    1.08
    
    
    $
    1.49
    (1)
    
    $
    0.52
    (2)
    
    $
    (1.10
    )(3)
    
    $
    1.01Weighted average basic common
shares
    
    
    25,078
    
    
    
    24,444
    
    
    
    24,488
    
    
    
    26,273
    
    
    
    25,949Weighted average diluted common
shares
    
    
    26,473
    
    
    
    25,864
    
    
    
    25,240
    
    
    
    26,273
    
    
    
    27,004BALANCE SHEET DATATotal assets
    
    $
    359,876
    
    
    $
    282,062
    
    
    $
    227,462
    
    
    $
    243,126
    
    
    $
    247,517Working capital
    
    
    200,561
    
    
    
    131,624
    
    
    
    93,156
    
    
    
    86,008
    
    
    
    60,799Shareholders equity
    
    
    207,305
    
    
    
    173,903
    
    
    
    126,837
    
    
    
    136,436
    
    
    
    168,121KEY RATIOSCurrent ratio
    
    
    3.64
    
    
    
    2.80
    
    
    
    2.41
    
    
    
    2.05
    
    
    
    1.93Dividends declared per share
    
    $
    0.18
    
    
    $
    0.10
    
    
    $
    0.05
    
    
    $
    0.04
    
    
    $
    0.04Return on beginning equity
    
    
    16.4
    %
    
    
    30.5
    %
    
    
    9.6
    %
    
    
    (17.2
    )%
    
    
    19.0
    %Return on beginning
equity-excluding charges and
litigation settlement
    
    
    16.4
    %
    
    
    23.6
    %(1)
    
    
    12.0
    %(2)
    
    
    7.8
    %(3)
    
    
    19.0
    %Net cash provided by operating
activities
    
    $
    54,890
    
    
    $
    77,195
    
    
    $
    75,006
    
    
    $
    17,339
    
    
    $
    33,380
  (1)
    
    2002 income before taxes includes $15.5 million of proceeds, net of
related expenses from a binding arbitration settlement, which increased
net income by $9.5 million, or $0.37 per share after tax. Without this
settlement,
we would have reported net income of $29.1 million ($1.13 per diluted share)
for the year ended December 31, 2002. 25




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(2)
    
    2001 operating income includes a pre-tax charge of $5.4 million, which
reduced net income by $3.4 million, or $0.13 per share after tax. This
pre-tax charge reflects the write-down of our investment in Inter-Tel.NET
to net realizable value.(3)
    
    2000 operating income includes pre-tax charges of $66.8 million, which
reduced net income by $42.0 million, or $1.60 per share after tax. These
pre-tax charges reflect the write-off of the Executone acquisition of
$50.9 million ($7.6 million of which is included in cost of sales) in the
second quarter, the write-off of IPRD in connection with the Executone
purchase of $5.4 million during the first quarter, the write-down to net
realizable value of Inter-Tel.NET assets of $2.0 million during the second
quarter, the equity share of the losses from an investment in a joint
venture of $5.9 million for the year, and the write-off of our investment
in such joint venture of $2.6 million (including reserve adjustments)
during the third quarter. Without these charges, we would have reported
net income of $13.1 million ($0.50 per diluted share) for the year ended
December 31, 2000. 
 ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Managements Discussion and Analysis of Financial Condition and
Results of Operations and other parts of this Annual Report on Form 10-K
contain forward-looking statements that involve risks and uncertainties. The
words expects, anticipates, believes, intends, will and similar
expressions identify forward-looking statements, which are based on information
available to us on the date hereof, and we assume no obligation to update any
such forward-looking statements. Our actual results could differ materially
from those anticipated in these forward-looking statements as a result of
certain factors, including those set forth in Factors That May Affect Future
Operating Results and elsewhere in thisForm 10-K. Overview Inter-Tel (Nasdaq: INTL), incorporated in 1969, is a single point of
contact, full service provider of converged voice and data business
communications systems, voice mail systems and networking applications. Our
customers include business enterprises, federal, state and local government
agencies and non-profit organizations. We market and sell the following
products and services:  
    
    Axxessby Inter-Tel and EncoreCX by Inter-Tel converged voice and
data business communication systems,  
    
    integrated voice mail, voice processing and unified messaging systems,  
    
    IP telephony voice and data routers, and e-commerce software,  
    
    managed services, including voice and data network design and traffic
provisioning, custom application development, and financial solutions
packages (leasing),  
    
    networking applications,  
    
    local and long distance calling services and other communications
services and peripheral products,  
    
    call accounting software, computer-telephone integration (CTI) applications, and  
    
    maintenance and support services for our products. We have developed a distribution network of direct sales offices, dealers
and value added resellers (VARs), which sell our products to organizations
throughout the United States and internationally, primarily targeting
small-to-medium enterprises, service organizations and governmental agencies.
As of March 5, 2004, we had fifty (50) direct sales offices in the United
States, one (1) in Japan, and a network of hundreds of dealers and VARs
primarily in the United States, that purchase directly from us. Included in
our sales office in Phoenix is the primary location for our national and
government accounts division, as well as our local, long distance and network
services divisions. Our wholesale distribution center is located in Tempe,
Arizona, which is the primary location from which we distribute products to our
network of direct sales offices, dealers and VARs. In addition, we maintain a
wholesale distribution office in the United Kingdom that supplies Inter-Tels
dealers and distributors throughout the UK and other parts of Europe, and we
have dealers in Japan and Mexico. We also maintain a research and development
and software sales office in the United Kingdom. Key performance indicators that we use in order to manage our business and
evaluate our financial and operating performance include: revenues, costs and
gross margins, and cash flows. 26




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##### Table of Contents



Inter-Tel recognized revenue from the following significant sources of
revenue:  
    
    End-user sales through our direct sales offices and government and
national accounts division. We recognize revenue from sales of systems
and services to end-user customers upon installation of the systems and
performance of the services, respectively, allowing for use by our
customers of these systems. We defer pre-payments for communications
services and recognize these pre-payments as revenue as the
communications services are provided.  
    
    Dealer and VAR sales. For shipments to dealers and other
distributors, our revenue is recognized as products are shipped and
services are rendered, because the sales process is complete. Title to
these products passes when goods are shipped (free-on-board shipping
point).  
    
    Resale of long distance. We recognize revenue from long distance
resale services as services are provided.  
    
    Sales-leases. For our sales-type lease accounting, we record the
discounted present values of minimum rental payments under sales-type
leases as sales, net of provisions for continuing administration and
other expenses over the lease period. We record the lease sales at the
time of system sale and installation as discussed above for sales to end
user customers, and upon receipt of the executed lease documents. The
net rental streams are sold to funding sources on a regular basis with
the income streams discounted by prevailing like-term rates at the time
of sale. Gains or losses resulting from the sale of net rental payments
from such leases are also recorded as net sales.  
    
    Maintenance. Maintenance revenue is recognized ratably over the term
of the maintenance agreement. Costs and gross margins. Our costs of products sold primarily consist of
materials, labor and overhead. Our costs of services performed consist
primarily of labor, parts and service overhead. Total costs of goods and
services sold decreased 5.5%, or $10.2 million, to $176.8 million for the year
ended December 31, 2003, compared to $187.0 million for the same period in
2002. Our consolidated gross margin percentage increased to 52.7% in 2003
compared to 51.0% in 2002, attributable to several factors, including a higher
proportion of recurring revenues from existing customers in our direct sales
offices and government and national accounts division, increased maintenance
and services revenues as a percentage of total sales, higher software content
in our products, cost containment efforts, product design improvements, and
efficiencies achieved with our manufacturing vendors. Sales of systems through our direct sales organization typically generate
higher gross margins than sales through our dealers and VARs, primarily because
we recognize both the wholesale and retail margins on these sales. Conversely,
sales of systems through our dealers and VARs typically generate lower gross
margins than sales through our direct sales organization, although direct sales
typically require higher levels of selling, general and administrative
expenses. In addition, our long distance services and Datanet products
typically generate lower gross margins than sales of software and system
products. For revenues recognized under sales-leases, we record the costs of
systems installed as costs of sales. Our margins may vary from period to
period depending upon distribution channel, product and software mix. In the
event that sales through our direct sales offices increase as a percentage of
net sales, our overall gross margin could improve. Conversely, in the event
net sales to dealers or sales of long distance services increase as a
percentage of net sales, our overall gross margin could decline. Our operating results depend upon a variety of factors, including the
volume and timing of orders received during a period, the mix of products sold
and the mix of distribution channels, general economic conditions and world
events impacting businesses, patterns of capital spending by customers, the
timing of new product announcements and releases by us and our competitors,
pricing pressures, the cost and effect of acquisitions and the availability and
cost of products and components from our suppliers. Historically, a
substantial portion of our net sales in a given quarter has been recorded in
the third month of the quarter, with a concentration of such net sales in the
last two weeks of the quarter. In addition, we are subject to seasonal
variations in our operating results, as net sales for the first and third
quarters are frequently less than those experienced during the fourth and
second quarters, respectively. 2003 followed this historical pattern and we do
not anticipate a significant change in this trend. Cash Flows. At December 31, 2003, Inter-Tels cash and short-term
investments totaled $174.5 million. We also maintain a $10 million unsecured,
revolving line of credit with BankOne, NA, which is available through June 1,
2004 and ordinarily used to support international letters of credit to
suppliers, if 27




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necessary. Historically, our primary source of cash has come
from net income plus non-cash charges for depreciation and amortization
expenses. We have generated cash from continuing operations in every year
since 1986. In 1993, 1995 and 1997, the Company received net proceeds from
stock offerings, offset in part by cash expended to repurchase the Companys
common stock. In addition, Inter-Tel historically has paid cash for capital
expenditures of property and equipment or acquisitions. Inter-Tel has also
received cash proceeds from the exercise of stock options and our Employee
Stock Purchase Plan. We believe our working capital and credit facilities,
together with cash generated from operations, will be sufficient to develop and
expand our business operations, to finance acquisitions of additional resellers
of telephony products and other strategic acquisitions or corporate alliances,
and to provide adequate working capital for the foreseeable future. Our consolidated revenues from all sources have declined slightly during
each of the past three years, but at a lower rate than the decline in revenues
of some of our primary competitors in the business communications systems
market. Net sales for the years ended December 31, 2001, 2002 and 2003 were
$385.7 million, $381.5 million and $373.8 million, respectively. The slight
decline in revenue in 2002 was primarily attributable to the sale of
Inter-Tel.NET in July 2001. Excluding Inter-Tel.NET revenues in 2001, revenues
increased by $9.8 million from 2001 to 2002. The 2.0% decline in net sales in
2003 resulted from the effect of general economic conditions and our customers
appeared less willing to spend significantly on business communications
systems. Although revenue declined slightly in 2003, revenue increased in the
fourth quarter of 2003 compared to the fourth quarter of 2002. The fourth
quarter increase in net sales can be attributed in part to new product releases
and improved sales in our long distance resale division. However, we cannot
provide assurance that the recent increase in revenue will continue in the
future as we believe businesses may continue to be reluctant to significantly
increase spending on enterprise communications systems in the near future. The decline in revenue from business communications systems may also be
attributable in part to business investments in systems made in the late 1990s
in anticipation of Year 2000 issues. We believe businesses may have been
reluctant to make additional investments in these communications systems until
their existing investments have been fully amortized over their useful life.
In addition, we believe many customers are hesitant to invest in traditional
voice communication systems as they may be anticipating broader adoption of
next-generation communications systems. We believe that enterprises continue to be concerned about their ability
to increase revenues and profitability, in part due to the uncertain economic
environment and slowdown in the past few years. To maintain or improve
profitability, we believe that businesses have attempted to reduce costs and
capital spending. We expect continued pressure on our ability to generate or
expand sales and it is not clear whether business communications spending will
improve significantly in the near term. We cannot predict the nature, timing
and extent of future business investments in communications systems and as a
result, if and when our net sales will increase. The markets we serve have been characterized by rapid technological
changes and increasing customer requirements. We have sought to address these
requirements through the development of software enhancements and
improvements to existing systems and the introduction of new systems,
products, and applications. Inter-Tels research and development efforts over
the last several years have been focused primarily on the development of, and
enhancements to, our Axxesssystem, including adding new applications,
enhancing our IP convergence applications and IP endpoints, developing Unified
Communications applications, developing presence management applications, and
developing speech-recognition and text-to-speech applications. More recently,
Inter-Tels research and development efforts have been focused on the
development of Session Initiation Protocol (SIP) interfaces and application as
well as the development and a new line of multi-protocol SIP IP endpoints. We offer our customers a package of lease financing and other services
under the name Total Solution (formerly, Totalease). Total Solution provides
our customers lease financing, maintenance and support services, fixed price
upgrades and other benefits. We finance this program through the periodic
resale of lease rental streams to financial institutions. Refer to Note D of
Notes to Consolidated Financial Statements for additional information regarding
our program. Results of Operations 28




