**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**
| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|------------|-----------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                    |
| ** ** | ** ** | **For the quarterly period ended July 31, 2006**                                              |
| ** ** | ** ** | ** **                                                                                    |
| **OR**     |
| ** ** | ** ** | ** **                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number 0-16231**

**XETA Technologies, Inc.**

(Exact name of registrantas 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  x      No  o

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

Largeaccelerated filer  o     Acceleratedfiler  o     Non-acceleratedfiler   x

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  Yes  o     No  x

Indicatethe number of shares outstanding of each of the registrant’s classes of commonstock, as of the latest practicable date.

| **Class**                      | ** ** | **Outstanding  at August 30, 2006** |
|--------------------------------|------------|-------------------------------------|
| Common Stock,  $.001 par value |       | 10,214,741                          |

 

 

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INDEX
| PART I. FINANCIAL INFORMATION |                                                                                               |                                                                                                 |
|-------------------------------|----------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------|
|                          |                                                                                               |                                                                                                 |
|                          | ITEM 1.                                                                                            | FINANCIAL STATEMENTS (Unaudited)                                                                     |   |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          |                                                                                               | Consolidated Balance  Sheets - July 31, 2006 and October 31, 2005                                    |   |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          |                                                                                               | Consolidated  Statements of Operations - For the Three and Nine Months Ended July 31, 2006  and 2005 |   |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          |                                                                                               | Consolidated Statement  of Shareholders’ Equity - For the Nine Months Ended July 31, 2006       |   |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          |                                                                                               | Consolidated  Statements of Cash Flows - For the Nine Months Ended July 31, 2006 and 2005            |   |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          |                                                                                               | Notes to  Consolidated Financial Statements                                                          |   |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          | ITEM 2.MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |                                                                                                 |   |
|                          |                                                                                               |                                                                                                 |   |   |
|                          | ITEM 3.                                                                                            | QUANTITATIVE  AND QUALITATIVE 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

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XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS
| ** **                                                                                                                                          | ** ** | **(Unaudited)  July 31, 2006** | ** ** | **(Audited)  October 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|-------------------------------------------|------------|
|                                                                                                                                                |       |                                     |       |                                      |       |
| ASSETS                                                                                                                                              |       |                                     |       |                                      |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| Current assets:                                                                                                                                     |       |                                     |       |                                      |       |
| Cash and cash  equivalents                                                                                                                          |       | $                                        | 43,872     |                                      | $          | 176,688 |   |
| Current portion  of net investment in sales-type leases and other receivables                                                                       |       | 361,056                                  |       | 533,114                                   |       |
| Trade accounts  receivable, net                                                                                                                     |       | 12,536,702                               |       | 11,634,030                                |       |
| Inventories, net                                                                                                                                    |       | 4,985,822                                |       | 5,650,027                                 |       |
| Deferred tax  asset, net                                                                                                                            |       | 621,540                                  |       | 727,222                                   |       |
| Prepaid taxes                                                                                                                                       |       | 19,222                                   |       | 888,842                                   |       |
| Prepaid expenses  and other assets                                                                                                                  |       | 384,096                                  |       | 139,525                                   |       |
| Total current  assets                                                                                                                               |       | 18,952,310                               |       | 19,749,448                                |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| Noncurrent assets:                                                                                                                                  |       |                                     |       |                                      |       |
| Goodwill                                                                                                                                            |       | 26,434,563                               |       | 26,476,245                                |       |
| Intangible  assets, net                                                                                                                             |       | 151,334                                  |       | 179,709                                   |       |
| Net investment  in sales-type leases, less current portion above                                                                                    |       | 115,429                                  |       | 167,399                                   |       |
| Property, plant  & equipment, net                                                                                                               |       | 10,439,074                               |       | 10,411,329                                |       |
| Other assets                                                                                                                                        |       | 5,437                                    |       | 34,411                                    |       |
| Total noncurrent  assets                                                                                                                            |       | 37,145,837                               |       | 37,269,093                                |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| Total assets                                                                                                                                        |       | $                                        | 56,098,147 |                                      | $          | 57,018,541 |   |
|                                                                                                                                                |       |                                     |       |                                      |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                          |       |                                     |       |                                      |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| Current liabilities:                                                                                                                                |       |                                     |       |                                      |       |
| Current portion  of long-term debt                                                                                                                  |       | $                                        | 344,864    |                                      | $          | 1,123,582 |   |
| Revolving line  of credit                                                                                                                           |       | 4,722,320                                |       | 4,394,727                                 |       |
| Lease payable                                                                                                                                       |       | 1,991                                    |       | 5,303                                     |       |
| Accounts payable                                                                                                                                    |       | 3,769,735                                |       | 4,847,799                                 |       |
| Current unearned  revenue                                                                                                                           |       | 1,977,564                                |       | 1,505,609                                 |       |
| Accrued  liabilities                                                                                                                                |       | 2,433,809                                |       | 2,392,846                                 |       |
| Total current  liabilities                                                                                                                          |       | 13,250,283                               |       | 14,269,866                                |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| Noncurrent liabilities:                                                                                                                             |       |                                     |       |                                      |       |
| Long-term debt,  less current portion above                                                                                                         |       | 1,568,722                                |       | 1,697,039                                 |       |
| Accrued  long-term liability                                                                                                                        |       | 688,791                                  |       | 144,100                                   |       |
| Noncurrent  unearned service revenue                                                                                                                |       | 57,408                                   |       | 64,895                                    |       |
| Noncurrent  deferred tax liability, net                                                                                                             |       | 3,164,180                                |       | 3,744,704                                 |       |
| Total noncurrent  liabilities                                                                                                                       |       | 5,479,101                                |       | 5,650,738                                 |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| Contingencies                                                                                                                                       |       |                                     |       |                                      |       |
|                                                                                                                                                |       |                                     |       |                                      |       |
| 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 July 31, 2006 and October 31, 2005, respectively |       | 11,233                                   |       | 11,197                                    |       |
| Paid-in capital                                                                                                                                     |       | 13,067,676                               |       | 12,999,074                                |       |
| Retained  earnings                                                                                                                                  |       | 26,534,513                               |       | 26,332,325                                |       |
| Less treasury  stock, at cost (1,018,788 shares at July 31, 2006 and October 31, 2005)                                                              |       | (2,244,659                               | )          | (2,244,659                                | )          |
| Total  shareholders’ equity                                                                                                                    |       | 37,368,763                               |       | 37,097,937                                |       |
| Total liabilities and  shareholders’ equity                                                                                                    |       | $                                        | 56,098,147 |                                      | $          | 57,018,541 |   |

 

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

3

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XETA TECHNOLOGIES,INC. AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF OPERATIONS

