===========================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
Commission file number 0-15938
FARMSTEAD TELEPHONE GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware 06-1205743
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
22 Prestige Park Circle, East Hartford, CT 06108-3728
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (860) 610-6000
Securities registered under Section 12(b) of the Act:
Title of each class Name of each Exchange on which registered
Common Stock, $.001 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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 period 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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [ ] No [X]
The aggregate market value of the voting and non-voting common equity held
by non-affiliates, computed by reference to the closing price on the last
business day of the registrant's most recently completed second fiscal
quarter, was $1,276,624.
As of March 31, 2005, the registrant had 3,322,182 shares of $0.001 par
value Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement to be filed with the
Securities and Exchange Commission in connection with the Annual Meeting of
Stockholders to be held July 14, 2005 are incorporated by reference into
Part III, Items 10 through 14 hereof. Certain exhibits filed with this
registrant's prior registration statements and forms 10-K are incorporated
by reference into Part IV of this Report.
===========================================================================
TABLE OF CONTENTS TO FORM 10-K
PART I
Page
----
ITEM 1. BUSINESS 3
ITEM 2. PROPERTIES 8
ITEM 3. LEGAL PROCEEDINGS 8
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 8
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES 8
ITEM 6. SELECTED FINANCIAL DATA 9
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 9
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 20
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 20
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE 20
ITEM 9A. CONTROLS AND PROCEDURES 20
ITEM 9B. OTHER INFORMATION 20
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 20
ITEM 11. EXECUTIVE COMPENSATION 20
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS 21
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 21
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 21
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES 21
SIGNATURES 22
2
PART I
ITEM 1. BUSINESS
GENERAL
Farmstead Telephone Group, Inc. ("Farmstead", the "Company", "we", or
"our") was incorporated in Delaware in 1986. We are principally engaged as
a provider of new and used Avaya, Inc. ("Avaya") business
telecommunications parts, complete systems, and services. From December
1998 to the program's termination in July 2004, we provided refurbished
"Classic Lucent(TM) " and "Classic Avaya(TM) " telecommunications equipment
pursuant to an "Authorized Remarketing Supplier Program" with Lucent
Technologies and Avaya. Since the termination of this program we have
continued to supply refurbished equipment to our customers. We also offer
Avaya's full-line of new telecommunications parts and complete systems as
an Avaya-certified "Gold Dealer". Our service revenues are under the aegis
of our "2 Star" Avaya Services Agreement. Our product offerings are
primarily customer premises-based private switching systems and peripheral
products, including voice messaging products. We also provide
telecommunications equipment installation, repair and refurbishing, short-
term rental, inventory management, and related value-added services. A
portion of our revenues is also derived from the sale of Avaya maintenance
contracts. We sell our products and services to large and mid-size, multi-
location businesses, as well as to small businesses, government agencies,
and other equipment resellers.
Effective February 1, 2001, we entered into a joint venture agreement
with TriNET Business Trust ("TriNET"), forming a limited liability
corporation operating under the name of InfiNet Systems, LLC ("InfiNet").
Under the agreement, we had a 50.1% ownership interest, and TriNET had a
49.9% ownership interest. Based in East Hartford, Connecticut, InfiNet was
organized for the purpose of selling new Avaya telecommunications systems
primarily to customers within the State of Connecticut and various counties
in the State of New York. Effective January 1, 2002, we acquired TriNET's
49.9% ownership interest in InfiNet. During 2002, however, we changed our
business strategy concerning the use of InfiNet, downsizing its operating
activities by eliminating its entire workforce and fulfilling systems sales
orders directly through Farmstead, which acquired its own systems dealer
license in 2002. As a result, InfiNet has since been inactive.
Our revenue has declined significantly over the past several years.
Revenue for the years ended December 31, 2004, 2003, and 2002 was $12.34
million, $14.9 million, and $19.46 million, respectively. The decline in
revenue and profit margins has been primarily attributable to reduced
business spending by our larger customers on enterprise communications
equipment coupled with intense competition between the Company and other
telecommunications equipment dealers and aftermarket resellers. The decline
in revenue and profit margins has also been the prime contributor to our
net losses for the years ended December 31, 2004, 2003, and 2002 of
$1,424,000, $709,000, and $2,530,000, respectively. Accordingly, we tried
to reduce our losses and return to profitability through cost reductions
and by broadening our product offerings. Cost reductions alone, however,
were not enough to offset the impact of continued revenue declines.
Business Reorganization. During the third and fourth quarters of
2004, we engaged the services of two independent business consultants to
evaluate our current business model and operating performance, and assist
in developing and implementing a strategic redirection. Effective October
1, 2004, we hired the first of these individuals, Mr. Jean-Marc
Stiegemeier, as our new President and Chief Executive Officer. On January
15, 2005, we hired the second consultant, Mr. Alfred Stein, as an Executive
Vice President, responsible for sales operations. On March 1, 2005 we hired
Mr. Nevelle Johnson as an Executive Vice President , responsible for the
implementation of our SMB Program as further described below. Refer to Item
1, "Executive Officers and Significant Employees of the Registrant" for
information on these persons' qualifications.
In the fourth quarter of 2004 we began implementing a strategic
redirection, which is principally based upon building a larger and more
highly qualified sales force, and diversifying the Company's product
offerings and targeted customers. The business strategy is to transition to
a full communications solutions provider, becoming less dependent on parts
sales, and developing more sources of recurring revenues, such as through
installation and maintenance services. We plan to expand our product
offerings beyond traditional voice communications products by offering
Internet Protocol, or IP, telephony products and unified communications
products including voice messaging, and we plan to expand our customer base
and revenues by targeting the small to medium-sized (under 200 employees)
business market ("SMB"). As further described in the "Overview" section of
Item 7, and in the "Relationship with Avaya Inc." section of Item 1, in
March 2005 we entered into a pilot program with Avaya designed to generate
incremental SMB revenues. We believe that this is the fastest growing
segment of the
3
telecommunications systems business. On March 1, 2005 we launched an SMB
program that is targeting this customer base and, in March 2005 we hired an
additional 23 experienced sales professionals that have been deployed in 12
states and 22 cities nationally. We intend to hire additional sales
professionals during 2005 to meet our 2005 SMB revenue expectations.
PRODUCTS
EQUIPMENT
---------
We sell a wide range of Avaya's traditional voice telephony parts and
systems, including Avaya's most advanced enterprise voice communications
system marketed under the DEFINITY(R) and MultiVantage product lines. These
server based product lines provide reliable voice communication and offer
integration with an enterprise's data networks. They support a wide variety
of voice and data applications such as call and customer contact centers,
messaging and interactive voice response. This product also facilitates the
ongoing transition at many enterprises from traditional voice telephony
systems to advanced systems that integrate voice and data traffic and
deploy increasingly sophisticated communications applications, including
"voice over internet protocol (VOIP)", popularized with Avaya's IP Office
product family. For smaller enterprises or small locations of larger ones,
we offer Avaya's, medium to small user voice communications products,
marketed under the MERLIN MAGIX(tm), SPIRIT(R) and PARTNER(R) Communications
Systems product families. We also offer Avaya voice messaging and unified
messaging products such as OCTEL(R) Messaging and INTUITY(tm) AUDIX(R)
Messaging, as well as the latest messaging release called Modular
Messaging.
Equipment sales consist of both new and refurbished parts (commonly
referred to as "aftermarket" sales), complete systems and software
applications. Aftermarket parts primarily consist of telephone sets and
circuit packs, and other system accessories such as headsets, consoles,
speakerphones and paging systems. Equipment sales revenues accounted for
approximately 89%, 87%, and 89% of total revenues in 2004, 2003, and 2002
respectively.
SERVICES AND OTHER REVENUE
--------------------------
We are committed to respond to our customers' service or project-
oriented telecommunications needs, and believe these services help
differentiate us from our competitors, as well as contribute to longer-
lasting customer relationships and incremental equipment sales. Services
include:
Installation Services: We use Avaya and other equipment installation
companies on a subcontract basis to install telecommunication parts and
systems nationwide, as well as to perform equipment moves, adds and
changes.
Repair and Refurbishing: We perform fee-based telecommunications
equipment repair and refurbishing services. Until 2003, these services were
provided through a combination of our in-house refurbishing center and the
use of subcontract repair shops. The in-house work primarily consisted of
cleaning, buffing and minor repairs, while major repairs of equipment,
including repair of circuit boards, was outsourced. By the end of 2003, we
had outsourced all equipment repair and refurbishing services to outside
repair shops.
Equipment Rentals: We provide rentals of equipment on a month-to-
month basis, servicing those customers that have temporary, short-term
equipment needs.
Other Services: Our technical staff currently provides system
engineering and configuration, project management, and technical "hot line"
telephone support services.
Other Revenue: A portion of our revenues is derived from commissions
received on the sale of Avaya communications equipment maintenance
contracts. In these transactions, once the contract is executed, we receive
a one-time commission, and all future service obligations are borne
entirely by Avaya.
Service revenues accounted for 8%, 10% and 9% of total revenues in
2004, 2003 and 2002, respectively, primarily attributable to installation
services. Other revenues accounted for 3%, 3% and 2% of revenues in 2004,
2003 and 2002, respectively.
4
RELATIONSHIP WITH AVAYA INC.
Avaya is one of the leading providers of communications products in
the United States. Avaya provides support to its dealer network and to the
telecommunications equipment aftermarket by providing installation and
maintenance services, technical and marketing support. Avaya also provides
up to a one-year warranty on its products.
We are currently one of several hundred independent companies in the
United States who are authorized "Dealers" of Avaya products and services.
We are an Avaya-certified Gold Dealer, selling new voice and data systems
and applications nationwide. Gold Dealer status also allows us certain
product purchasing discounts, and participation in incentive rebate
programs based upon purchasing volume and other cash incentive programs
connected with eligible business development and marketing initiatives. We
are also a "2 Star" Services partner selling Avaya installation,
maintenance, and moves, adds and changes (MAC) products. Our various dealer
agreements with Avaya principally contain language governing the products
we are authorized to sell, the territories in which we can sell these
products, our price structure under which we are charged for purchases of
their products for resale, the level of technical product knowledge we are
required to maintain, and product warranty and support provisions. No
agency relationship has been created in these agreements. These provisions
apply to the sale of both new and used products.
Until July 2004, we also had separate agreements with Avaya which
granted us a license to sell used equipment branded with a "Classic Avaya"
label. Under these agreements, we refurbished equipment to "like new"
condition under their quality standards, remarketing the finished product
as "Classic Avaya" equipment. This process was under the umbrella of an
"Authorized Remarketing Supplier" aftermarket program (initiated by Avaya's
predecessor, Lucent Technologies several years ago), in which we were one
of only five other companies nationwide authorized to refurbish and resell
Avaya product under their "Classic" trademark. As consideration for this
right, we paid Lucent/Avaya a license fee, calculated as a percentage
(which varied over the term of the agreement) of the sales price of
equipment sold with the "Classic" label. Effective July 30, 2004, Avaya
terminated this program, and we discontinued affixing their label to the
used equipment that we sell. We recorded in cost of revenues approximately
$110,000, $323,000, and $507,000 of fee expense in 2004, 2003 and 2002,
respectively. The revenues generated and subject to these license fees
approximated 11% (21% at the time of contract termination), 29% and 33% of
total revenues for 2004, 2003 and 2002, respectively. We do not believe
that the termination of this program has had, or will have, a material
adverse impact on our operations. Since the beginning of 2004, in
anticipation of this program winding down, we started selling refurbished
equipment branded with our own "Farmstead Certified" label for which we
have received widespread customer acceptance since Avaya will maintain and
service this equipment. In addition, we expect to enter into other revenue-
generating programs with Avaya, as further noted below.
Since the beginning of 2005, we have been working with Avaya to
structure a "strategic alliance" that would allow us to launch a nationwide
effort to sell Avaya SMB products and services. Effective March 1, 2005 we
concluded a non-binding agreement to commence a "pilot program", obtaining
authorization to market SMB products and services nationally. The purpose
of the program is to enable Avaya, and our Company, to increase market
share of SMB products and services. Under this trial agreement, Avaya will
provide marketing leads and other marketing and technical support, and we
will provide the direct sales team to generate sales in the authorized
territory. To this end, in March 2005 we hired 23 former Avaya sales and
support professionals and launched our SMB program. The pilot program
agreement may be terminated by either party upon 30 days prior notice.
MARKETING AND CUSTOMERS
We market our product offerings nationally through a direct sales
staff, which includes salespersons located along the Eastern seaboard, and
other areas of the country. Since 1999, we have also marketed Avaya
products through a call center operation. Our customers range from large
and mid-sized, multi-location corporations, to small companies, and to
equipment wholesalers, dealers, and government agencies and municipalities.
End-user customers accounted for approximately 87%, 91% and 83% of our
total revenues in 2004, 2003 and 2002, respectively, while sales to dealers
and other resellers accounted for approximately 13%, 9% and 17% of revenues
during the same respective periods. During the years ended December 31,
2004, 2003 and 2002, no single customer accounted for more than 10% of
revenues. We do not consider our business to be seasonal.
5
COMPETITION
We operate in a highly competitive marketplace. Over the years, our
marketplace has become subject to more rapid technological change as
communications systems have been evolving from stand-alone voice systems to
more highly integrated, software-driven systems. Since we principally sell
Avaya products, our competitive position in the marketplace is highly
dependent upon Avaya's ability to continue to be a market leader in the
product lines that we sell. Our competitors principally include Avaya and
other new equipment manufacturers that similarly compete against Avaya
products, including Nortel Networks Corporation, Siemens
Aktiengesellschaft, Alcatel S.A. and NEC Corporation along with their local
and regional dealers, and other Avaya dealers of which there are several
hundred nationwide. We believe that key competitive factors in our market
are price, timeliness of delivery, service and product quality and
reliability. Due to the reduction in business capital spending on
telecommunications products, which has developed in the U.S. over the past
few years, competitive pressures have intensified. We also anticipate
intensified competition from larger companies having substantially greater
technical, financial and marketing resources, as well as larger customer
bases and name recognition. As the industry further develops voice and data
converged products, we anticipate encountering a broader variety of
competitors, including new entrants from related computer and communication
industries.
SUPPLIERS
Our agreement with Avaya requires us to purchase new equipment from a
designated "master distributor", and accordingly we have used Catalyst
Telecom ("Catalyst") as our primary supplier over the last several years.
The performance of this distributor in meeting our product and delivery
demands has been satisfactory to date. Should there be an adverse change in
Catalyst's performance, we would have the ability to contract with another
"master distributor" to supply us with new Avaya telecommunications
equipment.
We acquire used equipment from a variety of sources, depending upon
price and availability at the time of purchase. These sources include other
aftermarket equipment dealers, leasing companies and end-users. The
equipment so acquired may be in a refurbished state and ready for resale,
or it may be purchased "as-is", requiring repair and/or refurbishing prior
to its resale. We are not dependent upon any single supplier for used
equipment. The Company believes that the number of aftermarket suppliers
and availability of used equipment in the marketplace is presently
sufficient to enable the Company to meet its customers' used equipment
delivery requirements.
PATENTS, LICENSES AND TRADEMARKS
No patent is considered material to our continuing operations. In
connection with the termination of the ARS program in July 2004 as
previously described, we are no longer licensed to utilize the Classic
Avaya(TM) trademark on the refurbished products that we sell. We presently
use a "Farmstead Certified" label on our used equipment, but this has not
been trademarked or registered
RESEARCH AND DEVELOPMENT
We did not incur any research and development expenses during the
three years ended December 31, 2004, and research and development
activities are not material to our business.
BACKLOG
The backlog of unshipped orders believed to be firm was approximately
$182,000 at December 31, 2004, compared to $397,000 at December 31, 2003.
We expect this entire backlog to ship and be recognized as revenue during
the current fiscal year.
EMPLOYEES
At December 31, 2004, we had 42 employees. Our employees are not
represented by any organized labor union and are not covered by any
collective bargaining agreements.
6
WEBSITE ACCESS TO SEC FILINGS
We maintain an Internet website at www.farmstead.com. We make
available free of charge through our Internet website our annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Exchange Act as soon as reasonably practicable after we
electronically file such material with, or furnish it to, the SEC.