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The following table sets forth certain statement of income data
expressed as a percentage of net sales for the periods indicated (amounts do
not add due to rounding): Year Ended December 312003
    
    2002
    
    2001Net sales
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    47.3
    
    
    
    49.0
    
    
    
    54.8Gross profit
    
    
    52.7
    
    
    
    51.0
    
    
    
    45.2Research and development
    
    
    5.9
    
    
    
    5.1
    
    
    
    4.6Selling, general and administrative
    
    
    34.5
    
    
    
    33.6
    
    
    
    33.3Amortization of goodwill and intangibles
    
    
    0.5
    
    
    
    0.3
    
    
    
    0.7Other charges
    
    
    
    
    
    
    
    
    
    
    1.4Operating income
    
    
    11.9
    
    
    
    12.0
    
    
    
    5.3Litigation settlement
    
    
    
    
    
    
    4.1
    
    
    
    Write-down/recovery of investment in Inter-Tel.NET/Vianet
    
    
    0.0
    
    
    
    (0.3
    )
    
    
    Interest and other income
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.3Foreign currency transaction gains (losses)
    
    
    0.0
    
    
    
    0.1
    
    
    
    (0.1
    )Interest expense
    
    
    (0.0
    )
    
    
    (0.0
    )
    
    
    (0.1
    )Income taxes
    
    
    4.7
    
    
    
    6.2
    
    
    
    2.0Net income
    
    
    7.6
    %
    
    
    10.1
    %
    
    
    3.4
    %
 Year Ended December 31, 2003 Versus Year Ended December 31, 2002 Net Sales.Net sales decreased 2.0% to $373.8 million in 2003 from $381.5
million in 2002, representing a decrease of $7.6 million. The decrease in net
sales was primarily attributable to a reduction in sales through our direct
sales offices and DataNet division, offset in part by sales increases from
Inter-Tel NetSolutions, dealer and international sales. Sales from our direct
sales offices decreased 6.9% in 2003 compared to 2002, due primarily to a
revenue shortfall in the first quarter of 2003 relative to the comparable
period in 2002. The first quarter of 2003 represented our worst quarter of the
year, due primarily to relatively weak economic conditions, uncertainties
associated with the war in Iraq and threatened terrorist attacks, and the
impact of adverse weather conditions in the eastern United States and Colorado.
Sales from our government and national accounts division decreased slightly by
2.0%, in 2003 compared to 2002. Sales from our DataNet division, which sells
networking products through our direct sales offices, government and national
accounts division and dealer channel, decreased $3.0 million, or 22.2% in 2003
compared to 2002 as a result of selling less third-party lower margin products.
Sales to our dealer network increased slightly by 1.2% in 2003. The 2003 decrease in net sales from our direct sales offices, government
and national accounts division and DataNet division was also attributable to
delayed customer buying decisions related to a continued deterioration in
industry and macroeconomic conditions, as well as increased competitive
pressures, among other factors identified above and further noted above.
Inter-Tel recognized lower revenues due to lower sales volumes of new system
installations collectively through the direct sales offices and government and
national accounts group, offset in part by sales increases in our NetSolutions
division, and to a lesser extent, dealer sales and international operations.
In some instances, prices of various telecommunications systems decreased, and
discounts or other highly competitive promotions that were offered to customers
to generate sales resulted in lower revenue through both our direct and
indirect channels. Although sales to new customers declined during 2003,
recurring revenues to existing customers increased in total dollars and as a
percentage of total sales. Sales from NetSolutions, our long distance resale division, increased
27.4%, or $8.2 million in 2003 to $38.3 million compared to $30.0 million in
2002 and represented the division with our largest percentage sales increase.
Sales increased in our long distance division despite downward price pressure
and significant competition. Increased sales volume has allowed NetSolutions,
our long distance resale division, to offer more competitive pricing, which
improved sales to our existing customer base. Sales from Network Services
Agency, a commission-based sales division acting as an agent to sell services
for selected RBOCs and CLECs, decreased 15.0% to $5.6 million, largely due to changes
in our commission compensation structure from one of the RBOCs. The change
in the RBOCs pricing structure resulted in a more deferred sales commission
structure on local and network services such as T-1 access, frame relay and
other voice and data circuit services. Net sales from lease financing were
flat in 2003 compared to 2002, an increase of 29




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0.2%, and international revenues
increased $0.9 million, or 9.1% in 2003 compared to 2002, primarily as a result
of a full year of revenues from Swan, which was acquired in December 2002 and
represented $0.6 million of the increase. Please refer to Note O of Notes to Consolidated Financial Statements for
additional segment reporting information. Gross Profit. Gross profit increased 1.3% to $197.1 million, or 52.7% of
net sales in 2003, from $194.5 million, or 51.0% of net sales, in 2002. Gross
profit and gross margin increased in 2003 compared to 2002 as a result of
several factors, including a higher proportion of recurring revenues from
existing customers in our direct sales offices and government and national
accounts division, increased maintenance and services revenues as a percentage
of total sales, higher software content in our products, cost containment
efforts, product design improvements, and efficiencies achieved with our
manufacturing vendors. During 2003, recurring revenues from existing customers in our direct
sales and national and government accounts channels increased as a percentage
of total sales from these same channels from approximately 46% in 2002 to
approximately 51% in 2003. Existing customers accounted for a significant
portion of our 2003 net sales from maintenance and other services, software
additions and/or upgrades, support, training and hardware products such as
video conferencing, headsets (wired and wireless), networking products and
speakerphones. Our business communications platforms allow for system migration
without the complete change-out of hardware, which enables us to offer
enhancements and new solutions through software-only upgrades to our existing
customers. Our gross margin is generally higher with recurring revenues
because we incur less materials costs compared to new installations.
Accordingly, our gross profit and gross margins improved in 2003 as a result of
this recurring revenue percentage increase. Sales from NetSolutions increased by 27.4%, or $8.2 million, in 2003
compared to 2002. Although gross margin is generally lower in this division
than our consolidated gross margin, the gross margin improved to 32.2% in 2003
compared to 28.7% in 2002, based in part on our ability to negotiate more
favorable pricing with vendors on higher resale volumes. In addition, sales
from our Network Services Agency decreased 15.0%, or $1.0 million, in 2003
compared to 2002, which partially offset our overall increase in gross margin.
This division generally receives commissions on network services we sell as an
agent for RBOCs. These sales carry little to no equipment costs and generated
margins of approximately 89% in 2003 compared to 91% in 2002. The decrease in
sales from this division therefore partially offset our overall increase in
consolidated gross profit and margins. The overall increases in gross margin noted above were also offset in part
by continued competitive pricing pressures in our direct sales offices,
government and national accounts and dealer channels in 2003, including pricing
discounts or special competitor promotions on telephone system and software
sales and related equipment. Our margins may vary from period to period
depending upon distribution channel, product and software mix. In the event
that sales through our direct sales offices increase as a percentage of net
sales, our overall gross margin could improve. Conversely, in the event net
sales to dealers or sales of long distance services increase as a percentage of
net sales, our overall gross margin could decline. Research and Development. Research and development expenses increased
13.6% to $22.0 million, or 5.9% of net sales in 2003, compared to $19.3
million, or 5.1% of net sales in 2002. The increase is attributable in large
part to the acquisition of Swan Solutions Limited (Swan) in December 2002.
The increase is also attributable, to a lesser extent, to increased research
and development spending related to convergence applications and new IP
endpoint development. In 2003, research and development expenses were directed
principally toward the continued development of the AXXESSsoftware and
systems, SIP applications, presence management applications, unified messaging
and voice processing software, speech recognition and text-to-speech
applications, call center applications, unified communications applications, IP
endpoint development, and certain CTI and IVR applications. We expect that
research and development
expenses will increase in absolute dollars as we continue to develop and
enhance existing and new technologies and products. These expenses may vary,
however, as a percentage of net sales. Selling, General and Administrative. Selling, general and administrative
expenses increased slightly in absolute dollars to $129.0 million in 2003,
compared to $128.3 million in 2002. These expenses also increased as a
percentage of net sales to 34.5% in 2003 compared to 33.6% in 2002. These
increases in absolute dollars and as a percentage of net sales were primarily
due to higher selling expenses relative to total sales. 30




