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 May 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 .
--- ---
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: 16,779,282 shares of Common
Stock, par value $.10 per share, as of July 1, 2005.
PART 1. FINANCIAL INFORMATION
-----------------------------
Item 1. Financial Statements
--------------------
eLEC Communications Corp. and Subsidiaries
Condensed Consolidated Balance Sheet
May 31, 2005
------------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents $ 490,645
Accounts receivable, net 1,809,890
Prepaid expenses and other current assets 76,398
------------
Total current assets 2,376,933
Property, plant and equipment, net 411,714
Other assets 95,729
Deferred finance costs 276,044
------------
Total assets $ 3,160,420
============
Liabilities and stockholders' equity deficiency
Current liabilities:
Short-term borrowings $ 295,636
Current maturities of long-term debt and capital lease
obligations 759,373
Accounts payable and accrued expenses 2,673,708
Taxes payable 786,725
Due to related party 74,876
Deferred revenue 486,750
------------
Total current liabilities 5,077,068
------------
Long-term debt 532,036
------------
Stockholders' equity deficiency:
Common stock, $.10 par value, 50,000,000 shares authorized,
16,779,282 shares issued 1,677,928
Capital in excess of par value 26,567,204
Deficit (30,686,582)
Accumulated other comprehensive loss, unrealized loss on
securities (7,234)
------------
Total stockholders' equity deficiency (2,448,684)
------------
Total liabilities and stockholders' equity deficiency $ 3,160,420
============
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 Six Months Ended For the Three Months Ended
May 31, 2005 May 31, 2004 May 31, 2005 May 31, 2004
------------ ------------ ------------ ------------
Revenues $ 8,678,855 $ 3,769,924 $ 4,815,376 $ 1,895,932
----------- ----------- ----------- -----------
Costs and expenses:
Costs of services 4,553,740 1,796,701 2,498,201 916,626
Selling, general and administrative 5,729,817 1,940,059 3,508,810 1,003,413
Depreciation and amortization 3,442 7,811 2,087 3,953
----------- ----------- ----------- -----------
Total costs and expenses 10,286,999 3,744,571 6,009,098 1,923,992
----------- ----------- ----------- -----------
Income (loss) from operations (1,608,144) 25,353 (1,193,722) (28,060)
----------- ----------- ----------- -----------
Other income (expense):
Interest expense (316,188) (3,544) (264,572) (782)
Interest and other income 34,973 51,069 17,709 21,988
Gain on sale of investment securities and other investments 29,634 770 29,634 770
Change in warrant valuation 116,993 -- 69,904 --
----------- ----------- ----------- -----------
Total other income (expense) (134,588) 48,295 (147,325) 21,976
----------- ----------- ----------- -----------
Income (loss) before bankruptcy reorganization
items and income tax benefit (1,742,732) 73,648 (1,341,047) (6,084)
----------- ----------- ----------- -----------
Reorganization items:
Gain on settlement with creditors -- 904,027 -- 852,553
Professional fees -- (161,008) -- (40,942)
----------- ----------- ----------- -----------
-- 743,019 -- 811,611
----------- ----------- ----------- -----------
Income (loss) before income tax benefit (1,742,732) 816,667 (1,341,047) 805,527
Income tax benefit -- (47,937) -- (2,937)
----------- ----------- ----------- -----------
Net income (loss) (1,742,732) 864,604 (1,341,047) 808,464
Other comprehensive loss -
unrealized loss on marketable securities (4,983) (2,296) (4,398) (2,296)
----------- ----------- ----------- -----------
Comprehensive income (loss)
($1,747,715) $ 862,308 ($1,345,445) $ 806,168
=========== =========== =========== ===========
Basic and diluted earnings (loss) per share ($0.10) $0.05 ($0.08) $0.05
=========== =========== =========== ===========
Weighted average number of common shares outstanding
Basic 16,722,359 16,258,730 16,762,108 16,259,782
=========== =========== =========== ===========
Diluted 16,722,359 16,580,715 16,762,108 16,592,854
=========== =========== =========== ===========
See notes to the condensed consolidated financial statements.
