10-Q 1 d10q.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q (Mark One) [X] Quarterly report pursuant to sections 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2001 OR [ ] Transition report pursuant to sections 13 or 15 (d) of the Securities Exchange Act of 1934 For the transition period from _____ to _____ Commission file number 333-33639 EVERCOM, INC. (Exact name of Registrant as specified in its charter) Delaware 75-2680266 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 8201 Tristar Drive Irving, Texas 75063 (972) 988-3737 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 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 [ ] As of November 14, 2001, 30,770 shares of Class A common stock, par value $0.01 per share, and 400 shares of Class B common stock, par value $0.01 per share, were issued and outstanding. 1 DOCUMENTS INCORPORATED BY REFERENCE Exhibits to the following documents filed with the Securities and Exchange Commission have been incorporated by reference in Part II of this Quarterly Report on Form 10-Q: 1. Registration Statement on Form S-4 (File No. 333-33639); 2. Quarterly Report on Form 10-Q, dated as of August 14, 1998; and 3. Quarterly Report on Form 10-Q, dated as of May 12, 1999; 4. Quarterly Report on Form 10-Q, dated as of June 7, 2001. 2 EVERCOM, INC. AND SUBSIDIARIES TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Item 1. Financial Statements............................. 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............. 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk...................................... 26 PART II - OTHER INFORMATION Item 1. Legal Proceedings................................ 27 Item 2. Changes in Securities and Use of Proceeds........ 27 Item 3. Defaults Upon Senior Securities.................. 27 Item 4. Submission of Matters to a Vote of Stockholders.. 27 Item 5. Other Information................................ 27 Item 6. Exhibits and Reports on Form 8-K................. 28 3 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS EVERCOM, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET

See notes to consolidated financial statements 4 EVERCOM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

See notes to consolidated financial statements 5 EVERCOM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See notes to consolidated financial statements 6 EVERCOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. CONSOLIDATED FINANCIAL STATEMENTS The consolidated financial statements as of September 30, 2001 for the three-month and nine-month periods ended September 30, 2000 and 2001, of Evercom, Inc. and its subsidiaries (the "Company") have been prepared by the Company without audit. In the opinion of management, all necessary adjustments (which include only normal recurring adjustments) to present fairly, in all material respects, the consolidated financial position, results of operations, and cash flows as of and for the respective periods, have been made. Certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. These financial statements should be read in conjunction with the Company's 2000 consolidated financial statements contained in its Form 10-K as filed with the Securities and Exchange Commission on June 1, 2001. Comprehensive Income Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," became effective as of the first quarter of 1999. This statement requires companies to report and display comprehensive income and its components (revenues, expenses, gains, and losses). Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. For the Company, comprehensive income is the same as net loss reported in the statements of consolidated operations, since there were no other items of comprehensive income for the periods presented. Business Combinations and Goodwill and Intangible Assets On June 29, 2001, the Financial Accounting Standards Board (FASB) approved for issuance SFAS No. 141, "Business Combinations," effective July 1, 2001, and SFAS No. 142, "Goodwill and Intangible Assets," effective January 1, 2002. SFAS No. 141 prohibits pooling of interests accounting for acquisitions. SFAS No. 142 specifies that goodwill and some intangible assets will no longer be amortized, but instead, will be subject to periodic impairment testing. The Company is evaluating the financial statement impact of SFAS No. 142. In October 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets for Long-Lived Assets to be Disposed Of" and related literature and establishes a single model, based on the framework established in SFAS No. 121, for long-lived assets to be disposed of by sale. The Company is required to adopt SFAS No. 144 for fiscal years beginning after December 15, 2001. The Company is evaluating the financial statement impact of SFAS No. 144. Reclassifications Certain reclassifications have been made in the three and nine months ended September 30, 2000 consolidated financial statements to conform to the classifications used in the three and nine months ended September 30, 2001. 2. FINANCING PLANS The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company believes that if current operating trends continue, the Company may be out of compliance with its bank covenants for the quarter ending December 31, 2001, which could have an adverse effect on the Company and which could effect its ability to satisfy its cash needs under its current business plan. To address this situation, the Company is discussing alternatives with its lenders and other potential investors. The Company is attempting to resolve this issue, but can give no assurance as to whether or when this effort will succeed. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. 7 3. ACCOUNTS RECEIVABLE Accounts receivable consist of the following:

At December 31, 2000 and September 30, 2001, the Company had advanced commissions to certain inmate facilities of $1,758,299 and $2,416,389 (unaudited), which are recoverable from such facilities as a reduction of earned commissions at specified monthly amounts. Amounts included in accounts receivable represent the estimated recoverable amounts during the next fiscal year with the remaining balance recorded in other assets. 4. PROPERTY AND EQUIPMENT Property and equipment consist of the following: December 31, September 30, 2000 2001 ------------ ------------ (Unaudited) Leasehold improvements $ 944,292 $ 962,103 Telephone system equipment 46,285,050 53,666,006 Vehicles 430,548 430,548 Office equipment 2,727,911 2,921,022 ------------ ------------ 50,387,801 57,979,679 Less accumulated depreciation (23,318,556) (30,458,352) ------------ ------------ $ 27,069,245 $ 27,521,327 ============ ============ Depreciation and impairment - Depreciation and impairment for the nine months ended September 30, 2000 and 2001, includes depreciation expense of $6,086,530 and $5,974,571, respectively. Also included in depreciation and impairment for the nine months ended September 30, 2001, is an impairment loss of $1.0 million on telephone system equipment removed from service. 8 5. INTANGIBLE AND OTHER ASSETS Intangible and other assets consist of the following: December 31, September 30, 2000 2001 ------------ ------------ (Unaudited) Intangible assets: Acquired telephone contracts $ 71,566,718 $ 75,680,133 Noncompete agreements 568,611 568,611 Deferred loan costs 9,042,247 9,654,112 Goodwill 84,730,834 87,118,881 Other intangibles 783,096 783,096 ------------ ------------ 166,691,506 173,804,833 Less accumulated amortization (81,221,978) (90,649,684) ------------ ------------ Total intangible assets 85,469,528 83,155,149 Deposits and other 418,150 441,958 Noncurrent portion of commission advances to facilities 103,704 193,310 ------------ ------------ $ 85,991,382 $ 83,790,417 ============ ============ 6. ACCRUED EXPENSES Accrued expenses consist of the following: December 31, September 30, 2000 2001 ----------- ------------ (Unaudited) Facility commissions $ 8,204,779 $ 7,924,899 Billing and collection fees 1,988,157 2,104,735 Accrued acquisition and financing costs 578,081 558,386 Accrued interest 541,530 3,615,805 Accrued excise taxes payable 1,958,017 1,376,578 Accrued dividends on preferred stock 2,142,434 2,920,840 Accrued payroll and bonuses 812,898 1,290,327 Accrued payable to joint venture partner 1,136,916 331,933 Deferred revenue 1,076,425 1,327,662 Other 1,991,059 990,876 ----------- ----------- $20,430,296 $22,442,041 =========== =========== 9 7. LONG-TERM DEBT The following is a summary of long-term debt: December 31, September 30, 2000 2001 ------------ ------------ (Unaudited) Senior Notes $115,000,000 $115,000,000 Senior Credit Facility: Revolving loan facility 13,500,000 13,000,000 Term loan acquisition facility 27,500,000 17,187,500 Additional term loan facility 5,500,000 5,500,000 Second additional term loan facility 5,000,000 5,000,000 Other 26,766 - ------------ ------------ 166,526,766 155,687,500 Less current portion of long-term debt (13,776,766) (13,750,000) ------------ ------------ $152,750,000 $141,937,500 ============ ============ Under the terms of the Senior Credit Facility, the term loan acquisition facility is due in quarterly installments