UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 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 000-29175
AVANEX CORPORATION
(Exact name of Registrant as Specified in its Charter)
| Delaware | 94-3285348 |
| (State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification Number) |
40919 Encyclopedia Circle
Fremont, California 94538
(Address of Principal Executive Offices including Zip Code)
(510) 897-4188
(Registrant's Telephone Number, Including Area Code)
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 [ ]
There were 69,342,946 shares of the Company's Common Stock, par value $.001 per share, outstanding on February 5, 2002.
AVANEX CORPORATION
FORM 10-Q
TABLE OF CONTENTS
| PART I. FINANCIAL INFORMATION | Page No. |
| | |
| Item 1. Financial Statements (unaudited): | |
| | |
| Condensed Consolidated Balance Sheets as of December 31, 2001 and June 30, 2001 | 3 |
| | |
Condensed Consolidated Statements of Operations for the
Three and Six Months Ended December 31, 2001 and 2000 | 4 |
| | |
Condensed Consolidated Statements of Cash Flows
for the Six Months Ended December 31, 2001 and 2000 | 5 |
| | |
| Notes to Condensed Consolidated Financial Statements | 6 |
| | |
| Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations | 9 |
| | |
| Item 3. Quantitative and Qualitative Disclosures About Market Risk | 25 |
| | |
| PART II. OTHER INFORMATION | |
| | |
| Item 1: Legal Proceedings | 25 |
| | |
| Item 2. Changes in Securities and Use of Proceeds | 26 |
| | |
| Item 4. Submission of Matters to a Vote of Security Holders | 26 |
| | |
| Item 6. Exhibits and Reports on Form 8-K | 27 |
| | |
| Signatures | 27 |
Part I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AVANEX CORPORATION
Condensed Consolidated Balance Sheets (In thousands)
December 31, June 30,
2001 2001
------------ ------------
(unaudited) (note 1)
ASSETS
Current assets:
Cash and cash equivalents........................... $ 63,788 $ 79,313
Short-term investments.............................. 96,939 125,278
Accounts receivable, net............................ 3,230 13,977
Inventories......................................... 3,723 6,451
Other current assets................................ 948 877
------------ ------------
Total current assets.............................. 168,628 225,896
Long-term investments................................. 41,354 16,462
Property and equipment, net........................... 23,117 25,864
Intangibles, net...................................... 44,562 42,724
Other assets.......................................... 626 643
------------ ------------
Total assets.................................. $ 278,287 $ 311,589
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Short-term borrowings............................... $ 6,756 $ 6,488
Accounts payable.................................... 5,606 13,506
Accrued compensation and related expenses........... 3,541 4,756
Current portion of accrued restructuring............ 3,678 7,333
Other accrued expenses.............................. 2,508 6,563
Warranty............................................ 4,266 5,589
Deferred revenue.................................... 16 1,948
Current portion of long-term obligations ........... 5,622 5,060
------------ ------------
Total current liabilities......................... 31,993 51,243
Long-term obligations................................. 10,257 12,527
Accrued restructuring................................. 2,013 2,465
------------ ------------
Total liabilities................................ 44,263 66,235
Commitments and contingencies
Stockholders' equity:
Common stock........................................ 69 65
Additional paid-in capital.......................... 499,708 489,204
Notes receivable from stockholders.................. (1,316) (2,048)
Deferred compensation............................... (15,601) (32,818)
Accumulated deficit................................. (248,836) (209,049)
------------ ------------
Total stockholders' equity........................ 234,024 245,354
------------ ------------
Total liabilities and stockholders' equity.... $ 278,287 $ 311,589
============ ============
See accompanying notes.
AVANEX CORPORATION
Condensed Consolidated Statements of Operations
(In thousands, except per share data)
(Unaudited)
Three Months Ended Six Months Ended
December 31, December 31,
-------------------------- --------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
Net revenue................................... $ 8,297 $ 47,948 15,475 $ 82,715
Cost of revenue............................... 4,961 25,305 14,432 44,560
------------ ------------ ------------ ------------
Gross profit ................................. 3,336 22,643 1,043 38,155
Operating expenses:
Research and development.................... 5,950 10,703 11,732 18,868
Sales and marketing......................... 1,562 4,758 3,031 8,723
General and administrative.................. 1,705 3,809 3,509 6,715
Stock compensation.......................... 6,191 12,791 15,130 33,932
Acquired in-process research and development 5,445 -- 5,445 4,700
Amortization of intangibles................. 2,619 2,619 5,238 4,417
Restructuring charge (recovery)............. (120) -- (451) --
------------ ------------ ------------ ------------
Total operating expenses.................. 23,352 34,680 43,634 77,355
------------ ------------ ------------ ------------
Loss from operations.......................... (20,016) (12,037) (42,591) (39,200)
Other income, net............................. 1,197 3,509 2,804 6,924
------------ ------------ ------------ ------------
Loss before income taxes...................... (18,819) (8,528) (39,787) (32,276)
Income taxes ................................. -- 2,754 -- 4,310
------------ ------------ ------------ ------------
Net loss...................................... $ (18,819) $ (11,282) $ (39,787) $ (36,586)
============ ============ ============ ============
Basic and diluted net loss
per common share............................ $ (0.29) $ (0.20) $ (0.64) $ (0.65)
============ ============ ============ ============
Weighted-average number of shares
used in computing basic
and diluted net loss per
common share................................ 63,797 56,914 62,528 55,991
============ ============ ============ ============
See accompanying notes.
AVANEX CORPORATION
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
Six Months Ended
December 31,
--------------------------
2001 2000
------------ ------------
OPERATING ACTIVITIES
Net loss................................................... $ (39,787) $ (36,586)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization............................ 5,020 4,971
Amortization of intangibles.............................. 5,238 4,417
Stock compensation....................................... 15,130 33,932
Acquired in-process research and development............. 5,445 4,700
Provision for excess inventory........................... 2,915 --
Changes in operating assets and liabilities:
Accounts receivable.................................... 10,752 (14,387)
Inventories............................................ (187) (12,088)
Other current assets................................... (105) (790)
Other assets........................................... (70) 1,075
Accounts payable....................................... (8,071) 9,673
Accrued compensation and related expenses.............. (1,245) 2,478
Accrued restructuring.................................. (3,907) --
Warranty............................................... (1,323) 2,465
Other accrued expenses and deferred revenue............ (6,842) 10,151
------------ ------------
Net cash provided by (used in) operating activities.. (17,037) 10,011
------------ ------------
INVESTING ACTIVITIES
Purchases of held-to-maturity securities................... (108,650) --
Maturities of held-to-maturity securities.................. 112,264 6,959
Acquisitions, net of cash assumed.......................... 234 (3,077)
Purchases of property and equipment........................ (1,363) (18,706)
------------ ------------
Net cash provided by (used in) investing activities.. 2,485 (14,824)
------------ ------------
FINANCING ACTIVITIES
Payments on long-term debt and capital lease obligations... (6,569) (2,262)
Payments on debt assumed in the acquisition................ -- (1,607)
Proceeds from short-term borrowings and long-term debt..... 4,057 --
Net proceeds from issuance of common stock................. 998 1,110
Repurchase of common stock................................. (191) --
Proceeds from payments of stockholders' notes receivable... 732 940
------------ ------------
Net cash used in financing activities................ (973) (1,819)
------------ ------------
Net decrease in cash and cash equivalents.................. (15,525) (6,632)
Cash and cash equivalents at beginning of period........... 79,313 90,964
------------ ------------
Cash and cash equivalents at end of period................. $ 63,788 $ 84,332
============ ============
SUPPLEMENTAL DISCLOSURES OF NONCASH TRANSACTIONS
Equipment acquired under capital leases.................... $ -- $ 6,824
============ ============
Conversion of preferred stock to common stock ............. $ -- $ --
============ ============
Common stock issued for notes receivable................... $ -- $ --
============ ============
Stock accretion............................................ $ -- $ --
============ ============
Warrants issued in connection with securing a line
of credit................................................ $ -- $ --
============ ============
See accompanying notes.
AVANEX CORPORATION
Notes To Condensed Consolidated Financial Statements
(unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements as of December 31, 2001, and for the three and six months ended December 31, 2001 and 2000 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial statements and pursuant to the rules and regulations of the Securities and Exchange Commission, and include the accounts of Avanex Corporation and its wholly-owned subsidiaries (collectively "Avanex" or the "Company"). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the consolidated financial position at December 31, 2001, the consolidated operating results for the three and six months ended December 31, 2001 and 2000, and the consolidated cash flows for the six months ended December 31, 2001 and 2000. These unaudited condensed consolidated financial statements should be read in conjunction with the Company's audited financial statements and notes for the year ended June 30, 2001.
The consolidated results of operations for the three and six months ended December 31, 2001 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending June 30, 2002. The balance sheet at June 30, 2001 has been derived from the audited consolidated financial statements at that date, but does not include the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The Company maintains its financial records on the basis of a fiscal year ending on June 30, with fiscal quarters ending on the Friday closest to the end of the period (thirteen-week periods). For ease of reference, all references to period end dates have been presented as though the period ended on the last day of the calendar month. The second quarter of fiscal 2002 and 2001 ended on December 28, 2001 and December 29, 2000, respectively.
2. Inventories
Inventories are stated at the lower of cost (determined on a first-in, first-out basis) or market. Inventories consisted of (in thousands):
December 31, June 30,
2001 2001
------------ ------------
Raw materials................................ $ 1,043 $ 1,963
Work-in-process.............................. 2,159 2,492
Finished goods............................... 521 1,996
------------ ------------
$ 3,723 $ 6,451
============ ============
Additionally, during the third and fourth quarters of fiscal 2001, there was a sudden and significant decrease in forecasted revenues. As a result, the Company reviewed items on hand to identify quantities in excess of those require to meet the Company 6-month demand forecast. Based on that review, we identified and charged to cost of revenue excess inventories of $34.7 million, including non-cancelable purchase obligations, at June 30, 2001 and $2.9 million as of the quarter ended September 30, 2001.
In the six-month ended December 31, 2001, the Company unexpectedly utilized and sold inventory previously written-off totaling $1.3 million. As a result, cost of revenue associated with this revenue was zero. In addition, the cost of revenue for the quarter ended December 31, 2001 was reduced by a $0.6 million favorable settlement of non-cancelable purchase obligations as well as a $1.3 million reduction of warranty accrual. The later was reduced to align the balance with the Company current estimated related future costs.
