INTER ACT SYSTEMS INC, 10-Q, 1997-08-14

INTER ACT SYSTEMS INC
10-Q, 1997-08-14
BUSINESS SERVICES, NEC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 1997
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 Number 333-12091

INTERACT SYSTEMS, INCORPORATED
(Exact name of registrant as specified in its charter)

NORTH CAROLINA 56-1817510
(State or other jurisdiction (I. R. S. Employer
of incorporation or organization) Identification No.)

14 WESTPORT AVENUE
NORWALK, CONNECTICUT 06851
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code (203) 750-0300

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 the number of shares outstanding of each of the
issuer's classes of common stock, as of the latest practicable date. As of
August 13, 1997 the registrant had 7,668,555 shares of common stock outstanding.

<PAGE>

INDEX
<TABLE>
<CAPTION>

Page
---------

Part I - Financial Information

<S> <C>

Item 1. Financial Statements (unaudited)
Consolidated Balance Sheets - June 30, 1997 and December 31, 1996.................................. 1
Consolidated Statements of Income for the three-month and six-month
periods ended June 30, 1997 and June 29, 1996 and for the period from
February 25, 1993 (Date of Inception) to June 30, 1997........................................ 2
Consolidated Statements of Cash Flows for the six-month periods ended
June 30, 1997 and June 29, 1996 and for the period from February 25, 1993
(Date of Inception) to June 30, 1997......................................................... 3
Notes to Consolidated Financial Statements........................................................ 4

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............... 5

Part II - Other Information

Item 1. Legal Proceedings................................................................................. 10

Item 4. Submission of Matters to a Vote of Security Holders................................................ 10

Item 6. Exhibits and Reports on Form 8-K....................................................................11

Signatures.................................................................................................. 12
</TABLE>

<PAGE>
PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

INTERACT SYSTEMS, INCORPORATED
(A Development Stage Company)
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>

June 30, December 31,
1997 1996
----------------- ------------
(Unaudited) Unaudited)
<S> <C> <C>

ASSETS
Current assets:
Cash and cash equivalents....................................... $ 72,380 $ 88,306
Receivables, net of allowance for doubtful accounts of $10 and
$4 at June 30, 1997 and December 31, 1996, respectively ... 1,182 617
Other current assets ........................................... 1,181 1,008
--------- ---------
Total current assets ...................................... 74,743 89,931
Property, plant and equipment, net ................................... 21,268 12,105
Bond issuance costs, net of accumulated amortization of $384 and
$169 at June 30, 1997 and December 31, 1996, respectively ...... 3,551 3,720
Patents, licenses and trademarks, net of accumulated amortization of
$79 and $34 at June 30, 1997 and December 31, 1996, respectively 838 227
Other noncurrent assets .............................................. 68 71
--------- ---------
Total assets .............................................. $ 100,468 $ 106,054
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Short-term debt and current portion of long-term debt .......... $ -- $ 97
Accounts payable ............................................... 2,634 1,243
Accrued expenses ............................................... 2,881 1,741
Deferred revenue ............................................... 1,581 479
--------- ---------
Total current liabilities ................................. 7,096 3,560
Long-term debt, net of discount ...................................... 85,146 77,095
Other noncurrent liabilities ......................................... 283 292
--------- ---------
Total liabilities ......................................... 92,525 80,947
--------- ---------
Common stock purchase warrants ....................................... 24,464 24,464
--------- ---------
Stockholders' equity (deficit):
Preferred stock, no par value, authorized 5,000,000 shares; none
outstanding ............................................... -- --
Common stock, no par value, authorized 20,000,000 shares;
7,668,555 shares issued and outstanding ................... 27,651 27,651
Additional paid-in capital ..................................... 768 768
Deferred compensation .......................................... (646) (723)
Deficit accumulated during development stage ................... (44,294) (27,053
--------- ---------
Total stockholders' equity (deficit)....................... (16,521) 643
--------- ---------
Total liabilites and stockholders' equity (deficit) ....... $ 100,468 $ 106,054
========= =========

</TABLE>

See Notes to Consolidated Financial Statements
1

<PAGE>

INTERACT SYSTEMS, INCORPORATED
(A Development Stage Company)
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
<TABLE>
<CAPTION>

For the
Three Months Ended Six Months Ended Period from
---------------------- -------------------- February 25, 1993
June 30, June 29, June 30, June 29, (Date of Inception)
1997 1996 1997 1996 to June 30, 1997
---------- --------- --------- ---------- ---------------
(Unaudited) (Unaudited) (Unaudited) (Unaudited) (Unaudited)

Gross sales ............................. $ 464 $ 87 $ 768 $ 154 $ 1,941
Less: Retailer reimbursements .... (267) (46) (453) (82) (1,128)
-------- -------- -------- -------- --------
Net sales ................. 197 41 315 72 813
-------- -------- -------- -------- --------
Operating expenses:
Direct costs ...................... 1,471 591 2,546 804 7,564
Selling, general and administrative
expenses ....................... 3,666 1,450 7,084 2,793 23,118
Depreciation and amortization of
intangibles .................... 896 228 1,527 347 3,045
-------- -------- -------- -------- --------
Total operating expenses ...... 6,033 2,269 11,157 3,944 33,727
-------- -------- -------- -------- --------
Operating loss .......................... (5,836) (2,228) (10,842) (3,872) (32,914)
-------- -------- -------- -------- --------
Other income (expense)
Interest income ................... 1,071 134 2,196 174 4,497
Interest expense .................. (4,421) (14) (8,539) (53) (15,820)
Other expense ..................... (57) -- (57) -- (57)
-------- -------- -------- -------- --------
Total other income (expense) .. (3,407) 120 (6,400) 121 (11,380)
-------- -------- -------- -------- --------

Net loss ................................ $ (9,243) $ (2,108) $(17,242) $ (3,751) $(44,294)
======== ======== ======== ======== ========

Loss per common share ................... $ (1.21) $ (0.29) $ (2.25) $ (0.61)
======== ======== ======== ========
Weighted average number of common shares
outstanding ....................... 7,669 7,222 7,669 6,179
======== ======== ======== ========
</TABLE>

See Notes to Consolidated Financial Statements
2

<PAGE>

INTERACT SYSTEMS, INCORPORATED
(A Development Stage Company)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
<TABLE>
<CAPTION>

For the
Six Months Ended Period from
-------------------------- February 25, 1993
June 30, June 29, (Date of Inception)
1997 1996 to June 30, 1997
------------- --------- ------------------
(Unaudited) (Unaudited) (Unaudited)
<S> <C> <C> <C> <C>

Cash flows from operating activities:
Net loss .............................................. $ (17,242) $ (3,751) $ (44,294)
Items not affecting cash:
Depreciation and amortization of intangible assets 1,527 347 3,045
Loss on disposal of assets ....................... 116 11 201
Non-cash interest on discounted bonds ............ 8,495 -- 15,338
Acquired research and development expenses ....... -- -- 611
Other items, net ................................. 9 (148) 296
Changes in working capital:
Receivables ...................................... (565) 47 (1,182)
Accounts payable and accrued expenses ............ 2,249 1,807 5,253
Other current assets ............................. 97 (213) (850)
Deferred revenues ................................ 1,102 -- 1,581
--------- --------- ---------
Net cash used in operating activities ....... (4,212) (1,900) (20,001)
--------- --------- ---------
Cash flows from investing activities:
Expenditures for property, plant and equipment ... (10,756) (6,706) (24,061)
Proceeds from disposal of assets ................. -- -- 57
Patent acquisition costs ......................... (657) (62) (676)
Other investments ................................ (301) -- (340)
--------- --------- ---------
Net cash used in investing activities ....... (11,714) (6,768) (25,020)
--------- --------- ---------
Cash flows from financing activities:
Net proceeds from issuance of 14% Senior Notes ... -- -- 90,767
Long-term debt repayments ........................ -- -- (51)
Proceeds from common stock issuance, net ......... -- 16,335 24,717
Net amount due to stockholders ................... -- 67 2,112
Net amount due from related parties .............. -- (394) (144)
--------- --------- ---------
Net cash provided by financing activities ... -- 16,008 117,401
--------- --------- ---------
Net (decrease) increase in cash and cash equivalents ........ (15,926) 7,340 72,380
Cash and cash equivalents at beginning of period ............ 88,306 76 --
--------- --------- ---------
Cash and cash equivalents at end of period .................. $ 72,380 $ 7,416 $ 72,380
========= ========= =========

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest .............................................. $ 44 $ 53 $ 482
========= ========= =========
Supplemental disclosures of non-cash financing activities:
Conversion of debt to common stock .................... $ 1,600 $ 1,600
========= =========
Conversion of accrued interest to common stock ........ $ 68 $ 68
========= =========
Conversion of amounts due to stockholders and
related parties to common stock .................. $ 418 $ 418
========= =========
Issuance of common stock in payment of consulting fees $ 55 $ 55
========= =========
Deferred compensation related to stock options granted $ -- $ 768
========= =========

