##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended
    
    Commission File Number:March 31, 2004
    
    0-10211
 INTER-TEL, INCORPORATED Incorporated in the State of Arizona
    
    I.R.S. No. 86-0220994
 1615 S. 52ndStreet
Tempe, Arizona 85281 (480) 449-8900   Title of Class
    
    Outstanding as of April 30, 2004Common Stock, no par value
    
    
    25,683,881
 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 [X] No [_] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No[_]




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INDEX INTER-TEL, INCORPORATED AND SUBSIDIARIES PagePART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (unaudited)Condensed consolidated balance sheets-March 31, 2004 and December 31, 2003
    
    
    3Condensed consolidated statements of income-three months ended March 31, 2004 and March 31, 2003
    
    
    4Condensed consolidated statements of cash flows-three months ended March 31, 2004 and March 31, 2003
    
    
    5Notes to condensed consolidated financial statements-March 31, 2004
    
    
    6Item 2.
    
    Management's Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4.
    
    Controls and Procedures
    
    
    34PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    34Item 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    34Item 3.
    
    Defaults Upon Senior Securities
    
    
    34Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    34Item 5.
    
    Other Information
    
    
    35Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    35SIGNATURES
    
    
    36MANAGEMENT CERTIFICATIONS
    
    
    37Ex-31.1Ex-31.2EX-32.1Ex-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 31,2004
    
    2003(in thousands, except share amounts)
    
    (Unaudited)
    
    (Note A)ASSETSCURRENT ASSETSCash and equivalents
    
    $
    134,290
    
    
    $
    115,197Short-term investments
    
    
    56,940
    
    
    
    59,334Total cash and short-term investments
    
    
    191,230
    
    
    
    174,531Accounts receivable, net of
allowances of $10,814 in 2004 and
$11,010 in 2003
    
    
    38,018
    
    
    
    43,434Inventories, net of allowances of
$6,768 in 2004 and $6,952 in 2003
    
    
    18,766
    
    
    
    14,648Net investment in sales-leases, net
of allowances of $822 in 2004 and
$749 in 2003
    
    
    16,403
    
    
    
    15,502Income taxes receivable
    
    
    2,934
    
    
    
    8,196Deferred income taxes
    
    
    13,456
    
    
    
    13,789Prepaid expenses and other assets
    
    
    6,994
    
    
    
    6,432TOTAL CURRENT ASSETS
    
    
    287,801
    
    
    
    276,532PROPERTY, PLANT & EQUIPMENT
    
    
    24,027
    
    
    
    24,657GOODWILL
    
    
    17,861
    
    
    
    17,967PURCHASED INTANGIBLE ASSETS
    
    
    8,043
    
    
    
    8,191NET INVESTMENT IN SALES-LEASES,net
of allowances of $1,940 in 2004 and
$1,985 in 2003
    
    
    32,932
    
    
    
    32,529$
    370,664
    
    
    $
    359,876LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIESAccounts payable
    
    $
    27,571
    
    
    $
    28,386Other current liabilities
    
    
    44,692
    
    
    
    47,585TOTAL CURRENT LIABILITIES
    
    
    72,263
    
    
    
    75,971DEFERRED TAX LIABILITY
    
    
    62,591
    
    
    
    57,996LEASE RECOURSE LIABILITY
    
    
    12,017
    
    
    
    12,020RESTRUCTURING RESERVE
    
    
    
    
    
    
    49OTHER LIABILITIES
    
    
    6,432
    
    
    
    6,535SHAREHOLDERS EQUITYCommon stock, no par value-authorized
100,000,000 shares; issued27,161,823
shares; outstanding25,655,381 at
March 31, 2004 and 25,429,642 shares
at December 31, 2003
    
    
    115,203
    
    
    
    113,960Retained earnings
    
    
    119,086
    
    
    
    113,299Accumulated other comprehensive income
    
    
    1,317
    
    
    
    1,025235,606
    
    
    
    228,284Less: Treasury stock at cost 
1,506,442 shares at March 31, 2004
and 1,732,181 shares at December 31,
2003
    
    
    (18,245
    )
    
    
    (20,979
    )TOTAL SHAREHOLDERS EQUITY
    
    
    217,361
    
    
    
    207,305$
    370,664
    
    
    $
    359,876
 See accompanying notes. 3




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INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (In thousands, except
    
    Three Months Ended March 31,per share amounts)
    
    2004
    
    2003NET SALES
    
    $
    98,031
    
    
    $
    84,169Cost of sales
    
    
    45,933
    
    
    
    40,095GROSS PROFIT
    
    
    52,098
    
    
    
    44,074Research & development
    
    
    6,035
    
    
    
    5,234Selling, general, and administrative
    
    
    35,004
    
    
    
    31,246Amortization of purchased intangible assets
    
    
    445
    
    
    
    42841,484
    
    
    
    36,908OPERATING INCOME
    
    
    10,614
    
    
    
    7,166Interest and other income
    
    
    506
    
    
    
    443Foreign currency transaction losses
    
    
    (161
    )
    
    
    (40
    )Interest expense
    
    
    (46
    )
    
    
    (32
    )INCOME BEFORE INCOME TAXES
    
    
    10,913
    
    
    
    7,537Income tax provision
    
    
    4,093
    
    
    
    2,865NET INCOME
    
    $
    6,820
    
    
    $
    4,672NET INCOME PER SHAREBasic
    
    $
    0.27
    
    
    $
    0.19Diluted
    
    $
    0.25
    
    
    $
    0.18DIVIDENDS PER SHARE
    
    $
    0.06
    
    
    $
    0.03Weighted average basic common shares
    
    
    25,543
    
    
    
    24,920Weighted average diluted common shares
    
    
    27,350
    
    
    
    26,039
 See accompanying notes. 4




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INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Three Months Ended March 31,(In thousands)
    
    2004
    
    2003OPERATING ACTIVITIESNet income
    
    $
    6,820
    
    
    $
    4,672Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation of fixed assets
    
    
    1,881
    
    
    
    1,798Amortization of patents included in research
and development expenses
    
    
    55
    
    
    
    55Amortization of purchased intangible assets
    
    
    445
    
    
    
    428Provision for losses on receivables
    
    
    429
    
    
    
    933Provision for losses on leases
    
    
    1,045
    
    
    
    1,120Provision for inventory valuation
    
    
    191
    
    
    
    80Decrease in other liabilities
    
    
    (996
    )
    
    
    (1,031
    )Loss on sale of property and equipment
    
    
    
    
    
    
    37Deferred income taxes
    
    
    4,928
    
    
    
    932Effect of exchange rate changes
    
    
    292
    
    
    
    70Changes in operating assets and liabilities
    
    
    1,122
    
    
    
    (2,033
    )NET CASH PROVIDED BY
OPERATING ACTIVITIES
    
    
    16,212
    
    
    
    7,061INVESTING ACTIVITIESPurchases of short-term investments
    
    
    (19,989
    )
    
    
    (33,153
    )Maturities and sales of short-term investments
    
    
    22,383
    
    
    
    18,698Additions to property and equipment and
equipment held under lease
    
    
    (1,219
    )
    
    
    (837
    )Proceeds from disposal of property and equipment
    
    
    8
    
    
    
    63NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
    
    
    1,183
    
    
    
