Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer o Non-accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes o No x
The aggregate market value of the voting stock held by non-affiliates of the registrant, computed by reference to the Nasdaq closing price on April 28, 2007, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $33,442,994.
The number of shares outstanding of the registrant’s Common Stock as of December 19, 2007 was 10,231,646.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Annual Meeting of Shareholders to be held April 8, 2008 are incorporated by reference into Part III, Items 10 through 14 hereof.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements relating to future events and our future performance and results. Many of these statements appear in the discussions under the headings “Business,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” All statements other than those that are purely historical may be forward-looking statements. Forward-looking statements can generally be identified by words such as “expects,” “anticipates,” “may”, “plans,” “believes,” “intends,” “projects,” “estimates,” and similar words or expressions. Forward-looking statements are not guarantees of performance, but rather reflect our current expectations, estimates, and forecasts about the industry and markets in which we operate, and our assumptions and beliefs based upon information currently available to us. These statements are subject to risks and uncertainties which are difficult to predict or which we are unable to control, including but not limited to such factors as customer demand for advanced communications products, capital spending trends within our market, the financial condition of our suppliers and changes by them in their distribution strategies and support, technological changes, product mix, the ability to attract and retain highly skilled personnel, competition and other risks and uncertainties specifically discussed under the heading “Risk Factors” under Part I of this report. As a result of these risks and uncertainties, actual results may differ materially and adversely from those expressed in forward-looking statements. Consequently, investors are cautioned to read and consider all forward-looking statements in conjunction with such risk factors and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe-harbor for forward-looking statements made by the Company.
PART I
ITEM 1. BUSINESS
Development and Description of Business
XETA Technologies, Inc. (“XETA”, the “Company”, “we”, “us”, or “our”), an Oklahoma corporation formed in 1981, is a leading provider of communications technologies with a comprehensive array of products and services available from market leaders. Our market focus is on enterprise-class communications solutions and managed services in the emerging, highly-technical world of converged communications. We specialize in helping our customers transition from traditional voice telephony to Internet Protocol (“IP”) based telephony, IP-based telephony enables our customers to reduce their total communications costs and more effectively serve their own customers through advanced applications such as contact centers, message management systems, and integrated multi-media applications. We provide these solutions and services to multi-location, mid and large sized enterprises throughout the United States. We also market our solutions and services to several vertical markets such as the hospitality industry, the federal government, and the healthcare industry. We provide services through our nationwide network of Company-employed design engineers and service technicians as well as our 24-hour, 7-days-per-week call center located in our headquarters building in Broken Arrow, Oklahoma.
We maintain the industry’s highest certifications as an Avaya Platinum National Business Partner, a Nortel Elite Advantage Partner, and a Mitel Premium PARTNER. We distribute products and services for these manufacturers under nationwide, non-exclusive dealer agreements. All three of the manufacturers provide us with important volume incentives and marketing expense reimbursements to carry their products. We purchase their products from large distributors who also provide pricing and volume incentives. We have distributed Avaya products since 1998 and Nortel products since 2004. In October, 2007 we added the Mitel product line to our product mix in response to market demand in the lodging industry. Mitel is a market-leader in voice communications for the lodging industry and, like Avaya and Nortel, has transitioned its product line to server-based systems that work effectively in converged voice and data environments. With the addition of Mitel products, we believe we will be able to expand our already strong market position in the lodging industry.
Our primary operating strategies in fiscal 2007 were to focus on our target customers, expand our wholesales services offerings, and create further alignment with our major business partners. We target our products and services at large enterprises with multiple locations and often with multiple technology platforms. Larger enterprises fit our key market advantages such as nation-wide coverage, 24-hour operations, and ability to support both Avaya and Nortel products, capabilities that most regional and local integrators do not possess. Our wholesale service strategy is based on partnering with manufacturers, network service providers, and large integrators (“wholesale customers”) to provide services to their end-user customers. Typically, we provide field services or specific technical expertise to supplement core services provided by our wholesale customers. Our ability to support multiple platforms is also often a key factor in this market as well. Our success in expanding our wholesale services revenues was a key factor in our revenue growth in fiscal 2007 and is discussed more fully below. Finally, we improved our alignment with our major business partners, Avaya and Nortel, in fiscal 2007. This strategy is focused on approaching the market in the manner which best fits each manufacturer. For Avaya, this means partnering with them to sell equipment to the enterprise market and selling their service capabilities and maintenance contracts. For Nortel, this means approaching the market with a regional focus and aligning with Nortel’s regional sales management. To accomplish significant progress toward this initiative, we dedicated senior sales management to each product line and have shaped each sales organization as well as their go-to-market strategies to more closely match their respective product lines.
