**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.   20549**

**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d)OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended January 31, 2007**

**OR**

**o**                                 TRANSITIONREPORT 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’stelephone number, including area code)

(Former name, former address and former fiscal year, if changed since lastreport)

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Acceleratedfiler o     Non-acceleratedfiler x

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

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

| **Class**                      | ** ** | **Outstanding  at February 28, 2007** |
|--------------------------------|------------|---------------------------------------|
| 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 — January 31, 2007  and October 31, 2006                                |       |       | 3      |   |   |
|                                                                                                     |       |       |   |   |   |
| Consolidated Statements of Operations — For the  Three Months Ended January 31, 2007 and 2006       |       |       | 4      |   |   |
|                                                                                                     |       |       |   |   |   |
| Consolidated Statement of Shareholders’ Equity — For  the  Three Months Ended January 31, 2007 |       |       | 5      |   |   |
|                                                                                                     |       |       |   |   |   |
| Consolidated Statements of Cash Flows — For the  Three Months Ended January 31, 2007 and 2006       |       |       | 6      |   |   |
|                                                                                                     |       |       |   |   |   |
| Notes to Consolidated Financial Statements                                                               |       |       | 7      |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION  AND RESULTS OF OPERATIONS     |       |       | 12     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                      |       |       | 16     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM  4. CONTROLS AND PROCEDURES                                                                         |       |       | 16     |   |   |
|                                                                                                     |       |       |   |   |   |
| PART  II. OTHER INFORMATION                                                                              |       |       |   |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM  1. LEGAL PROCEEDINGS                                                                               |       |       | 16     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM  1A. RISK FACTORS                                                                                   |       |       | 16     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND  USE OF PROCEEDS                                     |       |       | 17     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                                  |       |       | 17     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                             |       |       | 17     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM  5. OTHER INFORMATION                                                                               |       |       | 17     |   |   |
|                                                                                                     |       |       |   |   |   |
| ITEM 6.  EXHIBITS                                                                                        |       |       | 17     |   |   |

 

2

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**XETA TECHNOLOGIES,INC. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                | ** ** | **January 31, 2007** | ** ** | **October 31, 2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                | ** ** | **(Unaudited)**                | ** ** | ** **                     | ** ** |
| ASSETS                                                                                                                    |       |                           |       |                           |       |
| Current assets:                                                                                                           |       |                           |       |                           |       |
| Cash and cash  equivalents                                                                                                |       | $                              | 405,015    |                           | $          | 174,567 |   |
| Current portion  of net investment in sales-type leases and other receivables                                             |       | 170,485                        |       | 329,619                        |       |
| Trade accounts  receivable, net                                                                                           |       | 9,975,966                      |       | 12,245,507                     |       |
| Inventories, net                                                                                                          |       | 4,775,842                      |       | 4,942,973                      |       |
| Deferred tax  asset, net                                                                                                  |       | 735,585                        |       | 709,343                        |       |
| Prepaid taxes                                                                                                             |       | 31,977                         |       | 22,622                         |       |
| Prepaid expenses  and other assets                                                                                        |       | 601,218                        |       | 300,738                        |       |
| Total current  assets                                                                                                     |       | 16,696,088                     |       | 18,725,369                     |       |
|                                                                                                                      |       |                           |       |                           |       |
| Noncurrent assets:                                                                                                        |       |                           |       |                           |       |
| Goodwill                                                                                                                  |       | 26,406,775                     |       | 26,420,669                     |       |
| Intangible  assets, net                                                                                                   |       | 132,417                        |       | 141,875                        |       |
| Net investment  in sales-type leases, less current portion above                                                          |       | 119,008                        |       | 128,708                        |       |
| Property, plant  & equipment, net                                                                                     |       | 10,510,440                     |       | 10,485,018                     |       |
| Other assets                                                                                                              |       | 12,530                         |       | 11,124                         |       |
| Total noncurrent  assets                                                                                                  |       | 37,181,170                     |       | 37,187,394                     |       |
|                                                                                                                      |       |                           |       |                           |       |
| Total assets                                                                                                              |       | $                              | 53,877,258 |                           | $          | 55,912,763 |   |
|                                                                                                                      |       |                           |       |                           |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                |       |                           |       |                           |       |
|                                                                                                                      |       |                           |       |                           |       |
| Current liabilities:                                                                                                      |       |                           |       |                           |       |
| Current portion  of long-term debt                                                                                        |       | $                              | 171,123    |                           | $          | 171,123 |   |
| Revolving line  of credit                                                                                                 |       | 745,085                        |       | 3,119,445                      |       |
| Lease payable                                                                                                             |       | —                         |       | 810                            |       |
| Accounts payable                                                                                                          |       | 3,845,438                      |       | 4,325,758                      |       |
| Current unearned  revenue                                                                                                 |       | 2,277,764                      |       | 1,802,665                      |       |
| Accrued liabilities                                                                                                       |       | 3,099,348                      |       | 2,993,831                      |       |
| Total current  liabilities                                                                                                |       | 10,138,758                     |       | 12,413,632                     |       |
|                                                                                                                      |       |                           |       |                           |       |
| Noncurrent liabilities:                                                                                                   |       |                           |       |                           |       |
| Long-term debt,  less current portion above                                                                               |       | 1,483,177                      |       | 1,525,950                      |       |
| Accrued  long-term liability                                                                                              |       | 397,850                        |       | 436,850                        |       |
| Noncurrent  unearned service revenue                                                                                      |       | 73,880                         |       | 79,132                         |       |
| Noncurrent  deferred tax liability, net                                                                                   |       | 3,704,438                      |       | 3,572,089                      |       |
| Total noncurrent  liabilities                                                                                             |       | 5,659,345                      |       | 5,614,021                      |       |
|                                                                                                                      |       |                           |       |                           |       |
| 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 issued at January  31, 2007 and October 31, 2006 |       | 11,233                         |       | 11,233                         |       |
| Paid-in capital                                                                                                           |       | 13,091,611                     |       | 13,067,676                     |       |
| Retained earnings                                                                                                         |       | 27,220,970                     |       | 27,050,860                     |       |
| Less treasury  stock, at cost (1,018,788 shares at January 31, 2007 and October 31, 2006)                                 |       | (2,244,659                     | )          | (2,244,659                     | )          |
| Total  shareholders’ equity                                                                                          |       | 38,079,155                     |       | 37,885,110                     |       |
| Total liabilities and  shareholders’ equity                                                                          |       | $                              | 53,877,258 |                           | $          | 55,912,763 |   |

 

The accompanyingnotes are an integral part of these consolidated balance sheets.

