FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

Quarterly Report Under Section 13 or 15 (d)
of the Securities Exchange Act of 1934
For Quarter Ended September 30, 2004

Commission File Number 0-13898

Veramark Technologies, Inc.

3750 Monroe Avenue, Pittsford, NY 14534

(585) 381-6000

N/A

     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 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 requirement for the past 90 days.

YES  x NO o

Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule 12b-2 of the Act).

YES  o NO x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of October 31, 2004

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INDEX

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PART I — FINANCIAL INFORMATION

VERAMARK TECHNOLOGIES, INC.

     The accompanying notes are an integral part of these consolidated financial statements.

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VERAMARK TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

     The accompanying notes are an integral part of these consolidated financial statements.

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VERAMARK TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

     The accompanying notes are an integral part of these consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

     The accompanying notes are an integral part of these consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(1) GENERAL

     The accompanying unaudited consolidated financial statements include all adjustments of a normal and recurring nature which, in the opinion of Company’s management, are necessary to present fairly the Company’s financial position as of September 30, 2004, the results of its operations for the three and nine months ended September 30, 2004 and 2003, and cash flows for the nine months ended September 30, 2004 and 2003.

     Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s annual report on Form 10-K to the Securities and Exchange Commission for the year ended December 31, 2003.

     The results of operations and cash flows for the three and nine months ended September 30, 2004 are not necessarily indicative of the results to be expected for the full year’s operation.

(2) PROPERTY AND EQUIPMENT

     The major classifications of property and equipment at September 30, 2004, and December 31, 2003 were:

     For the three and nine months ended September 30, 2004, the Company recorded depreciation expense of $68,057 and $209,369, respectively.

(3) STOCK-BASED COMPENSATION

In 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” This standard provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Additionally, the standard also requires prominent disclosures in the Company’s financial statements about the method of accounting used for stock-based employee compensation, and the effect of the method used when reporting financial results.

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The Company accounts for stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123, the Company continues to measure compensation for such plans using the intrinsic value based method of accounting, prescribed by Accounting Principles Board (APB), Opinion No. 25, “Accounting for Stock Issued to Employees.” Had compensation cost for the Company’s stock-based compensation plans been determined based on the fair value at the grant dates for awards consistent with the method of SFAS No. 123, the Company’s net loss and net loss per common share would have been adjusted to the pro forma amounts indicated below. The 2003 proforma information inadvertently omitted forfeited options. Current proforma information appropriately reflects this information.

For purposes of the disclosure above, the fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2004 and 2003.

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(4) TOTAL COMPREHENSIVE INCOME (LOSS)

     Total comprehensive income (loss) for the three and nine months ended September 30, 2004 and 2003 was as follows:

(5) NET INCOME (LOSS) PER SHARE (EPS)

SFAS 128 “Earnings Per Share” requires the Company to calculate net income (loss) per share based on basic and diluted net income (loss) per share, as defined. Basic EPS excludes dilution and is computed by dividing net income (loss) by the weighted average number of shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The dilutive effect of outstanding options issued by the Company are reflected in diluted EPS using the treasury stock method. Under the treasury stock method, options will only have a dilutive effect when the average market price of common stock during the period exceeds the exercise price of the options.

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Calculations of Earnings (Loss) Per Share

Our agreements with customers generally require us to indemnify the customer against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of September 30, 2004 we had not experienced any material losses related to these indemnification obligations and no material claims with respect thereto were outstanding. We do not expect significant claims related to these indemnification obligations, and consequently, we have not established any related reserves.

The Company sponsors an employee incentive savings plan under Section 401(k) for all eligible employees. The Company’s contributions to the plan are discretionary. There were no contributions to the plan for the three and nine months ended September 30, 2004 and 2003.

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The Company also sponsors an unfunded Supplemental Executive Retirement Program (“SERP”), which is a non-qualified plan that provides certain key employees defined pension benefits. Periodic pension expense for the three and nine months ended September 30, 2004 and 2003 consists of the following:

The Company paid pension obligations of $124,600 and $119,351 for the nine months ended September 30, 2004 and 2003, respectively.

The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6% and 3% respectively, for the three and nine months ended September 30, 2004 and 7% and 3%, respectively, for the three and nine months ended September 30, 2003.

The Company maintains life insurance covering certain key employees under its Supplemental Executive Retirement Program with the Company named as beneficiary. The Company intends to use the death benefits of these policies, as well as loans against the accumulating cash surrender value of the policies, to fund the pension obligation. The total death benefit associated with these policies is $10.2 million, with an associated accumulated cash surrender value of approximately $2 million at September 30, 2004. The accumulated cash surrender values of these policies at December 31, 2003 was approximately $1,858,000.

