**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**ý****                              ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT OF 1934**

 

**For thequarterly period ended January 31, 2006**

 

**OR**

 

**o****                              ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 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, Broken Arrow, OK**                     | ** ** | **74012-1406**       |
| (Address  of principal executive offices)                 |       | (Zip  Code)          |
|                                                      |       |                 |
| **918-664-8200**                                          |
| (Registrant’s telephone number, including area code) |

 

 

(Former name, former address and former fiscal year, if changed sincelast 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  ý         No o

 

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

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o                                       No  ý

 

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

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

 

 

----

 

INDEX

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

 

2

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED BALANCESHEETS

(UNAUDITED)

 
| ** **                                                                                                                                                       | ** ** | **January 31, 2006** | ** ** | **October 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
|                                                                                                                                                             |       |                           |       |                           |       |
| ASSETS                                                                                                                                                           |       |                           |       |                           |       |
|                                                                                                                                                             |       |                           |       |                           |       |
| Current assets:                                                                                                                                                  |       |                           |       |                           |       |
| Cash and cash equivalents                                                                                                                                        |       | $                              | 625,180    |                           | $          | 176,688 |   |
| Current portion of net investment in sales-type leases  and other receivables                                                                                    |       | 647,410                        |       | 533,114                        |       |
| Trade accounts receivable, net                                                                                                                                   |       | 9,618,173                      |       | 11,634,030                     |       |
| Inventories, net                                                                                                                                                 |       | 4,923,878                      |       | 5,650,027                      |       |
| Deferred tax asset, net                                                                                                                                          |       | 710,719                        |       | 727,222                        |       |
| Prepaid taxes                                                                                                                                                    |       | 1,208,951                      |       | 888,842                        |       |
| Prepaid expenses and other assets                                                                                                                                |       | 492,642                        |       | 139,525                        |       |
| Total current assets                                                                                                                                             |       | 18,226,953                     |       | 19,749,448                     |       |
|                                                                                                                                                             |       |                           |       |                           |       |
| Noncurrent assets:                                                                                                                                               |       |                           |       |                           |       |
| Goodwill                                                                                                                                                         |       | 26,462,351                     |       | 26,476,245                     |       |
| Intangible assets, net                                                                                                                                           |       | 170,251                        |       | 179,709                        |       |
| Net investment in sales-type leases, less current  portion above                                                                                                 |       | 157,337                        |       | 167,399                        |       |
| Property, plant & equipment, net                                                                                                                        |       | 10,435,717                     |       | 10,411,329                     |       |
| Other assets                                                                                                                                                     |       | 32,824                         |       | 34,411                         |       |
| Total noncurrent assets                                                                                                                                          |       | 37,258,480                     |       | 37,269,093                     |       |
|                                                                                                                                                             |       |                           |       |                           |       |
| Total assets                                                                                                                                                     |       | $                              | 55,485,433 |                           | $          | 57,018,541 |   |
|                                                                                                                                                             |       |                           |       |                           |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                        |       |                           |       |                           |       |
|                                                                                                                                                             |       |                           |       |                           |       |
| Current liabilities:                                                                                                                                             |       |                           |       |                           |       |
| Current portion of long-term debt                                                                                                                                |       | $                              | 864,009    |                           | $          | 1,123,582 |   |
| Revolving line of credit                                                                                                                                         |       | 4,600,397                      |       | 4,394,727                      |       |
| Lease payable                                                                                                                                                    |       | 4,236                          |       | 5,303                          |       |
| Accounts payable                                                                                                                                                 |       | 2,720,549                      |       | 4,847,799                      |       |
| Current unearned revenue                                                                                                                                         |       | 2,468,973                      |       | 1,505,609                      |       |
| Accrued liabilities                                                                                                                                              |       | 1,951,576                      |       | 2,392,846                      |       |
| Total current liabilities                                                                                                                                        |       | 12,609,740                     |       | 14,269,866                     |       |
|                                                                                                                                                             |       |                           |       |                           |       |
| Noncurrent liabilities:                                                                                                                                          |       |                           |       |                           |       |
| Long-term debt, less current portion above                                                                                                                       |       | 1,654,267                      |       | 1,697,039                      |       |
| Accrued long-term liability                                                                                                                                      |       | 144,100                        |       | 144,100                        |       |
| Noncurrent unearned service revenue                                                                                                                              |       | 71,529                         |       | 64,895                         |       |
| Noncurrent deferred tax liability, net                                                                                                                           |       | 3,989,596                      |       | 3,744,704                      |       |
| Total noncurrent liabilities                                                                                                                                     |       | 5,859,492                      |       | 5,650,738                      |       |
|                                                                                                                                                             |       |                           |       |                           |       |
| Shareholders’ equity:                                                                                                                                       |       |                           |       |                           |       |
| Preferred stock; $.10 par value; 50,000 shares authorized,  0 issued                                                                                             |       | —                         |       | —                         |       |
| Common stock; $.001 par value; 50,000,000 shares  authorized, 11,228,361 and 11,197,025 issued at January 31, 2006 and October 31,  2004, respectively |       | 11,228                         |       | 11,197                         |       |
| Paid-in capital                                                                                                                                                  |       | 13,058,034                     |       | 12,999,074                     |       |
| Retained earnings                                                                                                                                                |       | 26,191,598                     |       | 26,332,325                     |       |
| Less treasury stock, at cost (1,018,788 shares at January 31,  2006 and October 31, 2005)                                                              |       | (2,244,659                     | )          | (2,244,659                     | )          |
| Total shareholders’ equity                                                                                                                                  |       | 37,016,201                     |       | 37,097,937                     |       |
| Total liabilities and shareholders’ equity                                                                                                                  |       | $                              | 55,485,433 |                           | $          | 57,018,541 |   |

 

The accompanying notes are an integral part of these consolidatedbalance sheets.