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Selling, general and administrative expenses increased as a percentage of
net sales in part due to the decrease in consolidated net sales by $7.6 million
in 2003 compared to 2002. We incurred higher relative selling expenses through
our combined direct sales offices and government and national accounts
divisions, as we had increased sales personnel and sales training and support
in anticipation of higher sales volumes and activity than actually
materialized, particularly in the early part of 2003. We also incurred higher
relative sales expenses in our long distance calling services division in 2003
relative to 2002 as a result of an increased number of sales personnel working
directly for this division. Selling, general and administrative expenses also
increased as a percentage of net sales due to higher costs of benefits,
including higher health insurance for our associates. Our consolidated bad
debt costs decreased in 2003 compared to 2002 and also decreased as a
percentage of total net sales, based on improved credit and collections on
existing accounts receivable. Depreciation expense was relatively flat in 2003
compared to 2002. We expect for the foreseeable future selling, general and
administrative expenses will increase sequentially in absolute dollars assuming
we increase sales and continue to enhance existing and develop new technologies
and products. These expenses may vary, however, as a percentage of net sales. Amortization of Goodwill and Purchased Intangible Assets. We adopted SFAS
No. 142 effective the beginning of fiscal 2002. In accordance with SFAS 142, we
ceased amortizing goodwill. We are required to perform goodwill impairment
tests on an annual basis and between annual tests in certain circumstances.
As of December 31, 2003, no impairment of goodwill has been recognized. There
can be no assurance that future goodwill impairment tests will not result in a
charge to earnings. For additional information regarding SFAS 142, see
Goodwill and Other Intangible Assets in Note A of Notes to Consolidated
Financial Statements. Amortization of purchased intangible assets included in operating expenses
was $1.8 million in 2003 compared to $1.1 million in 2002. The increases in
the amortization of purchased intangible assets for 2003 compared to 2002 was
primarily related to the additional amortization from recent acquisitions. For
additional information regarding purchased intangible assets, see Note
ASignificant Accounting Policies Goodwill and Other Intangible Assets and
Note B Acquisitions, Dispositions and Restructuring Charges  to
Consolidated Financial Statements. Litigation Settlement, Net of Costs Except for Taxes. In May 2001,
Inter-Tel entered into an agreement to submit to binding arbitration a lawsuit
we filed in 1996. The arbitration was completed in January 2002 and, as a
result of the arbitration, Inter-Tel received a one-time gross cash award of
$20 million in February 2002. Direct costs for attorneys fees, expert witness
costs, arbitration costs and additional payments and expenses, totaled
approximately $4.5 million in 2002, excluding income taxes, for a net award of
approximately $15.5 million. The net proceeds from this arbitration settlement
were approximately $9.5 million after taxes, or $0.37 per diluted share for the
year ended December 31, 2002. Interest and Other Income. In 2003, interest and other income totaling
$1.7 million consisted primarily of interest income and foreign currency
transaction gains. Other income in 2002 totaling $1.9 million also consisted
primarily of interest income and foreign currency transaction gains. Interest
and other income decreased approximately $253,000 in 2003 compared to 2002
based on lower interest rates, despite a higher level of invested funds in part
due to cash received from the litigation settlement noted above. During 2003,
we recognized foreign currency transaction gains of $18,000, a decrease of
$312,000 compared to gains of $330,000 in 2002. Interest expense. Interest expense was flat at $155,000 in 2003 compared
to $156,000 in 2002. Other. Since July 24, 2001, the date of the sale of 83% of Inter-Tel.NET
to Comm-Services/Vianet, we have used the cost method of accounting for our
remaining investment in Inter-Tel.NET/Vianet.
 Accordingly, we have not recorded revenues or operating expenses of that
entity since the date of sale. In 2002, the other component of this caption
included an expense of approximately $1.2 million related to the write-down of
Inter-Tels investment in Inter-Tel.NET/Vianet. In 2003, other income included
$124,000 related to a recovery of our investment and adjustment of projected
costs to actual costs associated with the 2002 write-down in the Vianet
investment. At December 31, 2003, our net investment in Vianet was recorded at
no value. Income Taxes. Our effective income tax rate for 2003 was relatively flat
at 38.0% compared to 37.8% for 2002. The net deferred tax liabilities increased
significantly in 2003 due primarily to accelerated depreciation of fixed
assets, and temporary differences relating to leases in our Total Solution
program. Most 31




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of the increase arose from deductions taken in the companys
2002 federal income tax return wherein the company decided in 2003 to elect to
take bonus depreciation and accelerated depreciation of fixed assets and
certain leased equipment when filing its 2002 return in 2003. The company filed
a change in accounting method with the Internal Revenue Service to utilize
accelerated depreciation for the 2002 tax year. Effective May 6, 2003, the
bonus depreciation increased from a 30% to a 50% depreciation deduction, which
favorably impacted the 2003 tax deduction and increased the deferred
liabilities for 2003. The depreciation deductions identified above generated a net operating
loss that was not fully utilized in a carryback claim to 2001; accordingly, the
loss was carried forward. This net operating loss created deferred assets for
net operating loss carryforwards and certain tax credit carryforwards, each of
which is separately identified in the components of deferred tax assets and
liabilities schedule included in Note K to the Consolidated Financial
Statements. We expect these carryforwards to be fully utilized by 2004. Our
effective income tax rate for 2003 was not significantly impacted by these
carryforwards. We expect the full-year 2004 tax rates to be comparable to the
effective tax rate for 2003. Net Income.Net income for 2003 decreased to $28.5 million, or $1.08 per
diluted share, compared to net income of $38.6 million, or $1.49 per diluted
share, including the litigation settlement in 2002. The decrease was
primarily attributable to income from net proceeds of an arbitration settlement
in 2002. The net proceeds from this arbitration settlement were approximately
$9.5 million after taxes, or $0.37 per diluted share for the year ended
December 31, 2002. Excluding the 2002 litigation settlement, we would have reported net
income of $29.1 million, or $1.13 per diluted share in 2002. The decrease in
net income of 2.2% in 2003, excluding the settlement, was primarily the result
of lower profits on a lower volume of sales, higher research and development
expenses and higher amortization costs, offset by higher gross profit margins
described in further detail above. Year Ended December 31, 2002 Versus Year Ended December 31, 2001 Net Sales.Net sales decreased 1.1% to $381.5 million in 2002 from $385.7
million in 2001, representing a decrease of $4.2 million. The decrease in net
sales was primarily attributable to the fact that sales from Inter-Tel.NET (of
which Inter-Tel sold 83% of its interest in July 2001) were not included in
2002. Inter-Tel.NET sales were $14.0 million in 2001. Sales from our direct
sales offices were relatively flat in 2002 compared to 2001 including sales
from McLeod offices acquired in 2002. Excluding the McLeod acquisition, sales
in this division declined by approximately 5.4%. Sales from our government and
national accounts division decreased $7.1 million, or 25.6%, in 2002 compared
to 2001. The DataNet division, which sells networking products through our
direct sales offices, government and national accounts division and dealer
channel, was purchased in the 2002 McLeod acquisition, and accounted for $13.5
million in sales in 2002. Sales to our dealer network decreased by 4.1% in
2002, due primarily to the impact of the McLeod acquisition, since, prior to
2002, McLeod was a dealer that purchased $4.2 million from Inter-Tel in 2001.
Excluding the McLeod acquisition, sales to the dealer network increased 1.5%. Sales from our long distance resale and network services divisions
increased $7.1 million in 2002 compared to 2001. Net sales from lease
financing increased 3.2% in 2002 compared to 2001 and international revenues
increased by less than 1% in 2002 compared to 2001. Since July 24, 2001, the date of the sale of 83% of Inter-Tel.NET, we have
used the cost method of accounting for our remaining investment in
Inter-Tel.NET/Comm-Services. Accordingly, we have not recorded revenues or
expenses of Inter-Tel.NET since the date of sale. The reduction in sales
attributable to Inter-Tel.NET was due entirely to our sale of 83% of this
subsidiary. The 2002 decrease in net sales from our direct sales offices, government
and national accounts division and dealer channel was also attributable to
delayed customer buying decisions related to a continued deterioration in
industry and macroeconomic conditions, among other factors as follows.
Inter-Tel recognized lower revenues due to lower sales volumes of systems
collectively through the direct sales offices, government and national accounts
group and dealer channel, offset in part by sales increases in our long
distance and network services divisions, sales from acquired McLeod operations,
and to a lesser extent, lease finance and international operations. In some
instances, prices of various telecommunications systems decreased, and
discounts or other highly competitive promotions that were offered to customers
to generate sales resulted in lower revenues through both our direct and
indirect channels. Sales of communications systems were heavily impacted by
delayed buying decisions, in particular in our national accounts division 32




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and
direct sales offices. Although sales to new customers declined during 2002,
recurring revenues to existing customers increased as a percentage of total
sales. Sales from long distance and network services increased in 2002 compared
to 2001 and represented the divisions with our largest percentage sales
increases. Sales increased in our long distance division by 17.5%, despite
downward price pressure and significant competition. Increased sales volume
has allowed NetSolutions, our long distance resale division, to offer more
competitive pricing, which improved sales to our existing customer base.
Network Services Agency revenues increased 66% in 2002 compared to 2001, on
higher volume of sales and commissions on local and network services such as
T-1 access, frame relay and other voice and data circuit services. Please
refer to Note O of Notes to Consolidated Financial Statements for additional
segment reporting information. Gross Profit. Gross profit increased 11.4% to $194.5 million, or 51.0% of
net sales in 2002, from $174.5 million, or 45.2% of net sales, in 2001. The
increases in gross profit and gross margins were the result of several
different factors. Gross profit and gross margin in 2002 improved as a result
of no longer including the results of Inter-Tel.NET, which experienced negative
gross margins of $5.9 million during 2001. Gross profit and margins also
increased in 2002 as compared to 2001 as a result of a higher proportion of
recurring revenues from existing customers, including increased maintenance and
services revenues as a percentage of total sales, higher software content in
our products, cost containment efforts, product design improvements,
efficiencies achieved with our manufacturing vendors and a more favorable sales
channel mix. During 2002, recurring revenues from existing customers in our direct
sales and national and government accounts channels increased as a percentage
of total sales from these same channels from approximately 44% in 2001 to more
than 46% in 2002. Existing customers accounted for a significant portion of
our 2002 net sales from maintenance and other services, software additions
and/or upgrades, support, training and hardware products such as video
conferencing, headsets (wired and wireless), networking products and
speakerphones. Our business communications platforms allow for system migration
without the complete change-out of hardware, which enables us to offer
enhancements and new solutions through software-only upgrades to our existing
customers. Our gross margins are generally higher with recurring revenues
because we incur less materials costs relative to new installations.
Accordingly, our gross profit and margins improved in 2002 as a result of this
recurring revenue percentage increase. Sales from NetSolutions increased by 17.5%, or $4.5 million, compared to
2001. Although gross margins are generally lower in this division than our
consolidated margins, the margins improved slightly in 2002 relative to 2001,
based in part on our ability to negotiate more favorable pricing with vendors
on higher resale volumes. In addition, sales from our Network Services Agency
increased 66%, or $2.6 million, in 2002 compared to 2001. This division
generally receives commissions on network services we sell as an agent for
RBOCs. These sales carry little to no equipment costs and generated margins of
approximately 91% in 2002. The increase in sales from this division therefore
improved our consolidated gross profit and margins. The increases in gross margin noted above were offset in part by continued
competitive pricing pressures in our direct sales offices, government and
national accounts and dealer channels in 2002, including pricing discounts or
special competitor promotions on telephone system and software sales and
related equipment. Research and Development. Research and development expenses increased
10.2% to $19.3 million, or 5.1% of net sales in 2002, from $17.6 million, or
4.6% of net sales in 2001. The increase is attributable in large part to the
acquisitions of Mastermind in late October 2001 and Swan in early December
2002. The increase is also attributable, to a lesser extent, to increased
research and development spending related to convergence applications and new
IP endpoint development. In 2002, research and development expenses were
directed principally toward the continued development of the AXXESSsoftware
and systems (including versions 6.0 and 7.0), unified messaging and voice
processing software, speech recognition and text-to-speech applications, call
center applications, unified communications applications, IP endpoint
development, and certain CTI and IVR applications. Selling, General and Administrative. Selling, general and administrative
expenses decreased slightly in absolute dollars to $128.3 million in 2002,
compared to $128.6 million in 2001. However, these expenses increased as a
percentage of net sales to 33.6% in 2002 compared to 33.3% in 2001. This
decrease in 33




