10-Q 1 d89969e10-q.txt FORM 10-Q FOR QUARTER ENDED JUNE 30, 2001 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____ TO _____ Commission file number 0-27709 PENTASTAR COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) DELAWARE 84-1502003 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 1660 WYNKOOP STREET, SUITE 1010, DENVER, COLORADO 80202 (Address of Principal Executive Offices) (303) 825-4400 (Registrant's Telephone Number, Including Area Code) NONE (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) 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 [ ] APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS Indicate by check mark whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [ ] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS As of August 8, 2001, the number of shares outstanding of the issuer's common stock, par value $.0001 per share, was 5,583,838. ================================================================================ 2 TABLE OF CONTENTS

1 3 PART I ITEM 1. FINANCIAL STATEMENTS INDEX TO FINANCIAL STATEMENTS PENTASTAR COMMUNICATIONS, INC. AND SUBSIDIARIES

F-1 4 PENTASTAR COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF JUNE 30, 2001 AND DECEMBER 31, 2000 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. F-2 5 PENTASTAR COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2001 and 2000 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED)

The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. F-3 6 PENTASTAR COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2001 AND 2000 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED)

The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. F-4 7 PENTASTAR COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2001 AND 2000 (IN THOUSANDS) (UNAUDITED)

The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. F-5 8 PENTASTAR COMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED) 1. BUSINESS AND ORGANIZATION PentaStar Communications, Inc., a Delaware corporation ("PentaStar" or the "Company"), was founded on March 15, 1999. The Company is a multi-regional company that designs, sells and facilitates the installation and usage of communications services for small and medium-size business customers. On October 26, 1999 PentaStar, through its wholly-owned subsidiaries, acquired the outstanding capital stock and other equity interests of two communications services agents and completed an initial public offering of its common stock (the "Offering"). Upon closing of the acquisitions and the Offering, PentaStar commenced its business operations as a sales agent for communications services including local access, long distance, wireless and Internet services for voice and data communications. PentaStar designs, procures and facilitates the installation and use of communications services to best meet its customers' specific needs. During fiscal year 2000, PentaStar completed the acquisition of 10 communications services agents. In the first quarter of fiscal 2001, PentaStar acquired two additional communications services agents to expand its operations (see Note 5). The financial statements as of June 30, 2001, and for the six months ended June 30, 2001 and 2000, are unaudited and prepared by the Company pursuant to the interim reporting rules and regulations of the Securities and Exchange Commission; however, the financial statements include all adjustments (consisting of normal recurring adjustments) considered necessary by management for a fair presentation of the financial position and results of operations for the periods presented. A description of our accounting policies and other financial information is included in the audited consolidated financial statements filed with the Securities and Exchange Commission in the Company's Annual Report on Form 10-KSB for the year ended December 31, 2000. The results of operations for interim periods are not necessarily indicative of the results that may be expected for the entire year. 2. VIOLATION OF COVENANTS ON CERTAIN BORROWINGS As of June 30, 2001, the Company did not meet certain financial covenants contained in its existing Credit and Security Agreement (the "Credit Agreement") with Wells Fargo Bank West, National Association ("Wells Fargo") resulting in a default. Terms of the Credit Agreement provide for maximum borrowings of $10 million limited to 75% of eligible accounts receivable, as defined, and requires compliance with financial loan covenants related to debt levels compared to annualized cash flows and working capital levels. The Credit Agreement is secured by accounts receivable and by substantially all of the assets of PentaStar, excluding any rights to future residual commission payments due to PentaStar from existing Ameritech contracts acquired in connection with the TCMM acquisition. The Credit Agreement expires on August 31, 2001. The Company is in current discussions with Wells Fargo and intends to obtain, prior to August 31, 2001, an extension with appropriate financial covenant waivers to the existing Credit Agreement or a restructured agreement with renegotiated financial covenants, although no assurance can be given that such waivers or a restructured agreement with terms acceptable to the Company will be obtained. Any such failure to obtain covenant relief or a restructured agreement could result in Wells Fargo declaring the entire amount due and payable immediately. As a result of our default under the