3
eLEC Communications Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
For the Six Months Ended
May 31, 2005 May 31, 2004
------------ ------------
Net cash used in operating activities: ($1,663,448) ($ 450,810)
----------- -----------
Cash flows used in investing activities:
Purchase of property and equipment (222,744) (3,319)
Purchase of investment securities (4,923) (4,546)
Proceeds from the sale of investment securities
and other investments 14,828 770
----------- -----------
Net cash used in investing activities (212,839) (7,095)
----------- -----------
Cash flows from financing activities:
Repayment of long-term debt (60,606) (4,422)
Proceeds from short-term borrowings 273,686 --
Proceeds from secured convertible note 1,744,500 --
Proceeds from the exercise of options 37,500 --
----------- -----------
Net cash provided by (used in) financing activities 1,995,080 (4,422)
----------- -----------
Increase (decrease) in cash and cash equivalents 118,793 (462,327)
Cash and cash equivalents at beginning of period 371,852 669,022
----------- -----------
Cash and cash equivalents at the end of period $ 490,645 $ 206,695
=========== ===========
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 six-month period ended May 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 six- and three-month periods ended May 31, 2005 was
$16,515 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 six- and three-month periods ended May 31, 2005 was
$14,553 and $8,065, respectively, and was included in interest expense using the
effective interest method.
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% as of
May 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 six- and
three-month periods ended May 31, 2005 was $360,290 and $302,841, respectively,
of which $111,016 and $92,859, respectively, was included in SG&A as financing
costs and $249,274 and $209,982, 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 six- and three-month periods ended
May 31, 2005, we recorded income of $116,993 and $69,904, 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 any assignor 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 any assignor 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 any assignor 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 May 1, June 1 and July 1, 2005 were made
in cash.
6
A registration rights agreement was executed requiring us to register the shares
of our common stock underlying the Convertible Note and warrants and was
declared effective on June 10, 2005.
Note 3 - Major Customer
-----------------------
During the six- and three-month periods ended May 31, 2005 and May 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 $20,850,000 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:
Six Months Ended
May 31, 2005 May 31, 2004
------------ ------------
Weighted average common shares outstanding 16,722,359 16,258,730
Dilutive effect of securities -- 321,985
---------- ----------
16,722,359 16,580,715
========== ==========
Three Months Ended
May 31, 2005 May 31, 2004
------------ ------------
Weighted average common shares outstanding 16,762,108 16,259,782
Dilutive effect of securities -- 333,072
---------- ----------
16,762,108 16,592,854
========== ==========
For the six- and three-month periods ended May 31, 2005, approximately 7,900,000
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 six- and
three-month periods ended May 31, 2004, approximately 1,700,000 of our stock
options and warrants were excluded from the calculation of diluted earnings per
share because the effect would be anti dilutive.
Note 6 - Subsidiary's Plan of Reorganization
--------------------------------------------
7
On July 29, 2002, Telecarrier Services, Inc. ("TSI"), a wholly-owned subsidiary,
had 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. For the year ended November 30, 2004, TSI reported a gain of
$904,027 as a result of being judicially released from these claims.
For the six- and three-month periods ended May 31, 2004, we reported a gain of
approximately $904,000 and $853,000, respectively, as a result of TSI's
settlement with creditors and approximately $161,000 and $41,000, respectively,
in professional fees. Included in our gain for the six-months ended May 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 transactions occurred in
the six- and three-month periods ended May 31, 2005.
8
Note 7 - Risks and Uncertainties
--------------------------------
We buy substantially all of our 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 telecommunications
business. In order to reduce regulatory risks going forward, our main 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.
- 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.