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absolute dollars was primarily due to the reduction in total net
sales of $4.2 million in 2002 compared to 2001. The increase in these expenses
as a percentage of net sales is in large part attributable to the sale of 83%
of Inter-Tel.NET operations in July 2001. Selling, general and administrative
expenses for Inter-Tel.NET were 16.8% of net sales when compared to the
consolidated average. Accordingly, when these operations were no longer
included in our consolidated results, our selling, general and administrative
expenses increased as a percentage of net sales. Inter-Tel.NET incurred selling, general and administrative expenses,
excluding amortization, of $2.3 million during 2001. Excluding the operations
of Inter-Tel.NET for comparative purposes, selling, general and administrative
expenses decreased as a percentage of net sales reflecting the lower percentage
of total sales generated through our combined direct sales offices and
government and national accounts divisions, including the acquired McLeod
operations in January 2002. Selling, general and administrative expenses also
decreased as a percentage of net sales due to lower depreciation and bad debt
costs relative to total sales. In addition, the growth in sales from the

resale of long distance calling services and Datanet products led to lower
selling, general and administrative costs relative to total sales. Amortization of Goodwill and Purchased Intangible Assets. We adopted SFAS
No. 142 effective the beginning of fiscal 2002. In accordance with SFAS 142, we
ceased amortizing goodwill. We are required to perform goodwill impairment
tests on an annual basis and between annual tests in certain circumstances.
As of December 31, 2002, no impairment of goodwill has been recognized.
Although amortization of goodwill ceased for 2002, goodwill amortization
totaled $1.9 million in 2001, reflecting amortization from acquisitions
completed prior to 2002. For additional information regarding SFAS 142, see
Goodwill and Other Intangible Assets in Note A of Notes to Consolidated
Financial Statements. Amortization of purchased intangible assets included in operating expenses
was $1.1 million in 2002 compared to $677,000 for 2001. The increases in the
amortization of purchased intangible assets for 2002 compared to 2001 was
primarily related to the additional amortization from recent acquisitions. For
additional information regarding purchased intangible assets, see Note A
Goodwill and Other Intangible Assets and Note B Acquisitions, Dispositions
and Restructuring Charges  to Consolidated Financial Statements. Other Charges. We recorded no charges in 2002. In connection with the
sale of 83 percent of our interest in Inter-Tel.NET in July 2001, we recorded a
pre-tax charge or $5.4 million during 2001, which reduced net income by $3.4
million, or $0.13 per share after-tax. This charge was associated with the
impairment of our remaining investment in Inter-Tel.NET. The impairment was
measured as the difference between the carrying value of Inter-Tels remaining
17% interest in Inter-Tel.NET and the estimated fair market value of the 17%
interest. Litigation Settlement, Net of Costs Except Taxes. In May 2001, Inter-Tel
entered into an agreement to submit to binding arbitration a lawsuit we filed
in 1996. The arbitration was completed in January 2002 and, as a result of the
arbitration, Inter-Tel received a one-time gross cash award of $20 million in
February 2002. Direct costs for attorneys fees, expert witness costs,
arbitration costs and additional payments and expenses, totaled approximately
$4.5 million in 2002, excluding income taxes, for a net award of approximately
$15.5 million. The estimated net proceeds from this arbitration settlement
were approximately $9.5 million after taxes, or $0.37 per diluted share for the
year ended December 31, 2002. Interest and Other Income. Interest and other income increased
approximately $855,000 in 2002 compared to 2001 based on a higher level of
invested funds, due in part to cash received from the litigation settlement
noted above, offset by expenditures relating to the McLeod and Swan
acquisitions. During 2002, we recognized foreign currency transaction gains of
$330,000, an improvement of $667,000 compared to losses of $337,000 in 2001. Interest expense. Interest expense was $156,000 in 2002, a decrease of
$312,000 compared to $468,000 in 2001, due primarily to reduced interest on
capital leases held by Inter-Tel.NET, 83% of which was sold in July 2001. Other. In 2002 included in other income was an expense of approximately
$1.2 million related to the write-down of Inter-Tels investment in
Inter-Tel.NET/Vianet. Other than the write-down, interest and other income in
all periods consisted primarily of interest income and foreign currency
transaction gains and losses. 34




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##### Table of Contents



Income Taxes. Our effective income tax rate for 2002 increased to 37.8%
compared to 37.0% for 2001. The rate increased primarily as a result of higher
marginal tax rates anticipated from higher net income. Net Income.Net income for 2002, including the litigation
settlement in 2002, increased to $38.6 million, or $1.49 per diluted share,
compared to 2001 net income of $13.0 million, or $0.52 per diluted share,
including the charge for the impairment of the investment in Inter-Tel.NET. Excluding the 2002 litigation settlement, we would have reported net
income of $29.1 million, or $1.13 per diluted share in 2002. Excluding both
the 2001 charge and entire 2001 business operations of Inter-Tel.NET, we
reported net income of $21.8 million, or $0.86 per diluted share, in 2001. The
increase is the result of higher gross profit and increased operating
efficiencies described in further detail above. 2001 and 2000 Other Charges. Set forth herein is a further description of the items reflected in other
charges during the years ended December 31, 2001 and 2000, as well as
subsequent events and activity occurring through 2003. Inter-Tel.NET/Comm-Services/Vianet.During the second quarter of 2000,
Inter-Tel recorded a pre-tax charge associated with Inter-Tel.NET operations of
$2.0 million ($1.2 million after-tax), related to the write-down to net
realizable value of network equipment and lease termination costs of certain
redundant facilities. The reserves established at the time of the write-down
have been fully utilized as of December 31, 2001. On July 24, 2001, Inter-Tel sold 83% of the stock of Inter-Tel.NET, Inc.
to Comm-Services Corporation for a note of $4.95 million, collateralized by
Comm-Services stock, other marketable securities of the shareholders of
Comm-Services and 100% of the net assets of Inter-Tel.NET. In connection with
the sale of 83% of Inter-Tel.NET, we assessed the fair value of the remaining
17% investment in Inter-Tel.NET. Pursuant to SFAS 121, we recorded a charge as
of the close of the second quarter of 2001 of $5.4 million ($3.4 million after
tax) associated with the impairment of our investment in Inter-Tel.NET. After
the impairment charge, the carrying value of our investment (the note
receivable from Comm-Services plus the 17% ownership interest in Comm-Services)
totaled $3.7 million as of December 31, 2001. The charge was primarily
non-cash. Inter-Tels management has not participated in the management of
Inter-Tel.NET since the sale in July 2001. As a result, since July 24, 2001,
we have accounted for the remaining Inter-Tel.NET/Comm-Services investment
using the cost method of accounting. On December 30, 2001, Comm-Services
entered into a merger agreement with Vianet. Inter-Tels 17% investment in
Comm-Services was converted to approximately 10% of Vianet stock and as a
result, the loan for the purchase was assumed by Vianet and Inter-Tel continued
to hold collateral from the former shareholders of Comm-Services until March
2003. During 2002, the net investment in the notes receivable and 10% interest
in Vianet (formerly Comm-Services) was written down by $1.2 million and was
recorded in other assets at a carrying value of
approximately $2.5 million as of December 31, 2002, which approximated
managements estimate of the related collateral value at that time. During 1999, 2000 and 2001, Inter-Tel.NET entered into operating lease
agreements totaling approximately $6.5 million from an equipment vendor for
network equipment and software. The lease agreements required Inter-Tel.NET to
purchase vendor maintenance on their products. Inter-Tel originally
guaranteed the indebtedness. In February 2003, we executed an agreement with
Vianet and this vendor releasing Inter-Tel from its guarantee of any and all of
these obligations, and Inter-Tel and Vianet released the vendor from claims
arising from the failure of the network equipment and software previously
leased. As part of this agreement, Inter-Tel also received payment from the
Vianet shareholders of $1.45 million, in exchange for the release of the
remaining collateral and as payment of the loan. Inter-Tel had also retained
a collateral interest in a Vianet shareholders variable forward option
contract that matured in April and May of 2003, and for which we received no
value for the collateral interest. After an adjustment of $124,000 in 2003
related to a recovery of our investment and adjustment of projected costs to
actual costs associated with the 2002 write-down in the Vianet investment, the
estimated value received in this transaction was equivalent to our remaining
investment value, less accruals for potential obligations to the vendor
discussed above. 35




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Inter-Tel retains its ownership interest in Vianet and will account for
the remaining investment interest of approximately 10% in Vianet using the cost
method of accounting. At December 31, 2003, our net investment in Vianet was
recorded at no value. Executone.On January 1, 2000 Inter-Tel purchased certain computer
telephony assets and assumed certain liabilities of Executone Information
Systems, Inc. (Executone). The Executone transaction was accounted for using
the purchase method of accounting. The aggregate purchase price was allocated
to the fair value of the assets and liabilities acquired, of which $5.4 million
($3.4 million after taxes) was written-off as purchased in-process research and
development. In connection with the Executone acquisition, we sold Executones
manufacturing assets and liabilities to Varian of Tempe, Arizona at a net book
value of $6.6 million. During the second quarter of 2000, we decided to close the primary
Executone facility in Milford, Connecticut and to recognize a restructuring
charge related to our exit plan and closure of the Executone operations. We
have accounted for the restructuring of the Executone operations, including
severance and related costs, the shut down and consolidation of the Milford
facility and the impairment of assets associated with the restructuring. We
finalized our plan for the exiting of activities and the involuntary
termination or relocation of the employees. Accrued costs associated with this
plan were estimates, although the original estimates made for the second
quarter of 2000 for reserve balances have not changed significantly as of
December 31, 2003. Exit costs associated with the closure of the Milford facility also
included liabilities for building, furniture and equipment lease, and other
contractual obligations. We are liable for the lease on the Milford buildings
through January 14, 2005. Various other furniture, computer and equipment
leases terminated on varying dates through September 2002. To date, we have
entered into sublease agreements with third parties to sublease portions of the
facility. The reserve for lease and other contractual obligations is
identified in the table below. The total restructuring charge from this event totaled $50.9 million. The
following tables summarize details of the restructuring charge in connection
with the Executone acquisition, including the description of the type and
amount of liabilities assumed, and activity in the reserve balances from the
date of the charge through December 31, 2003. Activity represents payments
made or amounts written off. (In thousands) Cash/
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    ReserveNon-
    
    Restructuring
    
    2000
    
    2001
    
    2002
    
    2003
    
    BalanceDescription
    
    Cash
    
    Charge
    
    Activity
    
    Activity
    
    Activity
    
    Activity
    
    At 12/31/03Personnel Costs:Severance and termination costs
    
    Cash
    
    $
    (1,583
    )
    
    $
    1,558
    
    
    $
    2
    
    
    $
    20
    
    
    $
    3
    
    
    $
    Other Plant closure costs
    
    Cash
    
    
    (230
    )
    
    
    30
    
    
    
    200
    
    
    
    
    
    
    
    
    
    
    
    Lease termination and other
contractual obligations (net
of anticipated recovery):Building and equipment leases
    
    Cash
    
    
    (7,444
    )
    
    
    1,348
    
    
    
    1,489
    
    
    
    2,594
    
    
    
    767
    
    
    
    (1,246
    )Other contractual obligations
    
    Cash
    
    
    (1,700
    )
    
    
    
    
    
    
    1,700
    
    
    
    
    
    
    
    
    
    
    
    Impairment of Assets:Inventories
    
    Non-Cash
    
    
    (3,454
    )
    
    
    1,376
    
    
    
    209
    
    
    
    1,869
    
    
    
    
    
    
    
    Prepaid inventory and other expenses
    
    Non-Cash
    
    
    (2,485
    )
    
    
    2,485
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Accounts receivable
    
    Non-Cash
    
    
    (1,685
    )
    
    
    521
    
    
    
    245
    
    
    
    88
    
    
    
    831
    
    
    
    Fixed assets
    
    Non-Cash
    
    
    (3,151
    )
    
    
    2,942
    
    
    
    
    
    
    
    53
    
    
    
    14
    
    
    
    (142
    )Net intangible assets
    
    Non-Cash
    
    
    (29,184
    )
    
    
    29,184
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    $
    (50,916
    )
    
    $
    39,444
    
    
    $
    3,845
    
    
    $
    4,624
    
    
    $
    1,615
    
    
    $
    (1,388
    )
 36




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Included in the total Executone restructuring costs of $50.9 million is a
$43.3 million restructuring charge for exit costs and asset impairment included
in other charges, and $7.6 million associated with the impairment of
inventories, which has accordingly been recorded as additional costs of sales. Inflation/Currency Fluctuation Inflation and currency fluctuations have not previously had a material
impact on Inter-Tels operations. International procurement agreements have
traditionally been denominated in U.S. currency. Moreover, a significant
amount of contract manufacturing has been or is expected to be moved to
alternative sources. The expansion of international operations in the United
Kingdom and Europe and increased sales, if any, in Japan and other parts of
Asia could result in higher international sales as a percentage of total
revenues; however, international revenues do not currently represent a
significant portion of our total revenues. Liquidity and Capital Resources (In thousands)
    