    (15,229
    )FINANCING ACTIVITIESCash dividends paid
    
    
    (1,525
    )
    
    
    (747
    )Treasury stock purchases
    
    
    
    
    
    
    (9
    )Payments on term debt
    
    
    (17
    )
    
    
    (13
    )Proceeds from exercise of stock options,
including shareholder loan repayments
    
    
    3,240
    
    
    
    240NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
    
    
    1,698
    
    
    
    (529
    )INCREASE (DECREASE) IN CASH
AND EQUIVALENTS
    
    
    19,093
    
    
    
    (8,697
    )CASH AND EQUIVALENTS AT
BEGINNING OF PERIOD
    
    
    115,197
    
    
    
    84,923CASH AND EQUIVALENTS AT END OF PERIOD
    
    $
    134,290
    
    
    $
    76,226
 See accompanying notes. 5




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INTER-TEL, INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
March 31, 2004 NOTE ABASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States for 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 three
months ending March 31, 2004 are not necessarily indicative of the results that
may be expected for the year ended December 31, 2004. The balance sheet at
December 31, 2003 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, 2003. Certain prior year amounts have been reclassified to conform with the
current period presentation. Stock-Based Compensation We grant stock options for a fixed number of shares to employees and
directors with an exercise price equal to the fair market value of the shares
at the date of grant. We account for such stock option grants using the
intrinsic-value method of accounting in accordance with Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees, (APB 25)
and related Interpretations. Under APB 25, we generally recognize no
compensation expense with respect to such awards. Also, we do not record any
compensation expense in connection with our Employee Stock Purchase Plan as
long as the purchase price is not less than 85% of the fair market value at the
beginning or end of each offering period, whichever is lower. The pro forma impact on net income and net income per share as if the fair
value of stock-based compensation plans had been recorded as a component of
compensation expense in the condensed consolidated financial statements as of
the date of grant of awards related to such plans, pursuant to the provisions
of the Statement of Financial Accounting Standards No. 123, Accounting for
Stock Based Compensation and Statement of Financial Accounting Standards No.
148, Accounting for Stock-Based Compensation  Transition and Disclosure an
amendment of FASB Statement No. 123, was determined using the modified
Black-Scholes option pricing model and is disclosed as follows: Three Months Ended March 31,(in thousands, except per share data)
    
    2004
    
    2003Net income, as reported
    
    $
    6,820
    
    
    $
    4,672Deduct: total stock-based compensation expense determined
under fair value based method for all awards, net of tax
    
    
    (783
    )
    
    
    (711
    )Pro forma net income
    
    $
    6,037
    
    
    $
    3,961Earnings per share of common stock
Basic  as reported
    
    $
    0.27
    
    
    $
    0.19Basic  pro forma
    
    $
    0.24
    
    
    $
    0.16Diluted  as reported
    
    $
    0.25
    
    
    $
    0.18Diluted  pro forma
    
    $
    0.22
    
    
    $
    0.15
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The fair value for these options was estimated at the date of grant using
a Black-Scholes option pricing model using the low end of reasonable
assumptions for input variables rather than attempting to identify a best-point
estimate. The option pricing model utilized the following weighted average
assumptions for 2004 and 2003, respectively: risk free interest rates of 2.81%
for 2004 and 2.73% for 2003; dividend yields of 0.82% for 2004 and 1.20% for
2003; volatility factors of the expected market price of our stock averaged
0.46 for 2004 and 0.59 for 2003. Employee stock options vest over four to five
year periods and director options vest at the end of six months from the grant
date. 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. However, at March 31, 2004, management did not believe
that the ultimate impact of various claims and pending litigation would have a
materially adverse impact on the financial condition of the Company. Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has provided Inter-Tel with a limited description of the evidence on
which the investigations are based. Inter-Tel is presently unable to predict
or determine the final outcome of, or to estimate the potential range of loss
with respect to, the investigations. Based upon the information known at this
time, we do not know what, if any, impact the investigations may have on the
Companys business or financial condition. If Inter-Tel is convicted of any
crime or subjected to sanctions, or debarred from certain government contracts
or if penalties, damages or other monetary remedies are assessed against
Inter-Tel in connection with or related to these and other investigations, our
business and operating results could be materially and adversely affected. The
existence and disclosure of the investigations may have already caused
competitive harm to Inter-Tel, and any unfavorable resolution to these matters
may further harm Inter-Tels business. Recent Accounting Standards and Pronouncements Revenue Arrangements with Multiple Deliverables. In November 2002, the
FASB issued Emerging Issues Task Force 00-21 (EITF 00-21), Revenue
Arrangements with Multiple Deliverables. EITF 00-21 requires revenue
arrangements with multiple deliverables to be divided into separate units of
accounting. If the deliverables in the arrangement meet certain criteria,
arrangement consideration should be allocated among the separate units of
accounting based on their relative fair values. Applicable revenue recognition
criteria are to be considered separately for separate units of accounting. The
guidance in EITF 00-21 was effective for revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. The Companys adoption of EITF
00-21 did not have a material impact on its financial position, results of
operations or liquidity. Variable Interest Entities:In January 2003, the FASB issued
Interpretation No. 46, Consolidation of Variable Interest Entities, an
interpretation of ARB 51 (FIN 46). The primary objectives of FIN 46 are to
provide guidance on the identification of entities for which control is
achieved through means other than through voting rights (VIEs) and how to
determine when and which business enterprise should consolidate the VIE. This
new model for consolidation applies to an entity which either (1) the equity
investors (if any) do not have a controlling financial interest or (2) the
equity investment at risk is insufficient to finance that entitys activities
without receiving additional subordinated financial support from other parties.
The Companys adoption of FIN 46 did not have a material impact on its
financial position, results of operations or liquidity. 7




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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 March 31,(In thousands, except per share amounts)
    
    2004
    
    2003Numerator:Net income
    
    $
    6,820
    
    
    $
    4,672Denominator:Denominator for basic earnings per
share  weighted average shares
    
    
    25,543
    
    
    
    24,920Effect of dilutive securities:Employee and director stock options
    
    
    1,807
    
    
    
    1,119Denominator for diluted earnings per share  adjusted
weighted average shares and assumed conversions
    
    
    27,350
    
    
    
    26,039Basic earnings per share
    
    $
    0.27
    
    
    $
    0.19Diluted earnings per share
    
    $
    0.25
    
    
    $
    0.18
 At March 31, 2004 and 2003, options to purchase 49,000 and 505,350 shares,
respectively, of Inter-Tel stock were excluded from the calculation of diluted
net earnings per share because the exercise price of these options was greater
than the average market price of the common shares for the respective fiscal
years, and therefore the effect would have been antidilutive. NOTE C  ACQUISITIONS, TECHNOLOGY INVESTMENTS AND RESTRUCTURING CHARGES New Sales Offices in Tennessee.In connection with opening two new sales
offices in Tennessee during January 2004, 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 $0.2
million and $0.5 million, respectively. Purchased intangibles recorded as a
result of the transaction totaled $0.3 million. No goodwill was recorded in
connection with this transaction. The balance included in other purchased
intangible assets will be amortized over a period of five years. New Sales Office in Philadelphia.In connection with opening a new sales
office in 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 $0.5
million and $0.9 million, respectively. Total goodwill and purchased
intangibles recorded as a result of the transaction were $0.3 million and $0.1
million, respectively. The goodwill balance will be accounted for in
accordance with SFAS 141 and 142. 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 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 will perform additional development
activities on a cost reimbursement basis through August 15, 2004. Under the
terms of the arrangement, the selling entity can also earn bonus payments
totaling up to $1,000,000 during 2004 for meeting certain development
milestones. Two milestones totaling $250,000 were achieved and expensed in
research and development costs for the quarter ended March 31, 2004. As of
March 31, 2004, we did not consider the remaining milestone bonuses to be
probable or reasonably estimable, nor had technological feasibility of the
underlying technology been achieved to provide for viable product sales;
therefore, no additional bonus payments have been accrued. In addition to the
milestone achievements charged to expense of $250,000 in the first quarter of
2004, the cost of services performed totaling approximately $262,000 have been
expensed in 8




