**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **ý**                         | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|------------------------------------|-----------------------------------------------------------------------------------------------|
|                               |                                                                                          |
| ** **                         | **For the quarterly period ended  April 30, 2006**                                            |
|                               |                                                                                          |
| **OR**                             |
|                               |                                                                                          |
| **o**                              | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|                               |                                                                                          |
| **Commission File Number 0-16231** |

 

**XETA Technologies, Inc.**

(Exact name ofregistrant as specified in its charter)

 

| **Oklahoma**                                                                        | ** ** | **73-1130045**      |
|-------------------------------------------------------------------------------------|------------|---------------------|
| (State or other  jurisdiction of                                                    |       | (I.R.S. Employee    |
| incorporation or  organization)                                                     |       | Identification No.) |
|                                                                                |       |                |
| **1814 W. Tacoma, Broken Arrow,  OK**                                               | ** ** | **74012-1406**      |
| (Address of principal  executive offices)                                           |       | (Zip Code)          |
|                                                                                |       |                |
| **918-664-8200**                                                                    |
| (Registrant’s telephone  number, including area code)                          |
|                                                                                |       |                |
|                                                                                |
| (Former name, former  address and former fiscal year, if changed since last report) |

 

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

 

Yes  ý      No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer”  in Rule 12b-2of the Exchange Act. (Check one):

 
| Large accelerated  filer  o | Accelerated  filer  o | Non-accelerated filer   ý |
|---------------------------------------|---------------------------------|------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes  o  No  ý

 

Indicate the number ofshares outstanding of each of the registrant’s classes of common stock, as ofthe latest practicable date.

 
| **Class**                      | ** ** | **Outstanding at May 15, 2006** |
|--------------------------------|------------|---------------------------------|
| Common Stock,  $.001 par value |       | 10,214,741                      |

 

 

----

 

INDEX

 
| PART I. FINANCIAL  INFORMATION |                   |
|--------------------------------|------------------------|
|                           |                   |
|                           | ITEM 1.                | FINANCIAL STATEMENTS  (Unaudited) |   |
|                           |                   |   |   |
|                           |                   | Consolidated  Balance Sheets - April 30, 2006 and October 31, 2005 |   |
|                           |                   |   |   |
|                           |                   | Consolidated  Statements of Operations - For the Three and Six Months Ended April 30, 2006  and 2005 |   |
|                           |                   |   |   |
|                           |                   | Consolidated  Statement of Shareholders’ Equity - For the Six Months Ended April 30, 2006 |   |
|                           |                   |   |   |
|                           |                   | Consolidated  Statements of Cash Flows - For the Six Months Ended April 30, 2006 and 2005 |   |
|                           |                   |   |   |
|                           |                   | Notes  to Consolidated Financial Statements |   |
|                           |                   |   |
|                           | ITEM  2.               | MANAGEMENT’S  DISCUSSION AND ANALYSIS |   |
|                           |                   |   |
|                           | ITEM  3.               | QUANTITATIVE  AND QUALITITATIVE DISCLOSURES ABOUT MARKET RISK |   |
|                           |                   |   |
|                           | ITEM  4.               | CONTROLS  AND PROCEDURES |   |
|                           |                   |   |
| PART II.  OTHER INFORMATION    |                   |
|                           |                   |
|                           | ITEM 1.                | LEGAL  PROCEEDINGS |   |
|                           |                   |   |
|                           | ITEM 1A. RISK  FACTORS |   |
|                           |                   |   |
|                           | ITEM 2.                | UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS |   |
|                           |                   |   |
|                           | ITEM 3.                | DEFAULTS UPON SENIOR  SECURITIES |   |
|                           |                   |   |
|                           | ITEM 4.                | SUBMISSION OF MATTERS TO A  VOTE OF SECURITY HOLDERS |   |
|                           |                   |   |
|                           | ITEM 5.                | OTHER INFORMATION |   |
|                           |                   |   |
|                           | ITEM 6.                | EXHIBITS |   |

 

2

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

 
| ** **                                                                                                                                           | ** ** | **April 30, 2006** | ** ** | **October 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
|                                                                                                                                                 |       |                         |       |                           |       |
| ASSETS                                                                                                                                               |       |                         |       |                           |       |
|                                                                                                                                                 |       |                         |       |                           |       |
| Current assets:                                                                                                                                      |       |                         |       |                           |       |
| Cash and cash  equivalents                                                                                                                           |       | $                            | 57,462     |                           | $          | 176,688 |   |
| Current portion  of net investment in sales-type leases and other receivables                                                                        |       | 404,668                      |       | 533,114                        |       |
| Trade accounts  receivable, net                                                                                                                      |       | 10,800,795                   |       | 11,634,030                     |       |
| Inventories, net                                                                                                                                     |       | 4,619,769                    |       | 5,650,027                      |       |
| Deferred tax  asset, net                                                                                                                             |       | 580,727                      |       | 727,222                        |       |
| Prepaid taxes                                                                                                                                        |       | 633,658                      |       | 888,842                        |       |
| Prepaid expenses  and other assets                                                                                                                   |       | 432,282                      |       | 139,525                        |       |
| Total current  assets                                                                                                                                |       | 17,529,361                   |       | 19,749,448                     |       |
|                                                                                                                                                 |       |                         |       |                           |       |
| Noncurrent  assets:                                                                                                                                  |       |                         |       |                           |       |
| Goodwill                                                                                                                                             |       | 26,448,457                   |       | 26,476,245                     |       |
| Intangible  assets, net                                                                                                                              |       | 160,792                      |       | 179,709                        |       |
| Net investment  in sales-type leases, less current portion above                                                                                     |       | 136,857                      |       | 167,399                        |       |
| Property, plant  & equipment, net                                                                                                                |       | 10,459,394                   |       | 10,411,329                     |       |
| Other assets                                                                                                                                         |       | 21,002                       |       | 34,411                         |       |
| Total noncurrent  assets                                                                                                                             |       | 37,226,502                   |       | 37,269,093                     |       |
| Total assets                                                                                                                                         |       | $                            | 54,755,863 |                           | $          | 57,018,541 |   |
|                                                                                                                                                 |       |                         |       |                           |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                            |       |                         |       |                           |       |
|                                                                                                                                                 |       |                         |       |                           |       |
| Current  liabilities:                                                                                                                                |       |                         |       |                           |       |
| Current portion  of long-term debt                                                                                                                   |       | $                            | 604,436    |                           | $          | 1,123,582 |   |
| Revolving line  of credit                                                                                                                            |       | 3,706,527                    |       | 4,394,727                      |       |
| Lease payable                                                                                                                                        |       | 3,133                        |       | 5,303                          |       |
| Accounts payable                                                                                                                                     |       | 3,446,437                    |       | 4,847,799                      |       |
| Current unearned  revenue                                                                                                                            |       | 2,234,216                    |       | 1,505,609                      |       |
| Accrued  liabilities                                                                                                                                 |       | 2,553,679                    |       | 2,392,846                      |       |
| Total current  liabilities                                                                                                                           |       | 12,548,428                   |       | 14,269,866                     |       |
|                                                                                                                                                 |       |                         |       |                           |       |
| Noncurrent  liabilities:                                                                                                                             |       |                         |       |                           |       |
| Long-term debt,  less current portion above                                                                                                          |       | 1,611,494                    |       | 1,697,039                      |       |
| Accrued  long-term liability                                                                                                                         |       | 144,100                      |       | 144,100                        |       |
| Noncurrent  unearned service revenue                                                                                                                 |       | 64,690                       |       | 64,895                         |       |
| Noncurrent  deferred tax liability, net                                                                                                              |       | 3,304,674                    |       | 3,744,704                      |       |
| Total noncurrent  liabilities                                                                                                                        |       | 5,124,958                    |       | 5,650,738                      |       |
|                                                                                                                                                 |       |                         |       |                           |       |
| Shareholders’  equity:                                                                                                                          |       |                         |       |                           |       |
| Preferred stock;  $.10 par value; 50,000 shares authorized, 0 issued                                                                                 |       | —                       |       | —                         |       |
| Common stock;  $.001 par value; 50,000,000 shares authorized, 11,233,529 and 11,197,025  issued at April 30, 2006 and October 31, 2005, respectively |       | 11,233                       |       | 11,197                         |       |
| Paid-in capital                                                                                                                                      |       | 13,067,676                   |       | 12,999,074                     |       |
| Retained  earnings                                                                                                                                   |       | 26,248,227                   |       | 26,332,325                     |       |
| Less treasury  stock, at cost (1,018,788 shares at April 30, 2006 and October 31, 2005)                                                              |       | (2,244,659                   | )          | (2,244,659                     | )          |
| Total  shareholders’ equity                                                                                                                     |       | 37,082,477                   |       | 37,097,937                     |       |
| Total  liabilities and shareholders’ equity                                                                                                     |       | $                            | 54,755,863 |                           | $          | 57,018,541 |   |

 

The accompanying notesare an integral part of these consolidated balance sheets.

