Dot Hill Systems (HILL) 10-Q 2001 Q2 Quarterly report

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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

or

/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to              

Commission file number 1-13317

DOT HILL SYSTEMS CORP.
(Exact name of registrant as specified in its charter)

New York (State or other jurisdiction of incorporation or organization)	13-3460176 (I.R.S. Employer Identification No.)
6305 El Camino Real, Carlsbad,CA (Address of principal executive offices)	92009 (Zip Code)

(760) 931-5500
(Registrant's telephone number, including area code)

(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 / /

    Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

    Common Stock, $.01 par value, 24,721,578 shares outstanding as of August 7, 2001.

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
INDEX

		Page
Part I. Financial Information
Item 1.	Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets — June 30, 2001 and December 31, 2000	1
	Condensed Consolidated Statements of Operations and Comprehensive Operations — Three and six months ended June 30, 2001 and 2000	2
	Condensed Consolidated Statements of Cash Flows — Six months ended June 30, 2001 and 2000	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	19
Part II. Other Information
Item 1.	Legal Proceedings	19
Item 2.	Changes in Securities and Use of Proceeds	19
Item 3.	Defaults Upon Senior Securities	19
Item 4.	Submission of Matters to a Vote of Security Holders	20
Item 5.	Other Information	20
Item 6.	Exhibits and Reports on Form 8-K	20
Signatures		21

Part I.—Financial Information

Item 1. Condensed Consolidated Financial Statements

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share information)

			June 30, 2001			December 31, 2000
			(unaudited)
ASSETS
Current Assets:
	Cash and cash equivalents		$	19,587		$	33,653
	Accounts receivable, net of allowance of $1,400 and $1,593			12,164			19,341
	Inventories, net			20,712			24,109
	Prepaid expenses and other			1,787			1,948
	Deferred income taxes			—			4,067
		Total current assets		54,250			83,118
Property and equipment, net				4,294			4,814
Other assets				104			94
Goodwill, net				396			448
Other intangible assets, net				11			49
Deferred income taxes				—			14,356
		Total assets	$	59,055		$	102,879
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
	Accounts payable		$	9,131		$	17,803
	Accrued compensation			2,346			2,748
	Accrued expenses			1,563			1,858
	Restructuring accrual			2,102			—
	Deferred revenue			2,767			2,866
	Income taxes payable			1,452			3,389
		Total current liabilities		19,361			28,664
Borrowings under line of credit				145			186
Other long-term liabilities				233			259
		Total liabilities		19,739			29,109
Shareholders' Equity:
Preferred stock, $.01 par value, 5,000 shares authorized, none issued				—			—
Common stock, $.01 par value, 40,000 shares authorized, 24,709 and 24,608 shares issued and outstanding				247			246
Additional paid-in capital				99,156			99,026
Accumulated other comprehensive operations				(344	)		(216	)
Accumulated deficit				(59,743	)		(25,286	)
		Total shareholders' equity		39,316			73,770
		Total liabilities and shareholders' equity	$	59,055		$	102,879

The accompanying notes are an integral part of these statements.

–1–

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE OPERATIONS
(unaudited)
(in thousands, except per share information)

		Three Months Ended June 30,						Six Months Ended June 30,
		2001			2000			2001			2000
Net revenue		$	14,898		$	33,443		$	33,483		$	64,296
Cost of goods sold			10,501			21,370			27,325			40,201
Gross margin			4,397			12,073			6,158			24,095
Operating expenses:
Sales and marketing			5,830			7,355			14,400			14,434
Engineering and product development			1,638			1,920			3,568			4,005
General and administrative			1,338			1,602			2,852			3,339
Restructuring expenses			1,470			—			4,405			—
	Total operating expenses		10,276			10,877			25,225			21,778
Operating (loss) income			(5,879	)		1,196			(19,067	)		2,317
Other income (expense):
Interest income			276			574			695			1,070
Interest expense			(17	)		(8	)		(43	)		(24	)
Other income, net			25			242			49			224
Loss on foreign currency transactions, net			(135	)		(88	)		(68	)		(105	)
	Total other income, net		149			720			633			1,165
(Loss) income before income taxes			(5,730	)		1,916			(18,434	)		3,482
Income tax provision			—			747			16,023			1,358
Net (loss) income		$	(5,730	)	$	1,169		$	(34,457	)	$	2,124
Basic and diluted net (loss) income per share		$	(0.23	)	$	0.05		$	(1.40	)	$	0.09
Weighted average shares used to calculate basic net (loss) income per share			24,686			24,169			24,649			24,108
Weighted average shares used to calculate diluted net (loss) income per share			24,686			25,131			24,649			25,093
Comprehensive operations:
Net (loss) income		$	(5,730	)	$	1,169		$	(34,457	)	$	2,124
Foreign currency translation adjustments			(124	)		102			(128	)		65
Comprehensive (loss) income		$	(5,854	)	$	1,271		$	(34,585	)	$	2,189

The accompanying notes are an integral part of these statements.

