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

 

Form 10-K

 

 

Commission file number: 1-31949

 

INX Inc.

(Exact name of Registrant as specified in its charter)

 

 

Registrant’s telephone number: (713) 795-2000

 

Securities registered pursuant to section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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 þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing price of the common stock on June 30, 2006 as reported on the Nasdaq Capital Market was approximately $26,342,388.

 

The number of shares of common stock, $0.01 par value, outstanding as of February 28, 2007 was 6,671,444.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement for the registrant’s 2007 Annual Meeting of Shareholders have been incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

INX Inc.

FORM 10-K
For the Year Ended December 31, 2006

TABLE OF CONTENTS

 

 

NOTE: Amounts are presented in thousands except per share and par value in all parts of this Form 10-K except in the Exhibits, unless otherwise stated.

 

Special Notice Regarding Forward-Looking Statements

 

This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 relating to future events or our future financial performance including, but not limited to, statements contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Readers are cautioned that any statement that is not a statement of historical fact, including but not limited to, statements which may be identified by words including, but not limited to, “anticipate”, “appear”, “believe”, “could”, “estimate”, “expect”, “hope”, “indicate”, “intend”, “likely”, “may”, “might”, “plan”, “potential”, “seek”, “should”, “will”, “would”, and other variations or negative expressions thereof, are predictions or estimations and are subject to known and unknown risks and uncertainties. Numerous factors, including factors that we have little or no control over, and factors that we may not be able to anticipate, may affect our actual results and may cause actual results to differ materially from those expressed in the forward-looking statements contained herein. In evaluating such statements, readers should consider the various matters identified in “Item 1. Risk Factors”, which are some of the factors that could cause actual events, performance or results to differ materially from those indicated by such statements.

 

General

 

We are a provider of IP communications solutions for enterprise-class organizations such as corporations, schools and federal, state and local governmental agencies. We provide solutions based primarily on Cisco Systems, Inc. (“Cisco”) technology and provide our customers with implementation and support services. We believe that our focus and expertise enables us to better compete in the markets that we serve. Because we have significant experience implementing and supporting the critical technology building blocks of Internet Protocol (“IP”) telephony systems for enterprises, we believe we are well positioned to deliver superior solutions and services to our customers.

 

The convergence of data, voice, and video into a single seamless IP communications infrastructure is increasingly responsible for driving business benefits through improved business operations. The foundation of a converged communication platform is a robust, secure, high-performance, high-availability IP network infrastructure. As part of our commitment to full life-cycle solutions for our customers, we are dedicated to excellence not only in IP telephony voice communications but also in the underlying network infrastructure components upon which IP telephony depends.

 

The IP communications solutions we offer are “Cisco-centric,” meaning they are based primarily on the products and technology of Cisco. These solutions include design, implementation and support of LAN/WAN routing and switching, IP telephony, voice over IP (“VoIP”), network security, network storage and wireless networks. We offer a full suite of advanced technology solutions that support the entire life-cycle of IP communications. Our solutions are designed with the complete life-cycle of our customer’s IP communications infrastructure in mind. Within a finite set of practice areas, we have standardized our design, implementation, and post-implementation support processes to drive a reliable and scaleable solution that can be tailored to meet the business objectives of our clients. Because of our substantial experience and technical expertise in the design, implementation and support of IP communications solutions, we believe we are well-positioned to take advantage of what we believe to be a growing trend of implementation by enterprise organizations of IP telephony and VoIP technology, and the use by enterprise organizations of the IP network as the platform for all forms of communications.

 

The market for IP communications solutions is extremely competitive. We compete with larger and better financed entities. We currently have thirteen physical offices, which are located in Texas, California, Idaho, Louisiana, New Mexico, Oregon, Washington and Washington DC. We primarily market to enterprise-class organizations headquartered in or making purchasing decisions from markets that we serve with branch offices. We plan to continue to expand to additional markets throughout the U.S. by establishing additional branch offices in other markets, either by opening additional new offices or through acquisition.

 

We derive revenue from sales of both products and services. Our product sales consist primarily of sales of Cisco brand products. Our services revenues are derived from two principal types of services: professional services that include design and implementation engineering services, and post-sale support services, which consist of remote monitoring and managed services for enterprise network infrastructure, which we offer through our NetSurant branded service offering. In 2006, 2005 and 2004, sales of products made up 86.7%, 88.1% and 91.2% of total revenue and services revenues made up 13.3%, 11.9% and 8.8% of total revenue.

 

Industry

 

IP Telephony and Convergence

 

IP telephony is a general term for an existing and rapidly expanding technology that uses an IP network to perform voice communications that have traditionally been conducted by conventional private branch exchange (“PBX”) telephone systems used by enterprises and by the public switched telephone network (the “PSTN”). IP telephony uses IP network infrastructure, such as a local area network (“LAN”) or a wide area network (“WAN”) to replace the telephony functions performed by an organization’s PBX telephone system. “Convergence” is a term generally used to describe the manner in which voice and video communications technology is converging with data communications onto the IP network. “IP communications” is a term generally used to describe data, voice and video communications using an IP network. In addition to offering potential long-term cost savings, implementation of IP telephony allows enterprises to reap other benefits of participating in the growing trend of convergence.

 

In the traditional enterprise communications model, different types of communication have been conducted by different means:

 

 

In contrast, the converged communications model enables data, voice and video to be carried by a single IP network infrastructure. Converged IP telephony and data communication over IP network infrastructures is already being used by many enterprises, and the trend is building rapidly.

 

Today, implementation of converged IP telephony and data communications networks can offer both significant long-term cost savings and increased productivity to enterprises. Among the potential long-term savings that an enterprise might experience are:

 

 

IP telephony as implemented by most enterprises often requires upgraded or new IP network infrastructure. Older networks designed solely for data communications are inadequate to accommodate IP telephony functions featuring the quality of telephony service demanded by most customers. To meet the demands of voice communications

delivered across an IP network, the network infrastructure must be able to distinguish between data communication packets and voice communication packets. It must also be capable of prioritizing and allocating the use of system resources between voice and data to achieve the quality of service required for voice and video communications.

 

As the use of IP telephony has become more prevalent over the past few years, the IP network technology environment has evolved, and we believe it will continue to evolve. Enterprise-class organizations today demand more from their IP network than ever before. Traditionally, network infrastructure was focused on achieving connectivity as its initial goal of networking. Now that reliable, quality connectivity has been achieved, business requirements have surpassed the desire for mere connectivity. IP-based voice, wireless communications, and network security represent a new breed of network-based applications that will position the IP network infrastructure to perform higher level, more complex problems and positively impact business productivity.

 

Until recently, the networking industry has treated network operations as “a sum of individual parts” that have not operated holistically. The approach has been to create point product solutions through the creation of individual products, uniquely designed to solve single problems, one at a time. These products, each with their unique design, have demanded individual administration, management, maintenance, sparing, and optimization that has created a challenging and expensive infrastructure.

 

We believe that over the coming years IP network infrastructure will move toward a technology environment in which there is a dependency between the component parts of the network that maintain relationships through time and change; a fully cooperating system that is flexible, stable, and predictable and more easily managed.

 

As a result of recently adding deterministic technologies to the IP network, the networking industry has begun to take its first unified steps toward building a system of products that more fully cooperate in their mission of moving payloads across an arrangement of networks. This has required that the IP network infrastructure evolve from route-specific performance to endpoint-to-endpoint performance, from route-level resiliency to service-level resiliency and from box-level management to system-wide management.

 

We believe that as the network evolves to perform higher-level functions the complexity of the IP network infrastructure, by necessity, will increase. As the network becomes more complex, the role of network architecture design, business process-mapping, policy decision making, implementation and ongoing service and support play increasingly important roles.

 

The Evolution to the “Business Ready Network”

 

We believe the IP network is evolving into what we refer to as a “business ready network” environment. By evolving from network architectures comprised solely of interacting devices to architectures that provide pervasive services and then to fully application-aware infrastructures, the corresponding business value grows from simply offering essential services to a network that enables and ultimately optimizes the organization.

 

The initial stage of the evolution towards the business ready network involves providing business essential functionality through a network of converged infrastructure “synergistic devices.” The network architecture during this current phase contains synergistic devices that must be fully interoperable and based on open standards and protocols in order to build a foundation upon which further phases of the business ready network can be built. During this phase of network evolution the network of devices must be fully functional, bringing to bear the full range of capabilities necessary for the business’ communications needs. As the network becomes the focal point of mission-critical communications and applications it must be fully available, with minimal downtime.

 

The network must also be converged. It is no longer feasible or practical to operate and maintain separate infrastructures for data, voice and video communications. A converged network not only brings these services onto a common IP-based network, but also opens the door for the next phases of the evolution by providing network characteristics such as quality of services to all applications riding on the network.

 

In a second phase of the evolution towards the business ready network, which we believe is beginning now, the network infrastructure begins to incorporate what we call “pervasive services” that truly become “business enabling” rather than simply providing business essential services. By our definition, a “business ready network” is integrated, accessible, flexible, transparent and highly secure. Network technologies such as security, storage,

voice and wireless are what we refer to as pervasively available network services. They are services that are available to, and needed by, many other resources on the network.

 

In a future phase of network evolution, we believe the IP network will become the application delivery platform of choice. In this phase, in which the network infrastructure is characterized by being aware, collaborative, and borderless, applications take full advantage of the network to provide business optimizing solutions. The power of pervasive services is further enhanced as applications become fully aware of their availability and can thereby inherently take advantage of these services to optimize the way business gets done. By breaking applications out of their individual silos of data and functionality and enabling them to be collaborative, business workflows and processes become much more meaningful and efficient. In this future phase of network evolution, the IP network enables applications to become “borderless” in a number of ways, including the virtualization of resources such as storage, CPU and computer memory residing anywhere on the network as well as the breaking down of borders between business process and their dependant information

 

Converged Infrastructure

 

The Business Ready Network is built on a foundation of devices that are specifically built to move and deliver payloads across a system of networks in a predictable manner. Deterministic payloads such as voice and video are being combined with data over IP network infrastructure to consolidate network costs and overlaps. As the network becomes more of an integrated and robust machine and less merely a number of components joined together, infrastructure design is evolving from one that is based on “point” solutions to one that operates at a “system” level. Previous specialized components, such as routers and switches, are no longer adequate to perform at a route-level resiliency but must evolve to operate at a service-level resiliency. Device-level management, therefore, must be system-wide. The integration of the traditional data network infrastructure and the call-flow layer required to enable voice on the network has enabled a system that is more aware, more capable and more empowered to cooperate with itself and the resources attached to it.

 

Once an organization’s voice communications is placed on the IP network its data network becomes its voice communications network. The “IP telephony” systems, including management systems, voice gateways, and messaging systems, are not only easier to set up than traditional PBX telephone system features, they save time and boost productivity. VoIP is commonly an enterprise organization’s first move toward a converged solution.

 

Unified messaging solutions allow a user to decide how and when they will receive messages. Unified messaging allows for retrieval of any communication form by any method, such as accessing voice messages from a computer or text e-mail, converted to speech, over the phone. This provides a greater level of control over communications, improving organizational productivity. Unified messaging is typically an enterprise organization’s second move toward a more completely converged solution.

 

Video communications that are seamlessly integrated into voice communications recently became available and are becoming more feasible, but are not yet popular, in part because video communications require more expensive endpoints (telephone handsets) and uses substantial network bandwidth. Over time, as network bandwidth improves and as high quality touch screen video endpoints become less expensive, we believe that integrated voice and video communications will become more popular.

 

Pervasively Available Network Services

 

Network technologies such as security, storage, voice and wireless are what we refer to as pervasively available network services. They are services that are available to, and needed by, many other resources on the network. A network that provides more efficient and flexible use of the resources attached to it is one that is more closely tied to, aware of, and responsive to the needs of its applications and devices. Today, service-level innovation baselines include: IPv6, quality-of-service (“QOS”), multicasting, network security and network management. Each of these services exists to provide an extension throughout the network that globally supports an organization’s storage, wireless and IP communications initiatives.

 

Security

 

Network security is progressively moving from a tertiary issue to a central component of information and communications technology architecture. Traditionally, much of the focus has been on securing the network edge through firewalls on Internet and Extranet connections. But business and technology drivers are dictating that security, like other services, be applied pervasively throughout the entire network infrastructure. Among the issues facing enterprise organizations today are the following:

 

 

Pervasive security solutions address these needs by weaving security throughout the information and communications technology infrastructure that go beyond the network edge in a number of ways. By making “policy enforcement points” ubiquitous and managing them centrally the security architecture can be designed to meet far wider threat characteristics than traditional designs. As users and systems are authenticated at the edge of the network their access can be appropriately designed for their requirements. Pervasive security systems allow the proper individuals to access the proper resources while guarding those same resources against accidental or deliberate compromise, and the consequent loss of access, and do so in an efficiently managed manner. As security becomes pervasive throughout the IP network architecture it is no longer a separate requirement but rather something that every device performs to some greater or lesser degree.

