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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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, 2007 as reported on the Nasdaq Capital Market was approximately $46,226,246.

 

The number of shares of common stock, $0.01 par value, outstanding as of February 29, 2008 was 7,561,181.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement for the registrant’s 2008 Annual Meeting of Shareholders have been incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

INX Inc. and Subsidiaries

 

FORM 10-K
For the Year Ended December 31, 2007

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 1A. 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 Internet Protocol (“IP”) network-based solutions for enterprise-class organizations such as corporations, schools and federal, state and local governmental agencies. Our solutions consist of network infrastructure, IP voice and video communications systems, wireless network connectivity, network storage systems, data center, and network and data security. Our network infrastructure and IP voice and video communications solutions are based primarily on Cisco Systems, Inc. (“Cisco”) technology. We provide our customers with both planning, design and implementation professional services as well as managed 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 planning, designing, implementing and supporting these IP network-based systems for enterprises, we believe we are well positioned to deliver superior solutions to our customers and well positioned to provide our customers with the best possible support of the solutions we provide.

 

Internet Protocol (“IP”) is the network data communications protocol deployed in the substantial majority of enterprise organization networks worldwide. Implementing voice over the IP network (“VoIP) is gaining widespread acceptance within enterprise organizations. In addition to voice communications, video communications are increasingly being deployed on the IP network. The convergence of data, voice, and video into a single seamless IP communications infrastructure is increasingly responsible for driving business benefits through improved productivity and cost savings. The foundation of a converged communications platform is a robust, secure, high-performance, high-availability IP network infrastructure. The call processing (telephone call set-up and tear-down) for a VoIP system is a software product commonly referred to as a “soft switch”. Prior to Cisco entering the market for telephone systems in approximately 1999, Avaya and Nortel were the market share leaders in the enterprise market for business telephone systems. Today, Cisco is the worldwide market share leader for telephony systems for enterprise-class organizations according to third party research. Microsoft announced in early 2007 that they were developing a soft switch technology, and it is widely anticipated that Microsoft will also become a major industry participant.

 

Increasingly, network attached storage (“NAS”) and storage area networks (“SAN”) are being “IP connected” and communicated with through IP network technology rather than through fibre channel network technology. This is due in part to the cost advantages of using existing, standard IP network rather than a dedicated fibre channel network and in part to the increasing popularity of “virtualization” of servers and data centers. VMware and other similar products allow servers to be “virtualized” to improve utilization of the investment an organization has made in server processing power resources by allowing an application to utilize the processing power of multiple servers on a network to perform large processing tasks. Virtualization is contributing to increasing popularity of IP network-connected network storage systems and servers through the use of iSCSI, a protocol that allows servers to

connect to network storage systems using standard IP network infrastructure rather than specialized fibre channel cabling. This allows the various virtualized servers and data storage devices used in a virtualized environment to communicate together no matter where they are physically located using standard IP network connectivity. Virtualization of the data center is also contributing to increased network data traffic due to the requirement to send data across the network to the various servers that are processing data in a virtualized server environment.

 

The trend towards the use of voice and video on the network and the use of IP-connected data storage devices and servers is driving the need for increased network bandwidth as well as a requirement that organizations’ network architecture be optimized for the manner in which the network is being used by the organization. Voice and video are sensitive to network delay, jitter and packet dropping. Server-to-server and server-to-storage-device communications have other desired network communications attributes. Quality of service (“QoS”) is a term used to describe the achievement of a previously determined and programmed priority on the network to various network applications, users or data flows, or to guarantee a certain level of performance to a data flow, and to optimize network performance for various network applications in the increasingly complex manner in which the IP network is being used by enterprise organizations.

 

Data and network security is becoming increasingly complex. Increasing use of wireless connectivity to organization’s networks, increasing numbers and types of devices connecting to the network, and the use of server and data center virtualization technology are all contributors to an increasingly complex network security environment.

 

IP network technology itself is changing; the manner in which the IP network is being used by enterprise organizations is changing and becoming more complex; and enterprise organizations are becoming more and more reliant upon the IP network. We believe this is creating an increasing desire by enterprise organizations to work with a focused technology solutions provider that possess expert skills in the increasingly complex areas of network infrastructure, unified communications, network data storage and network security. We also believe that enterprise organizations are increasingly appreciative of a technology solutions provider that is willing to take a proactive consultative approach, learning the customer’s environment and goals, and their strategic and tactical needs, rather than simply attempting to sell products and engineering resources.

 

The solutions we offer include planning, design, implementation and support of LAN/WAN routing and switching infrastructure, unified communications, network storage and data center management, wireless network connectivity and security. We offer a full suite of advanced technology solutions that support the entire life-cycle of IP network-based systems. Our solutions are designed with the complete life-cycle of our customer’s investment in IP network-based systems in mind. Within a finite set of practice areas, we have standardized our planning, design, implementation, and support offerings to drive a reliable and scaleable set of solutions that can be tailored to meet the business objectives of our clients. We believe we are well positioned to take advantage of the trend towards the IP network becoming the primary technology platform for virtually all enterprise communications because of our substantial focus, technical expertise and experience.

 

We currently have fourteen physical offices, which are located in Texas, California, Idaho, Massachusetts, New Mexico, Oklahoma, Oregon, Washington and Washington DC. We primarily market to “mid-tier” enterprise-class organizations with approximately 200 to 20,000 users of technology that are 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, but we also sell network storage products manufactured by Network Appliance, certain unified communications products from Microsoft, and various products that are “best-of-breed” in certain areas of the solutions that we provide, including products from Avotus, Cistera Networks, Converged Access, IPCelerate, Riverbed, Tandberg, VMWare and others.

