##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 For the quarter ended June 30, 2006
 Commission File Number: 0-10211
 INTER-TEL (DELAWARE), INCORPORATED
 Incorporated in the State of Delaware
    
    I.R.S. No. 86-0220994
 1615 S. 52 nd Street
Tempe, Arizona 85281
(480) 449-8900
 
 Title of Class
    
    Outstanding as of June 30, 2006Common Stock, par value $0.001
    
    26,621,991
 þ o
  o þ o
 o þ




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##### 



INDEX
 INTER-TEL (DELAWARE), INCORPORATED AND SUBSIDIARIES
 PagePART I. FINANCIAL INFORMATIONItem 1. Financial Statements (unaudited)Condensed Consolidated Balance SheetsJune 30, 2006 and December 31, 2005
    
    
    3Condensed Consolidated Statements of Incomethree and six months ended June 30, 2006 and June 30, 2005
    
    
    4Condensed Consolidated Statements of Cash Flowssix months ended June 30, 2006 and June 30, 2005
    
    
    5Notes to Condensed Consolidated Financial StatementsJune 30, 2006
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4. Controls and Procedures
    
    
    31PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    32Item 1A Risk Factors
    
    
    32Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    45Item 3. Defaults Upon Senior Securities
    
    
    46Item 4. Submission of Matters to a Vote of Security Holders
    
    
    46Item 5. Other Information
    
    
    47Item 6. Exhibits
    
    
    47SIGNATURES
    
    
    48EXHIBITS AND MANAGEMENT CERTIFICATIONS
    
    
    49EX-10.66EX-31.1EX-31.2EX-32.1
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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. FINANCIAL STATEMENTS
 INTER-TEL (DELAWARE), INCORPORATED AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 June 30,
    
    December 31,(in thousands, except share amounts)
    
    2006
    
    2005(Unaudited)
    
    (Note A)ASSETSCURRENT ASSETSCash and equivalents
    
    $
    116,032
    
    
    $
    103,774Short-term investments
    
    
    63,881
    
    
    
    63,689TOTAL CASH AND SHORT-TERM INVESTMENTS
    
    
    179,913
    
    
    
    167,463Accounts receivable, net of allowances of $6,319
in 2006 and $6,235 in 2005
    
    
    49,586
    
    
    
    44,072Inventories
    
    
    22,267
    
    
    
    19,644Net investment in sales-leases, net of allowances
of $900 in 2006 and $998 in 2005
    
    
    17,497
    
    
    
    19,699Income taxes receivable
    
    
    
    
    
    
    2,062Deferred income taxes
    
    
    11,895
    
    
    
    12,590Prepaid expenses and other assets
    
    
    17,694
    
    
    
    14,253TOTAL CURRENT ASSETS
    
    
    298,852
    
    
    
    279,783PROPERTY, PLANT & EQUIPMENT
    
    
    27,108
    
    
    
    28,236GOODWILL
    
    
    29,840
    
    
    
    29,840PURCHASED INTANGIBLE ASSETS
    
    
    21,346
    
    
    
    23,651NET INVESTMENT IN SALES-LEASES, net of allowances
of $1,756 in 2006 and $1,926 in 2005
    
    
    35,469
    
    
    
    34,758TOTAL ASSETS
    
    $
    412,615
    
    
    $
    396,268LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIESAccounts payable
    
    $
    30,492
    
    
    $
    29,879Other current liabilities
    
    
    58,673
    
    
    
    54,386TOTAL CURRENT LIABILITIES
    
    
    89,165
    
    
    
    84,265DEFERRED TAX LIABILITY
    
    
    69,191
    
    
    
    70,439LEASE RECOURSE LIABILITY
    
    
    14,095
    
    
    
    14,199OTHER LIABILITIES
    
    
    7,109
    
    
    
    7,034SHAREHOLDERS EQUITYCommon stock, $0.001 par value-authorized
100,000,000 shares; issued27,161,823 shares;
outstanding26,621,991 at June 30, 2006 and
26,264,458 shares at December 31, 2005
    
    
    27
    
    
    
    27Additional Paid-In Capital
    
    
    123,686
    
    
    
    120,462Retained earnings
    
    
    116,940
    
    
    
    114,653Accumulated other comprehensive income
    
    
    1,354
    
    
    
    (36
    )242,007
    
    
    
    235,106Less: Treasury stock at cost  539,832 shares at
June 30, 2006 and 897,365 shares at December 31,
2005
    
    
    (8,952
    )
    
    
    (14,775
    )TOTAL SHAREHOLDERS EQUITY
    
    
    233,055
    
    
    
    220,331TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    412,615
    
    
    $
    396,268
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INTER-TEL (DELAWARE), INCORPORATED AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
 (In thousands, except
    
    Three Months
    
    Six Monthsper share amounts)
    
    Ended June 30,
    
    Ended June 30,2006
    
    2005
    
    2006
    
    2005NET SALESTelecommunications systems, software and related
    
    $
    100,921
    
    
    $
    101,647
    
    
    $
    193,164
    
    
    $
    194,306Resale of local, long distance and network services
    
    
    15,004
    
    
    
    13,618
    
    
    
    29,684
    
    
    
    26,577TOTAL NET SALES
    
    
    115,925
    
    
    
    115,265
    
    
    
    222,848
    
    
    
    220,883COST OF SALESTelecommunications systems, software and related
    
    
    49,628
    
    
    
    46,904
    
    
    
    94,111
    
    
    
    90,301Resale of local, long distance and network services
    
    
    9,535
    
    
    
    8,316
    
    
    
    18,697
    
    
    
    16,572TOTAL COST OF SALES
    
    
    59,163
    
    
    
    55,220
    
    
    
    112,808
    
    
    
    106,873GROSS PROFIT
    
    
    56,762
    
    
    
    60,045
    
    
    
    110,040
    
    
    
    114,010Research and development
    
    
    8,799
    
    
    
    8,713
    
    
    
    17,106
    
    
    