 

Storage

 

Pervasive storage solutions are an essential component of a business ready network. Business continuance embodies the necessity and ability to efficiently consolidate data and manage, replicate, and mirror information in order to eliminate points of failure that occur during downtime or loss of information. To meet this challenge, technology is evolving from storage that is directly attached to and incorporated within a server and other forms of isolated storage networks to converged and intelligent network storage solutions delivering substantial performance and cost benefits. The need for improved productivity as well as regulatory requirements have accelerated the need for enterprise organizations to protect data, rapidly recover applications, and maintain uninterruptible access to information. This has caused storage requirements to grow at a dramatic pace as business process continues to depend on its applications.

 

Information, or data, can be classified by criticality, age, and the level of accessibility required. Such a lifecycle-oriented management approach allows an organization to prioritize and make intelligent decisions about the logistics and economics of how to manage different data types. This architecture enables operational

efficiencies of data and applications by providing intelligence embedded in the network infrastructure, and provides flexibility of data access integrated into the network.

 

Voice

 

To the extent that voice is integrated into every part of the network, the role of voice also extends across that network. Already part of video conference and telephone conversations, voice will become part of e-mail, documents, and Web URLs distributed inside and outside of an organization. This means creating a new standard for business applications. Voice communications will no longer sit on top of the network as a separate application but will be woven into the fabric of the network. Just as a word processing or e-mail application is aware of the qualities of a URL and can enable such URL to open a web browser that will redirect the user to specific information, so will voice become embedded into applications as a level of business logic. The result is a network that enhances efficiency of communication by allowing all of the communication devices within it to become easily available.

 

Wireless

 

Wireless connectivity to the IP network, as it continues to proliferate within offices, Wi-Fi hotspots in airports, coffee shops, and even on public transportation, is now becoming a mainstream service. This fact is demonstrative of Internet connectivity transpiring to a pervasive service. Although wireless solutions are becoming as readily available as electrical power and phone service, deployment of these pervasive wireless networks through the enterprise still presents a myriad of challenges.

 

The ease of access to a wireless network, while beneficial for public hotspots, becomes a challenge in securing against unauthorized usage while still providing appropriate levels of access for legitimate users. Likewise, the low-cost and low- complexity of consumer wireless products increases the likelihood that user’s will create unsecured wireless networks by simply connecting an access point to an open port on an enterprise organization’s network. Within the complexity of an organization, different classes of security must be established to differentiate between internal systems for authorized uses and basic Internet access to guests.

 

Increased availability of advanced IP network services that demand QOS, such as VoIP and IP telephony on Wi-Fi capable devices, demand QOS on wireless networks. Roaming throughout a building or campus must not only be secure, but seamless. Management of large scale wireless deployments can quickly become unwieldy, especially if access points are deployed as individually configured devices and not as an integrated, centrally managed system. Many organizations have policies driven by regulatory and compliance requirements (such as HIPPA, FIPS compliance and Sarbanes-Oxley) that dictate advanced security requirements for wireless networks. Pervasive wireless solutions meet the needs of the enterprise in providing secure, ubiquitous network access by making the wireless network a seamless extension of the entire network infrastructure.

 

Our Business

 

We serve enterprise-class organizations to intelligently deploy advanced networking technologies in a way that maximizes their investments. We are a top provider of Cisco’s advanced technology solutions, both in terms of the volume of these technologies deployed and in terms of positive customer experiences as evidenced by Cisco’s customer satisfaction surveys. We design, implement and support, for our enterprise-class organization customers, IP network routing and switching, VoIP, network security, network storage, wireless and other advanced network technologies.

 

As one of the earliest entrants to VoIP integration and support, we have successfully deployed and supported IP telephony solutions for a large and diverse customer base. We offer a complete range of products and services for Cisco-centric IP telephony solutions. Until approximately two years ago, most IP telephony solutions work we performed for customers involved our customer testing the technology rather than full-scale implementation of IP telephony. As the market for IP telephony solutions for enterprises continues to mature from testing to full scale deployment, we believe that offering a comprehensive range of products and services to our customers will be critical in differentiating us from our competitors.

 

Products

 

We generate revenue from the sale of products. The products we sell consist principally of network infrastructure components manufactured by Cisco, including routing and switching equipment, and related Cisco software, including Cisco Call Manager IP telephony software. We also offer other manufacturer’s products to augment Cisco technology, including storage solution products from Network Appliance and EMC and software applications from various third party providers.

 

Recently we began developing, manufacturing and offering our own “custom IP products” based on Cisco technology, which we are marketing under the trade name Routestep^tm Communications, but we have not yet generated any material revenue from these new products. These custom IP products are specialized products made to address highly specialized requirements of specific market segments. We believe we will be able to generate higher gross margins on sales of our custom IP products, as compared to the gross margin resulting from our reselling other manufacturer’s products, if and when we begin generating revenue from sales of these products. There can be no assurance that we will be successful marketing these new products.

 

Gross margin on product sales was 18.6%, 15.7% and 16.6% for 2006, 2005 and 2004, respectively. Product sales revenue grew 43.1%, 45.0% and 65.6%, and made up 86.7%, 88.1% and 91.2% of total revenue in 2006, 2005 and 2004, respectively.

 

Services

 

We generate services revenue by providing services to our customers. We provide two basic categories of service, implementation services and post-sale support services. Gross margin on services revenue was 25.9%, 29.2% and 33.4% for 2006, 2005 and 2004, respectively. Services revenue grew 62.3%, 103.0% and 48.6%, and made up 13.3%, 11.9% and 8.8% of total revenue in 2006, 2005 and 2004, respectively.

 

Design and Implementation Services

 

We design and implement Cisco-centric IP communications solutions. These solutions include design, implementation and support of VoIP, LAN/WAN routing and switching, network security, and wireless networks, as well as support services other than our NetSurant^® long-term support services discussed separately below. To provide these services, we employ highly trained network engineering staff, who are trained and experienced in both large, complex network infrastructure technology as well as Cisco IP telephony technology. We have developed not only expertise in the area of enterprise IP telephony solutions and converged communications, but also methodologies for designing and implementing large, complex, converged communications infrastructures for enterprise-class organizations.

 

During 2001 and 2002, as the move towards IP telephony technology by enterprises began to develop, the majority of our customer engagements were limited to the installation of pilot projects in which our customers tested the technology. These types of projects required long selling cycles, substantial pre-sale involvement by skilled engineers and significant IP network design and upgrade services. Our IP telephony implementation services were a comparatively small component of the total services we provided in these pilot projects because our customers were implementing only relatively small “test” sites. These projects were characterized by sporadic services revenue and generally depressed gross margin for our services because significant amounts of our engineering staff time was utilized in “pre-sales” support activities showing the customer that the technology worked. Additionally, our engineering staff was often not fully utilized between projects during this period. During 2003 and 2004 customers began to adopt IP telephony technology and we began to perform full implementations of the technology, which has resulted in our ability to more fully employ our engineering staff. During 2005 we saw what we believe to be the beginnings of the movement towards what we call “mass adoption” or “full adoption” of IP telephony technology, with fewer customers “testing” the product and more of our customer engagements involving moving customers towards actual implementation of IP telephony. Gross margin on our implementation services revenue was 25.5%, 29.1% and 38.4% for 2006, 2005 and 2004, respectively. Implementation services revenue grew 54.1%, 96.6% and 42.9%, and made up 88.2%, 92.9% and 95.9% of total services revenue in 2006, 2005 and 2004, respectively.

 

Post-Implementation Support Services

 

In our view, there are essentially two primary support models offered by competitors for IP telephony: the current model used to support traditional PBX systems and the model used to support data networks. We believe that neither the traditional PBX telephone support model nor the existing computer data network support model best suits the needs of customers operating a converged communications infrastructure. We have created a specialized support model for supporting Cisco-centric IP-based converged communications systems, which we have branded under the NetSurant^® name. These services include remote monitoring and management of the customer’s IP telephony and network infrastructure equipment and related applications. These NetSurant^® services are performed using specialized toolsets and a network support center with technical staff that are specifically trained and experienced in the area of Cisco IP telephony and complex, state-of-the-art IP network infrastructure. Customers are notified of system problems and we solve the problems detected either remotely or onsite.

 

Several years ago, when most customers were only testing IP telephony technology, rather than utilizing IP telephony enterprise-wide for their primary voice communication system, post-implementation support services were not a high priority for those customers. But as customers transition to the full implementation of IP telephony, we believe that post-implementation support of their converged IP communications infrastructure will become essential for them. Additionally, we believe that the quality of support services is likely to become among the more significant factors for enterprise-class customers when they are choosing a service provider. Through our branded NetSurant^® service offering we believe we are positioned to provide support services that enterprise-class organizations desire and require.

 

In order to provide our NetSurant^® post-sale support services we were required to make an investment in certain technology products and infrastructure, and in building and staffing a network support center, which we did in 2003. These direct costs of providing the NetSurant^® services initially resulted in negative gross profit margin on NetSurant^® support services, but as NetSurant^® support services have grown, gross margins became positive. There is a relatively high fixed cost associated with offering NetSurant^® services, but such costs do not increase in proportion with increases in NetSurant^® support services revenues. Therefore, we expect that as NetSurant^® revenue continues to grow that gross margin on NetSurant^® revenue will continue to improve and that NetSurant^® will provide operating profits. The improvement in NetSurant^® gross margin, and the relatively higher growth of NetSurant^® support services revenue, relative to implementation and support services revenue, has resulted in our gross margins on services revenue improving. Gross margin on our NetSurant^® support services revenue was negative in 2004, when we were first beginning to offer NetSurant^® support services, but improved to 29.1% for 2006 and 29.9% for 2005. NetSurant^® support services revenue made up an immaterial portion of our total services revenue in 2003 but grew 169.8%, 255.3% and 2,450.0%, to make up 11.8%, 7.1% and 4.1% of total services revenue in 2006, 2005, and 2004, respectively.

 

Why We Offer Cisco-Centric IP Telephony Solutions Exclusively

 

Although we sell products that are complementary with Cisco products, we offer only Cisco-centric network infrastructure solutions and Cisco-centric IP telephony solutions. We choose to do this because we believe it enables us to compete more effectively for large Cisco-centric IP telephony projects. Our sales force works closely with Cisco’s sales organization to identify and close IP telephony projects. By deliberately refraining from selling products that are competitive with Cisco’s products, we believe our relationship with Cisco is enhanced, and our sales staff and sales management, as well as our engineering staff, are more focused and knowledgeable about the products we sell.

 

We believe that most sales of Cisco IP telephony systems are market share gains by Cisco. This is because Cisco only entered the voice communications market in 1998, and does not have a large traditional PBX telephone systems customer base to protect against encroachment by competitors. Because sales of IP telephony systems to enterprises will be largely systems replacing existing traditional PBX telephone systems, the traditional PBX manufacturers will be seeking to retain their existing customers while each system sold by Cisco will be a new customer for Cisco at the expense of a competitor, resulting in market shares gains by Cisco.

 

The majority of the enterprise organization IP-based routing and switching equipment installed today is manufactured by Cisco. For that reason, we believe Cisco has a competitive advantage with respect to implementing IP telephony solutions, which are essentially an extension of the IP network, and has the potential to gain market share against its competitors as the move towards full adoption of IP telephony technology by enterprises continues. If we are able to grow to become a national leader in providing Cisco-centric network infrastructure, and if, as we expect, Cisco gains market share against its competitors, we believe that we will be able to substantially increase our revenues.

 

Because the IP telephony and network infrastructure solutions we offer are based on the IP telephony products and technology of Cisco, it is critical to our business that we maintain a good working relationship with Cisco. We believe that because of our focus on Cisco’s products, and our commitment to their strategy, our relationship with Cisco is excellent. We are an authorized reseller of Cisco products and have been awarded their “Gold” level status, which enables us to obtain the best published pricing discounts on the Cisco products that we sell, which in turn enables us to be competitive with larger competitors.

 

Competition

 

Our competition for IP communications solutions is highly fragmented, and we compete with numerous large and small competitors. In our efforts to market Cisco-centric IP telephony solutions we compete with manufacturers of IP telephony equipment such as Avaya, Inc. and Nortel Networks Corporation as well as with such manufacturers’ integrators and solution providers. For network infrastructure solutions, as well as Cisco-centric IP telephony solutions, we compete with large, well established systems integrators and solution providers, including most of the major national and international systems integrators, such as AT&T, EDS, IBM and others.

 

We believe that the principal competitive factor when marketing IP communications solutions is price. Other important factors include technical competence, the quality of our support services, the perception of the customer regarding our financial and operational ability to manage a project and to provide high quality service, and the quality of our relationship with Cisco.

 

The market for IP communications solutions is evolving rapidly, is highly competitive and is subject to rapid technological change. Many of our competitors are larger than we are and have greater financial, sales, marketing, technical and other resources. We expect to face increasing competitive pressures from both current and future competitors in the markets we serve.

 

The Geographic Markets We Currently Serve

 

A majority of our customers are located in, or make significant decisions concerning their IP communications infrastructure in the markets in which we maintain branch offices. We believe it is important to have local management, sales and engineering staff in a metropolitan market in order to be a leading competitor in the market. Our administrative offices are located in Houston, Texas and our operations headquarters offices are located in Dallas, Texas. As of February 28, 2007 we maintained branch offices in the following thirteen markets:

 

 

Our Washington, DC branch office markets primarily to the federal government. Eight of our thirteen branch offices have been opened or acquired during approximately the past twenty-four months.