 

Our services revenues are derived from two principal types of services: professional services, which include planning, design and implementation engineering services, and post-sale support services, which consist of remote monitoring and managed services for enterprise network infrastructure. In 2007, 2006 and 2005, products made up 86.7%, 86.7% and 88.1% of total revenue and services made up 13.3%, 13.3% and 11.9% of total revenue.

Industry

 

IP Telephony, Voice over IP, Convergence and Unified Communications

 

“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”), and a software product that handles the call processing (telephone call set-up and tear-down), commonly referred to as “soft switch” to replace the telephony functions performed by an organization’s PBX telephone system. The terms “Voice over IP” and “VoIP” are used to describe the process of utilizing the IP network to perform voice communications. “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. The term “unified communications” is a term used to describe a unified environment for e-mail, voicemail, instant messaging, voice and video communications functionality on a single, unified platform or system. “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 unified communications allows enterprises to reap other benefits of participating in the growing trend of convergence.

 

Historically, different types of communications were conducted by different means:

 

 

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

 

Implementation of unified communications on the IP network can offer both significant long-term cost savings and increased productivity to enterprises. Some of the potential long-term savings that an enterprise might experience include:

 

 

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. Implementation of IP telephony 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, video compression technology is further improved, and as high quality touch screen video endpoints become less expensive, we believe that integrated voice and video communications will become more popular.

 

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 enterprise 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 be set up to be capable of prioritizing and allocating the use of system resources between voice and data to achieve the QoS required for voice and video communications. As video becomes an increasingly popular component of business communications, network load will increase substantially due to the substantial network bandwidth required for video communications, and this trend will contribute to an increasing need for network routing and switching upgrades in the future.

 

Historically, Avaya and Nortel were the market share leaders in telephone systems for enterprise organizations; however, after entering the market in 1999 and evangelizing the advantages of VoIP, Cisco is now the market share leader. Most business telephone systems manufacturers are migrating their offerings to VoIP technology, and a number of new manufacturers have entered the market over the past several years. Early in 2007, Microsoft announced that they were in the process of developing a soft switch platform that would integrate the popular Microsoft Exchange contact and email management functionality with VoIP telephone technology. It is widely anticipated that Microsoft, once they have a viable product, will also become a major market share participant for IP telephony soft switch technology.

 

No matter which manufacturer wins or looses market share in the soft switch and desktop telephone handset markets (which may be different vendors in the future), the network must still be upgraded to accommodate the demands of voice over the IP network. Because Cisco has a substantial market share lead over all other network equipment manufacturers combined within the enterprise-class organization space, and because upgrading of the network infrastructure is essential to deploying unified communications, we believe that possessing a high degree of Cisco focus and expertise is important as a provider of unified communications solutions.

 

Network Storage and the Virtualization of the Data Center

 

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, and to provide seamless failover capability. 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. Storage requirements continue to grow at a dramatic pace as business process continues to depend on its applications. Networked storage improves availability and scalability, facilitates a tiered-storage approach, and reduces storage management complexity and cost.

 

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.

 

The use of products such as VMWare are allowing the data center to be virtualized, so that an enterprise organization’s investment in server processing power can be more fully utilized. While there are many benefits of server virtualization, there is also a cost in terms of increased load on the network, as data must be transported across the network to the various servers involved in processing data for any given application in a virtualized environment, and virtualization introduces additional security complexities.

 

The use of remote data duplication and replication for the purpose of data backup and automated and transparent failover capability is made possible by a network that is capable of transporting the huge volumes of data necessary to accomplish replication, and is another source of rapidly increasing network load and demand for network storage capacity.

 

Wireless Network Access and Mobility

 

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 common. Although wireless network connectivity is on the way to becoming almost as readily available as electrical power and phone service, deployment of these pervasive wireless networks through the enterprise presents myriad 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 use. 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 a wireless access point to an open port on an enterprise organization’s network.

 

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.

 

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:

 

 

 

Well designed enterprise-class security solutions address the organizations’ needs by weaving security throughout the information and communications technology infrastructure going much farther than simply securing the network edge.

 

Ramifications of Industry Trends

 

We believe the IP network is evolving into what we refer to as a “business ready network” environment. Traditionally, an enterprise organization’s network infrastructure was focused on achieving best-efforts connectivity between computers as its initial goal of “networking”. As reliable, quality connectivity has been achieved, business requirements have surpassed the desire for mere connectivity. Enterprise organizations today demand more from their IP network than ever before, while at the same time their organization’s success or failure is more dependent upon their IP network than ever before.

 

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 “system” 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 evolution towards what we refer to as the business ready network involves providing business essential functionality through a network of converged infrastructure “synergistic devices.” As the network becomes the focal point of mission-critical communications and applications it must be fully available, with minimal downtime. The business ready 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 QoS and deterministic routing to applications that require them.

 

Historically, the networking industry has treated network operations as “a sum of individual parts” that have not operated holistically. The approach was to create point product solutions through the creation of individual products designed to solve single problems, one at a time. These products demanded individual administration, management, maintenance, sparing, and optimization that created a challenging and expensive-to-maintain infrastructure.

 

We believe IP network infrastructure is moving 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 more fully cooperating system that is flexible, stable, predictable and more easily managed. This requires 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.

 

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

 

While the network is becoming more complex, enterprise organizations are becoming more and more dependent upon the network to deliver critical services such as their telephone communications and computer connectivity. We believe the only way to achieve 99.999% availability of all services dependent upon on the increasingly complex network and ensure desired levels of security is to have all network devices remotely monitored and managed such that issues can be identified and resolved before the issues become problems, and problems in turn become network failures. While enterprise organizations have not historically remotely monitored and managed their networks, we believe this is changing as organizations realize how much more their organization is dependent upon the IP network than was the case even just a few years ago.