</TABLE>

See Notes to Consolidated Financial Statements
3

<PAGE>

INTERACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 1997 AND
JUNE 29, 1996 (UNAUDITED)

1. BUSINESS DESCRIPTION

InterAct Systems, Incorporated ("InterAct") develops, owns and operates
proprietary electronic marketing systems that are designed to give consumer
products manufacturers (the "Manufacturers") and retailers the ability to
influence the purchasing behavior of consumers moments before shopping begins
and to track and analyze individual consumer purchasing behavior on an ongoing
basis. The Company's current commercial product offering utilizes interactive
"touch-screen" terminals inside the entrance of retail supermarkets that issue
individually targeted, and immediately usable, coupons and other promotional
incentives based on each consumer's cumulative purchasing history. As of
June 30, 1997, the Company had 1,528 terminals installed in 880 stores across
six grocery chains compared to 515 terminals in 278 stores across two chains
as of June 29, 1996.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying interim financial statements as of June 30, 1997 and
for the three-month and six-month periods ended June 30, 1997 and June 29, 1996
are unaudited; however, in the opinion of management, all adjustments, which
consist of normal recurring accruals, necessary for a fair presentation of the
financial position and results of operations from such interim periods, are
included. The results of operations for the interim periods presented are not
necessarily indicative of results for an entire year. For further information
refer to the consolidated financial statements and notes thereto included in the
Company's annual report on Form 10-K for the year ended September 28, 1996.
On February 13, 1997, the Company elected to change its fiscal year end
from the last Saturday in September to December 31, effective December 31, 1996.
The interim periods in 1996 ended on the last Saturday of the month, which, in
the case of June, ended on June 29, 1996.
Certain prior year amounts have been reclassified to conform with the
current year presentation.
Net income per common share is computed by dividing the net income
applicable to common stockholders by the weighted average number of common
shares outstanding during the period.

3. LITIGATION

In February 1996, the Company filed suit against Catalina Marketing
Corporation alleging that Catalina has infringed United States Letters Patent
No. 4,554,446 ( the "`446 Patent") under which the Company is licensee. The
Company alleges that Catalina is infringing the patent by making, using and
offering for sale devices and systems that incorporate and employ inventions
covered by the `446 Patent. The Company is seeking an injunction against
Catalina to stop further infringement of the patent, treble damages and the
costs and expenses incurred in connection with the suit. The complaint has been
amended to add additional detail, and Catalina has answered denying the
allegations, raising certain affirmative defenses, and seeking declaratory
judgment of non-infringement, invalidity or unenforceability of the `446 Patent.
In May 1997, Catalina asserted a second counterclaim alleging that the Company
is infringing a newly issued Catalina Patent U.S. Patent No. 5,612,868. The
Company has answered denying the allegations, raising affirmative defenses and
seeking declaratory judgment of non-infringement, invalidity and
unenforceability of U.S. Patent No. 5,612,868. Discovery on the claims and
counterclaims is proceeding and various motions are pending before the United
States District Court in the District of Connecticut. As with any litigation,
the ultimate outcome of the suit cannot be predicted. However, the Company
intends to pursue the action vigorously.

4
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion and analysis is qualified by reference to and
should be read in conjunction with the Company's Unaudited Consolidated
Financial Statements, including the Notes thereto, included elsewhere in this
Report. The Company's net sales and results of operations during the periods
presented have not been significantly affected by inflation. Operating results
for the three and six months ended June 30, 1997 are not necessarily indicative
of the results that may be expected for the year ending December 31, 1997 or any
other period.

Comparisons of operating results for the three-month and six-month
periods ended June 30, 1997 and June 29, 1996 can be misleading given that the
Company's principle activities during the period from inception (February 25,
1993) through June 29, 1996 were related to the development, testing and initial
installation of the INTERACT LOYALTY NETWORK ("ILN") and were limited by the
Company's relatively small capital base.

In the second quarter of 1997, the Company changed the reference to its
proprietary interactive multimedia system from INTERACT PROMOTION NETWORK
("IPN") to INTERACT LOYALTY NETWORK ("ILN") in order to more closely align the
marketing of InterAct's products and services to the supermarket industry, whose
participants are increasingly pursuing frequent shopper or "loyalty" card
programs, as well as to consumer products manufacturers, who typically seek to
win new customer loyalty. INTERACT LOYALTY NETWORK is a service mark of
InterAct Systems, Incorporated and an application for federal registration of
the mark is pending. Applications for INTERACT PROMOTION NETWORK and COUPON
CENTRAL are also pending.

RESULTS OF OPERATIONS

The following table provides information concerning the Company's store
installations as of June 30, 1997 and June 29, 1996 and redemption volumes and
Manufacturer/brand information for the six-month periods ended June 30, 1997 and
June 29, 1996, respectively.

JUNE 30, 1997 JUNE 29, 1996
------------- -------------
Terminals installed..................................... 1,528 515
Stores installed........................................ 880 278
Uninstalled stores under contract or letter of intent... 2,820 934

SIX MONTHS ENDED
JUNE 30, 1997 JUNE 29, 1996
------------- -------------
Total redemptions................... 5,000,900 707,000
Average redemptions/day/store...... 48 28
Paid redemptions/day/store......... 8 7
Manufacturers promoting on ILN..... 31 20
Brands promoting on ILN............ 86 70

SIX AND THREE MONTHS ENDED JUNE 30, 1997 COMPARED WITH SIX AND THREE MONTHS
ENDED JUNE 29, 1996

The Company installed 527 terminals in 310 stores in the second quarter
of 1997, bringing the total terminals and stores installed to 1,528 and 880,
respectively, as of June 30, 1997. This represents a significant improvement
over first quarter terminal and store installations of 378 and 235,
respectively. Total stores installed or under contract or letter of intent
increased by approximately 500 stores, to 3,700 stores, in the second quarter
primarily reflecting the signing of a multi-year contract with Lucky Stores,
Inc., a 400 store division of American Stores, Inc. Lucky Stores are located
predominantly in major northern and southern California markets. Installation of
ILN terminals is expected to begin later this year. Approximately 500 of the
2,820 uninstalled stores have older or less common point-of-sale systems that
will require more time in development than the chains using more modern or
market leading systems.
5
<PAGE>

Total redemptions for the six-month period ended June 30, 1997
increased seven-fold to over five million redemptions over the comparable period
in 1996. Average redemptions/day/store increased to 48 from 28 for the period
ended June 30, 1997 versus the comparable period in 1996. The increase was due
to increased stores in the ILN network and increasing consumer acceptance and
usage of the ILN terminals. Second quarter redemptions of 2.3 million fell
slightly from first quarter total redemptions of 2.7 million, and average
redemptions/day/store of 37 were lower than the first quarter's figure of 66.
The Company attributes this decline primarily to a reduction of available
incentives offered on the ILN terminals during the second quarter of 1997. The
reduced number of incentives offered resulted from a management decision to
reduce the number of "non-paid" promotions offered on the system in order to
reallocate such promotion funds to coincide with retailer event promotions later
in the year. Non-paid promotions represent consumer incentives and retailer
handling fees paid for by InterAct as opposed to contracted Manufacturers, and
are placed on the ILN in order to manage consumer usage levels. As the network
grows and is more widely accepted by Manufacturers, the Company believes the
need for non-paid promotions will diminish substantially. In response to the
decline of second quarter 1997 redemptions versus first quarter 1997
redemptions, the Company has since increased the number of incentives offered
on the ILN terminals, through non-paid incentives, and is closely monitoring the
effect on total redemptions. The substantial increase in store installations in
the second quarter also contributed to the decline in average
redemptions/day/store. New stores tend to show lower redemption volumes due to
initially low consumer familiarization with the ILN terminals as well as the
lack of customer purchasing history upon which the ILN's targeted promotions are
based.

Net sales during the six-month period ended June 30, 1997, increased to
$315,000 from $72,000 in the 1996 period, primarily as a result of the larger
installed base of ILN terminals and the increase in the number of brand
promotions on the ILN system in the 1997 period. Brand manufacturers promoting
on the ILN system for at least one week during the 1997 and 1996 periods
increased to 31 from 20, respectively, while total brand offerings promoted
increased to 86 from 70. During the three-month period ended June 30, 1997, net
sales increased to $197,000 from $41,000 in the same period in 1996. The
Company's sales activity in 1996 was limited due to the smaller installed base
of the ILN terminals. In the second quarter of 1997, the Company entered into a
one-year contract with Brown & Williamson, a major manufacturer of tobacco
products, to promote on the ILN from October 1997 through September 1998. The
contract is expected to generate approximately $7.7 million in gross revenues.
InterAct expects to earn between $1.2 million and $1.7 million of net revenue
from this contract, depending on redemption volume. No assurance can be given
that actual revenue will equal expected revenue.