9
- 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, combined with 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 May 31, 2005,
our ability to continue as a going concern is dependent upon factors including,
but not limited to (1) our ability to improve our operating results, (2)
generate sufficient cash from our businesses to meet our obligations as they
become due, and (3) raise additional cash through borrowings or equity
financing. We anticipate that we will be able to raise cash through the exercise
of our stock warrants in Talk, and, we are negotiating with lenders to provide
additional financing. There can be no assurance 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 for the six- and three- months
ended May 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 option 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. 123, "Accounting for Stock-Based
Compensation", as amended by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure":
For the Six Months Ended For the Three Months Ended
May 31, 2005 May 31, 2004 May 31, 2005 May 31, 2004
------------ ------------ ------------ ------------
Net income (loss) as reported ($1,742,732) $864,604 ($1,341,047) $808,464
Deduct: Total stock-based employee
compensation expense determined
under fair value-based method
for all awards, net of related
tax effects (200,329) (112,131) (100,902) (55,785)
----------- ----------- ----------- -----------
Pro forma net income (loss) ($1,943,061) $752,473 ($1,441,949) ($752,679)
----------- ----------- ----------- -----------
Earnings (loss) per share
Basic, as reported ($0.10) $.05 ($0.08) $.05
Basic, pro forma ($0.12) $.05 ($0.09) $.05
Diluted, as reported ($0.10) $.05 ($0.08) $.05
Diluted, pro forma ($0.12) $.05 ($0.09) $.05
Note 9 - Related Party Transactions
-----------------------------------
10
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 six-month period ended
May 31, 2004 (See Note 6).
During the six- and three-month periods ended May 31, 2005, we billed Cordia
Corporation ("Cordia"), a related party, $40,851 and $17,449, respectively, for
telecommunications services, commissions and other costs, and Cordia billed us
$350,846 and $181,535, respectively, for telecommunications services, billing
services and other sundry costs. During the six- and three-month periods ended
May 31, 2004, we billed Cordia, $298,030 and $88,934, respectively, for
telecommunications services, commissions and other costs, and Cordia billed us
$379,996 and $101,513, respectively, for telecommunications services, billing
services and other sundry costs. As of May 31, 2005, we owed Cordia $74,876.
Note 10 - Reclassification
--------------------------
Certain 2004 amounts related to the bankruptcy of TSI have been reclassified to
conform to the 2005 presentation.
Note 11 - 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 six- and three-month periods ended May 31, 2005 and 2004, we recorded
pension expense of $48,000 and $24,000 for each fiscal period. For the six-month
periods ended May 31, 2005 and 2004, we contributed $25,000 and $26,000,
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, of which two 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 significant.
12
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. Also, 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 subscriber lines, are
less than $100,000. We believe our server farm approach will provide us
significant capital savings when compared to other VoIP carriers that typically
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 throughout the remainder of the fiscal year.
While we plan to continue to lease lines from the RBOCs, and anticipate that the
wholesale service agreements we have with the RBOCs will allow us to continue to
obtain an acceptable gross margin on the POTS services we provide, our customer
acquisition focus going forward will be to acquire more lines on our own VoIP
platform rather than on the platform we lease from the RBOCs. We anticipate
that, given our limited financial resources, we will spend more of our marketing
budget to attract VoIP customers than POTS customers and that the total number
of POTS lines in our subscriber base will be decreasing as our VoIP subscriber
lines experience growth. Various industry groups, such as the International
Packet Communications Consortium, continue to predict that billions of minutes
will be transferring from traditional telecom routes to VoIP in the next two
years. We plan to take advantage of that transformation and capture as many VoIP
minutes as possible for VoX.
13
Six Months Ended May 31, 2005 vs. Six Months Ended May 31, 2004
---------------------------------------------------------------
Our revenue for the six-month period ended May 31, 2005 increased by
approximately $4,909,000, or approximately 130%, to approximately $8,679,000 as
compared to approximately $3,770,000 reported for the six-month period ended May
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. In the
future, we anticipate spending more money on VoIP line acquisition costs than on
CLEC line acquisition costs. Given our limited experience in acquiring new VoIP
customers, we are unable to anticipate if we can maintain the quarter-to-quarter
sales growth that we experienced in prior quarters. While the addition of two or
three large wholesale VoIP accounts could potentially account for thousands of
new subscriber lines, these lines may not all be added in the same month or
quarter.
