UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934.
For the quarterly period ended August 31, 2005.
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OR
[_] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934.
For the transition period from to .
-------------------- ---------------------
Commission file number 0-4465
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eLEC Communications Corp.
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(Exact Name of Small Business Issuer as Specified in Its Charter)
New York 13-2511270
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(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
75 South Broadway, Suite 302, White Plains, New York 10601
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(Address of Principal Executive Offices) (Zip Code)
Issuer's Telephone Number, Including Area Code 914-682-0214
------------
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [_].
Indicate by check mark whether the registrant is a shell company (as
defined by Rule 12b-2 of the Exchange Act). Yes [_] No [X .
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: 16,839,282 shares of Common
---------------------------
Stock, par value $.10 per share, as of October 1, 2005.
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PART 1. FINANCIAL INFORMATION
-----------------------------
Item 1. Financial Statements
------- --------------------
eLEC Communications Corp. and Subsidiaries
Condensed Consolidated Balance Sheet
August 31, 2005
---------------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents $ 413,896
Accounts receivable, net 1,342,716
Prepaid expenses and other current assets 85,077
------------
Total current assets 1,841,689
Property, plant and equipment, net 509,533
Other assets 167,165
Deferred finance costs 173,710
------------
Total assets $ 2,692,097
============
Liabilities and stockholders' equity deficiency Current liabilities:
Short-term borrowings $ 310,953
Current maturities of long-term debt and capital lease
obligations 759,373
Accounts payable and accrued expenses 2,628,288
Taxes payable 701,694
Due to related party 59,060
Deferred revenue 355,000
------------
Total current liabilities 4,814,368
------------
Long-term debt 520,403
------------
Stockholders' equity deficiency:
Common stock, $.10 par value, 50,000,000 shares authorized,
16,839,282 shares issued 1,683,928
Capital in excess of par value 26,743,533
Deficit (31,061,721)
Accumulated other comprehensive loss, unrealized loss on securities (8,414)
------------
Total stockholders' equity deficiency (2,642,674)
------------
Total liabilities and stockholders' equity deficiency $ 2,692,097
============
See notes to the condensed consolidated financial statements.
2
eLEC Communications Corp. and Subsidiaries
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)
(Unaudited)
For the Nine Months Ended For the Three Months Ended
Aug. 31, 2005 Aug. 31, 2004 Aug. 31, 2005 Aug. 31, 2004
------------- ------------- ------------- -------------
Revenues $ 12,825,614 $ 6,207,988 $ 4,146,759 $ 2,438,064
------------ ------------ ------------ ------------
Costs and expenses:
Costs of services 6,793,655 2,955,924 2,239,915 1,159,223
Selling, general and administrative 8,099,313 3,610,685 2,369,496 1,670,626
Depreciation and amortization 26,248 12,112 22,806 4,301
------------ ------------ ------------ ------------
Total costs and expenses 14,919,216 6,578,721 4,632,217 2,834,150
------------ ------------ ------------ ------------
Loss from operations (2,093,602) (370,733) (485,458) (396,086)
------------ ------------ ------------ ------------
Other income (expense):
Interest expense (580,025) (3,126) (263,837) --
Other income (loss) 51,301 28,153 16,328 (22,498)
Gain on sale of investment securities and
other investments 352,887 770 323,253 --
Change in warrant valuation 151,568 -- 34,575 --
------------ ------------ ------------ ------------
Total other income (expense) (24,269) 25,797 110,319 (22,498)
------------ ------------ ------------ ------------
Loss before bankruptcy reorganization items
and income tax benefit (2,117,871) (344,936) (375,139) (418,584)
------------ ------------ ------------ ------------
Reorganization items:
Gain on settlement with creditors -- 904,027 -- --
Professional fees -- (161,008) -- --
------------ ------------ ------------ ------------
-- 743,019 -- --
------------ ------------ ------------ ------------
Income (loss) before income tax benefit (2,117,871) 398,083 (375,139) (418,584)
Income tax benefit -- (47,937) -- --
------------ ------------ ------------ ------------
Net income (loss) (2,117,871) 446,020 (375,139) (418,584)
Other comprehensive loss -
unrealized loss on marketable securities (6,563) (2,566) (1,180) (270)
------------ ------------ ------------ ------------
Comprehensive income (loss) ($2,124,434) $ 443,454 ($376,319) ($418,854)
============ ============ ============ ============
Basic and diluted earnings (loss) per share ($0.13) $ 0.03 ($0.02) ($0.03)
============ ============ ============ ============
Weighted average number of common shares
outstanding
Basic 16,748,041 16,254,282 16,798,847 16,254,282
============ ============ ============ ============
Diluted 16,748,041 16,652,398 16,798,847 16,254,282
============ ============ ============ ============
See notes to the condensed consolidated financial statements.
3
eLEC Communications Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
For the Nine Months Ended
Aug. 31, 2005 Aug. 31, 2004
------------- -------------
Net cash used in operating activities: ($1,800,541) ($366,808)
----------- -----------
Cash flows used in investing activities:
Purchase of property and equipment (343,370) (88,569)
Purchase of investment securities (7,006) --
Proceeds from investment securities 356,699 770
----------- -----------
Net cash provided by (used in) investing activities 6,323 (87,799)
----------- -----------
Cash flows from financing activities:
Repayment of long-term debt (242,424) (7,260)
Principal payments on pre-petition debt in bankruptcy proceedings -- (23,830)
Proceeds from short-term borrowings 273,686 --
Proceeds from secured convertible note 1,744,500 --
Proceeds from the exercise of options 60,500 --
----------- -----------
Net cash provided by (used in) financing activities 1,836,262 (31,090)
----------- -----------
Increase (decrease) in cash and cash equivalents 42,044 (485,697)
Cash and cash equivalents at beginning of period 371,852 669,022
----------- -----------
Cash and cash equivalents at the end of period $ 413,896 $ 183,325
=========== ===========
See notes to the condensed consolidated financial statements.