Operating loss for the six-month period ended June 30, 1997 was $10.8
million versus $3.9 million in the 1996 comparable period. The increased loss
was primarily due to higher employee costs, non-paid promotions and depreciation
expense. Higher employee costs of approximately $2.1 million represents an
increase of 100 employees, from 54 employees at June 29, 1996 to 154 employees
at June 30, 1997. Most of the increase in headcount represents additional sales
and field service personnel to support the increase in number of terminals and
stores. Non-paid promotion expense increased by $1.6 million in the 1997
six-month period, to $1.9 million from $300,000 in the comparable 1996 period.
Depreciation expense increased by $1.2 million reflecting the addition of
approximately 1,000 terminals installed in 600 stores from June 29, 1996 to June
30, 1997. Second quarter 1997 operating loss of $5.8 million was $3.6 million
higher than in the second quarter 1996, primarily reflecting additional
headcount and expenses associated with increased installations of stores,
increased non-paid promotion expense of $700,000 and higher depreciation expense
of $668,000.

Net loss for the six month period ended June 30, 1997 increased by
approximately $13.4 million from $3.8 million to $17.2 million primarily due to
higher operating losses of $6.9 million and increased interest expense of $8.5
million offset by an increase in interest income of $2.0 million. Interest
expense of $8.5 million during the first six months of 1997 reflects the
interest expense on the issuance of $142 million of senior discount notes on
August 2, 1996. (See "-Liquidity and Capital Resources"). Interest income of
$2.2 million for the first half of 1997 reflects an increased cash balance
during the first six months of 1997 versus the comparable period in 1996. Cash
and cash equivalents at June 30, 1997 was $72.4 million as compared to $7.4
million at June 29, 1996. Net loss for the three-month period ended

6
<PAGE>

June 30, 1997 was $9.2 million, an increase of $7.1 million compared to the
same three-month period in 1996 due to increased operating losses and interest
expense of $3.6 million and $4.4 million, respectively offset by increased
interest income of $900,000.

LIQUIDITY AND CAPITAL RESOURCES

Cash used in operating activities was $4.2 million during the six
months ended June 30, 1997. From February 25, 1993, (Date of Inception) to June
30, 1997 the net cash used in operating activities was $20.0 million as the
Company generated minimal revenue yet incurred expenses related to the
development of its ILN technology, test marketing the product and recruiting
personnel. The Company has funded its operations through private sales of debt
and equity securities. From its inception through June 30, 1997, the Company's
stockholders had contributed $27.7 million of equity to the Company of which
$2.0 million was originally issued as debt and subsequently converted to equity.
The Company consummated a private offering of securities (the "Private
Placement") on August 2, 1996 for which it received net proceeds of
approximately $90.9 million. The Private Placement consisted of 142,000 units of
$142 million principal amount of 14% Senior Discount Notes Due 2003 (the
"Notes") and warrants (the "Warrants") to purchase initially an aggregate of
1,041,428 shares of common stock of the Company at $.01 per share. If the
Company has not completed a Qualifying Initial Public Offering (as herein
defined) by September 30, 1997, the Warrants that have not been exercised will
entitle the respective holders to purchase an aggregate of 1,338,918 shares of
common stock at $.01 per share. As of August 13, 1997, the Company does not
expect to complete such Qualifying Initial Public Offering by September 30,
1997.

In January 1997, the Company consummated an exchange offer (the
"Exchange Offer"), whereby the holders of the Notes issued in the Private
Placement exchanged such Notes for new Notes (the "Exchange Notes") that were
registered under the Securities Act of 1933, as amended. The Exchange Notes do
not bear legends restricting the transfer thereof.

Cash provided by financing activities was $117.4 million for the
period from February 25, 1993 (Date of Inception) through June 30, 1997. No cash
was provided by financing activities during the six-month period ended June 30,
1997. As of June 30, 1997, the Company had cash and cash equivalents of $72.4
million and working capital of $67.6 million as compared to cash and cash
equivalents of $88.3 million and working capital of $86.4 million at December
31, 1996.

Cash used in investing activities was $11.7 million and $25.0 million
in the six months ended June 30, 1997 and for the period from February 25, 1993
(Date of Inception) through June 30, 1997, respectively, primarily related to
expenditures for ILN equipment. As of June 30, 1997, the Company had contracts
and letters of intent to install and operate the ILN in approximately 3,700
stores, of which 880 were installed and operating. Installation expenditures
associated with the stores to be installed are estimated to be an aggregate of
approximately $35 million during calendar year 1997 of which $10.8 million had
been spent as of June 30, 1997.

The Company also plans to offer product promotions for which it will
bear the full cost of each redemption without reimbursement from Manufacturers
of an aggregate of approximately $6.4 million during 1997 of which $1.9 million
has been incurred during the six month period ended June 30, 1997.

The Company will continue to use the net proceeds from the Private
Placement to fund capital expenditures, working capital requirements and
operating losses incurred in connection with the increased commercialization of
its ILN during 1997. The Company believes that existing cash and cash
equivalents will be sufficient to meet the Company's currently anticipated
operating and capital expenditure requirements for the remainder of 1997.
However, the Company may seek additional capital prior to the end of calendar
1997 to fund its planned expansion in 1998 and to address any liquidity needs
caused by shortfalls in revenue. Because of the Company's early stage of
development and the risks inherent in its business, there are a number of
material uncertainties that could result in shortfalls in revenue. For example,
shortfalls could occur if the Company continues to experience delays in
installations of the ILN such that any growth in paid redemption volume is
delayed. If additional funds are raised through the

7
<PAGE>

issuance equity securities, the percentage ownership of the stockholders may
experience additional dilution, or such equity securities may have rights,
preferences or privileges senior to the Common Stock. If additional funds are
raised through debt financing, such financing will increase the financial
leverage of the Company and earnings would be reduced by the associated interest
expense. The Indenture permits the Company to incur additional indebtedness,
subject to certain limitations. There can be no assurance that additional
financing will be available when needed on terms favorable to the Company or at
all. If adequate funds are not available on acceptable terms, the Company may be
unable to continue its planned ILN installations, expand both the number and
dollar amount of Manufacturer commitments, or respond to competitive pressures,
any of which could have a material adverse effect on the Company's results of
operations and financial condition.

For a further description of the Notes and Warrants, see Notes 1, 7, and 8 to
the September 28, 1996 and September 30, 1995 Consolidated Financial Statements
filed with the Company's Annual Report on Form 10-K for the fiscal year ended
September 28, 1996.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In March 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per
Share". This statement establishes standards for computing and presenting
earnings per share ("EPS"), replacing the presentation of currently required
primary EPS with a presentation of Basic EPS. For entities with complex capital
structures, the statement requires the dual presentation of both Basic EPS and
Diluted EPS on the face of the statement of operations. Under this new standard,
Basic EPS is computed based on weighted average shares outstanding and excludes
any potential dilution; Diluted EPS reflects potential dilution from the
exercise or conversion of securities into common stock or from other contracts
to issue common stock and is similar to the currently required fully diluted
EPS. SFAS 128 is effective for financial statements issued for periods ending
after December 15, 1997, including interim periods, and earlier application is
not permitted. When adopted, the Company will be required to restate its EPS
data for all prior periods presented. The Company does not expect the impact of
the adoption of this statement to be material to previously reported EPS
amounts.

CAUTIONARY STATEMENT ON FORWARD LOOKING STATEMENTS

Except for historical matters, the matters discussed in Part I, Item 2.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," are forward-looking statements. Forward looking statements are
based on management's current views and assumptions and involve risks and
uncertainties that could significantly affect expected results. InterAct wishes
to caution the reader that the factors below in some cases have affected and
could affect InterAct's actual results, causing actual results to differ
materially from those in any forward-looking statement. These factors include:
(i) the Company's limited operating history, significant losses, accumulated
deficit and expected future losses, (ii) the dependence of the Company on its
ability to establish, maintain and expand relationships with Manufacturers to
promote brands on the ILN, the lengthy sales cycle in marketing the ILN to
Manufacturers and the uncertainty of market acceptance for the ILN, (iii) the
pressure that rapid growth places on the Company's managerial, operational and
financial resources, the uncertainty as to whether the Company will be able to
manage its growth effectively, the early stage of the Company's products and
services and technical and other problems that the Company has experienced and
may experience with the accelerated installation of the ILN, (iv) risks related
to the Company's substantial leverage and debt service obligations, (v) the
effective subordination of the Notes to the obligations of its subsidiaries,
(vi) the consequences of the Company's possible need for additional financing,
(vii) the lack of product diversification and the Company's dependence on the
consumer products advertising and promotional business and its expenditures,
(viii) the Company's dependence on third parties such as Thermo Information
Solutions, Inc., the manufacturer of ILN terminals, (ix) the intensely
competitive nature of the consumer product and promotional industry and the
greater resources of most of the Company's competitors, (x) risks that the
Company's rights related to patents, proprietary information and trademarks
may not adequately protect its business, (xi) the possible inability of new
management to perform their respective roles and the possible conflicts of
interest of the Company's directors, officers and principal

8
<PAGE>

shareholders in certain transactions with the Company. See "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations - Risk
Factors" of the Form 10-K for the fiscal year ended September 28, 1996 for a
more specific description of these risks.

