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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
    
    Commission File Number:March 31, 2005
    
    0-10211
 INTER-TEL, INCORPORATED Incorporated in the State of Arizona
    
    I.R.S. No. 86-0220994
 1615 S.
52ndStreetTempe, Arizona 85281 (480) 449-8900   Title of Class
    
    Outstanding as of March 31, 2005Common Stock, no par value
    
    26,709,745
 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter periods that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Act). Yes þ No o




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INDEX INTER-TEL, INCORPORATED AND SUBSIDIARIES PagePART I. FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (unaudited)
    
    
    3Condensed
Consolidated Balance SheetsMarch 31, 2005 and December 31, 2004
    
    
    3Condensed
Consolidated Statements of Incomethree months ended
March 31, 2005 and March 31, 2004
    
    
    4Condensed
Consolidated Statements of Cash Flowsthree months ended March 31, 2005 and March 31, 2004
    
    
    5Notes to Condensed
Consolidated Financial StatementsMarch 31, 2005
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    39Item 4.
    
    Controls and Procedures
    
    
    40PART II. OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    40Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    40Item 3.
    
    Defaults Upon Senior Securities
    
    
    40Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    40Item 5.
    
    Other Information
    
    
    40Item 6.
    
    Exhibits
    
    
    41SIGNATURES
    
    
    41MANAGEMENT CERTIFICATIONS
    
    
    42EXHIBIT 10EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS
 INTER-TEL, INCORPORATED AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 March 31,
    
    
    December 31,2005
    
    
    2004(in thousands, except share amounts)
    
    (Unaudited)
    
    
    (Note A)ASSETSCURRENT ASSETSCash and equivalents
    
    $
    125,824
    
    
    $
    152,330Short-term investments
    
    
    55,314
    
    
    
    52,644TOTAL CASH AND SHORT-TERM INVESTMENTS
    
    
    181,138
    
    
    
    204,974Accounts receivable, net of allowances of $9,442
in 2005 and $9,921 in 2004
    
    
    42,938
    
    
    
    45,176Inventories
    
    
    19,299
    
    
    
    16,055Net
investment in sales-leases, net of allowances of $861 in 2005 and $886 in 2004
    
    
    18,160
    
    
    
    17,151Income taxes receivable
    
    
    6,102
    
    
    
    4,017Deferred income taxes
    
    
    11,651
    
    
    
    9,905Prepaid expenses and other assets
    
    
    8,706
    
    
    
    7,194TOTAL CURRENT ASSETS
    
    
    287,994
    
    
    
    304,472LONG-TERM INVESTMENTS
    
    
    5,900
    
    
    
    9,900PROPERTY, PLANT & EQUIPMENT
    
    
    28,848
    
    
    
    27,840GOODWILL
    
    
    26,460
    
    
    
    19,890PURCHASED INTANGIBLE ASSETS
    
    
    26,870
    
    
    
    10,987NET INVESTMENT IN SALES-LEASES,net of allowances
of $1,960 in 2005 and $1,810 in 2004
    
    
    35,781
    
    
    
    33,877TOTAL ASSETS
    
    $
    411,853
    
    
    $
    406,966LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIESAccounts payable
    
    $
    32,274
    
    
    $
    30,801Accrued dividends payable on common stock
    
    
    28,846
    
    
    
    1,829Other current liabilities
    
    
    42,960
    
    
    
    50,367TOTAL CURRENT LIABILITIES
    
    
    104,080
    
    
    
    82,997DEFERRED TAX LIABILITY
    
    
    65,975
    
    
    
    65,234LEASE RECOURSE LIABILITY
    
    
    12,721
    
    
    
    12,241OTHER LIABILITIES
    
    
    7,018
    
    
    
    7,063SHAREHOLDERS EQUITYCommon stock, no par value-authorized 100,000,000
shares; issued27,161,823 shares;
outstanding26,709,745 at March 31, 2005 and
26,125,799 shares at December 31, 2004
    
    
    119,933
    
    
    
    116,598Retained earnings
    
    
    106,240
    
    
    
    134,455Accumulated other comprehensive income
    
    
    1,388
    
    
    
    924227,561
    
    
    
    251,977Less: Treasury stock at cost  452,078 shares at
March 31, 2005 and 1,036,024 shares at December
31, 2004
    
    
    (5,502
    )
    
    
    (12,546
    )TOTAL SHAREHOLDERS EQUITY
    
    
    222,059
    
    
    
    239,431TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    411,853
    
    
    $
    406,966
 See accompanying notes. 3




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INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
 Three Months(In thousands, except
    
    Ended March 31,per share amounts)
    
    2005
    
    
    2004NET SALESTelecommunications systems, software and related
    
    $
    92,659
    
    
    $
    86,049Resale of local, long distance and network services
    
    
    13,048
    
    
    
    11,982TOTAL NET SALES
    
    
    105,707
    
    
    
    98,031COST OF SALESTelecommunications systems, software and related
    
    
    43,397
    
    
    
    38,875Resale of local, long distance and network services
    
    
    8,256
    
    
    
    7,058TOTAL COST OF SALES
    
    
    51,653
    
    
    
    45,933GROSS PROFIT
    
    
    54,054
    
    
    
    52,098Research and development
    
    
    8,455
    
    
    
    6,035Selling, general and administrative
    
    
    38,723
    
    
    
    35,004Amortization of purchased intangible assets
    
    
    762
    
    
    
    445Write-off of in-process research and development costs
    
    
    2,600
    
    
    
    50,540
    
    
    
    41,484OPERATING INCOME
    
    
    3,514
    
    
    
    10,614Interest and other income
    
    
    947
    
    
    
    506Foreign currency transaction gains (losses)
    
    
    53
    
    
    
    (161
    )Interest expense
    
    
    (23
    )
    
    
    (46
    )INCOME BEFORE INCOME TAXES
    
    
    4,491
    
    
    
    10,913INCOME TAXES
    
    
    2,556
    
    
    
    4,093NET INCOME
    
    $
    1,935
    
    
    $
    6,820NET INCOME PER SHARE  BASIC
    
    $
    0.07
    
    
    $
    0.27NET INCOME PER SHARE  DILUTED
    
    $
    0.07
    
    
    $
    0.25DIVIDENDS PER SHARE
    
    $
    1.08
    
    
    $
    0.07Average number of common shares outstanding  Basic
    
    
    26,373
    
    
    
    25,543Average number of common shares outstanding  Diluted
    
    
    27,788
    
    
    
    27,350
 See accompanying notes. 4




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INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
 Three MonthsEnded March 31,(In thousands)
    
    2005
    
    
    2004OPERATING ACTIVITIESNet income
    
    $
    1,935
    
    
    $
    6,820Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation of fixed assets
    
    
    2,253
    
    
    
    1,881Amortization of patents included in R&D expenses
    
    
    55
    
    
    
    55Amortization of purchased intangible assets
    
    
    762
    
    
    
    445Purchased in-process research and development
    
    
    2,600Provision for losses on receivables
    
    
    481
    
    
    
    429Provision for losses on leases
    
    
    769
    
    
    
    1,045Provision for inventory valuation
    
    
    243
    
    
    
    191Decrease in other liabilities
    
    
    (165
    )
    
    
    (996
    )Loss on sale of property and equipment
    
    
    19
    
    
    
    Deferred income taxes
    
    
    494
    
    
    
    4,928E-Rate settlement
    
    
    (8,461
    )
    
    
    Changes in operating assets and liabilities
    
    
    (3,392
    )
    
    
    1,122NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES
    
    
    (2,407
    )
    
    
    15,920INVESTING ACTIVITIESPurchases of short-term investments
    
    
    (10,269
    )
    
    
    (19,989
    )Maturities and sales of short-term investments
    
    
    11,599
    
    
    
    22,383Additions to property, plant and equipment
    
    
    (2,218
    )
    
    
    (1,219
    )Proceeds from disposal of property, plant and equipment
    
    
    4
    
    
    
    8Cash used in acquisitions
    
    
    (27,579
    )
    
    
    NET CASH (USED IN) PROVIDED BY INVESTING ACTIVITIES
    
    
    (28,463
    )
    
    
    1,183FINANCING ACTIVITIESCash dividends paid
    
    
    (1,829
    )
    
    
    (1,525
    )Payments on term debt
    
    
    (11
    )
    
    
    (17
    )Proceeds from exercise of stock options
    
    
    5,740
    
    
    
    3,240NET CASH PROVIDED BY FINANCING ACTIVITIES
    
    
    3,900
    
    
    
    1,698EFFECT OF EXCHANGE RATE CHANGES
    
    
    464
    
    
    
    292INCREASE (DECREASE) IN CASH AND EQUIVALENTS
    
    
    (26,506
    )
    
    
    19,093CASH AND EQUIVALENTS AT BEGINNING OF PERIOD
    
    
    152,330
    
    
    
    115,197CASH AND EQUIVALENTS AT END OF PERIOD
    
    $
    125,824
    
    
    $
    134,290
 See accompanying notes. 5




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INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 NOTE ABASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in
conformity with U.S. generally accepted accounting principles applicable to interim financial
information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair presentation of the
results for the interim periods presented have been included. Operating results for the quarter
ending March 31, 2005 are not necessarily indicative of the results that may be expected for the
year ended December 31, 2005. The balance sheet at December 31, 2004 has been derived from the
audited financial statements at that date, but does not include all of the information and
footnotes required by accounting principles generally accepted in the United States for complete
financial statements. For further information, refer to the consolidated financial statements and
notes thereto included in the Companys annual report on Form 10-K for the year ended December 31,
2004. Certain prior year amounts have been reclassified to conform with the current period
presentation. Stock-Based Compensation In 2002, the Financial Accounting Standards Board (FASB) issued Statement No. 148
Accounting for Stock-Based CompensationTransition and Disclosure, an amendment of FASB Statement
No. 123 (SFAS No. 148), which provides alternative methods of transition for an entity that
voluntarily changes to the fair value based method of accounting for stock-based employee
compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent
disclosure about the effects on reported net income of an entitys accounting policy decisions with
respect to stock-based employee compensation. Finally, this statement amends APB Opinion No. 28,
Interim Financial Reporting, to require disclosure about those effects in interim financial
information. We adopted SFAS No. 148 in the fourth quarter of 2002. Since we have not changed to a
fair value method of stock-based compensation, the applicable portion of this statement only
affects our footnote disclosures. We do not recognize compensation expense relating to employee stock options because we only
grant options with an exercise price equal to the fair value of the stock on the effective date of
grant. At March 31, 2005, the Company has four stock-based employee and director incentive plans
and an employee stock purchase plan. The Company accounts for these plans under the recognition and
measurement principles of APB No. 25, Accounting for Stock Issued to Employees, and related
interpretations. Stock-based employee compensation costs are not reflected in net income, as all
options granted under the plans had an exercise price equal to the market value of the underlying
common stock on the date of grant. If we had elected to recognize compensation expense using a fair
value approach, and therefore determined the compensation based on the value as determined by the
modified Black-Scholes option pricing model, the pro forma net income and earnings per share would
have been as follows: 6




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Three Months Ended(In thousands, except
    
    March 31,per share amounts)
    
    2005
    
    
    2004Net income, as reported
    
    $
    1,935
    
    
    $
    6,820Deduct: total stock-based compensation expense,
determined under fair value based method for all
awards, net of tax
    
    
    (859
    )
    
    
    (783
    )Pro forma net income
    
    $
    1,076
    
    
    $
    6,037Earnings per share of common stock:Basic  as reported
    
    $
    0.07
    
    
    $
    0.27Basic  pro forma
    
    $
    0.04
    
    
    $
    0.24Diluted  as reported
    
    $
    0.07
    
    
    $
    0.25Diluted  pro forma
    
    $
    0.04
    
    
    $
    0.22
 Pro forma results disclosed are based on the provisions of SFAS 123 using the Black-Scholes
option valuation model and are not likely to be representative of the effects on pro forma net
income for future years. In addition, the Black-Scholes option valuation model was developed for
use in estimating the fair value of traded options, which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of highly subjective
assumptions including the expected stock price volatility. Because our stock options have
characteristics significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in our opinion, the
estimating models do not necessarily provide a reliable single measure of the fair value of our
stock options. The option pricing model utilized the following weighted average assumptions for
2005 and 2004: risk free interest rates of 3.73% for 2005 and 2.81% for 2004; dividend yields of
1.31% for 2005 and 0.82% for 2004; volatility factors of the expected market price of our stock
averaged 0.45 for 2005 and 0.46 for 2004. Employee stock options granted through March 31, 2005
vest over four to five year periods and director options vest at the end of six months from the
grant date. On April 26, 2005, the Compensation Committee of the Board of Directors of Inter-Tel, with the
approval of the board of directors, approved the acceleration of the vesting of certain unvested
stock options previously granted to employees under the Companys 1994 Long Term Incentive Plan,
1997 Long Term Incentive Plan and the Acquisition Stock Option Plan. With the exception of any
options granted to all Directors and Named Executive Officers, all unvested options with exercise
prices greater than the closing price as of the close of the Nasdaq stock market on May 3, 2005
($19.13) became exercisable in full. Such options would otherwise have vested from time to time
over the next five years. Approximately 617,000 options were accelerated at grant prices ranging
from $19.16 to $31.58. All other terms and conditions applicable to outstanding stock option
grants, including the exercise prices and number of shares subject to the accelerated options, were
unchanged. The stock option agreements with respect to the options will be amended accordingly. The Board of Directors considered several factors in determining to accelerate the vesting of
these options, including the effect on the Companys reported stock option expense in future
periods, administrative burden required to track and account for the vesting periods under new
accounting rules and the potential benefit to the Company and its shareholders in retaining the
services of the affected employees. As currently drafted, Statement of Financial Accounting
Standards No. 123 (Revised 2004) or SFAS 123R will require the Company to treat unvested stock
options as an expense effective with the fiscal quarter ending March 31, 2006. Contingencies We are a party to various claims and litigation in the normal course of business. Managements
current estimated range of liability related to various claims and pending litigation is based on
claims for which our management can estimate the amount and range of loss. Because of the
uncertainties related to both the amount and range of loss on the remaining pending claims and
litigation, management is unable to make a reasonable estimate of the liability that could result
from an unfavorable outcome. As 7