of $3,437,500, with the remaining unpaid balance for all borrowings under the Senior Credit Facility being due on December 31, 2002. Both the revolving and the term loan facilities are collateralized by substantially all of the assets of the Company. On June 29, 2001, the Company entered into an interest rate cap agreement that has been designated as a hedge against the Company's variable interest rate exposure under the Company's revolving and term loan agreement (the "Senior Credit Facility"). At September 30, 2001, the interest rate cap has an aggregate notional amount of $20.0 million, which matures in December 2002, and caps interest on the London Interbank Offering Rate ("LIBOR") portion of the term loan, up to the aggregate notional amount, at 7.5%, plus the applicable LIBOR margin. On May 30, 2001, and in conjunction with the commitment from existing shareholders and other investors to purchase 12,000 shares of the Company's Common stock for $750 per share, the Company and its Senior Credit Facility lenders amended the Company's Senior Credit Facility. The amendment changed the requirements and definitions of certain financial covenants through December 31, 2001, and increased the Company's ability to enter into capital lease arrangements from $2.5 million to $5.0 million. Additionally, the amendment waived the Senior Credit Facility Lender's rights to the proceeds from the May 30, 2001 issuance of common stock and waived all outstanding defaults under the Senior Credit Facility. An amendment fee equal to 0.75% of outstanding commitments, or $0.6 million, was paid to the Senior Credit Facility lenders to effect this amendment. Additionally, the amendment increased all interest rates under the Senior Credit Facility by 0.5% (50 basis points). 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below included forward-looking statements that involve risks and uncertainties. See "Special Note Regarding Forward-Looking Information; Risk Factors." Overview The Company is a provider of collect and prepaid calling services to local, county, state, and private correctional facilities in the U.S. The Company derives substantially all of its revenues from its operation of inmate telecommunications systems located in correctional facilities in 43 states and the District of Columbia. The Company's inmate telecommunications services consist of collect and prepaid calling services. The Company enters into multi-year agreements (generally three to five years) with the correctional facilities, pursuant to which the Company serves as the exclusive provider of telecommunications services to inmates within each facility. In exchange for the exclusive service rights, the Company pays a percentage of its revenue from each correctional facility as a commission to that facility. Typically, the Company installs and retains ownership of the telephones and related equipment and provides additional services to correctional facilities that are tailored to the specialized needs of the corrections industry and to the requirements of the individual correctional facility, such as call activity reporting and call blocking. The Company also generates revenues from public pay telephones that are ancillary to its inmate telephone business. The Company accumulates call activity data from its various installations and bills its revenues related to this call activity through local exchange carriers ("LECs") or through third-party billing services. In addition, the Company accrues the related telecommunications costs for validating, transmitting, billing and collection, and allowances for uncollectible accounts based on historical experience. The Company's traditional inmate business consists of collect and prepaid calling services provided to correctional facilities. The Company also provides its Solutions services, representing validation, fraud management and billing services to third parties. The Company's largest Solutions Customer is a major RBOC. Under the terms of the agreement, the Company acquires at a discount the related inmate accounts receivable from the RBOC for the calls that the Company processes. When the receivables are purchased, the Company accepts responsibility for all validation, uncollectible accounts, and billing and collections costs, with no recourse to the RBOC. However, under the terms of the agreement, all purchased receivables must be processed and validated through the Company's call management and billing system. The Company's revenues from this service equal the difference between the face value of the receivables purchased and the amount it pays the RBOC for the discounted accounts receivable. Because the Company's revenues associated with this contract represent only a percentage of the face value of the receivables purchased, the associated uncollectible account expense and billing and collection fees represent a much higher percentage of revenue as compared to the Company's traditional inmate business. Consequently, the Company's telecommunications costs represent a higher percentage of revenue under this contract. There are minimal selling, general, and administrative ("SG&A") costs associated with this contract. The contract term is through January 31, 2003, and has no minimum volume commitment. The Company pays no facility commissions under this agreement. The RBOC notified the Company of its plan to exit the inmate market and consequently, the Company expects its revenues to gradually decline from this contract over the next several years. The Company believes it is reasonable to expect that some portion of the RBOC's customers will be converted to Evercom's traditional inmate business. The 11 Company also provides Solutions services to other inmate telecommunications companies and is anticipating continued expansion of this business. The Company's principle operating expenses consist of (i) telecommunications costs; (ii) commissions paid to correctional facilities, which are typically expressed as a percentage of either gross or net revenues, (iii) field operations and maintenance costs, which consist primarily of field service on the Company's installed base of inmate telephones; and (iv) selling, general and administrative ("SG&A") costs. Telecommunications Costs. The principle components of telecommunication costs are long distance transmission costs, local access costs, third party billing costs, and costs of uncollectible accounts. Historically, long distance costs have consisted of charges for minutes of use purchased from interexchange carriers ("IXCs"). The Company has also entered into agreements to lease lines connecting urban areas and correctional facilities. Local access charges consist of monthly line and usage charges paid to RBOCs and other LECs for interconnection to the local network for local calls, which are computed on a flat monthly charge plus, for certain LECs, on a per message or per minute usage rate based on the time and duration of the call. Third-party billing charges consist of payments to LECs and other billing service providers for billing and collecting revenues from called parties. Expenses associated with uncollectible accounts are a significant cost in providing inmate telecommunications services. Commissions. The Company pays a percentage of its revenue from each facility to that facility as a commission. Commissions are generally set for the duration of the Company's multi-year contract with the facility, and in some cases are subject to monthly minimum amounts. Commission rates are one of the primary bases of competition for obtaining and retaining contracts. The Company's ability to offer increasingly attractive commission rates to facilities depends on its ability to control its operating expenses. Generally, contracts for larger facilities have higher commission rates, but these higher commission rates are typically offset by lower network charges, field maintenance, and SG&A expenses as a percentage of revenue. The commission rates paid by the Company have increased in each period, from 36.1% for the quarter ended September 30, 2000 to 38.7% for the quarter ended September 30, 2001. This increase is due primarily to higher facility commissions on renewals and new business. Commission rates are expected to gradually increase as a percentage of revenues in the future. The overall commission percentage to total revenues of 33.9% for the quarter ended September 30, 2001 includes the effect of Solutions services provided under the Company's agreement with a major RBOC, under which no commissions are paid. Field Operations and Maintenance. Field operations and maintenance consist of maintenance costs associated with inmate phones and related equipment. These costs are relatively small and more constant components of operating expenses. Selling, General and Administrative. SG&A expenses consist of corporate overhead and selling expenses. These costs are also relatively small and more constant components of operating expenses. 12 Results of Operations The following table sets forth, for the three months and nine months ended September 30, 2000 and 2001, respectively, the results of operations of the Company.