    17,168Selling, general and administrative
    
    
    40,179
    
    
    
    40,252
    
    
    
    78,711
    
    
    
    78,975Amortization of purchased intangible assets
    
    
    1,185
    
    
    
    1,122
    
    
    
    2,316
    
    
    
    1,884Write-off of in-process research and development costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,600Legal judgment and settlement
    
    
    
    
    
    
    
    
    
    
    1,300
    
    
    
    50,163
    
    
    
    50,087
    
    
    
    99,433
    
    
    
    100,627OPERATING INCOME
    
    
    6,599
    
    
    
    9,958
    
    
    
    10,607
    
    
    
    13,383Interest and other income
    
    
    1,542
    
    
    
    921
    
    
    
    2,822
    
    
    
    1,867Foreign currency transaction (losses) gains
    
    
    (358
    )
    
    
    88
    
    
    
    (362
    )
    
    
    141Interest expense
    
    
    (14
    )
    
    
    (23
    )
    
    
    (35
    )
    
    
    (46
    )INCOME BEFORE INCOME TAXES
    
    
    7,769
    
    
    
    10,944
    
    
    
    13,032
    
    
    
    15,345INCOME TAXES
    
    
    2,984
    
    
    
    4,003
    
    
    
    5,045
    
    
    
    6,446NET INCOME
    
    $
    4,785
    
    
    $
    6,941
    
    
    $
    7,987
    
    
    $
    8,899NET INCOME PER SHARE  BASIC
    
    $
    0.18
    
    
    $
    0.26
    
    
    $
    0.30
    
    
    $
    0.34NET INCOME PER SHARE  DILUTED
    
    $
    0.18
    
    
    $
    0.26
    
    
    $
    0.29
    
    
    $
    0.32DIVIDENDS PER SHARE
    
    $
    0.08
    
    
    $
    0.08
    
    
    $
    0.16
    
    
    $
    1.16Average number of common shares outstanding  Basic
    
    
    26,534
    
    
    
    26,301
    
    
    
    26,421
    
    
    
    26,337Average number of common shares outstanding  Diluted
    
    
    27,227
    
    
    
    27,069
    
    
    
    27,103
    
    
    
    27,429
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INTER-TEL (DELAWARE), INCORPORATED AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
 (In thousands)
    
    Six MonthsEnded June 30,2006
    
    2005OPERATING ACTIVITIESNet income
    
    $
    7,987
    
    
    $
    8,899Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation of fixed assets
    
    
    4,496
    
    
    
    4,723Amortization of patents included in R&D expenses
    
    
    9
    
    
    
    111Amortization of purchased intangible assets
    
    
    2,316
    
    
    
    1,884Purchased in-process research and development
    
    
    
    
    
    
    2,600Provision for losses on receivables
    
    
    323
    
    
    
    846Provision for losses on leases
    
    
    1,389
    
    
    
    1,814Provision for inventory valuation
    
    
    653
    
    
    
    256Share based compensation expense
    
    
    2,135
    
    
    
    Excess tax benefits from stock options exercised
    
    
    (1,090
    )
    
    
    Decrease in other liabilities
    
    
    (1,146
    )
    
    
    (442
    )(Gain) / Loss on sale of property and equipment
    
    
    (9
    )
    
    
    22Deferred income taxes
    
    
    (555
    )
    
    
    (129
    )Changes in operating assets and liabilities
    
    
    (3,295
    )
    
    
    (8,518
    )NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    13,213
    
    
    
    12,066INVESTING ACTIVITIESPurchases of available for sale short-term investments
    
    
    (38,762
    )
    
    
    (21,387
    )Maturities and sales of available for sale investments
    
    
    38,570
    
    
    
    21,132Additions to property, plant and equipment
    
    
    (3,391
    )
    
    
    (4,279
    )Proceeds from disposal of property, plant and equipment
    
    
    31
    
    
    
    16Cash used in acquisitions
    
    
    (9
    )
    
    
    (27,765
    )NET CASH USED IN INVESTING ACTIVITIES
    
    
    (3,561
    )
    
    
    (32,283
    )FINANCING ACTIVITIESCash dividends paid
    
    
    (4,212
    )
    
    
    (30,673
    )Treasury stock purchases
    
    
    
    
    
    
    (13,777
    )Payments on term debt
    
    
    (24
    )
    
    
    (23
    )Proceeds from stock issued under the Employee Stock
Purchase Plan
    
    
    542
    
    
    
    582Proceeds from exercise of stock options
    
    
    3,820
    
    
    
    6,320Excess tax benefits from stock options exercised
    
    
    1,090
    
    
    
    NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
    
    
    1,216
    
    
    
    (37,571
    )EFFECT OF EXCHANGE RATE CHANGES
    
    
    1,390
    
    
    
    (524
    )INCREASE (DECREASE) IN CASH AND EQUIVALENTS
    
    
    12,258
    
    
    
    (58,312
    )CASH AND EQUIVALENTS AT BEGINNING OF PERIOD
    
    
    103,774
    
    
    
    152,330CASH AND EQUIVALENTS AT END OF PERIOD
    
    $
    116,032
    
    
    $
    94,018
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INTER-TEL (DELAWARE), INCORPORATED AND SUBSIDIARIES
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
  NOTE ABASIS OF PRESENTATION
    Share-Based Payments
   6




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Contingencies
       7




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Inventories
  Recent Accounting Pronouncements
 How Taxes
Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income
Statement (That Is, Gross Versus Net Presentation).
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NOTE BEARNINGS PER SHARE
   Three Months Ended
    
    Six Months Ended(In thousands, except
    
    June 30,
    
    June 30,per share amounts)
    
    2006
    
    2005
    
    2006
    
    2005Numerator: Net income
    
    $
    4,785
    
    
    $
    6,941
    
    
    $
    7,987
    
    
    $
    8,899Denominator:Denominator for basic earnings
per share  weighted average
shares
    
    
    26,534
    
    
    
    26,301
    
    
    
