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U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
     
ž   QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
     
o   TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                                          to                                         .
Commission File Number: 000-27031
FullNet Communications, Inc.
(Exact name of small business issuer as specified in its charter)
         
Oklahoma       73—1473361
         
(State or other jurisdiction of       (I.R.S. Employer Identification No.)
incorporation or organization)        
201 Robert S. Kerr Avenue, Suite 210, Oklahoma City, Oklahoma 73102
(Address of principal executive offices)
(405) 236-8200
(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 ž No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ž
The number of shares outstanding of the Issuer’s Common Stock, $.00001 par value, as of August 10, 2006 was 6,741,135.
Transitional Small Business Disclosure Format (Check one): Yes o No ž

 

FORM 10—QSB
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PART I. FINANCIAL INFORMATION
        
 
        
Item 1. Financial Statements
        
 
        
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 Certification Pursuant to Rules 13a-14(a)/15d-14(a)
 Certification Pursuant to Rules 13a-14(a)/15d-14(a)
 Certification Pursuant to 18 U.S.C. Section 1350
 Certification Pursuant to 18 U.S.C. Section 1350

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
                 
    JUNE 30,     DECEMBER 31,  
    2006     2005  
ASSETS
                
CURRENT ASSETS
                
Cash
   $ 13,278     $ 14,974  
Accounts receivable, net
     109,998       122,616  
Prepaid expenses and other current assets
     61,591       108,631  
 
            
 
                
Total current assets
     184,867       246,221  
 
                
PROPERTY AND EQUIPMENT, net
     774,472       888,957  
 
                
INTANGIBLE ASSETS, net
     56,643       75,874  
 
                
OTHER ASSETS
     18,282       18,282  
 
            
 
                
TOTAL
   $ 1,034,264     $ 1,229,334  
 
            
 
                
LIABILITIES AND STOCKHOLDERS’ DEFICIT
                
 
                
CURRENT LIABILITIES
                
Accounts payable — trade
   $ 181,068     $ 160,998  
Accounts payable — related party
     237,552       218,982  
Accrued and other current liabilities
     777,004       709,999  
Accrued interest — related party
     168,066       152,197  
Notes payable, current portion
     598,607       594,804  
Notes payable — related party
     320,000       320,000  
Deferred revenue
     134,376       120,784  
 
            
 
                
Total current liabilities
     2,416,673       2,277,764  
 
                
NOTES PAYABLE, less current portion
     41,346       90,912  
 
                
OTHER LIABILITIES
     76,395       80,827  
 
                
STOCKHOLDERS’ DEFICIT
                
Common stock — $.00001 par value; authorized, 10,000,000 shares; issued and outstanding, 6,670,878 and 6,652,878 shares in 2006 and 2005, respectively
     68       66  
Common stock issuable, 70,257 shares in 2006 and 2005
     57,596       57,596  
Additional paid-in capital
     8,346,142       8,328,004  
Accumulated deficit
     (9,903,956 )     (9,605,835 )
 
            
 
                
Total stockholders’ deficit
     (1,500,150 )     (1,220,169 )
 
            
 
                
TOTAL
   $ 1,034,264     $ 1,229,334  
 
            
See accompanying notes to condensed consolidated financial statements.

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
                                 
    Three Months Ended     Six Months Ended  
    June 30, 2006     June 30, 2005     June 30, 2006     June 30, 2005  
REVENUES
                                
Access service revenues
   $ 188,880     $ 215,541     $ 383,612     $ 452,647  
Co-location and other revenues
     229,881       392,323       465,337       750,009  
 
                        
 
                                
Total revenues
     418,761       607,864       848,949       1,202,656  
 
                                
OPERATING COSTS AND EXPENSES
                                
Cost of access service revenues
     63,851       72,279       121,402       138,412  
Cost of co-location and other revenues
     58,328       50,193       114,984       87,358  
Selling, general and administrative expenses
     341,227       337,472       697,086       648,024  
Depreciation and amortization
     74,833       104,798       159,840       210,884  
 