Three Months Ended September 30, 2001 Compared to Three Months Ended September 30, 2000. Operating Revenues. The Company's operating revenues increased by $3.1 million, or 5.3%, from $58.0 million for the three months ended September 30, 2000, to $61.1 million for the three months ended September 30, 2001. The increase in operating revenue was primarily in the Company's traditional inmate business as a result of new sales initiatives coupled with higher equipment sales to Solutions customers. Operating Expenses. Total operating expenses increased $3.9 million, from $53.4 million for the three months ended September 30, 2000, to $57.3 million for the three months ended September 30, 2001. Operating expenses as a percentage of operating revenues increased 1.6% from 92.2% for the three months ended September 30, 2000, to 93.8% for the three months ended September 30, 2001. The increase in operating expenses as a percentage of revenues is primarily due to the factors discussed below. Telecommunication costs increased by $1.0 million from $23.1 million for the three months ended September 30, 2000, to $24.1 million for the three months ended September 30, 2001. Telecommunications costs represented 39.8% of operating revenues for the three months ended September 30, 2000, and 39.4% of operating revenues for the three months ended September 30, 2001. The decrease in telecommunications costs as a percentage of operating revenues is primarily due to savings generated from new long distance contracts, partially offset by increased expenses associated with uncollectible accounts that were due in part to changes in policies and procedures by several of the Company's LEC billing agents. 13 Facility commissions increased by $2.1 million, from $18.6 million for the three months ended September 30, 2000, to $20.7 million for the three months ended September 30, 2001. Facility commissions represented 32.1% of operating revenues for the three months ended September 30, 2000, and 33.9% of operating revenues for the three months ended September 30, 2001, an increase of 1.8%. Commission expense as a percentage of revenue for the Company's traditional inmate business was 36.1% and 38.7% for the three months ended September 30, 2000 and 2001, respectively. This increase is due to competition for new business and increased commission rates on renewals. Commission rates are expected to gradually increase in the future. Field operations and maintenance costs were $1.7 million for the three months ended September 30, 2000, and $2.0 million for the three months ended September 30, 2001. Field operations and maintenance costs represented 3.0% of operating revenues for the three months ended September 30, 2000, and 3.2% of operating revenues for the three months ended September 30, 2001, an increase of 0.2%. The increase as a percentage of operating revenues is primarily due to higher field equipment replacements during the three months ended September 30, 2001. SG&A costs increased by $0.5 million, from $4.4 million for the three months ended September 30, 2000, to $4.9 million for the three months ended September 30, 2001. SG&A represented 7.6% of operating revenues for the three months ended September 30, 2000, and 8.0% of operating revenues for the three months ended September 30, 2001, an increase of 0.4%. The increase is primarily due to increased staffing to execute new sales initiatives. Depreciation and impairment and amortization costs decreased by $0.7 million, from $5.4 million for the three months ended September 30, 2000, to $4.7 million for the three months ended September 30, 2001. During the three months ended September 30, 2001, the Company recorded an impairment loss of $0.2 million on telephone system equipment removed from service. Excluding this impairment, depreciation and amortization costs represented 9.4% of operating revenues for the three months ended September 30, 2000, and 7.4% of operating revenues for the three months ended September 30, 2001, a decrease of 2.0%. The decrease as a percentage of operating revenues is primarily due to amortization expense associated with the acquisitions of inmate facility contracts by the Company. The Company amortizes acquired inmate facility contracts over each contract's remaining term at the acquisition date. As the contract terms expire, the acquired inmate facility contracts become fully amortized and amortization expense declines. Operating Income. The Company's operating income decreased by $0.7 million, from $4.5 million for the three months ended September 30, 2000, to $3.8 million for the three months ended September 30, 2001, substantially due to the factors described above. The Company's operating income margin decreased from 7.8% for the three months ended September 30, 2000, to 6.2% for the three months ended September 30, 2001, primarily as a result of the factors described above. Interest Expense, net. Interest expense, net, decreased from $4.8 million for the three months ended September 30, 2000, to $4.6 million for the three months ended September 30, 2001. This decrease is primarily due to lower average debt outstanding during the three months ended September 30, 2001. Net Loss. The Company's net loss increased by $0.8 million, from $0.3 million for the three months ended September 30, 2000, to $1.1 million for the three months ended September 30, 2001, primarily as a result of the factors described above. EBITDA. Earnings before interest, income taxes, depreciation, and amortization ("EBITDA") decreased from $9.9 million for the three months ended September 30, 2000, to $8.5 million for the three months ended September 30, 2001. EBITDA as a percentage of operating revenues decreased from 17.1% for the three months ended September 30, 2000, to 13.9% for the three months ended September 30, 2001, primarily due to the factors 14 described above. Although EBITDA is not a measure of performance calculated in accordance with generally accepted accounting principles, the Company has included information concerning EBITDA in the Form 10-Q because it is commonly used by certain investors and analysts as a measure of a company's ability to service its debt obligations and is a component of the Company's debt compliance ratios. EBITDA should not be used as an alternative to, or be considered more meaningful than, operating income, net income, or cash flows as an indicator of the Company's operating income. Two of the Company's subsidiaries are subject to state income taxes. Consequently, the Company accrues income tax expense even in a loss period. Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 Operating Revenues. The Company's operating revenues increased by $6.3 million, or 3.6%, from $176.4 million for the nine months ended September 30, 2000, to $182.7 million for the nine months ended September 30, 2001. The increase in operating revenues was primarily due to an increase in the Company's traditional inmate business as a result of new sales initiatives and due to higher equipment sales to Solutions customers. Operating Expenses. Total operating expenses increased $5.1 million, from $164.9 million for the nine months ended September 30, 2000, to $170.0 million for the nine months ended September 30, 2001. Operating expenses as a percentage of operating revenues decreased 0.4% from 93.5% for the nine months ended September 30, 2000, to 93.1% for the nine months ended September 30, 2001. The decrease in operating expenses as a percentage of revenues is primarily due to the factors discussed below. Telecommunications costs decreased by $0.6 million, from $71.7 million for the nine months ended September 30, 2000, to $71.1 million for the nine months ended September 30, 2001. Telecommunications costs represented 40.7% of operating revenues for the nine months ended September 30, 2000, and 38.9% of operating revenues for the nine months ended September 30, 2001. The decrease in telecommunication costs as a percentage of operating revenues is primarily due to savings generated from new long distance contracts. Facility commissions increased by $4.5 million, from $56.3 million for the nine months ended September 30, 2000, to $60.8 million for the nine months ended September 30, 2001. Facility commissions represented 31.9% of operating revenues for the nine months ended September 30, 2000, and 33.3% of operating revenues for the nine months ended September 30, 2001, an increase of 1.4%. Commission expense as a percentage of revenue for the Company's traditional inmate business was 35.8% and 37.7% for the nine months ended September 30, 2000 and 2001, respectively. This increase is due to competition for new business and increased commission rates on renewals. Commission rates are expected to gradually increase in the future. Field operations and maintenance costs were $5.0 million for the nine months ended September 30, 2000, and $5.7 million for the nine months ended September 30, 2001. Field operations and maintenance costs represented 2.8% of operating revenues for the nine months ended September 30, 2000, and 3.1% for the nine months ended September 