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| INXI > SEC Filings for INXI > Form 10-K/A on 2-Sep-2009 | All Recent SEC Filings |
2-Sep-2009
Annual Report
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 technology infrastructure solutions for enterprise-class organizations such as corporations, schools and federal, state and local governmental agencies. Our solutions consist of three broad categories of technology infrastructure: network infrastructure, unified communications and data center. Network infrastructure solutions consist of network routing and switching, wireless networking and network security solutions. Unified communications solutions consist of Internet Protocol ("IP") network-based voice or telephone solutions as well as IP network-based video communications solutions. Data center solutions consist of network storage solutions and data center server virtualization solutions. We provide our customers with 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 types of technology infrastructure 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 technology infrastructure solutions we provide is characterized by rapidly evolving and competing technologies. We compete with larger and better financed entities. We currently have seventeen physical offices in sixteen markets, which are located in Texas, California, Connecticut, 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 2008, 2007 and 2006, sales of products made up 82.2%, 86.7% and 86.7% of total revenue and services revenues made up 17.8%, 13.3% and 13.3% 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 17.8%, 17.6% and 18.6% for 2008, 2007 and 2006, respectively, and our gross margin on service revenue was 28.8%, 28.6% and 25.9% 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 mix of large, competitively bid sales transactions as compared to smaller, less competitive transactions;
• the mix of new customer transactions, which tend to be more competitively bid by us, as compared to transactions with existing customers, which tend to be somewhat less competitive; and
• the mix of products sold, with certain newer, advanced product categories generating higher gross margin than other, more traditional products.
The principal factors that influence gross margin on service revenue include:
• the utilization of our technical engineering resources used to perform our professional services;
• the amount of managed support and hosting services as compared to the cost of operating our managed services support center and hosting operations, which costs are somewhat fixed;
• the mix between the different types of service.
We expect to be able to improve our gross margin on services revenues if our managed support services revenue increases 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 in the short term 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 sometimes in our best interest to open new offices even though doing so reduces near-term operating profitability. However, during 2007 and 2008 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 during 2007 and early 2008 prior to deteriorating economic conditions and customer demand caused operating profit margin to decline. In 2009, due to expected weak economic conditions, we anticipate that we will continue to favor acquisitions over new office openings 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.
While we have long-term goals of achieving both revenue growth and improved profitability, economic conditions will play an important role in our ability to achieve these goals. Our ability to improve operating profit margin is contingent upon our achievement of revenue growth, and leveraging certain fixed operating costs against a higher level of revenue. Economic conditions deteriorated substantially in 2008. To the extent that economic conditions improve our ability to achieve our goals of revenue growth and improved profitability will be less difficult, and to the extent economic conditions remain weak, or deteriorate further, achievement of our goals will be made more difficult because of a decreased ability to increase revenue due to lower relative levels of customer demand for the technology infrastructure solutions we provide.
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 as well as 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 20% to 23% 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:
• Aligning ourselves with the leading manufacturers of technology infrastructure products of the type we provide. To this end, Cisco has always been our primary supplier for network routing and switching and IP telephony products that we offer, and we align ourselves with what we believe to be the "best of breed" manufacturer in each area of technology or specific product in order to provide our customers with the best technology available.
• Promoting our managed support and hosting services to generate increased recurring services revenues and improve gross margin on service revenue.
• Increasing the gross revenues from our higher gross margin services offerings, as compared to product sales that typically produce relatively lower gross margins.
• Opening new branch offices in new markets.
• Expanding geographically by acquiring complementary businesses and by opening new offices.
• Marketing to larger customers as we become more of a "national" level provider of technology infrastructure solutions.
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 2008, 2007 and 2006, 82.2%, 86.7% and 86.7% of our revenue was attributable to product sales, while 17.8%, 13.3% and 13.3% 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 managed support and hosting 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.
Registered Direct Offering
In June, 2008, we sold 900,000 shares of common stock through a registered direct offering to certain institutional investors at a price of $11.00 per share. The net cash proceeds, after deducting the placement agent's fee and other offering expenses of $1,149, were approximately $8,751. The net cash proceeds were partially used to repay the $6,000 outstanding balance under the Acquisition Facility, with the remainder to be used for general corporate purposes including possible future acquisitions.
Acquisitions.
Access Flow, Inc.
Under an Asset Purchase Agreement dated June 6, 2008 (the "APA"), we purchased the operations and certain assets, and assumed specified liabilities of Access Flow, Inc. ("AccessFlow"). AccessFlow is a Sacramento, California-based consulting organization focused on delivering VMware-based data center virtualization solutions, with revenues for the twelve months ended March 31, 2008 of approximately $10,500. The acquisition was completed simultaneously with the execution of the APA. Neither AccessFlow nor any shareholder of AccessFlow has any prior affiliation with INX. The APA contains customary representations and warranties and requires AccessFlow and its Shareholders to indemnify us for certain liabilities arising under the APA, subject to certain limitations and conditions.