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Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

     Management’s Discussion and Analysis contains statements that are forward-looking. Such statements are identified by the use of words like “plans,” “expects,” “intends,” “believes,” “will,” “anticipates,” “estimates” and other words of similar meaning in conjunction with, among other things, discussions of future operations, financial performance, the Company’s strategy for growth, product development, regulatory approvals, market position and expenditures. Forward-looking statements are based on management’s expectations as of the date of this report. The Company cannot guarantee that any forward-looking statement will be accurate, although the Company believes that it has been reasonable in its expectations and assumptions. Forward-looking statements are subject to the risks identified in “Issues and Risks” and elsewhere in this report. Readers are cautioned not to place undue reliance on forward-looking statements and are advised to review the risks identified in “Issues and Risks” and elsewhere in this report. The Company has no obligation to update forward-looking statements.

     Sales of $2,781,986 for the three months ended September 30, 2004 decreased 5% from sales of $2,917,179 for the three months ended September 30, 2003. For the nine months ended September 30, 2004, sales of $8,023,283 were 7% less than sales of $8,619,714 for the first nine months of 2003.

     For the three months ended September 30, 2004, Veramark recorded a net loss of $33,759, or $0.00 per share, which compared with net income of $109,528, or $0.01 per share for the same quarter of the prior year. For the nine months ended September 30, 2004, Veramark’s net loss is $529,607, or $0.06 per share. For the nine months ended September 30, 2003, the net loss was $171,001, or $0.02 per share.

     For the nine months ended September 30, 2004, the company capitalized $926,829 of software development expenses, which compared with capitalization of $212,474 for the same nine months of 2003. The company’s policy is to capitalize software development costs when technological feasibility has been established in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.

     Veramark continues to experience fluctuating monthly order rates and their corresponding impact on sales revenues and cash balances. Orders for the third quarter of 2004 were encouraging, increasing 7% from orders received during the second quarter of 2004, and 26% from orders received during the first quarter of 2004.

     Veramark incurred a net cash outflow of approximately $203,000 for the quarter ended September 30, 2004. Net cash consists of cash in the bank and short-term investments. The reduction in net cash results from a 6% increase in gross operating expenses for the first nine months of 2004 versus the same nine months of 2003, combined with the 7% decrease in sales for the same nine month periods. The increased operating expenses are attributable to costs associated with the development and launch of VeraSMART® 2.0, our new enterprise level product offering, which was released for sale late in the second quarter of this year. Management is pleased with the customer acceptance of VeraSMART, which was the primary factor in the increased order rates experienced in the second and third quarters of 2004. It is management’s expectation that the additional revenues generated from sales of VeraSMART will be instrumental in providing future positive cash flows. Major VeraSMART orders received during the third quarter included orders from ESPN, Marshall University, Rainbow Media, and US Food Services, Inc.

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     With the release of VeraSMART 2.0, sales of enterprise level products and services for the three months ended September 30, 2004 increased 4% from the same three months of 2003. For the nine months ended September 30, 2004, sales of enterprise products and services decreased 9% from the first nine months of 2003. The year to date decline is attributable to the strategic 2003 phase-out of the Quantum Series® product, VeraSMART’s predecessor, which significantly reduced enterprise level product sales during the first half of 2004.

     Sales of core call accounting products and services for the three and nine months ended September 30, 2004, decreased 7% and 5%, respectively from the same three and nine month periods ended September 30, 2003. Sales of core call accounting products and services continue to be adversely impacted by Avaya, Inc.’s 2003 acquisition of Expanets, a significant source of distribution for the Company prior to 2004. Sales to the newly formed single channel of distribution are 37% less for the nine months ended September 30, 2004 than for the same nine months of 2003 when Avaya and Expanets were separate channels for the Company. Though we have seen an increase of 10% in sales of call accounting products and services through other distribution channels through September 30, 2004, they have not been sufficient enough to offset the loss of the Expanets sales realized in prior years.

     Sales generated by Veramark’s Outsourced Management Solutions group increased 5% for the three months ended September 30, 2004, and 12% for the nine months ended September 30, 2004 from the same three and nine month periods of 2003. By selecting Veramark’s Outsourcing capabilities, companies are able to realize the benefit of controls on their telemanagement expenses without making significant investments in equipment or internal staff to carry out those functions.

     Gross margins, defined as net sales less cost of sales, of $2,295,204 for the three months ended September 30, 2004 and $6,680,382 for the nine months ended September 30, 2004, represented 82% and 83% of total sales respectively. Gross Margins for the three and nine months ended September 30, 2003 were $2,458,847 and $7,271,560, representing 84% of total sales for both periods. The reduced margins in 2004 versus 2003, reflect increased amortization costs in 2004 associated with capitalized development expenses of VeraSMART 1.0 and 2.0 in prior periods.