    26,421
    
    
    
    26,337Effect of dilutive securities:Employee and director stock options
    
    
    693
    
    
    
    768
    
    
    
    682
    
    
    
    1,092Denominator for diluted earnings per
share  adjusted weighted average
shares and assumed conversions
    
    
    27,227
    
    
    
    27,069
    
    
    
    27,103
    
    
    
    27,429Basic earnings per share
    
    $
    0.18
    
    
    $
    0.26
    
    
    $
    0.30
    
    
    $
    0.34Diluted earnings per share
    
    $
    0.18
    
    
    $
    0.26
    
    
    $
    0.29
    
    
    $
    0.32Options excluded from diluted net
earnings per share calculations (1)
    
    
    1,120
    
    
    
    669
    
    
    
    1,120
    
    
    
    252
 (1)
    
    At June 30, 2006 and 2005, options to purchase shares of Inter-Tel stock were excluded from
the calculation of diluted net earnings per share because the exercise price of these options
was greater than the average market price of the common shares for the respective periods, and
therefore the effect would have been antidilutive.(2)
    
    The adoption of FAS123R, effective January 1, 2006 also changed the method of computation of
dilutive shares for 2006. If the same method used to determine dilutive shares in 2005 was
used in 2006, the dilutive shares would have been 769 and 772 for the three month and six
month periods ended June 30, 2006. This did not change the diluted earnings per share for the
three month or six month periods ended June 30, 2006. NOTE C  ACQUISITIONS
 Lake.
 ®
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NOTE D  SEGMENT INFORMATION
  ®
  As Of and For The Three Months Ended June 30, 2006Resale of Local,Long Distance(In thousands, except per share amounts)
    
    Principal
    
    and NetworkSegment
    
    Services
    
    TotalNet sales
    
    $
    100,921
    
    
    $
    15,004
    
    
    $
    115,925Gross profit
    
    
    51,293
    
    
    
    5,469
    
    
    
    56,762Operating income
    
    
    4,640
    
    
    
    1,959
    
    
    
    6,599Interest and other income
    
    
    1,505
    
    
    
    37
    
    
    
    1,542Foreign currency transaction losses
    
    
    (358
    )
    
    
    
    
    
    
    (358
    )Interest expense
    
    
    (14
    )
    
    
    
    
    
    
    (14
    )Net income
    
    $
    3,748
    
    
    $
    1,037
    
    
    $
    4,785Net income per diluted share (1)
    
    $
    0.14
    
    
    $
    0.04
    
    
    $
    0.18Weighted average diluted shares (1)
    
    
    27,227
    
    
    
    27,227
    
    
    
    27,227Goodwill
    
    $
    27,705
    
    
    $
    2,135
    
    
    $
    29,840Total assets
    
    
    398,772
    
    
    
    13,843
    
    
    
    412,615Depreciation and amortization
    
    $
    3,437
    
    
    $
    19
    
    
    $
    3,456
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As Of and For The Three Months Ended June 30, 2005Resale of Local,Long Distance(In thousands, except per share amounts)
    
    Principal
    
    and NetworkSegment
    
    Services
    
    TotalNet sales
    
    $
    101,647
    
    
    $
    13,618
    
    
    $
    115,265Gross profit
    
    
    54,743
    
    
    
    5,302
    
    
    
    60,045Operating income
    
    
    7,557
    
    
    
    2,401
    
    
    
    9,958Interest and other income
    
    
    884
    
    
    
    37
    
    
    
    921Foreign currency transaction gains
    
    
    88
    
    
    
    
    
    
    
    88Interest expense
    
    
    (19
    )
    
    
    (4
    )
    
    
    (23
    )Net income
    
    $
    5,613
    
    
    $
    1,328
    
    
    $
    6,941Net income per diluted share (1)
    
    $
    0.21
    
    
    $
    0.05
    
    
    $
    0.26Weighted average diluted shares (1)
    
    
    27,069
    
    
    
    27,069
    
    
    
    27,069Goodwill
    
    $
    27,705
    
    
    $
    2,135
    
    
    $
    29,840Total assets
    
    
    373,722
    
    
    
    10,269
    
    
    
    383,991Depreciation and amortization
    
    $
    3,633
    
    
    $
    14
    
    
    $
    3,647
 As Of and For The Six Months Ended June 30, 2006Resale of Local,Long Distance(In thousands, except per share amounts)
    
    Principal
    
    and NetworkSegment
    
    Services
    
    TotalNet sales
    
    $
    193,164
    
    
    $
    29,684
    
    
    $
    222,848Gross profit
    
    
    99,053
    
    
    
    10,987
    
    
    
    110,040Operating income
    
    
    5,767
    
    
    
    4,840
    
    
    
    10,607Interest and other income
    
    
    2,736
    
    
    
    86
    
    
    
    2,822Foreign currency transaction losses
    
    
    (362
    )
    
    
    0
    
    
    
    (362
    )Interest expense
    
    
    (34
    )
    
    
    (1
    )
    
    
    (35
    )Net income
    
    $
    5,065
    
    
    $
    2,922
    
    
    $
    7,987Net income per diluted share (1)
    
    $
    0.18
    
    
    $
    0.11
    
    
    $
    0.29Weighted average diluted shares (1)
    
    
    27,103
    
    
    
    27,103
    
    
    
    27,103Goodwill
    
    $
    27,705
    
    
    $
    2,135
    
    
    $
    29,840Total assets
    
    
    398,772
    
    
    
    13,843
    
    
    
    412,615Depreciation and amortization
    
    $
    6,782
    
    
    $
    39
    
    
    $
    6,821
 As Of and For The Six Months Ended June 30, 2005Resale of Local,Long Distance(In thousands, except per share amounts)
    
    Principal
    
    and NetworkSegment
    
    Services
    
    TotalNet sales
    
    $
    194,306
    
    
    $
    26,577
    
    
    $
    220,883Gross profit
    
    
    104,005
    
    
    
    10,005
    
    
    
