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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
 THE SECURITIES EXCHANGE ACT OF 1934
 For the quarter ended
    
    Commission File Number:September 30, 2004
    
    0-10211
 INTER-TEL, INCORPORATED Incorporated in the State of Arizona
    
    I.R.S. No. 86-0220994
 1615 S. 52nd Street
Tempe, Arizona 85281 (480) 449-8900   Title of Class
    
    Outstanding as of September 30, 2004Common Stock, no par value
    
    
    25,865,371
 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September 30, 2004
and December 31, 2003
    
    
    3Condensed Consolidated Statements of Incomethree and nine
months ended September 30, 2004 and September 30, 2003
    
    
    4Condensed Consolidated Statements of Cash Flowsnine
months ended September 30, 2004 and September 30, 2003
    
    
    5Notes to Condensed Consolidated Financial
StatementsSeptember 30, 2004
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    14Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    35Item 4.
    
    Controls and Procedures
    
    
    36PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    36Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    36Item 3.
    
    Defaults Upon Senior Securities
    
    
    36Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    36Item 5.
    
    Other Information
    
    
    36Item 6.
    
    Exhibits
    
    
    37SIGNATURES
    
    
    37MANAGEMENT CERTIFICATIONS
    
    
    38EX-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
 September 30,
    
    December 31,2004
    
    2003(in thousands, except share amounts)
    
    (Unaudited)
    
    (Note A)ASSETSCURRENT ASSETSCash and equivalents
    
    $
    152,634
    
    
    $
    115,197Short-term investments
    
    
    61,892
    
    
    
    59,334Total cash and short-term investments
    
    
    214,526
    
    
    
    174,531Accounts receivable, net of allowances of $11,117
in 2004 and $11,010 in 2003
    
    
    43,397
    
    
    
    43,434Inventories, net of allowances of $6,863 in 2004
and $6,952 in 2003
    
    
    17,193
    
    
    
    14,648Net investment in sales-leases, net of allowances
of $801 in 2004 and $749 in 2003
    
    
    16,888
    
    
    
    15,502Income taxes receivable
    
    
    2,612
    
    
    
    8,196Deferred income taxes
    
    
    15,655
    
    
    
    13,789Prepaid expenses and other assets
    
    
    6,328
    
    
    
    6,432TOTAL CURRENT ASSETS
    
    
    316,599
    
    
    
    276,532PROPERTY, PLANT & EQUIPMENT
    
    
    26,411
    
    
    
    24,657GOODWILL
    
    
    19,277
    
    
    
    17,967PURCHASED INTANGIBLE ASSETS
    
    
    7,462
    
    
    
    8,191NET INVESTMENT IN SALES-LEASES, net of allowances
of $1,741 in 2004 and $1,985 in 2003
    
    
    31,237
    
    
    
    32,529TOTAL ASSETS
    
    $
    400,986
    
    
    $
    359,876LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIESAccounts payable
    
    $
    29,763
    
    
    $
    28,386Other current liabilities
    
    
    46,173
    
    
    
    47,585TOTAL CURRENT LIABILITIES
    
    
    75,936
    
    
    
    75,971DEFERRED TAX LIABILITY
    
    
    71,378
    
    
    
    57,996LEASE RECOURSE LIABILITY
    
    
    12,344
    
    
    
    12,020RESTRUCTURING RESERVE
    
    
    
    
    
    
    49OTHER LIABILITIES
    
    
    7,317
    
    
    
    6,535SHAREHOLDERS EQUITYCommon stock, no par value-authorized 100,000,000
shares; issued27,161,823 shares;
outstanding25,865,371 at September 30, 2004 and
25,429,642 shares at December 31, 2003
    
    
    115,693
    
    
    
    113,960Retained earnings
    
    
    132,896
    
    
    
    113,299Accumulated other comprehensive income
    
    
    1,122
    
    
    
    1,025249,711
    
    
    
    228,284Less: Treasury stock at cost  1,296,452 shares
at September 30, 2004 and 1,732,181 shares at
December 31, 2003
    
    
    (15,700
    )
    
    
    (20,979
    )TOTAL SHAREHOLDERS EQUITY
    
    
    234,011
    
    
    
    207,305TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    400,986
    
    
    $
    359,876
 See accompanying notes. 3




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INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
 Three Months
    
    Nine Months(In thousands, except
    
    Ended September 30,
    
    Ended September 30,per share amounts)
    
    2004
    
    2003
    
    2004
    
    2003NET SALES
    
    $
    105,506
    
    
    $
    94,545
    
    
    $
    306,445
    
    
    $
    273,816Cost of sales
    
    
    49,572
    
    
    
    45,301
    
    
    
    144,114
    
    
    
    130,248GROSS PROFIT
    
    
    55,934
    
    
    
    49,244
    
    
    
    162,331
    
    
    
    143,568Research and development
    
    
    7,637
    
    
    
    5,718
    
    
    
    20,816
    
    
    
    16,378Selling, general and administrative
    
    
    34,575
    
    
    
    31,761
    
    
    
    103,916
    
    
    
    96,008Amortization of purchased intangible assets
    
    
    414
    
    
    
    445
    
    
    
    1,295
    
    
    
    1,35942,626
    
    
    
    37,924
    
    
    
    126,027
    
    
    
    113,745OPERATING INCOME
    
    
    13,308
    
    
    
    11,320
    
    
    
    36,304
    
    
    
    29,823Interest and other income
    
    
    732
    
    
    
    351
    
    
    
    1,808
    
    
    
    1,226Foreign currency transaction gains (losses)
    
    
    (7
    )
    
    
    5
    
    
    
    (281
    )
    
    
    (9
    )Interest expense
    
    
    (20
    )
    
    
    (34
    )
    
    
    (108
    )
    
    
    (137
    )INCOME BEFORE INCOME TAXES
    
    
    14,013
    
    
    
    11,642
    
    
    
    37,723
    
    
    
    30,903Income tax provision
    
    
    4,807
    
    
    
    4,424
    
    
    
    13,580
    
    
    
    11,744NET INCOME
    
    $
    9,206
    
    
    $
    7,218
    
    
    $
    24,143
    
    
    $
    19,159NET INCOME PER SHAREBasic
    
    $
    0.36
    
    
    $
    0.29
    
    
    $
    0.94
    
    
    $
    0.77Diluted
    
    $
    0.34
    
    
    $
    0.27
    
    
    $
    0.89
    
    
    $
    0.73DIVIDENDS PER SHARE
    
    $
    0.07
    
    
    $
    0.06
    
    
    $
    0.19
    
    
    $
    0.12Weighted average basic common shares
    
    
    25,816
    
    
    
    25,107
    
    
    
    25,691
    
    
    
    24,991Weighted average diluted common shares
    
    
    26,944
    
    
    
    26,865
    
    
    
    27,185
    
    
    
    26,291
 See accompanying notes. 4




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INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
 Nine MonthsEnded September 30,(In thousands)
    
    2004
    
    2003OPERATING ACTIVITIESNet income
    
    $
    24,143
    
    
    $
    19,159Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation of fixed assets
    
    
    5,849
    
    
    
    5,290Amortization of patents included in R&D expenses
    
    
    166
    
    
    
    166Amortization of purchased intangible assets
    
    
    1,295
    
    
    
    1,359Provision for losses on receivables
    
    
    1,417
    
    
    
    2,397Provision for losses on leases
    
    
    2,856
    
    
    
    3,831Provision for inventory valuation
    
    
    1,166
    
    
    
    479Decrease in other liabilities
    
    
    (1,268
    )
    
    
    (2,658
    )Loss on sale of property and equipment
    
    
    2
    
    
    
    91Deferred income taxes
    
    
    11,516
    
    
    
    14,885Effect of exchange rate changes
    
    
    97
    
    
    
    102Changes in operating assets and liabilities
    
    
    649
    
    
    
    (25,522
    )NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    47,888
    
    
    
    19,579INVESTING ACTIVITIESPurchases of short-term investments
    
    
    (75,133
    )
    
    
    (141,869
    )Maturities and sales of short-term investments
    
    
    72,575
    
    
    
    113,710Additions to property, plant and equipment
    
    
    (7,436
    )
    
    
    (5,219
    )Proceeds from disposal of property, plant and equipment
    
    
    21
    
    
    
    75Proceeds from investment in Inter-Tel.NET/Vianet
    
    
    
    
    
    
    1,450Cash used in acquisitions
    
    
    (1,458
    )
    
    
    (450
    )NET CASH USED IN INVESTING ACTIVITIES
    
    
    (11,431
    )
    
    
    (32,303
    )FINANCING ACTIVITIESCash dividends paid
    
    
    (4,611
    )
    
    
    (2,245
    )Treasury stock purchases
    
    
    
    
    
    
    (206
    )Payments on term debt
    
    
    (39
    )
    
    
    (89
    )Proceeds from exercise of stock options, including
shareholder loan repayments
    
    
    5,130
    
    
    
    3,260Proceeds from stock issued under the ESPP
    
    
    500
    
    
    
    468NET CASH PROVIDED BY FINANCING ACTIVITIES
    
    
    980
    
    
    
    1,188INCREASE (DECREASE) IN CASH AND EQUIVALENTS
    
    
    37,437
    
    
    
    (11,536
    )CASH AND EQUIVALENTS AT BEGINNING OF PERIOD
    
    
    115,197
    
    
    