(UNAUDITED)
| ** **                                   | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **Ended July 31,**            | ** ** | **Ended July 31,**           | ** ** |
| ** **                                   | ** ** | **2006**                                | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Systems sales                                |       | $                                       | 7,791,020  |                                   | $          | 6,645,819 |   | $ | 21,048,745 |   | $ | 19,280,129 |   |
| Services                                     |       | 7,778,472                               |       | 6,631,799                              |       | 21,445,590 |   | 20,931,843 |   |
| Other revenues                               |       | 91,003                                  |       | 244,346                                |       | 742,762 |   | 1,428,974 |   |
| Net sales and service revenues               |       | 15,660,495                              |       | 13,521,964                             |       | 43,237,097 |   | 41,640,946 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Cost of systems  sales                       |       | 6,155,423                               |       | 4,848,945                              |       | 15,996,821 |   | 14,321,043 |   |
| Services costs                               |       | 5,120,431                               |       | 4,730,050                              |       | 15,414,295 |   | 14,786,297 |   |
| Cost of other  revenues & corporate COGS |       | 224,989                                 |       | 326,980                                |       | 1,354,232 |   | 1,522,216 |   |
| Total cost of sales and service              |       | 11,500,843                              |       | 9,905,975                              |       | 32,765,348 |   | 30,629,556 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Gross profit                                 |       | 4,159,652                               |       | 3,615,989                              |       | 10,471,749 |   | 11,011,390 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Operating  expenses                          |       |                                    |       |                                   |       |   |   |   |   |
| Selling, general and administrative          |       | 3,574,585                               |       | 3,394,743                              |       | 9,716,843 |   | 10,301,019 |   |
| Amortization                                 |       | 103,356                                 |       | 99,450                                 |       | 307,085 |   | 285,326 |   |
| Total operating expenses                     |       | 3,677,941                               |       | 3,494,193                              |       | 10,023,928 |   | 10,586,345 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Income from  operations                      |       | 481,711                                 |       | 121,796                                |       | 447,821 |   | 425,045 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Interest expense                             |       | (25,096                                 | )          | (23,173                                | )          | (122,895 | ) | (77,955 | ) |
| Interest and other income                    |       | 13,671                                  |       | 4,917                                  |       | 33,262 |   | 157,127 |   |
| Total interest and other income (expense)    |       | (11,425                                 | )          | (18,256                                | )          | (89,633 | ) | 79,172 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Income before provision  for income taxes    |       | 470,286                                 |       | 103,540                                |       | 358,188 |   | 504,217 |   |
| Provision for  income taxes                  |       | 184,000                                 |       | 40,000                                 |       | 156,000 |   | 198,000 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Net income                                   |       | $                                       | 286,286    |                                   | $          | 63,540 |   | $ | 202,188 |   | $ | 306,217 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Earnings per  share                          |       |                                    |       |                                   |       |   |   |   |   |
| Basic                                        |       | $                                       | 0.03       |                                   | $          | 0.01 |   | $ | 0.02 |   | $ | 0.03 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Diluted                                      |       | $                                       | 0.03       |                                   | $          | 0.01 |   | $ | 0.02 |   | $ | 0.03 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Weighted average  shares outstanding         |       | 10,214,741                              |       | 10,093,628                             |       | 10,180,728 |   | 10,056,643 |   |
|                                         |       |                                    |       |                                   |       |   |   |   |   |
| Weighted average  equivalent shares          |       | 10,214,741                              |       | 10,116,712                             |       | 10,208,553 |   | 10,091,734 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

4

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XETA TECHNOLOGIES,INC. AND SUBSIDIARY

CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ 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                      |       | —     |       | —       |       | 52,548                   |       | — |   | 52,584 |   |
| Tax benefit of  stock options            |       | —                 |       | —                  |       | —     |       | —       |       | 16,054                   |       | — |   | 16,054 |   |
|                                     |       |                   |       |                    |       |       |       |         |       |                     |       |   |   |   |   |
| Net Income                               |       | —                 |       | —                  |       | —     |       | —       |       | —                   |       | 202,188 |   | 202,188 |   |
|                                     |       |                   |       |                    |       |       |       |         |       |                     |       |   |   |   |   |
| Balance- July 31, 2006                   |       | 11,233,529             |       | $                       | 11,233     |       | 1,018,788  |         | $          | (2,244,659               | )          | $ | 13,067,676 |   | $ | 26,534,513 |   | 37,368,763 |   |

 

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

5

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XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(UNAUDITED)
| ** **                                                                                                    | ** ** | **For the Nine Months** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                    | ** ** | **Ended July 31,**           | ** ** |
| ** **                                                                                                    | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                                        |       |                                   |       |   |   |
| Net income                                                                                                    |       | $                                      | 202,188    |   | $ | 306,217 |   |
|                                                                                                          |       |                                   |       |   |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                            |       |                                   |       |   |   |
| Depreciation                                                                                                  |       | 380,300                                |       | 539,531 |   |
| Amortization                                                                                                  |       | 307,084                                |       | 285,326 |   |
| Loss (gain) on sale of assets                                                                                 |       | 4,466                                  |       | (4,031 | ) |
| Ineffectiveness of cash flow hedge                                                                            |       |                                   |       | (12,476 | ) |
| Provision for returns & doubtful accounts  receivable                                                     |       |                                   |       | 15,263 |   |
| Provision for excess and obsolete inventory                                                                   |       | 76,500                                 |       | 36,611 |   |
| Change in assets and liabilities, net of  acquisitions:                                                       |       |                                   |       |   |   |
| Decreae in net investment in sales-type leases &  other receivables                                       |       | 224,028                                |       | 128,494 |   |
| (Increase) decrease in trade account receivables                                                              |       | (902,672                               | )          | 808,763 |   |
| Decrease (increase) in inventories                                                                            |       | 587,705                                |       | (760,648 | ) |
| Decrease in deferred tax asset                                                                                |       | 105,682                                |       | 195,833 |   |
| (Increase) in prepaid expenses and other assets                                                               |       | (215,597                               | )          | (70,470 | ) |
| Decrease (increase) in prepaid taxes                                                                          |       | 869,620                                |       | (677,441 | ) |
| (Decrease) increase in accounts payable                                                                       |       | (1,078,064                             | )          | 1,611,691 |   |
| Increase (decrease) in unearned revenue                                                                       |       | 464,468                                |       | (21,346 | ) |
| Increase in accrued taxes                                                                                     |       | 28,662                                 |       | 28,662 |   |
| Increase (decrease) in accrued liabilities and lease  payable                                                 |       | 582,342                                |       | (565,503 | ) |
| (Decrease) increase in deferred tax liability                                                                 |       | (551,450                               | )          | 865,512 |   |
| Total adjustments                                                                                             |       | 883,074                                |       | 2,403,771 |   |
|                                                                                                          |       |                                   |       |   |   |
| Net cash provided by operating activities                                                                     |       | 1,085,262                              |       | 2,709,988 |   |
|                                                                                                          |       |                                   |       |   |   |
| Cash flows from  investing activities:                                                                        |       |                                   |       |   |   |
| Acquisitions, net of cash acquired                                                                            |       | —                                 |       | (56,015 | ) |
| Additions to property, plant & equipment                                                                  |       | (708,852                               | )          | (560,524 | ) |
| Proceeds from sale of assets                                                                                  |       | 17,632                                 |       | 200 |   |
| Net cash used in investing activities                                                                         |       | (691,220                               | )          | (616,339 | ) |
|                                                                                                          |       |                                   |       |   |   |
| Cash flows from  financing activities:                                                                        |       |                                   |       |   |   |
| Proceeds from draws on revolving line of credit                                                               |       | 18,048,711                             |       | 16,143,574 |   |
| Principal payments on debt                                                                                    |       | (907,035                               | )          | (907,035 | ) |
| Payments on revolving line of credit                                                                          |       | (17,721,118                            | )          | (17,438,476 | ) |
| Exercise of stock options                                                                                     |       | 52,584                                 |       | 25,016 |   |
| Net cash (used in) financing activities                                                                       |       | (526,858                               | )          | (2,176,921 | ) |
|                                                                                                          |       |                                   |       |   |   |
| Net (decrease) in cash and cash equivalents                                                                   |       | (132,816                               | )          | (83,272 | ) |
|                                                                                                          |       |                                   |       |   |   |
| Cash and cash  equivalents, beginning of period                                                               |       | 176,688                                |       | 141,054 |   |
| Cash and cash  equivalents, end of period                                                                     |       | $                                      | 43,872     |   | $ | 57,782 |   |
|                                                                                                          |       |                                   |       |   |   |
| Supplemental  disclosure of cash flow information:                                                            |       |                                   |       |   |   |
| Cash paid during the period for interest, net of  amount capitalized of $227,934 in 2006 and $143,125 in 2005 |       | $                                      | 119,823    |   | $ | 82,295 |   |
| Cash paid during  the period for income taxes                                                                 |       | $                                      | 30,904     |   | $ | 40,011 |   |