    114,010In-process research and development
    
    
    2,600
    
    
    
    
    
    
    
    2,600Operating income
    
    
    9,016
    
    
    
    4,367
    
    
    
    13,383Interest and other income
    
    
    1,789
    
    
    
    78
    
    
    
    1,867Foreign currency transaction gains
    
    
    141
    
    
    
    
    
    
    
    141Interest expense
    
    
    (42
    )
    
    
    (4
    )
    
    
    (46
    )Net income
    
    $
    6,477
    
    
    $
    2422
    
    
    $
    8,899Net income per diluted share (1)
    
    $
    0.24
    
    
    $
    0.09
    
    
    $
    0.32Weighted average diluted shares (1)
    
    
    27,429
    
    
    
    27,429
    
    
    
    27,429Goodwill
    
    $
    27,705
    
    
    $
    2,135
    
    
    $
    29,840Total assets
    
    
    373,722
    
    
    
    10,269
    
    
    
    383,991Depreciation and amortization
    
    $
    6,688
    
    
    $
    30
    
    
    $
    6,718
 11




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(1)
    
    Options that are antidilutive because the exercise price was greater than the average
market price of the common shares are not included in the computation of diluted earnings per
share.  Quarter Ended June 30, 2006
    
    Quarter Ended June 30, 2005Source of net sales
    
    $
    
    %
    
    $
    
    %Domestic
    
    $
    103,941
    
    
    
    89.7
    %
    
    $
    104,279
    
    
    
    90.5
    %Lake Communications
    
    
    7,242
    
    
    
    6.2
    %
    
    
    7,907
    
    
    
    6.8
    %Other International
    
    
    4,742
    
    
    
    4.1
    %
    
    
    3,079
    
    
    
    2.7
    %Total net sales
    
    $
    115,925
    
    
    
    100.0
    %
    
    $
    115,265
    
    
    
    100.0
    %Six Months Ended June 30, 2006
    
    Six Months Ended June 30, 2005Source of net sales
    
    $
    
    %
    
    $
    
    %Domestic
    
    $
    201,645
    
    
    
    90.5
    %
    
    $
    203,943
    
    
    
    92.3
    %Lake Communications
    
    
    13,116
    
    
    
    5.9
    %
    
    
    10,497
    
    
    
    4.8
    %Other International
    
    
    8,087
    
    
    
    3.6
    %
    
    
    6,443
    
    
    
    2.9
    %Total net sales
    
    $
    222,848
    
    
    
    100.0
    %
    
    $
    220,883
    
    
    
    100.0
    %
   NOTE E NET INVESTMENT IN SALES-LEASES
  12




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##### Table of Contents



June 30,
    
    December 31,(in thousands)
    
    2006
    
    2005Lease balances included in consolidated accounts receivable, net
of allowances of $1,189 in 2006, and $980 in 2005
    
    $
    8,075
    
    
    $
    8,860Net investment in Sales-Leases:Current portion, net of allowances of $900 in 2006, and $998 in 2005
    
    
    17,497
    
    
    
    19,699Long-term portion, includes residual amounts of $1,103 in 2006 and,
$625 in 2005, net of allowances of $1,756 in 2006, and $1,926 in
2005
    
    
    35,469
    
    
    
    34,758Total investment in Sales-Leases, net of allowances of $3,845 in 2006,
and $3,904 in 2005
    
    
    61,041
    
    
    
    63,317Sold rental payments remaining unbilled (subject to limited recourse
provisions), net of allowances of $14,095 in 2006, and $14,199 in 2005
    
    
    258,240
    
    
    
    256,143Total balance of sales-leases and sold rental payments remaining
unbilled, net of allowances
    
    $
    319,281
    
    
    $
    319,460Total allowances for entire lease portfolio (including limited recourse
liabilities)
    
    $
    17,940
    
    
    $
    18,103
   Six Months Ended
    
    Year Ended(In thousands)
    
    June 30, 2006
    
    December 31, 2005Sales of rental payments
    
    $
    50,719
    
    
    $
    119,060Sold payments remaining unbilled at end of period
    
    $
    272,335
    
    
    $
    270,342
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NOTE F  SHARE BASED COMPENSATION
    Three
    
    SixMonths Ended
    
    Months EndedJune 30, 2006
    
    June 30, 2006Cost of Revenues
    
    $
    50
    
    
    $
    123Research and development
    
    
    282
    
    
    
    571Selling, General and Administrative
    
    
    752
    
    
    
    1,441Share-based compensation expense before income taxes
    
    
    1,084
    
    
    
    2,135Related income tax benefits
    
    
    198
    
    
    
    447Share-based compensation expense, net of taxes
    
    $
    886
    
    
    $
    1,688Net share-based compensation expense, per common share:Basic
    
    $
    0.03
    
    
    $
    0.06Diluted
    
    $
    0.03
    
    
    $
    0.06
 14




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WeightedWeighted
    
    AverageAverage
    
    Remaining
    
    AggregateNumber
    
    Exercise
    
    Contractual
    
    Intrinsicof Shares
    
    Price
    
    Term (years)
    
    ValueBalance at December 31, 2005
    
    
    3,855,988
    
    
    $
    16.36Granted
    
    
    616,750
    
    
    $
    23.17Exercised
    
    
    (326,573
    )
    
    $
    11.85Terminated/expired
    
    
    (103,127
    )
    
    $
    19.89Balance at June 30, 2006
    
    
    4,043,038
    
    
    $
    17.66
    
    
    
    6.4
    
    
    $
    13,746,329Exercisable at June 30, 2006
    
    
    2,709,081
    
    
    $
    16.65
    
    
    
    5.5
    
    
    $
    11,947,047
   Six Months Ended
    
    Six Months EndedJune 30, 2006
    
    June 30, 2005Expected dividend yield
    
    
    1.37%-1.53
    %
    
    
    1.52
    %Expected stock price volatility
    
    
    0.41-0.53
    
    
    