 

3

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENTSOF OPERATIONS

(UNAUDITED)

 
| ** **                                       | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **Ended April 30,**           | ** ** | **Ended April 30,**         | ** ** |
| ** **                                       | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Systems sales                                    |       | $                                       | 7,556,449  |                                  | $          | 6,282,216 |   | $ | 13,257,725 |   | $ | 12,634,310 |   |
| Services                                         |       | 7,248,178                               |       | 7,369,222                             |       | 13,667,118 |   | 14,300,044 |   |
| Other revenues                                   |       | 89,463                                  |       | 552,815                               |       | 651,759 |   | 1,184,628 |   |
| Net sales and  service revenues                  |       | 14,894,090                              |       | 14,204,253                            |       | 27,576,602 |   | 28,118,982 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Cost of systems  sales                           |       | 5,723,797                               |       | 4,606,365                             |       | 9,841,398 |   | 9,472,098 |   |
| Services costs                                   |       | 5,197,965                               |       | 5,135,046                             |       | 10,293,864 |   | 10,056,248 |   |
| Cost of other  revenues & corporate COGS     |       | 436,582                                 |       | 574,218                               |       | 1,129,243 |   | 1,195,236 |   |
| Total cost of  sales and service                 |       | 11,358,344                              |       | 10,315,629                            |       | 21,264,505 |   | 20,723,582 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Gross profit                                     |       | 3,535,746                               |       | 3,888,624                             |       | 6,312,097 |   | 7,395,400 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Operating  expenses                              |       |                                    |       |                                  |       |   |   |   |   |
| Selling, general  and administrative             |       | 3,315,060                               |       | 3,507,750                             |       | 6,142,258 |   | 6,906,275 |   |
| Amortization                                     |       | 102,532                                 |       | 94,415                                |       | 203,729 |   | 185,876 |   |
| Total operating  expenses                        |       | 3,417,592                               |       | 3,602,165                             |       | 6,345,987 |   | 7,092,151 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Income (loss)  from operations                   |       | 118,154                                 |       | 286,459                               |       | (33,890 | ) | 303,249 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Interest expense                                 |       | (25,902                                 | )          | (42,398                               | )          | (97,799 | ) | (54,782 | ) |
| Interest and  other income                       |       | 11,377                                  |       | 27,472                                |       | 19,591 |   | 152,210 |   |
| Total interest  and other income (expense)       |       | (14,525                                 | )          | (14,926                               | )          | (78,208 | ) | 97,428 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Income (loss)  before provision for income taxes |       | 103,629                                 |       | 271,533                               |       | (112,098 | ) | 400,677 |   |
| Provision  (benefit) for income taxes            |       | 47,000                                  |       | 107,000                               |       | (28,000 | ) | 158,000 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Net income  (loss)                               |       | $                                       | 56,629     |                                  | $          | 164,533 |   | $ | (84,098 | ) | $ | 242,677 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Earnings (loss)  per share                       |       |                                    |       |                                  |       |   |   |   |   |
| Basic                                            |       | $                                       | 0.01       |                                  | $          | 0.02 |   | $ | (0.01 | ) | $ | 0.02 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Diluted                                          |       | $                                       | 0.01       |                                  | $          | 0.02 |   | $ | (0.01 | ) | $ | 0.02 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Weighted average  shares outstanding             |       | 10,214,567                              |       | 10,048,783                            |       | 10,201,651 |   | 10,037,869 |   |
|                                             |       |                                    |       |                                  |       |   |   |   |   |
| Weighted average  equivalent shares              |       | 10,214,606                              |       | 10,084,358                            |       | 10,205,033 |   | 10,079,047 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

4

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY

(UNAUDITED)

 
| ** **                               | ** ** | **Common Stock**  | ** ** | **Treasury Stock** | ** ** | ** ** | ** ** | **Retained** | ** ** | ** **                | ** ** |
|------------------------------------------|------------|------------------------|------------|-------------------------|------------|------------|------------|--------------|------------|---------------------------|------------|
| ** **                               | ** ** | **Shares Issued** | ** ** | **Par Value**      | ** ** | **Shares** | ** ** | **Amount**   | ** ** | **Paid- in Capital** | ** ** | **Earnings** | ** ** | **Total** | ** ** |
|                                     |       |                   |       |                    |       |       |       |         |       |                      |       |   |   |   |   |
| Balance- October  31, 2005               |       | 11,197,025             |       | $                       | 11,197     |       | 1,018,788  |         | $          | (2,244,659                | )          | $ | 12,999,074 |   | $ | 26,332,325 |   | $ | 37,097,937 |   |
|                                     |       |                   |       |                    |       |       |       |         |       |                      |       |   |   |   |   |
| Stock options  exercised $.001 par value |       | 36,504                 |       | 36                      |       | —     |       | —       |       | 59,854                    |       | — |   | 59,890 |   |
| Tax benefit of  stock options            |       | —                 |       | —                  |       | —     |       | —       |       | 8,748                     |       | — |   | 8,748 |   |
|                                     |       |                   |       |                    |       |       |       |         |       |                      |       |   |   |   |   |
| Net loss                                 |       | —                 |       | —                  |       | —     |       | —       |       | —                    |       | (84,098 | ) | (84,098 | ) |
|                                     |       |                   |       |                    |       |       |       |         |       |                      |       |   |   |   |   |
| Balance- April  30, 2006                 |       | 11,233,529             |       | $                       | 11,233     |       | 1,018,788  |         | $          | (2,244,659                | )          | $ | 13,067,676 |   | $ | 26,248,227 |   | $ | 37,082,477 |   |

 

The accompanying notesare an integral part of this consolidated financial statement.