 

Our Plans for Geographic Expansion

 

By early 2005 we had grown to what we believe was the leading regional focused Cisco-centric IP telephony solutions provider for Texas, with offices in Austin, Dallas, Houston and San Antonio, Texas. Over approximately the past twenty months we made three acquisitions that added six additional branch offices and opened three new branch offices as new startup operations in new markets. We intend to continue opening new offices and making additional acquisitions to further expand our geographic coverage throughout the United States.

 

When we open a new branch office we expect that the new branch office will produce operating losses for a period of approximately six months to one year until revenue has ramped up to a level sufficient that gross profit exceeds normalized levels of operating expenses, and because during such start-up period sales and marketing expenses are higher than normal levels, relative to revenue, as we market our company in the new market. We believe it is sometimes advantageous to enter a new market by acquiring the assets and operations of an existing Cisco partner in the market. This is because acquiring an existing organization in a new market allows us to enter the market with an existing set of sales and engineering staff, existing customers, a relationship with the local Cisco branch office, and allows us to enter the market without the need to compete with the acquired organization. Our ability to acquire organizations in a new market is dependent upon an acceptable acquisition candidate organization existing in such new market and our ability to structure a transaction that is acceptable to both the seller and us.

 

With full adoption of IP telephony technology by enterprises at what we believe is an early stage, we intend to expand nationally, establishing offices in other major U.S. markets in order to create a national presence, with the goal of eventually becoming the leading focused, national provider of Cisco-based IP communications solutions to our target customers, enterprise-class organizations.

 

We believe that expanding to new markets creates a two-fold opportunity for us. First, adding new geographic markets provides us with new customer opportunities in those new markets. Second, we believe that becoming a recognized leading “national” provider of Cisco-based IP communications solutions will allow us to pursue larger customer opportunities in all of our markets, including our existing markets.

 

Customers

 

Today our customers are typically medium- to larger-sized corporate organizations, schools and governmental agencies with approximately 300 to 20,000 users of telephone and/or networked computer technology, although as we continue to expand to new markets throughout the United States we hope to be able to begin winning contracts with larger customers. A majority of our customers are located in, or make significant decisions concerning their network infrastructure and voice communications systems in, the markets in which we maintain branch offices. Our customers include private enterprises in numerous industries including healthcare, legal, banking, energy and utilities, hospitality, transportation, manufacturing and entertainment, as well as federal, state and local governmental agencies and private and public educational organizations. We typically refer to this type of organization as an “enterprise organization” or an “enterprise.” In addition to our direct sales model to enterprise customers, we also provide technical consulting and project management services as a sub-contractor for other large, national or international systems integrators. Although the majority of our customers are based in the United States, we have performed work at their locations internationally, and we have performed consulting and project management services as a subcontractor internationally.

 

During 2004 and early 2005, we performed an increased amount of business with educational and governmental customers, including schools that receive funding for network infrastructure under a federal program commonly referred to as the “E-Rate” program. These customers typically pay more slowly than our commercial customers, and to the extent a greater portion of our revenue is derived from these customers, our business cycle and collections cycle is extended and our working capital requirements are increased as a percent of our revenue.

 

No single customer represented 10% or more of our revenue for the year ended December 31, 2006. We had one customer that represented 10% or more of our revenue for each of the years ended December 31, 2005 and 2004. This customer, Micro System Enterprise, Inc./Acclaim Professional Services (“MSE”), an agent related to the Dallas Independent School District E-Rate funded program, represented approximately 12.8% and 20.9% of our

consolidated revenue for the years ended December 31, 2005 and 2004 respectively, and represented approximately 11.2% of our consolidated net accounts receivable at December 31, 2005.

 

Sales and Marketing

 

We market our products and services primarily through our sales personnel, including account managers and customer service representatives. These sales personnel are compensated in part based on productivity, specifically the profitability of sales that they participate in developing. We also promote our services through general and trade advertising, and participation in trade shows. Our sales organization works closely with the Cisco sales organization to identify opportunities.

 

Supply and Distribution

 

We purchase products for the network infrastructure and/or IP telephony solutions we provide to our customers. The majority of our product purchases are Cisco products, and the majority of our Cisco product purchases are made directly from Cisco. We also purchase some of our products through various distribution channels when a product is not available directly from Cisco. We attempt to keep minimal inventory on hand and attempt to purchase inventory only as needed to fulfill orders. We attempt to ship products directly from our supplier to our customer when possible in order to shorten the business cycle and avoid handling the product in our facility, and the substantial majority of the product that we purchase is shipped directly from Cisco to our customer.

 

Management Information Systems

 

We use an internally developed, highly customized management information system (“MIS”) to manage most aspects of our business. We use our MIS to manage accounts payable, accounts receivable and collections, general ledger, sales order processing, purchasing, service contracts, service calls and work orders, engineer and technician scheduling and time tracking, service parts acquisition and manufacturer warranties. Reporting can be generated for project profitability, contract and customer analysis, parts and inventory tracking, employee time tracking, etc.

 

Employees

 

At February 28, 2007 we employed approximately 287 people. Of these, approximately 89 were employed in sales, marketing and customer service, 126 were employed in engineering and technical positions and 72 were employed in administration, finance and MIS. We believe our ability to recruit and retain highly skilled and experienced technical, sales and management personnel has been, and will continue to be, critical to our ability to execute our business plans. None of our employees are represented by a labor union nor are any subject to a collective bargaining agreement. We believe our relations with our employees are good.

 

Seasonality

 

Historically, our second and third quarters have been stronger quarters than our first and fourth quarters, but we believe this seasonality was primarily the result of increased activity with educational customers during those periods, and our business with education type customers has been deemphasized over the past year. We therefore expect less of an impact from educational customers and therefore, past seasonal strength in the second and third quarters may not continue in the future.

 

Certain Milestones in Our Corporate Development

 

We started business as a technology systems integrator, computer reseller and information technology service provider in 1983. We added a traditional PBX telephone systems dealer business unit in 1994, and founded Stratasoft, Inc., a computer-telephony software company, in 1995. We conducted an initial public offering and became a public company in 1997. By 1999, we had grown to over $200 million in revenue, operating from five offices in Texas, with over 500 employees.

 

In 1999, we decided to sell both our computer products reselling business and our traditional PBX telephone systems business, which together accounted for approximately 90% of our total revenue at the time, and reposition

our company to take advantage of what we believed would become a significant opportunity in the area of converged communications using IP network infrastructure. We closed the sale of these two business units by mid-2000 and started the process of building our current Cisco-centric IP communications solutions organization, which we incorporated in July 2000 as InterNetwork Experts, Inc., a wholly-owned subsidiary.

 

When we sold our computer products and traditional PBX telephone systems business in 2000 we retained a small information technology services business. After mid-2000 we operated this IT services business through Valerent, Inc., a wholly-owned subsidiary. We also retained Stratasoft, Inc., the computer-telephony software company we had established in 1995. Thus, from mid-2000 until the end of 2005 we operated as a “holding company” with three subsidiaries, Valerent, Inc., Stratasoft, Inc. and InterNetwork Experts, Inc.

 

By 2005 our InterNetwork Experts subsidiary had grown to be over 90% of our total revenue and in late 2005 we decided to sell both Valerent and Stratasoft, eliminate our “holding company” structure, and concentrate all of our efforts and resources on our IP communications solutions business. Effective December 31, 2005 we merged our InterNetwork Experts, Inc. subsidiary, which we, Cisco and our customers commonly referred to as “INX,” into the parent publicly-traded company and changed the name of the parent publicly traded company from I-Sector Corporation to INX Inc. We sold Stratasoft in January 2006 and Valerent in October 2006.

 

General Information

 

Our corporate administrative headquarters are located at 6401 Southwest Freeway, Houston, Texas 77074, and our telephone number is (713) 795-2000. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are available without charge from us on our website at http://www.INXI.com, as reasonably practicable following the time they are filed with or furnished to the SEC.

 

We have a history of losses and may continue to incur losses.

 

We incurred a net loss from continuing operations in each fiscal year since 1999, except fiscal 2006, 2005, and 2003. During 2005 our income from continuing operations was $812 excluding the noncash charge for remeasurement of stock options discussed in Note 11 to consolidated financial statements in Part II, Item 8. We cannot assure you that profitability will be achieved or continue in upcoming quarters or years. In order to continue profitability, we will have to maintain or increase our operating margin. We cannot assure you that we will be able to continue to achieve improved operating margins, or that operating margin will not decrease in the future. If we were unable to increase revenue, if our gross margin decreases, or if we are unable to control our operating expenses, our business could produce losses. We have only recently become profitable and are in a rapidly changing industry. In addition, our business depends upon winning new contracts with new customers, the size of which may vary from contract to contract. When we open new branch offices to expand our geographic presence, we expect the newly opened branch offices to produce operating losses for a period of six months to over one year. We plan to open multiple new branch offices in the near future. Whether we are able to remain profitable in the future will depend on many factors, but primarily upon the commercial acceptance of IP telephony products and services, specifically those developed and marketed by Cisco.

 

Our success is dependent upon maintaining our relationship with Cisco.

 

Substantially all of our revenue for the years ended December 31, 2006, 2005, and 2004 was derived from the sale of Cisco products and related services. We anticipate that these products and related services will account for the majority of our revenue for the foreseeable future. We have a contract with Cisco to purchase the products that we resell, and we purchase substantially all of our Cisco products directly from Cisco. Cisco can terminate this agreement on relatively short notice. Cisco has designated us an authorized reseller and we receive certain benefits from this designation, including special pricing and payment terms. We have in the past, and may in the future, purchase Cisco-centric products from other sources. When we purchase Cisco-centric products from sources other than Cisco, the prices are typically higher and the payment terms are not as favorable. Accordingly, if we are unable to purchase directly from Cisco and maintain our status as an authorized reseller of Cisco network products, our business could be significantly harmed. If we are unable to purchase Cisco products from other sources on terms

that are comparable to the terms we currently receive, our business would be harmed and our operating results and financial condition would be materially and adversely affected.

 

Our success depends upon broad market acceptance of IP telephony.

 

The market for IP telephony products and services is relatively new and is characterized by rapid technological change, evolving industry standards and strong customer demand for new products, applications and services. As is typical of a new and rapidly evolving industry, the demand for, and market acceptance of, recently introduced IP telephony products and services are highly uncertain. We cannot assure you that the use of IP telephony will become widespread. The commercial acceptance of IP telephony products, including Cisco-centric products, may be affected by a number of factors including:

 

 

If the market for IP telephony fails to develop, develops more slowly than we anticipate, or if IP telephony products fail to achieve market acceptance, our business will be adversely affected.

 

Although our success is generally dependent upon the market acceptance of IP telephony, our success also depends upon a broad market acceptance of Cisco-centric IP telephony.

 

We cannot assure you that the Cisco-centric IP telephony products we offer will obtain broad market acceptance. Competition, technological advances and other factors could reduce demand for, or market acceptance of, the Cisco-centric IP telephony products and services we offer. In addition, new products, applications or services may be developed that are better adapted to changing technology or customer demands and that could render our Cisco-centric products and services unmarketable or obsolete. To compete successfully, the Cisco-centric IP telephony products we offer must achieve broad market acceptance and we must continually enhance our related software and customer services in a timely and cost- effective manner. If the Cisco-centric IP telephony products we offer fail to achieve broad market acceptance, or if we do not adapt our existing services to customer demands or evolving industry standards, our business, financial condition and results of operation could be significantly harmed.

 

Our business depends on the level of capital spending by enterprises for communications products and services.

 

As a supplier of IP telephony products, applications and services for enterprises, our business depends on the level of capital spending for communications products and services by enterprises in our markets. We believe that an enterprise’s investment in communications systems and related products and services depends largely on general economic conditions that can vary significantly as a result of changing conditions in the economy as a whole. The market for communications products and services may continue to grow at a modest rate or not at all. If our customers decrease their level of spending on communications systems and the related products and services, our revenue and operating results may be adversely affected.

 

Our profitability depends on Cisco product pricing and incentive programs.

 

Our annual and quarterly gross profits and gross margins on product sales are materially affected by Cisco product pricing and incentive programs. These incentive programs currently enable us to qualify for cash rebates or product pricing discounts and are generally earned based on sales volumes of particular Cisco products and customer satisfaction levels. We recognized vendor incentives as a reduction of a cost of sales amounting to $6,303, $2,876

and $3,480 in 2006, 2005 and 2004, respectively, representing 4.0%, 2.7%, and 4.9% of total revenues. From time to time Cisco changes the criteria upon which qualification for these incentives are based and there is no assurance that we will continue to meet the program qualifications. Cisco is under no obligation to continue these incentive programs.

 

A substantial portion of our customers are based in Texas.

