ITEM 1 - BUSINESS
FORWARD LOOKING STATEMENT
This Form 10-K contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. The forward looking statements involve risks and uncertainties that could cause actual results to differ materially from those expressed in, or implied by, the forward looking statements. Factors that might cause such a difference include, but are not limited to, those relating to: general economic conditions in the markets in which the Company operates, success in the development and market acceptance of new and existing products (particularly SONETLYNX, FIBRETRAX, LANscape, and CS4); dependence on suppliers, third party manufacturers and channels of distribution; customer and product concentration; fluctuations in customer demand; maintaining access to external sources of capital; ability to execute management's margin improvement and cost control plans; overall management of the Company's expansion; and other risk factors detailed from time to time in the Company's filings with the Securities and Exchange Commission.
THE COMPANY
Intelect Communications, Inc. (the "Company") was incorporated in Delaware on May 23, 1995. The Company's predecessor, Intelect Communications Systems Limited ("Intelect (Bermuda)") was incorporated under the laws of Bermuda in April 1980 and operated under the name Coastal International, Ltd. until September 1985 and as Challenger International Ltd. until December 1995. On December 4, 1997, the shareholders of Intelect (Bermuda) approved a merger proposal, the principal effect of which was to change the domicile of Intelect (Bermuda) so that it became a publicly traded United States-domiciled, Delaware corporation. The effect of the merger was that the shareholders of Intelect (Bermuda) became shareholders of the Company with the Company becoming the publicly traded company. In addition, the Company became the holding company for Intelect (Bermuda) and replaced Intelect (Bermuda) as the holding company for its subsidiaries. The merger was effected on December 4, 1997.
OVERVIEW
The Company is engaged in the business of designing, developing, manufacturing, marketing and selling products and services for managing digital signals and converging voice, data and video networks. The Company's current operations were established through a series of mergers in 1995 and 1996, at which time four communications product platforms were defined to respond to the increasing demands of speed and complexity in communications.
The Company is strategically focusing its product lines and services to take advantage of the convergence of telecommunications (telecom) and data communications (datacom). This convergence is being driven by the explosive growth of Internet applications such as E-commerce, which is accelerating the expansion of network capacities. These industry trends create requirements for today's network integrators and directors to manage multiple applications, at multiple locations, within bandwidth resources and while balancing the need for network reliability. The Company's product lines are designed to meet these evolving markets, applications and requirements.
The Company's objective is to develop and bring to market a new generation of intelligent, flexible, and scalable communications products designed to combine current voice, data and video networks (for example, telephones, computers, surveillance) into a single communications network, which would also upgrade communications into the latest generation of high-speed technologies, while using a single network management system.
PRODUCTS, TECHNOLOGIES AND SERVICES
Multi-service Access Platform (MAP)
Marketed initially and currently under the names SONETLYNX and FIBRETRAX, the Company believes the MAP is a revolutionary networking infrastructure product for public and private networks to cost-effectively create voice, data and/or video networks of virtually any size and application. It is defined as a platform because, from its basic architecture, it can be configured into many separate products for a variety of functions and applications. Through the use of different protocol cards, the MAP can simultaneously combine multiple communication transmissions such as video and graphics communications, data files, voice and any IP-based service over a single network. The products are compatible with Synchronous Optical Network (SONET) and Synchronous Digital Hierarchy (SDH) standards in order to provide fail-safe networks. The SONETLYNX and FIBRETRAX, in addition to providing add-drop multiplexing, provide the functions of traditional networking equipment such as bridges, channel banks, routers and video matrix switches, thus offering significant savings in cost and time for the user when OC-1 or OC-3 bandwidth is required. The MAP expands into markets horizontally by increasing the types of protocols (applications) it can transport, and vertically by increasing its capacity (transmission speed). Currently, the MAP can transport voice, Fast Ethernet (10/100baseT), JPEG video and low speed data protocols such as RS-232 and RS-422 at speeds up to the OC-3/STM-1 rate (155 Mbps). Product advancements scheduled during 1999 include adding the protocol cards for ISDN, digital modem pool and Frame Relay as well as increasing the MAP's transmission speed to the OC-12/STM-3 rate (622 Mbps). Video and high speed data modules are planned with higher port density. Network management systems are under development in the Windows NT version. The cost effectiveness and competition advantage of the MAP are expected to increase with the addition of each major protocol and increase in transmission speed.
Engineering Services
DNA Enterprises, the Company's engineering services operation, provides advanced product and system design and development services for a variety of clients in the communications industry. The Company believes DNA Enterprises is a leading contract and outsource development resource for the communications industry. DNA provides expertise in digital signal processing (DSP), switching and transport systems, computer telephony integration (CTI), embedded systems, data communications, intelligent networks, video processing, and wireless communications technologies.
Digital Signal Processing
The DSP Design Center is a Center of Excellence within DNA Enterprises that provides state-of-the-art digital signal processing technology to systems developers around the world to afford them leading-edge solutions, faster time-to-market, and reduced technical risk for their product development programs. The DSP Design Center has developed a product line consisting of standard designs for high performance circuit boards, and offers custom designed hardware, application support software, real-time operating systems, and consulting services to product manufacturers and application developers in the multimedia, image processing, communications, and remote sensing systems arenas. The bulk of the Design Center's activities center around the Texas Instruments ("TI") line of Digital Signal Processors, with emphasis on TI's high performance C5x and C8x devices and a particular focus on the new TI C6000 processor line.
Visual Communications
The LANscape product is designed to provide full motion, collaborative video communications in a single cost effective solution for desktop PCs to large room systems. The product has the capability to conduct up to a three-way conference call without a costly multiconferencing unit (MCU), transmit video broadcasts using IP multicast, and use its integrated software to switch between two incoming video sources. Each
incoming video is contained in an individual window which the user can control as to size and volume. In addition to video conferencing, LANscape features video record and playback controls for applications such as education/training and recorded event distribution. LANscape support of IP multicast allows for transmission of live or pre-recorded video from one to many.
CS4 Intelligent Services Platform
The Company believes the CS4 represents a revolutionary new class of product. It is an integrated enhanced network server. Its array of integrated capabilities transcends traditional product categories to introduce a flexible system that can host a wide range of intelligent services in a variety of network configurations. The design of the CS4 positions it to impact the proliferation and profitability of intelligent services in the network, as well as to improve the cost paradigm now in place for service nodes, intelligent peripherals, enhanced service platforms, and programmable switches. Key technological innovations reflected in the CS4 include highly distributed processing power to the port level, scalable port capacity that extends up to 64k ports, an advanced call processing structure, a powerful service creation facility, and an architecture that readily supports integration into low speed, high speed, and broadband networks, all designed for a fault-tolerant, NEBS compliant structure.
MARKETS AND CUSTOMERS
Multi-service Access Platform
Primary markets for SONETLYNX and FIBRETRAX are purpose-built networks such as advanced highway control systems and pipeline communication and control systems. Target markets include corporate/enterprise networks, utilities, airports, transportation entities, security services, prisons, health services, academia, and local and state government, as well as public and private bypass networks. The Company expects additional products being developed and planned for the MAP platform to enable increased penetration in public and private network access markets. The Company markets its SONETLYNX and FIBRETRAX network products primarily through 25 distributors, system integrators and value added resellers (51% of SONETLYNX and FIBRETRAX revenue in 1998). Sales are also made by a direct sales force and through representatives. During 1997, the Company's largest distributor, reselling to customers in the Republic of Korea, was responsible for 85% of SONETLYNX sales. In 1998, no customer or distributor accounted for more than 10% of consolidated sales. SONETLYNX is targeted for markets and applications where multiple protocol communication mandates the capacity and reliability of fiber, further strengthened by redundancy of critical components and architecture.
Engineering Services
The Company's engineering services are employed by clients that span the spectrum from start-up ventures seeking to launch new products to large multi-national corporations looking to access key know-how for extending current product lines or introducing new products/services. The products the Company develops range from compact circuit boards to multi-board systems that address the consumer, commercial, industrial, and defense market sectors. The Company markets its services directly to prospects worldwide. Principal customers for the Company's services include board manufacturers, telecommunications equipment vendors, semiconductor suppliers, and communications service providers.
Digital Signal Processing
The products developed by the DSP Design Center are marketed both directly by the Company and through sales channel partners to customers in North America, Europe, and Asia. Customers for these products have a common need for high-performance DSP capabilities for integration into their products, which include commercial telecommunications systems, industrial control products, video processing and image enhancement systems, and military communication systems.
Visual Communication Products
The Company generally markets its visual communication products directly and through distributors and value added resellers. Primary markets for its video communication products are businesses and educational and government institutions. These markets include corporate networks, financial trading networks, Internet deployment over digital subscriber lines and other high capacity services, Educational/Distance learning networks, medical networks and government networks.
CS4 Intelligent Services Platform
The CS4 is scheduled to commence initial field trials in early second quarter 1999. The Company currently intends to commercialize the CS4 through a separate business unit that provides leading-edge solutions for high-value intelligent voice services in wireline, wireless, and internet-related markets and is seeking to arrange third party participation in the continuing development and initial marketing of the CS4.
The CS4 was developed to meet the requirements of high growth segments in the telecommunications equipment and services market in both circuit-switched and packet-switched networks. International and domestic target markets include Competitive Local Exchange Carriers, Competitive Access Providers, PCS and Cellular Service Providers, Inter-exchange Carriers, Internet Service Providers, and emerging network infrastructures.
COMPETITION
The market for the Company's products and services is intensely competitive and rapidly changing. The Company competes, or may in the future compete, directly or indirectly for customers in the following categories of products and companies: (i) network transmission product manufacturers such as Lucent Technologies Corp., Northern Telecom, Ltd., and Reltec; (ii) video conferencing H.320/323-based product manufacturers such as VTEL Corp and PictureTel Corp.; (iii) Enhanced Services Platform and Intelligent Peripheral/Service Node providers such as Lucent Technologies, Ericsson, Nortel, Comverse Technology, Intervoice, and Centigram Communications Corporation.
In recent months, large telecom equipment companies including Lucent, Northern Telcom, Alcatel and Siemens have announced acquisitions of datacom companies. At the same time, a large datacom company, Cisco, has announced plans for equipment to carry voice, data and video traffic using Internet technology. These activities constitute the so-called "convergence" of voice and data switching technologies. Large customers for switching equipment, including AT&T and MCI WorldCom have announced their intentions to support this convergence. The Company believes these actions ratify its product design strategies, especially the development of the MAP and CS4. On the other hand, the recent actions by large companies also represent an environment of increasing direct competition for customers of the newly convergent technologies.
The Company believes that the principal competitive factors affecting the markets for its products and services include effectiveness, scope of product offerings, technical features, ease of use, reliability, customer service and support, distribution channels and price. Most competitors are better capitalized and have greater resources than the Company and, accordingly, may have a competitive advantage in product development and selling.