–2–

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)

					Six Months Ended June 30,
					2001			2000
Cash flows from operating activities:
	Net (loss) income				$	(34,457	)	$	2,124
	Adjustments to reconcile net (loss) income to net cash used in operating activities:
		Depreciation and amortization				773			777
		Deferred income taxes				18,423			—
		Impairment of property and equipment				1,007			—
		Provision for doubtful accounts				(193	)		225
		Changes in operating assets and liabilities:
			Accounts receivable			7,370			(3,415	)
			Inventories			3,397			(6,428	)
			Prepaid expenses and other assets			151			(524	)
			Accounts payable			(8,672	)		(711	)
			Accrued compensation and other expenses			(697	)		(71	)
			Restructuring accrual			2,102			(975	)
			Customer deposits			—			(762	)
			Deferred revenue			(99	)		(318	)
			Income taxes payable			(1,937	)		1,527
			Other liabilities			(26	)		(211	)
				Net cash used in operating activities		(12,858	)		(8,762	)
Cash flows from investing activities:
	Sales of short-term investments					—			3,500
	Purchases of property and equipment					(1,170	)		(741	)
				Net cash (used in) provided by investing activities		(1,170	)		2,759
Cash flows from financing activities:
	Payments on bank and other borrowings					(41	)		(40	)
	Proceeds from exercise of stock options					47			1,005
	Proceeds from sale of stock to employees					84			101
				Net cash provided by financing activities		90			1,066
Effect of exchange rate changes on cash						(128	)		65
Net decrease in cash and cash equivalents						(14,066	)		(4,872	)
Cash and cash equivalents, beginning of period						33,653			44,451
Cash and cash equivalents, end of period					$	19,587		$	39,579
Supplemental cash flow disclosure:
	Cash paid for income taxes				$	7		$	73
	Cash paid for interest				$	2		$	3

The accompanying notes are an integral part of these statements.

–3–

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. Basis of Presentation

    The accompanying unaudited condensed consolidated financial statements have been prepared by Dot Hill Systems Corp. ("Dot Hill" or the "Company") pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments and reclassifications considered necessary for a fair and comparable presentation have been included and are of a normal recurring nature. Certain reclassifications have been made to prior year financial statements to conform with the current year financial statement presentation. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000. Operating results for the six months ended June 30, 2001 are not necessarily indicative of the results that may be expected for the year ending December 31, 2001.

    Certain prior period amounts have been reclassified to conform to the current period presentation.

2.  Recent Accounting Pronouncements

    In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133,Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133, as amended, which was effective for the Company as of January 1, 2001, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The Company does not currently invest in derivative instruments and does not presently engage in nor does it intend to engage in hedging activities. Consequently, the adoption of SFAS No. 133 did not have a material impact on the Company's financials statements as of January 1, 2001.

    In June 2001, the FASB issued SFAS No. 141, "Business Combinations". SFAS No. 141 requires the use of the purchase method of accounting for all business combinations initiated after June 30, 2001 and eliminates the pool-of-interest method. The Company does not believe the adoption of SFAS No. 141 will have a significant impact on its financial statements.

    In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No. 142 requires that goodwill and other intangible assets with indefinite lives no longer be amortized, but instead tested for impairment at least annually. In addition, the standard includes provisions for the reclassification of certain existing intangible as goodwill and reassessment of the useful lives of existing recognized intangibles. SFAS No. 142 is effective for fiscal years beginning after December 31, 2001. The Company has not determined the impact, if any, that this statement will have on its financial statements.

3.  Earnings Per Share

    Basic net (loss) income per share is calculated by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted net (loss) income per share reflects the potential dilution of securities by including other common stock equivalents, such as stock options, in the weighted average number of common shares outstanding for a period, if dilutive.

–4–

    The following table sets forth the reconciliation of the denominator of the net (loss) income per share calculation (in thousands):

	Three Months Ended June 30,		Six Months Ended June 30,
	2001	2000	2001	2000
Shares used in computing basic net (loss) income per share	24,686	24,169	24,649	24,108
Dilutive effect of stock options	—	962	—	985
Shares used in computing diluted net (loss) income per share	24,686	25,131	24,649	25,093

    For the three and six months ended June 30, 2001, options to purchase 2,610,794 shares of the Company's common stock at exercise prices ranging from $.50 to $15.94 per share were outstanding, but were not included in the calculation of diluted net loss per share because their effect was antidilutive.

    For the three months ended June 30, 2000, options to purchase 172,348 shares of the Company's common stock at exercise prices ranging from $9.81 to $15.94 per share were outstanding, but were not included in the calculation of diluted net income per share because the exercise price of the options was greater than the average market price of the common shares. For the six months ended June 30, 2000, options to purchase 162,348 shares of the Company's common stock at exercise prices ranging from $9.94 to $15.94 per share were outstanding, but were not included in the calculation of diluted net income per share because the exercise price of the options was greater than the average market price of the common shares.

4.  Inventories

    Inventories are stated at the lower of cost (first-in, first-out) or market value and consist principally of purchased components used as raw materials. The following is a summary of inventories (in thousands):

	June 30, 2001		December 31, 2000
Purchased parts and materials	$	12,563	$	15,968
Work-in-process		1,031		519
Finished goods		7,118		7,622
	$	20,712	$	24,109

5.  Restructuring

    In March 2001, the Company announced plans to reduce its full-time workforce by up to 30% and reduce other expenses in response to delays in customer orders, lower than expected revenues and slowing market conditions. The cost reduction actions were designed to reduce the Company's breakeven point in light of the current economic downturn. The cost reductions resulted in a charge for employee severance, lease termination costs and other office closure expenses related to the consolidation of excess facilities. As a result of the restructuring, the Company recorded restructuring expenses during the three months ended March 31, 2001 totaling $2.9 million as follows (in thousands):

Employee termination costs		$	1,271
Impairment of property and equipment			1,007
Facility closures and related costs			637
Professional fees			20
	Total	$	2,935

–5–

    Employee termination costs consist primarily of severance payments for 126 employees. Impairment of property and equipment consists of the write down of certain fixed assets associated with the facility closures. The facility closures and related costs consist of lease termination costs for five sales offices and the consolidation of office space in the New York City branch location.