     Net engineering and software development expenses of $330,476 for the three months ended September 30, 2004, decreased 24% from net engineering and software development expenses of $432,449 for the three months ended September 30, 2003. For the nine months ended September 30, 2004, net engineering and software development expenses of $1,142,177 were 32% less than the expense level of $1,683,106 for the first nine months of 2003.

     Gross spending for engineering and software development, before the effects of software capitalization, increased by 4% and 9% for the three and nine months ended September 30, 2004, as compared to the same three and nine months periods of 2003.

     The table below details the gross expenses incurred for engineering and software development, costs capitalized, net engineering and software development expenses, amounts amortized, and the overall impact on the Company’s Statements of Operations for the three and nine months ended September 30, 2004 and 2003:

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     Our engineering and software development expenses continue to be concentrated on the further expansion of the functionality of the VeraSMART product, with the next version of the product scheduled for January 2005.

     Selling, general and administrative expenses of $1,996,384 and $6,068,131 for the three and nine months ended September 30, 2004, represent increases of 4% and 5% respectively from the selling, general and administrative expense of $1,920,823 and $5,772,174 for the three and nine months ended September 30, 2003.

     The reasons for the increased operating expenses for both the three and nine months ended September 30, 2004, as compared with the same three and nine months periods of 2003, are two-fold. The first is a 15% increase in marketing costs primarily associated with the sales launch of VeraSMART 2.0. Secondly, the Company has increased direct selling expenses by 9% from the prior year, primarily through staffing additions to support the new enterprise level business generated by VeraSMART and to increase its penetration into potential new markets for call accounting products and services.

     Liquidity and Capital Resources

     Veramark’s total cash position as of September 30, 2004 was $831,140 consisting of cash on hand plus short-term investments. This compares with a total cash position of $1,645,926 at December 31, 2003. The decline in cash position results primarily from the decrease in total sales, combined with increased gross operating expenses, for the nine months ended September 30, 2004, as compared with the first nine months of 2003. In addition to the cash balance referenced above, the Company has immediate access to approximately $2 million of cash surrender values of company-owned insurance policies to fund current operations should that become necessary.

     Accounts receivable at September 30, 2004 total $1,186,376 net of an allowance for doubtful accounts of $52,000. At December 31, 2003, accounts receivable were $1,324,794 net of an allowance for doubtful

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accounts of $65,000. The reduction in accounts receivable reflects lower sales volumes realized for 2004 versus 2003. We have not incurred any significant write-offs during 2004.

     For the nine months ended September 30, 2004, the Company has purchased $122,185 of new capital equipment, primarily computer hardware and software utilized in its development efforts. For the first nine months of 2003, spending on new capital equipment was $64,350. Additionally, the Company has disposed of $232,139 of obsolete equipment during 2004. A gain of approximately $2,000 was realized after the effects of accumulated depreciation and cash proceeds from the sale of a portion of these assets, and included in the Statement of Operations.

     Software development costs of $2,331,500 at September 30, 2004, have increased from $1,817,438 at December 31, 2003. For the first nine months of 2004, Veramark has capitalized $926,829 of development costs, and amortized $412,767 of previously capitalized costs, which has been charged to cost of sales. Development costs capitalized in 2004 have been entirely devoted to further development and expansion of the Company’s enterprise level VeraSMART® product line.

     Pension and related assets of $2,653,462 at September 30, 2004 include $2,000,457 of cash surrender values associated with Company-owned life insurance policies. The death benefit and cash values of these policies are intended to fund future pension obligations, though the cash values are also available, with Board of Director approval, to fund current operations, should that become necessary.

     Total current liabilities at September 30, 2004, of $3,560,497 have decreased from $3,834,681 at December 31, 2003, primarily as a result of a $271,192 decrease in deferred revenues. Deferred revenues decreased from $2,918,337 at December 31, 2003 to $2,647,145 at September 30, 2004. Deferred revenues are services for which the Company has billed customers for services such as maintenance and support, training and installation, but for which it has not yet performed the associated service. The majority of currently deferred services are expected to be provided over the next twelve months and recorded as revenue.

     As of September 30, 2004 the Company has an accumulated pension obligation of $4,316,502, under a non-qualified, unfunded, Supplemental Executive Retirement Program. The Company maintains life insurance policies covering certain key employees and intends to use the death benefits of these policies, as well as loans against the accumulating cash surrender value of these policies, to fund the pension obligation. The total death benefit associated with these policies is $10.2 million, and the accumulated cash surrender values as of September 30, 2004 is approximately $2.0 million.

     Stockholders’ equity at September 30, 2004 was $1,017,277, down from $1,508,687 at December 31, 2003, primarily reflecting the net loss incurred for the first nine months of 2004 of $529,607. For the nine months ended September 30, 2004, employees of the Company have exercised 76,937 stock options, and purchased 6,496 shares of common stock through the Company’s Employee Stock Purchase Plan, yielding proceeds to the Company of approximately $56,000.