 

5

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENTSOF CASH FLOWS

(UNAUDITED)

 
| ** **                                                                                                    | ** ** | **For the Six Months** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                    | ** ** | **Ended April 30,**         | ** ** |
| ** **                                                                                                    | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                                        |       |                                  |       |   |   |
| Net (loss)  income                                                                                            |       | $                                     | (84,098    | ) | $ | 242,677 |   |
|                                                                                                          |       |                                  |       |   |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities:                     |       |                                  |       |   |   |
| Depreciation                                                                                                  |       | 253,077                               |       | 361,979 |   |
| Amortization                                                                                                  |       | 203,729                               |       | 185,876 |   |
| Loss (gain) on  sale of assets                                                                                |       | 4,184                                 |       | (4,031 | ) |
| Ineffectiveness  of cash flow hedge                                                                           |       | —                                |       | (12,476 | ) |
| Provision for  excess and obsolete inventory                                                                  |       | 51,000                                |       | 36,611 |   |
| Change in assets  and liabilities, net of acquisitions:                                                       |       |                                  |       |   |   |
| Decrease in net  investment in sales-type leases & other receivables                                      |       | 158,988                               |       | 80,617 |   |
| Decrease in  trade account receivables                                                                        |       | 833,235                               |       | 1,035,930 |   |
| Decrease  (increase) in inventories                                                                           |       | 979,258                               |       | (291,459 | ) |
| Decrease in  deferred tax asset                                                                               |       | 146,495                               |       | 125,050 |   |
| Increase in  prepaid expenses and other assets                                                                |       | (279,348                              | )          | (238,453 | ) |
| Decrease  (increase) in prepaid taxes                                                                         |       | 255,184                               |       | (428,033 | ) |
| (Decrease)  increase in accounts payable                                                                      |       | (1,401,362                            | )          | 620,391 |   |
| Increase in  unearned revenue                                                                                 |       | 728,402                               |       | 303,325 |   |
| Increase in  accrued taxes                                                                                    |       | 19,108                                |       | 19,108 |   |
| Increase  (decrease) in accrued liabilities and lease payable                                                 |       | 158,663                               |       | (138,229 | ) |
| (Decrease)  increase in deferred tax liability                                                                |       | (415,296                              | )          | 658,201 |   |
| Total  adjustments                                                                                            |       | 1,695,317                             |       | 2,314,407 |   |
|                                                                                                          |       |                                  |       |   |   |
| Net cash  provided by operating activities                                                                    |       | 1,611,219                             |       | 2,557,084 |   |
|                                                                                                          |       |                                  |       |   |   |
| Cash flows from  investing activities:                                                                        |       |                                  |       |   |   |
| Acquisitions,  net of cash acquired                                                                           |       | —                                |       | (6,015 | ) |
| Additions to  property, plant & equipment                                                                 |       | (507,770                              | )          | (430,852 | ) |
| Proceeds from  sale of assets                                                                                 |       | 17,632                                |       | 200 |   |
| Net cash used in  investing activities                                                                        |       | (490,138                              | )          | (436,667 | ) |
|                                                                                                          |       |                                  |       |   |   |
| Cash flows from  financing activities:                                                                        |       |                                  |       |   |   |
| Proceeds from  draws on revolving line of credit                                                              |       | 11,602,866                            |       | 10,924,024 |   |
| Principal  payments on debt                                                                                   |       | (604,691                              | )          | (604,690 | ) |
| Payments on  revolving line of credit                                                                         |       | (12,291,066                           | )          | (12,503,977 | ) |
| Exercise of  stock options                                                                                    |       | 52,584                                |       | 16,601 |   |
| Net cash used in  financing activities                                                                        |       | (1,240,307                            | )          | (2,168,042 | ) |
|                                                                                                          |       |                                  |       |   |   |
| Net decrease in  cash and cash equivalents                                                                    |       | (119,226                              | )          | (47,625 | ) |
|                                                                                                          |       |                                  |       |   |   |
| Cash and cash  equivalents, beginning of period                                                               |       | 176,688                               |       | 141,054 |   |
| Cash and cash  equivalents, end of period                                                                     |       | $                                     | 57,462     |   | $ | 93,429 |   |
|                                                                                                          |       |                                  |       |   |   |
| Supplemental  disclosure of cash flow information:                                                            |       |                                  |       |   |   |
| Cash paid during  the period for interest, net of amount capitalized of $146,596 in 2006 and  $91,116 in 2005 |       | $                                     | 88,678     |   | $ | 59,266 |   |
| Cash paid during  the period for income taxes                                                                 |       | $                                     | 27,304     |   | $ | 36,961 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

6

----

 

**XETATECHNOLOGIES, INC. AND SUBSIDIARY**

**Notesto Consolidated Financial Statements**

**April 30, 2006**

(Unaudited)

 

1. BASIS OFPRESENTATION:

 

XETA Technologies, Inc. (“XETA”or the “Company”) is a leading provider of communications solutions with salesand service locations nationwide, serving business clients in sales,engineering, project management, installation, and service support. The Companysells products which are manufactured by a variety of manufacturers includingAvaya, Inc. (“Avaya”), Nortel Networks Corporation (“Nortel”), IgeaCareSystems, Inc., and Spectralink Corporation. In addition, the Companymanufactures and markets a line of proprietary call accounting systems to thehospitality industry. XETA is an Oklahoma corporation.

 

The accompanyingunaudited consolidated financial statements have been prepared by the Companypursuant to the rules and regulations of the Securities and Exchange Commission(the “Commission”). Certain information and footnote disclosures normallyincluded in annual financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to those rules and regulations, although theCompany believes that the disclosures made are adequate to make the informationpresented not misleading. It is suggested that these condensed financialstatements be read in conjunction with the consolidated financial statementsand the notes thereto made a part of the Company’s Annual Report on Form 10-K,Commission File No. 0-16231, which was filed with the Commission on January 9,2006. Management believes that the financial statements contain all adjustmentsnecessary for a fair statement of the results for the interim periods presented.All adjustments made were of a normal recurring nature. The results ofoperations for the interim period are not necessarily indicative of the resultsfor the entire fiscal year. Certain reclassifications of prior year amountshave been made to conform to current year presentations. These classificationshad no impact on net income.

 

Segment Information

 

The Company has threereportable segments:  commercial systemsales, lodging system sales, and installation and service. The Company definescommercial system sales as sales to the non-lodging industry. Installation andservice revenues represent revenues earned from installing and maintainingsystems for customers in both the commercial and lodging segments.

 

The reporting segmentsfollow the same accounting policies used for the Company’s consolidatedfinancial statements and described in the Summary of Significant AccountingPolicies in the Company’s Form 10-K described above. Company managementevaluates a segment’s performance based upon gross margins. Assets are notallocated to the segments. Sales to customers located outside of the U.S. areimmaterial.

 

7

----

 

The following istabulation of business segment information for the three months ended April 30,2006 and 2005.

 
| ** **    | ** ** | **Commercial  System  Sales** | ** ** | **Lodging  System  Sales** | ** ** | **Installation  and Service  Revenues** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|---------------|------------|-------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|--------------------|------------|-------------|------------|
| **2006**      |       |                          |       |                       |       |                                         |       |               |       |        |       |
| Sales         |       | $                             | 5,324,036  |                       | $          | 2,232,413                                    |       | $                  | 7,248,178  |        | $          | 89,463 |   | $ | 14,894,090 |   |
| Cost of sales |       | (4,044,850                    | )          | (1,678,947                 | )          | (5,197,965                                   | )          | (436,582           | )          | (11,358,344 | )          |
| Gross profit  |       | $                             | 1,279,186  |                       | $          | 553,466                                      |       | $                  | 2,050,213  |        | $          | (347,119 | ) | $ | 3,535,746 |   |
|          |       |                          |       |                       |       |                                         |       |               |       |        |       |
| **2005**      |       |                          |       |                       |       |                                         |       |               |       |        |       |
| Sales         |       | $                             | 4,820,155  |                       | $          | 1,462,061                                    |       | $                  | 7,369,222  |        | $          | 552,815 |   | $ | 14,204,253 |   |
| Cost of sales |       | (3,590,780                    | )          | (1,015,585                 | )          | (5,135,046                                   | )          | (574,218           | )          | (10,315,629 | )          |
| Gross profit  |       | $                             | 1,229,375  |                       | $          | 446,476                                      |       | $                  | 2,234,176  |        | $          | (21,403 | ) | $ | 3,888,624 |   |

 

The following istabulation of business segment information for the six months ended April 30,2006 and 2005.