    84,923CASH AND EQUIVALENTS AT END OF PERIOD
    
    $
    152,634
    
    
    $
    73,387
 See accompanying notes. 5




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INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 NOTE ABASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements
have been prepared in conformity with United States generally accepted
accounting principles applicable to interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation of the results for the
interim periods presented have been included. Operating results for the
quarter and nine months ending September 30, 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 In 2002, the Financial Accounting Standards Board (FASB) issued
Statement No. 148 Accounting for Stock-Based CompensationTransition and
Disclosure, an amendment of FASB Statement No. 123 (SFAS No. 148), which
provides alternative methods of transition for an entity that voluntarily
changes to the fair value based method of accounting for stock-based employee
compensation. It also amends the disclosure provisions of SFAS No. 123 to
require prominent disclosure about the effects on reported net income of an
entitys accounting policy decisions with respect to stock-based employee
compensation. Finally, this statement amends APB Opinion No. 28, Interim
Financial Reporting, to require disclosure about those effects in interim
financial information. We adopted SFAS No. 148 in the fourth quarter of 2002.
Since we have not changed to a fair value method of stock-based compensation,
the applicable portion of this statement only affects our footnote disclosures. We do not recognize compensation expense relating to employee stock
options because we only grant options with an exercise price equal to the fair
value of the stock on the effective date of grant. At September 30, 2004, the
Company has four stock-based employee and director incentive plans and an
employee stock purchase plan. The Company accounts for these plans under the
recognition and measurement principles of APB No. 25, Accounting for Stock
Issued to Employees, and related interpretations. Stock-based employee
compensation costs are not reflected in net income, as all options granted
under the plans had an exercise price equal to the market value of the
underlying common stock on the date of grant. If we had elected to recognize
compensation expense using a fair value approach, and therefore determined the
compensation based on the value as determined by the modified Black-Scholes
option pricing model, the pro forma net income and earnings per share would
have been as follows: 6




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Three Months Ended
    
    Nine Months Ended(In thousands, except
    
    September 30,
    
    September 30,per share amounts)
    
    2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    9,206
    
    
    $
    7,218
    
    
    $
    24,143
    
    
    $
    19,159Deduct: total
stock-based
compensation expense,
determined under fair
value based method for
all awards, net of tax
    
    
    (836
    )
    
    
    (896
    )
    
    
    (2,457
    )
    
    
    (2,281
    )Pro forma net income
    
    $
    8,370
    
    
    $
    6,322
    
    
    $
    21,686
    
    
    $
    16,878Earnings per share of common stock:Basic  as reported
    
    $
    0.36
    
    
    $
    0.29
    
    
    $
    0.94
    
    
    $
    0.77Basic  pro forma
    
    $
    0.32
    
    
    $
    0.25
    
    
    $
    0.84
    
    
    $
    0.68Diluted  as reported
    
    $
    0.34
    
    
    $
    0.27
    
    
    $
    0.89
    
    
    $
    0.73Diluted  pro forma
    
    $
    0.31
    
    
    $
    0.24
    
    
    $
    0.80
    
    
    $
    0.64
 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: risk free interest rates of 3.36% for 2004 and
2.98% for 2003; dividend yields of 1.13% for 2004 and 1.2% for 2003; volatility
factors of the expected market price of our stock averaged 0.480 for 2004 and
0.579 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 our management can
estimate the amount and range of loss. Because of the uncertainties related to
both the amount and range of loss on the remaining pending claims and
litigation, management is unable to make a reasonable estimate of the liability
that could result from an unfavorable outcome. As additional information
becomes available, we will assess the potential liability related to our
pending litigation and revise our estimates. Such revisions in our estimates of
the potential liability could materially impact our results of operations and
financial position. 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 description of the evidence on which
the investigations are based. Inter-Tel has been engaged in discussions with
various divisions of the Justice Department regarding the resolution or
settlement of these investigations, which include a civil lawsuit, currently
stayed, initiated by the San Francisco Unified School District and in which the
Justice Department intervened. 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. There can be no assurance,
however, that a resolution or settlement will be reached. 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. 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. 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
    
    Nine Months Ended(In thousands, except
    
    September 30,
    
    September 30,per share amounts)
    
    2004
    
    2003
    
    2004
    
    2003Numerator: Net income
    
    $
    9,206
    
    
    $
    7,218
    
    
    $
    24,143
    
    
    $
    19,159Denominator:Denominator for basic earnings per
share  weighted average shares
    
    
    25,816
    
    
    
    25,107
    
    
    
    25,691
    
    
    
    24,991Effect of dilutive securities:Employee and director stock options
    
    
    1,128
    
    
    
    1,758
    
    
    
    1,494
    
    
    
    1,300Denominator for diluted earnings per
share  adjusted weighted average
shares and assumed conversions
    
    
    26,944
    
    
    
    26,865
    
    
    
    27,185
    
    
    
    26,291Basic earnings per share
    
    $
    0.36
    
    
    $
    0.29
    
    
    $
    0.94
    
    
    $
    0.77Diluted earnings per share
    
    $
    0.34
    
    
    $
    0.27
    
    
    $
    0.89
    
    
    $
    0.73Options excluded from diluted net
earnings per share calculations (1)
    
    
    311
    
    
    
    227
    
    
    
    209
    
    
    
    301
 (1) At September 30, 2004 and September 30, 2003, options to purchase shares of
Inter-Tel stock were excluded from the calculation of diluted net earnings per
share for the periods presented because the exercise price of these options was
greater than the average market price of the common shares for the respective
fiscal periods, and therefore the effect would have been antidilutive. NOTE C  ACQUISITIONS, TECHNOLOGY INVESTMENTS AND RESTRUCTURING CHARGES New Sales Offices.In January and July 2004, we acquired certain assets
and assumed certain liabilities relating to the customer bases of two former
dealers, one in Tennessee and one in South Carolina. The total assets acquired
and liabilities assumed from these acquisitions were approximately $1 million
and $0.5 million, respectively. Purchased intangibles and goodwill recorded as
a result of the transactions totaled $0.7 million and $1.6 million,
respectively. The goodwill is non-amortizable. The balances included in other
purchased intangible assets will be amortized over a period of five years. 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 $0.6 million and $0.9 million,
respectively. Total goodwill and purchased intangibles recorded as a result of
the transaction were $0.2 million and $0.1 million, respectively. The goodwill
balance is non-amortizable. The balance included in the $0.1 million in other
purchased intangible assets is being amortized over a period of five years.
Refer to Note F, Subsequent Events for additional information regarding
acquisitions. 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 would perform additional development
activities on a cost reimbursement basis 8




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through August 15, 2004. Under the
terms of the arrangement, the selling entity could also earn bonus payments
totaling up to $1,000,000 for meeting certain development milestones.
Milestone bonuses totaling $750,000 for the nine months ended September 30,
2004, including $250,000 for the third quarter, were achieved and expensed as
research and development costs. Technological feasibility of the underlying
technology has not yet been achieved to provide for viable product sales. As
of September 30, 2004, the remaining milestone bonus of $250,000 is dependent
on future events and is not considered to be probable or reasonably estimable.
The following table summarizes details of the expenses in connection with this
technology investment recorded during the three and nine month periods ended
September 30: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(In thousands)
    
    2004
    
    2003
    
    2004
    
    2003Milestone bonus payments
    
    $
    250
    
    
    $
    
    
    
    $
    750
    
    
    $
    Development activities on a cost
reimbursement basis
    
    
    98
    
    
    
    164
    
    
    
    649
    
    
    
    164Totals
    
    $
    348
    
    
    $
    164
    
    
    $
    1,399
    
    
    $
    164
 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 June 30, 2004, portions of all
five $100,000 milestones had been achieved for which $450,436 was paid to the
Swan shareholders. Of this amount, the final $100,000 milestone achievement
was paid during the second quarter of 2004. Payments relating to the
achievement of performance milestones were capitalized and are being amortized
as purchased intangible assets. 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 September 30, 2004 and September 30, 2003, the
amortization of purchased intangible assets from Swan was approximately
$197,000 in each period, 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 the 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 September 30, 2004 was 7 years for each period,
respectively. The weighted-average amortization
period as of December 31, 2003 and September 30, 2004 for developed
technology was 7.5 years for each period, and 4.8 and 5.0 years, respectively,
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 9




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the second quarter of 2000
for reserve balances have not changed significantly through September 30, 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. 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 September
30, 2004: Activity
    
    
    
    
    
    ReserveCash/
    
    Restructuring
    
    Through
    
    2004
    
    BalanceDescription
    
    Non-Cash
    
    Charge
    
    2003
    
    Activity
    
    At 9/30/04Personnel 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
    
    
    
    976
    
    
    
    (270
    )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
    
    
    
    41
    
    
    
    (101
    )Net intangible assets
    
    Non-Cash
    
    
    (29,184
    )
    
    
    29,184
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    $
    (50,916
    )
    
    $
    49,528
    
    
    $
    1,017
    
    
    $
    (371
    )
 NOTE D  SEGMENT INFORMATION Inter-Tel follows Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information (SFAS
131). SFAS 131 established standards for reporting information regarding
operating segments in annual financial statements and requires selected
information for those segments to be presented in interim financial reports
issued to stockholders. SFAS 131 also established standards for related
disclosures about products and services and geographic areas. Operating
segments are identified as components of an enterprise about which separate
discrete financial information is available for evaluation by the chief
operating decision maker, or decision making group, in
making decisions as to how to allocate resources and assess performance.
The Companys chief decision maker, as defined under SFAS 131, is the Chief
Executive Officer. We view our operations as primarily composed of two segments: (1) our
principal segment, which includes sales of telephone systems,
telecommunications software, hardware and related services, and (2) network
services, including resale of local and long distance calling services, voice
circuits and data circuits through NetSolutions®, as well as commissions earned
by Network Services Agency, our wholly-owned subsidiary serving as an agent
selling local and network services such as T-1 access, frame relay and other
voice and data circuit services on behalf of Regional Bell Operating Companies
(RBOCs) and local exchange carriers (collectively, Network Services). Sales
of these systems, software, related services 10