                        
 
                                
Total operating costs and expenses
     538,239       564,742       1,093,312       1,084,678  
 
                        
 
                                
INCOME (LOSS) FROM OPERATIONS
     (119,478 )     43,122       (244,363 )     117,978  
 
                                
GAIN ON BAD DEBT RECOVERY, net
     —       17,500       —       17,500  
INTEREST EXPENSE
     (26,780 )     (30,988 )     (53,758 )     (64,238 )
 
                        
 
                                
INCOME (LOSS) before income taxes
     (146,258 )     29,634       (298,121 )     71,240  
 
                                
Income tax expense (benefit)
     —       —       —       —  
 
                        
 
                                
NET INCOME (LOSS)
   $ (146,258 )   $ 29,634     $ (298,121 )   $ 71,240  
 
                        
 
                                
Net income (loss) per share —basic
   $ (.02 )   $ NIL     $ (.04 )   $ .01  
 
                        
Net income (loss) per share — assuming dilution
   $ (.02 )   $ NIL     $ (.04 )   $ .01  
 
                        
 
                                
Weighted average shares outstanding — basic
     6,741,135       6,723,135       6,740,833       6,723,135  
 
                        
 
                                
Weighted average shares outstanding — assuming dilution
     6,741,135       8,509,533       6,740,833       8,402,262  
 
                        
See accompanying notes to condensed consolidated financial statements.

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIT (UNAUDITED)
Six Months Ended June 30, 2006
                                                 
                    Common                    
    Common stock     Stock     Additional     Accumulated        
    Shares     Amount     Issuable     paid-in capital     Deficit     Total  
     
Balance at January 1, 2006
     6,652,878     $ 66     $ 57,596     $ 8,328,004     $ (9,605,835 )   $ (1,220,169 )
 
                                                
Warrant exercise
     18,000       2       —       178       —       180  
 
                                                
Warrant extension granted in settlement of liabilities
     —       —       —       17,960       —       17,960  
 
                                                
Net loss
     —       —       —       —       (298,121 )     (298,121 )
 
                                    
 
                                                
Balance at June 30, 2006
     6,670,878     $ 68     $ 57,596     $ 8,346,142     $ (9,903,956 )   $ (1,500,150 )
 
                                    
See accompanying notes to the condensed consolidated financial statements.

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
                 
    Six Months Ended  
    June 30, 2006     June 30, 2005  
CASH FLOWS FROM OPERATING ACTIVITIES
                
Net income (loss)
   $ (298,121 )   $ 71,240  
Adjustments to reconcile net income (loss) to net cash provided by operating Activities
                
Depreciation and amortization
     159,840       210,884  
Gain on bad debt recovery
     —       (17,500 )
Provision for uncollectible accounts receivable
     19,503       17,511  
Net (increase) decrease in
                
Accounts receivable
     (6,885 )     196  
Prepaid expenses and other current assets
     47,040       (53,522 )
Net increase (decrease) in
                
Accounts payable — trade
     20,070       9,471  
Accounts payable — related party
     36,530       36,530  
Accrued and other liabilities
     62,573       28,574  
Accrued interest — related party
     15,869       15,869  
Deferred revenue
     13,592       (42,460 )
 
            
 
                
Net cash provided by operating activities
     70,011       276,793  
 
                
CASH FLOWS FROM INVESTING ACTIVITIES
                
Purchases of property and equipment
     (18,088 )     (80,038 )
Acquisition of assets
     (8,036 )     (31,396 )
 
            
 
                
Net cash used in investing activities
     (26,124 )     (111,434 )
 
CASH FLOWS FROM FINANCING ACTIVITIES
                
Principal payments on borrowings under notes payable
     (45,763 )     (117,654 )
Principal payments on note payable to related party
     —       (16,289 )
Principal payments on capital lease obligations
     —       (31,586 )
Proceeds from exercise of warrants
     180       —  
 