Credit Agreement a cross-default exists under the Reducing Revolver Loan and Security Agreement (the "Loan") with Merrill Lynch Business Financial Services, Inc. As of June 30, 2001, the amounts due under the Credit Agreement and the Loan were $5,445 and $3,718, respectively. As a result of the cross-default provisions, $2,826 of the outstanding Loan amount that would have been classified as long-term has been classified as current in the June 30, 2001 balance sheet. As a part of the Company's current discussions with its lenders, management has undertaken a review of its cost structure at certain of its operating companies and headquarters in order to increase annualized cash flows. The Company also continues to actively manage its order backlog with the related carriers in an attempt to reduce lag time between order submission and the related commission payment from the carrier. There can be no assurance that such efforts will increase annualized cash flows to such a level that would avoid future covenant violations. F-6 9 In the event that the Company is unable to successfully negotiate a new credit facility with Wells Fargo, alternative financing would be required. There is no assurance that such alternative financing will be available when needed by the Company. If alternative financing is not available, or the terms of the alternative financing are not acceptable to the Company, there would be substantial doubt about the Company's ability to continue as a going concern. 3. NEW ACCOUNTING STANDARDS In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations" (effective July 1, 2001) and SFAS No. 142, "Goodwill and Other Intangible Assets" (effective for the Company on 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 adoption of SFAS No. 142 will result in the Company's discontinuation of amortization of its goodwill; however, the Company will be required to test its goodwill for impairment under the new standard beginning in the first quarter of 2002, which could have an adverse effect on the Company's future results of operations if an impairment occurs. The annual impact of SFAS No. 142 due to the cessation of amortization on goodwill is expected to be $1,286. In fiscal 2001, the Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments and for hedging activities. Among other things, the statement requires that an entity recognize all derivative instruments on the balance sheet as either assets or liabilities, and to account for those instruments at fair value. The Company has not entered into any derivative financial instruments or hedging activities and therefore the adoption of SFAS No. 133 had no impact on the Company's financial position or results of operations. In July 2001, the Financial Accounting Standards Board issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This statement is effective for fiscal years beginning after June 15, 2002, and provides accounting requirements for asset retirement obligations associated with tangible long-lived assets. The Company has not yet determined the impact of adopting SFAS No. 143. 4. EARNINGS PER SHARE The Company applies SFAS No. 128, "Earnings Per Share." SFAS No. 128 provides for the calculation of "Basic" and "Diluted" earnings or net income per share. Basic net income per share includes no dilution and is computed by dividing earnings available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution of stock options and warrants using the treasury stock method. Options and warrants excluded from the calculation of diluted loss per share solely because the effect was antidilutive were 1,139,786 and 1,106,210 as of June 30, 2001 and 2000, respectively. 5. BUSINESS COMBINATIONS In the first quarter of fiscal 2001, PentaStar, through a wholly-owned subsidiary, acquired Digital Sales Support Net, Inc. ("Digital") and RKK Consulting Group, Inc. ("RKK"). Digital, headquartered in New York, New York, is a communications services agent focused on selling primarily Verizon data communications services. The owners of RKK, who manage the combined operations of Digital and RKK, have been focused on selling Verizon data oriented local products and long distance services in the New York and New Jersey markets. The initial purchase consideration for Digital consisted of $171 in cash and the issuance of 30,374 shares of PentaStar's common stock with a fair market value of $801. Of the 30,374 of issued shares, 18,984 with a fair market value of $500 were placed in escrow and will be released upon Digital attaining certain performance criteria for the period from January 1, 2001 through December 31, 2001. In addition, the agreement provides for additional consideration in the form of cash and PentaStar's common stock if certain operating performance criteria are met by Digital for the period from January 1, 2001 through December 31, 2001. The initial purchase consideration for RKK consisted of 37,968 of PentaStar's common stock with a fair market value of $1,001. Of the 37,968 of issued shares, 36,070 with a fair market value of $951 were placed in escrow and will be released upon RKK attaining certain performance criteria for the period from February 1, 2001 through January 31, 2002. In addition, the agreement provides for additional consideration in the form of cash and PentaStar's common stock if certain operating performance criteria are met by RKK for the period from February 1, 2001 through January 31, 2002. The acquisitions discussed above were recorded using the purchase method of accounting under which the purchase consideration was allocated to the identifiable assets and liabilities of the acquired companies and the excess of the purchase consideration over the fair value of the net assets acquired was recorded as goodwill. F-7 10 Purchase Consideration: Cash ....................... $171 PentaStar common stock ..... 351 Acquisition costs .......... 166 ---- $688 ====