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and Network Services are provided
through the Companys direct sales offices and dealer network to business
customers throughout the United States, and in parts of 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 Network Services
segment, if the operations were not included as part of the consolidated group,
could differ materially, as the operations are integral to the total telephony
solution offered by us to our customers. For the quarters and nine months ended September 30, 2004 and 2003, we
generated income from business segments as follows: Three Months Ended September 30, 2004Principal
    
    Network(In thousands, except per share amounts)
    
    Segment
    
    Services
    
    TotalNet sales
    
    $
    93,015
    
    
    $
    12,491
    
    
    $
    105,506Gross profit
    
    
    51,118
    
    
    
    4,816
    
    
    
    55,934Operating income
    
    
    11,150
    
    
    
    2,158
    
    
    
    13,308Interest and other income
    
    
    675
    
    
    
    57
    
    
    
    732Foreign currency transaction losses
    
    
    (7
    )
    
    
    
    
    
    
    (7
    )Interest expense
    
    
    (12
    )
    
    
    (8
    )
    
    
    (20
    )Net income
    
    $
    7,710
    
    
    $
    1,496
    
    
    $
    9,206Net income per diluted share (1)
    
    $
    0.28
    
    
    $
    0.06
    
    
    $
    0.34Weighted average diluted shares (1)
    
    
    26,944
    
    
    
    26,944
    
    
    
    26,944Total assets
    
    $
    377,596
    
    
    $
    23,390
    
    
    $
    400,986Depreciation and amortization
    
    
    2,324
    
    
    
    19
    
    
    
    2,343
 Three Months Ended September 30, 2003Principal
    
    Network(In thousands, except per share amounts)
    
    Segment
    
    Services
    
    TotalNet sales
    
    $
    83,527
    
    
    $
    11,018
    
    
    $
    94,545Gross profit
    
    
    44,816
    
    
    
    4,428
    
    
    
    49,244Operating income
    
    
    9,503
    
    
    
    1,817
    
    
    
    11,320Interest and other income
    
    
    308
    
    
    
    43
    
    
    
    351Foreign currency transaction gains
    
    
    5
    
    
    
    
    
    
    
    5Interest expense
    
    
    (34
    )
    
    
    
    
    
    
    (34
    )Net income
    
    $
    6,065
    
    
    $
    1,153
    
    
    $
    7,218Net income per diluted share (1)
    
    $
    0.23
    
    
    $
    0.04
    
    
    $
    0.27Weighted average diluted shares (1)
    
    
    26,865
    
    
    
    26,865
    
    
    
    26,865Total assets
    
    $
    294,402
    
    
    $
    20,275
    
    
    $
    314,677Depreciation and amortization
    
    
    2,219
    
    
    
    38
    
    
    
    2,257
 Nine Months Ended September 30, 2004Principal
    
    Network(In thousands, except per share amounts)
    
    Segment
    
    Services
    
    TotalNet sales
    
    $
    269,731
    
    
    $
    36,714
    
    
    $
    306,445Gross profit
    
    
    147,821
    
    
    
    14,510
    
    
    
    162,331Operating income
    
    
    29,900
    
    
    
    6,404
    
    
    
    36,304Interest and other income
    
    
    1,651
    
    
    
    157
    
    
    
    1,808Foreign currency transaction losses
    
    
    (281
    )
    
    
    
    
    
    
    (281
    )Interest expense
    
    
    (99
    )
    
    
    (9
    )
    
    
    (108
    )Net income
    
    $
    19,910
    
    
    $
    4,233
    
    
    $
    24,143Net income per diluted share (1)
    
    $
    0.73
    
    
    $
    0.16
    
    
    $
    0.89Weighted average diluted shares (1)
    
    
    27,185
    
    
    
    27,185
    
    
    
    27,185Total assets
    
    $
    377,596
    
    
    $
    23,390
    
    
    $
    400,986Depreciation and amortization
    
    
    7,219
    
    
    
    91
    
    
    
    7,310
 11




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##### Table of Contents



Nine Months Ended September 30, 2003Principal
    
    Network(In thousands, except per share amounts)
    
    Segment
    
    Services
    
    TotalNet sales
    
    $
    241,750
    
    
    $
    32,066
    
    
    $
    273,816Gross profit
    
    
    130,824
    
    
    
    12,744
    
    
    
    143,568Operating income
    
    
    24,680
    
    
    
    5,143
    
    
    
    29,823Interest and other income
    
    
    1,115
    
    
    
    111
    
    
    
    1,226Foreign currency transaction losses
    
    
    (9
    )
    
    
    
    
    
    
    (9
    )Interest expense
    
    
    (137
    )
    
    
    
    
    
    
    (137
    )Net income
    
    $
    15,901
    
    
    $
    3,258
    
    
    $
    19,159Net income per diluted share (1)
    
    $
    0.61
    
    
    $
    0.12
    
    
    $
    0.73Weighted average diluted shares (1)
    
    
    26,291
    
    
    
    26,291
    
    
    
    26,291Total assets
    
    $
    294,402
    
    
    $
    20,275
    
    
    $
    314,677Depreciation and amortization
    
    
    6,696
    
    
    
    119
    
    
    
    6,815
 (1) Options that are antidilutive because the exercise price was greater than
the average market price of the common shares are not included in the
computation of diluted earnings per share. Our revenues are generated predominantly in the United States. Total
revenues generated from U.S. customers totaled $296.7 million, or 96.8% of
total revenues, and $265.6 million, or 97.0% of total revenues for the nine
months ended September 30, 2004 and 2003, respectively. Total revenues
generated from U.S. customers totaled $102.3 million, or 96.9% of total
revenues, and $91.8 million, or 97.1% of total revenues for the quarters ended
September 30, 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 third quarters of 2004 and 2003,
revenues from customers located internationally accounted for 3.1% and 2.9% of
total revenues, respectively. In the nine months ended September 30, 2004 and
2003, revenues from customers located internationally accounted for 3.2% and
3.0% of total revenues, respectively. Our applicable long-lived assets at
September 30, 2004, included Property, Plant & Equipment; Goodwill; and
Purchased Intangible Assets. The net amount located in the United States was
$50.4 million and the amount in foreign countries was $2.8 million at September
30, 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 E NET INVESTMENT IN SALES-LEASES Net investment in sales-leases represents the value of sales-leases
presently held under our Total Solution program. We currently sell the rental
payments due to us from most of the sales-leases. We maintain reserves against
our estimate of potential credit losses for the balance of sales-leases held
and for the balance of sold rental payments remaining unbilled. The following
table provides detail on the total net balances in sales-leases: September 30,
    
    December 31,(in thousands)
    
    2004
    
    2003Lease balances included in consolidated accounts receivable, net of
allowances of $1,520 in 2004 and $1,774 in 2003
    
    $
    6,724
    
    
    $
    7,240Net investment in Sales-Leases:Current portion, net of allowances of $801 in 2004 and $749 in 2003
    
    
    16,888
    
    
    
    15,502Long-term portion, includes residual amounts of $472 in 2004 and
$652 in 2003, net of allowances of $1,741 in 2004 and $1,985 in
2003
    
    
    31,237
    
    
    
    32,529Total investment in Sales-Leases, net of allowances of $4,062 in 2004
and $4,508 in 2003
    
    
    54,849
    
    
    
    55,271Sold rental payments remaining unbilled (subject to limited recourse
provisions), net of allowances of $12,344 in 2004 and $12,020 in 2003
    
    
    221,433
    
    
    
    198,091
 12




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##### Table of Contents



September 30,
    
    December 31,(in thousands)
    
    2004
    
    2003Total balance of sales-leases and sold rental payments remaining
unbilled, net of allowances
    
    $
    276,282
    
    
    $
    253,362Total allowances for entire lease portfolio (including limited
recourse liabilities)
    
    $
    16,406
    
    
    $
    16,528
 Reserve levels are established based on portfolio size, loss experience,
levels of past due accounts and periodic, detailed reviews of the portfolio.
Recourse on the sold rental payments is contractually limited to a percentage
of the net credit losses in a given annual period as compared to the beginning
portfolio balance for a specific portfolio of sold leases. While our recourse
is limited, we maintain reserves at a level that we believe is sufficient to
cover all anticipated credit losses. The aggregate reserve for uncollectible
lease payments and recourse liability represents the reserve for the entire
lease portfolio. These reserves are either netted 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 are as follows: Nine Months Ended
    
    Year Ended(In thousands)
    