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research and development costs for the quarter ended March 31, 2004. No
costs were incurred during the quarter ended March 31, 2003, because the
agreement was not yet in effect. Swan.On December 3, 2002, Inter-Tel Integrated Systems, Inc., our
wholly-owned subsidiary, acquired 100% of the capital stock of Swan Solutions
Limited (Swan) in England and Wales, for $4.0 million in cash. $3.0 million
was paid at closing, $250,000 was paid in June 2003 and $250,000 was paid in
December 2003. The remaining $500,000 was subject to the achievement of five
performance milestones at $100,000 each. As of March 31, 2004, portions of
four of the five $100,000 milestones were achieved for which $350,436 was paid
to the Swan shareholders. The final $100,000 milestone achievement will be
determined by June 3, 2004. Payments relating to the achievement of
performance milestones were capitalized and are being amortized as purchased
intangible assets over five years. In total, the Company recorded amortizable
intangible technology assets totaling $3.9 million in connection with this
acquisition. These technology assets are being amortized over five years.
During the quarters ended March 31, 2004 and March 31, 2003, the amortization
of purchased intangible assets from Swan was approximately $197,000 and
$172,000, respectively. 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 acquisitions. The values for acquired developed technology were determined based on the
negotiated prices paid to acquire the technology. Each of our technology
acquisitions, including Swan and Technology Investment noted above and other
prior 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. The weighted-average amortization period for total purchased intangibles
as of December 31, 2003 and March 31, 2004 was 7 years. The weighted-average
amortization period as of December 31, 2003 and March 31, 2004 for developed
technology was 7.5 years, and 4.8 years for customer lists and non-compete
agreements. 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, 2004. Exit costs associated with the closure of the Milford facility also
included liabilities for building, furniture and equipment lease, and other
contractual obligations. We are liable for the lease on the Milford buildings
through January 2005. Various furniture leases ran concurrently through March
2002. Other capital leases for computer and other equipment terminated on
varying dates through September 2002. To date, we have entered into sublease
agreements with third parties to sublease portions of the facility and
equipment. The reserve for lease and other contractual obligations is
identified in the table below. The following table summarizes details of the restructuring charge taken
in the second quarter of 2000 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,
2004. 9




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Activity
    
    
    
    
    
    ReserveCash/
    
    Restructuring
    
    Through
    
    2004
    
    Balance At March(in thousands)
    
    Non-Cash
    
    Charge
    
    2003
    
    Activity
    
    31, 2004Personnel 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
    )
    
    
    6,198
    
    
    
    285
    
    
    
    (961
    )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
    )
    
    
    3,009
    
    
    
    
    
    
    
    (142
    )Net intangible assets
    
    Non-Cash
    
    
    (29,184
    )
    
    
    29,184
    
    
    
    
    
    
    
    Total
    
    
    
    $
    (50,916
    )
    
    $
    49,528
    
    
    $
    285
    
    
    $
    1,103
 NOTE D  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. Inter-Tel has not
recorded any amortization for acquisitions on amounts allocated to goodwill in
accordance with SFAS No. 141 after January 1, 2002. 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, 2003 and
determined that goodwill is not impaired and it is not necessary to record any
impairment losses related to goodwill. At March 31, 2004, the Companys
goodwill all relates to entities within the Company that generate revenues for
all segments of the Company. Therefore, the reporting unit has been defined as
the entire company and fair value has been determined for the Company as a
whole in order to determine the recoverability of the recorded goodwill. The
Company considered both the discounted cash flows for the Company and the
market capitalization using average common stock prices in determining that no
impairment has occurred. 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. 10




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At March 31, 2004 and December 31, 2003, goodwill, net of accumulated
amortization, totaled $17.9 million and $18.0 million, respectively. Other
acquisition-related intangibles, net of accumulated amortization, totaled $8.0
million at March 31, 2004 and $8.2 at December 31, 2003. Accumulated
amortization through March 31, 2004 was $11.5 million, including $5.0 million
of goodwill accumulated amortization and $6.5 million of accumulated
amortization of other acquisition-related intangibles. Accumulated amortization
through December 31, 2003 was $11.0 million, including $5.0 million of goodwill
accumulated amortization and $6.0 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 year lives) and non-competition agreements (2-5 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. NOTE E  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)
telephone systems, telecommunications software and hardware, and (2) local and
long distance calling services. These services are provided through the
Companys direct sales offices and dealer network to business customers
throughout the United States, Europe, Asia, Mexico and Canada. 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 local and long distance calling 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, 2004 and 2003, we generated income from
business segments as follows: Three Months Ended March 31, 2004Resale of Local andLong Distance(In thousands, except per share amounts)
    
    Principal Segment
    
    Services
    
    TotalNet sales
    
    $
    86,787
    
    
    $
    11,244
    
    
    $
    98,031Gross profit
    
    
    47,798
    
    
    
    4,300
    
    
    
    52,098Operating income
    
    
    8,442
    
    
    
    2,172
    
    
    
    10,614Interest and other income
    
    
    450
    
    
    
    56
    
    
    
    506Foreign currency transaction losses
    
    
    (161
    )
    
    
    
    
    
    
    (161
    )Interest expense
    
    
    (45
    )
    
    
    (1
    )
    
    
    (46
    )Net income
    
    $
    5,436
    
    
    $
    1,384
    
    
    $
    6,820Net income per diluted share
    
    $
    0.20
    
    
    $
    0.05
    
    
    $
    0.25Weighted average diluted shares
    
    
    27,350
    
    
    
    27,350
    
    
    
    27,350Total assets
    
    $
    350,924
    
    
    $
    19,740
    
    
    $
    370,664Depreciation and amortization
    
    
    2,367
    
    
    
    14
    
    
    
    2,381
 11




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Three Months Ended March 31, 2003Resale of Local andLong Distance(In thousands, except per share amounts)
    
    Principal Segment
    
    Services
    
    TotalNet sales
    
    $
    75,675
    
    
    $
    8,494
    
    
    $
    84,169Gross profit
    
    
    41,560
    
    
    
    2,514
    
    
    
    44,074Operating income
    
    
    5,980
    
    
    
    1,186
    
    
    
    7,166Interest and other income
    
    
    409
    
    
    
    34
    
    
    
    443Foreign currency transaction losses
    
    
    (40
    )
    
    
    
    
    
    
    (40
    )Interest expense
    
    
    (32
    )
    
    
    
    
    