Our gross profit for the six-month period ended May 31, 2005 increased by
approximately $2,152,000 to approximately $4,125,000 from approximately
$1,973,000 reported in the six-month period ended May 31, 2004. During the same
fiscal periods, our gross profit percentage decreased to 47.5% from 52.3%. The
increase in gross profit resulted from the increase in our customer base in the
first half of fiscal 2005 over the first half 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
Unbundled Network Elements Platform ("UNE-P") service offering. Our selling
strategy in 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%.
SG&A increased by approximately $3,790,000, or approximately 195%, to
approximately $5,730,000 for the six-month period ended May 31, 2005 from
approximately $1,940,000 reported in prior year fiscal period. Of this increase,
approximately $2,086,000 was for bad debt expense, approximately $507,000 was
for telemarketing costs, approximately $171,000 was for billing costs,
approximately $128,000 was for financing costs (See Note 2), and approximately
$472,000 was for increased personnel costs, of which approximately $170,000 was
related to VoX. From January 2005 until approximately the middle of 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 respectable credit scores. Although growth tends to be
easier in the residential market than in the business market, we are now 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 credit worthy 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 decreased to approximately $3,000 for the six-month period
ended May 31, 2005 as compared to approximately $8,000 for the six-month period
ended May 31, 2004.
14
Although VoIP revenues have been insignificant to date and we are confident that
our VoIP platform is functional, we have not yet begun the amortization of the
capitalized costs of approximately $380,000 of our VoIP platform as we were
still considered to be in the development and testing stage at May 31, 2005. In
June 2005, we began running live wholesale customers on our VoIP platform and we
plan to transfer all of our retail customers from our test platform to our live
platform during the third quarter. We therefore anticipate that we will begin to
amortize the costs of our VoIP platform in the third quarter of fiscal 2005.
Interest expense increased by approximately $312,000 to approximately $316,000
for the six-month period ended May 31, 2005 as compared to approximately $4,000
for the six-month period ended May 31, 2004, as a result of increased borrowings
under our financing agreements (See Note 2).
Interest and other income decreased by approximately $16,000, to approximately
$35,000 for the six-month period ended May 31, 2005 as compared to approximately
$51,000 for the six-month period ended May 31, 2004. The decrease resulted
primarily from a reduction in commission income.
For the six-month period ended May 31, 2005, we recorded income of approximately
$117,000, 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 six-month period ended May 31, 2004.
For the six-month periods ended May 31, 2005 and 2004, we recorded gain on the
sale of investment securities and other investments of approximately $30,000 and
$1,000, respectively, resulting from the sale of investment securities.
For the six-month period ended May 31, 2004, we reported a gain on settlement
with creditors of approximately $904,000, which was in part offset by
approximately $161,000 in professional fees (See Note 6).
For the six-month period ended May 31, 2004, we recorded a tax benefit of
$48,000, which resulted from the reduction of an estimated accrual of corporate
tax expense for fiscal 2003. No such benefit was recorded for the six-month
period ended May 31, 2005.
Three Months Ended May 31, 2005 vs. Three Months Ended May 31, 2004
-------------------------------------------------------------------
Our revenue for the three-month period ended May 31, 2005 increased by
approximately $2,919,000, or approximately 154%, to approximately $4,815,000 as
compared to approximately $1,896,000 reported for the three-month period ended
May 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. We anticipate
that revenues will not reach $4,815,000 for our third quarter. 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 have begun to sign up
VoIP customers in the third fiscal quarter, we do not believe the new VoIP
accounts will generate revenues quickly enough in the third quarter to offset
the decrease in CLEC POTS lines that will occur from normal attrition. In
addition to regular customer churn to other companies that compete with us for
POTS line service, we are experiencing an increasing number of customers that
disconnect service as they have decided to use only a cell phone or a VoIP line
in lieu of a POTS line. We plan to notify
15
our POTS line customer base of the availability of our VoIP services in an
effort to encourage our good CLEC customers to transfer to VoX, instead of
looking to another VoIP carrier.