In fiscal 2007, we completed a transition plan in our executive management ranks. In June, our previous Chief Executive Officer (“CEO”), Jack Ingram, stepped down and Greg Forrest, previously our President and Chief Operating Officer, was named CEO. Additionally, we separated the roles of Chairman of the Board of Directors and CEO and named Don Duke, a long-time director of the Company, as non-executive Chairman.
Commercial Systems Sales
We sell communications solutions to the general commercial market, federal government and healthcare market. These solutions are aimed at maximizing the effectiveness of our customers’ communications systems through the use of advanced technologies such as IP-based telephony. Through the use of these systems, our customers can reduce their total communications costs by establishing their voice communications as an application on their data networks and can increase
the productivity of their employees through the use of other voice applications that integrate with their data networks. Such applications include message management systems that integrate voicemail and fax messages with existing email systems, speech recognition systems, and multimedia applications such as streaming audio and video systems. We sell these systems under dealer agreements with Avaya and Nortel. Both of these manufacturers have significant installed bases in the communications equipment market and are migrating their customers from traditional telephony systems to new IP-based platforms. We receive incentive payments from both manufacturers which offset certain product costs, training expenses, and certain sales and marketing expenses. We purchase these products through major distributors and receive additional price incentives from these distributors. These incentive payments are material to our business. We sell data networking products to the commercial market under non-exclusive dealer agreements with Avaya, Nortel, Cisco Systems Inc., and Hewlett-Packard Company.
Sales of systems to commercial customers were $23.8 million in fiscal 2007 compared to $22.5 million and $21.4 million in 2006 and 2005, respectively. These sales represented 34%, 37%, and 37% of total revenues during fiscal years 2007, 2006, and 2005, respectively.
Hospitality Products
Communications Systems. We sell communications systems to the hospitality industry through nationwide, non-exclusive dealer agreements with Avaya, Nortel, and Mitel. In addition to most of the features available on the commercial systems above, the systems sold to hospitality customers are equipped with hospitality-specific software, which integrates with nearly all aspects of the hotel’s operations. We also offer a variety of related products such as voice mail systems, analog telephones, uninterruptible power supplies, announcement systems, and others, most of which also have hospitality-specific software features. Most of these additional products are sold in conjunction with the sale of new communications systems and, with the exception of voice mail systems, are purchased from regional and national suppliers. All of our sales of communications systems in fiscal 2007 were either Avaya or Nortel products. We expect Mitel product sales to begin in our second quarter of fiscal 2008 and to become material to our hospitality revenues in fiscal 2009.
Call Accounting Products. We market a line of proprietary call accounting products under the Virtual XLÒ and Virtual XL.2™ names. Introduced in 1998, the VXL series is a PC-based system designed to operate on a hotel’s local or wide area network. If that network is connected to the Internet, the VXL can also be accessed via an Internet connection. The original VXL was upgraded to a rack-mounted, server-style system in 2004 and is marketed under the name Virtual XL.2™. The VXL systems are our latest technology in a series of call accounting products we have successfully marketed since the Company’s inception. Many of those earlier products remain in operation at customer locations and are under maintenance contracts with us or generate time and materials (“T&M”) revenues for us. These revenues and the related gross profits are material to our business.
Sales of communications systems and products to the hospitality industry represented 11% of total revenues in fiscal 2007, 2006 and 2005. Marriott International, Host Marriott, and other Marriott-affiliated companies (“Marriott”) represent a single customer relationship for our Company and are a major customer to our hospitality business. Revenues earned from sales of hospitality systems sold to Marriott represented 32%, 21%, and 52% of our sales of hospitality systems in fiscal 2007, 2006, and 2005, respectively.
Services
Services revenue is our largest revenue stream. Due to its recurring nature and generally higher profitability, this portion of our business is of vital importance to our operating results. Our services product offering includes nation-wide customer service, project management, professional services, installation, consulting, and structured cabling implmentation to support our customers. The geographic reach and technical breadth of our services organization are key differentiators between us and our competitors.
