EXECUTONE INFORMATION SYSTEMS 10-Q JUNE 30, 1998
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File No. 0-11551
EXECUTONE Information Systems, Inc.
(Exact name of registrant as specified in its charter)
Virginia 86-0449210
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
478 Wheelers Farms Road, Milford, Connecticut 06460
(Address of principal executive offices) (Zip Code)
(203) 876-7600
(Registrant's telephone number, including area code)
N/A
(Former name, former address and former fiscal year,
if changed since last report)
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
The number of shares outstanding of registrant's Common Stock,
$.01 par value per share, as of July 31, 1998 was 49,766,256.
<PAGE>
INDEX
EXECUTONE Information Systems, Inc.
Page #
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets -
June 30, 1998 and December 31, 1997. 3
Consolidated Statements of Operations -
Three Months and Six Months Ended
June 30, 1998 and 1997. 4
Consolidated Statements of Cash Flows -
Six Months Ended June 30, 1998 and 1997. 5
Notes to Consolidated Financial Statements. 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 14
PART II. OTHER INFORMATION 20
SIGNATURES 21
2
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
(In thousands, except for share amounts) 1998 1997
(Unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 1,901 $ 7,727
Restricted cash --- 5,084
Accounts receivable, net of
allowance of $1,270 and $1,814 31,296 33,403
Inventories 23,453 20,436
Prepaid expenses and other current assets 4,380 4,091
Total Current Assets 61,030 70,741
PROPERTY AND EQUIPMENT, net 11,444 7,767
INTANGIBLE ASSETS, net 16,862 19,765
DEFERRED TAXES 21,378 18,577
OTHER ASSETS 26,178 22,014
$ 136,892 $ 138,864
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt $ 780 $ 951
Accounts payable 21,028 23,009
Accrued payroll and related costs 3,339 3,007
Accrued liabilities 13,255 13,123
Deferred revenue and customer deposits 5,051 2,541
Total Current Liabilities 43,453 42,631
LONG-TERM DEBT 16,059 14,643
OTHER LONG-TERM LIABILITIES 990 1,092
TOTAL LIABILITIES 60,502 58,366
STOCKHOLDERS' EQUITY:
Common stock: $.01 par value; 80,000,000 shares
authorized; 49,741,018 and 49,660,359 issued
and outstanding 497 497
Preferred stock: $.01 par value; Cumulative
Convertible Preferred Stock (Series A),
250,000 shares authorized, issued and outstanding;
Cumulative Contingently Convertible Preferred Stock
(Series B), 100,000 shares authorized, issued
and outstanding 7,300 7,300
Additional paid-in capital 71,593 71,500
Retained earnings (deficit) (since July 1, 1988) (3,000) 1,201
Total Stockholders' Equity 76,390 80,498
$ 136,892 $ 138,864
The accompanying notes are an integral part of these consolidated
balance sheets.
</TABLE>
3
<PAGE>
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
(In thousands, except for Three Months Ended Six Months Ended
per share amounts) June 30, June 30,
1998 1997 1998 1997
<S> <C> <C> <C> <C>
REVENUES $ 34,707 $ 34,777 $ 68,610 $ 73,796
COST OF REVENUES 22,857 24,878 45,922 49,777
Gross Profit 11,850 9,899 22,688 24,019
OPERATING EXPENSES:
Product development and engineering 2,540 3,437 5,053 6,737
Selling, general and administrative 9,591 10,197 19,216 20,244
Special charges 2,139 --- 4,483 ---
14,270 13,634 28,752 26,981
OPERATING LOSS (2,420) (3,735) (6,064) (2,962)
INTEREST EXPENSE (538) (503) (1,046) (937)
OTHER INCOME, net 87 296 110 811
LOSS BEFORE INCOME TAXES (2,871) (3,942) (7,000) (3,088)
INCOME TAX BENEFIT (1,148) (1,571) (2,799) (1,229)
NET LOSS $ (1,723) $ (2,371) $ (4,201) $ (1,859)
LOSS PER SHARE $ (0.03) $ (0.05) $ (0.08) $ (0.04)
WEIGHTED AVG. COMMON AND COMMON
EQUIVALENT SHARES OUTSTANDING 49,733 49,457 49,715 49,669
The accompanying notes are an integral part of these consolidated
statements.
</TABLE>
4
<PAGE>
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended
(In thousands) June 30,
1998 1997
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(4,201) $ (1,859)
Adjustments to reconcile net loss to net cash
used by operating activities:
Depreciation and amortization 1,777 1,512
Benefit for income taxes not currently payable (2,799) (1,229)
Noncash expenses, including noncash interest
expense, noncash provision for losses on
accounts receivable and income from
equity investment 165 171
Change in working capital items:
Accounts receivable 2,077 8,722
Inventories (3,094) (10,783)
Accounts payable and accruals (917) (2,643)
Restricted cash 5,084 ---
Other working capital items 48 706
NET CASH USED BY OPERATING ACTIVITIES (1,860) (5,403)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (519) (1,586)
Investment in Unistar (3,770) (2,547)
Other, net (384) (948)
NET CASH USED BY INVESTING ACTIVITIES (4,673) (5,081)
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under revolving credit facility 1,195 ---
Repayments of other long-term debt (571) (585)
Repurchase of stock --- (5,412)
Proceeds from issuance of stock 83 703
NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES 707 (5,294)
DECREASE IN CASH AND CASH EQUIVALENTS (5,826) (15,778)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD 7,727 27,696
CASH AND CASH EQUIVALENTS - END OF PERIOD $ 1,901 $ 11,918
The accompanying notes are an integral part of these consolidated statements.
</TABLE>
5
<PAGE>
EXECUTONE INFORMATION SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE A - NATURE OF THE BUSINESS
EXECUTONE Information Systems, Inc. (the Company) develops,
markets and supports voice and data communications systems.