3

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**XETA TECHNOLOGIES,INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**
| ** **                                       | ** ** | **For the Three Months** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **Ended January 31,**         | ** ** |
| ** **                                       | ** ** | **2007**                                | ** ** | **2006** | ** ** |
|                                             |       |                                    |       |   |   |
| Systems sales                                    |       | $                                       | 7,026,848  |   | $ | 5,701,276 |   |
| Services                                         |       | 8,776,763                               |       | 6,418,940 |   |
| Other revenues                                   |       | 247,068                                 |       | 562,296 |   |
| Net sales and  service revenues                  |       | 16,050,679                              |       | 12,682,512 |   |
|                                             |       |                                    |       |   |   |
| Cost of systems sales                            |       | 5,307,829                               |       | 4,117,601 |   |
| Services costs                                   |       | 6,348,097                               |       | 5,095,899 |   |
| Cost of other revenues  & corporate COGS     |       | 443,140                                 |       | 692,661 |   |
| Total cost of  sales and service                 |       | 12,099,066                              |       | 9,906,161 |   |
|                                             |       |                                    |       |   |   |
| Gross profit                                     |       | 3,951,613                               |       | 2,776,351 |   |
|                                             |       |                                    |       |   |   |
| Operating expenses                               |       |                                    |       |   |   |
| Selling, general  and administrative             |       | 3,528,410                               |       | 2,827,198 |   |
| Amortization                                     |       | 140,277                                 |       | 101,197 |   |
| Total operating  expenses                        |       | 3,668,687                               |       | 2,928,395 |   |
|                                             |       |                                    |       |   |   |
| Income (loss) from  operations                   |       | 282,926                                 |       | (152,044 | ) |
|                                             |       |                                    |       |   |   |
| Interest expense                                 |       | (10,387                                 | )          | (71,897 | ) |
| Interest and  other income                       |       | 17,571                                  |       | 8,214 |   |
| Total interest  and other income (expense)       |       | 7,184                                   |       | (63,683 | ) |
|                                             |       |                                    |       |   |   |
| Income (loss) before  provision for income taxes |       | 290,110                                 |       | (215,727 | ) |
| Provision (benefit) for  income taxes            |       | 120,000                                 |       | (75,000 | ) |
|                                             |       |                                    |       |   |   |
| Net income (loss)                                |       | $                                       | 170,110    |   | $ | (140,727 | ) |
|                                             |       |                                    |       |   |   |
|                                             |       |                                    |       |   |   |
| Earnings (loss) per  share                       |       |                                    |       |   |   |
| Basic                                            |       | $                                       | 0.02       |   | $ | (0.01 | ) |
|                                             |       |                                    |       |   |   |
| Diluted                                          |       | $                                       | 0.02       |   | $ | (0.01 | ) |
|                                             |       |                                    |       |   |   |
|                                             |       |                                    |       |   |   |
| Weighted average shares  outstanding             |       | 10,214,741                              |       | 10,189,497 |   |
|                                             |       |                                    |       |   |   |
| Weighted average equivalent shares               |       | 10,214,741                              |       | 10,189,497 |   |

 

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

 

4

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**XETA TECHNOLOGIES,INC. AND SUBSIDIARYCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY(UNAUDITED)**
| ** **                 | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **           | ** ** |
|----------------------------|------------|-----------------------|------------|-------------------------|------------|------------|------------|------------|------------|----------------------|------------|
| ** **                 | ** ** | **Shares  Issued**    | ** ** | **Par  Value**          | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Paid-in  Capital** | ** ** | **Retained   Earnings** | ** ** | **Total** | ** ** |
|                       |       |                  |       |                    |       |       |       |       |       |                 |       |   |   |   |   |
| Balance- October 31,  2006 |       | 11,233,529            |       | $                       | 11,233     |       | 1,018,788  |       | $          | (2,244,659           | )          | $ | 13,067,676 |   | $ | 27,050,860 |   | $ | 37,885,110 |   |
|                       |       |                  |       |                    |       |       |       |       |       |                 |       |   |   |   |   |
| Stock based compensation   |       |                  |       |                    |       |       |       |       |       | 23,935               |       |   |   | 23,935 |   |
| Net  Income                |       | —                |       | —                  |       | —     |       | —     |       | —               |       | 170,110 |   | 170,110 |   |
|                       |       |                  |       |                    |       |       |       |       |       |                 |       |   |   |   |   |
| Balance- January 31, 2007  |       | 11,233,529            |       | $                       | 11,233     |       | 1,018,788  |       | $          | (2,244,659           | )          | $ | 13,091,611 |   | $ | 27,220,970 |   | $ | 38,079,155 |   |

 

The accompanyingnotes are an integral part of this consolidated financial statement.