    In June 2001, the Company implemented further cost reductions in response to the continuing economic downturn and overall decrease in revenue. As a result of these additional restructuring actions, the Company recorded restructuring expenses during the three months ended June 30, 2001 totaling $1.5 million as follows (in thousands):

Employee termination costs		$	259
Impairment of property and equipment			350
Facility closures and related costs			861
	Total	$	1,470

    Employee termination costs consist primarily of severance payments for 54 employees. Impairment of property and equipment consists of the write-down of certain fixed assets associated with the facility closures. The facility closures and related costs consist of lease termination costs for four sales offices and the closure of the New York City branch location.

    The following is a summary of the accrued restructuring activity during the six months ended June 30, 2001 (in thousands):

		Restructuring expenses three months ended March 31, 2001		Amounts utilized three months ended March 31, 2001			Accrued restructuring expenses at March 31, 2001		Restructuring expenses three months ended June 30, 2001		Amounts utilized three months ended June 30, 2001			Accrued restructuring expenses at June 30, 2001
Employee termination costs		$	1,271	$	(248	)	$	1,023	$	259	$	(833	)	$	449
Impairment of property and equipment			1,007		(1,007	)		—		350		—			350
Facility closures and related costs			637		—			637		861		(215	)		1,283
Professional fees			20		—			20		—		—			20
	Total	$	2,935	$	(1,255	)	$	1,680	$	1,470	$	(1,048	)	$	2,102

    The Company anticipates that a majority of the remaining accrual at June 30, 2001, which consists of employee, lease and contract termination costs, will be paid in 2001. The Company estimates that approximately $561,000 of accrued lease termination costs will remain outstanding at the end of 2001.

6.  Credit Facilities

    In February 2001, the Company entered into an agreement with a commercial bank (the "Line of Credit"), which provides for borrowings of up to $15 million under a two-year revolving line of credit. Borrowings under the Line of Credit are collateralized by a pledge of the Company's deposits held at the bank. The Line of Credit incurs interest at the bank's prime rate or 50 basis points above LIBOR. Monthly payments consist of interest only, with the principal due at maturity. As of June 30, 2001 no amounts have been borrowed under the Line of Credit.

7.  Income Tax Provision

    In March 2001, the Company recorded a $16.0 million charge in connection with an increase in the valuation allowance provided for the Company's deferred income tax assets.

–6–

8.  Legal Matters

    In January 2001, a final settlement in the class action lawsuit filed against Box Hill Systems Corp., certain of its officers and directors, and the underwriters of the Company's September 16, 1997 initial public offering was approved by the United State District Court for the Southern District of New York, and the action was dismissed with prejudice. No plaintiffs objected to the settlement, no plaintiffs opted-out of the settlement, and the judgment has not been appealed. Therefore, the action has been finalized.

    The Company is subject to various other legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. The outcome of such claims against the Company cannot be predicted with certainty.

9.  Segment and Geographic Information

    Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company's chief operating decision-maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company's chief operating decision-maker is the Chief Executive Officer. The operating segments of the Company are managed separately because each segment represents a strategic business unit that offers different products or services.

    The Company's operating segments are organized on the basis of products and services. The Company has identified operating segments to consist of storage systems including SANnet™; tape backup; and service. The Company also identifies operating segments by market segment, which consists of e-commerce, telecommunications, and Internet, Applications and Storage Service Providers ("xSPs"); government; and commercial and other customers. The Company currently evaluates performance based on stand-alone segment revenue and gross margin. Because the Company does not currently evaluate performance based on segment operating income or return on assets at the operating segment level, Company operating expenses and total assets are not tracked internally by segment. Therefore, such information is not presented.

–7–

    Information concerning revenue by product and service is as follows (in thousands):

			Storage Systems		Tape Backup		Service		Total
Three months ended:
	June 30, 2001:
		Net revenue	$	12,071	$	1,208	$	1,619	$	14,898
		Gross margin		3,326		330		741		4,397
	June 30, 2000:
		Net revenue	$	28,157	$	3,109	$	2,177	$	33,443
		Gross margin		10,148		583		1,342		12,073
Six months ended:
	June 30, 2001:
		Net revenue	$	26,965	$	3,133	$	3,385	$	33,483
		Gross margin		4,515		796		847		6,158
	June 30, 2000:
		Net revenue	$	54,155	$	5,955	$	4,186	$	64,296
		Gross margin		20,676		1,074		2,345		24,095

    Information concerning revenue by market segment is as follows (in thousands):

			E-commerce, telecommunications and xSPs		Government		Commercial and other			Total
Three months ended:
	June 30, 2001:
		Net revenue	$	5,580	$	3,194	$	6,124		$	14,898
		Gross margin		1,508		1,346		1,543			4,397
	June 30, 2000:
		Net revenue	$	10,997	$	5,102	$	17,344		$	33,443
		Gross margin		3,873		2,253		5,947			12,073
Six months ended:
	June 30, 2001:
		Net revenue	$	12,072	$	7,393	$	14,018		$	33,483
		Gross margin (loss)		2,658		3,722		(222	)		6,158
	June 30, 2000:
		Net revenue	$	22,408	$	9,047	$	32,841		$	64,296
		Gross margin		8,292		3,959		11,844			24,095

–8–

    Information concerning principal geographic areas in which the Company operates is as follows (in thousands):

		Three Months Ended June 30,						Six Months Ended June 30,
		2001			2000			2001			2000
Net revenue:
	United States	$	10,992		$	27,428		$	22,913		$	50,252
	Europe		2,769			3,733			8,018			9,203
	Asia/Pacific		1,137			2,282			2,552			4,841
		$	14,898		$	33,443		$	33,483		$	64,296
Operating (loss) income:
	United States	$	(5,642	)	$	(443	)	$	(18,535	)	$	(1,510	)
	Europe		(222	)		1,005			(575	)		2,631
	Asia/Pacific		(15	)		634			43			1,196
		$	(5,879	)	$	1,196		$	(19,067	)	$	2,317

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

Cautionary Statement for Forward-Looking Information

    Certain statements contained in this report, including, but not limited to, statements regarding the development, growth and expansion of the Company's business, the intent, belief or current expectations of the Company, its directors or its officers, primarily with respect to the future operating performance of the Company and the products it expects to offer and other statements contained herein regarding matters that are not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by these sections. Future filings with the SEC, future press releases and future oral or written statements made by or with the approval of the Company, which are not statements of historical fact, may also contain forward-looking statements. Because such statements include risks and uncertainties, many of which are beyond the control of the Company, actual results may differ materially from those expressed or implied by such forward-looking statements.