Products and services include telephone systems, voice mail
systems, inbound and outbound call center systems, and
specialized healthcare communications systems. The Company's
UniStar Entertainment indirect subsidiary has an exclusive five-
year contract ending January 2003 with the Coeur d'Alene Tribe of
Idaho to design, develop, finance and manage the National Indian
Lottery. Executone's products and services are sold under the
EXECUTONE, INFOSTAR, IDS, LIFESAVER and INFOSTAR/ILS brand
names through a national network of independent distributors and
company direct sales and service employees.
NOTE B - BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have
been prepared in accordance with generally accepted accounting
principles for interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. In
the opinion of management, all adjustments, which include normal
recurring adjustments, considered necessary for a fair
presentation of the results for the interim periods presented
have been included. Certain prior year amounts have been
reclassified to conform to the current year's presentation.
The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
As of July 1, 1988, an accumulated deficit of approximately $49.7
million was eliminated.
NOTE C - INCOME TAXES
The Company accounts for income taxes in accordance with FAS No.
109, "Accounting for Income Taxes." The deferred tax asset
represents the benefits that are more likely than not to be
realized from the utilization of pre- and post-acquisition tax
benefit carryforwards, which include net operating losses, tax
credits and the excess of tax bases over the fair value of the
net assets of the Company.
For the six-month periods ended June 30, 1998 and 1997, the
Company made cash payments for income taxes of approximately
$59,000 and $389,000, respectively.
NOTE D - EARNINGS PER SHARE
Earnings per share is based on the weighted average number of
shares of common stock and dilutive common stock equivalents
(which include stock options and warrants) outstanding during
the periods. Common stock equivalents, the convertible preferred
stock and the convertible debentures which are antidilutive have
been excluded from the computations.
6
<PAGE>
A reconciliation of the Company's loss per share calculations for
the three-month and six-month periods ended June 30, 1998 and
1997, respectively, is as follows:
<TABLE>
<CAPTION>
Per Share
(in thousands, except for per share amounts) Loss Shares Amount
<S> <C> <C> <C>
For the three months ended June 30, 1998:
Basic and Diluted Loss Per Share: $(1,723) 49,733 $(0.03)
For the three months ended June 30, 1997:
Basic and Diluted Loss Per Share: $(2,371) 49,457 $(0.05)
For the six months ended June 30, 1998:
Basic and Diluted Loss Per Share: $(4,201) 49,715 $(0.08)
For the six months ended June 30, 1997:
Basic and Diluted Loss Per Share: $(1,859) 49,669 $(0.04)
</TABLE>
The Company's Convertible Subordinated Debentures are convertible
into approximately 1.5 million shares of common stock as of June
30, 1998. The shares issuable upon conversion of the Debentures
were not included in the computation of diluted earnings per
share because they would be antidilutive for each of the periods
presented. Due to the net losses for each of the periods
presented, all stock options and warrants were antidilutive,
regardless of the exercise prices. Options to purchase 823,000
and 1.5 million shares of common stock as of June 30, 1998 and
1997, respectively, were not included in the computation of
diluted earnings per share for the periods presented above
because of the net losses. The convertible preferred stock
issued in connection with the acquisition of Unistar is
antidilutive and has been excluded from the above calculations
(See Note F).
In 1997, the Company adopted FAS No. 128, "Earnings per Share,"
effective for periods ending after December 15, 1997. As a
result, the Company's reported earnings per share for prior
periods were restated. Reported earnings per share as of June 30,
1997 was unchanged as a result of this accounting change.
NOTE E - INVENTORIES
Inventories are stated at lower of first-in, first-out (FIFO)
cost or market and consist of the following at June 30, 1998 and
December 31, 1997:
<TABLE>
<CAPTION>
June 30, December 31,
(amounts in thousands) 1998 1997
<S> <C> <C>
Raw Materials $ 3,102 $ 4,672
Finished Goods 20,351 15,764
$ 23,453 $20,436
</TABLE>
7
<PAGE>
NOTE F - UNISTAR
On December 19, 1995, the Company acquired 100% of the common
stock of Unistar Gaming Corporation (Unistar Gaming) for 3.7
million shares of the Company's common stock valued at $5.4
million and 350,000 shares of newly issued preferred stock valued
at $7.3 million. Unistar Gaming's subsidiary, UniStar
Entertainment, Inc., has an exclusive five-year contract to
design, develop, finance and manage the National Indian Lottery
(NIL) for the Coeur d'Alene Tribe of Idaho ("CDA" or "the
Tribe"). The NIL comprises a national telephone lottery
authorized by federal law and by a compact between the State of
Idaho and CDA, as well as Internet-based lottery games. In
return for providing these management services to the NIL,
Unistar will be paid a fee equal to 30% of the profits of the
NIL. The excess of the purchase price over the value of the net
liabilities assumed has been included in intangible assets and is
being amortized over the five-year term of the contract
commencing with the three-month period ended March 31, 1998.
The preferred stock consists of 250,000 shares of Cumulative
Convertible Preferred Stock, Series A (Series A Preferred Stock)
and 100,000 shares of Cumulative Contingently Convertible
Preferred Stock, Series B (Series B Preferred Stock). The Series
A Preferred Stock has voting rights equal to one share of common
stock and will earn dividends equal to 18.5% of the consolidated
retained earnings of Unistar as of the end of a fiscal period,
less any dividends paid to the holders of the Series A Preferred
Stock prior to such date. The Series B Preferred Stock has
voting rights equal to one share of common stock and will earn
dividends equal to 31.5% of the consolidated retained earnings of
Unistar as of the end of a fiscal period, less any dividends paid
to the holders of the Series B Preferred Stock prior to such
date. All dividends on Preferred Stock are payable (i) when and
as declared by the Board of Directors, (ii) upon conversion or
redemption of the Series A and Series B Preferred Stock or (iii)
upon liquidation. As of June 30, 1998, no dividends have accrued
to the preferred stockholders. The Series A and Series B
Preferred Stock is redeemable for a total of 13.3 million shares
of common stock (Series A Preferred Stock for 4.925 million
shares and Series B Preferred Stock for 8.375 million shares) at
the Company's option. In the event that Unistar meets certain
revenue and profit parameters, the Series A Preferred Stock is
convertible for up to 4.925 million shares of common stock and
the Series B Preferred Stock is convertible for up to 8.375
million shares of common stock (a total of an additional 13.3
million shares of common stock).