 

Our Business

 

We serve enterprise-class organizations to intelligently deploy and support advanced IP network-based systems 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, unified communications, network security, network storage, wireless connectivity and other advanced network technologies.

 

As one of the earliest entrants to VoIP integration and support, we have successfully deployed and supported unified communications solutions for a large and diverse customer base. We offer a complete range of products and services for Cisco-centric IP network and IP telephony solutions. As the market for IP telephony solutions for enterprises matured from testing to full scale deployment over the last several years, we evolved our business model to offer a comprehensive post-implementation support offering in the form of a managed services offering through which we remotely monitor and manage our customer’s networks and network-dependent systems.

 

As the market has matured, the network has evolved to become the platform for virtually all enterprise communications. As this occurred we came to believe that offering a comprehensive range of products and services to our customers was critical in differentiating us from our competitors. Increasingly, our customers were asking us to not only design, upgrade and support their network and to implement voice on the network, but to also provide wireless connectivity solutions, network storage solutions, server virtualization, and to design and implement a network security solution that would provide comprehensive and effective security across their increasingly complex network. And customers increasingly demanded that the network be supported in a manner that would virtually guarantee high availability of the network and network dependent systems.

 

Today, we deliver a suite of advanced technology solution sets that address enterprise customer’s needs in a comprehensive manner, using a consultative approach. We derive revenue through the resale of technology products manufactured by a limited number of best-in-class vendors and through providing professional services and managed services.

 

Products

 

We generate revenue from the sale of products. The products we sell consist principally of Cisco brand products, but we also sell network storage products manufactured by Network Appliance, certain unified communications products from Microsoft, and various products that are best-of-class in certain areas of the solutions that we provide, including products from Avotus, Cistera Networks, Converged Access, IPCelerate, Riverbed, Tandberg, VMWare and others.

 

Gross margin on product sales was 17.6%, 18.6% and 15.7% for 2007, 2006 and 2005, respectively. Product sales revenue grew 33.3%, 43.1% and 45.0%, and made up 86.7%, 86.7% and 88.1% of total revenue in 2007, 2006 and 2005, 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 28.6%, 25.9% and

29.2% for 2007, 2006 and 2005, respectively. Services revenue grew 33.6%, 62.3% and 103.0%, and made up 13.3%, 13.3% and 11.9% of total revenue in 2007, 2006 and 2005, respectively.

 

Professional Services

 

We perform professional services related to the planning, design, implementation and support of the solutions that we provide. These services include planning, design, implementation and support of VoIP, LAN/WAN routing and switching, data management, wireless access/mobility, and network security. To provide these services, we employ highly trained and experienced engineering staff. We have developed not only substantial expertise in the various areas technology that we provide, but also methodologies for designing and implementing the solutions that we provide.

 

Gross margin on our implementation services revenue was 28.2%, 25.5% and 29.1% for 2007, 2006 and 2005, respectively. Implementation services revenue grew 30.4%, 54.1% and 96.6%, and made up 86.0%, 88.2% and 92.9% of total services revenue in 2007, 2006 and 2005, respectively.

 

Managed Services

 

We provide managed services, including remote monitoring and management of enterprise organizations’ network infrastructure, data center, wireless network and security technology.

 

In our view, there are essentially two primary support models offered by most competitors for IP telephony: the model used to support traditional PBX systems and the model used to support data networks. We believe that neither 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. Our managed services include remote monitoring, diagnostics and management of the customer’s IP telephony and network infrastructure equipment and related applications. These managed 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 issues either real time or through reporting, and we solve detected problems either remotely or onsite.

 

Several years ago, during the early stages of the move towards the adoption of IP telephony as the standard for voice communications, customers were only testing IP telephony technology, rather than utilizing IP telephony enterprise-wide for their primary voice communication system. During this period post-implementation support services were not a high priority for those customers. As customers transition to the full implementation of IP telephony, and as they become increasingly concerned about their growing dependency upon the IP network, we believe that post-implementation support that ensures high availability of their converged IP communications infrastructure and critical IP network-dependent systems is becoming 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 solutions provider. Through our managed services offering we believe we are well positioned to provide support services that enterprise-class organizations desire and require.

 

Gross margin on our managed support services revenue was 30.5%, 29.1% and 29.9% for 2007, 2006 and 2005, respectively. Managed support services revenue grew 58.0%, 169.8% and 255.3%, to make up 14.0%, 11.8% and 7.1% of total services revenue in 2007, 2006, and 2005, respectively.

 

Competition

 

Our competition for the solutions we provide 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, data management solutions, mobility solutions and security solutions, as well as 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, as well as many smaller regional systems integrators.

 

We believe that the principal competitive factor when marketing our 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 the manufacturer of the major products being supplied as a part of the solution.

 

We believe that customers appreciate technical focus and expertise, as well as size and broad geographic presence when choosing a key advanced technology solutions provider. Having grown from a regional Texas-focused organization several years ago, to a national-scope organization today, and having acquired several smaller regional organizations, we have witnessed first-hand the benefits of having a national presence. National presence has been a factor in our ability to win relationships with a number of larger, national-scope customers, who desired a national-scope solutions provider. We believe that smaller regional competitors are at a disadvantage, not only because of their lack of a national presence, but also because of typically smaller financial capacity and depth and breadth of technical resources. At the same time, we believe we have an advantage over many large national-scope solutions providers because of our focus and expertise as compared to what is often times a generalist, unfocused technology solutions provider, who while large, lacks the ability to deliver to the customer a team of subject matter experts and methodologies for a project as important as the design and upgrade of their advanced technology network and network-based technology systems.

