Tableof Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**x****               ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended April 30, 2010**

** **

**OR**

** **

**o****                  ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**CommissionFile Number 0-16231**

 

.

 

**XETA Technologies, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Oklahoma**                                 | ** ** | **73-1130045**       |
|----------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of             |       | (I.R.S. Employee     |
| incorporation or  organization)              |       | Identification  No.) |
|                                         |       |                 |
| **1814 W.  Tacoma Street, 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 last report)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes x No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes oNo x

 

Indicate by check mark whether theregistrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company (as defined by Rule 12b-2of the Exchange Act).

 

| Large accelerated filer o                      |   | Accelerated filer o         |
|------------------------------------------------|--------|-----------------------------|
|                                           |   |                        |
| Non-accelerated filer o                        |   | Smaller reporting company x |
| (Do not  check if a smaller reporting company) |   |                        |

 

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

 

Asof May 21, 2010 there were 10,301,308 shares of the registrant’s commonstock, par value $0.001, outstanding.

 

 

 

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INDEX

 
| ** **                                                                                               | **PAGE** |
|----------------------------------------------------------------------------------------------------------|----------|
| PART I. FINANCIAL  INFORMATION                                                                      |     |
|                                                                                                     |     |
| ITEM  1. FINANCIAL STATEMENTS (Unaudited)                                                                |     |
|                                                                                                     |     |
| Consolidated  Balance Sheets - April 30, 2010   and October 31, 2009                           | 3        |
|                                                                                                     |     |
| Consolidated Statements of Operations - For the  Three and Six Months Ended April 30, 2010 and 2009 | 4        |
|                                                                                                     |     |
| Consolidated Statement of Shareholders’ Equity - For  the  Six Months Ended April 30, 2010     | 5        |
|                                                                                                     |     |
| Consolidated Statements of Cash Flows - For the  Six Months Ended April 30, 2010 and 2009           | 6        |
|                                                                                                     |     |
| Notes to Consolidated Financial Statements                                                               | 7        |
|                                                                                                     |     |
| ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS                                                       | 14       |
|                                                                                                     |     |
| ITEM 4T. CONTROLS AND PROCEDURES                                                                         | 18       |
|                                                                                                     |     |
| PART II.  OTHER INFORMATION                                                                         |     |
|                                                                                                     |     |
| ITEM  1. LEGAL PROCEEDINGS                                                                               | 18       |
|                                                                                                     |     |
| ITEM  1A. RISK FACTORS                                                                                   | 18       |
|                                                                                                     |     |
| ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND  USE OF PROCEEDS                                     | 20       |
|                                                                                                     |     |
| ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                                  | 20       |
|                                                                                                     |     |
| ITEM  4. OTHER INFORMATION                                                                               | 20       |
|                                                                                                     |     |
| ITEM 5.  EXHIBITS                                                                                        | 20       |

 

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XETA TECHNOLOGIES,INC. AND SUBSIDIARY

CONSOLIDATEDBALANCE SHEETS

 
| ** **                                                                                                                        | ** ** | **(UNAUDITED)**          | ** ** | ** **                 | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                                                                                                        | ** ** | **April 30,  2010** | ** ** | **October 31,  2009** | ** ** |
|                                                                                                                              |       |                     |       |                       |       |
| ASSETS                                                                                                                            |       |
|                                                                                                                              |       |                     |       |                       |       |
| Current assets:                                                                                                                   |       |                     |       |                       |       |
| Cash and cash  equivalents                                                                                                        |       | $                        | 5,601,225  |                       | $          | 4,731,926 |   |
| Current portion of net  investment in sales-type leases and other receivables                                                     |       | 1,005,537                |       | 470,025                    |       |
| Trade accounts  receivable, net                                                                                                   |       | 10,475,209               |       | 13,832,452                 |       |
| Inventories, net                                                                                                                  |       | 4,559,408                |       | 5,036,198                  |       |
| Deferred tax asset                                                                                                                |       | 1,262,491                |       | 1,136,351                  |       |
| Prepaid taxes                                                                                                                     |       | 86,054                   |       | 39,784                     |       |
| Prepaid expenses and  other assets                                                                                                |       | 2,223,064                |       | 2,057,514                  |       |
| Total current assets                                                                                                              |       | 25,212,988               |       | 27,304,250                 |       |
|                                                                                                                              |       |                     |       |                       |       |
| Noncurrent assets:                                                                                                                |       |                     |       |                       |       |
| Goodwill                                                                                                                          |       | 12,004,187               |       | 12,031,975                 |       |
| Intangible assets, net                                                                                                            |       | 457,610                  |       | 570,740                    |       |
| Net investment in  sales-type leases and other receivables, less current portion above                                            |       | 334,891                  |       | 335,413                    |       |
| Property,  plant & equipment, net                                                                                        |       | 6,708,364                |       | 6,825,916                  |       |
| Deferred tax asset                                                                                                                |       | 94,864                   |       | 739,216                    |       |
| Other assets                                                                                                                      |       | 444                      |       | —                     |       |
| Total noncurrent assets                                                                                                           |       | 19,600,360               |       | 20,503,260                 |       |
|                                                                                                                              |       |                     |       |                       |       |
| Total assets                                                                                                                      |       | $                        | 44,813,348 |                       | $          | 47,807,510 |   |
|                                                                                                                              |       |                     |       |                       |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                        |       |
|                                                                                                                              |       |                     |       |                       |       |
| Current liabilities:                                                                                                              |       |                     |       |                       |       |
| Current portion of  long-term debt                                                                                                |       | $                        | —     |                       | $          | 1,183,475 |   |
| Accounts payable                                                                                                                  |       | 4,565,480                |       | 5,785,225                  |       |
| Current portion of  obligations under capital lease                                                                               |       | 157,081                  |       | 154,072                    |       |
| Current unearned  services revenue                                                                                                |       | 4,002,529                |       | 5,194,601                  |       |
| Accrued liabilities                                                                                                               |       | 3,107,108                |       | 3,444,396                  |       |
| Total current  liabilities                                                                                                        |       | 11,832,198               |       | 15,761,769                 |       |
|                                                                                                                              |       |                     |       |                       |       |
| Noncurrent liabilities:                                                                                                           |       |                     |       |                       |       |
| Accrued long-term  liability                                                                                                      |       | 144,100                  |       | 144,100                    |       |
| Long-term portion of  obligations under capital lease                                                                             |       | 26,776                   |       | 106,076                    |       |
| Noncurrent unearned  services revenue                                                                                             |       | 51,701                   |       | 36,691                     |       |
| Total noncurrent  liabilities                                                                                                     |       | 222,577                  |       | 286,867                    |       |
|                                                                                                                              |       |                     |       |                       |       |
| Contingencies                                                                                                                     |       |                     |       |                       |       |
|                                                                                                                              |       |                     |       |                       |       |
| Shareholders’ equity:                                                                                                        |       |                     |       |                       |       |
| Preferred stock; $.10  par value; 50,000 shares authorized, 0 issued                                                              |       | —                   |       | —                     |       |
| Common stock; $.001 par  value; 50,000,000 shares authorized, 11,256,193 issued at April 30, 2010  and October 31, 2009 |       | 11,255                   |       | 11,255                     |       |
| Paid-in capital                                                                                                                   |       | 13,773,873               |       | 13,704,460                 |       |
| Retained earnings                                                                                                                 |       | 21,068,312               |       | 20,223,169                 |       |
| Less treasury stock, at  cost (954,885 shares at April 30, 2010 and 993,763 shares at  October 31, 2009)                |       | (2,094,867               | )          | (2,180,010                 | )          |
| Total shareholders’  equity                                                                                                  |       | 32,758,573               |       | 31,758,874                 |       |
| Total liabilities and  shareholders’ equity                                                                                  |       | $                        | 44,813,348 |                       | $          | 47,807,510 |   |

 

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

 

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XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF OPERATIONS