3. Restructuring Charge/(Recovery)
During the fourth quarter of fiscal 2001, the Company announced a restructuring program to downsize its organizational structure, primarily in manufacturing and administration functions in Fremont, California facilities. Doing so realigned resources with the current business outlook and lowered the Company's cost structure. As a result of the restructuring program, the Company recorded a restructuring charge of $22.6 million in the fourth quarter of fiscal 2001. A summary of the activities in the restructuring liability is as follows (in thousands):
Accrued Adjustments Accrued
Restructuring to Accrued Restructuring
Charge at Restructuring (Cash Payments)/ Charge at
June 30, 2001 Charge Cash Receipts December 31, 2001
-------------- ------------- -------------- ---------------
Workforce reduction...................... $ 2,514 $ (15) $ (2,475) $ 24
Abandonment of excess equipment.......... -- (436) 436 --
Abandonment of excess leased facilities.. 4,009 -- (1,226) 2,783
Capital leases........................... 3,275 -- (391) 2,884
-------------- ------------- -------------- -----------------
Total ............................... 9,798 (451) (3,656) 5,691
Less current portion .................... 7,333 ============== ============== 3,678
-------------- -----------------
Long-term portion ....................... $ 2,465 $ 2,013
============== =================
Remaining cash expenditures related to workforce reduction will be completed in the third quarter of fiscal 2002. Amounts related to the abandonment of excess leased facilities will be paid as the payments are due in fiscal 2002. Capital leases payments are due over the leases terms through third quarter of fiscal 2005.
4. Net Loss per Common Share
The following table presents the calculation of basic and diluted net loss per common share (in thousands, except per share data):
Three Months Ended Six Months Ended
December 31, December 31,
-------------------------- --------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
Net loss...................................... $ (18,819) $ (11,282) (39,787) $ (36,586)
============ ============ ============ ============
Basic and diluted:
Weighted-average number of shares of common
stock outstanding........................ 67,597 65,209 66,734 64,982
Less: weighted-average number of shares
subject to repurchase.................... (3,800) (8,295) (4,206) (8,991)
------------ ------------ ------------ ------------
Weighted-average number of shares used in
computing basic and diluted
net loss per common share................... 63,797 56,914 62,528 55,991
============ ============ ============ ============
Basic and diluted net loss
per common share............................ $ (0.29) $ (0.20) (0.64) $ (0.65)
============ ============ ============ ============
5. Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141 ("SFAS 141") "Business Combinations" and Statement of Financial Accounting Standard No. 142 ("SFAS 142") "Goodwill and Other Intangible Assets". SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment-only method. Thus, amortization of goodwill, including amortization of goodwill recorded in past business combinations, will cease upon the adoption of this Standard, which for the Company will be July 1, 2002. However, for any acquisition completed after June 30, 2001, goodwill and intangibles with identified lives will not be amortized. The Company is currently evaluating the impact of the provisions of SFAS 141 and SFAS 142 with respect to the acquisition of Holographix. Amortization of Intangibles for the three months ended December 31, 2001 and 2000, and for the six months ended December 31, 2001 and 2000 amounted to $2,619,000, $2,619,000, $5,238,000, and $4,417,000, respectively. The acquisition of LambdaFlex was accounted for using the guidance of SFAS 141 and SFAS 142 (see Note 6).
In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). This statement addresses financial accounting and reporting for the impairment of disposal of long- lived assets. SFAS 144 supersedes Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", and provides guidance on classification and accounting for such assets when held for sale or abandonment. SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company does not expect that adoption of SFAS 144 will have a material effect on its financial position or results of operations.
6. Acquisition of LambdaFlex, Inc.
On November 19, 2001, the Company acquired LambdaFlex Inc., ("LambdaFlex"), a start-up Company that is developing intelligent optical modules for increased network flexibility. The transaction was accounted for as a purchase and accordingly, the accompanying financial statements include the results of operations of LambdaFlex subsequent to the acquisition date. The total purchase price of approximately $13 million included consideration of 2,750,318 shares of Avanex common stock, the issuance of options to purchase an aggregate of 106,801 shares of Avanex common stock in exchange for options to purchase LambdaFlex common stock and estimated direct transaction costs.
The total estimated purchase cost of LambdaFlex is as follows (in thousands):
Value of securities issued .............. $ 11,936
Assumption of LambdaFlex options ........ 429
--------
12,365
Estimated transaction costs and expenses. 600
--------
$ 12,965
========
The preliminary purchase price allocation is as follows (in thousands):
Amount
----------
Tangible net assets (liabilities).............. $ (46)
Intangible assets acquired:
In-process research and development........ 5,445
Deferred compensation ..................... 577
Goodwill................................... 6,989
----------
Total estimated purchase price allocation...... $ 12,965
==========
The purchase price allocation for LambdaFlex acquisition is preliminary. The Company will finalize the purchase price allocation subsequent to the receipt of the final independent appraisal and validation of its result by the Company. Tangible net assets acquired included cash, short-term investments, accounts receivable, and property and equipment. Liabilities assumed principally include accounts payable, deferred wages, and accrued expenses.
A portion of the purchase price has been allocated to in- process research and development ("IPR&D"). IPR&D was identified and valued through extensive interviews, analysis of data provided by LambdaFlex concerning developmental products, their stage of development, the time and resources needed to complete them, their expected income generating ability, target markets and associated risks. The income approach, which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing IPR&D.
The acquisition provided several benefits to the Company; first, LambdaFlex was developing certain technology that the Company believed could be leveraged across many other products in its portfolio, with technology that is thought to be industry leading in a market that is in its infancy. Second, the acquisition of LambdaFlex increases the potential to capitalize on opportunities in the market for next generation long haul and ultra long haul amplifiers and "intelligent" metro optical add-drop nodes. Third, the Company believed it was gaining a critical time-to-market advantage over its potential competitors in this market. Lastly, the Company believed there were synergies for LambdaFlex as part of the Company, including leveraging its know-how in the area of diffractive gratings, a key component of the DGFF product.
In valuing the IPR&D, the Company considered, among other factors, the importance of each project to the overall development plan, projected incremental cash flows from the projects when completed and any associated risks. The projected incremental cash flows were discounted back to their present value using a discount rate of 30%. The discount rate was determined after consideration of the Company's weighted average cost of capital and the weighted average return on assets. Associated risks include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets.
Deferred compensation is recognized for the intrinsic value of the unvested Avanex's options granted to LambdaFlex employees. The amount of approximately $577,000 of deferred compensation will be amortized over the remaining vesting period, of approximately 3 years.
Goodwill, which represents the excess of the purchase price of an investment in an acquired business over the fair value of the underlying net identifiable assets and deferred compensation, will not be amortized, based on the recently issued accounting pronouncements SFAS 141 and SFAS 142. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment-only method. The Company will be using an impairment-only method to evaluate the LambdaFlex goodwill in the future.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This quarterly report contains certain forward-looking statements (as such term is defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) and information relating to the Company that are based on the beliefs of the management of the Company as well as assumptions made by and information currently available to the management of the Company. For example, the following statements are forward-looking (i) our future product mix and future operating costs, and (ii) other statements that are not based on historical facts, which can be identified by the use of such words as "likely," "will," "suggests," "target," "may," "would," "could," "anticipate," "believe," "estimate," "expect," "intend," "plan," "predict," and similar expressions and their variants. Such statements reflect the judgment of the Company as of the date of this quarterly report and they involve many risks and uncertainties, such as those described below and those contained in "Risk Factors". These factors could cause actual results to differ materially from those predicted in any forward-looking statements and they include any accounting adjustments made during the close of the Company's quarter, general economic conditions, the pace of spending and the timing of economic recovery in the telecommunications industry (particularly the optical networks industry), the Company's inability to sufficiently anticipate market needs and develop products and product enhancements that achieve market acceptance, higher than anticipated expenses the Company may incur, or the inability to identify expenses which can be eliminated. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward-looking statements. The Company undertakes no obligation to update forward-looking statements.
The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 in this quarterly report and our audited consolidated financial statements and notes for the year ended June 30, 2001, included in our Form 10-K filed with SEC on September 17, 2001.
Overview
We design, manufacture and market fiber optic-based products, known as photonic processors, which are designed to increase the performance of optical networks. We sell our products to communication service providers and optical system manufacturers. We were founded in October 1997, and began making volume shipments of our products during the quarter ended September 30, 1999.
The market for photonic processors is new and evolving and the volume and timing of orders are difficult to predict. A customer's decision to purchase our products typically involves a commitment of its resources and a lengthy evaluation and product qualification process. This initial evaluation and product qualification process typically takes several months and includes technical evaluation, integration, testing, planning and implementation into the equipment design. Long sales and implementation cycles for our products, as well as the practice of customers in the communications industry to sporadically place large orders with short lead times, may cause our revenues, gross margins and operating results to vary significantly and unexpectedly from quarter to quarter.
We, like many of our peers in the communications equipment industry, have been affected by the downturn in telecommunications equipment spending. Our revenues decreased from $18.2 million in the quarter ended June 30, 2001 to $7.2 million in the quarter ended September 30, 2001 and slightly increased to $8.3 million in the quarter ended December 31, 2001. Due to the continued weakness in the general economy, and the telecom sector in particular, revenue in fiscal 2002 will be significantly less than fiscal 2001, putting downward pressure on margins and profits. During the fourth quarter of fiscal 2001, we implemented cost containment plans to reduce our operating spending and these cost cutting strategies have reduced our operating expenses, excluding charges for amortization of deferred stock compensation, excess inventory, restructuring activities, acquired in-process research and development and amortization of intangible assets, by almost 30% in the first and second quarter of fiscal 2002 from the fourth quarter of fiscal 2001.
Our operating results may fluctuate significantly from quarter to quarter due to several factors. Our expense levels are based in part on our management's expectations of future revenues. Although management has and will continue to take measures to adjust expense levels, if revenue levels in a particular period fluctuate, operating results may be affected adversely.
Results of Operations
Net Revenue
Net revenue for the quarter ended December 31, 2001 was $8.3 million, compared to $47.9 million for the quarter ended December 31, 2000. In the quarter ended December 31, 2001, we had two customers that each accounted for greater than 10% of net revenue, compared to three customers that each accounted for greater than 10% of net revenue in the quarter ended December 31, 2000. Net revenue for the six-month period ended December 31, 2001 was $15.5 million, compared with $82.7 million for the six-month period ended December 31, 2000. The decrease in net revenue was primarily due to the substantial decrease of shipments to customers, including WorldCom, reflecting reduced capital spending by telecommunication carriers and other telecommunication suppliers.
We currently derive our revenue primarily from the sale of our PowerFilter, PowerMux and PowerExchanger, which accounted for 89.1% of our total net revenue in the quarter ended December 31, 2001. To date, we have generated a substantial portion of our revenue from a limited number of customers. While we are seeking to diversify our customer base, we anticipate that our operating results for any given period will continue to depend on a small number of customers.
Cost of Revenue
Cost of revenue for the quarter ended December 31, 2001 was $5 million, compared to $25.3 million for the quarter ended December 31, 2000. Cost of revenue for the quarter ended December 31, 2001 was reduced by: 1) the unexpected utilization and sale of $1.3 million of inventory previously written-off, 2) the $0.6 million favorable settlement of non-cancelable purchase obligations, and 3) $1.3 million reduction of the warranty accrual. The later was reduced to align the balance with our current estimate of related costs.
During the second half of the year, certain customers may order products which may include components and parts previously written-off. While there is no assurance this will occur, we do not expect the effect to differ significantly from those of the first half of the year.
In addition, we are continuing negotiations with certain suppliers to further reduce our remaining $4.4 million non-cancelable purchase obligations. The results of these negotiations if any, will be recorded in the period in which they are ultimately settled.