    September 30, 2004
    
    December 31, 2003Sales of rental payments
    
    $
    84,172
    
    
    $
    88,352Sold payments remaining unbilled at end of period
    
    $
    233,777
    
    
    $
    210,111
 Sales of rental payments represent the gross selling price or total
present value of the payment stream on the sale of the rental payments to third
parties. Sold payments remaining unbilled at the end of the period represent
the total balance of leases that is not included in our balance sheet. We do
not expect to incur any significant losses in excess of reserves from the
recourse provisions related to the sale of rental payments. NOTE F  SUBSEQUENT EVENTS In October 2004, after the close of the third fiscal quarter of 2004, we
acquired selected assets and assumed certain liabilities of former Inter-Tel
dealers in Pittsburgh, Pennsylvania and Las Vegas, Nevada. In October 2004, we
also acquired selected assets and assumed certain liabilities of Linktivity,
which develops Web-based conferencing solutions, notably Linktivity® software.
These solutions are designed to provide real-time communications and remote
control software to enable instantaneous, browser-to-browser Web conferencing
and help desk support solutions. In October 2004, Inter-Tel also entered into
a source license arrangement for select audio conferencing and web presentation
technology from eDial, a subsidiary of Alcatel Marketing USA. Each of the acquisitions discussed above were not material business
acquisitions either individually or collectively and each will be accounted for
using the purchase method of accounting. The results of operations of each of
these acquisitions will be included in our accompanying consolidated statements
of operations from the date of the acquisitions, beginning in our fourth fiscal
quarter of 2004. 13




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##### Table of Contents



ITEM 2.
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS This Quarterly Report to Shareholders onForm 10-Q(10-Q) contains
forward-looking statements that involve risks and uncertainties. The
statements contained in this 10-Q that are not purely historical are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of
1934, as amended, including without limitation statements regarding our
expectations, beliefs, intentions or strategies for the future. All
forward-looking statements included in this document are based on information
available to us on the date hereof, and we assume no obligation to update any
such forward-looking statements. The cautionary statements made in this 10-Q
should be read as being applicable to all related forward-looking statements
wherever they appear in this document. Our actual results could differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including those set forth under Factors That May
Affect Future Operating Results below and elsewhere in this document. Overview Inter-Tel (Nasdaq: INTL), incorporated in 1969, is a single point of
contact, full service provider of converged voice and data business
communications systems, voice mail systems and networking applications. Our
customers include business enterprises, federal, state and local government
agencies and non-profit organizations. We market and sell the following
products and services:  
    
    Inter-Tel Axxess® and Inter-Tel EncoreCX® 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, including the design and implementation of
voice and data networks,  
    
    local and long distance calling services, voice circuits, data
circuits and other communications services and peripheral products,  
    
    call accounting software, computer-telephone integration (CTI) applications, and  
    
    maintenance and support services for our products. We have developed a distribution network of direct sales offices, dealers
and value added resellers (VARs), which sell our products to organizations
throughout the United States and internationally, primarily targeting
small-to-medium enterprises, service organizations and governmental agencies.
As of September 30, 2004, we had 57 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, voice and data circuits, and
network services (Network Services) divisions. Network Services includes
resale of local and long distance calling services, through NetSolutions®, as
well as commissions earned by Network Services Agency, our wholly-owned
subsidiary serving as an agent selling local and network services such as T-1
access, frame relay and other voice and data circuit services on behalf of
Regional Bell Operating Companies (RBOCs) and local exchange carriers. 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. Our primary research and development facility
is located in Chandler, Arizona. 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: 14




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##### Table of Contents




    
    End-user sales through our direct sales offices and government and
national accounts division. We recognize revenue from sales of systems,
software 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. Our direct sales force is
also responsible for sales of other services to end users, including
managed services; resale of local and long distance services; resale of
voice and data circuits; lease financing using sales-type lease
accounting; and maintenance agreements; as identified in greater detail
below.  
    
    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. Our consolidated net sales for the quarters ended September 30, 2004 and
2003 were $105.5 million and $94.5 million, respectively. The 11.6% increase in
revenue in the third quarter of 2004 compared to the third quarter of 2003 was
primarily attributable to improved general economic conditions, as our
customers were 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. We cannot provide
assurance, however, that the recent increase in revenue will continue in the
future as we believe businesses may be reluctant to significantly increase
spending on enterprise communications systems in the near future. In addition,
we believe uncertainty exists in the marketplace caused by the transition of
communication systems from circuit-switch to packet-switch architectures, and
some buyers may delay making investments in new systems. We believe that enterprises continue to be concerned about their ability
to increase revenues and profitability, in part due to the continued uncertain
economic environment and slowdown in the past few years. To maintain or improve
profitability, we believe that businesses have attempted to reduce costs and
capital spending. We expect continued pressure on our ability to generate or
expand sales and it is not clear whether business communications spending will
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 in which we compete have been characterized by rapid
technological changes and increasing customer requirements. We have sought to
address these requirements through the development of software enhancements and
improvements to existing systems and the introduction of new systems, products,
and applications. Inter-Tels research and development efforts over the last
several years have been focused primarily on the development of, and
enhancements to, 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 have been focused on the
development of converged systems and software, Session Initiation Protocol
(SIP) interfaces and applications, as well as the development of a new line of
multi-
protocol SIP IP endpoints. In addition, in October 2004, we also acquired
selected assets and assumed 15




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certain liabilities of Linktivity, which develops
Web-based conferencing solutions, notably Linktivity® software, and announced
an agreement to license certain intellectual property from eDial. These
solutions are designed to provide real-time communications and remote control
software to enable instantaneous, browser-to-browser Web conferencing and help
desk support solutions. We intend to further develop this technology and
integrate the applications and solutions into our product offerings. Refer to
Note F of Notes to Condensed Consolidated Financial Statements for additional
information. 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 9.4%, or $4.3 million, to $49.6 million for the quarter
ended September 30, 2004, compared to $45.3 million for the corresponding
period in 2003. Our consolidated gross margin percentage was 53.0% in the
third quarter of 2004 compared to 52.1% in the third quarter of 2003. The
increase in the dollar amount of the cost of goods sold was primarily
attributable to the higher volume of net sales. However, the gross margin
improvement was principally attributable to product design improvements, higher
relative software content in our products and cost containment efforts. Other
factors affecting both the increases in costs of goods sold and the gross
margin percentage are described in greater detail in Results of Operations
below. Sales of systems through our direct sales organization typically generate
higher gross margins than sales through our dealers and VARs, primarily because
we recognize both the wholesale and retail margins on these sales. Conversely,
sales of systems through our dealers and VARs typically generate lower gross
margins than sales through our direct sales organization, although direct sales
typically require higher levels of selling, general and administrative
expenses. In addition, our long distance services and DataNet products
typically generate lower gross margins than sales of software and system
products. Historically, sales of scrap have not been material and have not
affected our profit margins. For revenues recognized under sales-leases, we
record the costs of systems installed as costs of sales. Our margins may vary
from period to period depending upon 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. Net sales from the third quarter of 2004 did
not follow this historical pattern, since sales improved compared to the second
quarter of 2004; however, we do not anticipate a significant change in the
historical trend. Cash Flows. At September 30, 2004, Inter-Tels cash and short-term
investments totaled $214.5 million. We also maintain a $10 million unsecured,
revolving line of credit with BankOne, NA, which is available through June 1,
2006 and ordinarily used to support international letters of credit to
suppliers, if necessary. As of September 30, 2004, none of the credit line was
used. Historically, our primary source of cash has come from net income plus
non-cash charges for depreciation and amortization expenses. We have generated
cash from continuing operations in every year since 1986. In 1993, 1995 and
1997, the Company received net proceeds from stock offerings, offset in part by
cash expended to repurchase the Companys common stock in these and other
periods. In addition, Inter-Tel historically has paid cash for capital
expenditures 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. 16




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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 E of
Notes to Condensed Consolidated Financial Statements for additional information
regarding our program. Results of Operations The following table sets forth certain statement of operations data
expressed as a percentage of net sales for the periods indicated: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003NET SALES
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    47.0
    
    
    
    47.9
    
    
    
    47.0
    
    
    
    47.6GROSS PROFIT
    
    
    53.0
    
    
    
    52.1
    
    
    
    53.0
    
    
    
    52.4Research and development
    
    
    7.2
    
    
    
    6.0
    
    
    
    6.8
    
    
    
    6.0Selling, general and administrative
    
    
    32.8
    
    
    
    33.6
    
    
    
    33.9
    
    
    
    35.1Amortization of purchased intangibles
    
    
    0.4
    
    
    
    0.5
    
    
    
    0.4
    
    
    
    0.5OPERATING INCOME
    
    
    12.6
    
    
    
    12.0
    
    
    
    11.8
    
    
    
    10.9Interest and other income
    
    
    0.7
    
    
    
    0.4
    
    
    
    0.6
    
    
    
    0.4Foreign currency transaction gains
(losses)
    
    
    (0.0
    )
    
    
    0.0
    
    
    
    (0.1
    )
    
    
    (0.0
    )Interest expense
    
    
    (0.0
    )
    
    
    (0.0
    )
    
    
    (0.0
    )
    
    
    (0.1
    )Income before income taxes
    
    
    13.3
    
    
    
    12.3
    
    
    
    12.3
    
    
    
    11.3Income tax provision
    
    
    4.6
    
    
    
    4.7
    
    
    
    4.4
    
    
    