(UNAUDITED)

 
| ** **                                        | ** ** | **For  the Three Months** | ** ** | **For  the Six Months** | ** ** |
|---------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **Ended  April 30,** | ** ** | **Ended  April 30,**    | ** ** |
| ** **                                        | ** ** | **2010**                  | ** ** | **2009**                | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Systems sales                                     |       | $                         | 5,742,637  |                    | $          | 7,789,138 |   | $ | 16,609,695 |   | $ | 16,374,891 |   |
| Services                                          |       | 11,377,908                |       | 9,841,649               |       | 23,494,765 |   | 19,834,882 |   |
| Other revenues                                    |       | 77,452                    |       | 125,816                 |       | 137,680 |   | 126,855 |   |
| Net sales and services  revenues                  |       | 17,197,997                |       | 17,756,603              |       | 40,242,140 |   | 36,336,628 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Cost of systems sales                             |       | 4,173,003                 |       | 5,809,523               |       | 12,249,590 |   | 12,151,888 |   |
| Services costs                                    |       | 7,782,674                 |       | 6,768,814               |       | 16,013,754 |   | 13,752,553 |   |
| Cost of other  revenues & corporate COGS |       | 455,920                   |       | 435,275                 |       | 853,555 |   | 883,045 |   |
| Total cost of sales and  services                 |       | 12,411,597                |       | 13,013,612              |       | 29,116,899 |   | 26,787,486 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Gross profit                                      |       | 4,786,400                 |       | 4,742,991               |       | 11,125,241 |   | 9,549,142 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Operating expenses                                |       |                      |       |                    |       |   |   |   |   |
| Selling, general and  administrative              |       | 4,262,343                 |       | 4,081,197               |       | 9,387,626 |   | 8,537,306 |   |
| Amortization                                      |       | 187,230                   |       | 335,006                 |       | 374,085 |   | 657,257 |   |
| Total operating  expenses                         |       | 4,449,573                 |       | 4,416,203               |       | 9,761,711 |   | 9,194,563 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Income from operations                            |       | 336,827                   |       | 326,788                 |       | 1,363,530 |   | 354,579 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Interest expense                                  |       | (4,744                    | )          | (28,498                 | )          | (10,914 | ) | (58,401 | ) |
| Interest and other  income                        |       | 17,272                    |       | 3,998                   |       | 38,527 |   | 15,378 |   |
| Net interest and other  income (expense)          |       | 12,528                    |       | (24,500                 | )          | 27,613 |   | (43,023 | ) |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Income before provision  for income taxes         |       | 349,355                   |       | 302,288                 |       | 1,391,143 |   | 311,556 |   |
| Provision for income  taxes                       |       | 137,000                   |       | 119,000                 |       | 546,000 |   | 126,000 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Net income                                        |       | $                         | 212,355    |                    | $          | 183,288 |   | $ | 845,143 |   | $ | 185,556 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Earnings per share                                |       |                      |       |                    |       |   |   |   |   |
| Basic                                             |       | $                         | 0.02       |                    | $          | 0.02 |   | $ | 0.08 |   | $ | 0.02 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Diluted                                           |       | $                         | 0.02       |                    | $          | 0.02 |   | $ | 0.08 |   | $ | 0.02 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Weighted average shares  outstanding              |       | 10,230,851                |       | 10,225,395              |       | 10,212,244 |   | 10,223,944 |   |
|                                              |       |                      |       |                    |       |   |   |   |   |
| Weighted average  equivalent shares               |       | 10,284,564                |       | 10,225,411              |       | 10,252,895 |   | 10,223,973 |   |

 

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

 

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XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY

(UNAUDITED)

 
| ** **                                         | ** ** | **Common Stock**  | ** ** | **Treasury Stock** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **               | ** ** |
|----------------------------------------------------|------------|------------------------|------------|-------------------------|------------|------------|------------|------------|------------|--------------------------|------------|
| ** **                                         | ** ** | **Shares Issued** | ** ** | **Par Value**      | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Paid-in Capital** | ** ** | **Retained Earnings** | ** ** | **Total** | ** ** |
|                                               |       |                   |       |                    |       |       |       |       |       |                     |       |   |   |   |   |
| Balance-  October 31, 2009                    |       | 11,256,193             |       | $                       | 11,255     |       | 993,763    |       | $          | (2,180,010               | )          | $ | 13,704,460 |   | $ | 20,223,169 |   | $ | 31,758,874 |   |
|                                               |       |                   |       |                    |       |       |       |       |       |                     |       |   |   |   |   |
| Issuance of restricted  common stock from treasury |       | —                 |       | —                  |       | (38,878    | )          | 85,143     |       | (85,143                  | )          | — |   | — |   |
| Stock-based  compensation                          |       | —                 |       | —                  |       | —     |       | —     |       | 154,556                  |       | — |   | 154,556 |   |
|                                               |       |                   |       |                    |       |       |       |       |       |                     |       |   |   |   |   |
| Net income                                         |       | —                 |       | —                  |       | —     |       | —     |       | —                   |       | 845,143 |   | 845,143 |   |
|                                               |       |                   |       |                    |       |       |       |       |       |                     |       |   |   |   |   |
| Balance- April 30,  2010                      |       | 11,256,193             |       | $                       | 11,255     |       | 954,885    |       | $          | (2,094,867               | )          | $ | 13,773,873 |   | $ | 21,068,312 |   | $ | 32,758,573 |   |

 

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

 

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** **

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(UNAUDITED)

 
| ** **                                                                         | ** ** | **For  the Six Months**   | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                         | ** ** | **Ended  April 30,** | ** ** |
| ** **                                                                         | ** ** | **2010**                  | ** ** | **2009** | ** ** |
| Cash flows from  operating activities:                                             |       |                      |       |   |   |
| Net income                                                                         |       | $                         | 845,143    |   | $ | 185,556 |   |
|                                                                               |       |                      |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                      |       |   |   |
| Depreciation                                                                       |       | 598,184                   |       | 454,306 |   |
| Amortization                                                                       |       | 374,085                   |       | 657,260 |   |
| Stock-based  compensation                                                          |       | 134,729                   |       | 144,598 |   |
| Loss on sale of assets                                                             |       | —                    |       | 3,764 |   |
| Provision for  returns & doubtful accounts receivable                     |       | 30,000                    |       | 380,000 |   |
| Provision for excess  and obsolete inventory                                       |       | 51,000                    |       | 51,000 |   |
| Deferred taxes                                                                     |       | 546,000                   |       | 9,952 |   |
| Change in assets and  liabilities:                                                 |       |                      |       |   |   |
| Increase in net  investment in sales-type leases & other receivables      |       | (534,990                  | )          | (851,209 | ) |
| Decrease in trade  accounts receivable                                             |       | 3,327,243                 |       | 5,397,361 |   |
| Decrease in inventories                                                            |       | 425,790                   |       | 323,383 |   |
| Increase in prepaid  expenses and other assets                                     |       | (165,994                  | )          | (153,289 | ) |
| (Increase) decrease in  prepaid taxes                                              |       | (46,270                   | )          | 40,819 |   |
| Decrease in accounts  payable                                                      |       | (1,219,745                | )          | (1,796,759 | ) |
| Decrease in unearned  revenue                                                      |       | (1,177,062                | )          | (334,108 | ) |
| Decrease in accrued  liabilities                                                   |       | (317,461                  | )          | (815,269 | ) |
| Total adjustments                                                                  |       | 2,025,509                 |       | 3,511,809 |   |
|                                                                               |       |                      |       |   |   |
| Net cash provided by  operating activities                                         |       | 2,870,652                 |       | 3,697,365 |   |
|                                                                               |       |                      |       |   |   |
| Cash flows from  investing activities:                                             |       |                      |       |   |   |
| Additions to property,  plant & equipment                                 |       | (741,587                  | )          | (328,675 | ) |
| Proceeds from sale of  assets                                                      |       | —                    |       | 5,064 |   |
| Acquisitions, net of  cash acquired                                                |       | —                    |       | (701,957 | ) |
| Investment in  capitalized service contracts                                       |       | —                    |       | (750,000 | ) |
| Net cash used in  investing activities                                             |       | (741,587                  | )          | (1,775,568 | ) |
|                                                                               |       |                      |       |   |   |
| Cash flows from  financing activities:                                             |       |                      |       |   |   |
| Principal payments on  debt                                                        |       | (1,183,475                | )          | (85,545 | ) |
| Net payments on  revolving line of credit                                          |       | —                    |       | (1,764,861 | ) |
| Payments on capital  lease obligations                                             |       | (76,291                   | )          | (73,396 | ) |
| Payments to acquire  treasury stock                                                |       | —                    |       | (55,951 | ) |
| Net cash used in  financing activities                                             |       | (1,259,766                | )          | (1,979,753 | ) |
|                                                                               |       |                      |       |   |   |
| Net increase (decrease)  in cash and cash equivalents                              |       | 869,299                   |       | (57,956 | ) |
|                                                                               |       |                      |       |   |   |
| Cash and cash  equivalents, beginning of period                                    |       | 4,731,926                 |       | 63,639 |   |
| Cash and cash  equivalents, end of period                                          |       | $                         | 5,601,225  |   | $ | 5,683 |   |
|                                                                               |       |                      |       |   |   |
| Supplemental disclosure  of cash flow information:                                 |       |                      |       |   |   |
| Cash paid during the  period for interest                                          |       | $                         | 18,336     |   | $ | 65,595 |   |
| Cash paid during the  period for income taxes                                      |       | $                         | 46,270     |   | $ | 79,491 |   |