MANUFACTURING
The basis of the Company's manufacturing strategy is to identify and use the appropriate technology to obtain the most favorable combination of quality and end product cost. The Company's manufactured products consist largely of assembled printed circuit boards and chassis. These are sold either as assembled
systems (such as SONETLYNX or FIBRETRAX) or as a stand-alone product (such as LANscape). As the Company's product lines expand and mature, the Company expects to increase manufacturing capacity by means that could include adding employees, expanding current facilities, leasing or purchasing additional facilities or equipment, and expanding and adding outsourcing relationships. See ITEM 2
ITEM 2 - PROPERTIES
All of the Company's facilities are leased. The facilities are in Richardson, Texas, New York, New York, and London, England. The Company's principal operations are serviced from four leased facilities in Richardson, Texas, (comprising 103,000 square feet) and one in New York (comprising 20,000 square feet). These facilities include manufacturing, engineering, sales, marketing, and administrative offices. All of the
Company's manufacturing operations are located in a 28,000 square foot Richardson, Texas facility. The Company moved its headquarters from Hamilton, Bermuda to Richardson, Texas in March 1997. In March 1998, the Company closed its offices in New York and London. The Company believes these facilities, which total 124,000 square feet, are adequate for its present needs.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
The Company is involved in various legal proceedings and claims arising in the ordinary course of business.
On October 28, 1998, in the 192nd Judicial District Court for Dallas County, Texas, Richard Dzanski filed suit against Intelect Network Technologies Company, a wholly owned subsidiary of the Company, and Intelect Systems Corp., the predecessor of the Company. In the suit, the plaintiff has claimed a breach of an Irrevocable Option Agreement and that he has not received payments he claims are due to him in the amount of at least $386,000. The defendants deny liability to the plaintiff and intend to vigorously defend the case. The parties are in discovery and it is too early to determine if the outcome of this case will have a material impact on the Company.
Intelect (Bermuda) is contingently liable for certain potential liabilities related to its discontinued operations. Specifically, under a stock purchase agreement dated October 3, 1995 ("1995 Agreement"), Intelect (Bermuda) agreed to indemnify Savage Sports Corporation, the purchaser of Savage Arms, Inc. (a manufacturer of fire arms), for certain product liability, environmental clean-up costs and other contractual liabilities, including certain asserted successor liability claims. One of the liabilities assumed involves a firearms product liability lawsuit filed by Jack Taylor individually and as father of Kevin Taylor in Alaska Superior Court (the "Taylor litigation"). Intelect (Bermuda) is informed that a defendant in the Taylor litigation, Western Auto Supply Co., settled the lawsuit for $5 million and, in turn, has asserted a third-party claim against Savage Arms, Inc. for indemnification in the amount of the settlement plus attorneys' fees and related costs. Savage Arms has asserted defenses to the claims and Intelect (Bermuda) believes additional defenses may be available. Based on the information available to date, it is impossible to predict the outcome of this litigation or to assess the probability of any verdict.
Intelect (Bermuda) also has been notified that Savage Sports Corporation seeks indemnification under the 1995 Agreement in connection with certain other product liability claims. Most notably, Intelect (Bermuda) has undertaken the defense of a lawsuit filed against Savage Arms, Inc. by Emhart Industries, Inc. ("Emhart") in the United States District Court for the District of Massachusetts (the "Emhart litigation"). In the lawsuit, Emhart requests indemnification from Savage Arms, Inc. under an agreement Emhart allegedly executed in 1981 with Savage Industries, Inc., claiming that Savage Arms, Inc. is a successor to Savage Industries, Inc. To date, Emhart has claimed indemnification of approximately $2.2 million for five lawsuits it has defended or settled and also seeks a declaratory judgment that it is entitled to indemnification for losses and expenses related to firearms product liability actions which may be filed against Emhart in the future. Intelect (Bermuda) intends to assert additional defenses. The parties are in discovery and Intelect (Bermuda) cannot at this time predict the outcome of the litigation.
In the event the Taylor litigation and/or Emhart litigation were to be resolved adversely to Intelect (Bermuda), there would be a material adverse effect on the Company's financial condition and results of operations. See Note 20 to the Consolidated Financial Statements.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5
ITEM 5 - MARKETS FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The common stock of the Company is traded in the over-the-counter market and is listed on the Nasdaq Stock Market under the symbol "ICOM." The high and low bid prices for the Company's common stock for each full quarter of the last two fiscal years, as reported on Nasdaq, are as follows:
The Company believes that as of March 29, 1999, its outstanding shares of common stock were held by approximately 20,500 owners of record.
The closing bid price of the common stock on the Nasdaq National Market on March 29, 1999, was $1.00.
DIVIDEND POLICY
No cash dividends were paid by the Company during 1996, 1997 or 1998. The Company does not currently plan to pay any dividends on common stock in the foreseeable future. The Company is restricted by its agreements with lenders and the holders of certain of its preferred stock from any payment of dividends on common stock and from the payment of dividends on preferred stock except dividends payable with common stock. These restrictions remain in effect for so long as any balance remains payable on the debt or such preferred stock remains outstanding. See Note 14 to the Consolidated Financial Statements.
RECENT SALES OF UNREGISTERED SECURITIES
Effective as of January 1, 1999, the Company issued 144,681 shares of common stock in lieu of a $212,000 cash dividend on its Series A Preferred Stock for the quarter ended December 31, 1998.
On November 23, 1998 and December 4, 1998, in a transaction exempt from registration under Section 4(2) of the Securities Act, the Company issued 300,000 shares each in connection with the exercise of warrants to purchase common stock at a price of $2.00 per share.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The following tables set forth certain historical consolidated financial data for the Company.
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Results of operations consist of:
o the fiber optic multiplexer and special services switch businesses of Intelect Network Technologies Company ("INT") from its April 24, 1995 acquisition,
o the engineering services business of DNA Enterprises, Inc. ("DNA") from its February 13, 1996 acquisition,
o the digital signal processor products business of DNA since product introductions in 1997 and 1998,
o the visual communication system business of Intelect Visual Communications Corp. ("IVC") from its March 29, 1996 acquisition, and
o the information security business of Intelect Europe Limited ("IEL") from its August 31, 1995 acquisition until its liquidation in January 1997.
The following table shows the revenue and gross profits for the Company's products:
REVENUES
Revenues in 1998 decreased 49% from 1997 after having increased 304% over 1996. The revenue increase in 1997 was due to increased sales to Korean customers, which represented 59% of that year's total revenues. The decline in 1998 revenues was due to the decline in sales to the Korean market reflecting the financial condition of the Asian region. This decline was partially offset by a 20%, or $785,000 increase in non-Korean sales.
The Company is not basing future revenue expectations on recovery in Asia. Prospects for continued growth in non-Asian markets are supported by new orders in the United States for approximately $10,000,000 of fiber optic multiplexer product received early in 1999.
Engineering service revenues in 1998 approximated the level of 1997 when the revenues increased 99% over 1996. Growth of the services business was constrained by the concentration of resources on DSP product development in the DNA DSP Design Center.
DSP products, primarily those based on the Texas Instruments C6000 components, increased 871% to $2,690,000 in 1998. The year included the launch of development tools for the Texas Instruments components and end products with powerful computing and signal processing capabilities.
Visual communication product revenues in 1998 increased 127% over 1997 due to the first full year of availability of a redesigned product.
Switching and other revenues consist primarily of the voice and data switching products used in air traffic control applications, which have declined in strategic significance to the Company, and certain information security products phased out in 1996.
GROSS PROFIT (LOSS)
Gross profit decreased to $908,000 in 1998 from $14,251,000 in 1997. A ($2,621,000) gross loss was experienced in 1996. Changes in both years were primarily the result of the revenue levels of the fiber optic multiplexer products. The gross profit in 1998 includes the effect of a $900,000 reserve for obsolescence attributable to the air traffic control products line ("switching" products above).
The high level of fiber optic multiplexer products shipments in 1997 supported an economic production rate in manufacturing operations, a rate which was not sustained in 1998. The negative gross profit on fiber optic multiplexer products in 1998 included $1,820,000 of under absorbed overhead. At the production levels of 1997, underabsorbed overhead for the SONETLYNX/FIBRETRAX product was $613,000, all attributable to the first half year when production volume had not yet increased.
Engineering services gross profit maintained a similar percentage of sales in 1998 and 1997 (25% and 27% respectively). The increase in 1997 over 1996 was primarily the result of a near doubling of revenue.
DSP products contributed positive gross profit for the first time in 1998 as revenues grew to a level which allowed for a characteristic margin.
The LANscape video products contributed gross profit improvements in both 1998 and 1997 in line with increases in volume.
ENGINEERING & DEVELOPMENT (E&D) EXPENSES
E&D expense decreased to $10,217,000 in 1998 from $11,899,000 in 1997. The 1997 level was an increase from $8,719,000 in 1996. In all three years, certain amounts of software development costs were capitalized. Including those amounts, the total E&D expenditures were $12,117,000, $13,216,000 and $10,114,000, respectively, in the years 1998, 1997 and 1996. Total E&D expenditures by product line were distributed as follows:
Despite lower sales in 1998, the Company maintained engineering and development expenditures in order to advance, enhance and complete strategic products such as MAP, CS4, DSPs and LANscape. These expenditures are expected to result in new product contributions in 1999 which are intended to address new markets and maintain the Company's technological leadership.
The fiber optic multiplexer product line was most significantly expanded by the introduction of the international standard version, SDH (Synchronous Digital Hierarchy). Branded FIBRETRAX, the SDH version serves the approximately 70% of global markets for fiber optic transmission outside North America. SONETLYNX and FIBRETRAX were enhanced by the addition of interfaces for:
o Multi-point voice
o Ethernet
o Communication among multiple rings, including different speeds
o T1/E1 backup for seven other interfaces
o Module level protection for T1/E1 and Ethernet
o DS3 transport.
Network management systems were enhanced to support larger networks and to support mixed modes as well as SONET-only mode. Also the Telenium management system was offered to meet the demands of the public network environment. Progress, which did not result in product releases, included:
o Fast (100BaseT) Ethernet
o Byte synchronous E1
o Increased video switching speed and quality
o Management system TL-1 and SNMP interfaces
o An access product strategy
o A new architecture for lower cost and reduced time to market by allowing integration of third party products.
Progress in the CS4 development program continued with the design and development of the commercial version of the system. This included the design of second generation hardware to provide significantly more processing capacity for handling greater traffic loads and to afford greater flexibility for
product migration and manufacturing efficiency. In addition, the software architecture was refined to provide higher system performance and to address early stage requirements for product commercialization.
Systems were configured for CS4 subsystem testing, systems integration, load testing and performance analysis. A beta site customer was identified and a system was readied for commencement of field testing early in the second quarter of 1999. Planning for supporting the customer's applications and installation of the beta system at the customer's site was completed.
Videoconferencing products were developed in Windows NT version. Progress was made on development of PCI compliant hardware. A Gateway to H.320 conferencing systems was introduced. Enhancements were made to minimize the installation task.
Digital signal processing product developments built the foundation for the first year of significant revenues in 1998. Including work funded by a customer, these developments included:
o A development platform for the C6000 circuits of Texas Instruments, the EVM module
o A proprietary operating system for C6000 developers
o VME board-level products under a private label arrangement.