Of the total purchase consideration of $688, $3 was allocated to property and equipment, $94 to net working capital and $591 to goodwill. The financial statements reflect a preliminary allocation of the purchase price, to be finalized upon final evaluation of the fair market values of certain assets and liabilities acquired. Goodwill will be amortized over a twenty-year period. During the three months ended June 30, 2001, goodwill has been reduced by $24 resulting from the revaluation of certain assets and liabilities assumed and allocated in the original purchase price allocations of the Digital acquisition. During the three months ended March 31, 2001, goodwill has been reduced by $104 resulting from the revaluation of certain liabilities assumed and allocated in the original purchase price allocations of fiscal year 2000 acquisitions. The principal shareholders of Digital, RKK and certain other acquired companies that have received PentaStar common stock as purchase consideration, have entered into escrow and contingent stock agreements with PentaStar upon closing of the acquisitions. These agreements adjust the final consideration paid to those shareholders in return for their interests in the acquired companies. Under these agreements, shares of PentaStar common stock were placed into escrow. Based upon the earnings performance of an acquired company relative to that of all other acquired companies for the 12-month period prior to the earlier of a sale of substantially all of the assets or stock of PentaStar or five years, the shareholder associated with that company or seller of that company will receive back from escrow all, some or none of the shares such shareholder or seller placed in escrow. In addition, based upon the relative earnings performance of the acquired company, such shareholder or seller may receive additional shares of common stock from PentaStar. PentaStar, at its discretion, may distribute cash to such shareholder or seller in lieu of some or all of the additional shares in an amount equal to the fair market value of the additional shares not distributed. The agreements are designed, however, so that there will be no net change to the total number of shares of PentaStar common stock outstanding after the combined adjustments are made for all of the acquired companies. The Company has entered into various contingent purchase price arrangements under which additional consideration will be paid to the selling shareholders if established criteria are achieved by the acquired company. In determining the achievement of the established criteria, disputes may arise between PentaStar and the selling shareholders. 6. SHAREHOLDERS' EQUITY On May 16, 2001, the Company entered into a Settlement Agreement and Release (the "Agreement") with Jeffrey A. Veres, a founder of the Company and former owner of DMA Ventures, Inc., dba Access Communications. The Agreement settles certain disputes between PentaStar and Mr. Veres. The Agreement provides for, among other items, the transfer to the Company of 80,000 shares of the 424,100 shares of PentaStar common stock owned by Mr. Veres. These shares, valued at their market price on May 16, 2001, have been reflected as treasury shares on the June 30, 2001 consolidated balance sheet. 7. INCOME TAXES The Company records income tax expense or benefit based upon its estimated effective income tax rate for the year. The Company has changed its estimate of the effective income tax rate for the remainder of fiscal 2001 to zero. The Company has recorded a deferred tax asset of $1,840 as of June 30, 2001, which is net of a valuation allowance of $431. Management believes it is more likely than not that sufficient taxable income will be generated to realize the recorded deferred tax assets: however, it is reasonably possible that management's estimate of the realizable deferred tax assets may change in the near future. F-8 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain matters discussed in this Quarterly Report on Form 10-Q are "forward-looking statements," intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified as such because the context of the statement includes words such as "anticipates," "expects," "estimates," "plans," "believes" and "intends" or other similar words. Similarly, statements that describe our future plans, objectives or goals are also forward-looking statements. All forward-looking statements are subject to certain risks and uncertainties that could cause actual results or outcomes to differ materially from those currently anticipated. Factors that could affect actual results or outcomes are described in detail in prior filings by us with the Securities and Exchange Commission, including those under the heading "Risk Factors" contained in our Registration Statement on Form S-3 (Registration No. 333-64038) and include: o Our ability to obtain sufficient financing to continue to execute our business model. o Our lack of combined operating history and our untested business model. o Our success