4
eLEC COMMUNICATIONS CORP.
-------------------------
Notes To Condensed Consolidated Financial Statements (Unaudited)
----------------------------------------------------------------
Note 1-Basis of Presentation
----------------------------
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-QSB of Regulation
S-B. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the nine-month period ended August 31, 2005 are
not necessarily indicative of the results that may be expected for the year
ended November 30, 2005. For further information, refer to the consolidated
financial statements and footnotes thereto included in our Annual Report on Form
10-KSB for the year ended November 30, 2004.
Note 2-Principal Financing Arrangements
---------------------------------------
On December 17, 2004, we sold a promissory note (the "Note") in the principal
amount of approximately $328,767 and 160,000 shares of our restricted common
stock to an unaffiliated party for $300,000, of which $32,000 has been allocated
to common stock issuances. The Note is payable on December 17, 2005 and is
unsecured. The Note requires us to spend the proceeds of the Note on sales and
marketing efforts. We recorded costs of $36,314 in connection with the issuance
of the Note, which are being amortized over the term of the Note. Amortization
of these costs for the nine- and three-month periods ended August 31, 2005 was
$25,668 and $9,153, respectively, and was included in our selling, general and
administrative expenses ("SG&A") as financing costs. Amortization of the $32,000
debt discount for the nine- and three-month periods ended August 31, 2005 was
$22,619 and $8,066, respectively, and was included in interest expense.
On February 8, 2005, we entered into a secured financing arrangement with Laurus
Master Fund, Ltd. ("Laurus"). The financing consisted of a $2 million secured
convertible term note (the "Convertible Note") that bears interest at the rate
of prime (as published in the Wall Street Journal), plus three percent (9.5% as
of August 31, 2005), and was initially scheduled to mature on February 8, 2006
but was subsequently extended to February 8, 2008. The Convertible Note is
convertible into shares of our common stock at an initial fixed price of $0.63
per share. The fixed conversion price of the Convertible Note is subject to
anti-dilution protection, on a weighted-average basis, upon our issuance of
additional shares of our common stock at a price that is less than the fixed
conversion price.
In connection with the financing, Laurus was also issued warrants to purchase up
to 793,650 shares of our common stock. The warrants are exercisable as follows:
264,550 shares at $0.72 per share; 264,550 shares at $0.79 per share and the
balance at $0.95 per share. The underlying contracts contained certain
provisions providing for a cash settlement. EITF 00-19 precludes classifying the
warrants as equity, as all of the conditions stated in paragraphs 14-32 of EITF
00-19 were not satisfied. Accordingly, the warrants have been classified as
debt. The proceeds of the Convertible Note were allocated first to the fair
value of the warrants (liability) and the remainder to the debt instrument. We
computed the beneficial conversion feature embedded in
5
the debt instrument using the effective conversion price in accordance with EITF
98-5, EITF 00-19 and EITF 00-27. We recorded (i) debt discounts of $504,128 for
the valuation of the 793,650 warrants issued with the Convertible Note (computed
using a Black-Scholes model with an interest rate of 2.31%, volatility of 158%,
zero dividends and expected term of seven years); (ii) $705,866 for the
beneficial conversion feature inherent in the Convertible Note; and (iii)
$106,500 for debt issue costs paid to affiliates of the lender. In addition, we
issued to Source Capital Group Inc., an investment banking firm, warrants to
purchase up to 253,968 shares of our common stock as additional debt issue
costs. These warrants were valued at $149,783 using the Black-Scholes model as
discussed above. Total debt issuance costs incurred to third parties for
arranging the financing aggregated $311,287, including the value of the warrants
to Source Capital Group Inc. Amortization of these costs for the nine- and
three-month periods ended August 31, 2005 was $658,230 and $297,941,
respectively, of which $204,196 and $93,180, respectively, was included in SG&A
as financing costs and $454,035 and $204,761, respectively, was included in
interest expense. Discounts are being amortized over one year, the initial term
of the Convertible Note, using the effective interest method. The warrant
liability is adjusted at each reporting date to fair market value using the
Black-Scholes model, with a corresponding charge or credit to income. For the
nine- and three-month periods ended August 31, 2005, we recorded income of
$151,568 and $34,575, respectively.
To secure the payment of all of our obligations to Laurus, we entered into a
Master Security Agreement that assigns and grants to Laurus a continuing
security interest in all of the following property now owned or at any time
acquired by us or our subsidiaries, or in which we or any of our subsidiaries
now has or at any time in the future may acquire any right, title or interest:
all cash, cash equivalents, accounts, deposit accounts, inventory, equipment,
goods, documents, instruments (including, without limitation, promissory notes),
contract rights, general tangibles, chattel paper, supporting obligations,
investment property, letter-of-credit rights, trademarks, trademark
applications, patents, patent applications, copyrights, copyright applications,
and any other intellectual property, in each case, in which we or any of our
subsidiaries now has or may acquire any right, title or interest, all proceeds
and products thereof (including, without limitation, proceeds of insurance) and
all additions, accessions and substitutions. In the event we or any of our
subsidiaries wishes to finance an acquisition in the ordinary course of business
of any hereafter-acquired equipment and has obtained a commitment from a
financing source to finance such equipment from an unrelated third party, Laurus
has agreed to release its security interest on such hereafter-acquired equipment
so financed by such third party financing source.