 
| ** **    | ** ** | **Commercial  System  Sales** | ** ** | **Lodging  System  Sales** | ** ** | **Installation  and Service  Revenues** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|---------------|------------|-------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|--------------------|------------|-------------|------------|
| **2006**      |       |                          |       |                       |       |                                         |       |               |       |        |       |
| Sales         |       | $                             | 9,512,891  |                       | $          | 3,744,834                                    |       | $                  | 13,667,118 |        | $          | 651,759 |   | $ | 27,576,602 |   |
| Cost of sales |       | (7,058,654                    | )          | (2,782,744                 | )          | (10,293,864                                  | )          | (1,129,243         | )          | (21,264,505 | )          |
| Gross profit  |       | $                             | 2,454,237  |                       | $          | 962,090                                      |       | $                  | 3,373,254  |        | $          | (477,484 | ) | $ | 6,312,097 |   |
|          |       |                          |       |                       |       |                                         |       |               |       |        |       |
| **2005**      |       |                          |       |                       |       |                                         |       |               |       |        |       |
| Sales         |       | $                             | 9,677,931  |                       | $          | 2,956,379                                    |       | $                  | 14,300,044 |        | $          | 1,184,628 |   | $ | 28,118,982 |   |
| Cost of sales |       | (7,425,428                    | )          | (2,046,670                 | )          | (10,056,248                                  | )          | (1,195,236         | )          | (20,723,582 | )          |
| Gross profit  |       | $                             | 2,252,503  |                       | $          | 909,709                                      |       | $                  | 4,243,796  |        | $          | (10,608 | ) | $ | 7,395,400 |   |

 

Stock-Based CompensationPlans

 

In December 2004 the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial Accounting StandardsNo. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”). This newstatement superseded APB Opinion No. 25, “Accounting for Stock Issued toEmployees,” and its related implementation guidance. The statement focusesprimarily on accounting for transactions in which an entity obtains employeeservices in share-based payment transactions. SFAS No. 123R requires a publicentity to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award(with limited exceptions). That cost is to be recognized over the period duringwhich an employee is required to provide service in exchange for the award. TheCompany adopted the standard on November 1, 2005 using the modified prospectivemethod of transition provided in SFAS 123R. Under this method of transition,SFAS 123R applies to new equity-based awards or to awards modified after thedate of adoption. Additionally, compensation cost is to be recognized forpreviously issued, but unvested awards. Such cost is to be recognized over theremaining length of service required under the award and in an amount based on thesame value that was previously used for disclosure under SFAS 123. Becauseoption holders were fully vested in all outstanding options at the time ofadoption of SFAS 123R, the Company did not record any compensation expense inassociation with outstanding equity-based awards in the current period. Thetable below presents the impact of issued stock options on the prior year’s reportingperiod as if the expense had been recorded in the consolidated financialstatements based on the fair value method.

 

8

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| ** **                                                                                                                                                    | ** ** | **For the Three  Months Ended  April 30, 2005** | ** ** | **For the Six  Months Ended  April 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Net income as  reported                                                                                                                                       |       | $                                                                        | 164,533    |                                                                   | $          | 242,677 |   |
| Total  stock-based employee compensation expense or reduction of expense determined  under fair value based method for all awards, net of related tax effects |       | (106                                                                     | )          | 1,415                                                                  |       |
| Pro forma net income                                                                                                                                          |       | $                                                                        | 164,427    |                                                                   | $          | 244,092 |   |
|                                                                                                                                                          |       |                                                                     |       |                                                                   |       |
| EARNINGS PER  SHARE:                                                                                                                                          |       |                                                                     |       |                                                                   |       |
| As reported –  Basic                                                                                                                                     |       | $                                                                        | 0.02       |                                                                   | $          | 0.02 |   |
| As reported –  Diluted                                                                                                                                   |       | $                                                                        | 0.02       |                                                                   | $          | 0.02 |   |
|                                                                                                                                                          |       |                                                                     |       |                                                                   |       |
| Pro forma –  Basic                                                                                                                                       |       | $                                                                        | 0.02       |                                                                   | $          | 0.02 |   |
| Pro forma –  Diluted                                                                                                                                     |       | $                                                                        | 0.02       |                                                                   | $          | 0.02 |   |

 

Use of Estimates

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

 

2. ACCOUNTSRECEIVABLE:

 

Trade accounts receivableconsists of the following:

 
| ** **                           | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|--------------------------------------|------------|--------------------------|------------|----------------------------|------------|
|                                 |       |                     |       |                       |       |
| Trade  receivables                   |       | $                        | 11,086,298 |                       | $          | 11,932,173 |   |
| Less- reserve  for doubtful accounts |       | (285,503                 | )          | (298,143                   | )          |
| Net trade  receivables               |       | $                        | 10,800,795 |                       | $          | 11,634,030 |   |

 

3. INVENTORIES:

 

Inventories are stated at the lower of cost(first-in, first-out or average) or market and consist of the followingcomponents:

 
| ** **                                         | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|----------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
|                                               |       |                     |       |                       |       |
| Finished goods  and spare parts                    |       | $                        | 4,989,547  |                       | $          | 5,831,560 |   |
| Raw materials                                      |       | 175,406                  |       | 358,646                    |       |
|                                               |       | 5,164,953                |       | 6,190,206                  |       |
| Less- reserve  for excess and obsolete inventories |       | (545,184                 | )          | (540,179                   | )          |
| Total  inventories, net                            |       | $                        | 4,619,769  |                       | $          | 5,650,027 |   |

 

9

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4. PROPERTY, PLANT ANDEQUIPMENT:

 

Property, plant andequipment consists of the following:

 
| ** **                                                    | ** ** | **Estimated  Useful  Lives** | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|----------------------------|------------|
|                                                          |       |                         |       |                     |       |                       |       |
| Building                                                      |       | 20                           |       | $                        | 2,397,954  |                       | $          | 2,397,954 |   |
| Data processing  and computer field equipment                 |       | 3-10                         |       | 3,745,564                |       | 4,720,698                  |       |
| Software  development costs, work-in-process                  |       | N/A                          |       | 5,601,977                |       | 5,410,558                  |       |
| Software  development costs of components placed into service |       | 3-10                         |       | 1,752,547                |       | 1,695,370                  |       |
| Hardware                                                      |       | 3-5                          |       | 599,439                  |       | 589,905                    |       |
| Land                                                          |       | —                       |       | 611,582                  |       | 611,582                    |       |
| Office furniture                                              |       | 5                            |       | 1,096,956                |       | 1,114,073                  |       |
| Auto                                                          |       | 5                            |       | 405,684                  |       | 384,278                    |       |
| Other                                                         |       | 3-7                          |       | 267,215                  |       | 549,613                    |       |
|                                                          |       |                         |       |                     |       |                       |       |
| Total property,  plant and equipment                          |       |                         |       | 16,478,918               |       | 17,474,031                 |       |
| Less-  accumulated depreciation                               |       |                         |       | (6,019,524               | )          | (7,062,702                 | )          |
|                                                          |       |                         |       |                     |       |                       |       |
| Total property,  plant and equipment, net                     |       |                         |       | $                        | 10,459,394 |                       | $          | 10,411,329 |   |

 

Interest costs related toan investment in long-lived assets are capitalized as part of the cost of theasset during the period the asset is being prepared for use. The Companycapitalized $146,596 and $91,116 in interest costs in the six months ended April30, 2006 and 2005, respectively.