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additional information becomes available, we will assess the potential liability related to
our pending litigation and revise our estimates. Such revisions in our estimates of the potential
liability could materially impact our results of operations and financial position. On January 5, 2005, the Company received court approval of a civil settlement agreement (the
Civil Settlement) and a criminal plea agreement (the Plea Agreement) with the United States of
America, each dated as of December 8, 2004 and disclosed on that same date. The court approval of
the Civil Settlement and Plea Agreement resolves the investigation of the Department of Justice
into the participation of Inter-Tel Technologies, Inc., the Companys wholly-owned subsidiary
(Technologies) in a federally administered E-Rate program to connect schools and libraries to
the Internet. In connection with the Civil Settlement, Technologies agreed to pay a penalty of
$6,740,450 and forego the collection of certain accounts receivable of $259,540 related to
Technologies participation in the E-Rate program. In connection with the Plea Agreement,
Technologies entered guilty pleas to charges of mail fraud and an antitrust violation. Under the
Plea Agreement, Technologies agreed to pay a fine of $1,721,000 and observe a three-year
probationary period, which will, among other things, require Technologies to implement a
comprehensive corporate compliance program. The penalties and fines described above were paid
during the first quarter of 2005. In addition, on January 21, 2005, Inter-Tel Technologies received notification from the
Federal Communications Commission that Technologies was temporarily suspended from participation in
the E-Rate program pending a proposed debarment. Technologies has contested the scope and length
of the proposed debarment from the E-Rate program, but there can be no assurance that Technologies
will be successful in this regard. Revenues in 2004 relating to Technologies participation in the
E-Rate program were not significant. The existence and disclosure of the Civil Settlement, Plea Agreement and FCC Notice may have
already caused competitive harm to Inter-Tel, and these matters may further harm Inter-Tels
business. Inventories We value our inventories at the lower of cost (principally on a standard cost basis, which
approximates the first-in, first-out (FIFO) method) or market. Recent Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123R Share Based Payment.This statement is a
revision to SFAS No. 123, supersedes APB No. 25, Accounting for Stock Issued to Employees,and
amends SFAS No. 95, Statement of Cash Flows.This statement will require us to expense the cost
of employee services received in exchange for an award of equity instruments. This statement also
provides guidance on valuing and expensing these awards, as well as disclosure requirements, and is
effective for Inter-Tel for the first interim reporting period that begins January 1, 2006. SFAS
No. 123R permits public companies to choose between the following two adoption methods:  1.
    A modified prospective method in which compensation cost is recognized beginning with
the effective date (a) based on the requirements of SFAS No. 123R for all share-based
payments granted after the effective date and (b) based on the requirements of SFAS No. 123
for all awards granted to employees prior to the effective date of SFAS No. 123R that remain
unvested on the effective date, or2.
    A modified retrospective method which includes the requirements of the modified
prospective method described above, but also permits entities to restate based on the
amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures
either (a) all prior periods presented or (b) prior interim periods of the year of adoption. As permitted by SFAS No. 123, we currently account for share-based payments to employees using
the APB No. 25 intrinsic value method and recognize no compensation cost for employee stock options
or the employee stock purchase plan shares. As proposed, companies would be required to recognize
an expense for compensation costs related to share-based payment arrangements, including stock
options 8




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and employee stock purchase plans. The impact of the adoption of SFAS No. 123R cannot be
predicted at this time because it will depend on levels of share-based payments granted in the
future. However, valuation of employee stock options under SFAS No. 123R is similar to SFAS No.
123, with some exceptions. For information about what our reported results of operations and
earnings per share would have been had we adopted SFAS No. 123, see the table above under the
heading Stock Based Compensation. The adoption of SFAS No. 123Rs fair value method will have a
significant impact on our results of operations, although it will have no impact on our overall
financial position. Due to timing of the release of SFAS No. 123R, we have not yet completed the
analysis of the ultimate impact that this new pronouncement will have on the results of operations,
nor the method of adoption for this new standard. NOTE BEARNINGS PER SHARE Diluted earnings per share assume that outstanding common shares were increased by shares
issuable upon the exercise of all outstanding stock options for which the market price exceeds
exercise price, less shares which could have been purchased with related proceeds, if the effect
would not be antidilutive. The following table sets forth the computation of basic and diluted earnings per share: Three Months Ended(In thousands, except
    
    March 31,per share amounts)
    
    2005
    
    
    2004Numerator: Net income
    
    $
    1,935
    
    
    $
    6,820Denominator:Denominator for basic earnings per share  weighted
average shares
    
    
    26,373
    
    
    
    25,543Effect of dilutive securities:Employee and director stock options
    
    
    1,415
    
    
    
    1,807Denominator for diluted earnings per share  adjusted weighted
average shares and assumed conversions
    
    
    27,788
    
    
    
    27,350Basic earnings per share
    
    $
    0.07
    
    
    $
    0.27Diluted earnings per share
    
    $
    0.07
    
    
    $
    0.25Options excluded from diluted net earnings per share calculations (1)
    
    
    69
    
    
    
    49
    NOTE C  ACQUISITIONS, TECHNOLOGY INVESTMENTS AND RESTRUCTURING CHARGES Lake. On February 28, 2005, Inter-Tel Lake Ltd., a wholly owned Irish subsidiary of
Inter-Tel Incorporated (Inter-Tel) executed an agreement for the purchase of 100% of the issued
share capital of Lake Communications Limited and certain affiliated entities (collectively, Lake)
for $28.7 million (including capitalized transaction costs of $0.7 million), plus an earn-out of up
to $17.6 million based upon certain targets relating to operating results for Lake through the
first eighteen months following the closing date of the transaction. The transaction closed out of
escrow on March 4, 2005 upon the release from escrow of closing documentation. In total, the
company recorded $19.3 million of intangible assets of which $2.6 million was charged to expense in
the first quarter of 2005 as in-process research and development costs with the balance being
amortized over eight years. Additionally we recorded $6.6 million of goodwill, which is
non-amortizable. Lake, based in Dublin, Ireland, is a provider of converged communications products in the under 40
user market, including EncoreCX® products currently being distributed by Inter-Tel in the United
States. Lake 9




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designs and develops its products for sale through a distribution network of telecom operators and
distributors, including Inter-Tel in the United States. Lake outsources its manufacturing to
third-party suppliers. For more than a year, Lake has sold certain communication products to the
company in the ordinary course of business. New Sales Offices in 2004. In January, July and October 2004, we acquired certain
assets and assumed certain liabilities relating to the customer bases of former dealers in
Nashville and Memphis, Tennessee; Greenville, South Carolina; Pittsburgh, Pennsylvania and Las
Vegas, Nevada. The total assets acquired and liabilities assumed from these acquisitions were
approximately $1.7 million and $0.4 million, respectively. Purchased intangibles and goodwill
recorded as a result of the transactions totaled $0.9 million and $2.7 million, respectively. The
goodwill is non-amortizable. The balances included in other purchased intangible assets are being
amortized over a period of five years from the date of each acquisition. New Technology Investments in 2004. In October 2004, the Company acquired certain
assets and assumed certain liabilities of Converging Technologies, Inc. The acquired assets
primarily include Web-based conferencing solutions, notably Linktivity® software. Tangible assets
acquired, liabilities assumed and purchased intangibles (all technology related) acquired were $0.5
million, $0.3 million and $3.0 million, respectively. The purchased intangible is being amortized
over five years. Also in October 2004, the Company obtained a license of intellectual property
from eDial, a division of Alcatel USA Marketing, Inc. for a total price of $1.0 million. The eDial
intangible is being amortized over five years. New Sales Office in 2003. In connection with opening a new sales office in
Philadelphia, Pennsylvania during December 2003, we acquired certain assets and assumed certain
liabilities relating to a customer base of a former dealer. The total assets acquired and
liabilities assumed were approximately $0.6 million and $0.9 million, respectively. Total goodwill
and purchased intangibles recorded as a result of the transaction were $0.2 million and $0.1
million, respectively. The goodwill balance is non-amortizable. The balance included in the $0.1
million in other purchased intangible assets is being amortized over a period of five years. Technology Investment in 2003. In connection with the acquisition of the rights to
certain developed technology for a capitalized purchase price of $2.25 million (included in
purchased intangible assets) during the year ended December 31, 2003, the Company entered into an
arrangement with the selling entity under which the selling entity would perform additional
development activities on a cost reimbursement basis through August 15, 2004. Under the terms of
the arrangement, the selling entity could also earn bonus payments totaling up to $1,000,000 for
meeting certain development milestones. Milestone bonuses totaling $750,000 for the year ended
December 31, 2004 were achieved and expensed as research and development costs. Technological
feasibility of the underlying technology has not yet been achieved to provide for viable product
sales. As of March 31, 2005, the remaining milestone bonus of $250,000 is dependent on future
events and is not considered to be probable or reasonably estimable. The following table
summarizes details of the expenses in connection with this technology investment recorded during
the respective periods: Three Months
    
    
    Three MonthsEnded
    
    
    Ended(In thousands)
    
    March 31, 2005
    
    
    March 31, 2004Milestone bonus payments
    
    $
    
    
    
    $
    250Development activities on a cost
reimbursement basis
    
    
    
    
    
    
    259Totals
    
    $
    
    
    
    $
    509
 The values for acquired developed technology were determined based on the negotiated prices
paid to acquire the technology. Each of our technology acquisitions was made primarily to acquire
a specific technology, rather than for the purpose of acquiring an operating company. The
technologies acquired have been used to add additional features/applications to our current
products, sold separately as new products or obtained primarily for use with our next generation of
products. 10




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The weighted-average amortization period for total purchased intangibles as of March 31, 2005
and December 31, 2004 was approximately 7.45 years and 6.8 years for each period, respectively.
The weighted-average amortization period as of March 31, 2005 and December 31, 2004 for developed
technology was approximately 7.22 and 7.0 years for each period, respectively, and 7.75 and 5.0
years respectively for customer lists and non-compete agreements. Each of the acquisitions discussed above were not material business acquisitions either
individually or collectively and each has been accounted for using the purchase method of
accounting. The results of operations of each of these acquisitions have been included in our
accompanying consolidated statements of operations from the date of the acquisitions. Executone Restructuring Charge. During the second quarter of 2000, we recognized a
restructuring charge related to acquired Executone operations. We accounted for the restructuring
of the Executone operations, including severance and related costs, the shut down and consolidation
of the Milford facility and the impairment of assets associated with the restructuring as
identified in the table below. Accrued costs associated with this plan were estimates, although
the original estimates made for the second quarter of 2000 for reserve balances have not changed
significantly through March 31, 2005. Exit costs associated with the closure of the Milford facility also included liabilities for
building, furniture and equipment lease, and other contractual obligations. We were liable for the
lease on the Milford buildings through January 2005. We entered into sublease agreements with
third parties to sublease portions of the facility and equipment through that date. The reserve
activity for lease and other contractual obligations is identified in the table below. The total restructuring charge from this event totaled $50.9 million. The following table
summarizes details of the restructuring charge in connection with the Executone acquisition,
including the description of the type and amount of liabilities assumed, and activity in the
reserve balances from the date of the charge through March 31, 2005. Activity represents payments
made or amounts written off. Activity
    
    
    
    
    
    
    ReserveCash/
    
    
    Restructuring
    
    
    Through
    
    
    2005
    
    
    BalanceDescription
    
    Non-Cash
    
    
    Charge
    
    
    2004
    
    
    Activity
    
    
    At 3/31/05Personnel Costs:Severance and termination costs
    
    Cash
    
    $
    (1,583
    )
    
    $
    1,583
    
    
    $
    
    
    
    $
    Other plant closure costs
    
    Cash
    
    
    (230
    )
    
    
    230
    
    
    
    
    
    
    
    Lease termination and other
contractual obligations (net of
anticipated recovery):Building and equipment leases
    
    Cash
    
    
    (7,444
    )
    
    
    7,436
    
    
    
    8
    
    
    
    Other contractual obligations
    
    Cash
    
    
    (1,700
    )
    
    
    1,700
    
    
    
    
    
    
    
    Impairment of Assets:Inventories
    
    Non-Cash
    
    
    (3,454
    )
    
    
    3,454
    
    
    
    
    
    
    
    Prepaid inventory
and other expenses
    
    Non-Cash
    
    
    (2,485
    )
    
    
    2,485
    
    
    
    
    
    
    
    Accounts receivable
    
    Non-Cash
    
    
    (1,685
    )
    
    
    1,685
    
    
    
    
    
    
    
    Fixed assets
    
    Non-Cash
    
    
    (3,151
    )
    
    
    3,034
    
    
    
    3
    
    
    
    114Net intangible assets
    
    Non-Cash
    
    
    (29,184
    )
    
    
    29,184
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    $
    (50,916
    )
    
    $
    50,791
    
    
    $
    11
    
    
    $
    114
 11




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##### Table of Contents



NOTE D  SEGMENT INFORMATION Inter-Tel follows Statement of Financial Accounting Standards No. 131, Disclosures about
Segments of an Enterprise and Related Information (SFAS 131). SFAS 131 established standards
for reporting information regarding operating segments in annual financial statements and requires
selected information for those segments to be presented in interim financial reports issued to
stockholders. SFAS 131 also established standards for related disclosures about products and
services and geographic areas. Operating segments are identified as components of an enterprise
about which separate discrete financial information is available for evaluation by the chief
operating decision maker, or decision-making group, in making decisions as to how to allocate
resources and assess performance. The Companys chief decision maker, as defined under SFAS 131, is
the Chief Executive Officer. We view our operations as primarily composed of two segments: (1) our principal segment, which
includes sales of telephone systems, telecommunications software, hardware and related services,
and (2) network services, including resale of local and long distance calling services, voice
circuits and data circuits through NetSolutions®, as well as commissions earned by Network
Services Agency, our division serving as an agent selling local and network services such as T-1
access, frame relay and other voice and data circuit services on behalf of Regional Bell Operating
Companies (RBOCs) and local exchange carriers (collectively, Network Services). Sales of these
systems, software, related services and Network Services are provided through the Companys direct
sales offices and dealer network to business customers in North America, and in parts of Europe,
Australia, South Africa and Asia. As a result, financial information disclosed represents
substantially all of the financial information related to the Companys two principal operating
segments. Results of operations for the resale of local, long distance and network services
segment, if the operations were not included as part of the consolidated group, could differ
materially, as the operations are integral to the total telephony solution offered by us to our
customers. For the quarters ended March 31, 2005 and 2004, we generated income from business segments as
follows: Three Months Ended March 31, 2005Resale of Local,Long DistancePrincipal
    
    
    and Network(In thousands, except per share amounts)
    
    Segment
    
    
    Services
    
    
    TotalNet sales
    
    $
    92,659
    
    
    $
    13,048
    
    
    $
    105,707Gross profit
    
    
    49,262
    
    
    
    4,792
    
    
    
    54,054Operating income
    
    
    1,768
    
    
    
    1,746
    
    
    
    3,514Interest and other income
    
    
    906
    
    
    
    41
    
    
    
    947Foreign currency transaction gains
    
    
    53
    
    
    
    
    
    
    
    53Interest expense
    
    
    (23
    )
    
    
    
    
    
    
    (23
    )Net income
    
    $
    786
    
    
    $
    1,149
    
    
    $
    1,935Net income per diluted share (1)
    