    0.48-0.58Risk-free interest rate
    
    
    4.76%-4.98
    %
    
    
    3.77
    %Expected life of options
    
    3-5 Years
    
    3-5 years
   15




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THREE MONTHS ENDEDJUNE 30, 2005Net income, as reported
    
    $
    6,941Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (1)
    
    
    (6,518
    )Pro-forma net income
    
    $
    423Net income per common share:Basic, as reported
    
    $
    0.26Basic, pro forma
    
    $
    0.02Diluted, as reported
    
    $
    0.26Diluted, pro forma
    
    $
    0.02
 SIX MONTHS ENDEDJUNE 30, 2005Net income, as reported
    
    $
    8,899Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (1)
    
    
    (7,243
    )Pro-forma net income
    
    $
    1,656Net income per common share:Basic, as reported
    
    $
    0.34Basic, pro forma
    
    $
    0.06Diluted, as reported
    
    $
    0.32Diluted, pro forma
    
    $
    0.06
 
  Employee Stock Purchase Plan
  Performance Shares
  16




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NOTE G  SUBSEQUENT EVENT
 Acquisition Offer
 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
  Overview
  
    
    Inter-Tel Axxessâ and Inter-Tel 5000 Network Communications Solutions converged
voice and data business communication systems,
    
    Lake Communications converged voice and data business communication systems, including
those sold in the US under the EncoreCXâ brand,
    
    integrated voice mail, voice processing and unified messaging systems,
    
    managed services, including voice and data network design,
traffic provisioning, and financial solutions packages (leasing),
    
    networking applications, including the design and implementation of voice and data
networks,
    
    local and long distance calling services, voice circuits, data circuits and other
communications services and peripheral products,
    
    call accounting software, computer-telephone integration (CTI) applications, and
    
    maintenance and support services for our products.
  17




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Ò
   
    
    End-user sales and sales-type leases through our direct sales offices and national,
government and education accounts division. We recognize revenue from sales of systems and
services to end-user customers upon installation of the systems and performance of the
services, respectively, allowing for use by our customers of these systems. We defer
pre-payments for communications services and recognize these pre-payments as revenue as the
communications services are provided. For our sales-type lease accounting, we record the
discounted present values of minimum rental payments under sales-type leases as sales, net
of provisions for continuing administration and other expenses over the lease period. We
record the lease sales at the time of system sale and installation as discussed above for
sales to end user customers, and upon receipt of the executed lease documents. The net
rental streams are sold to funding sources on a regular basis with the income streams
discounted by prevailing like-term rates at the time of sale. Gains or losses resulting
from the sale of net rental payments from such leases are also recorded as net sales.
    
    Dealer and VAR sales. For shipments to dealers and other distributors, our revenue is
recognized as products are shipped to the dealers and VARs and services are rendered,
because the sales process is complete. Title to these products passes when goods are
shipped (free-on-board shipping point). However, in connection with our Lake acquisition,
shipments to one international dealer are initially held by that dealer on a consignment
basis. Such inventory is owned by Inter-Tel and reported on Inter-Tels books and records
until the inventory is sold to third parties, at which time the revenue is recorded.
    
    Resale of long distance. We recognize revenue from long distance resale services as
services are provided.
    
    Software Sales. We recognize revenues from sales of software, such as our new Linktivity
products discussed above upon shipment to dealers or end-users.
    
    Maintenance and software support. Maintenance and software support revenue is recognized
ratably over the term of the maintenance or support agreement.
 Costs and gross margins
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
    
    Customer leases generally expire at end of the month and commence at the beginning of
the month, which naturally leads to end-of-period sales. These factors apply to both
end-user and dealer sales.
    
    Internal sales compensation programs for our sales personnel are linked to revenues and
the sales commissions generally increase at accelerated rates as sales volumes increase.
Sales performance bonuses are also frequently tied to quarter-end and year-end performance
targets, providing incentives to sales personnel to close business before the end of each
quarter.
    
    Historically, some price discounting to our dealer channel occurred during the last
month of a quarter or year, and some dealers have purchased consistently to take advantage
of potential
pricing discounts or end-of-quarter promotions. However, such promotions are subject to
change at any time, and discounts have been reduced in recent periods in an effort to
minimize this trend. Dealer buying habits have been consistent for years.
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Cash Flows
   Axxess
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Results of Operations
  Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005NET SALESTelecommunications systems, software and related
    
    
    87.1
    %
    
    
    88.2
    %
    
    
    86.7
    %
    
    
    88.0
    %Resale of local, long distance and network services
    
    
    12.9
    
    
    
    11.8
    
    
    
    13.3
    
    
    
    12.0TOTAL NET SALES
    
    
    100
    %
    
    
    100.0
    %
    
    
    100
    %
    
    
    100.0
    %COST OF SALESTelecommunications systems, software and related
    
    
    42.8
    
    
    
    40.7
    
    
    
    42.2
    
    
    
    40.9Resale of local, long distance and network services
    
    
    8.2
    
    
    
    7.2
    
    
    
    8.4
    
    
    
    7.5TOTAL COST OF SALES
    
    
    51.0
    
    
    
    47.9
    
    
    
    50.6
    
    
    
    48.4GROSS PROFIT
    
    
    49.0
    
    
    
    52.1
    
    
    
    49.4
    
    
    
    51.6Research and development
    
    
    7.6
    
    
    
    7.6
    
    
    
    7.7
    
    
    
    7.8Selling, general and administrative
    
    
    34.7
    
    
    
    34.9
    
    
    
    35.3
    
    
    
    35.8Amortization of intangibles
    
    
    1.0
    
    
    
    1.0
    
    
    
    1.0
    
    
    
    0.9Write-off of in-process research and development
costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.2Legal judgment and settlement
    
    
    
    
    
    
    
    
    
    
    0.6
    
    
    
    OPERATING INCOME
    
    
    5.7
    
    
    
    8.6
    
    
    
    4.8
    
    
    
    6.1Interest and other income
    
    
    1.3
    
    
    