            
 
                
Net cash used in financing activities
     (45,583 )     (165,529 )
 
            
 
                
NET DECREASE IN CASH
     (1,696 )     (170 )
 
                
Cash at beginning of period
     14,974       12,226  
 
            
 
                
Cash at end of period
   $ 13,278     $ 12,056  
 
            
 
                
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
                
Cash paid for interest
   $ 10,320     $ 22,951  
Warrant extension granted in settlement of liabilities
     17,960       —  
See accompanying notes to the condensed consolidated financial statements.

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FullNet Communications, Inc. and Subsidiaries
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. UNAUDITED INTERIM FINANCIAL STATEMENTS
The unaudited condensed consolidated financial statements and related notes have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. The accompanying unaudited condensed consolidated financial statements and related notes should be read in conjunction with the audited consolidated financial statements of the Company and notes thereto for the year ended December 31, 2005.
The information furnished reflects, in the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results of the interim periods presented. Operating results of the interim period are not necessarily indicative of the amounts that will be reported for the year ending December 31, 2006. Certain reclassifications have been made to prior period balances to conform with the presentation for the current period.
2. MANAGEMENT’S PLANS
At June 30, 2006, current liabilities exceed current assets by $2,231,806. The Company does not have a line of credit or credit facility to serve as an additional source of liquidity. Historically the Company has relied on shareholder loans as an additional source of funds. The Company is in default on various loans and lease agreements (see Note 9. Notes Payable and Note 14. Related Party Transactions). These factors raise substantial doubts about the Company’s ability to continue as a going concern.
The ability of the Company to continue as a going concern is dependent upon continued operations of the Company that in turn is dependent upon the Company’s ability to meet its financing requirements on a continuing basis, to maintain present financing, to achieve the objectives of its business plan and to succeed in its future operations. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.
The Company’s business plan includes, among other things, expansion of its Internet access services through mergers and acquisitions and the development of its web hosting, co-location, and traditional telephone services. Execution of the Company’s business plan will require significant capital to fund capital expenditures, working capital needs and debt service. Current cash balances will not be sufficient to fund the Company’s current business plan beyond the next few months. As a consequence, the Company is currently focusing on revenue enhancement and cost cutting opportunities as well as working to sell non-core assets and to extend vendor payment terms. The Company continues to seek additional convertible debt or equity financing as well as the placement of a credit facility to fund the Company’s liquidity. There can be no assurance that the Company will be able to raise additional capital on satisfactory terms or at all.

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3. USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures; accordingly, actual results could differ from those estimates.
4. INCOME (LOSS) PER SHARE
Income (loss) per share — basic is calculated by dividing net income (loss) by the weighted average number of shares of stock outstanding during the period, including shares issuable without additional consideration. Income (loss) per share — assuming dilution is calculated by dividing net income (loss) by the weighted average number of shares outstanding during the period adjusted for the effect of dilutive potential shares calculated using the treasury stock method.
                                 
    Three Months Ended     Six Months Ended  
    June 30, 2006     June 30, 2005     June 30, 2006     June 30, 2005  
Numerator:
                                
Net income (loss)
   $ (146,258 )   $ 29,634     $ (298,121 )   $ 71,240  
Denominator:
                                
Weighted average shares outstanding — basic
     6,741,135       6,723,135       6,740,833       6,723,135  
Effect of dilutive stock options
     —       859,865       —       763,922  
Effect of dilutive warrants
     —       926,533       —       915,205  
 
                        
Weighted average shares outstanding — assuming dilution
     6,741,135       8,509,533       6,740,833       8,402,262  
 
                        
 
                                
Net income (loss) per share — basic
   $ (.02 )   $ NIL     $ (.04 )   $ .01  
 
                        
Net income (loss) per share — assuming dilution
   $ (.02 )   $ NIL     $ (.04 )   $ .01  
 