 

We have only recently expanded outside of Texas. Because a majority of the customers we offer our IP telephony products to are geographically concentrated in Texas, our customers’ level of spending on communication products may be affected by economic condition in Texas, in addition to general economic conditions in the United States. If demand for IP telephony products by enterprises in Texas decreases, our business, financial condition and results of operations could be significantly harmed.

 

Our strategy contemplates rapid geographic expansion, which we may be unable to achieve, and which is subject to numerous uncertainties.

 

A component of our strategy is to become one of the leading national providers of Cisco-centric IP telephony products. To achieve this objective, we must either acquire existing businesses or hire qualified personnel in various locations throughout the country, fund a rapid increase in operations and implement corporate governance and management systems that will enable us to function efficiently on a national basis. Identifying and acquiring existing businesses is a time-consuming process and is subject to numerous risks. Qualified personnel are in demand, and we expect the demand to increase as the market for IP telephony grows. We will also likely face competition from our existing competitors and from local and regional competitors in the markets we attempt to enter. A rapid expansion in the size and geographical scope of our business is likely to introduce management challenges that may be difficult to overcome. We cannot assure you that we will be successful in expanding our operations beyond Texas or achieving our goal of becoming a national provider. An unsuccessful expansion effort would consume capital and human resources without achieving the desired benefit and would have an adverse affect on our business.

 

We may require additional financing to achieve expansion of our business operations, and failure to obtain financing may prevent us from carrying out our business plan.

 

We may need additional capital to grow our business. Our business plan calls for the expansion of sales of our IP telephony products to enterprises in geographical markets where we currently do not operate, including expansion through acquisitions. If we do not have adequate capital or are not able to raise the capital to fund our business objectives, we may have to delay the implementation of our business plan. We can provide no assurance that we will be able to obtain financing if required, or if financing is available, there is no assurance that the terms would be favorable to existing stockholders. Our ability to obtain additional financing is subject to a number of factors, including general market conditions, investor acceptance of our business plan, our operating performance and financial condition, and investor sentiment. These factors may affect the timing, amount, terms or conditions of additional financing available to us.

 

We require access to significant working capital and vendor credit to fund our day-to-day operations. Our failure to comply with the financial and other covenants under our working capital facility could lead to a termination of the agreement and an acceleration of our outstanding debt.

 

We require access to significant working capital and vendor credit to fund our day-to-day operations. Our credit facility with Castle Pines Capital (“CPC”) contain a number of financial and other covenants. A breach of these financial or other covenants, unless waived, would be a default under the credit facility. Upon an event of default, CPC may terminate the facility and/or declare all amounts outstanding under such facility immediately due and payable. The acceleration of our debt could have a material adverse effect on our financial condition and liquidity. Additionally, the amount of working capital available to us under the credit facility is dependent upon the amount and quality of our accounts receivable. A significant default or payment delays of our accounts receivable could materially adversely affect our borrowing base and our access to sufficient working capital.

 

We may be unable to manage our growth effectively, which may harm our business.

 

The ability to operate our business in a rapidly evolving market requires effective planning and management. Our efforts to grow have placed, and are expected to continue to place, a significant strain on our personnel, management systems, infrastructure and other resources. Our ability to manage future growth effectively will require us to successfully attract, train, motivate and manage new employees, to integrate new employees into our operations and to continue to improve our operational, financial and management controls and procedures. If we are unable to implement adequate controls or integrate new employees into our business in an efficient and timely manner, our operations could be adversely affected and our growth could be impaired.

 

Our operating results have historically been volatile, and may continue to be volatile, particularly from quarter to quarter.

 

Our quarter-to-quarter revenue, gross profit and operating profitability have fluctuated significantly. During quarterly periods in which we realize lower levels of revenue our profitability is negatively impacted. Our quarterly operating results have historically depended on, and may fluctuate in the future as a result of, many factors including:

 

 

As a result of these and other factors, we have historically experienced, and may continue to experience, fluctuations in sales and operating results. In addition, it is possible that in the future our operating results may fall below the expectations of analysts and investors, and as a result, the price of our securities may fall.

 

We have many competitors and expect new competitors to enter our market, which could increase price competition and may affect the amount of business available to us and the prices that we can charge for our products and services.

 

The markets for our all of products and services, and especially our IP telephony products and services, are extremely competitive and subject to rapid change. Substantial growth in demand for IP telephony solutions has been predicted, and we expect competition to increase as existing competitors enhance and expand their products and services and as new participants enter the IP telephony market. IP telephony involves the application of traditional computer-based technology to voice communication, and the hardware component of the solution is readily available. Accordingly, there are relatively few barriers to entry to companies with computer and network experience. A rapid increase in competition could negatively affect the amount of business that we get and the prices that we can charge.

 

Additionally, many of our competitors and potential competitors have substantially greater financial resources, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater

name recognition and more established relationships than we do. We cannot be sure that we will have the resources or expertise to compete successfully. Compared to us, our competitors may be able to:

 

 

Some of our competitors may also be able to increase their market share by providing customers with additional benefits or by reducing their prices. We cannot be sure that we will be able to match price reductions by our competitors. In addition, our competitors may form strategic relationships with each other to better compete with us. These relationships may take the form of strategic investments, joint-marketing agreements, licenses or other contractual arrangements that could increase our competitors’ ability to serve customers.

 

Business acquisitions, dispositions or joint ventures entail numerous risks and may disrupt our business, dilute stockholder value or distract management attention.

 

As part of our business strategy, we plan to consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Any acquisition could materially adversely affect our operating results and/or the price of our securities. Acquisitions involve numerous risks, some of which we have experienced and may continue to experience, including:

 

 

Finally, to the extent that shares of our common stock or rights to purchase common stock are issued in connection with any future acquisitions, dilution to our existing stockholders will result and our earnings per share may suffer. Any future acquisitions may not generate the anticipated level of revenue and earnings or provide any benefit to our business, and we may not achieve a satisfactory return on our investment in any acquired businesses.

 

Our international operations, which we plan to expand, will subject us to additional risks that may adversely affect our operating results due to increased costs.

 

Revenue generated by products delivered and services provided outside the United States, as a percentage of consolidated revenue, was approximately 4.9%, 3.5% and 2.7% for 2006, 2005 and 2004, respectively. Substantially all of our international revenue represents products delivered or services provided in foreign countries for companies based in the United States or for United States Armed Forces under contracts entered into, administered

and paid in the United States. We intend to continue to pursue international opportunities. Pursuit of international opportunities may require us to make significant investments for an extended period before returns on such investments, if any, are realized. International operations are subject to a number of risks and potential costs, including:

 

 

Any of these factors could prevent us from increasing our revenue and otherwise adversely affect our operating results. We may not be able to overcome some of these barriers and may incur significant costs in addressing others.

 

If we lose key personnel we may not be able to achieve our objectives.

 

We are dependent on the continued efforts of our senior management team, including our Chairman and Chief Executive Officer, James Long, and our President and Chief Operating Officer, Mark Hilz. If for any reason, these or other senior executives or other key members of management do not continue to be active in management, our business, financial condition or results of operations could be adversely affected. We cannot assure you that we will be able to continue to retain our senior executives or other personnel necessary for the development of our business.

 

We may not be able to hire and retain highly skilled technical employees, which could affect our ability to compete effectively and could adversely affect our operating results.

 

We depend on highly skilled technical personnel to research and develop and to market and service our products. To succeed, we must hire and retain employees who are highly skilled in rapidly changing communications technologies. In particular, as we implement our strategy of focusing on IP telephony, we will need to:

 

 

Individuals who can perform the services we need to provide our products and services are scarce. Because the competition for qualified employees in our industry is intense, hiring and retaining qualified employees is both time-consuming and expensive. We may not be able to hire enough qualified personnel to meet our needs as our business grows or to retain the employees we currently have. Our inability to hire and retain the individuals we need could hinder our ability to sell our existing products, systems, software or services or to develop and sell new ones. If we are not able to attract and retain qualified employees, we will not be able to successfully implement our business plan and our business will be harmed.

 

If we are unable to protect our intellectual property rights, our business may be harmed.

 

Although we attempt to protect our intellectual property through patents, trademarks, trade secrets, copyrights, confidentiality and non-disclosure agreements and other measures, intellectual property is difficult to protect and

these measures may not provide adequate protection. Patent filings by third parties, whether made before or after the date of our patent filings, could render our intellectual property less valuable. Competitors may misappropriate our intellectual property, disputes as to ownership of intellectual property may arise and our intellectual property may otherwise become known or independently developed by competitors. The failure to protect our intellectual property could seriously harm our business because we believe that developing new products and technology that are unique to us is important to our success. If we do not obtain sufficient international protection for our intellectual property, our competitiveness in international markets could be significantly impaired, which would limit our growth and future revenue.

 

We may be found to infringe on third-party intellectual property rights.

 

Third parties may in the future assert claims or initiate litigation related to their patent, copyright, trademark and other intellectual property rights in technology that is important to us. The asserted claims and/or litigation could include claims against us or our suppliers alleging infringement of intellectual property rights with respect to our products or components of those products. Regardless of the merit of the claims, they could be time consuming, result in costly litigation and diversion of technical and management personnel, or require us to develop a non-infringing technology or enter into license agreements. There can be no assurance that licenses will be available on acceptable terms, if at all. Furthermore, because of the potential for high court awards, which are not necessarily predictable, it is not unusual to find even arguably unmeritorious claims resulting in large settlements. If any infringement or other intellectual property claim made against us by any third party is successful, or if we fail to develop non-infringing technology or license the proprietary rights on commercially reasonable terms and conditions, our business, operating results and financial condition could be materially adversely affected.

 

Costs of compliance with the Sarbanes-Oxley Act of 2002 and the related SEC regulations may harm our results of operations.

 

The Sarbanes-Oxley Act of 2002 requires heightened financial disclosure and corporate governance for all publicly traded companies. Although costs of compliance with the Sarbanes-Oxley Act are uncertain due to several factors, we expect that our general and administrative expenses will increase. Failure to comply with the Sarbanes-Oxley Act, Securities and Exchange Commission (“SEC”) regulations or NASDAQ listing requirements may result in penalties, fines or delisting of our securities from the NASDAQ, which could limit our ability to access the capital markets, having a negative impact on our financial condition and results of operations.

 

None.

 

We conduct operations at the following leased sites:

 

 

Through January 31, 2007, we leased a freestanding 48,000 square foot building for our operations, accounting, MIS, and corporate offices in Houston, Texas from a corporation owned by our Chairman and Chief Executive Officer. Approximately 16,773 square feet were subleased to Stratasoft, Inc. and Valerent, Inc., which were both sold during 2006. Effective February 1, 2007, the lease was reduced to 16,488 square feet as discussed further in

Note 13 to the consolidated financial statements in Part II, Item 8. The Dallas facility consists of 28,479 square feet. The remainder of the locations range in size from 800 to 7,800 square feet. We believe our existing leased properties are in good condition and suitable for the conduct of our business.

 

See discussion of legal proceedings in Note 14 to the consolidated financial statements included in Part II, Item 8 of this Report.

 

No matters were submitted to a vote of security holders during the fourth quarter of 2006.

 

Executive Officers of the Registrant

 

The executive officers of the Company are as follows:

 

 

James H. Long is our founder and has served as our Chairman of the Board and Chief Executive Officer since our inception in 1983. Mr. Long also served as our president through December of 2003. Prior to founding our company, Mr. Long served with the United States Navy in a technical position and was then employed by IBM in a technical position.

 

Mark T. Hilz was appointed as our President and Chief Operating Officer in December 2003. Mr. Hilz’ responsibilities include management of our operations. Mr. Hilz has also served as the President of InterNetwork Experts, Inc. since its founding in July 2000 until it was merged into I-Sector Corporation in December 2005. Mr. Hilz served as a director of our company from April 1999 until June 2001. From January 1999 to June 2000, Mr. Hilz was Vice President of Project Development at Mathews Southwest, LLC, Inc., a real estate investment and development firm headquartered in Dallas. From 1998 to July 2000, Mr. Hilz was one of our directors and the Chief Executive Officer of Nichecast, Inc., a privately held internet services company. From July 1990 to July 1998 Mr. Hilz was the founder, President and Chief Executive Officer of PC Service Source, Inc., a publicly held distributor of personal computer hardware for the repair industry. Before that, Mr. Hilz was founder, President and Chief Executive Officer of Hilz Computer Products, Inc., a privately held wholesale computer products distributor.

 

Brian Fontana has served as the Chief Financial Officer since January 2005. Mr. Fontana has an extensive financial management background that includes the management of the accounting, finance, investor relations, internal information systems and legal functions for large, complex organizations, including organizations that were executing strategies for rapid expansion through acquisitions. As CFO, he has managed multiple initial public offerings, follow-on equity offerings, private equity offerings, public debt placements and syndicated bank financings. He previously held the position of CFO at three NYSE listed public companies, one NASDAQ listed company and two privately held companies. His prior experience includes serving as Chief Financial Officer of Talent Tree, Inc., a privately-held workforce outsourcing organization; PerformanceRetail, Inc., an early-stage venture-capital funded software company; Drypers Corporation, a NASDAQ listed multinational diaper manufacturing company; Pentacon, Inc., a NYSE listed fastener distribution company; Prime Service, Inc., a NYSE listed equipment rental company; and National Convenience Stores, Inc., a NYSE listed operator of convenience stores. Mr. Fontana is a 1981 graduate of the University of Texas, where he earned a BBA in Finance.