SELLING AND ADMINISTRATIVE EXPENSES
Selling and administrative expenses of $17,724,000 includes $1,148,000 of warranty expense, primarily the extra costs of start up and first year operations of two major installations of the SONETLYNX product in Korea and on the Alyeska pipeline. Selling expense declined 11% from the prior year, excluding unusual warranty costs. Administrative expense of $6,547,000 in 1998 was 12% below the prior year level. Expenses in 1998 included sales development activities which resulted in the approximately $10,000,000 of orders received for SONETLYNX products early in 1999. General corporate expenses contributed $800,000 of the decrease from 1997 when extra costs were incurred to remove the corporate headquarters from Bermuda. The Company estimates that the usual level of warranty expenses would have been approximately $200,000 but for special startup difficulties caused by distance, cultural differences and unusual technical characteristics.
Selling and administrative expenses increased 28% to $18,671,000 in 1997 compared to 1996. Selling expense increased to $11,213,000 from $6,412,000, primarily due to higher revenues for SONETLYNX products and to market development activities for SONETLYNX and LANscape products. Administrative expense of $7,458,000 in 1997 was 9% below the prior year, partly due to the removal of corporate headquarters from Bermuda during 1997.
ASSET WRITE DOWNS
In accordance with the evolving focus of the Company's primary technologies, products and markets and forward growth plans, and in accordance with the Company's accounting policies, including reviews of realizability of its long-term assets, including goodwill, the Company wrote off the September 30, 1998 balance of $6,888,000 of goodwill from the acquisition in 1995 of Intelect Inc., which at that time was primarily engaged in the supply of communications systems for air traffic control and air defense installations, and is presently operating as Intelect Network Technologies, emphasizing the SONETLYNX and FIBRETRAX product lines. Goodwill amortization charges in the amount of $149,000 per quarter also will be eliminated following the writeoff of goodwill. The writeoff decision was determined by the recent loss of three major identified business opportunities, the absence of significant identified future opportunities and business combinations which strengthened competitors, all leading the Company to reassess the outlook for the air traffic control business segment. The Company concluded that the outlook for future business would not support a forecast of revenue and contribution margin adequate to liquidate inventories and support amortization of the goodwill asset.
Accounts and notes receivable from the Company's Korean distributor, and relating to the sales of the Company's products in Korea, totaled $4,696,000 at the end of September 1998, compared to $9,879,000 at December 31, 1997, from which $6,731,000 was collected and to which $1,730,000 of shipments were added during 1998. The Company was advised, at a meeting in October, of the distributor's illiquidity and inability to maintain any certain schedule of payments of receivables. Accordingly, the Company determined that it would be prudent and timely to write off or reserve substantially all the distributor's receivables adjusted for a collection of $1,000,000 received in February 1999. In connection with this collection, and contingent on certain future payments, the Company agreed not to pursue any further collections of the receivable.
In connection with the acquisition of IVC, certain assets and licenses, which constituted the design of a videoconferencing product, were purchased from a major computer company. The design proved to be flawed and market introduction was delayed approximately nine months. In 1996, the Company deemed the recoverability of IVC goodwill to be significantly impaired by the delay in introduction of the product to a rapidly changing market and accordingly reduced the carrying value of IVC goodwill by $4,175,000 (its remaining unamortized net book value at the time) and wrote off $51,000 of fixed assets deemed of no value. The Company's assessment of the future prospects for the information security products business in the United Kingdom led to a complete shut down of those operations in Chesterfield, England at the end of 1996. In January 1997, liquidation proceedings began. The Company was an unsecured creditor of IEL and wrote off all net assets related to those operations in England in the amount of $1,807,000.
INTEREST EXPENSE
Interest expense, primarily non-cash financing charges, of $4,385,000, $2,863,000 and $9,911,000 in the years ended December 31, 1998, 1997 and 1996 consists of:
Interest on debt instruments in 1998 was primarily attributable to amounts borrowed from St. James Capital Corp., SJMB, L.P., and the Coastal Trust. In 1997, the interest was attributable to St. James Capital Corp. and Coastal Trust borrowing and to two series of convertible debentures. In 1996, the interest was attributable to three series of convertible debentures.
Non-cash financing costs in 1998 and 1997 were the result of warrants to purchase common stock issued in connection with various financings. The reported expense amount is the value of the warrants determined by using the Black-Scholes pricing model. In 1996, in addition to $2,942,000 of warrant values, $4,592,000 of reportable expense was attributable to a beneficial conversion feature of the convertible debentures.
Other costs of financing consist primarily of legal and placement fees.
INCOME (LOSS) FROM DISPOSAL OF DISCONTINUED OPERATIONS
Losses in 1998, 1997 and 1996 represent legal expenses in connection with the indemnity agreement with Savage Sports Corporation. See ITEM 3, Legal Proceedings.
YEAR 2000 COMPLIANCE
The Company has conducted a review of its computer systems and products to identify those that could be affected by the "Year 2000 Problem," the result of computer programs using two digits rather than four to define the year portion of dates. The Company has determined that none of its significant systems or products fail to distinguish the year 2000 from the year 1900. The review continues, in an ongoing process, to examine the risk, if any, to the Company, of vendor or customer exposure to the Year 2000 Problem. To date, no exposure has been discovered which would have a material adverse effect on the Company. Certain purchased software, resold or used in company products, has been certified by the vendors to be compliant. The financial impact of Year 2000 compliance has not been and is not anticipated to be material to the Company's financial position or results of operations in any given year.
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LIQUIDITY AND CAPITAL RESOURCES
Year to year cash balances were lower by $1,103,000 at December 31, 1998. During the year, cash expended in operations ($22,929,000) and in investing activities ($4,144,000) was funded by the reduction of cash balances and by securing new financing of $25,970,000 (net of $14,831,000 of debt repayments).
OPERATING ACTIVITIES
Net cash applied in operations primarily reflects the $43,138,000 net loss offset by $8,170,000 of non-cash charges, non-cash asset write downs of $10,628,000, and the $3,948,000 net increase in working capital. The net cash requirement for operations is the combined effect of a reduced gross profit contribution compared to 1997 and a continuation of expenditures related to the Company's technology and product development programs and marketing, selling and distribution activities. The lower level of gross profit reflects mainly the abrupt discontinuance of sales in Korea and the lead times to develop sales in other markets and to launch new products into markets, distribution and sales.
o Accounts receivable were a source of funding due to $4,597,000 collections from customers in excess of new shipments and billings.
o Inventory increased $565,000 due to restocking, longer term purchase commitments, and production for orders received near the end of the year.
o Accounts payable were reduced $3,276,000 due to payments of obligations similarly related to prior year operating levels.
o The non-cash charges were primarily $4,357,000 of depreciation and amortization of intangible assets and $3,242,000 of amortization of deferred financing costs.
o Asset write downs reflect the decision to write off goodwill related to the air traffic control communication equipment business and the recognition that the Company's Korean distributor became illiquid and unable to pay accounts receivable.
INVESTING ACTIVITIES
Investments during 1998 were primarily $2,035,000 of fixed asset additions and $1,898,000 of capitalized SONETLYNX and LANscape product enhancements and advancements. The fixed asset additions were
concentrated in computers, software, and test equipment to support engineering activities, and manufacturing equipment for new products.
FINANCING ACTIVITIES
Cash uses were financed by the following transactions during 1998:
o $10,000,000 from the sale of Series C Preferred Stock in February
o $3,000,000 borrowed in February
o A deferred payment arrangement converting $2,100,000 originally due in February to monthly payments through December 1998, of which $440,000 remains owed and unpaid at year end
o $7,000,000 borrowed in April
o $5,000,000 from the sale of Series D Preferred Stock in May
o $5,000,000 from the sale of Series D Preferred Stock in June
o $5,000,000 borrowed in September through November
o $750,000 borrowed in November
o $1,200,000 from the exercise of common stock warrants in December
o $1,000,000 from the sale of common stock in December
Proceeds from these financings were used to retire maturing obligations of $13,410,000 and for additional working capital.
SUBSEQUENT FINANCING ACTIVITIES
In January 1999, the Company sold $1,800,000 of common stock in a private placement.
On January 13, 1999, the Coastal Trust extended the maturity of the Receivables Loan previously maturing on August 31, 1999, to February 12, 2000.
On January 13, 1999, the Company elected to extend to February 12, 2000 the maturity of the convertible promissory notes of the Credit Facility.
On March 2, 1999, the Company entered into a Security Purchase Agreement with a group of private investors. The Agreement provides for the sale of up to $9,600,000 of Series E preferred stock contingent on certain conditions. On March 5, 1999, the Company sold $3,000,000 of the Series E preferred stock in an Initial Closing. An additional $3,000,000 will become available to the Company in a Mandatory Closing contingent primarily on a registration statement becoming effective to cover resale of common stock issuable upon conversion of the preferred and the satisfaction of certain other conditions.
OUTLOOK
During the last three years, the Company has continued various programs and activities to design, develop, bring to market and establish distribution and sales for four product lines targeting multiple markets internationally. For the network access market, the SONETLYNX product line was introduced in 1996. The line was expanded in 1998 by the addition of the FIBRETRAX (SDH) international version. The Company has developed the CS4 Intelligent Services Platform for beta testing and commercial availability in 1999. The DSP Design Center in the Company's engineering services group continues to develop products using advanced DSP circuits and design skills applicable to a variety of companies in the networking and telecommunications industry. For video communication, the Company has developed LANscape, a standards-based video system offering full-motion collaborative communications for desktop and room applications. These four product lines
are each expected to have significant potential revenue and profit opportunities for the Company and have been the focus of considerable development and marketing expense during the last three years. The product lines and their applications are more fully described in the ITEM I above. The Company has incurred operating losses in 1998, 1997, and 1996 of $46,105,000, $20,798,000 and $43,039,000. Negative cash flows from operations in the same periods were, respectively, $22,929,000, $24,852,000 and $23,050,000. The cash flows were funded by proceeds from borrowings under credit facilities and sales of preferred stock and common stock in 1998 and 1997 and by proceeds from issuance of convertible debentures in 1996. The Company expects operating losses and negative operating cash flow to continue at least through mid-year 1999. It is uncertain when, if ever, the Company will report operating income or positive cash flow from operations.
Redeploying and refocusing resources and new activities to replace Korean with non-Korean business are still in process of producing results to recover sales levels and gross profit contribution.
In response to lower levels of sales and production, the Company has contained or reduced costs and expenses in engineering, selected product development, and sales areas (net of non-recurring expenses recognized primarily in connection with Korean business). Marketing and selling expenditures were maintained on the SONETLYNX product line in connection with new distribution relationships and the related quantity and quality of promising prospects. To better align costs with near-term prospects, expenses related to video product sales were reduced by closing offices in New York, California, and England. Development costs of SONETLYNX and FIBRETRAX products were reduced as certain schedules neared completion and lower cost outsourcing became feasible in some areas. Expense reductions have not been sufficient to fully compensate for the reduced gross margin contribution on lower sales volumes. Accordingly, lower production volumes and ongoing costs and expenses have impeded progress toward profitability and cash equilibrium.
The Company's initiative to arrange third party (partner) participation(s) in CS4 development, funding and/or marketing led to increases in spending from the recognition that potential interest is enhanced by the accelerated commercialization of marketable product applications. The increased spending of 1998 is being curtailed to a level supporting beta testing.