Cost of revenue for the six-month period ended December 31, 2001 was $14.4 million, comparedto $44.6 million for the same six-month period ended December 31, 2000. The decrease in cost of revenue was primarily due to the decease in revenue. Cost of revenue for the six- months ended December 31, 2001 was reduced by: 1) the unexpected utilization and sale of $1.3 million of inventory previously written-off, 2) the $0.6 million favorable settlement of non-cancelable purchase obligations, and 3) $1.3 million reduction of the warranty accrual. The later was reduced to align the balance with our current estimate of related costs. Our gross profit percentage decreased from 47% for the quarter ended December 31, 2000 to 40% for the quarter ended December 31, 2001. The decrease in gross profit percentage was primarily due to the decrease in the average selling price of some of our products, and manufacturing inefficiencies resulting from declining revenue. Our gross profits are and will be primarily affected by changes in manufacturing volume, mix of products sold, changes in our pricing policies and those of our competitors, and mix of sales channels through which our products are sold. We expect cost of revenue, as a percentage of net revenue, to fluctuate from period to period.
Our ability to achieve improvement in our gross margins is particularly dependent upon (1) substantially increasing revenues which improves manufacturing efficiencies and (2) reducing our manufacturing costs through increased use of third party contractors and establishing offshore manufacturing facilities in lower cost localities.
Research and Development
Research and development expenses decreased $4.7 million from $10.7 million for the quarter ended December 31, 2000 to $6.0 million for the quarter ended December 31, 2001, and decreased $7.2 million from $18.9 million for the six-month period ended December 31, 2000 to $11.7 million for the six-month period ended December 31, 2001. The decrease was primarily attributable to the implementation of new management processes, including reduced headcount and reduced use of consultants, that increase our operating effectiveness and realign our research and development projects with expected market demand.
Research and development expenses consist primarily of salaries and related personnel costs, fees paid to consultants and outside service providers, non-recurring engineering charges and prototype costs related to the design, development, testing, pre-manufacturing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a strong financial commitment to research and development is critical to the success of maintaining our leadership position in optical technology. We will increase our funding of research and development as we identify valuable products and technology solutions.
Sales and Marketing
Sales and marketing expenses decreased $3.2 million from $4.8 million for the quarter ended December 31, 2000 to $1.6 million for the quarter ended December 31, 2001, and decreased $5.7 million from $8.7 million for the six-month period ended December 31, 2000 to $3.0 million for the six-month period ended December 31, 2001. The decrease was primarily attributable to the decreased sales commissions associated with lower net revenue and decreased promotional and product marketing expenses.
General and Administrative
General and administrative expenses decreased $2.1 million from $3.8 million for the quarter ended December 31, 2000 to $1.7 million for the quarter ended December 31, 2001, and decreased $3.2 million from $6.7 million for the six-month period ended December 31, 2000 to $3.5 million for the six-month period ended December 31, 2001. The decrease was primarily attributable to decreased staffing for finance and human resources, and decreased recruiting and other infrastructure related expenses that resulted from the implementation of cost containment plans.
Stock Compensation
Stock compensation expenses decreased $6.6 million from $12.8 million for the quarter ended December 31, 2000 to $6.2 million for the quarter ended December 31, 2001, and decreased $18.8 million from $33.9 million for the six-month period ended December 31, 2000 to $15.1 million for the same six-month period ended December 31, 2001. From inception through December 31, 2001, we have expensed a total of $103.1 million of stock compensation, leaving an unamortized balance of $15.6 million on our December 31, 2001 unaudited condensed consolidated balance sheets. This decrease was partially attributable to decreased amortization of deferred stock compensation resulting from options cancelled as a result of the restructuring. Additionally, the decrease was due to decreased amortization of deferred stock compensation recognized for the intrinsic value of the unvested options assumed from Holographix. The deferred stock compensation for options assumed from Holographix and LambdaFlex was recorded upon the closing of the acquisition and is amortized over the remaining vesting period of the unvested options.
Acquired In-Process Research and Development ("IPR&D")
For the three- and six-month ended December 31, 2001, the Company recorded $5.4 million of acquired IPR&D resulting from the acquisition of LambdaFlex. See Note 6 of Notes to Condensed Consolidated Financial Statements. This amount was expensed on the acquisition date because the acquired technology had not yet reached technological feasibility and had no future alternative uses. There can be no assurance that acquisitions of businesses, products or technologies by us in the future will not result in substantial charges for acquired IPR&D that may cause fluctuations in our quarterly or annual operating results.
A portion of the purchase price has been allocated to IPR&D. IPR&D was identified and valued through extensive interviews, analysis of data provided by LambdaFlex concerning developmental products, their stage of development, the time and resources needed to complete them, their expected income generating ability, target markets and associated risks. The income approach, which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing the IPR&D.
In valuing the IPR&D, the Company considered, among other factors, the importance of each project to the overall development plan, projected incremental cash flows from the projects when completed and any associated risks. The projected incremental cash flows were discounted back to their present value using a discount rate of 30%. The discount rate was determined after consideration of the Company's weighted average cost of capital and the weighted average return on assets. Associated risks include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets.
Amortization of Intangibles
Amortization of intangibles for the quarter ended December 31, 2001 and for the quarter ended December 31, 2000 was $2.6 million. Amortization of intangibles increased $0.8 million from $4.4 million for the six-month period ended December 31, 2000 to $5.2 million for the six- month period ended December 31, 2001. This expense is due to the amortization of goodwill and other intangible assets recorded in connection with our acquisition of Holographix, which was accounted for as a purchase, and closed on July 25, 2000. These intangible assets are being amortized over their estimated remaining useful life of 3 to 5 years.
Our amortization of intangibles will continue to generate net losses for the foreseeable future. Amortization of intangibles could change because of other acquisitions or impairment of existing identified intangible assets and goodwill in future periods.
We periodically evaluate whether changes have occurred that would require revision of the remaining estimated useful life of property, equipment, and intangibles or render them not recoverable. We performed such an analysis as of December 31, 2001 and the estimated undiscounted future cash flow supported the carrying value of these assets. As a result, no revision of the estimated useful life or impairment charge was recorded other than as discussed in the following section.
Certain factors that the Company considers important which could trigger an impairment review include, but not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the Company's overall business, significant negative industry or economic trends, a significant decline in the Company's stock price for a sustained period, and the Company's market capitalization relative to net book value.
Other Income, Net
Other income, net consists primarily of interest on our cash investments offset by interest expense related to our financing obligations. Other income, net was $1.2 million for the quarter ended December 31, 2001 and $3.5 million for the comparable quarter in fiscal 2001. Other income, net was $2.8 million for the six-month period ended December 31, 2001 and $6.9 million for the six-month period ended December 31, 2000. The decrease inother income, net was primarily due to lower yields on our cash investments and additional interest charges on capital lease obligations and bank debt.
Liquidity and Capital Resources
Prior to our initial public offering, we financed our operations primarily through private sales of approximately $30.4 million of convertible preferred stock. We have also financed our operations through bank borrowings as well as through equipment lease financing. In February 2000, we received net proceeds of approximately $238 million from the initial public offering of our common stock and a concurrent sale of stock to corporate investors.
As of December 31, 2001, we had cash and cash equivalents and short-term investments of $160.7 million and long-term investment holdings of $41.4 million.
Cash used in operating activities was $17.0 million for the six months ended December 31, 2001, compared to $10.0 million of cash provided by operating activities for the comparative period of fiscal 2001. Our use of cash in operations was primarily the result of our operating loss, decreases in accounts payable, decrease in other accrued and deferred revenue, and cash restructuring liabilities. Offsetting this use of cash was our decrease in accounts receivable. Our use of cash was also partially offset by non-cash charges related to the provision for excess inventory, depreciation and amortization, stock compensation expense, amortization of intangibles, and acquired in-process research and development.
Cash generated by investing activities was $2.5 million for the six months ended December 31, 2001, primarily from the maturities of investment securities, net of purchases of held-to-maturities securities. Offsetting this was $1.4 million of cash used for the investments in production equipment, research and development equipment, and computers. Net cash used in investing activities was $14.8 million for the comparable period of fiscal 2001, principally for the net purchase activities of short and long- term investments, the purchases of property and equipment, and the acquisition of Holographix.
Net cash used in financing activities was $1.0 million for the six months ended December 31, 2001, primarily for payments on long-term debt and capital lease obligations. Offsetting the cash used were proceeds from short-term borrowings, cash payments received from stockholders' notes receivable and the proceeds from issuance of common stock. Net cash used in financing activities was $1.8 million for the comparable period of fiscal 2001. Our use of cash in financing activities in the six months ended December 31, 2000 was primarily the result of our payments on long-term debt and capital lease obligations. We financed capital purchases through cash, capital leases or equipment credit lines. The Company has a revolving line of credit from a financial institution, which allows maximum borrowings up to $20 million, of which $6.8 million was drawn down at December 31, 2001. The revolving credit agreement terminates July 10, 2002, at which time all outstanding principal and interest are due. The line bears interest at the prime rate.
From time to time, we may also consider the acquisition of, or evaluate investments in, products and businesses complementary to our business. Any acquisition or investment may require additional capital. Although we believe that our current cash and cash equivalents, short-term and long-term investment balance will be sufficient to fund our operations for at least the next 12 months, we cannot assure you that we will not seek additional funds through public or private equity or debt financing or from other sources within this time frame or that additional funding, if needed, will be available on terms acceptable to us, or at all.
Recently Issued Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141 ("SFAS 141") "Business Combinations" and Statement of Financial Accounting Standard No. 142 ("SFAS 142") "Goodwill and Other Intangible Assets". SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment-only method. Thus, amortization of goodwill, including amortization of goodwill recorded in past business combinations, will cease upon the adoption of this Standard, which for us will be July 1, 2002. However, for any acquisition completed after June 30, 2001, goodwill and intangibles with identified lives will not be amortized. We are currently evaluating the impact of the provisions of SFAS 141 and SFAS 142. The acquisition of LambdaFlex has occurred after June 30, 2001, therefore the goodwill is not being amortized, and will be accounted for using the guidance of SFAS 141 and SFAS 142.
In August 2001, the FASB issued Statement of Financial Accounting Standards No. 14, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS 144). This statement addresses financial accounting and reporting for the impairment of disposal of long-lived assets. SFAS 144 supersedes Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", and provides guidance on classification and accounting for such assets when held for sale or abandonment. SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company does not expect that adoption of SFAS 144 will have a material effect on its financial position or results of operations
RISK FACTORS
UNLESS WE GENERATE SIGNIFICANT REVENUE GROWTH, OUR EXPENSES AND NEGATIVE CASH FLOW WILL SIGNIFICANTLY HARM OUR FINANCIAL POSITION.
We have never been profitable. As of December 31, 2001, we had an accumulated deficit of $249 million. We may continue to incur operating losses for the foreseeable future, and these losses may be substantial. Further, for the quarter ended December 31, 2001, we had negative operating cash flow and for future quarters, we may continue to incur negative operating cash flow.