 

5. INCOME TAXES:

 

The tax effect oftemporary differences that give rise to significant portions of the deferredtax assets and deferred tax liabilities are presented below:

 
| ** **                                                 | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|------------------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| Deferred tax  assets:                                      |       |                     |       |                       |       |
| Net operating  loss carryforward                           |       | $                        | 890,590    |                       | $          | — |   |
| Currently  nondeductible reserves                          |       | 230,602                  |       | 238,379                    |       |
| Accrued  liabilities                                       |       | 198,672                  |       | 300,255                    |       |
| Prepaid service  contracts                                 |       | 97,672                   |       | 111,771                    |       |
| Other                                                      |       | 74,090                   |       | 87,972                     |       |
| Total deferred  tax asset                                  |       | 1,491,626                |       | 738,377                    |       |
|                                                       |       |                     |       |                       |       |
| Deferred tax  liabilities:                                 |       |                     |       |                       |       |
| Intangible  assets                                         |       | 3,340,634                |       | 2,992,299                  |       |
| Depreciation                                               |       | 842,668                  |       | 734,394                    |       |
| Tax income to be  recognized on sales-type lease contracts |       | 32,271                   |       | 29,166                     |       |
| Total deferred  tax liability                              |       | 4,215,573                |       | 3,755,859                  |       |
| Net deferred tax  liability                                |       | $                        | (2,723,947 | )                          | $          | (3,017,482 | ) |

 
| ** **                                                 | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|------------------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| Net deferred  liability as presented on the balance sheet: |       |                     |       |                       |       |
| Current deferred  tax asset                                |       | $                        | 580,727    |                       | $          | 727,222 |   |
| Noncurrent  deferred tax liability                         |       | (3,304,674               | )          | (3,744,704                 | )          |
| Net deferred tax  liability                                |       | $                        | (2,723,947 | )                          | $          | (3,017,482 | ) |

 

10

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The Company has recordeda tax benefit of $28,000 or 25% and a tax provision of $158,000 for the sixmonths ended April 30, 2006 and 2005, respectively, reflecting the statutoryfederal tax rate of 34% plus a blended state income tax rate of approximately5% less the impact of minimum income tax payments in certain states.

 

6. CREDIT AGREEMENTS:

 

The Company has arevolving credit and term loan agreement with a bank containing three separatenotes:  a term loan amortizing over 36months, a mortgage agreement amortizing over 13 years, and a $7.5 millionrevolving credit agreement to finance growth in working capital. The revolvingline of credit is collateralized by trade accounts receivable and inventories. AtApril 30, 2006 and October 31, 2005, the Company had approximately $3.707million and $4.395 million, respectively, outstanding on the revolving line ofcredit. The Company had approximately $3.793 million available under the revolvingline of credit at April 30, 2006. Advance rates are defined in the agreement,but are generally at the rate of 80% on qualified trade accounts receivable and40% of qualified inventories. The revolving line of credit matures on September28, 2006. Long-term debt consists of the following:

 
| ** **                                                                                                                                                                                                       | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| Term loan, payable  in monthly installments of $86,524 plus interest, due September 30, 2006,  collateralized by all assets of the Company                                                                       |       | $                        | 433,313    |                       | $          | 952,459 |   |
|                                                                                                                                                                                                             |       |                     |       |                       |       |
| Real estate term  note, payable in monthly installments of $14,257 plus interest, plus a fixed  payment of $1,198,080 due September 30, 2009, collateralized by a first  mortgage on the Company’s building |       | 1,782,617                |       | 1,868,162                  |       |
|                                                                                                                                                                                                             |       |                     |       |                       |       |
|                                                                                                                                                                                                             |       | 2,215,930                |       | 2,820,621                  |       |
|                                                                                                                                                                                                             |       |                     |       |                       |       |
| Less-current  maturities                                                                                                                                                                                         |       | 604,436                  |       | 1,123,582                  |       |
|                                                                                                                                                                                                             |       |                     |       |                       |       |
| Total long-term  debt, less current maturities                                                                                                                                                                   |       | $                        | 1,611,494  |                       | $          | 1,697,039 |   |

 

Interest on alloutstanding debt under the credit facility accrues at either a) the LondonInterbank Offered Rate (which was 5.04% at April 30, 2006) plus 1.25% to 2.75%depending on the Company’s funded debt to cash flow ratio, or b) the bank’sprime rate (which was 7.75% at April 30, 2006) minus 0% to minus 1.125% alsodepending on the Company’s funded debt to cash flow ratio. At April 30, 2006,the Company was paying 7.375% on the revolving line of credit borrowings, 6.829%on the term loan and 6.579% on the mortgage note. The credit facility containsseveral financial covenants common in such agreements, including tangible networth requirements, limitations on the amount of funded debt to earnings beforeinterest, taxes, depreciation and amortization, limitations on capitalspending, and debt service coverage requirements. The Company was in compliancewith these covenants.

 

7. EARNINGS PER SHARE:

 

Basic earnings per commonshare were computed by dividing net income by the weighted average number ofshares of common stock outstanding during the reporting periods. Dilutedearnings per common share were computed by dividing net income by the weightedaverage number of shares of common stock and dilutive potential common stockoutstanding during the reporting periods. A reconciliation of net income andweighted average shares used in computing basic and diluted earnings per shareis as follows:

 

11

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| ** **                        | ** ** | **For the Three Months Ended April 30, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                                                          | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic EPS                         |       |                                                                             |       |   |   |   |   |
| Net income                        |       | $                                                                                | 56,629     |   | 10,214,567 |   | $ | 0.01 |   |
| Dilutive effect  of stock options |       |                                                                             |       | 39 |   |   |   |
|                              |       |                                                                             |       |   |   |   |   |
| Diluted EPS                       |       |                                                                             |       |   |   |   |   |
| Net income                        |       | $                                                                                | 56,629     |   | 10,214,606 |   | $ | 0.01 |   |

 

12

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| ** **                        | ** ** | **For the Three Months Ended April 30, 2005** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                                                          | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic EPS                         |       |                                                                             |       |   |   |   |   |
| Net income                        |       | $                                                                                | 164,533    |   | 10,048,783 |   | $ | 0.02 |   |
| Dilutive effect  of stock options |       |                                                                             |       | 35,575 |   |   |   |
|                              |       |                                                                             |       |   |   |   |   |
| Diluted EPS                       |       |                                                                             |       |   |   |   |   |
| Net income                        |       | $                                                                                | 164,533    |   | 10,084,358 |   | $ | 0.02 |   |

 
| ** **                        | ** ** | **For the Six Months Ended April 30, 2006** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                                                        | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic EPS                         |       |                                                                           |       |   |   |   |   |
| Net loss                          |       | $                                                                              | (84,098    | ) | 10,201,651 |   | $ | (0.01 | ) |
| Dilutive effect  of stock options |       |                                                                           |       | 3,382 |   |   |   |
|                              |       |                                                                           |       |   |   |   |   |
| Diluted EPS                       |       |                                                                           |       |   |   |   |   |
| Net loss                          |       | $                                                                              | (84,098    | ) | 10,205,033 |   | $ | (0.01 | ) |

 
| ** **                        | ** ** | **For the Six Months Ended April 30, 2005** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                                                        | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic EPS                         |       |                                                                           |       |   |   |   |   |
| Net income                        |       | $                                                                              | 242,677    |   | 10,037,869 |   | $ | 0.02 |   |
| Dilutive effect  of stock options |       |                                                                           |       | 41,178 |   |   |   |
|                              |       |                                                                           |       |   |   |   |   |
| Diluted EPS                       |       |                                                                           |       |   |   |   |   |
| Net income                        |       | $                                                                              | 242,677    |   | 10,079,047 |   | $ | 0.02 |   |

 

Options to purchase 1,119,768shares of common stock at an average exercise price of $7.17 and 1,122,468  shares of common stock at an average exerciseprice of $7.17 were not included in the computation of diluted earnings pershare for the three months ended April 30, 2006 and 2005, respectively, becauseinclusion of these options would be antidilutive. Options to purchase 1,119,768shares of common stock at an average exercise price of $7.17 and 240,193 sharesof common stock at an average exercise price of $15.62 were not included in thecomputation of diluted earnings per share for the six months ended April 30,2006 and 2005, respectively, because inclusion of these options would beantidilutive.