 

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

6

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**XETATECHNOLOGIES, INC. AND SUBSIDIARY**

**Notes toConsolidated Financial Statements**

**July 31,2006**

(Unaudited except where noted)

1.  BASIS OF PRESENTATION:

XETATechnologies, Inc. (“XETA” or the “Company”) is a leading provider ofcommunications solutions with sales and service locations nationwide, servingbusiness clients in sales, engineering, project management, installation, andservice support.  The Company sellsproducts which are manufactured by a variety of manufacturers including Avaya,Inc. (“Avaya”), Nortel Networks Corporation (“Nortel”), IgeaCare Systems, Inc.,and Spectralink Corporation.  Inaddition, the Company manufactures and markets a line of proprietary callaccounting systems to the hospitality industry. XETA is an Oklahoma corporation.

Theaccompanying unaudited consolidated financial statements have been prepared bythe Company pursuant to the rules and regulations of the Securities andExchange Commission (the “Commission”). Certain information and footnote disclosures normally included in annualfinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted pursuant to those rules and regulations, although the Company believesthat the disclosures made are adequate to make the information presented notmisleading.  It is suggested that thesecondensed financial statements be read in conjunction with the consolidatedfinancial statements and the notes thereto made a part of the Company’s AnnualReport on Form 10-K, Commission File No. 0-16231, which was filed with theCommission on January 9, 2006. Management believes that the financial statements contain alladjustments necessary for a fair statement of the results for the interimperiods presented.  All adjustments madewere of a normal recurring nature.  Theresults of operations for the interim period are not necessarily indicative ofthe results for the entire fiscal year. Certain reclassifications of prior year amounts have been made to conformto current year presentations.  Thesereclassifications had no impact on net income.

Segment Information

TheCompany has three reportable segments: commercial system sales, lodging system sales, and installation andservice.  The Company defines commercialsystem sales as sales to the non-lodging industry.  Installation and service revenues representrevenues earned from installing and maintaining systems for customers in boththe commercial and lodging segments.

Thereporting segments follow the same accounting policies used for the Company’sconsolidated financial statements and described in the Summary of SignificantAccounting Policies in the Company’s Form 10-K described above.  Company management evaluates a segment’sperformance based upon gross margins. Assets are not allocated to the segments.  Sales to customers located outside of theU.S. are immaterial.

7

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The following is atabulation of business segment information for the three months ended July 31,2006 and 2005.
| ** **    | ** ** | **Commercial  System  Sales** | ** ** | **Lodging  System  Sales** | ** ** | **Installation  and Service  Revenues** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|---------------|------------|-------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|--------------------|------------|-------------|------------|
| **2006**      | ** ** | ** **                    | ** ** | ** **                 | ** ** | ** **                                   | ** ** | ** **         | ** ** | ** **  | ** ** |
| Sales         |       | $                             | 6,280,894  |                       | $          | 1,510,126                                    |       | $                  | 7,778,472  |        | $          | 91,003 |   | $ | 15,660,495 |   |
| Cost of sales |       | (4,987,908                    | )          | (1,167,515                 | )          | (5,120,431                                   | )          | (224,989           | )          | (11,500,843 | )          |
| Gross profit  |       | $                             | 1,292,986  |                       | $          | 342,611                                      |       | $                  | 2,658,041  |        | $          | (133,986 | ) | $ | 4,159,652 |   |
|          |       |                          |       |                       |       |                                         |       |               |       |        |       |
| **2005**      | ** ** | ** **                    | ** ** | ** **                 | ** ** | ** **                                   | ** ** | ** **         | ** ** | ** **  | ** ** |
| Sales         |       | $                             | 5,278,945  |                       | $          | 1,366,874                                    |       | $                  | 6,631,799  |        | $          | 244,346 |   | $ | 13,521,964 |   |
| Cost of sales |       | (3,877,831                    | )          | (971,114                   | )          | (4,730,050                                   | )          | (326,980           | )          | (9,905,975  | )          |
| Gross profit  |       | $                             | 1,401,114  |                       | $          | 395,760                                      |       | $                  | 1,901,749  |        | $          | (82,634 | ) | $ | 3,615,989 |   |

 

The following istabulation of business segment information for the nine months ended July 31,2006 and 2005.
| ** **    | ** ** | **Commercial  System  Sales** | ** ** | **Lodging  System  Sales** | ** ** | **Installation  and Service  Revenues** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|---------------|------------|-------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|--------------------|------------|-------------|------------|
| **2006**      | ** ** | ** **                    | ** ** | ** **                 | ** ** | ** **                                   | ** ** | ** **         | ** ** | ** **  | ** ** |
| Sales         |       | $                             | 15,793,785 |                       | $          | 5,254,960                                    |       | $                  | 21,445,590 |        | $          | 742,762 |   | $ | 43,237,097 |   |
| Cost of sales |       | (12,046,562                   | )          | (3,950,259                 | )          | (15,414,295                                  | )          | (1,354,232         | )          | (32,765,348 | )          |
| Gross profit  |       | $                             | 3,747,223  |                       | $          | 1,304,701                                    |       | $                  | 6,031,295  |        | $          | (611,470 | ) | $ | 10,471,749 |   |
|          |       |                          |       |                       |       |                                         |       |               |       |        |       |
| **2005**      | ** ** | ** **                    | ** ** | ** **                 | ** ** | ** **                                   | ** ** | ** **         | ** ** | ** **  | ** ** |
| Sales         |       | $                             | 14,956,876 |                       | $          | 4,323,253                                    |       | $                  | 20,931,843 |        | $          | 1,428,974 |   | $ | 41,640,946 |   |
| Cost of sales |       | (11,303,259                   | )          | (3,017,784                 | )          | (14,786,297                                  | )          | (1,522,216         | )          | (30,629,556 | )          |
| Gross profit  |       | $                             | 3,653,617  |                       | $          | 1,305,469                                    |       | $                  | 6,145,546  |        | $          | (93,242 | ) | $ | 11,011,390 |   |