30, 2001, an increase of 0.3%. This increase as a percentage of operating revenues is primarily due to higher field equipment replacements during the nine months ended September 30, 2001. SG&A costs increased by $1.5 million, from $13.3 million for the nine months ended September 30, 2000, to $14.8 million for the nine months ended September 30, 2001. SG&A represented 7.5% of operating revenues for the nine months ended September 30, 2000, and 8.1% of operating revenues for the nine months ended September 30, 2001, an increase of 0.6%. This increase is primarily due to increased staffing to support enhancements to the Company's information systems and to execute new sales initiatives. Additionally, the Company spent $0.2 million during the nine months ended September 30, 2001 for executive search fees. 15 Depreciation and impairment and amortization costs decreased by $2.4 million, from $18.0 million for the nine months ended September 30, 2000 to $15.6 million for the nine months ended September 30, 2001. During the nine months ended September 30, 2001, the Company recorded an impairment loss of $1.2 million on telephone system equipment removed from service. Excluding this impairment, depreciation and amortization costs represented 10.2% of operating revenues for the nine months ended September 30, 2000 and 7.9% of operating revenues for the nine months ended September 30, 2001, a decrease of 2.3%. The decrease as a percentage of operating revenues is primarily due to amortization expense associated with the acquisitions of inmate facility contracts by the Company. The Company amortizes acquired inmate facility contracts over each contract's remaining term at the acquisition date. As the contract terms expire, the acquired inmate facility contracts become fully amortized and amortization expense declines. Operating Income. The Company's operating income increased by $1.2 million, from $11.5 million for the nine months ended September 30, 2000 to $12.7 million for the nine months ended September 30, 2001, substantially due to the factors described above. The Company's operating income margin increased from 6.5% for the nine months ended September 30, 2000 to 6.9% for the nine months ended September 30, 2001, primarily as a result of the factors described above. Interest Expense, net. Interest expense, net, decreased from $14.4 million for the nine months ended September 30, 2000 to $14.0 million for the nine months ended September 30, 2001. This decrease is primarily due to lower average debt outstanding during the nine months ended September 30, 2001. Net Loss. The Company's net loss decreased by $1.2 million, from a $3.1 million for the nine months ended September 30, 2000 to $1.9 million for the nine months ended September 30, 2001, primarily as a result of the factors described above. EBITDA. EBITDA decreased by $1.1 million from $29.4 million for the nine months ended September 30, 2000 to $28.3 million for the nine months ended September 30, 2001. EBITDA as a percentage of operating revenues decreased from 16.7% for the nine months ended September 30, 2000 to 15.5% for the nine months ended September 30, 2001, primarily due to the factors described above. Although EBITDA is not a measure of performance calculated in accordance with generally accepted accounting principles, the Company has included information concerning EBITDA in the Form 10-Q because it is commonly used by certain investors and analysts as a measure of a company's ability to service its debt obligations and is a component of the Company's debt compliance ratios. EBITDA should not be used as an alternative to, or be considered more meaningful than, operating income, net income, or cash flows as an indicator of the Company's operating income. Two of the Company's subsidiaries are subject to state income taxes. Consequently, the Company accrues income tax expense even in a loss period. 16 Liquidity and Capital Resources The Company anticipates that its principal uses of liquidity will be to provide working capital, meet debt service requirements, and to repay principal under the Senior Credit Facility (as defined). The Company believes that if current operating trends continue, the Company may be out of compliance with its bank covenants for the quarter ending December 31, 2001, which could have an adverse effect on the Company and which could effect its ability to satisfy its cash needs under its current business plan. To address this situation, the Company is discussing alternatives with its bank group and other potential investors. The Company believes that it will reach a satisfactory resolution to this issue, but can give no assurance as to whether or when this effort will succeed. Regarding working capital, the Company received notice that one of its billing agents intends to begin remitting funds to the Company in 44 days as compared to their historical 30 day payment schedule. This change would reduce the Company's end of month liquidity by approximately $8 million. The billing agent has informally and tentatively agreed not to make this change until, at the earliest, December of 2001. The Company expects that its principal sources of funds will be cash flow from operations and borrowings under the existing or new credit facilities. The Company anticipates that its primary capital expenditures for the remainder of 2001 will be approximately $3.0 million for capital items required to implement new contracts and contract renewals entered into by the Company, upgrades to integrated systems, and capital expenditures associated with acquisitions in current and prior years. Total capital expenditures for the fiscal period ended December 31, 2001 are expected to be $14.3 million. The Company does not have material commitments for capital expenditures. On May 30, 2001, the Company acquired all of the capital stock of FortuneLinx, Inc., for 2,736 shares of the Company's Class "A" Common stock. 1,368 of the shares issued to acquire FortuneLinx will be forfeited by the sellers if certain financial performance objectives are not achieved within the first twelve months after the effective date of the acquisition. Additionally, options were issued to the sellers allowing them to purchase 456 shares of the Company's Class "A" Common Stock at an exercise price of $2,000 per share. In conjunction with the closing, a note payable to a FortuneLinx shareholder in the principal amount of $0.8 million was repaid plus accrued interest. Equity Offering and Senior Credit Facility Amendment On April 10, 2001, the Company's Board of Directors approved a plan to offer to sell 12,000 shares of the Company's Class "A" Common stock for $750 per share to the Company's existing shareholders. The Company received $9 million of proceeds from the issuance of this new equity on June 4, 2001. As part of this offer each subscribing shareholder received their pro-rata share of warrants equal to 4.5% of the Company's fully diluted common stock. The warrants expire on December 31, 2007 and are convertible to the Company's Class "A" Common Stock at $750 per share. On May 30, 2001, and in conjunction with the commitment from its existing shareholders and other investors to purchase 12,000 shares of the Company's Common stock for $750 per share, the Company and its Senior Credit Facility lenders amended the Company's Senior Credit Facility. The amendment changed the requirements and definitions of certain financial covenants through December 31, 2001 and increased the Company's ability to enter into capital lease arrangements from $2.5 million to $5 million. Additionally, the amendment waived the Senior Credit Facility Lender's rights to the proceeds from the May 30, 2001 issuance of common stock and waived all outstanding defaults under the Senior Credit Facility. An amendment fee equal to 0.75% of outstanding commitments, or $0.4 million, was paid to the Senior Credit Facility lenders to effect this 17 amendment. Additionally, the amendment increased all interest rates under the Senior Credit Facility by 0.5% (50 basis points). In March 1999, the Company raised $5 million of equity from its existing shareholders and warrant holders and/or their affiliates through the issuance of 5,000 investment units at a price of $1,000 per unit. Each unit consists of one share of newly authorized First Preferred Series "A" Stock and a warrant to acquire one share of Common Stock for $1,000 per share. The First Preferred Series "A" Stock is entitled to receive dividends at the applicable First Preferred Series "A" Rate, payable quarterly commencing on April 1, 1999. Such dividends are payable out of funds legally available therefore, are payable only when, as, and if declared by the Board of Directors, are cumulative, and, if undeclared or unpaid, shall bear interest at the applicable First Preferred Series "A" Rate until paid. The First Preferred Series "A" Rate was 8% per annum through March 31, 2001, 10% per annum from April 1, 2001 through September 30, 2001, and thereafter will increase by 0.5% for each additional three month period up to a maximum of 16% per annum. The