 

Larry Lawhorn was appointed as our Controller and Chief Accounting Officer in April 2005 and is responsible for our accounting and reporting functions. From August 2002 to April 2005, Mr. Lawhorn was the Vice President — Corporate Controller for Talent Tree, Inc., a privately-held workforce outsourcing organization headquartered in

Houston, Texas. From March 1987 to July 2001, Mr. Lawhorn served with Corporate Express, Inc. headquartered in Broomfield, Colorado as regional controller and division president in Houston, Texas and Baton Rouge, Louisiana, respectively. Previously, Mr. Lawhorn served with Coopers & Lybrand (now PriceWaterhouseCoopers) for eleven years. Mr. Lawhorn is a Certified Public Accountant and he is a member of the American Institute of Certified Public Accountants and the Texas Society of Certified Public Accountants.

 

Paul Klotz was appointed as the Vice President of Operations effective December 31, 2005 and held a similar position with InterNetwork Experts, Inc. since August 2000. Mr. Klotz’ responsibilities include the operations management of the IP communications business. From 1997 to July 2000, Mr. Klotz was the Vice President of Marketing of PC Service Source. Before that, Mr. Klotz served as the Vice President of Acme Keystone, a privately held consumer products manufacturing company.

 

Family Relationships

 

There are no family relationships among any of our directors and executive officers.

 

Market Information

 

Beginning April 24, 2006, our common stock and warrants began trading on the Nasdaq Capital Market under the symbols “INXI” and “INXIW”, respectively. From December 29, 2003 until April 24, 2006, our common stock has traded on the American Stock Exchange under the ticker symbol “ISR”. From June 8, 2004 until April 24, 2006, our warrants traded on the American Stock Exchange under the symbol “ISR.WS”.

 

Common Stock

 

The following table sets forth the price range of our common stock.

 

Warrants

 

The following table sets forth the price range of our warrants.

 

 

As of February 28, 2007, we had 135 stockholders of record of our common stock. On February 28, 2007, the closing sales price of our common stock and warrants as reported by the Nasdaq Capital Market was $9.57 per share and $2.30 per warrant.

 

Dividend Policy

 

Our policy has been to reinvest earnings to fund future growth. Accordingly, we have not declared or paid any cash dividends and do not anticipate declaring dividends on our common stock in the foreseeable future.

 

Equity Compensation Plan Information

 

The following table sets forth, as of December 31, 2006:

 

 

 

Equity incentive plans are further discussed in Note 10 to consolidated financial statements in Part II, Item 8.

Stock Performance Graph

 

The following graph compares the performance of the Common Stock with the Nasdaq Stock Market (U.S. Companies) Index and with the Russell 2000 Index. The graph assumes that $100 was invested on December 31, 2001, in the Common Stock and in each index and that any cash dividends were reinvested. The Company has not declared any dividends during the period covered by this graph.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
AMONG INX INC.,
THE NASDAQ STOCK MARKET (U.S.) INDEX AND THE RUSSELL 2000 INDEX

 

 

 

Fiscal year ending December 31.

 

ASSUMED INVESTMENT WITH REINVESTMENT OF DIVIDENDS

 

 

 

 

This graph depicts the past performance of the Common Stock and in no way should be used to predict future performance. The Company does not make or endorse any predictions as to future share performance.

 

This Stock Performance Graph and the information provided in this Stock Performance Graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to the liabilities under that Section and shall not be deemed to be incorporated by reference by any general statement incorporating by reference this Report on Form 10-K into any filing under the Securities Act of 1933, as amended, or the Exchange Act except to the extent INX specifically incorporates by reference this Stock Performance Graph.

 

The following selected financial data are derived from our consolidated financial statements. The data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors,” and our consolidated financial statements and notes.

 

 

 

 

Please read the following discussion of our financial condition and results of operations together with “Item 6. Selected Financial Data” and our consolidated financial statements and the notes to those statements included elsewhere in this report. The following discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under “Item 1A. Risk Factors” and elsewhere in this report.

 

General

 

We are a provider of IP communications solutions for enterprise-class organizations such as corporations, schools and federal, state and local governmental agencies. The solutions we provide are based primarily on Cisco technology and we offer our customers with implementation and support services related to the solutions we provide. We believe that our focus and expertise enables us to better compete in the markets we serve because we have significant experience implementing and supporting the critical technology building blocks of IP telephony systems and the underlying infrastructure components upon which IP telephony depends.

 

The market for IP communications solutions is characterized by rapidly evolving and competing technologies. We compete with larger and better financed entities. We currently have fourteen physical offices, which are located in Texas, California, Louisiana, Idaho, New Mexico, Oregon, Utah, Washington and Washington DC. We primarily market to enterprise-class organizations headquartered in, or making purchasing decisions from markets that we serve with branch offices. We plan to continue to expand throughout the U.S. by establishing additional branch offices in other markets, either by opening additional new offices or through acquisition.

 

We derive revenue from sales of both products and services. Services revenue has grown more rapidly than product sales recently. In 2006, 2005 and 2004, sales of products made up 86.7%, 88.1% and 91.2% of total revenue and services revenues made up 13.3%, 11.9% and 8.8% of total revenue.

 

A key component of our long-term operating strategies is to improve operating profitability. Our gross profit margin on product sales is lower than our gross margin on service revenues. Our gross margin on product sales was 18.6%, 15.7% and 16.6% for 2006, 2005 and 2004, respectively, and our gross margin on service revenue was 25.9%, 29.2% and 33.4% for those same periods. The market for the products we sell is competitive, and we compete with other suppliers for our customers’ business. The principal factors that determine gross margin on product sales include:

 

 

The principal factors that influence gross margin on service revenue include:

 

 

We expect to be able to improve our gross margin on services revenues if our NetSurant^® post-sale recurring support services revenue continue to increase at a more rapid rate than our implementation services revenue. This is because our cost of providing NetSurant^® support services is somewhat fixed and does not increase in direct proportion to revenue.

 

If we are able to maintain our gross margin on product sales, improve our gross margin on services revenues and change our revenue mix to include a larger amount of service revenue our gross margin on total revenue will improve, which is a key component of our strategy to improve operating profitability.

 

Certain of our selling, general and administrative expenses, such as sales commissions, vary with revenue or gross profit. Certain other selling, general and administrative expenses are somewhat fixed and do not vary directly with revenue or gross profit. We hope to be able to achieve a degree of leverage on certain categories of selling, general and administrative expenses as we continue to grow, so that these expenses will become a lower percentage of revenue, which combined with improvements in gross margin would increase operating profit margin from our existing branch offices.

 

To the extent we continue to open new branch offices our operating profitability will be negatively impacted because we expect that opening a new branch office will typically result in operating losses from the newly opened branch office for a period of six months to over one year. This is because when we open a new branch office we must hire sales and engineering staff before we generate sales and because we incur increased levels of sales and marketing expense in order to establish our presence in the new market, and to attract new customers. However, we believe it is important to expand rapidly to obtain a national presence, and that the return on our investment from opening new offices will be significant over an approximate three to five year period, relative to the investment required, and therefore we believe it is in our best interest to open new offices even though doing so reduces near-term operating profitability.

 

We begin Management’s Discussion and Analysis of Financial Condition and Results of Operations with an overview of our strategies for achieving our goals of revenue growth and improved profitability. From a financial perspective, these operating strategies have a number of important implications for our results of operations and financial condition.

 

Strategy

 

Over the course of the next several years we plan to improve profitability by implementing the strategies discussed below. We believe that our strategies will allow us to continue to increase total revenues. We also believe our strategies will enable us to improve our gross margins on our service revenue. At the same time, we will seek to limit the growth of certain relatively fixed components of our selling, general and administrative expenses relative to the growth of revenue so that those expenses become a relatively smaller percentage of total revenues. Through a combination of increased revenue, slightly increased gross margin and somewhat lesser growth of selling, general and administrative expenses, relative to the growth of revenue, we hope to be able to increase our operating margin and increase profitability at a more rapid rate than revenue increases, particularly from our existing branch offices. We expect that selling expenses can generally be expected to increase in proportion to our revenue increases. For example, our sales and sales management staff earn sales commissions that are typically calculated as a percentage of gross profit produced. Historically, sales commissions have been approximately 27% to 31% of gross profit and we expect sales commissions to continue to consume similar percentages of total gross profit. However, we believe that if we are successful in implementing our strategies, many categories of general and administrative expenses (such as management salaries, administrative wages and professional expenses) will decrease as a percentage of our total revenues over the long term because we believe we can achieve some levels of leverage on certain of these operating expenses.

 

Our key operating strategies include:

 

 

 

Increases in the size and volume of the projects we undertake can challenge our cash management. For example, larger projects can reduce our available cash by requiring that we carry higher levels of inventory. Larger projects can also require other investments in working capital. This is because, in some cases, we do not receive payments from our customers for extended periods of time. Until we invoice the customer and are paid, all of the cash expended on labor and products for the project remains invested in work-in-progress or accounts receivable. We expect that we will need increasing levels of working capital in the future if we are successful in growing our business as we intend. To meet our cash requirements to support planned growth, we expect to rely on capital provided from our operations and our credit facility, which is collateralized by our accounts receivable and substantially all of our other assets.

 

During 2006, 2005 and 2004, 86.7%, 88.1% and 91.2% of our revenue was attributable to product sales, while 13.3%, 11.9% and 8.8% was attributable to services revenues. The gross profit margins on our services revenues have been substantially higher than those for product sales. We hope to be able to increase revenue from services at a more rapid rate than increases in our product sales revenue. We believe this is possible if we are successful in marketing our NetSurant^® support services, which generate recurring services revenues. If we are successful at growing our service revenues at a more rapid rate than our product sales revenues our overall gross margin on total revenue should improve. The success of this aspect of our strategy depends in part on our ability to attract and retain highly skilled and experienced engineering employees and the acceptance by the market of our NetSurant^® support services offering.

 

For the last three years, the largest component of our total cost of sales and service has been purchases of Cisco-centric IP telephony products. The majority of those purchases were directly from Cisco. We typically purchase from various wholesale distributors only when we cannot purchase products directly from Cisco on a timely basis. Our reliance on Cisco as the primary supplier for the network and IP telephony products we offer means that our results of operations from period to period depend substantially on the terms upon which we are able to purchase these products from Cisco and, to a much lesser extent, from wholesale distributors of Cisco’s products. Therefore, our ability to manage the largest component of our cost of sales and service is very limited and depends to a large degree on maintaining and improving our relationship with Cisco. Our cost of products purchased from Cisco can be substantially influenced by whether Cisco sponsors sales incentive programs and whether we qualify for such incentives. There is a risk that we may not meet the required incentive criteria in the future. The respective timing of when vendor incentives become earned and determinable has created material fluctuations in our gross margin on product sales in the past.

 

We also plan to increase our business in other geographic areas through strategic acquisitions of similar businesses or by opening our own offices. This aspect of our strategy can affect our financial condition and results of operations in many ways. The purchase price for business acquisitions and the costs of opening offices may require substantial cash and may require us to incur long term debt. The expenses associated with opening a new office in a new market may well exceed the gross profit produced on revenues attributable to such new office for some time, even if it performs as we expect. It is possible that our acquisition activities may require that we record substantial amounts of goodwill if the consideration paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired, which we expect is likely. To the extent an acquisition results in goodwill, we will reevaluate the value of that goodwill at least annually and adjust the value as appropriate. If we determine that the value of the goodwill has been impaired, the resulting adjustment could result in a non-cash charge to earnings in the periods of revaluation.

 

We are developing our own custom IP communications products based on Cisco technology but to date have not generated any material revenues from the sale of such products. If we are successful in developing and marketing these new products we expect that we will generate higher levels of gross margin on the sales of such products, but developing and marketing these new products requires that we expend cash and incur research and development expenses, as well as advertising and marketing costs. New product development costs have been, and we expect will continue to be, expensed as incurred.

 

Elimination of Minority Interest in Our Former InterNetwork Experts, Inc. Subsidiary

 

On March 18, 2005 we eliminated a minority interest in our former InterNetwork Experts subsidiary by exchanging the minority interest for an interest in INX. The minority interest was created in April 2004 when our former InterNetwork Experts subsidiary issued shares of its common stock as part of the purchase consideration when it acquired the assets and operations of Digital Precision. When that occurred, our ownership percentage of INX’s common stock declined from 100% to approximately 92.4%, and we recognized $162,000 of minority interest on our balance sheet upon issuance.

 

Since we did not own 7.6% of the former InterNetwork Experts common stock during the period in which the minority interest existed, our interest in InterNetwork Experts’ profits and losses was reduced for the minority share during such period. Under accounting principles generally accepted in the United States of America, our consolidated financial statements for the period through the exchange reflects a minority interest adjustment of the reportable profits and losses of our former InterNetwork Experts subsidiary attributable to the minority ownership. For 2004, we reported income attributable to minority interest of $117,000 in our statement of operations and a minority interest balance of $279,000 in our balance sheet. For 2005 we reported income attributable to minority interest of $23,000 in our statement of operations for the period through March 18, 2005 when the minority interest was eliminated, including the minority interest balance of $302,000 in our balance sheet.