 

3

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENTSOF OPERATIONS

(UNAUDITED)

 
| ** **                                       | ** ** | **For the Three Months  Ended January 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                             | ** ** | **2005** | ** ** |
|                                             |       |                                                                 |       |   |   |
| Systems sales                                    |       | $                                                                    | 5,701,276  |   | $ | 6,352,094 |   |
| Services                                         |       | 6,418,940                                                            |       | 6,930,822 |   |
| Other revenues                                   |       | 562,296                                                              |       | 631,813 |   |
| Net sales and service revenues                   |       | 12,682,512                                                           |       | 13,914,729 |   |
|                                             |       |                                                                 |       |   |   |
| Cost of systems sales                            |       | 4,117,601                                                            |       | 4,865,733 |   |
| Services costs                                   |       | 5,095,899                                                            |       | 4,921,202 |   |
| Cost of other revenues & corporate COGS |       | 692,661                                                              |       | 621,018 |   |
| Total cost of sales and service                  |       | 9,906,161                                                            |       | 10,407,953 |   |
|                                             |       |                                                                 |       |   |   |
| Gross profit                                     |       | 2,776,351                                                            |       | 3,506,776 |   |
|                                             |       |                                                                 |       |   |   |
| Operating expenses                               |       |                                                                 |       |   |   |
| Selling, general and administrative              |       | 2,827,198                                                            |       | 3,398,525 |   |
| Amortization                                     |       | 101,197                                                              |       | 91,461 |   |
| Total operating expenses                         |       | 2,928,395                                                            |       | 3,489,986 |   |
|                                             |       |                                                                 |       |   |   |
| (Loss) income from operations                    |       | (152,044                                                             | )          | 16,790 |   |
|                                             |       |                                                                 |       |   |   |
| Interest expense                                 |       | (71,897                                                              | )          | (12,384 | ) |
| Interest and other income                        |       | 8,214                                                                |       | 124,738 |   |
| Total interest and other income (expense)        |       | (63,683                                                              | )          | 112,354 |   |
|                                             |       |                                                                 |       |   |   |
| (Loss) income before provision for income taxes  |       | (215,727                                                             | )          | 129,144 |   |
| (Benefit) provision for income taxes             |       | (75,000                                                              | )          | 51,000 |   |
|                                             |       |                                                                 |       |   |   |
| Net (loss) income                                |       | $                                                                    | (140,727   | ) | $ | 78,144 |   |
|                                             |       |                                                                 |       |   |   |
| (Loss) earnings per share                        |       |                                                                 |       |   |   |
| Basic                                            |       | $                                                                    | (0.01      | ) | $ | 0.01 |   |
|                                             |       |                                                                 |       |   |   |
| Diluted                                          |       | $                                                                    | (0.01      | ) | $ | 0.01 |   |
|                                             |       |                                                                 |       |   |   |
| Weighted average shares outstanding              |       | 10,189,497                                                           |       | 10,027,360 |   |
|                                             |       |                                                                 |       |   |   |
| Weighted average equivalent shares               |       | 10,189,497                                                           |       | 10,073,901 |   |

 

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

 

4

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY

(UNAUDITED)

 
| ** **                              | ** ** | **Common Stock**  | ** ** | **Treasury Stock** | ** ** | ** ** | ** ** | **Retained** | ** ** | ** **               | ** ** |
|-----------------------------------------|------------|------------------------|------------|-------------------------|------------|------------|------------|--------------|------------|--------------------------|------------|
| ** **                              | ** ** | **Shares Issued** | ** ** | **Par Value**      | ** ** | **Shares** | ** ** | **Amount**   | ** ** | **Paid-in Capital** | ** ** | **Earnings** | ** ** | **Total** | ** ** |
| Balance- October 31, 2005          |       | 11,197,025             |       | $                       | 11,197     |       | 1,018,788  |         | $          | (2,244,659               | )          | $ | 12,999,074 |   | $ | 26,332,325 |   | $ | 37,097,937 |   |
|                                    |       |                   |       |                    |       |       |       |         |       |                     |       |   |   |   |   |
| Stock options exercised $.001 par value |       | 31,336                 |       | 31                      |       | —     |       | —       |       | 51,380                   |       | — |   | 51,411 |   |
| Tax benefit of stock options            |       | —                 |       | —                  |       | —     |       | —       |       | 7,580                    |       | — |   | 7,580 |   |
|                                    |       |                   |       |                    |       |       |       |         |       |                     |       |   |   |   |   |
| Net loss                                |       | —                 |       | —                  |       | —     |       | —       |       | —                   |       | (140,727 | ) | (140,727 | ) |
|                                    |       |                   |       |                    |       |       |       |         |       |                     |       |   |   |   |   |
| Balance- January 31, 2006          |       | 11,228,361             |       | $                       | 11,228     |       | 1,018,788  |         | $          | (2,244,659               | )          | $ | 13,058,034 |   | $ | 26,191,598 |   | $ | 37,016,201 |   |

 

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

 

5

----

 

XETA TECHNOLOGIES, INC.AND SUBSIDIARY

CONSOLIDATED STATEMENTSOF CASH FLOWS

(UNAUDITED)

 
| ** **                                                                                                  | ** ** | **For the Three Months  Ended January 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2006**                                                             | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                                                       |       |                                                                 |       |   |   |
| Net (loss) income                                                                                           |       | $                                                                    | (140,727   | ) | $ | 78,144 |   |
|                                                                                                        |       |                                                                 |       |   |   |
| Adjustments to reconcile net (loss) income to net cash  provided by operating activities:                   |       |                                                                 |       |   |   |
| Depreciation                                                                                                |       | 128,233                                                              |       | 182,092 |   |
| Amortization                                                                                                |       | 101,198                                                              |       | 91,462 |   |
| Loss (gain) on sale of assets                                                                               |       | 3,780                                                                |       | (263 | ) |
| Ineffectiveness of cash flow hedge                                                                          |       | —                                                               |       | (12,476 | ) |
| Provision for excess and obsolete inventory                                                                 |       | 25,500                                                               |       | 36,611 |   |
| Change in assets and liabilities, net of  acquisitions:                                                     |       |                                                                 |       |   |   |
| (Increase) decrease in net investment in sales-type  leases & other receivables                    |       | (104,234                                                             | )          | 92,730 |   |
| Decrease in trade account receivables                                                                       |       | 2,015,857                                                            |       | 1,998,359 |   |
| Decrease (increase) in inventories                                                                          |       | 700,649                                                              |       | (1,303,851 | ) |
| Decrease (increase) in deferred tax asset                                                                   |       | 16,503                                                               |       | (27,479 | ) |
| Increase in prepaid expenses and other assets                                                               |       | (351,530                                                             | )          | (287,108 | ) |
| Increase in prepaid taxes                                                                                   |       | (320,109                                                             | )          | (228,678 | ) |
| (Decrease) increase in accounts payable                                                                     |       | (2,127,250                                                           | )          | 1,763,636 |   |
| Increase in unearned revenue                                                                                |       | 969,998                                                              |       | 453,205 |   |
| Increase in accrued taxes                                                                                   |       | 9,554                                                                |       | 9,554 |   |
| Decrease in accrued liabilities and lease payable                                                           |       | (442,337                                                             | )          | (409,063 | ) |
| Increase in deferred tax liability                                                                          |       | 256,812                                                              |       | 284,712 |   |
| Total adjustments                                                                                           |       | 882,624                                                              |       | 2,643,443 |   |
| Net cash provided by operating activities                                                                   |       | 741,897                                                              |       | 2,721,587 |   |
|                                                                                                        |       |                                                                 |       |   |   |
| Cash flows from investing activities:                                                                       |       |                                                                 |       |   |   |
| Additions to property, plant & equipment                                                           |       | (265,773                                                             | )          | (213,815 | ) |
| Acquisitions, net of cash acquired                                                                          |       | —                                                               |       | (6,015 | ) |
| Proceeds from sale of assets                                                                                |       | 17,632                                                               |       | 200 |   |
| Net cash used in investing activities                                                                       |       | (248,141                                                             | )          | (219,630 | ) |
|                                                                                                        |       |                                                                 |       |   |   |
| Cash flows from financing activities:                                                                       |       |                                                                 |       |   |   |
| Proceeds from draws on revolving line of credit                                                             |       | 6,564,271                                                            |       | 5,427,520 |   |
| Payments on revolving line of credit                                                                        |       | (6,358,601                                                           | )          | (7,715,289 | ) |
| Principal payments on debt                                                                                  |       | (302,345                                                             | )          | (302,346 | ) |
| Exercise of stock options                                                                                   |       | 51,411                                                               |       | 12,508 |   |
| Net cash (used in) financing activities                                                                     |       | (45,264                                                              | )          | (2,577,607 | ) |
|                                                                                                        |       |                                                                 |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                                        |       | 448,492                                                              |       | (75,650 | ) |
|                                                                                                        |       |                                                                 |       |   |   |
| Cash and cash equivalents, beginning of period                                                              |       | 176,688                                                              |       | 141,054 |   |
| Cash and cash equivalents, end of period                                                                    |       | $                                                                    | 625,180    |   | $ | 65,404 |   |
|                                                                                                        |       |                                                                 |       |   |   |
| Supplemental disclosure of cash flow information:                                                           |       |                                                                 |       |   |   |
| Cash paid during the period for interest, net of  amount capitalized of $70,941 in 2006 and $58,743 in 2005 |       | $                                                                    | 61,811     |   | $ | 34,933 |   |
| Cash paid during the period for income taxes                                                                |       | $                                                                    | 12,240     |   | $ | 12,890 |   |