In an attempt to block the NIL, certain states filed letters
under 18 U.S.C. Section 1084 to prevent the long-distance
carriers from providing telephone service to the NIL. In 1995,
the CDA initiated legal action against AT&T Corporation (AT&T) to
compel the long-distance carriers to provide telephone
service to the NIL. The CDA's position is that the lottery is
authorized by the Indian Gaming Regulatory Act (IGRA) passed by
Congress in 1988, that IGRA preempts state law, that 18 U.S.C.
Section 1084 is inapplicable and, therefore, that the states lack
authority to issue the Section 1084 notification letters to any
carrier. On February 28, 1996, the NIL was ruled lawful by the
CDA Tribal Court. The CDA Tribal Court found that all
requirements of IGRA have been satisfied and the Section 1084
letters issued by certain state attorneys general in an effort to
interfere with the lawful operation of the NIL are invalid. In
addition, the Tribal Court found that the long-distance carriers
cannot refuse to provide the service requested in the action
based upon 18 U.S.C. Section 1084. This ruling and a related
order dated May 1, 1996 were subsequently appealed to the Tribal
Appellate Court, which on July 2, 1997 affirmed the lower Tribal
Court's May 1, 1996 ruling and analysis upholding the CDA's right
to conduct the telephone lottery. On August 22, 1997, AT&T filed
a complaint for declaratory judgment against the CDA in the U.S.
District Court for the District of Idaho. The CDA has answered
that complaint and filed a motion for partial summary judgment,
which is currently pending. The attorneys general of nineteen
states have been granted leave to submit a brief as amicus curiae
in the case with respect to the Tribal Court's interpretation of
IGRA and in support of the position taken by AT&T.
8
<PAGE>
On May 28, 1997, the State of Missouri brought an action in the
Missouri Circuit Court in Kansas City against Unistar and the CDA
to enjoin the NIL's US Lottery Internet instant games offered by
the CDA and managed by Unistar. The complaint also seeks civil
penalties, attorney's fees and court costs. The complaint
alleged that the US Lottery violates Missouri anti-gaming laws
and that the marketing and promotion of the US Lottery violate
the Missouri Merchandising Practices Act. The CDA and Unistar
removed the case to the U.S. District Court for the Western
District of Missouri, which denied the State's subsequent motion
to remand the case back to the state court. The Court also
subsequently granted a motion to dismiss by CDA based on
sovereign immunity. The Court denied the motion to dismiss
Unistar based on sovereign immunity, although the Court indicated
it might reconsider that decision. Unistar filed a motion for
reconsideration of its motion for dismissal. The State of
Missouri has filed an appeal to the Eighth Circuit Court of
Appeals relating to the dismissal of the CDA.
On January 28, 1998, the State of Missouri sought to dismiss
voluntarily the existing case against Unistar and filed the next
day, a new action against the Company, Unistar and two tribal
officials, with essentially the same allegations, in a state
court in a different district. The State obtained a temporary
restraining order from a state judge enjoining the marketing of
the Internet and telephone lottery in the State of Missouri. On
February 5, 1998, the U.S. District Court for the Eastern
District of Missouri ruled that this second case also should be
heard in federal court, transferred the second case to the
Western District of Missouri, where the original case had been
filed, and dissolved the state court's temporary restraining
order, effective February 9, 1998. A motion to dismiss the
second case based on the sovereign immunity of all the defendants
and a motion to abstain in favor of the jurisdiction of the CDA
Tribal Court are pending. The State of Missouri has filed an
appeal of the denial of its motion to remand the case to State
Court or in the alternative to grant a preliminary injunction.
On July 31, 1998, the District Court for the Western District of
Missouri stayed proceedings in the case pending resolution of the
pending appeals in the Eighth Circuit and proposed federal
legislation.
On September 15, 1997, the State of Wisconsin filed an action in
the Wisconsin State Circuit Court for Dane County against the
Company, Unistar and the CDA, to permanently enjoin the US
Lottery offered by the Tribe on the Internet and managed by
Unistar. The complaint alleges that the offering of the US
Lottery violates Wisconsin anti-gambling laws and that legality
of the US Lottery has been misrepresented to Wisconsin residents
in violation of state law. In addition to an injunction, the
suit seeks restitution, civil penalties, attorneys' fees and
court costs. The Company, Unistar and the CDA have removed the case
to the U.S. District Court in Wisconsin. On February 18, 1998, the
District Court dismissed the Tribe from the case based on sovereign
immunity and dismissed the Company based on the State's failure
to state a claim against the Company. Motions to dismiss the
case against Unistar were denied. Unistar has appealed the
denial of its motion to dismiss to the Seventh Circuit Court of
Appeals. The State of Wisconsin is appealing the dismissal of
the Tribe.
The Company believes, based on consultation with and opinions
rendered by outside legal counsel, that the favorable rulings of
the tribal courts will be affirmed by the Idaho federal court.
The Company believes that Unistar also will prevail in the
Missouri and Wisconsin lawsuits. However, there is no assurance
of such a legal outcome.
