Summary of XETA TECHNOLOGIES INC

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

In fiscal 2008 earnings grew 44% on growth in revenues of 20% as we shipped and installed the largest order in our history while continuing to execute on strategies to focus on our target customers, increase our services revenues, and align our sales efforts with our manufacturers' go-to-market strategies. In November 2007, we announced the award of a series of orders from Miami-Dade County Public Schools ("M-DCPS") to sell and install new communications systems at approximately 160 schools in the M-DCPS district. The order was valued at over $13 million including equipment, implementation, professional services, cabling and on-going maintenance revenues.

We also enjoyed strong growth in our lodging business as a result of the robust new construction environment through most of the fiscal year and the successful roll-out of our Mitel product and service offering. We began selling Mitel products late in fiscal 2007. Mitel products are well-established in the lodging market and we were successful during the year in capturing market share from new and existing customers as a result of carrying Mitel products.

Our services business grew 17% during the year through a combination of increased implementation revenues, primarily from the M-DCPS contract and additional growth in our managed services business. Increasing our base of recurring revenues through both direct and wholesale services offerings is one of our key strategies. The rate of growth of these revenues dropped sharply in fiscal 2008 compared to fiscal 2007 reflecting some attrition in our wholesale partners' service programs and some difficulty in landing new large programs. We are continuing to invest in the growth of this area of our business and expect improved growth rates in fiscal 2009 as we expand our presence with existing and new partners and as economic pressures increase the level of service outsourcing by end-users.

Based on current U.S. and global economic conditions and the restrictions on credit, we expect fiscal 2009 to be a challenging year. We have taken prudent steps to trim our workforce and reduce discretionary costs. We are optimistic that the challenging environment will present some opportunities for us as many end-users may choose to maintain their current systems rather than replace them, and large users give stronger consideration to out-sourcing the support of their voice networks to shed high labor costs within their organizations. Additionally, we are focusing our marketing efforts and sales calls on high return on investment applications that will help companies lower their costs in the current environment. Finally, we believe consolidation of the dealer community may accelerate as the tight economy pressures liquidity and exposes weak operating models. We are actively reviewing potential acquisitive growth opportunities and those opportunities have increased. No assurance can be given, however, that these opportunities will prove worthwhile, can be purchased at reasonable prices, and/or that we can assemble sufficient capital through combinations of senior debt facilities, equity placements, seller financing, and/or other viable methods.

The discussion that follows provides more details regarding the factors and trends that affected our financial results, liquidity, and capital resources in fiscal 2008 when compared to the previous year.

Results of Operations

FISCAL YEAR 2008 COMPARED TO FISCAL YEAR 2007.

Revenues for fiscal 2008 were $84.3 million compared to $70.1 million in fiscal 2007, a 20% increase. Net income for fiscal 2008 was $2,056,000 compared to $1,432,000 in fiscal 2007. Discussed below are the major revenue, gross margin, and operating expense items that affected our financial results during fiscal 2008.

Services Revenues. Revenues earned from our services business were $43.5 million in fiscal 2008 compared to $37.3 million in fiscal 2007, a 17% increase. This growth reflects a 10% or $2.7 million increase in recurring services revenues, a 35% or $2.8 million increase in implementation revenues, and a 24% or $619,000 increase in structured cabling revenues.

The increases in our recurring services business, which includes revenues earned from maintenance contracts and time and materials ("T&M") based charges, consisted of growth in our contract maintenance revenues of 18%, partially offset by lower T&M revenues of 9%. The growth rate in contract revenues in fiscal 2008 was lower than expected due to lower growth in commercial contract revenues. Most of our efforts to increase our services revenues are focused on our commercial services offerings, particularly our wholesale managed services offerings in which we partner with Nortel, network services companies, and systems integrators to provide a variety of technical services to our partners' end-user customers. We have invested heavily in sales and technical resources to create opportunities with current and potential

wholesale partners. Once those relationships are established, we typically market our capabilities jointly with our partners to end-users who are requesting bids for new services or who are renewing existing contracts. This is a highly competitive market and end-users can demand both favorable pricing and high service levels because of their size and prominence. In most cases, our service performance is measured monthly, quarterly and/or annually by our wholesale partner. To date, our service ratings have been excellent. However, our experience to date indicates that excellent service ratings are expected from end-users, but pricing continues to drive most decisions. As a result, we have limited influence in contract negotiations between our wholesale partners and end-users. This is a key difference between our direct and wholesale service offerings. Our experience to date indicates that the growth in our wholesale services business will likely be choppy and will include large contract wins being partially mitigated by occasional large contract losses and the losses will likely be out of our control.