The consideration paid at closing pursuant to the APA was (a) $2,450 in cash and
(b) 262,692 shares of our common stock. The common stock was valued at $13.06
per share or $3,430. The number of common stock shares issued was determined by
dividing $2,627 by the lesser of (i) the average closing price per share for the
common stock, as reported by Nasdaq for the five consecutive trading days ending
prior to the second day before June 6, 2008, which was $12.96 per share or
(ii) $10.00 per share. 24,000 shares of the stock consideration were placed in
escrow under holdback provisions defined in the APA. The two shareholders of
AccessFlow entered into five-year noncompete agreements at closing, which
provide for payments to each in the aggregate amount of $50 in equal monthly
installments of approximately $8 each per month over the six month period
subsequent to closing. Broker costs and professional fees of $346 were incurred
in the purchase, of which $174 was paid in cash, $16 accrued, and $156 was paid
through the issuance of 11,935 shares of common stock.
Additional purchase consideration is payable to AccessFlow based on certain
financial performance during each of the two-year periods ending June 30, 2009
and June 30, 2010. The financial performance upon which such additional purchase
consideration is based includes the following business components: (i) the
acquired AccessFlow Sacramento, California branch office revenue excluding its
hosting business, (ii) the acquired AccessFlow hosting business, and
(iii) customer billings for certain virtualization products and services
specified in the APA generated by the Company's pre-existing fourteen branch
office locations. The APA specifies the computation of additional purchase
consideration earned under each business component, including a minimum and
maximum amount payable for each of the two years. For each business component
the minimum annual additional consideration payable is zero and the maximum
annual additional consideration payable is (i) $405, (ii) $405, and (iii) $540,
respectively. At our option, 50% of such additional consideration may be paid in
the form of common stock. Additional purchase consideration, if any, will be
recorded as goodwill.
NetTeks Technology Consultants, Inc.
Under an Asset Purchase Agreement dated November 14, 2008 (the "Agreement"), we purchased the operations and certain assets, and assumed specified liabilities of NetTeks Technology Consultants, Inc. ("NetTeks"). NetTeks is a Boston, Massachusetts-based network consulting organization with offices in downtown Boston and Glastonbury, Connecticut, with revenues for the twelve months ended September 30, 2008 of approximately $12,700. We completed the acquisition simultaneously with the execution of the Agreement. Neither NetTeks nor any shareholder of NetTeks has any prior affiliation with the INX. The Agreement contains customary representations and warranties and requires NetTeks and the Shareholders to indemnify us for certain liabilities arising under the Agreement, subject to certain limitations and conditions.
The consideration paid at closing pursuant to the Agreement was (a) $1,350 in cash and (b) 30,770 shares of our Common Stock, $0.001 par value (the "Common Stock"), of which 15,385 Common Stock shares were held in escrow under holdback provisions defined in the Agreement. The common stock was valued at $5.29 per share or $163. The number of Common Stock shares issued was determined by dividing $200 by $6.50 per share. Professional fees of $51 were paid in connection with the purchase.
Additional purchase consideration is payable based on NetTeks' branch office operating income contribution during each of the two-year periods ending November 30, 2009 and November 30, 2010. The Agreement specifies the computation of additional purchase consideration earned including a minimum of zero for each of the two-year periods and a maximum of $1,313 for the period ending November 30, 2009 and $1,488 for the period ending November 30, 2010. At our option, 50% of such additional purchase price may be paid in the form of Common Stock. Additional purchase consideration, if any, will be recorded as goodwill.
VocalMash
Under an Asset Purchase Agreement dated December 4, 2008 ("VocalMash APA"), we purchased the operations of VocalMash, a business owned and operated by INX's Vice President of Sales. VocalMash is an application integration company that utilizes Web 2.0 technologies to integrate unified communications systems with other enterprise applications. We completed the acquisition simultaneously with the execution of the VocalMash APA. The VocalMash APA contains customary representations and warranties and requires VocalMash and its Owner to indemnify INX for certain liabilities arising under the VocalMash APA, subject to certain limitations and conditions.
The consideration paid at closing pursuant to the VocalMash APA was 60,000 shares of our Common Stock, $0.001 par value (the "Common Stock"). The Common Stock was valued at $4.89 per share or $293. Additional purchase consideration of up to a maximum of $380 may be payable under the VocalMash APA based on the achievement of operating income contribution targets for 2009. Additional purchase consideration, if any, will be recorded as goodwill.
Select, Inc.
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. We completed the acquisition simultaneously with the execution of the SPA. The SPA contains customary representations and warranties and requires Select's shareholders ("Shareholders") to indemnify INX 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 $388 was paid in cash and $124 was paid through the issuance of 11,598 shares of common stock.
Additional purchase consideration may be 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, the revenue and operating profit contribution was less than the minimum required under the SPA resulting in no additional purchase consideration due the Shareholders. 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.
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, we introduced our managed support service offering 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 . . .
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