    $
    0.03
    
    
    $
    0.04
    
    
    $
    0.07Weighted average diluted shares
(1)
    
    
    27,788
    
    
    
    27,788
    
    
    
    27,788Goodwill
    
    $
    24,325
    
    
    $
    2,135
    
    
    $
    26,460Total assets
    
    
    403,885
    
    
    
    7,968
    
    
    
    411,853Depreciation and amortization
    
    
    3,062
    
    
    
    8
    
    
    
    3,070
 12




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##### Table of Contents



Three Months Ended March 31, 2004Resale of Local,Long DistancePrincipal
    
    
    and Network(In thousands, except per share amounts)
    
    Segment
    
    
    Services
    
    
    TotalNet sales
    
    $
    86,049
    
    
    $
    11,982
    
    
    $
    98,031Gross profit
    
    
    47,174
    
    
    
    4,924
    
    
    
    52,098Operating income
    
    
    8,455
    
    
    
    2,159
    
    
    
    10,614Interest and other income
    
    
    450
    
    
    
    56
    
    
    
    506Foreign currency transaction losses
    
    
    (161
    )
    
    
    
    
    
    
    (161
    )Interest expense
    
    
    (45
    )
    
    
    (1
    )
    
    
    (46
    )Net income
    
    $
    5,444
    
    
    $
    1,376
    
    
    $
    6,820Net income per diluted share (1)
    
    $
    0.20
    
    
    $
    0.05
    
    
    $
    0.25Weighted average diluted shares (1)
    
    
    27,350
    
    
    
    27,350
    
    
    
    27,350Goodwill
    
    $
    15726
    
    
    $
    2,135
    
    
    $
    17,861Total assets
    
    
    348,511
    
    
    $
    22,153
    
    
    $
    370,664Depreciation and amortization
    
    
    2,367
    
    
    
    14
    
    
    
    2,381
    Our revenues are generated predominantly in the United States. Total revenues generated from U.S.
customers totaled $99.8 million, or 94.4% of total revenues, and $94.8 million, or 96.7% of total
revenues for the three months ended March 31, 2005 and 2004, respectively. Refer to the table
below for additional geographical revenue data. Quarter Ended March 31, 2005
    
    
    Quarter Ended March 31, 2004Source of net sales
    
    $
    
    
    %
    
    
    $
    
    
    %Domestic
    
    
    99,753
    
    
    
    94.4
    %
    
    
    94,781
    
    
    
    96.7
    %Lake Communications
    
    
    2,590
    
    
    
    2.4
    
    
    
    
    
    
    
    Other International
    
    
    3,364
    
    
    
    3.2
    
    
    
    3,250
    
    
    
    3.3Total net sales
    
    
    105,707
    
    
    
    100.0
    %
    
    
    98,031
    
    
    
    100.0
    %
 In the first three months of 2005 and 2004, revenues from customers located internationally
accounted for 5.6% and 3.3% of total revenues, respectively. 2005 revenue percentages from foreign
sources primarily increased as a result of our acquisition of Lake in March 2005. Lake is based in
Dublin, Ireland with majority of its sales made to the United Kingdom, Australia, other European
countries, and South Africa. Other International revenues identified in the table above primarily
consist of revenues from Inter-Tels UK operations, including sales from Swan Solutions. Our UK
offices sell predominantly into the United Kingdom and other European countries. All sales made
between Inter-Tel divisions are eliminated and are not represented in the above amounts or in the
Consolidated Statements of Income. Our applicable long-lived assets at March 31, 2005, included Property, Plant & Equipment;
Goodwill; and Purchased Intangible Assets. The net amount located in the United States was $55.6
million and the amount in foreign countries was $26.6 million at March 31, 2005. At December 31,
2004, the net amount located in the United States was $56.1 million and the amount in foreign
countries was $2.6 million. NOTE E  NET INVESTMENT IN SALES-LEASES Net investment in sales-leases represents the value of sales-leases presently held under our
Total Solution program. We currently sell the rental payments due to us from most of the
sales-leases. We maintain reserves against our estimate of potential credit losses for the balance
of sales-leases held and
for the balance of sold rental payments remaining unbilled. The following table provides
detail on the total net balances in sales-leases: 13




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##### Table of Contents



March 31,
    
    
    December 31,(in thousands)
    
    2005
    
    
    2004Lease balances included in consolidated accounts receivable, net of
allowances of $1,206 in 2005, and $1,177 in 2004
    
    $
    5,348
    
    
    $
    6,390Net investment in Sales-Leases:Current portion, net of allowances of $861 in 2005, and $866 in 2004
    
    
    18,160
    
    
    
    17,151Long-term portion, includes residual amounts of $684 in 2005 and, $510 in 2004,
net of allowances of $1,960 in 2005, and $1,810 in 2004
    
    
    35,781
    
    
    
    33,877Total investment in Sales-Leases, net of allowances of $4,027 in 2005, and $3,873
in 2004
    
    
    59,289
    
    
    
    57,418Sold rental payments remaining unbilled (subject to limited recourse provisions),
net of allowances of $12,721 in 2005, and $12,241 in 2004
    
    
    236,337
    
    
    
    229,163Total balance of sales-leases and sold rental payments remaining unbilled, net of
allowances
    
    $
    295,626
    
    
    $
    286,581Total allowances for entire lease portfolio (including limited recourse liabilities)
    
    $
    16,748
    
    
    $
    16,114
 Reserve levels are established based on portfolio size, loss experience, levels of past
due accounts and periodic, detailed reviews of the portfolio. Recourse on the sold rental payments
is contractually limited to a percentage of the net credit losses in a given annual period as
compared to the beginning portfolio balance for a specific portfolio of sold leases. While our
recourse is limited, we maintain reserves at a level that we believe is sufficient to cover all
anticipated credit losses. The aggregate reserve for uncollectible lease payments and recourse
liability represents the reserve for the entire lease portfolio. These reserves are either netted against consolidated accounts receivable, netted against
current or long-term investment in sales-leases or included in long-term liabilities for sold
rental payments remaining unbilled. Sales of rental payments per period are as follows: Three Months Ended
    
    
    Year Ended(In thousands)
    
    March 31, 2005
    
    
    December 31, 2004Sales of rental payments
    
    $
    28,944
    
    
    $
    113,172Sold payments remaining unbilled at end of period
    
    $
    249,058
    
    
    $
    241,404
 Sales of rental payments represent the gross selling price or total present value of the
payment stream on the sale of the rental payments to third parties. Sold payments remaining
unbilled at the end of the period represent the total balance of leases that is not included in our
balance sheet. We do not expect to incur any significant losses in excess of reserves from the
recourse provisions related to the sale of rental payments. During the first quarter of 2005, the Company entered into a rate-lock agreement (the
Agreement) with a financial institution in the form of a commitment to sell the cash flow streams
for leases with a present value of at least $22.0 million in June 2005 at an interest rate to the
financial institution of 6.25 percent and $17.0 million in December 2005 at an interest rate to the
financial institution of 6.30 percent. Should interest rates decrease substantially, the Company
has the option to pay $500,000 to the financial institution to cancel the commitment for each of
the two sales. 14




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##### Table of Contents



ITEM 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
 This Quarterly Report to Shareholders onForm 10-Q(10-Q) contains forward-looking
statements that involve risks and uncertainties. The statements contained in this 10-Q that are
not purely historical are 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, including without limitation statements regarding our expectations, beliefs, intentions or
strategies for the future. All forward-looking statements included in this document are based on
information available to us on the date hereof, and we assume no obligation to update any such
forward-looking statements. The cautionary statements made in this 10-Q should be read as being
applicable to all related forward-looking statements wherever they appear in this document. Our
actual results could differ materially from those anticipated in these forward-looking statements
as a result of certain factors, including those set forth under Factors That May Affect Future
Operating Results below and elsewhere in this document. Overview Inter-Tel (Nasdaq: INTL), Incorporated in 1969, is a single point of contact, full service
provider of converged voice and data business communications systems, voice mail systems and
networking applications. Our customers include business enterprises, federal, state and local
government agencies and non-profit organizations. We market and sell the following products and
services:  
    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,
    IP telephony voice and data routers, and e-commerce software,
    managed services, including voice and data network design and traffic provisioning,
custom application development, 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. We have developed a distribution network of direct sales offices, dealers and value added
resellers (VARs), which sell our products to organizations throughout the United States and
internationally, primarily targeting small-to-medium enterprises, service organizations and
governmental agencies. As of March 31, 2005, we had fifty-nine (59) direct sales offices in the
United States and a network of hundreds of dealers and VARs, primarily in the United States, that
purchase directly from us. Included in our sales office in Phoenix is the primary location for our
national and government accounts division, as well as our local, long distance and network services
divisions. Our wholesale distribution center is located in Tempe, Arizona, which is the primary
location from which we distribute products to our network of direct sales offices, dealers and VARs
in North America. In addition, we maintain a wholesale distribution office in the United Kingdom
that supplies Inter-Tels dealers and distributors throughout the UK and other parts of Europe, and
we have dealers in South Africa and Japan. We also maintain research and development and software
sales offices in Tucson, Arizona and in the United Kingdom. In March 2005, as a result of the
closing of the Lake acquisition identified below, we will also maintain a wholesale distribution
office in Dublin, Ireland that supplies Inter-Tels dealers and distributors in the UK, Ireland,
other parts of Europe and Australia. On October 14, 2004, Inter-Tel announced the purchase by an operating subsidiary of selected
assets and assumption of certain liabilities of Converging Technologies, Inc. and Linktivity, Inc.
The acquired assets primarily include Web-based conferencing solutions, notably Linktivity®
software. These solutions
provide real-time communications and remote control software to enable instantaneous,
browser-to- 15




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##### Table of Contents



browser Web conferencing and
help desk support solutions. We expect the acquisition of these
selected assets to enable Inter-Tel to continue to expand its Presence Management and Collaboration
tools. Linktivity offers its products and services through its international distributors and
certified North American resellers. On that same date, Inter-Tel also announced the license of
intellectual property from eDial, a division of Alcatel USA Marketing, Inc., and provider of
Session Initiation Protocol (SIP) audio conferencing and collaboration solutions for enterprises
and service providers. The eDial and Linktivity technologies were selected to complement
Inter-Tels Converged Business Communication systems and to allow Inter-Tel to further enhance its
presence management, conferencing and collaboration products. On
February 28, 2005, Inter-Tel Lake Ltd., a wholly owned Irish
subsidiary of Inter-Tel,
Incorporated (Inter-Tel) executed an agreement for the purchase of 100% of the issued share
capital of Lake Communications Limited and certain affiliated entities (collectively, Lake) for
$28.7 million (including capitalized transaction costs of $0.7 million), plus an earn-out of up to
$17.6 million based upon certain targets relating to operating results for Lake through the first
eighteen months following the closing date of the transaction. The transaction closed out of
escrow on March 4, 2005 upon the release from escrow of closing documentation. Lake, based in
Dublin, Ireland, is a provider of converged communications products in the under 40-user market,
including EncoreCXÒ products distributed by Inter-Tel in the United States.
Lake designs and develops its products for sale through a distribution network of telecom operators
and distributors, including Inter-Tel in the United States. Lake outsources its manufacturing to
third-party suppliers. For more than a year, Lake has sold certain communications products to the
Company in the ordinary course of its business. Key performance indicators that we use in order to manage our business and evaluate our
financial and operating performance include revenues, costs and gross margins, and cash flows. Inter-Tel recognizes revenue from the following significant sources of revenue:  
    End-user sales and sales-type leases through our direct sales offices and government and
national 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 or 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 recent 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. Our costs of products sold primarily consist of materials, labor and
overhead. Our costs of services performed consist primarily of labor, materials and service
overhead. Total costs of goods and services sold increased 12.5%, or $5.7 million, to $51.7 million for
the quarter ended March 31, 2005, compared to $45.9 million for the corresponding period in 2004.
Our consolidated gross margin percentage was 51.1% in the first quarter of 2005 compared to 53.1%
in the first quarter of 16




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2004. The increase in the dollar amount of the cost of goods sold was
primarily attributable to the higher volume of net sales. However, the decrease in gross margin
was principally attributable to significant pricing pressures and product discounts, in particular
for larger deals, as well as greater than expected sales of lower margin products as a percentage
of total sales, and lower than expected sales in our direct sales offices and government and
national accounts businesses, which generally offer higher gross margins compared to our other
distribution channels and operations. Other factors affecting both the increases in costs of goods
sold and reductions in overall gross margin percentage are described in greater detail in Results
of Operations below. Sales of systems through our direct sales organization typically generate higher gross margins
than sales through our dealers and VARs, primarily because we recognize both the wholesale and
retail margins on these sales. Conversely, sales of systems through our dealers and VARs typically
generate lower gross margins than sales through our direct sales organization, although direct
sales typically require higher levels of selling, general and administrative expenses. In
addition, our long distance services and Datanet products typically generate lower gross margins
than sales of software and system products. For revenues recognized under sales-leases, we record
the costs of systems installed as costs of sales. Our margins may vary from period to period
depending upon the representation of various distribution channels, products and software as
relative percentages of our total sales. In the event that sales through our direct sales offices
increase as a percentage of net sales, our overall gross margin could improve. Conversely, in the
event net sales to dealers or sales of long distance services increase as a percentage of net
sales, our overall gross margin could decline. Additionally, our operating results depend upon a variety of factors, including the volume and
timing of orders received during a period, general economic conditions and world events impacting
businesses, patterns of capital spending by customers, the timing of new product announcements and
releases by us and our competitors, pricing pressures, the cost and
impact of acquisitions and the
availability and cost of products and components from our suppliers. Historically, a substantial
portion of our net sales in a given quarter has been recorded in the third month of the quarter,
with a concentration of such net sales in the last two weeks of the quarter. There are several
factors which attribute to this pattern, including the following:  
    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.
    Some price discounting to our dealer channel occurs during the last month of a quarter
or year, and some dealers purchase consistently to take advantage of potential pricing
discounts or end-of-quarter promotions. Dealer buying habits have been consistently
applied for years. In addition, we are subject to seasonal variations in our operating results, as net sales for
the first and third quarters are frequently less than those experienced during the fourth and
second quarters, respectively. Net sales from the first quarter of 2005 followed this historical
pattern, as sales declined compared to the fourth quarter of 2004, and we do not anticipate a
significant change in the historical trend. Cash Flows. At March 31, 2005, Inter-Tels cash and short-term investments totaled $181.1
million. We also maintain a $10 million unsecured, revolving line of credit with BankOne, NA,
which is available through June 1, 2006 and ordinarily used to support international letters of
credit to suppliers, if necessary. As of March 31, 2005, none of the credit line was used. Historically, our primary
source of cash has come from net income plus non-cash charges for depreciation and amortization
expenses. We have generated cash from continuing operations in every year since 1986. In 1993,
1995 and 1997, the Company received net proceeds from stock offerings, offset in part by cash
expended to repurchase the Companys common stock in these and other periods. In addition,
Inter-Tel historically has paid cash for capital expenditures 17