    
    (32
    )Net income
    
    $
    3,916
    
    
    $
    756
    
    
    $
    4,672Net income per diluted share
    
    $
    0.15
    
    
    $
    0.03
    
    
    $
    0.18Weighted average diluted shares
    
    
    26,039
    
    
    
    26,039
    
    
    
    26,039Total assets
    
    $
    262,714
    
    
    $
    17,743
    
    
    $
    280,457Depreciation and amortization
    
    
    2,269
    
    
    
    12
    
    
    
    2,281
 Our revenues are generated predominantly in the United States. Total
revenues generated from U.S. customers totaled $94.8 million, or 96.7% of total
revenues, and $81.7 million, or 97.0% of total revenues for the quarters ended
March 31, 2004 and 2003, respectively. The Companys revenues from
international sources were primarily generated from customers located in the
United Kingdom, Europe and Asia. In the first quarters of 2004 and 2003,
revenues from customers located internationally accounted for 3.3% and 2.9% of
total revenues, respectively. Our applicable long-lived assets at March 31,
2004, included Property, Plant & Equipment; Goodwill; and Purchased Intangible
Assets. The net amount located in the United States was $46.6 million and the
amount in foreign countries was $3.3 million at March 31, 2004. At December
31, 2003, the net amount located in the United States was $47.3 million and the
amount in foreign countries was $3.5 million. NOTE F 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 some of the sales-leases. We maintain reserves against
our estimate of potential recourse for the balance of sales-leases and for the
balance of sold rental payments remaining unbilled. The following table
provides detail on the total net balances in sales-leases: March 31,
    
    December 31,(in thousands)
    
    2004
    
    2003Lease balances included in consolidated accounts receivable, net of
allowances of $1,558 in 2004 and $1,774 in 2003
    
    $
    5,128
    
    
    $
    7,240Net investment in Sales-Leases:Current portion, net of allowances of $822 in 2004 and $749 in 2003
    
    
    16,403
    
    
    
    15,502Long-term portion, includes residual amounts of $987 in 2004 and
$652 in 2003, net of allowances of $1,940 in 2004 and $1,985 in
2003
    
    
    32,932
    
    
    
    32,529Total investment in Sales-Leases, net of allowances of $4,320 in 2004
and $4,508 in 2003
    
    
    54,463
    
    
    
    55,271Sold rental payments remaining unbilled (subject to limited recourse
provisions), net of allowances of $12,017 in 2004 and $12,020 in 2003
    
    
    205,328
    
    
    
    198,091Total balance of sales-leases and sold rental payments remaining
unbilled, net of allowances
    
    $
    259,791
    
    
    $
    253,362Total allowances for entire lease portfolio (including limited
recourse liabilities)
    
    $
    16,337
    
    
    $
    16,528
 12




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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 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 from 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: Quarter Ended Year Ended(In thousands)
    
    March 31, 2004
    
    December 31, 2003Sales of rental payments
    
    $
    26,868
    
    
    $
    88,352Sold payments remaining unbilled at end of period
    
    $
    217,345
    
    
    $
    210,111
 Sales of rental payments represents 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 represents
the total balance of leases that are 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. Inter-Tel is
compensated for administration and servicing of rental payments sold. 
 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:  
    
    Axxess® by Inter-Tel and EncoreCX® by Inter-Tel converged voice and
data business communication systems,  
    
    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,  
    
    local and long distance calling services and other communications
services and peripheral products,  
    
    call accounting software, computer-telephone integration (CTI) applications, and  
    
    maintenance and support services for our products. 13




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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, 2004, we had 52 direct sales offices in the United States, one
in Japan, and a network of hundreds of dealers and VARs, primarily in the
United States, which 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 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 Japan and Mexico. We also maintain a research and development and software
sales office in the United Kingdom. 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 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.  
    
    Dealer and VAR sales. For shipments to dealers and other
distributors, our revenue is recognized as products are shipped and
services are rendered, because the sales process is complete. Title to
these products passes when goods are shipped (free-on-board shipping
point). 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.  
    
    Sales-leases. 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. 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.  
    
    Maintenance. Maintenance revenue is recognized ratably over the term
of the maintenance 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, parts and service overhead. Total costs of goods and
services sold increased 14.6%, or $5.8 million, to $45.9 million for the
quarter ended March 31, 2004, compared to $40.1 million for the same period in
2003. Our consolidated gross margin percentage increased to 53.1% in the first
quarter of 2004 compared to 52.4% in the first quarter of 2003. This increase
was attributable to several factors, including a higher absorption of fixed
costs on increased sales volume, higher proportion of revenues from our direct
sales offices, higher software content in our products, and cost containment
efforts and product design improvements. 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. Historically, sales of scrap have not been material and have not
affected our profit margins. For revenues recognized 14




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under sales-leases, we record the costs of systems installed as costs of
sales. Our margins may vary from period to period depending upon distribution
channel, product and software mix. 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. Our operating results depend upon a variety of factors, including the
volume and timing of orders received during a period, the mix of products sold
and the mix of distribution channels, 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 effect 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. 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. The first quarter of 2004 followed this
historical pattern and we do not anticipate a significant change in this trend. Cash Flows. At March 31, 2004, Inter-Tels cash and short-term
investments totaled $191.2 million. We also maintain a $10 million unsecured,
revolving line of credit with BankOne, NA, which is available through June 1,
2004 and ordinarily used to support international letters of credit to
suppliers, if necessary. 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 addition, Inter-Tel historically has paid cash for capital
expenditures relating to property and equipment and for most 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, and to provide adequate working capital
for the foreseeable future. Our consolidated net sales for the quarters ended March 31, 2004 and 2003
were $98.0 million and $84.2 million, respectively. The 16.5% increase in
revenue in the first quarter of 2004 compared to the first quarter of 2003 was
primarily attributable to improved general economic conditions, as our
customers appeared more willing to spend on business communications systems.
The increase in net sales can also be attributed in part to new product
releases and improved sales in our long distance resale division. However, we
cannot provide assurance that the recent increase in revenue will continue in
the future as we believe businesses may continue to be reluctant to
significantly increase spending on enterprise communications systems in the
near future. In addition, we believe many customers are hesitant to invest in
traditional voice communication systems as they may be anticipating broader
adoption of next-generation communications systems. We believe that enterprises continue to be concerned about their ability
to increase revenues and profitability, in part due to the 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
improve significantly 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 we serve 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, our Axxess system, including adding new applications,
enhancing our IP convergence applications and IP endpoints, developing Unified
Communications applications, developing presence management applications, and
developing speech-recognition and text-to-speech applications. More recently,
Inter-Tels research and development efforts 15




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have been focused on the development of Session Initiation Protocol (SIP)
interfaces and applications as well as the development and a new line of
multi-protocol SIP IP endpoints. We offer our customers a package of lease financing and other services
under the name Total Solution (formerly, Totalease). 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 F of
Notes to Condensed Consolidated Financial Statements for additional information
regarding our program. Results of Operations The following table sets forth certain statement of income data
expressed as a percentage of net sales for the periods indicated (amounts have
been rounded to the nearest tenth of a percent): Three months ended March 31,2004
    
    2003Net sales
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    46.9
    
    
    
    47.6Gross profit
    
    
    53.1
    
    
    
    52.4Research and development
    
    
    6.2
    
    
    