 

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

 

6

----

 

**XETA TECHNOLOGIES, INC. AND SUBSIDIARY**

**Notes to Consolidated Financial Statements**

**January 31, 2006**

(Unaudited)

 

1. BASIS OFPRESENTATION:

 

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

 

The accompanyingunaudited consolidated financial statements have been prepared by the Companypursuant to the rules and regulations of the Securities and ExchangeCommission (the “Commission”). Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to those rules and regulations,although the Company believes that the disclosures made are adequate to makethe information presented not misleading. It is suggested that these condensedfinancial statements be read in conjunction with the consolidated financialstatements and the notes thereto made a part of the Company’s AnnualReport on Form 10-K, Commission File No. 0-16231, which was filedwith the Commission on January 9, 2006. Management believes that thefinancial statements contain all adjustments necessary for a fair statement ofthe results for the interim periods presented. All adjustments made were of anormal recurring nature. The results of operations for the interim period arenot necessarily indicative of the results for the entire fiscal year. Certainreclassifications of prior year amounts have been made to conform tocurrent year presentations. These classifications had no impact on net income.

 

Segment Information

 

The Company has threereportable segments: commercial system sales, lodging system sales, andinstallation and service. The Company defines commercial system sales as salesto the non-lodging industry. Installation and service revenues representrevenues earned from installing and maintaining systems for customers in boththe commercial and lodging segments.

 

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

 

7

----

 

The following is a tabulationof business segment information for the three months ended January 31,2006 and 2005.

 
| ** **    | ** ** | **Commercial  System  Sales** | ** ** | **Lodging  System  Sales** | ** ** | **Installation  and Service  Revenues** | ** ** | **Other  Revenue** | ** ** | **Total**   | ** ** |
|---------------|------------|-------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|--------------------|------------|-------------|------------|
| **2006**      |       |                          |       |                       |       |                                         |       |               |       |        |       |
| Sales         |       | $                             | 4,188,855  |                       | $          | 1,512,421                                    |       | $                  | 6,418,940  |        | $          | 562,296 |   | $ | 12,682,512 |   |
| Cost of sales |       | (3,013,804                    | )          | (1,103,797                 | )          | (5,095,899                                   | )          | (692,661           | )          | (9,906,161  | )          |
| Gross profit  |       | $                             | 1,175,051  |                       | $          | 408,624                                      |       | $                  | 1,323,041  |        | $          | (130,365 | ) | $ | 2,776,351 |   |
|          |       |                          |       |                       |       |                                         |       |               |       |        |       |
| **2005**      |       |                          |       |                       |       |                                         |       |               |       |        |       |
| Sales         |       | $                             | 4,857,776  |                       | $          | 1,494,318                                    |       | $                  | 6,930,822  |        | $          | 631,813 |   | $ | 13,914,729 |   |
| Cost of sales |       | (3,834,648                    | )          | (1,031,085                 | )          | (4,921,202                                   | )          | (621,018           | )          | (10,407,953 | )          |
| Gross profit  |       | $                             | 1,023,128  |                       | $          | 463,233                                      |       | $                  | 2,009,620  |        | $          | 10,795 |   | $ | 3,506,776 |   |

 

Stock-BasedCompensation Plans

 

In December 2004 theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”).This new statement superseded APB Opinion No. 25, “Accounting for StockIssued to Employees,” and its related implementation guidance. The statementfocuses primarily on accounting for transactions in which an entity obtainsemployee services in share-based payment transactions. SFAS No. 123Rrequires a public entity to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award (with limited exceptions). That cost is to be recognized over theperiod during which an employee is required to provide service in exchange forthe award. The Company adopted the standard on November 1, 2005 using themodified prospective method of transition provided in SFAS 123R. Under thismethod of transition, SFAS 123R applies to new equity-based awards or to awardsmodified after the date of adoption. Additionally, compensation cost is to berecognized for previously issued, but unvested awards. Such cost is to berecognized over the remaining length of service required under the award and inan amount based on the same value that was previously used for disclosure underSFAS 123. Because option-holders were fully vested in all outstanding optionsat the time of adoption of SFAS 123R, the Company did not record anycompensation expense in association with outstanding equity-based awards in thecurrent period. The table below presents the impact of issued stock options onthe previous reporting period as if the expense had been recorded in theconsolidated financial statements based on the fair value method.