The Convertible Note is to be repaid using cash or an equity conversion option
as follows: we are obligated to make monthly payments to Laurus in the amount of
$60,606, together with any accrued and unpaid interest to date. By the fifth
business day prior to each payment date, Laurus may deliver to us a written
notice directing that the monthly amount payable on the next payment date shall
be paid in either shares of common stock or a combination of cash and common
stock. If a repayment notice is not delivered by Laurus on or before the
applicable notice date for any payment date, then we are obligated to pay the
monthly amount due in cash. Any portion of the monthly amount paid in cash shall
be paid to Laurus in an amount equal to 102% of the principal portion of the
monthly amount due. If Laurus elects to receive all or a portion of the monthly
amount in shares of our common stock, the number of such shares to be issued by
us will be determined by dividing the portion of the monthly amount to be paid
in shares of common stock, by the applicable fixed conversion price, which is
presently $0.63 per share. Payments due on June 1, July 1, August 1 and
September 1, 2005 were made in cash.
6
A registration rights agreement was executed requiring us to register under the
Securities Act of 1933, as amended, the shares of our common stock underlying
the Convertible Note and warrants and our registration statement filed in
response to such requirement was declared effective on June 10, 2005.
Note 3-Major Customer
---------------------
During the nine- and three-month periods ended August 31, 2005 and August 31,
2004, no one customer accounted for more than 10% of revenue.
Note 4-Income Taxes
-------------------
At November 30, 2004, we had net operating loss carryforwards for Federal income
tax purposes of approximately $21,000,000 expiring in the years 2008 through
2024. There is an annual limitation of approximately $187,000 on the utilization
of approximately $2,450,000 of such net operating loss carryforwards under the
provisions of Internal Revenue Code Section 382.
Note 5-Earnings (Loss) Per Common Share
---------------------------------------
Basic earnings (loss) per common share are calculated by dividing net income
(loss) by the weighted average number of common shares outstanding during the
period. Diluted earnings per share is calculated by dividing net income by the
sum of the weighted average number of common shares outstanding plus all
additional common shares that would have been outstanding if potentially
dilutive securities had been issued unless such inclusion reduced the loss per
share. A reconciliation of the shares used in the computation of our basic and
diluted earnings per common share is as follows:
Nine Months Ended
Aug. 31, 2005 Aug. 31, 2004
------------- -------------
Weighted average common shares outstanding 16,748,041 16,254,282
Dilutive effect of securities -- 398,116
---------- ----------
16,748,041 16,652,398
========== ==========
Three Months Ended
Aug. 31, 2005 Aug. 31, 2004
------------- -------------
Weighted average common shares outstanding 16,798,847 16,254,282
Dilutive effect of securities -- --
---------- ----------
16,798,847 16,254,282
========== ==========
For the nine- and three-month periods ended August 31, 2005, approximately
7,800,000 of our stock options, warrants and shares issuable upon the potential
conversion of the Convertible Note were excluded from the calculation of diluted
earnings (loss) per share because the effect would be anti-dilutive. For the
nine- and three-month periods ended August 31, 2004, approximately 1,500,000 and
2,500,000 of our stock options and warrants were excluded from the calculation
of diluted earnings per share because the effect would be anti-dilutive.
7
Note 6-Subsidiary's Plan of Reorganization
------------------------------------------
On July 29, 2002, Telecarrier Services, Inc. ("TSI"), a wholly-owned subsidiary,
filed a voluntary petition for relief under Chapter 11 of the Federal Bankruptcy
Code in the United States Bankruptcy Court for the Southern District of New
York. On April 8, 2004, the United States Bankruptcy Court for the Southern
District of New York confirmed a Plan of Reorganization (the "Bankruptcy Plan")
for TSI. The Bankruptcy Plan authorized us to disburse $325,000 to creditors in
full satisfaction of claims amounting to approximately $1,229,000, when TSI
emerged from bankruptcy. For the nine-month period ended August 31, 2004, we
reported a gain of approximately $904,000 as a result of TSI's settlement with
creditors and approximately $161,000 in professional fees. Included in our gain
for the nine-months ended August 31, 2004 was a gain of approximately $51,000
that resulted from a court-stipulated reduction in post-petition liabilities
(See Note 9). These items are included under the heading "Reorganization items"
in our Condensed Consolidated Statement of Operations and Comprehensive Income
(Loss). No such transaction occurred in the three-month period ended August 31,
2004 or in the nine- and three-month periods ended August 31, 2005.
Note 7-Risks and Uncertainties
------------------------------
We buy substantially all of our landline telecommunication services from
Regional Bell Operating Companies ("RBOCs"), and are, therefore, highly
dependent upon them. We believe our relationship with the RBOCs from which we
purchase services is satisfactory. We also believe there are other suppliers of
telecommunication services in the geographical locations in which we conduct
business. In addition, we are at risk to regulatory changes that govern the
rates we are to be charged and the obligations of the RBOCs to interconnect
with, or provide unbundled network elements to their competitors. The Federal
Communications Commission ("FCC") and state public utility commissions have
adopted extensive rules to implement the Telecommunications Act of 1996, which
sets standards for relationships between communications providers, and they
revisit such regulations on an ongoing basis in response to the evolving
marketplace and court decisions. In light of the foregoing, it is possible that
the loss of our relationship with the primary RBOC that supplies us with
wholesale telephone services or a significant unfavorable change in the
regulatory environment would have a severe near-term impact on our ability to
conduct our landline telecommunications business. In order to reduce regulatory
risks going forward, our principal operating subsidiary has signed a
commercially negotiated wholesale services agreement with two of the RBOCs.
Future results of operations involve a number of risks and uncertainties.
Factors that could affect future operating results and cash flows and cause
actual results to vary materially from historical results include, but are not
limited to:
- Our business strategy with respect to bundled local and long
distance services may not succeed.
- Our business strategy with respect to Voice over Internet Protocol
("VoIP") may not succeed.
8
- Failure to manage, or difficulties in managing, our growth,
operations or restructurings, including attracting and retaining
qualified personnel and opening up new territories for our service
with favorable gross margins.
- Dependence on the availability or functionality of incumbent local
telephone companies' networks, which we purchase on a wholesale
basis and resell.
- Dependence on third party companies to process call records from our
customers and provide billing services.