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relating to property and equipment or
acquisitions. Inter-Tel has also received cash proceeds from the exercise of stock options and our
Employee Stock Purchase Plan. We believe our working capital and credit facilities, together with
cash generated from operations, will be sufficient to develop and expand our business operations,
to finance acquisitions of additional resellers of telephony products and other strategic
acquisitions or corporate alliances, to fund the special dividend of $1.00 per share to
shareholders of record on March 31, 2005, to repurchase shares of the Companys common stock
pursuant to a Board approved repurchase program of up to $75 million announced in February 2005,
and to provide adequate working capital for the foreseeable future. Our consolidated net sales for the quarters ended March 31, 2005 and 2004 were $105.7 million
and $98.0 million, respectively. The 7.8% increase in revenue in the first quarter of 2005 compared
to the first quarter of 2004 was primarily attributable to acquisitions completed in the second
half of 2004 and the Lake acquisition in March 2005 (as the sales from these acquired entities were
not included in the 2004 first quarter results), as well as slightly
higher net sales in our core
business. The increase in net sales can also be attributed in part to improved sales in our local,
long distance resale and network services division. Net sales in the first quarter of 2005 were
negatively impacted, however, by the delayed release of new products,
in particular the Inter-Tel 5000 Network
Communications Solutions, which were not released until late April 2005, and discounting of new
product sales in our direct sales channels. We cannot provide assurance that the recent increase
in revenue will continue in the future, as we believe businesses may be reluctant to significantly
increase spending on enterprise communications systems in the near future. In addition, we believe
uncertainty exists in the marketplace caused by the transition of communication systems from
circuit-switch to packet-switch architectures, including voice over Internet Protocol (VoIP)
systems, and some buyers may delay making investments in new systems. We believe that enterprises continue to be concerned about their ability to increase revenues
and profitability, in part due to the continued uncertain economic environment and slowdown in the
past few years. To maintain or improve profitability, we believe that businesses have attempted to
reduce costs and capital spending. We expect continued pressure on our ability to generate or
expand sales and it is not clear whether business communications
spending will increase in the near term. We cannot predict the nature, timing and extent of future business
investments in communications systems and as a result, if and when our net sales will increase. The markets in which we compete have been characterized by rapid technological changes and
increasing customer requirements. We have sought to address these requirements through the
development of software enhancements and improvements to existing systems and the introduction of
new systems, products, and applications. Inter-Tels research and development efforts over the
last several years have been focused primarily on the development of, and enhancements to, the
Inter-Tel 5000 Network Communications Solutions, our Axxess system, including adding new
applications, enhancing our IP convergence applications and IP endpoints, developing Unified
Communications applications, developing presence management applications, developing Session
Initiation Protocol (SIP) applications, and developing speech-recognition and text-to-speech
applications. More recently, Inter-Tels research and development efforts have been focused on the
development of converged systems and software, including the Inter-Tel 5000 Network Communications
Solutions, Session Initiation Protocol (SIP) interfaces and applications, as well as the
development of a new line of multi-protocol SIP IP endpoints. In addition, in October 2004, we
acquired selected assets and assumed certain liabilities of Linktivity, which develops Web-based
conferencing solutions, notably Linktivity® software, and announced an agreement to license
certain intellectual property from eDial. These solutions are designed to provide real-time
communications and remote control software to enable instantaneous, browser-to-browser Web
conferencing and help desk support solutions. We intend to further develop this technology and
integrate the applications and solutions into our product offerings. We offer our customers a package of lease financing and other services under the name Total
Solution. Total Solution provides our customers lease financing, maintenance and support services,
fixed price upgrades and other benefits. We finance this program through the periodic resale of
lease rental streams to financial institutions. Refer to Note E of Notes to Condensed Consolidated
Financial Statements for additional information regarding our program. 18




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Results of Operations The following table sets forth certain statement of operations data expressed as a percentage
of net sales for the periods indicated: Three Months EndedMarch 31,2005
    
    
    2004NET SALESTelecommunications systems, software and related
    
    
    87.7
    %
    
    
    88.5
    %Resale of local, long distance and network services
    
    
    12.3
    
    
    
    11.5TOTAL NET SALES
    
    
    100.0
    
    
    
    100.0COST OF SALESTelecommunications systems, software and related
    
    
    41.1
    
    
    
    39.7Resale of local, long distance and network services
    
    
    7.8
    
    
    
    7.2TOTAL COST OF SALES
    
    
    48.9
    
    
    
    46.9GROSS PROFIT
    
    
    51.1
    
    
    
    53.1Research and development
    
    
    8.0
    
    
    
    6.2Selling, general and administrative
    
    
    36.6
    
    
    
    35.7Amortization of intangibles
    
    
    0.7
    
    
    
    0.5Write-off of in-process research and development costs
    
    
    2.5
    
    
    
    OPERATING INCOME
    
    
    3.3
    
    
    
    10.8Interest and other income
    
    
    0.9
    
    
    
    0.5Foreign currency transaction gains (losses)
    
    
    0.1
    
    
    
    (0.2
    )Interest expense
    
    
    (0.0
    )
    
    
    (0.0
    )INCOME BEFORE INCOME TAXES
    
    
    4.2
    
    
    
    11.1INCOME TAXES
    
    
    2.4
    
    
    
    4.2NET INCOME
    
    
    1.8
    %
    
    
    7.0
    %
 Net Sales.Net sales increased 7.8%, or $7.7 million, to $105.7 million in the first quarter
of 2005, from $98.0 million in the first quarter of 2004. Excluding the Lake acquisition in first
quarter of 2005, non-GAAP net sales increased 5.2% or
$5.1 million compared to net sales for the corresponding prior
year period. Sales from our direct sales offices
(including revenues from lease financing), increased 5.1%, or $2.8 million, in the first quarter of
2005 compared to the corresponding period in 2004. Sales attributable to our dealer network
increased by 1.8%, or $0.4 million, in the first quarter of 2005, compared to the corresponding
period in 2004. Sales from our local and long distance resale and network services division
increased by 8.9%, or $1.1 million, in the first quarter of 2005, compared to the corresponding
period in 2004. Sales from our DataNet division increased 25.3%, or $0.7 million, in the first
quarter of 2005, compared to the corresponding period in 2004. International revenues excluding
the Lake acquisition increased by 3.5%, or $0.1 million, in the first quarter of 2005, compared to
the corresponding period in 2004. Lake sales totaled $2.6 million in the first quarter of 2005.
Overall, sales attributable to our government and national accounts division remained relatively
unchanged in first quarter of 2005 compared to the corresponding period in 2004. The increase in net sales for the first quarter of 2005 compared to the corresponding period
in 2004 from our direct sales offices, dealer channel, and international operations were primarily
attributable to acquisitions completed in the second half of 2004 and the Lake acquisition in March
2005, offset in part by continued competitive pricing pressures and some delayed buying decisions
and heavy discounting during the quarter in our direct sales offices. We believe that the
announcement of the E-Rate settlement also resulted in some deferred or lost sales. The increases
in net sales were also a result of higher volumes of systems sold. In some instances, prices of
various telecommunications systems decreased, and discounts or other promotions were offered to
customers to generate sales in both our direct and indirect
channels. 19




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Recurring revenues from existing customers increased on a percentage basis and
dollar volume relative to sales to new customers in our direct sales channel during the first
quarter of 2005. Sales from our local, long distance resale and network services divisions (NetSolutionsâ
and Network Services Agency) and our DataNet division increased in the first quarter of 2005 as
compared to the corresponding period in 2004. Net sales increased by 6.9%, or $0.8 million, to $12.0
million in the first quarter of 2005, compared to $11.2 million in the corresponding period in 2004
for NetSolutionsâ, despite downward pricing pressure and
significant competition. Increased sales volume has allowed NetSolutions â to
offer more competitive pricing, which improved sales to our existing customer base. Sales
increased in DataNet primarily due to additional sales to a few customers. Net sales from Network
Services Agency, a commission-based sales unit within the local, long distance resale and network
services division acting as an agent to sell services for selected RBOCs and CLECs, increased
$0.3 million, to $1.0 million in the quarter ended March 31, 2005 compared to $0.7
million in the corresponding period in 2004. See Note D of Notes
to Condensed Consolidated Financial Statements for additional segment reporting information. Gross Profit. Gross profit for the first quarter of 2005 increased 3.8% to $54.1 million, or
51.1% of net sales, from $52.1 million, or 53.1% of net sales, in the first quarter of 2004. The
increase in gross profit dollars in the first quarter of 2005 resulted primarily from a higher
volume of consolidated net sales. The decrease in gross profit as a percentage of sales was primarily a result of industry pricing pressures, leading to discounting and special
promotions on telephone system sales. Increased sales from the resale of local and long distance
services also had the effect of decreasing the consolidated gross profit percentage, as these
revenues typically generate lower gross margins. Higher relative recurring revenues from existing
customers partially offset the decreases in gross profit percentage. During the first quarter of 2005, recurring revenue dollars from existing customers in our
direct sales, DataNet and national and government accounts channels increased from these same
channels relative to the first quarter of 2004. As a percentage of sales, recurring revenues
increased in the direct sales and DataNet channels and remained relatively constant for the
national and government accounts channel. Existing customers accounted for a significant portion
of our net sales from maintenance and other services, software additions and/or upgrades, and other
peripheral products such as video conferencing, call logging solutions, wireless endpoints, power
protection, wired and wireless headsets, audio conferencing units and networking products during
the first quarter of 2005. Our business communications platforms allow for system migration
without the complete replacement of hardware, enabling us to offer enhancements and new solutions
through software-only upgrades to our existing customers. Consequently, our gross margins are
generally higher with recurring revenues because we incur less materials costs relative to new
installations. Sales from NetSolutionsâ increased by 6.9%, or $0.8 million, in the first quarter of
2005 as compared to the first quarter of 2004. Gross margins are generally lower in this division
than our consolidated margins. Sales from Network Services Agency, increased 40.0%, or $0.3
million, for the first quarter of 2005 compared to the corresponding period in 2004. This division
generally receives commissions on network services we sell as an agent for Regional Bell Operating
Companies. Sales from this division carry little to no equipment costs and generated margins of
86.2% during the first quarter of 2005. Accordingly, the increase in sales from this division
offset in part our decrease in consolidated gross profit percentage. We cannot accurately predict future consolidated gross margins because of period-to-period
variations in a number of factors, including among others, competitive pricing pressures, sales of
systems, software and services through different distribution channels, supplier and agency
agreements, and the mix of systems, software and services we sell. Research and Development. Research and development expenses for the first quarter of 2005
increased 40.1% to $8.5 million, or 8.0% of net sales, from $6.0 million, or 6.2% of net sales, for
the first quarter of 2004. Included in research and development expenses in both the first quarter
of 2005 and the first quarter of 2004 was amortization of patents totaling $55,000 in each period.
The increases in research and development expenses for the first quarter ended March 31, 2005 were
primarily attributable to the increased engineering headcount and third-party outsourcing of
selected development costs in connection
with our efforts to accelerate development of new products and software, as well as additional
research and development costs associated with our acquired Lake and Linktivity operations. The
increases were also 20




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attributable to increased research and development spending related to our
development of convergence applications and new SIP and IP endpoint technology. In the first
quarter ended March 31, 2005, research and development expenses were directed principally toward
the continued development of converged systems and software, including the Inter-Tel 5000, unified
messaging and voice processing software, speech recognition and text-to-speech applications, call
center applications, unified communications applications, IP endpoint development, and certain CTI
and IVR applications and SIP applications. Through 2005, we expect that research and development
expenses will increase in absolute dollars and as a percentage of net sales relative to 2004 due
primarily to research and development costs from the acquired Lake and Linktivity operations, and
our efforts to continue to develop and enhance existing and new technologies and products. Selling, general and administrative. In the first quarter of 2005, selling, general and
administrative expenses increased 10.6% to $38.7 million, or 36.6% of net
sales, from $35.0 million, or 35.7% of net sales, in the first quarter of 2004. The increases in
absolute dollars and as a percentage of net sales were primarily due to higher expenses associated
with the increases in consolidated net sales in 2005 compared to 2004. Expenses also increased as
a result of the acquisition of new sales offices in South Carolina, Las Vegas, Pittsburgh and
Tucson (Linktivity) during the second half of 2004, as well as the Lake operations in Dublin,
Ireland. In addition, higher net sales led to increased selling expenses and commission costs in
the first quarter of 2005 relative to such costs for the corresponding periods in 2004. In the
first quarter of 2005, selling, general and administrative expenses also increased as a result of
higher depreciation expense, offset in part by lower bad debts relative to 2004. We expect that
for the foreseeable future selling, general and administrative expenses may vary in absolute
dollars and as a percentage of net sales. Amortization of purchased intangible assets. We adopted Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) effective in the beginning
of fiscal 2002. In accordance with SFAS 142, we ceased amortizing goodwill. We are required to
perform goodwill impairment tests on an annual basis and between annual tests in certain
circumstances. As of March 31, 2005, no impairment of goodwill has been recognized in 2005. We
face the risk that future goodwill impairment tests may result in charges to earnings. Amortization of purchased intangible assets included in operating expenses was $762,000 in the
first quarter of 2005, compared to $445,000 in the first quarter of 2004. In addition, $55,000 of
amortization was included in research and development expenses for the first quarter of 2005 and
the first quarter of 2004. The increase in the amortization of purchased intangible assets for the
first quarter 2005 compared to the same period in 2004 was primarily related to the additional
amortization from recent acquisitions, primarily the Lake and Linktivity acquisitions. For
additional information regarding purchased intangible assets, see Note C Acquisitions, Technology
Investments and Restructuring Charges to the Condensed Consolidated Financial Statements. Write-off of in-process research and development (IPRD) costs. During the first quarter of
2005, Inter-Tel completed the acquisition of Lake (see NOTE C). The aggregate purchase price of the
Lake acquisition was allocated to the fair value of the assets and liabilities acquired, of which
$2.6 million, or $0.09 per diluted share, was written-off as purchased IPRD. Without this
write-off, the Company would have reported non-GAAP net income of $4.5 million ($0.16 per diluted share) for
the three months ended March 31, 2005 instead of the $1.9 million ($0.07 per diluted share) reported. Interest and Other Income. Interest and other income in 2005 and 2004 consisted primarily of
interest income and foreign currency transaction gains or losses. The net increase in interest and
other income of $441,000 in the first quarter of 2005 compared to the corresponding period in 2004
was due primarily to higher levels of invested funds, as well as higher interest rates. Net
foreign currency transaction gains in the first three months of 2005 were $53,000 compared to
losses of $161,000 in the first three months of 2004. Interest expense was nominal in both
periods, totaling $23,000 in the first three months of 2005 compared to $46,000 in the first three
months of 2004. Income Taxes. Inter-Tels income tax rate for the first quarter of 2005 was 56.9% compared to
37.5% for the first quarter of 2004. The increase in the rate was primarily attributable to the
write-off of in-process research and development costs in connection with our Lake acquisition,
because these costs are 21