EXECUTIVE OFFICERS AND SIGNIFCANT EMPLOYEES OF THE REGISTRANT
Name and age (1) Position(s) Held
---------------- --------------------------------------------------
Jean-Marc Stiegemeier President, Chief Executive Officer and Director
Age 59
George J. Taylor, Jr. Chairman of the Board of Directors, President and
Age 62 Chief Executive Officer (until October 1, 2004)
Robert G. LaVigne Executive Vice President, Chief Financial Officer,
Age 53 Secretary, Treasurer
Alfred G. Stein Executive Vice President (hired January 15, 2005)
Age 60
Nevelle R. Johnson Executive Vice President (hired March 1, 2005)
Age 47
Frederick E. Robertson, Jr. Vice President - Operations
Age 46
--------------------
As of January 1, 2005.
Mr. Stiegemeier has been our President and Chief Executive Officer,
and a Director, since October 1, 2004. From August 16, 2004 to October 1,
2004, he provided business consulting services to the Company. Mr.
Stiegemeier has extensive executive management experience in the
telecommunications industry. From 2002 to 2004 he was a business
consultant, advising companies on strategic redirections and turnarounds.
He also served on the board of directors for certain of these companies.
From 1997-2001, he served in various capacities including President,
Founder and Director of Exp@nets Inc., a voice and data solutions provider.
Prior thereto, Mr. Stiegemeier served as Chairman and CEO of Franklin
Industries Inc., Lucht, Inc., Ships Entertainment, Inc, California-
Telamerica Inc., Morrow Optical, Inc., and Telamerica, Inc. He was also the
President of Honeywell-Telamerica.
Mr. Taylor, Jr. has been our (including our predecessors) Chairman of
the Board of Directors since 1984, our Chief Executive Officer from 1984
until October 1, 2004, and our President from 1989 until October 1, 2004.
Mr. Taylor, Jr. was President of Lease Solutions, Inc. (formerly Farmstead
Leasing, Inc.), a business products and automobile leasing company, from
1981 to 1993 and Vice President - Marketing and Sales for National
Telephone Company from 1977 to 1981. Mr. Taylor was one of the founders of
the National Association of Telecommunication Dealers, has been a member
of, or advisor to, its Board of Directors since its inception in 1986, and
for two years served as its President and Chairman. He is the brother of
Mr. Hugh M. Taylor, a Director of the Company.
Mr. LaVigne has been an Executive Vice President since July 1997, and
our Chief Financial Officer, Corporate Secretary and Treasurer since 1988.
Mr. LaVigne was a Director of the Company from 1988 to 2001. He was the
Controller of Economy Electric Supply, Inc., a distributor of electrical
supplies and fixtures, from 1985 to 1988 and the Corporate Controller of
Hi-G, Inc., a manufacturer of electronic and electromechanical components,
from 1982 to 1985. Mr. LaVigne is a Certified Public Accountant.
Mr. Stein has been an Executive Vice President of our Company since
January 15, 2005. Mr. Stein was initially engaged by the Company in
September 2004 as an outside business consultant to assist management in
the
7
development of a strategic re-direction of the Company's sales organization
and product offerings. Mr. Stein has extensive experience in the
telecommunications industry. Since 2002 he served as founder and President
of Matthews & Wolf, LLC, a small business consulting firm. From 1998 to
2002 he served as Vice President - Business Process Development for
Exp@nets, Inc. a voice and data solutions provider with over $1 billion in
revenues. From 1983 to 1998, he was President of Eagle Intercommunications,
Inc. a New York based telecommunications solution provider selling Toshiba,
NYNEX and Avaya products and services. Eagle was acquired by Exp@nets in
May of 1998.
Mr. Johnson has been an Executive Vice President of our Company since
March 1, 2005. Mr. Johnson's responsibilities include the re-direction
and growth of our national sales organization, as well as the
implementation of new product and service offerings. Mr. Johnson has
extensive experience in the telecommunications industry. From November 2003
to March 2005 he was a Vice President of sales and services within Avaya
Inc. From 2000 to 2003 he was the Executive Vice President of sales and
services for Exp@nets, Inc. a voice and data solutions provider. From 1983
to 2000 he held various sales and executive positions with AT&T and Lucent
Technologies.
Mr. Robertson, Jr. has been our Vice President- Operations since
January 2003, and our Director of Provisioning from March 2001 to January
2003. Mr. Robertson, Jr. was Senior Director of Merchandising for Staples
Communications, Inc. from 1999 to 2001, Director of Corporate Purchasing
and Logistics for Claricom, Inc. from 1998 to 1999, and Corporate Manager,
Cost Control and Purchasing for Executone Information Systems, Inc. from
1996 to 1998.
ITEM 2. PROPERTIES
Our principal executive office and operations facility is located in
a 25,000 square foot, single-story leased building located in East
Hartford, Connecticut. The lease contract, which expires December 31, 2014,
contains one five-year renewal option. The lease also allows us the one-
time option to terminate the lease without penalty on December 31, 2009. We
also maintain a sales office in New York, New York, leasing approximately
1,700 square feet under a non-cancelable lease expiring May 31, 2007. If
new or additional space is required, we believe that adequate facilities
are available at competitive prices in the immediate areas of our current
operations.
ITEM 3. LEGAL PROCEEDINGS
From time to time we may be involved in legal proceedings arising in
the ordinary course of business. There is currently no litigation pending
that could have, individually or in the aggregate, a material adverse
effect on our financial position, results of operations or cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our Common Stock is traded on the American Stock Exchange, under the
symbol "FTG". The following sets forth, for the periods indicated, the
range of quarterly high and low sales prices for our Common Stock as
reported on the American Stock Exchange:
2004 2003
------------- -------------
Quarter Ended High Low High Low
------------- ---- --- ---- ---
March 31 $.79 $.50 $.35 $.21
June 30 .69 .31 .71 .26
September 30 .50 .26 .85 .41
December 31 .76 .36 .82 .57
8
There were 3,322,182 and 3,311,601 common shares outstanding at
December 31, 2004 and 2003, respectively. As of December 31, 2004 there
were 454 holders of record of the common stock representing approximately
2,225 beneficial stockholders, based upon the number of proxy materials
distributed in connection with our 2004 Annual Meeting of Stockholders. We
have paid no dividends and do not expect to pay dividends in the
foreseeable future as we intend to retain earnings to finance the growth of
our operations. Pursuant to our revolving credit agreement, we are
prohibited from declaring or paying any dividends or making any other
distribution on any of the shares of our capital stock, without the prior
consent of the lender.
EQUITY COMPENSATION PLAN INFORMATION
Securities authorized for issuance under equity compensation plans as
of December 31, 2004:
Number of securities
remaining available
Number of for future issuance
securities to be Weighted-average under equity
issued upon exercise price of compensation plans
exercise of outstanding (excluding securities
outstanding options, options, warrants reflected in column
warrants and rights and rights (a))
Plan Category (a) (b) (c)
------------------------------------------------------------------------------------------------------
Equity compensation plans
approved by security holders 2,388,119 $1.36 499,000
Equity compensation plans
not approved by security
holders 400,000 .39 -
------------------------------------------------------------------------------------------------------
Total 2,788,119 $1.22 499,000
======================================================================================================
ITEM 6. SELECTED FINANCIAL DATA
(In thousands, except per share amounts) Years ended December 31
----------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
---- ---- ---- ---- ----
Revenues $12,344 $14,909 $19,456 $33,631 $43,039
Income (loss) from continuing operations (1,424) (709) (2,530) (1,708) 1,753
Income (loss) from continuing operations
per common share:
Basic and diluted (.43) (.21) (.77) (.52) .54
Total Assets 4,050 5,291 5,873 10,342 15,494
Long term debt 39 - - - 1,726
Stockholders' equity 1,879 3,291 4,029 6,531 8,202
Dividends paid - - - - -
----------------------------------------------------------------------------------------------------
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Cautionary Statement Regarding Forward-Looking Statements
The discussions set forth below and elsewhere in this Annual Report
on Form 10-K contain certain statements, based on current expectations,
estimates, forecasts and projections about the industry in which we operate
and management's beliefs and assumptions, which are not historical facts
and are considered forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995 (the "Act"). Forward-
looking statements include, without limitation, any statement that may
predict, forecast, indicate, or imply future results, performance,
9
or achievements, and may contain the words "believe", "will be", "will
continue", "will likely result", "anticipates", "seeks to", "estimates",
"expects", "intends", "plans", "predicts", "projects", and similar words,
expressions or phrases of similar meaning. Our actual results could differ
materially from those projected in the forward-looking statements as a
result of certain risks, uncertainties and assumptions, which are difficult
to predict. Many of these risks and uncertainties are described under the
heading "Risk, Uncertainties and Other Factors That May Affect Future
Results" below. All forward-looking statements included in this document
are based upon information available to us on the date hereof. We undertake
no obligation to update publicly any forward-looking statements, whether as
a result of new information, future events or otherwise. In addition, other
written or oral statements made or incorporated by reference from time to
time by us or our representatives in this report, other reports, filings
with the Securities and Exchange Commission ("SEC"), press releases,
conferences, or otherwise may be forward-looking statements within the
meaning of the Act.
Overview
For the year ended December 31, 2004, we reported a net loss of
$1,424,000 or $.43 per share on revenues of $12,344,000. This compares with
a net loss of $709,000 or $.21 per share on revenues of $14,909,000
recorded for the year ending December 31, 2003. There are several factors
which have contributed to these results. First, there continues to be
intense competition in the market areas that we serve, particularly with
our larger, "Enterprise" customers. This has led to continued sales price
erosion and some loss of market share, particularly in the sale of parts,
which we believe has become more of a commodity and subject to "price
shopping" by customers. Our strategy to diversify our product offerings by
selling complete systems and system upgrades has not yet generated enough
incremental revenues to compensate for the decline in parts sales. Second,
our sales force has undergone significant turnover in the last two years,
and the productivity ramp-up of new salespersons has taken longer than
expected. Revenue growth is dependent upon a stable, and highly trained
sales force. Third, we continue to believe that corporations are still
cautious about capital equipment spending. We believe that equipment sales
have been affected by the downsizing of many of our customers over the last
few years, which resulted in excess equipment available for re-deployment
in their operations. Although there have been some signs of improvement in
our industry as evidenced by improved operating results from some of the
key manufacturers, and increased sales quotation activities, our overall
order flow has been below our expectations.
Until July 2004, we also had separate agreements with Avaya which
granted us a license to sell used equipment branded with a "Classic Avaya"
label. Under these agreements, we refurbished equipment to "like new"
condition under their quality standards, remarketing the finished product
as "Classic Avaya" equipment. Effective July 30, 2004, Avaya terminated
this program, and we discontinued affixing their label to the used
equipment that we sell. Refer to Item 1, "Relationship With Avaya Inc." for
a further discussion of this program and its impact on our operations.
During these times, we have attempted to reorganize our operations to
properly size our business in relation to current revenue run-rates, while
trying to preserve our key technical personnel that are critical to
maintaining and growing a systems and services business. Our primary focus
during 2004 has been on strategies to increase revenues while continuing
close controls over operating expenses. In reaction to lower than expected
revenue levels, during the first six months of 2004 we reduced our
workforce by 21%, primarily operations and administrative positions, but
keeping key technical resources intact. Refer to Item 1 "Business
Reorganization", for a further discussion of the measures undertaken by us
to refocus and redirect our operating activities and strategies, and recent
events which are expected to significantly impact our operations in 2005.
As further described in the "Liquidity and Capital Resources"
section below, our current cash position and borrowing capacity, which is
based upon revenue generation, could be a limiting factor to our growth,
particularly if operating losses continue. However, as of December 31,
2004 we had approximately $2.1million in working capital, and $412,000 in
borrowing availability under our then existing revolving credit facility.
On March 31, 2005 we concluded a financing transaction with Laurus Master
Fund, Ltd. which provides for a $3 million revolving credit facility,
replacing our $1.7 million facility with Business Alliance Capital
Corporation. Refer to Item 1, "Liquidity and Capital Resources" section
below and Note 16 to the consolidated financial statements included
herewith for further information on our new financing arrangements.
Additional information on our results of operations and financial condition
for the year ended December 31, 2004 follows below.
10
Results of Operations
Year Ended December 31, 2004 Compared To 2003
Revenues Year Ended December 31,
-----------------------------------
(Dollars in thousands) 2004 % 2003 %
------------------------------------------------------------------------
End-user equipment sales $ 9,323 76 $11,560 78
Equipment sales to resellers 1,641 13 1,368 9
------------------------------------------------------------------------
Total equipment sales 10,964 89 12,928 87
------------------------------------------------------------------------
Services 1,050 8 1,520 10
Other revenue 330 3 461 3
------------------------------------------------------------------------
Total services and other revenue 1,380 11 1,981 13
------------------------------------------------------------------------
Consolidated revenues $12,344 100 $14,909 100
========================================================================
Equipment Sales. Total equipment sales for the year ended December
31, 2004 were $10,964,000, down $1,964,000 or 15% from the comparable 2003
period. The decrease consisted of a $2,237,000 or 19% decline in end-user
sales, partly offset by a $273,000 or 20% increase in equipment sales to
resellers ("wholesale sales"). End-user sales consist of both parts sales
(new and refurbished), and systems sales (complete systems and system
upgrades). Factors affecting end-user equipment sales for 2004 have
previously been described in the "Overview" section above. The increase in
wholesale sales was the result of our efforts to pursue partnering
arrangements with other equipment dealers and aftermarket resellers as a
means to bolster equipment revenues. As a marketing tool to help generate
equipment revenues, we developed an electronic commerce framework called
"ECONNECT". Approximately 4% of our equipment sales were processed through
this on-line catalog.
During 2004, we continued a strategy of diversifying our product
offerings by marketing the sale of complete telecommunications systems to
our customer base. This is a growth strategy, designed to augment our long-
established aftermarket parts business that continues as our primary source
of revenues. For the year ended December 31, 2004 however, system sales
were $3,051,000, down $76,000 or 2% from 2003.
Service revenues for the year ended December 31, 2004 were
$1,050,000, down $470,000 or 31% from the comparable 2003 period. The
decrease was primarily attributable to a 30% decline in installation
revenues, due to (i) the decline in our parts sales resulted in lower move,
add and change billings and (ii) during 2004 we sold more systems for which
we were not contracted to perform the installation. An increase or decrease
in installation revenues does not always coincide with the reported
increase or decrease in system sales since installations may occur in
different periods than the related system sale, and as previously noted,
the Company may sell new systems or system upgrades without being
contracted to perform the installation. The decrease was secondarily
attributable to a 37% decline in equipment rental and repair revenues.
Equipment rental revenues are irregular and difficult to predict, since
they tend to be project-oriented.
Other revenue for the year ended December 31, 2004 was $330,000,
down $131,000 or 28% from 2003. The decrease was attributable to lower
commissions earned on Avaya maintenance contract sales and lower freight
billed to customers on product shipments due to lower sales volume. In the
sale of Avaya maintenance contracts, we act as a sales agent of Avaya, and
all of the equipment service obligations are borne entirely by Avaya.
Cost of Revenues and Gross Profit. Total cost of revenues for the
year ended December 31, 2004 was $9,451,000, down $1,572,000 or 14% from
the comparable 2003 period. The gross profit for the year ended December
31, 2004 was $2,893,000, down $993,000 or 26% from the comparable 2003
period. As a percentage of revenue, the overall gross profit margin was 23%
for 2004, compared to 26% for the comparable 2003 period.
In general, our gross profit margins are dependent upon a variety of
factors including (1) product mix - gross margins can vary significantly
among parts sales, system sales and our various service offerings. The
parts business, for example, involves hundreds of parts that generate
significantly varying gross profit margins depending upon their
availability, competition, and demand conditions in the marketplace; (2)
customer mix - we sell parts to both end-users and to other equipment
resellers. Our larger "Enterprise" companies often receive significant
purchase discounts from Avaya, which could cause us to accept lower gross
margins as we compete against Avaya directly for this business; (3) the
level and amount of vendor discounts and purchase rebates available to us
from Avaya and its master distributors; (4) excess capacity - as sales
volume falls, overhead costs, consisting primarily of product
11
handling, purchasing, and facility costs, become a higher percentage of
sales dollars; (5) competitive pressures - as a result of the slowdown in
capital equipment spending in our industry, and the large number of Avaya
dealers nationwide , we have been faced with increased price competition;
and (6) obsolescence charges. The combined effect of all of these factors
will result in varying gross profit margins from period to period.