We have experienced operating losses in each quarterly and annual period since inception. The following table shows our operating losses for the periods indicated:
Period Loss From Operations
- ---------------------------------------------------- ------------------
Six months ended December 31, 2001.................. $ (42,591,000)
Fiscal year ended June 30, 2001..................... (134,784,000)
Fiscal year ended June 30, 2000..................... (44,356,000)
Fiscal year ended June 30, 1999..................... (9,250,000)
From October 24, 1997 (inception) to June 30, 1998.. (1,133,000)
Due to insufficient cash generated from operations, we have funded our operations primarily through the sale of equity securities, bank borrowings and equipment lease financings. Although we began implementation of a cost containment program in the quarter ended September 30, 2001, we still have a large amount of fixed expenses, and we expect to continue to incur significant manufacturing, sales and marketing, product development and administrative expenses. As a result, we will need to generate higher revenues while containing costs and operating expenses if we are to achieve profitability.
OUR REVENUES AND OPERATING RESULTS ARE VOLATILE, AND AN UNANTICIPATED DECLINE IN REVENUE MAY DISPROPORTIONATELY AFFECT OUR NET INCOME OR LOSS IN A QUARTER.
Our revenues and operating results have fluctuated significantly from quarter-to-quarter in the past and may fluctuate significantly in the future as a result of several factors, some of which are outside of our control. These factors include, without limitation, the following:
- Fluctuations in demand for and sales of our products, which will depend on, among other things, the speed and magnitude of the transition to an all-optical network, the acceptance of our products in the marketplace and the general level of equipment spending in the telecommunications industry;
- Cancellations of orders and shipment rescheduling;
- Changes in customers' requirements in general as well as those specific to product specifications;
- Satisfaction of contractual customer acceptance criteria and related revenue recognition issues;
- Our ability to provide appropriate manufacturing capacity commensurate with the volatile demand levels for our products;
- Our ability to manage outsourced manufacturing, in which we have no previous experience;
- The ability of our outsourced manufacturers to timely produce and deliver subcomponents, and possibly complete products, in the quantity and of the quality we require;
- The mix of our products sold;
- The practice of companies in the communications industry to sporadically place large orders with short lead times;
- Competitive factors, including introductions of new products and product enhancements by potential competitors, entry of new competitors into the photonic processor market, including JDS Uniphase, Agere, Lucent Technologies, Nortel Networks, Fujitsu, Oplink Communications, Chorum Technologies, Wavesplitter and New Focus, and pricing pressures;
- Our ability to effectively develop, introduce, manufacture and ship new and enhanced products in a timely manner without defects;
- Our ability to control expenses, particularly in light of our limited operating history;
- Availability of components for our products and equipment and increases in the price of these components and equipment;
- Our ability to meet customer product specifications and qualifications;
- Volatility of customer demand. Demand is unpredictable as to timing and amount and it may be hard for us to prepare to meet in volume when received;
- Difficulties in collecting accounts receivable;
- Our ability to continue to attract and retain qualified, competent and experienced professional employees;
- Our ability to continue production operations in areas that are subject to irregular and increasing power disruptions;
- Our ability to introduce effective automation into our production process;
- Our ability to obtain the necessary basic services for our facilities, such as electricity, and the timing of any loss of these basic services, which halts our operations; and
- Economic conditions in general as well as those specific to the communications and related industries.
A high percentage of our expenses, including those related to manufacturing, engineering, sales and marketing, research and development and general and administrative functions are essentially fixed in the short term. As a result, if we experience delays in generating and recognizing revenue, our quarterly operating results are likely to be seriously harmed. For example, our loss in the second half of fiscal 2001 is partially attributable to the high level of fixed expenses in manufacturing and research and development. New product introductions can result in a mismatching of research and development expenses and sales and marketing expenses that are incurred in one quarter with revenues that are not recognized until a subsequent quarter when the new product is introduced. In addition, there may be significant costs relating to the introduction of new products into volume manufacturing. If growth in our revenues does not outpace the increase in our expenses, our results of operations could be seriously harmed.
Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results will not be meaningful. You should not rely on our results for one quarter as any indication of our future performance. It is likely that in future quarters our operating results may be below the expectations of public market analysts or investors. If this occurs, the price of our common stock would likely decrease.
MARKET CONDITIONS IN THE TELECOMMUNICATIONS MARKET MAY SIGNIFICANTLY HARM OUR FINANCIAL POSITION.
We sell our products primarily to a few large customers in the telecommunications market for use in infrastructure projects. In the telecommunications market, there has recently been a reduction in spending for infrastructure projects. The current economic downturn may lead to continued reductions in such infrastructure spending, and our customers may continue to significantly reduce their orders for our products. In addition, because we rely on a high percentage of our sales from only a few customers, any reductions in spending on our products by our current customers, or unwillingness to purchase our products by future customers, could significantly harm our financial position and results of operations. For example, declining orders from WorldCom contributed significantly to our sequential quarterly revenue decline in fiscal 2001 and declining orders from Nortel and Fujitsu have contributed to our quarterly revenue decline from the March 31, 2001 quarter through the September 30, 2001 quarter. Reduced infrastructure spending could also lead to increased price competition. If our customers and potential customers continue to reduce their infrastructure spending, we may fall short of our revenue expectations for future quarters or the fiscal year.
WE HAVE A LIMITED OPERATING HISTORY, WHICH MAKES IT DIFFICULT TO EVALUATE OUR PROSPECTS.
We are an early-stage company in the emerging photonic processor market. We were first incorporated on October 24, 1997. Because of our limited operating history, we have limited insight into trends that may emerge in our market and affect our business. The revenue and income potential of the photonic processor market, and our business in particular, are unproven. We began shipping our PowerFilter products to customers for evaluation in April 1999 and our PowerMux products for evaluation in the quarter ended December 31, 1999. Volume shipments of PowerFilter did not commence until the quarter ended September 30, 1999 while volume shipments of PowerMux did not commence until the quarter ended June 30, 2000. In addition, we only began shipping our PowerExpress product for beta testing purposes in the quarter ended December 31, 2000, and commenced commercial shipments in the quarter ended June 30, 2001. As a result of our limited operating history, we have limited financial data that you can use to evaluate our business. You must consider our prospects in light of the risks, expenses and challenges we might encounter because we are at an early stage of development in a new and rapidly evolving market.
OUR CUSTOMERS ARE NOT OBLIGATED TO BUY SIGNIFICANT AMOUNTS OF OUR PRODUCTS AND MAY CANCEL OR DEFER PURCHASES ON SHORT NOTICE.
Our customers typically purchase our products under individual purchase orders and may cancel or defer purchases on short notice without significant penalty. While we have executed a long-term contract with one of our customers and may enter into additional long-term contracts with other customers in the future, these contracts do not obligate the customers to buy significant amounts of our products, and are subject to cancellation or a slow down on delivery with little or no advance notice and little or no penalty. We also may enter into long-term contracts that do not guarantee orders, and may impose harsher terms and conditions on sales than previously received from that customer in purchase orders. Further, certain of our customers have a tendency to purchase our products near the end of our fiscal quarter. A cancellation or delay of such an order may therefore cause us to fail to achieve that quarter's financial and operating goals. Accordingly, sales in a particular period are difficult to predict. Decreases in purchases, cancellations of purchase orders or deferrals of purchases may have a material adverse effect on us, particularly if we do not anticipate them.
OUR INABILITY TO INTRODUCE NEW PRODUCTS AND PRODUCT ENHANCEMENTS COULD PREVENT US FROM INCREASING REVENUE.
We currently offer five products, PowerFilter, PowerMux, PowerExchanger, PowerExpress, and PowerShaper. The declines in demand for our PowerFilter and PowerMux products have resulted in the significant decrease in revenues during fiscal 2001 and the first half of fiscal 2002. In addition, we believe that our future growth and a significant portion of our future revenue will depend on the broad commercial success of our future products. If our target customers do not widely adopt, purchase and successfully deploy our products, our revenues will not grow significantly and may decline, and our business will be seriously harmed. The successful operation of our business depends on our ability to anticipate market needs and to develop and introduce new products and product enhancements that respond to technological changes or evolving industry standards on a timely and cost-effective basis. Our products are complex, and new products may take longer to develop than originally anticipated. These products may contain defects or have unacceptable manufacturing yields when first introduced or as new versions are released. If we do not introduce new products in a timely manner, we will not obtain incremental revenues from these products or be able to replace more mature products with declining revenues or gross margins. Customers that have designed our new products into their system could instead purchase products from our competitors, resulting in lost revenue over a longer term. We could also incur unanticipated costs in attempting to complete delayed new products or to fix defective products. We cannot be certain that we will successfully develop and market these types of products and product enhancements. In addition, our products could quickly become obsolete as new technologies are introduced and incorporated into new and improved products. For example, our PowerMux product, which incorporates our PowerFilter product and additional functionality, has replaced our PowerFilter product in most applications. We must continue to develop state-of-the-art products and introduce them into the commercial market quickly in order to be successful. Although we introduced our PowerShaper product during the quarter ended March 31, 2000, it is still in the beta testing stage. Our experience with PowerShaper demonstrates the substantial amount of time it may take for the qualification and commercial deployment of a product. Our failure to produce technologically competitive products in a cost-effective manner and on a timely basis will seriously harm our business, financial condition and results of operations. In particular, any failure of PowerMux, PowerShaper, PowerExpress, PowerExchanger or our other future products to achieve market acceptance could significantly harm our business.
IF WE FAIL TO PREDICT OUR MANUFACTURING REQUIREMENTS ACCURATELY, WE COULD INCUR ADDITIONAL COSTS OR EXPERIENCE MANUFACTURING DELAYS, WHICH COULD CAUSE US TO LOSE ORDERS OR CUSTOMERS AND RESULT IN LOWER REVENUES.
We currently use a rolling 6-month forecast based primarily on our anticipated product orders and our limited product order history to determine our requirements for components and materials. We provide these forecasts to our outsourced manufacturers, and we use them internally as well. It is very important that we accurately predict both the demand for our products and the lead-time required to obtain the necessary components and raw materials. Lead times for materials and components that we order vary significantly and depend on factors such as the specific supplier, the size of the order, contract terms and demand for each component at a given time. If we underestimate our requirements, we, and our third-party outsourced manufacturers may have inadequate manufacturing capacity or inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues. If we overestimate our requirements, we could have excess inventory of parts as well as over-capitalized manufacturing facilities. For example, the inventory write-off booked in the year ended June 30, 2001 and in the quarter ended December 31, 2001 is a result of our inability to forecast the sudden decrease in demand for our products. Cumulatively, we have booked $35.7 million inventory write-off, this provision is for inventory that is unique and we do not expect to use based on our 6-month sales forecast. There may be instances, however, where the Company, due to unforeseen future demand, may utilize this excess inventory. We also may experience shortages of components from time to time, which could delay the manufacturing of our products and could cause us to lose orders or customers.