In July 1998, the Senate passed S2260, an appropriations bill to
fund the departments of Commerce, Justice and State for fiscal
1999. Many amendments were attached to this bill including a ban
on Internet gaming offered by Senators John Kyl from Arizona and
Richard Bryan from Nevada. The measure would make certain
Internet gaming activities a crime punishable by up to four years
in prison and $20,000 in fines or the total amount of gambling
proceeds. The proposed ban would allow a number of exceptions,
including allowing states to create their own "closed loop"
computer gambling networks that do not extend to any machines out
of state.
9
<PAGE>
In order to become law, the measure now has to be melded with the
House version (HR4276), which currently contains no prohibition
of Internet gaming. The next step in the process is for the
House version without a ban on Internet gaming and the Senate
version with a ban on Internet gaming of the appropriation bill
to go to conference to be reconciled sometime in September.
The Company is continuing to support efforts to include
exceptions in these bills for gaming conducted by an Indian tribe
that is authorized by IGRA. If legislation is signed into law
which prohibits Internet gaming without such an exception, it
will have a material adverse effect on Unistar's business as it
relates to the NIL. However, the Company believes that if the
final legislation includes exceptions for states to create their
own computer gambling networks, it will create opportunities for
Unistar to service this potential market with its ELT system
(enhanced lottery terminals).
Funding for Unistar capital expenditures, including the computers
and software to build the telecommunications system, is being
capitalized and depreciated over the life of the management
agreement. The guaranteed monthly advance of $25,000 to the CDA,
which began in January 1996, will be reimbursed when the NIL is
making profit distributions to Unistar. In addition, the Company
has capitalized other fundings, consisting primarily of direct
Unistar expenses, professional fees and other expenses, which the
Company believes are reimbursable in accordance with the terms of
the management agreement. Cumulative funding as described above
totals $11.0 million ($3.2 million for the six-month period ended
June 30, 1998) and is reflected in property and equipment or
other non-current assets, as appropriate.
The Company has also funded legal and other accrued liabilities
assumed as part of the acquisition of Unistar totaling, on a
cumulative basis, $3.0 million ($0.6 million for the six-month
period ended June 30, 1998). Such cash flows, which were
previously reflected as part of the change in working capital
items, are now reflected as part of the investment in Unistar in
the statement of cash flows. Prior year amounts have been
reclassified to conform to the current year's presentation. The
investment in Unistar reflected on the statement of cash flows
includes the deferred charges and assumed liabilities noted
above for a cumulative total of $14.0 million ($3.8 million for
the six-month period ended June 30, 1998). Since inception, the
Company has also funded various Unistar expenses totaling $1.6
million (excluding depreciation and amortization), which are
reflected in the Company's consolidated net income. Cumulative
cash expenditures on Unistar, including Unistar expenses and
amounts paid on capital lease obligations, total $15.1 million as
of June 30, 1998.
During the three-month period ended June 30, 1998, certain
provisions in the Management Agreement have been clarified based
upon the current operational status of the NIL. These provisions
relate to whether or not certain pre- and post-acquisition costs
are reimbursable from the NIL. Accordingly, $5.0 million has
been reclassified to other assets representing additional amounts
reimbursable from the NIL, offset by a $2.8 million reduction in
goodwill (reflecting pre-acquisition costs) and $2.2 million in
deferred revenue (reflecting post-acquisition costs). These
adjustments reflect the additional expenditures which are
receivable from the NIL and will be repaid when the NIL is making
profit distributions.
The Company expects to fund an additional $3 million through the
end of 1998. The costs include capital expenditures for computers
and software to build the telecommunications system, funds to
complete the building on the CDA reservation, which is the
operations center for the lottery, and various start-up and
operating expenses including personnel-related costs and
advertising expenses. The Company is also required to make a
guaranteed payment of $300,000 per year to the CDA, which is
included in the above estimates. The Company expects it will be
able to obtain additional financing for these costs, if
necessary.
10
<PAGE>
In February 1997, the Company signed agreements with Virtual
Gaming Technologies (formerly Internet Gaming Technologies (IGT))
and CasinoWorld Holdings, Ltd. (CWH). The agreements required
the Company to invest $700,000 in IGT common stock in September
1996 under a previous agreement. In addition, the Company was
granted a 200,000-share, five-year option set at 15% more than
the price per share on the initial investment, or $3.45 per
share. CWH is providing project management services
overseeing the development of the software for the NIL, with the
Company contracting independently for system software
development. The Company will acquire all hardware for the system
without financial obligation by either IGT or CWH. Approximately
$800,000 in hardware costs were incurred as of June 30, 1998.
The investment in IGT is being accounted for under the cost
method. All hardware costs incurred are being capitalized and
depreciated over the useful life of the assets. As of June 30,
1998, $2.4 million in progress payments have been made toward the
software system. Such payments are being capitalized and
depreciated over the life of the asset or term of the management
agreement, whichever is shorter.
There are market and legal risks associated with the development
of the NIL. The Company believes there is a national market for
the NIL based upon research into the experience of other national
lotteries and the growth of the overall lottery market. In the
event that the telephone and Internet lotteries do not attain the
level of market acceptance anticipated by the Company or if the
outcome of the pending lawsuits or legislative proposals in
Congress is adverse, the Company would have to reevaluate its
investment in Unistar.
The Company periodically evaluates the recoverability of this
investment in Unistar in accordance with the provisions of FAS
No. 121, "Accounting for the Impairment of Long-Lived Assets" by
projecting future undiscounted net cash flows for the telephone
and Internet lotteries. If the sum of such cash flows is not
sufficient to recover the Company's investment in Unistar,
projected cash flows would then be discounted and the Company's
investment would be adjusted accordingly.