    Some of the factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements include risks related to the Company's ability to achieve profitability, the global economic downturn and its impact on the Company's business, customer acceptance of the Company's storage products, the Company's ability to provide customers with cost-effective new products on a timely basis, new product introductions by competitors and the highly competitive industry in which the Company operates, the Company's ability to attract and retain talented qualified management and other personnel, the impact of recent restructurings on the Company's ability to grow the business, the Company's ability to raise additional capital on acceptable terms and other risks referred to in the following discussion. However, the Company urges you to read the Company's Annual Report on Form 10-K for the year ended December 31, 2000, particularly the section entitled "Certain Risk Factors Related to the Company's Business," to learn more about the risks and uncertainties that the Company faces.

    Readers are cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and except as required by applicable law, the Company undertakes no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made.

–9–

Overview

    Dot Hill designs, manufactures, markets and supports carrier-class data storage systems for the open systems computing environment. In the United States, the Company employs a direct marketing strategy aimed at data-intensive industries which, to date, include financial services, telecommunications, xSPs, multimedia, healthcare, government/defense and academia. The Company's international strategy is to sell directly to end users in certain regions, and to use distributors in others. The Company focuses on providing storage solutions to high-end customers primarily in the UNIX, Windows, Linux and Novell environments. The Company's strategy is to leverage its expertise as a company focused exclusively on storage solutions.

    On August 2, 1999, Box Hill Systems Corp ("Box Hill") and Artecon, Inc ("Artecon") were merged in a tax-free, stock-for-stock transaction (the "Merger"). The Merger was accounted for as a pooling-of-interests. Subsequent to the Merger, the combined company changed its name to Dot Hill Systems Corp. Under the terms of the Merger agreement, Box Hill issued an aggregate of 8,734,523 shares of its common stock to the former Artecon shareholders, representing 0.4 shares of Box Hill common stock in exchange for each share of Artecon common stock outstanding. Additionally, Artecon's convertible Series "A" preferred shares were converted into an aggregate of 719,037 shares of Box Hill common stock.

    During fiscal 1997, Artecon and Storage Dimensions, Inc. ("SDI") completed a reverse merger accounted for as a purchase of SDI by Artecon, and the surviving company changed its name to Artecon. As such, the historical financial results of Artecon for all years prior to the SDI merger are those of Artecon. Additionally, in August 1997, Artecon acquired substantially all of the assets and liabilities of Falcon Systems, Inc. The acquisition was accounted for as a purchase.

    The Company's manufacturing operations consist primarily of the assembly and integration of components and subassemblies into the Company's products, with certain of those subassemblies manufactured by independent contractors. The Company's manufacturing operations are conducted from its facilities in Carlsbad, California. Generally, the Company extends to its customers the warranties provided to the Company by its suppliers. To date, the Company's suppliers have reimbursed the majority of the Company's warranty costs. On a quarterly and annual basis the Company's gross margins have been and will continue to be affected by a variety of factors, including competition, product configuration, product mix, the availability of new products and product enhancements, and the cost and availability of components.

–10–

Results of Operations

    The following table sets forth certain items from the Company's statements of operations as a percentage of net revenue for the periods indicated:

			Three Months Ended June 30,				Six Months Ended June 30,
			2001		2000		2001		2000
Net revenue			100.0	%	100.0	%	100.0	%	100.0	%
Cost of goods sold			70.5		63.9		81.6		62.5
		Gross profit	29.5		36.1		18.4		37.5
Operating expenses:
	Sales and marketing		39.1		22.0		43.0		22.5
	Engineering and product development		11.0		5.7		10.7		6.2
	General and administrative		9.0		4.8		8.5		5.2
	Restructuring expenses		9.9		—		13.2		—
		Total operating expenses	69.0		32.5		75.4		33.9
	Operating (loss) income		(39.5	)%	3.6	%	(56.9	)%	3.6	%
	Net (loss) income		(38.5	)%	3.5	%	(102.9	)%	3.3	%

Three Months Ended June 30, 2001 Compared to Three Months Ended June 30, 2000

Net revenue

    Net revenues reflect the invoiced amounts of products shipped, less reserves for estimated returns, and revenues from service contracts. Net revenue decreased 55.5% to $14.9 million for the three months ended June 30, 2001 from $33.4 million for the three months ended June 30, 2000.

–11–

The decrease in net revenue was primarily attributable to the global economic downturn and its effect on demand, particularly from telecommunications and other commercial sectors, as well as the Company's strategy to shift away from the Legacy products. During the second quarter of 2001, sales of the Company's storage systems, including the SANnet product line, accounted for approximately 81% of net revenue, tape backup for approximately 8% of net revenue, and service for approximately 11% of net revenue. Sales of the SANnet product line accounted for approximately 52% of net revenue. Sales to xSPs, telecommunications, and e-commerce customers accounted for 37% of net revenue, sales to government customers accounted for 21% of net revenue, and sales to other customers accounted for 42% of net revenue.