The Company is obligated to repay the Inventory Loan in two remaining payments of $250,000 each plus accumulated interest on April 1 and May 1, 1999. Obligations to two former shareholders of DNA, in the aggregate amount of approximately $500,000, remain unpaid. The Company is in discussion with the note holders and expects to reach agreement on a payment schedule for the balance of the notes. The Credit Facility and Receivables Loan become due on February 12, 2000. The Company intends to refinance those debts at the maturity date, but no assurance can be given that a refinancing can be arranged.
The Company may be obligated to redeem all of the outstanding shares of Series D and Series E Convertible Preferred Stock in the event of a Triggering Event, which can occur if the Company is unable to make effective the registration statement covering the resale of the shares issuable upon conversion of such shares effective by May 19, 1999 for the Series D and July 7, 1999 for the Series E. The Company currently does not have the cash resources available to effect such a required redemption, or pay the penalties required in the event of such a redemption.
CONCLUSION
Considering the available financial resources, current business prospects, the outlook for cash available from customer collections, the outlook for cash to be used in operations and investing, and actions to control spending, the Company believes it has or can obtain the financial resources to meet its business requirements for the balance of the current year. There can be no assurance, however, that the assumptions and projections underlying or supporting this outlook will be realized. If cash needs exceed available resources, there also can be no assurance that additional capital will be available through public or private equity or debt financings. The
financial statements have been prepared assuming the Company will continue as a going concern and do not include any adjustments that might result from the unfavorable outcome of such an uncertainty.
CONTINGENT LIABILITIES
As discussed in "ITEM 3 - Legal Proceedings" in the Company's Annual Report on Form 10-K, the Company is exposed to certain contingent liabilities which, if resolved adversely to the Company, would adversely affect its liquidity, its results of operations, and/or its financial position.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk with regard to financial instruments because two loans from The Coastal Trust bear interest based on the prime rate.
At December 31, 1998, a hypothetical 100 basis point increase in interest rates would result in a reduction of approximately $57,000 in annual pre-tax earnings. The estimated reduction is based upon the increased interest expense of the Company's variable rate debt and assumes no change in the volume or composition of debt at December 31, 1998.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
Board of Directors and Stockholders Intelect Communications, Inc.
We have audited the accompanying consolidated balance sheet of Intelect Communications, Inc., and subsidiaries as of December 31, 1998, and the related consolidated statements of operations, stockholder's equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Intelect Communications, Inc. and subsidiaries as of December 31, 1998, and the consolidated results of their operations and their consolidated cash flows for the year then ended in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has experienced continuing operating losses and negative cash flows. Its continued existence is dependent upon the successful development of its products and obtaining adequate capital, neither of which is assured. These matters raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Grant Thornton LLP
Dallas, Texas March 31, 1999
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To: The Board of Directors and Shareholders of Intelect Communications, Inc.
We have audited the accompanying consolidated balance sheet of Intelect Communications, Inc. (a Delaware corporation) as of December 31, 1997, and the related statements of operations, stockholders' equity and cash flows for the year ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Intelect Communications, Inc. as of December 31, 1997, and the results of their operations and their cash flows for the year ended December 31, 1997, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Dallas, Texas March 27, 1998
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Intelect Communications Systems Limited
We have audited the accompanying consolidated statements of operations, stockholders' equity and cash flows of Intelect Communications Systems Limited and its subsidiaries for the year ended December 31, 1996. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedule for the year ended December 31, 1996. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.
We conducted our audit in accordance with United States generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated statements referred to above present fairly, in all material respects, the results of operations and cash flows of Intelect Communications Systems Limited and its subsidiaries for the year ended December 31, 1996, in conformity with United States generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements, taken as a whole, presents fairly, in all material respects, the information set forth therein.
The accompanying consolidated financial statements and financial statement schedule have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from continuing operations and is dependent upon the successful development and commercialization of its products and its ability to secure adequate sources of capital until the Company is operating profitably. These matters raise substantial doubt about the Company's ability to continue as a going concern. Management's plans with regard to these matters are also described in Note 1. The consolidated financial statements and financial statement schedule do not include any adjustments that might result from the outcome of this uncertainty.
/s/ KPMG Peat Marwick
Chartered Accountants Hamilton, Bermuda April 9, 1997 ....
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1998 and 1997 (Thousands of dollars, except share data)
(continued)
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Balance Sheets (continued) December 31, 1998 and 1997 (Thousands of dollars, except share data)
See accompanying notes to consolidated financial statements.
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Operations (Thousands of dollars, except share data)
See accompanying notes to consolidated financial statements.
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Years ended December 31, 1998, 1997 and 1996 (Thousands of dollars, except share data)
See accompanying notes to consolidated financial statements
(continued)
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Years ended December 31, 1998, 1997 and 1996 (Thousands of dollars, except share data)
See accompanying notes to consolidated financial statements
(continued)
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Years ended December 31, 1998, 1997 and 1996 (Thousands of dollars, except share data)
See accompanying notes to consolidated financial statements
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 1998, 1997 and 1996 (Thousands of dollars)
See accompanying notes to consolidated financial statements
(Continued)
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (continued) Years ended December 31, 1998, 1997 and 1996 (Thousands of dollars)
See accompanying notes to consolidated financial statements.
INTELECT COMMUNICATIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Description of Business
Intelect Communications, Inc. (the "Company") was incorporated in Delaware on May 23, 1995, and is the successor company of a reorganization, effective December 4, 1997, whereby the Company became a U. S. domiciled public company. The previous public company, Intelect Communications Systems Limited ("Intelect (Bermuda)"), a Bermuda company, became a subsidiary of Intelect Communications, Inc. Intelect (Bermuda) had operated under the name of Coastal International, Ltd. until September 1985 and as Challenger International, Ltd. until December 1995. The Company operates in one industry segment and is an international communications technology and products company that designs, develops, manufactures, markets, and sells products and services for the integration of voice, data, and video networks. The Company's products include a multi-service access platform for fiber optic networks, digital signal processing system components, video communications equipment, and telecommunications system design and development services.
Former subsidiaries of the Company were engaged in information security product sales and services (from 1995 to 1997), in the manufacture and marketing of sporting arms (from 1989 to 1995), and in various energy related activities (from 1981 to 1988). These subsidiaries were sold or liquidated before December 31, 1997.
The Company has incurred significant operating losses and negative cash flows from operations in 1998, 1997 and 1996. The cash flows were funded by proceeds from borrowings under credit facilities and sales of preferred stock and common stock in 1998 and 1997 and by proceeds from issuance of convertible debentures in 1996. The Company expects operating losses and negative operating cash flow to continue at least through mid-year 1999. It is uncertain when, if ever, the Company will report operating income or positive cash flow from operations.
Considering the available financial resources, current business prospects, the outlook for cash available from customer collections, the outlook for cash to be used in operations and investing, and actions to control spending, the Company believes it has or can obtain the financial resources to meet its business requirements for the balance of the current year. There can be no assurance, however, that the assumptions and projections underlying or supporting this outlook will be realized. If cash needs exceed available resources, there also can be no assurance that additional capital will be available through public or private equity or debt financings. The financial statements have been prepared assuming the Company will continue as a going concern and do not include any adjustments that might result from the unfavorable outcome of such an uncertainty.
(2) Significant Accounting Policies and Practices
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles. The preparation of consolidated 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 and 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.
(a) Principles of Consolidation
The consolidated financial statements include the financial statements of the Company and its subsidiaries, all of which are wholly owned, since their dates of acquisition. All significant intercompany balances and transactions have been eliminated in consolidation.
(b) Fair Value of Financial Instruments
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the fair value of certain financial instruments for which it is practicable to estimate fair value. For purposes of the disclosure requirements, the fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation. The carrying values of cash, accounts receivable, marketable securities, notes payable and accounts payable are reasonable estimates of their fair value due to the short-term maturity of underlying financial instruments. It was not practical to estimate the fair value of the Company's long-term debt because quoted market prices do not exist and comparable securities were not available.
(c) Revenue and Expense Recognition
Revenue from product sales is recognized upon shipment of products. Reserves for estimated sales returns and allowances are recorded in the same accounting period as the related revenues.
Revenue from engineering services is recognized as the services are provided to the customers.
Contracts that are expected to be completed within one year are generally considered short-term contracts and revenue is recognized upon shipment to the customer. Revenue on longer-term contracts is generally recognized using the percentage-of-completion method. Under the percentage-of-completion method, revenue recognition is measured by the proportion of the contract costs incurred to date to estimated total costs for each contract. Contract costs include all direct material and labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools and repair costs. General, administrative and engineering and development costs are charged to expense as incurred. Changes in estimated profit on contracts are recognized in the period in which the revisions are determined. Provisions for estimated losses on uncompleted contracts are charged to earnings in the period in which such losses first become apparent.
(d) Inventories
Inventories consist of raw materials, work in progress and finished goods, and are stated at the lower of cost (determined on a first-in, first-out basis) or market.
(e) Property and Equipment
Property and equipment are stated at cost. Equipment under capital leases is stated at the present value of minimum lease payments.
Depreciation on equipment is calculated on the straight-line method over the estimated useful lives of the assets. Equipment held under capital leases and leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or estimated useful life of the assets and included in depreciation expense. The estimated useful lives are as follows:
(f) Deferred Financing Costs
Deferred financing costs in connection with the issuance of debt are amortized to interest expense using the effective interest method over the term of the related debt instrument (note 8). A portion of the proceeds from the issuance of convertible debt securities with beneficial conversion features and/or detachable stock purchase warrants is recognized as additional paid-in capital and as a discount to its related debt instrument and amortized to interest expense ratably from the date of issuance to the date the related debt first becomes convertible. Other costs in connection with the issuance of the same securities are also deferred and amortized in the same manner.
(g) Engineering and Development and Software Development Costs
Engineering and development costs are expensed as incurred. Capitalization of software development costs commences upon the establishment of technological feasibility and ceases when the product is generally available for sale. Both the establishment of technological feasibility and the ongoing assessment of recoverability of capitalized development costs involve judgments by management with respect to certain external factors, including, but not limited to, anticipated future revenues, estimated economic life and possible developments in software and hardware technologies. In 1996, the Company determined that technological feasibility and future revenue potential had been established for the SONETLYNX product line. In 1997, the Company's LANscape product line achieved technological feasibility and future revenue potential was established. During the years ended December 31, 1998, 1997 and 1996, the Company capitalized $1,987,735, $1,317,000 and $1,395,000 of software development costs and charged operations for $1,083,424, $477,000 and $6,000 of amortization, respectively. Amortization prior to 1998 is based on estimated product revenues over the next five years or straight line, whichever is greater. After 1997, amortization is based on the greater of product revenues or two years.
During the first three quarters of 1996, the Company capitalized software development costs associated with the development of the CS4 programmable switch, having established technological feasibility early in 1996. In December 1996, a reassessment of the product definition rendered invalid the establishment of technological feasibility because feasibility had not been attained for all the inter-related modules of the product. Accordingly, all costs that had been capitalized in previous quarters, totaling $2,442,000, were charged to engineering and development expense in the fourth quarter of 1996.