The growth in our implementation revenues in fiscal 2008 was due to the M-DCPS contract, which provided over $3 million in implementation revenues. These higher revenues resulted in improved utilization of services personnel and helped to absorb the fixed cost structure in this portion of our services organization.

Our structured cabling business grew by approximately 24% to $3.2 million in fiscal 2008. About one-half of the growth in structured cabling revenues related to the M-DCPS contract. In some school locations, the school system was required to install their new PBX systems in a new, more secure location in the school. The cost to rewire the building to support this requirement was included on some of the orders. The remainder of the growth in structured cabling was due to increased new construction and remodeling that occurred prior to the economic downturn and continued market acceptance of our nationwide structured cabling service offering.

Systems Sales. Sales of systems were $38.9 million in fiscal 2008 compared to $31.9 million in fiscal 2007, a 22% increase. Sales of systems to commercial customers were $30.3 million in fiscal 2008, a 27% increase compared to fiscal 2007. Sales of systems to hospitality customers were $8.6 million in fiscal 2008, an 8% increase compared to the prior year.

The increase in sales of systems to commercial customers is attributable to the M-DCPS contract which produced $9.4 million in equipment revenues during fiscal 2008. Under the terms of the M-DCPS contract, we installed 166 new Avaya PBX systems at schools across the district who qualified for the Federal E-rate funding program. Under the E-Rate program, the school district submits a proposal to the Federal agency that administers the program for the acquisition and installation of qualifying equipment at its schools which qualify for high levels of Federal assistance under the school lunch program. Under the program, the school district pays for 10% of qualifying equipment and installation and 100% of any non-qualifying equipment or services. As previously stated, we recognized all of the revenue from these orders in fiscal 2008.

The increase in lodging equipment sales was due to improved penetration into existing accounts and new customer acquisition. The lodging market is relatively mature, but a healthy new construction market and our introduction of the Mitel product line as part our equipment and service offerings combined to generate new opportunities for us throughout the year.

Fiscal 2009 may be a challenging year for selling new systems to both the commercial and lodging markets, although existing construction projects in the lodging industry may continue to drive demand in this sector for another six to nine months. Most U.S. businesses are experiencing some level of difficulty in the current economic recession and capital budgets are being reduced sharply. Recent forecasts for growth in capital spending on IT related products in 2009 were reduced from around 6% to just over 1%. While we have not seen such a rapid decline in our order rates as of the date of this report, there can be no assurance given that our equipment business will not suffer a sudden and severe decline in 2009.

Other Revenues. Other revenues were $1,937,000 in fiscal 2008 compared to $951,000 in fiscal 2007. Other revenues consist of commissions earned on the sale of Avaya maintenance contracts and sales of equipment and/or services made outside of our normal provisioning processes. The increase in other revenues is attributable to an increase in the sales of Avaya post-warranty maintenance contracts. Under our dealer agreement with Avaya, we are incentivized to market their maintenance contracts to the Avaya customer base. We are paid a commission on these contracts based on the size and length of the contract and the underlying equipment covered under the agreement. Sales of products provisioned outside of our normal processes generally reflects sales of phone sets to hospitality customers in which we earn a small, flat, per-phone profit on the transaction. Other revenues also include restocking fees earned on canceled orders.

Gross Margins. Gross margins were 26.4% in fiscal 2008 compared to 26.0% in fiscal 2007.

The gross margins earned on services revenues were 28.3% in fiscal 2008 compared to 30.6% in fiscal 2007. The margins earned on services revenues in fiscal 2008 were below our target for these revenues. Gross margins on services were negatively affected by the slow-down in the growth rate of recurring services revenues. This slow-down began in the first quarter of fiscal 2008 as our MAC/T&M revenues declined dramatically and the rate of growth in new wholesale services programs declined from fiscal 2007 levels. Because these revenues grew rapidly in the second half of fiscal 2007, the cost structure to support these revenues was growing rapidly as we entered the year. This momentum in cost build-up coupled with a sharp decline in the growth rate combined to produce lower than expected gross margins. As we adjusted the cost structure and as revenues rationalized in the second half of the year, our margins improved. Services margins in the second half of fiscal 2008 were also helped by stronger implementation and structured cabling revenues as a compressed M-DCPS installation schedule pushed more installations of systems into the third quarter and first half of the fourth quarter.