 
| ** **                                                                                                                                                    | ** ** | **January 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| Net income as reported                                                                                                                                        |       | $                          | 78,144     |   |
| Total stock-based employee compensation expense or  reduction of expense determined under fair value based method for all awards,  net of related tax effects |       | (1,522                     | )          |
| Pro forma net income                                                                                                                                          |       | $                          | 79,666     |   |
|                                                                                                                                                          |       |                       |       |
| EARNINGS PER SHARE:                                                                                                                                           |       |                       |       |
| As reported – Basic                                                                                                                                      |       | $                          | 0.01       |   |
| As reported – Diluted                                                                                                                                    |       | $                          | 0.01       |   |
|                                                                                                                                                          |       |                       |       |
| Pro forma – Basic                                                                                                                                        |       | $                          | 0.01       |   |
| Pro forma – Diluted                                                                                                                                      |       | $                          | 0.01       |   |

 

8

----

 

Use of Estimates

 

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

 

2. ACCOUNTSRECEIVABLE:

 

Trade accounts receivableconsists of the following:

 
| ** **                          | ** ** | **January 31,  2006** | ** ** | **October 31,  2005** | ** ** |
|-------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                |       |                       |       |                       |       |
| Trade receivables                   |       | $                          | 9,924,893  |                       | $          | 11,932,173 |   |
| Less- reserve for doubtful accounts |       | (306,720                   | )          | (298,143                   | )          |
| Net trade receivables               |       | $                          | 9,618,173  |                       | $          | 11,634,030 |   |

 

3. INVENTORIES:

 

Inventories are statedat the lower of cost (first-in, first-out or average) or market and consist ofthe following components:

 
| ** **                                        | ** ** | **January 31,  2006** | ** ** | **October 31,  2005** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                              |       |                       |       |                       |       |
| Finished goods and spare parts                    |       | $                          | 5,124,302  |                       | $          | 5,831,560 |   |
| Raw materials                                     |       | 323,498                    |       | 358,646                    |       |
|                                              |       | 5,447,800                  |       | 6,190,206                  |       |
| Less- reserve for excess and obsolete inventories |       | (523,922                   | )          | (540,179                   | )          |
| Total inventories, net                            |       | $                          | 4,923,878  |                       | $          | 5,650,027 |   |

 

9

----

 

4. PROPERTY, PLANT ANDEQUIPMENT:

 

Property, plant andequipment consists of the following:

 
| ** **                                                    | ** ** | **Estimated  Useful  Lives** | ** ** | **January 31,  2006** | ** ** | **October 31,  2005** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                                          |       |                         |       |                       |       |                       |       |
| Building                                                      |       | 20                           |       | $                          | 2,397,954  |                       | $          | 2,397,954 |   |
| Data processing and computer field equipment                  |       | 3-10                         |       | 4,390,397                  |       | 4,720,698                  |       |
| Software development costs, work-in-process                   |       | N/A                          |       | 5,504,453                  |       | 5,410,558                  |       |
| Software development costs of components placed into  service |       | 3-10                         |       | 1,723,417                  |       | 1,695,370                  |       |
| Hardware                                                      |       | 3-5                          |       | 597,083                    |       | 589,905                    |       |
| Land                                                          |       | —                       |       | 611,582                    |       | 611,582                    |       |
| Office furniture                                              |       | 5                            |       | 1,114,073                  |       | 1,114,073                  |       |
| Auto                                                          |       | 5                            |       | 405,718                    |       | 384,278                    |       |
| Other                                                         |       | 3-7                          |       | 491,650                    |       | 549,613                    |       |
|                                                          |       |                         |       |                       |       |                       |       |
| Total property, plant and equipment                           |       |                         |       | 17,236,327                 |       | 17,474,031                 |       |
| Less- accumulated depreciation                                |       |                         |       | (6,800,610                 | )          | (7,062,702                 | )          |
|                                                          |       |                         |       |                       |       |                       |       |
| Total property, plant and equipment, net                      |       |                         |       | $                          | 10,435,717 |                       | $          | 10,411,329 |   |

 

Interest costs related toan investment in long-lived assets are capitalized as part of the cost ofthe asset during the period the asset is being prepared for use. The Companycapitalized $70,941 and $58,743 in interest costs in the three months ended January 31,2006 and 2005, respectively.

 

5. INCOME TAXES:

 

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

 
| ** **                                                 | ** ** | **January 31,  2006** | ** ** | **October 31,  2005** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Deferred tax assets:                                       |       |                       |       |                       |       |
| Currently nondeductible reserves                           |       | $                          | 231,600    |                       | $          | 238,379 |   |
| Accrued liabilities                                        |       | 212,150                    |       | 300,255                    |       |
| Prepaid service contracts                                  |       | 172,054                    |       | 111,771                    |       |
| Other                                                      |       | 101,070                    |       | 87,972                     |       |
| Total deferred tax asset                                   |       | 716,874                    |       | 738,377                    |       |
|                                                       |       |                       |       |                       |       |
| Deferred tax liabilities:                                  |       |                       |       |                       |       |
| Intangible assets                                          |       | 3,169,079                  |       | 2,992,299                  |       |
| Depreciation                                               |       | 801,426                    |       | 734,394                    |       |
| Tax income to be recognized on sales-type lease  contracts |       | 25,246                     |       | 29,166                     |       |
| Total deferred tax liability                               |       | 3,995,751                  |       | 3,755,859                  |       |
| Net deferred tax liability                                 |       | $                          | (3,278,877 | )                          | $          | (3,017,482 | ) |

 
| ** **                                                 | ** ** | **January 31,  2006** | ** ** | **October 31,  2005** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Net deferred liability as presented on the balance  sheet: |       |                       |       |                       |       |
| Current deferred tax asset                                 |       | $                          | 710,719    |                       | $          | 727,222 |   |
| Noncurrent deferred tax liability                          |       | (3,989,596                 | )          | (3,744,704                 | )          |
| Net deferred tax liability                                 |       | $                          | (3,278,877 | )                          | $          | (3,017,482 | ) |

 

10

----

 

6. CREDIT AGREEMENTS:

 