During the year ended December 31, 1996, the Company advanced $396,000 to a software developer in connection with the development of certain software and related technology. Such amounts were charged to 1996 engineering and development expense.
(h) Earnings (Loss) Per Common Share
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share." SFAS 128 established standards for computing and presenting earnings per share (EPS) and is effective for financial statements issued for periods ending after December 15, 1997. This statement requires presentation of basic and dilutive EPS. Basic EPS excludes the effect of common stock equivalents while diluted EPS gives effect to all dilutive potential common shares outstanding during the period.
(i) Foreign Currency Translation
The Company's United Kingdom subsidiaries, Intelect Europe Limited ("IEL") and Intelect Network Systems Limited ("INSL"), used the local currency as the functional currency and translated net assets at the exchange rates in effect on the balance sheet dates, while income and expense accounts were translated at average rates. Foreign transaction exchange gains and losses were recognized as income or expense. Foreign currency translation adjustments and transaction amounts were not significant.
(j) Income Taxes
The Company accounts for income taxes under the liability method as required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and income tax bases of assets and liabilities and are measured using the enacted tax rates and laws expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
(k) Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash held in banks and time deposits having maturities within three months of the date of purchase by the Company.
(l) Goodwill
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over 10 to 15 years. Accumulated amortization at December 31, 1998 and 1997 was $4,076,000 and $2,951,000, respectively.
The Company assesses the recoverability of goodwill by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of the goodwill impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company's average cost of funds. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved.
During the year ended December 31, 1998, the Company charged $6,888,000 to operations for the writedown of goodwill in connection with the 1995 acquisition of Intelect Network Technology Company (INT) (See note 6(a)). The goodwill was considered impaired due to the loss of three significant bids for air traffic control (ATC) projects, the absence of any significant future prospects for the ATC products of INT, and the industry trend toward consolidation, all combining to diminish the outlook for the ATC business.
During the year ended December 31, 1996, the Company charged $4,175,000 to operations for the writedown of goodwill in connection with the 1996 acquisition of Intelect Visual Communications Corp. (see note 6(d)). The goodwill was considered impaired due to design flaws in the products acquired, which required design changes and enhancements and delayed market introduction. In addition, due to the liquidation of IEL, as described in note 6(b), goodwill of $740,000 associated with the 1995 acquisition of IEL was charged to 1996 operations.
The aforementioned writedowns were measured in accordance with the policy described above. At December 31, 1998, the Company believes that no significant impairment of the remaining goodwill has occurred and that no reduction of the estimated useful lives is warranted.
(m) Other Intangible Assets
Other intangible assets consist of a software license from a vendor (1996 only) and purchased product technology (note 7). Product technology assets are being amortized by the straight-line method over periods ranging from three to five years.
(n) Stock Option Plan
The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted SFAS No. 123, Accounting for Stock-Based Compensation, which permits pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied.
(o) Warranty Reserve
The Company accrues a reserve for warranty expense based on estimated future costs of startup and first year operations at customer sites.
(p) Reclassification
Certain prior period balances have been reclassified to conform to the current year presentation.
(3) Investments
Equity securities are considered available-for-sale and are stated at fair value. Unrealized holding gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Realized gains and losses from the sale of such securities are determined on a specific identification basis. Holdings of equity securities were sold in 1998. Certificates of deposit are interest-bearing and are pledged in the course of contractual performance and for the purpose of obtaining operating leases. A summary of such securities follows:
(4) Inventories
The components of inventories are as follows:
(5) Property and Equipment
Property and equipment are summarized as follows:
(6) Acquisitions
During 1995, the Company purchased Intelect Network Technologies Company ("INT") and Intelect Europe Limited ("IEL"). During 1996, the Company purchased DNA Enterprises, Inc. ("DNA") and Intelect Visual Communications Corp. ("IVC"). A summary of these acquisitions is as follows:
(a) Intelect Network Technologies Company
On January 13, 1995, the Company acquired 16% of the capital stock of INT (formerly known as Intelect, Inc.) for $400,000. On March 31, 1995, the Company entered into an agreement to purchase the remaining 84% of the capital stock of INT (the "Option Agreement"). Under the terms of the Option Agreement, the Purchase Price was payable as follows:
(i) $2,500,000 payable in debentures (the "Debentures") of INT plus the amount by which certain of INT's debts to two major customers (the "Debts") were settled for less than $6,000,000. The Debts were settled by the Company for $5,180,000 and, accordingly, the face value of the Debentures was increased to $3,320,000 ($2,500,000 plus $6,000,000 minus $5,180,000). The face value of the Debentures was reduced by the amount that defined net assets at the acquisition date (April 24, 1995) was less than $1,268,000. The amount of this reduction was $3,013,000 and, accordingly, the face value of the Debentures at December 31, 1995 was $307,000.
(ii) $4,000,000 in "Contingent Purchase Consideration" calculated on the future profitability of INT over the four year period from January 1, 1995. The additional payments were payable in cash or common stock, at the Company's option.
The first step of the acquisition of INT involved the purchase of a minority interest (16%) for cash. The Company's equity in the earnings of INT prior to acquisition of the remaining 84%, the second step, amounted to a loss of $280,000 and equity in the extraordinary gain arising from the restructuring of certain notes payable of $646,000, which were stated separately in the 1995 Consolidated Statements of Operations.
On October 7, 1996, the Company reached an agreement with the holders of the Debentures (the "Vendors"), under which the Vendors exchanged their remaining rights to the Debentures and Contingent Purchase Consideration in exchange for 169,986 shares of common stock. The transaction increased Goodwill by $660,000.
(b) Intelect Europe Limited
On August 31, 1995, the Company acquired 100% of the capital stock of IEL for $391,000 in cash and up to 300,000 of the Company's common shares in additional payments based on the future profitability of IEL over the five year period beginning August 31, 1995.
In December 1996, management made the decision to close the operations of IEL, which was subsequently placed in voluntary liquidation. The liquidation represented a disposal of a part of a line of business. Asset impairments were recorded and estimated liabilities to be incurred as a result of the liquidation were accrued, resulting in a charge to expense of $1,807,000 in 1996, including a writedown of $740,000 of unamortized goodwill.
(c) DNA Enterprises, Inc.
On February 13, 1996, the Company acquired 100% of the capital stock of DNA for $8,000,000, plus costs, payable as follows:
(i) $3,000,000 cash at closing.
(ii) $1,000,000 cash on the first anniversary of closing.
(iii) $400,000 cash on the second anniversary of closing.
(iv) Warrants to purchase 300,000 common shares at $5.00 per share on the first anniversary of closing.
(v) Warrants to purchase 300,000 common shares at $7.00 per share on the second anniversary of closing.
The Company agreed to redeem the $5.00 warrants at prices of $5.00, $5.50 and $6.00 per warrant share on the first, second, and third anniversaries of closing, respectively, and redeem the $7.00 warrants at prices of $5.50 and $6.00 per warrant share on the second and third anniversaries of closing, respectively, in each such case at the option of the warrant holders. The warrants were classified similar to redeemable preferred stock and included in long-term debt at their highest redemption price, totaling $3,600,000 at December 31, 1996 (note 9).
The Company is renegotiating terms of payment of its redemption obligations (notes 9 and 23). On the first and second anniversaries, the warrant holders elected to redeem all 300,000 common share warrants available on each date.
(d) Intelect Visual Communications Corporation
On March 29, 1996, the Company acquired 100% of the capital stock of IVC (formerly known as Mosaic Information Technologies, Inc.) for 479,370 common shares valued at $5.00 per share. The Company also paid $695,000 cash, and issued 66,050 common shares, valued at $5.375 per share, as payment of certain other acquisition costs. The total cost of the acquisition, including working capital advances prior to acquisition, was $4,747,000. An additional 50,000 common shares, valued at $5.00 per share, were issued to each of two selling shareholders pursuant to employment agreements, and charged to compensation expense.
All acquisitions have been accounted for by the purchase method of accounting and, accordingly, the purchase prices have been allocated to the assets acquired and the liabilities assumed based on the estimated fair values at the dates of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill, which is being amortized over 10 years for DNA. As discussed in note 2, all goodwill in connection with the acquisition of INT was written off in 1998, and in connection with the acquisitions of IVC and IEL was written off in 1996.
The estimated fair values of assets acquired and liabilities assumed on the respective transaction dates are summarized as follows:
Purchase prices include legal and other costs associated with the acquisitions.
Operating results of the acquisitions are included in the Company's consolidated results of operations from the effective dates of the acquisitions. The following unaudited pro-forma summary presents the consolidated results of operations as if the acquisitions of DNA and IVC had occurred at January 1, 1996 after giving effect to certain adjustments, including amortization of goodwill, additional interest expense on the acquisition debt and related income tax effects. These pro-forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made as of those dates or of results which may occur in the future:
(7) Other Intangible Assets
Other intangible assets are summarized as follows:
(8) Notes Payable
In August 1997, the Company executed an amended and restated loan agreement with The Coastal Corporation Second Pension Trust (the "Coastal Trust") providing for borrowing, on a revolving credit basis, of up to $5,000,000 and $3,000,000 was advanced in 1997. The balance was paid in connection with the revision to the Credit Facility (note 9) in May 1998. The balance due at December 31, 1997 was $2,598,000.
The note payable with a carrying value of $5,824,000 at December 31, 1997 was refinanced by the Credit Facility described in note 9.
In November 1998, the Company executed with the Coastal Trust a credit agreement for $750,000 secured primarily by inventory (the "Inventory Loan").
Notes payable at December 31, 1998, are as follows:
(9) Long-term Debt
In February 1998, the Company executed a revolving credit agreement with a private lender (the "Credit Facility") under which $3,000,000 was borrowed and warrants to purchase 450,000 shares of common stock were issued. The agreement was revised in April 1998, refinancing the existing borrowing of $3,000,000 and adding $7,000,000 to the Facility in exchange for warrants to purchase 1,050,000 shares of common stock. In February 1999, the due date was extended to March 12, 2000, in exchange for an additional 535,000 warrant shares. The balance due at December 31, 1997 on a refinanced facility with affiliates of the private lender, was $5,824,000.
In September 1998, the Company executed with the Coastal Trust a revolving credit agreement for up to $5,000,000 secured primarily by accounts receivable (the "Receivables Loan").
Components of long-term debt are as follows:
The Credit Facility prohibits additional debt, payment of dividends except on preferred stock, and encumbering any assets of the operating subsidiaries. The Credit Facility requires no payment of principal or interest until maturity. The outstanding balance is convertible into common stock at $9.082 per share, subject to anti-dilution adjustment, at the election of the lender. Financing costs in connection with the issuance of the Credit Facility were $3,053,000, including $2,980,000 in fair value of warrants to purchase 1,500,000 shares of common stock, valued using the Black-Scholes model, and $73,000 in cash. In 1998, amortization of financing costs, using the effective interest method over the loan period, was $2,665,000.