9
<PAGE>

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

(a) The annual meeting of the stockholders of the Company was held on
May 20, 1997.

(b) The name of each member of the Board of Directors elected at the
annual meeting of stockholders are set forth below.

(c) At the annual meeting of stockholders, the stockholders voted (i)
on the election of Directors to hold office until the 1998 Annual
Meeting of Shareholders for Class I directors; until the 1999
Annual Meeting of Shareholders for Class II directors and until
the 2000 Annual Meeting of Shareholders for Class III directors,
all until the election and qualification of their respective
successors, (ii) to amend the Articles of Incorporation to (I)
authorize 5,000,000 shares of preferred stock, (II) provide for
the removal of any director or of the entire Board of Directors
of the corporation only for cause and only by a supermajority
shareholder vote, (III) limit the personal liability of a
director or former director of the corporation to the corporation
or its shareholders to the extent permitted by the North Carolina
Business Corporation Act, (IV) provide for a supermajority
shareholder vote requirement for certain corporate transactions
between the corporation and beneficial owners of at least 10% of
its common stock, (V) empower the corporation's Board of
Directors to adopt, amend or repeal the bylaws of the
corporation, except to the extent limited by law, and to impose a
supermajority shareholder vote requirement for the adoption,
repeal, or amendment of the bylaws of the corporation, (iii) to
amend and restate the Bylaws of the Corporation, (iv) on the
approval of the Company's 1996 Nonqualified Stock Option Plan and
(v) on the approval of the Company's 1997 Long-Term Incentive
Plan. Of those present at the meeting, either by proxy or in
person, votes were cast for the election of the Directors as
follows:

<PAGE>

NAME OF DIRECTOR CLASS NUMBER OF VOTES CAST FOR ELECTION
---------------- ----- ---------------------------------
Paul A. Nash I 6,381,453
L. Richardson Preyer, Jr. I 6,381,453
Robert A. Silverberg I 6,381,453
Haynes G. Griffin II 6,381,453
William F. Penwell II 6,297,680
Robert M. DeMichele II 6,381,453
Brian A. Rich II 6,381,453
Richard P. Ludington III 6,381,453
William P. Emerson, Jr. III 6,381,453
Stephen R. Leeolou III 6,381,453
Stuart S. Richardson III 6,381,453

With respect to the resolution to amend the Articles of Incorporation
and the resolution to amend and restate the Bylaws of the corporation,
6,381,453 votes were cast for approval, and no votes were cast
against. With respect to the resolution to approve 1996 Nonqualified
Stock Option Plan, 6,360,295 votes were cast for approval, 21,158
votes were cast against. With respect to the resolution to approve the
1997 Long-Term Incentive Plan, 6,297,856 votes were cast for approval
and 83,597 votes cast against. There were no absentions on any votes.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a. Exhibits

EXHIBIT NO. DESCRIPTION
----------- -----------

*3(a)(1) Articles of Incorporation of the Company, as amended,
filed as Exhibit 3(a) to the Company's Registration
Statement of Form S-4 (Registration 333-12091)

3(a)(2) Articles of Amendment of the Company dated May 21,
1997 and effective June 3, 1997.

3(b) Amended and Restated Bylaws of the Company

*4(a) Specimen Certificate of the Company's Common Stock,
filed as Exhibit 4(a) to the Company's Registration
Statement of Form S-4 (Registration 333-12091)

*4(b) Indenture dated August 1, 1996, between the Company
and Fleet National Bank, as trustee, relating to
$142,000,000 in principal amount of 14% Senior
Discount Notes due 2003, filed as Exhibit 4(b) to the
Company's Registration Statement of Form S-4
(Registration 333-12091)

*4(c) Warrant Agreement dated August 1, 1996, between the
Company and Fleet National Bank, as Warrant Agent,
filed as Exhibit 10 (l) to the Company's Annual Report
on Form 10-K for the year ended September 28, 1996.

27. Financial Data Schedule.

* Incorporated by reference to the statement or report indicated.

b. Reports on Form 8-K
No reports on Form 8-K were filed during the three
months ended June 30, 1997.

<PAGE>

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

INTERACT SYSTEMS, INCORPORATED

By
Stephen R. Leeolou
Chairman & Chief Executive Officer

By:
Richard A. Vinchesi
Senior Vice President,
Chief Operating Officer
and Chief Financial Officer

ARTICLES OF AMENDMENT

INTERACT SYSTEMS, INCORPORATED

The undersigned corporation hereby submits pursuant to Section 55-10-06
of the North Carolina General Statutes these Articles of Amendment for the
purpose of amending its Articles of Incorporation:

1. The name of the corporation is InterAct Systems, Incorporated.

2. The Articles of Incorporation of the corporation are hereby
amended as follows:

A. Article 2 is amended in its entirety to read as follows:

2. The aggregate number of shares of capital stock which
the corporation shall have the authority to issue is
25,000,000, 20,000,000 of which shall be common stock
and 5,000,000 of which shall be preferred stock. The
shares of common stock shall have unlimited voting
rights and, after satisfaction of claims, if any, of
the holders of shares of preferred stock, shall be
entitled to receive the net assets of the corporation
upon distribution. The Board of Directors of the
corporation shall have full power and authority to
establish one or more series within the class of
preferred stock, to define the designations,
preferences, limitations and relative rights
(including conversion rights) of shares within such
class and to determine all variations between series.

B. Article 6 is added to read as follows:

6. Any director or the entire Board of Directors of the
corporation may be removed at any time, but only for
cause and only by the affirmative vote of the holders
of at least two-thirds (66 2/3%) of the outstanding
shares of capital stock of the corporation entitled
to vote generally in elections of directors
(considered for this purpose as a single class).

C. Article 7 is added to read as follows:

7. To the fullest extent permitted by the North Carolina
Business Corporation Act as it exists or may
hereafter be amended, no person who is serving or who
has served as a director of the corporation shall be
personally liable to the corporation or any of its
shareholders for monetary damages for breach of duty
as a director. No amendment or repeal of this
article, nor the addition of any provision to these
Articles of Incorporation inconsistent with this
article, shall eliminate or reduce the protection
granted herein with respect to any matter that
occurred prior to such amendment, repeal,

<PAGE>

or addition.

D. Article 8 is added to read as follows:

8. (a) As used in this Article 8, the term "Person"
includes any person, firm or corporation; any person,
firm or corporation controlling that Person,
controlled by that Person, or under common control
with that Person; and any group of which that Person
or any of the foregoing persons, firms or
corporations or members, or any other group
controlling that Person, controlled by that Person,
or under common control with that Person. As used
herein the term "group" includes persons, firms and
corporations acting in concert, whether or not as a
formal group. The term "equity security" means any
shares of stock or similar security, any security
convertible, with or without consideration, into such
a security, or carrying any warrant or right to
subscribe to or to purchase such a security; or any
such warrant or right.

(b) Except as authorized by section (d) of this
Article 8, if, as of the record date for the
determination of the identity of the shareholders of
the corporation entitled to notice and to vote on
such transaction, any Person is the record or
beneficial owner, directly or indirectly, of more
than ten percent (10%) of any class of equity
security of the corporation, the affirmative vote of
the holders of two-thirds (66 2/3%) of the shares of
capital stock of the corporation then entitled to
vote in elections of directors shall be required for
(1) the merger or consolidation of the corporation
with that Person; or (2) the sale, lease, or exchange
of substantially all of the assets of the corporation
or of that Person to the other; or (3) any
dissolution of the corporation. This affirmative vote
is in addition to any vote otherwise required by
North Carolina law or by any agreement between the
corporation and any national securities exchange.

(c) The Board of Directors of the corporation shall
have the power and duty to determine for purposes of
this Article 8, on the basis of information known to
the corporation, whether (1) the purported holder of
record or beneficial owner of any class of equity
security of the corporation is a "Person" within the
meaning of section (A); (2) whether such Person in
fact holds of record or owns beneficially more than
ten percent (10%) of any class of equity security of
the corporation; and (3) whether the approval of the
Board of Directors referred to in section (d) has
been obtained. Any such determination by the Board of
Directors shall be conclusive and binding for all
purposes of this Article 8.
<PAGE>

(d) The provisions of this Article 8 shall not apply
to (1) any one of the transactions specified in
section (b) if the Board of Directors of the
corporation shall by resolution, by a vote of a
majority of its members than in office other than
such Person, have approved such transaction and
recommended its approval by the shareholders; or (2)
any merger or consolidation of the corporation with,
or any sale, lease or exchange to the corporation or
any of its subsidiaries of any of the assets of, any
corporation of which a majority of the outstanding
shares of stock entitled to vote in elections of
directors of such other corporation is owned of
record or beneficially by the corporation and its
subsidiaries.