 

The market for the solutions that we provide 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 corporate administrative offices are located in Houston, Texas and our corporate operations offices are located in Dallas, Texas. As of February 29, 2008 we maintained branch offices in the following fourteen markets:

 

 

Our Washington, DC branch office markets primarily to the federal government. Three of our fourteen branch offices have been opened or acquired during 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 thirty-three months we made four acquisitions that added seven additional branch offices and opened two 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 six months to eighteen months 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

 

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”. Today our customers are typically medium- to larger-sized corporate organizations, schools and governmental agencies with approximately 200 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 plan to target selling to even 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. 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. In 2006 we decreased our focus on these types of transactions and this category of customers represented a substantially reduced portion of our total business in 2006 and 2007.

 

No single customer represented 10% or more of our revenue for the years ended December 31, 2007 and 2006. We had one customer that represented 10% or more of our revenue for the year ended December 31, 2005. 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% of our consolidated revenue for the year ended 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 29, 2008 we employed approximately 342 people. Of these, approximately 108 were employed in sales, marketing and customer service, 146 were employed in engineering and technical positions and 88 were employed in administration, finance and management information systems. 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

 

Prior to 2006, our second and third quarters were 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 was deemphasized starting in 2006. Thus, we expect less of an impact from educational customers and therefore, past seasonal strength in the second and third quarters due to the education customer factor 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 (“IT”) 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. Reports filed with the SEC may also be viewed at www.sec.gov or obtained at the SEC Public Reference Room in Washington, D.C. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.

 

 

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

 

While we have generated positive operating profits for the past two years, we incurred a net loss from continuing operations in 2000, 2001, 2002 and 2004. 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, which we cannot provide assurance of. 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 consistently profitable on a quarterly basis during less than the past two years, 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 to eighteen months or more. Whether we are able to remain profitable in the future will depend on many factors, but primarily upon the commercial acceptance of the technologies and product lines that we promote the use of, including, importantly, the network routing and switching products and IP telephony products 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, 2007, 2006, and 2005 was derived from or dependent upon 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.

 

A substantial portion of our revenue is derived directly from or dependent upon our customer implementing 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 the advanced technology products and services we offer.

 

As a supplier of advanced technology solutions for enterprises, our business depends on the level of capital spending for such solutions by enterprises in our markets. We believe that an enterprise’s investment in advanced technology systems such as network infrastructure, IP telephony, wireless networking, network data storage and network security, and related 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 the solutions we provide may continue to grow at a modest rate or not at all, or may decrease. If our customers decrease their level of spending our revenue and operating results would likely be adversely affected. In the latter part of 2007, and continuing into early 2008, we witnessed decreased spending by customers due to what we believe was uncertainty surrounding the status of the U.S. economy. To the extent that customers continue to delay moving forward with projects because of actual or perceived economic uncertainty, our revenue and profitability will be negatively impacted.

 

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 $7,200, $6,303 and $2,876 in 2007, 2006 and 2005, respectively, representing 3.5%, 4.0%, and 2.7% 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.

 

Until mid-2005 we were primarily a Texas-based organization and the majority of our customers were in Texas. While we are much less dependent upon Texas customers now than we were two years ago, a substantial portion of our customers are still based in Texas. Therefore, our revenue and therefore our profitability would be materially affected by a downturn in economic conditions in Texas, in addition to any general economic downturn in the United States. If demand for the products and services we provide to customers 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 the advanced technology solutions we provide. 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 the advanced technology solutions that we provide 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 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, financial condition and results of operations.

 

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 advanced technology solutions 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, which would have an adverse affect on our business, financial condition and results of operations.

 

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 generally 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 are extremely competitive and subject to rapid change. Substantial growth in demand for the advanced technology products we provide has been predicted by industry analysts, and we therefore expect competition to increase as existing competitors enhance and expand their products and services and as new participants enter the market. A rapid increase in competition could negatively affect the amount of business that we obtain and the prices that we are able to 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. A material and/or rapid increase in competition would likely have an adverse affect on our business, financial condition and results of operations

 

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 3.7%, 4.9% and 3.5% for 2007, 2006 and 2005, 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, our President and Chief Operating Officer, Mark Hilz, and our Vice President and Chief Financial Officer, Brian Fontana. 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 maintenance or 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 advanced technology solutions and to provide the services we provide to our customers. 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 advanced technology solutions, 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.

 

 

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 14 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 2,000 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 15 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 2007.

Family Relationships

 

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

 

 

Market Information

 

Beginning September 21, 2007, our common stock and warrants began trading on the Nasdaq Global Market. From April 24, 2006 to September 20, 2006, our common stock and warrants traded on the Nasdaq Capital Market. Trading of our common stock and warrants on the Nasdaq markets is under the symbols “INXI” and “INXIW”, respectively. From December 29, 2003 until April 23, 2006, our common stock has traded on the American Stock Exchange under the ticker symbol “ISR”. From June 8, 2004 until April 23, 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 29, 2008, we had 134 stockholders of record of our common stock. On February 29, 2008, the closing sales price of our common stock and warrants as reported by the Nasdaq Global Market was $8.09 per share and $0.55 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, 2007:

 

 

 

Equity incentive plans are further discussed in Note 11 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, 2002, 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 COMPOSITE 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.

 

Issuer Purchases of Equity Securities

 

The following table provides information regarding repurchases by the Company of its common stock during the fourth quarter ended December 31, 2007:

 

 

Effective December 4, 2007, the Board of Directors authorized the repurchase of up to $2,000 of the Company’s common stock on or before March 31, 2008. These repurchases were required to be made in open market or privately negotiated transactions in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended, subject to market and business conditions, applicable legal requirements and other factors. The plan also requires the repurchased shares to be retired as soon as practicable following the repurchase. The plan did not obligate the Company to purchase any particular amount of common stock, and could be suspended at any time at the Company’s discretion.