The Receivables Loan and the Inventory Loan prohibit additional debt, liens on property, dividends or distributions on capital stock (except dividends on preferred stock payable in common stock). Advances under the Receivables Loan are limited to 80% of "eligible accounts" as defined.
(10) Convertible Debentures
During the year ended December 31, 1996, the Company issued three series of convertible debentures: "June Debentures" in the aggregate principal amount of $5,000,000 bearing interest at 7.5%, "August Debentures" in the aggregate principal amount of $10,000,000 bearing interest at 7.5%, and "October Debentures" in the aggregate principal amount of $10,000,000 bearing interest at 7%.
At December 31, 1996, the June Debentures were fully converted into 773,514 shares of common stock, the August Debentures were partially converted into 883,691 shares of common stock, and the October Debentures were partially converted into 180,000 shares of common stock.
At December 31,1997, the August Debentures were fully converted into 2,582,106 shares of common stock and the October debentures were fully converted into 3,868,449 shares of common stock.
Financing costs incurred in 1996 in connection with the issuance of debentures were $9,687,000, including $4,947,000 allocated to beneficial conversion features, $3,117,000 in the fair value of warrants to purchase 420,063 shares of common stock (note 14), valued using the Black-Scholes model, and $1,623,000 in cash. Interest expense included $582,000 and $9,105,000 in 1997 and 1996, respectively.
(11) Lease Commitments
The Company is obligated under various capital equipment leases that expire during the next two years. The gross amounts of equipment and vehicles and related accumulated amortization recorded under capital leases were as follows:
The Company leases office space and certain equipment under leases expiring at various dates through 2004. Rental expense under operating leases was approximately$1,607,000, $1,528,000 and $1,032,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
Future minimum commitments as of December 31, 1998 under capital and operating leases are as follows:
Imputed interest included in future minimum commitments on capital leases is not material.
(12) Employee Benefit Plans
The Company sponsors defined contribution 401(k) plans for substantially all employees. Pursuant to the plans, employees may request the Company to deduct and contribute amounts from their salary on a pre-tax basis. Employee contributions are subject to certain limitations and the Company may make matching contributions, at its discretion. The Company may also make discretionary contributions in addition to matching contributions. Company contributions vest ratably over periods of four to five years, beginning in the second or first year of employment, respectively. Company contributions to the plans were $460,000, $345,000 and $459,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
(13) Income Taxes
Total income tax expense was allocated as follows:
Significant components of the provision for income taxes attributable to continuing operations for the years ended December 31, 1998, 1997 and 1996 are as follows:
The difference between the actual income tax benefit and the benefit computed by applying the statutory corporate income tax rate of 34% to pretax losses from continuing operations is attributable to the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are as follows:
At December 31, 1998, the Company had federal net operating loss carryforwards of approximately $89,225,000 and tax credit carryforwards of $298,000. The future utilization of $14,210,000 of the preacquisition net operating losses and the credit carryforwards related to the acquisition of INT and IVC will be limited under Internal Revenue Code Sections 382 and 383. The tax benefits from the utilization of the preacquisition operating loss carryforwards and the tax credits will be credited to goodwill when realized.
Following is a summary of the carryforwards and the expiration dates as of December 31, 1998:
In 1996, Intelect (Bermuda) was not subject to income tax in Bermuda and did not consider itself to be engaged in trade or business in the U.S. As such, Intelect (Bermuda) does not expect to be subject to direct United States taxation.
(14) Stockholders' Equity
Authorized share capital of $0.01 par value was as follows:
Share transactions during the year ended December 31, 1998, were as follows:
a. Authorized 12,500 and sold 10,000 shares of Series C convertible preferred stock for $10,000,000 in a private placement, resulting in net proceeds of $9,117,000 after issuance costs of $883,000. A premium accrues at 4% annually and is payable upon conversion in cash or common stock at the option of the Company. Shares may be redeemed at $1,100 per share plus 110% of accrued dividends. The preferred stock, plus accrued premium, may be converted after May 10, 1998 to common stock at a price which is the lower of $9.082 or 97% of the average of the three lowest closing bid prices for the ten trading days preceding a notice of conversion. Effective March 5, 1999, the variable conversion price is 83.5% of the average of the two lowest closing bid prices for the 40 trading days prior to the date of conversion.
b. Authorized and sold an aggregate of 10,000 shares of Series D convertible preferred stock for $10,000,000 in two separate private placements, resulting in net proceeds of $9,444,000 after issuance costs of $556,000. A premium accrues at 4% annually and is payable in cash or common stock at the option of the Company. Shares may be redeemed at $1,100 per share plus 110% of accrued premium. The preferred stock, plus accrued premium, may be converted to common stock at a price which is the lower of $2.998 or 97% of the average of the three lowest closing bid prices for the ten trading days preceding a notice of conversion. The conversion right was available June 8, 1998 for the first placement of 5,000 shares and September 24, 1998 for the second 5,000 shares. Effective March 5, 1999, the variable
conversion price is 83.5% of the average of the two lowest closing bid prices for the 40 trading days prior to the date of conversion.
c. Sold 1,000,000 shares of common stock in private placements at $1.00 per share, to accredited investors.
d. Issued 1,325,339 shares of common stock upon conversion of Series B preferred stock. Issued 4,006,532 shares of common stock upon conversion of Series C convertible preferred stock. Issued 784,184 shares of common stock upon conversion of Series D convertible preferred stock.
e. Issued 600,000 shares of common stock upon exercise of warrants at $2.00 per share by an assignee of St. James Capital Corp., LP.
f. Issued 226,458 shares of common stock upon exercise of employee stock options.
g. Issued 333,795 shares of common stock in payment for $1,309,000 of dividends on preferred stock.
h. Issued 18,000 shares of common stock in partial settlement of an employment dispute with a seller of Mosaic Information Technologies.
i. Issued 10,600 shares of common stock upon the partial conversion of a promissory note held by a former employee.
j. Issued warrants exercisable for common stock as follows:
The fair value of warrants issued was determined using the Black-Scholes option pricing model with the following assumptions:
At December 31, 1998, outstanding warrants were as follows:
*Surrendered February 19, 1999 in connection with payment of receivables.
**See comment above regarding antidilution effects.
Share transactions during the year ended December 31, 1997, were as follows:
a. Authorized 10,000,000 shares and sold 2,482,005 shares of $2.0145, 10% Cumulative Convertible Preferred Stock, Series A, for $5,000,000, in conjunction with a loan agreement with the Coastal Trust, resulting in net proceeds of $4,911,000, after issuance costs of $89,000. Dividends are payable quarterly, in cash or common stock, at the Company's option. The Company elected to pay dividends payable at September 30 and December 31, 1997, in common stock. The series may be redeemed, at the Company's option, at 110%, 105% and 100% of face value after June 1, 1999, 2000, and 2001, respectively, and is convertible into shares of common stock on a share for share basis, subject to anti-dilution provisions. The holders have the right of first refusal to participate in certain private equity or debt offerings. The series ranks in pari passu with the Series B and Series C preferred stock.
b. Authorized and sold 914,286 shares of $4.375, 10% Cumulative Convertible Preferred Stock, Series B, for $4,000,000, in a private placement, resulting in net proceeds of $3,877,000, after issuance costs of $123,000. Dividends are payable quarterly, in cash or common stock, at the Company's option, beginning March 31, 1998. The series may be redeemed, at the Company's option, at the greater of $5.25 per share or the average closing market bid price for the five consecutive trading days prior to the date of redemption. Beginning after May 31, 1998, 50% of the preferred stock is convertible into common stock and the remaining 50% is convertible into common stock on June 30, 1998. The number of common shares the holder is entitled to receive on conversion is the greater of (i) the number of shares of preferred stock multiplied by 1.10, or (ii) the number of shares of preferred stock multiplied by a number, the numerator of which is $4.375 and the denominator of which is 0.85 multiplied by the average daily closing market bid price for the common stock, as quoted on the Nasdaq National Market system, for the five trading days immediately preceding the date of the notice of election of conversion. The holders have the right of first refusal to participate in certain private equity or debt offerings. The series ranks in pari passu with the Series A and Series C preferred stock.
c. Sold 675,000 shares of common stock in private placements of 60,000 shares at $5.00 per share and 615,000 shares at $5.25 per share, to accredited investors, resulting in net proceeds of $3,330,000, after issuance costs of $199,000. An additional 21,400 shares were issued in payment for placement services related to the 615,000 shares.
d. Issued 780,583 shares of common stock upon the conversion of Series A preferred stock by the Coastal Trust.
e. Issued 930,000 shares of common stock upon the exercise of warrants. 750,000 common shares at $2.00 were issued to the Coastal Trust; 150,000 shares at $2.00 were issued to the Credit Facility private lender; and 30,000 shares at $4.50 were issued pursuant to a consulting agreement, resulting in net proceeds of $1,890,000 after issuance costs of $45,000.
f. Issued 542,182 shares of common stock at $1.5625, totaling $847,000, together with $60,000 cash in settlement of all future royalties under a technology purchase agreement. The royalty agreement had been initially executed in conjunction with certain technology purchased by the Company.
g. Issued 11,407 shares of common stock in payment for $58,000 of interest on Convertible Debentures, due June 30, 1997.
h. Issued 28,148 shares of common stock in payment for $296,000 of dividends on Series A preferred stock.
i. Issued warrants exercisable for common shares as follows:
The fair value of warrants issued was determined using the Black-Scholes option pricing model with the following assumptions:
Loan Agreements with Coastal Trust:
Equity Placement Services: July 2, 1997 Not valued because services were for placement of equity.
Share transactions during the year ended December 31, 1996, were as follows:
a. Issued 180,000 common shares at $2.50 per share and 180,000 common shares at $3.50 per share upon the exercise of warrants issued to the previous owners of Savage Corporation. The warrants had been issued in connection with the acquisition of Savage Corporation.
b. Issued 100,000 common shares at $3.75 per share in consideration for an investment of $375,000 in debentures with a CDN $500,000 face value, previously issued by Lakefield Arms Limited. The unsecured debentures bear interest at 8% per annum, and mature August 4, 1999.
c. Issued warrants exercisable for common shares in conjunction with the issuance of convertible debentures, and in conjunction with the acquisition of DNA Enterprises, Inc., as follows:
d. The fair value of warrants issued in conjunction with the convertible debentures was determined using the Black-Scholes option pricing model with the following assumptions:
There have been no dividends declared on common shares for any of the periods reported.
(15) Employee Stock Option Plan
In 1995, Intelect (Bermuda) adopted a stock option plan (the "Plan") pursuant to which the Company's Board of Directors may grant stock options to directors, officers and key employees. The Plan, adopted by the Company as part of the redomiciling process, authorizes grants of options to purchase up to 5,000,000 shares of authorized common stock. The exercise price for stock options granted may range from 25% to 110% of the fair market value of the shares on the date of grant. All stock options have 10-year terms and vest and become fully exercisable according to schedules determined by the Board of Directors, generally one-third on each of the first three anniversaries of the date of grant. At December 31, 1998, there were 560,840 shares available for grant under the Plan. The Plan replaced a predecessor plan which continues only to the extent that there are 140,000 unexercised options outstanding at December 31, 1998.