Gross Profit Margins on Equipment Sales. For the year ended December
31, 2004, the gross profit margin on equipment sales decreased to 27% from
32% in 2003. The decrease was attributable to lower profit margins on sales
of parts to both end-users and to wholesalers, partly offset by increased
profit margins on systems sales. The reduced profit margins are
attributable to the fact that the parts business has become more of a
"commodity" business and less of a "value-added" business. It has therefore
become more prone to price-shopping by customers, who are tending more
towards awarding contracts to the lowest bidder. In addition, increased
competition has led to downward pressure on our sales pricing in order to
capture business. We expect continued pressure on our equipment profit
margins going forward, particularly in the sale of parts to our larger
customers.
Gross Profit Margins on Services and Other Revenue. For the year
ended December 31, 2004, the gross profit margin on services and other
revenue increased to 38.7%, from 33.8%in 2003. The increase was
attributable to the installation services component, which generated a 25%
profit margin in 2004 compared to a 16% profit margin in 2003. The 16%
profit margin in 2003 included the effect of a loss incurred on the
installation of a large systems contract, without which the profit margin
would have otherwise been 24%. During 2004 we began outsourcing a higher
percentage of our installation work to subcontractors other than Avaya who
charge us lower hourly labor rates. We will continue to employ this
strategy in instances where our customer has no installer preference.
Other Cost of Revenues. Other cost of revenues consists of product
handling, purchasing and facility costs and expenses. For the year ended
December 31, 2004, these expenses were 25% lower than 2003, and represented
approximately 5.6% of 2004 equipment sales revenues, compared to 6.4% of
2003 equipment sales revenues. The reduction in other cost of revenues
primarily resulted from personnel reductions implemented during 2004 as
well as planned reductions in facility costs and expenses.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses
for the year ended December 31, 2004 were $4,295,000, down $266,000 or 6%
from the comparable 2003 period. SG&A expenses for the year ended December
31, 2004 were 35% of revenues, compared to 31% of revenues in 2003. In
response to lower sales levels, we have been actively managing our
headcount and tightly controlling discretionary SG&A expenses. The decrease
in SG&A expenses in 2004 was primarily attributable to (i) lower
compensation expense from lower personnel levels, and lower sales
commissions earned as a result of lower sales volume; (ii) lower facility
rental and operating costs as a result of a reduction in the number of
square feet leased, (iii) lower depreciation expense; and (iv)reductions in
various other administrative expenses as a result of cost reduction
initiatives. The decreases were partly offset by (i) $113,000 in fees and
expenses incurred by business consultants (prior to their being hired by
the Company in October 2004 and January 2005 as previously described in
this section and in Item 1, "Executive Officers and Significant Employees
of the Registrant"), hired during the latter half of the year to assist the
Company in developing a business turnaround plan, (ii) increased insurance
costs; (iii) higher costs incurred to support our ECONNECT on-line catalog,
and (iv) lower marketing rebates earned from Avaya. We expect our SG&A
expenses to increase as we complete the build out of our executive
management and sales team; however we will continue the close monitoring of
our expense levels going forward into 2005 and expect that our SG&A
expenses will decline as a percent of sales by the end of 2005.
Interest Expense and Other Income. Interest expense for the years
ended December 31, 2004 and 2003 was $28,000. Although average borrowing
rates were slightly higher in 2004 than 2003, our average borrowings were
$179,000 as compared with $250,000 during 2003. Other income for the year
ended December 31, 2004 was $6,000 compared to $7,000, consisting of
interest earned on invested cash.
Provision for Income Taxes. The provision for income taxes represents
estimated minimum state taxes in all reported periods. The minimum state
tax expense of $8,000 recorded in 2004 was fully offset by an overaccrual
of prior year state taxes. We maintain a full valuation allowance against
our net deferred tax assets, which consist primarily of net operating loss
and capital loss carryforwards, and timing differences between the book and
tax treatment of inventory and other asset valuations. Realization of these
net deferred tax assets is dependent upon our ability to generate future
taxable income.
12
Year Ended December 31, 2003 Compared To 2002.
The following analysis does not take into consideration the
reclassification of freight billed to customers to other revenues. Prior to
2004, freight billed to customers on product sales was recorded in cost of
sales as a contra account to freight expense. Accordingly, the amounts
presented below in services and other revenue, and in consolidated
revenues, would have increased by $230,000 for 2003 and $306,000 for 2002.
For the year ended December 31, 2003, we reported a net loss of
$709,000 or $.21 per share on revenues of ($14,680,000). This compares with
a net loss of $2,530,000 or $.77 per share on revenues of $19,456,000
($19,150,000) recorded for the year ending December 31, 2002. The net loss
for 2002 included (i) a $455,000 charge to fully reserve for all deferred
tax assets; (ii) $333,000 in inventory valuation charges and (iii) a
$101,000 charge to write off all recorded goodwill arising from the
acquisition of InfiNet.
Revenues Year Ended December 31,
-----------------------------------
(Dollars in thousands) 2003 % 2002 %
------------------------------------------------------------------------
End-user equipment sales $11,792 81 $14,146 74
Equipment sales to resellers 1,368 9 3,205 17
Services 1,520 10 1,799 9
------------------------------------------------------------------------
Consolidated revenues $14,680 100 $19,150 100
========================================================================
Equipment Sales. Total equipment sales for the year ended December
31, 2003 were $12,929,000, down $4,392,000 or 25% from the comparable 2002
period. The decrease consisted of a $2,555,000 or 18% decline in end-user
sales, and a $1,837,000 or 57% decline in equipment sales to resellers
("wholesale sales"). End-user sales consist of both parts sales (new and
refurbished), and systems sales (complete systems and system upgrades). For
the year ended December 31, 2003 system sales were $3,127,000, up 18% from
the prior year period.
During the year ended December 31, 2002, end-user equipment sales
revenues, consisting of sales of both new and refurbished parts and systems
sales, decreased by $12,216,000 or 46% from the comparable 2001 period.
Additionally, equipment sales to resellers ("wholesale sales") decreased by
$1,314,000 or 29% from the comparable 2001 period. Management attributes
these sales declines primarily to the deteriorated market conditions in the
U.S. economy which has resulted in reduced capital spending by businesses
on telecommunications equipment. These conditions have, in turn, led to
increased competition and downward pressure on sales prices. Another factor
affecting sales levels has been the transitioning of our sales force.
During 2002, we continued a strategy of developing a systems sales
business, begun in 2001 with the formation of InfiNet, and continuing with
Farmstead's appointment as a systems dealer by Avaya in January 2002. This
is a growth strategy, designed to augment our long-established aftermarket
parts business that continues as our primary source of revenues. This
strategy necessitated the hiring of sales, service and technical design
personnel experienced in systems and applications design and sales. As a
result, we have increased our focus on selling new systems and system
upgrades, which coupled with the turnover of certain experienced parts
salespersons over the last two years, has contributed to the reduction in
aftermarket parts sales. Management remains committed to the continuing
growth of its systems business and is currently implementing strategies to
increase its parts business, which will include the development of on-line
ordering processes and other direct-marketing approaches.
Significant portions of our sales revenues are derived from "Business
Partner" relationships with Avaya. For the past several years, Avaya has
been pursuing a strategy of more fully utilizing its dealer channel as a
revenue source. Through our relationships with various Avaya sales
personnel, we are often referred business by Avaya. Such referrals however,
have been subject to fluctuation as Avaya's direct sales business itself
fluctuates.
Services. For the year ended December 31, 2003, service revenues were
$1,520,000, down $279,000 or 16% from 2002, primarily attributable to lower
installation revenues. For the year ended December 31, 2003, other revenue
was $231,000, up $201,000 from 2002. Other revenue consisted primarily of
commissions earned from selling Avaya maintenance contracts. In these
transactions we act as a sales agent of Avaya, and the service obligations
are borne entirely by Avaya. During 2003 we have increased our focus on
selling these contracts as part of our strategy to develop new and
profitable sources of revenue for the Company
During the year ended December 31, 2002, service revenues decreased
by $659,000 or 27% from the comparable 2001 period. The decrease was
primarily attributable to lower installation revenues and secondarily to
13
lower equipment rentals. Installation revenues are generated primarily from
the sale of systems and system upgrades which as noted above, have been
negatively affected by the market downturn.
Cost of Revenues and Gross Profit. Total cost of revenues for the
year ended December 31, 2003 was $10,794,000, down $4,733,000 or 30% from
the comparable 2002 period. The gross profit for the year ended December
31, 2003 was $3,886,000, up $263,000 or 7% from the comparable 2002 period.
As a percentage of revenue, the gross profit margin was 26% for 2003,
compared to 19% for the comparable 2002 period. The year 2002 recorded
gross profit margins were negatively affected by inventory valuation
charges of $333,000 in 2002 necessitated by industry market conditions.
Excluding these adjustments, the gross profit margin would have been 20%
for 2002.
The reduction in gross profit dollars during the year ended December
31, 2002 was primarily attributable to lower sales levels, for the reasons
discussed above. The gross profit margin for 2002, excluding the effect of
the inventory valuation charges noted above, was affected by (1) increased
sales competition, and downward pressure on sales pricing in our
aftermarket end-user parts sales channel; (2) increased wholesale sales as
a percent of total sales revenues. Wholesale sales generate margins that
are lower than end-user margins and for 2002 were 17% of revenue compared
with 14% in 2001; and (3) overhead costs, consisting principally of higher
overhead costs as a percent of revenues. As a partial offset, we recorded
improved gross profit margins on both systems sales and installation
services in 2002, as compared with the comparable prior year periods, and
also benefited from license fee reductions implemented by Avaya during
2002.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses
for the year ended December 31, 2003 were $4,561,000, down $1,192,000 or
21% from the comparable 2002 period. SG&A expenses for the year ended
December 31, 2003 were 31% of revenues, compared to 30% of revenues in
2002. In response to lower sales levels, we have been actively managing our
headcount and tightly controlling SG&A expenses. Approximately 56% of the
decrease in SG&A expenses was attributable to a reduction in compensation
expenses, resulting from an 11% reduction in the average number of
employees and lower sales commissions. We also experienced reductions in
travel, consulting, office, depreciation, and other employment related
expenses, offset by higher bad debt and property tax expenses.
SG&A expenses for the year ended December 31, 2002 were $5,753,000, a
decrease of $2,366,000 or 29% from the comparable 2001 period. SG&A
expenses were 30% of revenues in 2002 as compared to 24% of revenues in
2001. Of the total decrease in SG&A, $909,000 was attributable to the
downsizing of the operations of InfiNet. This was the result of the
acquisition by Farmstead of its own systems dealer license in January 2002,
and a change in strategy concerning the business use of InfiNet. As a
result, InfiNet was inactive for most of 2002. The remaining $1,457,000
decrease in SG&A expenses was attributable to the operations of Farmstead
and included (i) an $880,000 (20%) reduction in payroll expenses as a
result of lower employment levels than the prior year period, lower sales
commissions due to lower sales levels, and management and director pay
reductions; (ii) cost-reduction initiatives in response to lower sales
levels, which has resulted in reduced marketing, travel, legal, consulting
and other office and employment-related expenses; (iii) $201,000 in reduced
bad debt expense resulting from a $33,000 reserve reduction due to better
than expected receivable collections, a $15,234 bad debt recovery and lower
sales volume and (iv) lower depreciation expense. In connection with the
downsizing of InfiNet, we wrote off $101,000 of goodwill associated with
its acquisition.
Interest Expense and Other Income. Interest expense for the year
ended December 31, 2003 was $28,000, compared with $24,000 for the
comparable 2002 period. The increase in interest expense was attributable
to higher interest rates on borrowings as our credit facility moved from
Wachovia Bank to Business Alliance Capital Corporation ("BACC"). Other
income for the year ended December 31, 2003 was $7,000 compared to $97,000,
consisting of interest earned on invested cash, compared to $97,000
recorded in 2002. Other income in 2002 included $82,000, from the sale of
common stock of Anthem, Inc., which we received at no cost, as part of the
conversion of Anthem Insurance Companies, Inc. from a mutual insurance
company to a stock insurance company. The balance of other income for 2002
consisted primarily of interest earned on invested cash.
Provision for Income Taxes. The provision for income taxes for the
year ended December 31, 2003 was $13,000 compared to $473,000 recorded in
2002. The provision for income taxes in 2003 consisted entirely of
estimated minimum state taxes. Tax expense in 2002 consisted of a provision
of $18,000 for estimated state taxes and a $455,000 charge to increase the
valuation allowance against our net deferred tax assets at December 31,
2002. We maintain a full valuation allowance against our net deferred tax
assets, which consist primarily of net operating
14
loss and capital loss carryforwards, and timing differences between the
book and tax treatment of inventory and other account valuations.
Realization of these net deferred tax assets is dependent upon our ability
to generate future taxable income.
Liquidity and Capital Resources
Working capital, defined as current assets less current liabilities,
was $2,136,000 at December 31, 2004, a decrease of $993,000 or 32% from
$3,129,000 at December 31, 2003. The working capital ratio was 2.4 to 1 at
December 31, 2004 compared to 3.1 to 1 at December 31, 2003. Operating
activities used $1,037,000 during 2004, compared to the use of $87,000 in
2003. Net cash used by operating activities in 2004 consisted of a net loss
of $1,424,000 adjusted for non-cash items of $247,000, and net cash
generated by changes in operating assets and liabilities of $132,000. Net
cash generated by changes in operating assets and liabilities was primarily
attributable to reductions in inventory and increases in accrued expenses
and other liabilities, partly offset by a decrease in accounts payable.
Investing activities used $29,000 during 2004, compared to $83,000 in
2003. Net cash used by investing activities in 2004 and 2003 consisted of
capital expenditures. There are currently no material commitments for
capital expenditures. Pursuant to our loan agreement with BACC, we are
restricted from committing to capital expenditures in any fiscal year
period in excess of $150,000 without BACC's prior approval.
Financing activities provided $456,000 during 2004 principally from
borrowings against the cash value of an insurance policy and net borrowings
under our revolving credit line. Financing activities provided $4,000
during 2004 from the issuance of 10,581 shares of common stock to employees
under our employee stock purchase plan.
On February 19, 2003 we entered into a one-year, $1.5 million
revolving loan agreement (the "BACC Agreement") with BACC". On February 19,
2004, the BACC Agreement was extended for an additional one-year term with
an increase in the advance limit to $1.7 million. On February 19, 2005, the
BACC Agreement was again extended for an additional one-year term. As of
December 31, 2004, there was $179,812 of borrowings under the BACC credit
facility, and based upon borrowing formulas, we had $412,000 in remaining
borrowing availability. The average and highest amounts borrowed during the
year ended December 31, 2004 were approximately $179,000 and $423,000,
respectively.
On March 31, 2005, we completed a three-year, $3 million credit
facility with Laurus Master Fund, Ltd, ("Laurus"). The facility consists of
a $2.5 million convertible secured revolving note and a $500,000
convertible minimum borrowing note. The outstanding balance on the notes
are convertible into shares of the Company's common stock, subject to
certain limitations set forth in the agreement based upon the stock's
trading volume and Laurus' ownership position. The Company also issued to
Laurus a five-year warrant to purchase up to 500,000 shares of common stock
of the Company. Borrowings under the revolving note will be based upon a
percentage of eligible accounts receivable and inventories as defined in
the agreement. This new credit facility replaces the $1.7 million revolving
credit facility the Company had with Business Alliance Capital Corporation.
Refer to Note 16 of the Notes to consolidated financial statements included
herewith for further information on this financing transaction.
We are dependent upon generating positive cash flow from operations
and upon our credit facility to provide cash to satisfy working capital
requirements. Historically, our working capital borrowings have increased
during periods of revenue growth. This is because our cash receipts cycle
is longer than our cash disbursements cycle. As our revenues from systems
sales increases, as management expects, the cash receipts cycle may
lengthen, unless we can consistently negotiate up-front deposits and
progress payments under our systems sales contracts. No assurances can be
given that we will have sufficient cash resources to finance all of our
future growth plans, and it may become necessary to seek additional
financing sources for such purposes. In order to obtain additional
financing, we may first need to demonstrate improved operating performance.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 123 (Revised 2004),
"Share-Based Payment," ("SFAS No. 123 (revised 2004)"), revising FASB
Statement 123, "Accounting for Stock-Based Compensation" and superseding
APB Opinion No. 25, "Accounting for Stock Issued to Employees". This
Statement establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services,
focusing primarily on
15
transactions in which an entity obtains employee services in share-based
payment transactions. SFAS No. 123 (Revised 2004) requires a public entity
to measure the cost of employee services received in exchange for an award
of equity instruments based on the grant-date fair value of the award (with
limited exceptions). That cost will be recognized over the period during
which an employee is required to provide service in exchange for the award.