Accounting Pronouncements

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Critical Accounting Policies

     The preparation of financial statements requires management to make estimates and assumptions that affect amounts reported therein. The most significant of these involving difficult or complex judgments in 2004 include:

     In each situation, management is required to make estimates about the effects of matters or future events that are inherently uncertain.

     The Company recognizes revenue in accordance with SOP 97-2, “Software Revenue Recognition,” and related interpretations. Our software licensing with customers typically have terms and conditions that are described in signed orders. Revenue from perpetual licenses is recognized upon delivery of the licensed product, provided that acceptance has occurred and a signed contractual obligation has been received, the price is fixed and determinable, and collectibility of the receivable is probable.

     Service revenues consist principally of software installation, implementation, upgrades, and customer training, as well as software maintenance agreements that include both customer support and the right to upgrades. The Company estimates the value of post-contract customer support sold together with perpetual licenses by reference to published price lists which generally represent the prices at which customers could purchase renewal contracts for such services. Revenue from maintenance contracts is recognized ratably over

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the term of the contract, usually one year. Revenue from training, support and other services is recognized as the services are performed.

     The Company believes its revenue recognition policies are appropriate, in all circumstances, and that its policies are reflective of complexities arising from customer arrangements involving such features as maintenance, warranty agreements, license agreements, and other normal course of business arrangements.

     The Company capitalizes software development costs when technological feasibility has been established for the software in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” Such capitalized costs are amortized on a product-by-product basis over their economic life or the ratio of current revenues to current and anticipated revenues from such software, whichever provides the greater amortization. The Company periodically reviews the carrying value of capitalized software development costs and impairments are recognized in the results of operations when the expected future undiscounted operating cash flow derived from the capitalized software is less than its carrying value. Should the Company inaccurately determine when a product reaches technological feasibility or the economic life of a product, results could differ materially from those reported. Veramark uses what it believes are reasonable assumptions and where applicable, established valuation techniques in making its estimates.

     The Company maintains allowances for doubtful accounts for estimated losses resulting from the potential inability of its customers to make required payments. Management specifically analyzes accounts receivable, historical bad debts, credit concentrations and customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.

     The Company sponsors an unfunded Supplemental Executive Retirement Program (“SERP”), which is a nonqualified plan that provides certain key employees a defined pension benefit. In order to properly record the net present value of future pension obligations a number of assumptions are required to be made by Company’s management. These assumptions include years of service, life expectancies, and projected future salary increases for each participant. In addition, management must make assumptions with regard to the proper long-term interest and liability discount rates to be applied to these future obligations.

     Should the Company need to alter any of these assumptions, there is the potential for significant adjustments to future projected pension liabilities.

Issues and Risks

     The following factors, among others discussed herein and in the Company’s filings under the Act, could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements: economic, competitive, governmental and technological factors, increased operating costs, failure to obtain necessary outside financing, risks related to natural disasters and financial market fluctuations. Such factors also include:

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Item 3 Quantitative and Qualitative Disclosures About Market Risk

     The Company has no long-term bank debt obligations. The Company has no foreign currency exchange risk and has no foreign currency exchange contracts.

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Item 4 Controls and Procedures

     Based upon an evaluation as of the end of the period covered by this report, the Company’s Chief Executive Officer and Treasurer (Chief Accounting Officer) concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. There have been no changes in the Company’s internal controls over financial reporting, that occurred during the period covered by this report, that have materially affected, or are reasonably likely to materially affect the Company’s internal controls over financial reporting.

     The Company’s disclosure controls and procedures and internal controls over financial reporting provide reasonable, but not absolute, assurance that all deficiencies in design or operation of those control systems, or all instances of errors or fraud, will be prevented or detected. Those control systems are designed to provide reasonable assurance of achieving the goals of those systems in light of the Company’s resources and nature of the Company’s business operations. The Company’s disclosure controls and procedures and internal control over financial reporting remain subject to risks of human error and the risk that controls can be circumvented for wrongful purposes by one or more individuals in management or non-management positions.

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PART II — OTHER INFORMATION

(I) Registrant’s Condensed Financial Statements for the three and nine months ended September 30, 2004 and 2003 are set forth in Part I, Item 1 of this Quarterly Report on Form 10-Q.

(31.1) CEO Certification Pursuant to Rule 13a-14(a) and 15d-14(a), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

(31.2) Treasurer Certification Pursuant to Rule 13a-14(a) and 15d-14(a), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

(32.1) CEO Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(32.2) Treasurer Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

VERAMARK TECHNOLOGIES, INC.

REGISTRANT

Date: November 12, 2004

Date: November 12, 2004

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