(e) No amendment of the Articles of Incorporation of
the corporation shall amend, alter, repeal or change
any of the provisions of this Article 8, unless the
amendment effecting such amendment, alteration,
change or repeal shall receive the affirmative vote
of the holders of two-thirds (66 2/3%) of the shares
of capital stock of the corporation then entitled to
vote in elections of directors.

E. Article 9 is added to read as follows:

9. (a) Notwithstanding any other provision of the
Articles of Incorporation or the bylaws of the
corporation, the Board of Directors of the
corporation shall have the power to adopt, amend or
repeal the bylaws of the corporation except to the
extent limited by law. The shareholders of the
corporation may exercise their power to adopt, amend
or repeal the bylaws of the corporation only by the
affirmative vote of the holders of at least
two-thirds (66 2/3%) of the outstanding shares of
capital stock of the corporation entitled to vote
generally in the election of directors (considered
for this purpose as one class and notwithstanding
that some lesser percentage may be permitted by law,
or permitted or required by the Articles of
Incorporation or the bylaws of the corporation).

(b) No amendment of the Articles of Incorporation of
the corporation shall amend, alter, repeal or change
any of the provisions of this Article 9 unless the
amendment effecting such amendment, alteration,
change or repeal shall receive the affirmative vote
of the holders of two-thirds (66 2/3%) of the shares
of capital stock of the corporation then entitled to
vote in elections of directors.

3. The foregoing amendments were approved on the 20th day of May, 1997
by the shareholders of the corporation as required by the North Carolina
Business Corporation Act.

This the 21st day of May, 1997.

INTERACT SYSTEMS, INCORPORATED

By: /s/ Stephen R. Leeolou
Stephen R. Leeolou, Chairman & Chief
Executive Officer

<PAGE>

AMENDED AND RESTATED

BYLAWS

INTERACT SYSTEMS, INCORPORATED

ARTICLE I

Offices

1. Principal Office. The principal office of the corporation shall be
located at such place as the Board of Directors may determine.

2. Other Offices. The corporation may have offices at such other
places, either within or without the State of North Carolina, as the Board of
Directors may from time to time determine, or as the affairs of the corporation
may require.

ARTICLE II

Shareholders' Meetings

1. Place of Meetings. All meetings of the shareholders shall be held at
the principal office of the corporation, or at such other place, either within
or without the State of North Carolina, as shall be designated in the notice of
the meeting or agreed upon by a majority of the shareholders entitled to vote
thereat.

2. Annual Meetings. The annual meeting of shareholders shall be held in
May of each year on a date to be determined by the Board of Directors for the
purpose of electing directors of the corporation and for the transaction of such
other business as may be properly brought before the meeting.

3. Substitute Annual Meetings. If the annual meeting shall not be held
on the day designated by these bylaws, a substitute annual meeting may be called
in accordance with the provisions of Section 4 of this Article. A meeting so
called shall be designated and treated for all purposes as the annual meeting.

4. Special Meetings. Special meetings of the shareholders may be called
at any time by the Chairman, President, Secretary or Board of Directors of the
corporation.

5. Notice of Meetings. Written or printed notice stating the time and
place of the meeting shall be delivered no fewer than 10 nor more than 60 days
before the date thereof, either personally or by mail, by or at the direction of
the President, the Secretary, or other person calling the meeting, to each
shareholder of record entitled to vote at such meeting and to each nonvoting

<PAGE>

shareholder entitled to notice of the meeting. If the corporation is required by
law to give notice of proposed action to nonvoting shareholders and the action
is to be taken without a meeting pursuant to Section 9 of this Article, written
notice of such proposed action shall be delivered to such shareholders not less
than 10 days before such action is taken.

If notice is mailed, such notice shall be effective when deposited in
the United States mail with postage thereon prepaid and correctly addressed to
the shareholder's address shown in the corporation's current record of
shareholders.

In the case of an annual or substitute annual meeting, the notice of
meeting need not specifically state the business to be transacted thereat unless
it is a matter with respect to which specific notice to the shareholders is
expressly required by the provisions of the North Carolina Business Corporation
Act. In the case of a special meeting the notice of meeting shall specifically
state the purpose or purposes for which the meeting is called.

When a meeting is adjourned for more than 120 days after the date fixed
for the original meeting or if a new record date for the adjourned meeting is
fixed, notice of the adjourned meeting shall be given as in the case of an
original meeting. When a meeting is adjourned for 120 days or less and no new
record date for the adjourned meeting is fixed, it is not necessary to give
notice of the adjourned meeting other than by announcement at the meeting at
which the adjournment is taken.

6. Waiver of Notice. A shareholder may waive any notice required by
law, the Articles of Incorporation, or these bylaws before or after the date and
time stated in the notice. Such waiver must be in writing, be signed by the
shareholder entitled to the notice, and be delivered to the corporation for
inclusion in the minutes or filing with the corporate records. A shareholder's
attendance at a meeting waives objection to lack of notice or defective notice
of the meeting, unless the shareholder at the beginning of the meeting objects
to holding the meeting or transacting business at the meeting. A shareholder's
attendance at a meeting also waives objection to consideration of a particular
matter at the meeting that is not within the purpose or purposes described in
the notice of meeting, unless the shareholder objects to considering the matter
before it is voted upon.

7. Quorum. Shares representing a majority of the outstanding votes
entitled to vote upon a particular matter within each voting group represented
in person or by proxy shall constitute a quorum at meetings of shareholders. If
there is no quorum at the opening of a meeting of shareholders, such meeting may
be adjourned from time to time by a vote of a majority of the votes on the
motion to adjourn; at any adjourned meeting at which a quorum is present, any
business may be transacted which might have been transacted at the original
meeting unless a new record date is or must be set for the adjourned meeting.

Once a share is represented for any purpose at a meeting, it is deemed
present for quorum purposes for the remainder of the meeting and for any
adjournment of that meeting unless a new record date is set for that adjourned
meeting.

8. Voting of Shares. Except to the extent the Articles of Incorporation
provide for multiple or fractional votes per share for certain classes of
capital stock, each outstanding share having voting rights shall be entitled to
one vote on each matter submitted to a vote at a meeting

<PAGE>

of the shareholders. Except in the election of directors, a majority of the
votes cast on any matter at a meeting of shareholders at which a quorum is
present shall be the act of the shareholders on that matter, unless a greater
vote is required by law, by the Articles of Incorporation or by a bylaw adopted
by the shareholders of the corporation.

9. Informal Action by Shareholders. Any action which is required or
permitted to be taken at a meeting of the shareholders may be taken without a
meeting if a consent in writing, setting forth the action so taken, shall be
signed, either before or after the time the action which is the subject of the
shareholder approval is taken, by all of the persons who would be entitled to
vote upon such action at a meeting and delivered to the corporation for
inclusion in the minutes or filing with the corporate records. Unless otherwise
fixed by law or these bylaws, the record date for determining the shareholders
entitled to take action without a meeting shall be the date the first
shareholder signs the consent.

10. Voting Lists. After fixing a record date for a meeting, the
corporation shall prepare an alphabetical list of the names of all the
shareholders entitled to notice of such meeting, arranged by voting group and
within each voting group by class or series of shares, with the address of and
number of shares held by each shareholder. Such list shall be available for
inspection by any shareholder, beginning two business days after notice is given
of the meeting for which the list was prepared and continuing through the
meeting, at the corporation's principal office or at a place identified in the
meeting notice in the city where the meeting will be held. A shareholder, or his
agent or attorney, is entitled on written demand to inspect and, subject to the
requirements of North Carolina law, to copy the list, during regular business
hours and at his expense, during the period it is available for inspection. This
list shall also be produced and kept open at the time and place of the meeting
and shall be subject to inspection by any shareholder, or his agent or attorney,
during the whole time of the meeting or any adjournment.

11. Proxies. Shares may be voted either in person or by one or more
agents authorized by a written appointment form executed by the shareholder or
by his duly authorized attorney in fact. An appointment form is valid for 11
months from the date of its execution, unless a different period is expressly
provided in the appointment form. An appointment is revocable by the shareholder
unless the appointment form conspicuously states that it is irrevocable and the
appointment is coupled with an interest.

12. Shares Held by Nominees. The corporation may establish a procedure
by which the beneficial owner of shares that are registered in the name of a
nominee is recognized by the corporation as a shareholder. The extent of this
recognition may be determined in the procedure.

