Preliminary Note Regarding Forward-Looking Statements

In the following discussion, we make forward-looking statements concerning future performance, events and results. Other than purely historical statements, all others are likely forward-looking. Forward-looking statements generally include words such as "expects," "anticipates," "may," "plans," "believes," "intends," "projects," "estimates," "targets," "should" and similar expressions. Such statements reflect our perspective on the industry and markets in which we operate. Any statements containing estimates and forecasts are not guarantees of performance, but rather, our assumptions and beliefs based upon information currently available to us. These statements are subject to risks and uncertainties that are difficult to predict or beyond our control. Examples of these risks include: the condition of U.S. economy and its impact on capital spending; reduced availability of credit; the Nortel Networks bankruptcy filing; the financial condition of our suppliers and changes in their distribution strategies and support; our ability to maintain and improve current gross profit margins; unpredictable quarter to quarter revenues; continuing market success of the Mitel product and services offerings; intense competition; industry consolidation; our dependence upon a few large wholesale customers in our Managed Services offering; and our ability to attract and retain talented sales, operational and technical personnel. These and other risks and uncertainties are discussed under the heading "Risk Factors" under Part I of the Company's Form 10-K for the fiscal year ended October 31, 2008 (filed with the Commission on January 23, 2009), and in updates to such risk factors set forth in Item 1A of Part II of our quarterly reports during fiscal 2009. Because of these risks and uncertainties, actual results may differ materially and adversely from those expressed in forward-looking statements. Consequently, we caution investors to read and consider all forward-looking statements in conjunction with such risk factors and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe-harbor for forward-looking statements made by the Company.

Overview

Strategy.

During the third quarter management continued to lead execution of the five primary strategies identified at the outset of fiscal 2009. These strategies include: continue to acquire market share through targeted sales activities; take advantage of Avaya's new channel-centric go-to-market strategy; focus on fast growing applications such as unified communications; focus on industry verticals such as hospitality, healthcare and education; and augment growth through targeted acquisitions.

In addition to monitoring trends in order rates and holding discussions with customers, management also monitors macroeconomic conditions, sales trends among our major suppliers, and sales activity across the communications industry. Based on information derived from these activities, management believes that market conditions will remain challenging for the fourth fiscal quarter and perhaps beyond. As such, in the third quarter management developed and executed a multi-pronged cost reduction plan designed to align sales and operating costs with market conditions.

The reductions were carefully designed to aggressively reduce costs, while preserving the key resources necessary to fully realize growth opportunities as the market recovers. The beneficial effects of these actions were only partially realized in the third quarter. Management anticipates the full benefit of these measures will materialize in the fourth quarter, and into next fiscal year.

Our third quarter financial results reflect an impairment charge on goodwill and other assets of $14.0 million. Poor economic conditions and uncertainty regarding Nortel's product line contributed to continued deterioration of our commercial equipment business. Additionally, we experienced a sustained decline in our market valuation. These factors, taken together, prompted a review of the value of goodwill and certain other long-lived assets. Through applying the applicable accounting rules, we determined that the carrying cost of our Oracle ERP would not be recovered over the near term and that a write-down of that asset to its estimated replacement cost was appropriate. Accordingly, we recorded a $3.0 million impairment on this asset. Likewise, we conducted step one of the impairment test on goodwill and determined that the carrying

value of goodwill is estimated to be impaired between $9.0 million and $13.0 million. Accordingly, we recorded an impairment charge of $11.0 million as our best estimate of the impairment at the time of filing this report. We will adjust the impairment charge, if necessary, after completing step two of the impairment test during our fourth fiscal quarter. These items are discussed in additional detail in "Results of Operations" below and in Note 1 to the Consolidated Condensed Financial Statements above.

In April 2009 XETA purchased the assets of Summatis Communications, LLC ("Summatis") located in Southboro, MA. Summatis provides communications solutions, integration and maintenance services primarily targeted at the Nortel product line. The acquisition strengthens our presence in the northeastern U.S. and adds to our Nortel competencies. While the acquisition is not material to our financial position or results of operations, it represents an incremental step in our overall acquisitions strategy.

