U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended March 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from __________ to __________. Commission file number 000-27305 TELKONET, INC. (Exact name of Issuer as specified in its charter) Utah 87-0627421 (State of Incorporation) (IRS Employer Identification No.) 20374 Seneca Meadows Parkway, Germantown, MD 20876 (Address of Principal Executive Offices) (240) 912-1800 Issuer's Telephone Number Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). 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: 44,678,872 shares of Common Stock ($.001 par value) as of May 2, 2005. 1 TELKONET, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTERLY PERIOD ENDING MARCH 31, 2005 Table of Contents Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited) Condensed Consolidated Balance Sheets: March 31, 2005 and December 31, 2004 3 Condensed Consolidated Statements of Losses: Three Months Ended March 31, 2005 and 2004 4 Condensed Consolidated Statement of Stockholders' Equity January 1, 2005 through March 31, 2005 5 Condensed Consolidated Statements of Cash Flows: Three Months Ended March 31, 2005 and 2004 6-7 Notes to Unaudited Condensed Consolidated Financial Information: March 31, 2005 8-18 Item 2. Management's Discussion and Analysis 19-26 Item 3. Quantitative and Qualitative Disclosures About Market Risk 26 Item 4. Controls and Procedures 27 PART II. OTHER INFORMATION 27 Item 1. Legal Proceedings 27 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 27 Item 3. Defaults Upon Senior Securities 27 Item 4. Submission of Matters to a Vote of Security Holders 27 Item 5. Other Information 27 Item 6. Exhibits 28 2
Item 1. Financial Statements (Unaudited) TELKONET, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) March 31, 2005 December 31, 2004 ----------------- ----------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 9,203,498 $ 11,838,702 Accounts Receivable: net of allowance for doubtful accounts of $13,000 at March 31, 2005 and December 31, 2004 93,046 63,147 Inventory (Note G) 1,753,069 1,873,718 Prepaid expenses and deposits 225,399 124,852 ----------------- ----------------- Total current assets 11,275,012 13,900,419 PROPERTY AND EQUIPMENT: Furniture and equipment, at cost 803,227 704,689 Less: accumulated depreciation 173,287 137,739 ----------------- ----------------- Total property and equipment, net 629,940 566,950 EQUIPMENT UNDER OPERATING LEASES: Capitalized equipment, at cost 739,944 525,664 Less: accumulated depreciation 115,306 75,329 ----------------- ----------------- Total equipment under operating leases, net 624,638 450,335 OTHER ASSETS: Long-term investments 550,000 500,000 Deposits 78,708 76,288 ----------------- ----------------- TOTAL ASSETS $ 13,158,298 $ 15,493,992 ================= ================= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and accrued liabilities $ 1,230,056 $ 1,195,924 Convertible debentures, net of discounts - including related parties (Note B) 155,933 -- Customer deposits 87,779 32,975 ----------------- ----------------- Total current liabilities 1,473,768 1,228,899 LONG TERM LIABILITIES: Senior notes payable (Note C) 450,000 450,000 Convertible debentures, net of discounts - including related parties (Note B) -- 137,910 Deferred lease liability 41,215 30,911 ----------------- ----------------- Total long term liabilities 491,215 618,821 COMMITMENTS AND CONTINGENCIES -- -- STOCKHOLDERS' EQUITY : Preferred stock, par value $.001 per share; 15,000,000 shares authorized; none issued and outstanding at March 31, 2005 and December 31, 2004 (Note E) -- -- Common stock, par value $.001 per share; 100,000,000 shares authorized; 44,614,174 and 44,335,989 shares issued and outstanding at March 31, 2005 and December 31, 2004, respectively (Note E) 44,615 44,336 Additional paid-in-capital 41,442,515 40,811,208 Accumulated deficit (30,293,815) (27,209,272) ----------------- ----------------- Stockholders' equity 11,193,315 13,646,272 ----------------- ----------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 13,158,298 $ 15,493,992 ================= ================= See accompanying footnotes to the unaudited condensed consolidated financial information 3
TELKONET, INC. CONDENSED CONSOLIDATED STATEMENTS OF LOSSES (UNAUDITED) For The Three Months Ended March 31, 2005 2004 ------------ ------------ Revenues, net: Product $ 129,273 $ 119,790 Rental 116,915 20,309 ------------ ------------ Total Revenue 246,188 140,099 Cost of Sales: Product 90,982 128,538 Rental 66,408 5,866 ------------ ------------ Total Cost of Sales 157,390 134,404 Gross Profit 88,798 5,695 Costs and Expenses: Research and Development 447,925 432,715 Selling, General and Administrative 2,399,960 1,354,191 Non-Employee Stock Options and Warrants (Note D) 292,925 213,541 Depreciation and Amortization 39,303 14,990 ------------ ------------ Total Operating Expense 3,180,113 2,015,437 Loss from Operations (3,091,315) (2,009,742) Other Income (Expenses): Interest Income 37,937 18,880 Interest Expense (31,165) (46,100) ------------ ------------ Total Other Income (Expenses) 6,772 (27,220) Loss Before Provision for Income Taxes (3,084,543) (2,036,962) Provision for Income Taxes -- -- ------------ ------------ Net Loss $ (3,084,543) $ (2,036,962) ============ ============ Loss per common share (basic and assuming dilution) $ (0.07) $ (0.09) ============ ============ Weighted average common shares outstanding 44,604,389 22,171,554 See accompanying footnotes to the unaudited condensed consolidated financial information 4
TELKONET, INC. CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED) FOR THE PERIOD FROM JANUARY 1, 2005 TO MARCH 31, 2005 Preferred Additional Preferred Stock Common Common Paid in Accumulated Shares Amount Shares Stock Amount Capital Deficit Total ------------ ------------ ------------ ------------ ------------ ------------ ------------ BALANCE AT JANUARY 1, 2005 -- -- 44,335,989 $ 44,336 $ 40,811,208 $(27,209,272) $ 13,646,272 Shares issued for employee stock options exercised at approximately $1.10 per share -- -- 177,567 178 195,246 -- 195,424 Shares issued in exchange for non-employee options exercised at $1.00 per share -- -- 20,833 21 20,812 -- 20,833 Shares issued in exchange for warrants exercised at $1.00 per share -- -- 70,000 70 69,930 -- 70,000 Shares issued to consultants in exchange for services rendered at approximately $5.73 per share -- -- 785 1 4,499 -- 4,500 Shares issued to an employee in exchange for services at approximately $5.32 per share -- -- 9,000 9 47,895 -- 47,904 Stock options and warrants granted to consultants in exchange for services rendered (Note D) -- -- -- -- 292,925 -- 292,925 Net Loss -- -- -- -- -- (3,084,543) (3,084,543) ------------ ------------ ------------ ------------ ------------ ------------ ------------ BALANCE AT MARCH 31, 2005 -- $ -- 44,614,174 $ 44,615 $ 41,442,515 $(30,293,815) $ 11,193,315 ============ ============ ============ ============ ============ ============ ============ See accompanying footnotes to the unaudited condensed consolidated financial information 5
TELKONET, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) For The Three Months Ended March 31, 2005 2004 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net loss from operating activities $ (3,084,543) $ (2,036,962) Adjustments to reconcile net loss from operations to cash used in operating activities Amortization of debt discount - beneficial conversion feature of convertible debentures 5,712 5,472 Amortization of debt discount - value of warrants attached to convertible debentures 12,311 2,538 Stock options and warrants issued in exchange for services rendered (Note D) 292,925 213,541 Common stock issued in exchange for services rendered (Note E) 52,404 103,253 Common stock issued in exchange for conversion of interest (Note B) -- 23,276 Depreciation and amortization 76,130 14,990 Increase / decrease in: Accounts receivable (29,899) (62,030) Inventory 120,649 (95,329) Prepaid expenses and deposits (48,163) (62,358) Accounts payable and accrued expenses 34,132 (108,781) Deferred lease liability 10,304 -- ------------ ------------ NET CASH (USED IN) OPERATING ACTIVITIES (2,558,038) (2,002,390) CASH FLOWS FROM INVESTING ACTIVITIES: Costs of equipment under operating leases (214,885) (24,186) Investment in Amperion and BPL Global (Note F) (50,000) -- Purchase of property and equipment, net (98,538) (22,681) ------------ ------------ NET CASH (USED IN) INVESTING ACTIVITIES (363,423) (46,867) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of common stock, net of costs -- 12,726,843 Proceeds from exercise of warrants attached to notes payable 70,000 3,940,200 Proceeds from exercise of employee and non-employee stock options and warrants 216,257 297,666 Payment of capital leases -- (8,667) ------------ ------------ NET CASH PROVIDED BY FINANCING ACTIVITIES 286,257 16,956,042 NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS (2,635,204) 14,906,785 CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE PERIOD 11,838,702 5,177,918 ------------ ------------ CASH AND CASH EQUIVALENTS AT THE END OF THE PERIOD $ 9,203,498 $ 20,084,703 ============ ============ See accompanying footnotes to the unaudited condensed consolidated financial information 6
TELKONET, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) For The Three Months Ended March 31, 2005 2004 ---------- ---------- Supplemental Disclosures of Cash Flow Information Cash paid during the period for interest $ 9,000 $ 72,941 Income taxes paid -- -- Non-cash transactions: Issuance of stock options and warrants in exchange for services rendered (Note D) 292,925 213,541 Common stock issued for services rendered 52,404 103,253 Common stock issued in exchange for interest (Note B) -- 23,276 Common stock issued in exchange for conversion of Senior Notes (Note C) -- 2,539,000 Common stock issued in exchange for convertible debentures (Note B) -- 172,000 Write-off of beneficial conversion feature of conversion of debenture (Note B) -- 134,134 Write-off of value of warrants attached to debenture in connection with conversion (Note B) -- 531 See accompanying footnotes to the unaudited condensed consolidated financial information 7
TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE A - SUMMARY OF ACCOUNTING POLICIES - --------------------------------------- General - ------- The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. 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. Accordingly, the results from operations for the three-month period ended March 31, 2005, are not necessarily indicative of the results that may be expected for the year ended December 31, 2005. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, 2004 financial statements and footnotes thereto included in the Company's Form 10-KSB for the year ended December 31, 2004. Basis of Presentation - --------------------- Telkonet, Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed on November 3, 1999 under the laws of the state of Utah. The Company is engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of voice and data over electric utility lines. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Telkonet Communications, Inc. Significant intercompany transactions have been eliminated in consolidation. Reclassification - ---------------- Certain reclassifications have been made to conform prior periods' data to the current presentation. These reclassifications had no effect on reported losses. Concentrations of Credit Risk - ----------------------------- Financial instruments and related items, which potentially subject the Company to concentrations of credit risk, consist primarily of cash and cash equivalents. The Company places its cash and temporary cash investments with credit quality institutions. At times, such investments may be in excess of the FDIC insurance limit. The allowance for doubtful accounts was $13,000 at March 31, 2005 and December 31, 2004. Stock Based Compensation - ------------------------ In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS 123." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25 and related interpretations. Accordingly, compensation expense for stock options is measured as the excess, if any, of the fair market value of the Company's stock at the date of the grant over the exercise price of the related option. The Company has adopted the annual disclosure provisions of SFAS No. 148 in its financial reports for the year ended December 31, 2004 and has adopted the interim disclosure provisions for its financial reports for the subsequent periods. 8 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE A - SUMMARY OF ACCOUNTING POLICIES - --------------------------------------- Stock Based Compensation (Continued) - ------------------------------------ Had compensation costs for the Company's stock options been determined based on the fair value at the grant dates for the awards, the Company's net loss and losses per share would have been as follows (transactions involving stock options issued to employees and Black-Scholes model assumptions are presented in Note D): For the three months ended March 31, 2005 2004 ----------- ----------- Net loss - as reported $(3,084,543) $(2,036,962) Add: Total stock based employee compensation expense as reported under intrinsic value method (APB. No. 25) -- -- Deduct: Total stock based employee compensation expense as reported under fair value based method (SFAS No. 123) (2,107,545) (1,466,590) ----------- ----------- Net loss - Pro Forma $(5,192,088) $(3,503,552) Net loss attributable to common stockholders - Pro forma $(5,192,088) $(3,503,552) Basic (and assuming dilution) loss per share - as reported $ (0.07) $ (0.09) Basic (and assuming dilution) loss per share - Pro forma $ (0.12) $ (0.16) On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R (revised 2004), "Share-Based Payment" which is a revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation". Statement 123R supersedes APB opinion No. 25, "Accounting for Stock Issued to Employees", and amends FASB Statement No. 95, "Statement of Cash Flows". Generally, the approach in Statement 123R is similar to the approach described in Statement 123. However, Statement 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro-forma disclosure is no longer an alternative. On April 14, 2005, the SEC amended the effective date of the provisions of this statement. The effect of this amendment by the SEC is that the Company will have to comply with Statement 123R and use the Fair Value based method of accounting no later than the first quarter of 2006. Management has not determined the impact that this statement will have on Company's consolidated financial statements. Revenue Recognition - ------------------- For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, REVENUE RECOGNITION ("SAB104"), which superceded Staff Accounting Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL STATEMENTS ("SAB101"). SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management's judgments regarding the fixed nature of the selling prices of the products delivered and the collectibility of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The Company defers any revenue for which the product has not been delivered or is subject to refund until such time that the Company and the customer jointly determine that the product has been delivered or no refund will be required. SAB 104 incorporates Emerging Issues Task Force 00-21 ("EITF 00-21"), MULTIPLE-DELIVERABLE REVENUE ARRANGEMENTS. EITF 00-21 addresses accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets. 9 Currently, there are no warranties provided with the purchase of the Company's products. The cost of replacing defective products and product returns have been immaterial and within management's expectations. In the future, when the Company deems warranty reserves are appropriate, such costs will be accrued to reflect anticipated warranty costs. For equipment under lease, revenue is recognized over the lease term for operating lease and rental contracts. All of the Company's leases are accounted for as operating leases. At the inception of the lease, no lease revenue is recognized and the leased equipment, together with the initial direct costs of installation and support are capitalized, and appear on the balance sheet as "Equipment Under Operating Leases." The capitalized cost of this equipment is depreciated from two to three years, on a straight-line basis down to the Company's original estimate of the projected value of the equipment at the end of the scheduled lease term. Monthly lease payments are recognized as rental income. NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE - --------------------------------------------- A summary of convertible promissory notes payable at March 31, 2005 and December 31, 2004 is as follows: March 31, 2005 December 31, 2004 -------------- ----------------- Convertible notes payable ("Series B Debenture"), in quarterly installments of interest only at 8% per annum, unsecured and due three years from the date of the note with the latest maturity February 2006; Noteholder has the option to convert unpaid note principal, together with accrued and unpaid interest, to the Company's common stock at a rate of $.55 per share six months after issuance. 210,000 210,000 Debt Discount - beneficial conversion feature, net of accumulated amortization of $61,560 and $49,249 at March 31, 2005 and December 31, 2004, respectively. (36,932) (49,243) Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $28,553 and $22,841 at March 31, 2005 and December 31, 2004, respectively. (17,135) (22,847) -------------- ----------------- Total 155,933 137,910 -------------- ----------------- Less: current portion (155,933) -- -------------- ----------------- $ -- $ 137,910 ============== ================= 10
TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED) - --------------------------------------------------------- Series B Debentures - ------------------- In 2002, the Company issued convertible promissory notes (the "Series B Debentures") to Company officers, shareholders, and sophisticated investors in exchange for $472,900, exclusive of placement costs and fees. The Series B Debentures accrue interest at 8% per annum and are due and payable three years from the date of the note with the latest maturity date of December 2005. Noteholders have the option to convert any unpaid note principal, together with accrued and unpaid interest, to the Company's common stock at a rate of $.55 per share beginning six months after issuance. In accordance with EITF 98-5, the Company recognized an imbedded beneficial conversion feature present in the Series B Debenture note. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid-in capital. The Company recognized and measured an aggregate of $147,859 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Series B Debentures. The debt discount attributed to the beneficial conversion feature is amortized over the Series B Debentures maturity period (three years) as interest expense. In connection with the placement of the Series B Debentures in 2002, the Company issued non-detachable warrants granting the holders the right to acquire, in the aggregate, 472,900 shares of the Company's common stock at $1.00 per share. In accordance with EITF 00-27 the Company recognized the value attributable to the warrants in the amount of $68,595 to additional paid in capital and a discount against the Series B Debentures. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 3 years, an average risk free interest rate of 1.67%, a dividend yield of 0%, and volatility of 26%. The debt discount attributed to the value of the warrants issued is amortized over the Series B Debentures maturity period (three years) as interest expense. In 2003, the Company issued convertible Series B Debentures to Company officers, shareholders, and sophisticated investors in exchange for $2,027,100, exclusive of placement costs and fees. The Series B Debentures accrue interest at 8% per annum and are payable and due three years from the date of the note with the latest maturity date of February 2006. Noteholders have the option to convert any unpaid note principal together with accrued and unpaid interest to the Company's common stock at a rate of $.55 per share beginning six months after issuance. In accordance with EITF 98-5, the Company recognized an imbedded beneficial conversion feature present in the Series B Debenture note. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid-in capital. The Company recognized and measured an aggregate of $1,761,675 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Series B Debentures. The debt discount attributed to the beneficial conversion feature is amortized over the Series B Debentures maturity period (three years) as interest expense. In connection with the placement of the Series B Debenture notes in 2003, the Company issued non-detachable warrants granting the holders the right to acquire, in the aggregate, 2,027,100 shares of the Company's common stock at $1.00 per share. In accordance with EITF 00-27, the Company recognized the value attributable to the warrants in the amount of $265,425 to additional paid in capital and a discount against the Series B Debentures. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 3 years, an average risk free interest rate of 1.25%, a dividend yield of 0%, and volatility of 26%. The debt discount attributed to the value of the warrants issued is amortized over the Series B Debentures maturity period (three years) as interest expense. 11 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED) - --------------------------------------------------------- Debenture-1 - ----------- During the year ended December 31, 2001, the Company issued convertible promissory notes (the "Debenture-1") to Company officers, shareholders, and sophisticated investors in exchange for $940,000, exclusive of placement costs and fees. The Debenture-1 accrues interest at 8% per annum and is due and payable three years from the date of the note with the latest maturity date of November 2004. The noteholders have the option to convert any unpaid note principal, together with accrued and unpaid interest, to the Company's common stock at a rate of $.50 per share beginning six months after issuance. In accordance with EMERGING ISSUES TASK FORCE ISSUE 98-5, ACCOUNTING FOR CONVERTIBLE SECURITIES WITH A BENEFICIAL CONVERSION FEATURES OR CONTINGENTLY ADJUSTABLE CONVERSION RATIOS ("EITF 98-5"), the Company recognized an imbedded beneficial conversion feature present in the Debenture-1 note. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid in capital. The Company recognized and measured an aggregate of $837,874 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Debenture-1. The debt discount attributed to the beneficial conversion feature is amortized over the Debenture-1's maturity period (three years) as interest expense. In connection with the placement of the Debenture-1 notes, the Company issued non-detachable warrants granting the holders the right to acquire, in the aggregate, 940,000 shares of the Company's common stock at $1.00 per share. In accordance with EMERGING ISSUES TASK FORCE ISSUE 00-27, APPLICATION OF ISSUE NO. 98-5 TO CERTAIN CONVERTIBLE INSTRUMENTS ("EITF 00-27"), the Company recognized the value attributable to the warrants in the amount of $77,254 to additional paid-in capital and a discount against the Debenture-1. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 3 years, an average risk free interest rate of 1.25%, a dividend yield of 0%, and volatility of 26%. The debt discount attributed to the value of the warrants issued is amortized over the Debenture-1's maturity period (three years) as interest expense. During the year ended December 31, 2002, the Company issued the Debenture-1 to Company officers, shareholders, and sophisticated investors in exchange for $749,100, exclusive of placement costs and fees. The Debenture-1 accrues interest at 8% per annum and is due and payable three years from the date of the note with the latest maturity date of May 2005. Noteholders have the option to convert any unpaid note principal together with accrued and unpaid interest to the Company's common stock at a rate of $.50 per share beginning six months after issuance. In accordance with EITF 98-5, the Company recognized an imbedded beneficial conversion feature present in the Debenture-1 note. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid in capital. The Company recognized and measured an aggregate of $693,018 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid-in capital and a discount against the Debenture-1. The debt discount attributed to the beneficial conversion feature is amortized over the Debenture-1's maturity period (three years) as interest expense. In connection with the placement of the Debenture-1 notes in 2002, the Company issued non-detachable warrants granting the holders the right to acquire, in the aggregate, 749,100 shares of the Company's common stock at $1.00 per share. In accordance with EITF 00-27, the Company recognized the value attributable to the warrants in the amount of $56,082 to additional paid in capital and a discount against the Debenture-1. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 3 years, an average risk free interest rate of 1.67%, a dividend yield of 0%, and volatility of 26%. The debt discount attributed to the value of the warrants issued is amortized over the Debenture-1's maturity period (three years) as interest expense. 12 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE B - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED) - --------------------------------------------------------- The Company amortized the Debenture 1 and the Series B Debenture debt discount attributed to the beneficial conversion feature and the value of the attached warrants and recorded non-cash interest expense of $18,023 and $8,010 for the three months ended March 31, 2005 and 2004, respectively. During the year ended December 31, 2003, the Debenture-1 noteholders demanded registration of that number of common shares of the Company sufficient to cover the conversion of their debentures and exercise of the attached warrants. Accordingly, the Company notified the Series B Debenture noteholders, Senior noteholders (Note C) and warrant holders with piggy-back registration rights of their right to participate in the registration. During the year ended December 31, 2003, the Company issued an aggregate of 7,217,836 shares of common stock in connection with the conversion of $1,627,100 aggregate principal amount of the Debenture-1 and $2,180,000 aggregate principal amount of the Series B Debentures. The Company also issued an aggregate of 525,403 shares of common stock in exchange for accrued interest of $195,148 and $85,586 for Debenture 1 and Series B Debentures, respectively. During the three months ended March 31, 2004, the Company issued an aggregate of 324,001 shares of common stock in connection with the conversion of $62,000 aggregate principal amount of the Debenture-1 and $110,000 aggregate principal amount of the Series B Debentures. The Company also issued an aggregate of 42,999 shares of common stock in exchange for accrued interest of $23,276 for Debenture 1 and Series B Debentures. All Debentrure-1 had been converted to common stock. There was no Debenture-1 outstanding at March 31, 2005 and December 31, 2004. The remaining outstanding Series B Debenture at March 31, 2005 and December 31, 2004 was $210,000. In connection with the conversion of Debenture-1 and Series B Debentures, the Company wrote off the unamortized debt discount attributed to the beneficial conversion feature and the value of the attached warrants in the amount of $2,046,479 and $296,470, respectively, as of December 31, 2003, and an additional $134,134 and $531, respectively, during the three months ended March 31, 2004. NOTE C - SENIOR NOTES PAYABLE - ----------------------------- In the second quarter of 2003, the Company issued Senior Notes to Company officers, shareholders, and sophisticated investors in exchange for $5,000,000, exclusive of placement costs and fees. The Senior Notes are denominated in units of $100,000, accrue interest at 8% per annum and are due three years from the date of issuance with the latest maturity date of June 2006. Attached to each Senior Note are warrants to purchase 125,000 shares of common stock. The warrants have a three-year contractual life and are exercisable immediately after the issuance of the Senior Note at an exercise price of $1.00 per share. The Senior Notes are secured by a first priority security interest in all intellectual property assets of the Company. In September 2003, certain Senior noteholders elected to surrender their Senior Note as consideration for the exercise of warrants to purchase shares of common stock of the Company. The Company issued an aggregate of 2,011,000 restricted shares of common stock for warrants exercised at $1.00 per share, in exchange for $2,011,000 of Senior Notes. In January 2004, certain noteholders requested to convert their senior notes into Company restricted shares of common stock. The Company's Board of Directors approved this request by amending the terms of the Senior Note for a limited time. The Company immediately notified all of the outstanding Senior Note Holders of this temporary conversion option, and indicated that it would accept the surrender of the Senior Notes as consideration for the purchase of the registrant's common shares at a price of $2.10 per share. The conversion price represented the current market price of the Company's common stock. The remaining outstanding senior notes at March 31, 2005 and December 31, 2004 was $450,000. 