 

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 Internet Protocol (“IP”) network-based solutions for enterprise-class organizations such as corporations, schools and federal, state and local governmental agencies. Our solutions consist of network infrastructure, IP voice and video communications systems, wireless network connectivity, network storage systems, data center, and network and data security. Our network infrastructure and IP voice and video communications solutions are based primarily on Cisco Systems, Inc. (“Cisco”) technology. We provide our customers with both planning, design and implementation professional services as well as managed 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 planning, designing, implementing and supporting these IP network-based systems for enterprises, we believe we are well positioned to deliver superior solutions to our customers and well positioned to provide our customers with the best possible support of the solutions we provide.

 

The market for the advanced technology solutions we provide 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, Idaho, Massachusetts, New Mexico, Oklahoma, 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. In 2007, 2006 and 2005, sales of products made up 86.7%, 86.7% and 88.1% of total revenue and services revenues made up 13.3%, 13.3% and 11.9% 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 17.6%, 18.6% and 15.7% for 2007, 2006 and 2005, respectively, and our gross margin on service revenue was 28.6%, 25.9% and 29.2% 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 post-sale managed support services revenue continues to increase at a more rapid rate than our professional services revenue. This is because our cost of providing managed 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 to eighteen months or more. 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. 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. However, during 2007 we focused on organic growth of our existing offices and acquisitions to produce growth in order to improve operating profit margin, which we were successful in doing. In 2008 we anticipate that we will continue to favor acquisitions as the preferred method of geographic expansion, but we will continue to look at opportunities to open new offices in new markets on a case-by-case basis.

 

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 and thus vary in correlation with gross profit for any given period. Based on our sales commission plans, we expect variable sales commissions to be approximately 21% to 25% of gross profit, which percentage can vary from period to period depending on gross profit production under our various sales commission plans, and due to variations between gross profit on a financial statement and gross profit that sales staff are paid on, which can vary due to engineering resource utilization and other factors. However, other than sales commissions, our other categories of operating expenses do not vary in direct proportion to either sales or gross profit, and 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 2007, 2006 and 2005, 86.7%, 86.7% and 88.1% of our revenue was attributable to product sales, while 13.3%, 13.3% and 11.9% 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 managed support services offering.

 

For the last three years, the largest component of our total cost of sales and service has been purchases of Cisco 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 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. 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.

 

Results of Operations

 

Overview

 

Sources of Revenue.  Our revenue consists of product and service revenue. Product revenue consists of reselling technology products manufactured by others. Cisco products represent the majority of the products we sell, but we also sell network storage products manufactured by Network Appliance and EMC, certain unified communications products from Microsoft, and various products that are “best-of-breed” in certain areas of the solutions that we provide, including products from Avotus, Cistera Networks, Converged Access, IPCelerate, Riverbed, Sagem-Interstar, Tandberg, Variphy, VMWare and others. Service revenue is generated by fees from a variety of implementation and support services. Product prices are typically set by the market for the products we sell and provide our lowest gross margins. Gross margin on service revenue varies based on the cost of technical resources and our utilization of our 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 professional services, which we believe varies somewhat in proportion to our product sales. Professional 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 professional services revenue and less volatility in the amount of quarterly professional services revenue realized. The normal sales cycle for corporate customers typically ranges from approximately 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 of the Universal Services Administrative Corporation (the “SLD”), indicates that the sales cycle for these projects is generally about six to twelve months or longer.

 

In mid-2004, INX introduced NetSurant^®, its branded managed support service that consists primarily of customer service personnel and a support center. This support service offering requires that we incur the fixed cost to operate a network operations center to monitor and manage customers’ systems. Early in the development of our managed services offering this fixed cost, as compared to the level of managed service revenue, resulted in negative gross margins from our managed service offering. As revenue improved, gross margin from our managed services offering turned positive and has improved recently. If we are successful in continuing to realize increasing levels of managed services revenue, we anticipate that our gross margin on managed services will eventually exceed our gross margin on professional services and will improve overall services gross margins. We recognize support service revenue evenly over the entire service period for the customer.

 

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 $7,200, $6,303, and $2,876 in 2007, 2006 and 2005, 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, whichever 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 professional 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, and the fact that we opened multiple new offices in the latter half of 2005 and first half of 2006 caused gross margin on our professional services to be reduced during the latter half of 2005 through the early part of 2007 . If we open new offices in new markets in the future we expect gross margin on our professional services to be negatively impacted by such new branch office operations. The extent to which total professional services gross margin will be negatively impacted will vary based on the number and size of new branch offices we open in 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. Prior to 2007, sales commissions were approximately 27% to 31% of gross profit and in 2007, sales commissions were approximately 21.5% of gross profit. 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 a Stock Purchase Agreement dated August 31, 2007 (the “SPA”), we purchased all issued and outstanding capital stock of Select, Inc. (“Select”). Located in Boston, Massachusetts, Select is a Cisco-centric solutions provider focused on delivering IP Telephony, IP Storage and network infrastructure solutions throughout New England with approximately $40,000 in annual revenues. The acquisition was completed simultaneously with the execution of the SPA. The SPA contains customary representations and warranties and requires Select’s shareholders (“Shareholders”) to indemnify us for certain liabilities arising under the SPA, subject to certain limitations and conditions.