Our services organization includes our National Service Center (“NSC”) housed at our headquarters in Broken Arrow, Oklahoma. The NSC supports our commercial and hospitality customers who have purchased maintenance contracts on their systems, as well as other customers who engage us on a T&M basis. We employ a network of highly trained technicians who are strategically located in major metropolitan areas and can be dispatched by the NSC to support our customers in the field or to install new systems. We also employ design engineers (which we refer to as our Professional Services Organization or “PSO”), to design voice, data, and converged networks to meet specific customer applications. Much of the work done by the PSO represents pre-sales work and is often not recovered in revenues, representing a
significant investment. We believe, however, that by hiring the most qualified personnel possible and keeping their talents in-house, we create a competitive advantage in the marketplace.
To our non-hospitality end-users of Nortel equipment, we sell our own maintenance contracts. Additionally, we aggressively market our Nortel services capabilities to existing and potential wholesale customers. By providing national coverage at competitive hourly rates, the NSC is a valuable resource to wholesale customers by providing geographic coverage or technical capabilities to service their customers directly. Our largest wholesale customer opportunities are with the Regional Bell Operating Companies (“RBOCs”). RBOCs are the largest Nortel dealers in the U.S. and as such have large installed bases of customers with Nortel systems. Under a wholesale customer agreement, the RBOCs use the NSC to service customers out of the RBOCs’ regional service area and/or handle overflow work during peak periods. Another significant wholesale customer is Nortel itself. Nortel has maintenance contracts with many large, “Fortune 1000”-type customers. Nortel out-sources much of the on-site service work for these customers to its authorized service providers, including us.
For Avaya products sold to non-hospitality customers, we sell Avaya’s post-warranty maintenance contracts, for which we earn a commission. These commissions are recorded as other revenues in our financial statements.
For Avaya, Nortel, and Mitel communications systems sold to hospitality customers, we sell our own maintenance agreements. For our proprietary products, we offer post-warranty service contracts to our hospitality customers under one-year and multi-year service contracts. The revenues earned from the sale of our maintenance contracts are an important part of our business model as they provide a predictable stream of profitable recurring revenue. We earn a significant portion of our recurring service revenues from hospitality customers who maintain service contracts on their systems.
For our distributed products, we typically pass on the manufacturer’s limited warranty, which is generally one year in length. Labor costs associated with fulfilling the warranty requirements are generally borne by us. For proprietary call accounting products sold to the hospitality industry, we provide our customers with a limited one-year warranty covering parts and labor.
Services revenues represented 53%, 50%, and 49% of total revenues for fiscal years 2007, 2006 and 2005, respectively. Marriott is a significant customer and services revenues earned from Marriott represented 13%, 15%, and 15% of total services revenues in fiscal years 2007, 2006, and 2005, respectively.
Marketing
We market our products and services primarily through our direct sales force to a wide variety of customers including large national companies, mid-size companies, government agencies, and the hospitality industry.
Because the technology we sell is now typically an application running on an existing data network, the focus of our marketing efforts has had to adjust toward data networking decision makers, many of whom have long-standing relationships with their data products and services dealers. Furthermore, because most customers are making the decision to convert their traditional voice networks to IP-based platforms for the first time, the decision to do so is often considered riskier and is therefore being made at higher levels within the organization. As a result, we have also adjusted our marketing efforts to provide assurances to customers that we are capable of designing and implementing these new systems effectively.
We hold specific events to support our direct marketing to customers. Additionally, a significant aspect of our marketing effort centers on our relationships with Avaya and Nortel. As a national dealer for both manufacturers, we have certain technical and geographical capabilities that help differentiate us in the marketplace. We aggressively market these capabilities to Avaya and Nortel. Both manufacturers utilize us in a variety of ways, from fulfilling certain customer orders to handling entire customer relationships. We have carefully positioned ourselves as a leading dealer for both manufacturers by building our in-house engineering capabilities, providing nationwide implementation services, and through access to our 24-hour, 7 days-per-week service center.
Our marketing efforts to the hospitality industry rely heavily on our experience and reputation in that industry. Over the course of serving this market for more than 25 years, we have built strong long-term relationships with a wide range of personnel (corporate hotel chain personnel, property management officials, industry consultants, hotel owners, and on-site financial and/or operating officers) that are the key decision makers for the purchase of hotel communications technology. We have relationships with nearly all hotel chains and major hospitality property management companies. These relationships are key to our past and future success and our hospitality marketing efforts are targeted at strengthening and deepening those relationships rather than the more broad promotional efforts sometimes employed in our marketing efforts to the commercial sector.