WE WILL NOT ATTRACT ORDERS AND CUSTOMERS OR WE MAY LOSE CURRENT ORDERS AND CUSTOMERS AND WILL NOT BE SUCCESSFUL IN OUR INDUSTRY IF WE ARE UNABLE TO COMMIT TO DELIVER SUFFICIENT QUANTITIES OF OUR PRODUCTS TO SATISFY MAJOR CUSTOMERS' NEEDS.
Communications service providers and optical systems manufacturers typically require that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver sufficient quantities of our products to satisfy a customer's anticipated needs, we will lose the order and the opportunity for significant sales to that customer for a lengthy period of time. We will be unable to pursue many large orders if we do not have sufficient manufacturing capacity to enable us to commit to provide customers with specified quantities of products.
OUR DEPENDENCE ON INDEPENDENT MANUFACTURERS MAY RESULT IN PRODUCT DELIVERY DELAYS AND MAY HAVE AN ADVERSE AFFECT ON OUR OPERATIONS.
We rely on a small number of outsourced manufacturers to manufacture our subcomponents. We intend to deepen our relationship with outsourced manufacturers so that they will eventually manufacture a substantial portion of our commercial volume, and possibly our products in the future. The qualification of these manufacturers is an expensive and time-consuming process, and these outsourced manufacturers build optical components for other companies, including our competitors. In addition, we do not have contracts in place with many of these manufacturers. We have very limited experience in working with third party manufacturers and we may not be able to effectively manage our relationships with our manufacturers. We cannot be certain that they will be able to fill our orders in a timely manner. If we cannot effectively manage these manufacturers or they fail to deliver components in a timely manner, we could experience significant delays in shipping our product. Product delays may have an adverse effect on our business and results of operations.
Our outsourced manufacturers have a limited history of manufacturing optical subcomponents and have no history of manufacturing our products on a turnkey basis. Any interruption in the operations of these outsourced manufacturers could harm our ability to meet our scheduled product deliveries to our customers, which could cause the loss of existing or potential customers. In addition, the products and subcomponents that these outsourced manufacturers build for us may be insufficient in quality or in quantity to meet our needs. The inability of our outsourced manufacturers to provide us with adequate supplies of high-quality products and subcomponents in the future could cause a delay in our ability to fulfill customer orders while we obtain a replacement manufacturer and could seriously harm our business.
To successfully meet our overall production goals, we will also have to coordinate effectively our operations in California with those of our outsourced manufacturers in China. We have very limited experience in coordinating and managing production operations that are located on different continents or in the transfer of manufacturing operations from one facility to another. The geographic distance between our headquarters in California and outsourced manufacturers' manufacturing facilities in China will make it difficult for us to manage the relationship and oversee operations there to assure product quality and timely delivery. Our failure to successfully coordinate and manage multiple sites or to transfer our manufacturing operations could seriously harm our overall production.
Because our outsourced manufacturers' manufacturing facilities are located in China, these outsourced manufacturers will be subject to the risk of political instability in China and the possible imposition of restrictive trade regulations and tariffs. We will also be exposed to risks of foreign currency exchange rate fluctuations and lack of adequate protection of intellectual property under Chinese law.
In addition, our outsourced manufacturers may begin to integrate these subcomponents for us to produce turnkey products for us, which will add to the complexity and difficulty of obtaining sufficient quantities of these products at acceptable quality from these outsourced manufacturers. Any failure of these outsourced manufacturers to timely produce turnkey products for us in the quantities and quality needed will seriously harm our business.
IF WE FAIL TO EFFECTIVELY MANAGE OUR FINANCIAL AND MANAGERIAL CONTROLS, REPORTING SYSTEMS AND PROCEDURES, OUR BUSINESS MAY NOT SUCCEED.
Our revenues have changed from $6.5 million in the quarter ended December 31, 1999 to $47.9 million in the quarter ended December 31, 2000, to $8.3 million in the quarter ended December 31, 2001. We had 740 employees as of June 30, 2000, and as of June 30, 2001. However, in April and July 2001, we had reductions-in-force which reduced our employees by approximately 654 people, including temporary employees. As of December 31, 2001, we had 436 employees. We currently operate facilities in Fremont, California and in Richardson, Texas. We also have a sales office with a regional sales manager in Newtown, Pennsylvania and a sales manager who services our customers in Canada. In addition, in July 2000, we acquired substantially all of the assets and certain liabilities of Holographix Inc., a Delaware corporation located in Hudson, Massachusetts. As of December 31, 2002, this unit had six full-time and two part-time employees. The rapidly changing number of employees and volatile quarterly revenue, combined with the challenges of managing geographically dispersed operations, has placed, and will continue to place, a significant strain on our management systems and resources. We expect that we will need to continue to improve our financial and managerial controls, reporting systems and procedures, and will need to continue to manage our work force worldwide. However, we may not be able to install adequate control systems in an efficient and timely manner, and our current or planned operational systems, procedures and controls may not be adequate to support our future operations. Delays in the implementation of new systems or operational disruptions when we transition to new systems would impair our ability to accurately forecast sales demand, manage our product inventory and record and report financial and management information on a timely and accurate basis.
IF WE DO NOT REDUCE COSTS, INTRODUCE NEW PRODUCTS OR INCREASE SALES VOLUME, OUR GROSS MARGIN WILL DECLINE.
Over our short operating history, the average selling prices of our products has decreased over time and we expect this trend to continue and potentially accelerate. Future price decreases may be due to a number of factors, including competitive pricing pressures, rapid technological change and sales discounts. Therefore, to maintain or increase our gross margin, we must develop and introduce new products and product enhancements on a timely basis. We must also continually reduce our costs of production. As our average selling prices decline, we must increase our unit sales volume to maintain or increase our revenue. If our average selling prices decline more rapidly than our costs of production, our gross margin will decline, which could seriously harm our business, financial condition and results of operations.
OUR PRODUCTS MAY HAVE DEFECTS THAT ARE NOT DETECTED UNTIL FULL DEPLOYMENT OF A CUSTOMER'S SYSTEM, WHICH COULD RESULT IN A LOSS OF CUSTOMERS, DAMAGE TO OUR REPUTATION AND SUBSTANTIAL COSTS.
Our products are designed to be deployed in large and complex optical networks and must be compatible with other components of the system, both current and future. In addition, our products may not operate as expected or guaranteed over long periods of time. Our products can only be fully tested for reliability when deployed in networks for long periods of time. Our customers may discover errors, defects or incompatibilities in our products after they have been fully deployed and operated under peak stress conditions. They may also have errors, defects or incompatibilities that we find only after a system upgrade is installed. If we are unable to fix errors or other problems, we could experience:
- Loss of customers or customer orders;
- Loss of or delay in revenues;
- Loss of market share;
- Loss or damage to our brand and reputation;
- Inability to attract new customers or achieve market acceptance;
- Diversion of development resources;
- Increased service and warranty costs;
- Legal actions by our customers; and
- Increased insurance costs.
In some of our contracts and agreements, we have agreed to indemnify our customers against certain liabilities arising from defects in our products. While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. To date, product defects have not had a material negative affect on our results of operations. However, we cannot be certain that product defects will not have a material negative affect on our results of operations in the future. A material product liability claim may have significant consequences on our ability to compete effectively and generate positive cash flow and may seriously harm our business, financial condition and results of operations.
IF WE DO NOT ACHIEVE ACCEPTABLE MANUFACTURING YIELDS IN A COST-EFFECTIVE MANNER OR ACHIEVE SUFFICIENT PRODUCT RELIABILITY, THIS COULD DELAY PRODUCT SHIPMENTS TO OUR CUSTOMERS OR REQUIRE US TO DEVELOP NEW MANUFACTURING PROCESSES, WHICH WOULD IMPAIR OUR OPERATING RESULTS.
Manufacturing our products involves complex, labor intensive and precise processes. Changes in our manufacturing processes or those of our suppliers, or the inadvertent use of defective materials by our suppliers or us, could significantly reduce our manufacturing yields and product reliability. Because the majority of our manufacturing costs are relatively fixed, manufacturing yields are critical to our results of operations. Lower than expected production yields could delay product shipments and impair our gross margins. We may not obtain acceptable yields in the future.
In some cases, existing manufacturing techniques, which involve substantial manual labor, may not allow us to cost- effectively meet our production goals so that we maintain acceptable gross margins while meeting the cost targets of our customers. We will need to develop new manufacturing processes and techniques that will involve higher levels of automation to increase our gross margins and achieve the targeted cost levels of our customers. We may not achieve manufacturing cost levels that will fully satisfy customer demands.
Because we plan to introduce new products and product enhancements regularly, we must effectively transfer production information from our product development department and our pilot production line to our manufacturing group or contract manufacturers and coordinate our efforts with those of our suppliers to rapidly achieve volume production. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed.
WE DEPEND ON KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE AND RETAIN QUALIFIED PERSONNEL, OUR ABILITY TO SELL OUR PRODUCTS COULD BE HARMED.
Our future success depends, in large part, on our ability to attract and retain highly skilled personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly engineers, sales personnel and marketing personnel, may seriously harm our business, financial condition and results of operations. In particular, our future success depends upon the continued services of our executive officers, particularly Paul Engle, our President and Chief Executive Officer, and Xiaofan (Simon) Cao, our Chief Technology Officer and Senior Vice President of Business Development, and other key engineering, sales, marketing, manufacturing and support personnel. None of our officers or key employees is bounded by an employment agreement for any specific term and these personnel may terminate their employment at any time. In addition, we do not have "key person" life insurance policies covering any of our employees.
Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. Competition for highly skilled personnel is intense, especially in the San Francisco Bay Area. We may not be successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs. The current challenging environment will place a significant demand on our management and operational resources. Many of the members of our management team have only been with us for a relatively short period of time. For example, our Chief Executive Officer joined us in September 2000, and four out of our eight current executive officers have joined us since September 1999. Failure of the new management team to work effectively together could seriously harm our business.
WE FACE RISKS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS THAT COULD PREVENT US FROM SUCCESSFULLY MANUFACTURING, MARKETING AND DISTRIBUTING OUR PRODUCTS INTERNATIONALLY.
We intend to expand our international operations in the future, including developing several contract manufacturers to produce a significant portion of our products overseas. Further, we intend to increase our international sales and the number of our international customers. This expansion will require significant management attention and financial resources to develop successfully direct and indirect international sales and support channels and manufacturing. We may not be able to establish or maintain international market demand for our products. We currently have little or no experience in manufacturing, marketing and distributing our products internationally.
In addition, international operations are subject to inherent risks, including without limitation the following:
- Greater difficulty in accounts receivable collection and longer collection periods;
- Difficulties and costs of staffing and managing foreign operations with personnel who have expertise in optical network technology;
- Unexpected changes in regulatory or certification requirements for optical systems or networks;
- Reduced protection for intellectual property rights in some countries, including China, where some of our subcomponents and products will be manufactured; and
- Political and economic instability.
While we expect our international revenues and expenses to be denominated predominantly in U.S. dollars, a portion of our international revenues and expenses may be denominated in foreign currencies in the future. Accordingly, we could experience the risks of fluctuating currencies and could choose to engage in currency hedging activities. We do not currently engage in currency hedging activities to limit the risks of exchange rate fluctuations. Therefore, fluctuations in the value of foreign currencies could have a negative impact on the profitability of our global operations, which would seriously harm our business, financial condition and results of operations.