First Preferred Series "A" Stock ranks senior to all classes of the Company's common stock but ranks junior to the Senior Preferred Stock of the Company (the "Senior Preferred Stock") with respect to dividend rights and rights upon liquidation. The warrants have a strike price of $1,000 per share and will expire, if not sooner exercised, on December 31, 2007. As a result of the issuance of the First Preferred Series "A" Stock and warrants, the Company was required to obtain a waiver from its Senior Credit Facility group of lenders that waived the lenders' rights to the proceeds raised by the Company from the issuance. In conjunction with the March 1999 equity offering, the preferred dividend rates on the original Senior Preferred Stock were modified to mirror the preferred dividend rates on the First Preferred Series "A" Stock. Also, in March 1999 and in conjunction with the issuance of the First Preferred Series "A" Stock and warrants, the Company amended and restated its Senior Credit Facility. The amendment increased the Company's borrowing capacity under the term loan facility of the Senior Credit Facility by $5.5 million, which bears interest at similar rates to the existing borrowings under the Senior Credit Facility. The Company borrowed the additional $5.5 million in March 1999 and concurrently repaid $5 million under the revolving portion of the Senior Credit Facility. Net cash provided by operating activities decreased by $4.9 million from $15.4 million for the nine months ended September 30, 2000, to $10.5 million for the nine months ended September 30, 2001. This decrease was due to a $1.1 million decrease in operating income before consideration of depreciation and amortization, an increase in inventory of $4.0 million primarily due to new installation activity and timing of certain cash receipts and disbursements in the normal course of business. Cash used in investing activities was $9.8 million for the nine months ended September 30, 2000, as compared to $11.3 million for the nine months ended September 30, 2001, consisting primarily of both cash outflows for investments in new business and customer contract renewals. Cash used in financing activities was $6.7 million for the nine months ended September 30, 2000, as compared to $2.8 million for the nine months ended September 30, 2001, consisting primarily of net proceeds raised through the issuance of common stock and new borrowings under the Senior Credit Facility, offset by principal repayments under the Senior Credit Facility. The Senior Credit Facility, as amended on May 30, 2001, consists of (a) $55.0 million term loan acquisition facility all of which has been borrowed and upon which $34.3 million of scheduled principal payments had been made as of September 30, 2001, (b) $10.5 million of additional term loan facilities which has been borrowed as of September 30, 2001 (availability of a $2.5 million additional term loan expired because the 18 Company did not achieve certain financial performance for the year ended December 31, 2000), and (c) a $25.0 million revolving loan facility (which includes a $10.0 million letter of credit facility) upon which $13.0 million had been borrowed as of September 30, 2001. Scheduled principal payments under the Senior Credit Facility bear interest, at the option of the Company, at either (i) the Base Rate (i.e., the higher of Canadian Imperial Bank of Commerce's ("CIBC") reference rate or the overnight federal funds rate plus 0.5%) plus a margin that varies from 150 to 350 basis points, depending on the Company's Total Debt to EBITDA Ratio (as defined in the Senior Credit Facility); or (ii) the LIBOR plus a margin that varies from 275 to 450 basis points, depending on the Company's Total Debt to EBITDA Ratio. The Senior Credit Facility requires quarterly interest payments to be made on base rate loans and periodic interest-only payments based on the applicable interest period on LIBOR loans, at least quarterly, in each case until maturity. In addition, the Senior Credit Facility requires mandatory prepayments out of the proceeds of certain equity or debt offerings, asset dispositions, receipt of insurance proceeds not applied as provided in the Senior Credit Facility, and receipts of funds from certain escrow accounts. Remaining scheduled principal payments on the term loan facilities are approximately $3.4 million and $24.2 million during the years ended 2001, and 2002, respectively. All outstanding principal and interest under the Senior Credit Facility is due December 31, 2002. The Senior Credit Facility is secured by substantially all the assets of the Company and its subsidiaries. The Senior Credit Facility also requires the Company to meet certain financial tests on a consolidated basis, some of which may be more restrictive in future years. Based on the Company's current forecast, certain of these financial tests are likely to not be met by December 31, 2001. The Company's failure to comply with its obligations under the Senior Credit Facility, or in agreements relating to indebtedness incurred in the future, could result in an event of default under such agreements, which could permit acceleration of the related debt and acceleration of debt under other financing arrangements that may contain cross-acceleration or cross-default provisions. On June 29, 2001, the Company entered into an interest rate cap agreement that has been designated as a hedge against the Company's variable interest rate exposure under the Senior Credit Facility. At September 30, 2001, the interest rate cap has an aggregate notional amount of $20.0 million, which matures in December, 2002 and caps interest on the LIBOR portion of the term loan, up to the aggregate notional amount, at 7.5%, plus the applicable LIBOR margin. As of November 13, 2001, the Company had $8.9 million of available borrowing capacity under the Senior Credit Facility and $0.5 million of cash. As of September 30, 2001 the Company had approximately $155.7 million of long-term indebtedness outstanding including the current portion, a deficit in stockholders' equity of $40.0 million, and $0.6 million of cash. The Company intends to evaluate additional acquisitions to expand its base of installed inmate telephones and value added services and will continue to evaluate possible acquisition opportunities. There can be no assurance that the Company will have sufficient available capital resources to realize its acquisition strategy. Such future acquisitions, depending on their size and the form of consideration, may require the Company to seek additional debt or equity financing. Changes in Accounting Standards SFAS No. 141, "Business Combinations," effective July 1, 2001, and SFAS No. 142 "Goodwill and Intangible Assets," effective January 1, 2002 were issued on June 29, 2001. SFAS No. 141 prohibits pooling of 19 interest accounting for acquisitions. SFAS No. 142 specifies that goodwill and some intangible assets will no longer be amortized, but instead will be subject to periodic impairment testing. The Company is evaluating the financial statement impact of SFAS No. 142. In October 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets for Long-Lived Assets to be Disposed Of" and related literature and establishes a single model, based on the framework established in SFAS No. 121, for long-lived assets to be disposed of by sale. The Company is required to adopt SFAS No. 144 for fiscal years beginning after December 15, 2001. The Company is evaluating the financial statement impact of SFAS No. 144. Special Note Regarding Forward-Looking Information Certain statements in this Quarterly Report Form 10-Q constitute forward- looking statements. These forward-looking statements are all statements that are not statements of historical fact or that might otherwise be considered opinion, belief, or projection. These forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results, levels of activity, performance, or achievements of the Company, or industry results, to be materially different from any future results, levels of activity, performance, or achievements. The risks, uncertainties, and other factors to which forward-looking statements are subject include, among others, those set forth under the caption "Risk Factors" below. Such factors include, without limitation, the following: competitors with greater resources; risks associated with uncollectible accounts; risks associated with carrying a large amount of debt; risks associated with our limited operating history and accumulated deficits; risks associated with our dependency on facilities-based carriers; risks associated with market growth stagnating or declining; lack of patents and possible infringement; technological change and new services; control by principal shareholders; changes in the telecommunications industry; availability of key personnel; and changes in or the failure to comply with, governmental regulations. All subsequent written or oral forward-looking statements attributable to the company or persons acting on its behalf are expressly qualified in their entirety by such factors. In some cases, forward-looking statements can be identified by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue" or the negative of such terms or other comparable terminology. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, as a result of the foregoing and other factors, no assurance can be given as to future results, levels of activity, performance, or achievements, and neither the Company nor any other person assumes responsibility for the accuracy and completeness of such forward-looking statements. All forward- looking statements included in the Quarterly Report on Form 10-Q are based on information available to the Company on the date hereof, and the Company is under no duty to update any of the forward-looking statements after the date hereof. Risk Factors Our Competitors Have Greater Resources Than We Do The inmate telecommunications industry is highly competitive. We compete with numerous providers of inmate telephone services such as RBOCs, LECs, IXCs, including major long distance carriers such as AT&T, MCI, and Sprint, and independent public pay telephone and inmate telephone companies. Many of our competitors are larger and better capitalized and have greater financial resources available than we do. We believe that the principal competitive factors in the inmate telecommunications market are . rates of commissions paid to the correctional facilities; . system features and functionality; . system reliability and service; . the ability to customize inmate call processing systems to the specifications and needs of the particular correctional facility; and . relationships with correctional facilities. 20 If we are required to pay higher commissions to retain our existing contracts or obtain new contracts, there could be a material adverse effect on us and on the value of our Senior Notes. Historically, federal and state facilities, which are generally bid on a system-wide basis, have been served by RBOCs, large LECs, and IXCs. These providers have generally not, however, focused on the smaller city and county correctional systems, which are typically negotiated on a facility-by-facility basis. As a result, a significant portion of city and county correctional facilities, which constitute a substantial majority of our customers, are served by independent inmate telephone and independent public pay telephone companies. A decision by RBOCs, large LECs, or IXCs to pursue actively contracts with city and county correctional facilities could have a material adverse effect on us and on the value of our Senior Notes. Our ability to offer competitive commission rates depends on effectively controlling costs, which in turn necessitates capital expenditures for software and systems. If IXCs, RBOCs, and large LECs, which have significantly greater financial resources than we do and are able to connect calls on their owned networks for a negligible marginal cost, were to focus on the inmate telecommunications market, we could face substantial competition and subsequent increases in commission rates or reduction in market share, which could have a material adverse effect on us and on the value of our Senior Notes. Some of What We Bill is Uncollectible, and We May Underestimate This Number We are required to carry a reserve on our books for future charge-backs from LECs and third party clearinghouses for uncollectible amounts when such amounts exceed the reserves initially withheld by the LECs and clearinghouses. We set the reserves on our books using historical data on charge-backs for each LEC or other billing service providers. The setting of these reserves requires substantial use of estimation, and actual expenses associated with uncollectible accounts could differ from our estimates. Factors that could cause actual expenses associated with uncollectible accounts to vary from our estimates include difficulties in estimating reserves for acquired contracts and variations in expenses associated with uncollectible accounts among LECs. These variations could potentially lead to an increase in our expenses associated with uncollectible accounts, which could have a material adverse effect on us and on the value of our Senior Notes. Our Acquisition Strategy May Be Unsuccessful, and We Must Successfully Integrate Companies That We Acquire We constantly evaluate acquisition opportunities and are currently evaluating possible acquisition candidates. We evaluate specific acquisition opportunities based on market conditions and economic factors existing at the time and intend to pursue favorable opportunities as they arise. We may encounter increased competition for acquisitions in the future, which could result in higher prices for acquisition candidates. We cannot assure you that we will find suitable acquisition candidates at acceptable prices, have sufficient available capital resources to realize our acquisition strategy, be successful in entering into definitive agreements for desired acquisitions, or that any such acquisitions, if consummated, will prove to be advantageous to us. The success of our growth strategy is also dependent on our ability to integrate acquired operations into existing operations. In addition, our success is dependent on our ability to expand internal operations. Our ability to manage our anticipated future growth will depend on a number of factors, including our ability to: . evaluate new contract opportunities, . monitor operations, . control costs, 21 . maintain effective quality control, . obtain satisfactory and cost- effective lease rights from and interconnection agreements with companies that own transmission lines, and . expand our internal management, technical, and accounting systems. Our rapid growth has placed, and our planned future growth will continue to place, a significant strain on our financial, management, and operational resources. We cannot assure you that the integration of the operations of future acquisitions and continued expansion of internal operations will not require the investment of capital or result in unforeseen difficulties or absorb significant management resources at levels higher than that anticipated by our management, or that we will realize meaningful economies of scale or operating efficiencies from our acquisitions. In addition, acquisitions and the establishment of new operations will entail considerable expenses in advance of anticipated revenues and may cause substantial fluctuations in our operating results. Our failure to successfully integrate acquired operations could have a material adverse effect on us and the value of our Senior Notes. Our acquisition strategy results in the amortization of acquired contracts over a relatively short period of time, generally one to three years. We had capitalized $75.7 million of acquired facility contracts as of September 30, 2001. As of September 30, 2001, we had capitalized $87.1 million of goodwill. This could lead to operating losses that could have a material adverse effect on us and on the value of our Senior Notes. We Are Carrying a Large Amount of Debt That Restricts Our Ability to Operate Our Business We have significant debt and debt service obligations. Our Senior Credit Facility with Canadian Imperial Bank of Commerce as an agent for a syndicate of lenders provides for (a) a term loan acquisition facility of $55.0 million (b) an additional $10.5 million term loan facility and (c) a revolving loan facility of $25.0 million (which includes a $10.0 million letter of credit facility). In addition, on June 27, 1997, we sold $115,000,000 principal amount of 11% Senior Notes due 2007. At September 30, 2001, we had approximately $155.7 million of long-term debt outstanding (including current maturities). Our significant debt level will have several important consequences to holders of our Common Stock, including, but not limited to, the following: . we will be required to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal repayment obligations in connection with the Senior Notes, the Senior Credit Facility, and other permitted indebtedness thereby reducing the funds available for our operations, capital expenditures, and other purposes; . our debt level and the covenants contained in the Senior Credit Facility and the indenture with respect to the Senior Notes will limit our ability to obtain additional financing, pay dividends, repurchase stock, make investments, grant liens, and take other actions that may be in the best interests of our stockholders; and . our substantial debt level may make us more vulnerable to economic fluctuations, limit our ability to withstand competitive pressures, and reduce our flexibility in responding to changing business and economic conditions. In addition, our indebtedness under the Senior Credit Facility bears interest at floating rates, which could adversely affect our ability to service our debt if interest rates rise. 22 The Company believes that if current operating trends continue, the Company may be out of compliance with its bank convenants for the quarter ending December 31, 2001, which could have an adverse effect on the Company and which could effect its ability to satisfy its cash needs under its current business plan. To address this situation, the Company is discussing alternatives with its lenders and other potential investors. The Company is attempting to resolve this issue, but can give no assurance as to whether or when this effort will succeed. We cannot assure you that we will be able to meet our debt service obligations. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments, or if we otherwise fail to comply with the various covenants contained in our debt obligations, we would be in default under the terms thereof, which would permit the holders of such indebtedness to accelerate the maturity thereof and could cause defaults under our other indebtedness. Our ability to repay or refinance our obligations with respect to our indebtedness will depend on our future financial and operating results, which in turn, will be subject to prevailing economic and competitive conditions and to certain financial, business, and other factors, many of which are beyond our control. We Have a Limited Operating History and Have Accumulated Deficits We were founded in December 1996. Accordingly, we have a limited operating history upon which an evaluation of us and our prospects can be based. We believe that our future success will depend on our ability to significantly increase revenues, which we cannot assure you will happen. Additionally, our limited operating history makes the accurate prediction of future operating results difficult or impossible, and we cannot assure you that our revenues will increase or even continue at their current level or that we will maintain profitability or generate cash from operations in future periods. As of September 30, 2001, we had an accumulated deficit of $75.1 million. We may experience losses in the future which could have a material adverse effect on us and on the value of our Senior Notes. We Are Dependent On Transmission Facilities-Based Carriers We do not own telecommunications transmission lines. Accordingly, telephone calls made from correctional facilities are connected through transmission lines that we lease under a variety of arrangements with transmission facilities-based long distance carriers, some of which are or may become our competitors. Our calls are transmitted via facilities leased on a per minute or monthly basis. Accordingly, we are vulnerable to increases in our cost basis. If there is an increase in demand for telecommunications services (for example, data services) beyond the increase in supply of transmission facilities, our costs could increase, which could have a material adverse effect on us and on the value of our Senior Notes. Changes in Regulation Could Adversely Affect Our Business The inmate telecommunications industry is regulated by both the Federal Communications Commission (the "FCC") and state public utility commissions. Our operations are also significantly affected by the regulation of other telecommunications businesses, including LECs and IXCs. Changes in the laws and regulations governing our business or other telecommunications businesses could have a material adverse effect on us and on the value of our Senior Notes. At the federal level, the industry is currently in a period of substantial regulatory change in the aftermath of the Telecommunications Act of 1996 (the "Telecom Act"), which, among other things, directed the FCC to restructure and to change the regulatory framework of the pay telephone industry, including the inmate telephone industry. Because the FCC is still in the process of implementing its new regulations, and because several aspects of rule changes proposed by the FCC are subject to requests for reconsideration, clarification, and final resolution in related proceedings, the ultimate effect of regulatory changes on our business is uncertain. 23 In addition to adopting regulations implementing the Telecom Act, the FCC also recently adopted new regulations for interstate calls requiring inmate telephone service providers to announce to called parties, before the called party incurs any charges, that rate quotes may be obtained by dialing no more than two digits or remaining on the line. We were required to come into compliance with these new rules by October 1, 1999, and we believe that we are substantially in compliance. Regulatory authorities do have authority to impose fines and other sanctions for any violation of these rules. These new regulations could result in an increase in our costs by slightly increasing the non-billable network hold time for interstate collect calls. In addition, the announcement of rate quotes may lead to called parties refusing to accept calls. The exact effect of the new regulations is difficult to predict, as it will depend in large part on how frequently called parties opt to receive a rate quote. We charge relatively high rates for completing inmate collect, and prepaid calls. Many states have set maximum rates that can be charged for inmate collect calls. If regulators reduce the rates that may be charged, there could be a material adverse effect on us and on the value of our Senior Notes. Our Market Growth May Stagnate or Decline Our future growth could be affected by negative trends in the growth of the number of correctional facilities or the number of prisoners. If the societal and political trends that have led to this growth rate abate, the growth of the corrections industry could stagnate or decline, and this would have a material adverse effect on us and on the value of our Senior Notes. In particular, if the drug laws or mandatory sentencing laws that have been enacted in the last decade are repealed or reduced in scope, there could be an adverse effect on the growth of the inmate population, which could effect our future success and the value of our Senior Notes. In addition, state prison authorities in the State of Texas have adopted policies severely restricting the making of telephone calls by inmates in state correctional facilities. The adoption of similar policies by other states could severely reduce the size of the inmate telecommunications market and have a material adverse effect on us and on the value of our Senior Notes. Our New Business Line is Unproven For Us and May Prove Unsuccessful We are pursuing a new line of business that we call the "Solutions" business. The Solutions business is similar to the capabilities and services that we provide to one of the RBOCs today. The foundation of our Solutions business is our intelligent call management, billing, and fraud control capabilities. We are strengthening the underlying Solutions applications, and have been successful in creating interest with potential new customers as evidenced by recent new contract activity. We have limited experience in obtaining contracts to provide, and in providing, such services to third parties, and we cannot assure you that we will be successful in either of these endeavors. Our failure to secure opportunities to provide these services to third parties, to successfully provide these services, or to generate revenues from these services could have a material adverse effect on our future success and on the value of our Senior Notes. If We Cannot Recruit and Retain Key Personnel, We Will Have Difficulty Executing Our Strategy Our success is dependent on the efforts of certain of our officers, senior management, technical, and other personnel, and on our ability to continue to attract, retain, and motivate qualified personnel. The competition for such employees is intense, and we believe that it would be difficult to replace the expertise and experience of such persons in the event that the services of one or more such persons were to become unavailable. Accordingly, the loss of the services of one or more of these individuals without adequate replacement could have a material adverse effect on us and our ability to implement our business strategy and to 24 achieve our goals, and could have a material adverse effect on the value of our Senior Notes. In addition, our failure to attract and retain additional management to support our business strategy could also have a material adverse effect on us. We Lack Patents and Might Be Challenged For Infringement None of our internally developed call processing technology has been patented. Accordingly, such technology and intellectual property rights could infringe on other parties' intellectual property rights and could be contested or challenged. We have received notice from two parties that certain features of our call processing technology may infringe upon such parties' patents. Should our call processor or any material feature thereof be determined to violate applicable patents, we would be required to cease using the technology or features or seek to obtain appropriate licenses (which the Company may not be able to obtain) for the use of such technology, either of which could have a material adverse effect upon us and on the value of our Senior Notes. We Have Governmental Entities As Customers Our customers include state and local governmental entities