The Company has arevolving credit and term loan agreement with a bank containing three separatenotes: a term loan amortizing over 36 months, a mortgage agreement amortizingover 13 years, and a $7.5 million revolving credit agreement to finance growthin working capital. The revolving line of credit is collateralized by tradeaccounts receivable and inventories. At January 31, 2006 and October 31,2005, the Company had approximately $4.600 million and $4.395 million,respectively, outstanding on the revolving line of credit. The Company hadapproximately $2.9 million available under the revolving line of credit at January 31,2006. Advance rates are defined in the agreement, but are generally at the rateof 80% on qualified trade accounts receivable and 40% of qualified inventories.The revolving line of credit matures on September 28, 2006. Long-term debtconsists of the following:

 
| ** **                                                                                                                                                                        | ** ** | **January 31,  2006** | ** ** | **October 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Term loan, payable in monthly installments of  $86,524 plus interest, due September 30, 2006, collateralized by all  assets of the Company                                   |       | $                          | 692,886    |                       | $          | 952,459 |   |
|                                                                                                                                                                              |       |                       |       |                       |       |
| Real estate term note, payable in monthly  installments of $14,257 plus interest, due September 30, 2009,  collateralized by a first mortgage on the Company’s building |       | 1,825,390                  |       | 1,868,162                  |       |
|                                                                                                                                                                              |       |                       |       |                       |       |
|                                                                                                                                                                              |       | 2,518,276                  |       | 2,820,621                  |       |
|                                                                                                                                                                              |       |                       |       |                       |       |
| Less-current maturities                                                                                                                                                           |       | 864,009                    |       | 1,123,582                  |       |
|                                                                                                                                                                              |       |                       |       |                       |       |
| Total long-term debt, less current maturities                                                                                                                                     |       | $                          | 1,654,267  |                       | $          | 1,697,039 |   |

 

Interest on alloutstanding debt under the credit facility accrues at either a) the LondonInterbank Offered Rate (which was 4.57% at January 31, 2006) plus 1.25% to2.75% depending on the Company’s funded debt to cash flow ratio, or b) the bank’sprime rate (which was 7.50% at January 31, 2006) minus 0% to minus 1.125%also depending on the Company’s funded debt to cash flow ratio. At January 31,2006, the Company was paying 7.125% on the revolving line of credit borrowings,6.39% on the term loan and 6.14% on the mortgage note. The credit facilitycontains several financial covenants common in such agreements, includingtangible net worth requirements, limitations on the amount of funded debt toearnings before interest, taxes, depreciation and amortization, limitations oncapital spending, and debt service coverage requirements. The Company was incompliance with these covenants.

 

7. EARNINGS PER SHARE:

 

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

 

11

----

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

 

 
| ** **                       | ** ** | **For the Three Months Ended January 31, 2005** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Income**                                                                         | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
|                             |       | **(Numerator)**                                                                    |       | **(Denominator)** |   |   |   |
| Basic EPS                        |       |                                                                               |       |   |   |   |   |
| Net income                       |       | $                                                                                  | 78,144     |   | 10,027,360 |   | $ | 0.01 |   |
| Dilutive effect of stock options |       |                                                                               |       | 46,541 |   |   |   |
|                             |       |                                                                               |       |   |   |   |   |
| Diluted EPS                      |       |                                                                               |       |   |   |   |   |
| Net income                       |       | $                                                                                  | 78,144     |   | 10,073,901 |   | $ | 0.01 |   |

 

Options to purchase 1,126,536shares of common stock at an average exercise price of $7.15 and 1,122,968 sharesof common stock at an average exercise price of $7.17 were not included in thecomputation of diluted earnings per share for the three months ended January 31,2006 and 2005, respectively, because inclusion of these options would beantidilutive.

 

12

----

 

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

 

**Thefollowing discussion contains various “forward-looking statements.” Allstatements, other than statements of historical fact, which address activities,events or developments that the Company expects or anticipates will or may occurin the future, are forward-looking statements. These statements include, butare not limited to, statements concerning future revenues, future costs, futureearnings or losses, future capital expenditures, business strategy, competitivestrengths, competitive weaknesses, goals, plans, references to future successor difficulties and other similar information. These and other forward-lookingstatements generally contain, and can be identified by words such as “expect,” “intend,”“believe,” “estimate,” “plan,” “anticipate” “forecast,” “project” and similarwords or expressions, and by discussions of strategy or intentions. Forward-lookingstatements are not guarantees of performance but rather reflect our currentexpectations, assumptions and beliefs based upon information currentlyavailable to us. Investors are cautioned that all forward-looking statementsare subject to certain risks and uncertainties which are difficult to predictand that could cause actual results to differ materially from those projected. Manyof these risks and uncertainties are described below under Item 1.A RiskFactors under Part II of this report. Consequently, all forward-lookingstatements should be read in conjunction with the risk factors discussed hereinand throughout this report, together with the additional risk factorsidentified in the Company’s Annual Report on Form 10-K, which was filed onJanuary 9, 2006.**

 

# **Overview**

# ** **

Strategy. In the first quarter offiscal 2006 we focused our energies around top line revenue growth, sellingmanaged services, improving productivity, and aligning the structure of ourorganization for better accountability for revenue results.

 

During the first quarter, we maintained our heavy investment in oursales forces supporting both the Avayaand Nortel product lines. While our first quarter equipment sales revenues werelower than expected, we continue to believe that we are building momentum toincrease our sales funnels and win-rates. During the quarter, we securedseveral contracts with significant customers to provide managed services. Revenuesfrom these contracts will begin during our second and third quarters and willbe recurring in nature. We believe that revenues from these contracts as wellas other opportunities which have not yet been secured will begin to producerevenue growth and gross profit improvement later in the year. In addition,management is reviewing key transaction processes to streamline operations andreduce per transaction costs. Most of these ongoing efforts are in our Servicesarea. These reviews include examination of our service billing rates, tyingpricing of Services to customer service levels and locations, and reducingusage of third party contractors where feasible. Finally, management has alsobeen reviewing the organizational structure of the company to increaseaccountability for customer satisfaction and to push decision-making closer tothe customer.

 

Operating Summary.Our revenues for the first quarter of fiscal 2006 were $12.7 million, adecrease of 9% compared to the first quarter of fiscal 2005. This decreaseconsisted of decreases in systems sales of $651,000 or 10%, decreases in Servicesrevenues of $512,000 or 7%, and a decrease in other revenues of $70,000 or 11%.Our operating results in the first quarter of fiscal 2006 were a net loss of$141,000 compared to net income of $78,000 in the first quarter of last year. Theseresults reflect significantly lower gross margins earned on our Servicesrevenues, partially offset by improved margins on systems sales, lower selling,general and administrative expenses, and improved incentive payments from majorvendors. These items are discussed in more detail under “Results of Operations”below.

 

Financial PositionSummary. Our financialcondition improved slightly during the first quarter as working capitalincreased 2.5%, term debt was reduced 11%, and cash earned from operations was$742,000. The amount outstanding on our revolving line of credit at January 31,2006 was $4.600 million compared to $4.395 million at October 31, 2005.