 

Stock-BasedCompensation Plans

InDecember 2004 the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards No. 123 (revised 2004), Share-BasedPayment (“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-basedawards or to awards modified after the date of adoption.  Additionally, compensation cost is to berecognized for previously issued, but unvested awards.  Such cost is to be recognized over the remaininglength of service required under the award and in an amount based on the samevalue that was previously used for disclosure under SFAS 123.  Because option holders were fully vested inall outstanding options at the time of adoption of SFAS 123R, the Company didnot record any compensation expense in association with outstandingequity-based awards in the current period. The table below presents the impact of issued stock options on the prioryear’s reporting period as if the expense had been recorded in the consolidatedfinancial statements based on the fair value method.
|                                                                                                                                                               | ** ** | **For the Three  Months Ended  July 31, 2005** | ** ** | **For the Nine  Months Ended  July 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Net income as  reported                                                                                                                                       |       | $                                                                       | 63,540     |                                                                   | $          | 306,217 |   |
| 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                                                                    | )          | 1,309                                                                  |       |
| Pro forma net  income                                                                                                                                         |       | $                                                                       | 63,434     |                                                                   | $          | 307,526 |   |
|                                                                                                                                                          |       |                                                                    |       |                                                                   |       |
| EARNINGS PER  SHARE:                                                                                                                                          |       |                                                                    |       |                                                                   |       |
| As reported –  Basic                                                                                                                                     |       | $                                                                       | 0.01       |                                                                   | $          | 0.03 |   |
| As reported –  Diluted                                                                                                                                   |       | $                                                                       | 0.01       |                                                                   | $          | 0.03 |   |
|                                                                                                                                                          |       |                                                                    |       |                                                                   |       |
| Pro forma –  Basic                                                                                                                                       |       | $                                                                       | 0.01       |                                                                   | $          | 0.03 |   |
| Pro forma – Diluted                                                                                                                                      |       | $                                                                       | 0.01       |                                                                   | $          | 0.03 |   |

 

8

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Use of Estimates

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Actualresults could differ from those estimates.

2.  ACCOUNTS RECEIVABLE:

Trade accountsreceivable consists of the following:
|                                      | ** ** | **July 31,  2006** | ** ** | **(Audited)  October 31,  2005** | ** ** |
|--------------------------------------|------------|-------------------------|------------|---------------------------------------|------------|
|                                 |       |                    |       |                                  |       |
| Trade  receivables                   |       | $                       | 12,796,258 |                                  | $          | 11,932,173 |   |
| Less- reserve  for doubtful accounts |       | (259,556                | )          | (298,143                              | )          |
| Net trade receivables                |       | $                       | 12,536,702 |                                  | $          | 11,634,030 |   |

 

3.  INVENTORIES:

Inventoriesare stated at the lower of cost (first-in, first-out or average) or market andconsist of the following:
|                                                   | ** ** | **July 31,  2006** | ** ** | **(Audited)  October 31,  2005** | ** ** |
|---------------------------------------------------|------------|--------------------|------------|----------------------------------|------------|
|                                              |       |               |       |                             |       |
| Finished goods and spare parts                    |       | $                  | 5,580,677  |                             | $          | 6,190,206 |   |
| Less- reserve for excess and obsolete inventories |       | (594,855           | )          | (540,179                         | )          |
| Total inventories, net                            |       | $                  | 4,985,822  |                             | $          | 5,650,027 |   |

 

9

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4.  PROPERTY, PLANT AND EQUIPMENT:

Property,plant and equipment consists of the following:
|                                                               | ** ** | **Estimated  Useful  Lives** | ** ** | **July 31,  2006** | ** ** | **(Audited)  October 31,  2005** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|---------------------------------------|------------|
|                                                          |       |                         |       |                    |       |                                  |       |
| Building                                                      |       | 20                           |       | $                       | 2,397,954  |                                  | $          | 2,397,954 |   |
| Data processing  and computer field equipment                 |       | 3-10                         |       | 2,695,995               |       | 4,720,698                             |       |
| Software  development costs, work-in-process                  |       | N/A                          |       | 5,704,957               |       | 5,410,558                             |       |
| Software  development costs of components placed into service |       | 3-10                         |       | 1,783,307               |       | 1,695,370                             |       |
| Hardware                                                      |       | 3-5                          |       | 599,751                 |       | 589,905                               |       |
| Land                                                          |       | —                       |       | 611,582                 |       | 611,582                               |       |
| Office furniture                                              |       | 5                            |       | 1,065,413               |       | 1,114,073                             |       |
| Auto                                                          |       | 5                            |       | 405,684                 |       | 384,278                               |       |
| Other                                                         |       | 3-7                          |       | 267,215                 |       | 549,613                               |       |
|                                                          |       |                         |       |                    |       |                                  |       |
| Total property,  plant and equipment                          |       |                         |       | 15,531,858              |       | 17,474,031                            |       |
| Less- accumulated  depreciation                               |       |                         |       | (5,092,784              | )          | (7,062,702                            | )          |
|                                                          |       |                         |       |                    |       |                                  |       |
| Total property, plant  and equipment, net                     |       |                         |       | $                       | 10,439,074 |                                  | $          | 10,411,329 |   |

 

Interestcosts related to an investment in long-lived assets are capitalized as part ofthe cost of the asset during the period the asset is being prepared foruse.  The Company capitalized $227,934and $143,125 in interest costs in the nine months ended July 31, 2006 and 2005,respectively.

5.  INCOME TAXES:

Thetax effect of temporary differences that give rise to significant portions ofthe deferred tax assets and deferred tax liabilities are presented below:
|                                                            | ** ** | **July 31,  2006** | ** ** | **(Audited)  October 31,  2005** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|---------------------------------------|------------|
| Deferred tax  assets:                                      |       |                    |       |                                  |       |
| Net operating loss carryforward                            |       | $                       | 1,248,356  |                                  | $          | — |   |
| Currently nondeductible reserves                           |       | 222,694                 |       | 238,379                               |       |
| Accrued liabilities                                        |       | 308,526                 |       | 300,255                               |       |
| Prepaid service contracts                                  |       | 55,764                  |       | 111,771                               |       |
| Other                                                      |       | 49,866                  |       | 87,972                                |       |
| Total deferred tax asset                                   |       | 1,885,206               |       | 738,377                               |       |
|                                                       |       |                    |       |                                  |       |
| Deferred tax  liabilities:                                 |       |                    |       |                                  |       |
| Intangible assets                                          |       | 3,513,707               |       | 2,992,299                             |       |
| Depreciation                                               |       | 885,788                 |       | 734,394                               |       |
| Tax income to be recognized on sales-type lease  contracts |       | 28,351                  |       | 29,166                                |       |
| Total deferred tax liability                               |       | 4,427,846               |       | 3,755,859                             |       |
| Net deferred tax  liability                                |       | $                       | (2,542,640 | )                                     | $          | (3,017,482 | ) |

 
|                                                           | ** ** | **July 31,  2006** | ** ** | **(Audited)  October 31,  2005** | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|---------------------------------------|------------|
|                                                      |       |                    |       |                                  |       |
| Net deferred liability as presented on the balance sheet: |       |                    |       |                                  |       |
| Current deferred tax asset                                |       | $                       | 621,540    |                                  | $          | 727,222 |   |
| Noncurrent deferred tax liability                         |       | (3,164,180              | )          | (3,744,704                            | )          |
| Net deferred tax liability                                |       | $                       | (2,542,640 | )                                     | $          | (3,017,482 | ) |

 

10

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TheCompany has recorded a tax provision of $156,000 or 44% and $198,000 or 39% forthe nine months ended July 31, 2006 and 2005, respectively, reflecting thestatutory federal tax rate of 34% plus a blended state income tax rate ofapproximately 5% and plus the impact of minimum income tax payments in certainstates.