 

5

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**XETA TECHNOLOGIES,INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)**
| ** **                                                                                                   | ** ** | **For the Three Months** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                   | ** ** | **Ended January 31,**         | ** ** |
| ** **                                                                                                   | ** ** | **2007**                                | ** ** | **2006** | ** ** |
| Cash flows from  operating activities:                                                                       |       |                                    |       |   |   |
| Net income  (loss)                                                                                           |       | $                                       | 170,110    |   | $ | (140,727 | ) |
|                                                                                                         |       |                                    |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                           |       |                                    |       |   |   |
| Depreciation                                                                                                 |       | 123,102                                 |       | 128,233 |   |
| Amortization                                                                                                 |       | 140,277                                 |       | 101,198 |   |
| Stock based  compensation                                                                                    |       | 23,935                                  |       | — |   |
| Loss (gain) on  sale of assets                                                                               |       | (5,000                                  | )          | 3,780 |   |
| Provision for  excess and obsolete inventory                                                                 |       | 25,500                                  |       | 25,500 |   |
| Increase  (decrease) in deferred tax liability                                                               |       | 146,243                                 |       | (101,057 | ) |
| Change in assets  and liabilities, net of acquisitions:                                                      |       |                                    |       |   |   |
| Decrease  (increase) in net investment in sales-type leases & other receivables                          |       | 168,834                                 |       | (104,234 | ) |
| Decrease in  trade account receivables                                                                       |       | 2,269,541                               |       | 2,015,857 |   |
| Decrease in  inventories                                                                                     |       | 141,631                                 |       | 700,649 |   |
| (Increase)  decrease in deferred tax asset                                                                   |       | (26,242                                 | )          | 16,503 |   |
| (Increase) in  prepaid expenses and other assets                                                             |       | (301,886                                | )          | (351,530 | ) |
| (Increase)  decrease in prepaid taxes                                                                        |       | (9,355                                  | )          | 37,760 |   |
| (Decrease) in  accounts payable                                                                              |       | (480,320                                | )          | (2,127,250 | ) |
| Increase in  unearned revenue                                                                                |       | 469,847                                 |       | 969,998 |   |
| Increase in  accrued taxes                                                                                   |       | —                                  |       | 9,554 |   |
| Increase  (decrease) in accrued liabilities and lease payable                                                |       | 65,707                                  |       | (442,337 | ) |
| Total  adjustments                                                                                           |       | 2,751,814                               |       | 882,624 |   |
|                                                                                                         |       |                                    |       |   |   |
| Net cash  provided by operating activities                                                                   |       | 2,921,924                               |       | 741,897 |   |
|                                                                                                         |       |                                    |       |   |   |
| Cash flows from  investing activities:                                                                       |       |                                    |       |   |   |
| Acquisitions,  net of cash acquired                                                                          |       |                                    |       |   |   |
| Additions to  property, plant & equipment                                                                |       | (279,343                                | )          | (265,773 | ) |
| Proceeds from  sale of assets                                                                                |       | 5,000                                   |       | 17,632 |   |
| Net cash used in  investing activities                                                                       |       | (274,343                                | )          | (248,141 | ) |
|                                                                                                         |       |                                    |       |   |   |
| Cash flows from  financing activities:                                                                       |       |                                    |       |   |   |
| Proceeds from  draws on revolving line of credit                                                             |       | 5,461,702                               |       | 6,564,271 |   |
| Principal  payments on debt                                                                                  |       | (42,773                                 | )          | (302,345 | ) |
| Payments on  revolving line of credit                                                                        |       | (7,836,062                              | )          | (6,358,601 | ) |
| Exercise of  stock options                                                                                   |       | —                                  |       | 51,411 |   |
| Net cash used in  financing activities                                                                       |       | (2,417,133                              | )          | (45,264 | ) |
|                                                                                                         |       |                                    |       |   |   |
| Net increase in  cash and cash equivalents                                                                   |       | 230,448                                 |       | 448,492 |   |
|                                                                                                         |       |                                    |       |   |   |
| Cash and cash  equivalents, beginning of period                                                              |       | 174,567                                 |       | 176,688 |   |
| Cash and cash  equivalents, end of period                                                                    |       | $                                       | 405,015    |   | $ | 625,180 |   |
|                                                                                                         |       |                                    |       |   |   |
| Supplemental disclosure  of cash flow information:                                                           |       |                                    |       |   |   |
| Cash paid during  the period for interest, net of amount capitalized of $64,652 in 2007 and  $70,941 in 2006 |       | $                                       | 29,226     |   | $ | 61,811 |   |
| Cash paid during the  period for income taxes                                                                |       | $                                       | 9,355      |   | $ | 12,240 |   |

 

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

6

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**XETA TECHNOLOGIES,INC. AND SUBSIDIARYNotes to Consolidated Financial StatementsJanuary 31, 2007**(Unauditedexcept where noted)

1.                                       BASISOF PRESENTATION:

XETA Technologies, Inc. (“XETA” or the “Company”) is aleading provider of communications solutions with sales and service locationsnationwide, serving business clients in sales, engineering, project management,installation, and service support.  TheCompany sells products which are manufactured by a variety of manufacturersincluding Avaya, Inc. (“Avaya”), Nortel Networks Corporation (“Nortel”), andSpectralink Corporation.  In addition,the Company manufactures and markets a line of proprietary call accountingsystems to the hospitality industry. XETA is an Oklahoma corporation.

The accompanying unaudited consolidated financialstatements have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission (the “Commission”).  Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to those rules and regulations, although theCompany believes that the disclosures made are adequate to make the informationpresented not misleading.  It issuggested that these condensed financial statements be read in conjunction withthe consolidated financial statements and the notes thereto made a part of theCompany’s Annual Report on Form 10-K, Commission File No. 0-16231, which wasfiled with the Commission on January 16, 2007. 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 toconform to current year presentations. These reclassifications had no impact on net income.

Segment Information

The Company has three reportable segments:  commercial system sales, lodging systemsales, and installation and service.  TheCompany defines commercial system sales as sales to the non-lodgingindustry.  Installation and servicerevenues represent revenues earned from installing and maintaining systems forcustomers in both the commercial and lodging segments.

The reporting segments follow the same accountingpolicies used for the Company’s consolidated financial statements and describedin the Summary of Significant Accounting Policies in the Company’s Form 10-Kdescribed above.  Company managementevaluates a segment’s performance based upon gross margins.  Assets are not allocated to thesegments.  Sales to customers locatedoutside of the U.S. are immaterial.