- Increased price competition in local and long distance service.
- Failure or interruption in our network and information systems.
- Changes in government policy, regulation and enforcement.
- Failure of our collection management system and credit controls
efforts for customers.
- Inability to adapt to technological change.
- Competition in the telecommunications industry.
- Inability to manage customer attrition and bad debt expense.
- Adverse change in our relationship with third party carriers.
- Failure or bankruptcy of other telecommunications companies upon
whom we rely for services and revenues.
- Lack of capital or borrowing capacity, and inability to generate
cash flow.
- Inability to launch our VoIP telephony product, the success of which
may be dependent upon a variety of factors, including scalability of
our systems, product and feature selection, timely implementation of
new products, product performance, implementation of service
features mandated by federal and state laws, effectiveness of
promotional efforts, cost effectiveness of our products, and
appropriate identification of market demand for our existing and new
products.
Because of the unexpected level of losses that we have incurred in the current
year, as well as other factors, including, but not limited to, (1) the
significant use of our cash resources during the current year, (2) our negative
working capital, and (3) our negative shareholders equity as of August 31, 2005,
our ability to continue as a going concern is dependent upon factors, including,
but not limited to, our ability to (x) improve our operating results, (y)
generate sufficient cash from our businesses to meet our obligations as they
become due, and (z) raise additional cash through borrowings or equity
financings. We anticipate that we will be able to raise cash through our current
lender, with whom we have a good relationship. We have initially approached our
current lender to fund the growth of VoX, and it has responded in a positive
manner to our inquiries. There can be no assurance, however, that we will be
able to successfully accomplish these objectives.
Note 8-Stock-Based Compensation Plans
-------------------------------------
We issue stock options to our employees and outside directors pursuant to
stockholder-approved and non-approved stock option programs. We account for our
stock-based compensation plans under the intrinsic value method of accounting,
as defined by Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees, and related interpretations. No stock-based employee
compensation cost was reflected in net income (loss) for the nine- and
9
three- months ended August 31, 2005 and 2004, as all options granted under these
plans had an exercise price equal to the fair market value of the underlying
common stock on the date of the grant. For pro forma disclosures, the estimated
fair value of the options was amortized over the vesting periods, which range
from immediate vesting to three years. The following table illustrates the
affect on net income (loss) per share if we had accounted for our stock option
and stock purchase plans under the fair value method of accounting under
Statement of Financial Accounting Standards ("SFAS") No. 123R, "Accounting for
Stock-Based Compensation", as amended by SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure":
For the Nine Months Ended For the Three Months Ended
Aug. 31, 2005 Aug. 31, 2004 Aug. 31, 2005 Aug. 31, 2004
------------- ------------- ------------- -------------
Net income (loss) as reported ($2,117,871) $446,020 ($375,139) ($418,584)
Deduct: Total stock-based employee
compensation expense determined
under fair value-based method
for all awards, net of related
tax effects (279,664) (168,724) (79,315) (56,593)
----------- -------- --------- ---------
Pro forma net income (loss) ($2,397,535) $277,296 ($454,454) ($475,177)
----------- -------- --------- ---------
Earnings (loss) per share
Basic, as reported ($0.13) $.03 ($0.02) ($.03)
Basic, pro forma ($0.14) $.02 ($0.03) ($.03)
Diluted, as reported ($0.13) $.03 ($0.02) ($.03)
Diluted, pro forma ($0.14) $.02 ($0.03) ($.03)
Note 9-Related Party Transactions
---------------------------------
TSI had an agreement, effective January 2, 2002, with Telco Services, Inc.
("Telco"), a corporation owned by a former shareholder, under which Telco
provided TSI with collection, sales and other services. As a result of a
court-stipulated agreement between TSI and Telco, entered into on February 6,
2004, the amount owed Telco for such services was reduced by approximately
$51,000. Such reduction was reported as a gain for the nine-month period ended
August 31, 2004 (See Note 6).
During the nine- and three-month periods ended August 31, 2005, we billed Cordia
Corporation ("Cordia"), a related party, $57,394 and $16,542, respectively, for
commissions and other costs, and Cordia billed us $454,851 and $104,005,
respectively, for telecommunications services, billing services and other sundry
costs. During the nine- and three-month periods ended August 31, 2004, we billed
Cordia, $306,804 and $8,773, respectively, for telecommunications services,
commissions and other costs, and Cordia billed us $531,352 and $142,856,
respectively, for telecommunications services, billing services and other sundry
costs. As of August 31, 2005, we owed Cordia $59,060.
10
Note 10-Defined Benefit Plan
----------------------------
We sponsor a defined benefit plan covering two active employees and a number of
former employees. Our funding policy with respect to the defined benefit plan is
to contribute annually not less than the minimum required by applicable law and
regulation to cover the normal cost and to fund supplemental costs, if any, from
the date each supplemental cost was incurred. Contributions are intended to
provide not only for benefits attributable to service to date, but also for
those expected in the future.
For the nine- and three-month periods ended August 31, 2005 and 2004, we
recorded pension expense of $72,000 and $24,000, respectively. For the
nine-month periods ended August 31, 2005 and 2004, we contributed $25,000 and
$64,000, respectively, to our defined benefit plan. We expect to contribute an
additional $75,000 to our defined benefit plan in remainder of fiscal 2005. The
current investment strategy for the defined benefit plan is to invest in
conservative debt and equity securities. The expected long-term rate of return
on plan assets is 8%.