    4.3Net income
    
    
    8.7
    %
    
    
    7.6
    %
    
    
    7.9
    %
    
    
    7.0
    %
 Net Sales.Net sales increased 11.6%, or $11.0 million, to $105.5 million
in the third quarter of 2004 from $94.5 million in the third quarter of 2003.
Net sales increased 11.9%, or $32.6 million, to $306.4 million in the first
nine months of 2004 from $273.8 million in the first nine months of 2003.
Sales from our direct sales offices (including revenues from lease financing),
increased 11.7%, or $6.0 million, in the third quarter of 2004 and 11.1%, or
$16.5 million, in the first nine months of 2004 compared to the corresponding
periods in 2003. Sales from our dealer network increased by 9.4%, or $2.0
million, in the third quarter of 2004, and 11.4%, or $7.0 million, in the first
nine months of 2004 compared to the corresponding periods in 2003. Sales from
our Network Services divisions increased by 13.4%, or $1.5 million, in the
third quarter of 2004 and 14.5%, or $4.6 million, in the first nine months of
2004 compared to the corresponding periods in 2003. Sales from our DataNet
division increased 40.2%, or $1.2 million, in the third quarter of 2004 and
46.6%, or $3.3 million, for the first nine months of 2004, compared to the
corresponding periods in 2003. International revenues increased by 17.6%, or
$0.5 million, in the third quarter of 2004 and 18.9%, or $1.5 million, for the
first nine months of 2004 compared to the corresponding periods in 2003. These
changes in the third quarter and first nine months of 2004 were offset in small
part by decreases of 1.8%, or $0.1 million, in the third quarter and 2.5% or
$0.4 million for the first nine months of 2004 from our government and national
accounts division compared to the corresponding periods in 2003. The increase in net sales for the third quarter and first nine months of
2004 compared to the corresponding periods in 2003 from our direct sales
offices, dealer channel, international operations and NetSolutions® division
were primarily attributable to improved economic conditions affecting our
industry, as well as improved revenues in the core business and Network
Services operations, despite continued competitive pressures and some delayed
buying decisions. 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 on a
percentage basis relative to recurring revenues from existing customers during
the third quarter and first
nine months of 2004; however, recurring revenue to existing customers
increased in dollar volume compared to the corresponding periods in 2003. 17




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Sales from our Network Services (NetSolutions® and Network Services Agency
divisions) and DataNet divisions increased significantly on a percentage basis
in the third quarter and first nine months of 2004 as compared to the
corresponding periods in 2003. Net sales increased in NetSolutions®, our long
distance resale division, 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. Sales
increased in DataNet primarily due to additional sales to a few customers.
Offsetting the net increase in sales from Network Services was a decrease of
$0.2 million and $1.7 million, respectively, in Network Services Agency
revenues in the quarter and nine months ended September 30, 2004 compared to
the corresponding periods in 2003, related 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 D of Notes to Condensed Consolidated Financial Statements
for additional segment reporting information. Gross Profit. Gross profit for the third quarter of 2004 increased 13.6%
to $55.9 million, or 53.0% of net sales, from $49.2 million, or 52.1% of net
sales, in the third quarter of 2003. Gross profit increased 13.1% to $162.3
million, or 53.0% of net sales, in the first nine months of 2004 compared to
$143.6 million, or 52.4% of net sales, in the first nine months of 2003. The
increase in gross profit dollars in the third quarter of 2004 resulted
primarily from a higher volume of consolidated net sales, and gross profit also
improved as a percentage of net sales relative to the corresponding period in
2003. For the nine month period ended September 30, 2004, consolidated gross
profit improved 13.1% compared to the corresponding period in 2003, and gross
profit also improved as a percentage of net sales relative to the corresponding
period in 2003. Factors affecting the increased consolidated gross profit
percentage in both corresponding periods include higher relative software
content in our products, product design improvements and cost containment
efforts. Factors which offset in part the increase in gross profit as a
percentage of net sales included lower relative recurring revenues from
existing customers; increased sales volume in the resale of local and long
distance services; greater competitive pricing pressures throughout our
operations; and pricing discounts or special promotions on telephone system
sales. During the third quarter and first nine months of 2004, recurring revenue
dollars from existing customers in our direct sales and national and government
accounts channels increased from these same channels relative to the third
quarter and first nine months of 2003, but recurring revenues as a percentage
of net sales declined slightly. Existing customers accounted for a significant
portion of our net sales from maintenance and other services, software
additions and/or upgrades, and other peripheral products such as video
conferencing, call logging solutions, wireless endpoints, power protection,
wired and wireless headsets, audio conferencing units and networking products
during the third quarter of 2004. Our business communications platforms allow
for system migration without the complete replacement of hardware, enabling us
to offer enhancements and new solutions through software-only upgrades to our
existing customers. Consequently, our gross margins are generally higher with
recurring revenues because we incur less materials costs relative to new
installations. The slight decline in recurring revenues was more than offset
by other factors noted above, including higher relative software content in our
products, product design improvements and cost containment efforts. Sales from NetSolutions® increased by 22.8%, or $6.4 million, in the first
nine months of 2004 as compared to the first nine months of 2003, and 16.7% or
$1.7 million in the third quarter of 2004 compared to the corresponding period
in 2003. Although gross margins are generally lower in this division than our
consolidated margins, the margins improved slightly in the third quarter and
first nine months of 2004 relative to the corresponding periods in 2003, based
in part on our ability to negotiate more favorable pricing with vendors on
higher resale volumes. Sales from Network Services Agency, however, decreased
17.4%, or $0.2 million, for the third quarter and 41.1%, or $1.7 million, in
the first nine months of 2004 compared to the corresponding periods in 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 85.1% during the first
nine months of 2004 and 90.9% during the first nine months 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 18




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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 third
quarter of 2004 increased 33.6% to $7.6 million, or 7.2% of net sales, from
$5.7 million, or 6.0% of net sales, for the third quarter of 2003. Research
and development expenses increased 27.1% to $20.8 million, or 6.8% of net
sales, in the first nine months of 2004 compared to $16.4 million, or 6.0% of
net sales, in the first nine months of 2003. Included in research and
development expenses in both the third quarter of 2004 and the third quarter of
2003 was amortization of patents totaling $55,000 in each period. The
increases in research and development expenses for both the third quarter and
the nine months ended September 30, 2004 were primarily attributable to the
increased engineering headcount and third-party outsourcing of selected
development costs in connection with our efforts to accelerate development of
new products and software. To a lesser extent, the increases were also
attributable to increased research and development spending related to our
development of convergence applications and new SIP and IP endpoint technology.
In the third quarter and nine months ended September 30, 2004, research and
development expenses were directed principally toward the continued development
of converged systems and software, unified messaging and voice processing
software, speech recognition and text-to-speech applications, call center
applications, unified communications applications, IP endpoint development, and
certain CTI and IVR applications and SIP applications. We expect that research
and development expenses will increase in absolute dollars and as a percentage
of net sales relative to the prior year as we continue to develop and enhance
existing and new technologies and products. Selling, general and administrative. In the third quarter of 2004,
selling, general and administrative expenses, excluding amortization, increased
8.9% to $34.6 million, or 32.8% of net sales, from $31.8 million, or 33.6% of
net sales, in the third quarter of 2003. For the nine months ended September
30, 2004 selling general and administrative expenses increased 8.2% to $103.9
million, or 33.9% of net sales, from $96.0 million, or 35.1% of net sales,
compared to the corresponding period in 2003. The increases in absolute
dollars were primarily due to increased expenses associated with the increases
in consolidated net sales in 2004 compared to 2003 and to the opening of new
sales offices in Philadelphia, Tennessee and South Carolina. In addition,
higher net sales in our long distance resale division led to increased selling
expenses and commission costs in the third quarter and first nine months of
2004 relative to such costs for the corresponding periods in 2003. In the
third quarter and nine months ended September 30, 2004, selling, general and
administrative expenses decreased as a percentage of net sales, primarily due
to the greater leverage of fixed expenses on the higher volume of sales,
relative to the corresponding periods in 2003. We expect that for the
foreseeable future selling, general and administrative expenses may vary in
absolute dollars and as a percentage of net sales. Amortization of purchased intangible assets. We adopted Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets
(SFAS 142) effective in the beginning of fiscal 2002. In accordance with SFAS
142, we ceased amortizing goodwill. We are required to perform goodwill
impairment tests on an annual basis and between annual tests in certain
circumstances. As of September 30, 2004, no impairment of goodwill has been
recognized in 2004. We face the risk that future goodwill impairment tests may
result in charges to earnings. Amortization of purchased intangible assets included in operating expenses
was $414,000 in the third quarter of 2004, compared to $445,000 in the third
quarter of 2003. In addition, $55,000 of amortization was included in research
and development expenses for the third quarter of 2004 and the third quarter of
2003. Amortization of purchased intangible assets included in operating
expenses was $1.3 million for the nine months ended September 30, 2004,
compared to $1.4 million for the nine months ended September 30, 2003. An
additional $166,000 of amortization was included in research and development
expenses for each of the nine months ended September 30, 2004 and September 30,
2003. The slight decreases in the amortization of purchased intangible assets
for the third quarter and nine months ended September 30, 2004, compared to the
corresponding periods in 2003 were primarily related to full amortization of
certain previously purchased intangibles, offset by additional amortization
from recent acquisitions. For additional information regarding purchased
intangible assets, see Note C
Acquisitions, Dispositions and Restructuring Charges  to the Condensed
Consolidated Financial Statements. Interest and Other Income. Interest and other income in 2004 and 2003
consisted primarily of interest income and foreign currency transaction gains
or losses. The net increase in interest and other 19