6.  CREDIT AGREEMENTS:

TheCompany has a revolving credit and term loan agreement with a bank containingthree separate notes:  a term loanamortizing over 36 months, a mortgage agreement amortizing over 13 years, and a$7.5 million revolving credit agreement to finance growth in workingcapital.  The revolving line of credit iscollateralized by trade accounts receivable and inventories.  At July 31, 2006 and October 31, 2005, theCompany had approximately $4.722 million and $4.395 million, respectively,outstanding on the revolving line of credit. The Company had approximately $2.778 million available under the revolvingline of credit at July 31, 2006.  Advancerates are defined in the agreement, but are generally at the rate of 80% onqualified trade accounts receivable and 40% of qualified inventories.  The revolving line of credit matures onSeptember 28, 2006.  Long-term debtconsists of the following:
|                                                                                                                                                                                                                  | ** ** | **July 31,  2006** | ** ** | **(Audited)  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                                                                       |       | $                       | 173,741    |                                  | $          | 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 |       | 1,739,845               |       | 1,868,162                             |       |
|                                                                                                                                                                                                             |       |                    |       |                                  |       |
|                                                                                                                                                                                                             |       | 1,913,586               |       | 2,820,621                             |       |
|                                                                                                                                                                                                             |       |                    |       |                                  |       |
| Less-current  maturities                                                                                                                                                                                         |       | 344,864                 |       | 1,123,582                             |       |
|                                                                                                                                                                                                             |       |                    |       |                                  |       |
| Total long-term debt,  less current maturities                                                                                                                                                                   |       | $                       | 1,568,722  |                                  | $          | 1,697,039 |   |

 

Intereston all outstanding debt under the credit facility accrues at either a) theLondon Interbank Offered Rate (which was 5.39% at July 31, 2006) plus 1.25% to2.75% depending on the Company’s funded debt to cash flow ratio, or b) the bank’sprime rate (which was 8.25% at July 31, 2006) minus 0% to minus 1.125% alsodepending on the Company’s funded debt to cash flow ratio.  At July 31, 2006, the Company was paying7.875% on the revolving line of credit borrowings, 7.084% on the term loan and7.334% on the mortgage note.  The creditfacility contains several financial covenants common in such agreements,including tangible net worth requirements, limitations on the amount of fundeddebt to earnings before interest, taxes, depreciation and amortization,limitations on capital spending, and debt service coverage requirements.  The Company was in compliance with thesecovenants at July 31, 2006.

7.  EARNINGS PER SHARE:

Basicearnings per common share were computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the reportingperiods.  Diluted earnings per commonshare were computed by dividing net income by the weighted average number ofshares of common stock and dilutive potential common stock outstanding duringthe reporting periods.  A reconciliationof net income and weighted average shares used in computing basic and dilutedearnings per share is as follows:

11

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| ** **                        | ** ** | **For the Three Months Ended July 31, 2006** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income**                                                                      | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
| ** **                        | ** ** | **(Numerator)**                                                                 | ** ** | **(Denominator)** | ** ** | ** ** | ** ** |
| Basic EPS                         |       |                                                                            |       |   |   |   |   |
| Net income                        |       | $                                                                               | 286,286    |   | 10,214,741 |   | $ | 0.03 |   |
| Dilutive effect of  stock options |       |                                                                            |       | — |   |   |   |
|                              |       |                                                                            |       |   |   |   |   |
| Diluted EPS                       |       |                                                                            |       |   |   |   |   |
| Net income                        |       | $                                                                               | 286,286    |   | 10,214,741 |   | $ | 0.03 |   |

 
| ** **                        | ** ** | **For the Three Months Ended July 31, 2005** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income**                                                                      | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
| ** **                        | ** ** | **(Numerator)**                                                                 | ** ** | **(Denominator)** | ** ** | ** ** | ** ** |
| Basic EPS                         |       |                                                                            |       |   |   |   |   |
| Net income                        |       | $                                                                               | 63,540     |   | 10,093,628 |   | $ | 0.01 |   |
| Dilutive effect of  stock options |       |                                                                            |       | 23,084 |   |   |   |
|                              |       |                                                                            |       |   |   |   |   |
| Diluted EPS                       |       |                                                                            |       |   |   |   |   |
| Net income                        |       | $                                                                               | 63,540     |   | 10,116,712 |   | $ | 0.01 |   |

 
| ** **                        | ** ** | **For the Nine Months Ended July 31, 2006** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **Income**                                  | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
| ** **                        | ** ** | **(Numerator)**                             | ** ** | **(Denominator)** | ** ** | ** ** | ** ** |
| Basic EPS                         |       |                                        |       |   |   |   |   |
| Net income                        |       | $                                           | 202,188    |   | 10,180,728 |   | $ | 0.02 |   |
| Dilutive effect of  stock options |       |                                        |       | 27,825 |   |   |   |
|                              |       |                                        |       |   |   |   |   |
| Diluted EPS                       |       |                                        |       |   |   |   |   |
| Net income                        |       | $                                           | 202,188    |   | 10,208,553 |   | $ | 0.02 |   |

 
| ** **                        | ** ** | **For the Nine Months Ended July 31, 2005** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Income**                                                                     | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
| ** **                        | ** ** | **(Numerator)**                                                                | ** ** | **(Denominator)** | ** ** | ** ** | ** ** |
| Basic EPS                         |       |                                                                           |       |   |   |   |   |
| Net income                        |       | $                                                                              | 306,217    |   | 10,056,643 |   | $ | 0.03 |   |
| Dilutive effect of  stock options |       |                                                                           |       | 35,091 |   |   |   |
|                              |       |                                                                           |       |   |   |   |   |
| Diluted EPS                       |       |                                                                           |       |   |   |   |   |
| Net income                        |       | $                                                                              | 306,217    |   | 10,091,734 |   | $ | 0.03 |   |

 

Options topurchase 1,119,768 shares of common stock at an average exercise price of $7.17and 1,122,468  shares of common stock atan average exercise price of $7.17 were not included in the computation ofdiluted earnings per share for the three months ended July 31, 2006 and 2005,respectively, because inclusion of these options would be antidilutive.  Options to purchase 1,105,668 shares ofcommon stock at an average exercise price of $7.17 and 1,122,468 shares ofcommon stock at an average exercise price of $7.17 were not included in thecomputation of diluted earnings per share for the nine months ended July 31,2006 and 2005, respectively, because inclusion of these options would beantidilutive.