Gross margin

    Gross margin decreased 63.6% to $4.4 million for the three months ended June 30, 2001, from $12.1 million for the comparable period of 2000. As a percentage of net revenue, gross margin decreased to 29.5% for the three months ended June 30, 2001, from 36.1% for the comparable period of 2000. The decrease in gross margin as a percentage of net revenue is primarily attributable to the less efficient absorption of fixed manufacturing costs due to the decrease in revenue.

Sales and marketing expenses

    Sales and marketing expenses consist primarily of salaries and commissions, advertising and promotional costs and travel expenses. Sales and marketing expenses decreased 20.7% to $5.8 million for the three months ended June 30, 2001 from $7.4 million for the three months ended June 30, 2000. The decrease in selling and marketing expenses is primarily attributable to reductions in salaries and related expenses as a result of reduction in headcount, and lower commissions as a result of lower revenue. As a percentage of net revenue, sales and marketing expenses increased to 39.1% for the three months ended June 30, 2001 from 22.0% for the comparable period of 2000. The increase in the percentage of net revenue was primarily attributable to the lower sales revenue in the second quarter of 2001.

Engineering and product development expenses

    Engineering and product development expenses consist primarily of prototype expenses and salaries for employees directly engaged in research and development. Engineering and product development expenses decreased 14.7% to $1.6 million for the three months ended June 30, 2001 from $1.9 million for the same period in 2000. The decrease in engineering and product development expenses is primarily attributable to a decrease in prototype and test equipment expenses. As a percentage of net revenue, engineering and product development expenses increased to 11.0% for the three months ended June 30, 2001 from 5.7% for the comparable period of 2000 as a result of lower sales revenue in the second quarter of 2001.

General and administrative expenses

    General and administrative expenses consist primarily of compensation to officers and employees performing the Company's administrative functions and expenditures for administrative facilities. General and administrative expenses decreased to $1.3 million for the three months ended June 30, 2001 from $1.6 million for the three months ended June 30, 2000. The decrease in general and administrative expenses is primarily attributable to a decrease in executive compensation expenses and a decrease in amortization expense for certain intangible assets that were fully amortized as of June 30, 2000. As a percentage of net revenue, general and administrative expenses increased to 9.0% for the three months ended June 30, 2001 from 4.8% for the comparable period of 2000 primarily as a result of lower sales revenue in the second quarter of 2001.

–12–

Restructuring expenses

    See Item 2—"Six Months Ended June 30, 2001 Compared to Six Months Ended June 30, 2000, Restructuring Expenses."

Other income

    Other income is comprised of interest income earned on the Company's cash and cash equivalents, interest expense and other income and expense items. Other income decreased to $149,000 for the three months ended June 30, 2001 from $720,000 for the same period in 2000. The decrease in other income is primarily attributable to two factors: a reduction in interest income earned on cash and cash equivalents as a result of a decrease in the investment portfolio in the three months ended June 30, 2001 compared to the same period in 2000, and $250,000 of other income recorded in the three months ended June 30, 2000 as a result of a settlement reached with a former vendor.

Income tax provision

    The Company did not record a benefit for income taxes for the three months ended June 30, 2001 as a result of a full $16.0 million charge in connection with an increase in the valuation allowance provided for the Company's deferred income tax assets. The Company's effective income tax rate was 39% for the three months ended June 30, 2000, reflecting federal, state and local income taxes, partially offset by permanent items.

Six Months Ended June 30, 2001 Compared to Six Months Ended June 30, 2000

Net revenue

    Net revenues reflect the invoiced amounts of products shipped, less reserves for estimated returns, and revenues from service contracts. Net revenue decreased 48.0% to $33.5 million for the six months ended June 30, 2001 from $64.3 million for the six months ended June 30, 2000. The decrease in net revenue was primarily attributable to a reduction in demand from the telecommunications and other commercial sectors, as well as the Company's strategy to shift away from the Legacy products. During the six months ended June 30, 2001, sales of the Company's storage systems, including the SANnet product line, accounted for approximately 80% of net revenue, tape backup for approximately 10% of net revenue, and service for approximately 10% of net revenue. Sales of the SANnet product line accounted for approximately 51% of net revenue. Sales to xSPs, telecommunications, and e-commerce customers accounted for 36% of net revenue, sales to government customers accounted for 22% of net revenue, and sales to other customers accounted for 42% of net revenue.

Gross margin

    Gross margin decreased 74.4% to $6.2 million for the six months ended June 30, 2001, from $24.1 million for the comparable period of 2000. As a percentage of net revenue, gross margin decreased to 18.4% for the six months ended June 30, 2001, from 37.5% for the comparable period of 2000. The decrease in gross margin as a percentage of net revenue is primarily attributable to the less efficient absorption of fixed manufacturing costs due to the decrease in revenue and a $2.0 million increase in the inventory reserve related to the downturn in market conditions since the start of 2001. Excluding the $2.0 million increase in the inventory reserve for the first half of 2001, gross margin for the six months ended June 30, 2001 was 24.4% of net revenue compared to 37.5% for the comparable period of 2000.

–13–

Sales and marketing expenses

    Sales and marketing expenses consist primarily of salaries and commissions, advertising and promotional costs and travel expenses. Sales and marketing expenses decreased 0.2%, or $34,000, for the six months ended June 30, 2001 compared to the six months ended June 30, 2000. The decrease in selling and marketing expenses is primarily attributable to the decrease in salaries and sales compensation as a result of the restructuring actions taken in the first and second quarters of 2001 offset by higher marketing and advertising expenses in the six months ended June 30, 2001. As a percentage of net revenue, sales and marketing expenses increased to 43.0% for the six months ended June 30, 2001 from 22.5% for the comparable period of 2000. The increase in the percentage of net revenue was primarily attributable to the lower sales revenue in the first six months of 2001.