Accounting for share-based compensation transactions using the intrinsic
method supplemented by pro forma disclosures will no longer be permissible.
This statement is effective as of the beginning of the first interim or
annual reporting period that begins after June 15, 2005 and the Company
will adopt the standard in the third quarter of fiscal 2005. The adoption
of this standard will have an impact on the Company's results of operations
as it will be required to expense the fair value of all share based
payment; however the Company has not yet determined whether or not this
impact will be significant.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an
amendment of ARB No. 43, Chapter 4," which clarifies the types of costs
that should be expensed rather than capitalized as inventory. This
statement also clarifies the circumstances under which fixed overhead costs
associated with operating facilities involved in inventory processing
should be capitalized. The provisions of SFAS No. 151 are effective for
fiscal years beginning after June 15, 2005 and the Company will adopt this
standard in its third quarter of fiscal 2005. The Company has not
determined the impact, if any, that this statement will have on its
consolidated financial position or results of operations.
Critical Accounting Policies and Estimates
Our financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America. These
accounting principles require management to make a number of assumptions
and estimates about future events that affect the reported amounts of
assets, liabilities, revenue and expenses in our consolidated financial
statements and accompanying notes. Management bases its estimates on
historical experience and various other assumptions about future events
that are believed to be reasonable. These estimates are based on
management's best knowledge of current events and actions that may impact
the Company in the future. Actual results could differ from these
estimates, and any such differences could be material to the financial
statements. We believe that the following policies may involve a higher
degree of judgment and complexity in their application and represent the
critical accounting policies used in the preparation of our financial
statements.
Revenue recognition and post-sales obligations. We recognize revenue
from sales of equipment (both parts and the equipment component of system
sales) when the equipment is shipped, which is generally easily determined,
even when equipment is shipped to our customer directly from our supplier.
Revenues from installation and service transactions are recognized upon
completion of the activity and customer acceptance, which sometimes
requires our judgment. We record reductions to revenue for estimated
product returns, and we establish warranty repair reserves (which to date
have been immaterial to our results of operations), which are based on our
historical experience, current trends and other judgments on our part in
order to estimate our liability for such obligations.
Inventory valuation. We periodically assess the valuation of
inventory and adjust the value for estimated excess and obsolete inventory
based upon assumptions about current and future demand and market
conditions. Such estimates are difficult to make under current volatile
economic conditions. Reviews for excess and potentially obsolete inventory
are done periodically during the year and required reserve levels are
calculated with reference to the projected ultimate usage of that
inventory. In order to determine the ultimate usage, we take into account
recent sales history, sales forecasts and projected obsolescence in
relation to our current inventory stocking levels. If actual market
conditions are less favorable than those projected by management,
additional write-downs may be required. If actual market conditions are
more favorable than anticipated, inventory previously written down may be
sold, resulting in lower cost of sales and higher earnings from operations
than expected in that period.
Collectibility of Accounts Receivable. The allowance for doubtful
accounts is based upon our assessment of the collectibility of specific
customer accounts and the aging of the accounts receivable. Reviews of our
receivables are performed continuously during the year, and reserve levels
are adjusted when determined necessary. If there were a deterioration of a
major customer's creditworthiness, or actual defaults were higher than our
historical experience, we could be required to increase our allowance and
our earnings could be adversely affected.
Long-Lived Assets. We have recorded property and equipment and
intangible assets at cost less accumulated depreciation. The determination
of useful lives and whether or not those assets are impaired involves
significant judgment. We conducted the required annual goodwill impairment
review during the fourth quarter of 2002. In considering the facts that our
wholly-owned subsidiary, InfiNet, was downsized during the year, was
inactive at
16
year-end with no operating employees, and that management had no current
plans for generating business through InfiNet, we recorded a goodwill
impairment charge of $101,000 as an operating expense, fully writing off
all previously recorded goodwill from the acquisition of this entity.
Income Taxes and Deferred Tax Assets. Significant judgment is
required in determining our provision for income taxes and in determining
whether deferred tax assets will be realized in full or in part. The
deferred tax valuation allowance was calculated in accordance with the
provisions of SFAS No. 109, "Accounting for Income Taxes", which places
primary importance on a company's cumulative operating results for the
current and preceding years. Additionally, when it is more likely than not
that all or some portion of specific deferred tax assets such as net
operating loss carryovers will not be realized, a valuation allowance must
be established for the amount of the deferred tax assets that are
determined not to be realizable. In our judgment, the significant losses
incurred in 2004, 2003, and 2002 represented sufficient evidence to require
a valuation allowance, and therefore we established a full allowance
against our deferred tax assets as of December 31 of each year. In 2002,
that resulted in a fourth quarter charge to income tax expense of $455,000.
Risks, Uncertainties and Other Factors That May Affect Future Results
Our prospects are subject to many uncertainties and risks. Management
recognizes the challenges that it faces, particularly during this period of
diminished sales levels, and has adopted a number of strategies and action
steps to deal with its current operating environment. Disclosure of our
strategies and action steps is contained in the discussions set forth in
Item 7. "Management's Discussion and Analysis of Financial Condition and
Results of Operations", and elsewhere herein. These risks and uncertainties
are also detailed from time to time in reports we file with the SEC,
including Forms 8-K, 10-Q, and 10-K, and include, among other factors, the
following principal risks:
* Our business is materially impacted by capital spending levels for
telecommunications products and services in the United States.
As a result of the economic downturn that commenced in 2001, many
businesses have reduced or deferred capital expenditures for
telecommunications equipment. Our reported 2004 revenues were 17% lower
than 2003, and 2003 revenues were 23% lower than 2002 revenues. In
addition, this environment has resulted in increased pricing and
competitive pressures, which have contributed to our revenue erosion. If
business capital spending for telecommunications products does not improve,
or if economic conditions in the U.S. deteriorate, our revenues may
continue to decline and our operating results will be adversely affected.
We remain cautious about the telecommunications product marketplace going
forward, and cannot predict whether the level of capital spending for the
Company's products will improve in the near term. As a result, we believe
that there will be continued pressure on our ability to generate revenue in
excess of current levels.
* Our business is heavily dependent upon Avaya, as our primary
supplier of equipment for resale.
We primarily sell Avaya telecommunications products and services
through various Dealer agreements with Avaya. The Company is dependent upon
the quality and price-competitiveness of current Avaya products as well as
Avaya's continued development of new products in order to compete. The
Company's current sales levels for new parts and systems would be adversely
impacted should market demand for these Avaya products significantly
decline. Should Avaya's operations deteriorate to the point that it either
cannot continue to introduce technologically new products or effectively
compete with other equipment manufacturers, our long-term business strategy
to continue as an Avaya dealer would be adversely affected.
Our new parts and systems sales levels would also be adversely
impacted if the Avaya dealer agreements were terminated, or if Avaya
eliminated its "Business Partner" programs. It is Avaya's current intent to
generate a larger percentage of its revenues from its dealer base, of which
we are one. Effective July 30, 2004, Avaya terminated the ARS aftermarket
program, and by September 30, 2004 we were no longer authorized to sell
refurbished product under the "Classic Avaya" label. We believe, however,
that the termination of this program did not have a material adverse impact
on our sales of refurbished equipment, primarily because we have continued
to sell refurbished equipment under our "Farmstead-Certified" label , and
because Avaya continues to offer installation and maintenance of its
refurbished equipment with or without their "Classic Avaya" label.
17
* Our gross profit margins vary from period to period.
Our gross profit margins are dependent upon a variety of factors
including (1) product mix - gross margins can vary significantly among
parts sales, system sales and our various service offerings. The parts
business, for example, involves hundreds of parts that generate
significantly varying gross profit margins depending upon their
availability, competition, and demand conditions in the marketplace; (2)
customer mix - we sell parts to both end-users and to other equipment
resellers. Our larger "Enterprise" companies often receive significant
purchase discounts from Avaya, which could lower our gross margins as we
compete against Avaya directly for this business; (3) the level and amount
of vendor discounts and purchase rebates available to us from Avaya and its
master distributors; (4) excess capacity - as sales volume falls, overhead
costs become a higher percentage of sales dollars; (5) competitive
pressures - as a result of the slowdown in capital equipment spending in
our industry, and the several hundred Avaya dealers nationwide , we have
been faced with increased price competition; and (6) obsolescence charges.
The combined effect of all of these factors will result in varying gross
profit margins from period to period.
* Our gross profit margins and operating expenses could be adversely
affected by a reduction in purchase discount and other rebate or incentive
programs currently offered by Avaya.
As an Avaya Dealer, we receive substantial rebates and other cash
incentives from Avaya, based upon volume levels of certain product
purchases, which are material to our operating results and which help
reduce product purchase costs, market development and marketing expenses.
These incentive programs are subject to change by Avaya, and no assurances
can be given that they would not be altered so as to adversely impact our
profit margins or operating expenses.
* We may not have adequate cash or credit lines to finance the
Company's working capital requirements or growth plans.
As further discussed under "Liquidity and Capital Resources", our
operating losses over the past three years have significantly reduced the
amount of credit available to us from outside lenders, and increased the
cost of borrowed funds. We are currently dependent upon cash generated from
operations, and borrowings under a revolving credit facility, to satisfy
our working capital requirements. Our revolving credit borrowings are based
upon the generation of eligible accounts receivable. As our revenues have
declined, so too have our receivables and borrowing availability. A
material adverse change in our business going forward could prompt our
lender to terminate our credit facility. In addition, continued losses
could consume our current cash reserves, and negatively affect our ability
to obtain replacement financing until we could demonstrate improved
operating results or a return to profitability. No assurances can be given
that we will have sufficient cash resources to finance future growth, and
it may become necessary to raise additional funds through public or private
debt or equity financings, which may also not be available to us until
operating performance improves, and which may dilute stockholder ownership
in us. If, however, we perform according to our expectations, we believe
that additional sources of financing would become available to us.
* We are faced with intense competition and rapidly changing
technologies, and we may become unable to effectively compete in our
marketplace.
We operate in a highly competitive marketplace. Over the years, our
marketplace has become subject to more rapid technological change as
communications systems have been evolving from stand-alone voice systems to
more highly integrated, software-driven systems. Since we principally sell
Avaya products, our competitive position in the marketplace is highly
dependent upon Avaya's ability to continue to be a market leader in the
product lines that we sell. Our competitors principally include Avaya and
other new equipment manufacturers that similarly compete against Avaya
products, including Nortel Networks Corporation, Siemens
Aktiengesellschaft, Alcatel S.A. and NEC Corporation along with their local
and regional dealers, and the other Avaya business partners,. We believe
that key competitive factors in our market are price, timeliness of
delivery, service and product quality and reliability. Due to the reduction
in business capital spending on telecommunications products, which has
developed in the U.S. over the past few years, competitive pressures have
intensified. We also anticipate intensified competition from larger
companies having substantially greater technical, financial and marketing
resources, as well as larger customer bases and name recognition. As the
industry further develops voice and data converged products, we anticipate
encountering a broader variety of competitors, including new entrants from
related computer and communication industries.
18
* If we are unable to attract and retain key management and sales
employees, we will not be able to compete effectively and our business may
not be successful.
Our success is highly dependent upon our ability to hire and retain
key technical, sales and executive personnel. Competition for such
personnel is currently intense in our industry, and our deterioration in
revenues over the past two years has been partly due to turnover of such
key employees. If we fail to hire and retain a sufficient number of high-
quality personnel, we may not be able to maintain or expand our business.
We have been attempting to expand our systems sales business, which
requires more highly skilled technical and sales personnel than our
aftermarket parts business, and a failure to hire and retain such personnel
would restrict our ability to effectively develop this sales growth
strategy.
* We could be delisted by the American Stock Exchange.
On May 7, 2004 we received notice from the American Stock Exchange
(the "Amex") that we did not meet certain of the Amex's continued listing
standards as a result of having stockholders' equity less than $4 million
and net losses in three out of our four most recent fiscal years, as set
forth in Section 1003 (a) (ii) of the Amex Company Guide. We were afforded
the opportunity to submit a plan of compliance to the Amex and on June 15,
2004 presented our plan. On July 19, 2004 the Amex notified us that it
accepted our plan of compliance and granted us an extension of time to
regain compliance with the continued listing standards. We are subject to
periodic review by Amex Staff during the extension period which expires
November 7, 2005. Failure to make progress consistent with our plan or to
regain compliance with the continued listing standards by the end of the
extension period could result in our being delisted from the Amex.
Should we continue to record operating losses, remain below minimum
required levels of stockholders' equity, remain below required minimum
shareholder or market capitalization levels and /or if our common stock
continues to trade at a "low price per share", we could be subject to
delisting from the Amex. In considering whether a security warrants
continued trading and/or listing on the Amex, many factors are taken into
account, such as the degree of investor interest in the company, its
prospects for growth, the reputation of its management, the degree of
commercial acceptance of its products, and whether its securities have
suitable characteristics for auction market trading. Thus, any developments
which substantially reduce the size of a company, the nature and scope of
its operations, the value or amount of its securities available for the
market, or the number of holders of its securities, may occasion a review
of continued listing by the Amex. The determination as to whether a
security warrants continued trading is not based on any precise
mathematical formula rather, each case is considered on the basis of all
relevant facts and circumstances and in light of the objectives of the
Amex's policies regarding continued listing.
* Other risks
In addition to the specific risks and uncertainties discussed above,
our future operating performance can also be affected by: performance and
reliability of products; the maintenance of our level of customer service
and customer relationships; adverse publicity; business disruptions; acts
of terrorism within the U.S., and the impact of those acts on the U.S.
economy; and other events that can impact revenues and business costs. The
risks included here are not exhaustive. Other sections of this report may
include additional factors, which could adversely affect our business and
financial performance. Moreover, we operate in a very competitive and
rapidly changing environment. New risk factors emerge from time to time and
it is not possible for management to predict all such risk factors, nor can
it assess the impact of all such risk factors on its business or the extent
to which any factor, or combination of factors, may cause actual results to
differ materially from those contained in any forward-looking statements.
Given these risks and uncertainties, investors should not place undue
reliance on forward-looking statements as a prediction of actual results.
Investors should also be aware that while we do, from time to time,
communicate with securities analysts, it is against our policy to disclose
to them any material information unless such information shall have been
previously or is simultaneously disclosed in a manner intended to provide
broad, non-exclusionary distribution of the information to the public.
Accordingly, shareholders should not assume that we agree with any
statement or report issued by any analyst irrespective of the content of
the statement or report. Furthermore, we have a policy against issuing or
confirming financial forecasts or projections issued by others. Thus, to
the extent that reports issued by securities analysts contain any
projections, forecasts or opinions, such reports are not our
responsibility.
19
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate risk: We are exposed to market risk from changes in the
interest rate related to our revolving credit facility, which is based upon
the Prime Rate, which is a floating interest rate. Assuming an average
borrowing level of $179,000 (which amount approximated the average amount
borrowed under our revolving credit facility during the year ended December
31, 2004), each 1 percentage point increase in the Prime Rate would have
resulted in $1,790 of additional annual interest charges, which was not
material to our operating results or cash flows for 2004. However, as our
borrowing levels increase, fluctuations in interest rates could materially
impact our operating results and cash flows. We do not currently use
interest rate derivative instruments to manage exposure to interest rate
changes.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the Index to Financial Statements and Financial Statement
Schedule in Item 15.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. Our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of our
disclosure controls and procedures (as such term is defined in Rules 13a-
15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended
(the "Exchange Act")) as of the end of the period covered by this Annual
Report on Form 10-K. Based on such evaluation, such officers have concluded
that our disclosure controls and procedures are effective in alerting them
on a timely basis to material information relating to our Company required
to be included in our reports filed or submitted under the Exchange Act.