Backlog
At December 1, 2007 our backlog of orders for systems sales was $12.7 million compared to $2.6 million at the same time last year. Approximately $10 million of this backlog is from a single customer. Based on current installation schedules, we expect the revenue from this customer’s orders to be recognized as revenue ratably over fiscal 2008. We expect the remainder of our backlog to also ship and be recognized as revenue by October 31, 2008, with the majority of these orders being shipped in the first half of the year. However, our customers frequently change their installation plans which can significantly disrupt the timing of our revenue recognition. Therefore no assurance can be given that our current expectations will be realized regarding the full recognition of revenues currently in our backlog. Additionally, we currently have approximately $21 million in contracted maintenance revenues which we expect to recognize over the next fiscal year. Most of the contracts are cancelable upon thirty days notice by the customer or us.
Competition
Commercial. The market for communications systems, applications and services is evolving at a rapid pace due to the convergence of voice and data networks and the speed at which new applications are being introduced. Our market has always been highly competitive, as both Avaya and Nortel have extensive dealer organizations, including the Regional Bell Operating Companies, nationwide dealers like us, and smaller regionally-focused dealers. In addition to other Avaya and Nortel dealers, we also face competition from dealers of other large manufacturers such as Cisco Systems, Inc., Siemens Aktiengesellschaft, Alcatel S.A. and NEC Corporation, as well as from a number of other companies, some of which focus on particular segments of the market such as call centers or message management. With the addition of data products dealers, particularly Cisco dealers, the competition has been heightened. Many of our new competitors have long-standing relationships with the information technology (“IT”) decision makers of our customers, increasing the fierceness of the competition.
Hospitality. , We face similar competitive pressures in our hospitality business to those discussed above under “Commercial” competition. However, since the hospitality market is a small niche market, we believe our most effective competitive strengths are the performance and reliability of our proprietary hospitality systems and our high level of service commitment to this niche market. Despite these strengths, we expect to experience a period of testing as we begin distributing the Mitel product line to the hospitality industry, including to long-term customers. In all previous new product line introductions, customers have required us to prove our capabilities in installing and maintaining the product prior to releasing significant orders to us. We expect this period of proving to last most of fiscal 2008 with material Mitel orders beginning late in the year or in fiscal 2009. While we are confident that we will successfully establish ourselves as a Mitel dealer and that our reputation and nationwide presence will continue to contribute significantly to our success in the hospitality market, there can be no assurance given that we will be able to continue to expand our market share in the future.
Manufacturing
We assemble the Virtual XL™ and Virtual XL.2™ systems, our proprietary call accounting systems sold exclusively to the hospitality industry. The sale of these systems comprise less than 1% of our total revenues. We assemble these systems from an inventory of components, parts and sub-assemblies obtained from various suppliers. These components are purchased from a variety of regional and national distributors at prices that fluctuate based on demand and volumes purchased. Some components, although widely distributed, are manufactured by a single, usually foreign, source and are therefore subject to shortages and price fluctuations if manufacturing is interrupted. We maintain adequate inventories of components to mitigate short-term shortages and believe the ultimate risk of long-term shortages is minimal.
We use outside contractors to assemble our proprietary printed circuit boards that are part of our proprietary call accounting systems. The components and blank circuit boards are purchased, inventoried, and supplied to the outside contractors for assembly and quality-control testing. We perform various quality-control procedures, including powering up completed systems and allowing them to “burn in” before being assembled into a final unit for a specific customer location, and performing final testing prior to shipment.
All of the other products we sell are purchased as finished goods from the manufacturers’ distributors.
Employees
We employed 364 and 309 employees at December 1, 2007 and 2006, respectively.
Copyrights, Patents And Trademarks
We own registered United States trademarks on the following names for use in the marketing of our hospitality services and systems: “XETA,” “XPERT,” “XL,” “Virtual XL,” and “XTRAMILE”. All of these trademarks are registered on the principal register of the United States Patent and Trademark Office.
ITEM 1A. RISK FACTORS
Our business and prospects are subject to many risks and uncertainties. The following items are representative of the risks, uncertainties and assumptions that could affect our business, our future performance and the outcome of the forward-looking statements we make.
We may not be successful in our overall strategy, a key component of which is to focus on the marketing of advanced communications products and applications and related services.
Our operating results may be adversely affected if we are not able to successfully position ourselves as a leader in the implementation of these new advanced communications technologies. To be successful, we must continue to: train our sales employees on the capabilities and technical specifications of these new technologies; train our services employees to service these new products and applications; develop relationships with new types of qualified service providers to supplement our internal capabilities; and develop new relationships with different disciplines and at higher management levels within our customers’ organizations.