13 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE D - STOCK OPTIONS AND WARRANTS - ----------------------------------- Employee Stock Options - ---------------------- The following table summarizes the changes in options outstanding and the related prices for the shares of the Company's common stock issued to employees of the Company under a non-qualified employee stock option plan. Options Outstanding Options Exercisable ------------------- ------------------- Weighted Average Weighted Weighted Number Remaining Contractual Average Number Average Exercise Prices Outstanding Life (Years) Exercise Price Exercisable Exercise Price --------------- ----------- ------------ -------------- ----------- -------------- $1.00 - $1.99 6,018,600 7.69 $ 1.00 4,506,100 $ 1.00 $2.00 - $2.99 2,173,600 8.52 $ 2.29 606,650 $ 2.25 $3.00 - $3.99 1,230,000 9.14 $ 3.41 170,583 $ 3.47 $4.00 - $4.99 140,000 9.79 $ 4.58 -- $ -- $5.00 - $5.99 295,000 9.80 $ 5.29 -- $ -- ----------- ------------ -------------- ----------- -------------- 9,857,200 8.15 $ 1.77 5,283,333 $ 1.22 =========== ============ ============== =========== ============== Transactions involving stock options issued to employees are summarized as follows: Weighted Average Number of Shares Price Per Share ----------------- ----------------- Outstanding at January 1, 2003 1,950,000 1.00 Granted 7,202,333 1.22 Exercised (109,333) 1.01 Cancelled or expired (750,000) 1.00 ----------------- ----------------- Outstanding at December 31, 2003 8,293,000 $ 1.19 ================= ================= Granted 2,108,000 3.06 Exercised (540,399) 1.08 Cancelled or expired (245,834) 1.74 ----------------- ----------------- Outstanding at December 31, 2004 9,614,767 $ 1.61 ================= ================= Granted 460,000 4.98 Exercised (177,567) 1.10 Cancelled or expired (40,000) 2.34 ----------------- ----------------- Outstanding at March 31, 2005 9,857,200 $ 1.77 ================= ================= The weighted-average fair value of stock options granted to employees during the period ended March 31, 2005 and 2004 and the weighted-average significant assumptions used to determine those fair values, using a Black-Scholes option pricing model are as follows: 2005 2004 ------------- ---------- Significant assumptions (weighted-average): Risk-free interest rate at grant date 3.50 to 4.00% 1.00% Expected stock price volatility 76% 32% Expected dividend payout -- -- Expected option life-years 5.0 10.0
If the Company recognized compensation cost for the non-qualified employee stock option plan in accordance with SFAS No. 123, the Company's pro forma net loss and net loss per share would have been $(5,192,088) and $(0.12) for the period ended March 31, 2005 and $(3,503,552) and $(0.16) for the period ended March 31, 2004, respectively. 14 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE D - STOCK OPTIONS AND WARRANTS (CONTINUED) - ----------------------------------- Non-Employee Stock Options - -------------------------- The following table summarizes the changes in options outstanding and the related prices for the shares of the Company's common stock issued to the Company consultants. These options were granted in lieu of cash compensation for services performed. Options Outstanding Options Exercisable ------------------- ------------------- Weighted Average Weighed Weighted Number Remaining Contractual Average Number Average Exercise Price Outstanding Life (Years) Exercise Price Exercisable Exercise Price -------------- ----------- ------------ -------------- ----------- -------------- $ 1.00 1,918,336 7.09 $ 1.00 1,585,000 $ 1.00 $ 3.45 120,000 9.25 $ 3.45 75,000 $ 3.45 -------------- ----------- ------------ -------------- ----------- -------------- 2,038,336 7.22 $ 1.14 1,660,000 $ 1.11 =========== ============ ============== =========== ============== Transactions involving options issued to non-employees are summarized as follows: Weighted Average Number of Shares Price Per Share ----------------- ----------------- Outstanding at January 1, 2003 1,555,000 1.00 Granted 1,900,000 1.00 Exercised (187,500) 0.96 Canceled or expired -- -- ----------------- ----------------- Outstanding at December 31, 2003 3,267,500 $ 1.00 ================= ================= Granted 60,000 3.45 Exercised (328,331) 1.00 Canceled or expired (1,000,000) 1.00 ----------------- ----------------- Outstanding at December 31, 2004 1,999,169 $ 1.07 ================= ================= Granted 60,000 3.45 Exercised (20,833) 1.00 Canceled or expired -- -- ----------------- ----------------- Outstanding at March 31, 2005 2,038,336 $ 1.14 ================= =================
The estimated value of the non-employee stock options vested during the period ended March 31, 2005 was determined using the Black-Scholes option pricing model and the following assumptions: estimated option life of 1 to 3 years, a risk free interest rate of 3.50 to 4.00%, a dividend yield of 0% and volatility of 76%. The amount of the expense charged to operations in connection with granting the options was $288,144 and $213,541 during the period ended March 31, 2005 and 2004, respectively. 15 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE D - STOCK OPTIONS AND WARRANTS (CONTINUED) - ----------------------------------- Warrants - -------- The following table summarizes the changes in warrants outstanding and the related prices for the shares of the Company's common stock issued to non-employees of the Company. These warrants were granted in lieu of cash compensation for services performed or financing expenses and in connection with placement of convertible debentures. Warrants Outstanding Warrants Exercisable -------------------- -------------------- Weighted Average Weighed Weighted Number Remaining Contractual Average Number Average Exercise Prices Outstanding Life (Years) Exercise Price Exercisable Exercise Price --------------- ----------- ------------ -------------- ----------- -------------- $ 1.00 470,900 0.92 $ 1.00 470,900 $ 1.00 $ 2.97 35,000 1.14 $ 2.97 35,000 $ 2.97 --------------- ----------- ------------ -------------- ----------- -------------- 505,900 0.94 $ 1.14 505,900 $ 1.14 =========== ============ ============== =========== ============== Transactions involving warrants are summarized as follows: Weighted Average Number of Shares Price Per Share ----------------- ----------------- Outstanding at January 1, 2003 3,531,460 $ 0.84 Granted 8,591,800 1.01 Exercised (6,963,770) 0.92 Canceled or expired -- -- ----------------- ----------------- Outstanding at December 31, 2003 5,159,490 $ 1.01 ================= ================= Granted -- -- Exercised (4,468,590) 0.99 Canceled or expired (115,000) 1.00 ----------------- ----------------- Outstanding at December 31, 2004 575,900 $ 1.12 ================= ================= Granted -- -- Exercised (70,000) 1.00 Canceled or expired -- -- ----------------- ----------------- Outstanding at March 31, 2005 505,900 $ 1.14 ================= =================
The Company did not grant any compensatory warrants to non-employees during the period ended March 31, 2005. The estimated value of previously granted warrants vested during the period ended March 31, 2005 was determined using the Black-Scholes option pricing model and the following assumptions: warrant remaining life of 0.94 years, a risk free interest rate of 3.30%, a dividend yield of 0% and volatility of 76%. Compensation expense of $4,782 was charged to operations for the period ended March 31, 2005. 16 TELKONET, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION MARCH 31, 2005 (UNAUDITED) NOTE E - CAPITAL STOCK - ---------------------- The Company has authorized 15,000,000 shares of preferred stock, par value $.001 per share. As of March 31, 2005 and December 31, 2004, the Company had no preferred stock issued and outstanding. The Company has authorized 100,000,000 shares of common stock, par value $.001 per share. As of March 31, 2005 and December 31, 2004, the Company had 44,614,174 and 44,335,989 shares of common stock issued and outstanding, respectively. During the period ended March 31, 2005, the Company issued an aggregate of 177,567 shares of common stock for an aggregate purchase price of $195,424 to certain employees upon exercise of employee stock options at approximately $1.10 per share. Additionally, the Company issued an aggregate of 20,833 shares of common stock for an aggregate purchase price of $20,833 to consultants upon exercise of non-employee stock options at $1.00 per share. During the period ended March 31, 2005, the Company issued an aggregate of 785 shares of common stock, having an aggregate fair market value of $4,500, to consultants in exchange for services rendered, which approximated the fair value of the shares issued during the period services were completed and rendered. Compensation costs of $4,500 were charged to operations. The Company issued an aggregate of 70,000 shares of common stock to consultants upon the exercise of warrants at approximately $1.00 per share. The Company issued an aggregate of 9,000 shares of common stock to an employee in exchange for $47,904 of services rendered, which approximated the fair value of the shares issued during the period services were completed and rendered. Compensation costs of $47,904 were charged to operations. Share amounts presented in the consolidated balance sheets and consolidated statements of stockholders' equity reflect the actual share amounts outstanding for each period presented. NOTE F - LONG-TERM INVESTMENTS - ------------------------------ Amperion, Inc. - -------------- On November 30, 2004, the Company entered into a Stock Purchase Agreement ("Agreement") with Amperion, Inc. ("Amperion"), a privately held company. Amperion is engaged in the business of developing networking hardware and software that enables the delivery of high-speed broadband data over medium-voltage power lines. Pursuant to the Agreement, the Company invested $500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred Stock for an equity interest of approximately 4.7%. The Company has the right to appoint one person to Amperion's seven-person board of directors. The Company accounted for this investment under the cost method, as the Company does not have the ability to exercise significant influence over operating and financial policies of the investee. BPL Global, Ltd. - ---------------- On February 4, 2005, the Company approved an investment of $100,000 in BPL Global, Ltd. ("BPL Global"), a privately held company. This investment when fully funded will represent an equity interest of approximately 5.8%. BPL Global, is engaged in the business of developing broadband services via power lines through joint ventures in the United States, Asia, Eastern Europe and the Middle East. As of March 31, 2005, the Company has funded $50,000 of this commitment and anticipates the remaining balance funded in the second quarter of 2005. The Company accounted for this investment under the cost method, as the Company does not have the ability to exercise significant influence over operating and financial policies of the investee. It is the policy of the Company to regularly review the assumptions underlying the operating performance and cash flow forecasts in assessing the carrying values of the investment. The Company identifies and records impairment losses on investments when events and circumstances indicate that such decline in fair value is other than temporary. Such indicators include, but are not limited to, limited capital resources, limited prospects of receiving additional financing, and limited prospects for liquidity of the related securities. The fair value of the Company's investment in Amperion and BPL Global,. remained at $500,000 and $50,000, respectively, as of March 31, 2005. 