NOTE G - UNISTAR SPINOFF
As previously announced, in April 1998, the Company's Board of
Directors determined that it would be in the best interests of
the shareholders of the Company to separate Executone and its
wholly owned subsidiary Unistar. Under the terms of the existing
preferred stock, such a separation would cause immediate
conversion of the preferred stock into Executone Common Stock,
creating a 21% dilution to Executone shareholders including 21%
dilution of the common shareholders' interest in Unistar after
the separation. On August 12, 1998, Executone reached an
agreement with the preferred stockholders of Executone whereby
they will receive a 15% interest in Unistar upon separation and
shares of a new Unistar preferred stock that will be contingently
convertible into Unistar common stock in an amount, including the
common stock initially issued to them and giving effect to the
conversion, equal to 34% of the Unistar common stock. The new
Unistar preferred stock will retain many of the same rights as
the Executone preferred stock including convertibility into
additional shares of Unistar if the original milestones are met
and dividend rights. As a result of the agreement, the preferred
stockholders will not receive any shares of Executone in the
separation.
The Company intends to separate Unistar by a distribution to its
common shareholders of rights to purchase 85% of the common stock
of Unistar. Unistar currently plans to distribute one right for
each share of Executone common stock outstanding. Each five
rights will entitle the holder to purchase one share of Unistar
common stock upon payment of the exercise price of $.05 per right
or a total of $.25 per
11
<PAGE>
Unistar common share. Upon separation of Unistar, the Company
will provide a capital contribution to Unistar which will be
sufficient to fund continuing operations. Approximately half of
the anticipated cash contribution will be financed from the
Company's working capital and the rest will be financed through
the rights offering. The Company expects there will be a public
market for these rights in the event a shareholder does not wish
to exercise the right during the 30-day exercise period. An
investment group controlled by some of the Executone preferred
shareholders has agreed to exercise, at the same exercise price,
any rights that remain unexercised at the end of the exercise
period.
The Company currently expects the separation of Unistar to be
completed by the end of 1998.
NOTE H - SPECIAL CHARGES
During the three-month period ended June 30, 1998, the Company
recorded $2.1 million in reorganization and other special
charges. These charges consist of approximately $1.1 million in
severance and benefit continuation costs associated with actions
taken by the Company to de-layer its senior management structure,
along with provision for loss relating to subleased space at the
Company's corporate headquarters. During June 1998, the Company
was notified by a sublessee that it would be terminating its
sublease agreement for office space for which the Company is the
lessee. Based upon prevailing market conditions in the area, the
Company anticipates that it could be 12 to 18 months before the
space can be subleased again. As a result, the Company has
provided $1.0 million to reflect the rental cost during the
period the space is vacant.
During the three-month period ended March 31, 1998, the Company
recorded $2.3 million in reorganization and other special
charges. These charges included a total of $1.5 million in
severance for the Company's former Chief Executive Officer (CEO)
and recruiting expenses for the new CEO, along with $0.8 million
for severance and benefits resulting from a workforce reduction
during January and February 1998 and facility closure costs.
NOTE I - AMENDED DISTRIBUTOR AGREEMENT
On March 30, 1998, the Company entered into an Amended and
Restated Distributor Agreement (the "Amended Agreement") with
Claricom, purchaser of the direct sales offices and the Company's
largest distributor. The Amended Agreement, effective April
1,1998 and continuing through December 31, 2001, provides, among
other things, that Claricom will be a non-exclusive distributor
of the Company's telephony products and that Claricom can market
products competing with those sold by the Company. Upon
execution of the Amended Agreement, Claricom released to the
Company the $5 million plus interest being held in escrow to
satisfy potential indemnity claims under the 1996 Asset Purchase
Agreement and waived all potential contract claims under the
prior distributor agreement.
NOTE J - OTHER MATTERS
For the six-month periods ended June 30, 1998 and 1997,
respectively, the Company made cash payments of approximately
$0.9 million and $0.8 million for interest expense on
indebtedness.
During the six-month periods ended June 30, 1998 and 1997,
respectively, noncash financing activities included capital lease
obligations incurred in connection with computer software and
equipment acquisitions of $0.5 million and $1.2 million.
12
<PAGE>
For the six-month periods ended June 30, 1998 and 1997, more than
10% of the Company's revenue were derived from a single,
independent distributor. Revenues from the distributor were $7.8
million and $12.9 million, respectively, for the six-month
periods ended June 30, 1998 and 1997 (see Note I).
Refer to the Consolidated Statements of Cash Flows for
information on all cash-related operating, investing and
financing activities.
FAS No. 130, "Reporting Comprehensive Income", became effective
for fiscal years beginning after December 15, 1997. This
Statement does not apply to the Company because it had no items
of other comprehensive income in any of the periods presented.
In April 1998, the American Institute of Certified Public
Accountants issued Statement of Position 98-5, "Reporting on the
costs of Start-Up Activities" (SOP 98-5). SOP 98-5 requires
costs of start-up activities and organization costs to be
expensed as incurred. In addition, the pronouncement requires
that, effective January 1, 1999, previously capitalized start-up
costs be expensed and classified as a cumulative effect of a
change in accounting principle. The Company anticipates that
approximately $2.0 million in start-up costs relating to Unistar,
currently classified as assets, will be written off
effective January 1, 1999 in accordance with this new
pronouncement, if the separation of the Unistar business is not
completed before the end of the first quarter of 1999.
13
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
The Company develops, markets and supports voice and data
communications systems. Products and services include telephone
systems, voice mail systems, inbound and outbound call center
systems and specialized healthcare communications systems. The
Company's UniStar Entertainment indirect subsidiary has the
exclusive right to design, develop and manage the National Indian
Lottery (NIL). The Company's products are sold under the
EXECUTONE, INFOSTAR, IDS, LIFESAVER and INFOSTAR/ILS brand
names through a national network of independent distributors and
company direct sales and service employees.
Revenues are derived from product sales to distributors, direct
sales of healthcare products, and direct sales to national
accounts and government customers, as well as installations,
additions, changes, upgrades or relocation of previously
installed systems, maintenance contracts, and service charges to
the existing base of healthcare, national account and government
customers.