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not deductible for tax
purposes. Inter-Tel currently expects the
full-year 2005 tax rate to be 37.8%, subject to prospective changes in the tax laws or other
factors. Excluding the acquisition of Lake, the non-GAAP, or pro
forma, full-year rate for 2005 is currently projected to
be 36%, a decrease compared to 2004. This pro forma decrease compared
to 2004 is expected due to several
factors, including the differences between the projected 2005 and 2004 results, in particular
higher projected 2005 tax-exempt interest and higher utilization of 2005 research and development
credits. The 2005 rate is subject to change based on the projected results of operations,
including the Lake acquisition and other factors identified above. Net Income. Net income for the first quarter of 2005 was $1.9 million ($0.07 per diluted
share), a decrease of 71.6% compared to net income of $6.8 million ($0.25 per diluted share) in the
first quarter of 2004. The decrease in net income for the first quarter and of 2005 compared to the corresponding
period in 2004 was primarily attributable to the write-off of IPRD costs in connection with the Lake
acquisition, lower gross margins as a result of competitive pressures and product discounting,
higher research and development expenses, higher selling, general and administrative expenses, and
higher amortization expenses, offset in part by operating profits from higher relative net sales.
Excluding the write-off of IPRD, the Company would have reported net income of $4.5 million ($0.16
per diluted share) for the three months ended March 31, 2005. Additional information regarding
other items is described in further detail above. Inflation/Currency Fluctuation Inflation and currency fluctuations have not previously had a material impact on Inter-Tels
operations. Inter-Tels International procurement agreements have traditionally been denominated
in U.S. currency. Moreover, a significant amount of contract manufacturing has been or may be
moved to alternative sources. The expansion of international operations in the United Kingdom and
Europe and increased sales, if any, in Ireland, Europe and Australia as a result of the 2005 Lake
acquisition could result in higher international sales as a percentage of total revenues; however,
international revenues do not currently represent a significant portion of our total revenues. Liquidity and Capital Resources Three Months EndedMarch 31,(In thousands)
    
    2005
    
    
    2004Net cash (used in) provided by operating activities
    
    $
    (2,407
    )
    
    $
    15,920Net cash (used in) provided by investing activities
    
    
    (28,463
    )
    
    
    1,183Net cash provided by financing activities
    
    
    3,900
    
    
    
    1,698Effect of exchange rate changes
    
    
    464
    
    
    
    292Increase (decrease) in cash and equivalents
    
    
    (26,506
    )
    
    
    19,093Cash and equivalents at beginning of period
    
    
    152,330
    
    
    
    115,197Cash and equivalents at end of period
    
    $
    125,824
    
    
    $
    134,290
 At March 31, 2005, cash and equivalents and short-term investments totaled $181.1 million, a
decrease of approximately $23.8 million from the balance at December 31, 2004. In addition,
long-term investments in marketable debt securities totaled $5.9 million at March 31, 2005, a
decrease of $4.0 million from the balance at December 31, 2004. We maintain a $10 million
unsecured, revolving line of credit with JPMorgan Chase Bank, N.A.
(formerly BankOne, NA) that is available through June 1, 2006. Under
the credit facility, we have the option to borrow at a prime rate or adjusted LIBOR interest rate.
Historically, we have used the credit facility primarily to support international letters of credit
to suppliers. As of March 31, 2005, none of the credit line was used. The remaining cash balances
may be used for acquisitions, strategic alliances, working capital, dividends and general corporate
purposes. Net cash used in operating activities totaled $2.4 million for the three months ended March
31, 2005, compared to $15.9 million provided by operating activities for the corresponding period
in 2004. Cash used in operating activities in the first three months of 2005 was primarily the
result of an $11.9 million change in operating assets and liabilities (including E-Rate of $8.5
million), offset by cash generated from profitable operations, adding back non-cash items such as
depreciation, amortization, purchased in process research 22




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and development and provisions for
losses. The net cash provided by operating activities in the first three months of 2004 was
primarily the result of cash generated from profitable operations as in 2005; however, the 2004
period did not include any purchased in-process research and development costs. In addition, the
first three months of 2004 reflected cash generated by an increase in deferred income taxes of $4.9
million and a change of operating assets and liabilities of $1.1 million. The cash used in the
change in operating assets and liabilities in the first three months of 2005 was primarily due to
the payment of the E-rate settlement costs totaling $8.5 million (described below), as well as an
increase in inventories, investment in sales-leases and income tax receivables, offset in part by
increases in accounts payable and a decrease in accounts receivable. The $1.1 million cash
provided by the change in operating assets and liabilities in the first three months of 2004 was
primarily a result of a decrease in the income tax receivable and accounts receivable, offset in
part by an increase in inventories and a decrease in accrued expenses. We expect to expand sales
through our direct sales offices and dealer networks, which is expected to require the expenditure
of working capital for increased accounts receivable, inventories and net investment in
sales-lease. Net cash used in investing activities totaled $28.5 million for the quarter ended March 31,
2005, compared to cash provided by investing activities of $1.2 million for the quarter ended March
31, 2004. The change from 2004 to 2005 was primarily a result of $27.6 million in cash used for
acquisitions in the first quarter of 2005. There was no cash used for acquisitions in the first
quarter of 2004. Net cash generated by maturities and sales of short-term investments during the
first three months of 2005 was $11.6 million, offset by net cash used in the purchase of short-term
investments of $10.3 million. Net cash was generated by maturities and sales of short-term
investments of $22.4 million in the first quarter of 2004, offset by cash used in the purchase of
long-term and short-term investments of $20.0 million. Net cash of $2.2 million was used to
acquire additional property, plant and equipment during the first quarter of 2005 compared to $1.2
million for the corresponding period in 2004. Net cash provided by financing activities totaled $3.9 million for the quarter ended March 31,
2005, compared to $1.7 million for the corresponding period in 2004. Net cash used for cash
dividends totaled $1.8 million in the first quarter of 2005 compared to $1.5 million in the same
period for 2004. Net cash provided by proceeds from the exercise of stock options totaled $5.7
million in the first quarter of 2005 compared to $3.2 million in the same period for 2004. During
the first quarter of 2005 we reissued treasury shares through stock option exercises and issuances,
with the proceeds received totaling less than the cost basis of the treasury stock reissued.
Accordingly, the difference was recorded as a decrease to retained earnings of $1.3 million.
During the first quarter of 2004 we reissued treasury shares through stock option exercises and
issuances, with the proceeds received totaling more than the cost basis of the treasury stock
reissued. Accordingly, the difference was recorded as an increase to retained earnings of $0.5
million. We offer to our customers lease financing and other services, including our Total Solution
(formerly Totalease) program, through our Inter-Tel Leasing, Inc. subsidiary. We fund our Total
Solution program in part through the sale to financial institutions of rental payment streams under
the leases. Sold lease rentals totaling $249.1 million and $241.4 million remained unbilled at
March 31, 2005 and December 31, 2004, respectively. We are obligated to repurchase such income
streams in the event of defaults by lease customers and, accordingly, maintain reserves based on
loss experience and past due accounts. Although, to date, we have been able to resell the rental
streams from leases under the Total Solution program profitably and on a substantially current
basis, the timing and profitability of lease resales could impact our business and operating
results, particularly in an environment of fluctuating interest rates and economic uncertainty. If
we are required to repurchase rental streams and realize losses thereon in amounts exceeding our
reserves, our operating results will be adversely affected. During the first quarter of 2005, the Company entered into a rate-lock agreement (the
Agreement) with a financial institution in the form of a commitment to sell the cash flow streams
for leases with a present value of at least $22.0 million in June 2005 at an interest rate to the
financial institution of 6.25 percent and $17.0 million in December 2005 at an interest rate to the
financial institution of 6.30 percent. Should interest rates decrease substantially, the Company
has the option to pay $500,000 to the financial institution to cancel the commitment for each of
the two sales. 23




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On January 5, 2005, the Company received court approval of a civil settlement agreement (the
Civil Settlement) and a criminal plea agreement (the Plea Agreement) with the United States of
America, each dated as of December 8, 2004 and disclosed on that same date. The court approval of
the Civil Settlement and Plea Agreement resolves the investigation of the Department of Justice
into the participation of Inter-Tel Technologies, Inc., the Companys wholly-owned subsidiary
(Technologies) in a federally administered E-Rate program to connect schools and libraries to
the Internet.In connection with the Civil Settlement, Technologies agreed to pay a penalty of
$6,740,450 and forego the collection of certain accounts receivable of $259,540 related to
Technologies participation in the E-Rate program.In connection with the Plea Agreement,
Technologies entered guilty pleas to charges of mail fraud and an antitrust violation. Under the
Plea Agreement, Technologies agreed to pay a fine of $1,721,000 and observe a three-year
probationary period, which will, among other things, require Technologies to implement a
comprehensive corporate compliance program. The penalties and fines described above were paid in
the first quarter of 2005. In addition, on January 21, 2005, Inter-Tel Technologies received notification from the
Federal Communications Commission that Technologies was temporarily suspended from participation in
the E-Rate program pending a proposed debarment. Technologies has contested the scope and length
of the proposed debarment from the E-Rate program, but there can be no assurance that Technologies
will be successful in this regard. Revenues in 2004 relating to Technologies participation in the
E-Rate program were not significant. The existence and disclosure of the Civil Settlement, Plea Agreement and FCC Notice may have
already caused competitive harm to Inter-Tel, and these matters may further harm Inter-Tels
business. We believe our working capital and credit facilities, together with cash generated from
operations, will be sufficient to develop and expand our business operations, to finance
acquisitions of additional resellers of telephony products and other strategic acquisitions or
corporate alliances, to fund the special dividend of $1.00 per share to shareholders of record on
March 31, 2005, to repurchase shares of the Companys common stock pursuant to the Board-approved
$75 million repurchase program announced in February 2005, and to provide adequate working capital
for the foreseeable future. However, to the extent additional funds are required in the future to
address working capital needs and to provide funding for capital expenditures, expansion of the
business or additional acquisitions, we will seek additional financing. There can be no assurance
additional financing will be available when required or on acceptable terms. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions that involve
unconsolidated entities or financial partnerships, such as entities often referred to as structured
finance or special purpose entities, which have been established for the purpose of facilitating
off-balance sheet arrangements or other contractually narrow or limited purposes. However, we
offer to our customers lease financing and other services through our Inter-Tel Leasing, Inc.
subsidiary. We fund our Total Solution program in part through the sale to financial institutions
of rental payment streams under the leases. Such financial institutions have the option to require
us to repurchase such income streams, subject to limitations, in the event of defaults by lease
customers and, accordingly, we maintain reserves based on loss experience and past due accounts.
For more information regarding our lease portfolio and financing, please see Liquidity and Capital
Resources and Note E of Notes to Condensed Consolidated Financial Statements. Critical Accounting Policies and Estimates The methods, estimates and judgments we use in applying our most critical accounting policies
have a significant impact on the results we report in our condensed consolidated financial
statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on
historical experience and on assumptions that we believe to be reasonable under the circumstances. Our
experience and assumptions form the basis for our judgments about the carrying value of assets and
liabilities that are not readily apparent from other sources. Actual results may vary from what we
anticipate and different assumptions or estimates about the future could change our reported
results. We believe the following accounting policies are the most critical to us, in that they
are important to the portrayal of our 24




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financial statements and they require our most difficult,
subjective or complex judgments in the preparation of our condensed consolidated financial
statements: Revenue Recognition. In December 2003, the Securities and Exchange Commission (SEC) issued
Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition. The Company applies the
provisions of SAB 104 to all revenue transactions. SAB 104 supercedes SAB 101, Revenue Recognition
in Financial Statements. The primary purpose of SAB 104 is to rescind accounting guidance
contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of
the issuance of EITF 00-21. Additionally, SAB 104 rescinded the SECs Revenue Recognition in
Financial Statements Frequently Asked Questions and Answers (the FAQ) issued with SAB 101 that
had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been
incorporated into SAB 104. While the wording of SAB 104 has changed to reflect the issuance of EITF
00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of
SAB 104. The issuance of SAB 104 did not have a material impact on the Companys financial
position, results of operations or cash flows. End-user sales through our direct sales offices and government and national accounts division.
Revenue is recognized when all four of the following criteria are met: (i) persuasive evidence
that arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the
selling price is both fixed and determinable and; (iv) collectibility is reasonably probable.
Revenue derived from sales of systems and services to end-user customers is recognized upon primary
installation of the systems and performance of the services, respectively, allowing for use by our
customers of these systems. Pre-payments for communications services are deferred and recognized
as revenue as the communications services are provided. We do not generally allow sales returns
either by the terms of our contracts or in practice, except for returns related to warranty
provisions. Dealer and VAR sales. For shipments to dealers and other distributors, our revenues are
recorded as products are shipped and services are rendered, when the sales process is complete.
These shipments are primarily to third-party dealers and distributors, and title passes when goods
are shipped (free-on-board shipping point). However, in connection with our recent 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. We do
not generally allow sales returns either by the terms of our contracts or in practice, except for
returns related to warranty provisions. We provide a number of incentives, promotions and awards
to certain dealers and other distributors. These incentives primarily represent discounts (which
are recognized as a reduction of sales), advertising allowances and awards (which are recognized as
marketing expense) and management assistance (which is expensed as incurred). Resale of long distance. We recognize revenue from long distance resale services as services
are provided. Maintenance revenues. We recognize maintenance revenue ratably over the term of applicable
maintenance agreements. Sales-Leases. For our sales-type lease accounting, we follow the guidance provided by FASB
Statement No. 13, Accounting for Leases and FASB Statement No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities
 A Replacement of FASB Statement
No. 125. 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 pursuant to Staff
Accounting Bulletin No. 104, as discussed above for sales to end user customers. The costs of
systems installed under these sales-leases are recorded as costs of sales. 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 recorded as net sales. We establish and maintain reserves against potential recourse following the resales based upon
historical loss experience, past due accounts and specific account analysis. The allowance for
uncollectible minimum lease payments and recourse liability at the end of the year represents
reserves against the entire lease portfolio. Management reviews the adequacy of the allowance on a
regular basis and adjusts the allowance as required. These reserves are either netted in the
accounts receivable, current and long-term components 25