On January 14, 2009 Nortel Networks Corporation filed for bankruptcy protection in the United States Bankruptcy Court for the District of Delaware. The administrators of the bankruptcy have adopted a business disposal strategy. Under this strategy, the administrators have segmented Nortel into three business units: Virtual Service Switches, CDMA businesses and Enterprise Solutions. We conduct all of our Nortel business through the Enterprise Solutions unit. On July 21, 2009, the administrators of the bankruptcy announced they had entered into a stalking horse assets and share sale agreement with Avaya for the Enterprise Solutions unit and this process is proceeding. Due to the nature of the stalking horse auction process, a final determination of the purchaser of the Enterprise Solutions unit is not expected until near the end of our fiscal year. Nortel is one of our major suppliers and represents a significant portion of our business. As such this filing is of considerable concern. At the time of filing this Form 10-Q, our post-petition relationship with Nortel continues without interruption. However, management recognizes the potential impact of Nortel's filing on the Company's financial performance (see Item 1A. "Risk Factors" below). Nortel owes XETA approximately $685,000 in pre-petition accounts receivable. Presently, Nortel has until September 11, 2009 to file its reorganization plan. However, this date is subject to further extension. Until a plan of reorganization is filed, our ability to assess the probability of recovering pre-petition amounts due is limited. On July 17, 2009 the bankruptcy court granted our request for offset of $116,000 in charges we owed Nortel at the time of the filing. As of July 31, 2009 we have recorded $350,000 as a reserve against possible Nortel bad debts. We are following developments in the bankruptcy case and will assert our legal rights and defenses as appropriate.

Operating Summary.

In the third quarter of fiscal 2009 we recorded a net loss of $8.6 million on revenues of $17.2 million compared to net income of $591,000 on revenues of $23.2 million in the third quarter of last year. Excluding the $14.0 million impairment charge and related tax benefit of $5.5 million in the third quarter, our non-GAAP net loss was $87,000. For the first nine months of fiscal 2009 we recorded a net loss of $8.4 million on revenues of $53.5 million compared to net income of $1.4 million on revenues of $62.0 million. Excluding the impairment charge and tax benefit, our non-GAAP net income for the first nine months of fiscal 2009 was $98,000. Apart from the impairment charges to goodwill and our Oracle ERP system which are discussed in more detail above, these results primarily reflect the challenging market conditions stemming from the ongoing macroeconomic contraction and the associated decline in demand for commercial systems. We discuss this and other contributing factors in more detail under "Results of Operations" below.

Financial Position Summary.

Since October 31, 2008 we have generated positive cash flows from operations of $7.9 million, primarily through the collections of accounts receivable. We have used these cash flows to reduce borrowings and have improved our working capital approximately 5%. We discuss these and other financial items in more detail under "Financial Condition" below.

The following discussion presents additional information regarding our financial condition and results of operations for the three- and nine-month periods ended July 31, 2009 and 2008 and should be considered in conjunction with our above comments as well as the "Risk Factors" section below.

Financial Condition

During the first three fiscal quarters of 2009 our working capital increased by 5% to $9.8 million. We generated $7.9 million in cash flows from operations. These cash flows included a decrease in accounts receivable of $8.6 million and a decrease in inventory of $296,000. These increases were partially offset by a decrease in deferred tax liabilities of $5.5 million; a decrease in accounts payable of $2.7 million; a decrease in accrued liabilities of $408,000; and other changes in working capital items, which netted a decrease in cash of $356,000. The impairment charge to goodwill and other assets of $14.0 million did not impact cash flows in the period. Other Non-cash charges included amortization of $1.0 million; depreciation of $723,000; provisions for doubtful accounts receivable and obsolete inventories of $471,000; stock-based compensation of $219,000; and a loss on the sale of assets of $4,000.

We used these positive cash flows to reduce borrowings on our working capital line of credit by $2.5 million; to make asset purchases of capitalized hospitality service contracts as well as certain net assets of Summatis, together totaling $1.53 million; acquire capital assets of $636,000; reduce our mortgage balance through scheduled principal payments by $128,000; and fund other financing and investing activities of $169,000. The acquisition of capital assets included $414,000 spent as part of normal replacement of our Information Technology infrastructure and headquarters facility improvements. The remaining $222,000 was spent on our Oracle ERP implementation.

At July 31, 2009 there were no outstanding draws on our working capital revolver. Based on the collateral base defined in the credit facility, there was $5.2 million available for borrowing on the $7.5 million facility at the end of the quarter and our cash balance was $3.0 million. We believe our cash balances and available borrowing capacity are sufficient to support our operating requirements for the foreseeable future. The working capital revolver and the mortgage on our headquarters facility are scheduled to mature on September 30, 2009. We are in discussions with several lenders, including our existing bank, to secure a new credit facility prior to the expiration of our existing agreement. We expect to establish a new credit facility prior to the expiration of the current agreement. However, given current credit market conditions, it is likely any new credit agreement will contain higher borrowing costs and/or reduced availability for unsecured borrowings. In addition to the available capacity under our working capital line of credit, to finance investments beyond our current operating needs we believe we may have access to a variety of capital sources such as private placements of subordinated debt, and public or private sales of equity.