Engineering and product development expenses

    Engineering and product development expenses consist primarily of prototype expenses and salaries for employees directly engaged in research and development. Engineering and product development expenses decreased 10.9% to $3.6 million for the six months ended June 30, 2001 from $4.0 million for the same period in 2000. The decrease in engineering and product development expenses is primarily attributable to a decrease in prototype and test equipment expenses. As a percentage of net revenue, engineering and product development expenses increased to 10.7% for the six months ended June 30, 2001 from 6.2% for the comparable period of 2000 as a result of lower sales revenue in the first six months of 2001.

General and administrative expenses

    General and administrative expenses consist primarily of compensation to officers and employees performing the Company's administrative functions and expenditures for administrative facilities. General and administrative expenses decreased to $2.9 million for the six months ended June 30, 2001 from $3.3 million for the six months ended June 30, 2000. The decrease in general and administrative expenses is primarily attributable to a decrease in executive compensation expenses and a decrease in amortization expenses for certain intangible assets that were fully amortized as of June 30, 2000. As a percentage of net revenue, general and administrative expenses increased to 8.5% for the six months ended June 30, 2001 from 5.2% for the comparable period of 2000 primarily as a result of lower sales revenue in the first six months of 2001.

Restructuring expenses

    In March 2001, the Company announced plans to reduce its full-time workforce by up to 30% and reduce other expenses in response to delays in customer orders, lower than expected revenues and slowing market conditions. The cost reduction actions were designed to reduce the Company's breakeven point in light of the current economic downturn. The cost reductions resulted in a charge for employee severance, lease termination costs and other office closure expenses related to the consolidation of excess facilities. As a result of the restructuring, the Company recorded restructuring expenses in the first quarter of 2001 totaling $2.9 million as follows (in thousands):

Employee termination costs	$	1,271
Impairment of property and equipment		1,007
Facility closures and related costs		637
Professional fees		20
Total	$	2,935

–14–

    Employee termination costs consist primarily of severance payments for 126 employees. Impairment of property and equipment consists of the write down of certain fixed assets associated with the facility closures. The facility closures and related costs consist of lease termination costs for five sales offices and the consolidation of office space in the New York City branch location.

    In June 2001, the Company implemented further cost reductions in response to the continuing economic downturn and overall decrease in revenue. As a result of these additional restructuring actions, the Company recorded expenses during the three months ended June 30, 2001 totaling $1.5 million as follows (in thousands):

Employee termination costs	$	259
Impairment of property and equipment		350
Facility closures and related costs		861
Total	$	1,470

    Employee termination costs consist primarily of severance payments for 54 employees. Impairment of property and equipment consists of the write-down of certain fixed assets associated with the facility closures. The facility closures and related costs consist of lease termination costs for four sales offices and the closure of the New York City branch location.

    The major components of the charges and the remaining accrual balance as of June 30, 2001 is as follows (in thousands):

	Restructuring expenses three months ended March 31, 2001		Amounts utilized three months ended March 31, 2001			Accrued restructuring expenses at March 31, 2001		Restructuring expenses three months ended June 30, 2001		Amounts utilized three months ended June 30, 2001			Accrued restructuring expenses at June 30, 2001
Employee termination costs	$	1,271	$	(248	)	$	1,023	$	259	$	(833	)	$	449
Impairment of property and equipment		1,007		(1,007	)		—		350		—			350
Facility closures and related costs		637		—			637		861		(215	)		1,283
Professional fees		20		—			20		—		—			20
Total	$	2,935	$	(1,255	)	$	1,680	$	1,470	$	(1,048	)	$	2,102

–15–

Other income

    Other income is comprised of interest income earned on the Company's cash and cash equivalents, interest expense and other income and expense items. Other income decreased to $633,000 for the six months ended June 30, 2001 from $1.2 million for the same period in 2000. The decrease in other income is primarily attributable to a decrease in interest income earned on cash and cash equivalents as a result of a decrease in the investment portfolio and $250,000 of other income recorded in the six months ended June 30, 2000 as a result of a settlement reached with a former vendor.

Income tax provision

    During the six months ended June 30, 2001, the Company recorded a $16.0 million charge in connection with an increase in the valuation allowance provided for the Company's deferred income tax assets. The majority of the Company's deferred income tax assets consist of net operating loss and tax credit carryforwards. The Company's effective income tax rate was 39% for the six months ended June 30, 2000, reflecting federal, state and local income taxes, partially offset by permanent items.

Liquidity and Capital Resources

    As of June 30, 2001, the Company had $19.6 million of cash and cash equivalents compared to $33.7 million at December 31, 2000. As of June 30, 2001, working capital was $34.9 million.

    For the six months ended June 30, 2001, cash used in operating activities was $12.9 million. The use of cash in operating activities was primarily attributable to a loss before incomes taxes of $18.4 million and an $8.7 million decrease in accounts payable. These uses of cash were offset by an $7.4 million decrease in accounts receivable, a $3.4 million decrease in inventories, and a $2.1 million increase in accrued restructuring costs.

    Cash used in investing activities was $1.2 million for the six months ended June 30, 2001 as a result of purchases of property and equipment. Cash provided by financing activities was $90,000 for the six months ended June 30, 2001 as a result of $131,000 received from the exercise of stock options under the Company's Equity Incentive Plan and from purchases under the Company's Employee Stock Purchase Plan.

    The Company's Japanese subsidiary has two lines of credit with a Japanese bank for borrowings of up to an aggregate of 35 million Yen (approximately US $281,000 at June 30, 2001) at interest rates ranging from 1.8% to 2.5%. Interest is due monthly, with principal due and payable on various dates through August 2005. Borrowings are secured by the inventories of the Japanese subsidiary. As of June 30, 2001, the total amount outstanding under the two credit lines was 18 million Yen (approximately US $145,000 at June 30, 2001).