 

On February 1, 2005, we entered into an agreement with the former InterNetwork Experts subsidiary minority shareholder group to eliminate the InterNetwork Experts minority interest, contingent upon INX stockholder approval. Upon stockholder approval on March 18, 2005, InterNetwork Experts became a wholly-owned subsidiary of the company. The exchange of the minority interest resulted in a remeasurement of the stock options that were part of the minority interest and such remeasurement resulted in a $5.7 million one-time non-cash charge to earnings, which was equal to the intrinsic value of the stock options on March 18, 2005. This one-time non-cash charge to earnings, which did not impact assets or liabilities, reduced reported net income and earnings per share in our quarter ended March 31, 2005. The elimination of the minority interest simplified our capital structure and eliminated the minority interest on our financial statements, but increased the shares used to compute diluted earnings per share due to the shares of our common stock issued in the exchange and because of the increased number of stock options resulting from exchanging the former InterNetwork Experts subsidiary stock options for our stock options. Based on the closing stock price of $6.25 on March 18, 2005, the shares used in computing diluted earnings per share increased by approximately 1,161,592 shares as a result of the exchange of the minority interest.

 

Elimination of Holding Company Structure and Sale of Two Subsidiaries

 

On November 3, 2005, our Board of Directors approved a plan to sell the Stratasoft and Valerent subsidiaries. This action was taken due to continuing losses at Stratasoft and the decision to build value with a focused strategy in the operations at INX. Under a Stock Purchase Agreement (“Agreement”) dated January 26, 2006, we sold all outstanding shares of Stratasoft’s common stock for a pretax gain on disposal of $302. Key terms of the sale are summarized as follows:

 

 

 

 

 

We incurred transaction costs of $815 in connection with the transaction, including the $128 value of warrants issued to the investment banker for the transaction for 40,000 shares of common stock with an exercise price of $6 per share. The warrants expire 5 years after January 26, 2006. Additional transaction costs of up to $120 are payable based on the final sale price. Additional costs of $134 were recorded as a reduction of the gain on sale for space leased by INX that will not be subleased to Stratasoft in the future.

 

The sale of Valerent operations involved two separate transactions which were closed in October 2006. The managed services business and related inventory, property and equipment were sold to OuterNet Management, L.P. for a cash sales price of $185. The consulting business and related property and equipment were sold to Vicano Acquisition Corp., a company owned by Valerent’s former President and brother-in-law of our CEO and largest shareholder. The consulting business was sold for cash paid at closing of $50 and a $70 promissory note to be received in twenty-four monthly installments of $3 plus interest of 10%. Additional sales price is due to us if certain revenue thresholds and conditions are met. We recorded a gain of $25 on the cash component of the transactions and will record a gain on proceeds under the $70 promissory note as received, of which $6 was received at December 31, 2006.

 

Results of Operations

 

Overview

 

Sources of Revenue.  Our revenue consists of product and service revenue. Product revenue consists of reselling Cisco products and limited amounts of complementary products from other manufacturers. Service revenue is generated by fees from a variety of implementation and support services. Product prices are set by the market for Cisco products and provide our lowest gross margins. Gross margin on service revenue varies based on the cost of technical resources, which are reflected as a cost of service. Certain fixed and flat fee service contracts that extend over three months or more are accounted for on the percentage of completion method of accounting.

 

Historically, the majority of our services revenue has been generated from implementation services, which we believe varies somewhat in proportion to our product sales. Implementation services revenue is project oriented and tends to be somewhat volatile on a quarter-to-quarter basis as projects start and stop and we redeploy technical resources to new projects. As the number, frequency and size of our projects continue to grow, we hope to achieve better utilization of our engineering resources, resulting in improved gross margins on implementation services revenue and less volatility in the amount of quarterly implementation services revenue realized. The normal sales cycle for corporate customers typically ranges from three to six months depending on the nature, scope and size of the project. Our experience with educational organizations utilizing E-Rate funding, which is a federal government funding program for schools administered by the Schools and Libraries Division Universal Services Administrative Corporation (the “SLD”), indicates that the sales cycle is generally about six to twelve months or longer.

 

In mid-2004, INX introduced NetSurant^®, its branded support service that consists primarily of customer service personnel and a support center. This new support service offering requires that we incur the fixed cost to operate a network operations center to monitor and manage customers’ systems. Until recently, this fixed cost, as compared to the level of NetSurant^® service revenue has resulted in negative gross margins from this new NetSurant^® service offering. We recognize support service revenue evenly over the entire service period for the customer. Eventually, we expect that the NetSurant^® support offering will improve overall services gross margins.

 

Gross Profit and Gross Profit Margin.  The mix of our various revenue components, each of which has substantially different levels of gross margin, materially influences our overall gross profit and gross margin in any particular quarter. In periods in which service revenue is high as compared to product sales, our gross margin generally improves as compared to periods in which we have higher levels of product sales. Our gross margin for product sales also varies depending on the type of product sold, the mix of large revenue product sales contracts, which typically have lower gross margin as compared to smaller revenue product sales contracts, which typically have higher gross margin. Gross margin percentage on product sales is generally positively influenced by repeat

business with existing customers, which are typically smaller transactions that generate slightly higher levels of gross margin as compared to large, competitively bid projects.

 

Our annual and quarterly gross profit and gross margin on product sales are materially affected by vendor incentives, most of which are Cisco incentive programs. The incentive programs sponsored by Cisco currently enable us to qualify for cash rebates or product pricing discounts. The most significant incentive is a Cisco incentive that is generally earned based on sales volumes of particular Cisco products and customer satisfaction levels. The amounts earned and costs incurred under these programs are recorded as a reduction of cost of goods sold, and the increased gross profit results in an increase in selling, general and administrative expenses related to sales commissions. We recognized vendor incentives of $6,303, $2,876, and $3,480 in 2006, 2005 and 2004, respectively. The amounts earned under these programs are accrued when they are deemed probable and can be reasonably measured; otherwise, they are recorded when they are declared by the vendor or the cash is received, which ever is earlier. Our product cost and resulting gross profit can vary significantly from quarter to quarter depending upon vendor incentive criteria and our ability to qualify for and recognize such incentives.

 

A significant portion of our cost of services is comprised of labor, particularly for our implementation services revenue. Our gross margin on service revenue fluctuates from period to period depending not only upon the prices charged to customers for our services, but also upon the level of utilization of our technical staff. Management of labor cost is important to maximize gross margin. Our gross margin is also impacted by such factors as contract size, time and material pricing versus fixed fee pricing, discounting, vendor incentives and other business and marketing factors normally incurred during the conduct of business. Several years ago we purposely over staffed technical and engineering staff in order to have the technical competency necessary to gain market share and create a successful organization. Over the past several years as we have grown, we have been able to better utilize our technical and engineering staff and this has helped to improve the gross margin percentage on service revenue in more recent years as compared to several years ago. When we open new branch offices in new markets, we also must over staff technical and engineering resources in order to have the personnel necessary to win customer relationships in the new market. Because we expect to open multiple new offices in new markets over the upcoming year we expect gross margin on our implementation services to be negatively impacted by such new branch office operations. The extent to which total implementation services gross margin will be negatively impacted will vary based on the number and size of new branch offices we have recently opened for any given period, relative to the number of and size of mature branch offices.

 

Selling, General and Administrative Expenses.  Our selling, general and administrative expenses include both fixed and variable expenses. Relatively fixed categories of expenses in selling, general and administrative expenses include rent, utilities, and administrative wages. Variable categories of expenses in selling, general and administrative expenses include sales commissions and travel, which will usually vary based on our sales and gross profit. Selling, general and administrative expenses also include expenses which vary significantly from period to period but not in proportion to sales or gross profit. These include legal expenses and bad debt expense, both of which vary based on factors that are difficult to predict.

 

A significant portion of our selling, general and administrative expenses relate to personnel costs, some of which are variable and others that are relatively fixed. Our variable personnel costs consist primarily of sales commissions. Sales commissions are typically calculated based upon our gross profit on a particular sales transaction and thus generally fluctuate because of the size of the transaction and the mix of associated products and services with our overall gross profit. Historically, sales commission expense has been approximately 27% to 31% of gross profit, and we expect that it will continue to approximate that level in the future. Bad debt expense generally fluctuates somewhat in proportion to sales levels, although not always in the same periods as increases or decreases in sales. Legal expense varies based on legal issue activity, which can vary substantially from period to period. Other selling, general and administrative expenses are relatively fixed and do not vary in direct proportion to increases in revenue, but will generally increase over time as the organization grows. We believe that we can achieve some level of leverage on these somewhat fixed operating expenses, relative to revenue growth, and if we are successful in doing so that this will help to increase our net operating margin.

 

Acquisitions.  Under an Asset Purchase Agreement dated February 3, 2006, we purchased the assets and operations of Datatran Network Systems (“DNS”). DNS is a specialized provider of network solutions serving

the Southern California market. DNS designs, implements and supports solutions based on Cisco technologies with a primary focus on IP Telephony. We completed the acquisition simultaneously with the execution of the Asset Purchase Agreement. The consideration paid at closing pursuant to the Asset Purchase Agreement was $1,000 in cash, including $100 placed in escrow under holdback provisions defined in the Asset Purchase Agreement and 71,003 shares of our common stock valued at $500. Legal and other costs of $47 were paid in connection with the transaction, of which $32 was paid in cash and $15 was paid through the issuance of 2,105 shares of common stock. Additional consideration is payable based on the DNS branch office revenue during the twelve-month period ending February 28, 2007. If the revenue for that period (i) equals or exceeds $9,000 but is less than $9,250, then the amount of the additional purchase consideration will be $125, (ii) equals or exceeds $9,250 but is less than $9,500, then the amount of the additional purchase consideration will be $250, (iii ) equals or exceeds $9,500 but is less than $10,000, then the amount of the additional purchase consideration will be $375, (iv) equals or exceeds $10,000 then the amount of the additional purchase consideration will be $500 or (v) is less than $9,000, then there will be no additional purchase consideration. At our option, 50% of any additional purchase price consideration, if any, may be paid in the form of common stock. Additional purchase price consideration, if any, will be recorded as goodwill.

 

Effective May 26, 2005, we acquired the operations and certain assets of Network Architects, Corp. (“Network Architects”), a data network and IP telephony systems design, installation and support business with branches in Albuquerque, New Mexico, and El Paso, Texas. We paid cash at closing in the amount of $2,000, common stock valued at $2,000, and payment of a note payable to a bank in the amount of $300. We incurred legal and other costs of $65 in connection with the transaction. Additional purchase price consideration valued at $965 and recorded as goodwill was paid to Network Architects in June 2006 for achievement of certain operating profit milestones during the twelve-month period ended May 31, 2006. The consideration was comprised of $394 paid in cash and 97,413 shares of our common stock. We will pay Network Architects additional purchase price consideration if certain financial milestones are achieved during 2007 and 2008. We will issue Network Architects a maximum of 75,000 shares of common stock following each of the twelve-month periods ending May 31, 2007 and 2008 if operating profit during such periods exceeds $660 and $726, respectively. If operating profit is less than the applicable milestone for any of the two years, the number of shares of common stock issuable will be equal to 75,000 multiplied by the percentage of actual operating profit during the period as compared to the applicable milestone. Additional purchase price consideration, if any, will be recorded as goodwill.

 

Effective June 29, 2005, we acquired the operations and certain assets of the InfoGroup Northwest, Inc. (“InfoGroup”) network solutions business with branches in Seattle, Washington, and Portland and Eugene, Oregon. We paid cash at closing in the amount of $1,900 and shares of our common stock valued at $500. Legal, broker, and other costs of $123, were incurred in connection with the transaction, of which $12 was paid through the issuance of 1,586 shares of common stock and the remainder paid in cash. Additional purchase price consideration valued at $1,430 and recorded as goodwill was paid to InfoGroup in August 2006 for achievement of certain operating profit milestones during the twelve-month period ending June 30, 2006. The consideration consisted of $715 paid in cash and $715 in shares of our common stock. Additionally, cash and stock valued at $71 was paid to the broker of the transaction.

 

Tax Loss Carryforward.  Because of our operating losses in 2003 and 2005, we have accumulated a net operating loss carryforward for federal income tax purposes that, at December 31, 2006, was approximately $2,369. Since United States tax laws limit the time during which an NOL may be applied against future taxable income and tax liabilities, we may not be able to take full advantage of our NOL carryforward for federal income tax purposes. The carryforward will expire during the period 2023 through 2025 if not otherwise used. A change in ownership, as defined by federal income tax regulations, could significantly limit the company’s ability to utilize its carryforward. If we achieve sustained profitability, which may not happen, the use of net operating loss carryforwards would reduce our tax liability and increase our net income and available cash resources. When all operating loss carryforwards have been used or have expired, we would again be subject to increased tax expense.