Our gross profit for the three-month period ended May 31, 2005 increased by
approximately $1,338,000 to approximately $2,317,000 from approximately $979,000
reported in the three-month period ended May 31, 2004. During the same fiscal
periods, our gross profit percentage decreased to 48.1% from 51.7%. The increase
in our gross profit resulted from the increase in our customer base in second
quarter of fiscal 2005 over the second 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 $2,506,000, or approximately 250%, to
approximately $3,509,000 for the three-month period ended May 31, 2005 from
approximately $1,003,000 reported in prior year fiscal period. Of this increase,
approximately $1,354,000 was for bad debt expense, approximately $360,000 was
for telemarketing costs, approximately $97,000 was for billing costs,
approximately $102,000 was for financing costs (See Note 2), and approximately
$260,000 was for increased personnel costs, of which approximately $99,000 was
related to VoX. In the third quarter of fiscal 2005, we anticipate our CLEC line
acquisition costs and our bad debt expense to be substantially lower than the
second quarter figures, as we have adjusted how we market to potentially new
customers and are spending fewer dollars on attracting new CLEC customers. We
believe the VoIP customers, for which we require a credit card on file, will
generate very little bad debt expense, and we are looking to have an
increasingly large percentage of our new line acquisitions to be VoIP accounts
in lieu of POTS line customers. VoIP wholesale customers, which could generate
significant revenues, are required to be credit checked and to pay a deposit.
Depreciation expense decreased to approximately $2,000 for the three-month
period ended May 31, 2005 as compared to approximately $4,000 for the
three-month period ended May 31, 2004. Although we have limited VoIP revenues
and are confident that our VoIP platform is functional, we have not started to
amortize the capitalized costs of our VoIP platform as we are still in the final
testing stages. We anticipate that our final live platform, which is co-located
in a major data center, will be launched during the third quarter of fiscal
2005.
Interest expense increased by approximately $264,000 to approximately $265,000
for the three-month period ended May 31, 2005 as compared to approximately
$1,000 for the three-month period ended May 31, 2004, as a result of increased
borrowings under our recent financing agreements (See Note 2).
Interest and other income decreased by approximately $4,000, to approximately
$18,000 for the three-month period ended May 31, 2005 as compared to
approximately $22,000 for the three-month period ended May 31, 2004. The
decrease resulted primarily from a reduction in commission income.
For the three-month period ended May 31, 2005, we recorded income of
approximately $70,000 related to the change in the market value of the warrants
issued to Laurus as part of the Laurus
16
financing (See Note 2). No such income was recorded in the three-month period
ended May 31, 2004.
For the three-month periods ended May 31, 2005 and 2004, we recorded gain on the
sale of investment securities and other investments of approximately $30,000 and
$1,000, respectively, resulting from the sale of investment securities.
For the three-month period ended May 31, 2004, we reported a gain on settlement
with creditors of approximately $853,000, which was offset in part by
approximately $41,000 in professional fees (See Note 6).
Liquidity and Capital Resources
-------------------------------
At May 31, 2005, we had cash and cash equivalents of approximately $491,000 and
negative working capital of approximately $2,700,000.
Net cash used in operating activities aggregated approximately $1,663,000 and
$451,000 in the six-month periods ended May 31, 2005 and 2004, respectively. The
principal use of cash in fiscal 2005 was the loss for the period of
approximately $1,743,000. The principal use of cash in fiscal 2004 was the net
change in operating assets and liabilities, which was partially offset by the
income for the period of approximately $865,000.
Net cash used in investing activities in the six-month periods ended May 31,
2005 and 2004 aggregated approximately $213,000 and $7,000, respectively. The
principal use of cash in fiscal 2005 was the expenditures related to our VoIP
initiative of approximately $223,000, which was partially offset by the proceeds
of the sale of investments of approximately $15,000. The principal use of cash
in fiscal 2004 was for the purchase of equipment and investment securities.