    0.8
    
    
    
    1.3
    
    
    
    0.8Foreign currency transaction (losses) gains
    
    
    (0.3
    )
    
    
    0.1
    
    
    
    (0.2
    )
    
    
    0.1Interest expense
    
    
    (0.0
    )
    
    
    0.0
    
    
    
    (0.0
    )
    
    
    0.0INCOME BEFORE INCOME TAXES
    
    
    6.7
    
    
    
    9.5
    
    
    
    5.8
    
    
    
    6.9INCOME TAXES
    
    
    2.6
    
    
    
    3.5
    
    
    
    2.3
    
    
    
    2.9NET INCOME
    
    
    4.1
    %
    
    
    6.0
    %
    
    
    3.6
    %
    
    
    4.0
    %
 Net Sales.
 21




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®
  Gross Profit
  22




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Research and Development
 Selling, general and administrative.
 23




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Amortization of purchased intangible assets
  Write-off of in-process research and development (IPRD) costs
 Interest and Other Income
 Income Taxes
 24




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Net Income
  Inflation/Currency Fluctuation
  Liquidity and Capital Resources
 Six Months EndedJune 30,(In thousands)
    
    2006
    
    2005Net cash provided by operating activities
    
    $
    13,213
    
    
    $
    12,066Net cash used in investing activities
    
    
    (3,561
    )
    
    
    (32,283
    )Net cash (used in) provided by financing activities
    
    
    1,216
    
    
    
    (37,571
    )Effect of exchange rate changes
    
    
    1,390
    
    
    
    (524
    )Increase (decrease) in cash and equivalents
    
    
    12,258
    
    
    
    (58,312
    )Cash and equivalents at beginning of period
    
    
    103,774
    
    
    
    152,330Cash and equivalents at end of period
    
    $
    116,032
    
    
    $
    94,018
  25




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26




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27




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Off-Balance Sheet Arrangements
  Critical Accounting Policies and Estimates
  Revenue Recognition
 End-user sales through our direct sales offices and government and national accounts division
 Dealer and VAR sales
 28




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Resale of long distance
 Maintenance revenues
 Sales-Leases
  Goodwill and Other Intangible Assets. Business Combinations Goodwill and Other Intangible Assets.
   29




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Allowance for Doubtful Accounts
 Inventories
 Contingencies
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
      31




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ITEM 4. CONTROLS AND PROCEDURES
 Evaluation of disclosure controls and procedures
 Changes in internal controls over financial reporting
 INTER-TEL (DELAWARE), INCORPORATED AND SUBSIDIARIES
 
 PART II. OTHER INFORMATION
 
 ITEM 1. LEGAL PROCEEDINGS
  
 ITEM 1A. RISK FACTORS
 FORWARD
LOOKING STATEMENTS
 This Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934,
as amended. You can identify these statements by the fact that they
do not relate strictly to historical or current facts. They use words
such as anticipate, estimate,
expect, project, intend,
plan, believe and other words and terms of
similar meaning. Any or all of our forward-looking statements in this
report and in any other public statements we make may turn out to be
wrong. They can be affected by inaccurate assumptions we might make
or by known or unknown risks and uncertainties. No forward-looking
statement can be guaranteed, and you are cautioned not to place undue
reliance on these forward-looking statements. Actual future results
may differ materially.
   Risks Related to Our Business
 Our operating results have historically depended on a number of factors, and these factors may
cause our operating results to fluctuate in the future.
  
    
    volume and timing of orders received during the quarter;
    
    gross margin fluctuations associated with the mix of products sold;
    
    the mix of distribution channels;
    
    general economic conditions and the condition of the markets our business addresses;
    
    patterns of capital spending by customers;
    
    the timing of new product announcements and releases by us and our competitors and other
competitive factors;
    
    pricing pressures;
    
    the cost and effects of acquisitions;
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
    
    the availability and cost of products and components from our suppliers, including shipping
and manufacturing problems associated with subcontracted vendors;
    
    the impact on our business of the E-Rate settlement, the one year debarment of Inter-Tel
Technologies from E-Rate opportunities by the FCC, and expected fines and penalties associated
with the GSA variances and noncompliance which could affect both our government business and
our commercial business;
    
    government business and our commercial business;
    
    the impact on our business of settlements, continuing litigations, proceedings and other
contingencies, which could affect our business;
    
    the impact on our business of costs and uncertainties resulting from shareholder actions,
including actual or potential proxy contests or tender offers;
    
    the potential impact of accounting pronouncements, such as FIN 48 or FAS 123R;
    
    national and regional weather patterns; and
    
    threats of or outbreaks of war, hostilities, terrorist acts or other civil disturbances.
   Our market is subject to rapid technological change and to compete successfully, we must
continually introduce new and enhanced products and services that achieve broad market acceptance.
  33




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Our future success largely depends on increased commercial acceptance of our Inter-Tel 5000 series
and Inter-Tel 7000 Network Communications Solutions, the Lake OfficeLink product (branded
EncoreCXâ in North America), the Lake Sigma product (branded Sprint Connection
Central TM in North America), speech recognition, Interactive Voice Response, presence
management, collaboration, messaging products, Session Initiation Protocol (SIP) applications, and
related computer-telephony products, as well as continued acceptance of our Axxessâ systems
and software.
 ® ®
 We have many competitors and expect new competitors to enter our market, which could increase price
competition and spending on research and development and which may impair our ability to compete
successfully.
  