7

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The following is atabulation of business segment information for the three months ended January31, 2007 and 2006.
| ** **    | ** ** | **Commercial  System  Sales** | ** ** | **Lodging  System  Sales** | ** ** | **Managed  Services  Revenues** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|---------------|------------|-------------------------------|------------|----------------------------|------------|---------------------------------|------------|--------------------|------------|-------------|------------|
| **2007**      |       |                          |       |                       |       |                            |       |               |       |        |       |
| Sales         |       | $                             | 5,252,398  |                       | $          | 1,774,450                       |       | $                  | 8,776,763  |        | $          | 247,068 |   | $ | 16,050,679 |   |
| Cost of sales |       | (3,984,231                    | )          | (1,323,598                 | )          | (6,348,097                      | )          | (443,140           | )          | (12,099,066 | )          |
| Gross profit  |       | $                             | 1,268,167  |                       | $          | 450,852                         |       | $                  | 2,428,666  |        | $          | (196,072 | ) | $ | 3,951,613 |   |
|          |       |                          |       |                       |       |                            |       |               |       |        |       |
| **2006**      |       |                          |       |                       |       |                            |       |               |       |        |       |
| Sales         |       | $                             | 4,188,855  |                       | $          | 1,512,421                       |       | $                  | 6,418,940  |        | $          | 562,296 |   | $ | 12,682,512 |   |
| Cost of sales |       | (3,013,804                    | )          | (1,103,797                 | )          | (5,095,899                      | )          | (692,661           | )          | (9,906,161  | )          |
| Gross profit  |       | $                             | 1,175,051  |                       | $          | 408,624                         |       | $                  | 1,323,041  |        | $          | (130,365 | ) | $ | 2,776,351 |   |

 

Stock-Based CompensationPlans

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS123(R)”).  SFAS 123(R) requires companiesto measure all employee stock-based compensation awards using a fair valuemethod and recognize compensation cost in its financial statements.  The valuation provisions of SFAS 123(R) applyto new awards and to awards that are outstanding at the effective date andsubsequently modified or cancelled.  TheCompany adopted on a prospective basis SFAS 123(R) beginning November 1, 2005for stock-based compensation awards granted after that date and for unvestedawards outstanding at that date using the modified prospective applicationmethod.  The Company recognizes the fairvalue of stock-based compensation awards as selling, general and administrativeexpense as appropriate in the consolidated statements of operations on astraight-line basis over the vesting period. We recognized compensation expense of $23,935 and $0 in operatingexpenses in the statement of operations for the three months ended January 31,2007 and 2006, respectively.

Use of Estimates

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the U.S. requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

Reclassifications

Certainreclassifications of prior year amounts have been made to conform to currentyear presentations.  Thesereclassifications had no impact on net income.

New AccountingPronouncements

In June 2006, theFASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109, to clarify certainaspects of accounting for uncertain tax position, including issues related tothe recognition and measurement of those tax positions. This interpretation iseffective for fiscal years beginning after December 15, 2006, and thereforewill apply beginning with the Company’s fiscal year ending October 31, 2008. TheCompany is evaluating the impact of this interpretation.

In September 2006,the FASB issued Statement of Financial Standards No. 157, “Fair ValueMeasurements” (“SFAS 157”).  SFAS 157defines fair value, establishes a framework for measuring fair value inaccordance with accounting principles generally accepted in the United States,and expands disclosures about fair value measurements.  This statement does not require any new fairvalue measurements; rather, it applies under other accounting pronouncementsthat require or permit fair value 

8

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measurements. Theprovisions of SFAS 157 are effective for fiscal years beginning after November15, 2007.  The Company does not expectthe adoption of SFAS 157 to have a material impact on the Company’sconsolidated financial position or results of operations.

InFebruary 2007, the FASB issued Statement of Financial Accounting Standards No.159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Liabilities”.  SFAS 159 permits entities to choose tomeasure many financial instruments and certain other items at fair value.  SFAS 159 will be effective for the Company’sfiscal year beginning November 1, 2008. Early adoption is permitted. TheCompany has not determined the impact, if any, that adopting this standard mayhave on its consolidated financial position or results of operations.

2.                                       ACCOUNTSRECEIVABLE:

Trade accountsreceivable consists of the following:
| ** **                           | ** ** | **January 31,  2007** | ** ** | **(Audited)  October 31,  2006** | ** ** |
|--------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
|                                 |       |                       |       |                                  |       |
| Trade  receivables                   |       | $                          | 10,216,220 |                                  | $          | 12,499,407 |   |
| Less- reserve  for doubtful accounts |       | (240,254                   | )          | (253,900                              | )          |
| Net trade receivables                |       | $                          | 9,975,966  |                                  | $          | 12,245,507 |   |

 

3.                                       INVENTORIES:

Inventories are statedat the lower of cost (first-in, first-out or average) or market and consist ofthe following:
| ** **                                         | ** ** | **January 31,  2007** | ** ** | **(Audited)  October 31,  2006** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
|                                               |       |                       |       |                                  |       |
| Finished goods  and spare parts                    |       | $                          | 5,452,099  |                                  | $          | 5,565,484 |   |
| Less- reserve  for excess and obsolete inventories |       | (676,257                   | )          | (622,511                              | )          |
| Total  inventories, net                            |       | $                          | 4,775,842  |                                  | $          | 4,942,973 |   |

 

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4.                                       PROPERTY,PLANT AND EQUIPMENT:

Property, plantand equipment consists of the following:
| ** **                                                    | ** ** | **Estimated  Useful  Lives** | ** ** | **January 31,  2007** | ** ** | **(Audited)  October 31,  2006** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
|                                                          |       |                         |       |                       |       |                                  |       |
| Building                                                      |       | 20                           |       | $                          | 2,397,954  |                                  | $          | 2,397,954 |   |
| Data processing and  computer field equipment                 |       | 3–10                    |       | 2,584,187                  |       | 2,469,671                             |       |
| Software development  costs, work-in-process                  |       | N/A                          |       | 4,819,730                  |       | 5,274,299                             |       |
| Software development  costs of components placed Into service |       | 3–10                    |       | 2,909,865                  |       | 2,339,644                             |       |
| Hardware                                                      |       | 3–5                     |       | 599,751                    |       | 599,751                               |       |
| Land                                                          |       | —                       |       | 611,582                    |       | 611,582                               |       |
| Office furniture                                              |       | 5                            |       | 932,252                    |       | 932,252                               |       |
| Auto                                                          |       | 5                            |       | 451,166                    |       | 428,214                               |       |
| Other                                                         |       | 3–7                     |       | 270,670                    |       | 252,780                               |       |
|                                                          |       |                         |       |                       |       |                                  |       |
| Total property, plant  and equipment                          |       |                         |       | 15,577,157                 |       | 15,306,147                            |       |
| Less- accumulated  depreciation                               |       |                         |       | (5,066,717                 | )          | (4,821,129                            | )          |
|                                                          |       |                         |       |                       |       |                                  |       |
| Total property, plant and equipment, net                      |       |                         |       | $                          | 10,510,440 |                                  | $          | 10,485,018 |   |

 

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 $64,652 and$70,941 in interest costs in the three months ended January 31, 2007 and 2006,respectively.

5.                                       INCOMETAXES:

Thetax effect of temporary differences that give rise to significant portions ofthe deferred tax assets and deferred tax liabilities are presented below:
| ** **                                                 | ** ** | **January 31,  2007** | ** ** | **(Audited)  October 31,  2006** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
| Deferred tax assets:                                       |       |                       |       |                                  |       |
| Net operating  loss carryforward                           |       | $                          | 1,269,256  |                                  | $          | 1,156,913 |   |
| Currently  nondeductible reserves                          |       | 268,918                    |       | 256,764                               |       |
| Accrued  liabilities                                       |       | 345,594                    |       | 392,449                               |       |
| Prepaid service  contracts                                 |       | 95,119                     |       | 30,770                                |       |
| Other                                                      |       | 35,971                     |       | 40,436                                |       |
| Total deferred  tax asset                                  |       | 2,014,858                  |       | 1,877,332                             |       |
|                                                       |       |                       |       |                                  |       |
| Deferred tax  liabilities:                                 |       |                       |       |                                  |       |
| Intangible  assets                                         |       | 3,859,852                  |       | 3,686,779                             |       |
| Depreciation                                               |       | 1,105,308                  |       | 1,032,788                             |       |
| Tax income to be  recognized on sales-type lease contracts |       | 18,551                     |       | 20,511                                |       |
| Total deferred  tax liability                              |       | 4,983,711                  |       | 4,740,078                             |       |
| Net deferred tax  liability                                |       | $                          | (2,968,853 | )                                     | $          | (2,862,746 | ) |

 

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| ** **                                                 | ** ** | **January 31,  2007** | ** ** | **(Audited)  October 31,  2006** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
| Net deferred liability  as presented on the balance sheet: |       |                       |       |                                  |       |
| Current deferred  tax asset                                |       | $                          | 735,585    |                                  | $          | 709,343 |   |
| Noncurrent  deferred tax liability                         |       | (3,704,438                 | )          | (3,572,089                            | )          |
| Net deferred tax  liability                                |       | $                          | (2,968,853 | )                                     | $          | (2,862,746 | ) |

 

TheCompany has recorded a tax provision of $120,000 or 41% and a tax benefit of$75,000 or 35% for the three months ended January 31, 2007 and 2006,respectively, reflecting the statutory federal tax rate of 34% plus a blendedstate income tax rate of approximately 5% and the impact of minimum income taxpayments in certain states.

6.                                       CREDITAGREEMENTS:

The Company’scredit facility consists of a revolving credit and term loan agreement with acommercial bank including a mortgage agreement maturing on September 30, 2009and amortizing based on a13 year life and a $7.5 million revolving creditagreement to finance growth in working capital. The revolving line of credit is collateralized by trade accountsreceivable and inventories.  At January31, 2007 and October 31, 2006, the Company had approximately $745 thousand and$3.119 million, respectively, outstanding on the revolving line of credit.  The Company had approximately $6.8 millionavailable under the revolving line of credit at January 31, 2007.  Advance rates are defined in the agreement,but are generally at the rate of 80% on qualified trade accounts receivable and40% of qualified inventories.  Therevolving line of credit matures on September 28, 2007.  Long-term debt consisted of the following:
| ** **                                                                                                                                                                                                       | ** ** | **January 31,  2007** | ** ** | **(Audited)  October 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
|                                                                                                                                                                                                             |       |                       |       |                                  |       |
| Real estate term  note, payable in monthly installments of $14,257 plus interest, plus a fixed  payment of $1,198,061 due September 30, 2009, collateralized by a first  mortgage on the Company’s building |       | $                          | 1,654,300  |                                  | $          | 1,697,073 |   |
|                                                                                                                                                                                                             |       |                       |       |                                  |       |
| Less-current  maturities                                                                                                                                                                                         |       | 171,123                    |       | 171,123                               |       |
|                                                                                                                                                                                                             |       |                       |       |                                  |       |
| Total long-term debt,  less current maturities                                                                                                                                                                   |       | $                          | 1,483,177  |                                  | $          | 1,525,950 |   |

 

Intereston all outstanding debt under the credit facility accrues at either a) theLondon Interbank Offered Rate (which was 5.32% at January 31, 2007) plus 1.25%to 2.75% depending on the Company’s funded debt to cash flow ratio, or b) thebank’s prime rate (which was 8.25% at January 31, 2007) minus 0% to minus1.125% also depending on the Company’s funded debt to cash flow ratio.  At January 31, 2007, the Company was paying7.875% on the revolving line of credit borrowings and 7.072% on the mortgagenote.  The credit facility containsseveral financial covenants common in such agreements, including tangible networth requirements, limitations on the amount of funded debt to earnings beforeinterest, taxes, depreciation and amortization, limitations on capitalspending, and debt service coverage requirements.  The Company was in compliance with thesecovenants at January 31, 2007.