    In February 2001, the Company entered into an agreement with a commercial bank (the "Line of Credit"), which provides for borrowings of up to $15 million under a two-year revolving line of credit. Borrowings under the Line of Credit are collateralized by a pledge of the Company's deposits held at the bank. The Line of Credit incurs interest at the bank's prime rate or 50 basis points above LIBOR. Monthly payments consist of interest only, with the principal due at maturity. As of June 30, 2001, no amounts had been borrowed under the Line of Credit.

    The Company presently expects that cash and cash equivalents, cash generated from operations, and amounts available under the Line of Credit will be sufficient to meet its operating and capital requirements for at least the next twelve months. However, the Company may need additional capital to pursue acquisitions or significant capital improvements, neither of which is currently contemplated. The actual amount and timing of working capital and capital expenditures that the Company may incur in future periods may vary significantly and will depend upon numerous factors, including the amount and timing of the receipt of revenues from continued operations, the increase in manufacturing capabilities, the timing and extent of the introduction of new products and services, and growth in personnel and operations.

–16–

    Competitive pricing pressures exist in the data storage market, and have had, and may in the future have, an adverse effect on the Company's revenues and earnings. The Company believes that pricing pressures are likely to continue as competitors of the Company develop more competitive product offerings and as larger all-purpose computer vendors continue to focus on their storage offerings.

    Many of the Company's current and potential competitors are significantly larger than the Company and have significantly greater financial, technical, marketing, purchasing, and other resources than the Company, and, as a result, may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or devote greater resources to the development, promotion and sale of products than the Company, or to deliver competitive products at lower end-user prices. The Company also expects that competition will increase as a result of industry consolidations. Current and potential competitors have established and may in the future establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the Company's prospective customers. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share, any of which could have a material adverse effect on the Company's business, operating results and financial condition.

    The open systems storage market in which the Company operates is characterized by rapid technological change, frequent new product introductions, increasing competition and evolving industry standards. Customer preferences in that market are difficult to predict. The introduction of products embodying new technologies and the emergence of new industry standards could render the Company's existing products, as well as its new products, including SANnet, SANpath™ and SANscape™, obsolete. The Company is encouraging customers to move from Legacy products to its new products, which could delay orders, result in unknown or unforeseen defects or bugs, make it difficult to predict future financial performance and generally disturb current customers. Also, a number of mergers and acquisitions have taken place among open systems storage companies recently, and that type of activity may continue. Such corporate transactions may quickly and unpredictably alter the market, including the competitive landscape and the availability of key components and third party products. Such constant changes make accurate market predictions difficult. In the past, the Company's revenue and earnings results have fallen short of market projections; and such shortfalls could occur again in the future.

    The Company generally does not enter into long-term contracts with its customers and sales cycles can be lengthy, particularly since the introduction of the Company's SANnet product line. Customers generally have certain rights to delay or cancel orders, which could materially and adversely affect Dot Hill's operating results. Recently, the U.S. economy has experienced a drastic and swift downturn. Important customers of the Company have experienced budget freezes and disruptive workforce reductions. This also has resulted in a lengthening of sales cycles and the delay of orders. It is not known when the downturn in the economy will reverse or when the Company's customers will return to more predictable ordering patterns. Until such time, the Company's business, operating results and financial condition will continue to be materially and adversely effected.

    The Company relies on other companies to supply components for its products and certain products that it resells, which are available only from limited sources in the quantities and quality demanded by the Company. The loss of one or more suppliers could adversely affect Dot Hill's ability to manufacture and sell products. The Company has historically targeted industries requiring high-end storage products, and a material portion of the Company's net revenue to date has been derived from sales to xSPs and customers in the financial services and telecommunications industries. Historically, a majority of the Company's net revenue in each year has been derived from a limited number of customers, many of whom have been adversely effected by the recent downturn in the economy.

–17–

The Company's international business activities represented approximately 20% of net revenues in 2000, and the Company currently has sales offices in Japan, France, England, Germany, Israel and the Netherlands. These international operations are subject to a variety of risks associated with conducting business internationally.

    The Company's future operating results depend in part upon its ability to attract, train, retain and motivate qualified management, technical, manufacturing, sales and support personnel for its operations, which may be difficult due to the Company's recent workforce reduction.

    At this time, the Company has no significant patent protection for its products and has attempted to protect its proprietary software and other intellectual property rights through copyrights, trade secrets and other measures, which measures may prove to be inadequate. Further, the patents of others may affect the Company's ability to do business. The Company expects that providers of storage will increasingly be subject to infringement claims as the number of products and competitors grow. Although Dot Hill believes that its products and trade designations do not infringe on the proprietary rights of third parties, there can be no assurance that third parties will not assert infringement claims against the Company in the future. From time to time, the Company receives letters from patent owners that indicate a possible infringement and request to explore a licensing relationship. In 1999, the Company received two such letters, one of which is being actively pursued by the sender. If such inquiries result in the lodging of formal claims, the Company will evaluate such claims as they relate to its products and, if appropriate, may seek licenses to use the protected technology. There can be no assurance that the Company will be able to obtain licenses to use such technology or that licenses could be obtained on terms that would not have a material adverse effect on the Company. If the Company or its suppliers are unable to license protected technology, the Company could be prohibited from marketing products that incorporate such technology. The Company could also incur substantial costs to redesign its products or to defend any legal action taken against it. Should the Company's products be found to infringe protected technology, Dot Hill could be required to pay damages to the infringed party or be enjoined from manufacturing and selling such products.

    For a more detailed list of some of the risks and uncertainties related to the Company's business and industry, please see the Company's Annual Report on Form 10-K for the year ended December 31, 2000.