 

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

 

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**XETATECHNOLOGIES, INC. AND SUBSIDIARY**

**Notes to Consolidated Financial Statements**

**April 30, 2010**

(Unaudited)

 

1.  BASIS OF PRESENTATION:

 

XETA Technologies, Inc.(“XETA”, the “Company”, “we”, “us”, or “our”), an Oklahoma corporation formedin 1981, is a leading integrator of advanced communications technologies withnationwide sales and service.  XETA provides sales, design, projectmanagement, implementation, and maintenance services in support of the productsit represents.  The Company sells and/orsupports products produced by several manufacturers including Avaya, Inc.(“Avaya”), Mitel Corporation (“Mitel”), and Samsung Business CommunicationsSystems (“Samsung”).  In addition, theCompany manufactures and markets a line of proprietary call accounting systemsto the hospitality industry.

 

The Company prepared theaccompanying unaudited consolidated financial statements 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. TheCompany believes that the disclosures are reasonably adequate to ensure theinformation is not misleading. Management suggests that these condensed financial statements be read inconjunction with the consolidated financial statements and the notes theretomade a part of the Company’s Annual Report on Form 10-K.  The Company filed the 10-K as Commission FileNo. 0-16231, with the Commission on January 8, 2010.  Management believes that the financialstatements contain the necessary adjustments for a fair statement of theresults for the interim periods presented. All adjustments were of a normal recurring nature.  The results of operations for the interimperiod are not necessarily indicative of the results for the entire fiscalyear.

 

Fair Value of Financial Instruments

 

Thefollowing methods and assumptions were used to estimate the fair value of eachclass of financial instruments for which it is practicable to estimate thevalue:

 

The carrying value ofcash and cash equivalents, customer deposits, trade accounts receivable,sales-type leases, accounts payable and short-term debt approximate theirrespective fair values due to their short maturities.

 

Based upon the borrowingrates currently available to the Company for bank loans with similar terms andaverage maturities, the fair value of the long-term debt approximates thecarrying value.

 

Segment Information

 

The Company has threereportable segments: services, commercial system sales, and hospitality systemsales.  Services revenues representrevenues earned from installing and maintaining systems for customers in boththe commercial and hospitality segments. The Company defines commercial system sales as sales to the non-hospitalityindustry.

 

The reporting segmentsfollow the same accounting policies used for the Company’s consolidatedfinancial statements and are described in the Summary of Significant AccountingPolicies in the Company’s Form 10-K described above.  Company management evaluates a segment’sperformance based on gross margins. Assets are not allocated to the segments.  Sales outside of the U.S. are immaterial.

 

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The following is atabulation of business segment information for the three months ended April 30,2010 and 2009:

 
| ** **     | ** ** | **Services  Revenues** | ** ** | **Commercial  Systems  Sales** | ** ** | **Hospitality  Systems  Sales** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|----------------|------------|------------------------|------------|--------------------------------|------------|---------------------------------|------------|--------------------|------------|-------------|------------|
| **2010**       |       |                   |       |                           |       |                            |       |               |       |        |       |
| Sales          |       | $                      | 11,377,908 |                           | $          | 4,727,332                       |       | $                  | 1,015,305  |        | $          | 77,452 |   | $ | 17,197,997 |   |
| Cost  of sales |       | (7,782,674             | )          | (3,456,380                     | )          | (716,623                        | )          | (455,920           | )          | (12,411,597 | )          |
| Gross  profit  |       | $                      | 3,595,234  |                           | $          | 1,270,952                       |       | $                  | 298,682    |        | $          | (378,468 | ) | $ | 4,786,400 |   |
|           |       |                   |       |                           |       |                            |       |               |       |        |       |
| **2009**       |       |                   |       |                           |       |                            |       |               |       |        |       |
| Sales          |       | $                      | 9,841,649  |                           | $          | 5,279,778                       |       | $                  | 2,509,360  |        | $          | 125,816 |   | $ | 17,756,603 |   |
| Cost  of sales |       | (6,768,814             | )          | (3,961,332                     | )          | (1,848,191                      | )          | (435,275           | )          | (13,013,612 | )          |
| Gross  profit  |       | $                      | 3,072,835  |                           | $          | 1,318,446                       |       | $                  | 661,169    |        | $          | (309,459 | ) | $ | 4,742,991 |   |

 

The following is atabulation of business segment information for the six months ended April 30,2010 and 2009:

 
| ** **     | ** ** | **Services  Revenues** | ** ** | **Commercial  Systems  Sales** | ** ** | **Hospitality  Systems  Sales** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|----------------|------------|------------------------|------------|--------------------------------|------------|---------------------------------|------------|--------------------|------------|-------------|------------|
| **2010**       |       |                   |       |                           |       |                            |       |               |       |        |       |
| Sales          |       | $                      | 23,494,765 |                           | $          | 14,765,913                      |       | $                  | 1,843,782  |        | $          | 137,680 |   | $ | 40,242,140 |   |
| Cost  of sales |       | (16,013,754            | )          | (10,997,365                    | )          | (1,252,225                      | )          | (853,555           | )          | (29,116,899 | )          |
| Gross  profit  |       | $                      | 7,481,011  |                           | $          | 3,768,548                       |       | $                  | 591,557    |        | $          | (715,875 | ) | $ | 11,125,241 |   |
|           |       |                   |       |                           |       |                            |       |               |       |        |       |
| **2009**       |       |                   |       |                           |       |                            |       |               |       |        |       |
| Sales          |       | $                      | 19,834,882 |                           | $          | 11,576,483                      |       | $                  | 4,798,408  |        | $          | 126,855 |   | $ | 36,336,628 |   |
| Cost  of sales |       | (13,752,553            | )          | (8,763,099                     | )          | (3,388,789                      | )          | (883,045           | )          | (26,787,486 | )          |
| Gross  profit  |       | $                      | 6,082,329  |                           | $          | 2,813,384                       |       | $                  | 1,409,619  |        | $          | (756,190 | ) | $ | 9,549,142 |   |

 

Stock-Based CompensationPlans

 

The Company applies theprovisions of ASC 718, “Compensation — Stock Compensation”, which requirescompanies to measure all employee stock-based compensation awards using a fairvalue method and recognize compensation cost in its financial statements. The Company recognizes the fair value of stock-based compensation awards asselling, general and administrative expense in the consolidated statements ofoperations on a straight-line basis over the vesting period.  Compensationexpense was recognized in the statements of operations as follows:

 
| ** **                         | ** ** | **2010** | ** ** | **2009** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Three  months ended April 30, |       | $        | 60,669     |     | $          | 74,233 |   |
|                               |       |     |       |     |       |
| Six  months ended April 30,   |       | $        | 134,729    |     | $          | 144,598 |   |

 

Use of Estimates

 

The preparation of thefinancial statements conforms to the accounting principles generally acceptedin the U.S., and requires management to make estimates and assumptionsaffecting the reported amounts of assets and liabilities: 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 may differ from theseestimates.