    6.2Selling, general and administrative
    
    
    35.7
    
    
    
    37.1Amortization of purchased intangible assets
    
    
    0.5
    
    
    
    0.5Operating income
    
    
    10.8
    
    
    
    8.5Interest and other income
    
    
    0.5
    
    
    
    0.5Foreign currency transaction gains (losses)
    
    
    (0.2
    )
    
    
    0.0Interest expense
    
    
    (0.0
    )
    
    
    (0.0
    )Income taxes
    
    
    4.2
    
    
    
    3.4Net income
    
    
    7.0
    %
    
    
    5.6
    %
 Net Sales.Net sales increased 16.5% to $98.0 million in the first
quarter of 2004 compared to $84.2 million in the first quarter of 2003,
representing an increase of $13.9 million. Sales from our direct sales offices
increased 18.9%, or $7.7 million, in the first quarter of 2004 compared to the
first quarter of 2003, including sales attributable to acquisitions in
Philadelphia and Tennessee. Excluding these acquisitions, direct office sales
increased 16.6% in the first quarter of 2004 compared to 2003. Sales to our
dealer network increased by 16.2%, or $3.0 million, in the first quarter of
2004 compared to the first quarter of 2003. Sales from our long distance
resale division increased 32.4%, or $2.75 million, sales from our DataNet
division increased 39.5%, or $750,000 and international revenues increased
32.5%, or $0.8 million, in the first quarter of 2004 compared to the first
quarter of 2003. These increases in the first quarter of 2004 were offset in
part by decreases of $0.7 million in sales from our government and national
accounts division and $0.8 million in sales from our Network Services Agency
division, which receives commissions on local and network services such as T-1
access, frame relay and other voice and data circuit services. The increases in net sales for the first quarter of 2004 compared to the
first quarter of 2003 from our direct sales offices, dealer channel and
international operations were primarily attributable to improved economic
conditions affecting our industry, as well as improved revenues in the core
business and long distance operations, despite continued competitive pressures
and some delayed buying decisions by customers. The increases in net sales
were also primarily 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. Sales to new customers in our direct
sales channel increased during the first quarter of 2004 on a percentage basis
relative to recurring revenues; however, recurring revenues to existing
customers increased in dollar volume compared to the same quarter in 2003. The
increase in consolidated net sales was offset in part by decreases in net sales
in our government and national accounts division, which did not achieve
anticipated sales volumes in part due to changes in the management personnel of
this division and related lack of focus in the divisions sales and operations. 16




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Sales from long distance and network services represented a significant
percentage of our sales increase in the first quarter of 2004 as compared to
the first quarter of 2003. Sales increased in NetSolutions, our long distance
resale division, by 32.4%, despite downward pricing pressure and significant
competition. Increased sales volume has allowed NetSolutions to offer more
competitive pricing, which improved sales to our existing customer base. On
the other hand, network services revenues decreased 52.8% in the first quarter
of 2004 compared to the first quarter of 2003, due primarily to revisions to
our agency commissions agreement with a Regional Bell Operating Company (RBOC),
which deferred revenue recognition on sales and commissions on local and
network services such as T-1 access, frame relay and other voice and data
circuit services. See Note E of Notes to Condensed Consolidated Financial
Statements for additional segment reporting information. Gross Profit. Gross profit for the first quarter of 2004 increased 18.2%
to $52.1 million, or 53.1% of net sales, from $44.1 million, or 52.4% of net
sales, in the first quarter of 2003. The increase in gross profit dollars
resulted primarily from a higher volume of consolidated net sales. Gross
profit, as a percentage of sales (or gross margin), increased as a result of
several different factors, including a higher proportion of revenues from
direct sales offices, higher relative software content in our products, cost
containment efforts and product design improvements. These factors were offset
in part by greater competitive pricing pressures and by pricing discounts or
special promotions on telephone system and software sales and related
equipment. During the first quarter of 2004, recurring revenue dollars increased from
existing customers in our direct sales offices, but recurring revenues
decreased as a percentage of total sales from this same channel relative to the
first quarter of 2003. Existing customers accounted for a significant portion
of our net sales from maintenance and other services, additions and/or
upgrades, support and training during the first quarter of 2004. Our business
communications platforms allow for system migration without the complete
change-out of hardware, which enables us to offer enhancements and new
solutions through upgrades to our existing customers. Our gross margins are
generally higher with recurring revenues because we incur less materials costs
relative to new installations, although our gross margins improved in the first
quarter of 2004 despite lower recurring revenues as a percentage of total net
sales, based on the factors discussed above. Sales from NetSolutions increased by 32.4%, or $2.75 million, in the first
quarter of 2004 as compared to the first quarter of 2003. Although gross
margins are generally lower in this division than our consolidated margins, the
margins improved in the first quarter of 2004 relative to the first quarter of
2003, based in part on our ability to negotiate more favorable pricing with
vendors on higher resale volumes. However, as discussed in further detail
above, sales from our network services division decreased 52.8% in the first
quarter of 2004 compared to the first quarter of 2003. 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 more than 84% during the first quarter of 2004
and more than 92% during the first quarter of 2003. Accordingly, the decrease
in sales from this division offset in part our increase in consolidated gross
profit and gross margins. We cannot accurately predict future consolidated gross margins based on 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 2004 increased 15.3% to $6.0 million, or 6.2% of net sales, from
$5.2 million, or 6.2% of net sales, for the first quarter of 2003. Included in
research and development expenses in both the first quarter of 2004 and the
first quarter of 2003 is amortization of patents totaling $55,000 in each
period. The increase in research and development expenses was primarily
attributable to third-party outsourcing of selected development costs,
increased personnel to support accelerated Session Initiation Protocol (SIP)
applications development and expenses related to testing and launching our
Model 8690 phone. The increase is also attributable, to a lesser extent, to
increased research and development spending related to our development of
convergence applications and new IP endpoint technology. In the first quarter
of 2004, research and development expenses were directed principally toward the
continued development of the Axxess software and systems (including versions
8.2 and 9.0), unified messaging and voice processing 17