7.                                       EARNINGSPER SHARE:

Basic earnings percommon share were computed by dividing net income by the weighted averagenumber of shares of common stock outstanding during the reporting periods.  Diluted earnings per common share werecomputed by dividing net income by the weighted average number of shares ofcommon stock and 

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dilutive potentialcommon stock outstanding during the reporting periods.  A reconciliation of net income and weightedaverage shares used in computing basic and diluted earnings per share is asfollows:
| ** **                       | ** ** | **For the Three Months Ended January 31, 2007** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Income  (Numerator)**                                                            | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic EPS                        |       |                                                                               |       |   |   |   |   |
| Net income                       |       | $                                                                                  | 170,110    |   | 10,214,741 |   | $ | 0.02 |   |
| Dilutive effect of stock options |       |                                                                               |       | — |   |   |   |
|                             |       |                                                                               |       |   |   |   |   |
| Diluted EPS                      |       |                                                                               |       |   |   |   |   |
| Net income                       |       | $                                                                                  | 170,110    |   | 10,214,741 |   | $ | 0.02 |   |

 
| ** **                       | ** ** | **For the Three Months Ended January 31, 2006** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Income  (Numerator)**                                                            | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic EPS                        |       |                                                                               |       |   |   |   |   |
| Net loss                         |       | $                                                                                  | (140,727   | ) | 10,189,497 |   | $ | (0.01 | ) |
| Dilutive effect of stock options |       |                                                                               |       | — |   |   |   |
|                             |       |                                                                               |       |   |   |   |   |
| Diluted EPS                      |       |                                                                               |       |   |   |   |   |
| Net loss                         |       | $                                                                                  | (140,727   | ) | 10,189,497 |   | $ | (0.01 | ) |
|                             |       |                                                                               |       |   |   |   |   |

 

Options topurchase 1,104,068 shares of common stock at an average exercise price of $7.18and 1,126,536 shares of common stock at an average exercise price of $7.15 werenot included in the computation of diluted earnings per share for the threemonths ended January 31, 2007 and 2006, respectively, because inclusion ofthese options would be anti-dilutive.

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

**Preliminary NoteRegarding Forward-Looking Statements**

In the following discussion, we make forward-lookingstatements regarding future events and our future performance and results.  These and other forward-looking statementsare not guarantees of performance, but rather reflect our current expectations,estimates, and forecasts about the industry and markets in which we operate,and our assumptions and beliefs based upon information currently available tous.  Forward-looking statements can generallybe identified by words such as “expects,” “anticipates,” “may”, “plans,” “believes,”“intends,” “projects,” “estimates,” and similar words or expressions.  These statements are subject to risks anduncertainties which are difficult to predict or which we are unable to control,including but not limited to such factors as customer demand for advancedcommunications products, capital spending trends within our market, thefinancial condition of our suppliers and changes by them in their distribution strategiesand support, technological changes, product mix, the ability to attract andretain highly skilled personnel and competition.  These and other risks and uncertainties arediscussed under the heading “Risk Factors” under Part I of the Company’s Form10-K for the fiscal year ended October 31, 2006 (filed with the Commission onJanuary 16, 2007), and in updates to such risk factors set forth in Item 1A ofPart II of this quarterly report.  As aresult of these risks and uncertainties, actual results may differ materiallyand adversely from those expressed in forward-looking statements.  Consequently, investors are cautioned to readand consider all forward-looking statements in conjunction with such riskfactors and uncertainties.  The PrivateSecurities Litigation Reform Act of 1995 provides a safe-harbor forforward-looking statements made by the Company.

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**Overview**

Strategy.  In the first quarter of fiscal 2007, wecontinued to build on last year’s success in our Managed Services business,particularly in the commercial sector of this business.  This sector represents recurring contractmaintenance fees and time and materials revenues, implementation fees, andcabling revenues earned from commercial customers.  These revenues grew 94% in the first quartercompared to last year.  One of ourprimary strategies in fiscal 2007 is to continue to expand our commercialManaged Services business, particularly the recurring portion of this businessthrough our wholesale and retail service offerings.  This initiative is integral to our long-termstrategy to reduce our financial dependence on systems sales in favor of morepredictable, recurring services revenues.

Additionally, wehave improved the alignment of our sales organization with our two majorsystems manufacturers, Avaya and Nortel. We now have sales teams focused on each product line with an experiencedsales executive leading each team.  As aresult of this realignment and increased sales management talent, we believe wecan increase the sales of our systems in fiscal 2007 compared to previousyears.  Our first quarter systems salesincreased 23% compared to the prior year. This increase was due to the favorable timing of shipments and weaksystems sales in the first quarter of fiscal 2006.

Operating Summary.  During the first quarter of fiscal 2007, ourrevenues were $16.1 million, a 27% increase over the first quarter of fiscal2006.  This increase consisted ofincreases in systems sales of $1.3 million or 23% and increases in servicerevenues of $2.4 million or 37%.  Theseincreases were partially offset by a decrease in other revenues of $316,000 or56%.  Our operating results in the firstquarter of fiscal 2007 were net income of $170,000 compared to a net loss of$141,000 in the first quarter last year. These items are discussed in more detail under “Results of Operations”below.

Financial Position Summary.  Our financial condition improved during thefirst quarter.  We generated positivecash flows from operations of $2.9 million in the quarter and used that cashprimarily to reduce the borrowings on our working capital revolver by $2.4million or over 76%.  These and otherfinancial position items are discussed in more detail under “FinancialCondition” below.

The following discussionpresents additional information regarding our financial condition and resultsof operations for the three-month periods ending January 31, 2007 and 2006 andshould be read in conjunction with our comments above as well as the “RiskFactors” section below.