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of Net investments in Sales-Leases on the balance sheet, or included in long-term
liabilities on our balance sheet for off-balance sheet leases. Historically, our reserves have been adequate to cover write-offs. Our total reserve for
losses related to the entire lease portfolio, including amounts classified as accounts receivable
in our balance sheet, increased slightly from 5.32% at December 31, 2004 to 5.36% at March 31,
2005, primarily as a result of reviews of our write-off experience and accounts receivable agings.
Should the financial condition of our customers deteriorate in the future, additional reserves in
amounts that could be material to the financial statements could be required. Goodwill and Other Intangible Assets.On January 1, 2002, Inter-Tel adopted SFAS No. 141,
Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets.Purchase prices of
acquired businesses that are accounted for as purchases have been allocated to the assets and
liabilities acquired based on the estimated fair values on the respective acquisition dates. Based
on these values, the excess purchase prices over the fair value of the net assets acquired were
allocated to goodwill. Prior to January 1, 2002, Inter-Tel amortized goodwill over the useful life of the underlying
asset, not to exceed 40 years. On January 1, 2002, Inter-Tel began accounting for goodwill under
the provisions of SFAS Nos. 141 and 142 and discontinued the amortization of goodwill after January
1, 2002. As of March 31, 2005, Inter-Tel had gross goodwill of $31.5 million and accumulated
amortization of $5 million. Inter-Tel completed one acquisition through March 31, 2005 and five in
2004 and has not recorded any amortization for these acquisitions on amounts allocated to goodwill
in accordance with SFAS No. 141. The Company performs an annual impairment test on Goodwill using the two-step process
prescribed in SFAS No. 142. The first step is a screen for potential impairment, while the second
step measures the amount of the impairment, if any. In addition, the Company will perform
impairment tests during any reporting period in which events or changes in circumstances indicate
that an impairment may have incurred. Inter-Tel performed the first step of the required impairment
tests for goodwill as of December 31, 2004 and determined that goodwill is not impaired and it is
not necessary to record any impairment losses related to goodwill. At March 31, 2005 and December
31, 2004, $24.4 million and $17.8 million, respectively, of the Companys goodwill, net of
amortization, relates to the Companys principal segment and $2.1 million relates to the Resale of
Local, Long Distance and Network Services segment. There is only one reporting unit (i.e., one
component) as defined in paragraph 30 of SFAS 142 within each of the Companys two operating
segments as defined in paragraph 10 of SFAS 131. Therefore the reporting units are identical to
the segments. Fair value has been determined for each segment in order to determine the
recoverability of the recorded goodwill. At December 31, 2004, the Company primarily considered an
allocated portion of the market capitalization for the entire Company using average common stock
prices in determining that no impairment had occurred. This allocated market capitalization value
far exceeded the net carrying value of the goodwill included in the financial statements.
Therefore, the second step for potential impairment was unnecessary. The Company evaluates the remaining useful lives of its purchased intangible assets, all of
which are subject to amortization, each reporting period. Any changes to estimated remaining lives
prospectively effect the remaining period of amortization. In addition, the purchased intangible
assets are reviewed for possible impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. A loss would be recognized for any
excess of the carrying amount over the estimated fair value. As of March 31, 2005, Inter-Tel had
gross purchased intangible assets of $35.8 million and accumulated amortization of $8.9 million. At March 31, 2005 and December 31, 2004, goodwill, net of accumulated amortization, totaled
$26.5 million and $19.9 million, respectively. Other acquisition-related intangibles, net of
accumulated amortization, totaled $26.9 million at March 31, 2005 and $11.0 million at December 31,
2004. Accumulated amortization through March 31, 2005 was $13.9 million, including $5.0 million of
accumulated amortization attributable to goodwill and $8.9 million of accumulated amortization of
other acquisition-related intangibles. Accumulated amortization through December 31, 2004 was
$13.1 million, including $5.0 million of accumulated amortization attributable to goodwill and $8.1
million of accumulated amortization of other acquisition-related intangibles. Other
acquisition-related intangibles, comprised primarily of developed technology (5-10 year lives),
customer lists (5-8 year lives) and non-competition 26




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agreements (2-8 year lives), are amortized on a straight-line basis. The useful lives for
developed technology are based on the remaining lives of patents acquired or the estimated useful
life of the technology, whichever is shorter. The useful lives of the customer lists are based on
the expected period of value for such lists. The useful lives for non-competition agreements are
based on the contractual terms of the agreements. Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated
losses resulting from the inability of our customers to make required payments. Additional
reserves or allowances for doubtful accounts are recorded for our sales-type leases, discussed
above in Sales-Leases. We establish and maintain reserves against estimated losses based upon
historical loss experience, past due accounts and specific account analysis. Management reviews
the level of the allowances for doubtful accounts on a regular basis and adjusts the level of the
allowances as needed. In evaluating our allowance we consider accounts in excess of 60 days old as
well as other risks in the more current portions of the accounts included. At March 31, 2005, our
allowance for doubtful accounts for accounts receivable were $9.4 million of our $52.4 million in
gross accounts receivable. If the financial condition of our customers or channel partners were to
deteriorate, resulting in an impairment of their ability to make payments, additional allowances
may be required. Inventories. We value our inventories at the lower of cost (principally on a standard cost
basis, which approximates the first-in, first-out (FIFO) method) or market. Significant management
judgment is required to determine the reserve for obsolete or excess inventory and we make our
assessment primarily on a significant product-by-product basis for the immediately preceding
twelve-month period, adjusted for expected changes in projected sales or marketing demand.
Inventory on hand may exceed future demand either because the product is outdated or obsolete, or
because the amount on hand is more than can be used to meet estimated future needs. We consider
criteria such as customer demand, product life cycles, changing technologies, slow moving inventory
and market conditions and we reserve for our excess and possible obsolete inventory. Historically,
sales of scrap have not been material and have not affected our profit margins. At March 31, 2005,
our inventory reserves were $7.0 million of our $26.3 million gross inventories. If actual
customer demand, product life cycles, changing technologies and market conditions are less
favorable than those projected by management, additional inventory reserves may be required in the
future. Contingencies. We are a party to various claims and litigation in the normal course of
business. Managements current estimated range of liability related to various claims and pending
litigation is based on claims for which management can estimate the amount and range of loss, or
can estimate a minimum amount of a loss. Because of the uncertainties related to both the amount
and range of loss on the remaining pending claims and litigation, management is unable to make a
reasonable estimate of the liability that could result from an unfavorable outcome. As additional
information becomes available, we will assess the potential liability related to our claims and
pending litigation, revise our estimates and accrue for any losses to the extent that they are
probable and the amount is estimable. Such revisions in our estimates of the potential liability
could materially impact our results of operations and financial position. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS This Report onForm 10-Qcontains 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. Actual results could differ materially from those projected in the forward-looking
statements as a result of many risk factors including, without limitation, those set forth under
Factors That May Affect Future Results Of Operations below. In evaluating Inter-Tels business,
shareholders and prospective investors should consider carefully the following factors in
addition to the other information set forth in this document. 27




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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. Our quarterly operating results have historically depended on, and may fluctuate in the future
as a result of, many factors including:  
    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 effect of acquisitions;
    the availability and cost of products and components from our suppliers, including shipping and manufacturing problems
associated with subcontracted vendors;
    the impact of the E-Rate settlement and possible FCC debarment, which could effect both our government business and our
commercial business;
    the potential impact of new accounting pronouncements such as FAS 123R;
    national and regional weather patterns; and
    threats of or outbreaks of war, hostilities, terrorist acts or other civil disturbances. In addition, we have historically operated with a relatively small backlog, with sales and
operating results in any quarter depending principally on orders booked and shipped in that
quarter. In the past, we have recorded a substantial portion of our net sales for a given quarter
in the third month of that quarter, with a concentration of such net sales in the last two weeks of
the quarter. Market demand for investment in capital equipment such as business communications
systems and associated call processing and voice processing software applications depends largely
on general economic conditions and can vary significantly as a result of changing conditions in the
economy as a whole, as well as heightened competitive pressures. We cannot assure you that we can
continue to be successful operating with a small backlog or whether historical backlog trends will
continue in the future. Our expense levels are based in part on expectations of future sales and, if sales levels do
not meet expectations, our operating results could be harmed. In addition, because sales of
business communications systems through our dealers typically produce lower gross margins than
sales through our direct sales organization, operating results have varied, and will continue to
vary based upon the mix of sales through direct and indirect channels. In addition, in the recent
past we have derived a significant part of our revenue from recurring revenue streams, which
typically produce higher gross margins. If we do not maintain recurring revenue streams at current
or historic levels, our operating results would suffer unless we significantly increased sales to
new customers. Moreover, particularly in an environment of fluctuating interest rates, the timing
and profitability of lease resales from quarter to quarter could impact operating results. Long
distance and DataNet sales, which typically carry lower gross margins than our core business, have
grown in recent periods at a faster rate than our overall net sales, although gross margins may
fluctuate in these divisions from period to period. Consolidated gross margins could be harmed if
long distance calling services continue to increase as a percentage of net sales or if gross
margins from this division decline. We also experience seasonal fluctuations in our operating
results, as net sales for the first quarter is frequently less than the fourth quarter, and net
sales for the third quarter is frequently less than the second quarter. As a result of these and
other factors, we have historically experienced, and could continue to experience in the future,
fluctuations in net sales and operating results on a quarterly basis. 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. The market for our products and services is characterized by rapid technological change,
evolving industry standards and vigorous customer demand for new products, applications and
services. To compete successfully, we must continually enhance our existing telecommunications
products, related 28




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software and customer services, and develop new technologies and applications in a timely and
cost-effective manner. If we fail to introduce new products and services that achieve broad market
acceptance and on a timely basis, or if we do not adapt our existing products and services to
customer demands or evolving industry standards, our business could be significantly harmed.
Problems and delays associated with new product development have in the past contributed to lost
sales. In addition, current competitors or new market entrants may offer products, applications or
services that are better adapted to changing technology or customer demands and that could render
our products and services unmarketable or obsolete. In addition, if the markets for computer-telephony applications, Internet Protocol network
products, or related products fail to develop or continue to develop more slowly than we
anticipate, or if we are unable for any reason to capitalize on any of these emerging market
opportunities, our business, financial condition and operating results could be significantly
harmed. Our future success largely depends on increased commercial acceptance of our Inter-Tel 5000 Network
Communications Solutions, Axxessâ system, the Lake OfficeLink product (branded
EncoreCXâ in North America), speech recognition, Interactive Voice Response, presence
management, collaboration, messaging products, Session Initiation Protocol (SIP) applications, and
related computer-telephony products. Over the past 18 to 24 months, we have introduced a number of new products and platforms,
including: Unified Communicatorâ software, a web-based, speech-recognition, wireless PDA, and
Wireless Application Protocol (WAP) software application for controlling and managing calls,
contacts and presence status; Enterpriseâ Conferencing and Enterpriseâ Instant
Messaging software, a SIP-based web and audio conferencing application; Inter-Tel Webconferencing
and Inter-Tel Remote support (collaboration) solutions; Model 8500 series digital endpoints; Model
8600 series Multi-protocol SIP endpoints; Inter-Tel Application Platform, a highly flexible
speech-recognition, text-to-speech and CTI application generation platform; enhanced convergence
features on the Axxess system, including support of standard Session Initiation Protocol (SIP)
endpoints and trunk gateways; and several other telephony-related products. In recent history,
sales of our Axxess business communications systems and related software have comprised a
substantial portion of our net sales. Our future success depends, in large part, upon increased
commercial acceptance and adoption of the products or platforms identified above, as well as the
Axxess system, the Inter-Tel 5000 Network Communications products, the Application Platform, the
Unified Communicator and related computer-telephony products, the Linktivity collaboration
technology, the Lake Communications converged systems and software, SIP standards-based
applications and devices, new speech recognition and Interactive Voice Response products, and
future upgrades and enhancements to these products and networking platforms. We cannot assure you
that these products or platforms will achieve commercial acceptance in the future. 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. Our telecommunications products and software are highly complex. Although our new products
and upgrades are examined and tested prior to release, they can only be fully tested when used by a
large customer base. Consequently, our customers have in the past and may in the future discover
program errors, or bugs, or other defects after new products and upgrades have been released.
Some of these bugs may result from defects contained in component parts or software from our
suppliers or other third parties that are intended to be compatible with our products and over
which we have little or no control. Although we have test procedures and quality control standards
in place designed to minimize the number of errors and defects in our products, we cannot assure
you that our new products and upgrades will be free of bugs when released. If we are unable to
quickly or successfully correct bugs identified after release, we could experience the following,
any of which would harm our business:  
    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; 29




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
    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. Due to the complexity of our products and software, we have in the past experienced and expect
in the future to experience delays in the development and release of new products or product
enhancements. If we fail to introduce new software, products or services in a timely manner, or
fail to release upgrades to our existing systems or products and software on a regular and timely
basis, customer demand for our products and software could decline, which would harm our business. Business acquisitions, new business ventures, dispositions or joint ventures entail numerous risks
and may disrupt our business, dilute shareholder value and distract management attention. As part of our business strategy, we consider acquisitions of, or significant investments in,
businesses that offer products, services and technologies complementary to ours. Such acquisitions
could materially adversely affect our operating results and/or the price of our common stock.
Acquisitions also entail numerous risks, some of which we have experienced and may continue to
experience, including:  
    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. In particular, in prior years our operating results were materially adversely affected by
several of the factors described above, including substantial operating losses and impairment
charges resulting from Executone and Inter-Tel.NET. Refer to Note C to the Condensed Consolidated
Financial Statements for additional information concerning our acquisitions. We completed two acquisitions in 2002, one acquisition and one technology investment in 2003,
five acquisitions and one technology investment in 2004, and one acquisition in 2005. The 2002
acquisitions included certain assets and liabilities of an operating company and the stock of a
United Kingdom technology company. In 2003, we acquired selected assets and assumed certain
liabilities of a former Inter-Tel dealer and we acquired the rights to certain developed
technology. In 2004, we acquired certain assets and assumed certain liabilities of four former
Inter-Tel dealers. In addition, we completed one technology related acquisition, coupled with a
license of technology in 2004. In March of 2005, we acquired all of the outstanding stock of Lake
and its several related entities in Ireland. These entities are similar in nature to our wholesale
operations and also include significant technology-related assets. These acquisitions are subject
to risks and uncertainties including, but not limited to, those indicated above. Finally, to the extent that shares of our stock or the rights to purchase stock are issued in
connection with any future acquisitions, dilution to our existing shareholders will result and our
earnings per share may suffer. Any future acquisitions may not generate additional revenue or
provide any benefit to our business, and we may not achieve a satisfactory return on our investment
in any acquired businesses. 30