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software, speech recognition and text-to-speech applications, call center
applications, unified communications applications, IP endpoint development,
certain CTI and IVR applications, and SIP applications. We expect that
research and development expenses will increase in absolute dollars as we
continue to develop and enhance existing and new technologies and products.
These expenses may vary, however, as a percentage of net sales. Selling, general and administrative. In the first quarter of 2004,
selling, general and administrative expenses, including amortization, increased
11.9% to $35.4 million, or 36.2% of net sales, from $31.7 million, or 37.6% of
net sales, in the first quarter of 2003. The increase in absolute dollars was
primarily due to the increase in volume of consolidated net sales of 16.5%.
Selling, general and administrative expenses also increased in absolute dollars
in part due to higher costs associated with opening new sales offices in
Philadelphia and Tennessee, and higher compensation and performance incentive
plan costs on higher sales volumes and improved achievement against 2004 goals
and profit sharing plans as compared to lower performance against 2003
incentive-based plans. In addition, higher relative sales through our long
distance and network services agency divisions led to high selling expenses and
commission costs relative to total sales. Selling, general and administrative
expenses decreased, as a percentage of net sales, primarily as a result of
higher absorption of fixed costs. 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. Amortization of purchased
intangible assets included in operating expenses was $445,000 in the first
quarter of 2004, compared to $428,000 in the first quarter of 2003. An
additional $55,000 of amortization was included in research and development
expenses for both the first quarter of 2004 and the first quarter of 2003. The
increase in the amortization of purchased intangible assets for the first
quarter 2004 compared to the same period in 2003 was primarily related to the
additional amortization from recent acquisitions. For additional information
regarding purchased intangible assets, see Note C  Acquisitions, Technology
Investments and Restructuring Charges to the Condensed Consolidated Financial
Statements. Interest and Other Income. Interest and other income in the first quarter
of 2004 and the first quarter of 2003 consisted primarily of interest income
and foreign currency transaction losses. Income from interest and short-term
investments in the first quarter of 2004 increased 14.2% to $506,000 compared
to $443,000 in the first quarter of 2003, due primarily to the higher level of
invested funds. Other changes in other income primarily reflected higher net
foreign currency transaction losses of $121,000 in 2004 compared to 2003.
Interest expense in the first quarter of 2004 increased slightly by only
$14,000 compared to the first quarter of 2003. Income Taxes. Inter-Tels income tax rate for the first quarter of 2004
decreased to 37.5% compared to 38.0% for the first quarter of 2003. Inter-Tel
expects the full-year 2004 tax rate to be 37.5%, based on higher levels of
tax-exempt interest income on investments and lower effective foreign tax rates
on foreign source income. Net Income. Net income for the first quarter of 2004 increased 46.0% to
$6.8 million ($0.25 per diluted share), compared to net income of $4.7 million
($0.18 per diluted share) in the first quarter of 2003. The increase in net
income for the first quarter of 2004 compared to the first quarter of 2003
resulted from higher operating profits primarily due to the higher volume of
net sales achieved in the first quarter of 2004 compared to the first quarter
of 2003 and other items described in further detail above. Inflation/Currency Fluctuation Inflation and currency fluctuations have not previously had a material
impact on Inter-Tels operations or financial condition. International
procurement agreements have traditionally been denominated in U.S. currency.
Moreover, a significant amount of contract manufacturing has been or could be
moved to alternative sources. The expansion of international operations in the
United Kingdom and Europe and increased sales, if any, in Japan and other parts
of Asia 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. 18




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Liquidity and Capital Resources March 31,(In thousands)
    
    2004
    
    2003Net cash provided by operating activities
    
    $
    16,212
    
    
    $
    7,061Net cash provided by (used in) investing activities
    
    
    1,183
    
    
    
    (15,229
    )Net cash provided by (used in) financing activities
    
    
    1,698
    
    
    
    (529
    )Increase (decrease) in cash and equivalents
    
    
    19,093
    
    
    
    (8,697
    )Cash and equivalents at beginning of period
    
    
    115,197
    
    
    
    84,923Cash and equivalents at end of period
    
    $
    134,290
    
    
    $
    76,226
 At March 31, 2004, cash and equivalents and short-term investments totaled
$191.2 million, which represented an increase of approximately $16.7 million
from the $174.5 million total at December 31, 2003. We maintain a $10 million
unsecured, revolving line of credit with BankOne, NA, which is available
through June 1, 2004. 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 and we intend to renew this facility again in 2004. A portion of our
cash balances may be used for, among other things, acquisitions, strategic
alliances, working capital and general corporate purposes. Net cash provided by operating activities totaled $16.2 million for the
three months ended March 31, 2004, compared to $7.1 million for the same period
in 2003. Cash provided by operating activities in the first quarter of 2004
was primarily the result of cash generated from profitable operations,
including non-cash depreciation and amortization charges. Cash generated from
the increase in deferred taxes totaled $4.9 million for the three months ended
March 31, 2004, compared to $932,000 for the same period in 2003. Cash
generated by the change in operating assets and liabilities in the first
quarter of 2004 was $1.1 million, including $7.2 million for income tax
refunds, compared to cash used from the change in operating assets and
liabilities of $2.0 million in 2003. At March 31, 2004, accounts receivable
totaled $38.0 million compared to $43.4 million at December 31, 2003. The
$5.4 million in cash generated by the decrease in accounts receivable was
substantially offset by increases in inventories of $4.1 million, as well as
decreases in accounts payable and other accrued expenses, primarily reflecting
payments on accrued commissions, bonuses, 401(k) matching contributions and
profit sharing in the first quarter of 2004 from year-end accruals. In the
first quarter of 2003, Inter-Tel received payment from the Vianet shareholders
of $1.45 million, as payment of a loan in connection with the sale of 83% of
our interest in Inter-Tel.NET, and in exchange for the full release of our
former guarantee of vendor obligations. If we are able to expand sales through
our direct sales offices, dealer network and government and national accounts
divisions, this would likely require the future use of cash for increased
accounts receivable and inventories. Net cash provided by investing activities totaled $1.2 million for the
quarter ended March 31, 2004, primarily in the form of $2.4 million from sales
and maturities of short-term investments, net of purchases, compared to cash
used in investing activities of $15.2 million for the quarter ended March 31,
2003, including $14.5 million used in the purchase of investments, net of sales
and maturities. During the first quarter of 2004, net cash used for capital
expenditures totaled approximately $1.2 million compared to $837,000 used to
acquire additional property and equipment during the first quarter 2003. We
expended no cash for acquisitions during either of the first quarters of 2004
or 2003. We anticipate continued capital expenditures during 2004, principally
relating to expenditures for equipment and management information systems used
in operations, facilities expansion and acquisition activities. Net cash provided by financing activities totaled $1.7 million in the
three months ended March 31, 2004, compared to cash used in financing
activities of $529,000 for the same period in 2003. Net cash provided by the
exercise of stock options totaled $3.2 million and $240,000, respectively,
during the first quarters of 2004 and 2003, which was offset in each period by
cash used for dividends, which totaled approximately $1.5 million and $747,000,
respectively. During the first quarter of 2004 and the first quarter of 2003,
we reissued treasury shares through stock option exercises and issuances. In
the three month period ending March 31, 2004, the proceeds received from these
reissued treasury shares totaled more than the cost basis of the treasury stock
reissued; accordingly, the difference was recorded as an increase to retained
earnings. However, during the quarter ending March 31, 2003, the proceeds
received from these reissued treasury shares were approximately the same as the
cost basis of the treasury stock reissued, recording a minimal impact on
retained earnings. 19




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We offer to our customers lease financing and other services, including
our TotalSolution (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 $217.3 million and $210.1 million remained unbilled at
March 31, 2004 and December 31, 2003, respectively. 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. Although to date, we have been able to resell the rental streams
from leases under the TotalSolution 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. Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has provided Inter-Tel with a limited description of the evidence on
which the investigations are based. Inter-Tel is presently unable to predict
or determine the final outcome of, or to estimate the potential range of loss
with respect to, the investigations. Based upon the information known at this
time, we do not know what, if any, impact the investigations may have on the
Companys business or financial condition. If Inter-Tel is convicted of any
crime or subjected to sanctions, or debarred from certain government contracts
or if penalties, damages or other monetary remedies are assessed against
Inter-Tel in connection with or related to these and other investigations, our
business and operating results could be materially and adversely affected. The
existence and disclosure of the investigations may have already caused
competitive harm to Inter-Tel, and any unfavorable resolution to 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, 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 F 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 financial 20