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income of $381,000 in the
third quarter of 2004 compared to the corresponding period in 2003, was due
primarily to higher levels of invested funds, as well as slightly higher
interest rates. The changes in both foreign transaction gains and losses and
interest expense in the quarter ended September 30, 2004 were nominal compared
to the quarter ended September 30, 2003. Income from interest and short-term
investments in the first nine months of 2004 increased $582,000 compared to the
first nine months of 2003 due primarily to higher levels of invested funds and
higher interest rates. Net foreign currency transaction losses in the first
nine months of 2004 were $281,000 compared to losses of $9,000 in the first
nine months of 2003. Interest expense in the first nine months of 2004 was
$108,000, a slight reduction compared to $137,000 in the first nine months of
2003. Income Taxes. Inter-Tels income tax rate for the third quarter of 2004
was 34.3% compared to 38.0% for the third quarter of 2003, and 36.0% in the
first nine months of 2004 compared to 38.0% for the corresponding period in
2003. The decrease in the rate is primarily attributable to increases in
tax-exempt income earned from short-term investments and higher utilization of
research and development credits based on higher costs. Inter-Tel currently
expects the full-year 2004 tax rate to be comparable to the tax rate effective
for the first nine months of 2004, subject to prospective changes in the tax
laws or other factors. Net Income. Net income for the third quarter of 2004 was $9.2 million
($0.34 per diluted share), an increase of 27.5% compared to net income of $7.2
million ($0.27 per diluted share) in the third quarter of 2003. Net income for
the nine months ended September 30, 2004 was $24.1 million ($0.89 per diluted
share), an increase of 26.0% compared to net income of $19.2 million ($0.73 per
diluted share) for the nine months ended September 30, 2003. The increases in net income for the third quarter and nine months ended
September 30, 2004 compared to corresponding periods in 2003 are primarily
attributable to higher gross profit and increased operating efficiencies,
offset in part by higher research and development expenses. Additional
information regarding other items is described in further detail above. Inflation/Currency Fluctuation Inflation and currency fluctuations have not previously had a material
impact on Inter-Tels operations. International procurement agreements have
traditionally been denominated in U.S. currency. The potential 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. Liquidity and Capital Resources Nine Months EndedSeptember 30,(In thousands)
    
    2004
    
    2003Net cash provided by operating activities
    
    $
    47,888
    
    
    $
    19,579Net cash used in investing activities
    
    
    (11,431
    )
    
    
    (32,303
    )Net cash provided by financing activities
    
    
    980
    
    
    
    1,188Increase (decrease) in cash and equivalents
    
    
    37,437
    
    
    
    (11,536
    )Cash and equivalents at beginning of period
    
    
    115,197
    
    
    
    84,923Cash and equivalents at end of period
    
    $
    152,634
    
    
    $
    73,387
 At September 30, 2004, cash and equivalents totaled $152.6 million, an
increase of approximately $37.4 million from the balance of $115.2 million at
December 31, 2003. At September 30, 2004, cash and
equivalents and short-term investments totaled $214.5 million, an increase
of approximately $40.0 million from the balance of $174.5 million at December
31, 2003. We maintain a $10 million unsecured, revolving line of credit with
Bank One, NA that is available through June 1, 2006. Under the credit
facility, we have the option to borrow at a prime rate or adjusted LIBOR
interest rate. Historically, we have used the credit facility primarily to
support international letters of credit to suppliers. However, as of September
30, 2004, none of the credit line was used. The remaining cash balances may be
used for acquisitions, strategic alliances, working capital, dividends and
general corporate purposes. 20




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Net cash provided by operating activities totaled $47.9 million for the
nine months ended September 30, 2004, compared to $19.6 million for the
corresponding period in 2003. Cash provided by operating activities in the
first nine months of 2004 was primarily the result of cash generated from
profitable operations, including non-cash depreciation, provisions for losses
and amortization charges. In addition, an increase in deferred income taxes of
$11.5 million in the first nine months of 2004 contributed to the increase.
Cash provided by operating activities in the first nine months of 2003 was
primarily the result of cash generated from profitable operations as in 2004;
however, the 2003 period included an increase in deferred income taxes of $14.9
million. Additionally, cash provided by the changes in operating assets and
liabilities in the first nine months of 2004 was $0.6 million, compared to cash
used in the changes in operating assets and liabilities of $25.5 million for
the corresponding period in 2003. The cash provided by the change in operating
assets and liabilities in the first nine months of 2004 was primarily due to a
decrease in income tax receivables, offset in part by an increase in
inventories and slight increases in lease receivables. The $25.5 million use
of cash in the change in operating assets and liabilities in the first nine
months of 2003 was primarily a result of an increase in the accounts
receivable, investment in sales-leases and income tax receivables. If we are
able to expand sales through our direct sales offices, dealer network and
government and national accounts divisions, this would likely require
additional working capital for increased accounts receivable and inventories. Net cash used in investing activities totaled $11.4 million for the nine
months ended September 30, 2004 compared to $32.3 million for the nine months
ended September 30, 2003. Net cash generated by maturities and sales of
short-term investments during the first nine months of 2004 was $72.6 million,
offset by net cash used in the purchase of short-term investments of $75.1
million during the nine months ended September 30, 2004. Net cash used in the
purchase of short-term investments during the nine months ended September 30,
2003 was $141.9 million, offset in part by maturities and sales of short-term
investments of $113.7 million in the first nine months of 2003. Net cash of
$7.4 million was used to acquire additional property, plant and equipment
during the first nine months of 2004 compared to $5.2 million for the
corresponding period in 2003, and net cash of $1.5 million was used in
acquisitions in the first nine months of 2004 compared to $450,000 for the
corresponding period in 2003. In the first quarter of 2003, Inter-Tel also
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 guarantee of vendor obligations. Net cash provided by financing activities totaled approximately $980,000
for the nine months ended September 30, 2004, compared to cash provided by
financing activities of $1.2 million for the corresponding period in 2003. Net
cash provided by proceeds from the exercise of stock options and from stock
issued under the Companys employee stock purchase plan totaling $5.6 million
in the first nine months of 2004 was offset in part by cash used for dividends,
which totaled approximately $4.6 million during the same period. Net cash
provided by the exercise of stock options and from stock issued under the
Companys employee stock purchase plan totaled $3.7 million during the first
nine months of 2003, which was offset in part by cash used for dividends
totaling approximately $2.2 million in the same period. During the first nine
months of 2004 and 2003, we reissued treasury shares through stock option
exercises and issuances. In the nine month period ending September 30, 2004,
the proceeds received from these reissued treasury shares were higher than the
cost basis of the treasury stock reissued, resulting in an increase to retained
earnings of approximately $140,000. In the nine month period ending September
30, 2003, the proceeds received from these reissued treasury shares were higher
than the cost basis of the treasury stock reissued, resulting in an increase in
retained earnings of $151,000. We offer to our customers lease financing and other services, including
our Total Solution (formerly Totalease) program, through our Inter-Tel Leasing,
Inc. subsidiary. We fund our Total Solution program in part through the sale
to financial institutions of rental payment streams under the leases. Sold
lease
rentals totaling $233.8 million and $210.1 million remained unbilled at
September 30, 2004 and December 31, 2003, respectively. We are obligated to
repurchase such income streams in the event of defaults by lease customers and,
accordingly, maintain reserves based on loss experience and past due accounts.
Although, to date, we have been able to resell the rental streams from leases
under the Total Solution program profitably and on a substantially current
basis, the timing and profitability of lease resales could impact our business
and operating results, particularly in an environment of fluctuating interest
rates and 21




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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 description of the evidence on which
the investigations are based. Inter-Tel has been engaged in discussions with
various divisions of the Justice Department regarding the resolution or
settlement of these investigations, which include a civil lawsuit, currently
stayed, initiated by the San Francisco Unified School District and in which the
Justice Department intervened. 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. There can be no assurance,
however, that a resolution or settlement will be reached. 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 that 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 that 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 that additional financing will be available when required
or on acceptable terms. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions
that involve unconsolidated entities or financial partnerships, such as
entities often referred to as structured finance or special purpose entities,
which have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. However, we
offer to our customers lease financing and other services through our Inter-Tel
Leasing, Inc. subsidiary. We fund our Total Solution program in part through
the sale to financial institutions of rental payment streams under the leases.
Such financial institutions have the option to require us to repurchase such
income streams, subject to limitations, in the event of defaults by lease
customers and, accordingly, we maintain reserves based on loss experience and
past due accounts. For more information regarding our lease portfolio and
financing, please see Liquidity and Capital Resources and Note E of Notes to
Condensed Consolidated Financial Statements. Critical Accounting Policies and Estimates The methods, estimates and judgments we use in applying our most critical
accounting policies have a significant impact on the results we report in our
condensed consolidated financial statements. We evaluate our estimates and
judgments on an on-going basis. We base our estimates on historical experience
and on assumptions that we believe to be reasonable under the circumstances.
Our experience and assumptions form the basis for our judgments about the
carrying value of assets and liabilities that are not readily apparent from
other sources. Actual results may vary from what we anticipate and different
assumptions or estimates about the future could change our reported results.
We believe the following accounting policies are the most critical to us, in
that they are important to the
portrayal of our financial statements and they require our most difficult,
subjective or complex judgments in the preparation of our condensed
consolidated financial statements: Revenue Recognition. In December 2003, the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue
Recognition. The Company applies the provisions of SAB 104 to all revenue
transactions. SAB 104 supercedes SAB 101, Revenue Recognition in Financial
Statements. The primary purpose of SAB 104 is to rescind accounting guidance
contained in SAB 101 22