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We may not be able to adequately protect our proprietary technology and may be infringing upon
third-party intellectual property rights. Our success depends in part upon protecting our proprietary technology. As of March 31, 2005,
we held twenty-seven (27) U.S. patents for telecommunication and messaging products, systems and
processes and had applied to the U.S. Patent and Trademark Office for fifteen (15) additional
patents. We also rely on copyright and trade secret law and contractual provisions to protect our
intellectual property. Despite these precautions, third parties could copy or otherwise obtain and
use our technology without authorization, or develop similar technology independently. Any patent, trademark or copyright that we own or have applied to own is subject to being
invalidated, circumvented or challenged by a third party. Effective protection of intellectual
property rights may be unavailable or limited in foreign countries. The telecommunications and
networking industries are heavily patented and we cannot assure that the protection of our
proprietary rights will be adequate or that competitors will not independently develop similar
technology, duplicate our services or design around any patents or other intellectual property
rights we hold. Litigation may be necessary in the future to enforce our intellectual property
rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights
of others, or to defend against claims of infringement or invalidity. Litigation could be costly,
absorb significant management time and harm our business. Many of our competitors have large patent portfolios and we are subject to or could become
subject to third party claims that our current or future products or services infringe upon the
rights of others. For example, we are subject to claims initiated by Avaya and Lucent, two of our
primary competitors, alleging that certain of our key products infringe upon their intellectual
property rights, including patents, trademarks, copyrights or other intellectual property rights.
We have viewed presentations from Avaya alleging that our Axxess business communications system and
associated applications utilize inventions covered by certain of their patents. We have also made
claims against Avaya for infringement of our patents. We are continuing the process of
investigating these matters. The ultimate outcomes by their nature are uncertain and we cannot
assure you that these matters, individually or collectively, would not have a material adverse
impact on our financial position and future results of operations. When any such claims are asserted against us, among other means to resolve the dispute, we may
seek to license the third partys intellectual property rights. Purchasing such licenses can be
expensive, and we cannot assure you that a license will be available on prices or other terms
acceptable to us, if at all. Alternatively, we could resort to litigation to challenge such a
claim. Litigation could require us to expend significant sums of cash and divert our managements
attention. In the event a court renders an enforceable decision with respect to our intellectual
property, we may be required to pay significant damages, develop non-infringing technology or
acquire licenses to the technology subject to the alleged infringement. Any of these actions or
outcomes could harm our business. If we are unable or choose not to license technology, or decide
not to challenge a third partys rights, we could encounter substantial and costly delays in
product introductions. These delays could result from efforts to design around asserted third
party rights or our discovery that the development, manufacture or sale of products requiring these
licenses could be foreclosed. 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. The markets for our products and services are extremely competitive and we expect competition
to increase in the future. Our current and potential competitors in our primary business segments
include:  
    PABX, converged systems and IP-PBX providers, distributors, or resellers such as Alcatel, Altigen, Avaya, Cisco
Systems, Comdial, 3Com, EADS Telecom, Iwatsu, Interactive Intelligence, Lucky Goldstar, Mitel, NEC, Nortel, Panasonic,
Samsung, ShoreTel, Siemens, Toshiba, Vertical Networks/ArtiSoft 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);
    web collaboration product and service providers, such as Centra, eDial (a division of Alcatel), IBM, Microsoft,
Raindance Communications, and WebEx;
    long distance services providers such as AT&T, MCI, Qwest and Sprint; 31




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
    large computer and software corporations such as IBM, HP, Intel and Microsoft;
    regional Bell operating companies, or RBOCs, competitive local exchange companies (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. These and other companies may form strategic relationships with each other to compete with us.
These relationships may take the form of strategic investments, joint-marketing agreements,
licenses or other contractual arrangements. Strategic relationships and business combinations
could increase our competitors ability to address customer needs with their product and service
offerings. Many of our competitors and potential competitors have substantially greater financial,
customer support, technical and marketing resources, larger customer bases, longer operating
histories, greater name recognition and more established relationships in the industry than we do.
We cannot be sure that we will have the resources or expertise to compete successfully. Compared
to us, our competitors may be able to:  
    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. Some of our competitors may also be able to provide customers with additional benefits at
lower overall costs or to reduce their gross margins aggressively in an effort to increase market
share. We cannot be sure we will be able to match cost reductions by our competitors. In recent
periods, due to competitive pressures, we have discounted pricing on our telephone systems and
offered promotions. In addition, we believe there is likely to be further consolidation in our
markets, which could lead to having even larger and more formidable competition and other forms of
competition that could cause our business to suffer. 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. We currently obtain certain key components for our digital communication platforms, including
certain microprocessors, integrated circuits, power supplies, voice processing interface cards and
IP telephony cards, from a limited number of suppliers and manufacturers. Our reliance on these
limited suppliers and contract manufacturers involves risks and uncertainties, including the
possibility of a shortage or delivery delay for some key components. We currently manufacture our
products, including products manufactured for Lake, through third-party subcontractors located in
the United States, Mexico, the Peoples Republic of China and the United Kingdom. Foreign
manufacturing facilities are subject to changes in governmental policies, imposition of tariffs and
import restrictions and other factors beyond our control. We have experienced occasional delays in
the supply of components and finished goods that have harmed our business. If inventory levels are
not adequately maintained and managed we are at risk of not having the appropriate inventory
quantities on hand to meet sales demand. We may experience similar delays in the future. Our reliance on third party manufacturers and OEM partners involves a number of additional
risks, including reduced control over delivery schedules, quality assurance and costs. Our
business may be harmed by any delay in delivery or any shortage of supply of components or finished
goods from a supplier caused by any number of factors, including but not limited to the acquisition
of the vendor by another company (which has recently occurred with one of our primary suppliers).
Our business may also be harmed if we are unable to develop alternative or additional supply
sources as necessary. To date, we have been able to obtain supplies of components and products in
a timely manner even though we do not have long-term supply contracts with any of our contract
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we will be able to continue to obtain components or finished goods in sufficient quantities or
quality or on favorable pricing or delivery terms in the future. 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 derive a substantial portion of our net sales through our network of independent dealers.
We face intense competition from other telephone, voice processing, and voice and data router
system manufacturers for these dealers business, as most of our dealers carry other products that
compete with our products. Our dealers may choose to promote the products of our competitors to
our detriment. We have developed programs and expended capital as incentives to our dealers to
promote our products, and we cannot assure you that these techniques will continue to be
successful. The loss of any significant dealer or group of dealers, or any event or condition
harming our dealer network, could harm our business, financial condition and operating results. 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. On January 5, 2005, the Company received court approval of a civil settlement agreement (the
Civil Settlement) and a criminal plea agreement (the Plea Agreement) with the United States of
America, each dated as of December 8, 2004 and disclosed on that same date. The court approval of
the Civil Settlement and Plea Agreement resolves the investigation of the Department of Justice
into the participation of Inter-Tel Technologies, Inc., the Companys wholly-owned subsidiary
(Technologies) in a federally administered E-Rate program to connect schools and libraries to
the Internet. In connection with the Civil Settlement, Technologies agreed to pay a penalty of
$6,740,450 and forego the collection of certain accounts receivable of $259,540 related to
Technologies participation in the E-Rate program. In connection with the Plea Agreement,
Technologies entered guilty pleas to charges of mail fraud and an antitrust violation. Under the
Plea Agreement, Technologies agreed to pay a fine of $1,721,000 and observe a three-year
probationary period, which will, among other things, require Technologies to implement a
comprehensive corporate compliance program. The penalties and fines described above were paid
during the first quarter of 2005. In addition, on January 21, 2005, Inter-Tel Technologies received notification from the
Federal Communications Commission that Technologies was temporarily suspended from participation in
the E-Rate program pending a proposed debarment. Technologies has contested the scope and length
of the proposed debarment from the E-Rate program, but there can be no assurance that Technologies
will be successful in this regard. Revenues in 2004 relating to Technologies participation in the
E-Rate program were not significant. The existence and disclosure of the Civil Settlement, Plea Agreement and FCC Notice may have
already caused competitive harm to Inter-Tel, and these matters may further harm Inter-Tels
business. Inter-Tel is also subject to litigation in the ordinary course of business. We cannot assure
you that any adverse outcome in connection with such litigation would not impair our business or
financial condition. Managing our international sales efforts may expose us to additional business risks, which may
result in reduced sales or profitability in our international markets. We are currently expending resources to maintain and expand our international dealer network
in the countries in which we already have a presence and in new countries and regions.
International sales are subject to a number of risks, including changes in foreign government
regulations and telecommunication standards, export license requirements, tariffs and taxes, other
trade barriers, difficulties in protecting our intellectual property, fluctuations in currency
exchange rates, difficulty in collecting receivables, difficulty in staffing and managing foreign
operations, and political and economic instability. In particular, the terrorist acts of September
11, 2001, continued hostilities in Iraq and turmoil in the Middle East and North Korea have created
an uncertain international economic environment and we cannot predict the impact of these acts, any
future terrorist acts or any related military action on our efforts to expand our international
sales. Fluctuations in currency exchange rates could cause our products to become relatively more
expensive to customers in a particular country, leading to a reduction in sales or profitability in
that country. In addition, 33




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the costs associated with developing international sales or an international dealer network
may not be offset by increased sales in the short term, or at all. Any of these risks could cause
our products to become relatively more expensive to customers in a particular country, leading to
reduced sales or profitability in that country. During the past year, Inter-Tel has been in the process of establishing a new dealer
relationship in South Africa and launched that relationship in 2005. It is possible that this
business many not materialize as soon as expected and may require additional support expenses to
reach the expected revenue levels. In December 2004, we wrote off our Japan operations. As a result, Inter-Tel assigned selected
assets and the customer base of the Inter-Tel Japan direct sales office to a new dealer in Japan
that will sell and support Inter-Tel products to our Japan customers. We may continue to incur
expenses related to the winding down of our direct presence over the next few quarters. The Lake acquisition closed in March 2005. Among other acquisition-related risks, we face
risks of deterioration of international sales during the integration process, loss of key customers
or that projected growth could be delayed or may not materialize at all. If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may
not be able to achieve our objectives. We depend on the continued service of, and our ability to attract and retain, qualified
technical, marketing, sales and managerial personnel, many of whom would be difficult to replace.
Competition for qualified personnel is intense, and we have historically had difficulty in hiring
employees in the timeframe we desire, particularly skilled engineers or sales personnel. The loss
of any of our key personnel or our failure to effectively recruit additional key personnel could
make it difficult for us to manage our business, complete timely product introductions or meet
other critical business objectives. Moreover, our operating results could be impaired if we lose a
substantial number of key employees from recent acquisitions, including personnel from acquisitions
identified in Note B to the Consolidated Financial Statements. We cannot assure you we will be
able to continue to attract and retain the qualified personnel necessary for the development of our
business. 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. Inter-Tels IP telephony and network products may be vulnerable to computer viruses or similar
disruptive problems. Computer viruses or problems caused by third parties could lead to
interruptions, delays or cessation of service that could harm our operations and revenues. In
addition, we may lose customers if inappropriate use of the Internet or other IP networks by third
parties jeopardizes the security of confidential information, such as credit card or bank account
information or the content of conversations over the IP network. In addition, user concerns about
privacy and security may cause IP networks in general to grow more slowly, and impair market
acceptance of our IP network products in particular, until more comprehensive security technologies
are developed and deployed industry-wide. We may be unable to achieve or manage our growth effectively, which may harm our business. The ability to operate our business in an evolving market requires an effective planning and
management process. Our efforts to achieve growth in our business have placed, and are expected to
continue to place, a significant strain on our personnel, management systems, infrastructure and
other resources. In addition, our ability to manage any potential future growth effectively will
require us to successfully attract, train, motivate and manage new employees, to integrate new
employees into our overall operations and to continue to improve our operational, financial and
management controls and procedures. Furthermore, we expect we will be required to manage an
increasing number of relationships with suppliers, manufacturers, customers and other third
parties. If we are unable to implement adequate controls or integrate new employees into our
business in an efficient and timely manner, our operations could be adversely affected and our
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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. In the past few years, we introduced IP telephony enhancements to the Axxessâ system as
well as presence management and collaboration applications, which are typically sold to larger
customers at a higher average selling price and often represent a significant expenditure in
communications infrastructure by the prospective enterprise customer. Accordingly, the purchase of
our products typically involves numerous internal approvals relating to the evaluation, testing,
implementation and acceptance of new technologies. This evaluation process frequently results in a
lengthy sales process, which can range from a few months to more than 12 months, thereby subjecting
our sales cycle to a number of significant uncertainties concerning budgetary constraints and
internal acceptance reviews. The length of our sales cycle also may vary substantially from
customer to customer and along product lines. While our customers are evaluating our products
before placing an order with us, we may incur substantial sales and marketing expenses and expend
significant management effort. In addition, installation of multiple systems for large, multi-site
customers may occur over an extended period of time, and depending on the contract terms with these
customers, revenues may be recognized over more than one quarter, as systems are completed in
separate phases and accepted by the customers. Consequently, if sales forecasted from a specific
customer for a particular quarter are not realized in that quarter, our operating results could be
materially adversely affected. We rely heavily upon third-party packaged software systems to manage and run our business processes
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. We currently run third-party applications for data processing in our distribution center
operations, shipping, materials movement, customer service, invoicing, financial record keeping and
reporting, and for other operations and administrative functions. The nature of the software
industry is to upgrade software systems to make architectural changes, increase functionality,
improve controls and address software bugs. Over time, older versions of the software become less
supported or unsupported by our vendors for financial and other reasons and eventually become
obsolete. Oracle, the primary supplier of our third-party applications, provides notice of the
dates that Oracle will de-support the software and companies are expected to either make plans to
upgrade to newer versions or operate without Oracle support. While Oracle and other third-party
vendors may provide advanced notice of product upgrade schedules and take other steps to make the
upgrade process as straightforward as possible, we are subject to risks associated with the
process, and in some cases we may choose to continue to utilize and maintain the unsupported
third-party software using our own information systems personnel. Our software systems could
become unstable following an upgrade process and impact our ability to process data properly in
these systems, including timely and accurate shipment of products, invoicing our customers properly
and the production of accurate and timely financial statements. There are risks associated with
failing to apply necessary security upgrades intended to resolve vulnerabilities. While we strive
to take necessary precautions and properly test security-related upgrades before applying these
upgrades, we must weigh the risks of not applying the upgrade against the risks of vulnerabilities
being exploited for malicious purposes by an outside entity. Should a security vulnerability be
exploited, our systems could become unstable and/or data could be compromised, thereby adversely
affecting our business. We expect to affect software upgrades in the future and cannot assure you
these software upgrades or enhancements will operate as intended or be free from bugs or that we
will be able to operate effectively using unsupported third-party software using our existing
personnel and resources. If we are unable to successfully integrate new software into our
information systems, our operations, customer service and financial reporting could be adversely
affected and could harm our business. Our stock price has been and may continue to be volatile, impairing your ability to sell your
shares at or above purchase price. The market price for our common stock has been highly volatile. The volatility of our stock
could be subject to continued wide fluctuations in response to many risk factors listed in this
section, and others beyond our control, including: 35