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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
rescinds 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). 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 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. 21




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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, declined from
6.1% at December 31, 2003 to 5.9% at March 31, 2004, primarily as a result of
improved 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. Inter-Tel has not
recorded any amortization for acquisitions on amounts allocated to goodwill in
accordance with SFAS No. 141 after January 1, 2002. 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, 2003 and
determined that goodwill is not impaired and it is not necessary to record any
impairment losses related to goodwill. At March 31, 2004, the Companys
goodwill all relates to entities within the Company that generate revenues for
all segments of the Company. Therefore, the reporting unit has been defined as
the entire company and fair value has been determined for the Company as a
whole in order to determine the recoverability of the recorded goodwill. The
Company considered both the discounted cash flows for the Company and the
market capitalization using average common stock prices in determining that no
impairment has occurred. 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. At March 31, 2004 and December 31, 2003, goodwill, net of accumulated
amortization, totaled $17.9 million and $18.0 million, respectively. Other
acquisition-related intangibles, net of accumulated amortization, totaled $8.0
million at March 31, 2004 and $8.2 at December 31, 2003. Accumulated
amortization through March 31, 2004 was $11.5 million, including $5.0 million
of goodwill accumulated amortization and $6.5 million of accumulated
amortization of other acquisition-related intangibles. Accumulated amortization
through December 31, 2003 was $11.0 million, including $5.0 million of goodwill
accumulated amortization and $6.0 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 year lives) and non-competition agreements (2-5 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 22




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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, 2004, our allowance for doubtful accounts for accounts
receivable were $10.8 million of our $49.0 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. We write down our excess and obsolete
inventory equal to the difference between the cost of inventory and the
estimated market value. Historically, sales of scrap have not been material
and have not affected our profit margins. At March 31, 2004, our inventory
reserves were $6.8 million of our $25.5 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 write-downs 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. However, at March 31, 2004, management did not believe
that the ultimate impact of various claims and pending litigation would have a
materially adverse impact on the financial condition of the Company. Recent Accounting Standards and Pronouncements Revenue Arrangements with Multiple Deliverables. In November 2002, the
FASB issued Emerging Issues Task Force 00-21 (EITF 00-21), Revenue
Arrangements with Multiple Deliverables. EITF 00-21 requires revenue
arrangements with multiple deliverables to be divided into separate units of
accounting. If the deliverables in the arrangement meet certain criteria,
arrangement consideration should be allocated among the separate units of
accounting based on their relative fair values. Applicable revenue recognition
criteria are to be considered separately for separate units of accounting. The
guidance in EITF 00-21 was effective for revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. The Companys adoption of EITF
00-21 did not have a material impact on its financial position, results of
operations or liquidity. Variable Interest Entities:In January 2003, the FASB issued
Interpretation No. 46, Consolidation of Variable Interest Entities, an
interpretation of ARB 51 (FIN 46). The primary objectives of FIN 46 are to
provide guidance on the identification of entities for which control is
achieved through means other than through voting rights (VIEs) and how to
determine when and which business enterprise should consolidate the VIE. This
new model for consolidation applies to an entity which either (1) the equity
investors (if any) do not have a controlling financial interest or (2) the
equity investment at risk is insufficient to finance that entitys activities
without receiving additional subordinated financial support from other parties.
The Companys adoption of FIN 46 did not have a material impact on its
financial position, results of operations or liquidity. 23




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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. 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;  
    
    pricing pressures;  
    
    the cost and effect of acquisitions;  
    
    the availability and cost of products and components from our suppliers; and  
    
    national and regional weather patterns. 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. 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 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 will suffer if we do not significantly increase sales to new customers.
For example, in the most recent quarter ended March 31, 2004, sales to new
customers through our direct sales offices, dealer network, long distance
division, DataNet, international and leasing divisions increased as a
percentage of total sales, resulting in increased net sales and operating
income compared to the quarter ended March 31, 2003. 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 have 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 both continue to increase as a percentage of net sales and 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 24




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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 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, 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
Axxess system, EncoreCX, speech recognition, Interactive Voice Response,
presence management, collaboration, messaging products, Session Initiation
Protocol (SIP) applications, and related computer-telephony products. Over the past 18 months, we have introduced Unified Communicator®
software, a web-based, speech-recognition, wireless PDA, and Wireless
Application Protocol (WAP) software application for controlling and managing
calls, contacts and presence status; Enterprise Conferencing and Enterprise
Instant Messaging, a SIP-based web and audio conferencing application; 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. During the past 12 months, 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
identified above, as well as the Axxess system, the Application Platform, the
Unified Communicator and related computer-telephony products, EncoreCX
products, 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; 25




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
    
    failure to achieve market acceptance or loss of market share;  
    
    increased service and warranty costs;  
    
    liabilities to our customers; and  
    
    increased insurance costs. The complexity of our products could cause delays in the development and
release of new products and services. As a result, customer demand for our
products could decline, which could harm our business. 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 recent years our operating results were materially
adversely affected by several of the factors described above, including
substantial acquisition-related charges and operating losses from the Executone
acquisition. Refer to Note B to the Condensed Consolidated Financial
Statements for additional information. We completed one acquisition and one technology purchase during 2003 and
one acquisition during January 2004. At the beginning of the third quarter of
2003, we acquired rights to certain developed technology and in December 2003,
we acquired selected assets and assumed certain liabilities of a former
Inter-Tel dealer in the Philadelphia metropolitan area. In January 2004, we
acquired selected assets and assumed certain liabilities of a former Inter-Tel
dealer in Nashville and Memphis, Tennessee. These acquisitions are subject to
risks and uncertainties including 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. We may not be able to adequately protect our proprietary technology and may be
infringing upon third-party intellectual property rights. Our success depends upon our proprietary technology. We currently hold
patents for twenty-four (24) telecommunication and messaging products and have
also applied to the U.S. Patent and Trademark Office for twelve (12) additional
patents. We also rely on copyright and trade secret law and contractual 26




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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. 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. We are also 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 proceedings initiated by Avaya, 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, one of our primary competitors, alleging that our
Axxess business communications system and associated applications utilize
inventions covered by certain of their patents. We are continuing the process
of investigating this matter and we have made claims against Avaya for
infringement of our patents. 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 and converged systems providers, distributors, or resellers such as Alcatel, Altigen, Avaya, Cisco Systems,
Comdial, 3Com, Iwatsu, Mitel, NEC, Nortel, Panasonic, Shoreline, Siemens, Toshiba, Vertical Networks and Vodavi;  
    
    large data routing and convergence companies such as 3Com and Cisco Systems;  
    
    voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a subsidiary of NEC America),
Avaya, and Captaris (formerly AVT);  
    
    long distance services providers such as AT&T, MCI, Qwest and Sprint;  
    
    large computer and software corporations such as IBM, HP, Intel and Microsoft;  
    
    regional Bell operating companies, or RBOCs, cable television companies, IP Centrex service providers, and
satellite and other wireless broadband service providers; 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 27




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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 through third-party
subcontractors located in the United States, Mexico, the Peoples Republic of
China and the United Kingdom. Varian, Inc. currently manufactures a
significant portion of our products at Varians Tempe, Arizona facility,
including substantially all of the printed circuit boards used in the Axxess
systems. 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. 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
manufacturers. However, we cannot assure you 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. 28