 

13

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**ITEM 2. MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**The following discussion containsvarious “forward-looking statements.” All statements, other than statements of historical fact, which addressactivities, events or developments that the Company expects or anticipates willor may occur in the future, are forward-looking statements. These statementsinclude, but are not limited to, statements concerning future revenues, futurecosts, future earnings or losses, future capital expenditures, businessstrategy, competitive strengths, competitive weaknesses, goals, plans,references to future success or difficulties and other similar information. Theseand other forward-looking statements generally contain, and can be identifiedby words such as “expect,” “intend,” “believe,” “estimate,” “plan,” “anticipate”“forecast,” “project” and similar words or expressions, and by discussions ofstrategy or intentions. Forward-looking statements are not guarantees ofperformance but rather reflect our current expectations, assumptions andbeliefs based upon information currently available to us. Investors arecautioned that all forward-looking statements are subject to certain risks anduncertainties which are difficult to predict and that could cause actualresults to differ materially from those projected. Many of these risks anduncertainties are described below under Item 1.A Risk Factors under Part II ofthis report and in the Company’s Annual Report on Form 10-K, which was filed onJanuary 9, 2006. All forward-looking statements should be read in conjunctionwith these risk factors.**

 

# **Overview**

 

Strategy. In our second fiscal quarter, we beganto experience positive results from our fiscal 2006 strategies of focusing on top-linerevenue growth, sales of managed services, and services gross margins. Ourtotal revenues in the second quarter increased 17% compared to the firstquarter of this year and were up 5% compared to the second quarter of lastfiscal year.

 

During the secondquarter, we continued our balanced investment in our sales force supporting theNortel and Avaya product lines and we enjoyed increases in the sales of systemscompared to the first quarter of fiscal 2006 and compared to last year. Wecontinue to closely monitor the productivity of our sales force and makechanges as appropriate. Also contributing to the increase in total revenueswere newly acquired services revenues from our managed services initiative. Managedservices represent our service relationships with systems integrators orequipment manufacturers in which we maintain communications systems for their mid-sizedto large, multi-location customers who desire to work with just one vendor fortheir technical support needs. Generally, we earn recurring revenues from thesecustomers in the form of fixed monthly maintenance fees and time and materialscharges for services not covered under the maintenance contract. Securing thesecontracts usually requires an extended sales effort and substantial on-goingdedicated service and administrative support to meet the demands of these highprofile customers. We are focusing some existing sales resources as well as newsales resources on this initiative as part of our strategy to increase ourservices revenues as a proportion of total revenues. We believe that thisinitiative is integral to our long-term strategy. The increased revenues frommanaged services contracts coupled with the addition of other new servicecontracts helped to improve the margins earned in our National Service Center (“NSC”)by absorbing our substantial investment in Nortel technical talent.

 

Operating Summary. Our revenues for the second quarter offiscal 2006 were $14.9 million, an increase of 5% compared to the secondquarter of fiscal 2005. This increase consists of a 20% increase in sales ofsystems partially offset by a 2% decrease in services revenues and an 84%decrease in other revenues. Revenues for the six months ending April 30, 2006were $27.6 million, a decrease of 2% over the same period last year. Thisdecrease consisted of decreases in services revenues and other revenues of 4%and 45%, respectively, partially offset by a 5% increase in systems sales. Ouroperating results in the second quarter of fiscal 2006 were net income of$57,000 compared to net income of $165,000 in the second quarter of last yearand a net loss of $84,000 for the six months ended April 30, 2006 compared tonet income of $243,000 last year. These results generally reflect lower grossmargins earned in the current year which have been partially offset by slightlylower operating expenses. These items are discussed in more detail under “Resultsof Operations” below.

 

14

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Financial Position Summary. Our financial condition improved duringthe second quarter as term debt was reduced 12%, revolver debt was reduced 19%,and cash earned from operations was $813,000. For the six-month period endedApril 30, 2006, our term debt has been reduced 21%, our revolver debt has beenreduced 16% and our cash earned from operations was $1.6 million. These itemsare discussed in more detail under “Financial Condition” below.

 

Expectations. We expect to see continued improvementin our operating results during the balance of the fiscal year. We expect theseimprovements to come from both increased systems sales and services revenues,particularly our managed services initiative. We expect operating expenses toremain relatively stable for the remainder of the year. All of these factorsare critical to our expectation of improved operating results in the third andfourth quarters. Additional risk factors that might affect our short- andlong-term results are presented in the “Risk Factors” section below and in ourmost recently filed Form 10-K.

 

The following discussion presents additionalinformation regarding our financial condition and results of operations for thethree- and six-month periods ending April 30, 2006 and should be read inconjunction with our comments above as well as the “Risk Factors” sectionbelow.

 

# **FinancialCondition**

# ** **

Cash provided by operations in the first half offiscal 2006 was $1.6 million. These cash flows included non-cash charges of$512,000 that offset the operating loss of $84,000 coupled with an $833,000reduction in accounts receivable, a $979,000 reduction in inventories, and$772,000 in net increases in other working capital items, primarily unearnedrevenue. These increases in cash flows were partially offset by a decrease inaccounts payable of $1.4 million. These net operating cash flows were usedprimarily to reduce our term debt by $604,000, reduce borrowings on our workingcapital revolver by $688,000, and to fund capital expenditures of $490,000. Mostof our capital expenditures during the first half of the year were forupgrading our internal voice and data infrastructure and for our Oraclesoftware implementation.

 

Our business is generallynot capital intensive and most capital expenditures relate to maintaining,updating and expanding our technology infrastructure to support our employeebase. We continue to test the functionality of our new Oracle software platformby transitioning certain transaction and/or customer sets from the legacyplatforms to Oracle. When fully implemented, Oracle will support all of ouroperating and financial reporting activities, will condense three existingsoftware platforms down to one, and will provide a long-term solution that willsupport rapid expansion of our customer base and revenues.

 

Our total debt at April 30, 2006 was $5.9million, which consisted of a mortgage on our corporate headquarters buildingof $1.8 million, a term note of $0.433 million, and $3.7 million outstanding onthe working capital revolver. Payments on the mortgage note are based on a13-year amortization schedule and the note is due in full or will be refinancedby September 30,2009. The term note is secured by the generalassets of the Company. Payments on the term note are based on a three-yearamortization schedule and it is due and will be amortized in full on September30, 2006. Required principal payments on the two notes total $302,000 perquarter. The credit agreement, which encompasses both the notes discussed aboveand the line of credit, contains certain financial covenants common in such agreements.These covenants include tangible net worth requirements, limitations on theamount of funded debt to Earnings Before Interest, Taxes, Depreciation, andAmortization, limitations on capital spending, and debt service coveragerequirements. At April 30, 2006, we were in compliance with all the covenants.

 

The total amount available under the workingcapital revolver is based on the qualified balances of accounts receivable andinventories and is subject to a maximum of $7.5 million. At April 30, 2006there was $3.8 million available for future borrowings under the revolver.

 

The table below presentsour contractual obligations at April 30, 2006 as well as payment obligationsover the next five years:

 

15

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| ** **                       | ** ** | ** ** | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **Less than  1 year**           | ** ** | **2 – 3  Years** | ** ** | **4 – 5  Years** | ** ** |
| Long-term debt                   |       | $          | 2,559,693  |                                      | $          | 723,701 |   | $ | 532,728 |   | $ | 1,303,264 |   |
| Operating leases                 |       | 743,040    |       | 270,831                                   |       | 376,201 |   | 96,008 |   |
| Total                            |       | $          | 3,302,733  |                                      | $          | 994,532 |   | $ | 908,929 |   | $ | 1,399,272 |   |

 

# **Resultsof Operations**

# ** **

For the second quarter of fiscal 2006 we earnednet income of $57,000 on revenues of $14.9 million compared to net income of$165,000 on revenues of $14.2 million in the second quarter of last year. Forthe six month period ending April 30, 2006, we recorded a net loss of $84,000on revenues of $27.6 million compared to net income of $243,000 on revenues of$28.1 million for the same period last year. The narrative below providesfurther explanation of these results.