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
    announcements of developments relating to our business;
    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 of the E-Rate settlement and possible FCC debarment, which could affect both our government business and our
commercial 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; In addition, stock prices of technology companies in general, and for voice and data
communications companies in particular, have experienced extreme price fluctuations in recent years
which have often been unrelated to the operating performance of affected companies. We cannot
assure you the market price of our common stock will not experience significant fluctuations in the
future, including fluctuations unrelated to our performance. Our Chairman of the Board of Directors, CEO and President controls 19.4% of our Common Stock and is
able to significantly influence matters requiring shareholder approval. As of March 31, 2005, Steven G. Mihaylo, Inter-Tels Chairman of the Board of Directors, Chief
Executive Officer and President, beneficially owned approximately 19.4% of the existing outstanding
shares of the common stock of Inter-Tel. As a result, he has the ability to exercise significant
influence over all matters requiring shareholder approval. In addition, the concentration of
ownership could have the effect of delaying or preventing a change in control of Inter-Tel. Changes in stock option accounting rules may adversely impact our reported operating results
prepared in accordance with generally accepted accounting principles, our stock price and our
competitiveness in the employee marketplace. Technology companies like ours have a history of using broad based employee stock option
programs to hire, provide incentives for and retain our workforce in a competitive marketplace.
Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation
(SFAS 123) allowed companies the choice of either using a fair value method of accounting for
options, which would result in expense recognition for all options granted, or using an intrinsic
value method, as prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees (APB 25), with a pro forma disclosure of the impact on net income (loss) of
using the fair value option expense recognition method. We have elected to apply APB 25 and
accordingly we generally do not recognize any expense with respect to employee stock options as
long as such options are granted at exercise prices equal to the fair value of our Common Stock on
the date of grant. In December 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (SFAS
123R), which replaces SFAS No. 123, Accounting for Stock-Based Compensation, (SFAS 123) and
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires all
share-based payments to employees, including grants of employee stock options and employee stock
purchase plan shares, to be recognized in the financial statements based on their fair values
beginning with 36




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the Companys fiscal year beginning January 1, 2006. The pro forma disclosures previously
permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing
share-based payments, the amortization method for compensation cost and the transition method to be
used at date of adoption. The transition methods include prospective and retroactive adoption
options. Under the retroactive option, prior periods may be restated either as of the beginning of
the year of adoption or for all periods presented. The prospective method requires that
compensation expense be recorded for all unvested stock options and restricted stock at the
beginning of the first quarter of adoption of SFAS 123R, while the retroactive methods would record
compensation expense for all unvested stock options and restricted stock beginning with the first
period restated. We are evaluating the requirements of SFAS 123R and expect that the adoption of
SFAS 123R will have a material impact on our consolidated results of operations and earnings per
share. We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and we
have not determined whether the adoption will result in amounts that are similar to the current pro
forma disclosures under SFAS 123. In addition, this new statement could impact our ability to
utilize broad-based employee stock plans to reward employees and could result in a competitive
disadvantage to us in the employee marketplace. Risks Related to Our Industry Reductions in spending on enterprise communications equipment may materially and adversely affect
our business. The overall economic slowdown of the last several years has had and may continue to have a
harmful effect on the market for enterprise communications equipment. Our customers have reduced
significantly their capital spending on communications equipment in an effort to reduce their own
costs and bolster their revenues. The market for enterprise communications equipment may only grow
at a modest rate or possibly not grow at all, and our financial performance has been and may
continue to be materially and adversely affected by the reductions in spending on enterprise
communications equipment. The emerging market for IP network telephony is subject to market risks and uncertainties that
could cause significant delays and expenses. The market for IP network voice communications products has begun to develop only recently, is
evolving rapidly and is characterized by an increasing number of market entrants who have
introduced or developed products and services for Internet or other IP network voice
communications. As is typical of a new and rapidly evolving industry, the demand for and market
acceptance of, recently introduced IP network products and services are highly uncertain. We
cannot assure you that IP voice networks will become widespread. Even if IP voice networks become
more widespread in the future, we cannot assure that our products, including the IP telephony
features of the Axxesssystems and Inter-Tel 5000 Network Communication Solutions, our IP endpoints
and IP applications will successfully compete against other market players and attain broad market
acceptance. Moreover, the adoption of IP voice networks and importance of development of products using
industry standards such as MGCP and SIP, generally require the acceptance of a new way of
exchanging information. In particular, enterprises that have already invested substantial
resources in other means of communicating information may be reluctant or slow to adopt a new
approach to communications. If the market for IP network voice communications fails to develop or
develops more slowly than we anticipate, our IP network telephony products could fail to achieve
market acceptance, which in turn could significantly harm our business, financial condition and
operating results. This growth may be inhibited by a number of factors, such as quality of
infrastructure; security concerns; equipment, software or other technology failures; regulatory
encroachments; inconsistent quality of service; poor voice quality over IP networks as compared to
circuit-switched networks; and lack of availability of cost-effective, high-speed network capacity.
Moreover, as IP-based data communications and telephony usage grow, the infrastructure used to
support these IP networks, whether public or private, may not be able to support the demands placed
on them and their performance or reliability may decline. The technology that allows voice and
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communications over the Internet and other data networks, and the delivery of other
value-added services, is still in the early stages of development. Government regulation of third party long distance and network service entities on which we rely
may harm our business. Our supply of telecommunications services and information depends on several long distance
carriers, RBOCs, local exchange carriers, or LECs, and competitive local exchange carriers, or
CLECs. We rely on these carriers to provide local and long distance services, including voice and
data circuits, to our customers and to provide us with billing information. Long distance services
are subject to extensive and uncertain governmental regulation on both the federal and state level.
We cannot assure you that the increase in regulations will not harm our business. Our current
contracts for the resale of services through long distance carriers include multi-year periods
during which we have minimum use requirements and/or costs. The market for long distance services
is experiencing, and is expected to continue to experience significant price competition, and this
may cause a decrease in end-user rates. We cannot assure you that we will meet minimum use
commitments, that we will be able to negotiate lower rates with carriers if end-user rates decrease
or that we will be able to extend our contracts with carriers at favorable prices. If we are
unable to secure reliable Network Services from certain long distance carriers, RBOCs, LECs and
CLECs, or if these entities are unwilling or unable to provide telecommunications services and
billing information to us on favorable terms, our ability to expand our own Network Services will
be harmed. Carriers that provide telecommunications services to us may also experience financial
difficulties, up to and including bankruptcies, which could harm our ability to offer
telecommunications services. Consolidation within the telecommunications industry could increase competition and adversely
affect our business. There has been a trend in the telecommunications industry toward consolidation and we expect
this trend to continue as the industry evolves. As a result of this consolidation trend, new
stronger companies may emerge that have improved financial resources, enhanced research and
development capabilities and a larger and more diverse customer base. The changes within the
telecommunications industry may adversely affect our business, operating results and financial
condition. Terrorist activities and resulting military and other actions could harm our business. Terrorist attacks in New York and Washington, D.C. in September of 2001 disrupted commerce
throughout the world. The continued threat of terrorism, the conflict in Iraq and the potential for
additional military action and heightened security measures in response to these threats may
continue to cause significant disruption to commerce throughout the world. To the extent that
disruptions result in a general decrease in corporate spending on information technology or
advertising, our business and results of operations could be harmed. We are unable to predict
whether the conflict in Iraq and its aftermath, the threat of terrorism or the responses thereto
will result in any long-term commercial disruptions or if such activities or responses will have a
long-term adverse effect on our business, results of operations or financial condition.
Additionally, if any future terrorist attacks were to affect the operation of the Internet or key
data centers, our business could be harmed. These and other developments arising out of the
potential attacks may make the occurrence of one or more of the factors discussed herein more
likely to occur. We Are Exposed To Increased Costs And Risks Associated With Compliance With Changing Laws,
Regulations And Standards In General, and Specifically With Increased And New Regulation Of
Corporate Governance And Disclosure Standards. We are spending an increased amount of management time and external resources to comply with
existing and changing laws, regulations and standards in general, and specifically relating to
corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC
regulations, PCAOB and Nasdaq Stock Market rules, as well as commercial dealings with other
government entities. In particular, Section 404 of the Sarbanes-Oxley Act of 2002 requires
managements annual review and 38




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evaluation of our internal control systems, and attestations of the effectiveness of these
systems by our management and by our independent auditors. We have completed our documentation and
testing of our internal control systems and procedures for 2004. This process required us to hire
additional personnel and use outside advisory services and resulted in additional accounting and
legal expenses. The results of the documentation and testing for 2004 indicate that we currently
have adequate internal controls over financial reporting; however, if in the future our chief
executive officer, chief financial officer or independent auditors determine that our controls over
financial reporting are not effective as defined under Section 404, investor perceptions of
Inter-Tel may be adversely affected and could cause a decline in the market price or our stock.
Failure to comply with other existing and changing laws, regulations and standards could also
adversely affect the Company. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following discussion about our market risk disclosures involves forward-looking
statements. Actual results could differ materially from those projected in the forward-looking
statements. We are exposed to market risk related to changes in interest rates and foreign currency
exchange rates. We do not use derivative financial instruments. INVESTMENT PORTFOLIO. We do not use derivative financial instruments in our non-trading investment
portfolio. Inter-Tel maintains a portfolio of highly liquid cash equivalents typically maturing in
three months or less as of the date of purchase. Inter-Tel places its investments in instruments
that meet high credit quality standards, as specified in our investment policy guidelines. The Company also maintains short-term and long-term investments. Those investments that are
classified as available for sale have been recorded at fair value, which approximates cost. Those
investments that are classified as held-to-maturity have been recorded at cost and amortized to
face value. Short-term investments include certificates of deposit, auction rate certificates,
auction rate preferred securities, municipal preferred securities, federal agency issues and mutual
funds. The auction rate securities are adjustable-rate securities with dividend rates that are
reset periodically by bidders through periodic Dutch auctions generally conducted every 7 to 49
days by a trust company or broker/dealer on behalf of the issuer. The Company believes these
securities are highly liquid investments through the related auctions; however, the collateralizing
securities have stated terms of up to thirty-four (34) years. The long-term investments consist of
federal agency issues. Both the short-term and long-term instruments are rated A or higher by
Standard & Poors Ratings Group, or equivalent. The Companys investments are intended to
establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids
inappropriate concentrations and delivers an appropriate yield in relationship to the Companys
investment guidelines and market conditions. Given the short-term nature of the majority of these
investments, and that we have no borrowings outstanding, we are not subject to significant interest
rate risk. LEASE PORTFOLIO. We offer to our customers lease financing and other services, including our Total
Solutions program, through our Inter-Tel Leasing subsidiary. We fund these programs in part
through the sale to financial institutions of rental payment streams under the leases. Upon the
sale of the rental payment streams, we continue to service the leases and maintain limited recourse
on the leases. We maintain reserves for loan losses on all leases based on historical loss
experience, past due accounts and specific account analysis. Although to date we have been able to
resell the rental streams from leases under our lease programs profitably and on a substantially
current basis, the timing and profitability of lease resales could impact our business and
operating results, particularly in an environment of fluctuating interest rates and economic
uncertainty. If we were required to repurchase rental streams and realize losses thereon in
amounts exceeding our reserves, our operating results could be materially adversely affected. See
Liquidity and Capital Resources and Critical Accounting Policies and Estimates in Managements
Discussion and Analysis for more information regarding our lease portfolio and financing. IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our international
subsidiaries primarily in the local currencies of our subsidiaries for product and service
revenues. Inter-Tel is exposed to foreign exchange rate fluctuations as the financial results of
foreign subsidiaries are translated into U.S. dollars in consolidation. The impact of foreign
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ITEM 4. CONTROLS AND PROCEDURES Evaluation of disclosure controls and procedures. Except as discussed in the following
paragraph, our management evaluated, with the participation of our Chief Executive Officer and our
Chief Financial Officer, the design and operation of our disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or
the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q.
Based on this evaluation, our management, including our Chief Executive Officer and Chief Financial
Officer have concluded that our disclosure controls and procedures are designed, and are effective
to give reasonable assurance that information we are required to disclose in reports that we file
or submit under the Exchange Act, is recorded, processed, summarized and reported within the time
periods specified in Securities and Exchange Commission rules and forms and to ensure that
information required to be disclosed in the reports filed or submitted under the Exchange Act is
accumulated and communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, in a manner that allows timely decisions regarding required disclosure. On February 28, 2005, the Company completed the acquisition of Lake. The recorded cost of the
acquisition including capitalized transaction costs was $28.7 million. Net revenues from the Lake
subsidiary included in the consolidated net income for the quarter were $2.6 million. See Note C
to the Condensed Consolidated Financial Statements for further discussion of this acquisition. We
have not completed our evaluation of the design and operation of the disclosure controls and
procedures for this consolidated subsidiary as of March 31, 2005. We expect to complete such
evaluation prior to the end of 2005. Changes in internal controls over financial reporting. There were no changes in our internal
controls over financial reporting that occurred during the period covered by this Quarterly Report
on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our
internal controls over financial reporting. INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS We are involved from time to time in litigation incidental to our business. We believe that the
outcome of current litigation will not have a material adverse effect upon our business, financial
condition or results of operations and will not disrupt our normal operations. 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Board Authorization to Repurchase up to $75 Million of Inter-Tel Stock.On February 15, 2005,
Inter-Tel announced that its Board of Directors approved a stock repurchase program, with no stated
expiration date, in which Inter-Tel may purchase up to $75 million of its Common Stock in the open
market from time to time, depending upon general market conditions, the Companys share price, the
level of employee stock option exercises, the level of employee stock purchase plan purchases, the
availability of funds and other factors. While the Company has made and intends to continue to
make repurchases in subsequent periods, no Common Stock was repurchased pursuant to the Plan during
the Companys first fiscal quarter of 2005. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNot Applicable 
 ITEM 5. OTHER INFORMATION Not Applicable 40




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ITEM 6. EXHIBITS: Exhibit 10:
    
    Share Purchase Agreement, signed February 28, 2005Exhibit 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 Pursuant to 18 U.S.C. Section 1350,
as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002Exhibit 32.2:
    
    Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350,
as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized. INTER-TEL, INCORPORATEDMay 10, 2005
    
    /s/ Steven G. MihayloSteven G. MihayloChairman of the Board, Chief Executive
Officer and PresidentMay 10, 2005
    
    /s/ Kurt R. KneipKurt R. KneipSenior Vice President and
Chief Financial Officer
 41