11
Item 2. Management's Analysis and Discussion or Plan of Operation
------- ---------------------------------------------------------
The statements contained in this Report that are not historical facts are
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 with respect to our financial condition, results
of operations and business, which can be identified by the use of
forward-looking terminology, such as "estimates," "projects," "plans,"
"believes," "expects," "anticipates," "intends," or the negative thereof or
other variations thereon, or by discussions of strategy that involve risks and
uncertainties. Management wishes to caution the reader of the forward-looking
statements, that such statements, which are contained in this Report, reflect
our current beliefs with respect to future events and involve known and unknown
risks, uncertainties and other factors, including, but not limited to, economic,
competitive, regulatory, technological, key employee, and general business
factors affecting our operations, markets, growth, services, products, licenses
and other factors discussed in our other filings with the Securities and
Exchange Commission, and that these statements are only estimates or
predictions. No assurances can be given regarding the achievement of future
results, as actual results may differ materially as a result of risks facing us,
and actual events may differ from the assumptions underlying the statements that
have been made regarding anticipated events. Factors that may cause our actual
results, performance or achievements, or industry results, to differ materially
from those contemplated by such forward-looking statements include, without
limitation: (1) the availability of additional funds to successfully pursue our
business plan; (2) the impact of changes the Federal Communications Commission
or State Public Service Commissions may make to existing telecommunication laws
and regulations, including laws dealing with Internet telephony; (3) the
cooperation of incumbent carriers that have signed a wholesale service agreement
with us to replace the unbundled network elements platform; (4) our ability to
maintain, attract and integrate internal management, technical information and
management information systems; (5) our ability to market our services to
current and new customers and generate customer demand for our product and
services in the geographical areas in which we operate; (6) our success in
gaining regulatory approval to access new markets; (7) our ability to negotiate
and maintain suitable interconnection agreements with the incumbent carriers;
(8) the availability and maintenance of suitable vendor relationships, in a
timely manner, at reasonable cost; (9) the intensity of competition; and (10)
general economic conditions. All written and oral forward looking statements
made in connection with this Report that are attributable to us or persons
acting on our behalf are expressly qualified in their entirety by these
cautionary statements. Given the uncertainties that surround such statements,
prospective investors are cautioned not to place undue reliance on such
forward-looking statements.
Overview
eLEC Communications Corp. is a telecommunications service holding company with
operations in three wholly-owned subsidiaries. Two of our subsidiaries focus on
delivering integrated telephone service by leasing landlines as a competitive
local exchange carrier ("CLEC") and one subsidiary focuses on delivering such
services by utilizing high-speed Internet connections to provide VoIP services.
We offer small businesses and residential consumers an integrated set of
telecommunications products and services, including local exchange, local
access, domestic and international long distance telephone, VoIP, and a full
suite of features and calling plans. More recently, we began operating as a
facilities-based VoIP carrier for other VoIP companies, as we provide
origination and termination of VoIP traffic as a service to other carriers. To
date, VoIP revenues have not been material. Based upon the contracts that
customers have recently signed with us for VoIP services and the number of
potential customers who are negotiating contracts
12
for our VoIP services, we anticipate that VoIP revenues in fiscal 2006 will be
more than 50% of our consolidated revenues, and could conceivably be
substantially higher.
Our VoIP service is provided by a wholly-owned subsidiary, VoX Communications
Corp. ("VoX"). VoX owns proprietary source code and a softswitch that enables it
to provide more than 20 Class 5 call features, voice mail and enhanced call
handling on its own Session Initiation Protocol ("SIP") server suite. Our SIP
servers are part of a cluster of servers, which we refer to as a server farm, in
which each server performs different network tasks, including back-up and
redundant services. We believe the server farm structure can be easily and
cost-effectively scaled as our VoIP business grows. In addition, servers within
our server farm can be assigned different tasks as demand on the network
dictates. If a server goes down, our server farm is designed in a manner that
subscribers should not have a call interrupted. VoX supports origination and
termination using both the G.711 and G.729 voice codecs. Our research indicates
that approximately 90% of the VoIP traffic in the United States is carried at
G.711, and therefore, for our wholesale customers who have already established a
VoIP business that uses G.711, we provide this service. For our own retail
customers and for the technologically-advanced wholesale accounts, we use the
more efficient G.729 codec, which utilizes significantly less bandwidth in the
transmission of voice services.
We believe our server farm provides us a superior approach to providing voice
services over the Internet because it requires significantly less capital
expenditures than other VoIP strategies. Our equipment expenditures required to
build one server farm, which we project will carry 10,000 retail subscriber
lines, are approximately $100,000. We believe our server farm approach will
provide us significant capital savings when compared to other VoIP carriers that
may purchase one large switch for more than $2 million and then seek to market
to consumers as quickly as possible to bring the switch to an acceptable
utilization level. We also believe our approach is significantly better than the
traditional telecom approach that required hundreds of millions of dollars in
capital expenditures in order to build a network.
Plan of Operation
When we lease landlines in our CLEC business, we utilize the network of an RBOC.
We are dependent on the RBOC for significant operational items such as access to
its back-office support systems, repair functions and switching functions in
order to provide our customers with Plain Old Telephone Service ("POTS").
Although we have been able to successfully provide POTS lines, and we believe we
can continue to do so, we also believe there is greater value in operating as a
facilities-based VoIP carrier, in which case we will no longer be dependent upon
the RBOC, and other carriers will depend on us to carry their traffic. Beginning
in the second quarter of fiscal 2005, we have focused a greater amount of our
corporate resources on the development and implementation of our VoIP platform.
We plan to continue this focus going forward so that the majority of our
revenues will eventually come from our VoIP services.
We plan to grow two kinds of VoIP customer bases, wholesale and retail. A
wholesale customer is a carrier, such as a cable company or a CLEC that has an
existing customer base and desires to provide our VoIP services to its
customers. Depending upon how our wholesale customer wants to operate, we will
either provide it with VoIP services on a private-label basis, in which case the
customer of our wholesale customer will not know they are receiving VoX
services; or as a VoX product, with the sponsorship of our wholesale customer.