17 NOTE G - INVENTORIES - -------------------- Inventories are stated at the lower of cost or market determined by the first-in, first-out (FIFO) method. Inventories primarily consist of Gateways, eXtenders, Couplers and iBridges, which are the significant components of the Telkonet solution. Components of inventories as of March 31, 2005 and December 31, 2004 are as follows: March 31, 2005 December 31, 2004 -------------- ----------------- Raw Materials $ 539,696 $ 748,110 Finished Goods 1,213,373 1,125,608 -------------- ----------------- $ 1,753,069 $ 1,873,718 ============== ================= 18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto, included elsewhere within this Report. Description of the Company Telkonet, Inc. ("Telkonet" or the "Company") was formed in 1999 to develop products for use in the powerline communications (PLC) industry. PLC products use existing electrical wiring in commercial buildings and residences to carry high speed data communications signals, including the Internet. Since the Company's formation, it has focused on development and marketing of its PLC technology. The Company's PLC technology, the "PlugPlus(TM)" product suite, consists of four primary components, the Gateway, the eXtender, the Coupler and the iBridge. The Gateway, the hub of the PlugPlus(TM)product suite, is a modular, self-contained unit that accepts data from an existing network on one port and distributes it via a second port. The Gateway integrates a communications processor that runs a series of proprietary applications under Linux. The signal generated by the Gateway can be directly coupled into low voltage wiring via the Coupler, which interfaces directly between the Gateway and the building's electrical panel. Multi-panel buildings typically require multiple Couplers, which are connected to the Gateway via inexpensive coaxial cable and concentrated using standard radio frequency splitters. A suite of software applications running on the Gateway can perform communications functions or system management functions. The iBridge serves as the user's network access device and connects to a user's personal computer through a standard Ethernet cable. The iBridge's AC line cord serves as its power source as well as its network interface. The eXtender is used to extend the reach of the Gateway in larger buildings or campus environments. The PlugPlus(TM) product suite delivers data to the user at speeds in excess of 7 Mega bits per second (Mbps), with burst speeds of 12.6 Mbps. The PlugPlus(TM) product suite is installed by connecting an incoming broadband signal (DSL, TL, satellite or cable modem) into the Gateway and connecting the Gateway to a building's electrical panel using one or more Couplers. Once installed, the Gateway distributes the high-speed Internet signal throughout the entire existing network of electrical wires within the building. The user may access a high-speed Internet signal by plugging the iBridge into any electrical outlet and connecting a personal computer to the iBridge using the computer's built-in Ethernet port. Multiple personal computers connected to the iBridge can communicate with one another and can share a single broadband resource via the Gateway. The Company is a member of the HomePlug(TM) Powerline Alliance, an industry trade group that engages in marketing and educational initiatives, and sets standards and specifications for products, in the powerline communications industry. The Company's principal executive offices are located at 20374 Seneca Meadows Parkway, Germantown, MD 20876 Forward Looking Statements This report may contain "forward-looking statements," which represent the Company's expectations or beliefs, including, but not limited to, statements concerning industry performance and the Company's results, operations, performance, financial condition, plans, growth and strategies, which include, without limitation, statements preceded or followed by or that include the words "may," "will," "expect," "anticipate," "intend," "could," "estimate," or "continue" or the negative or other variations thereof or comparable terminology. Any statements contained in this report or the information incorporated by reference that are not statements of historical fact may be deemed to be forward-looking statements within the meaning of Section 27(A) of the Securities Act of 1933 and Section 21(F) of the Securities Exchange Act of 1934. For such statements, the Company claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. These statements by their nature involve substantial risks and uncertainties, some of which are beyond the Company's control, and actual results may differ materially depending on a variety of important factors, many of which are also beyond the Company's control. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. The Company does not undertake any obligation to update or release any revisions to these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events, except to the extent such updates and/or revisions are required by applicable law. 19 REVENUES -------- In 2004, the Company changed its sales model in the Hospitality and Multi-Dwelling markets from principally product sales to include a recurring (lease) model. Accordingly, revenues associated with these leases are recognized ratably over a three to five year lease term. The table below outlines product versus recurring (lease) revenues for comparable periods: ----------------------------------------------------------- Three Months Ended ----------------------------------------------------------- Revenue: March 31, 2005 March 31, 2004 Variance Recurring (lease) $ 116,915 47% $ 20,309 14% $ 96,606 476% Product 129,273 53% 119,790 86% 9,483 8% --------- --------- --------- --------- --------- --------- Total $ 246,188 100% $ 140,099 100% $ 106,089 76% ========= ========= ========= ========= ========= ========= RECURRING REVENUE The increase in recurring (lease) revenue was primarily due to the increase in non-cancelable leases. Revenues to be recognized under these non-cancelable leases (backlog) was approximately $1,335,000 and $125,000 as of March 31, 2005 and 2004, respectively. The weighted average remaining lease term was approximately 31 and 34 months, respectively. The associated unamortized capitalized costs in connection with these leases was approximately $625,000 and $49,000, respectively. PRODUCT REVENUE Product revenue principally arises from the sale of iBridges and other PlugPlus(TM) components directly to customers. Revenues to date have primarily been derived from the Hospitality and Multi-Dwelling business units. The Company has expanded its marketing efforts in the International and Government markets based on its European certification (CE) received in March 2005 and anticipation of its FIPS-140-2 certification for the Government market. International revenues are expected to commence in the second quarter of 2005. COST OF SALES ------------- ---------------------------------------------------------- Three Months Ended ---------------------------------------------------------- Cost of Sales: March 31, 2005 March 31, 2004 Variance Recurring (lease) $ 66,408 57% $ 5,866 29% $ 60,542 1032% Product 90,982 70% 128,538 107% (37,556) (29%) --------- --------- ----------- Total $ 157,390 64% $ 134,404 96% $ 22,986 17% ========= ========= =========== RECURRING (LEASE) COSTS Lease Cost primarily represents the amortization of the capitalized costs which are amortized over the lease term and include Telkonet equipment, installation labor and customer support. This increase compared to the prior year quarter is commensurate with the increase in leases. PRODUCT COSTS Product cost primarily includes Telkonet equipment cost and installation labor. During the quarter ended March 31, 2004, certain complex installations resulted in additional installation labor as the Company was implementing its initial installations. The Company continues to refine its installation processes enabling lower costs. 