 

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New AccountingPronouncements

 

In February 2010 theFinancial Accounting Standards Board (“FASB”) issued Accounting StandardsUpdate (“ASU”) 2010-09, “Subsequent Events: Amendments to Certain Recognitionand Disclosure Requirments”.  The guidance in ASU 2010-09 removesthe requirement for SEC filers to disclose the date through which subsequentevents have been evaluated.  Theadoption of this update did not have a material impact on the Company’sfinancial position or results of operations.

 

In November 2009 theCompany adopted Accounting Standards Codification (“ASC”) 810, “Consolidation”. ASC 810 changes the accounting and reporting for minority interests, which arenow recharacterized as non-controlling interests and classified as a componentof equity.   The Company does not have any minority interests;therefore the adoption of this statement did not have an impact on the Company’sconsolidated financial statements.

 

In November 2009 theCompany adopted ASC 805, “Business Combinations”.  Under ASC 805, an entity is required torecognize the assets acquired, liabilities assumed, contractual contingencies,and contingent consideration at their fair value on the acquisition date.  It further requires that acquisition-relatedcosts are recognized separately from the acquisition and expensed as incurred,restructuring costs generally expensed in periods subsequent to the acquisitiondate, and changes in accounting for deferred tax asset valuation allowances andacquired income tax uncertainties after the measurement period impact incometax expense.  The Company will apply theguidance prospectively to business combinations.

 

In November 2009 theCompany adopted ASC 350 “Intangibles —Goodwill and Other”.  The guidanceamends the factors that should be considered in developing renewal or extensionassumptions used to determine the useful life of intangible assets.  Theintent of the guidance is to improve the consistency between the useful life ofa recognized intangible asset under the accounting standards and the period ofthe expected cash flows used to measure the fair value of the asset.  TheCompany will apply the guidance prospectively to intangible assets acquiredafter adoption.

 

In October 2009 theFASB issued ASU 2009-13, “Revenue Recognition - Multiple-Deliverable Revenue Arrangements”.  The guidance in ASU 2009-13 amends thecriteria for separating consideration in multiple-deliverablearrangements and expands required disclosures related to a company’smultiple-deliverable revenue arrangements. ASU 2009-13 is effective prospectively for fiscal years beginning on orafter June 15, 2010.  The Company iscurrently assessing the impact that adoption will have on its financialposition or results of operations.

 

Other accountingstandards that have been issued or proposed that do not require adoption untila future date are not expected to have a material impact on our consolidatedfinancial statements upon adoption.

 

2.  ACCOUNTS RECEIVABLE:

 

Trade accounts receivableconsist of the following:

 
| ** **                           | ** ** | **April 30,  2010** | ** ** | **(Audited)  October 31,  2009** | ** ** |
|--------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
|                                 |       |                     |       |                                  |       |
| Trade  accounts receivables          |       | $                        | 10,931,766 |                                  | $          | 14,393,681 |   |
| Less-  reserve for doubtful accounts |       | (456,557                 | )          | (561,229                              | )          |
| Net  trade accounts receivables      |       | $                        | 10,475,209 |                                  | $          | 13,832,452 |   |

 

On January 14, 2009,Nortel Networks Corporation filed for bankruptcy protection in the UnitedStates Bankruptcy Court for the District of Delaware.  Subsequent to the filing the administratorsof the bankruptcy adopted a business disposal strategy.  Under thestrategy, the administrators segmented Nortel into three primary businessunits: Virtual Service Switches, CDMA businesses and Enterprise Solutions. Weconducted all of our Nortel business through the Enterprise Solutions unit.

 

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On December 18,2009, Avaya completed the purchase of Nortel’s Enterprise Solutions businessunit.  Nortel owes XETA approximately$700,000 in pre-petition accounts receivable. On July 17, 2009 the bankruptcy court granted our request foroffset of $116,000 in charges we owed Nortel at the time of the filing.  In fiscal year 2009, we recorded $350,000 asa reserve against possible Nortel bad debts. Nortel has until July 13, 2010 to file its reorganization plan;however, this date is subject to further extension.  Until the administrators file Nortel’sreorganization plan our ability to assess the probability of recoveringpre-petition amounts due is limited.

 

The Company is carefullyfollowing developments associated with the bankruptcy case and will assert itslegal rights and defenses as appropriate.

 

3.  INVENTORIES:

 

Inventoriesare stated at the lower of average cost or market and consist of the following:

 
| ** **                                         | ** ** | **April 30,  2010** | ** ** | **(Audited)  October 31,  2009** | ** ** |
|----------------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
|                                               |       |                     |       |                                  |       |
| Finished  goods and spare parts                    |       | $                        | 5,552,419  |                                  | $          | 5,977,703 |   |
| Less-  reserve for excess and obsolete inventories |       | (993,011                 | )          | (941,505                              | )          |
| Total  inventories, net                            |       | $                        | 4,559,408  |                                  | $          | 5,036,198 |   |

 

4.  PROPERTY, PLANT AND EQUIPMENT:

 

Property, plant andequipment consist of the following:

 
| ** **                                                    | ** ** | **Estimated  Useful  Lives** | ** ** | **April 30,  2010** | ** ** | **(Audited)  October 31,  2009** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
|                                                          |       |                         |       |                     |       |                                  |       |
| Building  and building improvements                           |       | 3-20                         |       | $                        | 3,340,945  |                                  | $          | 3,253,693 |   |
| Data  processing and computer field equipment                 |       | 2-7                          |       | 3,680,252                |       | 3,248,126                             |       |
| Software  development costs, work-in-process                  |       | N/A                          |       | 208,194                  |       | 197,097                               |       |
| Software  development costs of components placed into service |       | 3-10                         |       | 2,708,930                |       | 2,697,806                             |       |
| Hardware                                                      |       | 3-5                          |       | 643,635                  |       | 643,635                               |       |
| Land                                                          |       | ––                 |       | 611,582                  |       | 611,582                               |       |
| Office  furniture                                             |       | 5-7                          |       | 807,985                  |       | 779,588                               |       |
| Auto                                                          |       | 5                            |       | 540,575                  |       | 537,300                               |       |
| Other                                                         |       | 3-7                          |       | 145,779                  |       | 149,484                               |       |
|                                                          |       |                         |       |                     |       |                                  |       |
| Total  property, plant and equipment                          |       |                         |       | 12,687,877               |       | 12,118,311                            |       |
| Less-  accumulated depreciation and amortization              |       |                         |       | (5,979,513               | )          | (5,292,395                            | )          |
|                                                          |       |                         |       |                     |       |                                  |       |
| Total  property, plant and equipment, net                     |       |                         |       | $                        | 6,708,364  |                                  | $          | 6,825,916 |   |

 

5.  INCOME TAXES:

 

Thetax provision reflects the effective Federal tax rate plus the composite stateincome tax rates adjusted for states that require minimum tax payments even iftax losses are incurred.  Generally, weexpect our tax provision rate to be approximately 40%.