(b) Changes in Internal Control over Financial Reporting. There were no
significant changes in our internal controls over financial reporting that
occurred during our fourth fiscal quarter of 2004 that has materially
affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 is included, in part, in Item 1,
"Executive Officers and Significant Employees of the Registrant", and is
incorporated by reference to our Proxy Statement in connection with our
Annual Meeting of Stockholders to be held July 14, 2005, which will be
filed with the SEC pursuant to regulation 14A on or before April 30, 2005.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference to
our Proxy Statement in connection with our Annual Meeting of Stockholders
to be held July 14, 2005, which will be filed with the SEC pursuant to
regulation 14A on or before April 30, 2005.
20
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated by reference to
our Proxy Statement in connection with our Annual Meeting of Stockholders
to be held July 14, 2005, which will be filed with the SEC pursuant to
regulation 14A on or before April 30, 2005.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference to
our Proxy Statement in connection with our Annual Meeting of Stockholders
to be held July 14, 2005, which will be filed with the SEC pursuant to
regulation 14A on or before April 30, 2005.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is incorporated by reference to
our Proxy Statement in connection with our Annual Meeting of Stockholders
to be held July 14, 2005, which will be filed with the SEC pursuant to
regulation 14A on or before April 30, 2005.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Index to Financial Statements and Financial Statement Schedule
Page
----
Report of Carlin, Charron & Rosen LLP 23
Consolidated Balance Sheets - December 31, 2004 and 2003 24
Consolidated Statements of Operations -
Years Ended December 31, 2004, 2003 and 2002 25
Consolidated Statements of Changes in Stockholders' Equity -
Years Ended December 31, 2004, 2003, and 2002 25
Consolidated Statements of Cash Flows -
Years Ended December 31, 2004, 2003, and 2002 26
Notes to Consolidated Financial Statements 27
Financial Statement Schedule:
Report of Carlin, Charron & Rosen LLP 40
Schedule II - Valuation and Qualifying Accounts 41
(b) Exhibits: See Index to Exhibits on page 42.
21
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 on April
6, 2005.
FARMSTEAD TELEPHONE GROUP, INC.
By: /s/ Jean-Marc Stiegemeier
-------------------------
Jean-Marc Stiegemeier
President, Chief Executive
Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated as of April 6, 2005.
Signature Title(s)
--------- --------
/s/ Jean-Marc Stiegemeier President, Chief Executive Officer and Director
------------------------------ (Principal Executive Officer)
Jean-Marc Stiegemeier
/s/ Robert G. LaVigne Executive Vice President, Chief Financial Officer,
------------------------------ Secretary and Treasurer
Robert G. LaVigne (Principal Financial and Accounting Officer)
/s/ George J. Taylor, Jr. Chairman of the Board of Directors
------------------------------
George J. Taylor, Jr.
/s/ Harold L. Hansen Director
------------------------------
Harold L. Hansen
/s/ Joseph J. Kelley Director
------------------------------
Joseph J. Kelley
/s/ Ronald P. Pettirossi Director
------------------------------
Ronald P. Pettirossi
/s/ Hugh M. Taylor Director
------------------------------
Hugh M. Taylor
22
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Farmstead Telephone Group, Inc.
We have audited the accompanying consolidated balance sheets of Farmstead
Telephone Group, Inc. (the "Company") as of December 31, 2004 and 2003, and
the related consolidated statements of operations, changes in stockholders'
equity and cash flows for the years ended December 31, 2004, 2003 and 2002.
These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the consolidated financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide
a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Farmstead
Telephone Group, Inc. as of December 31, 2004 and 2003, and the results of
their operations and their cash flows for the years ended December 31, 2004,
2003 and 2002 in conformity with accounting principles generally accepted in
the United States of America.
/s/ CARLIN, CHARRON & ROSEN, LLP
Glastonbury, Connecticut
March 18, 2005, except for Notes 6 and 16, as to which the date is
March 31, 2005
23
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2004 and 2003
(In thousands, except share amounts) 2004 2003
-----------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 217 $ 827
Accounts receivable, net 1,453 1,408
Inventories, net 1,627 1,969
Other current assets (Note 10) 378 447
-----------------------------------------------------------------------------------------------------
Total Current Assets 3,675 4,651
-----------------------------------------------------------------------------------------------------
Property and equipment, net 268 313
Other assets 107 327
-----------------------------------------------------------------------------------------------------
Total Assets $ 4,050 $ 5,291
=====================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,110 $ 1,350
Accrued expenses and other current liabilities 242 172
Short-term borrowings and current portion of note payable (Notes 6 and 16) 187 -
-----------------------------------------------------------------------------------------------------
Total Current Liabilities 1,539 1,522
-----------------------------------------------------------------------------------------------------
Postretirement benefit obligation (Note 12) 593 478
Note payable (Note 6) 39 -
-----------------------------------------------------------------------------------------------------
Total Liabilities 2,171 2,000
-----------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 10)
Stockholders' Equity:
Preferred stock, $0.001 par value; 2,000,000 shares authorized;
no shares issued and outstanding - -
Common stock, $0.001 par value; 30,000,000 shares authorized;
3,322,182 and 3,311,601 shares issued and outstanding
at December 31, 2004 and 2003, respectively 3 3
Additional paid-in capital 12,320 12,316
Accumulated deficit (10,420) (8,996)
Accumulated other comprehensive loss (24) (32)
-----------------------------------------------------------------------------------------------------
Total Stockholders' Equity 1,879 3,291
-----------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 4,050 $ 5,291
=====================================================================================================
See accompanying notes to consolidated financial statements.
24
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2004, 2003 and 2002
(In thousands, except per share amounts) 2004 2003 2002
------------------------------------------------------------------------------------------------
Revenues:
Equipment $10,964 $12,928 $17,321
Services and other revenue 1,380 1,981 2,135
------------------------------------------------------------------------------------------------
Net revenues 12,344 14,909 19,456
------------------------------------------------------------------------------------------------
Cost of revenues:
Equipment 7,987 8,886 13,105
Services and other revenue 846 1,310 1,320
Other cost of revenues 618 827 1,408
------------------------------------------------------------------------------------------------
Total cost of revenues 9,451 11,023 15,833
------------------------------------------------------------------------------------------------
Gross profit 2,893 3,886 3,623
Selling, general and administrative expenses 4,295 4,561 5,753
------------------------------------------------------------------------------------------------
Operating loss (1,402) (675) (2,130)
Interest expense (28) (28) (24)
Other income 6 7 97
------------------------------------------------------------------------------------------------
Loss before income taxes (1,424) (696) (2,057)
Provision for income taxes - 13 473
------------------------------------------------------------------------------------------------
Net loss $(1,424) $ (709) $(2,530)
================================================================================================
Basic and diluted net loss per common share $ (.43) $ (.21) $ (.77)
Basic and diluted weighted average common shares outstanding 3,317 3,305 3,289
================================================================================================
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES
IN STOCKHOLDERS' EQUITY
Years Ended December 31, 2004, 2003, and 2002
Accumulated
Common Stock Additional Accum- Other
----------------- Paid-in ulated Comprehensive
(In thousands) Shares Amount Capital Deficit Loss Total
---------------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 3,272 $3 $12,285 $ (5,757) $ - $ 6,531
Net loss - - - (2,530) - (2,530)
Compensatory stock options issued - - 15 - - 15
Issuance of common stock 26 - 13 - - 13
---------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 3,298 3 12,313 (8,287) - 4,029
Net loss - - - (709) - (709)
Pension liability adjustment - - - - (32) (32)
-------
Comprehensive loss - - - - - (741)
Issuance of common stock 13 - 3 - - 3
---------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003 3,311 3 12,316 (8,996) (32) 3,291
Net loss - - - (1,424) - (1,424)
Amortization of pension liability
adjustment - - - - 8 8
-------
Comprehensive loss - - - - - (1,416)
Issuance of common stock 11 - 4 - - 4
---------------------------------------------------------------------------------------------------------------
Balance at December 31, 2004 3,322 $3 $12,320 $(10,420) $(24) $ 1,879
===============================================================================================================
See accompanying notes to consolidated financial statements.
25
FARMSTEAD TELEPHONE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2004, 2003 and 2002
(In thousands) 2004 2003 2002
---------------------------------------------------------------------------------------------------
Operating Activities:
Net loss $(1,424) $(709) $(2,530)
Adjustments to reconcile net loss to net cash flows
used in operating activities:
Provision for (reversal of) doubtful accounts receivable 18 75 (33)
Provision for losses on inventories 106 28 143
Depreciation and amortization 123 164 215
Decrease in accumulated other comprehensive loss 8 - -
Provision for impairment of goodwill - - 101
Deferred income taxes - - 455
Value of compensatory stock options issued - - 15
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable (63) 386 1,297
Decrease in inventories 236 312 1,975
Decrease (increase) in other assets 14 (467) 36
(Decrease) increase in accounts payable (240) 137 (1,683)
Increase (decrease) in accrued expenses and other liabilities 185 (13) (95)
---------------------------------------------------------------------------------------------------
Net cash used in operating activities (1,037) (87) (104)
---------------------------------------------------------------------------------------------------
Investing Activities:
Purchases of property and equipment (29) (83) (104)
Acquisition of InfiNet - - (153)
---------------------------------------------------------------------------------------------------
Net cash used in investing activities (29) (83) (257)
---------------------------------------------------------------------------------------------------
Financing Activities:
Borrowing under revolving credit line 179 - -
Borrowing against cash value of insurance policy 275 - -
Repayment of long-term debt (2) - -
Proceeds from issuance of common stock 4 3 13
Repayments of capital lease obligation - - (37)
Capital distribution to minority interest partner - - (100)
---------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 456 3 (124)
---------------------------------------------------------------------------------------------------
Net decrease in cash and cash equivalents (610) (167) (485)
Cash and cash equivalents at beginning of year 827 994 1,479
---------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 217 $ 827 $ 994
===================================================================================================
Supplemental disclosures of cash flow information:
Cash paid during the year for: Interest $ 26 $ 26 $ 25
Income taxes 5 5 16
Non-cash financing and investing activities:
Acquisition of vehicle for debt 49 - -
Increase in accrued benefit obligation recorded in
Stockholders' equity - 32 -
See accompanying notes to consolidated financial statements.
26
FARMSTEAD TELEPHONE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business Operations
Farmstead Telephone Group, Inc. ("Farmstead" or the "Company") is
principally engaged as a provider of new and used Avaya, Inc. ("Avaya")
business telecommunications parts and complete systems. Its products are
primarily customer premises-based private switching systems and peripheral
products, including voice processing systems. The Company also provides
telecommunications equipment installation, repair and refurbishing, short-
term rental, inventory management, and related value-added services. The
Company sells its products and services to large and mid-size, multi-
location businesses as well as to small businesses, government agencies,
and other equipment resellers. During the years ended December 31, 2004,
2003 and 2002, no single customer accounted for more than 10% of revenues.
Business Reorganization Activities
During the third and fourth quarters of 2004, the Company engaged the
services of two independent business consultants to evaluate the Company's
current business model and operating performance, and assist in developing
and implementing a strategic redirection. Effective October 1, 2004, the
Company hired the first of these individuals as its new President and Chief
Executive Officer. On January 15, 2005, the Company hired the second
consultant as an Executive Vice President, responsible for sales
operations.
In the fourth quarter of 2004 the Company began implementing a
strategic redirection, which is principally based upon building a larger
and more highly qualified sales force, and diversifying the Company's
product offerings and targeted customers. The business strategy is to
transition to a full communications solutions provider, becoming less
dependent on parts sales, and developing more sources of recurring
revenues, such as through installation and maintenance services. The
Company plans to expand its product offerings beyond traditional voice
communications products by offering Internet Protocol, or IP, telephony
products and unified communications products including voice messaging, and
it plans to expand its customer base and revenues by targeting the small to
medium-sized (under 200 employees) business market ("SMB") The Company
believes that this is the fastest growing segment of the telecommunications
systems business. On March 1, 2005 the Company launched a nationwide SMB
program that is targeting this customer base and, in March 2005 hired an
additional 23 experienced sales professionals that have been deployed in 12
states and 22 cities nationally. The Company intends to hire additional
sales professionals during 2005 to meet its 2005 SMB revenue expectations.
Principles of Consolidation
The consolidated financial statements presented herein consist of the
accounts of Farmstead Telephone Group, Inc. and its wholly-owned
subsidiaries, FTG Venture Corporation (inactive) and InfiNet Systems, LLC
(inactive). All intercompany balances and transactions have been
eliminated.
Use of Estimates
The preparation of consolidated financial statements in conformity
with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, revenues and expenses and
related disclosures in the consolidated financial statements. Actual
results could differ from those estimates. Estimates are used in accounting
for the allowances for uncollectible receivables, inventory obsolescence,
depreciation, taxes and contingencies, among others. Estimates are also
used in determining product sales returns, which are reflected as
reductions to revenues. Estimates and assumptions are reviewed periodically
and the effects of revisions are reflected in the consolidated financial
statements in the period they are determined to be necessary.
Revenue Recognition
The Company records revenues from the sale of equipment (including
parts, complete systems and system upgrades), the sale of installation
services (in connection with the sale of systems, as well as on a time-and-
materials basis), the sale of Avaya maintenance contracts, and the
provision of other value-added services such as the provision of short-term
equipment rentals and the repair of customer-owned equipment. In general,
revenue from sales of equipment is recognized when persuasive evidence of
an agreement exists, shipment has occurred (FOB shipping point), the sales
price is fixed and determinable, and collection of the resulting receivable
is probable. The Company typically sells systems or system upgrades under
single contracts to provide the equipment and the
27
installation service (although customers may choose to provide their own
installation). These contracts separately price the installation and any
associated professional services based on the current market value for
such services. The Company outsources installation services to third
party vendors under subcontract arrangements which include project bids.
The Company recognizes revenue on the sale of systems and system upgrades
using the guidelines contained in Emerging Issues Task Force ("EITF") Issue
No. 00-21 "Revenue Arrangements with Multiple Deliverables" ("EITF 00-21").
EITF 00-21 addresses accounting methodologies for a vendor in arrangements
with multiple revenue-generating elements, such as those including products
with installation requirements. Under EITF 00-21, revenue is recognized for
each element of the transaction based on its relative fair value. The
revenue associated with each delivered element should be recognized
separately provided (i) it has stand-alone value; (ii) there is objective
and reliable evidence of the fair value of each element; (iii) delivery of
the undelivered element is probable and substantially controlled by the
vendor, and performance of the undelivered element is not essential to the
functionality of the delivered element. Under these guidelines, the Company
recognizes revenue on equipment sales upon shipment of the equipment and
installation sales revenues upon completion of the installation of the
equipment.
The Company recognizes commission revenues from sales of Avaya
maintenance contracts upon customer execution of the contract. Once the
contract is executed, the Company receives a one-time commission, and all
future service obligations are borne entirely by Avaya. Revenues from
short-term equipment rentals are recognized ratably over the term of the
rental agreement. Revenues from the provision of customer equipment repair
services, and on other provided services, are recognized upon completion of
the service. Reductions to revenues are recorded for estimated product
returns, based on historical experience.
Accounting for Manufacturer Incentives
The Company receives various forms of incentive payments, rebates,
and negotiated price discounts from Avaya and its designated master
distributors. Rebates and negotiated price discounts directly related to
specific customer sales are recorded as a reduction in the cost of goods
sold on those product sales. Rebates that are based on purchasing certain
product lines exclusively from one manufacturer ("loyalty rebates") are
also recorded as a reduction in cost of goods sold when the products are
purchased. Incentive payments designed to offset marketing expenses and
certain growth initiatives supported by Avaya are recorded as a contra
expense to the related expenditure. All incentive payments are recorded
when earned under the specific rules of the incentive plan.
Shipping and Handling Fees
In accordance with Emerging Issues Task Force Issue 00-10,
"Accounting for Shipping and Handling Fees and Costs," freight billed to
customers is included in net sales and service revenues in the consolidated
statements of operations, while freight billed by vendors is included in
cost of sales in the consolidated statements of operations.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an
initial maturity of three months or less to be cash equivalents.
Inventories
Inventories are stated at the lower of cost or market, and are valued
on an average cost basis. The Company periodically assesses the valuation
of inventory and will adjust the value for estimated excess and obsolete
inventory based upon assumptions about current and future demand and market
conditions.
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the
related assets, which range from three to ten years, except for leasehold
improvements, which are amortized over the shorter of the estimated useful
life or the remaining lease term. Maintenance, repairs and minor renewals
are charged to operations as incurred. When assets are retired or sold, the
cost of the assets and the associated accumulated depreciation is removed
from the accounts and any resulting gain or loss is recorded that period.