    
    PABX, converged systems and IP-PBX providers, distributors, or resellers such as Aastra,
Adtran, Alcatel, Altigen, Avaya, Cisco Systems, 3Com, Iwatsu, Interactive
Intelligence, Lucky Goldstar, Mitel, NEC, Nortel, Panasonic, Samsung, ShoreTel, Siemens,
Toshiba, Vertical Networks/ArtiSoft/Comdial and Vodavi;
    
    large data routing and convergence companies such as 3Com, Adtran and Cisco Systems;
    
    voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a
subsidiary of NEC America), Avaya, and Captaris (formerly AVT);
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
    
    web collaboration product and service providers, such as Centra, eDial (a division of
Alcatel), IBM, Microsoft, Raindance Communications, and WebEx;
    
    hosting service providers such as Layered Technologies and Vonage using servers to host
call processing functions that have traditionally been owned by customers;
    
    long distance services providers such as AT&T, MCI, Qwest and Sprint;
    
    large computer and software corporations such as IBM, HP, Intel and Microsoft;
    
    peer-to-peer softphone services such as Skype/eBay;
    
    regional Bell operating companies, or RBOCs, competitive local exchange companies, or
CLECs; cable television companies, IP Centrex service providers, and satellite and other
wireless and wireline broadband service providers offering IP centrex services such as AT&T,
Covad, Level-3, Qwest, SBC, and Time-Warner Telecom; and
    
    independent leasing companies that provide telecom equipment financing.
   
    
    offer broader product and service offerings;
    
    develop and expand their product and service offerings more quickly;
    
    offer greater price discounts or make substantial product promotions;
    
    adapt to new or emerging technologies and changing customer needs faster;
    
    take advantage of acquisitions and other opportunities more readily;
    
    negotiate more favorable licensing agreements with vendors;
    
    devote greater resources to the marketing and sale of their products; and
    
    address customers service-related issues more adequately.
  Our products are complex and may contain errors or defects that are detected only after their
release, which may cause us to incur significant unexpected expenses and lost sales.
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
    
    costs associated with the remediation of any problems;
    
    costs associated with design modifications;
    
    loss of or delay in revenues;
    
    loss of customers;
    
    damage to our reputation;
    
    failure to achieve market acceptance or loss of market share;
    
    increased service and warranty costs;
    
    liabilities to our customers; and
    
    increased insurance costs.
 The complexity of our products could cause delays in the development and release of new products
and services. As a result, customer demand for our products could decline, which could harm our
business. Additionally, changes in technology could render current inventories obsolete.
  Our founder and former Chief Executive Officer controls approximately 19.5% of our Common Stock,
may be able to exert significant influence over the Company and has signaled his willingness to
engage with the Company with respect to significant matters.
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Business acquisitions, new business ventures, dispositions or joint ventures entail numerous risks
and may disrupt our business, dilute shareholder value and distract management attention.
  
    
    unanticipated costs and liabilities;
    
    difficulty of assimilating the operations, products and personnel of the acquired business;
    
    difficulties in managing the financial and strategic position of acquired or developed
products, services and technologies;
    
    difficulties in maintaining customer relationships;
    
    difficulties in servicing and maintaining acquired products, in particular where a
substantial portion of the targets sales were derived from our competitors products and
services;
    
    difficulty of assimilating the vendors and independent contractors of the acquired business;
    
    the diversion of managements attention from the core business;
    
    inability to maintain uniform standards, controls, policies and procedures; and
    
    impairment of relationships with acquired employees and customers occurring as a result of
integration of the acquired business.
   We may not be able to adequately protect our proprietary technology and may be infringing upon
third-party intellectual property rights.
  37




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rd
  Our reliance on a limited number of suppliers for key components and our dependence on contract
manufacturers could impair our ability to manufacture and deliver our products and services in a
timely and cost-effective manner.
  38




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We derive a substantial portion of our net sales from our dealer network and if these dealers do
not effectively promote and sell our products, our business and operating results could be harmed.
  We have been the subject of government investigations, which have resulted in convictions and civil
penalties and may cause further competitive and financial harm to our business.
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We have been involved in legal disputes, which have resulted in a jury verdict, legal settlement
and associated legal costs, which may cause further competitive and financial harm to our business.
    40




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Managing our international sales efforts may expose us to additional business risks, which may
result in reduced sales or profitability in our international markets.
  If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may
not be able to achieve our objectives.
  Our IP network products may be vulnerable to viruses, other system failure risks and security
concerns, which may result in lost customers or slow commercial acceptance of our IP network
products.
  We may be unable to achieve or manage our growth effectively, which may harm our business.
  41




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The introduction of new products and services has lengthened our sales cycles, which may result in
significant sales and marketing expenses.
 â
 We rely heavily upon third-party packaged software systems to manage and run our business
processes, to provide certain products and services and to produce our financial statements. From
time to time we upgrade these systems to ensure continuation of support and to expand the
functionality of the systems to meet our business needs. The risks associated with the upgrade
process include disruption of our business processes, which could harm our business.
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Our stock price has been and may continue to be volatile, impairing your ability to sell your
shares at or above purchase price.
  
    
    announcements of developments relating to our business;
    
    investors reactions to the proxy contest and/or settlement thereof, as well as the recent
proposal by Mr. Mihaylo and Vector Capital Corporation to acquire the company and the
corresponding prospective response by Inter-Tels board of directors to such offer;
    
    fluctuations in our operating results;
    
    the impact of our dividend announcements, repurchase program or sales of stock by officers
and directors;
    
    shortfalls in revenue or earnings relative to securities analysts expectations;
    
    announcements of technological innovations or new products or enhancements by us or our
competitors, including product delays;
    
    announcements of acquisitions or planned acquisitions of other companies or businesses;
    
    investors reactions to acquisition announcements or any forecasts of our future results;
    
    general economic conditions in the telecommunications industry;
    
    the market for Internet-related voice and data products and services;
    
    changes in the national or worldwide economy;
    
    changes in legislation or regulation affecting the telecommunications industry;
    
    developments relating to our intellectual property rights and the intellectual property
rights of third parties;
    
    litigation or governmental investigations of our business practices;
    
    the impact on our business of the E-Rate settlement, the one year debarment of Technologies
from the E-Rate program, and expected fines and penalties associated with the GSA variances
and noncompliance which could affect both our government business and our commercial business;
    
    the impact on our business of settlements, continuing litigations, proceedings and other
contingencies, which could affect our business;
    
    changes in our relationships with our customers and suppliers, including shipping and
manufacturing problems associated with subcontracted vendors;
    
    national and regional weather patterns; and
    
    threats of or outbreaks of war, hostilities, terrorist acts or other civil disturbances.
  Changes in stock option accounting rules have adversely impacted our reported operating
results prepared in accordance with generally accepted accounting principles, and may affect our
stock price and our competitiveness in the employee marketplace.
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Risks Related to Our Industry
 Reductions in spending on enterprise communications equipment may materially and adversely affect
our business.
  The emerging market for IP network telephony is subject to market risks and uncertainties that
could cause significant delays and expenses.
 Axxess
  44