BECAUSE WE DEPEND ON SINGLE OR LIMITED SOURCES OF SUPPLY WITH LONG LEAD TIMES FOR SOME OF THE KEY COMPONENTS IN OUR PRODUCTS AND SOME OF OUR EQUIPMENT, WE COULD ENCOUNTER DIFFICULTIES IN MEETING SCHEDULED PRODUCT DELIVERIES TO OUR CUSTOMERS, WHICH COULD CAUSE CUSTOMERS TO CANCEL ORDERS.
We purchase several key components used in our products and equipment from single or limited sources of supply, including Nippon Sheet Glass, Mitsubishi Corporation, Wave Precision, Inc., REO, Inc., VLOC, Inc., Ericsson Corporation, Browave Corporation, Foxconn Optical Technology and Agilent Technologies. These key components include filters, lenses, specialty glass and test and measurement equipment. We have no guaranteed supply arrangements with any of these suppliers, and we typically purchase our components and equipment through purchase orders. We have experienced shortages and delays in obtaining components and equipment in the past, which adversely impacted delivery of our products, and we may fail to obtain these supplies in a timely manner in the future. Any interruption or delay in the supply of any of these components or equipment, or the inability to obtain these components or equipment from alternate sources at acceptable prices, at acceptable quality and within a reasonable amount of time, would impair our ability to meet scheduled product deliveries to our customers and could cause customers to cancel orders. Lead times for components and equipment vary significantly and depend on numerous factors at any given time, including the specific supplier, specifications for the component or item of equipment, the size of the order, contract terms and market demand for a component or item of equipment. For substantial increases in production levels, suppliers may need longer-than-normal lead times and some may need at least nine months.
Furthermore, financial or other difficulties faced by these suppliers, or significant changes in demand for these components and equipment, could limit the availability of these components and equipment. In addition, a third party could acquire control of one or more of our suppliers and cut off our access to raw materials, components or equipment. For example, in 2000, JDS Uniphase acquired Casix, Inc., which was then one of our critical suppliers of specialty glass. Obtaining components and equipment from alternate suppliers is difficult because we must qualify each new supplier, and this process is time-consuming and expensive.
Because lead times for materials, components and equipment used in the assembly of our products are long and vary significantly, we may have excess or inadequate inventory of some materials, components and equipment if orders do not match forecasts. For example, in the year ended June 30, 2001 and in the quarter ended December 31, 2001, we have cumulatively booked a $35.7 million inventory provision, including non-cancelable purchase order commitments. Furthermore, if we change suppliers, our customers may require that our products be re-qualified by them, which is time consuming and expensive.
We must obtain supplies and materials that are of sufficient quantity and quality in order for us to manufacture our products in acceptable quantities and with acceptable yields. Our inability to obtain supplies and materials in sufficient quality or quantity will seriously harm the yield and production of our products and could seriously harm our business.
OUR FACILITIES ARE VULNERABLE TO DAMAGE FROM EARTHQUAKES AND OTHER NATURAL DISASTERS.
Our assembly facilities are located on or near known earthquake fault zones and are vulnerable to damage from fire, floods, earthquakes, power loss, telecommunications failures and similar events. If such a disaster occurs, our ability to assemble, test and ship our products would be seriously, if not completely, impaired, which would seriously harm our business, financial condition and results of operations. We cannot be certain that the insurance we maintain against fires, floods and general business interruptions will be adequate to cover our losses in any particular case.
OUR FACILITIES ARE VULNERABLE TO POWER OUTAGES.
Our assembly facilities are located in the state of California, which presently is experiencing a severe shortage of electrical power. We have experienced several power outages in the recent past, and we may experience additional power outages in the future. These power outages have halted our production operations. If such future power outages occur, our ability to assemble, test and ship our products would be seriously impaired, which could seriously harm our business, financial condition and results of operations, particularly if these power outages occur in the last month of our fiscal quarter. We cannot be sure that the insurance we maintain against general business interruptions will be adequate to cover our losses in this particular case, if at all.
WE COULD INCUR COSTS AND EXPERIENCE DISRUPTIONS COMPLYING WITH ENVIRONMENTAL REGULATIONS AND OTHER REGULATIONS.
We handle small amounts of hazardous materials as part of our manufacturing activities, especially at our Holographix Inc. subsidiary in Hudson, Massachusetts. Although we believe that we have complied to date with all applicable environmental regulations in connection with our operations, we may be required to incur environmental remediation costs to comply with current or future environmental laws.
We introduced our PowerExpress product, which is currently in commercial deployment, during the quarter ended March 31, 2001. Our PowerExpress product is the first product offered by us that incorporates firmware and electronic components. In the future, we plan to introduce more products, which will incorporate firmware and electronic components. The additional level of complexity created by combining firmware and electronic components with our optical components require that we comply with additional regulations, both domestically and abroad, including without limitation, environmental compliance, power consumption, electrical emission regulations and other regulations known as homologation. Any failure to successfully obtain the necessary permits or comply with the necessary regulations in a timely manner or at all could seriously harm our sales of these products and our business.
WE MAY EXPERIENCE INCREASED COMPETITION FROM COMPANIES IN THE PHOTONIC PROCESSOR MARKET AND IN THE OPTICAL SYSTEMS AND COMPONENT INDUSTRY, WHICH COULD CAUSE REDUCED SALES LEVELS AND RESULT IN PRICE REDUCTIONS, REDUCED GROSS MARGINS OR LOSS OF MARKET SHARE.
The markets we are targeting are new and rapidly evolving, and we expect these markets to become highly competitive in the future. We anticipate that other companies will expand into our market in the future, and introduce competitive products. We also face indirect competition from public and private companies providing products that address the same optical network problems that our products address. The development of alternative solutions to optical transmission problems by competitors, particularly systems companies who also manufacture components, could significantly limit our growth.
WE EXPECT COMPETITION TO INCREASE.
Some companies in the optical systems and component industry may compete with us in the future, including Lucent Technologies, Nortel Networks, Alcatel, Fujitsu, Agere, Corning, JDS Uniphase, Oplink Communications, New Focus, Inc., Wavesplitter and Chorum Technologies, and some compete with us now using different technologies. Some of these are large public companies that have longer operating histories and significantly greater financial, technical, marketing and other resources than we have. As a result, some of these competitors are able to devote greater resources to the development, promotion, sale and support of their products. In addition, our competitors that have larger market capitalizations or cash reserves are much better positioned than we are to acquire other companies in order to gain new technologies or products that may displace our product lines. Any of these acquisitions could give our competitors a strategic advantage. Many of our competitors and potential competitors have significantly more established sales and customer support organizations than we do. In addition, many of our competitors have much greater name recognition and have more extensive customer bases, better developed distribution channels and broader product offerings than our company. These companies can use their customer bases and broader product offerings and adopt aggressive pricing policies to gain market share. We expect to encounter potential customers that, due to existing relationships with our competitors, are committed to the products offered by these competitors. As a result, these potential customers may not consider purchasing our products.
Some existing customers and potential future customers are also our competitors. These customers may develop or acquire additional competitive products or technologies in the future, which may cause them to reduce or cease their purchases from us. In addition, customers who are also competitors may unfairly disparage our products in order to gain a competitive advantage. Further, these customers may reduce or discontinue purchasing our products if they perceive us as a serious competitive threat in those or other products with their customers, especially as we develop, manufacture and sell products, which incorporate higher levels of sophistication such as our PowerExpress product.
As a result of these factors, we expect that competitive pressures will intensify and may result in price reductions, reduced margins and loss of market share.
AS OUR COMPETITORS CONSOLIDATE, THEY MAY OFFER PRODUCTS OR PRICING, WHICH WE CANNOT MEET, WHICH COULD CAUSE OUR REVENUES TO DECLINE.
Consolidation in the fiber optic component industry could intensify the competitive pressures that we face. For example, three of our competitors, JDS Uniphase, SDL, Inc. and E-Tek Dynamics, Inc. merged over the past several years. This merged company has announced its intention to offer more integrated products that could make our products less competitive. Our customers may prefer to purchase products from certain of our competitors who offer broader product lines, which would negatively affect our sales and operating results.
WE RELY ON A LIMITED NUMBER OF CUSTOMERS, AND ANY DECREASE IN REVENUES FROM, OR LOSS OF, ONE OR MORE OF THESE CUSTOMERS WITHOUT A CORRESPONDING INCREASE IN REVENUES FROM OTHER CUSTOMERS WOULD HARM OUR OPERATING RESULTS.
Our customer base is limited and highly concentrated. Three customers accounted for an aggregate of 58.7% of our net revenue in the quarter ended December 31, 2001. We expect that the majority of our revenues will continue to depend on sales of our products to a small number of customers.
If current customers do not continue to place significant orders, or cancel or delay current orders, we may not be able to replace these orders. In addition, any downturn in the business of existing customers could result in significantly decreased sales to these customers, which could seriously harm our revenues and results of operations.
Sales to any single customer may vary significantly from quarter to quarter. Customers in the communications industry tend to order large quantities of products on an irregular basis. They base these orders on a decision to deploy their system in a particular geographic area and may not order additional products until they make their next major deployment decision. This means that customers who account for a significant portion of our net revenue in one quarter may not place any orders in the succeeding quarter. These ordering patterns can result in significant quarterly fluctuations in our operating results.
IF OUR CUSTOMERS DO NOT QUALIFY OUR MANUFACTURING LINES FOR VOLUME SHIPMENTS, OUR PRODUCTS MAY BE DROPPED FROM SUPPLY PROGRAMS AND OUR OPERATING RESULTS COULD SUFFER.
Customers generally will not purchase any of our products, other than limited numbers of evaluation units, before they qualify our products, approve our manufacturing process and approve our quality system. Our existing manufacturing line, as well as each new manufacturing line, must pass through various levels of approval with our customers. Customers may require that we be registered and maintain registration under international quality standards, such as ISO 9001. We successfully passed the ISO 9001 registration audit and received formal registration of our Quality System in August 2000 and passed the review in August 2001. Our products may also have to be qualified to specific customer requirements. This customer approval process determines whether we can consistently achieve the customers' quality, performance and reliability standards. In order for outsourced manufacturers to manufacture products or discrete components for us in the future, their manufacturing process and Quality System may also need to be qualified by our customers. Delays in product qualification or losing ISO 9001 registration by us, our suppliers or our outsourced manufacturers may cause a product to be dropped from a long-term supply program and result in significant lost revenue opportunity over the term of that program.
OUR LENGTHY AND VARIABLE QUALIFICATION AND SALES CYCLE MAKES IT DIFFICULT TO PREDICT THE TIMING OF A SALE OR WHETHER A SALE WILL BE MADE, WHICH MAY CAUSE US TO HAVE EXCESS MANUFACTURING CAPACITY OR INVENTORY AND NEGATIVELY IMPACT OUR OPERATING RESULTS.