Results of Operations
Revenues for the three-month period ended June 30, 1998 were $34.7
million, with an operating loss of $2.4 million and a net loss of
$1.7 million or ($.03) per common share. These results include a
$2.1 million charge, covering severance and benefits continuation
costs and an accrual for idle space in the Company's corporate
headquarter (see "Special Charges"). Excluding the special
charges, the operating loss was $0.3 million for the three-month
period ended June 30, 1998. Revenues for the three-month period
ended June 30, 1997 were $34.8 million, with operating loss of
$3.7 million and a net loss of $2.4 million or ($.05) per common
share. Compared to the same period last year, the Company
increased revenues from its independent distributors, excluding
Claricom, by 11% along with increased government systems revenues.
These increases were offset by the lower sales to Claricom,
purchaser of the direct offices in 1996 and the Company's largest
distributor, and a reduction in new installations and system
upgrades by the national accounts group for the period.
For the six-month period ended June 30, 1998, revenues were $68.6
million, with an operating loss of $6.1 million and a net loss of
$4.2 million or ($0.08) per share. The results include $4.5
million in special charges. The operating loss was $1.6 million,
excluding the special charges. For the same period last year,
revenues were $73.8 million, with an operating loss of $3.0
million and a net loss of $1.9 million or ($0.04) per share. The
decrease in revenue of $5.2 million is due to the shortfall in
revenue from Claricom. Revenues from the independent distributors
increased 15% over the periods, along with a 30% increase in
government systems revenues. The increases were offset by lower
revenue from the national accounts group and reduction in new call
center installations.
Sales to Claricom during the three-month periods ended June 30,
1998 and 1997, respectively, were $3.2 million and $3.5 million.
For the six-month periods ended June 30, 1998 and 1997,
respectively, sales to Claricom were $7.8 and $12.9,
respectively, a decrease of $5.1 million. In light of the
decline in purchases by Claricom, the Company amended its
distributor agreement with Claricom. Effective
April 1, 1998, Claricom became a non-exclusive distributor of the
Company's products in all parts of its territory (see "Other
Matters").
14
<PAGE>
Gross profit for the three-month period ended June 30, 1998 was
$11.9 million or 34.1 % of revenue, compared to gross profit of
$9.9 million or 28.5% of revenue for the same period last year.
The increase in gross profit margin percentage is a result of
favorable product mix in Computer Telephony and Healthcare. For
the six-month period ended June 30, 1998, gross profit was $22.7
million or 33.1% of revenue compared to $24.0 million or 32.5% of
revenue for the same period in 1997. The impact of lower sales
volume during the 1998 period more than offset favorable variances
in product mix in Computer Telephony, Healthcare and the National
Accounts group.
Operating expense variances for both the three-month and six-month
periods ended June 30, 1998 are favorable compared to the same
periods last year. This is primarily due to the Company's cost
reduction efforts which have lowered and reduced headcount.
Product development and engineering costs are approximately 25%
lower than the comparable three-month and six-month periods in
1997. While significantly lower that the comparable periods last
year, the current level of expenditures is sufficient to maintain
the Company's current and future production development efforts
with its existing employees and strategic R&D partnerships.
Selling, general and administrative expenses for the three-month
period ended June 30, 1998 were $9.6 million or 27.6% of revenue,
a decrease of $0.6 million compared to the same period in 1997.
For the six-month period ended June 30, 1998, selling, general and
administrative expenses were $19.2 million or 28% of sales, a
decrease of $1.0 million compared to the same period in 1997. As
a percentage of sales for the six-month period ended June 30,
1998, it is higher than the comparable period last year due to the
lower volume.
Interest expense is higher during the three-month and six-month
periods ended June 30, 1998 compared to the same periods last
year due to the increased borrowings in 1998 versus 1997.
Special Charges
During the three-month period ended June 30, 1998, the Company
recorded $2.1 million in reorganization and other special
charges. These charges consist of approximately $1.1 million in
severance and benefit continuation costs associated with actions
taken by the Company to de-layer its senior management structure,
along with a provision for loss relating to subleased space at
the Company's corporate headquarters. During June 1998, the
Company was notified by a sublessee that it would be terminating
its sublease agreement for office space for which the Company is
the lessee. Based upon prevailing market conditions in the area,
the Company anticipates that it could be 12 to 18 months before
the space can be subleased again. As a result, the Company has
provided $1.0 million to reflect the rental cost during the
period the space is vacant.
During the three-month period ended March 31, 1998, the Company
recorded $2.3 million in reorganization and other special
charges. These charges included a total of $1.5 million in
severance for the Company's former Chief Executive Officer (CEO)
and recruiting expenses for the new CEO, along with $0.8 million
for severance and benefits resulting from a workforce reduction
during January and February 1998 and facility closure costs.
Unistar
On December 19, 1995, the Company acquired 100% of the common
stock of Unistar Gaming, a privately-held company which, through
its wholly-owned subsidiary, UniStar Entertainment, Inc., has an
exclusive five-year contract to design, develop, finance and
manage the National Indian Lottery (NIL) for the Coeur d'Alene
Tribe of Idaho ("CDA" or "the Tribe"). See Note F of the Notes
to Consolidated Financial Statements for the terms of the
agreement with the Tribe.
15
<PAGE>
Unistar's original mission was to develop, install and manage a
national Indian lottery accessible by telephone. Unistar
developed a state-of-the-art Internet and telephone-based system
providing both instant and draw lottery games, full player
accounting and tracking and automatic credit or debit card
clearance. As a hedge against potential adverse legal and
political decisions, Unistar began investigating alternative
applications and markets for its technology. Unistar has
developed an Intranet option whereby the games can be played from
dedicated kiosks (enhanced lottery terminals or "ELT's") located
anywhere and connected to a central system. Unlike slot machines
and Video Lottery Terminals (VLT's), the ELT system is a lottery
system and can be deployed by a state lottery under their
existing authority without additional legislation. The instant
games still offer similar play action. Since growth in lottery
revenues has slowed down and actually declined in some cases, a
number of state lotteries are considering the deployment of the
Unistar ELT system as an extension of their lottery product line.