Net cash provided by (used in) financing activities aggregated approximately
$1,995,000 and ($4,000) in the six-month periods ended May 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 $37,500, respectively, which was partially offset by debt
repayment of approximately $61,000. In fiscal 2004, net cash used in financing
activities resulted from the repayment of debt.
For the six-month period ended May 31, 2005, we had approximately $223,000 in
capital expenditures primarily related to our VoIP initiative. We expect to make
equipment purchases of approximately $50,000 to $75,000 in the third quarter of
fiscal 2005. We expect that other capital expenditures over the next 12 months
will relate primarily to a continued roll-out of VoIP services and will only be
required to support a growing customer base of VoIP subscribers.
We have stock purchase warrants that entitle us to purchase approximately 95,000
shares of Talk America Holdings Inc. ("Talk"). The warrant exercise price is
$6.30 per share and, at July 1, 2005, our warrants were in-the-money, as Talk
common stock was trading at approximately $10.21 per share at such date. The
warrants expire on August 9, 2005 and we plan to exercise them before they
expire. Talk has notified us that it plans to file a registration statement in
July 2005 to register the shares underlying our warrants. It will be helpful to
us in exercising the warrants and selling the underlying stock if the
registration statement is declared effective, by the Securities and Exchange
Commission, before our warrants expire.
17
While we have reported profits in the last two fiscal years, we have also
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 that current cash and cash equivalents may not be sufficient to finance
our operations through at least the next twelve 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, at a price that would be acceptable to us. Failure to generate
sufficient revenues, raise additional capital or reduce certain discretionary
spending could 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; and
o Lack of quantity of staff, which led to issues related to the timely
preparation and filing of municipal telecommunications tax returns.
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
18
misstatement in our financial statements might not be prevented or detected by
our employees in the normal course of performing their assigned functions.
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 on a monthly basis,
instead of quarterly or semi-annually. 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 for 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. Other than as described below, during
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.
During fiscal year 2004, we reported that we had been overstating our
telecommunications taxes payable for certain taxes we had paid directly to our
carrier. We have changed the way we analyze our carrier bills and our tax
liability accounts so that both our cost of services and taxes payable accounts
are not overstated, and we have enhanced the training of personnel involved in
the various processes. We believe these actions have remediated the reported
deficiency.
We hired an additional accountant for our accounting department in June
2005. We believe this action has helped us address issues relating to
segregation of duties and tax filings, but we are still assessing whether the
steps we have taken in conjunction with this action is enough to remediate the
reported deficiencies.
19
eLEC COMMUNICATIONS CORP.
-------------------------
PART II-OTHER INFORMATION
-------------------------
Item 1. Legal Proceedings
------- -----------------
None
Item 2. Changes in Securities and Purchases of Equity Securities
------- --------------------------------------------------------
In May 2005, we issued an aggregate of 20,000 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 such
person 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 4. Submission of Matters to a Vote of Security Holders
------- ---------------------------------------------------
The 2005 Annual Meeting of Shareholders (the "2005 Annual Meeting")
was duly held on June 15, 2005. All director nominees to the Board
of Directors were duly elected at the 2005 Annual Meeting. Set forth
below is a brief description of each other matter voted upon at the
2005 Annual Meeting and the results of vote with respect to each
matter.
(i) The approval and adoption of our 2004 Equity Incentive
Plan.
Votes For ......... 4,759,723
Votes Against ..... 256,934
Votes Abstaining .. --
Non-Vote .......... 10,194,160
(ii) Ratification of the appointment of Nussbaum Yates &
Wolpow, P. C. as our auditors.
Votes For ......... 15,155,550
Votes Against ..... 33,664
Votes Abstaining .. 37,360
Item 5. Other Information
------- -----------------
None
Item 6. Exhibits
------- --------
20
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)
21
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.
July 15, 2005 By: /s/ Paul H. Riss
------------- ----------------------------
Date Paul H. Riss
Chief Executive Officer
(Principal Financial and
Accounting Officer)
22