in carrying out our acquisition strategy. o Our reliance on regional bell operating companies and other service providers for communications services. o Our ability to increase revenues from service providers other than local access service providers. Shareholders, potential investors and other readers are urged to consider these factors in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included in this Report are only made as of the date of this Report and we undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances. INTRODUCTION The following discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes as of June 30, 2001 and for the six and three months ended June 30, 2001 and 2000. OVERVIEW We were incorporated on March 15, 1999 under Delaware law. Upon the closing of our first two acquisitions in the fourth quarter of fiscal 1999, we commenced our business operations as a communications services agent for communications services including local access, long distance, wireless and Internet services for voice and data communications. We design, procure and facilitate the installation and use of communications services to best meet our customers needs. In fiscal year 2000 and first quarter of fiscal 2001, we acquired ten and two additional communications services agents, respectively. As a result of these 14 acquisitions, we have become the nation's largest communications services agent. We currently act as a sales agent for more than 12 communications services providers. We may continue to acquire other communications services agents and to enter into agency agreements with other communications services providers. Substantially all of our revenues are generated from the commissions we receive from selling communications services as agents for communications services providers. Currently we primarily sell advanced communications services and basic dial tone services for the local access market to facilitate data, voice and video communications. We expect that, over time, the percentage of advanced communications services revenues will increase as a percentage of revenues because of increased demand for, and availability of, these services which typically pay higher commissions. Basic dial tone services in general are telephone connections, voice messaging and call management services. Advanced communications services are all other voice and data communications services, including: 2 12 o data transmission oriented services; o dedicated high-capacity transmission services; o high speed real time communications access, including digital subscriber line, or DSL; o packet-based transmission for wide area networks, including frame relay service; and o an advanced digital network for data, video, voice and Internet traffic, including integrated services digital network, or ISDN. In addition to acting as a sales agent for local access, long distance, wireless and Internet, we also offer, to a limited extent, products such as telephone equipment and the related hardware installation. Salaries and commissions expenses consist principally of salary and incentive compensation that our operating companies pay their sales and marketing, operations and engineering support and administrative staff. Cost of product sales consists of the cost of the product sold and any subcontract labor incurred in installing the equipment. General and administrative expenses include communications expenses, office rent and utilities, travel and marketing for the operating companies. These expenses also include the operations and staffing related to our corporate office. We experience some seasonal variations in our businesses. Orders for communications services tend to slow in the last quarter of the calendar year due to customers' budgetary constraints. Generally, orders increase in the first quarter of the following year. Because of the time lag between order and installation, revenues in the first four months of each calendar year are typically below the average of revenues for the remaining portion of the year. In recent months, economic uncertainty in the U.S. has resulted in decreased demand from end users for many companies' products and services, including ours. As a result, certain of our customers and potential customers have delayed and or cancelled, and may continue to delay or cancel, plans to expand or upgrade their communication systems, which has caused, and may continue to cause, our revenues and profitability to decline. Recent Acquisitions. In the first quarter of fiscal 2001, we acquired Digital Sales Support Net, Inc. and RKK Consulting Group, Inc. Digital, headquartered in New York, New York, is a communications services agent focused on selling primarily Verizon data communications services. The owners of RKK, who manage the combined operations of Digital and RKK, have been focused on selling Verizon data oriented local products and long distance services in the New York and New Jersey markets. The initial purchase consideration for Digital consisted of $171 in cash and the issuance of 30,374 shares of our common stock with a fair market value of $801. Of the 30,374 of issued shares, 18,984 with a fair market value of $500 were placed in escrow and will be released upon Digital attaining certain performance criteria for the period from January 1, 2001 through December 31, 2001. In addition, the agreement provides for additional consideration in the form of cash and our common stock if certain