Customers typically expend significant efforts in evaluating and qualifying our products and manufacturing processes. This evaluation and qualification process frequently results in a lengthy sales cycle, typically ranging from three to nine months and sometimes longer. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long-lead-time supplies prior to receiving an order. Even after this evaluation process, it is possible that a potential customer will not purchase our products for deployment. In addition, product purchases are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity.
If we increase capacity and order supplies in anticipation of an order that does not materialize, our gross margins will decline and we will have to carry or write off excess inventory. Even if we receive an order, the additional manufacturing capacity that we add to service the customer's requirements may be underutilized in a subsequent quarter, especially if an order is delayed or cancelled. Either situation could cause our results of operations to be below the expectations of investors and public market analysts, which could, in turn, cause the price of our common stock to decline. Our long sales cycles, as well as the practice of companies in the communications industry to sporadically place large orders with short lead times, may cause our revenues and operating results to vary significantly and unexpectedly from quarter to quarter.
In addition, we cannot be certain that the sales cycle for our products will not lengthen in the future. In addition, the emerging and evolving nature of the photonic processor market may cause prospective customers to delay their purchase decisions as they evaluate new technologies and develop and implement new systems. As the average order size for our products grows, the process for approving purchases is likely to become more complex, leading to potential delays in receipt of these orders. As a result, our long and unpredictable sales cycle contributes to the uncertainty of our future operating results.
WE WILL LOSE SIGNIFICANT CUSTOMER SALES AND OPPORTUNITIES AND MAY NOT BE SUCCESSFUL IF OUR CUSTOMERS DO NOT QUALIFY OUR PRODUCTS TO BE DESIGNED INTO THEIR PRODUCTS AND SYSTEMS.
In the communications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. Once they decide to use a particular supplier's product or component, these potential customers design the product into their system, which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that company until at least the adoption of a future redesigned system. Even then, many companies may be reluctant to design entirely new products into their new systems, as it could involve significant additional redesign efforts. If we fail to achieve design-in wins in our potential customer's qualification process, we will lose the opportunity for significant sales to that customer for a lengthy period of time.
IF CARRIERS FOR NEW TELECOMMUNICATIONS SYSTEMS DEPLOYMENTS DO NOT SELECT OUR SYSTEMS-LEVEL CUSTOMERS, OUR SHIPMENTS AND REVENUES WILL BE REDUCED.
Sales of our components depend on sales of fiber optic telecommunications systems by our systems-level customers, which are shipped in quantity when telecommunications service providers, or carriers, add capacity. Systems manufacturers compete for sales in each capacity deployment. If systems manufacturers that use our products in their systems do not win a contract, their demand for our products will decline, reducing our future revenues. Similarly, a carrier's delay in selecting systems manufacturers for a deployment could delay our shipments and revenues.
SALES IN THE FUTURE TO CUSTOMERS BASED OUTSIDE THE UNITED STATES MAY ACCOUNT FOR AN INCREASED PORTION OF OUR REVENUE, WHICH EXPOSES US TO RISKS INHERENT IN INTERNATIONAL OPERATIONS.
Our increased international operations are subject to a variety of risks associated with conducting business internationally any of which could seriously harm our business, financial condition and results of operations. These risks include without limitation:
- Greater difficulty in accounts receivable collections;
- Import or export licensing and product certification requirements;
- Tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;
- Potential adverse tax consequences;
- Fluctuations in currency exchange rates;
- Seasonal reductions in business activity in some parts of the world;
- Unexpected changes in regulatory requirements;
- Burdens of complying with a wide variety of foreign laws, particularly with respect to intellectual property, license requirements, environmental requirements, and homologation;
- Difficulties and costs of staffing and managing foreign operations;
- Political instability, terrorism and war;
- The impact of recessions in economies outside of the United States; and
- Limited ability to enforce agreements, intellectual property and other rights in some foreign countries.
IF WE DO NOT SUBSTANTIALLY EXPAND OUR DIRECT AND INDIRECT SALES OPERATIONS, WE MAY NOT BE ABLE TO INCREASE MARKET AWARENESS AND SALES OF OUR PRODUCTS AND OUR REVENUES WILL SUFFER.
Our products and services require a long, involved sales effort targeted at several departments within our prospective customers' organizations. Therefore, our sales effort requires the prolonged efforts of executive personnel, specialized system and application engineers and marketing personnel working together with dedicated salespersons in making sales. Because we have a relatively small number of dedicated salespersons and application engineers, our sales could be significantly disrupted if we failed to retain our team. Competition for these individuals is intense, and we might not be able to hire the type and number of sales personnel, system and application engineers and marketing personnel we need.
In addition, we believe that our future success depends significantly on our ability to establish relationships successfully with a variety of distribution partners, such as original equipment manufacturers, value-added resellers and distributors, both domestically and internationally. To date, we have entered into agreements with two distributors in Japan, and we have entered into agreements with one supplier manufacturer sales representative in Italy and a distributor in Israel. These distributors also sell products that compete with our products. We cannot be certain that we will be able to reach agreement with additional distribution partners or representatives on a timely basis or at all, or that our distribution partners and representatives will devote adequate resources to selling our products. Even if we enter into agreements with additional distribution partners or representatives, they may not result in increased product sales.
If we are unable to expand our direct and indirect sales operations, we may not be able to increase market awareness or sales of our products, which may prevent us from increasing our revenues.
IF THE INTERNET AND OTHER COMMUNICATION MEDIA DO NOT CONTINUE TO EXPAND AS A WIDESPREAD COMMUNICATION AND COMMERCE MEDIA, DEMAND FOR OUR PRODUCTS MAY DECLINE SIGNIFICANTLY.
Our future success depends on the continued growth of the Internet as a widely-used medium for commerce and communication and the continuing demand for increased bandwidth over communications networks. If the Internet does not continue to expand as a widespread communication medium and commercial marketplace, the need for significantly increased bandwidth across networks and the market for optical transmission products may not develop. As a result, it would be unlikely that our products would achieve commercial success.
IF THE COMMUNICATIONS INDUSTRY DOES NOT ACHIEVE A RAPID AND WIDESPREAD TRANSITION TO OPTICAL NETWORKS, OUR BUSINESS WILL NOT SUCCEED.
The market for our products is relatively new and evolving. Future demand for our products is uncertain and will depend to a great degree on the speed of the widespread adoption of optical networks. If the transition occurs too slowly or ceases altogether, the market for our products and the growth of our business will be significantly limited.
OUR MARKET IS NEW AND IS CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGES AND EVOLVING STANDARDS, AND IF WE DO NOT RESPOND IN A TIMELY MANNER, OUR PRODUCTS WILL NOT ACHIEVE MARKET ACCEPTANCE.
The communications market is characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. In developing our products, we have made, and will continue to make, assumptions with respect to which standards will be adopted within our industry. If the standards that are actually adopted are different from those that we have chosen to support, our products may not achieve significant market acceptance.
OUR STOCK PRICE IS HIGHLY VOLATILE.
The trading price of our common stock has fluctuated significantly since our initial public offering in February 2000 and is likely to remain volatile in the future. In addition, the trading price of our common stock could be subject to wide fluctuations in response to many events or factors, including without limitation, the following:
- Quarterly variations in our operating results;
- Changes in financial estimates by securities analysts;
- Changes in market valuations or financial results of telecommunications-related companies;
- Announcements by us or our competitors of technology innovations, new products or of significant acquisitions, strategic partnerships or joint ventures;
- Any deviation from projected growth rates in revenues;
- Any loss by us of a major customer or a major customer order;
- Additions or departures of key management or engineering personnel;
- Any deviations in our net revenues or in losses from levels expected by securities analysts;
- Activities of short sellers and risk arbitrageurs;
- Future sales of our common stock; and
- Volume fluctuations, which are particularly common among highly volatile securities of telecommunications-related companies.
In addition, the stock market has experienced volatility that has particularly affected the market prices of equity securities of many high technology companies and that often has been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. As long as we continue to depend on a limited customer base, and particularly when a substantial majority of their purchases consist of a limited number of types of our products, there is substantial risk that our quarterly results will vary widely.
Furthermore, if our stockholders sell substantial amounts of our common stock, including shares issued upon exercise of outstanding options or warrants, in the public market during a short period of time, our stock price may decline significantly.
WE MAY IN THE FUTURE BE THE TARGET OF SECURITIES CLASS ACTION OR OTHER LITIGATION, WHICH COULD BE COSTLY AND TIME CONSUMING TO DEFEND.
In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may in the future be targeted for similar litigation. Our acquisition activity may involve us in disputes from time to time. Litigation that may arise from these disputes may lead to volatility in our stock price or may result in our being the target of securities class action litigation. Securities litigation may result in substantial costs and divert management's attention and resources, which may seriously harm our business, financial condition and results of operations.
In August 2001, two putative class action lawsuits were filed against us, certain officers and directors, and underwriters in our initial public offering. The lawsuits allege that the underwriters received excessive commissions and manipulated our stock price after the initial public offering. While we do believe we have meritorious defenses and will vigorously defend ourselves against these charges, an unfavorable result to this litigation could be costly to us.
IF WE ARE UNABLE TO PROTECT OUR PROPRIETARY TECHNOLOGY, THIS TECHNOLOGY COULD BE MISAPPROPRIATED, WHICH WOULD MAKE IT DIFFICULT TO COMPETE IN OUR INDUSTRY.
We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights.Although as of December 31, 2001, we had 39 U.S. patents issued or allowed and 3 foreign patents issued or allowed, we cannot assure you that the remaining 65 U.S. patent applications and 19 foreign patent applications that we have filed as of December 31, 2001 and have not been approved will be approved. In addition, we cannot assure you that any patents that have been issued or may issue will protect our intellectual property or that any patents issued will not be challenged by third parties. Much of our intellectual property has trade secrets implications, which requires much more monitoring and control mechanisms to protect. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology. Further, other parties may independently develop similar or competing technology or design around any patents that may be issued to us. We use various methods to attempt to protect our intellectual property rights. However, we cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property, particularly in foreign countries, such as China, where the laws may not protect our proprietary rights as fully as in the United States.
OUR PRODUCTS MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES, WHICH MAY RESULT IN LAWSUITS AND PROHIBIT US FROM SELLING OUR PRODUCTS.
We believe there is a risk that third parties have filed, or will file applications for, or have received or will receive, patents or obtain additional intellectual property rights relating to materials or processes that we use or propose to use. As a result, from time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to us. In addition, third parties may assert claims or initiate litigation against us or our manufacturers, suppliers or customers with respect to existing or future products, trademarks or other proprietary rights. Any claims against us or customers that we indemnify against intellectual property claims, with or without merit, may be time-consuming, result in costly litigation and diversion of technical and management personnel or require us to develop non-infringing technology. If a claim is successful, we may be required to obtain a license or royalty agreement under the intellectual property rights of those parties claiming the infringement. If we are unable to obtain the license, we may be unable to market our products. Limitations on our ability to market our products and delays and costs associated with monetary damages and redesigns in compliance with an adverse judgment or settlement could harm our business, financial condition and results of operations.