The per share weighted-average fair value of stock options granted during 1998, 1997 and 1996 was $1.91, $2.04 and $4.66, respectively, on the dates of grants. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, with the following weighted-average assumptions:
The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, has recognized compensation expense with respect to certain options granted at exercise prices less than the stock's market value on the date of grant. During the years ended December 31, 1998, 1997 and 1996, the Company recognized compensation expense of $101,000, $354,000 and $487,000, respectively.
Had the Company determined compensation cost based on the fair value on the grant date for its stock options under SFAS No. 123, the Company's net losses would have been increased to pro forma amounts as follows:
Pro forma net losses reflect only options granted in 1998, 1997 and 1996. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net loss amounts presented above because compensation cost is reflected over the option's vesting period of three years and compensation cost for options granted prior to November 1, 1995 is not considered. Furthermore, the effects of applying SFAS No. 123 may not be representative of the effects on reported net income for future years.
Stock option activity during the periods indicated was as follows:
At December 31, 1998, 1997 and 1996, the number of options exercisable was 1,316,341, 1,056,659, and 734,332, respectively, and the weighted-average exercise price of those options was $2.49, $3.78, and $2.79 respectively.
At December 31, 1998, the range of exercise prices and the weighted-average remaining contractual life of outstanding options, was $1.00 to $6.25 and 8.8 years, as shown in the following table:
(16) Income (Loss) Per Share
Basic and diluted income (loss) per share is based on the weighted average number of common shares outstanding for the period. Potential common shares relating to the exercise of stock options and stock warrants, conversion of preferred stock or conversion of convertible debt have been excluded from the computation as the effects would have been anti-dilutive.
Contingent shares, which were part of the INT and IVC acquisitions, have been excluded from the calculations because it was considered unlikely that the underlying performance criteria would be met.
(17) Contingencies
On October 28, 1998, in the 192nd Judicial District Court for Dallas County, Texas Richard Dzanski filed suit against Intelect Network Technologies Company, a wholly owned subsidiary of the Company, and Intelect Systems Corp., the predecessor of the Company. In the suit, the plaintiff has claimed a breach of an Irrevocable Option Agreement and that he has not received payments he claims are due to him in the amount of at least $386,000. The defendants deny liability to the plaintiff and intend to vigorously defend the case. The parties are in discovery and it is too early to determine if the outcome of this case will have a material impact on the Company.
Intelect (Bermuda) is contingently liable for certain potential liabilities related to its discontinued operations. Specifically, under a stock purchase agreement dated October 3, 1995 ("1995 Agreement"), Intelect (Bermuda) agreed to indemnify Savage Sports Corporation, the purchaser of Savage Arms, Inc. (a manufacturer of firearms), for certain product liability, environmental clean-up costs and other contractual liabilities, including certain asserted successor liability claims. One of the liabilities assumed involves a firearms product liability lawsuit filed by Jack Taylor individually and as father of Kevin Taylor in Alaska Superior Court (the "Taylor litigation"). Intelect (Bermuda) is informed that a defendant in the Taylor litigation, Western Auto Supply Co., settled the lawsuit for $5 million and, in turn, has asserted a third-party claim against Savage Arms, Inc. for indemnification in the amount of the settlement plus attorneys' fees and related costs. Savage Arms has asserted defenses to the claims and Intelect (Bermuda) believes additional defenses may be available. Based on the information available to date, it is impossible to predict the outcome of this litigation or to assess the probability of any verdict.
Intelect (Bermuda) also has been notified that Savage Sports Corporation seeks indemnification under the 1995 Agreement in connection with certain other product liability claims. Most notably, Intelect (Bermuda) has undertaken the defense of a lawsuit filed against Savage Arms, Inc. by Emhart Industries, Inc. ("Emhart") in the United States District Court for the District of Massachusetts (the "Emhart litigation"). In the lawsuit, Emhart requests indemnification from Savage Arms, Inc. under an agreement Emhart allegedly executed in 1981 with Savage Industries, Inc., claiming that Savage Arms, Inc. is a successor to Savage Industries, Inc. To date, Emhart has claimed indemnification of approximately $2.2 million for five lawsuits it has defended or settled and also seeks a declaratory judgment that it is entitled to indemnification for losses and expenses related to firearms product liability actions which may be filed against Emhart in the future. Intelect (Bermuda) intends to assert additional defenses. The parties are in discovery and Intelect (Bermuda) cannot at this time predict the outcome of the litigation.
In the event the Taylor litigation and/or Emhart litigation were to be resolved adversely to Intelect (Bermuda), there would be a material adverse effect on the Company's financial condition and results of operations.
(18) Segments of Business and Geographic Areas
See Products, Technologies and Services in ITEM I for a description of the segments in which the Company does business.
Sales to external customers:
In 1997, 59% of sales were to Asia, substantially all to the Republic of Korea. See note 20 for a description of customer concentration.
Segment-specific margins (Gross Profit less total engineering and development costs, including capitalized software, and asset write downs for the segment):
Assets, capital expenditures and depreciation are identifiable only by combined segments, as grouped below:
(19) Related Party Transactions
During the year ended December 31, 1998, the following related party transactions were recorded:
(a) Renewed a loan to an officer in the amount of $171,000, including accrued interest and additional advances, which was outstanding at December 31, 1998. The 5% note is secured by a stock pledge agreement.
(b) Repaid a loan of $200,000 from an officer, including interest of $4,000.
During the year ended December 31, 1997, the following related party transactions were recorded:
(a) Borrowed $200,000 from a director in May and repaid the loan in September, including interest of $8,000.
(b) Renewed a loan to an officer in the amount of $95,000, including accrued interest, which was outstanding at December 31, 1997. The 5% note is secured by a stock pledge agreement.
(c) Borrowed $643,000 from a group of individuals, including $233,000 from directors, $200,000 from an officer and $210,000 from employees.
During the year ended December 31, 1996, the following related party transactions were recorded:
(a) Purchased patents, intellectual property and related proprietary information from a company owned by an officer for $125,000 and entered into a royalty agreement with respect to products sold by the Company which are covered by the patents.
(b) Loaned an officer $135,000, of which $91,000, including accrued interest, remained outstanding at December 31, 1996. The 5% note is secured by a stock pledge agreement.
(c) Borrowed $500,000 from a company controlled by a director who was also the Company's president in July, and repaid the loan in September, including interest of $13,000.
(d) Paid $120,000 for management fees and rented facilities from a company controlled by a director who was also the Company's president.
(e) Amended employment agreements with the now former president and the present chairman which, generally upon termination, provide for continuation of salaries for three years following the current year of employment.
(20) Significant Customers and Concentration of Credit Risk
In 1998, no customer accounted for more than 10% of consolidated net revenues.
In 1997, a distributor and one customer represented 59% and 11%, respectively, of consolidated net revenues. The distributor sold to at least five end users in the Republic of Korea.
In 1996, one customer represented 25% of consolidated net revenue.
The Company is subject to credit risk through trade receivables. At December 31, 1997, the distributor responsible for all revenue from Korea accounted for $9,879,000 (63%) of the accounts receivable. In October 1998, the Company was advised of the illiquidity of the distributor and wrote off or reserved substantially all of the $4,696,000 receivables remaining unpaid at the end of September 1998, adjusted, effective in December 1998, for a payment of $1,000,000 in February 1999.
(21) Supplemental Disclosure of Cash Flow Information
Noncash Items
During the year ended December 31, 1998, the Company recorded the following noncash transactions:
(a) Converted notes payable into common stock -$21,000.
(b) Converted 914,286 shares of Series B preferred stock and 8,157 shares of Series C preferred stock and 1,750 shares of Series D preferred stock into 5,997,819 shares of common stock.
(c) Issued common stock in payment of preferred stock dividends - $1,309,000
(d) Issued common stock warrants in conjunction with notes payable -$2,980,000.
(e) Issued common stock warrants in conjunction with an advisory services agreement -$155,000.
(f) Allocation of retained earnings to beneficial conversion feature of preferred stock issued -$618,000.
During the year ended December 31, 1997, the Company recorded the following noncash transactions:
(a) Converted convertible debentures into common stock - $14,913,000.
(b) Converted notes payable into preferred stock - $5,000,000.
(c) Converted preferred stock into common stock (par value only) - $8,000.
(d) Applied a note payable against a technology license asset upon settlement of a contractual dispute - $2,363,000.
(e) Issued common stock in conjunction with termination of a royalty agreement - $847,000.
(f) Issued common stock in payment of preferred stock dividends - $296,000.
(g) Issued preferred stock in payment of interest on notes payable - $72,000.
(h) Issued common stock in payment of interest on convertible debentures - $58,000.
(i) Issued common stock warrants in conjunction with notes payable - $1,661,000.
(j) Issued common stock warrants in conjunction with a distributor agreement - $162,000.
(k) Issued common stock warrants in conjunction with an advisory services agreement - $58,000.
(l) Issued common stock warrants upon termination of credit facility - $30,000.
(m) Allocation of retained earnings to beneficial conversion feature of preferred stock issued - $31,000.
(n) Acquired equipment under capital leases - $117,000.
During the year ended December 31, 1996, the Company recorded the following noncash transactions:
(a) Converted convertible debentures into stock - $10,087,000.
(b) Allocation of proceeds from convertible debentures to beneficial conversion features - $4,947,000.
(c) Issued common stock warrants in conjunction with convertible debentures - $3,117,000.
(d) Obtained a technology license in exchange for a note - $3,267,000.
(e) Issued stock in final settlement of the Intelect, Inc. acquisition - $850,000.
(f) Issued stock as part of employment agreements - $500,000.
(g) Recognized compensation expense on stock options granted at less than market price - $487,000.
(h) Acquired a long term asset with stock - $375,000.
(i) Acquired equipment under capital leases - $111,000.
(22) Valuation and Qualifying Accounts
Notes: (a) Accounts written off (b) Scrapped, sold or other disposition (c) Includes liquidation of subsidiary.
(23) Subsequent Events
On March 5, 1999, the Company sold 3,000 shares of series E Convertible Preferred Stock, in the Initial Closing of a private placement, for $3,000,000. Premiums accumulate at the rate of 8% per year, are payable on conversion and may be paid in cash or common stock at the Company's option. The preferred stock will automatically convert into common stock on March 5, 2004 and may be converted prior to that date at the holder's option. The conversion price is the lesser of $1.80 per common share or 83.5% of the average of the two lowest closing bid prices of the common stock for the forty consecutive trading days before the date of conversion. Purchasers of the preferred stock received warrants to purchase 300,000 of common stock at a price of 110% of the "Market Price" (as defined) on the date of the Initial Closing . Redemption of the preferred stock may be required by the holders upon the occurrence of Major Transactions, such as merger or sale of substantially all assets, or in case of Triggering Events, such as failure to register the resale of conversion shares by July 2, 1999 and certain other events which would impair the ability of preferred stockholders to resell conversion shares. The March 5 Initial Closing is the first of multiple closings subject to satisfaction of terms and conditions in a Securities Purchase Agreement all as more fully described in the Form 8-K of the Company filed March 2, 1999.