The Company has made a significant investment in Unistar, which
upon acquisition created 8% dilution to the Company's
stockholders and, subsequent to the acquisition, has totaled an
additional $15.1 million in cash. During the six-month period
ended June 30, 1998, the Company invested $4.1 million as part of
the cost to develop the software systems, building and other
costs related to the project, most of which have been recorded as
assets on the balance sheet. The total Unistar investment as of
June 30, 1998 is $28.8 million, including $13.0 million in
goodwill and the remainder consisting of property and equipment
and other non-current assets, along with funded Unistar expenses.
In the opinion of the Company's management, this investment is
justified based upon the potential returns.
Certain provisions in the Management Agreement have been
clarified based upon the current operational status of the NIL.
These provisions relate to whether or not certain pre- and post-
acquisition costs are reimbursable from the NIL. Accordingly,
$5.0 million has been reclassified to other assets representing
additional amounts reimbursable from the NIL, offset by a $2.8
million reduction in goodwill (reflecting pre-acquisition costs)
and $2.2 million in deferred revenue (reflecting post-
acquisition costs). These adjustments reflect the additional
expenditures which are receivable from the NIL and will be repaid
when the NIL is making profit distributions.
The NIL conducts business under the US Lottery trade name. The US
Lottery began test marketing its Instant ticket games on the
Internet in July 1997 and, on April 3, 1998, announced five new
instant games on the Internet. On January 20, 1998, the US
Lottery launched its first Draw game, the "Super6", a national
weekly draw lottery. Tickets for the Super6 can be purchased
either over the Internet or by telephone. The US Lottery also
expects to announce a $10 million lottery jackpot as well as a
"Pick 3" draw game later this year. As of June 30, 1998, the
registered base of the US Lottery was approximately 29,000
people. Through June 30, 1998, the US Lottery has generated
cumulative revenues of $8.3 million. Ticket purchases have
increased by an average of 14% per month for the first six months
of 1998. Assuming this level of increased ticket purchases
continues through the end of the year, Unistar expects the US
Lottery will be generating revenues of approximately $7 million
per quarter by the end of 1998. However, based upon current
results and as a result of decisions not to launch new lottery
games or advertising due to legislative activity, Unistar
currently expects that it will not be operating on a cash
breakeven basis before the end of 1998. Due to advertising,
professional fees and other startup costs, the NIL has yet to
generate a profit. As a result, Unistar has not recognized any
revenue under the terms of the Management Agreement as of June
30, 1998.
See Note F of the Notes to Consolidated Financial Statements for
a discussion of legal issues and legislative proposals relating
to Unistar.
16
<PAGE>
Other Matters
On March 30, 1998, the Company entered into an Amended and
Restated Distributor Agreement with Claricom (the "Amended
Agreement"). The Amended Agreement, effective April 1, 1998 and
continuing through December 31, 2001, provides, among other
things, that Claricom will be a non-exclusive distributor of the
Company's telephony products and that Claricom can market
products competing with those sold by the Company. Upon
execution of the Amended Agreement, Claricom released to the
Company the $5 million plus interest being held in escrow to
satisfy potential indemnity claims under the 1996 Asset Purchase
Agreement and waived all potential contract claims under the
prior distributor agreement.
The Amended Agreement provides the opportunity to supplement
sales in the Claricom territories with additional distribution.
Other distributors are in the process of being identified to sell
the Company's products in certain parts of Claricom's territory.
The Company estimates it will take six months to a year from the
time a new distributor is assigned territory to grow product
sales to provide the level of penetration contemplated in the
original Claricom agreement.
The Company has conducted a review of its computer systems to
identify systems that could be affected by the "Year 2000" issue.
Systems that do not properly recognize such information could
generate erroneous data or fail. Although the Company estimates
the cost to resolve the Year 2000 issue through its current
software system is less than $0.5 million, it has decided as part
of its long-term information systems plan to convert to a new and
more comprehensive software system which will cost approximately
$2.0 million, including installation and data conversion costs.
These costs will be capitalized and depreciated over the expected
service life of the system beginning in 1999. The Company
believes that the conversion to new software , which is currently
underway and on schedule, will resolve the Year 2000 issue.
However, if the conversion is not completed timely, the Year 2000
problem may have a material impact on the operations of the
Company.
FAS No. 130, "Reporting Comprehensive Income" became effective
for fiscal years beginning after December 15, 1997. This
Statement does not apply to the Company because it had no items
of other comprehensive income in any of the periods presented.
In April 1998, the American Institute of Certified Public
Accountants issued Statement of Position 98-5, "Reporting on the
costs of Start-Up Activities" (SOP 98-5). SOP 98-5 requires
costs of start-up activities and organization costs to be
expensed as incurred. In addition, the pronouncement requires
that, effective January 1, 1999, previously capitalized start-up
costs be expensed and classified as a cumulative effect of a
change in accounting principle. The Company anticipates that
approximately $2.0 million in start-up costs relating to Unistar,
currently classified as assets, will be written off
effective January 1, 1999 in accordance with this new
pronouncement, if the separation of the Unistar business is not
completed before the end of the first quarter of 1999.
Liquidity and Capital Resources
On August 6, 1998, the Company received a commitment for a new
credit facility with Fleet Capital Corp.(FCC). The new credit
facility would provide for a maximum overall credit line of $30
million consisting of a revolving line of credit for direct
borrowings, with standby and trade letters of credit. Direct
borrowings and letter of credit advances will be made available
pursuant to a formula based on the levels of eligible accounts
receivable and inventories. To minimize interest on the
revolving line of
17
<PAGE>
credit, the Company will have the option to borrow based upon an
adjusted prime borrowing rate or an adjusted eurodollar rate. The
credit facility will be secured by substantially all of the Company's
assets and will have a term of five years from the closing date.