 

Systems Sales. Systems sales were $7.6 million comparedto $6.3 million in the second quarter of fiscal 2006 and 2005, respectively, a20% increase. This increase consisted of an increase in sales of systems tocommercial customers of $504,000 or 10%, and an increase in sales of systems tolodging customers of $770,000 or 53%. For the six-month period ending April 30,systems sales were $13.3 million compared to $12.6 million in the first sixmonths of fiscal 2006, respectively, a 5% increase. These increases included anincrease of $788,000 or 27% in sales of systems to lodging customers, which waspartially offset by a decrease in sales of systems to commercial customers of$165,000 or 2%. The increases in sales of systems to lodging customers infiscal 2006 to date reflects the health of the hospitality industry as mostmajor hotel chains are building new hotels and expanding or remodeling existingproperties. We expect our sales to lodging customers to return to historicallevels for the remainder of the fiscal year. The improvement in sales ofsystems to commercial customers in the second quarter reflects the improvedsales funnels and increased bookings that we began to see in the first quarter.We are cautiously optimistic that this trend will continue for the balance ofthe fiscal year.

 

Service Revenues. Service revenues consist of thefollowing:

 
| ** **                                | ** ** | **For the Three Months Ended  April 30,** | ** ** | **For the Six Months Ended  April 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                                           | ** ** | **2005**                                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| National Service  Center                  |       | $                                                                  | 5,491,000  |                                                             | $          | 5,116,000 |   | $ | 10,641,000 |   | $ | 10,387,000 |   |
| Installation  & Professional Services |       | 1,757,000                                                          |       | 2,253,000                                                        |       | 3,026,000 |   | 3,913,000 |   |
| Total  installation and service revenue   |       | $                                                                  | 7,248,000  |                                                             | $          | 7,369,000 |   | $ | 13,667,000 |   | $ | 14,300,000 |   |

 

Revenues earned by our NSC increased 7% and 2%in the three- and six-month periods ending April 30, 2006, respectively. Mostof this growth reflects results from our emphasis on selling managed services,primarily to Nortel end-user customers. This growth initiative is a keystrategy in fiscal 2006 as we reorient our revenue base toward recurringservice revenues as a greater proportion of our total revenues. During thesecond quarter, we began earning revenues from managed services sales contractswhich were secured in the fourth quarter of fiscal 2005 and first quarter ofthis year. We are continuing to commit sales resources to this effort asinvestment will allow and we expect continued growth in this segment of ourbusiness. However, because of the long sales cycles and existing contractualcommitments of potential customers with their current providers, it is notpossible to predict the timing of the expected growth.

 

Our installation and professional servicesrevenues declined 22% and 23% in the three- and six-month periods ending April30, 2006, respectively. Installation and professional services revenueshistorically trends with sales of systems. However, in the first and secondquarters of fiscal 2005 we enjoyed a boost in our installation revenues as theresult of a subcontractor arrangement with the Metropolitan Atlanta RapidTransit Authority (“MARTA”) as the end-user customer. Under this contract, weearned installation-only revenues last year by installing communicationssystems at multiple MARTA locations. There was not a similar revenue event inthe first half of fiscal 2006. Consequently, our installation revenues infiscal 2006 have resumed their historical relationship with systems sales.

 

Gross Margins. The table below presents the grossmargins earned on our primary revenue streams for:

 

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| ** **                        | ** ** | **For the Three  Months Ended  April 30,** | ** ** | **For the Six  Months Ended  April 30,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **Gross Margins**            | ** ** | **2006**                                                       | ** ** | **2005**                                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| Systems sales                     |       | 24.3                                                           | %          | 26.7                                                         | %          | 25.8 | % | 25.0 | % |
| Service revenues                  |       | 28.3                                                           | %          | 30.3                                                         | %          | 24.7 | % | 29.7 | % |
| Other revenues                    |       | 10.1                                                           | %          | 56.5                                                         | %          | 33.6 | % | 55.8 | % |
| Corporate cost  of goods sold     |       | -2.4                                                           | %          | -2.3                                                         | %          | -2.5 | % | -2.4 | % |
| Total sales and  service revenues |       | 23.7                                                           | %          | 27.4                                                         | %          | 22.9 | % | 26.3 | % |

 

The gross margins on systems sales declinedslightly in the second quarter of fiscal 2006 compared to last year, but remainslightly ahead of last year for the year-to-date period. The decline in grossmargins in the second quarter reflects the continued pressure on gross marginsas we try to increase our systems sales revenues. Year-to-date margins remainedrelatively stable because the mix of products sold earned higher than averagevendor rebates in the first quarter of this year. We expect to continue to facepressure on our systems sales gross margins and our desire to maintain thesemargins may impact our revenue volumes and may limit our ability to increaseour revenues.

 

Our gross marginsearned on Services revenues improved in the second quarter of fiscal 2006compared to the first quarter of the year. The improvements, which includedimprovements in both installation and NSC gross margins, primarily reflected increasedrevenues which absorbed the substantial investment in Nortel technicalcompetency we have made. We believe this revenue increase, particularly the NSCrevenue improvement, is sustainable. Services gross margins earned in both thesecond quarter and six-month periods ending April 30, 2006 were lower than thegross margins earned in those same periods last year primarily because of theadditional revenues earned last year during these periods from the MARTAcontract which is discussed under Services revenues above.

 

A final component to our gross margins is themargins earned on other revenues and our corporate cost of goods sold. Aportion of our other revenues typically represent sales and cost of goods soldon equipment or services outside our normal provisioning processes and by theirnature vary significantly in both sales volume and gross margins earned. Anothersegment of other revenues represents the sale of Avaya maintenance contractsfor which we earn either a gross profit or commissions from Avaya. We have nocontinuing service obligation associated with these revenues and gross profits.The decline in the gross margin on other revenues primarily reflects a declinein sale of these maintenance contracts. This is an unpredictable revenue streamwhich is dependent upon expiration dates of existing contracts, installationdates of new systems, and the number of years that customers contract forservices. We expect these revenues to return to their historical levels, but noassurance can be given. Corporate cost of goods sold represents our materiallogistics and purchasing functions that support all of our revenue segments.

 

Operating Expenses. Our total operating expenses decreased$185,000 or 5% in the second quarter of fiscal 2006 compared to the second quarterof fiscal 2005 and decreased $746,000 or 11% for the first half of fiscal 2006compared to last year. These decreases reflected decreases in selling andgeneral and administrative expenses. Sales expenses declined primarily due tolower headcounts in both account executives and sales engineers compared tolast year. General and administrative expenses declined as a result of lowermarketing costs, reduced auditing and legal fees, and lower informationtechnology department spending. The year-to-date decline in operating expensesalso reflects higher vendor marketing reimbursements which are recorded ascontra expense. These reimbursements reflect the resolution of incentives thatrelated to fiscal 2005 purchases, but were not approved by the vendors untilthe first quarter. We expect vendor incentive payments to return to historicallevels for the remainder of the fiscal year. Partially offsetting thesedecreases were higher insurance costs, the addition of one executive officer,and increased property taxes on our headquarters building due to the expirationof an ad valorem tax rebate.

 

Interest Expense and Other Income. Net interest expense and other incomewas $15,000 in expense in both the second quarters of fiscal 2006 and 2005. Forthe six months ending April 30, 2006, we recorded net interest and otherexpense of $78,000 in expense compared to $97,000 in income for the year agoperiod. Other income was unusually high in the first quarter of last year dueto the collection of $87,000 for an accounts receivable that had beenpreviously written off. There was not a similar significant transaction in thecurrent quarter.