 

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6.  CREDIT AGREEMENTS:

 

In November 2009,the Company entered into a one-year loan agreement with a new financialinstitution. This agreement replaced our previous credit facility, which wasscheduled to mature on November 30, 2009. The loan agreement consists of an $8.5 million revolving credit facilitycollateralized by trade accounts receivable, inventories, and real estate.

 

At April 30, 2010,the Company did not have an outstanding balance on the revolving line ofcredit.  The Company had approximately$8.5 million available under the revolving line of credit at April 30,2010.  The advance rates are defined inthe agreement, but are generally at the rate of 75% on qualified trade accountsreceivable and 50% of qualified inventories and real estate, subject to amaximum of $2.0 million each.  Long termdebt consisted of the following:

 
| ** **                                                                                                                                            | ** ** | **April 30,  2010** | ** ** | **(Audited)  October 31,  2009** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
|                                                                                                                                                  |       |                     |       |                                  |       |
| Term  note, payable with a fixed payment of $1,183,475 due November 30, 2009,  collateralized by a first mortgage on the Company’s building |       | $                        | —     |                                  | $          | 1,183,475 |   |
|                                                                                                                                                  |       |                     |       |                                  |       |
| Less-current  maturities                                                                                                                              |       | —                   |       | 1,183,475                             |       |
|                                                                                                                                                  |       |                     |       |                                  |       |
| Total  long-term debt, less current maturities                                                                                                        |       | $                        | —     |                                  | $          | — |   |

 

Interest on alloutstanding debt under the credit facility accrues at the greater of either theLondon Interbank Offered Rate (“LIBOR”) (0.28% at April 30, 2010) plus3.0% or 4.5%.  The credit facilitycontains several financial covenants common in such agreements includingtangible net worth requirements, limitations on the amount of funded debt toannual earnings before interest, taxes, depreciation and amortization,limitations on cash dividends, and debt service coverage requirements.  At April 30, 2010 the Company was incompliance with the covenants of the credit facility.

 

7.  EARNINGS PER SHARE:

 

The Company computesbasic earnings per common share by dividing net income by the weighted averagenumber of shares of common stock outstanding during the reporting periods.  Dividing net income by the weighted averagenumber of shares of common stock and dilutive potential common stockoutstanding during the reporting periods computes diluted earnings per commonshare.  A reconciliation of net incomeand weighted average shares used in computing basic and diluted earnings pershare is as follows:

 
| ** **                        | ** ** | **For the Three Months Ended April 30, 2010** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                            | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic  EPS                        |       |                                               |       |   |   |   |   |
| Net  income                       |       | $                                                  | 212,355    |   | 10,230,851 |   | $ | 0.02 |   |
| Dilutive  effect of stock options |       |                                               |       | 53,713 |   |   |   |
|                              |       |                                               |       |   |   |   |   |
| Diluted  EPS                      |       |                                               |       |   |   |   |   |
| Net  income                       |       | $                                                  | 212,355    |   | 10,284,564 |   | $ | 0.02 |   |

 
| ** **                        | ** ** | **For the Three Months Ended April 30, 2009** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                            | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic  EPS                        |       |                                               |       |   |   |   |   |
| Net  income                       |       | $                                                  | 183,288    |   | 10,225,395 |   | $ | 0.02 |   |
| Dilutive  effect of stock options |       |                                               |       | 16 |   |   |   |
|                              |       |                                               |       |   |   |   |   |
| Diluted  EPS                      |       |                                               |       |   |   |   |   |
| Net  income                       |       | $                                                  | 183,288    |   | 10,225,411 |   | $ | 0.02 |   |

 

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| ** **                        | ** ** | **For the Six Months Ended April 30, 2010** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                          | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic  EPS                        |       |                                             |       |   |   |   |   |
| Net  income                       |       | $                                                | 845,143    |   | 10,212,244 |   | $ | 0.08 |   |
| Dilutive  effect of stock options |       |                                             |       | 40,651 |   |   |   |
|                              |       |                                             |       |   |   |   |   |
| Diluted  EPS                      |       |                                             |       |   |   |   |   |
| Net  income                       |       | $                                                | 845,143    |   | 10,252,895 |   | $ | 0.08 |   |

 
| ** **                        | ** ** | **For the Six Months Ended April 30, 2009** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|
| ** **                        | ** ** | **Income  (Numerator)**                          | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| Basic  EPS                        |       |                                             |       |   |   |   |   |
| Net  income                       |       | $                                                | 185,556    |   | 10,223,944 |   | $ | 0.02 |   |
| Dilutive  effect of stock options |       |                                             |       | 29 |   |   |   |
|                              |       |                                             |       |   |   |   |   |
| Diluted  EPS                      |       |                                             |       |   |   |   |   |
| Net  income                       |       | $                                                | 185,556    |   | 10,223,973 |   | $ | 0.02 |   |

 

Options to purchase901,699 shares of common stock at an average exercise price of $6.99 and1,398,000 shares of common stock at an average exercise price of $6.06 were notincluded in the computation of diluted earnings per share for the three monthsended April 30, 2010 and 2009, respectively, because inclusion of theseoptions would be antidilutive.  Optionsto purchase 925,042 shares of common stock at an average exercise price of$6.90 and 1,398,000 shares of common stock at an average exercise price of$6.06 were not included in the computation of diluted earnings per share forthe six months ended April 30, 2010 and 2009, respectively, becauseinclusion of these options would be antidilutive.

 

8.  CONTINGENCIES:

 

In addition to potentiallosses related to Nortel’s pre-petition receivables, the Company may be subjectto preference payment claims asserted by Nortel.  It is routine in bankruptcy proceedings forthe debtor in possession or bankruptcy trustee to assert a statutory “preferenceclaim” to seek to recover payments made by the bankrupt entity to creditorsduring the 90-day period immediately preceding the filing of the bankruptcypetition.  This period is known as the “preference period”.  Althoughthe debtor is entitled to make a claim based solely upon when the payments weremade, the payments are not recoverable if they were made in the debtor’sordinary course of dealings with the creditor.  Nortel has filed aschedule showing approximately $1.6 million in payments made to the Companyduring the preference period.  To dateNortel has not asserted a preference claim against the Company.  However,if a preference claim is brought, the Company believes it has good defenses toany such potential claim against it, including that the subject payments weremade in the ordinary course of the Company’s business dealings withNortel.  These defenses must be argued on each individual Company invoicepaid during the preference period.  The Company has not completed itsevaluation of its potential defenses against each individual invoice. As suchthe Company is unable at this time to determine the extent, if any, of anymaterial loss that might occur if a claim to recover preference paymentsis asserted.  Therefore, no provision for loss has been made beyond theamount discussed above related to unpaid invoices at the time of the bankruptcyfiling.

 

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9.  CAPITAL LEASES:

 

During 2008 the Companyleased software licenses under an agreement that is classified as a capitallease. The book value of the licenses is included in the balance sheet asproperty, plant and equipment and was $177,536 at April 30, 2010.  Accumulated amortization of the leasedlicenses at April 30, 2010 was $278,984. Amortization under the capital lease is included in depreciationexpense.  The future minimum leasepayments required under the capital lease and the present value of the net minimumlease payments as of April 30, 2010, are as follows:

 
| ** **                                           | ** ** | **Capital  Lease Payments** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|
|                                                 |       |                             |       |
| 2010                                                 |       | $                                | 161,435    |   |
| 2011                                                 |       | 26,906                           |       |
| Total  minimum lease payments                        |       | 188,341                          |       |
| Less-  imputed interest                              |       | 4,484                            |       |
| Present  value of minimum payments                   |       | 183,857                          |       |
| Less-current  maturities of capital lease obligation |       | 157,081                          |       |
| Long-term  capital lease obligation                  |       | $                                | 26,776     |   |

 

10.  SUBSEQUENT EVENTS:

 

In connection with thepreparation of the Consolidated Financial Statements for the six months ended April 30,2010, the Company has evaluated subsequent events for potential recognition anddisclosures through the date of financial statement issuance.