The cable companies that have signed with us are already providing high-speed
Internet access to their customers. We believe these cable customers would like
to up-sell their Internet subscribers VoIP services before another
13
VoIP provider offers these customers a VoIP product. For wholesale customers
that are CLECs, we anticipate that several of these accounts will be able to
sell VoIP services to many consumers beyond their existing customer base. One of
our new wholesale customers has attracted more than 10,000 end-users as a CLEC
operating in only one state, and now plans to use the same marketing strategies
in all 50 states to sell our VoIP services. In addition to the larger
geographical market that VoIP can offer a CLEC, we anticipate that our wholesale
VoIP services will be an attractive solution to many CLECs that are looking for
an alternative to reselling the services offered by a RBOC.
We plan to offer our retail VoIP product directly to consumers via
telemarketing, agents and Internet offers. We will incur a direct customer
acquisition cost when we obtain a new retail customer, whereas with our
wholesale accounts, the customer acquisition cost is borne by the wholesale
account. In launching our retail program, we are working with telesales
companies and agents to spread our acquisition costs over several months in
order to limit the amount of upfront capital required to create revenue growth.
Nine Months Ended August 31, 2005 vs. Nine Months Ended August 31, 2004
-----------------------------------------------------------------------
Our revenue for the nine-month period ended August 31, 2005 increased by
approximately $6,618,000, or approximately 107%, to approximately $12,826,000 as
compared to approximately $6,208,000 reported for the nine-month period ended
August 31, 2004. The growth in revenues was directly related to the growth in
the number of local access lines that we served in our CLEC customer base.
Beginning with the third quarter, we have focused more or our efforts and
financial resources on building our VoIP operations and acquiring wholesale VoIP
customers. It is more difficult for us to estimate wholesale line growth than
retail line growth, as we are dependent on the wholesale customer to market the
VoIP services to the end-user. We find the wholesale model beneficial to us, as
we believe smaller cash expenditures are required on our part to secure new
accounts. In order to better control and estimate our future revenue growth, in
October 2005, we began using telemarketing to acquire new VoIP retail customers.
We have established agreements with call centers that allow us to pay for our
customer acquisition costs over a three-month period so that these costs can be
paid from the cash payments we receive from our newly-acquired customers. If our
telemarketing efforts are an effective manner for adding new retail customers,
we believe the deferred payment arrangement offered by the call centers will
allow us rapidly to scale our retail customer base.
Our gross profit for the nine-month period ended August 31, 2005 increased by
approximately $2,780,000 to approximately $6,032,000 from approximately
$3,252,000 reported for the nine-month period ended August 31, 2004. During the
same fiscal periods, our gross profit percentage decreased to 47.0% from 52.4%.
The increase in gross profit resulted from the increase in our customer base in
the first nine months of fiscal 2005 over the same period in fiscal 2004. The
decrease in our gross profit percentage during the 2005 period resulted from the
higher cost of services that we are now incurring under our wholesale services
agreement with Verizon, as compared to the costs we previously incurred under
the Unbundled Network Elements Platform ("UNE-P") service offering. Our selling
strategy in the remainder of fiscal 2005 is to continue to penetrate states that
offer the opportunity to achieve gross margins that are higher than 40%. We
anticipate that our VoIP product will also be able to yield gross margins in
excess of 40%.
14
SG&A increased by approximately $4,488,000, or approximately 124%, to
approximately $8,099,000 for the nine-month period ended August 31, 2005 from
approximately $3,611,000 reported for the prior year fiscal period. Of this
increase, approximately $2,765,000 was for bad debt expense, approximately
$661,000 was for increased personnel costs, of which approximately $290,000 was
related to VoX, approximately $241,000 was for billing costs, approximately
$232,000 was for financing costs (See Note 2), approximately $107,000 was for
non-employee option costs, and approximately $97,000 was for other VoX operating
costs. From January 2005 until mid-April 2005, our CLECs attracted an unusually
high number of residential consumers that did not pay our invoices, and for
which we subsequently terminated services, even though such customers had
qualifying credit scores. Although growth tends to be easier in the residential
market than in the business market, in the third quarter we began selling
approximately 75% of our new CLEC lines to business customers, who we have found
are better at paying their monthly telephone bills. We are also allocating
significantly less marketing dollars to new CLEC line acquisition costs. Going
forward, we do not anticipate the continuation of this high percentage of bad
debt expense with our CLEC customers, as the residential customers we are
accepting from outside marketing agencies must be more creditworthy and must pay
their first bill in order for the marketing company to receive its full
commission. With our VoIP customers, we anticipate almost no bad debt expense,
as we require credit card payment from our residential VoIP users, and all of
our wholesale accounts are credit checked and required to pay us a deposit for
future services. We also believe VoIP customers will generate a significantly
lower bad debt percentage because they tend to be more sophisticated Internet
users that are already paying for a broadband connection.
Depreciation expense increased to approximately $26,000 for the nine-month
period ended August 31, 2005 as compared to approximately $12,000 for the
nine-month period ended August 31, 2004 as we began to amortize the capitalized
costs of our VoIP platform in the third quarter of fiscal 2005. In June 2005, we
began running live customers on our VoIP platform and consequently, we have
begun to depreciate the cost of the platform.
Interest expense increased by approximately $577,000 to approximately $580,000
for the nine-month period ended August 31, 2005 as compared to approximately
$3,000 for the nine-month period ended August 31, 2004, as a result of increased
borrowings under our financing agreements (See Note 2).
Other income amounted to approximately $51,000 and $28,000 for the nine-month
periods ended August 31, 2005 and 2004, respectively. For fiscal 2005, income of
approximately $51,000 resulted primarily from commission income. For fiscal 2004
income of approximately $28,000 resulted primarily from commission income of
approximately $88,000, which was partially offset by approximately $45,000 in
additional costs associated with the sale of our headquarters building in the
fourth quarter of fiscal 2003.