 

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Tax Provision. We recorded a combined federal and statetax benefit of 45% for the second quarter of fiscal 2006 compared to provisionof 39% for the same period last year. For the six months ending April 30, 2006,we recorded a tax benefit of 25% compared to a tax provision of 39% for thesame period a year ago. The tax benefit recorded for the year-to-date periodreflects the effective federal tax rate plus the composite state income taxrates adjusted for states that require minimum tax payments even if tax lossesare incurred.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

Market risks relating to our operations result primarily from changesin interest rates. We did not use derivative financial instruments forspeculative or trading purposes during the three months ending April 30, 2006.

 

*Interest Rate Risk*. We are subject to the risk of fluctuation in interest rates in the normal course of business due to our utilization of variable debt. Our credit facility bears interest at a floating rate at either the London Interbank Offered Rate (“LIBOR”) (5.04% at April 30, 2006) plus 1.25% to 2.75% or the bank’s prime rate (7.75% at April 30, 2006) less 0.0% to minus 1.125%. A hypothetical 1% increase in interest rates would not have a material impact on our financial position or cash flows.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

*Evaluationof Disclosure Controls and Procedures.* Based on an evaluation conducted as of April 30,2006 by our management, including our Chief Executive Officer (“CEO”) and ourChief Financial Officer (“CFO”), our CEO and CFO have concluded that ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) are effective to reasonably ensure that information required to bedisclosed in reports that we file or submit under the Exchange Act, isrecorded, processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms, and that such informationis accumulated and communicated to our management, including the CEO and CFO,as appropriate to allow timely decisions regarding required disclosure.

 

*Changesin Internal Controls.* There were no significant changes in our internal controls or in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation. There were no significant deficiencies or materialweaknesses and, therefore, there were no corrective actions taken.

 

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**PART II.  OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

We continue to monitorPhonometrics’ efforts to challenge certain awards of attorneys’ fees against it.A detailed description of the Phonometrics’ cases is contained in our AnnualReport on Form 10-K for the fiscal year ended October 31, 2005, and updated inour Form 10-Q for the quarter ended January 31, 2006.

 

**ITEM1A. RISK FACTORS**

 

The information presented below is an update tothe “Risk Factors” included in the Company’s Annual Report on Form 10-K for thefiscal year ended October 31, 2005 and should be read in conjunction therewith.Except as set forth below, the Risk Factors included in the Company’s Form 10-Kfor its 2005 fiscal year have not materially changed.

 

The gross margins earned on our Servicesrevenues have declined sharply over the past year and we may be unable torestore them to their previous levels.

 

Our margins earned on Services revenues have declinedin the first half of fiscal 2006, particularly the gross margins earned by theNSC. As discussed above under “Gross Margins” in the “Results of Operations”section, we have undertaken some actions to correct this decline, but theunderlying causes of this decline may be tied to changes in the mix of ourServices revenues, increased competition, and tougher negotiating by customers.As such, it may not be possible to restore our Services gross margins to thelevels enjoyed in previous years.

 

For our current operating model to beprofitable, our systems sales need to improve while maintaining current grossprofit margins.

 

Our operating model, specifically the salesinfrastructure and related compensation plans, require higher levels of systemssales revenues at gross margin percentages similar to those earned to date thisyear. Many of our competitors have very different operating models with lowerfixed sales costs and outsourcing models for installations of systems. As such,they are willing to sell equipment at lower gross margins. We believe that ourcompetitors have successfully captured some of our market share with a lowerprice, low service commitment strategy. There can be no assurance given that wecan maintain our focus on gross margins and also increase our systems sales inthe future.

 

If operating losses widen or continue forseveral quarters, we would likely become out of compliance with the financialcovenants in our credit facility.

 

Our credit facility contains covenants based onvarious financial ratios including a funded debt to EBIDA ratio and a debtservice coverage ratio. If operating results should continue at levelsexperienced in the first half of fiscal 2006 or if they should widensignificantly, we might become out of compliance with these covenants and be intechnical default of the credit agreement. While we would not expect our bankto immediately terminate the credit facility and demand payment of alloutstanding debt, they would have the right to do so. Alternatively, the bankmight take other actions that would restrict our access to borrowings to fundour business. Such actions could severely restrict our ability to purchaseequipment and services from vendors and could materially and negatively impactour results of operations and financial condition.

 

We are subject toa variety of other general risks and uncertainties inherent in doing business. 

 

In addition to thespecific factors discussed above, we are subject to certain risks that areinherent in doing business, such as general industry and market conditions andgrowth rates, general economic and political conditions, costs of obtaininginsurance, unexpected death or changes in key employees, changes in employmentlaws and regulations, changes in tax laws and regulations, and other eventsthat can impact revenues and the cost of doing business.

 

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**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIESAND USE OF PROCEEDS.**

 

None.

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES.**

 

None.

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.**

 

On April 4, 2006, at ourAnnual Meeting of Shareholders, the following incumbent directors werere-elected to the Board of Directors, and the votes cast for each nominee wereas follows:

 
| **Nominee**             | ** ** | **For**   | ** ** | **Withhold** | ** ** |
|-------------------------|------------|-----------|------------|--------------|------------|
|                    |       |      |       |         |       |
| Ron B. Barber           |       | 8,544,921 |       | 721,999      |       |
| Donald T. Duke          |       | 8,737,173 |       | 529,747      |       |
| Robert D.  Hisrich      |       | 8,430,617 |       | 836,303      |       |
| Jack R. Ingram          |       | 8,607,581 |       | 659,339      |       |
| Ronald L.  Siegenthaler |       | 8,622,417 |       | 644,503      |       |

 

The shareholders also voted at theAnnual Meeting to ratify the selection of Tullius Taylor Sartain & SartainLLP as our independent auditors, with votes cast as follows:

 
| **For**   | ** ** | **Against** | ** ** | **Withhold** | ** ** |
|-----------|------------|-------------|------------|--------------|------------|
|      |       |        |       |         |       |
| 8,926,714 |       | 50,301      |       | 289,905      |       |

 

**ITEM 5. OTHER INFORMATION.**

 

On May 24, 2006 the AuditCommittee of the Board of Directors retained Ron Barber to serve as an advisorto the Audit Committee for a fee of $15,000. Mr. Barber, a director of theCompany, is not a member of the Audit Committee.

 

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**ITEM6.   EXHIBITS.**

 

Exhibits(filed herewith):

 
| ** ** | **SEC Exhibit No.** | ** ** | **Description**                                                                                                                                                          |
|------------|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                |       |                                                                                                                                                                     |
|       | 31.1                |       | Rule  13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                                                       |
|       |                |       |                                                                                                                                                                     |
|       | 31.2                |       | Rule  13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                                                       |
|       |                |       |                                                                                                                                                                     |
|       | 32.1                |       | Certification  of Chief Executive Officer Pursuant to Title 18, United States Code, Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|       |                |       |                                                                                                                                                                     |
|       | 32.2                |       | Certification  of Chief Financial Officer Pursuant to Title 18, United States Code, Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                | XETA Technologies, Inc. |
|---------------------|-------------------------|
|                | (Registrant)            |
|                |                    |
|                |                    |
| Dated: May 26, 2006 | By:                     | /s/ Jack R. Ingram |   |
|                |                    | Jack R. Ingram |
|                |                    | Chief Executive Officer |
|                |                    |   |
| Dated: May 26, 2006 | By:                     | /s/ Robert B. Wagner |   |
|                |                    | Robert B. Wagner |
|                |                    | Chief Financial Officer |

 

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EXHIBITINDEX

 
| **SEC Exhibit No.** | ** ** | **Description**                                                                                                                                                          |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                     |
| 31.1                |       | Rule  13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                                                       |
|                |       |                                                                                                                                                                     |
| 31.2                |       | Rule  13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                                                       |
|                |       |                                                                                                                                                                     |
| 32.1                |       | Certification  of Chief Executive Officer Pursuant to Title 18, United States Code, Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                                     |
| 32.2                |       | Certification  of Chief Financial Officer Pursuant to Title 18, United States Code, Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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