Additionally, because these technologies are still in the early stages of their development, we cannot predict whether: (i) the demand for advanced communications products, applications, and services, including IP telephony systems, will grow as fast as we anticipate; (ii) new technologies may cause the market to evolve in a manner different than we expect; or (iii) technologies developed by manufacturers that we do not represent may become more accepted or the standard in our industry.
Our significant investment of resources into the launch of our Mitel product and services offering may not produce satisfactory results.
Beginning in the first quarter of fiscal 2008, we are training our technical workforce, our PSO organization, and our hospitality sales team to design, sell, install and maintain Mitel products. These investments may not produce the revenues and gross profits that we expect.
If we incur delays in our anticipated installation schedule, significant installation challenges, product performance issues, or weather-related catastrophes, our expected revenues and gross profits in fiscal 2008 from the sale of equipment and installation services to the Miami-Dade County Public School (“MDCPS”) system could be materially less than expected.
In November, 2007, we announced the award of a series of orders from MDCPS totaling in excess of $10 million to provide and install communications equipment. The equipment for ten of the schools was shipped prior to the end of fiscal 2007 to support initial installations. We expect the remaining revenues and gross profits to be recognized in fiscal 2008 based on current installation schedules. However, we may experience delays in the installation schedule due to circumstances out of our control as we are reliant on MDCPS personnel to assist us in coordinating each installation. Furthermore, we could experience delays or a halt in installations due to a variety of other factors including catastrophic weather conditions such as hurricanes which are prone to the Miami area. Additionally, unexpected technical installation challenges or product performance issues could occur, also resulting in delays in the recognition of revenues or erosion of gross profits from these orders.
Avaya was recently acquired by private investors who may materially alter Avaya’s strategies, including their vendor incentive programs, which might be detrimental to our operating results.
Avaya has been acquired by a consortium of private equity firms and is no longer a public company. Avaya’s goals, focus and strategies may change materially as the new owners’ influence on Avaya’s operations increases. The changes could be detrimental to our own strategies and goals and could negatively impact our short-term and or long-term operating results.
Additionally, Avaya has historically provided various financial incentive programs to support increasing the market share, promotion, and sale of its products. The sum of these incentive amounts are material to our operating results. Typically, Avaya announces changes to these programs at least annually, and in some years those changes have had a negative impact on the incentive payments we have received. It is possible that as a result of strategic decisions by Avaya’s new owners, future changes could be more frequent and more adverse to our business model and, therefore, we may experience difficulty in maintaining the level of incentive payments which we have enjoyed in prior years.
The financial condition of Nortel is uncertain and actions they may take could hurt our operating results.
In recent years, Nortel has endured severe financial difficulties, made significant senior management changes, and restated its financial results numerous times. Recent developments indicate that these financial and accounting difficulties may be subsiding. However, substantial litigation and government investigations continue to be unresolved and it is possible that unfavorable outcomes or settlements of these matters might require Nortel to take actions that could be detrimental to our operating results or financial condition.
Microsoft Corporation has announced it is entering the unified communications market, which could result in significant disruption to the current communications market landscape.
Microsoft Corporation (“Micrsosoft”) has announced several new products that will compete directly with existing Avaya and Nortel applications. Microsoft represents a significant entrant into the converged communications market and may cause a significant disruption to our strategy of aligning our efforts with current market leaders Avaya and Nortel. The timing and quality of our reaction to Microsoft’s entrance into the market, the quality of these new products, and the market acceptance of these products will dictate the potential positive or negative impact to us.
We are faced with intense competition fueled by rapid changes in the technologies and markets in which we operate.
The market for our products and services is highly competitive and subject to rapidly changing technologies. As the industry evolves and new technologies and products are introduced into the marketplace, new participants enter the market and existing competitors seek to strengthen their positions and expand their product/service offerings. There has been a trend toward industry consolidation, which can lead to the creation of stronger competitors who may be better able to compete as a sole-source vendor for customers. While we believe that through our transformation and expansion during the last few years, we are well-positioned to compete effectively in the marketplace, our failure to maintain or enhance this position could adversely affect our business and results of operations.
Revenues and gross profits earned by hotels from guest calls continue to decline, which may result in hotels canceling their call accounting maintenance agreements with us.
Increasing use of cell phones by guests has caused a rapid decline in hotels’ revenues and gross profits earned from long distance and other telephone-related fees. This development has severely reduced the importance of call accounting systems in hotels. As a result, we have experienced some erosion in our base of maintenance contracts as customers cancelled their call accounting maintenance contracts with us. In fiscal 2007 we earned $3.0 million in revenues associated with these maintenance contracts compared with $3.7 in fiscal 2006. The additional loss of or reduction in these revenues could materially and negatively impact our operating results.