Gross margins on systems sales were 26.2% in fiscal 2008 compared to 24.0% in fiscal 2007. These margins are slightly higher than our expectations and reflect our continued focus on systems sales margins through controls around contract acceptance and margin reviews. We also work closely with both our manufacturers and our product distributors to maximize vendor support through their rebate, promotion, and competitive discount programs. These programs have been relatively unchanged for the past three fiscal years allowing us to maximize our capture of these discounts and rebates. Despite producing higher margins on systems sales in fiscal 2008, this remains a highly competitive market and downward margin pressure is a constant in this segment of our business. We continue to believe that the techniques and disciplines we have employed over the last three fiscal years will enable us to maintain our gross margins on systems sales. However, we can give no assurance regarding possible changes in our vendor support programs or other market factors that could either increase or lower margins.

A final component to our gross margins is the margins earned on other revenues. These include costs incurred to market and administer the Avaya post-warranty maintenance contracts we sell and our corporate cost of goods sold expenses. While we earn a commission on the sale of Avaya post-warranty maintenance contracts which has no direct cost of goods sold, we incur costs in marketing and administration of these contracts before submitting them to Avaya. Corporate cost of goods sold represents the cost of our material logistics, warehousing, advance replacement of service spare parts, and purchasing functions. Corporate cost of goods sold was 1.8% of revenues in fiscal 2008 compared to 2% of revenues in fiscal 2007.

Operating Expenses. Operating expenses were $18.6 million or 22.0% of revenues in fiscal 2008 compared to $15.8 million or 22.5% of revenues in fiscal 2007. Increases in operating expenses included increased selling expenses primarily in the form of increased sales personnel targeted at selling our wholesale services initiative. Other significant increases were increased costs associated with the support of our Oracle platform, increased FAS 123(R) compensation expense due to the issuance of incentive stock options, increased legal fees related to higher levels of litigation, and increased amortization expense driven by expanded utilization of our enterprise technology platform and the amortization of intangible assets from small acquisitions. We continue to be optimistic that the growth in our operating expenses will decline to between 18% and 20% of our revenues as we increase our revenue base and our sales efficiency improves through higher proportions of recurring revenues. We have targeted our rate of growth in operating expenses, particularly selling, general and administrative expenses, to be approximately one-half the rate of growth in revenues to bring these costs in line with our expectations.

Interest Expense and Other Income. Interest expense consists primarily of interest paid or accrued on our credit facility. Interest expense increased in fiscal 2008 by approximately $241,000 compared to fiscal 2007 reflecting higher average borrowing during the year and the fact that we ceased capitalization of interest cost on the Oracle implementation project at the end of fiscal 2007. The cash cycle on the M-DCPS project was extremely long and forced us to borrow heavily on our revolving line of credit in fiscal 2008 to meet working capital needs. Net other income in fiscal 2008 was approximately $24,000 compared to net other income of approximately $50,000 in 2007.

Tax Expense. We have recorded a combined Federal and state tax provision of approximately 39.2% in fiscal 2008 compared to 39.6% in fiscal 2007. This rate reflects the effective Federal tax rate plus the estimated composite state income tax rate.

Operating Margins. Our net income as a percent of revenues in fiscal 2008 was 2.4% compared to 2.0% in 2007. This increase reflects improved gross profit margins on the sale of equipment in fiscal 2008. Our current business model targets an operating margin of 4% to 6% to be reached in the next three to five years. However, we will have to realize sustained growth in our revenues, continued improvements in total gross margins, primarily in our service gross margins, and a significantly slower growth rate in operating expenses to meet this target.

FISCAL YEAR 2007 COMPARED TO FISCAL YEAR 2006.

Net revenues for fiscal 2007 were $70.1 million compared to $59.9 million in fiscal 2006, a 17% increase. Net income for fiscal 2007 was $1,432,000 compared to $718,000 in fiscal 2006. Discussed below are the major revenue, gross margin, and operating expense items that affected our financial results during fiscal 2007.