                        
Basic and diluted losses per share were the same for the three and six months ended June 30, 2006 because there was a net loss for each period.
Stock options exercisable for the purchase of 1,199,921 common stock shares at exercise prices ranging from $0.08 to $3.00 per share were outstanding for the three and six months ended June 30, 2005, but were not included in the calculation of income (loss) per share — assuming dilution because the options were not dilutive.
Warrants exercisable for the purchase of 1,023,248 common stock shares at exercise prices ranging from $0.08 to $2.00 per share were outstanding for the three and six months ended June 30, 2005, but were not included in the calculation of income (loss) per share — assuming dilution because the warrants were not dilutive.
Convertible promissory notes convertible into 1,003,659 common stock shares at a conversion price of $1.00 per share were outstanding for the three and six months ended June 30, 2005, but were not included in the calculation of income (loss) per share — assuming dilution because the convertible notes were not dilutive.
5. ACCOUNTS RECEIVABLE
Accounts receivable consist of the following:

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    June 30, 2006     December 31, 2005  
Accounts receivable
   $ 238,670     $ 231,785  
Less allowance for doubtful accounts
     (128,672 )     (109,169 )
 
            
 
   $ 109,998     $ 122,616  
 
            
6. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
                 
    June 30, 2006     December 31, 2005  
Computers and equipment
   $ 1,313,115     $ 1,296,856  
Leasehold improvements
     941,861       940,032  
Software
     56,512       56,512  
Furniture and fixtures
     19,153       19,153  
 
            
 
     2,330,641       2,312,553  
Less accumulated depreciation
     (1,556,169 )     (1,423,596 )
 
            
 
   $ 774,472     $ 888,957  
 
            
Depreciation expense for the three months ended June 30, 2006 and 2005 was $66,192 and $66,662, respectively. Depreciation expense for the six months ended June 30, 2006 and 2005 was $132,573 and $134,303, respectively.
7. INTANGIBLE ASSETS
Intangible assets consist primarily of acquired customer bases and covenants not to compete and are carried net of accumulated amortization. Upon initial application of SFAS 142 as of January 1, 2002, the Company reassessed useful lives and began amortizing these intangible assets over their estimated useful lives and in direct relation to any decreases in the acquired customer bases to which they relate. Management believes that such amortization reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used.
Amortization expense for the three months ended June 30, 2006 and 2005 relating to intangible assets was $8,641 and $38,136, respectively. Amortization expense for the six months ended June 30, 2006 and 2005 relating to intangible assets was $27,267 and $76,581, respectively.
8. ACCRUED AND OTHER CURRENT LIABILITIES
Accrued and other current liabilities consist of the following:
                 
    June 30, 2006     December 31, 2005  
Accrued interest
   $ 266,122     $ 237,165  
Accrued deferred compensation
     396,912       353,917  
Accrued other liabilities
     113,970       118,917  
 
            
 
   $ 777,004     $ 709,999  
 
            

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9. NOTES PAYABLE
Notes payable consist of the following:
                 
    June 30,     December 31,  
    2006     2005  
Note payable to a bank, payable in monthly installments of $8,768, including interest of 9.5%, maturing September 2008; collateralized by property and equipment, accounts receivable and Company common stock owned by the founder and CEO of the Company; guaranteed by the founder and CEO of the Company; partially guaranteed by the Small Business Administration
   $ 124,317     $ 170,080  
 
                
Interim loan, from a related party, interest at 10%, requires payments equal to 50% of the net proceeds received by the Company from its private placement of convertible promissory notes, matured December 2001; unsecured (1)
     320,000       320,000  
 
                
Convertible promissory notes; interest at 12.5% of face amount, payable quarterly; these notes are unsecured and are matured at June 30, 2006 (convertible into approximately 1,003,659 shares at June 30, 2006 and December 31, 2005) (2)
     510,636       510,636  
 
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