responsible for the administration and operation of correctional facilities. We are subject, therefore, to the administrative policies and procedures employed by, and the regulations that govern the activities of, these governmental entities, including policies, procedures, and regulations concerning the procurement and retention of contract rights and the provision of services. We cannot assure you that our operations will not be adversely affected by the policies and procedures employed by, or the regulations that govern the activities of, these governmental entities or that we will not be limited in our ability to secure additional customer contracts, renew existing customer contracts, or consummate acquisitions as a result of such policies, procedures, and regulations. Our Business Experiences Rapid Technological Change and New Services The telecommunications industry has been characterized by rapid technological advancements, frequent new service introductions, and evolving industry standards. Management believes that our future success will depend on its ability to anticipate and respond to such changes and new technology. We cannot assure you that we will not be materially adversely affected by the introduction and acceptance of new technology. Some of our technology, such as our call processor technology, has not yet been implemented in all of the facilities that we service. 25 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There were no material changes from the information reported in the Company's Form 10-K, which information is incorporated herein by reference. 26 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is from time to time a party to legal proceedings that arise in the ordinary course of business. Management does not believe that the resolution of any threatened or pending legal proceedings will have a material adverse affect on the Company. None of the Company's internally developed call processing technology has been patented. Accordingly, such technology and intellectual property rights could infringe on other parties' intellectual property rights and could be contested or challenged. The Company has received notice from two parties that certain features of the Company's call processing technology may infringe upon such parties' patents. A competitor holds certain patents, which, if valid, might be relevant to our call processing technology and such competitor has recently consolidated the ownership of certain intellectual property which may increase the likelihood of a claim of infringement. Should our call processor or any material feature thereof be determined to violate applicable patents, we would be required to cease using the technology or features or seek to obtain appropriate licenses (which the Company may not be able to obtain) for the use of such technology. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS This item is not applicable to the Registrant. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS (With respect to Form 10-Q for the quarterly period ending September 30, 2001) (a) An annual meeting of shareholders was held on October 2, 2001. (b) The shareholders elected the following directors at the annual meeting, constituting the entire board of directors: Richard H. Hochman Jay R. Levine Nina E. McLemore Bruce I. Raben Julius E. Talton Richard Falcone Gregg L. Engles Todd W. Follmer David A. Sachs Roger K. Sallee Joseph P. Urso (c) The shareholders voted upon 3 matters: (i) The election of the Board of Directors of the Company; (ii) The Amendment of the Amended and Restated Certificate of Incorporation of the Company to increase the number of shares of Class A Common Stock authorized for issuance thereunder by 50,000 shares; and (iii) The Amendment of the 1998 Stock Option Plan (the "Plan") to increase to 5,000 shares, the number of share of Class A Common Stock which may be issued and sold pursuant to options granted under the Plan. 22,498.41 votes were cast for the above matters and there were no votes cast against the matters or abstentions or broker nonvotes. (d) Not Applicable. ITEM 5. OTHER INFORMATION None. 27 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits Exhibit No. Description of Exhibit ------- ---------------------- 3.1 Certificate of Incorporation of the Company (filed as Exhibit 3.1 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 3.2 Bylaws of the Company (filed as Exhibit 3.2 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 3.3 Certificate of Amendment to Restated Certificate of Incorporation of the Company, dated as of July 23, 1998 (filed as Exhibit 3.3 to the Company's Quarterly Report on Form 10-Q, dated as of August 14, 1998 and incorporated herein by reference). 3.4 Certificate of Amendment to Restated Certificate of Incorporation of the Company, dated as February 11, 1999. (filed as Exhibit 3.4 to the Company's Quarterly Report on Form-10-Q dated as of May 12, 1999 and incorporated herein by reference). 3.5* Certificate of Amendment to Restated Certificate of Incorporation, dated as of October 2, 2001. 4.1 Indenture, dated as of June 27, 1997, between the Company and U.S. Trust Company of Texas, N.A. (filed as Exhibit 4.1 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.2 Form of Note (contained in Indenture filed as Exhibit 4.2 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.3 Form of Subsidiary Guaranty (contained in Indenture filed as Exhibit 4.3 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.4 Registration Rights Agreement, dated as of June 27, 1997, between the Company and the Initial Purchaser (filed as Exhibit 4.4 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.5 Registration Rights Agreement, dated as of December 27, 1996m by and among the Company and certain Holders named therein (filed as Exhibit 4.5 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.6 Shareholders Agreement, dated as December 27, 1996, by among the Company and certain Persons named therein (filed as Exhibit 4.6 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.7 Warrant Agreement, dated as of December 27, 1996, between the Company and CIBC Wood Gundy Ventures, Inc. (filed as Exhibit 4.7 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.8 Warrant Agreement, dated as of December 27, 1996, between the Company and Gregg L. Engles (filed as Exhibit 4.8 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.9 Warrant Agreement, dated as of December 27, 1996, between the Company and Gregg L. Engles (filed as Exhibit 4.9 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.10 Warrant Agreement, dated as of December 27, 1996, between the Company and Gregg L. Engles (filed as Exhibit 4.10 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.11 Warrant Agreement, dated as of December 27, 1996, between the Company and Onyx Talton Partners, L.P. (filed as Exhibit 4.11 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.12 Warrant Agreement, dated as of December 27, 1996, between the Company and Onyx Talton Partners, L.P. (filed as Exhibit 4.12 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 28 4.13 Warrant Agreement, dated as of December 27, 1996, between the Company and Onyx Talton Partners, L.P. (filed as Exhibit 4.13 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.14 Warrant Agreement, dated as of December 27, 1996, between the Company and Joseph P. Urso (filed as Exhibit 4.14 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.15 Warrant Agreement, dated as of December 27, 1996, between the Company and Joseph P. Urso (filed as Exhibit 4.15 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.16 Warrant Agreement, dated as of December 27, 1996, between the Company and Joseph P. Urso (filed as Exhibit 4.16 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.17 Warrant Agreement, dated as of December 27, 1996, between the Company and Todd W. Follmer (filed as Exhibit 4.17 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.18 Warrant Agreement, dated as of December 27, 1996, between the Company and Todd W. Follmer (filed as Exhibit 4.18 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.19 Warrant Agreement, dated as of December 27, 1996, between the Company and Todd W. Follmer (filed as Exhibit 4.19 to the Company's Registration Statement No. 333-33639 and incorporated herein by reference). 4.20 Form of Warrant Agreement, dated as of March 12, 1999 (filed as Exhibit 4.20 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 and incorporated herein by reference). 4.21 Form of Warrant Agreement, dated as of May 30, 2001 (filed as Exhibit 4.21 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 and incorporated herein by reference). 10.1* Amendment to Stock Option Plan. * Filed herewith. (b) Reports on Form 8-K No reports on Form 8-K have been filed during the period subject to this Quarterly Report on Form 10-Q. 29 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 thereunto duly authorized. EVERCOM, INC. By:/s/ RICHARD FALCONE Richard Falcone Chief Executive Officer By:/s/ KEITH KELSON Keith Kelson Chief Financial Officer Date: November 14, 2001 30

EVERCOM INC 10-Q