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Thefollowing discussion contains various “forward-looking statements.”  All statements, other than statements ofhistorical fact, which address activities, events or developments that theCompany expects or anticipates will or may occur in the future, areforward-looking statements.  Thesestatements include, but are not limited to, statements concerning futurerevenues, future costs, future earnings or losses, future capital expenditures,business strategy, competitive strengths, competitive weaknesses, goals, plans,references to future success or difficulties and other similarinformation.  These and otherforward-looking statements generally contain, and can be identified by wordssuch as “expect,” “intend,” “believe,” “estimate,” “plan,” “anticipate,” “forecast,”“project” and similar words or expressions, and by discussions of strategy orintentions.  Forward-looking statementsare not guarantees of performance but rather reflect our current expectations,assumptions and beliefs based upon information currently available to us.  Investors are cautioned that allforward-looking statements are subject to certain risks and uncertainties whichare difficult to predict and that could cause actual results to differmaterially from those projected.  Many ofthese risks and uncertainties are described under Item 1.A Risk Factors in theCompany’s Annual Report on Form 10-K which was filed on January 9, 2006, and inupdates to such risk factors set forth below under Item 1.A  Risk Factors under Part II of thisreport.  All forward-looking statementsshould be read in conjunction with these risk factors.**

# **Overview**

Strategy.  In the third quarter of fiscal 2006, weearned our highest level of quarterly net income in two years.  We accomplished these results by executing onour strategies of top line growth through increased sales of managed servicesand increased systems sales, and through improved services margins.  Our managed services revenues improved 11% inthe third quarter compared to last year and our systems sales improved 17% inthe third quarter compared to last year. Our gross margins earned on all services revenues in the third quarterwere 34% compared to 29% in the third quarter of last year.  Improved gross margins on managed servicesactivities led the increase in overall services margins.

Managed servicesrepresent our service relationships with systems integrators or equipmentmanufacturers 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.  Managedservices also include our service relationships directly with end-users.  Most of our current growth in this marketrelates to our Nortel product initiative. Generally, we earn recurring revenues from these customers in the formof fixed monthly maintenance contract fees and time and materials charges forservices not covered under the maintenance contract.  Securing these contracts usually requires anextended sales effort and substantial on-going dedicated service andadministrative support to meet the demands of these high profilecustomers.  We are focusing some existingsales resources as well as new sales resources on this initiative as part ofour strategy to increase our services revenues as a proportion of totalrevenues.  We believe that thisinitiative is integral to our long-term strategy to reduce our financialdependence on systems sales in favor of more predictable, recurring servicesrevenues.  The increased revenues frommanaged services contracts also helped to improve the margins earned in ourNational Service Center (“NSC”) by absorbing our substantial investment inNortel technical talent.  Since our entryinto the Nortel market, we have made substantial investments in hiring Nortelcertified technicians and in the training and certification of our existingtechnical force.  These investments weremade substantially ahead of revenues which have negatively impacted ourservices gross margins for the past two years. The increases in managed services revenues we have enjoyed over the pasttwo fiscal quarters have helped to return our services margins to theirhistorical levels.

Operating Summary.  During the third quarter of fiscal 2006, ourrevenues were $15.7 million—a 16% increase compared to the third quarter offiscal 2005—and included a 17% increase in systems sales revenues, a 17%increase in services revenues, and a 63% decrease in other revenues.  Revenues for the nine months ending July 31,2006 were $43.2 million, an increase of 4% over the same period last year.  This increase consisted of an increase insystems sales revenues of 9%, an increase in services revenues of 2%, and a 48%

13

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decrease in otherrevenues. Our operating results in the third quarter of fiscal 2006 were netincome of $286,000 compared to net income of $64,000 in the third quarter oflast year, and net income of $202,000 for the nine months ended July 31, 2006compared to net income of $306,000 last year. These items are discussed in more detail under “Results of Operations”below.

Financial PositionSummary.  Our financial condition remained strongduring the quarter.  Our term debt wasreduced by 14% during the quarter and our working capital also improved by 14%during the quarter.  Since the beginningof the year, our term debt has been reduced by 32% and our working capital hasgrown by 4%.  These items are discussedin more detail under “Financial Condition” below.

The following discussionpresents additional information regarding our financial condition and resultsof operations for the three- and nine-month periods ending July 31, 2006 andshould be read in conjunction with our comments above as well as the “RiskFactors” section below.

# **FinancialCondition**

Cash provided byoperations for the nine months ended July 31, 2006 was $1.1 million.  These cash flows included net income andnon-cash charges of $971,000 and an $115,000 in net changes in working capitalitems.  Changes in working capital itemsincluded a $1.1 million reduction in accounts payable, a $600,000 reduction ininventories during the year, and an increase in accounts receivable of $903,000caused by the timing of orders and shipments during the third quarter.

During the year, we havefunded capital expenditures of $704,000 and reduced our term debt by$907,000.  Most of our capitalexpenditures during the first nine months of the year were for upgrading ourinternal voice and data infrastructure and for our Oracle softwareimplementation.  Our business isgenerally not capital intensive and most capital expenditures relate to maintaining,updating and expanding our technology infrastructure to support our employeebase.  We continue to test thefunctionality of our new Oracle software platform by transitioning certaintransaction and/or customer sets from the legacy platforms to Oracle.  When fully implemented, Oracle will supportall of our operating and financial reporting activities, will condense threeexisting software platforms down to one, and will provide a long-term solutionthat will support rapid expansion of our customer base and revenues.

On September 30, 2006 wewill retire one of our term notes and our annual debt service obligation willbe reduced to $171,000 from its current level of $1.2 million.  Our total debt at July 31, 2006 was $6.6million, which consisted of a mortgage on our corporate headquarters buildingof $1.7 million, a term note of $0.174 million, and $4.7 million outstanding onthe working capital revolver.  Paymentson the mortgage note are based on a 13-year amortization schedule and the noteis due in full or will be refinanced by September 30,2009.  The term note is secured by the generalassets of the Company.  Payments on theterm note are based on a three-year amortization schedule and it is due andwill be amortized in full on September 30, 2006.  Required principal payments on the two notestotal $302,000 per quarter.  The creditagreement, which encompasses both the notes discussed above and the line ofcredit, contains certain financial covenants common in such agreements.  These covenants include tangible net worthrequirements, limitations on the amount of funded debt to Earnings BeforeInterest, Taxes, Depreciation, and Amortization, limitations on capitalspending, and debt service coverage requirements.  At July 31, 2006, we were in compliance withall the covenants.

The total amountavailable under the working capital revolver is based on the qualified balancesof accounts receivable and inventories and is subject to a maximum of $7.5million.  At July 31, 2006 there was $2.8million available for future borrowings under the revolver.