Under the terms of the new credit facility, the Company would have had
$14.6 million available as of June 30, 1998. The Company's liquidity,
represented by cash, cash equivalents and cash availability would
have been approximately $16.5 million as of June 30, 1998
compared to $28 million as of December 31, 1997.
At June 30, 1998 and December 31, 1997, cash and cash equivalents
amounted to $1.9 million and $7.7 million, respectively, an
decrease of $5.8 million. The decrease in cash is primarily due
to the funding of operating activities. Excluding the March 1998
release of $5.1 million held in escrow since the sale of the
direct offices in 1996, $6.9 million of cash was used to fund
operating activities, including the payment of $2.3 million in
special charges. An additional $3.8 million was used for Unistar
expenditures for software development and to fund NIL operating
expenses, primarily payroll-related, advertising and professional
fees. Capital expenditures, debt repayment and other
miscellaneous expenditures accounted for the remaining $1.4
million of cash usage for the six-month period ended June 30,
1998. Sources of cash during the six-month period ended June 30,
1998 were a result of the release of the escrow cash mentioned
above and borrowings on the Company's existing credit facility of
$1.2 million.
Total debt at June 30, 1998 was $16.8 million, an increase of
$1.2 million from $15.6 million at December 31, 1997. The
increase is due to borrowings of $1.2 million from the Company's
existing credit facility, a capital lease obligation of $0.5
million incurred in connection with the acquisition of a new
computer software system, and an increase to the carrying value
of the convertible subordinated debentures of $0.1 million due to
accretion. Debt was reduced by the repayment of $0.6 million in
capital lease obligations incurred in connection with equipment
and software acquisitions.
The Company believes that borrowings available under the credit
facility and cash flow from operations will be sufficient to meet
working capital and other requirements for the next twelve
months.
Forward-Looking Statements
This Report includes certain forward-looking statements and
information that are based on management's beliefs as well as on
assumptions made by and information currently available to
management. When used in this Report, the words "anticipate,"
"intend," "believe," "estimate," and similar expressions are
intended to identify forward-looking statements. Such statements
are not guarantees of future performance and involve certain
risks, uncertainties and assumptions, including, but not limited
to, the following factors that could cause the Company's future
results and stockholder values to differ materially from those
expressed in any forward-looking statements made by or on behalf
of the Company. The Company's forward-looking statements
regarding projected results for 1998 are based on assumptions,
projections and estimates regarding continuing growth of the
economy, the telecommunications industry in general and specific
events that may directly affect the Company's performance. The
Company's markets are very competitive and some of the Company's
competitors have greater financial resources that allow them to
price products aggressively. These assumptions, projections and
estimates include and relate to the ability of its distributors'
to market the products effectively, the pricing of products in
the markets in which the Company competes, the strength and
effects of competition, the market's acceptance of the products
offered by the Company, the timing of customer orders, decisions
by intermediaries in the distribution channels regarding sales
hiring and
18
<PAGE>
training, pricing, advertising, promotions and other areas
affecting end-user demand for products, and the lack of any
material disruption of product supply or demand. In addition,
all forward-looking statements regarding Unistar and the US Lottery
are based on the assumptions that there will not be any further
deterioration in the business due to the legal/regulatory environment.
If actual events differ materially from the Company's assumptions,
projections and estimates, the Company's actual results could vary
significantly from the performance projected in the forward-looking
statements.
19
<PAGE>
PART II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
See Note F of the Notes to Consolidated Financial
Statements in Part I, Item 1) for details on legal
proceedings.
Item 2. CHANGES IN SECURITIES
Not applicable.
Item 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
Item 5. OTHER INFORMATION
Not applicable.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
11 - Statement Regarding Computation of Per
Share Earnings (see Note D of Notes to
Consolidated Financial Statements in Part I,
Item 1).
b) Reports on Form 8-K
None.
20
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of
1934, the registrant has duly caused this Report to be signed on
its behalf by the undersigned thereunto duly authorized.
EXECUTONE Information Systems, Inc.
Dated: August 14, 1998 /s/ Stanley J. Kabala
Stanley J. Kabala
Chairman, President and
Chief Executive Officer
Dated: August 14, 1998 /s/ Anthony R. Guarascio
Anthony R. Guarascio
Vice President Finance and Administration
Chief Financial Officer
21
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
financial statements included in the registrant's filing on Form 10-Q for
the quarterly period ended June 30, 1998 and is qualified in it's entirety
by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> JUN-30-1998
<CASH> 1,901
<SECURITIES> 0
<RECEIVABLES> 32,566
<ALLOWANCES> 1,270
<INVENTORY> 23,453
<CURRENT-ASSETS> 61,030
<PP&E> 24,477
<DEPRECIATION> 13,033
<TOTAL-ASSETS> 136,892
<CURRENT-LIABILITIES> 43,453
<BONDS> 16,059
0
7,300
<COMMON> 497
<OTHER-SE> 68,593
<TOTAL-LIABILITY-AND-EQUITY> 136,892
<SALES> 68,610
<TOTAL-REVENUES> 68,610
<CGS> 45,922
<TOTAL-COSTS> 45,922
<OTHER-EXPENSES> 28,752
<LOSS-PROVISION> 188
<INTEREST-EXPENSE> 1,046
<INCOME-PRETAX> (7,000)
<INCOME-TAX> (2,799)
<INCOME-CONTINUING> (4,201)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (4,201)
<EPS-PRIMARY> (0.08)
<EPS-DILUTED> (0.08)
</TABLE>