Results of Operations

In the third quarter of fiscal 2009 revenues were $17.2 million compared to $23.2 million in the third quarter 2008. Our net loss in the third quarter of fiscal 2009 was $8.6 million compared to net income of $591,000 compared to the same quarter a year ago. In the first nine months of the year, revenues were $53.5 million compared to $62.0 million for the first nine months of fiscal 2008. Our net loss for the first nine months of fiscal 2009 was $8.4 million compared to net income of $1.4 million in the first nine months of fiscal 2008.
Net of the impairment charges and tax benefits recorded in the third quarter we incurred a non-GAAP net loss of $87,000 in the third quarter and generated non-GAAP net income of $98,000 year-to-date. Apart from the impairment charges on goodwill and other assets of $14.0 million which are discussed above under "Overview", these results primarily reflect lower sales of commercial systems and lower commissions earned from the sale of Avaya post-warranty maintenance contracts. The year-to-date results were also impacted by the $350,000 bad debt provision associated with Nortel's bankruptcy filing. The narrative below provides further explanation of these results.

Systems Sales.

In the third quarter of fiscal 2009 systems sales decreased approximately $4.1 million or 39% compared to the same period last year. This decrease includes a $4.3 million or 52% decrease in sales of systems to commercial customers partially offset by a $194,000 or 8% increase in sales of systems to hospitality customers. Year-to-date systems sales decreased $5.8 million or 20% compared to last year. This decrease includes a decrease in sales of systems to commercial customers of $7.6 million or 33% which was partially offset by an increase in sales of systems to hospitality customers of $1.8 million or 33%. The decrease in systems sales to commercial customers reflects difficult comparisons related to the revenues earned from the Miami-Dade County Public School's ("M-DCPS") project. Additionally macroeconomic conditions, Nortel's bankruptcy and shipments scheduled for the third quarter but delayed at the customers' request, impacted our sales results.

Throughout fiscal 2008 we enjoyed strong commercial systems sales, installation revenues, and cabling revenues generated by the series of orders received from M-DCPS. In total, these orders generated over $10 million in revenues for the Company during the year. We have not received a similar order during fiscal 2009, making comparisons to last year's results more difficult. Additionally, customers continue to reduce capital spending in response to recessionary conditions, and access to credit remains problematic. As these conditions have intensified, customers have limited their capital spending to necessity purchases and investments with clear, rapid returns. Finally, uncertainty around the Nortel bankruptcy continues to severely dampen demand for equipment in this product line.

The quarterly and year to date growth in sales of systems to hospitality customers, particularly during a challenging hospitality market, reflects our continued success in this niche market. Results support our strategy to expand our product offering to Mitel products which has provided us with the opportunity to work with hotel chains and property management companies that have previously standardized on the Mitel product line. While we anticipate continued success in the hospitality market, given economic conditions, downward pressure on revenues in this segment may intensify and as such revenues may be at or less than historical levels in the fourth quarter of the fiscal year.

Services Revenues.



Services revenues consist of the following:



                            For the Three Months Ended       For the Nine Months Ended
                                     July 31,                        July 31,
                               2009             2008            2009            2008
Contract & T&M            $     7,358,000   $  7,202,000   $   21,384,000   $ 21,438,000
Implementation                  2,469,000      3,864,000        6,926,000      8,251,000
Cabling                           697,000        962,000        2,049,000      2,199,000
Total Services revenues   $    10,524,000   $ 12,028,000   $   30,359,000   $ 31,888,000

Contract and time-and-materials (T&M) revenues increased 2% and decreased 0.3%, respectively in the third quarter and year-to-date periods. This year-to-date performance reflects relatively flat revenues in our wholesale services programs and a modest decline in T&M service revenues. We believe T&M revenues were influenced by general economic conditions as customers reduced spending on non-critical services. We continue to aggressively market our national service footprint and multi-product line technical capabilities to end-users, network service providers, and large integrators of voice and data technologies. In the third quarter we realized beneficial returns from the new service programs with Marriott International and Lockheed Martin Corporation that we secured in the second quarter. Additionally, the acquired customer relationships from Summatis beneficially influenced our results. We expect these new programs and relationships to positively impact our Contract & T&M revenues for the foreseeable future.

Implementation revenues decreased 36% and 16%, respectively in the third fiscal quarter and year-to-date periods. These declines, while significant, reflect a lower rate of decline than the corresponding decrease in systems sales, traditionally the primary driver of these revenues. We attribute this to increasing demand for more complex communications systems requiring significant fee-generating design and engineering services provided by our Professional Services Organization ("PSO"). In the near term, Implementation revenues will continue to be closely aligned with the sale of new systems. From a long term perspective, however, as customers displace conventional communications platforms and adopt more complex systems, we anticipate growth in this area of our business through the fee-based utilization of these highly skilled technical resources.

Cabling revenues decreased 28% and 7%, respectively in the third fiscal quarter and year-to-date periods. The third quarter decline in cabling revenues is primarily associated with the difficult comparisons to fiscal 2008 which were helped significantly by the M-DCPS orders as discussed above.

Gross Margins.