The table belowpresents our contractual obligations at July 31, 2006 as well as paymentobligations over the next five years:
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **2 — 3  Years** | ** ** | **4 — 5  Years** | ** ** |
| Long-term debt                   |       | $                                         | 2,258,013  |   | $ | 468,319 |   | $ | 548,312 |   | $ | 1,241,382 |   |
| Operating leases                 |       | 679,580                                   |       | 264,165 |   | 339,603 |   | 75,812 |   |
|                             | Total      |                                      | $          | 2,937,593 |   | $ | 732,484 |   | $ | 887,915 |   | $ | 1,317,194 |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

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# **Resultsof Operations**

For the third quarter offiscal 2006 we earned net income of $286,000 on revenues of $15.7 millioncompared to net income of $64,000 on revenues of $13.5 million in the thirdquarter of last year.  For the nine-monthperiod ending July 31, 2006, we earned net income of $202,000 on revenues of$43.2 million compared to net income of $306,000 on revenues of $41.6 millionfor the same period last year.  Thenarrative below provides further explanation of these results.

Systems Sales.  Systems sales were $7.8 million compared to$6.6 million in the third quarter of fiscal 2006 and 2005, respectively, a 17%increase.  This increase consisted of anincrease in sales of systems to commercial customers of $1.0 million or 19%,and an increase in sales of systems to lodging customers of $143,000 or10%.  For the nine-month period endingJuly 31, systems sales were $21.0 million compared to $19.3 million in thefirst nine months of fiscal 2005, a 9% increase.  These increases included an increase of$837,000 or 6% in sales of systems to commercial customers and a $932,000 or22% increase in sales of systems to lodging customers.  In the first half of fiscal 2006, we enjoyedespecially strong sales of systems to lodging customers as most major hotelchains are building new hotels and expanding or remodeling existingproperties.  As expected, this trendmoderated in the third quarter and these sales returned to their historicallevels.  The improvement in sales ofsystems to commercial customers in the second and third fiscal quartersreflects the improved sales funnels and increased bookings that we began to seein the first quarter.

Service Revenues.  Service revenues consist of the following:
|                                           | ** ** | **For the Three Months Ended  July 31,** | ** ** | **For the Nine Months Ended  July 31,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                                          | ** ** | **2005**                                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| National Service  Center                  |       | $                                                                 | 5,762,000  |                                                             | $          | 5,188,000 |   | $ | 16,403,000 |   | $ | 15,575,000 |   |
| Installation  & Professional Services |       | 2,016,000                                                         |       | 1,444,000                                                        |       | 5,043,000 |   | 5,357,000 |   |
| Total services revenue                    |       | $                                                                 | 7,778,000  |                                                             | $          | 6,632,000 |   | $ | 21,446,000 |   | $ | 20,932,000 |   |

 

Revenues earned by ourNSC increased 11% and 5% in the three- and nine-month periods ending July 31,2006, respectively.  Most of this growthreflects results from our emphasis on selling managed services, primarily toNortel end-user customers.  This growthinitiative is our key strategy in fiscal 2006 as we reorient our revenue basetoward recurring service revenues as a greater proportion of our totalrevenues.  We are continuing to commitsales resources to this effort and we expect continued growth in this segmentof our business.  However, in some cases,long sales cycles and existing contractual commitments of potential customerswith their current providers, delay the timing of these new revenues.

Our installation andprofessional services revenues increased 40% in the third quarter of fiscal2006 compared to the prior year, but are down 6% on the year-to-datebasis.  The increase in installationrevenues in the third quarter reflects the increase in systems sales coupledwith the timing of systems installations that were shipped in the secondquarter, but installed in our third quarter. Most of the decline in the year-to-date results reflect the fact that inthe first and second quarters of fiscal 2005 we enjoyed a boost in ourinstallation revenues as the result of a subcontractor arrangement with theMetropolitan Atlanta Rapid Transit Authority (“MARTA”) as the end-usercustomer.  Under this contract, we earnedinstallation-only revenues last year by installing communications systems atmultiple MARTA locations.  There has notbeen a similar revenue event in fiscal 2006. Consequently, our installation revenues in fiscal 2006 have resumedtheir historical relationship with systems sales.

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Gross Margins.  The table below presents the gross margins earnedon our primary revenue streams for:

|                                   | ** ** | **For the Three  Months Ended  July 31,** | ** ** | **For the Nine  Months Ended  July 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **Gross Margins**            | ** ** | **2006**                                                      | ** ** | **2005**                                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| Systems sales                     |       | 21.0                                                          | %          | 27.0                                                         | %          | 24.0 | % | 25.7 | % |
| Service revenues                  |       | 34.2                                                          | %          | 28.7                                                         | %          | 28.1 | % | 29.4 | % |
| Other revenues                    |       | 243.7                                                         | %          | 101.5                                                        | %          | 59.3 | % | 63.6 | % |
| Corporate cost  of goods sold     |       | -2.3                                                          | %          | -2.4                                                         | %          | -2.4 | % | -2.4 | % |
| Total sales and service  revenues |       | 26.6                                                          | %          | 26.7                                                         | %          | 24.2 | % | 26.4 | % |

 

The gross margins onsystems sales reflects the shipment of a large, lower margin project in thethird quarter of fiscal 2006 and higher than normal margins on some largerorders and upgrades in the third quarter of last year.  Installation revenues associated with thisorder will be realized in the fourth fiscal quarter and we are hopeful thatthis customer will become a significant, managed services customer in thefuture.  The decline in year-to-datemargins occurred in the third quarter due to the factors described above. Weexpect to continue to face pressure on our systems sales gross margins and ourdesire to maintain these margins may impact our revenue volumes and may limitour ability to increase our revenues.

Theimprovement in the gross margins earned on Service revenues in the thirdquarter came entirely from improvements in gross margins earned by the NSC asgross margins earned on installation activities declined slightly.  As described above, the increases in NSCrevenues have absorbed the extra layer of costs we have incurred tosuccessfully add the Nortel product line to our business.  Year-to-date services margins were slightlylower than in the previous year primarily because of the additional revenuesearned last year from the MARTA contract which is discussed under Servicesrevenues above.  The gross margins oninstallation revenues associated with systems sales depend primarily on thevolume of installation revenues that can be achieved in each period.  There is a large fixed component associatedwith the costs in the installation department and historically, we havestruggled to earn enough installation revenues each quarter to produce aconsistent and acceptable gross margin on these revenues.  These fixed costs primarily representpersonnel costs of certified engineers and technicians capable of installingthe complex systems we sell.  We expectthe installation of new systems and upgrades to continue to produce lowermargins than our other revenue streams.

A final component to ourgross margins is the margins earned on other revenues and our corporate cost ofgoods sold.  A portion of our otherrevenues typically represent sales and cost of goods sold on equipment orservices outside our normal provisioning processes and by their nature varysignificantly in both sales volume and gross margins earned.  Another segment of other revenues representsthe sale of Avaya maintenance contracts for which we earn either a gross profitor commission from Avaya.  We have nocontinuing service obligation associated with these revenues and grossprofits.  The decline in the gross marginon other revenues primarily reflects a decline in sale of these maintenancecontracts.  This is an unpredictablerevenue stream which is dependent upon expiration dates of existing contracts,installation dates of new systems, and the number of years that customerscontract for services.  Corporate cost ofgoods sold represents our material logistics and purchasing functions thatsupport all of our revenue segments.