operating performance criteria are met by Digital for the period from January 1, 2001 through December 31, 2001. The initial purchase consideration for RKK consisted of 37,968 of our common stock with a fair market value of $1,001. Of the 37,968 of issued shares, 36,070 with a fair market value of $951 were placed in escrow and will be released upon RKK attaining certain performance criteria for the period from February 1, 2001 through January 31, 2002. In addition, the agreement provides for additional consideration in the form of cash and our common stock if certain operating performance criteria are met by RKK for the period from February 1, 2001 through January 31, 2002. RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2000 Revenues. Total revenue of $15,761 and $11,990 was recorded for the six months ended June 30, 2001 and 2000, respectively. The increase was primarily attributable to the reporting of additional companies' results of operations in 2001 as compared to 2000 as a result of our acquisition activity after June 30, 2000. Advanced communications services revenue increased from $7,152 for the six months ended June 30, 2000 to $9,724 for the six months ended June 30, 2001 for the reason discussed above. Basic dial tone services revenue increased from $3,957 for the six months ended June 30, 2000 to $5,585 for the six months ended June 30, 2001 for the 3 13 reason discussed above. Product sales and other revenue decreased from $881 for the six months ended June 30, 2000 to $452 for the six months ended June 30, 2001 as a result of a decreased focus on the sales of telephone equipment and the related hardware installation. Costs and expenses. Salaries and commissions expense of $12,973 and $9,769 was recorded for the six months ended June 30, 2001 and 2000, respectively. The increase was primarily attributable to the reporting of additional companies' results of operations in 2001 as compared to 2000 as a result of our acquisition activity after June 30, 2000. Salaries and commission expense as a percentage of total revenue was 82% and 81% for the six months ended June 30, 2001 and 2000, respectively. Salaries and commissions expense consists principally of salaries and incentive compensation that our operating companies pay their sales and marketing, operations and engineering support and administrative staff. Cost of product sales decreased from $270 for the six months ended June 30, 2000 to $156 for the six months ended June 30, 2001 as a result of decreased product sales. Cost of product sales as a percentage of product sales and other revenue was 35% and 31% for the six months ended June 30, 2001 and 2000, respectively. This increase was primarily attributable to our product sales in 2001 requiring more subcontract labor than 2000. Cost of product sales consists of the cost of the product sold and any subcontract labor incurred in installing the equipment. General and administrative expense of $3,015 and $2,846 was recorded for the six months ended June 30, 2001 and 2000, respectively. The increase was primarily attributable to the same reason as the salaries and commissions increase discussed above. General and administrative expenses as a percentage of total revenue was 19% and 24% for the six months ended June 30, 2001 and 2000, respectively. The decrease was primarily attributable to the efficiencies realized by consolidating certain functions formerly performed at the operating company level. General and administrative expenses include communications expenses, office rent and utilities, travel and marketing for the operating companies. These expenses also include the operations and staffing related to our corporate office. Depreciation and amortization expense of $1,176 and $840 was recorded for the six months ended June 30, 2001 and 2000, respectively. This increase was attributable to additional acquisitions made after June 30, 2000. Depreciation and amortization expense consists of depreciation expense on property and equipment and the amortization of goodwill associated with our acquisitions. Loss from operations. A loss from operations of $1,559 and $1,735 was recorded for the six months ended June 30, 2001 and 2000, respectively, due to the factors discussed above. Other (income) expense, net. Other (income) expense, net, of $367 and ($13) was recorded for the six months ended June 30, 2001 and 2000, respectively. The difference was primarily attributable to interest expense on borrowings in the first two quarters of 2001 versus the interest income earned in the first two quarters of 2000 on invested cash proceeds from our initial public offering. Income taxes. A benefit of $231 and $503 was recorded for the six months ended June 30, 2001 and 2000, respectively, representing an effective tax rate of 12.0% and 29.2%, respectively. The difference between the federal statutory rate of 35% and the effective rate is due to state income taxes offset by nondeductible goodwill amortization, other permanent differences, and not recording a benefit for the three months ended June 30, 2001. We expect our effective tax rate to remain zero for the remainder of the fiscal year. Deferred tax assets and liabilities are provided for differences between the financial statement and tax basis of assets and liabilities using enacted tax rates. We have recorded a deferred tax asset of $1,840 as of June 30, 2001, which is net of a valuation allowance of $431. We did not record additional deferred