Services Revenues. Revenues earned from our services business were $37.3 million in fiscal 2007 compared to $29.9 million in fiscal 2006, a 25% increase and included growth in all three major services revenue streams including our recurring services, implementation services, and our national cabling business.

Recurring services revenues increased $4.0 million or 18% in fiscal 2007 compared to fiscal 2006, primarily reflecting our success in the expansion of our wholesale services initiative.

Our implementation revenues were $8.2 million in fiscal 2007, an increase of $2.6 million or 47% compared to the prior year. The growth in our implementation revenues was a key factor in our success in fiscal 2007 as higher levels of revenues resulted in better absorption of the significant fixed-cost structure in this portion of our services organization. The 47% growth rate was significantly greater than our growth in systems sales, the historical driver of these revenues. The additional growth came from several large installation and professional services contracts sold separately from systems sales. Additionally, the proportion of installation and professional services fees continued to increase in comparison to the total project price as the complexity of the applications we sell increased. All of these increased revenues improved our utilization of our resources and contributed to the overall increase in our services gross profits during fiscal 2007.

Our structured cabling revenues grew 40% to $2.6 million in fiscal 2007 compared to fiscal 2006. The increase in these revenues was a direct result of the establishment of a national structured cabling business that markets our cabling services to existing and new customers.

Systems Sales. Sales of systems were $31.9 million in fiscal 2007 compared to $29.2 million in fiscal 2006, a 9% increase. Sales of systems to commercial customers were $23.8 million in fiscal 2007, a 6% increase compared to fiscal 2006. The increase in sales of systems to commercial customers was primarily the result of the success of our strategy to focus on our manufacturers' lines of business. Sales of systems to hospitality customers were $8.0 million in fiscal 2007, an 18% increase compared to fiscal 2006. This increase reflected our strong market position in the hospitality market and the acceptance of our Nortel product line to hospitality customers.

Other revenues were $951,000 in fiscal 2007 compared to $822,000 in fiscal 2006. The increase in other revenues was attributable to an increase in the sales of Avaya post-warranty maintenance contracts.

Gross Margins. Gross margins were 26.0% in fiscal 2007 compared to 24.6% in fiscal 2006.

The gross margins earned on services revenues were 30.6% in fiscal 2007 compared to 27.6% in fiscal 2006. This increase reflected improvements in gross margins earned on recurring services and implementation revenues, while gross margins on cabling revenues were relatively flat compared to the prior year. The margins on recurring services improved slightly due to better utilization of our contact center and field services personnel, lower materials costs and improved utilization of qualified third-party service providers. The profitability of implementation and professional services was the largest contributor to the significant increase in overall services profitability in fiscal 2007. As discussed above under services revenues, increased implementation revenues resulted in improved absorption of the fixed costs of this element of our services organization. The gross margins earned on cabling revenues were consistent with fiscal 2006 and with our expectations for fiscal 2007.

Gross margins on systems sales were 24.0% in fiscal 2007 compared to 24.2% in fiscal 2006. These margins were consistent with our expectations for systems sales.

A final component to our gross margins was the margins earned on other revenues. See discussion of gross margins on other revenues in the caption "Gross Margins" under "FISCAL YEAR 2008 COMPARED TO FISCAL YEAR 2007" above for an explanation of composition of these margins. Corporate cost of goods sold decreased 0.3% in fiscal 2007 compared to fiscal 2006.

Operating Expenses. Operating expenses were $15.8 million or 23% of revenues in fiscal 2007 compared to $13.4 million or 22% of revenues in fiscal 2006. The increase in operating expenses was due to increased sales expenses to support our wholesale services sales initiative, increased gross profit- and net income-based incentive payments to

employees due to improved profitability, increased FAS 123(R) compensation expense due to the issuance of stock options in fiscal 2007 and 2006, increased amortization expense from the expanded utilization of our enterprise technology platform, and increased marketing expenses related to a major marketing event held around the PGA Championship during our fourth fiscal quarter of 2007.

Interest and Other Income. Interest expense decreased in fiscal 2007 by approximately $77,000 compared to fiscal 2006. This change primarily reflects lower overall borrowing costs in 2007 compared to the previous year due to less outstanding debt. During fiscal 2007, we reduced our mortgage debt by $171,000 through cash on hand and funds generated from operations and enjoyed lower average amounts outstanding under our revolving line of credit.