**FinancialCondition**

Cash provided byoperations for the three months ended January 31, 2007 was $2.9 million,consisting primarily of net income and non-cash charges of $483,000 and areduction in accounts receivable of $2.3 million.  Other changes in working capital items nettedto an increase in cash of $169,000.  Weused these cash flows to reduce our borrowings on our working capital line ofcredit by $2.4 million, reduce our mortgage balance by $43,000, and to fundcapital expenditures of $274,000. Non-cash charges included depreciation expense of $123,000, amortizationexpense of $140,000, stock-based compensation expense of $24,000, and aprovision for obsolete inventory of $25,000.

At January 31, 2007 ourtotal borrowings were $2.4 million consisting of a mortgage on our headquartersbuilding of $1.7 million and $700,000 due on our revolving line of credit.  At January 31, 2007 there was $6.8 millionavailable under the revolver to meet working capital needs.

In October, 2006 we announced thatour board of directors had approved a stock repurchase program authorizing theCompany to utilize up to $960,000 per year to repurchase our common stock inopen market, block purchases or in privately negotiated transactions and atprices we deem appropriate.  Theserepurchases would be funded from cash flows previously dedicated to reductionof term debt stemming from our acquisitions made between November 1999 andNovember 2000.  This term debt wasretired in September, 2006.  To date, nostock repurchases have been made under the program.

The table belowpresents our contractual obligations at January 31, 2007 as well as paymentobligations over the next five years:

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| ** **                       | ** ** | ** ** | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **Less than  1 year**           | ** ** | **2 – 3  Years** | ** ** | **4 – 5  Years** | ** ** |
| Long-term debt                   |       | $          | 1,924,599  |                                      | $          | 282,568 |   | $ | 1,642,031 |   | $ | — |   |
| Operating leases                 |       | 540,615    |       | 238,860                                   |       | 267,295 |   | 34,460 |   |
| Total                            |       | $          | 2,465,214  |                                      | $          | 521,428 |   | $ | 1,909,326 |   | $ | 34,460 |   |

 

**Results ofOperations**

For the first quarter offiscal 2007 we earned net income of $170,000 on revenues of $16.1 millioncompared to a net loss of $141,000 on revenues of $12.7 million in the firstquarter of last year.  The narrativebelow provides further explanation of these results.

Systems Sales.  Systems sales were $7.0 million compared to$5.7 million in the first quarter of fiscal 2007 and 2006, respectively, a 23%increase.  This increase consisted of anincrease in sales of systems to commercial customers of $1.1 million or 25%,and an increase in sales of systems to lodging customers of $262,000 or17%.  As discussed above, these increasesare primarily due to the favorable timing of equipment shipments and unusuallylow prior year comparisons. Historically, our systems sales in the first half of our fiscal year areweaker than the second half.  We expectthis trend to continue and also expect that our first half systems sales infiscal 2007 will come into balance with last year’s results which includedespecially strong second quarter systems sales.

Managed ServicesRevenues.  Managed Services revenues consist of thefollowing:

|                                 | ** ** | **For the Three Months  Ended January 31,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2007**                                                             | ** ** | **2006** | ** ** |
| Contract &  T&M revenue |       | $                                                                    | 6,005,000  |   | $ | 4,985,000 |   |
| Implementation                  |       | 2,132,000                                                            |       | 1,054,000 |   |
| Cabling                         |       | 640,000                                                              |       | 380,000 |   |
| Total Managed Services  revenue |       | $                                                                    | 8,777,000  |   | $ | 6,419,000 |   |

 

Managed servicesrevenues increased 37% for the quarter ending January 31, 2007 compared to thesame period last year.  Most of thisgrowth came from the acquisition of new commercial customers adopting ourManaged Services offerings.  As a result,recurring contract and T&M revenues earned from commercial customersincreased 72% in the first quarter compared to last year.  We have both a wholesale and retail ManagedServices offering to our commercial Managed Services customers.  Our wholesale offering is currently theprimary driver of our revenue growth and represents relationships with networkproviders, manufacturers and systems integrators in which we function as asubcontractor, usually providing field services resources.  Under our retail strategy, we contract and serveend-users directly.

Implementation servicesrevenues increased 102% in the first quarter of fiscal 2007 compared to theprior year.  Generally, ourimplementation services revenues, which include revenues earned from bothinstallation and professional services activities, are expected to average from18% to 20% of systems sales revenues over the course of an entire year.  However, this percentage can vary widely onindividual projects due to vast differences in the complexity ofimplementations and the software applications purchased by the customer.  In the first quarter of fiscal 2007,implementation revenues were 30% of systems sales compared to 18% in the firstquarter of fiscal 2006 primarily reflecting disproportionately higherprofessional services fees earned on one large installation.

Cabling revenuesincreased 68% in the first quarter compared to last year.  This increase reflects our emphasis on thisgrowing market.  We believe this portionof our Managed Services business will improve over time, but is not yet apredictable revenue stream.

Gross Margins.  The table below presents the gross marginsearned on our primary revenue streams:

14

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|                               | ** ** | **For the Three Months Ended  January 31,** | ** ** |
|-------------------------------|------------|----------------------------------------------------------------------|------------|
| **Gross Margins**        | ** ** | **2007**                                                             | ** ** | **2006** | ** ** |
| Systems sales                 |       | 24.5                                                                 | %          | 27.8 | % |
| Managed Services  revenues    |       | 27.7                                                                 | %          | 20.6 | % |
| Other revenues                |       | 62.1                                                                 | %          | 37.3 | % |
| Corporate cost  of goods sold |       | -2.2                                                                 | %          | -2.7 | % |
| Total                         |       | 24.6                                                                 | %          | 21.9 | % |

 

The gross margins onsystems sales in the first quarter were within our range of expectations.  The gross margins earned in the first quarterof fiscal 2006 were on the high end of our range of expectations.  There is constant pricing pressure on theequipment we sell as the hardware portion of the sale becomes increasinglycommoditized.  We expect this pressure tocontinue and possibly accelerate.  Tooffset these factors, we emphasize our in-house installation expertise,nationwide geographic presence, and after-installation care to focus customerson the value of purchasing systems from us. Additionally, we work closely with our distributors and manufacturers tomaximize their pricing support.  Ourdesire to maintain the gross margins at their historical levels may impact ourrevenue volumes and may limit our ability to increase our revenues.