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related to multiple element revenue arrangements,
superceded as a result of the issuance of EITF 00-21. Additionally, SAB 104
rescinded the SECs Revenue Recognition in Financial Statements Frequently
Asked Questions and Answers (the FAQ) issued with SAB 101 that had been
codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ
have been incorporated into SAB 104. While the wording of SAB 104 has changed
to reflect the issuance of EITF 00-21, the revenue recognition principles of
SAB 101 remain largely unchanged by the issuance of SAB 104. The issuance of
SAB 104 did not have a material impact on the Companys financial position,
results of operations or cash flows. End-user sales through our direct sales offices and government and
national accounts division. Revenue is recognized when all four of the
following criteria are met: (i) persuasive evidence that arrangement exists;
(ii) delivery of the products and/or services has occurred; (iii) the selling
price is both fixed and determinable and; (iv) collectibility is reasonably
probable. Revenue derived from sales of systems and services to end-user
customers is recognized upon primary installation of the systems and
performance of the services, respectively, allowing for use by our customers of
these systems. Pre-payments for communications services are deferred and
recognized as revenue as the communications services are provided. We do not
generally allow sales returns either by the terms of our contracts or in
practice, except for returns related to warranty provisions. Dealer and VAR sales. For shipments to dealers and other distributors,
our revenues are recorded as products are shipped and services are rendered,
when the sales process is complete. These shipments are primarily to
third-party dealers and distributors, and title passes when goods are shipped
(free-on-board shipping point). 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. 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 5.6% at September 30, 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. 23




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Goodwill and Other Intangible Assets.On January 1, 2002, Inter-Tel
adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and
Other Intangible Assets.Purchase prices of acquired businesses that are
accounted for as purchases have been allocated to the assets and liabilities
acquired based on the estimated fair values on the respective acquisition
dates. Based on these values, the excess purchase prices over the fair value of
the net assets acquired were allocated to goodwill. Prior to January 1, 2002, Inter-Tel amortized goodwill over the useful
life of the underlying asset, not to exceed 40 years. On January 1, 2002,
Inter-Tel began accounting for goodwill under the provisions of SFAS Nos. 141
and 142 and discontinued the amortization of goodwill after January 1, 2002.
As of September 30, 2004, Inter-Tel had gross goodwill of $24.3 million and
accumulated amortization of $5.0 million. Inter-Tel completed two acquisitions
through September 30, 2004 and one in 2003 and has not recorded any
amortization for these acquisitions on amounts allocated to goodwill in
accordance with SFAS No. 141. The Company performs an annual impairment test on Goodwill using the
two-step process prescribed in SFAS No. 142. The first step is a screen for
potential impairment, while the second step measures the amount of the
impairment, if any. In addition, the Company will perform impairment tests
during any reporting period in which events or changes in circumstances
indicate that an impairment may have incurred. Inter-Tel performed the first
step of the required impairment tests for goodwill as of December 31, 2003 and
determined that goodwill is not impaired and it is not necessary to record any
impairment losses related to goodwill. At September 30, 2004 and December 31,
2003, $17.1 million of the Companys goodwill, net of amortization, relates to
the Companys principal segment and $2.1 million relates to the Network
Services segment. There is only one reporting unit (i.e., one component) as
defined in paragraph 30 of SFAS 142 within each of the Companys two operating
segments as defined in paragraph 10 of SFAS 131. Therefore the reporting units
are identical to the segments. Fair value has been determined for each segment
in order to determine the recoverability of the recorded goodwill. At December
31, 2003, the Company primarily considered an allocated portion of the market
capitalization for the entire Company using average common stock prices in
determining that no impairment has occurred. This allocated market
capitalization value far exceeded the net carrying value of the goodwill
included in the financial statements. Therefore, the second step for potential
impairment was unnecessary. The Company evaluates the remaining useful lives of its purchased
intangible assets, all of which are subject to amortization, each reporting
period. Any changes to estimated remaining lives prospectively effect the
remaining period of amortization. In addition, the purchased intangible assets
are reviewed for possible impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. A loss would be recognized for any excess of the carrying amount
over the estimated fair value. As of September 30, 2004, Inter-Tel had gross
purchased intangible assets of $14.9 million and accumulated amortization of
$7.4 million. At September 30, 2004 and December 31, 2003, goodwill, net of accumulated
amortization, totaled $19.3 million and $18.0 million, respectively. Other
acquisition-related intangibles, net of accumulated amortization, totaled $7.5
million at September 30, 2004 and $8.2 at December 31, 2003. Accumulated
amortization through September 30, 2004 was $12.4 million, including $5.0
million of accumulated amortization attributable to goodwill and $7.4 million
of accumulated amortization of other acquisition-related intangibles.
Accumulated amortization through December 31, 2003 was $11.0 million, including
$5.0 million of accumulated amortization attributable to goodwill 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 24




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accounts and specific account
analysis. Management reviews the level of the allowances for doubtful accounts
on a regular basis and adjusts the level of the allowances as needed. In
evaluating our allowance we consider accounts in excess of 60 days old as well
as other risks in the more current portions of the accounts included. At
September 30, 2004, our allowance for doubtful accounts for accounts receivable
were $11.1 million of our $54.5 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 September 30, 2004, our inventory
reserves were $6.9 million of our $24.1 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. 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 and other competitive factors;  
    
    pricing pressures;  
    
    the cost and effect of acquisitions; 25




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
    
    the availability and cost of products and components from our suppliers, including shipping and manufacturing problems
associated with subcontracted vendors;  
    
    national and regional weather patterns; and  
    
    threats of or outbreaks of war, hostilities, terrorist acts or other civil disturbances. In addition, 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.
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 continue to increase as a percentage of net
sales or if gross margins from this division decline. We also experience
seasonal fluctuations in our operating results, as net sales for the first
quarter is frequently less than the fourth quarter, and net sales for the third
quarter is frequently less than the second quarter. As a result of these and
other factors, we have historically experienced, and could continue to
experience in the future, fluctuations in net sales and operating results on a
quarterly basis. Our market is subject to rapid technological change and to compete
successfully, we must continually introduce new and enhanced products and
services that achieve broad market acceptance. The market for our products and services is characterized by rapid
technological change, evolving industry standards and vigorous customer demand
for new products, applications and services. To compete successfully, we must
continually enhance our existing telecommunications products, related 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 to 24 months, we have introduced Unified Communicator®
software, a web-based, speech-recognition, wireless PDA, and Wireless
Application Protocol (WAP) software application for 26




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controlling and managing
calls, contacts and presence status; Enterprise® Conferencing and Enterprise®
Instant Messaging software, 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 to 18 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, converged systems and software, SIP standards-based
applications and devices, new speech recognition and Interactive Voice Response
products, and future upgrades and enhancements to these products and networking
platforms. We cannot assure you that these products or platforms will achieve
commercial acceptance in the future. Our products are complex and may contain errors or defects that are detected
only after their release, which may cause us to incur significant unexpected
expenses and lost sales. Our telecommunications products and software are highly complex. Although
our new products and upgrades are examined and tested prior to release, they
can only be fully tested when used by a large customer base. Consequently, our
customers have in the past and may in the future discover program errors, or
bugs, or other defects after new products and upgrades have been released.
Some of these bugs may result from defects contained in component parts or
software from our suppliers or other third parties that are intended to be
compatible with our products and over which we have little or no control.
Although we have test procedures and quality control standards in place
designed to minimize the number of errors and defects in our products, we
cannot assure you that our new products and upgrades will be free of bugs when
released. If we are unable to quickly or successfully correct bugs identified
after release, we could experience the following, any of which would harm our
business:  
    
    costs associated with the remediation of any problems;  
    
    costs associated with design modifications;  
    
    loss of or delay in revenues;  
    
    loss of customers;  
    
    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; 27




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
    
    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 C 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 and one in July 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 Tennessee and in July 2004, we acquired
selected assets and assumed certain liabilities of a former Inter-Tel dealer in
South Carolina. These acquisitions are subject to risks and uncertainties
including, but not limited to, those indicated above. In October 2004, after
the close of the fiscal third quarter of 2004, we acquired selected assets and
assumed certain liabilities of former Inter-Tel dealers in Pittsburgh,
Pennsylvania and Las Vegas, Nevada. In October 2004, we also acquired selected
assets and assumed certain liabilities of Linktivity, which develops Web-based
conferencing solutions, notably Linktivity® software. These solutions are
designed to provide real-time communications and remote control software to
enable instantaneous, browser-to-browser Web conferencing and help desk support
solutions. In October 2004, Inter-Tel also entered into a source license
arrangement for select audio conferencing and web presentation technology from
eDial, a subsidiary of Alcatel Marketing USA. 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
twenty-five (25) U.S. patents for telecommunication and messaging products,
systems and processes and have applied to the U.S. Patent and Trademark Office
for eleven (11) additional patents. We also rely on copyright and trade secret
law and contractual provisions to protect our intellectual property. Despite
these precautions, third parties could copy or otherwise obtain and use our
technology without authorization, or develop similar technology independently. Any patent, trademark or copyright that we own or have applied to own is
subject to being invalidated, circumvented or challenged by a third party.
Effective protection of intellectual property rights may be unavailable or
limited in foreign countries. 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 or could become subject to third party claims that
our current or future products or services infringe upon the rights of others.
For example, we are subject to claims initiated by Avaya, one of our primary
competitors, alleging that certain of our key products infringe upon their
intellectual property rights, including patents, trademarks, copyrights or
other intellectual property rights. We have viewed presentations from Avaya
alleging that our Axxess business communications system and 28




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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, Lucky Goldstar, Mitel, NEC, Nortel, Panasonic, Samsung, ShoreTel, 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 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 29