Stock Compensation Plans
The Company accounts for stock option and warrant awards granted to
officers, directors and employees (collectively "employees") under the
recognition and measurement principles of Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25").
Under APB 25, no stock-based employee compensation cost is reflected in net
income, as all options granted to employees under these plans have
28
been granted at no less than fair market value on the date of grant. The
Company applies the disclosure only provisions of Financial Accounting
Standards Board Statement ("SFAS") No. 123, "Accounting for Stock-based
Compensation" ("SFAS 123") and SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure" ("SFAS 148") for such employee
stock option awards. The Company accounts for stock option awards granted
to consultants under the fair value recognition provisions of SFAS 123.
Under this method, options are valued using the Black-Scholes option
pricing method, and the calculated option value is recorded as an expense
in the financial statements. Had compensation cost for the Company's stock
option and warrant awards been determined in accordance with the fair
value-based method prescribed under SFAS 123, the Company's net loss and
basic and diluted net loss per share would have approximated the pro forma
amounts indicated below (dollars in thousands except per share amounts):
Year ended December 31,
-------------------------------
2004 2003 2002
-------------------------------------------------------------------------------------
Net loss, as reported $(1,424) $(709) $(2,530)
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (149) (78) (178)
-------------------------------------------------------------------------------------
Pro forma net loss $(1,573) $(787) $(2,708)
=====================================================================================
Loss per share:
As reported $ (.43) $(.21) $ (.77)
Pro forma $ (.47) $(.24) $ (.82)
=====================================================================================
The weighted-average fair value of options and warrants granted
during 2004, 2003 and 2002 was $.15, $.27, and $.62, respectively. The fair
value of stock options and warrants used to compute pro forma net loss and
net loss per share disclosures was estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:
2004 2003 2002
---- ---- ----
Dividend yield 0% 0% 0%
Average risk-free rate 3.1 - 3.3% 2.93% 3.68%
Expected volatility 50% 108% 113%
Expected option holding period (yrs.) 3.0 - 3.5 4.7 5.6
Income Taxes
The Company provides for income taxes under the asset and liability
method, under which deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax basis. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that includes the enactment
date. Deferred tax assets are reduced by a valuation allowance if it is
probable that a benefit will not be realized in the future.
Net Loss per Common Share
Basic net loss per common share is computed by dividing net loss (the
numerator) by the weighted average number of common shares outstanding (the
denominator) during the period. Diluted net loss per common share is
computed by increasing the denominator by the weighted average number of
additional shares that could have been outstanding from securities
convertible into common stock, such as stock options and warrants, unless
their effect on net loss per share is antidilutive. The following table
shows securities outstanding as of December 31 that could potentially
dilute basic earnings or loss per common share in the future that were not
included in the current computation of diluted loss per common share
because to do so would have been antidilutive.
(In thousands) 2004 2003 2002
-------------------------------------------
Stock Options 2,388 1,871 1,852
Warrants 400 - -
29
Segment Information
In the opinion of management, the Company operates in one industry
segment, which is the sale of telecommunications equipment.
Fair Value of Financial Instruments
The carrying amounts of Farmstead's financial instruments, including
cash and cash equivalents, accounts receivable, debt obligations, accounts
payable and accrued expenses, approximate fair value due to their short
maturities.
Reclassifications
Certain amounts in prior years' financial statements and related
notes have been reclassified to conform to the 2004 presentation.
2. CASH AND CASH EQUIVALENTS
Cash and cash equivalents totaled $217,126 and $826,764 at December
31, 2004 and 2003, respectively. Included in each period are investments in
a money market fund consisting of high quality short term instruments,
principally U.S. Government and Agency issues and commercial paper.
3. ACCOUNTS RECEIVABLE, NET
As of December 31, the components of accounts receivable were as
follows (in thousands):
2004 2003
-----------------------------------------------------------
Trade accounts receivable $1,379 $1,410
Less: allowance for doubtful accounts (60) (80)
-----------------------------------------------------------
Trade accounts receivable, net 1,319 1,330
Other receivables 134 78
-----------------------------------------------------------
Accounts receivable, net $1,453 $1,408
===========================================================
Other receivables consist of commissions, rebates and other dealer
incentives due from Avaya, Inc. Refer to Note 1, Accounting for
Manufacturer Incentives.
4. INVENTORIES, NET
As of December 31, the components of inventories were as follows (in
thousands):
2004 2003
------------------------------------------------------------------------
Finished goods and spare parts $1,341 $1,817
Work in process 352 450
Rental equipment 52 61
------------------------------------------------------------------------
1,745 2,328
Less: reserves for excess and obsolete inventories (118) (359)
------------------------------------------------------------------------
Inventories, net $1,627 $1,969
========================================================================
Work in process inventories consists of used equipment requiring
repair or refurbishing.
5. PROPERTY AND EQUIPMENT, NET
As of December 31, the components of property and equipment, net were
as follows (in thousands):
30
Estimated
Useful Lives (Yrs.) 2004 2003
-----------------------------------------------------------------------------------------------
Computer and office equipment 3 - 5 $ 1,071 $ 1,174
Furniture and fixtures 5 - 10 288 290
Leasehold improvements 10 171 190
Capitalized software development costs 5 98 92
Automobile 5 50 -
-----------------------------------------------------------------------------------------------
1,678 1,746
Less: accumulated depreciation and amortization (1,410) (1,433)
-----------------------------------------------------------------------------------------------
Property and equipment, net $ 268 $ 313
===============================================================================================
The Company has capitalized software development costs incurred by
subcontract programmers in the development of on-line product catalogs and
ordering processes. Depreciation and amortization expense was $123,306,
$164,009, and $215,294 for the years ended December 31, 2004, 2003, and
2002, respectively.
6. DEBT OBLIGATIONS
Debt obligations consisted of the following as of December 31 (in
thousands):
2004 2003
-------------------------------------------------
Revolving credit facility note $ 179 $ -
Installment purchase note 47 -
------------------------------------------------
226 -
Less: current maturities (187) -
------------------------------------------------
Notes payable $ 39 $ -
================================================
Revolving Credit Facility Note:
-------------------------------
On February 19, 2003 the Company entered into a one-year, $1.5
million revolving loan agreement (the "BACC Agreement") with Business
Alliance Capital Corporation ("BACC"). On February 19, 2004, the BACC
Agreement was extended for an additional one-year term with an increase in
the advance limit to $1.7 million. On February 19, 2005, the BACC Agreement
was again extended for an additional one-year term. On March 31, 2005, the
BACC facility was terminated, and the Company incurred a $68,000 early
termination fee. The BACC facility was replaced with a $3 million credit
facility with Laurus Master Fund, Ltd., as further described in Note 16,
"Subsequent Events". As of December 31, 2004, there was $179,812 of
borrowings under the BACC credit facility, and based upon borrowing
formulas, the Company had $412,000 in remaining borrowing availability. The
average and highest amounts borrowed during the year ended December 31,
2004 were approximately $179,000 and $423,000, respectively.
Installment Purchase Note:
--------------------------
The Company is financing an automobile through a $50,056, 3.75% note
payable to a finance company. The note is payable in 38 monthly
installments of $799, with a final payment of $24,236 on January 7, 2008.
7. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
As of December 31, the components of accrued expenses and other
current liabilities were as follows (in thousands):
2004 2003
----------------------------------------------------------------
Salaries, commissions and benefits $167 $120
Other 75 52
----------------------------------------------------------------
Accrued expenses and other current liabilities $242 $172
================================================================
8. STOCK OPTIONS AND WARRANTS
Stock Options:
--------------
On April 3, 2002, the Board of Directors adopted the Farmstead
Telephone Group, Inc. 2002 Stock Option Plan (the "2002 Plan"), which was
approved by stockholders at the June 13, 2002 Annual Meeting of
Stockholders. The 2002 Plan replaced the 1992 Stock Option Plan that
terminated in May 2002. Options previously granted under
31
the 1992 Plan, of which there are 1,587,119 options outstanding at December
31, 2004, may continue to be exercised in accordance with the terms of the
individual grants. The 2002 Plan permits the granting of options to
employees, directors and consultants of the Company, which shall be either
incentive stock options ("ISOs") as defined under Section 422 of the
Internal Revenue Code, or non-qualified stock options ("NSOs"). ISOs may be
granted at no less than market value at the time of grant, with a maximum
term of ten years except, for a 10% or more stockholder, the exercise price
shall not be less than 110% of market value, with a maximum term of five
years. NSOs may be granted at no less than 50% of market value at the time
of granting, with a maximum term of 10 years. Any option granted pursuant
to this Plan which for any reason fails to qualify as an ISO shall be
deemed to have been granted as an option not qualified under Section 422 of
the Code. The maximum number of shares issuable under the 2002 Plan, which
expires April 3, 2012, is 1,300,000, of which there were 801,000 options
outstanding at December 31, 2004. Options currently granted expire on
various dates through 2014. A summary of stock option transactions for each
of the three years in the period ended December 31, 2004 is as follows:
Weighted
Average
Number Exercise Exercise
of Shares Price Range Price
----------------------------------------------------------------------------
Outstanding at December 31, 2001 1,874,806 $.68 - 11.80 $1.91
Granted 254,500 .29 - 1.50 .79
Exercised - - -
Canceled or expired (277,000) .68 - 2.04 1.53
--------------------------------------------------------------------------
Outstanding at December 31, 2002 1,852,306 .29 - 11.80 1.81
Granted 101,500 .28 - .79 .35
Exercised - - -
Canceled or expired (83,100) .28 - 11.80 1.78
--------------------------------------------------------------------------
Outstanding at December 31, 2003 1,870,706 $.28 - 7.30 $1.73
Granted 656,000 .34 - .76 .41
Exercised - - -
Canceled or expired (138,587) .28 - 7.30 1.86
--------------------------------------------------------------------------
Outstanding at December 31, 2004 2,388,119 $.28 - 2.50 $1.36
==========================================================================
As of December 31, 2004:
Exercisable 1,696,869 $.28 - 2.50 $1.75
Available for future grant 499,000
The following summarizes information about stock options outstanding
and exercisable as of December 31, 2004:
Options Outstanding Options Exercisable
--------------------------------------------------------- ------------------------------
Weighted Avg.
Range of Number Remaining Weighted Avg. Number Weighted Avg.
Exercise Prices Outstanding Contractual Life (Yrs) Exercise Price Exercisable Exercise Price
--------------- ----------- ---------------------- -------------- ----------- --------------
$ .00 - 0.50 715,500 9.5 $ .39 74,000 $ .40
$0.51 - 1.00 144,500 7.6 .78 99,750 .79
$1.01 - 1.50 207,150 4.0 1.32 206,650 1.32
$1.51 - 2.00 1,310,469 3.0 1.96 1,305,969 1.96
$2.01 - 2.50 10,500 4.0 2.32 10,500 2.32
----------------------------------------------------------------------------------------------------------------
Total 2,388,119 5.3 $1.36 1,696,869 $1.75
================================================================================================================
Warrants:
---------
On October 1, 2004, the Company's new Chief Executive Officer was
issued a Warrant to purchase up to Four Hundred Thousand (400,000) shares
of common stock at fair market value. The Warrant is currently exercisable
and expires five years from the date of grant. The underlying common stock
is unregistered as of December 31, 2004.
9. INFINET SYSTEMS, LLC
Effective February 1, 2001, the Company entered into a joint venture
agreement with TriNet Business Trust ("TriNET"), forming a limited
liability corporation operating under the name of InfiNet Systems, LLC
("InfiNet").
32
Under the agreement, the Company had a 50.1% ownership interest, and TriNET
had a 49.9% ownership interest. With operations based in East Hartford, CT,
InfiNet became an Avaya dealer, authorized to sell new Avaya
telecommunications systems primarily to customers within the State of
Connecticut and various counties in the State of New York. Effective
January 1, 2002, the Company acquired TriNET's 49.9% ownership interest in
InfiNet for an aggregate cash purchase price of $153,334. The $100,512
excess of the purchase price over the fair value of the net assets acquired
was initially allocated to goodwill, in accordance with SFAS 142. Due to
the downsizing of InfiNet's operating activities during 2002, which
included the reduction of its entire workforce and a business decision to
fulfill systems sales orders directly through Farmstead, the entire
$100,512 balance of goodwill was written off as an operating expense in
December 2002.
10. LEASES AND OTHER COMMITMENTS AND CONTINGENCIES
Lease Agreements. On March 23, 2004, the Company entered into a new
lease agreement on its corporate offices and distribution center located at
22 Prestige Park Circle, East Hartford, CT. This agreement replaced the
Company's existing lease due to expire in December 2004. Under the new
lease agreement, which became effective May 1, 2004, the Company is leasing
25,051 square feet for a term expiring December 31, 2014. The lease
contains one five-year renewal option. The lease also allows the Company
the one-time option to terminate the lease without penalty on December 31,
2009. Minimum monthly rent is $11,377 for 2004, $13,047 for years 2005 -
2009, and $13,569 for years 2010 - 2014. The Company is additionally
obligated to pay the lessor its proportionate share of the property
operating costs at an amount equal to $1.20 per square foot, subject to a
2% annual increase.
On March 31, 2004, the Company terminated, without penalty, its lease
agreement on 15,137 square feet of warehouse space that was scheduled to
expire December 31, 2004. The lease termination was effective April 1,
2004. The Company also leases approximately 1,700 square feet of office
space in New York, NY under a non-cancelable lease expiring May 31, 2007.
The Company additionally leases a house for the benefit of its Chief
Executive officer at a rental payment of $5,000 per month expiring October
2005.
As of December 31, 2004, aggregate future minimum annual rental
payments under the initial terms of the leases were as follows: $259,966
for 2005, $216,611 for 2006, $181,770 for 2007, and $156,569 for 2008 and
2009. Rent expense was $254,581 in 2004, $313,692 in 2003, and $285,946 in
2002.
Employment Agreements: On October 1, 2004, the Company entered into
an employment agreement, expiring December 31, 2009, (the "Agreement") with
Mr. Jean-Marc Stiegemeier (the "Executive") in connection with his
appointment as President and Chief Executive Officer of the Company through
December 31, 2009. Executive succeeded Mr. George J. Taylor, Jr. who
continues to serve the Company as Chairman of the Board of Directors. The
Agreement includes the following key provisions: (i) an annual base salary
of $300,000, which may be increased by the Board in its discretion or
decreased by the Board under certain defined circumstances; (ii) a one-time
special bonus of $37,500, $25,000 of which was paid October 1, 2004, with
the balance paid in January 2005; (iii) an annual bonus of up to 100% of
Executive's base salary based upon the attainment of a Board-approved
earnings target for that year; and (iv) as an incentive to reduce the
Company's "acquisition" costs, Executive would receive an "acquisition
incentive bonus" equal to one percent (1%) of the Purchase Price, as
defined in the Agreement) for each acquisition that is concluded during the
term of this Agreement without any obligation by the Company to pay any
fees, commissions or any other cash or equity-based compensation to any
third party(ies) for or in connection with (a) the identification of the
entity that is the subject of the acquisition; (b) the valuation of the
acquisition or (c) the negotiation of the purchase price and other key
business terms of the acquisition with the selling party or its
representatives. Concurrent with the effective date of the Agreement,
Executive was issued a Warrant to purchase up to Four Hundred Thousand
(400,000) shares of common stock at fair market value. The Warrant was
exercisable immediately and expires five years from the date of grant. The
underlying common stock is currently unregistered. The Executive was also
granted an option to purchase up to Six Hundred Thousand (600,000) shares
of common stock under the 2002 Stock Option Plan at an exercise price equal
to the fair market value of the common stock. Three Hundred Thousand
(300,000) shares are exercisable one year after the grant date, with the
remainder exercisable two years after the grant date. The options expire
ten years after the grant date.
The Agreement also provides severance pay for the Executive during
the term of the Agreement under certain circumstances. Should the Company
terminate the agreement without "cause", or if the Executive terminates the
Agreement "for good reason", or in the event the Executive resigns after a
"change in control", as all are defined in the Agreement, then severance
pay will equal three times the "Executive Compensation Amount" as defined.
The Executive will not, however, be entitled to any severance or other
compensation if he voluntarily terminates his
33
employment or if the Company terminates the Agreement "for cause", as
defined. From August 16, 2004 to October 1, 2004, the Executive provided
business consulting services to the Company for which the Executive earned
$50,000 in fees.