<PAGE>

ARTICLE III

Directors

1. General Powers. Subject to the Articles of Incorporation, all
corporate powers shall be exercised by or under the authority of, and the
business and affairs of the corporation be managed under the direction of, its
Board of Directors.

2. Number, Term and Qualifications. The number of directors of the
corporation shall be not less than 7 nor more than 12. The number of directors
may be fixed or changed from time to time, within the foregoing range, by the
shareholders or the Board of Directors. The Board of Directors may also increase
or decrease this number, but not by more than 30%, during any twelve-month
period. Directors need not be residents of the State of North Carolina or
shareholders of the corporation.

3. Term and Election. The Board of Directors shall be divided into
classes, as nearly equal in number as the then total number of directors
constituting the entire Board permits, designated as Class I Directors, Class II
Directors and Class III Directors, respectively, at the time of their election
and shall have the terms of office as follows: The term of office of Class I
Directors shall expire at the 1998 Annual Meeting of Shareholders; the term of
office of Class II Directors shall expire at the 1999 Annual Meeting of
Shareholders; and the term of office of Class III Directors shall expire at the
2000 Annual Meeting of Shareholders; with the members of each class of directors
to hold office until their successors are elected and qualified. At each Annual
Meeting of the Shareholders subsequent to the 1997 Annual Meeting of
Shareholders, directors elected to succeed those whose terms are expiring shall
be elected for a term of office to expire at the third succeeding Annual Meeting
of Shareholders and until their respective successors are elected and qualified.
Persons who receive a plurality of the votes cast at any election of directors
shall be deemed to have been elected.

4. Removal. Notwithstanding any other provision of the bylaws of the
corporation, any director or the entire Board of Directors of the corporation
may be removed at any time, but only for cause and only by the affirmative vote
of the holders of at least two-thirds (66 2/3%) of the outstanding shares of
capital stock of the corporation entitled to vote generally in elections of
directors (considered for this purpose as a single class). If any directors are
so removed, new directors may be elected at the same meeting.

A director may not be removed by the shareholders at a meeting unless
the notice of the meeting states that the purpose, or one of the purposes, of
the meeting is removal of the director.

5. Vacancies. Unless the Articles of Incorporation provide otherwise,
if a vacancy occurs on the Board of Directors, including, without limitation, a
vacancy resulting from an increase in the number of directors or from the
failure by the shareholders to elect the full authorized number of directors,
the vacancy may be filled by the shareholders or the Board of Directors. If the
directors remaining in office constitute fewer than a quorum of the Board of
Directors, vacancies may be filled by the affirmative vote of a majority of all
the directors, or by the sole remaining director. A vacancy that will occur at a
specific later date may be filled before the vacancy occurs but the new director
may not take office until the vacancy occurs. A director elected to fill a

<PAGE>

vacancy shall serve for the unexpired term of his predecessor in office and
until his successor is elected and qualified.

6. Chairman. There may be a Chairman of the Board of Directors elected
by the directors from their number at any meeting of the Board. The Chairman
shall preside at all meetings of the Board of Directors and perform such other
duties as may be directed by the Board. The Board of Directors may designate the
Chairman of the Board or any Vice-Chairman of the Board as an officer of the
corporation.

7. Compensation. The Board of Directors may compensate a director for
his services as such and may provide for the payment of all expenses incurred by
a director in attending regular and special meetings of the Board or in
otherwise fulfilling his duties as a director.

8. Executive and Other Committees. Unless otherwise provided in the
Articles of Incorporation or the bylaws, the Board of Directors, by resolution
adopted by a majority of the number of directors then in office, may designate
from among its members an executive committee and one or more other committees,
each consisting of two or more directors. To the extent specified by the Board
of Directors or in the Articles of Incorporation of the corporation, such
committees shall have and may exercise all of the authority of the Board of
Directors in the management of the business and affairs of the corporation,
except that a committee may not authorize distributions; approve or propose to
shareholders action that North Carolina law requires be approved by
shareholders; fill vacancies on the Board of Directors or on any committee;
amend the Articles of Incorporation; adopt, amend, or repeal bylaws; approve a
plan of merger not requiring shareholder approval; authorize or approve
reacquisition of shares of capital stock of the corporation, except according to
a formula or method prescribed by the Board of Directors; or authorize or
approve the issuance or sale or contract for sale of shares, or determine the
designation and relative rights, preferences, and limitations of a class or
series of shares, except that the Board of Directors may authorize a committee
(or a senior executive officer of the corporation) to do so within limits
specifically prescribed by the Board of Directors.

ARTICLE IV

Meetings of Directors

1. Regular Meetings. A regular meeting of the Board of Directors shall
be held immediately after, and at the same place as, the annual meeting of the
shareholders. The Board of Directors may also provide, by resolution, the time
and place, either within or without the State of North Carolina, for the holding
of additional regular meetings.

2. Special Meetings. Special meetings of the Board of Directors may be
called by or at the request of the Chairman of the Board, the President or any
two directors. Such meetings may be held within or without the State of North
Carolina.

3. Notice of Meetings. Regular meetings of the Board of Directors may
be held without notice.

The person or persons calling a special meeting of the Board of
Directors shall, at least

<PAGE>

two days before the meeting, give notice thereof by any usual means of
communication. Such notice need not specify the purpose for which the meeting is
called.

4. Waiver of Notice. Any director may waive any required notice before
or after the date and time stated in the notice. Attendance at or participation
by a director in a meeting shall constitute a waiver of notice of such meeting,
unless the director at the beginning of the meeting (or promptly upon his
arrival) objects to holding the meeting or transacting any business at the
meeting and does not thereafter vote for or assent to action taken at the
meeting.

5. Quorum. A majority of the number of directors prescribed, or, if no
number is prescribed, the number in office immediately before the meeting
begins, shall constitute a quorum for the transaction of business at any meeting
of the Board of Directors.

6. Manner of Acting. Except as otherwise provided by law, the Articles
of Incorporation or these bylaws, an act of the majority of the directors
present at a meeting at which a quorum is present shall be the act of the Board
of Directors.

The vote of a majority of the directors then holding office shall be
required to adopt, amend or repeal a bylaw, if otherwise permissible. Approval
of a transaction in which one or more directors have an adverse interest shall
require a majority, not less than two, of the disinterested directors then in
office, even though less than a quorum.

7. Presumption of Assent. A director of the corporation who is present
at a meeting of the Board of Directors or a committee of the Board of Directors
when corporate action is taken shall be deemed to have assented to the action
taken unless his contrary vote is recorded; he objects at the beginning of the
meeting (or promptly upon his arrival) to holding it or transacting business at
the meeting; his dissent or abstention is entered in the minutes of the meeting;
or he files written notice of dissent or abstention with the presiding officer
of the meeting before its adjournment or with the corporation immediately after
the adjournment of the meeting. The right of dissent or abstention is not
available to a director who voted in favor of such action.

8. Informal Action by Directors and Attendance by Telephone. Action
taken by a majority of the directors without a meeting is nevertheless Board
action if written consent to the action in question, describing the action
taken, is signed by all the directors and filed with the minutes of the
proceedings of the Board or with the corporate records, whether done before or
after the action so taken. Such action shall be effective when the last director
signs the consent, unless the consent specifies a different effective date. The
Board of Directors may permit any or all directors to participate in a regular
or special meeting by, or conduct the meeting through the use of, any means of
communication by which all directors participating may simultaneously hear each
other during the meeting. A director participating in a meeting by this means is
deemed to be present in person at the meeting.
9. Loans to Directors. Except as otherwise provided by law, the
corporation shall not directly or indirectly lend money to or guarantee the
obligation of a director of the corporation unless the particular loan or
guarantee is approved by a majority of the votes represented by the outstanding
voting shares of all classes, voting as a single voting group, except the votes
of shares owned by or voted under control of the benefited director, or unless
the corporation's Board of Directors determines that the loan or guarantee
benefits the corporation and either

<PAGE>

approves the specific loan or guarantee or a general plan authorizing loans and
guarantees. The fact that a loan or guarantee is made in violation of this
Section does not affect the borrower's liability on the loan.

ARTICLE V

Officers

1. Designation and Number of Officers. The officers of the corporation
shall consist of Executive Officers and Nonexecutive Officers. The Executive
Officers of the corporation shall consist of the Chairman, the President, any
Executive Vice Presidents and Senior Vice Presidents, the Secretary, the
Treasurer and any Vice Presidents or other officers designated an Executive
Officer by the Board of Directors. Nonexecutive Officers are all officers other
than Executive Officers including, without limitation, Assistant Vice
Presidents, Assistant Secretaries, Assistant Treasurers and Vice Presidents.

The Board of Directors may designate any Executive Officer as Chief
Executive Officer, Chief Operating Officer, Chief Financial Officer, Chief
Accounting Officer or Chief Technical Officer, which officer shall have such
authority as the Board of Directors may designate. Any two or more offices may
be held by the same person, except the offices of President and Secretary, but
no officer may act in more than one capacity where action of two or more
officers is required. It shall not be necessary for any officer to be a
shareholder of the corporation.