The consideration paid at closing pursuant to the SPA was (a) $6,250 in cash, including $1,000 placed in escrow under holdback provisions defined in the SPA and (b) 231,958 shares of our Common Stock, $0.01 par value (the “Common Stock”) valued at $10.60 per share or $2,459, which amount of shares was determined by dividing $2,250 by $9.70, which is the greater of (i) average closing price per share for the Common Stock as reported by Nasdaq for the five consecutive trading days ending August 28, 2007 and (ii) $9.50. The President and major shareholder of Select entered into a five-year noncompete agreement at closing providing for equal monthly payments of $21 over two years, which were recorded at their present value of $450. Cash of $6,000 was borrowed from the Acquisition Facility under the Credit Agreement with Castle Pines Capital LLC. In connection with the stock purchase, the Credit Agreement with Castle Pines Capital LLC was amended for the modification of certain financial covenants and for the addition of Select as a party to the Credit Agreement. Broker costs and professional fees of $512 were incurred in the purchase, of which $339 was paid in cash, $50 accrued, and $123 was paid through the issuance of 11,598 shares of common stock.

 

Additional purchase consideration is payable based on the Select branch office revenue and operating profit during the two years subsequent to the date of the SPA. For the twelve-month period ending August 31, 2008, if revenue is greater than $44,000 and operating profit contribution is greater than or equal to $1,760, then we shall pay the Shareholders additional purchase consideration of $600 and will pay the Shareholders an additional $50 for each $145 of operating profit contribution in excess of $1,760 of operating profit contribution up to a maximum of $600 with aggregate maximum of $1,200 in additional purchase consideration. For the twelve-month period ending August 31, 2009, if revenue is greater than $53,000 and operating profit contribution is greater than or equal to $3,710, then we shall pay the Shareholders additional purchase consideration of $600 and will pay an additional $50 for each $150 of operating profit contribution in excess of $3,710 up to a maximum of $600 with an aggregate maximum of $1,200 in additional purchase consideration. At our option, 50% of such additional purchase price may be paid in the form of Common Stock. Additional purchase price consideration, if any, will be recorded as goodwill.

 

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 purchase price consideration valued at $500 and recorded as goodwill was paid to DNS in June 2007 for achievement of certain operating profit milestones during the twelve-month period ending February 28, 2007. The consideration consisted of a cash payment of $250 and issuance of 25,253 shares of our common stock with a value of $250. The calculation of the number of shares of common stock was determined by dividing $250 by $9.90, the average closing price per share for the common stock as reported by NASDAQ for the five consecutive trading days prior to March 1, 2007. Additionally, cash of $36 was paid to the broker of the transaction.

 

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 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 the our common stock valued at the average closing price per share as reported by NASDAQ for the five consecutive trading days ending June 28, 2006. Additional purchase price consideration consisting of 75,000 shares of our common stock, were issued to Network Architects in June 2007 for achievement of certain operating profit milestones during the twelve-month period ending May 31, 2007. The additional purchase price consideration was valued at $677, determined by multiplying the shares issued by the closing price per share for the common stock as reported by NASDAQ on June 29, 2007. The additional purchase price consideration was recorded as goodwill.

Under the terms of the Asset Purchase Agreement, we will issue Network Architects a maximum of 75,000 shares of common stock as additional purchase price consideration following the twelve-month period ending May 31, 2008 if operating profit during such period exceeds $726. 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, 2005 and 2006 and exercises of stock options, we have accumulated a net operating loss carryforward for federal income tax purposes that, at December 31, 2007, was approximately $5,650. 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 2026 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 occur, 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.

 

Deferred Tax Assets.  In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which temporary differences, as determined pursuant to SFAS No. 109, “ Accounting for Income Taxes,” become deductible. Management considers the reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Management’s evaluation of the realizability of deferred tax assets must consider both positive and negative evidence. The weight given to the potential effects of positive and negative evidence is based on the extent to which it can be objectively verified. During the fourth quarter of 2007, we reversed the valuation allowance related to the net operating loss carryforwards and other temporary items as we determined it was now more likely than not that we would be able to use the assets to reduce future tax liabilities. The reversal resulted in recognition of an income tax benefit of $535 in 2007 and a corresponding increase in the deferred tax asset on the Consolidated Balance Sheet in Part II, Item 8.

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, 2007 Compared to Year Ended December 31, 2006

 

Total Revenue.  Total revenue increased by $51,954, or 33.3%, to $207,967 from $156,013. Products revenue increased by $44,994 or 33.3%, to $180,311 from $135,317. The increase in products revenue is primarily due to four months revenue contribution of the Select, Inc. acquisition ($12,890) and growth in our Austin location ($11,900), Federal Division ($8,918), Northwest Region ($6,371), and Los Angeles location ($4,264). Services revenue increased by $6,960 or 33.6%. to $27,656 from $20,696. The increase in services revenue is primarily due to growth across substantially all locations, four months revenue contribution of the Select, Inc. acquisition, and continued growth in the NetSurant^® post-sale recurring support services revenue.

 

Gross Profit.  Total gross profit increased by $9,150, or 30.0%, to $39,647 from $30,497. Overall gross profit as a percentage of sales decreased to 19.1% from 19.5%. Gross profit on product sales increased $6,615, or 26.3%, to $31,747 from $25,132 and, as a percentage of product sales, decreased to 17.6% from 18.6%. Products gross profit percentage decreased due to lower vendor rebates as a percentage of products sales, primarily due to Cisco rebate program changes and proportionately lower vendor rebates earned on products sales by the newly acquired Boston location. Vendor rebates represented 4.0% and 4.7% of products sales in 2007 and 2006, respectively. Gross profit on services revenue increased $2,535 or 47.3% to $7,900 from $5,365 and gross profit as a percent of services revenue increased to 28.6% from 25.9%. The increase in services gross margin was the result of improved utilization of engineering staff in 2007 compared to 2006, higher NetSurant^® margins increasing to 30.5% in 2007 from 29.1% in 2006, and the positive margin impact of revenue recognized ($520) as a result of early cessation of the implementation portion of a contract with IBM Corporation.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased by $7,442, or 25.9% to $36,152 from $28,710. As a percentage of total revenue, these expenses decreased to 17.4% from 18.4%. The decrease in selling, general and administrative expenses as a percentage of sales was due to improved

leverage resulting from lower expense growth compared to revenue growth. 2007 selling, general and administrative expenses increased due to the sales and administrative costs of the newly acquired Boston location, additional sales compensation costs on substantially higher revenues, increased performance based compensation expense resulting from improved operating results, and higher professional fees due to increased audit fees and Sarbanes-Oxley consulting fees. 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.  Operating income increased $1,708 to $3,495 from $1,787, primarily due to product and service revenue increasing 33.3% compared to the 25.9% increase in selling, general and administrative expenses.