tax assets for the three months ended June 30, 2001 because we did not conclude that it was "more likely than not" that the additional deferred tax assets would be realized over a reasonable period of time. Although realization is not assured for the remaining deferred tax asset, we believe that we will generate sufficient taxable income in the future to recover that asset. We based our belief upon our internal projections and the historical results of our acquired companies which have been generating taxable income prior to our acquisition. However, we cannot provide any assurance that we will in fact generate taxable income sufficient to utilize the deferred tax assets we have recorded on the balance sheet. If our views about the prospects of generating future taxable income were to change, then we would have to record a charge to income to write-off some or all of those deferred tax assets. It is at least reasonably possible that our view as to the realizability of the remaining deferred tax assets may change in the near future. Net loss. For the reasons discussed above, a net loss of $1,695 and $1,219 was recognized for the six months ended June 30, 2001 and 2000, respectively. FOR THE THREE MONTHS ENDED JUNE 30, 2001 COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2000 Revenues. Total revenue of $7,772 and $7,550 was recorded for the three months ended June 30, 2001 and 2000, respectively. The increase was primarily attributable to the reporting of additional companies' results of operations in 2001 as compared to 2000 as a 4 14 result of our acquisition activity after June 30, 2000. Total revenue for acquisitions reporting in both periods reflected a decrease attributable to weakness in the economy in 2001 and delays experienced with installations by the service providers. Advanced communications services revenue increased from $4,734 for the three months ended June 30, 2000 to $4,748 for the three months ended June 30, 2001 for the reasons discussed above. Basic dial tone services revenue increased from $2,242 for the three months ended June 30, 2000 to $2,842 for the three months ended June 30, 2001 for the reasons discussed above. Product sales and other revenue decreased from $574 for the three months ended June 30, 2000 to $182 for the three months ended June 30, 2001 as a result of a decreased focus on the sales of telephone equipment and the related hardware installation. Costs and expenses. Salaries and commissions expense of $6,541 and $5,894 was recorded for the three months ended June 30, 2001 and 2000, respectively. The increase was attributable to the reporting of additional companies' results of operations in 2001 as compared to 2000 as a result of our acquisition activity after June 30, 2000. Salaries and commission expense as a percentage of total revenue was 84% and 78% for the three months ended June 30, 2001 and 2000, respectively. This increase as a percentage of total revenue is primarily attributable to a reduction in our revenues related to the acquisitions reporting in both periods as discussed above when compared to our fixed cost salaries related to operations and administrative staff. Salaries and commissions expense consists principally of salaries and incentive compensation that our operating companies pay their sales and marketing, operations and engineering support and administrative staff. Cost of product sales decreased from $139 for the three months ended June 30, 2000 to $74 for the three months ended June 30, 2001 as a result of decreased product sales. Cost of product sales as a percentage of product sales and other revenue was 41% and 24% for the three months ended June 30, 2001 and 2000, respectively. This increase was primarily attributable to our product sales in 2001 requiring more subcontract labor than 2000. Cost of product sales consists of the cost of the product sold and any subcontract labor incurred in installing the equipment. General and administrative expense of $1,612 and $1,869 was recorded for the three months ended June 30, 2001 and 2000, respectively. This decrease was attributable to efficiencies realized by consolidating certain functions formerly performed at the operating company level. General and administrative expenses as a percentage of total revenue was 21% and 25% for the three months ended June 30, 2001 and 2000, respectively. This decrease was primarily attributable to the reason discussed above related to the decrease in general and administrative expenses. General and administrative expenses include communications expenses, office rent and utilities, travel and marketing for the operating companies. These expenses also include the operations and staffing related to our corporate office. Depreciation and amortization expense of $590 and $545 was recorded for the three months ended June 30, 2001 and 2000, respectively. This increase was attributable to additional acquisitions made after June 30, 2000. Depreciation and amortization expense consists of depreciation expense on property and equipment and the amortization of goodwill associated with our acquisitions. Loss from operations. A loss from operations of $1,045 and $897 was recorded for the three months ended June 30, 2001 and 2000, respectively, for the reasons discussed above. Other (income) expense, net. Other (income) expense, net, of $209 and $85 was recorded for the three months ended June 30, 2001 and 2000, respectively. This difference was primarily