 

Expectations.We believe that we will see improvement in our sales of systems and equipmentto commercial customers during the balance of the year. Despite our lower thanexpected systems sales in the

 

13

----

 

first quarter, webelieve that the effectiveness of our commercial sales force is improving and weexpect improved results in the second quarter. While no assurance can be given,we expect our sales of systems to lodging customers to remain strong and likelybe improved in fiscal 2006 compared to 2005. The severe decline in our Servicesgross margins is being addressed through changes in our Services pricingstructure, changes in the utilization of both our full-time technicians and ournetwork of third party technicians, and through changes in the organizationalstructure of the Service organization. We believe that we can improve the grossmargins in the Services area in the second quarter, but no assurance can begiven that Services gross margins will return to their historical levels. Generally,we do not expect to see improvements in the level of vendor compensationprovided to us to assist in the expansion of our business. Although we enjoyedincreased vendor payments in the first quarter, those payments primarilyreflect the resolution of incentives that related to fiscal 2005 purchases, butwere not approved by the vendors until the first quarter. We expect ouroperating expenses to remain relatively stable for the remainder of the fiscalyear. In summary, for our operating results to improve, we must see dramaticimprovement in services gross margins and improved revenues from sales ofsystems.

 

Additional risk factorsthat might affect our short- and long-term results are presented in the “Outlookand Risk Factors” section below and in our most recently filed Form 10-K.

 

The following discussionpresents additional information regarding our financial condition and resultsof operations for the three months ending January 31, 2006 and should beread in conjunction with our comments above as well as the “Outlook and RiskFactors” section below.

 

# **Financial Condition**

# ** **

Cash provided byoperations in the first quarter of fiscal 2006 was $742,000. These cash flowswere derived from non-cash charges of $229,000 that offset the operating lossof $141,000 coupled with a $2.0 million reduction in accounts receivable, a $701,000reduction in inventories, and a $970,000 increase in unearned revenue. Theseincreases in cash flows were partially offset by decreases in accounts payableof $2.1 million, increases in prepaid expenses and prepaid taxes totaling $672,000,and a decrease in accrued liabilities of $442,000. Additional individuallyimmaterial changes in working capital accounts produced a net increase in cashflows of $196,000. These cash flows were used primarily to reduce our term debtby $302,000 and fund capital expenditures of $248,000. Most of our capitalexpenditures during the first quarter were for upgrading our internal voice anddata infrastructure and for our Oracle software implementation.

 

Our business is generallynot capital intensive and most capital expenditures relate to maintaining,updating and expanding our technology infrastructure to support our employeebase. We continue to test the functionality of our new Oracle software platform.This system, when fully implemented, will support all of our operating andfinancial reporting activities, will condense three existing software platformsdown to one, and will provide a long-term solution that will support rapidexpansion of our customer base and revenues.

 

Our total debt at January 31,2006 was $7.1 million, which consisted of a mortgage on our corporateheadquarters building of $1.8 million, a term note of $0.693 million, and $4.6million outstanding on the working capital revolver. Payments on the mortgagenote are based on a 13-year amortization schedule and the note is due infull or will be refinanced by September 30,2009. The term noteis secured by the general assets of the Company. Payments on the term note arebased on a three year amortization schedule and it is due and will beamortized in full on September 30, 2006. Required principal payments onthe two notes total $302,000 per quarter. The credit agreement, whichencompasses both the notes discussed above and the line of credit, containscertain financial covenants common in such agreements. These covenants includetangible net worth requirements, limitations on the amount of funded debt toEarnings Before Interest, Taxes, Depreciation, and Amortization, limitations oncapital spending, and debt service coverage requirements. At January 31,2006, we were in compliance with all the covenants.

 

The total amountavailable under the working capital revolver is based on the qualified balancesof accounts receivable and inventories and is subject to a maximum of $7.5million. At January 31, 2006, there was $2.9 million available for futureborrowings under the revolver.

 

14

----

 

The table below presentsour contractual obligations at January 31, 2006 as well as paymentobligations over the next five years:

 
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **2 – 3  Years** | ** ** | **4 – 5  Years** | ** ** |
| Long-term debt                   |       | $                                         | 2,876,191  |   | $ | 987,243 |   | $ | 525,260 |   | $ | 1,363,688 |   |
| Operating leases                 |       | $                                         | 714,998    |   | 230,109 |   | 368,156 |   | 116,733 |   |
| Total                            |       | $                                         | 3,591,189  |   | $ | 1,217,352 |   | $ | 893,416 |   | $ | 1,480,421 |   |

 

# **Results of Operations**

# ** **

Our operating resultsfor the first quarter of fiscal 2006 reflected a net loss of $141,000 comparedto net income of $78,000 for the first quarter of fiscal 2005. The narrativebelow provides further explanation of these changes.

 

Systems Sales.Our systems in the first quarter of fiscal 2006 were $5.7 million, a 10%decline compared to the first quarter of last year. This decline consisted of a$669,000 or 14% decline in sales of systems to commercial customers which werepartially offset by an increase in sales of systems sold to lodging customersof $18,000 or 1%. Our bookings of new orders in the first quarter of fiscal2006 were consistent with bookings for new orders received in the first quarterof fiscal 2005. However, because of customer-driven shipping and installationdates on some of our larger orders received in the first quarter, recognitionof revenues was not consistent with the prior year or with historical trends. Weexpect shipments and installations of these larger orders to not begin untillate in the second quarter and will extend into our third fiscal quarter.

 

Service Revenues.Service revenues consist of the following:

 

| ** **                                    | ** ** | **For the Three Months Ended  January 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                                             | ** ** | **2005** | ** ** |
| Service Center                                |       | $                                                                    | 5,150,000  |   | $ | 5,271,000 |   |
| Installation & Professional Services |       | 1,269,000                                                            |       | 1,660,000 |   |
| Total installation and service revenue        |       | $                                                                    | 6,419,000  |   | $ | 6,931,000 |   |

 

Revenues earned by ourNational Service Center (“NSC”) decreased 2% in the first quarter compared tothe first quarter of last year. This slight decline was due primarily to lowerrevenues from structured wiring projects and lower revenues earned from timeand materials (“T&M”) services provided to lodging customers. Both of thesedeclines are within the normal variability of these revenue streams.

 

Our installation andprofessional services revenues declined 24% in the first quarter reflectinglower commercial systems sales which is typically the primary driver for thisrevenue stream. Additionally, in the first quarter of 2005, our installationrevenues were boosted by a series of installations performed under a multi-location,installation-only, contract with a subcontractor to the Metropolitan AtlantaRapid Transit Authority (“MARTA”). There was not a similar revenue event in thefirst quarter of fiscal 2006.