    In the course of business, the Company is subject to legal proceedings and claims, both asserted or unasserted. See "Part II—Item 1. Legal Proceedings."

Subsequent Event

    The Company has received notification from the New York Stock Exchange that from mid-June into July of 2001, the Company failed to meet a NYSE continued listing requirement that both the Company's average global market capitalization and total shareholder equity must not fall below $50 million for more than 30 consecutive trading days. Although as of the date of this Quarterly Report on Form 10-Q, the Company is in compliance with the NYSE's continued listing standards and its global market capitalization is now above $50 million, the Company is taking steps to comply with all the NYSE procedural requirements. Under the rules of the NYSE, Dot Hill must submit a response to the NYSE's Listings and Compliance Committee describing how it will remain in compliance with the NYSE continued listing requirements. If the NYSE does not approve the response, formal delisting procedures may begin. Should that occur, the Company would have the opportunity to appeal the decision to a Committee of the Board of Directors of the NYSE.

The Euro Conversion

    On January 1, 1999, eleven of the fifteen member countries of the European Union established fixed conversion rates between their existing sovereign currencies and the euro. These countries agreed

–18–

to adopt the euro as their common legal currency on that date. The euro now trades on currency exchanges and is available for non-cash transactions. These countries issue sovereign debt exclusively in euro and re-denominate outstanding sovereign debt. Effective on this date, these countries no longer control their own monetary policies by directing independent interest rates for the legacy currencies. Instead, the authority to direct monetary policy, including money supply and official interest rates for the euro, is exercised by the new European Central Bank.

    Following introduction of the euro, the legacy currencies will remain legal tender in these countries as denominations of the euro between January 1, 1999 and January 1, 2002 (the "transition period"). During the transition period, public and private parties may pay for goods and services using either the euro or the country's legacy currency on a "no compulsion, no prohibition" basis. However, conversion rates no longer are computed directly from one legacy currency to another. Instead a "triangulation" process is applied whereby an amount denominated in one legacy currency first is converted into an amount denominated in euro, and the resultant euro-denominated amount is converted into the second legacy currency.

    Three countries that have converted to the euro, the Netherlands, France, and Germany, generated revenue of approximately $1.0 million, $74,000 and $1.2 million, respectively, or 6.8% of Dot Hill's net revenue, for the six months ended June 30, 2001. Based on this percentage of net revenue generated from these countries, Dot Hill does not anticipate that the conversion of the euro will have a significant impact on its financial condition or results of operations. The Company is continuing to evaluate the impact that the euro conversion will have on its financial condition and results of operations.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

    There have been no significant changes to the quantitative and qualitative information disclosed in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. However, the average interest rate earned on the Company's cash equivalents during the six months ended June 30, 2001 did not change from a rate of 4.2% for the year 2000.

Part II—Other Information

Item 1. Legal Proceedings

    In January 2001, a final settlement in the class action lawsuit filed again Box Hill Systems Corp., certain of its officers and directors, and the underwriters of the Company's September, 16, 1997 initial public offering was approved by the United State District Court for the Southern District of New York, and the action was dismissed with prejudice. No plaintiffs objected to the settlement, no plaintiffs opted-out of the settlement, and the judgment has not been appealed. Therefore, the action has been finalized.

    The Company is subject to various other legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. The outcome of such claims against the Company cannot be predicted with certainty.

Item 2. Changes in Securities and Use of Proceeds

    None.

Item 3. Defaults upon Senior Securities

    None.

–19–

Item 4. Submission of Matters to a Vote of Security Holders

    The Annual Meeting of Shareholders of Dot Hill Systems Corp. was held on May 18, 2001 (the "Annual Meeting"). Dot Hill had 24,619,032 shares of common stock outstanding as of April 2, 2001, the record date for the Annual Meeting. At the Annual Meeting, holders of 24,102,275 shares of common stock were present in person or by proxy.

    At the Annual Meeting, the following proposals, all as more fully described in the Proxy Statement relating to such meeting, were approved: (1) a proposal to elect three directors to hold office until the 2004 Annual Meeting of Shareholders; (2) a proposal to amend the Company's Amended and Restated Certificate of Incorporation to increase the number of shares of common stock authorized for issuance from 40,000,000 to 100,000,000 shares and the number of shares of preferred stock authorized for issuance from 5,000,000 to 10,000,000 shares; (3) a proposal to approve the change in the Company's state of incorporation from New York to Delaware; (4) a proposal to ratify the selection of Deloitte and Touche LLP as independent auditors of the Company for its fiscal year ending December 31, 2001.

    The following sets forth information regarding the results of the voting at the Annual Meeting:

	FOR	AGAINST	ABSTAIN
Proposal 1: Election of Benjamin Brussell, Dr. Benjamin Monderer, Eng. Sc.D, and Chong Sup Park as Directors	23,787,196	315,079	—
Proposal 2: Approval of Increase in Number of Authorized Shares of Capital Stock	17,093,192	1,049,882	35,941
Proposal 3: Approval of a change in the Company's state of incorporation from New York to Delaware	17,345,070	813,526	20,419
Proposal 4: To ratify the selection of Deloitte & Touche LPP as independent auditors of the Company for its fiscal year ending December 31, 2001.	23,978,138	99,532	24,605

Item 5. Other information

    None.

Item 6. Exhibits and reports on Form 8-K

(a)

Exhibits

10.1 Promissory Note dated June 21, 2001 between the Registrant and Dana Kammersgard.

(b)

Reports on Form 8-K

    None.

–20–

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.

Date: August 14, 2001	By:	/s/ JAMES L. LAMBERT   James L. Lambert Chief Executive Officer (Principal Executive Officer)
Date: August 14, 2001	By:	/s/ PRESTON ROMM   Preston Romm Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

–21–

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