 

On May 24,2010, the Company completed the purchase of the operating assets of HotelTechnologies Solutions, Inc., dba Lorica Solutions (“Lorica”), aprivately-held company headquartered in Buffalo, New York.  Lorica is an emerging leader in the deliveryof high-speed internet access and network administration to the hospitalityindustry.  The purchase price included $833,000paid in cash at closing; 397,878 shares of XETA common stock valued at $1.5million based on the May 21, 2010 closing price of $3.77; five yearwarrants to purchase 150,000 shares of XETA common stock at $3.77; and $167,000cash deposited into an escrow account as required under the purchaseagreement.  The Company used existingcash to fund the cash portion of the purchase price.  The acquisition is not material to theCompany’s financial position or results of operations.

 

On April 2,2010, the Company entered into a non-binding Letter of Intent to purchase thestock of Pyramid Communications Services, Inc., (“Pyramid”) a Dallas,Texas based privately held company providing communications equipment and relatedservices.  Pyramid’s 2009 revenuesexceeded $10.0 million.  The Company iscurrently conducting due diligence on Pyramid’s financial condition andoperations.  The Company expects to closethis purchase during its third fiscal quarter.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**Preliminary Note RegardingForward-Looking Statements**

 

This report containsforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995, relating to future events and our futureperformance and results.  Many of these statements appear in thediscussions under the headings “Risk Factors,” and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”  All statements other than those that arepurely historical may be forward-looking statements.  Forward-lookingstatements can generally be identified by words such as “expects,” “anticipates,”“may,” “likely,” “plans,” “believes,” “intends,” “projects,” “estimates,” andsimilar words or expressions. Forward-looking statements are not guarantees ofperformance, but rather reflect management’s current expectations, estimates,and forecasts about the industry and markets in which we operate, and ourassumptions and beliefs based upon information currently available tomanagement.  Investors are cautioned that all forward-looking statementsare subject to certain risks and uncertainties which are difficult to predictor which we are unable to control, and that could cause actual results todiffer materially from those projected, including but not limited to suchfactors as the condition of the U.S. economy and its impact on capital spendingtrends in the Company’s markets, the risk that various closing conditions foracquisitions that we have announced this past quarter may not be satisfied orwaived; and the integration of the acquired businesses into that of the Companyand realization of anticipated synergies and growth opportunities from thetransaction may not occur; the financial condition of our suppliers and changesby them in their distribution strategies and support, the Nortel Networksbankruptcy filing and the impact that such action will continue to have on theCompany’s Nortel products and services offering; unpredictable quarter toquarter revenues, changes in Avaya’s strategies regarding the provision ofequipment and services to its customers, and in its policies regarding theavailability of tier IV hardware and software support; inconsistent grossprofit margins, the Company’s ability to maintain and improve upon currentgross profit margins; continuing acceptance and success of the Mitel productand services offering, availability of credit to finance growth, intensecompetition and industry consolidation, dependence upon a few large wholesalecustomers in the Company’s Managed Services offering, the availability andretention of revenue professionals and certified technicians.  These andother risks and uncertainties are discussed under the heading “Risk Factors”under Part I of the Company’s Form 10-K for the fiscal year ended October 31,2009 (filed with the Commission on January 8, 2010) and in updates to suchrisk factors set forth in Item 1A of Part II of this quarterlyreport.  As a result of these risks anduncertainties, actual results may differ materially and adversely from thoseexpressed in forward-looking statements.  Consequently, investors arecautioned to read and consider all forward-looking statements in conjunctionwith such risk factors and uncertainties.  The Private SecuritiesLitigation Reform Act of 1995 provides a safe-harbor for forward-lookingstatements made by the Company.

 

# **Overview**

# ** **

Strategy.

In advance of fiscal2010, senior management conducted its periodic review of the strategicdirection of the Company.  This reviewresulted in a threefold refinement of the strategic focus and direction of theorganization.  First, we will continue toemphasize aggressive growth in our managed services business.  Second, we will use our unique position tosearch out and pursue organic and acquisitive growth opportunities resultingfrom Avaya’s acquisition of Nortel’s enterprise business.  Finally we will advance a longer-termbusiness initiative focused on the sales, design, integration and maintenanceand repair of collaborative technologies and advanced applications.

 

Management believes theserefinements of our longstanding strategies are necessary to fully realize thebenefits of our investments in high value talent and competencies, tocapitalize on the market realignment resulting from Avaya’s acquisition ofNortel and to ready ourselves in anticipation of growth in demand for advancedapplications and collaborative technologies.

 

At the end of the firstfiscal quarter of 2010 it appeared our market was in the early stages ofrecovery from the economic downturn that affected our business throughoutfiscal 2009.  Presently market indicators,

 

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while tepid, point tomarket growth in the second half of 2010. However, as evidenced by our results in the second fiscal quarter of2010 market conditions remain challenging. We are optimistic that the Company is positioned to capitalize onopportunities resulting from an improving economy.

 

In April 2010 theCompany signed a letter of intent to purchase Pyramid Communicastions Services, Inc.(“Pyramid”), a privately held company headquartered in Dallas, Texas.  Pyramid provides communications equipment andrelated services.  The transaction istargeted to close during the Company’s third fiscal quarter subject to theexecution of a definitive purchase agreement, satisfactory completion of duediligence, and other customary closing conditions.

 

OnMay 24, 2010, the Company completed the purchase of the operating assetsof Hotel Technologies Solutions, Inc., dba Lorica Solutions (“Lorica”), aprivately-held company headquartered in Buffalo, New York.  Lorica is an emerging leader in the deliveryof high-speed internet access and network administration to the hospitalityindustry.  The terms of the purchaseagreement are described in Note 10 of the Notes to Consolidated FinancialStatements.

 

OperatingSummary.

Inthe second quarter of fiscal 2010, we recorded net income of $212,000 on revenues of $17.2 million compared to netincome of $183,000 on revenues of $17.8 million in the second quarter of lastyear.  For the first six months of fiscal2010, we earned $845,000 in net income on revenues of $40.2 million compared tonet income of $186,000 on revenues of $36.3 million for the first six months oflast year.  These results primarilyreflect an increase in gross profits partially offset by increased operationgcosts.  We discuss this and othercontributing factors in more detail under “Results of Operations” below.

 

FinancialPosition Summary.

SinceOctober 31, 2009, we have generated positive cash flows from operations of$2.9 million and we primarily used these cash flows to reduce borrowings andmake capital expenditures to support our operations.  We have improved our working capitalapproximately 16%.  We discuss these andother financial items in more detail under “Financial Condition” below.

 

Thefollowing discussion presents additional information regarding our financialcondition and results of operations for the three- and six-month periods ended April 30,2010 and 2009 and should be considered in conjunction with our above commentsas well as the “Risk Factors” section below.

 

# **Financial Condition**

# ** **

Duringthe first two fiscal quarters of 2010 our working capital increased by 16% to$13.4 million.  We generated $2.9 millionin cash flows from operations.  Thesecash flows included earnings and non-cash charges of $2.0 million; a decreasein accounts receivable of $3.3 million; a decrease in inventory of $426,000;and a decrease in deferred taxes of $546,000. These positive cash flow items were partially offset by a decrease inaccounts payable of $1.2 million; a decrease in unearned revenue of $1.1million; a decrease in accrued liabilities of $317,000; and other changes inworking capital items.  These itemsnetted a decrease in cash of $747,000. Non-cash charges included amortization of $374,000; depreciation of$598,000; provisions for doubtful accounts receivable and obsolete inventoriesof $81,000; and stock-based compensation of $135,000.

 

Weused these positive cash flows to pay off term debt of $1.2 million; acquirecapital assets of $742,000; and fund other financing and investing activitiesof $76,000.  The acquisition of capitalassets was part of normal replacement of Information Technology infrastructureand headquarters facility improvements.