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Government regulation of third party long distance and network service entities on which we rely
may harm our business.
  Consolidation within the telecommunications industry could increase competition and adversely
affect our business.
  Terrorist activities and resulting military and other actions could harm our business.
  We Are Exposed To Costs And Risks Associated With Compliance With Changing Laws, Regulations And
Standards In General, and Specifically With Regulation Of Corporate Governance And Disclosure
Standards.
  45




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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 Board Authorization to Repurchase up to $75 Million of Inter-Tel Stock .
 46




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ISSUER PURCHASES OF EQUITY SECURITIES
 (d) Maximum Number (or(a) Total
    
    
    
    
    
    (c) Total Number of
    
    Approximate Dollar Value)Number of
    
    (b) Average
    
    Shares (or Units)
    
    of Shares (or Units) thatShares (or
    
    Price Paid
    
    Purchased as Part of
    
    May Yet Be PurchasedUnits)
    
    per Share
    
    Publicly Announced
    
    Under the Plans orPeriod
    
    Purchased
    
    (or Unit)
    
    Plans or Programs
    
    Programs2005April 1 to April 30
    
    None
    
    
    N/A
    
    
    NoneMay 1 to May 31
    
    
    716,500
    
    
    $
    19.228
    
    
    
    716,500June 1 to June 30
    
    None
    
    
    N/A
    
    
    None2006
    
    None
    
    
    N/A
    
    
    NoneTotal
    
    
    716,500
    
    
    $
    19.228
    
    
    
    716,500
    
    
    $
    61,223,000
    (1)
 
 (1)
    
    On February 15, 2005, the Board of Directors approved and the Company announced a plan to
repurchase up to $75 million of the common stock of the Company. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES
 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  1.
    
    Election of Directors: J. Robert Anderson, Alexander L. Cappello, Jerry W. Chapman, Gary D.
Edens, Steven E. Karol, Steven G. Mihaylo, Dr. Anil K. Puri, Robert Rodin, Norman Stout,
Kenneth L. Urish and Agnieszka Winkler were elected to serve as directors until the 2007
Annual Meeting of Shareholders. The votes were as follows:
 Nominee
    
    For:
    
    Against:
    
    Abstain:J. Robert Anderson
    
    
    19,365,302
    
    
    
    972,877
    
    
    
    541,556Alexander L. Cappello
    
    
    19,752,698
    
    
    
    585,481
    
    
    
    541,556Jerry W. Chapman
    
    
    11,337,241
    
    
    
    10,720,210
    
    
    
    541,556Gary D. Edens
    
    
    19,652,843
    
    
    
    685,336
    
    
    
    541,556Steven E. Karol
    
    
    19,783,560
    
    
    
    554,619
    
    
    
    541,556Steven G. Mihaylo
    
    
    19,542,220
    
    
    
    795,959
    
    
    
    541,556Dr. Anil K. Puri
    
    
    19,672,791
    
    
    
    665,388
    
    
    
    541,556Robert Rodin
    
    
    19,403,979
    
    
    
    934,200
    
    
    
    541,556Norman Stout
    
    
    19,648,037
    
    
    
    690,142
    
    
    
    541,556Kenneth L. Urish
    
    
    19,672,575
    
    
    
    665,604
    
    
    
    541,556Agnieszka Winkler
    
    
    19,385,350
    
    
    
    952,829
    
    
    
    541,556
 47




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##### Table of Contents



2.
    
    The shareholders voted on and approved a proposal to change the Companys state of
incorporation from Arizona to Delaware (the Reincorporation). The votes were as follows:
 For:
    
    Against:
    
    Abstain:Proposal to change the Companys
state of incorporation
    
    
    17,957,389
    
    
    
    3,109,293
    
    
    
    22,277
 3.
    
    The shareholders voted on and approved a proposal to approve a special resolution authorizing
the Companys Board of Directors to effect an amendment to the Companys Charter Documents
requiring the approval of a majority of disinterested shareholders to effect certain business
combination transactions involving interested parties. The votes were as follows:
 For:
    
    Against:
    
    Abstain:Proposal to approve a special
resolution
    
    
    18,785,864
    
    
    
    2,265,078
    
    
    
    38,017
 4.
    
    The shareholders voted on and approved a proposal to ratify the appointment of Ernst & Young
LLP to act as the independent auditors to audit our and our subsidiaries financial statements
for the year 2006. The votes were as follows:
 For:
    
    Against:
    
    Abstain:Proposal to ratify the appointment
of independent auditors
    
    
    20,821,891
    
    
    
    263,715
    
    
    
    3,353
  
 ITEM 5. OTHER INFORMATION
 
 ITEM 6. EXHIBITS:
 Exhibit 10.66:
    
    Form of Performance Share Notice of Grant and Agreement Pursuant to the 1997
Long-Term Incentive PlanExhibit 31.1:
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002Exhibit 31.2:
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002Exhibit 32.1:
    
    Certification of Chief Executive Officer and Chief Financial Officer Pursuant
to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
 48




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##### Table of Contents



SIGNATURES
  INTER-TEL (DELAWARE), INCORPORATEDAugust 9, 2006
    
    
    
    /s/ Norman StoutNorman StoutChief Executive OfficerAugust 9, 2006
    
    
    
    /s/ Kurt R. KneipKurt R. KneipSenior Vice President andChief Financial Officer
 49