 

Period Comparisons.  The following tables set forth, for the periods indicated, certain financial data derived from our consolidated statements of operations. Percentages shown in the table below are percentages of total revenue, except for the product and service components of cost of goods sold and gross profit, which are percentages of product and service revenue, respectively.

 

 

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

 

Total Revenue.  Total revenue increased by $48,694, or 45.4%, to $156,013 from $107,319. Products revenue increased by $40,747 or 43.1%, to $135,317 from $94,570. The increase in products revenue is primarily due to the full year revenue contribution from acquisitions and growth in our Federal Division business, partially offset by the absence of revenue from two large education projects generated in 2005. Services revenue increased by $7,947 or 62.3%. to $20,696 from $12,749. The increase in services revenue is primarily due to the full year revenue contribution from acquisitions, growth in the NetSurant^® post-sale recurring support services revenue, and increased Federal government contract revenue.

 

Gross Profit.  Total gross profit increased by $11,921, or 64.2%, to $30,497 from $18,576. Overall gross profit as a percentage of sales increased to 19.5% from 17.3%. Gross profit on product sales increased $10,277, or 69.2%, to $25,132 from $14,855 and, as a percentage of product sales, to 18.6% from 15.7%. Products gross profit percentage improved due to a greater amount of large volume low margin projects in 2005 than 2006 and reduced costs of sales resulting from higher Cisco rebates. Cisco rebates represented 4.7% and 3.0% of products sales in 2006 and 2005, respectively. Gross profit on services revenue increased $1,644 or 44.2% to $5,365 from $3,721 and gross profit as a percent of services revenue decreased to 25.9% from 29.2%. The decrease in services gross margin was the result of the increased cost of service related to hiring new engineering staff prior to generating additional service revenue, and higher NetSurant^® costs incurred to support increased current business and expected future growth.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased by $5,951, or 26.1% to $28,710 from $22,759. As a percentage of total revenue, these expenses decreased to 18.4% from 21.2%. The decrease in selling, general and administrative expenses as a percentage of sales was due to a one-time noncash charge of $5,729 recorded in March 2005 for the remeasurement of options exchanged as part of the purchase of the minority interest in the former InterNetwork Experts, Inc. subsidiary. Excluding this one-time charge, 2005 selling, general and administrative expenses were $17,030 or 15.9% of total 2005 revenue. 2006 selling, general and administrative expenses increased due to costs to open new offices, full year costs in acquired locations, additional sales compensation costs on substantially higher revenues, additional sales and administrative personnel costs from headcount increases. The 2006 adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, increased 2006 selling, general and administrative expenses by $350. We expect our future selling, general and administrative expenses to continue to increase for anticipated revenue growth. However, we expect to limit the increase of selling, general and administrative expenses so that these expenses grow at a lesser rate than revenue increases because some of these expenses are relatively fixed in nature.

 

Operating Income (Loss).  Operating income increased $5,970 to income of $1,787 from a loss of $4,183, primarily due to the 2005 remeasurement of options expense which resulted in a charge of $5,729, increased gross profit resulting from higher revenues and improved margins, partially offset by increased selling, general and administrative expenses in 2006.

 

Interest and Other Income (Expense), net.  Interest and other income (expense), net, changed by $4 to an expense of $232 from an expense of $236 primarily due lower average borrowings under our credit facility.

 

Loss from Discontinued Operations, net of tax.  Loss from discontinued operations decreased by $2,651, to a loss of $316 from a loss of $2,967. The loss from discontinued operations of $316 in 2006 consisted of a loss from operations of $1,118, partially offset by the gain on disposal of Stratasoft in January 2006 of $302, a $469 gain from settlement of a lawsuit in the Computer Products Division, and a $31 gain from the sale of Valerent. The loss from discontinued operations of $2,967 in 2005 consisted of a loss from operations of $2,973, the cumulative effect of the change in Stratasoft’s method of applying the percentage of completion accounting method of $566, a gain from the adjustment of previously recorded accruals in the Telecom and Computer Products Divisions of $106, and an income tax benefit of $466.

 

Net Income (Loss).  Net income increased $9,079 to net income of $1,195 from a net loss of $7,884, primarily due to the 2005 remeasurement of options expense of $5,729, reduced loss from discontinued operations of $2,651, and increased gross profit resulting from higher revenues and improved margins, partially offset by increased selling, general and administrative expenses in 2006.

 

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

Total Revenue.  Total revenue increased by $35,832, or 50.1%, to $107,319 from $71,487. Products revenue increased by $29,363 or 45.0%, to $94,570 from $65,207. The increase in products revenue is primarily due to the revenue contribution from 2005 acquisitions and large projects for Austin Independent School District and CenterPoint Energy. Services revenue increased by $6,469 or 103.0% to $12,749 from $6,280. The increase in services revenue is primarily due to the revenue contribution from 2005 acquisitions, growth in the NetSurant^® post-sale recurring support services revenue, and increased Federal government contract revenue.

 

Gross Profit.  Total gross profit increased by $5,635, or 43.5%, to $18,576 from $12,941. Gross profit as a percentage of sales decreased to 17.3% from 18.1%, due to the decrease in products and services margins as a percent of sales in 2005 as compared to 2004. Gross profit on the products revenue component increased $4,011 or 37.0%, to $14,855 from $10,844. Product gross margin decreased to 15.7% from 16.6% primarily due to lower vendor rebates in 2005 due to the initial recognition of vendor rebates on the accrual basis beginning in 2004. In 2004, information became readily available from the vendor so that the incentives earned were reasonably determinable. As a result, Cisco rebates represented 3.0% and 5.3% of products sales in 2005 and 2004, respectively. Gross profit on services revenue increased $1,624 or 77.4% to $3,721 from $2,097 and gross profit as a percent of services revenue decreased to 29.2% from 33.4%. The decrease in services gross margin was primarily as a result of lower service margins in acquired locations.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased by $11,491, or 102.0% to $22,759 from $11,268. As a percentage of total revenue, these expenses increased to 21.2% from 15.8%. The increase in selling, general and administrative expenses as a percentage of sales was due to a one-time noncash charge of $5,729 recorded in March 2005 for the remeasurement of options exchanged as part of the purchase of the minority interest in the former InterNetwork Experts, Inc. subsidiary. Excluding this one-time charge, 2005 selling, general and administrative expenses were $17,030 or 15.9% of total 2005 revenue, approximating the same relationship to total revenue as in 2004.

 

Operating Income (Loss).  Operating income decreased $5,856 to a loss of $4,183 from income of $1,673, primarily due to the 2005 remeasurement of options expense which resulted in a charge of $5,729.

 

Interest and Other Income (Expense), net.  Interest and other income (expense), net, changed by $140 to expense of $236 from expense of $96, primarily due to increased borrowings under our credit facility resulting from delays in payment by the Schools and Libraries Division of the Universal Services Administrative Corporation on school district accounts receivable and due to funding the cash portion of the purchase price for acquisitions.

 

Income (Loss) from Discontinued Operations, net of tax.  Loss from discontinued operations increased by $3,387, to a loss of $2,967 from income of $420. The loss from discontinued operations of $2,967 in 2005 consisted of a loss from operations of $2,973, the cumulative effect of the change in Stratasoft’s method of applying the percentage of completion accounting method of $566, a gain from the adjustment of previously recorded accruals in the Telecom and Computer Products Divisions of $106, and an income tax benefit of $466. The income from discontinued operations of $420 in 2004 consisted of income from operations of $14, a gain from the adjustment of previously recorded accruals in the Telecom and Computer Products Divisions of $57, and an income tax benefit of $349.

 

Net Income (Loss).  Net income decreased $9,414 to a net loss of $7,884 from net income of $1,530, primarily due to the $5,729 noncash charge for stock option remeasurement and $3,387 increased loss from discontinued operations. Net income from continuing operations decreased to a net loss of $4,917 from a net profit of $1,110 primarily due to the $5,729 noncash charge for stock option remeasurement and increased interest and income tax expense.

 

Quarterly Results

 

The following table sets forth certain unaudited quarterly financial information for each of our last eight quarters and, in the opinion of management, includes all adjustments (consisting of only normal recurring adjustments) that we consider necessary for a fair presentation of the information set forth therein. Our quarterly results may vary significantly depending on factors such as the timing of large customer orders, timing of new product introductions, adequacy of product supply, variations in our product costs, variations in our product mix, promotions, seasonal influences and fluctuations in competitive pricing pressures. The results of any particular quarter may not be indicative of results for the full year or any future period.

 

 

One acquisition was completed in the first quarter of 2006, Datatran Network Systems, and two acquisitions were completed in the second quarter of 2005, Network Architects and InfoGroup Northwest (see Note 3 to consolidated financial statements in Part II, Item 8). The second and third quarters of 2005 also reflected large projects for Austin Independent School District and CenterPoint Energy. Growth in the locations acquired in 2005 and 2006 fueled revenue increases in the second, third and fourth quarters of 2006 combined with increased revenue growth in previously existing locations during the last half of 2006.

 

Our gross profit has fluctuated between quarters primarily due to changes in our revenue mix between products and services revenues and variations in Cisco vendor rebates. Services gross profit and gross margin varied primarily based on the level of utilization of billable technical staff and the type of service revenues generated, which can vary from period to period and result in varying levels of gross profit and gross margin. Increased products revenue in the second, third and fourth quarters of 2006 did not result in lower gross margins as was experienced in 2005 due to the larger number of smaller projects.

 

The respective timing of when vendor incentives become earned and determinable can create significant quarter to quarter gross margin fluctuations. During the fourth quarter of 2006, additional incentives of $691 were recorded as a change in estimate increasing 2006 income from continuing operations and net income. While we expect vendor incentives will remain earned and determinable in future periods, we do not have any assurance that we will continue to meet the vendor incentive criteria required to receive the incentive or that the vendor will continue to offer incentive programs during the future.

 

The unusually high selling, general and administrative expense in our first quarter ended March 31, 2005 was primarily due to a $5,729 one-time non-cash charge related to the remeasurement of stock options.

 

Net loss from continuing operations in the first quarter of 2005 reflects the $5,729 charge for the remeasurement of stock options resulting from the elimination of the InterNetwork Experts, Inc. minority interest as discussed further in Note 11 to consolidated financial statements in Part II, Item 8.

 

Critical Accounting Policies

 

Revenue Recognition

 

We have a number of different revenue sources for which revenue is recognized differently based on the following policies:

 

Products revenue occurs when products manufactured or otherwise provided by other parties are purchased and resold to a customer and product payment is not contingent upon performance of installation or service obligations. If product acceptance and payment are contingent on installation or service obligations as specified in the customer contract, revenue is not recognized until installation occurs. Revenue is recognized from the sales of hardware when the rights and risks of ownership have passed to the customer and upon shipment or receipt by the customer, depending on the terms of the sales contract with the customer. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and collectibility is reasonably assured. Amounts billed to customers for shipping and handling are classified as revenue.

 

We sell hardware maintenance contracts that are serviced and supported solely by a third party, who is the primary obligor of these contracts. There are multiple factors under EITF 99-19, but the primary obligor is a strong factor in determining whether we act as a principal or agent and whether gross or net revenue presentation is appropriate. As we have concluded that we are more of an agent in the sale of hardware maintenance contracts, revenue is reported net of the cost of the hardware maintenance contracts from the third party.

 

For arrangements where the customer agrees to purchase products but we retain possession until the customer requests shipment, or “bill and hold” arrangements, revenue is not recognized until delivery to the customer has occurred and all other revenue recognition criteria have been met.

 

Software is accounted for in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations. Revenue from the sales of software not requiring significant modification or customization is recognized upon delivery or installation. Installation services for third party software do not include significant alterations to its features or functionality. Third party software vendors provide all post-contract support for software sold. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured.

 

Technical support services revenue, consisting of remote monitoring and management of customers’ IP telephony and network infrastructure equipment and applications, is recognized ratably over the term of the underlying customer contract. Commission costs paid in advance are deferred and recognized ratably over the term of the underlying customer contract.

 

Revenue for fixed and flat fee services contracts related to customized network and IP telephony solutions are recognized under a proportional performance model utilizing an input based approach (labor hours). Our contracts function similar to a time and materials type contract and generally do not specify or quantify interim deliverables or milestones. Such service contracts encompass the design and installation of IP telephony and computer networks under which customers receive the benefit of services provided over the period of contract performance.

 

Other service revenue is earned from providing stand-alone services such as billings for engineering and technician time, installation and programming services, which are provided on either an hourly basis or a flat-fee basis, and the service component of maintenance and repair service ticket transactions. These services are contracted for separately from any product sale. Other service revenues are recognized when the service is performed and when collection is reasonably assured. Revenue arrangements generally do not include specific customer acceptance criteria. In instances where final acceptance of the system or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met.

 

Arrangements with multiple deliverables are arrangements under which a combination of products and services are provided to customers. Such arrangements are evaluated under Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” (“EITF 00-21”), which addresses certain aspects of accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. The application of the appropriate accounting guidance requires judgment and is dependent upon the specific transaction and whether the sale includes hardware, software, services or a combination of these items.