20 GROSS PROFIT ------------ ---------------------------------------------------------- Three Months Ended ---------------------------------------------------------- Gross Profit: March 31, 2005 March 31, 2004 Variance Recurring (lease) $ 50,507 43% $ 14,443 71% $ 36,064 250% Product 38,291 30% (8,748) (7%) 47,039 538% --------- --------- --------- Total $ 88,798 36% $ 5,695 4% $ 83,103 1459% ========= ========= ========= Gross profit associated with both the recurring lease and product revenues for the current quarter improved over the same quarter last year primarily as a result of improved installation processes, including upfront site surveys and standardized training. Historically the effects of inflation and any other changes in prices, in management's opinion, have not been material. OPERATING EXPENSES ------------------ Overall expenses increased $1,164,676 or 57.8% compared to the first quarter in 2004. This increase is principally due to payroll and related costs. The number of employees increased from 30 at March 31, 2004 to 61 at March 31, 2005. This increase was principally due to salary and travel costs related to sales and marketing functions. Other increased costs were incurred in non-employee compensation for services, advertising and trade shows, and rent. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- The Company's current assets exceeded current liabilities as of March 31, 2005 and December 31, 2004 by $9,801,244 and $12,671,520, respectively. Of the total current assets as of March 31, 2005 of $11,275,012 and as of December 31, 2004 of $13,900,419, cash represented $9,203,498 and $11,838,702, respectively. In January 2004, the Board of Directors determined to permit the Senior Noteholders, for a limited period of time, to convert their Senior Notes into the Company's common stock at a conversion price of $2.10 per share. In connection with this transaction, Senior Noteholders converted Senior Notes having an aggregate principal value of $2,539,000 In February 2004, Telkonet completed a private placement of its common stock resulting in net proceeds to the Company of approximately $12.8 million. The Company sold 6,387,600 shares of its common stock at a discount of 18% to the average market price of the Company's common stock for the preceding 30 days. In March 2004, the Company received $3.9 million upon the exercise of 4,235,007 warrants to purchase the Company's common stock. Additionally, $0.2 million of debentures were converted into 324,000 shares of the Company's common stock. While the Company believes it has sufficient capital to meet its working capital requirements for the next twelve months, additional financing may be required in order to meet growth opportunities in financing and/or investing activities. If additional capital is required and the Company is not successful in generating sufficient liquidity from operations or in raising sufficient capital resources on terms acceptable to the Company, this could have a material adverse effect on the Company's business, results of operations, liquidity and financial condition. PRODUCT RESEARCH AND DEVELOPMENT -------------------------------- Company-sponsored research and development costs related to both present and future products are expended in the period incurred. Total expenses for the quarter ended March 31, 2005 increased $15,210, or 3.5%, over the comparable period in 2004. This increase was primarily related to an increase in salaries and related costs associated with the addition of 4 full-time employees and costs related to CE and FIPS 140-2 certifications of the Company's product. 21 SELLING, GENERAL AND ADMINISTRATIVE ----------------------------------- Selling, general and administrative expenses increased for the quarter ended March 31, 2005 over the comparable prior year by $1,045,769, or 77.2%. This increase is related to an increase in payroll and associated costs for sales and marketing resources, advertising, trade shows, and rent and related facility costs. ACQUISITION OR DISPOSITION OF PROPERTY AND EQUIPMENT ---------------------------------------------------- During the quarter ended March 31, 2005, fixed assets increased $98,538 or 14%, which is primarily related to sales support software and computer equipment related to new employees. The Company does not anticipate the sale or purchase of any significant property, plant or equipment during the next twelve months, other than computer equipment and peripherals to be used in the Company's day-to-day operations. In April 2005, the Company entered into a lease agreement for 6,742 square feet of commercial office space in Crystal City, Virginia. Pursuant to this lease, the Company has agreed to assume a portion of the build-out cost for this facility. The Company anticipates that it will spend approximately $200,000 in connection with this relocation, which expenses include security deposit, office furniture and telephone equipment. NUMBER OF EMPLOYEES ------------------- As of May 2, 2005, the Company had sixty-nine (69) full time employees. In order for the Company to attract and retain quality personnel, the Company anticipates it will continue to offer competitive salaries to current and future employees. The Company anticipates that it will increase its employment base to meet the needs outlined in its business plan. As the Company continues to expand, the Company plans to incur additional costs for personnel. This projected increase in personnel is dependent upon the Company generating revenues and obtaining sources of financing in excess of its existing capital resources. Although the Company believes it has sufficient capital as of May 2, 2005 to support the anticipated growth in operations, there can be no assurance that the Company will be successful in raising the funds required or generating revenues sufficient to fund the projected increase in the number of employees. Disclosure of Contractual Obligations ----------------------------------------------------------------------------------------------- PAYMENT DUE BY PERIOD - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- CONTRACTUAL OBLIGATIONS TOTAL LESS THAN 1 YEAR 1-3 YEARS 3-5 YEARS MORE THAN 5 YEARS - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- Long-Term Debt - - - - - Obligations - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- Capital Lease - - - - - Obligations - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- Operating Lease $1,687,935 $349,333 $1,026,489 $312,113 - Obligations (1) - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- Purchase Obligations - - - - - - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- Other Long-Term - - - - - Liabilities Reflected on the Registrant's Balance Sheet Under GAAP - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- Total $1,687,935 $349,333 $1,026,489 $312,113 - - ------------------------- ----------------- ------------------- -------------------- ---------------- ------------------- (1) Obligations represent Real Estate leases for Corporate and Sales Offices and includes the commercial office space lease in Crystal City, VA which commenced in April 2005. 22
Trends, Risks and Uncertainties - ------------------------------- The Company has sought to identify what it believes to be the most significant risks to its business, but cannot predict whether or to what extent any of such risks may be realized nor can there be any assurances that the Company has identified all possible risks that might arise. Investors should carefully consider all such risk factors in evaluating the Company's financial outlook. TELKONET RECENTLY EMERGED FROM ITS DEVELOPMENT STAGE AND HAS NO OPERATING HISTORY ON WHICH TO BASE AN EVALUATION OF ITS CURRENT BUSINESS AND FUTURE PROSPECTS. The Company recently emerged from its development stage as of December 31, 2003. As a result, it has no operating history upon which to base an evaluation of its current business and future prospects. The Company has not generated substantial revenues since its inception. Because of the Company's lack of an operating history, management has limited insight into trends that may emerge and could materially adversely affect the Company's business. Prospective investors should consider the risks and difficulties the Company may encounter in its new and rapidly evolving market, especially given the Company's lack of operating history. These risks include the Company's ability to: o market the PlugPlus(TM) product suite; o build a customer base; o generate revenues; o compete favorably in a highly competitive market; o access sufficient capital to support growth; o recruit and retain qualified employees; o introduce new products and services; and o build technology and support systems. THE COMPANY HAS A HISTORY OF OPERATING LOSSES AND AN ACCUMULATED DEFICIT AND EXPECTS TO CONTINUE TO INCUR LOSSES FOR THE FORESEEABLE FUTURE. Since inception through March 31, 2005, the Company has incurred cumulative losses of $30,293,815 and has never generated enough funds through operations to support its business. The Company expects to continue to incur substantial operating losses through 2005. The Company's losses to date have resulted principally from: o research and development costs relating to the development of the PlugPlus(TM) product suite; o costs and expenses associated with manufacturing, distribution and marketing of the Company's products; o general and administrative costs relating to the Company's operations; and o interest expense related to the Company's indebtedness. The Company is currently unprofitable and may never become profitable. Since inception, the Company has funded its research and development activities primarily from private placements of equity and debt securities, a bank loan and short term loans from certain of its executive officers. As a result of its substantial research and development expenditures and limited product revenues, the Company has incurred substantial net losses. The Company's ability to achieve profitability will depend primarily on its ability to successfully commercialize the PlugPlus(TM) product suite. POTENTIAL FLUCTUATIONS IN OPERATING RESULTS COULD HAVE A NEGATIVE EFFECT ON THE PRICE OF THE COMPANY'S COMMON STOCK. The Company's operating results may fluctuate significantly in the future as a result of a variety of factors, most of which are outside the Company's control, including: o the level of use of the Internet; o the demand for high-tech goods; 23 o the amount and timing of capital expenditures and other costs relating to the expansion of the Company's operations; o price competition or pricing changes