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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. 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 description of the evidence on which
the investigations are based. Inter-Tel has been engaged in discussions with
various divisions of the Justice Department regarding the resolution or
settlement of these investigations, which include a civil lawsuit, currently
stayed, initiated by the San Francisco Unified School District and in which the
Justice Department intervened. 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. There can be no assurance, however,
that a resolution or settlement will be reached. 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 30




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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. 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 C 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. 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 31




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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 or unsupported by our vendors for financial and other reasons and
eventually become obsolete. Oracle, the primary supplier of our third-party
applications, provides notice of the dates that Oracle will de-support the
software and companies are expected to either make plans to upgrade to newer
versions or operate without Oracle support. While Oracle and other third-party
vendors may provide advanced notice of product upgrade schedules and take other
steps to make the upgrade process as straightforward as possible, we are
subject to risks associated with the process, and in some cases we may choose
to continue to utilize and maintain the unsupported third-party software using
our own information systems personnel. Our software systems could become
unstable following an upgrade process and impact our ability to process data
properly in these systems, including timely and accurate shipment of products,
invoicing our customers properly and the production of accurate and timely
financial statements. We expect to affect software upgrades in the future and
cannot assure you these software upgrades or enhancements will operate as
intended or be free from bugs or that we will be able to operate effectively
using unsupported third-party software using our existing personnel and
resources. If we are unable to successfully integrate new software into our
information systems, our operations, customer service and financial reporting
could be adversely affected and could harm our business. Our stock price has been and may continue to be volatile, impairing your
ability to sell your shares at or above purchase price. The market price for our common stock has been highly volatile. The
volatility of our stock could be subject to continued wide fluctuations in
response to many risk factors listed in this section, and others beyond our
control, including: 32




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
    
    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, terrorist acts or other civil disturbances;  
    
    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, including shipping and manufacturing problems associated
with subcontracted vendors; 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. Our Chairman of the Board of Directors, CEO and President controls 20.0% of our
Common Stock and is able to significantly influence matters requiring
shareholder approval. As of September 30, 2004, Steven G. Mihaylo, Inter-Tels Chairman of the
Board of Directors, Chief Executive Officer and President, beneficially owned
approximately 20.0% of the existing outstanding shares of the common stock of
Inter-Tel. As a result, he has the ability to exercise significant influence
over all matters requiring shareholder approval. In addition, the
concentration of ownership could have the effect of delaying or preventing a
change in control of Inter-Tel. Risks Related to Our Industry Reductions in spending on enterprise communications equipment may materially
and adversely affect our business. The overall economic slowdown 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 and bolster their revenues. The market
for enterprise communications equipment may only grow at a modest rate or
possibly not grow at all, and our financial performance has been and may
continue to be materially and adversely affected by the reductions in spending
on enterprise communications equipment. The emerging market for IP network telephony is subject to market risks and
uncertainties that could cause significant delays and expenses. The market for IP network voice communications products has begun to
develop only recently, is evolving rapidly and is characterized by an
increasing number of market entrants who have introduced or developed products
and services for Internet or other IP network voice communications. As is
typical of a new and rapidly evolving industry, the demand for and market
acceptance of, recently introduced IP network products and services are highly
uncertain. We cannot assure you that IP voice networks will become widespread.
Even if IP voice networks become more widespread in the future, we cannot
assure that our products, including the IP telephony features of the Axxess
systems our IP endpoints and IP applications will successfully compete against
other market players and attain broad market acceptance. Moreover, the adoption of IP voice networks and importance of development
of products using industry standards such as MGCP and SIP, generally require
the acceptance of a new way of exchanging 33




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information. In particular,
enterprises that have already invested substantial resources in other means of
communicating information may be reluctant or slow to adopt a new approach to
communications. If the market for IP network voice communications fails to
develop or develops more slowly than we anticipate, our IP network telephony
products could fail to achieve market acceptance, which in turn could
significantly harm our business, financial condition and operating results.
This growth may be inhibited by a number of factors, such as quality of
infrastructure; security concerns; equipment, software or other technology
failures; regulatory encroachments; inconsistent quality of service; poor voice
quality over IP networks as compared to circuit-switched networks; and lack of
availability of cost-effective, high-speed network capacity. Moreover, as
IP-based data communications and telephony usage grow, the infrastructure used
to support these IP networks, whether public or private, may not be able to
support the demands placed on them and their performance or reliability may
decline. The technology that allows voice and 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 local and long distance services, including voice and data circuits, to
our customers and to provide us with billing information. Long distance
services are subject to extensive and uncertain governmental regulation on both
the federal and state level. We cannot assure you that the increase in
regulations will not harm our business. Our current contracts for the resale
of services through long distance carriers include multi-year periods during
which we have minimum use requirements and/or
costs. The market for long distance services is experiencing, and is
expected to continue to experience significant price competition, and this may
cause a decrease in end-user rates. We cannot assure you that we will meet
minimum use commitments, that we will be able to negotiate lower rates with
carriers if end-user rates decrease or that we will be able to extend our
contracts with carriers at favorable prices. If we are unable to secure
reliable Network Services from certain long distance carriers, RBOCs, LECs and
CLECs, or if these entities are unwilling or unable to provide
telecommunications services and billing information to us on favorable terms,
our ability to expand our own Network Services will be harmed. Carriers that
provide telecommunications services to us may also experience financial
difficulties, up to and including bankruptcies, which could harm our ability to
offer telecommunications services. Consolidation within the telecommunications industry could increase competition
and 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
results and financial condition. Terrorist activities and resulting military and other actions could harm our
business. Terrorist attacks in New York and Washington, D.C. in September of 2001
disrupted commerce throughout the world. The continued threat of terrorism, the
conflict in Iraq and the potential for additional military action and
heightened security measures in response to these threats may continue to cause
significant disruption to commerce throughout the world. To the extent that
disruptions result in a general decrease in corporate spending on information
technology or advertising, our business and results of operations could be
harmed. We are unable to predict whether the conflict in Iraq and its
aftermath, the threat of terrorism or the responses thereto will result in any
long-term commercial disruptions or if such activities or responses will have a
long-term adverse effect on our business, results of operations or financial
condition. Additionally, if any future terrorist attacks were to affect the
operation of the Internet or key data centers, our business could be harmed.
These and other developments arising out of the potential attacks may make the
occurrence of one or more of the factors discussed herein more likely to occur. 34




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We Are Exposed To Increased Costs And Risks Associated With Complying With
Increasing And New Regulation Of Corporate Governance And Disclosure Standards. We are spending an increased amount of management time and external
resources to comply with changing laws, regulations and standards relating to
corporate governance and public disclosure, including the Sarbanes-Oxley Act of
2002, new SEC regulations and Nasdaq Stock Market rules. In particular, Section
404 of the Sarbanes-Oxley Act of 2002 requires managements annual review and
evaluation of our internal control systems, and attestations of the
effectiveness of these systems by our management and by our independent
auditors. We are currently documenting and testing our internal control
systems and procedures and considering improvements that may be necessary in
order for us to comply with the requirements of Section 404 by the end of 2004.
This process has required us to hire additional personnel and outside advisory
services and has resulted in additional accounting and legal expenses. In
addition, the evaluation and attestation processes required by Section 404 are
new and neither companies nor auditing firms have significant experience in
testing or complying with these requirements. Accordingly, we may encounter
problems or delays in completing the review and evaluation, the implementation
of improvements and the receipt of a positive attestation by our independent
auditors. While we believe that we currently have adequate internal controls
over financial reporting, in the event that our chief executive officer, chief
financial officer or independent auditors determine that our controls over
financial reporting are not effective as defined under Section 404, investor
perceptions of Inter-Tel may be adversely affected and could cause a decline in
the market price or our stock. 
 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. 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 35




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affected. See Liquidity and Capital Resources and
Critical Accounting Policies and Estimates in Managements Discussion and
Analysis for more information regarding our lease portfolio and financing. IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our
international subsidiaries primarily in the local currencies of our
subsidiaries for product and service revenues. Inter-Tel is exposed to foreign
exchange rate fluctuations as the financial results of foreign subsidiaries are
translated into U.S. dollars in consolidation. The impact of foreign currency
rate changes have historically been 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-15(e) and 15d-15(e) 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 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. Sarbanes-Oxley 404 Compliance.We continue the detailed assessment of our
internal controls as called for by the Sarbanes-Oxley Act of 2002. We are
simultaneously working to complete our evaluation of design phase where we have
identified what may be control deficiencies in our system of internal controls,
and have been performing the testing phase of our project. We expect to
validate any potential control deficiencies and to assess whether or not they
rise to the level of significant deficiencies or material weaknesses. We
believe we are prepared to investigate any potential control deficiencies, and,
where appropriate, to remediate them. Although we have made this project a top
priority for the Company, there can be no assurances that all control
deficiencies identified and validated will be remediated before the end of the
Companys fiscal year or that the remaining unresolved control deficiencies
will not rise to the level of significant deficiencies or material weaknesses. INTER-TEL, INCORPORATED AND SUBSIDIARIES 
 PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS We are involved from time to time in litigation incidental to our business. We
believe that the outcome of current litigation will not have a material adverse
effect upon our business, financial condition or results of operations and will
not disrupt our normal operations. 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not
Applicable 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNot Applicable 
 ITEM 5. OTHER INFORMATION Not Applicable 36




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ITEM 6. 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
 
 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, INCORPORATEDNovember 5, 2004
    
    /s/ Steven G. MihayloSteven G. MihayloChairman of the Board, Chief ExecutiveOfficer and PresidentNovember 5, 2004
    
    /s/ Kurt R. KneipKurt R. KneipSenior Vice President andChief Financial Officer
 37