Operating Expenses.  Our total operating expenses increased$184,000 or 5% in the third quarter of fiscal 2006 compared to the thirdquarter of fiscal 2005 and decreased $562,000 or 5% for the first nine monthsof fiscal 2006 compared to last year. The increase in operating expenses in the third quarter reflects highercommissions and other incentive compensation due to higher gross margins andprofitability.  For the year-to-dateperiod, increased commissions and incentive compensation expenses were morethan offset by lower  sales, marketing,and legal expenses and increased vendor incentive payments to produce overalllower operating expenses.

Interest Expense andOther Income.  Net interest expense and other income was$11,000 in expense in the third quarter of fiscal 2006 compared to $18,000 inexpense in the third quarter of fiscal 2005. For the nine months ending July 31, 2006, we recorded net interest andother expense of $90,000 in expense compared to $79,000 in income for the yearago period.  Other income was unusuallyhigh in the first quarter of last year due to the collection of $87,000 for anaccounts receivable that had been previously written off.  There was not a similar significanttransaction in the current quarter.

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Tax Provision.  We recorded a combined federal and state taxprovision of 39% for both the third quarters of fiscal 2006 and 2005.  For the nine months ending July 31, 2006, werecorded a tax provision of 44% compared to a tax provision of 39% for the sameperiod a year ago.  The tax provisionrecorded for the year-to-date period reflects the effective federal tax rateplus the composite state income tax rates adjusted for states that requireminimum tax payments even if tax losses are incurred.

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

Market risks relating toour operations result primarily from changes in interest rates.  We did not use derivative financialinstruments for speculative or trading purposes during the three months endingJuly 31, 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”) (5.39% at July 31, 2006) plus 1.25% to 2.75% or the bank’s prime rate (8.25% at July 31, 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 ANDPROCEDURES**

*Evaluation of Disclosure Controlsand Procedures.* Based on an evaluation conducted as ofJuly 31, 2006 by our management, including our Chief Executive Officer (“CEO”)and our Chief Financial Officer (“CFO”), our CEO and CFO have concluded thatour disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)) are effective to reasonably ensurethat information required to be disclosed in reports that we file or submitunder the Exchange Act, is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms, and that such information is accumulated and communicated to ourmanagement, including the CEO and CFO, as appropriate to allow timely decisionsregarding required disclosure.

*Changes in Internal Controls.*There were no changes in our internal controls or in other factors that couldmaterially affect, or is reasonably likely to materially affect, these controlssubsequent to the date of their evaluation. There were no significantdeficiencies or material weaknesses and, therefore, there were no correctiveactions taken.

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**PART II.  OTHER INFORMATION**

**ITEM1.  LEGAL PROCEEDINGS.**

We continue to monitorPhonometrics’ efforts to challenge certain awards of attorneys’ fees againstit.  A detailed description of thePhonometrics’ cases is contained in our Annual Report on Form 10-K for thefiscal year ended October 31, 2005, and updated in our Form 10-Q for thequarter ended January 31, 2006.

**ITEM1A.  RISK FACTORS**

The informationpresented below is an update to the “Risk Factors” included in the Company’sAnnual Report on Form 10-K for the fiscal year ended October 31, 2005 andshould be read in conjunction therewith. Except as set forth below, the Risk Factors included in the Company’sForm 10-K for its 2005 fiscal year have not materially changed.

**A significant portion of ourexpected growth in managed service revenues is dependent upon our relationshipwith a single customer.**

Much of the currentgrowth in our managed services offering is coming from a single customer asthey use us as a subcontractor to service many of their high profile end-usercustomers.  While we believe ourrelationship with this customer is strong, future changes in personnel,negative service events, and competitive factors could jeopardize this revenuestream.

**Hitachi’sdecision to cease manufacturing communications systems for the hospitalitymarket has caused some uncertainty with respect to our future relationship withour Hitachi installed base of hospitality customers.**

Hitachi, once one of theleading suppliers of traditional PBX systems to the hospitality market, ceasedselling systems for this market in March 2005. We have many long-time hospitality customers with significant portfoliosof Hitachi systems in their hotels.  Wehave several hundred Hitachi systems under service contracts producingrecurring contract revenues and gross profits for our business.  Over the next 8 to 9 years, all of these customerswill have to transition their communications systems to new platformspresenting a risk to us that another vendor may be selected.

We believe theuncertainty caused by Hitachi’s departure from the market is significantlymitigated by two important factors. First, we believe our relationship with our Hitachi customers isstrong.  Consequently, we believe that inmost instances we will be in a favorable position to supply a new system to ourcustomers when they decide to replace their Hitachi system.  Secondly, during the third quarter of fiscal2006 we assumed the remaining assets and liabilities of Hitachi’s United Stateshospitality market.  Included in theassets assumed was a substantial supply of new and refurbished inventory thatwill enable us to continue to serve our Hitachi customers well into thefuture.  Despite these mitigatingfactors, no assurance can be given that Hitachi’s decision will not negativelyimpact our financial results in the future.

**Revenuesand gross profits earned by hotels from guest calls continue to decline, whichmay result in hotels canceling their call accounting maintenance agreementswith us.**

Primarily because of theincreasing use of cell phones by guests, hotels have experienced a rapiddecline in their revenues and gross profits earned from long distance and othertelephone-related fees.  This developmenthas severely reduced the importance of call accounting systems in hotels and asa result, many of our customers are considering reducing or eliminating their callaccounting maintenance contracts with us. A few already have taken steps in this direction resulting in a declinein revenues from call accounting contracts an average of 3% per year for thepast three fiscal years.  We have beennotified by one of our major customers of their intention to cancel many oftheir call accounting maintenance contracts with us and instead contract forour services on an as-needed, time and material basis.  Presently, we cannot quantify the impact, ifany, of this potential action by our customer. However, it is possible that the sudden cancellation of a large block ofthese contracts could have a material impact on our profitability in futureperiods.

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**We aresubject to a variety of other general risks and uncertainties inherent in doingbusiness.**

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.

**ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS.**

None.

**ITEM3.  DEFAULTS UPON SENIOR SECURITIES.**

None.

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.**

None.

**ITEM5.  OTHER INFORMATION.**

None.

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**ITEM6.   EXHIBITS.**

Exhibits (filed herewith):

| SEC Exhibit No. | ** ** | **Description**                                                                                                                                                          |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1            |       | Letter Agreement with Ron Barber                                                                                                                                         |
|            |       |                                                                                                                                                                     |
| 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**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                    | XETA Technologies, Inc. |
|-------------------------|-------------------------|
|                    | (Registrant)            |
|                    |                    |   |
|                    |                    |   |
| Dated: August  29, 2006 | By:                     | /s/ Jack R. Ingram |   |
|                    |                    | Jack R. Ingram |
|                    |                    | Chief Executive  Officer |
|                    |                    |   |
| Dated: August  29, 2006 | By:                     | /s/ Robert B. Wagner |   |
|                    |                    | Robert B. Wagner |
|                    |                    | Chief Financial  Officer |

 

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EXHIBIT INDEX
| SEC Exhibit No. | ** ** | **Description**                                                                                                                                                          |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1            |       | Letter Agreement with Ron Barber                                                                                                                                         |
|            |       |                                                                                                                                                                     |
| 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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