 

Interest and Other Income (Expense), net.  Interest and other income (expense), net, changed by $153 to an expense of $79 from an expense of $232 primarily due to lower average borrowings under our credit facility and increased interest income on the short-term investment of excess cash.

 

Income Tax Expense (Benefit).  Income tax expense (benefit) changed by $280 to a benefit of $236 from expense of $44. The 2007 income tax benefit resulted from the reversal of the valuation allowance related to the net operating loss carryforwards and other temporary items of $402, partially offset by federal and state income tax expense of $166. The reversal of the valuation allowance was a result of the determination that it was now more likely than not that we would be able to use deferred tax assets to reduce future tax liabilities. This tax benefit was partially offset by federal and state income tax accruals, which included $135 for the new Texas Margin Tax initially assessed for 2007.

 

Income (Loss) from Discontinued Operations, net of tax.  Income (loss) from discontinued operations increased by $399, to income of $83 from a loss of $316. Income from discontinued operations of $83 was due to the gain on sale of Valerent of $60, operating income from Valerent and Stratasoft totaling $51, less income tax expense of $28. 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.

 

Net Income.  Net income increased $2,540 to $3,735 from $1,195, primarily due to product and service revenue increasing more rapidly than increase in selling, general and administrative expenses combined with the income tax benefit of reversing the valuation allowance related to the net operating loss carryforwards and other temporary items and increased income from discontinued operations.

 

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.

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.

 

 

The Select, Inc. acquisition was completed in the third quarter of 2007 and the Datatran Network Systems acquisition was completed in the first quarter of 2006 (see Note 3 to consolidated financial statements in Part II, Item 8). The Select, Inc. acquisition contributed revenues of $3,937 and $9,601 in the third and fourth quarters of 2007, respectively. The revenue increase between the first and second quarters of 2007 was primarily a result of increased sales in our Austin, Los Angeles, and Albuquerque locations. The fourth quarter of 2007 reflected the positive margin impact of revenue recognized ($520) as a result of early cessation of the implementation portion of a contract with IBM Corporation.

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.

 

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.

 

Selling, general and administrative expenses fluctuate between quarters primarily due to variations in sales compensation directly related to fluctuations in the amount of gross profit and variations in bonus compensation due executives and managers resulting from fluctuations in quarterly profitability. The fourth quarter of 2007 included an adjustment of $167 for the accrual of vacation pay.

 

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 Emerging Issues Task Force Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” or 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 2007, 2006 and 2005 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 2007, we generated cash flow from operating activities of continuing operations of $9,997 and cash flow from discontinued operations of $28. By the fourth quarter of 2007, borrowings under the interest-bearing portion of our Credit Facility had been eliminated except for acquisition purposes. Our working capital increased to $9,583 at December 31, 2007 from $7,632 at December 31, 2006 as a result of improved operating results.

 

To give us greater flexibility to efficiently raise capital and put us in a position to take advantage of favorable market conditions as they arise, we have filed a shelf registration statement on Form S-3 for primary offerings of securities. The shelf registration provides the ability to offer and sell, from time to time, in one or more offerings, shares of our common stock and/or warrants to purchase common stock for proceeds in the aggregate amount up to $100 million. The terms of any offering under this registration statement will be established at the time of the offering and will be stated in a prospectus supplement if and when we decide to sell securities under the shelf registration statement. We currently intend to use the net proceeds from any offering under the shelf registration statement for working capital and other general corporate purposes, and to fund the acquisition of companies, businesses, technologies, products or assets, as set forth in the registration statement. However, we currently have no commitments or agreements for any specific acquisitions, nor do we have any immediate commitments or plans to offer or sell any securities under the shelf registration statement.

 

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 $45,128 and $42,424 at December 31, 2007 and 2006, respectively. The increase in accounts receivable was attributable to significantly higher sales in the fourth quarter of 2007 compared to 2006 partially offset by improved collections.

Inventory.  We had inventory of $1,439 and $1,157 at December 31, 2007 and 2006, respectively. The higher level of 2007 inventory is attributable to customer orders to be shipped in the first quarter of 2008. 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 $37,233 and $28,798 at December 31, 2007 and 2006, respectively. The increase in accounts payable was attributable to significantly increased purchases directly related to increased sales in the fourth quarter of 2007 compared to 2006.

 

Contractual Obligations

 

Our contractual cash obligations with terms in excess of one year primarily 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, 2007:

 

 

Other obligations represent contractual requirements under a noncompete agreement as discussed in Note 3 to consolidated financial statements in Part II, Item 8. 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.  On April 30, 2007, we entered into a new $50,000 senior credit facility agreement (“Agreement”) with Castle Pines Capital LLC (“CPC”) to provide inventory financing and to fund working capital requirements. The new facility with CPC replaced the $40,000 senior credit facility with CPC. Key terms of the Agreement are summarized as follows:

 

 

 

On August 1, 2007, we entered into an amendment (“Amendment”) to the above Agreement to provide an additional $10 million credit facility specifically for acquisitions (“Acquisition Facility”). Advances under the Acquisition Facility will be specific to each acquisition and subject to approval by CPC based on pre-established criteria contained in the Amendment. Key terms of the Amendment are summarized as follows:

 

 

As of December 31, 2007, we have used $6,000 of the borrowing capacity under the Acquisition Facility, which accrues interest at the rate of 9.25% (prime plus 2.0%).