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We are currently the target of government investigations and in the future we
may be subject to litigation, which, if they result in any convictions,
sanctions or penalties against us, could harm our business. Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has provided Inter-Tel with a limited description of the evidence on
which the investigations are based. Inter-Tel is presently unable to predict or determine the final outcome
of, or to estimate the potential range of loss with respect to, the
investigations. If Inter-Tel is convicted of any crime or subjected to
sanctions, or debarred from certain government contracts or if penalties,
damages or other monetary remedies are assessed against Inter-Tel in connection
with these and other investigations, our business and operating results could
be materially and adversely affected. The existence and disclosure of the
investigations may have already caused competitive harm to Inter-Tel, and any
unfavorable resolution to 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, 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. 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. In addition, our operating results could be impaired if we lose a
substantial number of key employees from acquisitions, as was the case in our
acquisition of Executone. 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 Condensed
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. 29




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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. 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 growth could be impaired. 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
Axxess® 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 and
address software bugs. Over time, older versions of the software become less
supported 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 30




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may provide advanced notice of product upgrade schedules and take other
steps to make the upgrade process as straight-forward as possible, we are
subject to risks associated with the process. 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. 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. 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:  
    
    announcements of developments relating to our business;  
    
    fluctuations in our operating results;  
    
    shortfalls in revenue or earnings relative to securities analysts expectations;  
    
    announcements of technological innovations or new products or enhancements by us or our competitors;  
    
    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;  
    
    threats of or outbreaks of war, hostilities or terrorist acts;  
    
    developments relating to our intellectual property rights and the intellectual property rights of third parties;  
    
    litigation or governmental investigations of our business practices;  
    
    changes in our relationships with our customers and suppliers; and  
    
    national and regional weather patterns. 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. The Chairman of our Board of Directors, CEO and President controls 20.2% of our
Common Stock as of March 31, 2004 and is able to significantly influence
matters requiring shareholder approval. As of March 31, 2004, Steven G. Mihaylo, Inter-Tels Chairman of the Board
of Directors, Chief Executive Officer and President, beneficially owned
approximately 20.2% of the existing outstanding shares of our common stock. 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. Risks Related to Our Industry Reductions in spending on enterprise communications equipment may materially
and adversely affect our business. Although our results for the first quarter of 2004 improved compared to
the same period in 2003, the overall economic slowdown in recent years has had
and continues 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. The market for enterprise 31




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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 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 Axxess systems and our IP endpoints and
related 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 SIP generally require the
acceptance of a new way of exchanging information. In particular, enterprises
that have already invested substantial resources in traditional or alternative
communication structures 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 facsimile 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 network services 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
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 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 long distance and
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 long distance and 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 reduce our customer base. There has been a trend in the telecommunications industry towards
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
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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 communications solutions, 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. 
 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 investments, which are all
classified as available for sale, and have been recorded at fair value, which
approximates cost. Fair value has been determined to approximate cost based on
broker statements. We have also historically purchased and sold similar
investments at face value. Short-term investments include certificates of
deposit, auction rate certificates, auction rate preferred securities,
municipal preferred securities 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 (30) years. These instruments are rated A or higher by Standard &
Poors Ratings Group, or equivalent. The Companys short-term 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 these investments, and that
we have no borrowings outstanding other than short-term letters of credit, 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 33




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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 currency rate changes have historically been relatively
insignificant. 
 ITEM 4. CONTROLS AND PROCEDURES Evaluation of disclosure controls and procedures. Our management
evaluated, with the participation of our Chief Executive Officer and our Chief
Financial Officer, the effectiveness of our disclosure controls and procedures
(as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act
of 1934, as amended) as of the end of the period covered by this Quarterly
Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that our disclosure controls and
procedures were effective to ensure that the information we are required to
disclose in reports that we file or submit under the Securities Exchange Act of
1934, as amended, is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission rules and forms. 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. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIESNot Applicable 
 ITEM 3. DEFAULTS ON SENIOR SECURITIESNot Applicable 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our Annual Meeting of Shareholders was held April 27, 2004 (the Annual
Meeting). On March 19, 2004 we mailed a Proxy Statement, pursuant to
Regulation 14A under the Securities Exchange Act of 1934, as amended, to our
shareholders to solicit their votes regarding the following matters that were
discussed and approved by our shareholders at our Annual Meeting:  1.
    
    Election of Directors: Steven G. Mihaylo, J. Robert Anderson, Jerry W.
Chapman, Gary D. Edens and C. Roland Haden were elected to serve as
directors until the 2005 Annual Meeting of Shareholders. The votes were
as follows: Nominee
    
    For:
    
    Against:
    
    Abstain:Steven G. Mihaylo
    
    
    23,725,483
    
    
    
    508,695
    
    
    
    J. Robert Anderson
    
    
    23,759,566
    
    
    
    474,612
    
    
    
    Jerry W. Chapman
    
    
    23,770,834
    
    
    
    463,344
    
    
    
    Gary D. Edens
    
    
    23,772,144
    
    
    
    462,034
    
    
    
    C. Roland Haden
    
    
    23,620,945
    
    
    
    613,233
    
    
    
    
 34




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2.
    
    The shareholders also voted on and approved a proposal to ratify the
appointment of Ernst & Young LLP to act as the independent auditors to
audit our and our subsidiaries financial statements for the year 2004.
The votes were as follows: For:
    
    Against:
    
    Abstain:Proposal to ratify
the appointment of
independent
auditors
    
    
    23,896,953
    
    
    
    316,332
    
    
    
    20,893
 
 ITEM 5. OTHER INFORMATION Pursuant to Rule 14a-4(c)(1) under the Securities Exchange Act of 1934, as
amended, in connection with the Companys annual meeting of shareholders, if a
shareholder of the Company fails to notify the Company at least 45 days prior
to the month and day of mailing of the prior years proxy statement, then the
proxies of management would be allowed to use their discretionary voting
authority when any such proposal is raised at the Companys annual meeting of
shareholders, without any discussion of the matter in the proxy statement.
Since the Company mailed its proxy statement for the 2004 annual meeting of
shareholders on March 19, 2004, the deadline for receipt of any such
shareholder proposal for the 2005 annual meeting of shareholders is February 2,
2005. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K: Exhibits: Exhibit 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
 Reports on Form 8-K: On February 17, 2004, we filed a Current Report on Form 8-K under Item
7 (Financial Statements and Exhibits) and furnished disclosure under
Item 12 (Results of Operations and Financial Condition) to report our
press release dated February 17, 2004 announcing GAAP and non-GAAP
results for the fiscal year ended December 31, 2003, and comparing such
results with the results for the year ended December 31, 2002. On April 27, 2004, we filed a Current Report on Form 8-K under Item 7
(Financial Statements and Exhibits) and furnished disclosure under Item
12 (Results of Operations and Financial Condition) to report our Press
release dated April 27, 2004 announcing financial results for the
fiscal quarter ended March 31, 2004, and comparing such results with
the results for the quarter ended March 31, 2003. 35




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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, 2004
    /s/    Steven G. MihayloSteven G. MihayloChairman of the Board, Chief Executive
Officer and President May 10, 2004
    /s/     Kurt R. KneipKurt R. KneipSr. Vice President and
Chief Financial Officer 36