The success of our business depends significantly upon our ability to retain and recruit highly skilled personnel.
Our ability to attract, train, motivate and retain highly skilled and qualified technical and sales personnel is critical to our success. Competition for such employees in the rapidly changing communications industry is fierce. As we have transformed our company into an integrated communications solutions provider, we have invested heavily in the hiring and training of personnel to sell and service our portfolio of products and services. If we are unable to retain our skilled employees or to hire additional qualified personnel as needed, it could adversely impact our ability to implement our strategies efficiently and effectively.
The technology we sell is highly complex and changes rapidly, increasing our reliance upon the manufacturers for technical assistance and increasing the risk that our inventories on hand will become obsolete.
The communications equipment we sell is highly complex and requires significant technical resources to design, install, and maintain. This complexity may require us to rely heavily upon the manufacturers’ technical staff to support the installation and maintenance of communications systems. This reliance may result in lower services revenue or lower profit margins earned on our services revenue. In addition to their complexity, the systems are evolving rapidly as product enhancements are introduced by the manufacturers. These rapid changes present risks that our inventory on hand will become obsolete, resulting in the need to reduce sales margins to sell the equipment or in direct write-offs in the value of the equipment. Any of these results would be detrimental to our profitability.
Our business is directly affected by capital spending trends in the United States and, in particular, market conditions for communications and networking equipment and services.
The direction and relative strength of the U.S. economy has recently been increasingly uncertain due to softness in the housing market, rising oil prices, and continuing geopolitical uncertainties. Because our business is directly affected by capital spending on technology equipment in the U.S., our business would be directly and negatively impacted if these concerns continue to grow to the point that large enterprises begin curtailing their capital spending,.
The loss of either our Elite designation or Platinum Level status with Nortel and Avaya, respectively, could negatively impact our ability to differentiate our products and services in the market.
Both Nortel and Avaya have different status levels for their business partners based on technical and sales capabilities and purchasing volumes. Currently, we hold the highest level of status with each manufacturer. We emphasize the fact that we are one of the few providers in our market to have the highest status level with each manufacturer and we believe that this is a significant differentiator with some customers. While we expect to be able to maintain the technical capabilities, sales skill sets, and purchasing volumes to maintain our statuses, a downgrade in our status with either manufacturer or both could have a material impact on our reputation in the market, which in turn could negatively impact our operating results.
The introduction of new products could result in reduced revenues, reduced gross margins, reduced customer satisfaction, and longer collection periods.
We are selling a variety of new, highly complex products that incorporate leading-edge technology, including both hardware and software. The early versions of these products, which we are selling currently, can contain software “bugs” and other defects that can cause the products to not function as intended. We will be dependent upon Avaya and Nortel to fix these problems as they occur. An inability of the manufacturer to correct these problems quickly could result in damage to our reputation, reduced revenues, reduced customer satisfaction, delays in payments from customers for products purchased, and potential liabilities.
Compliance with new corporate governance regulations may require a material increase in our operating expenses beginning in fiscal 2008.
We are required to comply with a host of new government-mandated corporate governance and accounting regulations, the most significant of which is section 404 of the Sarbanes-Oxley Act of 2002. Under the current guidelines issued by the Securities and Exchange Commission, our management report on internal controls over financial reporting must be complete by our fiscal year ended October 31, 2008 and our auditor’s attestation report on internal control over financial reporting will be initially required for our fiscal year ended October 31, 2010. We believe, based on new guidance provided to small public companies from the Public Companies Accounting Oversight Board and discussions with our external auditors and consultants in this field that expenditures required to comply with these regulations will not be material to our overall operating results. However, since we have not completed our work in this area and will not complete it until the end of the fiscal year, we cannot provide assurance that significant unexpected costs might be incurred which could materially impact our operating results.
A significant portion of our expected growth in services revenues is dependent upon our relationship with a few wholesale customers.
Much of the current growth in our services business is coming from Nortel and Verizon as they use us as a subcontractor to service many of their high profile end-user customers. While we believe our relationship with these companies is strong, future changes in Nortel personnel, negative service events, and competitive factors could jeopardize this revenue stream.
Hitachi’s decision to cease manufacturing communications systems for the hospitality market has caused some uncertainty with respect to our future relationship with our Hitachi installed base of hospitality customers.