in the industry; o technical difficulties or system downtime; o economic conditions specific to the internet and communications industry; and o general economic conditions. The Company's quarterly results may also be significantly impacted by certain accounting treatment of acquisitions, financing transactions or other matters. Such accounting treatment could have a material impact on the Company's results of operations and have a negative impact on the price of the Company's common stock. THE COMPANY'S DIRECTORS AND EXECUTIVE OFFICERS OWN A SUBSTANTIAL PERCENTAGE OF THE COMPANY'S ISSUED AND OUTSTANDING COMMON STOCK. THEIR OWNERSHIP COULD ALLOW THEM TO EXERCISE SIGNIFICANT CONTROL OVER CORPORATE DECISIONS. As of March 31, 2005, the Company's officers and directors owned 22.6% of the Company's issued and outstanding common stock. This means that the Company's officers and directors, as a group, exercise significant control over matters upon which the Company's stockholders may vote, including the selection of the Board of Directors, mergers, acquisitions and other significant corporate transactions. FURTHER ISSUANCES OF EQUITY SECURITIES MAY BE DILUTIVE TO CURRENT STOCKHOLDERS. Although the funds raised in the Company's debenture offerings, the note offering and the private placement of common stock are being used for general working capital purposes, it is likely that the Company will be required to seek additional capital in the future. This capital funding could involve one or more types of equity securities, including convertible debt, common or convertible preferred stock and warrants to acquire common or preferred stock. Such equity securities could be issued at or below the then-prevailing market price for the Company's common stock. Any issuance of additional shares of the Company's common stock will be dilutive to existing stockholders and could adversely affect the market price of the Company's common stock. THE EXERCISE OF OPTIONS AND WARRANTS OUTSTANDING AND AVAILABLE FOR ISSUANCE MAY ADVERSELY AFFECT THE MARKET PRICE OF THE COMPANY'S COMMON STOCK. As of March 31, 2005, the Company had outstanding employee options to purchase a total of 9,857,200 shares of common stock at exercise prices ranging from $1.00 to $5.08 per share, with a weighted average exercise price of $1.77. As of March 31, 2005, the Company had outstanding non-employee options to purchase a total of 2,038,336 shares of common stock at exercise prices ranging from $1.00 to $3.45 per share, with a weighted average exercise price of $1.14 per share. As of March 31, 2005, the Company had warrants outstanding to purchase a total of 505,900 shares of common stock at exercise prices ranging from $1.00 to $2.97 per share, with a weighted average exercise price of $1.14. In addition, as of March 31, 2005, the Company had 33,974 additional shares of common stock which may be issued in the future under the Amended and Restated Telkonet, Inc. Stock Incentive Plan. The Company anticipates that the Board will authorize the issuance of additional shares under the plan. The exercise of outstanding options and warrants and the sale in the public market of the shares purchased upon such exercise will be dilutive to existing stockholders and could adversely affect the market price of the Company's common stock. THE POWERLINE COMMUNICATIONS INDUSTRY IS INTENSELY COMPETITIVE AND RAPIDLY EVOLVING. The Company operates in a highly competitive, quickly changing environment, and the Company's future success will depend on its ability to develop and introduce new products and product enhancements that achieve broad market acceptance in commercial and governmental sectors. The Company will also need to respond effectively to new product announcements by its competitors by quickly introducing competitive products. Delays in product development and introduction could result in: o loss of or delay in revenue and loss of market share; o negative publicity and damage to the Company's reputation and brand; and o decline in the average selling price of the Company's products. 24 GOVERNMENT REGULATION OF THE COMPANY'S PRODUCTS COULD IMPAIR THE COMPANY'S ABILITY TO SELL SUCH PRODUCTS IN CERTAIN MARKETS. FCC rules permit the operation of unlicensed digital devices that radiate radio frequency emissions if the manufacturer complies with certain equipment authorization procedures, technical requirements, marketing restrictions and product labeling requirements. Differing technical requirements apply to "Class A" devices intended for use in commercial settings, and "Class B" devices intended for residential use to which more stringent standards apply. An independent, FCC-certified testing lab has verified that the Company's PlugPlus(TM) product suite complies with the FCC technical requirements for Class A and Class B digital devices. No further testing of these devices is required and the devices may be manufactured and marketed for commercial and residential use. Additional devices designed by the Company for commercial and residential use will be subject to the FCC rules for unlicensed digital devices. Moreover, if in the future, the FCC changes its technical requirements for unlicensed digital devices, further testing and/or modifications of devices may be necessary. Failure to comply with any FCC technical requirements could impair the Company's ability to sell its products in certain markets and could have a negative impact on its business and results of operations. PRODUCTS SOLD BY THE COMPANY'S COMPETITORS COULD BECOME MORE POPULAR THAN THE COMPANY'S PRODUCTS OR RENDER THE COMPANY'S PRODUCTS OBSOLETE. The market for powerline communications products is highly competitive. The Company believes it has the only commercial integrated three phase solution for "in-building" distribution of broadband utilizing the electrical wiring infrastructure. The Linksys Division of Cisco Systems, Inc. (Linksys) and Netgear, Inc. offer similar PLC solutions for the residential market. Althought Linksys and Netgear do not presently complete with the Company in the commercial market, there can be no assurance that Linksys, Netgear or any other company will not develop PLC products that compete with the Company's products in the future. These potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales, marketing and other resources. These potential competitors may, among other things, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, obtain more favorable pricing from suppliers and manufacturers and exert more influence on the sales channel than the Company can. As a result, the Company may not be able to compete successfully with these potential competitors and these potential competitors may develop or market technologies and products that are more widely accepted than those being developed by the Company or that would render the Company's products obsolete or noncompetitive. The Company anticipates that potential competitors will also intensify their efforts to penetrate the Company's target markets. These potential competitors may have more advanced technology, more extensive distribution channels, stronger brand names, bigger promotional budgets and larger customer bases than the Company does. These companies could devote more capital resources to develop, manufacture and market competing products than the Company could. If any of these companies are successful in competing against the Company, sales could decline, margins could be negatively impacted, and the Company could lose market share, any of which could seriously harm the Company's business and results of operations. THE FAILURE OF THE INTERNET TO CONTINUE AS AN ACCEPTED MEDIUM FOR BUSINESS COMMERCE COULD HAVE A NEGATIVE IMPACT ON THE COMPANY'S RESULTS OF OPERATIONS. The Company's long-term viability is substantially dependent upon the continued widespread acceptance and use of the Internet as a medium for business commerce. The Internet has experienced, and is expected to continue to experience, significant growth in the number of users. There can be no assurance that the Internet infrastructure will continue to be able to support the demands placed on it by this continued growth. In addition, delays in the development or adoption of new standards and protocols to handle increased levels of Internet activity or increased governmental regulation could slow or stop the growth of the Internet as a viable medium for business commerce. Moreover, critical issues concerning the commercial use of the Internet (including security, reliability, accessibility and quality of service) remain unresolved and may adversely affect the growth of Internet use or the attractiveness of its use for business commerce. The failure of the necessary infrastructure to further develop in a timely manner or the failure of the Internet to continue to develop rapidly as a valid medium for business would have a negative impact on the Company's results of operations. FAILURE OF THE COMPANY'S SERVICES AND PRODUCTS TO BE SUCCESSFUL IN THE MARKETPLACE COULD HAVE A NEGATIVE EFFECT ON THE COMPANY'S RESULTS OF OPERATIONS. Since the Company is just emerging from its development stage, it does not know with any certainty whether its services and/or products will be accepted within the business marketplace. If the Company's services and/or products prove to be unsuccessful within the marketplace, or if the Company fails to attain market acceptance, it could have a negative effect on the Company's results of operations. 