For the nine-month period ended August 31, 2005, we recorded income of
approximately $152,500, which resulted from the change in the market value of
the warrants issued to Laurus as part of the Laurus financing (See Note 2). No
such income was recorded in the nine-month period ended August 31, 2004.
For the nine-month periods ended August 31, 2005 and 2004, we recorded gain on
the sale of investment securities of approximately $353,000 and $1,000,
respectively.
15
For the nine-month period ended August 31, 2004, we reported a gain on
settlement with creditors of approximately $904,000, which was offset in part by
approximately $161,000 in professional fees (See Note 6).
For the nine-month period ended August 31, 2004, we recorded a tax benefit of
$48,000 that resulted from the reduction of an estimated accrual of corporate
tax expense for fiscal 2003. No such benefit was recorded for the nine-month
period ended August 31, 2005.
Three Months Ended August 31, 2005 vs. Three Months Ended August 31, 2004
-------------------------------------------------------------------------
Our revenue for the three-month period ended August 31, 2005 increased by
approximately $1,709,000, or approximately 70%, to approximately $4,147,000 as
compared to approximately $2,438,000 reported for the three-month period ended
August 31, 2004. The growth in revenues was directly related to the growth in
the number of local access lines served by our CLEC customer base. As we manage
the launch of our VoIP platform, we expect to use funds that previously would
have been used to maintain or grow our CLEC customer base to pay for the
expenses associated with launching our VoIP operation. Although we began signing
up VoIP customers in the third quarter of fiscal 2005, it is difficult to
project the level of success of our VoIP telemarketing efforts and our VoIP
wholesale program until we have several months of experience selling our product
in this manner.
Our gross profit for the three-month period ended August 31, 2005 increased by
approximately $628,000 to approximately $1,907,000 from approximately $1,279,000
reported for the three-month period ended August 31, 2004. During the same
fiscal periods, our gross profit percentage decreased to 46.0% from 52.5%. The
increase in our gross profit resulted from the increase in our customer base in
the third quarter of fiscal 2005 over the third quarter of fiscal 2004. The
decrease in our gross profit percentage during the 2005 period resulted from the
higher cost of services that we are now incurring under our wholesale services
agreement with Verizon, as compared to the costs we previously incurred under
the UNE-P service offering. As discussed above, our selling strategy in fiscal
2005 is to continue to penetrate states that offer the opportunity to achieve
POTS gross margins that are higher than 40%. We anticipate that our VoIP product
will also be able to yield gross margins in excess of 40%.
SG&A increased by approximately $698,000, or approximately 42%, to approximately
$2,369,000 for the three-month period ended August 31, 2005 from approximately
$1,671,000 reported for the prior year fiscal period. Of this increase,
approximately $680,000 was for bad debt expense, approximately $189,000 was for
increased personnel costs, of which approximately $120,000 was related to VoX,
approximately $70,000 was for billing costs, approximately $104,000 was for
financing costs (See Note 2), approximately $43,000 was for non-employee option
costs, and approximately $60,000 was for other VoX operating costs. This
increase in expense was partially offset by a reduction in telemarketing costs
of approximately $506,000. As discussed above, going forward, we do not
anticipate the continuation of this high percentage of bad debt expense with our
CLEC customers, as the residential customers we are accepting from outside
marketing agencies must be creditworthy and must pay their first bill in order
for the marketing company to receive its full commission.
Depreciation expense increased to approximately $23,000 for the three-month
period ended August 31, 2005 as compared to approximately $4,000 for the
three-month period ended August 31, 2004 as we began to amortize the capitalized
costs of our VoIP platform in the third quarter of fiscal 2005.
16
Interest expense for the three-month period ended August 31, 2005 was
approximately $264,000, as a result of increased borrowings under our recent
financing agreements (See Note 2). We had no interest expense for the
three-month period ended August 31, 2004.
Other income (loss) for the three-month periods ended August 31, 2005 and 2004
was approximately $16,000 and ($22,000), respectively. For fiscal 2005, income
of approximately $16,000 resulted primarily from commission income. For fiscal
2004, loss of approximately ($22,000), resulted primarily from commission income
of approximately $22,000 that was offset by approximately $45,000 in additional
costs associated with the sale of our headquarters building in the fourth
quarter of fiscal 2003
For the three-month period ended August 31, 2005, we recorded income of
approximately $35,000 related to the change in the market value of the warrants
issued to Laurus as part of the Laurus financing (See Note 2). No such income
was recorded in the three-month period ended August 31, 2004.
For the three-month period ended August 31, 2005 we recorded gain on the sale of
investment securities and other investments of approximately $323,000.
Liquidity and Capital Resources
-------------------------------
At August 31, 2005, we had cash and cash equivalents of approximately $414,000
and negative working capital of approximately $2,973,000.
Net cash used in operating activities aggregated approximately $1,801,000 and
$367,000 in the nine-month periods ended August 31, 2005 and 2004, respectively.
The principal use of cash in fiscal 2005 was the loss for the period of
approximately $2,118,000. The principal use of cash in fiscal 2004 was the net
change in operating assets and liabilities and the pay-off of bankruptcy
liabilities, partially offset by the income for the period of approximately
$446,000.
Net cash provided by (used in) investing activities in the nine-month periods
ended August 31, 2005 and 2004 aggregated approximately $6,000 and ($88,000),
respectively. The principal source of cash in fiscal 2005 was the proceeds of
the sale of investment securities of approximately $356,000, which was partially
offset by capital expenditures of approximately $343,000. The principal use of
cash in fiscal 2004 was for capital expenditures.
Net cash provided by (used in) financing activities aggregated approximately
$1,836,000 and ($31,000) in the nine-month periods ended August 31, 2005 and
2004, respectively. In fiscal 2005, net cash provided by financing activities
resulted from the proceeds of short-term and long-term notes, warrants and stock
issuances and the exercise of stock options in the amounts of approximately
$2,018,000 and $60,500, respectively, which was partially offset by debt
repayment of approximately $242,000. In fiscal 2004, net cash used in financing
activities resulted from the repayment of debt.