 

As of December 31, 2007, borrowing capacity and availability under the Credit Facility was 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 (7.25% at December 31, 2007) plus 0.5%.

As defined in the Credit Facility there are restrictive covenants that are measured at each quarter and year end. The covenants effective January 1, 2008, require us to:

 

 

At December 31, 2007, 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 2007, our cash increased by $7,545. Operating activities provided $10,025, investing activities used $5,584 and financing activities provided $3,104.

 

Operating Activities.  Operating activities provided $10,025 in 2007 as compared to using cash of $710 in 2006 and providing cash of $8,050 in 2005. Adjustments for non-cash-related items in 2007 of $2,150 included $1,659 from depreciation and amortization and $653 from share-based compensation. Changes in asset and liability accounts provided $4,112. The most significant source was accounts receivable which provided $2,733 from improved timeliness of collections as reflected in the reduction of Days Sales Outstanding from 66 to 62. Discontinued operations provided $28 in cash, primarily from the collection of notes receivable.

 

Investing Activities.  Investing activities used $5,584 in 2007 compared to the use of $2,606 in 2006 and $5,084 in 2005. Investing activities related to cash paid for acquisitions were $4,011 in 2007, $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 in 2006 of $1,492 as a result of the sales of Stratasoft and Valerent.

 

Financing Activities.  Financing activities provided $3,104 compared to providing $2,514 in 2006 and using $5,344 in 2005. Borrowings under the acquisition credit facility established during 2007 and utilized for the Select, Inc. acquisition provided cash of $6,000. Borrowings under the Credit Facility used cash of $4,350 in 2007, provided cash of $1,886 in 2006, and used cash of $5,658 in 2005. Stock option holders exercised stock options, which provided cash of $1,449, $613, and $209 in 2007, 2006, and 2005, respectively.

 

Recent Accounting Pronouncements

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS 141R). The purpose of issuing the statement is to replace current guidance in SFAS 141 to better represent the economic value of a business combination transaction. The changes to be effected with SFAS 141R from the current guidance include, but are not limited to: (1) acquisition costs will be recognized separately from the acquisition; (2) known contractual contingencies at the time of the acquisition will be considered part of the liabilities acquired measured at their fair value; all other contingencies will be part of the liabilities acquired measured at their fair value only if it is more likely than not that they meet the definition of a liability; (3) contingent consideration based on the outcome of future events will be recognized and measured at the time of the acquisition; (4) business combinations achieved in stages (step acquisitions) will need to recognize the identifiable assets and liabilities, as well as noncontrolling interests, in the acquiree, at the full amounts of their fair values; and (5) a bargain purchase (defined as a business combination in which the total acquisition-date fair value of the identifiable net assets acquired exceeds the fair value of the consideration transferred plus any noncontrolling interest in the acquiree) will require that excess to be recognized as a gain attributable to the acquirer. The Company does anticipate that the adoption of SFAS 141R will have a future impact on the way in which business combinations will be accounted for compared to current practice. SFAS 141R is effective for the Company beginning January 1, 2009. Early adoption is not permitted. The Company is currently evaluating the impact that SFAS 141R will have on its financial statements and disclosures.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (SFAS 160). SFAS 160 was issued to improve the relevance, comparability, and transparency of financial information provided to investors by requiring all entities to report noncontrolling (minority) interests in subsidiaries in the same way, that is, as equity in the consolidated financial statements. Moreover, SFAS 160 eliminates the diversity that currently exists in accounting for transactions between an entity and noncontrolling interests by requiring they be treated as equity transactions. SFAS 160 is effective for the Company beginning January 1, 2009. The adoption of SFAS 160 is not expected to have a material impact on the Company’s consolidated financial statements.

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. It also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 does not: (a) affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value; (b) establish requirements for recognizing and measuring dividend income, interest income, or interest expense; or (c) eliminate disclosure requirements included in other accounting standards. SFAS 159 is effective for the Company beginning January 1, 2008. The adoption of SFAS 159 is not expected to have a material impact on the Company’s consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157 (“SFAS 157”), “Fair Value Measurements,” which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for the Company beginning January 1, 2009. However, on December 14, 2007, the FASB issued proposed FSP FAS 157-b which would delay the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This proposed FSP partially defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. Effective for 2008, the Company will adopt SFAS 157 except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in proposed FSP FAS 157-b. The partial adoption of SFAS 157 is not expected to have a material impact on the Company’s consolidated financial statements.

 

 

Interest Rate Risk

 

We attempt to manage our borrowings under the our senior credit facility (“Senior Facility”) and under our acquisition facility (“Acquisition Facility”) with Castle Pines Capital LLC to minimize interest expense. The interest rate of the Senior Facility is the prime rate plus 0.5% and the interest rate of the Acquisition Facility is the prime rate plus 2.0% (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, 2007, the interest rates of borrowings under the Senior Facility ranged from 7.75% to 8.75% and the interest rates of borrowings under the Acquisition Facility ranged from 9.25% to 10.25%. A one percent change in variable interest rates will not have a material impact on our results of operations or cash flows.

 

INX INC. AND SUBSIDIARIES

 

INDEX TO THE CONSOLIDATED 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, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. 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, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, 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 Payment. 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

March 5, 2008

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