    2003
    
    2002
    
    2001Net cash provided by operating activities
    
    $
    54,890
    
    
    $
    77,195
    
    
    $
    75,006Net cash used in investing activities
    
    
    (27,040
    )
    
    
    (56,565
    )
    
    
    (17,604
    )Net cash provided by (used in) financing activities
    
    
    2,424
    
    
    
    5,498
    
    
    
    (25,710
    )Increase in cash and equivalents
    
    
    30,274
    
    
    
    26,128
    
    
    
    31,692Cash and equivalents at beginning of year
    
    
    84,923
    
    
    
    58,795
    
    
    
    27,103Cash and equivalents at end of year
    
    $
    115,197
    
    
    $
    84,923
    
    
    $
    58,795
 At December 31, 2003, cash and equivalents and short-term investments
totaled $174.5 million, which represented an increase of approximately $48.7
million from the $125.8 million total at December 31, 2002. We maintain a $10
million unsecured, revolving line of credit with BankOne, NA, which is
available through June 1, 2004. Under the credit facility, we have the option
to borrow at a prime rate or adjusted LIBOR interest rate. Historically, we
have used the credit facility primarily to support international letters of
credit to suppliers and we intend to renew this facility again in 2004. A
portion of our cash balances may be used for, among other things, acquisitions,
strategic alliances, working capital and general corporate purposes. Net cash provided by operating activities totaled $54.9 million for the
year ended December 31, 2003, compared to $77.2 million for the same period in
2002. Cash provided by operating activities in 2003 primarily resulted from
net income plus non-cash charges for depreciation and amortization expenses,
provision for losses on receivables and leases, and increased deferred income
taxes which was partially offset by cash used in the period by the change in
operating assets and liabilities. Cash generated by the increase in deferred
income taxes in 2003 totaled $30.3 million compared to $5.0 million in 2002.
Cash used in 2003 by the change in operating assets and liabilities was $19.0
million, compared to cash generated by the change in operating assets and
liabilities of $15.5 million in 2002. The primary factors for the use of cash
for operating accounts in 2003 was an increase in inventories, increased income
taxes receivable and increased net investment in sales-leases. We expect to
expand sales through our direct
sales office and dealer networks, which is expected to require the
expenditure of working capital for increased accounts receivable and
inventories. Net cash used in investing activities totaled $27.0 million for the year
ended December 31, 2003, primarily in the form of $18.4 million used to
purchase short-term investments net of sales and maturities, as well as capital
expenditures, compared to net cash used in investing activities of $56.6
million in 2002, including $37.9 million used to purchase short-term
investments. Cash used in acquisitions and other investments totaled
approximately $3.1 million in 2003 compared to $11.4 million in 2002. Capital
expenditures totaled approximately $7.0 million for 2003 compared to $7.6
million in 2002. We anticipate continued capital expenditures during 2004,
principally relating to expenditures for equipment and management information
systems used in operations, facilities expansion and acquisition activities. Net cash provided by financing activities totaled $2.4 million during 2003
compared to net cash provided of $5.5 million in 2002. We expended
approximately $207,000 and $13,000 for stock repurchases during 2003 and 2002,
respectively, funded by existing cash balances during each period. Repayment
of our long-term debt for the year 2003 was $102,000 compared to $481,000 in
2002. During 2003, we reissued treasury shares through stock option exercises
and issuances, with the proceeds received totaling less than 37




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##### Table of Contents



the cost basis of
the treasury stock reissued. Accordingly, the difference was recorded as a
reduction to retained earnings. Net cash used for cash dividends totaled $3.8
million in 2003 and $2.2 million during 2002. Cash provided by the exercise of
stock options and stock issuances pursuant to our Employee Stock Purchase Plan
totaled $6.5 million in 2003 and $8.2 million in 2002. We offer to our customers lease financing and other services, including
our TotalSolution (formerly Totalease) program, through our Inter-Tel Leasing,
Inc. subsidiary. We fund our Total Solution program in part through the sale
to financial institutions of rental payment streams under the leases. Sold
lease rentals totaling $210.1 and $205.8 million remained unbilled at December
31, 2003 and December 31, 2002, respectively. Such financial
institutions have the option to require us to repurchase
such income streams, subject to limitations, in the event of defaults by lease customers and,
accordingly, we maintain reserves based on loss experience and past due accounts.
Although we to date have been able to resell the rental streams from leases
under the TotalSolution program profitably and on a substantially current
basis, the timing and profitability of lease resales could impact our business
and operating results, particularly in an environment of fluctuating interest
rates and economic uncertainty. If we are required to repurchase rental
streams and realize losses thereon in amounts exceeding our reserves, our
operating results will be adversely affected. Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has provided Inter-Tel with only a limited description of the
evidence on which the investigations are based. Inter-Tel is presently unable
to predict or determine the final outcome of, or to estimate the potential
range of loss with respect to, the investigations. Based upon the information
known at this time, we do not know what, if any, impact the investigations may
have on the Companys business or financial condition. If Inter-Tel is
convicted of any crime or subjected to sanctions, or debarred from certain
government contracts or if penalties, damages or other monetary remedies are
assessed against Inter-Tel in connection with or related to these and other
investigations, our business and operating results could be materially and
adversely affected. The existence and disclosure of the investigations may
have already caused competitive harm to Inter-Tel, and any unfavorable
resolution to these matters may further harm Inter-Tels business. We believe our working capital and credit facilities, together with cash
generated from operations, will be sufficient to develop and expand our
business operations, to finance acquisitions of additional resellers of
telephony products and other strategic acquisitions or corporate alliances, and
to provide adequate working capital for the foreseeable future. However, to
the extent additional funds are required in the future to address working
capital needs and to provide funding for capital expenditures, expansion of the
business or additional acquisitions, we will seek additional financing. There
can be no assurance additional financing will be available when required or on
acceptable terms. Contractual Obligations We had the following contractual obligations outstanding: Amount of Commitment Expiration Per Period(in thousands)Less Than
    
    
    
    
    
    
    
    
    
    After 5Total
    
    1 Year
    
    1-3 Years
    
    4-5 Years
    
    YearsDecember 31, 2003Operating lease obligations,
primarily for building and
equipment leases
    
    $
    22,740
    
    
    $
    9,896
    
    
    $
    9,609
    
    
    $
    3,235
    
    
    $
    Letters of credit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Totals at December 31, 2003
    
    $
    22,740
    
    
    $
    9,896
    
    
    $
    9,609
    
    
    $
    3,235
    
    
    $
    December 31, 2002Operating lease obligations,
primarily for building and
equipment leases
    
    $
    28,819
    
    
    $
    9,390
    
    
    $
    13,939
    
    
    $
    5,142
    
    
    $
    348Letters of credit
    
    
    545
    
    
    
    545
    
    
    
    
    
    
    
    
    
    
    
    Totals at December 31, 2002
    
    $
    29,364
    
    
    $
    9,935
    
    
    $
    13,939
    
    
    $
    5,142
    
    
    $
    348
 38




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Noncancellable operating leases are primarily for buildings. Included in
the operating lease obligation totals noted above are payments due on our
building lease in Milford, Connecticut associated with the Executone
acquisition in 2000. In connection with the Executone charge taken in 2000, we
included in the charge anticipated lease costs through the lease termination
date, offset by expected sublease receipts. The total costs included in
operating lease obligations referred to above, which are associated with the
Milford lease, total $2.9 million in 2004 and $121,000 in 2005. The Milford
lease expires on January 14, 2005 and we will not renew that lease. Certain of
the leases contain provisions for renewal options and scheduled rent increases.
At December 31, 2003, future minimum commitments under noncancellable leases,
including our headquarters facility and a 15 year lease for our research and
development facility and 63 month lease for our distribution and support
facility, are as follows: 2004  $9,896,000; 2005  $5,646,000; 2006 
$3,963,000; 2007  $2,502,000; 2008  $733,000. In connection with the acquisition of the rights to certain developed
technology for a capitalized purchase price of $2.25 million (included in
purchased intangible assets) during the year ended December 31, 2003, the
Company entered into an arrangement with the selling entity under which the
selling entity will perform additional development activities on a cost
reimbursement basis through August 15, 2004. Under the terms of the
arrangement, the selling entity can also earn bonus payments totaling up to
$1,000,000 during 2004 for meeting certain development milestones. As of
December 31, 2003, we did not consider the milestone bonuses to be probable or
reasonably estimable, nor had technological feasibility of the underlying
technology been achieved to provide for viable product sales; therefore, no
bonus payments have been accrued, and the monthly cost of services performed
totaling approximately $525,000 has been expensed in research and development
costs for the year ended December 31, 2003. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions
that involve unconsolidated entities or financial partnerships, such as
entities often referred to as structured finance or special purpose entities,
which have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. However, we
offer to our customers lease financing and other services through our Inter-Tel
Leasing, Inc. subsidiary. We fund our Total Solution program in part through
the sale to financial institutions of rental payment streams under the leases.
Such financial institutions have the option to require us to
repurchase such income streams, subject to limitations, in the event of defaults by
lease customers and, accordingly, we maintain reserves based on loss experience
and past due accounts. For more information regarding our lease portfolio and
financing, please see Liquidity and Capital Resources above and Notes A and D
of Notes to Consolidated Financial Statements. Critical Accounting Policies and Estimates The methods, estimates and judgments we use in applying our most critical
accounting policies have a significant impact on the results we report in our
consolidated financial statements. We evaluate our estimates and judgments on
an on-going basis. We base our estimates on historical experience and on
assumptions that we believe to be reasonable under the circumstances. Our
experience and assumptions form the basis for our judgments about the carrying
value of assets and liabilities that are not readily apparent from other
sources. Actual results may vary from what we anticipate and different
assumptions or estimates about the future could change our reported results. We
believe the following accounting policies are the most critical to us, in that
they are important to the portrayal of our financial statements and they
require our most difficult, subjective or complex judgments in the preparation
of our consolidated financial statements: Revenue Recognition. In December 2003, the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue
Recognition. The Company applies the provisions of SAB 104 to all revenue
transactions. SAB 104 supercedes SAB 101, Revenue Recognition in Financial
Statements. The primary purpose of SAB 104 is to rescind accounting guidance
contained in SAB 101 related to multiple element revenue arrangements,
superceded as a result of the issuance of EITF 00-21. Additionally, SAB 104
rescinds the SECs Revenue Recognition in Financial Statements Frequently Asked
Questions and Answers (the FAQ) issued with SAB 101 that had been codified in
SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been
incorporated into SAB 104. While the wording of SAB 104 has changed to reflect
the issuance of EITF 00-21, the revenue recognition principles of SAB 101
remain largely unchanged by the issuance of SAB 104. The issuance of SAB 104
did not have a material impact on the Companys financial position, results of
operations or cash flows. 39




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Accordingly, revenue is recognized when all four of the following criteria
are met: (i) persuasive evidence that arrangement exists; (ii) delivery of the
products and/or services has occurred; (iii) the selling price is both fixed
and determinable and; (iv) collectibility is reasonably probable. Revenue
derived from sales of systems and services to end-user customers is recognized
upon primary installation of the systems and performance of the services,
respectively, allowing for use by our customers of these systems. Pre-payments
for communications services are deferred and recognized as revenue as the
communications services are provided. For shipments to dealers and other distributors, our revenues are recorded
as products are shipped and services are rendered, because the sales process is
complete. These shipments are primarily to third-party dealers and
distributors, and title passes when goods are shipped (free-on-board shipping
point). Long distance services revenues are recognized as service is provided. Sales-Leases. For our sales-type lease accounting, we follow the guidance
provided by FASB Statement No. 13, Accounting for Leases and FASB Statement No.
140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities  A Replacement of FASB Statement No. 125. We
record the discounted present values of minimum rental payments under
sales-type leases as sales, net of provisions for continuing administration and
other expenses over the lease period. We record the lease sales at the time of
system sale and installation pursuant to Staff Accounting Bulletin No. 104, as
discussed above for sales to end user customers, and upon receipt of the
executed lease documents. The costs of systems installed under these
sales-leases are recorded as costs of sales. The net rental streams are sold
to funding sources on a regular basis with the income streams discounted by
prevailing like-term rates at the time of sale. Gains or losses resulting from
the sale of net rental payments from such leases are recorded as net sales. We
establish and maintain reserves against potential recourse following the
resales based upon historical loss experience, past due accounts and specific
account analysis. The allowance for uncollectible minimum lease payments and
recourse liability at the end of the year represents reserves against the
entire lease portfolio. Management reviews the adequacy of the allowance on a
regular basis and adjusts the allowance as required. These reserves are either
netted in the accounts receivable, current and long-term components of Net
investments in Sales-Leases on the balance sheet, or included in long-term
liabilities on our balance sheet for off-balance sheet leases. Historically, our reserves have been adequate to cover write-offs. During
the year ended December 31, 2003, our total reserve for losses related to the
lease portfolio declined from 6% to 5.7%, primarily as a result of improved
write-off experience and accounts receivable agings. Should the financial
condition of our customers deteriorate in the future, additional reserves in
amounts that could be material to the financial statements could be required. Goodwill and Other Intangible Assets. We assess the impairment of
goodwill and other identifiable intangibles whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Some
factors we consider important which could trigger an impairment review include
the following:  
    
    Significant under-performance relative to historical, expected or
projected future operating results;  
    
    Significant changes in the manner of our use of the acquired assets or
the strategy for our overall business;  
    
    Our market capitalization relative to net book value, and  
    
    Significant negative industry or economic trends. When we determine that the carrying value of goodwill and other identified
intangibles may not be recoverable, we measure any impairment based on a
projected discounted cash flow method using a discount rate determined by our
management to be commensurate with the risk inherent in our current business
model. In accordance with SFAS No. 142, Goodwill and Other Intangible
Assets, on January 1, 2002, we ceased amortizing goodwill arising from
acquisitions completed prior to July 1, 2001. Inter-Tel has tested goodwill
for impairment using the two-step process prescribed in SFAS 142. The first
step is a screen for potential impairment, while the second step measures the
amount of the impairment, if any. Inter-Tel has performed the first of the
required impairment tests for goodwill as of December 31, 2003 and has
determined that the carrying amount of goodwill is not impaired. 40




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Inter-Tel has adopted SFAS 142 effective January 1, 2002. Application of
the nonamortization provisions of SFAS 142 resulted in an increase in income
from continuing operations before income taxes of approximately $1.8 million in
2003 and 2002. Allowance for Doubtful Accounts. We maintain allowances for doubtful
accounts for estimated losses resulting from the inability of our customers to
make required payments. Additional reserves or allowances for doubtful
accounts are recorded for our sales-type leases, discussed above in
Sales-Leases. We establish and maintain reserves against estimated losses
based upon historical loss experience, past due accounts and specific account
analysis. Management reviews the level of the allowances for doubtful
accounts on a regular basis and adjusts the level of the allowances as needed.
In evaluating our allowance we consider accounts in excess of 60 days old as
well as other risks in the more current portions of the accounts included. If
the financial condition of our customers or channel partners were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. Inventories. We value our inventories at the lower of cost (principally
on a standard cost basis, which approximates the first-in, first-out (FIFO)
method) or market. Significant management judgment is required to determine
the reserve for obsolete or excess inventory and we make our assessment
primarily on a significant product by product basis for the immediately
preceding twelve-month period, adjusted for expected changes in projected sales
or marketing demand. Inventory on hand may exceed future demand either because
the product is outdated or obsolete, or because the amount on hand is more than
can be used to meet estimated future needs. We consider criteria such as
customer demand, product life-cycles, changing technologies, slow moving
inventory and market conditions. We write down our excess and obsolete
inventory equal to the difference between the cost of inventory and the

estimated market value. If actual customer demand, product life cycles,
changing technologies and market conditions are less favorable than those
projected by management, additional inventory write-downs may be required in
the future. Contingencies. We are a party to various claims and litigation in the
normal course of business. Managements current estimated range of liability
related to various claims and pending litigation is based on claims for which
our management can estimate the amount and range of loss, or can estimate a
minimum amount of a loss. Because of the uncertainties related to both the
amount and range of loss on the remaining pending claims and litigation,
management is unable to make a reasonable estimate of the liability that could
result from an unfavorable outcome. As additional information becomes
available, we will assess the potential liability related to our claims and
pending litigation, revise our estimates and accrue for any losses to the
extent that they are probable and the amount is estimable. Such revisions in
our estimates of the potential liability could materially impact our results of
operations and financial position. However, at
December 31, 2003, management did not believe that the ultimate impact of
various claims and pending litigation would have a materially adverse impact on
the Company. Recent Accounting Pronouncements In June 2002, the Financial Accounting Standards Board (FASB) issued
SFAS No. 146, Accounting for Costs Associated with Exit or Disposal
Activities. SFAS No. 146 supersedes Emerging Issues Task Force (EITF) No.
94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring). SFAS No. 146 eliminates the provisions of EITF No. 94-3 that
required a liability to be recognized for certain exit or disposal activities
at the date an entity committed to an exit plan. SFAS No. 146 requires a
liability for costs associated with an exit or disposal activity to be
recognized when the liability is incurred. SFAS No. 146 is effective for exit
or disposal activities that are initiated after December 31, 2002. The
adoption of this statement did not have a material impact on the Companys
results of operations or financial position. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. SFAS No. 148 amends FASB
Statement No. 123, Accounting for Stock-Based Compensation, to provide
alternative methods of transition to SFAS No. 123s fair value method of
accounting for stock-based employee compensation. Statement 148 also amends
the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, Interim
Financial Reporting, to require disclosure in the summary of significant
accounting policies of the effects of an entitys accounting policy with
respect to stock-based employee compensation on reported net income and
earnings per share in annual and interim financial statements. While SFAS No.
148 does not amend SFAS No. 123 to require companies to account for employee
stock options using the fair value method, the disclosure provisions of SFAS
No. 148 are applicable to all companies with stock-based employee compensation,
regardless of whether they account 41




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for that compensation using the fair value
method of SFAS No. 123 or the intrinsic value method of APB Opinion No. 25. As
allowed by SFAS No. 123, the Company has elected to continue to utilize the
accounting method prescribed by APB Opinion No. 25 and has adopted the
disclosure requirements of SFAS No. 123 as of December 31, 2002. The adoption
of this statement did not have a material impact on the Companys results of
operations or financial position. In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (FIN 45). This statement requires that a
liability be recorded in the guarantors balance sheet upon issuance of a
guarantee. In addition, FIN 45 requires disclosures about the guarantees that
an entity has issued, including a rollforward of the entitys product warranty
liabilities. We will apply the recognition provisions of FIN 45 prospectively
to guarantees issued after December 31, 2002. The disclosure provisions of FIN
45 were effective for financial statements of interim and annual periods ending
December 15, 2002. The adoption of this statement did not have a material
impact on the Companys results of operations or financial position. In January 2003, the FASB issued FASB Interpretation No. 46,
Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51
(FIN 46). This statement requires specified variable interest entities to be
consolidated by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. FIN 46 is effective for all new variable interest entities created or
acquired after January 31, 2003 and beginning July 1, 2003 for variable
interest entities created or acquired prior to February 1, 2003. Our exposure
to variable interest entities is limited and the adoption of FIN 46 did not
have a material impact on the Companys financial position or results of
operations. In May 2003, the FASB issued Statement of Financial Accounting Standards
No. 150, Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity (SFAS 150). SFAS 150 establishes standards for how
an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. SFAS 150 is effective for
financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. The adoption of SFAS 150 did not have a material effect on
the Companys financial position, results of operations, or cash flows. 
 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following discussion about our market risk disclosures involves
forward-looking statements. Actual results could differ materially from those
projected in the forward-looking statements. We are exposed to market risk
related to changes in interest rates and foreign currency exchange rates. We do
not use derivative financial instruments. INVESTMENT PORTFOLIO. We do not use derivative financial instruments in
our non-trading investment portfolio. Inter-Tel maintains a portfolio of highly
liquid cash equivalents typically maturing in three months or less as of the
date of purchase. Inter-Tel makes investments in instruments that meet high
credit quality standards, as specified in our investment policy guidelines. The Company also maintains short-term investments, which are all
classified as available for sale, and have been recorded at fair value, which
approximates cost. Short-term investments include certificates of deposit,
auction rate certificates, auction rate preferred securities, municipal
preferred securities and mutual funds. The auction rate securities are
adjustable-rate securities with dividend rates that are reset periodically by
bidders through periodic Dutch auctions generally conducted every 7 to 49
days by a trust company or broker/dealer on behalf of the issuer. The Company
believes these securities are highly liquid investments through the related
auctions; however, the collateralizing securities have stated terms of up to
thirty (30) years. These instruments are rated A or higher by Standard &
Poors Ratings Group, or equivalent. The Companys short-term investments are
intended to establish a high-quality portfolio that preserves principal, meets
liquidity needs, avoids inappropriate concentrations and delivers an
appropriate yield in relationship to the Companys investment guidelines and
market conditions. Given the short-term nature of these investments, and that
we have no borrowings outstanding other than short-term letters of credit, we
are not subject to significant interest rate risk. 42




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LEASE PORTFOLIO. We offer to our customers lease financing and other
services, including our Total Solutions program, through our Inter-Tel Leasing
subsidiary. We fund these programs in part through the sale to financial
institutions of rental payment streams under the leases. Upon the sale of the
rental payment streams, we continue to service the leases and maintain limited
recourse on the leases. We maintain reserves for loan losses on all leases
based on historical loss experience, past due accounts and specific account
analysis. Although to date we have been able to resell the rental streams from
leases under our lease programs profitably and on a substantially current
basis, the timing and profitability of lease resales could impact our business
and operating results, particularly in an environment of fluctuating interest
rates and economic uncertainty. If we were required to repurchase rental
streams and realize losses thereon in amounts exceeding our reserves, our
operating results could be materially adversely affected. See Liquidity and
Capital Resources in Managements Discussion and Analysis and Notes A and D of
Notes to Consolidated Financial Statements for more information regarding our
lease portfolio and financing. IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our
international subsidiaries primarily in the local currencies of our
subsidiaries for product and service revenues. Inter-Tel is exposed to foreign
exchange rate fluctuations as the financial results of foreign subsidiaries are
translated into U.S. dollars in consolidation. The impact of foreign currency
rate changes have historically been insignificant. 
 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is incorporated herein by reference to
Exhibit 13.0. 
 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 
 ITEM 9A. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we conducted
an evaluation of the effectiveness of the design and operation of our
disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e)
under the
Securities Exchange Act of 1934, as amended, as of the end of the period
covered by this report (the Evaluation Date). Based on this evaluation, our
principal executive officer and principal financial officer concluded as of the
Evaluation Date that our disclosure controls and procedures were effective such
that the material information relating to Inter-Tel, including our consolidated
subsidiaries, required to be disclosed in our Securities and Exchange
Commission (SEC) reports is recorded, processed, summarized and reported
within the time periods specified in SEC rules and forms, and was made known to
our principal executive officer and principal accounting officer during the
period when this report was being prepared to allow timely decisions regarding
required disclosure. In addition, there were no significant changes in our internal controls or in
other factors that could significantly affect these controls subsequent to the
Evaluation Date. We have not identified any significant deficiencies or
material weaknesses in our internal controls, and therefore there were no
corrective actions taken. 
 PART III Certain information required by Part III is omitted from this report in
that the Registrant will file a definitive proxy statement pursuant to
Regulation 14A (the Proxy Statement) not later than 120 days after the end
of the fiscal year covered by this report, and the information included therein
is incorporated herein by reference to the extent the information required by
Part III is not provided below. 
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The names of the executive officers of Inter-Tel and their ages, titles, and
biographies as of the end of the period covered by this report
are set forth below. 43




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Steven G. Mihaylo; age 60; Chairman of the Board of Directors, Chief
Executive Officer and President.Mr. Mihaylo, the founder of Inter-Tel, has
served as Chairman of the Board of Directors of Inter-Tel from July 1969 to
October 1982 and from September 1983 to the present. He served as President of
Inter-Tel from 1969 to 1983, from 1984 to December 1994, and from May 1998 to
present. Mr. Mihaylo has served as Inter-Tels Chief Executive Officer since
the Companys formation in July 1969. Craig W. Rauchle; age 48; Executive Vice President and Chief Operating
Officer. Mr. Rauchle was elected Chief Operating Officer in August 2001 and
has been our Executive Vice President since December 1994. As Chief Operating
Officer, Mr. Rauchle is responsible for Inter-Tels sales and support
functions, marketing, procurement, distribution and research and development
activities. He had been our Senior Vice President and continues as President
of Inter-Tel Technologies, Inc., our wholly owned sales subsidiary. Mr.
Rauchle joined Inter-Tel in 1979 as Branch General Manager of the Denver Direct
Sales Office and in 1983 was appointed the Central Region Vice President and
subsequently the Western Regional Vice President. From 1990 to 1992, Mr.
Rauchle served as President of Inter-Tel Communications, Inc. Mr. Rauchle
holds a Bachelor of Arts degree in Communications from the University of
Denver. Norman Stout; age 46; Executive Vice President and Chief Administrative
Officer.Mr. Stout was elected Executive Vice President, Chief Administrative
Officer and President of Inter-Tel Software and Services in June 1998. As
Chief Administrative Officer, Mr. Stout is responsible for Inter-Tels
strategic planning, mergers and acquisitions, leasing business and centralized
corporate support functions including finance, treasury, accounting, human
resources, legal, MIS and eCommerce. From October 1994 to June 1998, he served
as one of our directors. Prior to joining Inter-Tel, Mr. Stout was Chief
Operating Officer of Oldcastle Architectural Products and since 1996, Mr. Stout
also had served as President of Oldcastle Architectural West. Mr. Stout was
previously President of Superlite Block, a subsidiary of Oldcastle
Architectural Products and a manufacturer of concrete products, since February
1993. Prior thereto he was employed by Boorhem-Fields, Inc. of Dallas, Texas,
a manufacturer of crushed stone, as Chief Executive Officer from 1990 to 1993
and as Chief Financial Officer from 1986 to 1990. Prior to that, Mr. Stout was
a Certified Public Accountant with Coopers & Lybrand. He currently serves on
the board of Hypercom Corporation, a public company headquartered in Phoenix,
Arizona. Mr. Stout holds a Bachelor of Science degree in Accounting from Texas
A&M and an MBA from the University of Texas. Jeffrey T. Ford; age 42; Senior Vice President and Chief Technology
Officer.Mr. Ford was elected Senior Vice President in May 1998 and has served
as our Chief Technology Officer since 1997. He was elected President of
Inter-Tel Integrated Systems, Inc. (IIS) in May 1998, after serving as Senior
Vice President of IIS for one year and Vice President of Software Engineering
of Inter-Tel Integrated Systems from 1993 to 1997. He joined Inter-Tel in
1983 as a software design engineer. Mr. Ford holds a Bachelor of Science
degree in Computer Systems Engineering from Arizona State University and an SEP
certificate from the Stanford Graduate School of Business. Kurt R. Kneip; age 41; Chief Financial Officer, Senior Vice President and
Secretary.Mr. Kneip has served as our Chief Financial Officer since September
1993. He has served as Senior Vice President since February 2003 and as Vice
President from September 1993 to February 2003. He was elected Secretary and
Treasurer in October 1994. In May 1996 he was elected Assistant Treasurer, as
John Abbott was elected Treasurer. He joined Inter-Tel in May 1992 as Director
of Corporate Tax, after seven years with the accounting firms of Ernst & Young
and KPMG Peat Marwick. Mr. Kneip is a Certified Public Accountant, and holds
a Bachelor of Science degree in Commercial Economics from South Dakota State
University and a Masters Degree in Professional Accountancy from the
University of South Dakota. Code of Business
Conduct Inter-Tel has a Code of Business Conduct (Code) that applies to all of
our employees, including our principal executive officer and principal
financial and accounting officer. This code is posted on our Internet web
site. The Internet address for our web site is http://www.inter-tel.com, and
the code may be found as follows:  1.
    
    From our main web page, first click on About Inter-Tel.2.
    
    Next, click on Code of Business Conduct. We will provide a copy of the Code upon request made by email to
financialinfo@inter-tel.com or by writing to us at Inter-Tel, Incorporated,
Attention: Investor Relations, 1615 S. 52nd Street, Tempe, Arizona 85281. We
intend to satisfy the disclosure requirement under Item 10 of Form 8-K
regarding an amendment to, or waiver from, a provision of this Code by posting
such information on our web site, at the address and 44




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location specified above,
and to the extent required, by filing a Current Report on Form 8-K with the SEC
disclosing such information. Additional information required by this Item is incorporated herein by
reference to the Companys Proxy Statement. 
 ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is included under the caption Executive
Compensation in the Companys Proxy Statement incorporated herein by
reference. 
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is included under the caption Security
Ownership of Management in the Companys Proxy Statement incorporated herein
by reference. 
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is included under the caption
Certain Relationships and Related Party Transactions in the Companys Proxy
Statement incorporated herein by reference. 
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this Item is included under the caption Principal
Accountant Fees and Services in the Companys Proxy Statement incorporated
herein by reference. 45




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PART IV




ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K

(a)  The following documents are filed as part of this Report:

1. Financial Statements

The following consolidated financial statements of Inter-Tel, Incorporated,
and subsidiaries, are incorporated by reference to Exhibit 13.0:

|                                                                                             |  |  |  | 
|-------------------------------------------------------------------------------------------- |  |  |  | 
|Report of Ernst & Young LLP, Independent Auditors                                            |  |  |  | 
|Consolidated balance sheetsDecember 31, 2003 and 2002                                       |  |  |  | 
|Consolidated statements of incomeyears ended December 31, 2003, 2002
and 2001               |  |  |  | 
|Consolidated statements of shareholders equityyears ended December
31, 2003, 2002 and 2001 |  |  |  | 
|Consolidated statements of cash flowsyears ended December 31, 2003,
2002 and 2001           |  |  |  | 
|Notes to consolidated financial statements                                                   |  |  |  | 

2. Financial Statement Schedules

The following consolidated financial statement schedule of Inter-Tel,
Incorporated, and subsidiaries is filed as part of this Report and should be
read in conjunction with the Consolidated Financial Statements of Inter-Tel,
Incorporated and subsidiaries, and the notes thereto.



| |  | Schedule for the three years ended December 31, 2003:
| |  | -----------------------------------------------------

|                                              |  |            
|--------------------------------------------- |  | -----------
|Schedule IIValuation and Qualifying Accounts |  | Page No. 51

Schedules not listed above have been omitted because they are not
applicable or are not required or the information required to be set forth
therein is included in the Consolidated Financial Statements or notes thereto.

3. Exhibits

|            |  |                                                                                                                                               
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|3.1(10)     |  | Articles of Incorporation, as amended.                                                                                                        
|            |  |                                                                                                                                               
|3.2(16)     |  | By-Laws, as amended.                                                                                                                          
|            |  |                                                                                                                                               
|10.15(1)    |  | Registrants form of standard Distributor Agreement.                                                                                          
|            |  |                                                                                                                                               
|10.16(1)    |  | Registrants form of standard Service Agreement.                                                                                              
|            |  |                                                                                                                                               
|10.35(3)    |  | Agreement between Registrant and Samsung Semiconductor and
Telecommunications Company, Ltd. dated October 17, 1984.                           
|            |  |                                                                                                                                               
|10.37(3) *  |  | Tax Deferred Savings Plan.                                                                                                                    
|            |  |                                                                                                                                               
|10.51(11) * |  | 1990 Directors Stock Option Plan and form of Stock Option Agreement.                                                                         
|            |  |                                                                                                                                               
|10.52(15) * |  | Inter-Tel, Incorporated Long-Term Incentive Plan and forms of Stock Option Agreements.                                                        
|            |  |                                                                                                                                               
|10.53(12)   |  | Agreement between Registrant and Maxon Systems, Inc. dated February 27, 1990.                                                                 
|            |  |                                                                                                                                               
|10.54(12)   |  | Agreement between Registrant and Varian Tempe Electronics
Center dated February 26, 1991.                                                     
|            |  |                                                                                                                                               
|10.55(12)   |  | Agreement between Registrant and Jetcrown Industrial Ltd. dated
February 18, 1993.                                                            
|            |  |                                                                                                                                               
|10.56(13) * |  | Employee Stock Ownership Plan.                                                                                                                
|            |  |                                                                                                                                               
|10.57(14)   |  | Loan and Security Agreement dated March 4, 1997 between Bank One,
Arizona, N.A. and Registrant and Modification Agreement dated July 25,
1997.