Hitachi, once one of the leading suppliers of traditional PBX systems to the hospitality market, ceased selling systems for this market in March 2005. We have many long-time hospitality customers with significant portfolios of Hitachi systems in their hotels. We have several hundred Hitachi systems under service contracts producing recurring contract revenues and gross profits for our business. Over the next seven to eight years, all of these customers will have to transition their communications systems to new platforms, presenting a risk to us that another vendor may be selected to service their communications systems. Our entry into the Mitel product line is in part a response to Hitachi’s exit of the hospitality market.
While Hitachi’s exit from the market created some uncertainty in our relationship with existing customers, we believe our relationship with our Hitachi customers is strong. Consequently, we believe that in most instances we will be in a favorable position to supply a new system to our customers when they decide to replace their Hitachi system. Additionally, during the third quarter of fiscal 2006 we acquired the remaining assets and liabilities of Hitachi’s U.S. hospitality market. Included in the assets acquired was a substantial supply of new and refurbished inventory that enables us to serve our Hitachi customers. Despite these mitigating factors, no assurance can be given that Hitachi’s exit from this market will not negatively impact our financial results in the future.
We are connecting our products to our customers’ computer networks and problems with the implementation of these products could cause disruption to our customers’ entire operations.
Unlike traditional stand-alone voice systems, our new IP-based products typically are connected to our customers’ existing local and wide area networks. While we believe the risk of our products disrupting other traffic or operations on these networks is low, such problems could occur, which could cause significant disruption to our customers’ operations. These disruptions, in turn, could result in reduced customer satisfaction, delays in payments from customers for products and services purchased, damage to our reputation, and potential liabilities.
We expect our gross margins to vary over time.
Our gross margins are impacted by a variety of factors, including changes in customer and product mix, increased price competition, changes in vendor incentive programs, and changes in shipment volume. We expect these factors to cause our gross margins to be inconsistent as we make quarter-to-quarter and year-to-year comparisons.
If our dealer agreements with the original equipment manufacturers are terminated prematurely or unexpectedly, our business could be adversely affected.
We sell communications systems under dealer agreements with Avaya, Nortel, and Mitel. We are a major dealer for Avaya and Nortel and consider our relationship with both to be good. Nevertheless, if our strategic relationship with our manufacturers were to be terminated prematurely or unexpectedly, our operating results would be adversely impacted. Furthermore, these agreements require that we meet certain volume commitments to earn the pricing structure provided in the dealer agreements. Failure to meet these requirements could cause material adverse consequences to our gross margins and overall operating results.
We are dependent upon a few suppliers.
Our growth and ability to meet customer demand depends in part on our capability to obtain timely deliveries of products from suppliers. All of our manufacturers utilize a two-tier distribution model in which a few third-party companies (super distributors) distribute their products to their respective dealer communities. In the case of one such distributor, they distribute both Avaya and Nortel products. The limited amount of distribution available for each of these product lines increases our risk of interruptions in the supply of products in the future.
We might have to record a significant goodwill impairment loss in the event our business was to suffer a severe decline.
Under SFAS No. 142, “Goodwill and Other Intangible Assets”, we are required to evaluate the fair value of each of our reporting units annually to determine if the fair value is less than the carrying value of those reporting units. If we determine that is the case, then an impairment loss will be recorded in our statement of operations. The determination of fair value is a highly subjective exercise and can produce significantly different results based on the assumptions used and methodologies employed. It is likely that if our financial results were to decline substantially and if macroeconomic conditions eroded, we would have to record a non-cash impairment loss in our statement of operations.
If our business grows significantly over the next three years, the successful completion of our Oracle implementation project will be critical to our ability to effectively and efficiently operate our business in the future; implementation of the system will significantly increase our amortization expense.
As XETA approaches the threshold of $100 million in revenues, timely and accurate business information will be increasingly important. Implementing our business plan and monitoring progress depends on the efficient accumulation and distribution and analysis of business intelligence. We have been working on a major upgrade to our technology infrastructure and information systems to consolidate our mission-critical legacy systems from four to one. From fiscal 2001 through fiscal 2006 we purposely imposed constraints on capital spending and slowed the development of this system and the consolidation.. Furthermore, at current revenue and transaction levels, conversion to this new system is not essential to our near-term success. However, we have proceeded with the project while our revenues are at lower levels, in anticipation of future growth, which will require upgraded and consolidated infrastructure. While we are taking great care to properly plan this implementation and to fully test the solution prior to the conversion, we cannot guarantee that the conversion will not disrupt our operations. We recognized $619,000 and $429,000 in amortization expense in fiscal 2007 and 2006, respectively reflecting the fact that certain functions of the system were available and used in our business operations. When fully implemented we estimate that the annual amortization expense will increase to $1.2 million. Although a non-cash charge, this expense will have a material, negative impact on our operating results.