 

Gross Margins.The table below presents the gross margins earned on our primary revenuestreams for the three months ended January 31, 2006 and 2005:

 

| ** **                       | ** ** | **For the Three  Months Ended  January 31,** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------|------------|
| **Gross Margins**           | ** ** | **2006**                                                         | ** ** | **2005** | ** ** |
| Systems sales                    |       | 27.8                                                             | %          | 23.4 | % |
| Services revenues                |       | 20.6                                                             | %          | 29.0 | % |
| Other revenues                   |       | 37.3                                                             | %          | 55.1 | % |
| Corporate cost of goods sold     |       | -2.7                                                             | %          | -2.4 | % |
| Total sales and service revenues |       | 21.9                                                             | %          | 25.2 | % |

 

15

----

 

The gross margins earnedon our systems sales revenues in the first quarter of fiscal 2006 improvedcompared to the first quarter of last year. This improvement reflects ourcontinued focus on maintaining systems gross margins by emphasizing our valueadditions such as in-house installation expertise, nationwide geographicpresence, and after-installation customer care and by working closely with ourmanufacturers to maximize their pricing support. We expect to continue to facepressure on our systems sales gross margins and our desire to maintain thesemargins may impact our revenue volumes and may limit our ability toincrease our revenues.

 

Ourgross margins earned on Services revenues were well below our expectations andprevious run-rates. This decline in Services gross margins reflects lowerinstallation revenues in the first quarter of fiscal 2006 coupled with higheroperating expenses incurred by the NSC. Our costs associated with ourinstallation department are relatively fixed and were unchanged in the firstquarter of fiscal 2006 compared to the prior year. However, as discussed aboveunder “Services Revenues”, revenues earned from installation activitiesdeclined 24% driving down the gross margins on installation activities. Thegross margins earned by the NSC decreased about 5 percentage points in thefirst quarter of fiscal 2006 compared to last year. While NSC revenues weredown slightly (2%), costs increased more than 5%. There are several factorscreating this increase in NSC costs: 1) hiring of experienced Norteltechnicians prior to the establishment of revenues ; 2) increased utilizationof third party subcontractors; and 3) increased materials costs to supportcommercial customers. We purposely have added certified and experienced Norteltechnicians to our staff to gain credibility in the Nortel market. Much of thecost of this investment is not yet covered by sufficient services revenues toproduce the gross profit margins which we typically enjoy from our servicesactivities. In addition, we are working to address the remaining factors above byexamining pricing of our services to capture full value for the level ofexpertise we are putting into the field, training dispatch personnel to betterutilize internal technical staff and lower utilization of third partysubcontractors, and reviewing the organization structure of the NSC to providemore accountability for profitability. While we expect these actions to produceimprovements in gross margin during the balance of the fiscal year, noassurance can be given that gross margins on our Services revenues will returnto their historical levels.

 

A final component to ourgross margins is the margins earned on other revenues and our corporate cost ofgoods sold. A portion of our other revenues typically represent sales and costof goods sold on equipment or services outside our normal provisioningprocesses and by their nature vary significantly in both sales volume and grossmargins earned. Another segment of other revenues represents the sale of Avayamaintenance contracts for which we earn either a gross profit or commissionsfrom Avaya. We have no continuing service obligation associated with theserevenues and gross profits. Corporate cost of goods sold represents ourmaterial logistics and purchasing functions that support all of our revenuesegments.

 

Operating Expenses.Our total operating expenses decreased $562,000 or 16% in the first quarter offiscal 2006 compared to the first quarter of fiscal 2005. This decreasereflected decreases in selling, general and administrative expenses andincreases in vendor marketing reimbursements which are recorded as contraexpense items. Sales expenses declined primarily due to lower headcounts inboth account executives and sales engineers compared to last year. General andadministrative expenses declined as a result of lower marketing costs, reducedauditing and legal fees, and lower information technology department spending. Thesedecreases were partially offset by higher insurance costs, the addition of oneexecutive officer, and increased property taxes on our headquarters buildingdue to the expiration of an ad valorem tax rebate. Our vendor incentivepayments related to sales and marketing expenses were higher in the firstquarter of fiscal 2006 than a year ago due to the resolution of incentives thatrelated to fiscal 2005 purchases, but were not approved by the vendors untilthe first quarter. We expect vendor incentive payments to return to lowerlevels for the remainder of the fiscal year.

 

Interest Expense andOther Income. Net interest expenseand other income was $64,000 in expense in the first quarter of fiscal 2006compared to $112,000 in income in the first quarter of fiscal 2005. Thisdecrease consists of higher interest expense of $60,000 and lower other incomeof $117,000. The higher interest expense is due to increased debt outstandingon our revolving line of credit and increased interest rates. Other income wasunusually high in the first quarter of last year due to the collection of$87,000 for an

 

16

----

 

accounts receivable thathad been previously written-off. There was not a similar significanttransaction in the current quarter.

 

Tax Provision.The Company has recorded a combined federal and state tax benefit of 35% forthe first quarter of fiscal 2006 and a tax provision of 39% for the firstquarter of fiscal 2005. The effective tax benefit rate of 35% in the firstquarter reflects the effective federal tax rate plus the composite state incometax rates adjusted for states that require minimum tax payments even if taxlosses are incurred.

 

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

 

Market risks relating to our operations resultprimarily from changes in interest rates. We did not use derivative financialinstruments for speculative or trading purposes during the three months ending January 31,2006.

 

*Interest Rate Risk*. We are subject to the risk of fluctuation in interest rates in the normal course of business due to our utilization of variable debt. Our credit facility bears interest at a floating rate at either the London Interbank Offered Rate (“LIBOR”) (4.57% at January 31, 2006) plus 1.25% to 2.75% or the bank’s prime rate (7.50% at January 31, 2006) less 0.0% to minus 1.125%. A hypothetical 1% increase in interest rates would not have a material impact on our financial position or cash flows.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controls and Procedures.*Based on an evaluation conducted as of January 31,2006 by our management, including our Chief Executive Officer (“CEO”) and ourChief Financial Officer (“CFO”), our CEO and CFO have concluded that ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) are effective to reasonably ensure that information required to bedisclosed in reports that we file or submit under the Exchange Act, isrecorded, processed, summarized and reported within the time periods specifiedin Securities and Exchange Commission rules and forms, and that suchinformation is accumulated and communicated to our management, including theCEO and CFO, as appropriate to allow timely decisions regarding requireddisclosure.

 

*Changes in Internal Controls.* There were no significant changes in our internalcontrols or in other factors that could significantly affect these controlssubsequent to the date of their evaluation. There were no significantdeficiencies or material weaknesses and therefore, there were no correctiveactions taken.

 

17

----

 

**PART II. OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

Wecontinue to monitor Phonometrics’ efforts to challenge certain awards ofattorneys’ fees against it. In December, 2005 Phonometrics lost its appeal tothe United States Court of Appeals for the Federal Circuit. A detaileddescription of the Phonometrics’ cases is contained in our Annual Report on Form 10-Kfor the fiscal year ended October 31, 2005 filed with the Commission.