 

We enter into product and service contracts for customers that are generally considered a single arrangement and which include separate units of accounting for product and for service. Product primarily consists of IP telephony and computer network infrastructure components and third party software. Service encompasses the design and installation of IP telephony and computer networks and installation of third party software. Installation services for third party software do not include significant alterations to its features or functionality. All products and services are regularly sold separately. For products and services sold in a single arrangement, the product is typically delivered first and the related services are completed within four to six weeks. Product is shipped, billed, and recognized as revenue independent of services because:

 

 

We recognize revenue for multiple element arrangements based on the relative fair value of the separate elements. Comparable products and services are sold on a stand alone basis and under multiple element arrangements at the same prices. Stand alone pricing is vendor-specific objective evidence under EITF 00-21. Customers are not required to and frequently do not select the same vendor for product and service. The customers’ decision does not impact the pricing of the portion of the bid selected.

 

Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. Determination that the fee is fixed or determinable is based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. Accruals for estimated sales returns and other allowances and deferrals are recorded as a reduction of revenue at the time of revenue recognition. These provisions are based on contract terms and prior claims experience and involve significant estimates. If these estimates are significantly different from actual results, our revenue could be impacted.

 

We maintain allowances for doubtful accounts receivable for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required.

 

Credit and collections policy inherent in our revenue recognition policy is the determination of the collectibility of amounts due from our customers, which requires us to use estimates and exercise judgment. We routinely monitor our customer’s payment history and current credit worthiness to determine that collectibility is reasonably assured and, then in some instances, require letters of credit in support of contracted amounts.

 

This requires us to make frequent judgments and estimates in order to determine the appropriate period to recognize a sale to a customer and the amount of valuation allowances required for doubtful accounts. We record provisions for doubtful accounts when it becomes evident that the customer will not be able to make the required payments either at contractual due dates or in the future. Changes in the financial condition of our customers, either adverse or positive, could impact the amount and timing of any additional provision for doubtful accounts that may be required.

 

Vendor Incentive Recognition

 

We participate in vendor incentive programs, including a significant vendor incentive program with our primary vendor, Cisco. These incentives are generally earned based on sales volume and customer satisfaction levels. The amounts earned under these programs are accrued when they are deemed probable and can be reasonably measured; otherwise, they are recorded when they are declared by the vendor or the cash is received, which ever is earlier. As a result of these estimates, the amount of rebates declared by the vendor, or the amount of rebates received in cash, the effect of vendor incentives on cost of goods can vary significantly between quarterly and annual reporting periods. Failure to achieve the requirements set by the vendor to earn a particular incentive could result in us not receiving a vendor incentive and result in lower gross margin on our product sales revenue. The incentives are recorded as a reduction of cost of goods. Selling, general and administrative expenses are increased for any associated commission expense and payroll tax related to the incentives.

 

Share-Based Compensation Expense

 

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”) which requires the measurement and recognition of compensation expense based on estimated fair values for share-based payment awards. SFAS 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R. We have utilized the guidance of SAB 107 in the adoption of SFAS 123R.

 

SFAS 123R requires all share-based payments to be recognized in the results of operations at their grant-date fair values. We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our 2006 fiscal year. Under this transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. In accordance with the modified prospective method of adoption, our results of operations and financial position for prior periods have not been restated.

 

We use the Black-Scholes option pricing model to calculate the grant-date fair value of an award. The fair value of options granted during the 2006, 2005 and 2004 periods were calculated using the following estimated weighted average assumptions:

 

 

Expected volatility is based on historical volatility over the period IP communications solutions was our primary line of business. Beginning in 2006, we used the simplified method outlined in SAB 107 to estimate expected lives for options granted during the period. The risk-free interest rate is based on the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected term assumption. We have not historically issued any dividends and do not expect to in the future.

 

We use the straight-line attribution method to recognize expense for unvested options. The amount of share-based compensation recognized during a period is based on the value of the awards that are ultimately expected to vest. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We will re-evaluate the forfeiture rate annually and adjust it as necessary, and the adjustments could be material.

 

Liquidity and Capital Resources

 

Sources of Liquidity

 

Our principal sources of liquidity are collections from our accounts receivable and our credit facility with Castle Pines Capital (the “Credit Facility”), which we believe are sufficient to meet our short-term and long-term liquidity requirements. We use the Credit Facility to finance the majority of our purchases of inventory, and to provide working capital when our cash flow from operations is insufficient. In 2006, we experienced negative cash flow from operating activities of continuing operations of $26 and negative cash flow from discontinued operations of $684. During 2006 the increase in use of our Credit Facility and cash flow from operations approximated the increase in accounts receivable and inventory. Our working capital increased slightly to $7,632 at December 31, 2006 from $7,392 at December 31, 2005.

 

Accounts Receivable.  The timing of our collection of accounts receivable and payments of our accounts payable is one of the principal influences on our cash flow from operations. We typically sell our products and services on short-term credit terms. We try to minimize our credit risk by performing credit checks, obtaining letters of credit in certain instances, and conducting our own collection efforts. Our accounts receivable, net of allowance for doubtful accounts, were $42,424 and $24,903 at December 31, 2006 and 2005, respectively. The increase in accounts receivable was attributable to significantly increased sales in the fourth quarter of 2006 compared to 2005.

 

Inventory.  We had inventory of $1,157 and $79 at December 31, 2006 and 2005, respectively. The higher level of 2006 inventory is attributable to customer orders to be shipped in the first quarter of 2007. We try to minimize the amount of inventory on hand to reduce the risk that the inventory will become obsolete or decline in value. We are able to do this by relying on the ready availability of products from our principal suppliers. As noted above, we rely principally on our Credit Facility to finance our inventory purchases.

 

Accounts Payable.  We rely on our Credit Facility to finance a substantial portion of our trade accounts payable under terms ranging from 30 to 60 days. Credit Facility balances within terms are non-interest bearing and classified as accounts payable in our balance sheet. Credit Facility balances outstanding in excess of terms are interest bearing and classified as notes payable in our balance sheet. Our accounts payable were $28,798 and $13,825 at December 31, 2006 and 2005, respectively. The increase in accounts payable was attributable to significantly increased purchases directly related to increased sales in the fourth quarter of 2006 compared to 2005.

 

Contractual Obligations

 

Our contractual cash obligations with terms in excess of one year consist of lease obligations, substantially all of which are for office space. All notes payable and other debt, including our Credit Facility discussed above, have remaining terms of less than one year. The following table summarizes contractual cash obligations with terms in excess of one year as of December 31, 2006:

 

 

Purchase obligations represent contractual requirements under a software license agreement. We do not have material purchase obligations for inventory. We purchase inventory to fulfill in-hand orders from customers and we

try to minimize the amount of inventory on hand to reduce the risk that the inventory will become obsolete or decline in value. We are able to do this by relying on the ready availability of products from our principal suppliers.

 

We expect to be able to meet our contractual cash payment obligations by their due dates through cash generated from operations, augmented, if needed, by borrowings under the Credit Facility.

 

Credit Facility.  We have a $40.0 million senior credit facility with Castle Pines Capital LLC (“CPC”) to provide inventory financing and to fund working capital requirements. Key terms of the Agreement are summarized as follows:

 

 

As of December 31, 2006, borrowing capacity and availability were as follows (amounts in thousands):

 

 

The “unused availability” is the amount not borrowed, but eligible to be borrowed. The borrowing base restrictions generally restrict our borrowings under the Credit Facility to 85% of the eligible receivables, 100% of our Floorplanned inventory and 75% of Cisco vendor rebates receivable.

 

We use the Credit Facility to finance purchases of Cisco products from Cisco and from certain wholesale distributors. Cisco provides 60-day terms, and other wholesale distributors typically provide 30-day terms. Balances under the Credit Facility that are within those respective 60-day and 30-day periods (the “Free Finance Period”) do not accrue interest and are classified as accounts payable in our balance sheet. We refer to non-interest bearing balances as “inventory floor plan borrowings”.

 

To the extent that we have credit availability under the Credit Facility, it gives us the ability to extend the payment terms past the Free Finance Period. Amounts extended past the Free Finance Period accrue interest and are classified as notes payable on our balance sheet. These extended payment balances under the Credit Facility accrue interest at the prime rate (8.25% at December 31, 2006) plus 0.5%.

 

As defined in the Credit Facility there are restrictive covenants that are measured at each quarter and year end. These covenants require us to:

 

 

 

At December 31, 2006, we were in compliance with the loan covenants, and we anticipate that we will be able to comply with the loan covenants during the next twelve months. If we violate any of the loan covenants, we would be required to seek waivers from CPC for those non-compliance events. If CPC refused to provide waivers, the amount due under the Credit Facility could be accelerated and we could be required to seek other sources of financing.

 

Cash Flows.  During 2006, our cash decreased by $802. Operating activities used $710, investing activities used $2,606 and financing activities provided $2,514.

 

Operating Activities.  Operating activities used $710 in 2006 as compared to providing cash of $8,050 in 2005 and using cash of $10,488 in 2004. Adjustments for non-cash-related items of $1,991 included $1,178 from depreciation and amortization, $415 from share-based compensation, and $316 from discontinued operations, net of tax.

 

Changes in asset and liability accounts used $3,212. The most significant source was accounts payable which increased $14,981 from increased purchases of product for resale to our customers. Significant uses of cash were increased accounts receivable of $17,584 resulting from growth in the business and increased inventory of $1,053 for customer orders shipping in the first quarter of 2007.

 

Discontinued operations used $684 in cash due to operating losses, partially offset by the collection of accounts and notes receivable.

 

Investing Activities.  Investing activities used $2,606 in 2006 compared to the use of $5,084 in 2005 and $931 in 2004. Investing activities related to cash paid for acquisitions were $2,177 in 2006 and $4,562 in 2005. Our investing activities related to capital expenditures in all three years were primarily related to purchases of computer equipment and software, and to a lesser degree, leasehold improvements. Discontinued operations provided cash from investing activities of $1,492 as a result of the sales of Stratasoft and Valerent during 2006 compared to using cash of $77 and $89 for capital expenditures in 2005 and 2004, respectively.

 

Financing Activities.  Financing activities provided $2,514 compared to using $5,344 in 2005 and providing $14,145 in 2004. Borrowings under the Credit Facility provided cash of $1,886 in 2006, used cash of $5,658 in 2005, and provided cash of $6,423 in 2004. Proceeds from an offering of equity securities provided $7,548 in 2004. Our changes in stock price resulted in stock option holders exercising stock options, which provided $613, $209, and $280 in 2006, 2005, and 2004, respectively.

 

Recent Accounting Pronouncements

 

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides related guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. FIN 48 is effective beginning January 1, 2007. The adoption of FIN 48 is not expected to have a material effect on the Company’s financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact on the Company’s consolidated financial statements.

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108 provides guidance on the consideration of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The staff believes registrants must quantify the impact of correcting all misstatements, including both carryover and reversing effects of prior year misstatements, on the current year consolidated financial statements. The staff prescribes two approaches to assessing the materially of misstatements; the “rollover” approach, which quantifies misstatements based on the amount of error originating in the current year

income statement and the “iron curtain approach”, which quantifies misstatements based on the effects of correcting the cumulative effect existing in the balance sheet at the end of the current year. If under either approach, misstatements are deemed material, we are required to adjust our financial statements, including correcting prior year financial statements, even though such correction was and continues to be immaterial to the prior year financial statements. Correcting prior year financial statements for immaterial errors would not require us to amend previously filed reports, rather such corrections may be made the next time we file our prior year statements.

 

Since inception the Company recorded audit professional fees in the year under audit and tax professional fees in the year for which the tax returns were filed. Generally accepted accounting principles require audit and tax professional fees to be expensed as incurred, which are primarily in the year subsequent to the year under audit or year for which tax returns are filed. Prior to 2006, the difference between the two methods was immaterial to the Company’s financial position and results of operations. Applying the guidance of SAB 108, the Company corrected its accounting for audit and tax fees in 2006 by reducing the January 1, 2006 retained deficit in the amount of $125 for the cumulative effect of the correction.

 

Interest Rate Risk

 

We attempt to manage our borrowings under the Castle Pines Capital Facility (“Facility”) to minimize interest expense. The interest rate of the Facility is the prime rate plus 0.5% (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”). During the year ended December 31, 2006, the interest rates of borrowings under the Facility ranged from 7.75% to 8.75%. A one percent change in variable interest rates will not have a material impact on our financial condition.

 

INX INC.

 

INDEX TO FINANCIAL STATEMENTS

AND FINANCIAL STATEMENT SCHEDULE

 

 

To the Stockholders of INX Inc.:

 

We have audited the accompanying consolidated balance sheets of INX Inc. (formerly I-Sector Corporation) (a Delaware corporation) and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. 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 audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of INX Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 2 to the consolidated financial statements, effective January 1, 2006 the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments.” Also as discussed in Note 2 to the consolidated financial statements, the Company recorded a cumulative effect adjustment as of January 1, 2006, in connection with the adoption of SEC Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.”

 

 

Houston, Texas

February 27, 2007

INX INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these consolidated financial statements

INX INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS