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EONC > SEC Filings for EONC > Form 10-K on 29-Oct-2012All Recent SEC Filings

Show all filings for EON COMMUNICATIONS CORP

Form 10-K for EON COMMUNICATIONS CORP


29-Oct-2012

Annual Report


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

OVERVIEW

eOn Communications Corporation™ ("eOn" or the "Company") is a provider of communications solutions. Backed with over 20 years of telecommunications engineering expertise, the Company's solutions enable its customers to use the eOn products to communicate more effectively. eOn's offerings are built on open architectures that enable adoption of emerging technologies, such as Voice over Internet Protocol (VoIP) and concepts such as Service Oriented Architectures (SOA).

The Company completed its acquisition of Cortelco on April 1, 2009. For additional information, refer to the amended and restated Merger Agreement among the Company, Cortelco Holding, and a subsidiary of the Company, setting forth the terms and conditions of the acquisition, filed as an exhibit to the Company 8-K dated as of December 18, 2008. Cortelco, Inc. ("Cortelco"), eOn Communications wholly owned subsidiary, provides customer premise equipment (CPE) commercial grade telephone products primarily for use in businesses, government agencies, colleges and universities, telephone companies, and utilities. Cortelco has formed strategic alliances with distributors and provides the support needed to supply customers with quality sales, marketing, customer service, technical support, and training.

eOn Communications is the majority shareholder of Cortelco Systems Puerto Rico, Inc. ("CSPR"). CSPR's operations include the sale and service of integrated communications systems, data equipment, security products and telephony billing services.

CRITICAL ACCOUNTING POLICIES

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties and that could potentially result in materially different results under different assumptions and conditions. We believe that our critical accounting policies are limited to those described below. For a detailed description of our accounting policies, see Footnote 2, "Summary of Significant Accounting Policies," in the notes to the consolidated financial statements.


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Revenue Recognition

The Company's revenues from its six product lines are the result of separate,
individual deliverables:



                                                     Type of Revenues Earned
Product Line                    Equipment/Software   Professional Services   Maintenance Contracts

Millennium PBX System            Individual sale               -                       -

eQueue Contact Center System     Individual sale        Individual sale         Individual sale

VOIP Telephones                  Individual sale               -                       -

Cortelco Products                Individual sale               -                       -

CSPR Products                    Individual sale        Individual sale         Individual sale

CSPR Telephony Billing                  -               Individual sale                -

Because the eQueue system is very flexible in its applications, some customers contract for professional services to tailor their system to specific requirements. Professional services are invoiced separately upon completion. eQueue customers can also elect to enter into maintenance contracts to receive software updates and free technical support. Revenue is booked quarterly for each maintenance period as provided. The VOIP phones can be deployed with either the Millennium or eQueue systems to provide lower call costs as well as flexible telecom management across multiple locations. These phones may be sold with a new system, but are often sold subsequent to the system sale.

Telephony billing revenues from the resale of Puerto Rico Telephone services are recognized monthly as services are provided to the customers.

Revenues from our products are recognized only when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price to the customer is fixed or determinable, and collectibility is reasonably assured. Generally, revenue is recognized (1) upon shipment for equipment and software, (2) as work is performed for professional services, and (3) in equal periodic amounts over the term of the contract for software and hardware maintenance. The Company's revenue recognition policies are in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition, and Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 985, Software.

Product Warranties

We generally provide customers a one year product warranty from the date of purchase. Warranty for the Cortelco product line ranges from one to five years based on the product purchased. We estimate the costs of satisfying warranty claims based on analysis of past claims experience and provide for these future claims in the period that revenue is recognized. The cost of satisfying warranty claims, which approximates 0.5% - 2.4% of product revenues, has historically been comprised of materials and direct labor costs. We perform quarterly evaluations of these estimates and any changes in estimates, which could potentially be significant, are included in earnings in the period in which the evaluations are completed.

Inventory Obsolescence

We carry inventories at the lower of cost or market. This policy depends on the timely identification of those items included in inventory whose market price may have declined below carrying value, such as slow-moving or obsolete items, and we record any necessary valuation reserves. We perform an analysis of slow-moving or obsolete inventory on a quarterly basis and any necessary valuation reserves, which could potentially be significant, are included in earnings in the period in which the evaluations are completed.


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Software Development

We capitalize costs for developing software upon determination that technological feasibility has been established for the product, if that product is to be sold, leased or otherwise marketed. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense. When the product or enhancement is available for general release to customers, capitalization is ceased, and previously capitalized costs are amortized based on current and anticipated future revenues for the product, but with an annual amortization amount at least equal to the straight-line amortization over an estimated economic life of five years.

For the year ended July 31, 2011, the Company capitalized eConn IP product software development costs of approximately $218,000. Amortization of the software development costs began in the first fiscal quarter of 2011. Subsequent to the general release of the eConn product to customers in the first fiscal quarter of 2011, the product did not reach the anticipated level of market acceptance. Consequently, the Company recorded an impairment charge of approximately $916,000 in the fourth quarter of fiscal 2011.

No software development cost was capitalized for the year ended July 31, 2012.

Allowance for Uncollectible Accounts Receivable

We typically grant standard credit terms to customers in good credit standing. As a result, we must estimate the portion of our accounts receivable that are uncollectible and record any necessary valuation reserves. We generally reserve for estimated uncollectible accounts on a customer-by-customer basis, which requires us to make judgments about each individual customer's ability and intention to fully pay balances payable to us. We make these judgments based on our knowledge of and relationships with our customers and we update our estimates on a monthly basis. Any changes in estimate, which can be significant, are included in earnings in the period in which the change in estimate occurs.

Stock-Based Compensation

Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.

We currently use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. Expected volatilities are based on historical daily closing prices adjusted for our expected future volatility. The Company believes that implied volatility is more reflective of market conditions and a better indicator of expected volatility than historical volatility. The Company uses historical information to calculate the expected life of option grants. The Company believes that historical information is currently reflective of the economic life of outstanding option grants. The dividend yield is determined by dividing the expected per share dividend during the coming year by the average fair market value of the stock during the period. The Company has not historically declared any cash dividends on our common stock. We currently intend to retain any earnings to finance the operation and expansion of our business and therefore do not expect to pay cash dividends on our common stock in the foreseeable future. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The estimated fair value of the employee stock options are amortized to expense using the straight-line method over the vesting period.

If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods or if we decide to use a different valuation model, the future periods may differ significantly from what we have recorded in the current period and could materially affect our operating income, net income and net income per share.


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The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and employee stock purchase plan shares. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. There currently is no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.

See Note 11 Stock-Based Compensation to the consolidated financial statements for further information regarding ASC Topic 718, Stock Compensation.

Deferred Taxes

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Because of substantial losses from inception through fiscal year 2011, the Company has available net operating loss ("NOL") carry-forwards of approximately $25,375,000.

Accounting principles generally accepted in the United States of America require the recording of a valuation allowance against the net deferred tax asset associated with this NOL and other timing differences if it is "more likely than not" that the Company will not be able to utilize the NOL to offset future taxes. Due to the size of the NOL carry-forward in relation to the Company's taxable income in recent years and to the continuing uncertainties surrounding future earnings, to the extent that it is more likely than not that deferred tax assets may not be realized, management has provided for an allowance on its net deferred tax assets. The Company currently provides for income taxes only to the extent of expected cash payments of taxes, primarily state and foreign income taxes.

Should the Company's earnings trend cause management to conclude that it is more likely than not the Company will realize all or a material portion of the NOL carry-forward, management would record the estimated net realizable value of its deferred tax asset at that time. The Company would then provide for income taxes at a rate equal to its combined federal and state effective rates, which would approximate 39% under current tax rates. Subsequent revisions to the estimated net realizable value of the deferred tax asset could cause the provision for income taxes to vary significantly from period to period, although the Company's cash tax payments would remain unaffected until the benefit of the NOL is utilized.


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RESULTS OF OPERATIONS

The following table presents our statements of operations expressed as a percentage of net revenues for fiscal years 2012 and 2011:

                                                         For the Years Ended July 31,
                                                      2012                         2011
Net revenue                                               100.0 %                      100.0 %
Cost of revenue                                            72.8 %                       73.1 %

Gross profit                                               27.2 %                       26.9 %
Operating expense:
Selling, general and administrative                        22.0 %                       24.6 %
Research and development                                    2.0 %                        2.1 %
Asset impairment                                            0.0 %                        3.9 %
Other                                                       0.1 %                        0.2 %

Total operating expense                                    24.1 %                       30.8 %

Income (loss) from operations                               3.1 %                       (3.9 %)
Interest expense, net                                      (0.7 %)                      (0.9 %)

Income (loss) before income taxes and
discontinued operations                                     2.4 %                       (4.8 %)
Income tax expense                                          0.1 %                        0.2 %

Net income (loss) from continuing
operations                                                  2.3 %                       (5.0 %)
Income (loss) from discontinued
operations                                                  0.0 %                       (0.5 %)

Net income (loss)                                           2.3 %                       (5.5 %)
Less: net income attributable to the
noncontrolling interest                                     0.2 %                        0.4 %

Net income (loss) attributable to common
shareholders                                                2.1 %                       (5.9 %)

NET REVENUE

Revenue is comprised of product revenue generated by our Millennium, eQueue, Cortelco and CSPR product lines and maintenance and professional service revenue generated by our eQueue and CSPR product line. Net revenue decreased approximately 4% to $22,497,000 for the year ended July 31, 2012 from $23,416,000 for the previous fiscal year. Lower CSPR, eQueue and Millennium revenue is partially offset by additional Cortelco revenue compared to the prior year.

COST OF REVENUE AND GROSS PROFIT

Cost of revenue is primarily comprised of purchases from our contract manufacturers and other suppliers and costs incurred for final assembly of our phones and systems. Gross profit from continuing operations decreased approximately 3% to $6,112,000 for the year ended July 31, 2012 compared to $6,307,000 for the previous fiscal year. The decrease in gross profit reflects lower Cortelco and CSPR gross profit partially offset by additional Millennium and eQueue product, maintenance and professional service gross profit. Gross profit in the prior fiscal year was negatively impacted by inventory reserve provisions for excess and obsolete inventory of approximately $629,000, excluding approximately $133,000 in inventory reserve provisions related to discontinued operations in China. Our gross margins were 27% and 27% for fiscal years 2012 and 2011, respectively.


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SELLING, GENERAL, AND ADMINISTRATIVE EXPENSE

Selling, general and administrative expenses were $4,936,000 for the year ended July 31, 2012, a decrease of 14% from $5,750,000 in the prior fiscal year. The decrease reflects lower personnel costs, overhead and other expenses.

RESEARCH AND DEVELOPMENT EXPENSE

Research and development expenses are primarily comprised of personnel and related expenses for our engineering staff. Research and development expenses were $459,000 for the year ended July 31, 2012, which represents a decrease of approximately 5% from $483,000 in fiscal year 2011. The decrease primarily reflects lower subcontract costs and overhead expenses. The Company capitalized approximately $218,000 of software development costs in fiscal 2011 related to a new eConn IP PBX and IP ACD that were under development. Subsequent to the general release of the eConn IP PBX to customers in the first fiscal quarter of 2011, the product did not reach the anticipated level of market acceptance. Consequently, capitalized cost accumulated to-date were written off in the fourth quarter of fiscal 2011. Although not actively marketed, the Company continues to sell the eConn IP-PBX. No software development cost was capitalized in fiscal 2012.

ASSET IMPAIRMENT

Asset impairment is comprised of software development and process technology impairment in fiscal 2011. Subsequent to the general release of the eConn IP PBX to customers in the first fiscal quarter of 2011, the product did not reach the anticipated level of market acceptance. Consequently, capitalized costs of approximately $916,000 were written off in the fourth quarter of fiscal year 2011.

OTHER EXPENSE

Other expense is primarily comprised of bank service charges, franchise taxes, currency differences and gains or losses from disposal of fixed assets. Other expense was $25,000 in fiscal 2012 compared to an expense of $50,000 in fiscal year 2011.

INTEREST EXPENSE, NET

Interest expense was $160,000 in fiscal year 2012 and $219,000 in fiscal year 2011. Fiscal year 2012 reflects imputed interest of $150,000 on the note payable to the former Cortelco shareholders compared to $206,000 in fiscal year 2011.

INCOME TAX EXPENSE

Income tax expense totaled $20,000 in fiscal 2012 and $54,000 in fiscal 2011. Income tax expense differed from tax expense at the statutory federal income tax rate due to state income taxes and the valuation allowance established.

DISCONTINUED OPERATIONS

Loss from discontinued operations of the Company's wholly-owned subsidiary in China was $125,000 in fiscal year 2011. The loss in fiscal year 2011 included approximately $167,000 of inventory write downs and was partially offset by the reversal of approximately $107,000 in accumulated foreign currency adjustments.

LIQUIDITY AND CAPITAL RESOURCES

As of July 31, 2012, the Company had cash and cash equivalents of $2,162,000 compared to $1,542,000 as of July 31, 2011. The increase in cash and cash equivalents of $620,000 during fiscal year 2012 was primarily attributable to net income, lower receivables and inventories partially offset by decreased accounts payable and purchases of equipment. The Company had a working capital balance of $7,753,000 at July 31, 2012.


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Our operating activities resulted in net cash inflows of $891,000 for fiscal year 2012 compared to net cash outflows of $1,420,000 for fiscal year 2011. The increase in net operating cash flow for the current fiscal year primarily reflects net income (adjusted for non cash items) for the year, lower accounts receivable and inventories partially offset by lower accounts payable.