 

**ITEM 1A. RISK FACTORS**

 

The following discussionis an update to the “Outlook and Risk Factors” discussed in the Company’sAnnual Report on Form 10-K for the year ended October 31, 2005. Thediscussions in the report regarding “Marketing of Advanced CommunicationsProducts”, “Investment to Add Nortel Products and Services to Our Product Line”,“Financial Condition of Nortel”, “Declining Revenues and Gross Profits Earnedby Hotels on Guest Calls”, “Our Dependence Upon a Few Suppliers”, “Recruitingand Retaining Highly Skilled Personnel”, “Complex and Rapidly ChangingTechnology”, “Trends in Capital Spending on Technology We Sell”, “Changes inVendor Incentive Programs”, “Compliance with Corporate Governance Regulations”,“Hitachi’s Exit from the Communications Systems Market”, “Connection of OurProducts to Customer Networks”, “Variability of Our Gross Margins”, “EarlyTermination of Dealer Agreements”, “Intense Competition”, “Accounting forGoodwill”, “Upgrading our Technology Infrastructure”, “Volatility of Our StockPrice”, “Natural Catastrophes”, and “Infringement Claims and Litigation” arestill considered current and should be given equal consideration together withthe matters discussed below.

 

The gross margins earnedon our Services revenues have declined sharply over the past year and we may beunable to restore them to their previous levels.

 

Our margins earned onServices revenues declined steeply in the first quarter of fiscal 2006,particularly the gross margins earned by the NSC. The underlying causes of thisdecline may be tied to changes in the mix of our Services revenues,increased competition, and tougher negotiating by customers. As such, it may notbe possible to restore our Services gross margins to the levels enjoyed inprevious years.

 

For our currentoperating model to be profitable, our systems sales need to improve whilemaintaining current gross profit margins.

 

Our operating model,specifically the sales infrastructure and compensation plans, require higherlevels of systems sales revenues at gross margin percentages similar to thoseearned in the first quarter. Many of our competitors have very differentoperating models with lower fixed sales costs and outsourcing models forinstallations of systems. As such, they are willing to sell equipment at lowergross margins. We believe that our competitors have successfully captured someof our market share with a lower price, low service commitment strategy. Therecan be no assurance given that we can maintain our focus on gross margins andalso increase our systems sales in the future.

 

If operating losseswiden or continue for several quarters, we would likely become out ofcompliance with the financial covenants in our credit facility.

 

Our credit facilitycontains covenants based on various financial ratios including a funded debt toEBIDA ratio and a debt service coverage ratio. If operating losses shouldcontinue at the rate experienced in the first quarter of fiscal 2006 or if theyshould widen significantly, we might become out of compliance with thesecovenants and be in technical default of the credit agreement. While we wouldnot expect our bank to immediately terminate the credit facility and demandpayment of all outstanding debt, they would have the right to do so. Alternatively,the bank might take other actions that would restrict our access to borrowingsto fund our business. Such actions could severely restrict our ability topurchase equipment and services from vendors and could materially andnegatively impact our results of operations and financial condition.

 

We are subject to a variety of other general risks anduncertainties inherent in doing business. 

 

In addition to the specific factors discussed above, we are subject tocertain risks that are inherent in doing

 

18

----

 

business, such as general industry and market conditions and growthrates, general economic and political conditions, costs of obtaining insurance,unexpected death or changes in key employees, changes in employment laws andregulations, changes in tax laws and regulations, and other events that canimpact revenues and the cost of doing business.

 

**ITEM2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

None.

 

**ITEM3. DEFAULTS UPON SENIOR SECURITIES.**

 

None.

 

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

 

None.

 

**ITEM 5. OTHER INFORMATION.**

 

In December 2005,the Board of Directors, upon recommendation of the Compensation Committee,authorized a small discretionary bonus pool of $146,405 for 2005 fiscal yearperformance. From this pool, bonuses totaling $43,225 were awarded to theCompany’s four executive officers, as follows:

 
| Jack R. Ingram, CEO                                  |   | $      | 13,300 |   |
|------------------------------------------------------|--------|--------|--------|--------|
| Robert B. Wagner, CFO                                |   | 13,300 |   |
| Greg D. Forrest, President                           |   | 3,325  |   |
| Larry N. Patterson, Executive Director of Operations |   | 13,300 |   |

 

These bonuses are paid inquarterly installments during fiscal 2006 and are subject to forfeiture if theemployee is not employed at the time of payment.

 

The salary freezeimplemented in 2001 on salaries of executive officers and on standard directorcompensation remains in effect.

 

Payment of $5,000 wasmade to director Donald T. Duke on February 27, 2006 for his work inexploring, on behalf of the Board of Directors and pursuant to the Board’sauthorization in July 2005, a potential business opportunity presented tothe Company during fiscal 2005.

 

19

----

 

**ITEM6. EXHIBITS.**

 

a)                                      Exhibits (filedherewith):

 
| **SEC Exhibit No.** | ** ** | **Description**                                                                                                                                                                    |
|-------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                          |       |                                                                                                                                                                               |
| 10.1                          |       | Summary  of Executive Officer Compensation                                                                                                                                         |
|                          |       |                                                                                                                                                                               |
| 10.2                          |       | Summary  of Director Compensation                                                                                                                                                  |
|                          |       |                                                                                                                                                                               |
| 31.1                          |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                       |
|                          |       |                                                                                                                                                                               |
| 31.2                          |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                       |
|                          |       |                                                                                                                                                                               |
| 32.1                          |       | Certification  of Chief Executive Officer Pursuant to Title 18, United States Code, Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                          |       |                                                                                                                                                                               |
| 32.2                          |       | Certification  of Chief Financial Officer Pursuant to Title 18, United States Code, Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                                | XETA  Technologies, Inc. |
|-------------------------------------|-------------------------------|
|                                | (Registrant)                  |
|                                |                          |   |
|                                |                          |   |
| Dated:  February 28, 2006 | By:                           | /s/ Jack R.  Ingram |
|                                |                          | Jack R. Ingram |
|                                |                          | Chief Executive  Officer |
|                                |                          |   |
| Dated:  February 28, 2006 | By:                           | /s/ Robert B.  Wagner |
|                                |                          | Robert B. Wagner |
|                                |                          | Chief Financial  Officer |

 

20

----

 

EXHIBIT INDEX

 
| **SEC Exhibit No.** | ** ** | **Description**                                                                                                                                                                    |
|-------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                          |       |                                                                                                                                                                               |
| 10.1                          |       | Summary  of Executive Officer Compensation                                                                                                                                         |
|                          |       |                                                                                                                                                                               |
| 10.2                          |       | Summary  of Director Compensation                                                                                                                                                  |
|                          |       |                                                                                                                                                                               |
| 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. |

 

21

----