Net other income in fiscal 2007 was approximately $50,000 compared to net other income of approximately $42,000 in 2006.

Tax Expense. We recorded a combined Federal and State tax provision of approximately 39.6% in fiscal 2007 compared to 40.5% in fiscal 2006. This rate reflected the effective Federal tax rate plus the estimated composite state income tax rate.

Operating Margins. Our net income as a percent of revenues in fiscal 2007 was 2.0% compared to 1.2% in 2006. This increase reflected improved gross profit margins partially offset by higher operating expenses as discussed above.

Liquidity and Capital Resources

Our financial condition improved during fiscal 2008 as our working capital grew by 10% to $9.4 million and we generated $2.4 million in cash flows from operations. These cash flows included cash from earnings and non-cash charges of $4.2 million, increases in accounts payable of $1.0 million, and increases in deferred tax liabilities of $973,000. These increases were partially offset by an increase in accounts receivable of $3.7 million, an increase in inventory of $963,000 and other changes in working capital items, which netted to a decrease in cash of $947,000. We used these cash flows to reduce borrowings on our working capital line of credit by $235,000, reduce our mortgage balance through scheduled principal payments by $171,000, to fund other financing and investing activities of $1.1 million and to fund capital expenditures of $1.3 million. Of these capital expenditures, $744,000 was spent on capital equipment as part of normal replacement of our Information Technology infrastructure and headquarters facility. The remaining $568,000 was spent on our Oracle implementation. Non-cash charges included depreciation expense of $744,000, amortization expense of $1,018,000, stock-based compensation expense of $247,000, a provision for doubtful accounts receivable of $23,000, and a provision for obsolete inventory of $102,000. At October 31, 2008 we had capitalized $9.3 million on the Oracle project. We have segregated the cost of this asset into four classifications with estimated useful lives of three, five, seven and ten years. In fiscal 2005 we began amortizing the cost of those portions of the system that were ready for use. Our operating results for fiscal years 2008 and 2007 include $906,000 and $619,000, respectively, in amortization expense related to the project.

As noted above, our deferred tax liabilities increased $973,000 during fiscal 2008 and the balance of our noncurrent deferred tax liabilities was $5.5 million at October 31, 2008. Most of this balance and the annual increase in this account are due to the difference in accounting for Goodwill between generally accepted accounting principles ("GAAP") and the U.S. tax code. Under GAAP, Goodwill is not amortized, but instead is evaluated for impairment. This evaluation is conducted as conditions warrant, but not less than annually under the guidelines set forth in SFAS 142, "Goodwill and Other Intangible Assets". For tax purposes, Goodwill is amortized on a straight-line basis over 15 years. As a result, the Company receives a tax deduction of approximately 1/15th of its Goodwill balance each year in its tax return. This difference between $0 amortization expense being recorded in the GAAP-based operating statements and approximately $1.8 million in deductions taken on the tax return is recognized in the balance sheet as an additional noncurrent deferred taxliability. The amount recorded is the difference multiplied by the effective tax rate. This difference is recorded as a non current item because under GAAP deferred taxes are recorded as current or noncurrent based on the classification of the asset or liability which generated the deferred tax item. The deferred tax liability associated with Goodwill accounting will not be reduced unless the Company records in impairment charge to Goodwill in a future accounting period.

At October 31, 2008 the balance on our working capital revolver was $2.5 million, leaving $5.0 million available for additional borrowings. We believe that this available capacity is sufficient for our operating needs for the foreseeable future. The revolver and the mortgage on our headquarters facility are scheduled to mature on September 30, 2009, however we expect to renew them for 12-month and 36-month periods, respectively prior to their expiration with similar terms. At October 31, 2008, we were in compliance with the covenants of our debt agreements. In addition to the available capacity under our working capital line of credit, we believe we have access to a variety of capital sources such as

private placements of subordinated debt, and public or private sales of additional equity. However, there are currently no plans to issue such securities.

Recent Accounting Pronouncements

In September 2006, the FASB issued Statement of Financial Standards No. 157, "Fair Value Measurements" ("SFAS 157"). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements; rather, it applies under other accounting pronouncements that require or permit fair value measurements. The provisions of SFAS 157 are effective for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS 157 to have a material impact on the Company's consolidated financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business Combinations" ("SFAS No. 141(R)"). Under SFAS No. 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs are recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the . . .