Our investing activities resulted in net cash outflows of $232,000 for fiscal year 2012 compared to net cash outflows of $306,000 in fiscal year 2011. Cash used in investing activities for fiscal year 2012 was for capital expenditures. Cash used in investing activities for fiscal year 2011 included capitalized software development costs of $218,000 and capital expenditures.

Our financing activities resulted in net cash outflows of $39,000 in fiscal year 2012 compared to net cash outflows of $842,000 in fiscal year 2011. Cash used in financing activities during fiscal year 2012 and 2011 was attributable to payments on the Cortelco Note partially offset by purchases under the Employee Stock Purchase Plan.

We believe that our available funds will satisfy our projected working capital and capital expenditure requirements for at least the next twelve months. To the extent future revenues are not realized or we grow more rapidly than expected, we may need additional cash to finance our operating activities and capital expenditures. Should we need financing, there can be no assurances that financing will be available to us on economically acceptable terms.

Due to the current state of the credit markets, we are not able to predict with any certainty whether we could obtain debt or equity financing to provide additional sources of liquidity, should the need arise, at favorable rates.

Liquidity

Since inception, the Company has financed its operations through debt financing and proceeds generated from public offerings of its common stock. The proceeds from these transactions have been used primarily to fund research and development costs, and selling, general and administrative expenses.

The Company has incurred substantial net operating losses since inception and negative cash flows from operating activities resulting in an accumulated deficit of $49,305,000. The Company recorded net income of $464,000 in fiscal year 2012. As of July 31, 2012, the Company had $2,162,000 in cash and cash equivalents available to fund operations.

The Company is largely dependent on available cash and operating cash flow to finance operations and meet its other capital needs. Cortelco has a line of credit based on an asset formula involving accounts receivable and inventory up to a maximum of $1,000,000, none of which was drawn on as of July 31, 2012. The line of credit is secured by substantially all of Cortelco's assets. The loan's interest rate is floating based on LIBOR and expires December 15, 2012. CSPR has a $500,000 revolving line of credit secured by trade accounts receivable and bears interest at 2% over prime. The line of credit, none of which was drawn on as of July 31, 2012, is subject to certain covenant requirements and expires November 30, 2012. If such sources are not sufficient, alternative funding sources may not be available. The Company believes that cash on hand, short-term marketable securities, and the lines of credit plus the additional liquidity that it expects to generate from operations will be sufficient to cover its working capital and fund expected capital expenditures over at least the next twelve months.

Capital Resources

The Company believes that the cash, short-term marketable securities on hand, lines of credit, plus the additional liquidity that we expect to generate from operations will be sufficient to meet the cash requirements of the business including capital expenditures and working capital needs for at least the next twelve months. Should


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actual results differ significantly from our current assumptions, our liquidity position could be adversely affected and the Company could be in a position that would require the Company to raise additional capital, which may not be available to the Company or may not be available on acceptable terms.

NET INCOME (LOSS)

Net income was $464,000 in fiscal year 2012 compared to a net loss of $1,380,000 in fiscal year 2011. Reported net income has been materially impacted by the imputed interest expense due to the amortization of the difference between the face value of the contingent obligation to the former Cortelco shareholders and the discounted present value of the note payable recorded on the balance sheet. The table below presents a non-GAAP financial disclosure to provide a quantitative analysis of the impact of the imputed interest expense on reported net income (loss) and income (loss) per share. Management does not include this expense in its analysis of financial results or how resources are allocated. Because of this, we deemed it meaningful to provide this non-GAAP disclosure of the impact of this significant item on our financial results.

Non-GAAP Financial Disclosure

(In thousands, except per share amounts)

                                                         Year Ended             Year Ended
                                                       July  31, 2012         July  31, 2011
Net income (loss) reported                            $            464        $        (1,380 )
Interest imputed                                                   150                    206

Net income (loss) less imputed interest                            614                 (1,174 )
Loss from discontinued operations                                    0                   (125 )

Net income (loss) from continuing operations
less imputed interest                                 $            614        $        (1,299 )

Net income (loss) per common share as reported
Continuing operations                                             0.16                  (0.44 )
Discontinued operations                                             -                   (0.04 )

Total                                                 $           0.16        $         (0.48 )

Interest imputed per common share                                 0.05                   0.07
Net income (loss) per common share less imputed
interest
Continuing operations                                             0.21                  (0.37 )
Discontinued operations                                             -                   (0.04 )

. . .
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