IF NECESSARY LICENSES OF THIRD-PARTY TECHNOLOGY BECOME UNAVAILABLE TO US OR BECOME VERY EXPENSIVE, WE MAY BECOME UNABLE TO DEVELOP NEW PRODUCTS AND PRODUCT ENHANCEMENTS, WHICH WOULD PREVENT US FROM OPERATING OUR CURRENT BUSINESS.
From time to time we may be required to license technology from third parties to develop new products or product enhancements. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. The inability to obtain any third-party license required to develop new products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, either of which could prevent us from operating our business.
We license technology from Fujitsu Limited that is critical to our PowerShaper product and other products that use their proprietary virtually imaged phased array technology. The license agreement is subject to termination upon the acquisition of more than a 50% interest in us by certain major communications system suppliers. Thus, if we are acquired by any of these specified companies, we will lose this license. The existence of this license termination provision may have an anti-takeover effect in that it would discourage those specified companies from acquiring us.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS, WHICH COULD DIVERT MANAGEMENT ATTENTION, CAUSE US TO INCUR SIGNIFICANT COSTS AND PREVENT US FROM SELLING OR USING THE CHALLENGED TECHNOLOGY.
In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. As a result of the proliferation of the Internet and other networking technologies, there has been, and we expect that there will continue to be, an increasing amount of this litigation in our industry. Many companies in the high-technology industry aggressively use their patent portfolios to bring infringement claims against their competitors. As a result, it is possible that we may be a party to litigation in the future to protect our intellectual property or as a result of an alleged infringement of others' intellectual property, or we may be subject to litigation to defend our intellectual property against infringement claims of others. These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:
- Stop selling, incorporating or using our products that use the challenged intellectual property;
- Obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, or at all; or
- Redesign the products that use the technology.
If we are forced to take any of these actions, our business may be seriously harmed. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed.
We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights in order to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could result in costly litigation and the diversion of our technical and management personnel.
IF WE ARE UNABLE TO RAISE ANY NEEDED ADDITIONAL CAPITAL, WE MAY NOT BE ABLE TO GROW OUR BUSINESS, WHICH COULD LOWER THE VALUE OF YOUR INVESTMENT.
We may need to raise additional funds, and additional financing may not be available on favorable terms, if at all. We may also require additional capital to acquire or invest in complementary businesses or products or obtain the right to use complementary technologies. The development and marketing of new products will require a significant commitment of resources. In addition, if the market for photonic processors continues to develop at a slower pace than we had anticipated or if we fail to establish significant market share and achieve a significantly increased level of revenue, we may continue to incur significant operating losses and utilize significant amounts of capital. If cash from available sources is insufficient, or if cash is used for acquisitions or other unanticipated uses, we may need to raise additional capital. We cannot be certain that additional debt or equity capital will be available to us at all, or that, if it is available, it will be on terms favorable to us. Any inability to raise additional capital when we require it would seriously harm our business. Any additional issuance of equity or equity-related securities will dilute our existing stockholders' percentage ownership in us. In addition, if our stockholders sell substantial amounts of our common stock, including shares issued upon exercise of outstanding options or warrants, in the public market during a short period of time, our stock price may decline significantly, which would make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate.
ACQUISITIONS AND INVESTMENTS MAY ADVERSELY AFFECT OUR BUSINESS.
We regularly review acquisition and investment prospects that would complement our existing product offerings, augment our market coverage, secure supplies of critical materials or enhance our technological capabilities. For example, in July 2000, we acquired substantially all of the assets and certain liabilities of Holographix Inc. and in November 2001, we acquired LambdaFlex, a developer of technologies for dynamic optical networks. Acquisitions or investments could result in a number of financial consequences, including without limitation:
- Potentially dilutive issuances of equity securities;
- Large one-time write-offs;
- Reduced cash balances and related interest income;
- Higher fixed expenses which require a higher level of revenues to maintain gross margins;
- The incurrence of debt and contingent liabilities; and
- Amortization expenses related to goodwill and other intangible assets.
Furthermore, acquisitions involve numerous operational risks, including without limitation:
- Difficulties in the integration of operations, personnel, technologies, products and the information systems of the acquired companies;
- Diversion of management's attention from other business concerns;
- Diversion of resources from our existing businesses, products or technologies;
- Risks of entering geographic and business markets in which we have no or limited prior experience; and
- Potential loss of key employees of acquired organizations.
CERTAIN PROVISIONS COULD DELAY OR PREVENT A CHANGE OF CONTROL OF US.
Certain provisions of our certificate of incorporation and bylaws and Delaware law may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions allow us to issue preferred stock with rights senior to those of our common stock and impose various procedural and other requirements that could make it more difficult for our stockholders to effect certain corporate actions.
In addition, our license agreement with Fujitsu Limited could discourage certain companies from making a bid to acquire us because it terminates if certain major communications systems suppliers acquire us.
INSIDERS HAVE SUBSTANTIAL CONTROL OVER AND COULD DELAY OR PREVENT A CHANGE IN OUR CORPORATE CONTROL, WHICH MAY NEGATIVELY AFFECT YOUR INVESTMENT.
As of December 31, 2001, our executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 20% of our outstanding common stock. These stockholders, if acting together, would be able to influence significantly all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We place our investments with high credit issuers in short-term and long-term securities with maturities ranging from overnight up to 24 months. The average maturity of the portfolio will not exceed 18 months. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. We have no investments denominated in foreign country currencies and therefore our investments are not subject to foreign exchange risk.
The following table summarizes the expected maturity, average interest rate and fair market value of the short-term and long-term securities held by the Company (in thousands).
As of December 31, 2001:
Total Fair
Years Ended December 31, Amortized Market
2002 2003 Cost Value
------------ ----------- --------- ---------
Held-to-maturity securities.. $ 96,771 $ 41,354 $ 138,125 $ 138,573
Average interest rate........ 3.8% 3.9%
As of June 30, 2001:
Total Fair
Years Ended June 30, Amortized Market
2002 2003 Cost Value
------------ ------------ ------------ ------------
Held-to-maturity securities.. $ 125,278 $ 16,462 $ 141,740 $ 142,144
Average interest rate........ 5.4% 5.3%
Exchange Rate Sensitivity
We operate primarily in the United States, and all sales to date have been made in U.S. dollars. Accordingly, there has not been any material exposure to foreign currency rate fluctuations.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
E-Tek Litigation
On December 7, 1999, before the effective date of our initial public offering, E-Tek Dynamics, Inc. (E-Tek), now a subsidiary of JDS Uniphase, filed a complaint with the Superior Court of California, County of Santa Clara. E-Tek initially named us and Ma Li, a third party individual not associated with Avanex Corporation, as defendants in the complaint. E-Tek has recently amended its complaint to add Edward Ning, an employee of Avanex, as an additional named defendant.
E-Tek's complaint alleges that we, through Ma Li and Edward Ning, have participated in illegal recruitment of E-Tek employees. Specifically and without limitation, E-Tek alleges that we worked through Edward Ning, who then worked through Ma Li, to recruit and hire E-Tek employees in violation of Ma Li's agreement with E-Tek. Ma Li has agreed to a permanent injunction, and E-Tek has subsequently dismissed its case against Ma Li. E-Tek seeks a permanent injunction, damages to be determined at trial, and costs and attorney's fees. We believe that this allegation is without merit and intend to vigorously defend against it. We believe that this complaint will not have a material effect on our business.
IPO Class Action Lawsuit
On August 6, 2001, a putative securities class action, captionedBeveridge v. Avanex Corporation et al., Civil Action No. 01-CV-7256, was filed against the Company, certain company officers and directors (the "individual defendants"), and four underwriters in the Company's initial public offering ("IPO"), in the United States District Court for the Southern District of New York. The complaint seeks unspecified damages on behalf of a purported class of purchasers of common stock between February 3, 2000 and December 6, 2000 (the "class period"). Several complaints substantially identical toBeveridge were later filed against the Company, the individual defendants, and several of the IPO underwriters in the Southern District of New. These cases have been consolidated under Civil Action No. 01-CV-6890.
These complaints generally allege that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities. The complaints bring claims for violation of several provisions of the federal securities laws against those underwriters, and also against Avanex Corp. and certain of its directors and officers. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 300 other companies. The lawsuit and all other "IPO allocation" securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. The Company believes that it has meritorious defenses to the claims against it and intends to defend itself vigorously.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Our Registration Statement on Form S-1 (File No. 333-92097) was declared effective on February 3, 2000 and we commenced our initial public offering ("IPO") on February 4, 2000. In the IPO, we sold an aggregate of 6,900,000 shares of common stock (including 900,000 shares sold in connection with the exercise of the underwriters' over-allotment option) at $36.00 per share. The sale of the shares of common stock generated aggregate gross proceeds of approximately $248.4 million for the Company. The aggregate net proceeds were approximately $228.2 million, after deducting underwriting discounts and commissions of approximately $17.4 million and directly paying expenses of the offering of approximately $2.8 million. Concurrently with the completion of this offering, we sold to Microsoft Corporation and MCI WorldCom Venture Fund, an affiliate of WorldCom, an aggregate of 769,230 shares of our common stock for $13.00 per share. The proceeds from the sales of these shares were approximately $10 million.
Of the net proceeds, as of December 31, 2001[Update], we have used approximately $26.5 million for general corporate purposes, including working capital and capital expenditures. Additionally, approximately $9.6 million of the proceeds were used to repay long-term debt and capital lease obligations.
In connection with our acquisition of LambdaFlex, we issued 2,750,318 shares of our common stock (the "Merger Shares") to the existing stockholders of LambdaFlex in exchange for all of the outstanding shares of capital stock of LambdaFlex. In addition, outstanding options to purchase LambdaFlex common stock were converted into options to purchase approximately 106,801 shares of our common stock. The Merger Shares were issued pursuant to Section 4(2) of the Securities Act of 1933, as amended, without general solicitation or advertising. Each purchaser was an accredited investor or a sophisticated investor with access to all relevant information necessary, and we used reasonable care to assure that the stockholders of LambdaFlex were not underwriters.
In the future, we expect to use the net proceeds from the sale of the common stock for general corporate purposes, including working capital and capital expenditures. The amounts actually expended for such purposes may vary significantly and will depend on a number of factors, including our future revenues and cash generated by operations and the other factors described under "Risk Factors". Accordingly, we retain broad discretion in the allocation of the net proceeds of the offering. A portion of the net proceeds may also be used to acquire or invest in complementary businesses, technologies or product offerings; however, there are no current material agreements or commitmentswith respect to any such activities.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the quarter ended December 31, 2001.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) List of Exhibits
None
(b) Reports on Form 8-K:
Report on Form 8-K as filed on October 23, 2001 reports the first quarter earnings press release for the quarter ended September 30, 2001 and reports the acquisition of LambdaFlex, a developer of technologies for dynamic optical network.
Report on Form 8-K as filed on January 24, 2002 reports the second quarter earnings press release for the quarter ended December 31, 2001.
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.
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| | Jessy Chao |
| | Chief Financial Officer
(Duly Authorized Officer and Principal Financial and Accounting Officer) |
Date: February 11, 2002