Theimprovement in the gross margins earned on Managed Services revenues in thefirst quarter came primarily from the increases in revenues from the commercialsector of this business.  As the contractand T&M revenues earned from commercial customers began to grow duringfiscal 2006, our gross margins on overall Managed Services revenues improveddramatically as we were able to absorb the extra costs we incurred to build ourNortel capability.  As discussed above,this portion of our business is an important growth driver, as it representsthe greatest opportunity for revenue growth while at the same time improvingoverall gross margins.  Gross marginsearned on implementation activities improved in the first quarter compared tolast year, but continued to be lower than our expectations.  We believe we can increase the gross marginsearned on implementation revenues through increased utilization of our internalresources for  installations and throughpartnering with manufacturers and systems integrators to generate incrementalrevenues not associated with our own systems sales.

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 or servicesoutside 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$740,000 or 25% in the first quarter of fiscal 2007 compared to the firstquarter of fiscal 2006.  This increaseprimarily reflects increased commissions and incentive compensation costs dueto higher revenues and gross profits. Other increases in operating expenses included increased personnel costsand additional marketing expenses. Amortization expense in the first quarter was $140,000, an increase of$39,000 over the first quarter of last year.

Interest Expense andOther Income.  Net interest expense and other income was$7,000 in income in the first quarter of fiscal 2007 compared to $64,000 inexpense in the first quarter of fiscal 2006. This change reflects lower overall borrowing costs in 2007 compared tolast year.

Tax Provision.  We recorded a combined federal and state taxprovision of 41.4% for the first quarter of fiscal 2007 compared to an incometax benefit rate of 34.8% recorded in the first quarter of last year.  Due to large tax deductions generated fromthe tax amortization of goodwill balances and the relatively low profitabilityover the past several fiscal years, we have not been in a tax payingposition.  However, many states requireminimum taxes to be paid even if tax losses are generated and in some states,tax losses are not available for carry-forward to future periods.  As a result, our tax provision recorded forthe first quarter 

15

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reflects the effectivefederal tax rate plus the composite state income tax rates adjusted for statesthat require minimum tax payments even if tax losses are incurred.

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

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 endingJanuary 31, 2007.

*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”) (5.32% at January 31, 2007) plus 1.25% to 2.75% or the bank’s prime rate (8.25% at January 31, 2007) less 0.0% to minus 1.125%.  A hypothetical 1% increase in interest rates would not have a material impact on our financial position or cash flows.

**ITEM 4.   CONTROLS AND PROCEDURES**

*Evaluation of Disclosure Controlsand Procedures.* Basedon an evaluation conducted as of January 31, 2007 by our management, includingour Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”),our CEO and CFO have concluded that our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) are effective toreasonably ensure that information required to be disclosed in reports that wefile or submit under the Exchange Act, is recorded, processed, summarized andreported within the time periods specified in Securities and ExchangeCommission rules and forms, and that such information is accumulated andcommunicated to our management, including the CEO and CFO, as appropriate toallow timely decisions regarding required disclosure.

*Changes in Internal Controls.* There were no changes in our internalcontrols or in other factors that could materially affect, or is reasonablylikely to materially affect, these controls subsequent to the date of their evaluation.There were no significant deficiencies or material weaknesses and, therefore,there were no corrective actions taken.

**PARTII.  OTHER INFORMATION**

**ITEM 1.  LEGAL PROCEEDINGS.**

None.

**ITEM 1A.  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, 2006 andshould be read in conjunction therewith. Except as set forth below, the Risk Factors included in the Company’sForm 10-K for its 2006 fiscal year have not materially changed.

**Our expected growth in ManagedServices revenues will likely be derived from a handful of large companies,therefore exposing us to the risk of a significant negative impact in the eventof the loss of any one of such companies as a customer.**

To date, much of oursuccess in growing the commercial portion of our Managed Services business hascome from Nortel who contracts us to serve as a subcontractor to fulfillservice requirements to end-user companies. Our target market for our Managed Services offerings is manufacturerssuch as Nortel, large communications carriers such as the regional BellOperating Companies, and systems integrators. Typically, these companies will contract with us to provide technical resourcesin the field on a subcontract basis and parts fulfillment.  The end-users served are often some of ourcustomer’s largest and most prestigious clients and therefore it is imperativethat our customer satisfaction ratings remain high.  Once these revenue streams 

16

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are established, theloss of any particular relationship could result in a material, adverse impacton our operating results.

**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS.**

None.

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

None.

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.**

None.

**ITEM 5.  OTHER INFORMATION.**

None.

**ITEM6.   EXHIBITS.**

Exhibits (filed herewith):
| SEC Exhibit No. | ** ** | **Description**                                                                                                                                                          |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                     |
| 10.1            |       | Description of Informal Compensatory Arrangements  with Certain Named Executive Officers                                                                                 |
|            |       |                                                                                                                                                                     |
| 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. |

 

17

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**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: February 28, 2007 |   | By:                     |   | /s/ Jack R. Ingram |
|                     |   |                    |   | Jack R. Ingram |
|                     |   |                    |   | Chief Executive Officer |
|                     |   |                    |   |   |
| Dated: February 28, 2007 |   | By:                     |   | /s/ Greg D. Forrest |
|                     |   |                    |   | Greg D. Forrest |
|                     |   |                    |   | President |
|                     |   |                    |   |   |
| Dated: February 28, 2007 |   | By:                     |   | /s/ Robert B. Wagner |
|                     |   |                    |   | Robert B. Wagner |
|                     |   |                    |   | Chief Financial Officer |

 

18

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EXHIBITINDEX
| SEC Exhibit No. | ** ** | **Description**                                                                                                                                                          |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                     |
| 10.1            |       | Description of Informal Compensatory Arrangements  with Certain Named Executive Officers                                                                                 |
|            |       |                                                                                                                                                                     |
| 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. |

 

19

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