For the nine-month period ended August 31, 2005, we had approximately $326,000
in capital expenditures primarily related to our VoIP initiative. We expect that
other capital expenditures over the next 12 months will relate primarily to the
continued roll-out of our VoIP services and will only be required to support a
growing customer base of VoIP subscribers.
17
While we have reported profits in the last two fiscal years, we also have
sustained net losses from operations during those periods, as we have worked to
build our customer base. Our operating losses have been funded through the sale
of non-operating assets, the issuance of equity securities and borrowings. We
believe our current cash and cash equivalents may not be sufficient to finance
our operations through at least the next 12 months. We will continue to evaluate
our cash needs and growth opportunities and we anticipate seeking additional
equity or debt financing in order to achieve our overall business objectives.
There can be no assurance that such financing will be available, or, if
available, will be at a price that will be acceptable to us. Failure to generate
sufficient revenues, raise additional capital or reduce certain discretionary
spending will likely have an adverse impact on our ability to achieve our
longer-term business objectives.
Item 3. Controls and Procedures
------- -----------------------
Disclosure Controls and Procedures. We maintain disclosure controls and
procedures designed to ensure that information required to be disclosed in our
reports under the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), is recorded, processed, summarized and reported within the time periods
specified in the Exchange Act, and that such information is accumulated and
communicated to our management, including our chief executive officer/chief
financial officer, as appropriate to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and procedures,
management recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving the
desired control objectives, and management necessarily was required to apply its
judgment in evaluating the cost-benefit relationship of possible controls and
procedures.
In connection with the completion of its audit of, and the issuance of an
unqualified report on, our consolidated financial statements for the fiscal year
ended November 30, 2004, our independent auditors, Nussbaum Yates and Wolpow,
P.C. ("NYW"), communicated to our Audit Committee that the following matters
involving our internal controls and operations were considered to be "reportable
conditions," as defined under standards established by the American Institute of
Certified Public Accountants or AICPA:
o Lack of quantity of staff, which led to issues related to lack of
segregation of duties, inadequate supervision, timeliness of
financial reporting and year-end closing process;
o Lack of quantity of staff, which led to issues related to the timely
preparation and filing of municipal telecommunications tax returns;
and
o Lack of quantity of staff, which led to tax payments being
classified as cost of services and an overstatement of
telecommunications taxes payable.
Reportable conditions are matters coming to the attention of our independent
auditor that, in its judgment, relate to significant deficiencies in the design
or operation of internal controls and could adversely affect our ability to
record, process, summarize and report financial data consistent with the
assertions of management in the financial statements. In addition, NYW has
advised us that it considers the first matter noted above, which relates to the
lack of a segregation of duties, to be a "material weakness" that may increase
the possibility that a material misstatement in our financial statements might
not be prevented or detected by our employees in the normal course of performing
their assigned functions.
18
As required by SEC Rule 13a-15(b), we carried out an evaluation under the
supervision and with the participation of our management, including our chief
executive officer/chief financial officer, of the effectiveness of the design
and operations of our disclosure controls and procedures. Based on the
foregoing, our chief executive officer/chief financial officer determined that
the deficiencies identified by NYW could cause our disclosure controls and
procedures to be less effective at a reasonable assurance level than was
desirable. However, we are actively seeking to remedy the deficiencies
identified herein, including hiring additional staff to assure segregation of
duties, additional review procedures and timeliness of financial reporting, as
well as preparing and filing telecommunications tax returns. Our chief executive
officer/chief financial officer did not note any other material weakness or
significant deficiencies in our disclosure controls and procedures during this
evaluation. We continue to improve and refine our internal controls. This
process is ongoing. In June 2005, we hired an additional staff member for our
accounting department to address the segregation of duties issues and to help
with tax filings.
Internal Control Over Financial Reporting. Other than the matters
discussed above, our chief executive officer/chief financial officer has
determined that our internal controls and procedures were effective as of the
end of the period covered by this report. During the third quarter of fiscal
2005, there were no significant changes in our internal control over financial
reporting or in other factors that materially affected, or are reasonably likely
to materially affect, our internal controls over financial reporting.
19
eLEC COMMUNICATIONS CORP.
-------------------------
PART II-OTHER INFORMATION
-------------------------
Item 1. Legal Proceedings
------- -----------------
None
Item 2. Changes in Securities and Purchases of Equity Securities
------- --------------------------------------------------------
In June and August 2005, we issued an aggregate of 60,000 shares of
our common stock in conjunction with the exercise of options granted
under our Employee Stock Option Plan, as amended. Such shares were
issued in reliance upon the exemption from registration provided by
Section 4(2) of the Securities Act of 1933, as amended, on the basis
that such issuance did not involve a public offering, no underwriter
fees or commissions were paid in connection with such issuance and
each recipient of such shares was an `accredited investor,' as
defined in Regulation D under the Securities Act of 1933, as
amended.
Item 3. Defaults Upon Senior Securities
------- -------------------------------
None
Item 5. Other Information
------- -----------------
None
Item 6. Exhibits
------- --------
31.1 Certification of our Chief Executive Officer and Chief
Financial Officer, Paul H. Riss, Pursuant to 18 U.S.C.
1350 (Section 302 of the Sarbanes-Oxley Act of 2002)
32.1 Certification of our Chief Executive Officer and Chief
Financial Officer, Paul H. Riss, Pursuant to 18 U.S.C.
1350 (Section 906 of the Sarbanes-Oxley Act of 2002)
20
Signatures
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
eLEC Communications Corp.
October 17, 2005 By: /s/ Paul H. Riss
---------------- ------------------------
Date Paul H. Riss
Chief Executive Officer
(Principal Financial and
Accounting Officer)
21