2. Election or Appointment and Term. The Executive Officers of the
corporation shall be elected by the Board of Directors. Such election may be
held at any regular or special meeting of the Board. Unless otherwise determined
by the Board of Directors, the Chief Executive Officer may appoint Nonexecutive
Officers. Appointments by the Chief Executive Officer shall become effective
upon the Chief Executive Officer's executing minutes of appointment and
inserting such minutes into the corporation's minute book. Each Executive and
Nonexecutive Officer shall hold office until his death, resignation, retirement,
removal, disqualification or until his successor is elected or appointed and
qualified.

3. Removal. Any officer or agent of the corporation may be removed by
the Board with or without cause. Any officer or agent appointed by the Chief
Executive Officer may be removed by him with or without cause. The removal of an
officer or agent pursuant to this section shall be without prejudice to the
contract rights, if any, of the person so removed.

4. Compensation. The compensation of all Executive Officers shall be
fixed by the Board of Directors. Unless otherwise determined by the Board, the
compensation of Nonexecutive Officers appointed by the Chief Executive Officer
of the corporation shall be fixed by him. No officer shall serve the corporation
in any other capacity and receive compensation therefor unless such additional
compensation be authorized by the Board of Directors.

5. Chairman. The Chairman shall preside at all meetings of the Board of
Directors and of the shareholders and shall perform such other duties as may be
assigned to him by the Board.

6. President. The President shall, unless otherwise determined by the
Board of Directors,

<PAGE>

be the Chief Executive Officer of the corporation and, subject to the control of
the Board of Directors, shall supervise and control the management of the
corporation according to these bylaws. He shall, in the absence of the Chairman,
preside at all meetings of the shareholders. He shall sign, with any other
proper officer, certificates for shares of the corporation, and any deeds,
mortgages, bonds, contracts or other instruments that may lawfully be executed
on behalf of the corporation, except where required or permitted by law to be
otherwise signed and executed and except where the signing and execution thereof
shall be delegated by the Board of Directors to some other officer or agent;
and, in general, he shall perform all duties incident to the office of President
and such other duties as may be prescribed by the Board of Directors from time
to time.

7. Vice Presidents. The Vice Presidents shall perform such duties and
shall have such other powers as the Board of Directors or the President shall
prescribe. The Board of Directors may designate one or more Vice Presidents as
Executive or Senior Vice President, or any other title that the Board of
Directors deems appropriate, and may rank the Vice Presidents in order of
authority. The Vice President, or, if more than one, the highest ranking
available Vice President, shall, in the absence or disability of the President,
perform the duties and exercise the powers of that office.

8. Secretary. The Secretary shall keep accurate records of the acts and
proceedings of all meetings of shareholders and directors. He shall give all
notices required by law and by these bylaws. He shall have general charge of the
corporate records and books and of the corporate seal, and he shall affix the
corporate seal to any lawfully executed instruments requiring it. He shall have
general charge of the stock transfer books of the Corporation and shall keep, at
the registered or principal office of the Corporation, a record of shareholders
showing the name and address of each shareholder and the number and class of the
shares held by each. He shall sign such instruments as may require his
signature, and in general, shall perform all duties incident to the office of
Secretary and such other duties as may be assigned to him from time to time by
the President or by the Board of Directors.

9. Treasurer. The Treasurer shall have custody of all funds and
securities belonging to the Corporation and shall receive, deposit or disburse
the same under the direction of the Board of Directors and the President. He
shall keep full and accurate records of the finances of the Corporation in books
especially provided for the purpose; and he shall prepare or cause to be
prepared, for each fiscal year, annual financial statements of the corporation
including a balance sheet as of the end of the fiscal year, an income statement
for that year, and a statement of cash flows for the year, all in reasonable
detail, including particulars as to convertible securities then outstanding,
which financial statements or written notice of their availability shall be
mailed to each shareholder within 120 days after the close of each fiscal year.
The Treasurer shall, in general, perform all duties incident to his office and
such other duties as may be assigned to him from time to time by the President
or by the Board of Directors.

10. Assistant Officers. The Assistant Vice Presidents, Secretaries and
Treasurers shall, in the absence or disability of their superiors, perform the
duties and exercise the powers of those offices and shall, in general, perform
such other duties as shall be assigned to them by the President or by the
respective officers to whom they report.

<PAGE>

11. Internal Auditor. The Chief Executive Officer may appoint one or
more internal auditors with the concurrence of the Audit Committee of the Board
of Directors. Any internal auditors so appointed may not be dismissed without
the concurrence of the Audit Committee.

12. Contract Rights. The appointment of an officer does not itself
create contract rights in the office.

13. Bonds. The Board of Directors may by resolution require any or all
officers, agents and employees of the corporation to give bond to the
corporation, with sufficient sureties, conditioned on the faithful performance
of the duties of their respective offices or positions, and to comply with such
other conditions as may from time to time be required by the Board of Directors.

ARTICLE VI

Contracts, Checks and Deposits

1. Contracts. The Board of Directors may authorize any officer or
officers, agent or agents, to enter into any contract or execute and deliver any
instrument on behalf of the corporation, and such authority may be general or
confined to specific instances.

2. Checks and Drafts. All checks, drafts or orders for the payment of
money issued in the name of the corporation shall be signed by such officer or
officers, agent or agents of the corporation and in such manner as shall from
time to time be determined by resolution of the Board of Directors.

3. Deposits. All funds of the corporation not otherwise employed shall
be deposited from time to time to the credit of the corporation in such
depositories as the Board of Directors shall direct.

<PAGE>

ARTICLE VII

Certificates for Shares and Transfer Thereof

1. Certificates for Shares. The Chairman or the President and the
Secretary or the Treasurer or any other two officers designated by the Board of
Directors shall sign (either manually or in facsimile) share certificates.
Shares may but need not be represented by certificates. Unless otherwise
provided by law, the rights and obligations of shareholders are identical
whether or not their shares are represented by certificates. If shares are
issued without certificates, the corporation shall, within a reasonable time
after such issuance, send the shareholder a written statement of the information
required on certificates by law. At a minimum each share certificate or
information statement shall state on its face the following information: the
name of the corporation and that it is organized under the law of North
Carolina; the name of the person to whom issued; the number and class of shares
and the designation of the series, if any, the certificate or information
statement represents; if the corporation is authorized to issue different
classes of shares or different series within a class, a summary of, or
alternatively, a conspicuous statement on the back or front of the certificate
or contained in the information statement that the corporation will furnish in
writing and without charge, the designations, relative rights, preferences, and
limitations applicable to each class and the variations in rights, preferences,
and limitations determined for each series (and the authority of the Board of
Directors to determine variations for future series); and, a conspicuous
statement of any restrictions on the transfer or registration of transfer of the
shares.

2. Transfer of Shares. Transfer of shares of the corporation evidenced
by certificates shall be made only on the stock transfer books of the
corporation by the holder of record thereof, or by his legal representative, who
shall furnish proper evidence of authority to transfer, or by his attorney
thereunto authorized by power of attorney duly executed and filed with the
Secretary or other officer or agent designated by the Board of Directors, and on
surrender for cancellation of the certificate for such shares. Transfer of
shares of the corporation not evidenced by certificates shall be made upon
delivery to the corporation of such documentation as the corporation shall
require.

3. Fixing Record Date. For the purpose of determining the shareholders
entitled to notice of a meeting of shareholders, to vote, to take any other
action, or to receive a dividend with respect to their shares, the Board of
Directors may fix in advance a date as the record date for any such
determination of shareholders. Such record date fixed by the Board of Directors
under this Section shall not be more than 70 days before the meeting or action
requiring a determination of shareholders.

If no record date is fixed for the determination of shareholders
entitled to notice of or to vote at a meeting of shareholders, or shareholders
entitled to a dividend, the close of the business day before the first notice is
delivered to shareholders or the date on which the Board of Directors authorizes
the dividend, as the case may be, shall be the record date for such
determination of shareholders.

When a determination of shareholders entitled to vote at any meeting of
shareholders has been made as provided in this Section, such determination shall
apply to any adjournment thereof unless the Board of Directors fixes a new
record date, which it must do if the meeting is

<PAGE>

adjourned to a date more than 120 days after the date fixed for the original
meeting.

4. Lost Certificates. If a shareholder claims that a certificated
security has been lost, apparently destroyed or wrongfully taken, the
corporation shall issue a new certificated security or, at the option of the
corporation, an equivalent noncertificated security in place of the original
security, if the shareholder so requests before the corporation has notice that
the security has been acquired by a bona fide purchaser, files with the
corporation a sufficient indemnity bond if so required by the corporation, and
satisfies any other reasonable requirements imposed by the corporation.