The Company has an employment agreement with Mr. Taylor, Jr. (the
"Chairman") dated January 1, 1998 and as amended at various times between
August 1, 2001 and October 1, 2004. The current agreement contains an
employment term expiring December 31, 2007. The agreement also contains the
following major provisions: (i) a base salary of $200,000 for 2005,
increasing to $250,000 in 2006 and $300,000 in 2007; (ii) an annual bonus
of up to 100% of the Chairman's base salary based upon the attainment of a
Board-approved earnings target for that year; and (iii an "acquisition
incentive bonus" as described above for Executive. The Chairman's agreement
provides severance pay should he terminate the Agreement for "good cause",
as defined, or should the Company terminate his agreement without cause, or
in the event of a change in control of the Company, as defined. Severance
pay would amount to three times (i) the amount of the then-current base pay
(deemed to be $300,000 for purposes of severance pay calculations), plus
(ii) the average bonus paid during the three most recent calendar years.
The Chairman will not be entitled to any severance or other compensation if
he voluntarily terminates his employment or if the Company terminates the
Agreement "for cause", as defined.
Letter of Credit: In connection with the Company's revolving credit
agreement with BACC, the Company issued a $300,000 irrevocable standby
letter of credit ("LC") in favor of BACC. The LC can be drawn upon by BACC
to satisfy any outstanding obligations under the Company's loan agreement
ninety days after an event of default. The LC is secured by cash, and
since this cash is restricted from use by the Company during the term of
the LC, it has been classified under other current assets in the
consolidated balance sheet at December 31, 2004 and 2003.
11. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 123 (Revised 2004),
"Share-Based Payment," ("SFAS No. 123 (revised 2004)"), revising FASB
Statement 123, "Accounting for Stock-Based Compensation" and superseding
APB Opinion No. 25, "Accounting for Stock Issued to Employees". This
Statement establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services,
focusing primarily on transactions in which an entity obtains employee
services in share-based payment transactions. SFAS No. 123 (Revised 2004)
requires a public entity to measure the cost of employee services received
in exchange for an award of equity instruments based on the grant-date fair
value of the award (with limited exceptions). That cost will be recognized
over the period during which an employee is required to provide service in
exchange for the award. Accounting for share-based compensation
transactions using the intrinsic method supplemented by pro forma
disclosures will no longer be permissible. This statement is effective as
of the beginning of the first interim or annual reporting period that
begins after June 15, 2005 and the Company will adopt the standard in the
third quarter of fiscal 2005. The adoption of this standard will have an
impact on the Company's results of operations as it will be required to
expense the fair value of all share based payment; however the Company has
not yet determined whether or not this impact will be significant.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an
amendment of ARB No. 43, Chapter 4," which clarifies the types of costs
that should be expensed rather than capitalized as inventory. This
statement also clarifies the circumstances under which fixed overhead costs
associated with operating facilities involved in inventory processing
should be capitalized. The provisions of SFAS No. 151 are effective for
fiscal years beginning after June 15, 2005 and the Company will adopt this
standard in its third quarter of fiscal 2005. The Company has not
determined the impact, if any, that this statement will have on its
consolidated financial position or results of operations.
12. EMPLOYEE BENEFIT PLANS
Supplemental Executive Retirement Plan. The Company maintains a
Supplemental Executive Retirement Plan ("SERP") for the benefit of Mr.
Taylor, Jr., structured to provide him with an annual retirement benefit of
$100,000 per year, payable over 15 years beginning at age 65. In 2003, the
Company recognized expense using a 7% discount rate, which it lowered to
6.25% at year-end. For 2004, the Company utilized a 6.25% discount rate for
both expense and disclosure purposes. The amount of the unrecognized
actuarial loss of $23,929 at December 31, 2004
34
and $31,906 at December 31, 2003 has been recorded in Accumulated Other
Comprehensive Loss as a component of Stockholders' Equity.
The components of the net periodic benefit cost included in the
results of operations for the three years ended December 31, 2004 are set
forth as follows (in thousands):
2004 2003 2002
---------------------------------------------------------
Service cost $ 80 $69 $65
Interest cost 35 29 23
Amortization of actuarial loss 8 - -
---------------------------------------------------------
Net expense $123 $98 $88
=========================================================
The following information summarizes activity in the SERP for the two
years ended December 31, 2004 (in thousands):
2004 2003
--------------------------------------------------------------------------------
Changes in Accumulated Benefit Obligation:
Accumulated Benefit obligation at beginning of year $ 478 $ 348
Service cost 80 69
Interest cost 35 29
Actuarial loss - 32
--------------------------------------------------------------------------------
Accumulated Benefit obligation at end of year $ 593 $ 478
================================================================================
Fair Value of Plan Assets $ - $ -
================================================================================
Reconciliation of Funded Status:
Funded status $(593) $(478)
Unrecognized actuarial loss 24 32
--------------------------------------------------------------------------------
Accrued net periodic pension cost $(569) $(446)
================================================================================
Amounts Recognized in the Consolidated Balance Sheets:
Accrued accumulated benefit obligation $(593) $(478)
Accumulated other comprehensive loss 24 32
--------------------------------------------------------------------------------
Net liability reflected in the consolidated balance sheets $(569) $(446)
================================================================================
The benefits expected to be paid under the SERP in each of the next
five fiscal years, and in the aggregate for the five fiscal years
thereafter are as follows: $0 (2005 - 2006), $100,000 (2007), $100,000
(2008), $100,000 (2009) and $500,000 (2010 - 2014).
Employee Stock Purchase Plan ("ESPP"). In September 2001, the Company
established an ESPP, following stockholder approval, under which an initial
250,000 shares of common stock could be sold to employees. The shares
issuable pursuant to the ESPP were registered on Form S-8 (No. 333-69290)
dated September 11, 2001. Beginning in 2003, an annual increase of the
lesser of (i) 100,000 shares of common stock, (ii) 2% of the Company's
issued and outstanding capital stock on January 1 of such year, and (iii)
an amount determined by the Company's board of directors, can be added to
the ESPP. No shares have since been added to the ESPP. The ESPP covers all
employees working more than 20 hours per week, excluding employees owning
5% or more of the combined voting power of all classes of shares of the
Company or its subsidiary corporations. The ESPP provides for six-month
"offering periods" beginning September 14, 2001, with a final offering
period beginning March 1, 2011, and during such periods employees can
participate through payroll deductions of up to 10% of their earnings. At
the end of each offering period, participating employees are able to
purchase stock at a 15% discount to the market price of Company stock at
either the beginning or end of the offering period, whichever is lower.
Shares purchased through the ESPP cannot exceed $25,000 in fair market
value per person per calendar year. The shares purchased are allocated to
an account established for each participant at a brokerage firm. During the
two years ended December 31, 2004, the Company issued 10,581, and 12,643
shares, respectively, of Common Stock.
35
401(K) Plan. The Company offers its employees a 401(K) plan, pursuant
to which it may make discretionary contributions. The Company made no
contributions in 2004, and contributed $5,300 in 2003.
13. INCOME TAXES
The following table provides a summary of the current and deferred
components of the provision for federal and state income taxes attributable
to earnings before income taxes for the three years ended December 31 (in
thousands):
2004 2003 2002
------------------------------------------------------
Federal income tax expense:
Current $ - $ - $ -
Deferred - - 436
State income tax expense:
Current - 13 18
Deferred - - 19
------------------------------------------------------
Provision for income taxes $ - $13 $473
======================================================
Differences between the tax expense reflected in the consolidated
financial statements and the amounts calculated at the federal statutory
income tax rate of 34% for the three years ended December 31 are as follows
(in thousands):
2004 2003 2002
--------------------------------------------------------------------------------
Income tax benefit at statutory rate $(484) $(237) $ (699)
Increase (reduction) in income taxes
resulting from:
State and local income taxes, net of federal
income tax benefit - (9) (12)
Non-deductible life insurance 9 (8) 30
Non-deductible meals and entertainment 8 7 17
Change in valuation allowance, net of temporary
differences for which benefit has not been
provided 467 260 1,137
--------------------------------------------------------------------------------
Provision for income taxes $ - $ 13 $ 473
================================================================================
The tax effects of temporary differences that give rise to
significant portions of deferred tax assets and liabilities at December 31,
2004 and 2003 are as follows (in thousands):
2004 2003
------------------------------------------------------------------
Deferred tax assets:
Allowance for doubtful accounts $ 20 $ 27
Inventory allowances 38 122
Accrued retirement obligation 193 152
Property and equipment 19 34
Other 16 20
Net operating loss and other carryforwards 2,830 2,192
------------------------------------------------------------------
Total gross deferred tax assets 3,116 2,547
Less: valuation allowance (3,116) (2,547)
------------------------------------------------------------------
Net deferred tax assets $ - $ -
==================================================================
The Company has federal net operating loss carryforwards of
approximately $7,028,000 that expire through 2025. In 2004 and 2003, the
valuation allowance was increased by an amount that fully offset the
Company's deferred tax assets as of December 31, 2004 and 2003,
respectively. Management believes that the present valuation allowance is
prudent due to the net losses sustained during the three years ended
December 31, 2004 and the unpredictability of future earnings.
36
14. STOCKHOLDERS' EQUITY
On May 7, 2004 the Company received notice from the American Stock
Exchange (the "Amex" or the "Exchange") that it did not meet certain of the
Exchange's continued listing standards as a result of having stockholders'
equity less than $4 million and net losses in three out of its four most
recent fiscal years, as set forth in Section 1003 (a) (ii) of the Amex
Company Guide. The Company was afforded the opportunity to submit a plan of
compliance to the Exchange and on June 15, 2004 presented its plan to the
Exchange. On July 19, 2004 the Exchange notified the Company that it
accepted its plan of compliance and granted the Company an extension of
time to regain compliance with the continued listing standards. The Company
will be subject to periodic review by Exchange Staff during the extension
period which expires November 7, 2005. Failure to make progress consistent
with the plan or to regain compliance with the continued listing standards
by the end of the extension period could result in the Company being
delisted from the American Stock Exchange.
15. CONCENTRATIONS OF CREDIT RISK
The principal financial instruments subject to credit risk are as
follows:
Accounts Receivable. The Company extends credit to its customers in
the normal course of business. As of December 31, 2004, one customer
accounted for 17% of accounts receivable. As of December 31, 2003, two
customers accounted for 15% and 10% of accounts receivable. Although the
Company is subject to changes in economic conditions which may impact its
overall credit risk, the Company sells to a wide variety of customers, and
does not focus on any particular industry sector. The Company establishes
its allowance for doubtful accounts based upon factors surrounding the
credit risk of specific customers, historical trends and experience, and
other information available to it. Management considers the Company's
credit risk to be satisfactorily diversified and believes that its
allowance for doubtful accounts is adequate to absorb estimated losses as
of December 31, 2004. During the three years ended December 31, 2004, no
single customer accounted for more than 10% of revenues.
Cash and Cash Equivalents. The Company maintains cash and cash
equivalents with various financial institutions. Cash equivalents consist
of investments in money market funds consisting of high quality short term
instruments, principally U.S. Government and Agency issues and commercial
paper, and the fair value approximates the carrying value at each reporting
period. At times such amounts may exceed insurance limits.
16. SUBSEQUENT EVENTS
On March 31, 2005, the Company entered into a financing transaction
with Laurus Master Fund, Ltd., ("Laurus"), providing for a three-year, $3
million ("Capital Availability Amount") revolving loan credit facility.
Pursuant to this transaction, the Company issued a Secured Convertible
Minimum Borrowing Note (the "Note") in the aggregate principal amount of
$500,000 and a Secured Revolving Note (the "Revolving Note") in the
aggregate principal amount of $2,500,000. Amounts outstanding under the
Note and the Revolving Note will either be paid in cash at their March 31,
2008 maturity date or, at Laurus' option, by converting such amounts into
shares of the Company's common stock from time to time. The Company also
issued Laurus a five-year warrant (the "Warrant") to purchase an aggregate
of 500,000 shares of common stock of the Company at an exercise price of
$1.82 per share. The warrant exercise price was set at 130% of the average
closing price of the Company's common stock over the ten trading days
preceding the execution of the agreement, and is subject to anti-dilution
protection adjustments. This transaction was completed in a private
offering pursuant to an exemption from registration under Section
4(2) of the Securities Act of 1933, as amended. This new credit facility
replaces the $1.7 million revolving credit facility the Company had with
Business Alliance Capital Corporation
The following describes certain of the material terms of the
financing transaction with Laurus. The description below is not a complete
description of the material terms of the financing transaction and is
qualified in its entirety by reference to the agreements entered into in
connection with the financing which are included as exhibits to this Annual
Report on Form 10-K:
Principal Borrowing Terms and Prepayment: Borrowings are advanced pursuant
to a formula consisting of (i) 90% of eligible accounts receivable, as
defined (primarily receivables that are less than 90 days old), and (ii)
30% of eligible inventory, as defined (primarily inventory classified as
"finished goods"), up to a maximum inventory advance of $600,000, less any
reserves required by Laurus. Interest on the outstanding borrowings is
charged at the per annum rate of two percentage points (2%) above the prime
rate, but not less than 6%. The interest rate charged,
37
however, will be decreased by 2% (or 200 basis points) for every 25%
increase in the market price of the Company's common stock above the fixed
conversion price, down to a minimum interest charge of 0.0%. The Company
will additionally be charged a fee equal to 0.25% of the unused portion of
the facility. Should the Company terminate the financing agreement with
Laurus prior to the maturity date, the Company will incur an early payment
fee equal to 4%, 3% and 2% of the Capital Availability Amount if terminated
in the first, second or third year, respectively, of the term.
Security and Events of Default. Borrowings under the Note and the Revolving
Note are secured by a lien on substantially all of the Company's assets.
The Security Agreement contains no specific financial covenants; however,
it defines certain circumstances under which the agreement can be declared
in default and subject to termination, including among others if (i) there
is a material adverse change in the Company's business or financial
condition; (ii) an insolvency proceeding is commenced; (iii) the Company
defaults on any of its material agreements with third parties or there are
material liens or attachments levied against the Company's assets; (iv) the
Company's common stock ceases to be publicly traded; and (v) the Company
fails to comply with the terms, representations and conditions of the
agreement. Upon the occurrence of an Event of Default, the interest rate
charged will be increased by 1-1/2 % per month until the default is cured;
should the default continue beyond any applicable grace period, Laurus
could require the Company to repay 120% of any principal and interest
outstanding under the agreement.
Conversion Rights. All or a portion of the outstanding principal and
interest due under the Note and the Revolving Note may be converted, at the
option of the Holder, into shares of the Company's common stock, subject to
certain limitations as defined in the Note and the Revolving Note, if the
market price of the common stock is 15% above the Fixed Conversion Price of
$1.54 per share for five consecutive trading days in any month. The fixed
conversion price was originally set at 110% of the average closing price of
the Company's common stock over the ten trading days preceding the
execution of the agreement, and is subject to anti-dilution protection
adjustments. The fixed conversion price will be reset once $1.5 million of
debt has been converted. Upon receipt of a conversion notice from the
Holder, the Company can elect to pay cash to the Holder in lieu of issuing
shares of common stock, at a price per share equal to the intraday high
price of the stock.
Registration Rights. Pursuant to the terms of a Registration Rights
Agreement, the Company is obligated to file and obtain effectiveness for a
registration statement registering the resale of shares of the Company's
common stock issuable upon conversion of the Note, the Revolving Note and
the exercise of the Warrant. If the registration statement is not timely
filed, or declared effective the Company will be subject to certain
penalties.
17. RELATED PARTY TRANSACTIONS
As described in Note 10, on October 1, 2004, the Company entered into
an employment agreement with Mr. Jean-Marc Stiegemeier in connection with
his appointment as President and Chief Executive Officer of the Company.
From August 16, 2004 to October 1, 2004, he provided business consulting
services to the Company for which he earned $50,000 in fees. During 2002,
PFS Venture Group LLC ("PFS") provided business-consulting services to the
Company. Mr. Bruce S. Phillips, a director of the Company from June 2001
until August 2002, was the principal owner of PFS. During 2002, PFS earned
$51,000 in fees, and Mr. Phillips received 11,250 options to acquire common
stock at exercise prices of $1.00 to $1.50 per share.
18. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized quarterly financial data for 2004 and 2003 is as follows
(in thousands except earnings (loss) per share):
Quarter
-------------------------------------------------------------------------------------------
2004 First Second Third Fourth (a)
-------------------------------------------------------------------------------------------
Revenues $3,406 $2,889 $3,338 $2,711
Gross Profit 877 604 804 608
Operating loss (333) (406) (176) (487)
Net loss (341) (414) (175) (494)
Loss per common share:
Basic and diluted (.10) (.12) (.05) (.16)
Weighted average common shares outstanding:
Basic and diluted 3,313 3,316 3,317 3,322
===========================================================================================
38
Quarter
-------------------------------------------------------------------------------------------
2003 First Second Third Fourth (b)
-------------------------------------------------------------------------------------------
Revenues $4,504 $3,870 $3,295 $3,240
Gross Profit 1,136 975 946 829
Operating loss (139) (119) (134) (283)
Net loss (145) (132) (149) (283)
Loss per common share:
Basic and diluted (.04) (.04) (.05) (.09)
Weighted average common shares outstanding:
Basic and diluted 3,299 3,305 3,306 3,311
===========================================================================================
--------------------
(a) Includes a $26,000 credit to income from a reduction in the Company's
reserves for sales and product returns.
(b) Includes a $93,000 credit to income from a reduction in the Company's
reserves for sales and product returns, and a $41,000 charge to bad
debt expense.
39
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Farmstead Telephone Group, Inc.
We have audited the consolidated financial statements of Farmstead
Telephone Group, Inc. (the "Company") as of December 31, 2004 and 2003, and
for the years ended December 31, 2004, 2003 and 2002, and have issued our
report thereon dated March 18, 2005, except for Notes 6 and 16, to which
the date is March 31, 2005; such consolidated financial statements and
report are included elsewhere in this Form 10-K. Our audit also includes
the financial statement schedule of Farmstead Telephone Group, Inc., listed
in Item 15. This financial statement schedule is the responsibility of the
Company's management. Our responsibility is to express an opinion based on
our audits. In our opinion, such financial statement schedule, when
considered in relation to the basic consolidated financial statements taken
as a whole, presents fairly, in all material respects the information set
forth therein.
/s/ CARLIN, CHARRON & ROSEN, LLP
Glastonbury, Connecticut
March 18, 2005
40
SCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS
(In thousands)
Column C- Additions
-------------------------------
(1) (2)
Column B- Charged Charged Column E-
Balance at (credited) to (credited) to Balance at
beginning of costs and other Column D- End of
Column A- Description period expenses accounts Deductions period
-------------------------------------- ------------ ------------- ------------- ---------- ----------
Year 2004
---------
Allowance for doubtful accounts $ 80 $ 18 - $ 38* $ 60
Inventory valuation reserves 359 106 - 347* 118
Deferred tax asset valuation allowance 2,547 569** - - 3,116
Year 2003
---------
Allowance for doubtful accounts $ 47 $ 75 - $ 42* $ 80
Inventory valuation reserves 562 28 - 231* 359
Deferred tax asset valuation allowance 2,216 331** - - 2,547
Year 2002
---------
Allowance for doubtful accounts $ 150 $ (33) - $ 70* $ 47
Inventory valuation reserves 1,382 143 - 963* 562
Deferred tax asset valuation allowance 1,039 1,177 - - 2,216
--------------------
* Represents write-offs of inventories and uncollectible accounts
receivable.
** Recorded to fully reserve for the increase in the Company's net
deferred tax assets.
41
INDEX TO EXHIBITS
The following documents are filed as Exhibits to this report on Form
10-K or incorporated by reference herein. Any document incorporated by
reference is identified by a parenthetical referencing the SEC filing which
included such document.
3(a) Certificate of Incorporation [Exhibit 3(a) to the S-18
Registration Statement of the Company's securities declared
effective on April 13, 1987 (File No. 3-9556B)]
3(b) Certificate of Amendment of Certificate of Incorporation
[Exhibit 3(a) to Amendment No. 2 to SB-2 Registration
Statement dated July 22, 1996 (Registration No. 333-5103)]
3(c) Certificate of Amendment of Certificate of Incorporation of
Farmstead Telephone Group, Inc., dated July 10, 1991
[Exhibit 10.12 to the Annual Report on Form 10-K for the
year ended December 31, 1991]
3(d) Amended and Restated By-Laws [Exhibit 3(d) to the Annual
Report on Form 10-K for the year ended December 31, 2000]
3(e) Certificate of Amendment of Certificate of Incorporation of
Farmstead Telephone Group, Inc. dated July 9, 2001 [Exhibit
3(e) to the Quarterly Report on Form 10-Q for the quarter
ended June 30, 2001]
4(a) Form of Unit Warrant [ Exhibit 4(a) to the S-18 Registration
Statement of the Company's securities declared effective on
April 13, 1987 (File No. 3-9556B)]
4(b) Amended Form of Underwriter's Option [ Exhibit 4(b) to the
S-18 Registration Statement of the Company's securities
declared effective on April 13, 1987 (File No. 3-9556B)]
4(c) Resolutions adopted by Unanimous Written Consent of the
Company's Board Of Directors dated as of July 9, 1992
amending terms of Warrants and Underwriter's Options
[Exhibit 4(a) to the Form S-3 Registration Statement of the
Company's securities declared effective on October 29, 1992
(Registration No. 33-50432)]
4(d) Amended 1992 Stock Option Plan [Exhibit to the Proxy
Statement on Schedule 14A filed April 14, 1998 (File No.
001-12155)]
4(e) Form of Underwriter's Warrant Agreement (including Form of
Underwriter's Warrant) [Exhibit 4.2 to the SB-2 Registration
Statement dated June 3, 1996 (Registration No. 333-5103)]
4(f) Form of Warrant Certificate [Exhibit 4.1 to Amendment No. 2
to SB-2 Registration Statement dated July 22, 1996
(Registration No. 333-5103)]
4(g) Form of Warrant Agreement [Exhibit 4.3 to Amendment No. 2 to
SB-2 Registration Statement dated July 22, 1996
(Registration No. 333-5103)]
4(h) Form of Unit Certificate [Exhibit 4.4 to Amendment No. 2 to
SB-2 Registration Statement dated July 22, 1996
(Registration No. 333-5103)]
4(i) Resolutions adopted by the Company's Board of Directors June
18, 1998, amending terms of Warrants and Underwriter's
Options [Exhibit 4(I) to the Annual Report on Form 10-KSB
for the year ended December 31, 1998]
4(j) Resolutions adopted by the Company's Board of Directors July
19, 2001, amending terms of warrants and Underwriter's
Options. [Exhibit 4(j) to the Quarterly Report on Form 10-Q
for the quarter ended June 30, 2001]
4(k) Farmstead Telephone Group, Inc. 2002 Stock Option Plan
[Appendix A to the Proxy Statement on Schedule 14A filed
April 19, 2002 for the 2002 Annual Meeting of Stockholders]
4(l) Warrant to Purchase common stock of Farmstead Telephone
Group, Inc. issued to Jean-Marc Stiegemeier October 1, 2004
[Exhibit 4(a) to the Form 8-K Current Report filed October
6, 2004]
4(m) Security Agreement dated March 31, 2005 by and among Laurus
Master Fund, Ltd. and Farmstead Telephone Group, Inc.
[Exhibit 99.1 to the Form 8-K Current Report filed April 5,
2005]
4(n) Secured Revolving Note dated as of March 31, 2005. [Exhibit
99.2 to the Form 8-K Current Report filed April 5, 2005]
4(o) Secured Convertible Minimum Borrowing Note dated as of March
31, 2005 [Exhibit 99.1 to the Form 8-K Current Report filed
April 5, 2005]
4(p) Common Stock Purchase Warrant dated as of March 31, 2005
[Exhibit 99.1 to the Form 8-K Current Report filed April 5,
2005]
4(q) Minimum Borrowing Note Registration Rights Agreement dated
as of March 31, 2005 [Exhibit 99.1 to the Form 8-K Current
Report filed April 5, 2005]
42
10(a) Form of Underwriter's Consulting Agreement [Exhibit 10.1 to
the SB-2 Registration Statement dated June 3, 1996
(Registration No. 333-5103)]
10(b) Letter of Agreement dated June 3, 1996 between Farmstead
Telephone Group, Inc. and Lucent Technologies, Inc. [Exhibit
10.2 to Amendment No. 1 to SB-2 Registration Statement dated
July 22, 1996 (Registration No. 333-5103)]
10(c) Agreement of Lease By and between Tolland Enterprises and
Farmstead Telephone Group, Inc., dated November 5, 1996
[Exhibit 10.1 to the Quarterly Report on Form 10-QSB for the
quarter ended September 30, 1996]
10(d) Employment Agreement dated as of January 1, 1998 between
Farmstead Telephone Group, Inc. and George J. Taylor, Jr.
[Exhibit 10.5 to the Annual Report on Form 10-KSB for the
year ended December 31, 1997]
10(e) Supplemental Executive Retirement Plan, effective as of
January 1, 1998 [Exhibit 10.6 to the Annual Report on Form
10-KSB for the year ended December 31, 1997]
10(f) ARS Dealer Agreement Between Lucent Technologies and
Farmstead Telephone Group, Inc. For Business Communications
Systems [Exhibit 10(s) to the Annual Report on Form 10-KSB
for the year ended December 31, 1998]
10(g) ARS License Agreement Between Lucent Technologies and
Farmstead Telephone Group, Inc. For Authorized Remarketing
Supplier Program [Exhibit 10(t) to the Annual Report on Form
10-KSB for the year ended December 31, 1998]
10(h) Rider #1 to Lease Dated November 5, 1996 By and Between
Tolland Enterprises ("Landlord") and Farmstead Telephone
Group, Inc. ("Tenant"), attached as of May 27, 1999 [Exhibit
10(cc) to the Annual Report on Form 10-K for the year ended
December 31, 1999]
10(i) First Amendment of Lease, dated June 30, 1999, By and
Between Tolland Enterprises ("Landlord") and Farmstead
Telephone Group, Inc. ("Tenant") [Exhibit 10(dd) to the
Annual Report on Form 10-K for the year ended December 31,
1999]
10(j) Loan Agreement, dated September 27, 2000 between First Union
National Bank and Farmstead Telephone Group, Inc. [Exhibit
10(ee) to the Quarterly Report on Form 10-Q for the quarter
ended September 30, 2000]
10(k) Promissory Note, dated September 27, 2000 between First
Union National Bank and Farmstead Telephone Group, Inc.
[Exhibit 10(ff) to the Quarterly Report on Form 10-Q for the
quarter ended September 30, 2000]
10(l) Employment Agreement dated as of January 1, 2000 between
Farmstead Telephone Group, Inc. and Robert G. LaVigne
[Exhibit 10(ee) to the Annual Report on Form 10-K for the
year ended December 31, 2000]
10(m) Amendment to Lucent ARS License Agreement Between Lucent
Technologies Inc. and Farmstead Telephone Group, Inc., dated
February 2, 2001. [Exhibit 10(ff) to the Annual Report on
Form 10-K for the year ended December 31, 2000]
10(n) Amendment to Lucent ARS Dealer Agreement Between Lucent
Technologies Inc. and Farmstead Telephone Group, Inc., dated
February 2, 2001. [Exhibit 10(gg) to the Annual Report on
Form 10-K for the year ended December 31, 2000]
10(o) Farmstead Telephone Group, Inc. Employee Stock Purchase Plan
[Appendix B to the to the Proxy Statement on Schedule 14A
filed April 13, 2001 for the 2001 Annual Meeting of
Stockholders]
10(p) Limited Liability Company Agreement of InfiNet Systems LLC,
effective February 1, 2001 [Exhibit 10(dd) to the Annual
Report on Form 10-K for the year ended December 31, 2001]
10(q) First Modification to Loan Agreement, entered into December
19, 2001 [Exhibit 10(ee) to the Annual Report on Form 10-K
for the year ended December 31, 2001]
10(r) Restated First Addendum To That Certain Employment Agreement
Between Farmstead Telephone Group, Inc. and George J.
Taylor, Jr., effective August 1, 2001 [Exhibit 10(ff) to the
Annual Report on Form 10-K for the year ended December 31,
2001]
10(s) Avaya Inc. Reseller Master Terms and Conditions; Agreement
No. AVNERA1-060601, dated May 31, 2002 . [Exhibit 10(a) to
the Quarterly Report on Form 10-Q for the quarter ended June
30, 2002]
10(t) Third Modification to Loan Agreement, dated September 23,
2002 between Farmstead Telephone Group, Inc. and Wachovia
Bank, National Association (f/k/a First Union National
Bank). [Exhibit 10(a) to the Quarterly Report on Form 10-Q
for the quarter ended September 30, 2002]
10(u) Modification Number One To Promissory Note, dated October 9,
2002 between Farmstead Telephone Group, Inc. and Wachovia
Bank, National Association. [Exhibit 10(b) to the Quarterly
Report on Form 10-Q for the quarter ended September 30,
2002]
43
10(v) Fourth Modification to Loan Agreement, dated October 9, 2002
between Farmstead Telephone Group, Inc. and Wachovia Bank,
National Association (f/k/a First Union National Bank).
[Exhibit 10(c) to the Quarterly Report on Form 10-Q for the
quarter ended September 30, 2002]
10(w) Loan and Security Agreement dated February 19, 2003 by and
between Business Alliance Capital Corp. and Farmstead
Telephone Group, Inc. 2001 [Exhibit 10(v) to the Annual
Report on Form 10-K for the year ended December 31, 2002]
10(x) Revolving Credit Master Promissory Note dated February 19,
2003 between Business Alliance Capital Corporation and
Farmstead Telephone Group, Inc. [Exhibit 10(w) to the Annual
Report on Form 10-K for the year ended December 31, 2002]
10(y) Second Addendum to That Certain Employment Agreement Between
Farmstead Telephone Group, Inc. and George J. Taylor, Jr.,
Dated as of January 1, 1998, as Amended by That Certain
Restated First Addendum Dated as of August 1, 2001[Exhibit
10(x) to the Annual Report on Form 10-K for the year ended
December 31, 2002]
10(z) Revolving Credit Master Promissory Note dated February 19,
2004 between Business Alliance Capital Corporation and
Farmstead Telephone Group, Inc.
10(aa) Modification Agreement dated February 19, 2004 between
Business Alliance Capital Corporation and Farmstead
Telephone Group, Inc.
10(bb) Third Addendum to That Certain Employment Agreement Between
Farmstead Telephone Group, Inc. and George J. Taylor, Jr.,
Dated as of January 1, 1998, as Amended by That Certain
Restated First Addendum Dated as of August 1, 2001 and as
Further Amended by That Certain Second Addendum Dated as of
January 1, 2003
10(cc) Second Addendum to That Certain Employment Agreement between
Farmstead Telephone Group, Inc. and Robert G. LaVigne dated
as of January 1, 2000 as Amended by That First Addendum
Dated as of January 1, 2003
10(dd) Amendment to Reseller Master Terms and Conditions:
Authorized Remanufactured Supplier (ARS) Program Between
Avaya Inc. and Farmstead Telephone Group, Inc., dated
October 28, 2003
10(ee) Employment Agreement dated October 1, 2004 between Farmstead
Telephone Group, Inc. and Jean-Marc Stiegemeier. [Exhibit
10(a) to the Form 8-K Current Report filed October 6, 2004]
10(ff) Fourth Addendum to that Certain Employment Agreement Between
Farmstead Telephone Group, Inc. and George J. Taylor, Jr.
Dated as of January 1, 1998 as Amended by that Certain
Restated First Addendum Dated as of August 1, 2001; as
Further Amended by that Certain Second Addendum Dated as of
January 1, 2003; and as Further Amended by that Certain
Third Addendum Dated as of January 1, 2004. [Exhibit 10(b)
to the Form 8-K Current Report filed October 6, 2004]
10(gg) Agreement between Farmstead Telephone Group, Inc. and Jean-
Marc Stiegemeier dated August 16, 2004 [Exhibit 10(c ) to
Form 10-Q for the quarter ended September 30, 2004].
21 Subsidiaries *
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) or 15d-14(a)as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002. *
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) or 15d-14(a)as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002. *
32.1 Certification of the Chief Executive Officer, pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002. *
32.2 Certification of the Chief Financial Officer, pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002. *
--------------------
* filed herewith.
44