In connection with the Initial Closing of the Series E preferred stock, the Company agreed to allow holders to sell all of their remaining 1,843 shares of Series C preferred stock and 1,144 shares of Series D preferred stock to new investors. In connection with the issuance of the Series E preferred stock, the holders of the Series C and Series D preferred stock have the right under the Certificates of Designations of such securities to use the variable conversion price of the Series E preferred stock. Thus, after the Initial Closing, when the holders of the Series C and Series D preferred stock submit a conversion notice, they will likely elect to use the variable conversion price of the Series E preferred stock instead of the variable conversion price of the Series C and D preferred stock (which is 97% of the average of the three lowest closing bid prices in the ten prior trading days). In addition, the Company has agreed that the new investors are not required to limit their conversions of the Series C and Series D preferred stock to 1,200,000 shares of Common Stock in any continuing thirty (30) day period. Original holders will continue to be subject to contractually agreed conversion restrictions.
During January 1999, the Company sold in a private placement 1,800,000 shares of common stock at a price of $1.00 per share and warrants to purchase 540,000 shares of common stock in connection with the private placement. The warrants have an exercise price of $2.998. The offering was made solely to accredited investors. The Company granted to the purchasers registration rights covering the resale of the common stock and the warrant shares.
Effective January 13, 1999, the Coastal Trust agreed to extend the maturity date of the Receivables Loan which previously matured on August 31, 1999, to February 12, 2000. In addition, the Coastal Trust agreed to extend the maturity date on the Inventory Loan to May 1, 1999, with payments of $250,000 plus accrued interest due on each of March 1, April 2 and May 1, 1999.
Effective January 13, 1999, as permitted under the terms of the Credit Facility dated as of February 12, 1998, the Company elected to extend the maturity date of the Convertible Promissory Notes issued pursuant to the Facility to February 12, 2000. In connection with the extension, the Company issued to the investor warrants to purchase an aggregate of 535,000 shares of common stock of the Company. The exercise price of the warrants is $1.81. The warrants are subject to antidilution provisions which are triggered in the event that the Company issues or sells common stock or securities convertible or exercisable into common stock at a price less than the exercise
price then in effect. Such provisions would enable the holder to obtain a reduction in the warrant exercise price as well as an increase in the applicable number of warrant shares.
On February 12, 1999, the Company reached an agreement with its distributor in Korea to forbear from collection of remaining receivable balances due from the distributor in exchange for (1) immediate payment of $1,000,000, (2) delivery to the Company of a proprietary product design, (3) assumption by the distributor of warranty obligations to Korean customers, (4) surrender of exclusive distribution rights in Korea after 1999, and (5) surrender of warrants to purchase 40,500 shares of common stock. The forbearance is voidable if the distributor fails either to order an additional $1,000,000 of the Company's products before February 10, 2000 or to pay $250,000 by January 31, 2000.
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The Company's Board of Directors, in accordance with the recommendation of its Audit Committee, which is composed of non-employees of the Company, has requested Grant Thornton LLP ("Grant Thornton") to act as independent auditors of the Company for the 1998 fiscal year, subject to shareholder approval, in replacement of Arthur Andersen LLP ("Arthur Andersen").
As disclosed in the Form 10-Q of the Company filed on November 16, 1998, the Company's previous independent auditors, Arthur Andersen, resigned on November 13, 1998. The report by Arthur Andersen LLP for the year ended December 31, 1997 contained no adverse opinion or disclaimer of opinion, nor was it qualified or modified as to audit scope or accounting principles. There have been no disagreements by the Company with Arthur Andersen LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope and procedure, which disagreement(s), if not resolved to the satisfaction of Arthur Andersen LLP would have caused it to make reference to the subject matter of the disagreement(s) in connection with its report. There are no "reportable events" as set forth in Regulation S-K, Item 304(a)(1)(v)(A)-(D) except as follows: (1) Arthur Andersen LLP informed the Company that it appears likely its auditor's report for 1998 would have contained a qualification as to the Company's ability to continue as a going concern, (2) Arthur Andersen informed the Audit Committee Chairman, the Chairman of the Board and the Chief Financial Officer that with respect to Capitalized Software Development Costs, compliance with SFAS #86 had not been evaluated particularly as it relates to current year additions and realizability of such asset and (3) Arthur Andersen informed the Audit Committee Chairman, the Chairman of the Board and the Chief Financial Officer that as a result of the revenue restatement for the quarter ended June 30, 1998, they would have had to expand the scope of the 1998 audit if they had not resigned. Arthur Andersen encouraged the Audit Committee Chairman, the Chairman of the Board and the Chief Financial Officer to closely monitor these matters. Substantive audit tests and further investigation into these matters would have been a necessary part of Arthur Andersen's audit procedures for the year-end December 31, 1998 financial statements had the client/auditor relationship not terminated. Arthur Andersen has been authorized by the Company to respond to any and all inquiries by the successor auditors, without limitation. The Company has indicated that it will cooperate fully with the new auditors to address these matters. Arthur Andersen has provided to the Company a letter to the Securities and Exchange Commission stating that it has reviewed the disclosure provided in this Form 10-Q and has no disagreement with relevant portions of this disclosure, pursuant to the requirements of Item 304(a)(3) of Regulation S-K. A copy of such letter, dated November 16, 1998, is filed as an exhibit to the Form 10-Q filed on November 16, 1998.
As disclosed in the Form 8-K of the Company filed on August 18, 1997, the term of the Company's previous independent auditors, KPMG, expired at the Company's annual general meeting of its stockholders held August 13, 1997. The KPMG report dated April 9, 1997 on the consolidated financial statements of the Company for the year ended December 31, 1996, noted that the Company has suffered recurring losses from continuing operations and is dependent upon the successful development and commercialization of its products and its ability to secure adequate sources of capital until the Company is operating profitably and noted that these matters raise substantial doubt about the Company's ability to continue as a going concern, and that management's plans with regard to these matters were described in Note 1 to the consolidated financial statements.
During the two years ended December 31, 1995 and December 31, 1996, and the subsequent interim period through the date of the appointment of Arthur Andersen as the Company's new outside auditors, there were no "disagreements" between the Registrant and KPMG as described in Item 304(a)(1)(iv) of Regulation S-K. The Registrant requested KPMG to furnish it with a letter addressed to the SEC stating whether or not it agreed with the above statements. A copy of such letter, dated August 14, 1997, was filed as an Exhibit to the Form 8-K of the Company filed on August 18, 1997.
Arthur Andersen LLP has consented to the Company's inclusion of Arthur Andersen's report on the company's financial statements for a certain prior period (1997). In connection with this consent, Arthur Andersen has asked the Company to indemnify and hold harmless Arthur Andersen LLP for any loss incurred as a result of the consent to the inclusion of Arthur Andersen's report, unless such loss results from Arthur Andersen's being adjudicated by a court, after appeal, to be liable as a result of consenting to the use of its report. The Company agreed to such request for an indemnification and hold harmless agreement.
KPMG has consented to the Company's inclusion of KPMG's report on the Company's financial statements for certain prior periods. In connection with the consent, KPMG asked the Company to indemnify KPMG for any loss incurred as a result of the consent to the inclusion of KPMG's report, unless such loss results from KPMG's professional malpractice. The Company agreed to such request for indemnification.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Company will file with the Securities and Exchange Commission a definitive Proxy Statement no later than 120 days after the close of its fiscal year ended December 31, 1998 (the "Proxy Statement"). The information required by this Item is incorporated by reference from the Proxy Statement.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference from the Proxy Statement.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference from the Proxy Statement.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference from the Proxy Statement.
PART IV
ITEM 14
ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
A. The Financial Statements filed as part of this report are listed and indexed on Page 20. Schedules other than those listed in the index have been omitted because they are not applicable or the required information has been included elsewhere in this report.
B. Listed below are all Exhibits filed as part of this report. Certain Exhibits are incorporated by reference to documents previously filed by the Registrant with the Securities and Exchange Commission pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, as amended. Exhibits which are incorporated by reference are indicated by the information in the parenthetical following such exhibit.
- ---------------------------------------------
*Management contract or other compensatory plan or arrangement.
(1) Incorporated herein by reference to the Company's Form S-4 filed October 30, 1997
(2) Incorporated herein by reference to the Company's Form 8-K filed December 5, 1997
(3) Incorporated herein by reference to the Company's Form 8-K filed February 17, 1998
(4) Incorporated herein by reference to the Company's Form 10-Q filed November 13, 1996
(5) Incorporated herein by reference to the Company's Form 8-K dated November 10, 1995
(6) Incorporated herein by reference to the Company's Form 8-K/A dated April 12, 1996
(7) Incorporated herein by reference to the Company's Form 10-K filed April 15, 1997
(8) Incorporated herein by reference to the Company's Form 8-K dated February 20, 1996
(9) Incorporated herein by reference to the Company's Form 10-K for the year ending December 31, 1995
(10) Incorporated herein by reference to the Company's Form 8-K dated April 12, 1996
(11) Incorporated herein by reference to the Company's Form 10-Q filed May 15, 1997
(12) Incorporated herein by reference to the Company's Form 10-Q filed August 14, 1997
(13) Incorporated herein by reference to the Company's Form S-3 filed September 17, 1997
(14) Incorporated herein by reference to the Company's Form 10-Q filed November 13, 1997
(15) Incorporated herein by reference to the Company's Form 8-K filed August 19, 1997
(16) Incorporated herein by reference to the Company's Form 8-K filed on May 11, 1998
(17) Incorporated herein by reference to the Company's Form 8-K filed on June 29, 1998
(18) Incorporated herein by reference to the Company's Form 8-K filed on September 16, 1998
(19) Incorporated herein by reference to the Company's Form 8-K filed on March 2, 1999
(20) Incorporated herein by reference to the Company's Form 8-K filed on March 8, 1999
(21) Incorporated herein by reference to the Company's Form S-3 filed on August 10, 1998
(22) Incorporated herein by reference to the Company's Form 10-K filed on March 31, 1998
(23) Incorporated herein by reference to the Company's Form 10-Q filed on August 14, 1998
(24) Incorporated herein by reference to the Company's Form 10-Q filed on November 16, 1998
(25) Incorporated herein by reference to the Company's Definitive Proxy Statement filed on April 28, 1998.
C. The Registrant has not filed any reports on Form 8-K during the last quarter of the period covered by this Report, except as follows:
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
INTELECT COMMUNICATIONS, INC. (Registrant)
Date: April 2, 1999 By: /s/ Herman M. Frietsch ---------------------------------- Herman M. Frietsch Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
/s/ Herman M. Frietsch /s/ ANTON VON AND ZU LIECHTENSTEIN - ------------------------------------------ ---------------------------------- Herman M. Frietsch Anton von and zu Liechtenstein, Chief Executive Officer and Director Director (Principal Executive Officer)
/s/ EDWIN J. DUCAYET, JR. /s/ PHILIP P. SUDAN, JR. - ------------------------------------------ ---------------------------------- Edwin J. Ducayet, Jr. Philip P. Sudan, Jr., Director Chief Financial Officer (Principal Financial and Accounting Officer)
/s/ ROBERT E. GARRISON, II ---------------------------------- Robert E. Garrison, II, Director
INDEX TO EXHIBITS