 

AtApril 30, 2010, our cash balance was $5.6 million and there was nooutstanding balance on our working capital revolver.  In accordance with the collateral basedefined in the credit facility, $8.5 million was available for borrowing on the$8.5 million facility at the end of the quarter.  The working capital revolver is scheduled tomature on November 5, 2010.  Weexpect to renew this instrument for a 12-month period prior to the expiration.  It is possible that the renewal could resultin higher borrowing costs and/or reduced availability for unsecured borrowings.

 

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Weexpect to utilize a variety of common financing tools to fundacquisitions.  We believe our cashbalances, expected free cash flows from operations, and available borrowingcapacity will be our primary sources of capital.  However, we also expect to employ sellerfinancing in the form of subordinated notes, earn-out agreements, indemnityhold-backs, and occasionally restricted stock and/or warrants.  The level to which we employ these variousmethods, particularly the use of our equity, will depend upon a multitude offactors which are unique to each negotiation. In addition to the available capacity under our working capital line ofcredit, we believe we have access to a variety of capital sources such asprivate placements of subordinated debt, and public or private sales of equityto finance investments beyond our current needs.

 

# **Results of Operations**

# ** **

Inthe second quarter of fiscal 2010 revenues were $17.2 million compared to $17.8million in the second quarter 2009.  Ournet income in the second quarter of fiscal 2010 was $212,000, compared to netincome of $183,000 in the same quarter a year ago.  These results primarly reflect increasedservices revenues offset by lower equipment revenues and higher operatingcosts.  In the first six months of theyear, revenues were $40.2 million compared to $36.3 million for the first sixmonths of fiscal 2009.  Our net incomefor the first six months of fiscal 2010 was $845,000 compared to net income of$186,000 in the first six months of fiscal 2009.  The year-to-date results primarily reflectour strong first quarter results in all of our major revenue and gross profitcategories.  The narrative below providesfurther explanation of these results.

 

SystemsSales.

In the second quarter offiscal 2010 systems sales decreased approximately $2.0 million or 26% comparedto the same period last year.  Thisdecrease includes a $552,000 or 11% decrease in sales of systems to commercialcustomers and a $1.5 million or 60% decrease in sales of systems to hospitalitycustomers.  Year-to-date systems salesincreased $235,000 or 1% compared to last year. This increase includes a increase in sales of systems to commercialcustomers of $3.2 million or 28% which was offset by a decrease in sales ofsystems to hospitality customers of $3.0 million or 62%.  The second quarter decrease in systems salesreflects the general unpredictable nature of this segment of our business.  We expect uneven growth of the U.S. economyin the second half of fiscal year 2010.  Giventhe increased visibility in our systems sales business expectancies, we arecautiously optimistic about the balance of the year; however, the marketcontinues to present many complex challenges. Furthermore, as evidenced by the decline in revenues in our hospitalitysystems sales, some sectors of the economy remain mired in difficult economiccircumstances.  Based on our experience,we believe the hospitality industry as a whole is experiencing cyclicalweakness in demand.  In response thismarket segment has limited its spending on new communications equipment andsolutions.

 

ServicesRevenues.

Servicesrevenues consist of the following:

 
| ** **                     | ** ** | **For the Three Months Ended  April 30,** | ** ** | **For the Six Months Ended  April 30,** | ** ** |
|--------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                     | ** ** | **2010**                                       | ** ** | **2009**                                     | ** ** | **2010** | ** ** | **2009** | ** ** |
| Maintenance &  repair |       | $                                              | 8,233,000  |                                         | $          | 7,050,000 |   | $ | 15,731,000 |   | $ | 14,026,000 |   |
| Implementation                 |       | 2,527,000                                      |       | 2,272,000                                    |       | 6,289,000 |   | 4,457,000 |   |
| Cabling                        |       | 618,000                                        |       | 520,000                                      |       | 1,475,000 |   | 1,352,000 |   |
| Total  Services revenues       |       | $                                              | 11,378,000 |                                         | $          | 9,842,000 |   | $ | 23,495,000 |   | $ | 19,835,000 |   |

 

Maintenanceand repair revenues increased 17% and 12%, respectively in the second quarterand year-to-date periods.  Thisyear-to-date performance reflects the continued success of our wholesaleservices programs and repair revenues. We continue to aggressively market our national service footprint andmulti-product line technical capabilities to existing and potential wholesaleservice partners such as network service providers, and large voice and dataintegrators.  We also continue to marketour service capabilities to end-users. We expect growth in these programs to positively impact our maintenanceand repair revenues for the foreseeable future.

 

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Implementationrevenues increased 11% in the second fiscal quarter reflecting an increase inrevenues from our Professional Services Organization (“PSO”) and a decrease inour installation revnues driven by lower equipment revenues.  For the year-to-date period, Implementationrevenues increased 41% reflecting an increase in revenues from PSO and strongfirst quarter installation revenues.  Weattribute this to increasing demand for more complex communications systemsrequiring significant fee-generating design and engineering services.  In the near term, Implementation revenueswill continue to be closely aligned with the sale of new systems.  From a long term perspective, however, ascustomers displace conventional communications platforms and adopt more complexsystems, we anticipate growth in this area of our business through thefee-based utilization of these highly skilled technical resources.

 

Cablingrevenues increased 19% and 9%, respectively in the second fiscal quarter andyear-to-date periods.  These increasesare primarily from a new wholesale service program added late in fiscal 2009.

 

GrossMargins.

Thetable below presents the gross margins earned on our primary revenue streams:

 
| ** **                    | ** ** | **For the Three  Months Ended  April 30,** | ** ** | **For the Six  Months Ended  April 30,** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **Gross Margins**        | ** ** | **2010**                                        | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Services  revenues            |       | 31.6                                            | %          | 31.2                                          | %          | 31.8 | % | 30.7 | % |
| Systems  sales                |       | 27.3                                            | %          | 25.4                                          | %          | 26.3 | % | 25.8 | % |
| Other  revenues               |       | -7.6                                            | %          | 40.2                                          | %          | 4.2 | % | -24.5 | % |
| Corporate  cost of goods sold |       | -2.2                                            | %          | -2.0                                          | %          | -1.8 | % | -2.0 | % |
| Total                         |       | 27.8                                            | %          | 26.7                                          | %          | 27.6 | % | 26.3 | % |

 

Grossmargins earned on Services revenues primarily reflect an increase in recurringservice revenues combined with improved cost controls, the use of third partyQuality Service Partners, and improved utilization of our professional servicespersonnel for consulting and fee-based engagements.  These items contributed to gross Servicesmargins in our target range of 30-35%.

 

Grossmargins on systems sales in the second quarter and the year-to-date periods areslightly above our target of 23% to 25% for systems revenues.  This success is due to continued focus on coststhroughout the supply chain, disciplined pricing practices and pricing supportreceived from our manufacturers in the form of project-specific discounts andincentive rebates which are recorded as reductions to cost of goods sold.  These discounts and incentives are materialto our gross margins.

 

Thefinal component of our gross margins is the margins earned on other revenues andour corporate cost of goods sold.  Weearn the majority of other revenues from the sale of Avaya maintenancecontracts on which we earn either a commission or gross profit.  We have no continuing service obligationassociated with these revenues and gross profits.  This is an unpredictable revenue stream thatdepends on the expiration dates of existing contracts, installation dates ofnew systems, customer type as defined by Avaya, and number of years thatcustomers contract for services.  Otherrevenues may also include sales and cost of goods sold on equipment or servicessold outside our normal provisioning processes. These revenues vary in both sales volume and gross margins earned.  Corporate cost of goods sold represents ourmaterial logistics and purchasing functions that support all of our revenuesegments.

 

OperatingExpenses.