The table below presents the gross margins earned on our primary revenue streams:

                                For the Three      For the Nine
                                 Months Ended      Months Ended
                                   July 31,          July 31,
Gross Margins                   2009      2008     2009     2008
Services revenues                28.7 %    30.4 %   30.0 %  27.5 %
Systems sales                    28.9 %    26.4 %   26.7 %  26.1 %
Other revenues                   41.4 %    22.1 %    9.6 %  62.2 %
Corporate cost of goods sold     -2.0 %    -1.6 %   -2.0 %  -1.9 %
Total                            26.8 %    26.7 %   26.5 %  25.8 %

Gross margins earned on Services revenues reflect mixed results between improved margins earned on our contract & T&M services which were offset by significantly lower margins earned on implementation activities. As a result of improved cost controls and reduced headcounts, we earned higher gross margins on our contract & T&M services revenues in the third quarter and in the year-to-date periods. However, due to lower utilization of installation and professional services personnel in the implementation department and difficult comparisons to the third quarter of fiscal 2008, our gross margins in this area suffered dramatically in the third quarter. For the year-to-date period implementation gross margins are also down, but cost reductions and on-boarding the new Samsung service program have helped to dampen the impact of lower revenues in this area. Similar to the Samsung program, developing additional billable consulting services which are not directly associated with new system installations is an important aspect of our services strategy to create more predictability and higher gross margins in this area.

Gross margins on systems sales in the third quarter and the year-to-date periods are above our target of 23% to 25% for systems revenues. We continue to receive considerable pricing support from our manufacturers in the form of project-specific discounts and incentive rebates. These incentives are material to our gross margins and we work diligently to maximize this support; however, no assurance can be given that future support will continue at historical levels.

The final component of our gross margins is the margins earned on other revenues and our corporate cost of goods sold. We earn the majority of other revenues from the sale of Avaya maintenance contracts on which we earn either a commission or gross profit. We have no continuing service obligation associated with these revenues and gross profits. In the first three quarters of fiscal 2009 we experienced a dramatic drop in other revenues as compared to the same period last year. Some decline in this segment was expected as we benefited from accelerated customer decisions throughout 2008. In 2008 many customers accelerated their purchases or renewals of Avaya service contracts in anticipation of manufacturer-driven changes in the structure of these service programs. This is an unpredictable revenue stream that depends on the expiration dates of existing contracts, installation dates of new systems, the customer type as defined by Avaya, and the number of years that customers contract for services. While no assurance can be given, we expect sales of Avaya service contracts to return to pre fiscal 2008 levels. Other revenues may also include sales and cost of goods sold on equipment or services sold outside our normal provisioning processes. These revenues vary in both sales volume and gross margins earned. Corporate cost of goods sold represents our material logistics and purchasing functions that support all of our revenue segments.

Operating Expenses.

Our total operating expenses increased $13.6 million in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. Operating expenses, including the $14.0 million impairment charges, were 109.0% of revenues in the third quarter compared to 22.1% in the third quarter last year. Excluding the impairment charges, operating expenses were 27.5% of revenue in the third quarter. Operating expenses were 52.2% of revenues in the first three quarters of fiscal 2009 compared to 21.8% last year. Excluding the impairment charges operating expenses in the first three quarters of fiscal 2009 were 26.0% of revenues. Apart from the impairment charges recognized in the third quarter, our year-to-date operating expenses reflect the following factors:

†          A significant bad debt provision in response to the Nortel bankruptcy
filing

†          The addition of sales expense as a result of the Summatis acquisition

†          Increased legal fees to support litigation and board governance
activities

†          Increased amortization of: the Oracle platform in association with

The level of operating expenses as a percentage of revenues is above our targets and we took steps in the third quarter to bring these costs more in line with our expectations. These steps included reductions of our sales force and sales support staffs, company-wide temporary suspension of the matching contribution on our 401k Plan, and a mandatory week of unpaid leave for each employee in the company. These steps were taken during the last half of the third quarter and had minimal impact to our third quarter results. Presently, rapidly declining systems sales make it difficult to meet our targets for operating expenses as a percent of revenues. Furthermore, we consider it tactically appropriate, given our strong cash flows, to support operating expenses above our targets in the near term to take advantage of improving economic conditions in subsequent quarters.

Interest Expense and Other Income.

Net interest and other expense was $22,000 in the third quarter of fiscal 2009 compared to $96,000 in net other expense in the third quarter of fiscal 2008. Net interest and other expense was $65,000 for the nine-month period ended July 31, 2009 compared to $241,000 in net other expense in the same period last year. This decrease reflects both lower interest rates and a reduction in borrowings.

Tax Provision.

The tax provision reflects the effective Federal tax rate plus the composite state income tax rates adjusted for states that require minimum tax payments even if tax losses are incurred. Generally, we expect our tax provision rate to be approximately 40%.