attributable to additional interest expense on borrowings in the second quarter of 2001 compared to the second quarter of 2000 and interest income earned in the second quarter of 2000 on invested cash proceeds from our initial public offering. Income taxes. A benefit of $264 was recorded for the three months ended June 30, 2000 representing an effective tax rate of 26.9%. The difference between the federal statutory rate of 35% and the effective rate is due to state income taxes offset by nondeductible goodwill amortization, other permanent differences. A benefit was not recorded for the three months ended June 30, 2001. The Company expects the effective tax rate to remain zero for the remainder of the fiscal year. Net loss. For the reasons discussed above, a net loss of $1,255 and $719 was recognized for the three months ended June 30, 2001 and 2000, respectively. LIQUIDITY AND CAPITAL RESOURCES Our operations used net cash of $1,493 for the six months ended June 30, 2001 and provided cash of $136 for the six months ended June 30, 2000. This difference between periods was primarily attributable to the significant collections of accounts receivable in 2000 compared to 2001. We used cash of $877 and $5,626 in investing activities for the six months ended June 30, 2001 and 2000, respectively. These uses of cash are the result of our acquisition activity. The decrease in cash used was primarily attributable to fewer acquisitions during 2001 as compared to 2000. 5 15 Our financing activities provided cash of $2,189 for the six months ended June 30, 2001 compared to cash used of $644 for the six months ended June 30, 2000. The cash provided for the six months ended June 30, 2001 was primarily attributable to net borrowings on our line of credit and proceeds from the issuance of common stock related to stock option exercises. As of June 30, 2001, we did not meet certain financial covenants contained in its existing Credit and Security Agreement (the "Credit Agreement") with Wells Fargo Bank West, National Association ("Wells Fargo") resulting in a default. Terms of the Credit Agreement provide for maximum borrowings of $10 million limited to 75% of eligible accounts receivable, as defined, and requires compliance with financial loan covenants related to debt levels compared to annualized cash flows and working capital levels. The Credit Agreement is secured by accounts receivable and by substantially all of the assets of PentaStar, excluding any rights to future residual commission payments due to PentaStar from existing Ameritech contracts acquired in connection with the TCMM acquisition. The Credit Agreement expires on August 31, 2001. We are in current discussions with Wells Fargo and intend to obtain, prior to August 31, 2001, an extension with appropriate financial covenant waivers to the existing Credit Agreement or a restructured agreement with renegotiated financial covenants, although no assurance can be given that such waivers or a restructured agreement with terms acceptable to us will be obtained. Any such failure to obtain covenant relief or a restructured agreement could result in Wells Fargo declaring the entire amount due and payable immediately. As a result of our default under the Credit Agreement a cross-default exists under the Reducing Revolver Loan and Security Agreement (the "Loan") with Merrill Lynch Business Financial Services, Inc. As of June 30, 2001, the amounts due under the Credit Agreement and the Loan were $5,445 and $3,718, respectively. As a result of the cross-default provisions, $2,826 of the outstanding Loan amount that would have been classified as long-term has been classified as current in the June 30, 2001 balance sheet. As a part of our current discussions with our lenders, we have undertaken a review of our cost structure at certain of our operating companies and headquarters in order to increase annualized cash flows. We also continue to actively manage our order backlog with the related carriers in an attempt to reduce lag time between order submission and the related commission payment from the carrier. There can be no assurance that such efforts will increase annualized cash flows to such a level that would avoid future covenant violations. In the event that we are unable to successfully negotiate a new credit facility with Wells Fargo, alternative financing would be required. There is no assurance that such alternative financing will be available when needed by us. If alternative financing is not available, or the terms of the alternative financing are not acceptable to us, there would be substantial doubt about our ability to continue as a going concern. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations" (effective July 1, 2001) and SFAS No. 142, "Goodwill and Other Intangible Assets" (effective for us on 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 adoption of SFAS No. 142 will result in the discontinuation of amortization of our goodwill; however, we will be required to test goodwill for impairment under the new standard beginning in the first quarter of 2002, which could have an adverse effect on our future results of operations if an impairment occurs. The annual impact of SFAS No. 142 due to the cessation of amortization on goodwill is expected to be $1,286. In fiscal 2001, we adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments and for hedging activities. Among other things, the statement requires that an entity recognize all derivative instruments on the balance sheet as either assets or liabilities, and to account for those instruments at fair value. We have not entered into any derivative financial instruments or hedging activities and therefore the adoption of SFAS No. 133 had no impact on our financial position or results of operations. In July 2001, the Financial Accounting Standards Board issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This statement is effective for fiscal years beginning after June 15, 2002, and provides accounting requirements for asset retirement obligations associated with tangible long-lived assets. We have not yet determined the impact of adopting SFAS No. 143. 6 16 PART II ITEM 3. DEFAULTS UPON SENIOR SECURITIES As of June 30, 2001, the Company did not meet certain financial covenants contained in its existing Credit and Security Agreement (the "Credit Agreement") with Wells Fargo Bank West, National Association ("Wells Fargo") resulting in a default. Terms of the Credit Agreement provide for maximum borrowings of $10 million limited to 75% of eligible accounts receivable, as defined, and requires compliance with financial loan covenants related to debt levels compared to annualized cash flows and working capital levels. The Credit Agreement is secured by accounts receivable and by substantially all of the assets of PentaStar, excluding any rights to future residual commission payments due to PentaStar from existing Ameritech contracts acquired in connection with the TCMM acquisition. The Credit Agreement expires on August 31, 2001. The Company is in current discussions with Wells Fargo and intends to obtain, prior to August 31, 2001, an extension with appropriate financial covenant waivers to the existing Credit Agreement or a restructured agreement with renegotiated financial covenants, although no assurance can be given that such waivers or a restructured agreement with terms acceptable to the Company will be obtained. Any such failure to obtain covenant relief or a restructured agreement could result in Wells Fargo declaring the entire amount due and payable immediately. As a result of our default under the Credit Agreement a cross-default exists under the Reducing Revolver Loan and Security Agreement (the "Loan") with Merrill Lynch Business Financial Services, Inc. As of June 30, 2001, the amounts due under the Credit Agreement and the Loan were $5,445 and $3,718, respectively. As a result of the cross-default provisions, $2,826 of the outstanding Loan amount that would have been classified as long-term has been classified as current in the June 30, 2001 balance sheet. As a part of the Company's current discussions with its lenders, management has undertaken a review of its cost structure at certain of its operating companies and headquarters in order to increase annualized cash flows. The Company also continues to actively manage its order backlog with the related carriers in an attempt to reduce lag time between order submission and the related commission payment from the carrier. There can be no assurance that such efforts will increase annualized cash flows to such a level that would avoid future covenant violations. In the event that the Company is unable to successfully negotiate a new credit facility with Wells Fargo, alternative financing would be required. There is no assurance that such alternative financing will be available when needed by the Company. If alternative financing is not available, or the terms of the alternative financing are not acceptable to the Company, there would be substantial doubt about the Company's ability to continue as a going concern. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 31, 2001, PentaStar held its Annual Meeting of Shareholders. At such meeting, PentaStar's shareholders elected Mr. Robert S. Lazzeri as a director to the Board of Directors to serve for a term until the 2004 annual meeting. (The terms of Messrs. Carleton A. Brown, Reynaldo U. Otrtiz, Richard M. Tyler and Craig J. Zoellner as directors, continued after the meeting). The number of votes cast in matters is set forth below:

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) The following exhibits are attached. EXHIBIT NUMBER DESCRIPTION OF DOCUMENT 2.18(1) Agreement and Plan of Merger among PentaStar Communications, Inc., PentaStar Acquisition Corp. VIII, Digital Sales Support Net, Inc. and the Shareholders of Digital Sales Support Net, Inc. dated March 29, 2001. 2.19(1) Letter Agreement among PentaStar Communications, Inc., PentaStar Acquisition Corp. VIII, Digital Sales Support Net, Inc. and the Shareholders of Digital Sales Support Net, Inc. dated April 9, 2001. 7 17 2.20(1) Agreement and Plan of Merger among PentaStar Communications, Inc., PentaStar Acquisition Corp. VIII, RKK Consulting Group, Inc. and the Shareholders of RKK Consulting Group, Inc. dated March 29, 2001. 10.23 Settlement Agreement and Release among PentaStar Communications, Inc., PentaStar Acquisition Corp. I, Jeffrey A. Veres and Linda Veres dated May 16, 2001. ---------- (1) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2001. (b) Reports on Form 8-K: None. 8 18 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 14, 2001. PENTASTAR COMMUNICATIONS, INC. By: /s/ DAVID L. DUNHAM ------------------------------------------ David L. Dunham Chief Financial Officer 9 19 INDEX TO EXHIBITS

(1) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2001. 10

PENTASTAR COMMUNICATIONS INC 10-Q