46



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##### Table of Contents



|            |  |                                                                                                                                                                                                                
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.58 (16)  |  | Development, Supply and License Agreement between Registrant
and QUALCOMM dated January 17, 1996.                                                                                                              
|            |  |                                                                                                                                                                                                                
|10.59(17) * |  | Inter-Tel, Incorporated 1997 Long-Term Incentive Plan.                                                                                                                                                         
|            |  |                                                                                                                                                                                                                
|10.60(18) * |  | Inter-Tel, Incorporated 1997 Employee Stock Purchase Plan.                                                                                                                                                     
|            |  |                                                                                                                                                                                                                
|10.61(19) * |  | Inter-Tel, Incorporated Acquisition Stock Option Plan and form of Stock Option Agreement.                                                                                                                      
|            |  |                                                                                                                                                                                                                
|10.62(20)   |  | Computer Telephony Asset Purchase Agreement dated as of October 17,
1999 by and between Executone Information Systems, Inc., Inter-Tel,
Incorporated and Executone Inter-Tel Business Information Systems, Inc.
|            |  |                                                                                                                                                                                                                
|10.63(21) * |  | Form of Key Employee Tier 1 Change of Control Severance Agreement.                                                                                                                                             
|            |  |                                                                                                                                                                                                                
|10.64(21) * |  | Form of Key Employee Tier 2 Change of Control Severance Agreement.                                                                                                                                             
|            |  |                                                                                                                                                                                                                
|13.0 (21)   |  | Excerpts from Annual Report to Security Holders.                                                                                                                                                               



---

|(1)  |  | Incorporated by reference to Registrants Registration Statement on
Form S-1 (File No. 2-70437).                                                                                                                                                                                          
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|(2)  |  | Incorporated by reference to Registrants Registration Statement on
Form S-8 (File No. 2-94805).                                                                                                                                                                                          
|    
|(3)  |  | Incorporated by reference to Registrants Annual Report on Form
10-K for the year ended November 30, 1984 (File No. 0-10211),
Registration Statement on Form S-8 (File No. 333-106868) and
Registrants Annual Report on Form 11-K for the year ended December 31,
2002 (File No. 0-10211)
|    
|(10) |  | Incorporated by reference to Registrants Annual Report on Form
10-K for the year ended December 31, 1988 (File No. 0-10211).                                                                                                                                                             
|    
|(11) |  | Incorporated by reference to Registrants Registration Statement on
Form S-8 (File No. 33-40353).                                                                                                                                                                                         
|    
|(12) |  | Incorporated by reference to Registrants Registration Statement on
Form S-1 (File No. 33-70054).                                                                                                                                                                                         
|    
|(13) |  | Incorporated by reference to Registrants Registration Statement on
Form S-8 (File No. 33-73620).                                                                                                                                                                                         
|    
|(14) |  | Incorporated by reference to Registrants Annual Report on Form
10-K for the year ended December 31, 1998 (File No. 0-10211).                                                                                                                                                             
|    
|(15) |  | Incorporated by reference to Registrants Proxy Statement dated
March 23, 1994 and to Registrants Registration Statement on Form S-8
(File No. 33-83826).                                                                                                                                
|    
|(16) |  | Incorporated by reference to Registrants Annual Report on Form
10-K for the year ended December 31, 1995 (File No. 0-10211).                                                                                                                                                             
|    
|(17) |  | Incorporated by reference to Registrants Registration Statements
on Forms S-8 (File Nos. 333-41197, 333-85098 and 333-104642).                                                                                                                                                           
|    
|(18) |  | Incorporated by reference to Registrants Registration Statements
on Forms S-8 (File Nos. 333-41197 and 333-87474).                                                                                                                                                                       
|    
|(19) |  | Incorporated by reference to Registrants Registration Statements
on Forms S-8 (File Nos. 333-56872, 333-67261 and 333-85098).                                                                                                                                                            
|    
|(20) |  | Incorporated by reference to Registrants Report on Form 8-K (File
No. 333-67261).                                                                                                                                                                                                        
|    
|(21) |  | Filed herewith, except as noted.                                                                                                                                                                                                                                                          
|    
|*    |  | Management contracts or compensatory plan or arrangement required
to be filed as an exhibit to this report on Form 10-K.                                                                                                                                                                  

47



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##### Table of Contents



(b)  Reports on Form 8-K.



| | 1. |  | On October 21, 2003, we filed a Current Report on Form 8-K under
Item 7 (Financial Statements and Exhibits) and furnished disclosure
under Item 12 (Results of Operations and Financial Condition) to
report our press release dated October 20, 2003 announcing GAAP and
non-GAAP results for the fiscal quarter ended September 30, 2003, and
comparing such results with the results for the quarter ended
September 30, 2002.                         
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 2. |  | On February 17, 2004, we filed a Current Report on Form 8-K under
Item 7 (Financial Statements and Exhibits) and furnished disclosure
under Item 12 (Results of Operations and Financial Condition) to
report our press release dated February 17, 2004 announcing GAAP and
non-GAAP results for the fiscal quarter and year ended December 31,
2003, and comparing such results with the results for the fiscal
quarter and year ended December 31, 2002.

(c)  Exhibits.

|      |  |                                                                                                                                                  
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|10.63 |  | Form of Key Employee Tier 1 Change of Control Severance Agreement                                                                                
|      |  |                                                                                                                                                  
|10.64 |  | Form of Key Employee Tier 2 Change of Control Severance Agreement                                                                                
|      |  |                                                                                                                                                  
|13.0  |  | Excerpts from Annual Report to Security Holders.                                                                                                 
|      |  |                                                                                                                                                  
|21    |  | Subsidiaries of Inter-Tel, Incorporated                                                                                                          
|      |  |                                                                                                                                                  
|23.0  |  | Consent of Ernst & Young LLP, Independent Auditors.                                                                                              
|      |  |                                                                                                                                                  
|24.1  |  | Power of Attorney (See signature page of this Annual Report on
Form 10-K and incorporated herein by reference).                                  
|      |  |                                                                                                                                                  
|31.1  |  | Certification of Chief Executive Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002                                               
|      |  |                                                                                                                                                  
|31.2  |  | Certification of Chief Financial Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002                                               
|      |  |                                                                                                                                                  
|32.1  |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
|      |  |                                                                                                                                                  
|32.2  |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002

See Item 15(a) 3 also.

(d)  Financial Statement Schedule. The response to this portion of Item 15
is submitted as a separate section of this report. See Item 8.

48



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant, Inter-Tel, Incorporated, has
duly caused this Report to be signed on its behalf by the undersigned,
thereunto duly authorized.

| |  |                         |  |                                     
| |  | ----------------------- |  | ------------------------------------
| |  | INTER-TEL, INCORPORATED
| |  |                         |  |                                     
| |  | BY:                     |  | /s/ Steven G. Mihaylo               
| |  |                         |  |                                     
| |  |                         |  | Steven G. Mihaylo                   
| |  |                         |  | Chairman and Chief Executive Officer

Dated: March 12, 2004

EXHIBIT 24.1POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Steven G. Mihaylo and Kurt R. Kneip, jointly and
severally, his attorneys-in-fact, each with the power of substitution, for him
in any and all capacities, to sign any amendments to this Report on Form 10-K,
and to file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.

|                                           |  |                                                |  |               
|------------------------------------------ |  | ---------------------------------------------- |  | --------------
|Signature                                  |  | Title                                          |  | Date          
|                                           |  |                                                |  |               
|/s/ Steven G. Mihaylo

Steven G. Mihaylo   |  | Chairman and Chief
Executive Officer           |  | March 10, 2004
|                                           |  |                                                |  |               
|/s/ Kurt R. Kneip

Kurt R. Kneip           |  | Sr. Vice President and
Chief Financial Officer |  | March 10, 2004
|                                           |  |                                                |  |               
|/s/ J. Robert Anderson

J. Robert Anderson |  | Director                                       |  | March 10, 2004
|                                           |  |                                                |  |               
|/s/ Jerry W. Chapman

Jerry W. Chapman     |  | Director                                       |  | March 9, 2004 
|                                           |  |                                                |  |               
|/s/ Gary D. Edens

Gary D. Edens           |  | Director                                       |  | March 10, 2004
|                                           |  |                                                |  |               
|/s/ C. Roland Haden

C. Roland Haden       |  | Director                                       |  | March 10, 2004

49



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SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS

(In thousands)

|                                |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|------------------------------- |  | ---------- | ------ | ---------- |  | --------- | ----- | ---------- |  | --------- | ----- | ---- |  | - | ------ | ------ |  | - | ------ | 
|                                |  | COL. A     |        | COL. B     |  | COL. C    |       | COL. D     |  | COL. E   
|                                |  |            |        |            |  |           |       |            |  |          
|                                |  |            |        |            |  | ADDITIONS |       |            |  |           |       |      |  |   |        |        |  |  
|                                |  |            |        |            |  |           |       | Charged    |  |           |       |      |  |   |        |       
|                                |  | Balance at |        | Charged    |  | to Other  |       | Charged to |  | Balance  
|                                |  | Beginning  |        | to Costs   |  | Accounts  |       | Deductions |  | at End of
|DESCRIPTION                     |  | of Period  |        | & Expenses |  | Describe  |       | Describe   |  | Period   
|                                |  |            |        |            |  |           |       |            |  |          
|Year ended December 31, 2003    |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Deducted from asset accounts:   |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Allowance for doubtful accounts |  | $          | 12,159 |            |  | $         | 3,164 |            |  | $         | (770  | )(4) |  | $ | 3,543  | (2)    |  | $ | 11,010 | 
|Allowance for lease accounts    |  |            | 13,052 |            |  |           | 4,528 |            |  |           |      |      |  |   | 2,826  | (2)    |  |   | 14,754 | 
|Inventory allowance             |  |            | 10,558 |            |  |           | 991   |            |  |           |      |      |  |   | 4,597  | (3)    |  |   | 6,952  | 
|                                |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Year ended December 31, 2002    |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Deducted from asset accounts:   |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Allowance for doubtful accounts |  | $          | 11,858 |            |  | $         | 4,177 |            |  | $         | 517   | (4)  |  | $ | 4,393  | (2)    |  | $ | 12,159 | 
|Allowance for lease accounts    |  |            | 10,736 |            |  |           | 6,356 |            |  |           |      |      |  |   | 4,040  | (2)    |  |   | 13,052 | 
|Inventory allowance             |  |            | 13,202 |            |  |           | 1,526 |            |  |           |      |      |  |   | 4,170  | (3)    |  |   | 10,558 | 
|                                |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Year ended December 31, 2001    |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Deducted from asset accounts:   |  |            |        |            |  |           |       |            |  |           |       |      |  |   |        |        |  |   |        | 
|Allowance for doubtful accounts |  |            | 17,187 |            |  |           | 6,260 |            |  |           | 207   | (4)  |  |   | 11,796 | (1, 2) |  |   | 11,858 | 
|Allowance for lease accounts    |  |            | 9,200  |            |  |           | 5,840 |            |  |           |      |      |  |   | 4,304  | (2)    |  |   | 10,736 | 
|Inventory allowance             |  |            | 11,897 |            |  |           | 1,614 |            |  |           | 2,000 | (4)  |  |   | 2,309  | (3)    |  |   | 13,202 | 



---

|(1) |  | Includes $4.6 million related to Executone acquisition adjustments and
included in the balance at end of 2000. Additionally, this includes $1.9
million transferred to Comm-Services with the sale of Inter-Tel.NET that
was also included in the balance at end of period.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Uncollectible accounts written off, net of recoveries.                                                                                                                                                                                                                     
|   
|(3) |  | Inventory written off or sold.                                                                                                                                                                                                                                             
|   
|(4) |  | Acquisition related adjustments.                                                                                                                                                                                                                                           

50



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##### Table of Contents






Exhibit Index

|      |  |                                                                                                                                                  
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|10.63 |  | Form of Key Employee Tier 1 Change of Control Severance Agreement                                                                                
|      |  |                                                                                                                                                  
|10.64 |  | Form of Key Employee Tier 2 Change of Control Severance Agreement                                                                                
|      |  |                                                                                                                                                  
|13.0  |  | Excerpts from Annual Report to Security Holders. Filed herewith.                                                                                 
|      |  |                                                                                                                                                  
|21    |  | Subsidiaries of Inter-Tel, Incorporated                                                                                                          
|      |  |                                                                                                                                                  
|23.0  |  | Consent of Ernst & Young LLP, Independent Auditors.                                                                                              
|      |  |                                                                                                                                                  
|24.1  |  | Power of Attorney (See signature page of this Annual Report on
Form 10-K and incorporated herein by reference).                                  
|      |  |                                                                                                                                                  
|31.1  |  | Certification of Chief Executive Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002                                               
|      |  |                                                                                                                                                  
|31.2  |  | Certification of Chief Financial Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002                                               
|      |  |                                                                                                                                                  
|32.1  |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
|      |  |                                                                                                                                                  
|32.2  |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002