25 THE COMPANY MAY NOT BE ABLE TO OBTAIN PATENTS, WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON ITS BUSINESS. The Company's ability to compete effectively in the powerline technology industry will depend on its success in acquiring suitable patent protection. The Company currently has several patents pending. The Company also intends to file additional patent applications that it deems to be economically beneficial. If the Company is not successful in obtaining patents, it will have limited protection against those who might copy its technology. As a result, the failure to obtain patents could negatively impact the Company's business and results of operations. INFRINGEMENT BY THIRD PARTIES ON THE COMPANY'S PROPRIETARY TECHNOLOGY AND DEVELOPMENT OF SUBSTANTIALLY EQUIVALENT PROPRIETARY TECHNOLOGY BY THE COMPANY'S COMPETITORS COULD NEGATIVELY IMPACT THE COMPANY'S BUSINESS. The Company's success depends partly on its ability to maintain patent and trade secret protection, to obtain future patents and licenses, and to operate without infringing on the proprietary rights of third parties. There can be no assurance that the measures the Company has taken to protect its intellectual property, including those integrated to its PlugPlus(TM) product suite, will prevent misappropriation or circumvention. In addition, there can be no assurance that any patent application, when filed, will result in an issued patent, or that the Company's existing patents, or any patents that may be issued in the future, will provide the Company with significant protection against competitors. Moreover, there can be no assurance that any patents issued to, or licensed by, the Company will not be infringed upon or circumvented by others. Infringement by third parties on the Company's proprietary technology could negatively impact its business. Moreover, litigation to establish the validity of patents, to assert infringement claims against others, and to defend against patent infringement claims can be expensive and time-consuming, even if the outcome is in the Company's favor. The Company also relies to a lesser extent on unpatented proprietary technology, and no assurance can be given that others will not independently develop substantially equivalent proprietary information, techniques or processes or that the Company can meaningfully protect its rights to such unpatented proprietary technology. Development of substantially equivalent technology by the Company's competitors could negatively impact its business. THE COMPANY DEPENDS ON A SMALL TEAM OF SENIOR MANAGEMENT, AND IT MAY HAVE DIFFICULTY ATTRACTING AND RETAINING ADDITIONAL PERSONNEL. The Company's future success will depend in large part upon the continued services and performance of senior management and other key personnel. If the Company loses the services of any member of its senior management team, its overall operations could be materially and adversely affected. In addition, the Company's future success will depend on its ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, marketing, purchasing and customer service personnel when they are needed. Competition for these individuals is intense. The Company cannot ensure that it will be able to successfully attract, integrate or retain sufficiently qualified personnel when the need arises. Any failure to attract and retain the necessary technical, managerial, marketing, purchasing and customer service personnel could have a negative effect on the Company's financial condition and results of operations. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Short Term Investments We held no marketable securities as of March 31, 2005. Our excess cash is held in money market accounts in a bank and brokerage firms both of which are nationally ranked top tier firms with an average return of approximately 200 basis points. Due to the conservative nature of our investment portfolio, an increase or decrease of 100 basis points in interest rates would not have a material effect on our results of operations or the fair value of our portfolio. Investments in Privately Held Companies We have invested in privately held companies, which are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. As a result, we could lose our entire initial investment in these companies. In addition, we could also be required to hold our investment indefinitely, since there is presently no public market in the securities of these companies and none is expected to develop. These investments are carried at cost, which as of May 2, 2005 was $550,000, compared with $500,000 at December 31, 2004, and are recorded in other assets in the Consolidated Balance Sheets. To date, there has been no impairment charges based on management's assessment of these investments. Both investments are recent transactions which have occurred within the last six months. 26 Item 4. Controls and Procedures. As of March 31, 2005, the Company performed an evaluation, under the supervision and with the participation of management, including the Chief Executive and Chief Financial Officers, of the effectiveness of the design and operation of its disclosure controls and procedures as defined in Rules 13a - 15(e) and 15d - 15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Chief Executive and Chief Financial Officers concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information required to be included in the Company's periodic filings with the U.S. Securities and Exchange Commission. There were no significant changes in the Company's internal controls or in other factors that have materially affected, or are reasonable likely to materially affect, the Company's internal controls subsequent to the date of the most recent evaluation. PART II. OTHER INFORMATION Item 1. Legal Proceedings. NONE Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. During the three months ended March 31, 2005, the Company agreed to issue 9,000 shares of common stock to Ronald W. Pickett, the Company's Chief Executive Officer, pursuant to his employment agreement, dated January 30, 2004. The foregoing was effected in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 and/or Rule 506 of Regulation D promulgated thereunder. During the three months ended March 31, 2005, the Company granted options to purchase 460,000 shares of common stock to certain employees of the Company. These options are exercisable for a period of ten years following the date of grant at an average exercise price of $4.98 per share. The options were issued pursuant to the Amended and Restated Telkonet, Inc. Stock Incentive Plan. The shares of common stock underlying the options have been registered with the Securities and Exchange Commission on a Form S-8 Registration Statement. ISSUER PURCHASES OF EQUITY SECURITIES ------------------------------------- - ------------------------ --------------------- ------------------- ---------------------- ---------------------- (D) MAXIMUM NUMBER (OR APPROXIMATE DOLLAR VALUE) OF (C) TOTAL NUMBER OF SHARES THAT MAY YET SHARES PURCHASED AS BE PURCHASED UNDER PART OF PUBLICLY THE PLANS OR PROGRAMS (A) TOTAL NUMBER OF (B) AVERAGE PRICE ANNOUNCED PLANS OR PERIOD SHARES PURCHASED PAID PER SHARE PROGRAMS - ------------------------ --------------------- ------------------- ---------------------- ---------------------- January 1-January 30, 0 n/a 0 0 2005 - ------------------------ --------------------- ------------------- ---------------------- ---------------------- February 1-February 28, 0 n/a 0 0 2005 - ------------------------ --------------------- ------------------- ---------------------- ---------------------- March 1-March 31, 2005 0 n/a 0 0 - ------------------------ --------------------- ------------------- ---------------------- ---------------------- Total 0 n/a 0 0 - ------------------------ --------------------- ------------------- ---------------------- ----------------------
Item 3. Defaults Upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Other Information. None. 27 Item 6. Exhibits Exhibits No. Description - --- ----------- 3.1 Articles of Incorporation of the Registrant (incorporated by reference to our Form 8-K (No. 000-27305), filed on August 30, 2000, and our Form S-8 (No. 333-47986), filed on October 16, 2000) 3.2 Bylaws of the Registrant (incorporated by reference to our Registration Statement on Form S-1 (No. 333 108307), filed on August 28, 2003) 4.1 Form of Series A Convertible Debenture (incorporated by reference to our Form 10-KSB (No. 000-27305), filed on March 31, 2003) 4.2 Form of Series A Non-Detachable Warrant (incorporated by reference to our Form 10- KSB (No. 000-27305), filed on March 31, 2003) 4.3 Form of Series B Convertible Debenture (incorporated by reference to our Form 10-KSB (No. 000-27305), filed on March 31, 2003) 4.4 Form of Series B Non-Detachable Warrant (incorporated by reference to our Form 10- KSB (No. 000-27305), filed on March 31, 2003) 4.5 Form of Senior Note (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003) 4.6 Form of Non-Detachable Senior Note Warrant (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003) 10.1 Amended and Restated Telkonet, Inc. Incentive Stock Option Plan (incorporated by reference to our Registration Statement on Form S-8 (No. 333-412), filed on April 17, 2002) 10.2 Employment Agreement by and between Telkonet, Inc. and Stephen L. Sadle, dated as of January 18, 2003 (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003 10.3 Employment Agreement by and between Telkonet, Inc. and Robert P. Crabb, dated as of January 18, 2003 (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003) 10.4 Employment Agreement by and between Telkonet, Inc. and Ronald W. Pickett, dated as of January 30, 2003 (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003) 10.5 Employment Agreement by and between Telkonet, Inc. and E. Barry Smith, dated as of February 17, 2003 (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003) 24 Power of Attorney (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August 28, 2003) 31.1 Certification of Ronald W. Pickett pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of E. Barry Smith pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Ronald W. Pickett pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of E. Barry Smith pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K filed during the three months ended March 31, 2005. None SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Telkonet, Inc. Registrant Date: May 10, 2005 By: /s/ Ronald W. Pickett - --------------------------- ----------------------- Ronald W. Pickett Chief Executive Officer 28