If industry consolidation continues, it may become more difficult to compete in our market.
Recently there has been significant merger and acquisition activity in our industry which has created larger and stronger competitors. If consolidation continues, XETA may become one of the smaller national dealers of the products and services we sell. This could negatively impact our ability to market our services to national customers.
Our stock price may continue to be volatile.
Historically, our stock is not widely followed by investment analysts and is subject to price and trading volume volatility. This volatility is sometimes tied to overall market conditions and may or may not reflect our financial performance. It is likely that this volatility will continue.
Our business is subject to the risks of tornadoes and other natural catastrophic events and to interruptions caused by man-made problems such as computer viruses or terrorism.
Our corporate headquarters and NSC are located in northeastern Oklahoma, a region known as “tornado alley”. A significant natural disaster, such as a tornado, could have a material adverse impact on our business, operating results, and financial condition. In addition, despite our implementation of network security measures, our servers are vulnerable to computer viruses, hacking, and similar disruptions from unauthorized tampering of our computer systems. Any such event could also cause a similar material adverse impact. In addition, acts of war or terrorism could have a material adverse impact on our business, operating results, and financial condition. The continued threat of terrorism and associated security and military response, or any future acts of terrorism may further disrupt our national economy and create further uncertainties. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders, or impact the assembly or shipment of our products, our business, operating results and financial condition could be materially and adversely affected.
We may be subject to infringement claims and litigation, which could cause us to incur significant expenses or prevent us from selling certain products and services.
Third parties, including customers, may assert claims or initiate legal action against our manufacturers, suppliers, customers or us, alleging that the products we sell infringe on another’s proprietary rights. Regardless merit such claims can be time-consuming, expensive, and/or require us to enter into costly license agreements. In some instances, a successful claim could prevent us from selling a particular product or service. We have not conducted patent searches on the third party-products we distribute to independently determine if they infringe upon another’s proprietary rights; nor would it be practical or cost-effective for us to do so. Rather, we rely on infringement indemnities provided by the equipment manufacturers. However, because these indemnities are not absolute and in some instances have limits of coverage, no assurance can be given that in the event of a claim, our indemnification by the equipment manufacturer will be adequate to hold us harmless or that we are entitled to indemnification by the equipment manufacturer.
If any infringement or other intellectual property claim is brought against us succeeds, whether it is based upon a third-party manufacturer’s equipment that we distribute or upon our own proprietary products, our business, operating results and financial condition could be materially and adversely affected.
We are subject to a variety of other general risks and uncertainties inherent in doing business.
In addition to the specific factors discussed above, we are subject to risks that are inherent to doing business.These include growth rates, general economic and political conditions, customer satisfaction with the quality of our services, costs of obtaining insurance, unexpected death of key employees, changes in employment laws and regulations, changes in tax laws and regulations, and other events that can impact revenues and the cost of doing business.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not Applicable.
ITEM 2. PROPERTIES
Our principal executive offices and the NSC are located in a 37,000 square foot, Company-owned, single story building located in a suburban business park near Tulsa, Oklahoma. This facility also houses a warehouse and assembly area. The building is located on a 13-acre tract of land subject to a mortgage held by Bank of Oklahoma, NA to secure our credit facility.
We have additional leased facilities located near St. Louis, Missouri. In addition to our primary warehouse and shipping operation, this facility houses sales staff, technical design, professional services and installation support personnel. Our Seattle branch office is located in leased office space in Bellevue, Washington, a suburb of Seattle. This facility houses sales and technical personnel.
We also lease other office space throughout the U.S. for sales, consulting, and technical staff and have informal office arrangements with our regional technicians to allow for storage of spare parts inventory.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Market Information
Our common stock is traded on the Nasdaq Global Market under the symbol “XETA.” The following table sets forth, for the periods indicated, the high and low sales prices of our common stock as reported on the Nasdaq National Market.
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Quarter Ended: |
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High |
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Low |
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High |
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Low |
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January 31 |
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$ |
4.00 |
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$ |
2.76 |
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$ |
2.57 |
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$ |
2.15 |
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April 30 |
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$ |
3.80 |
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$ |
2.79 |
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$ |
2.61 |
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$ |
1.86 |
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July 31 |
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$ |
3.78 |
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