5. Holder of Record. The corporation may treat as absolute owner of
shares the person in whose name the shares stand of record on its books just as
if that person had full competency, capacity and authority to exercise all
rights of ownership irrespective of any knowledge or notice to the contrary or
any description indicating a representative, pledge or other fiduciary relation
or any reference to any other instrument or to the rights of any other person
appearing upon its record or upon the share certificates except that any person
furnishing to the corporation proof of his appointment as a fiduciary shall be
treated as if he were a holder of record of its share.

The corporation may reject a vote, consent, waiver, or proxy
appointment if the Secretary or other officer or agent authorized to tabulate
votes, acting in good faith, has reasonable basis for doubt about the validity
of the signature on it or about the signatory's authority to sign for the
shareholder.

6. Reacquired Shares. The corporation may acquire its own shares and
shares so acquired constitute authorized but unissued shares.

7. Rights, Options and Warrants. The corporation may issue rights,
options or warrants for the purchase of shares of the corporation. The Board of
Directors shall determine the terms upon which the rights, options or warrants
are issued, their form and content, and the consideration for which the shares
are to be issued. Without limitation, the Board of Directors may include on such
rights, options and warrants restrictions or conditions that preclude or limit
the exercise, transfer or receipt of such rights, options or warrants by the
holder or holders, or beneficial owner or owners, of a specified number or
percentage of the outstanding voting shares of the corporation or by any
transferee of such holder or owner, or that invalidate or void such rights,
options or warrants held by any such holder or owner or by such transferee. In
addition, the Board of Directors may implement rights plans that create purchase
or conversion rights that are not exercisable by a hostile bidder involved in a
hostile takeover of the corporation.

<PAGE>

ARTICLE VIII

Indemnification

1. Extent. In addition to the indemnification otherwise provided by
law, the corporation shall indemnify and hold harmless its directors and
Indemnified Officers (as hereinafter defined) against liability and expenses in
any proceeding, including reasonable attorneys' fees, arising out of their
status as directors or officers or their activities in any of such capacities or
in any capacity in which any of them is or was serving, at the corporation's
request, in another corporation, partnership, joint venture, trust or other
enterprise, and the corporation shall indemnify and hold harmless those
directors and officers who are deemed to be fiduciaries of the corporation's
present and future employee pension and welfare benefit plans as defined under
the Employee Retirement Income Security Act of 1974 ("ERISA fiduciaries")
against liability and expenses in any proceeding, including reasonable
attorneys' fees, arising out of their status or activities as ERISA fiduciaries;
provided, however, that the corporation shall not indemnify a director or
Indemnified Officer against liability or litigation expense that he may incur on
account of his activities that at the time taken were known or reasonably should
have been known by him to be clearly in conflict with the best interests of the
corporation, and the corporation shall not indemnify an ERISA fiduciary against
any liability or litigation expense that he may incur on account of his
activities that at the time taken were known or reasonably should have been
known by him to be clearly in conflict with the best interests of the employee
benefit plan to which the activities relate. The corporation shall also
indemnify the director, Indemnified Officer, and ERISA fiduciary for reasonable
costs, expenses and attorneys' fees in connection with the enforcement of rights
to indemnification granted herein, if it is determined in accordance with
Section 2 of this Article that the director, Indemnified Officer and ERISA
fiduciary is entitled to indemnification hereunder.

2. Determination. Any indemnification under Section 1 of this Article
shall be paid by the corporation in any specific case only after a determination
that the director, Indemnified Officer or ERISA fiduciary did not act in a
manner, at the time the activities were taken, that was known or reasonably
should have been known by him to be clearly in conflict with the best interests
of the corporation, or the employee benefit plan to which the activities relate,
as the case may be. Such determination shall be made (a) by the affirmative vote
of a majority (but not less than two) of directors who are or were not parties
to such action, suit or proceeding or against whom any such claim is asserted
("disinterested directors") even though less than a quorum, or (b) if a majority
(but not less than two) of disinterested directors so direct, by independent
legal counsel in a written opinion, or (c) if there are less than two
disinterested directors, by the affirmative vote of all of the directors, or (d)
by the vote of a majority of all of the voting shares other than those owned or
controlled by directors or officers who were parties to such action, suit or
proceeding or against whom such claim is asserted, or by a unanimous vote of all
of the voting shares, or (e) by a court of competent jurisdiction.

3. Advanced Expenses. Expenses incurred by a director, Indemnified
Officer or ERISA fiduciary in defending a civil or criminal claim, action, suit
or proceeding may, upon approval of a majority (but not less than two) of the
disinterested directors, even though less than a quorum, or, if there are less
than two disinterested directors, upon unanimous approval of the Board of
Directors, be paid by the corporation in advance of the final disposition of
such claim, action, suit or proceeding upon receipt of an undertaking by or on
behalf of the director, Indemnified Officer

<PAGE>

or ERISA fiduciary to repay such amount unless it shall ultimately be determined
that he is entitled to be indemnified against such expenses by the corporation.

4. Corporation. For purposes of this Article, references to directors
or officers of the "corporation" shall be deemed to include directors, officers
and ERISA fiduciary of Vanguard Cellular Systems, Inc., its subsidiaries, and
all constituent corporations absorbed into Vanguard Cellular Systems, Inc. or
any of its subsidiaries by a consolidation or merger.

5. Indemnified Officer. For purposes of this Article, "Indemnified
Officer" shall mean all officers of the corporation who are elected by the Board
of Directors.

6. Reliance and Consideration. Any director, Indemnified Officer or
ERISA fiduciary who at any time after the adoption of this Bylaw serves or has
served in any of the aforesaid capacities for or on behalf of the corporation
shall be deemed to be doing or to have done so in reliance upon, and as
consideration for, the right of indemnification provided herein. Such right
shall inure to the benefit of the legal representatives of any such person and
shall not be exclusive of any other rights to which such person may be entitled
apart from the provision of this Bylaw. No amendment, modification or repeal of
this Article VIII shall adversely affect the right of any director, Indemnified
Officer or ERISA fiduciary to indemnification hereunder with respect to any
activities occurring prior to the time of such amendment, modification or
repeal.

7. Insurance. The corporation may purchase and maintain insurance on
behalf of its directors, officers, employees and agents and those persons who
were serving at the request of the corporation as a director, officer, partner,
trustee, employee, or agent of, or in some other capacity in, another
corporation, partnership, joint venture, trust, employee benefit plan, or other
enterprise against any liability asserted against him and incurred by him in any
such capacity, or arising out of his status as such, whether or not the
corporation would have the power to indemnify him against such liability under
the provisions of this Article or otherwise. Any full or partial payment made by
an insurance company under any insurance policy covering any director, officer,
employee or agent made to or on behalf of a person entitled to indemnification
under this Article shall relieve the corporation of its liability for
indemnification provided for in this Article or otherwise to the extent of such
payment, and no insurer shall have a right of subrogation against the
corporation with respect to such payment.

ARTICLE IX

General Provisions

1. Dividends. The Board of Directors may from time to time declare, and
the corporation may pay, dividends on its outstanding shares in such manner and
upon such terms and conditions as are permitted by law and by its Articles of
Incorporation.

2. Waiver of Notice. Whenever any notice is required to be given to any
shareholder or director under the provisions of the North Carolina Business
Corporation Act or under the provisions of the Articles of Incorporation or
bylaws of the corporation, a waiver thereof in writing signed by the person or
persons entitled to such notice, whether before or after the time stated
therein, shall be equivalent to such notice.

<PAGE>

3. Fiscal Year. Unless otherwise ordered by the Board of Directors, the
fiscal year of the corporation shall be the calendar year.

4. Inspection of Records by Shareholders. The shareholders shall not be
entitled to inspect or copy any accounting records of the corporation or any
records of the corporation with respect to any matter which the corporation
determines in good faith may, if disclosed, adversely affect the corporation in
the conduct of its business or may constitute material nonpublic information at
the time the shareholder's notice of demand to inspect and copy is received by
the corporation.

5. Amendments. Notwithstanding any other provision of the Articles of
Incorporation or the Bylaws of the corporation, the Board of Directors of the
corporation shall have the power to adopt, amend or repeal the bylaws of the
corporation except to the extent limited by laws. The shareholders of the
corporation may exercise their power to adopt, amend or repeal the bylaws of the
corporation only by the affirmative vote of the holders of at least two-thirds
(66 2/3%) of the outstanding shares of capital stock of the corporation entitled
to vote generally in the election of directors (considered for this purpose as
one class and notwithstanding that some lesser percentage may be permitted by
law, or permitted or required by the Articles of Incorporation or the bylaws of
the corporation).

6. Inapplicability of Article 9A. Article 9A of Chapter 55 of the
General Statutes of North Carolina, entitled "Control Share Acquisition Act,"
shall not apply to this corporation.

<ARTICLE> 5

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