Ourtotal operating expenses increased $33,000 in the second quarter of fiscal 2010compared to the second quarter of fiscal 2009. Operating expenses were 25.9% of revenues in the second quarter comparedto 24.9% in the second quarter last year. Operating expenses increased $567,000 or 6% for the first half of fiscal2010 compared to the same period a year ago. Operating expenses were 24.3% of revenues in the first half of fiscal2010 compared to 25.3% last year.  Thelevel of operating expenses as a percentage of revenues are above ourtargets.  We consider it tacticallyappropriate, given our strong cash flows, to support operating expenses aboveour targets in the near term to capitalize on opportunities to expand ourrevenues and increase our net profit margins. Therefore we have increased our expenditures to support our keystrategies to grow our managed services business and to execute on ouracquisition strategy.  Also, we haveincreased investments in our Information Technology group to increaseefficiencies and improve customer satisfaction.

 

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InterestExpense and Other Income.

Netinterest and other income was $13,000 in the second quarter of fiscal 2010compared to $25,000 in net other expense in the second quarter of fiscal2009.  Net interest and other income was$28,000 for the six-month period ended April 30, 2010 compared to $43,000in net other expense in the same period last year.  This reflects both reduced debt levels andlower interest rates.

 

TaxProvision.

Thetax provision reflects the effective Federal tax rate plus the composite stateincome tax rates adjusted for states that require minimum tax payments even iftax losses are incurred.  Generally, weexpect our tax provision rate to be approximately 40%.

 

**ITEM 4T.   CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controls and Procedures.* Basedon an evaluation conducted as of April 30, 2010 by our management,including our 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 during the last fiscal quarter that have materially affected, orare reasonably likely to materially affect, these controls over financialreporting.

 

**PART II.  OTHERINFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS.**

 

On May 26,2010 the Company and Pangaia Partners agreed to a confidential settlement andmutual release agreement in the lawsuit originally filed by Pangaia against twoof its former employees who are currently employed by the Company.  Thesuit, which was filed in Bergen County Superior Court of New Jersey LawDivision, sought to enforce non-competition agreements between Pangaia and itsformer employees, and involved claims of unfair competition, tortuousinterference with prospective economic advantage, tortuous interference withcontract, misappropriation of trade secrets, conversion and unjustenrichment.  The Company was named as an additional defendant in thislawsuit on November 10, 2009.  The settlement of this matter is notmaterial to the Company’s financial condition or results of operations.

 

**ITEM 1A. RISK FACTORS.**

 

Theinformation presented below is an update to the “Risk Factors” included in theCompany’s Annual Report on Form 10-K for the fiscal year ended October 31,2009 and should be read in conjunction therewith.  Except as set forth below, the Risk Factorsincluded in the Company’s Form 10-K for its 2009 fiscal year have notmaterially changed.

 

**Theacquisition and integration of businesses by the Company may not produce thedesired financial and/or operating results.**

 

We have recently announced the acquisition of Lorica Solutions. Inaddition we are negotiating a stock purchase agreement and conducting duediligence to purchase all of the capital stock of Pyramid CommunicationServices, Inc.  These developmentsare a part of our stated strategy to take advantage of the current disruptionin our market by acquiring assets that increase our market share and establisha presence 

 

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in the advanced communications applications market segment.  Integrating new operating assets into anexisting organization is a complex business proposition.   Expected synergies and growth often do notmaterialize as planned.  We will useexisting cash balances to fund the acquisitions and their integrationcosts.  Furthermore, we will devotesignificant time and effort to improve the probablity of success for theseinvestments.  However, no assurance canbe given that these acquisitions will meet our expectations for revenues andoperating results, or that our capital could have been used more efficiently toimprove our financial condition or operating results.

 

**Nortel’s Chapter 11 Bankruptcyfiling and subsequent sale of its enterprise solution business to Avaya maynegatively impact our revenues and/or financial condition.**

 

Nortel filed a voluntarypetition for Chapter 11 bankruptcy protection on January 14, 2009.  To date Nortel has not filed its plan ofreorganization.  In the meantime theadministrators of the bankruptcy have adopted a business disposal strategy,pursuant to which they have sold the Nortel enterprise solution business (“NES”)to Avaya.  All of the foregoingdevelopments pose a variety of risks to our business, as follows:

 

·                  Uncertaintysurrounding Nortel’s bankruptcy has significantly dampened demand for equipmentin this product line.  Until Nortel files it plan of reorganization, thisuncertainty is likely to continue. Nortel has until July 13, 2010 to file its plan of reorganizationunless such date is further extended by the court.  Although Avaya’s acquisition of NES may helpto reduce the uncertainly in the market over the course of fiscal 2010, in thenear term we anticipate continued weakness in demand for Nortel equipment.

·                  Weare owed approximately $717,000 in pre-petition accounts receivable lessapproximately $116,000 in approved offsets for amounts we owed to Nortel at thetime of the filing.  If our pre-petitionclaims are not collectible either in whole or in large part, we couldexperience material, negative operating results in the near term.

·                  Nortelhas filed a statement of financial affairs under which it shows payments to theCompany against multiple invoices of approximately $1.6 million which were madeduring the 90-day statutory “preference period” under bankruptcy law. XETA’sfigure for these payments is $1.135 million.  As such, these payments are considered “preferencepayments” and are subject to a “preference claim” which can be asserted byNortel.  Bankruptcy law allows the debtorto recover these payments unless the creditor successfully establishes that thepayments were made in the ordinary course of business between the debtor andcreditor or if the payments were offset by subsequent new value given by XETAin the form of goods or services.  IfNortel elects to assert a preference claim against the Company for this amountor any portion thereof and the Company is unable to successfully defend theclaim, the Company would have to return any such amounts to Nortel.

·                  Avaya’spurchase of NES may result in a significant disruption and/or material declinein our revenues and gross profits.  NESis both one of our major suppliers and is an important customer in that NESoutsources significant volumes of service calls to us under various managedservices programs NES has with end-user customers.  Avaya and NES are large, complex companieswith global operations.  They have hadvery different marketing strategies and both have long, deep culturaltraditions.  The integration of these twocompanies will be challenging and disruptive to the market.  There can be no assurance given that thecombination of Avaya and NES will not have near-term and/or long-term material,negative impact on our operating results, financial position, market position,and overall reputation.

 

**Avaya’srecently published requirements regarding minimum level service agreements andhardware and software upgrade requirements could have a material, negativeimpact on our services gross margins.**

 

Avayahas announced new policies, effective July 1, 2010, requiring allcustomers to contract with Avaya for minimum service levels to access Tier IVsupport, and to maintain their software at no more than two trailing majorversion releases than the current version. We areevaluating the impact of these changes to our business. These impacts couldinclude a decline in our services gross margins if we are required to purchaseAvaya service contracts on behalf of our customers.  Conversly, if we chose to forego suchpurchases on behalf of our customers, we risk reduced customer satisfaction dueto the lack of access to Avaya’s Tier IV support. We might also experiencereduced sales of new Avaya systems if customers choose to abandon the productline due to increased costs for the mandantory Avaya maintenance contract.

 

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It is too early todetermine with confidence the impact of these changes on our business.  Avaya continues to refine these changes basedon feedback from end users and business partners and we anticipatemodifications to the plan based on this input. At this time, no assurance can be given that these policy changes, ifimplemented by Avaya will not have a material, adverse impact on our operatingresults.

 

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

None.

 

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

 

None.

 

**ITEM 4. OTHER INFORMATION.**

 

None.

 

**ITEM 5.   EXHIBITS.**

 

Exhibits(filed herewith):

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

 

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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: June 1, 2010       | By:                           | /s/ Greg D. Forrest |
|                      |                          | Greg D. Forrest |
|                      |                          | Chief Executive Officer |
|                      |                          |   |
| Dated: May 28,  2010 | By:                           | /s/ Robert B. Wagner |
|                      |                          | Robert B. Wagner |
|                      |                          | Chief Financial Officer |

 

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EXHIBIT INDEX

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

 

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